Paulson’s remark came in response to Lewis’ request for a letter from Fed Chairman Ben Bernanke, acknowledging the government’s insistence that Bank of America acquire Merrill Lynch, despite the brokerage firm’s mounting mega-billion-dollar losses.

This one little phrase probably tells you everything you need to know about Henry Paulson, the man who put the “secret” in Secretary. And this one little phrase certainly tells you everything you need to know about the structure and actual objectives of the bailout campaigns Paulson orchestrated.

Specifically, the Paulson bailouts sought to divert hundreds of billions of taxpayer dollars toward Wall Street finance companies, and to do so as secretly as possible. In the name of “systemic risk,” the former Treasury Secretary dispensed hundreds of billions of dollars to the likes of AIG, Citigroup, and his former employer, Goldman Sachs, without ever seeking or receiving a single vote from an elected official. Thus, as it turns out, the only system genuinely at risk during Paulson’s tenure was the American system of honest and transparent financial markets.

The initial bailout facilities were created and implemented by Paulson and Bernanke, two unelected officials. And none of the initial bailout schemes ever faced scrutiny from elected officials, much less a formal vote. Even though some of the subsequent bailout programs, like the TARP, did face a vote in Congress, the Treasury Secretary continued to champion numerous ex-legislative activities, like the backdoor bailout of Goldman Sachs through the $170 billion bailout of AIG, and the shotgun takeover of Merrill Lynch by Bank of America.

According to the February 26th testimony of Bank of America CEO, Ken Lewis, before New York State Attorney General, Andrew Cuomo, Paulson strong-armed Lewis into completing the Merrill takeover, without disclosing to B of A shareholders that Merrill’s losses were much larger than publicly disclosed.

“Lewis testified that he asked Federal Reserve Chairman Ben S. Bernanke to ‘put something in writing’ regarding the US government’s plan to support pack of America’s acquisition in view of Merrill’s mounting losses,” Bloomberg news reported yesterday. “After Bernanke said he would consider the idea, Paulson called Lewis and said, according to Lewis, ‘First, it would be so watered down, it wouldn’t be as strong as what we were going to say to you verbally, and secondly, this would be a disclosable event and we do not want a disclosable event.”

Inconveniently, non-disclosable events are also illegal events. “Paulson kept the Securities and Exchange Commission, which is responsible for making sure companies disclose material information to their investors, in the dark, according to Cuomo,” Bloomberg news continued. “The allegations [by Cuomo] suggest Paulson and other policymakers may have resorted to breaking securities laws in order to protect a fragile financial system…”

Do the ends justify the means? Yes, if you’re a muckety-muck at Merrill Lynch or Goldman Sachs. No, if you’re anybody else. Paulson’s groundbreaking lawbreaking facilitated the survival of institutions that deserved death, in the process amassing trillions of dollars of fresh liabilities for American taxpayers who deserved to be left alone.

The adverse effects of these criminal acts extend far beyond annoying your California editor. For one thing, bailing out incompetent executives enables the incompetent executives to continue their incompetent behavior. For another thing, lavishing hundreds of billions of dollars upon ailing, functionally bankrupt companies, promotes a web of deception and illusion that impedes the healing process that would lead to a bona fide recovery.

If you hand $10 billion to any bankrupt company in America, that company will seem healthy for a while. The truth of the matter is that the Paulson bailouts, along with subsequent multi-trillion initiatives, have injected various finance companies with short-term stimulants that produce an image of health, while leaving the underlying disease untreated.

The resulting fraud is that diseased corporate entities appear to be recovering. They can pretend they are A-OK once again, while the top brass at these companies can pretend they no longer require government assistance – certainly not any of that dreaded TARP money that imposes limits on obscene executive compensation.

Eventually, as a result of all these falsehoods, investors begin to imagine that they actually see what the finance companies’ CEOs pretend to see. And before you know it, you’ve got a great big rally in bank stocks, fueled by nothing more than deception, hype and hope.

Is your California editor being too hard on the Wall Street boys and girls? He thinks not…and neither does his colleague at the Australia Daily Reckoning, Dan Denning:

“So the banks have returned to profitability have they? If that were true, bank balance sheets would also be recovering. But that’s not true.

“The big three banks reporting recently – Citibank, Goldman Sachs, and JP Morgan – all reported huge revenues from their trading desks. As we reported last week, Goldman’s $6.6 billion in trading revenues was not only 70% of total revenues, but it was also a ten billion dollar improvement on a $4 billion loss in the fourth quarter.

“JP Morgan reported nearly $5 billion in revenues from trading fixed-income securities. And Citigroup reported $4.69 billion in fixed-income trading. In fact, all of Citigroup’s other major operating segments reported declining revenues for the quarter. Its global credit card revenues fell by 10%. Consumer banking revenues were down 18%. And Citi’s Global Wealth Management revenues were down 20%.

“But something magical happened in the fixed-income trading group for Citi. If you dig into the quarterly report, you’ll learn that fixed-income trading revenues were boosted by a net $2.5 billion positive CVA on derivative positions, excluding monoclines, mainly due to the widening of Citi’s CDS spread.

“That takes some sorting out. A CVA is a ‘credit value adjustment.’ As you can learn here, it’s the credit risk premium of a derivative contract. Once you sort it out, you learn that Citi ‘made’ $2.5 billion on a derivatives position designed to profit when the companies own credit default swaps spreads widen.

“Or, in plain English, Citi profited because it made a bet that the cost of insuring itself against a default would go up. The credit default swap market is the place where you can bet on the credit worthiness of a firm, or, essentially, the chance that a firm might default on its bonds. Citi appears to have reported a $2.5 billion trading gain in the fourth quarter precisely because the market thought the company stood a good chance of failing (hence the widening CDS spread).

“As far as we can tell, if you use this kind of perverted logic, the closer Citi gets to bankruptcy, the more money it would ‘make’ on its derivatives. That shows you how bogus the quarterly number was. The company reported declining revenues in its core banking and lending activities. But thanks to fixed income and this handy $2.5 billion CVA, the company was able to report $1.5 billion in net income.

“Also, don’t forget that all of the banks benefitted from what financial sector analyst Meredith Whitney called back door financing.” Whitney described what amounts to Fed-sanctioned front-running of the fixed income market by the banks. The Fed publicly telegraphed its intention to buy $750 billion mortgage-backed securities from Fannie Mae and Freddie Mac and $300 billion in U.S. Treasury bonds. And that was AFTER it announced in late November of last year it would be wading in as a buyer for all agency bonds to support the U.S. mortgage market. In other words, the big banks were able to take positions in the exact securities that they knew the Fed would be buying. Huge profits were not guaranteed, just highly likely.

“Since the financial statements of the banks don’t break trading revenues out a line item basis, it’s hard to say how much money each bank may have made by frontrunning the Fed’s actions in the bond market.

“But from the looks of it, what we have here is a kind of back door subsidy to bank profitability provided by the Fed. First quarter earnings were strongly boosted by an increase in the valuations of mortgage-backed securities that went up with Fed buying. Before you get all excited about the recovery in financial stocks, you may want to keep that in mind.”

And let’s also bear in mind, dear investor, that the AIG bailout may have contributed mightily to Wall Street’s enormous trading profits in the first quarter. According to a widely circulated theory to which we alluded in the March 19, 2009 edition of the Rude Awakening, Paulson bailed out AIG so that AIG could bail out Goldman Sachs and other ailing Wall Street firms.

Whether directly or indirectly, intentionally or unintentionally, the federal government enabled the big Wall Street banks to produce billion-dollar profits in the first quarter. Certainly, the federal government will attempt to repeat the performance in the second quarter. But we suspect the jig is up. We suspect the trading profits of the first quarter were one-off events that will not become two-off events.

As a result, we suspect that finance company earnings will resume their downward trajectory throughout the rest of the year, as adverse real-world trends swamp government-subsidized trading profits.

The truth is that banking profitability is not actually recovering, and neither is the economy. And that means that every stock market rally rests on shaky ground. The nearby chart tells the tale…or at least most of the tale.

Foreclosures have become nearly as numerous as home sales. Unless and until the two lines on the chart above begin to diverge, rather than converge, a recovery in the finance sector will remain a deception, a recovery in the economy will remain a false hope and a recovery in the stock market will remain a dangerous illusion.

And one final thought: Would America be any worse off if Paulson had simply told the truth?

Source: The Recovery That Isn’t

To preview our conclusions: we’re betting on inflation.

So what is this thing called, “inflation?”

According to the 1962 edition of Webster’s New World Dictionary, inflation is “an increase in the amount of currency in circulation or a marked expansion of credit, resulting in a fall in the value of the currency and a sharp rise in prices.” That’s the classic definition

But for those of us who are not economists, theorists or ivory tower residents, inflation is simply the thing that turns a nickel Coke into a $2 Coke. And it is the thing that causes gold to rise from $32 an ounce to $1,000…on its way to a much higher number.

The classic definition of inflation – an increase in the supply of currency and/or credit – and the Main Street definition – rising prices – are different, but related. The first excess causes the second excess.

At this very moment, the supply of currency and credit is expanding at an alarming pace here in the U.S.A., and yet, the prices of goods and service are falling. So this curious condition has led many folks to speculate that deflationary forces will triumph over inflationary forces.

We are skeptical.

The U.S. Government has embarked on a massive monetary experiment – an experiment that is more sorcery than science. The Federal Reserve is in the process of conjuring up trillions of dollars from the cauldrons of the Treasury to help finance the government’s bailout campaigns.

No one knows, least of all Ben Bernanke or Timothy Geithner, if the Fed will conjure up one dollar too many. And no one knows if the Fed could ever coax its magical deflation-fighting dollars back into the cauldron, once their services were no longer needed.

At least, in theory, no one knows…

In reality, everyone knows: the excess dollars will never return to the cauldron. They will escape into the economy at large, where they will run rampant, and cause the price of eggs to increase to $10 a dozen…or $20…or maybe even $100.

The monetary sorcerers at the Fed – and at all the other central banks of the world – know everything about inciting inflation, but absolutely nothing about reigning it in. Furthermore, inflation is not exactly Public Enemy #1. Most of the world’s central banks are far more worried about deflation – so much so that they will openly admit to printing currency.

“Chancellor of the Exchequer Alistair Darling suggested the Bank of England could start printing money as soon as this week to help revive the economy,” Bloomberg News reports. “Bank of England policy makers sought permission from the Treasury to create money to buy securities…The bank should get authority to use as much as 200 billion pounds for purchases of government bonds and other assets…”

In times past, an announcement this brazen would have caused a panic selloff in the currency in question. But today, the announcement attracts scant attention. Think about it; the Bank of England declared to all the world that it would print $300 billion worth of currency, backed by nothing more than paper and ink, and that it would use this currency to buy government bonds. That’s shocking. And yet, no one seemed to care. The British pound barely moved in yesterday’s trading.

Deflation is the fear du jour. Not inflation.

The consensus prediction/expectation goes something like this: A powerful deflationary trend will overwhelm all inflationary impulses for a year or so. Then, a new inflationary trend will emerge, and it will likely develop into a 70s-style hyper-inflation. Inflation might become a problem in 2011 or 2012. But not now.

Therefore, says this anonymous consensus, the smart money should have nothing to do with inflation hedges like gold, commodities or TIPs. Instead, the smart money should be gobbling up DE-flation hedges like long-dated Treasury bonds.

This tidy consensus might be dead on the mark…or it might already be dead in the water.

For example, what if inflation arrives much sooner than expected? What if the widely anticipated deflation never materializes? The holders of long-dated Treasurys would fare very, very poorly. And the non-buyers of gold would be very chagrined, at best. So consider this two-part question:

1) Is the 2.89% yield of a 10-year Treasury so thoroughly compelling that it justifies risking an enormous capital loss, (if inflation appears sooner than expected)?

2) Are commodity plays at their current depressed quotes so thoroughly risky investors should continue to shun them, no matter the price?

Certainly, the reasoning behind the “theory of imminent deflation” relies upon the intuitive and unassailable logic that recessions tend to suppress demand and, therefore, prices. Furthermore, depressions tend to suppress demand and prices even more than recessions.

This logic enjoys some noteworthy historical precedents, like the Great Depression. And it is certainly true that slowing economic activity tends to suppress demand. But this argument ignores the supply side of the deflation equation – not just the supply of goods and services, but the supply of money as well.

Depressions do not merely suppress demand; they can also restrict supplies of essential commodities and goods. As the producers of these products struggle with access to credit and with falling prices for their goods, some producers reduce production or go out of business entirely – a factor that contributes to rising prices, all else being equal.

Furthermore, in some macroeconomic settings, the money supply can wield an even greater influence over price trends than the supply of goods and services. In some unfortunate corners of the globe, for example, where desperate governments have printed one too many pesos, bolivars, rupees, marks or rubles, the inflation rate has skyrocketed, even while inflation remains stable in other corners of the globe.

In Zimbabwe, the infamous issuer of the world’s first billion-dollar note, inflation has been raging for years. But prices have remained relatively stable in all the developing economies. More recently, while the entire Western World trembles about the onset of deflation, prices (in local currency terms) for basic staples are soaring in Russia, Mexico, Latvia, Poland, Iceland, Korea and many other places.

If falling demand, alone, caused deflation, why are so many dramatic inflationary episodes sprouting up around the globe?

These recent inflationary episodes in the developing world are sending an unmistakable signal to those of us in the developed world that the difference between inflation and deflation lives on a razor’s edge – or perhaps, on a printing press’ edge.

Let’s review:

1) Deflation seems like a legitimate threat at the moment.

2) So the Fed is fighting this threat with an unprecedented expansion of its balance sheet – i.e. money-printing campaign.

3) Money printing tends to cause the rise in goods and services that we ordinary folks call, “inflation.”

4) The timing and magnitude of a new inflationary trend is unknowable, even though it is extremely likely to occur.

5) Therefore, buy gold. Oops…we did not get to that part yet.

But we’re out of time to day. So check in tomorrow as we take a peek at a few specific inflation plays.

Source: Monetary Sorcery

This from Eric:

The flaming embers of inflation have already landed atop the thatched roof of American finance. And yet, investors can still buy inflation insurance on the cheap. In the next 1,373 words, we’ll examine a few of these “insurance policies”to assess their virtues and drawbacks.

Since a powerful new inflationary trend is very likely to occur, the prudent investor should probably take steps to guard against it. “But wait a second!” some readers be saying. “What if a powerful deflationary trend occurs first?”

Good question. It might. But we’d begin preparing for inflation anyway. Why not prepare for the near-certain arrival of inflation, rather than the uncertain timing of it.

If an infallible clairvoyant told you that your house would burn down in one of the next five years, would you say to yourself, “Gosh, maybe I should try to figure out which year it will be and not buy fire insurance during the other four years.”

You might actually guess correctly, in which case you would have saved yourself four years worth of insurance premiums. But you might guess incorrectly, in which case you would have lost your house.

Your call.

To this market observer, inflation seems like a near-certainty. Not an absolute certainty, mind, you, just a near-certainty, sometime within the next three years. So why not beat the rush to buy inflation insurance? Why not buy some now?

The nearby chart displays a sampling of inflation hedges, and how they performed during the last eight years of the infamous 1970s. Gold was clearly the standout winner. But we’d put an asterisk next to this result, due to a performance-enhancing assist from the U.S. government. During most of the preceding four decades, the US government had been artificially suppressing the gold price, while also forbidding private citizens from owning it. Therefore, once the government stopped its meddling, the gold price partied like a teenager whose parents had just left town.

Aside from gold, very few assets managed to keep pace with inflation, as measured by the Consumer Price Index (CPI). Hard assets like the CRB index of commodity prices and the Swiss franc did outpace the CPI, but stocks and bonds both lagged miserably.

Skipping ahead about 30 years, we can see that the modern versions of the 1970s inflation hedges have performed quite poorly during the last 14 months. Clearly, inflation is not a widespread concern. But that’s part of the reason it concerns us, and also part of the reason why we’d be inclined to take action now, while inflation hedges remain relatively cheap.

Our contrarian instincts lead us –rightly or wrongly – to distrust the consensus, especially when the consensus trusts in an idea as stupid as deflation…just kidding. We don’t think deflation is stupid, just unlikely. (More precisely, we suspect that deflationary indicia will be seasonal, like daffodils. For a while, they will seem to be everywhere. Then, just as suddenly, you won’t be able to find a single one).

So with that biased and unscientific preface, let’s sweep through a Reader’s Digest review of ETFs that might provide some kind of hedge against inflation:

1. Gold – The “Old Faithful” of hedges. It’s always worked before. Enough said. ETFs like the SPDR Gold Trust (GLD) provide easy access. With a $30 billion market capitalization, this is the “go-to”gold ETF. The next largest entrant is the iShares Comex Gold Trust (IAU) with a market cap of $2 billion. Both ETFs enable an investor to buy gold with a mouse-click. No muss. No fuss. But purists may wish to buy bullion coins like Krugerrands or Maple Leafs. As a gold investment, bullion coins have the advantage of being shiny, pretty and portable. But they have the disadvantage of costing 6% to 10% more than bullion itself, while also being so shiny and pretty that someone might want to steal them.
2. Gold Stocks – The bastard brood of gold and the stock market. As inflation hedges, gold stocks can be somewhat unpredictable and capricious. Over a multi-year span of time, they tend to reflect that gold side of their heredity. But during shorter time spans, gold stocks can behave much more like stocks than like gold…and that’s not always a good thing. That said, ETFs like the Market Vectors Gold Miners (GDX) provides a handy way to buy a basket of gold stocks.
3. Commodities –Like gold, a basket of commodities that includes crude oil, copper, wheat, gold etc. tends to provide a very reliable hedge against inflation. Unlike gold, a basket of commodities provides diversification across multiple assets and therefore, much lower volatility than gold. The largest commodity ETFs available are the PowerShares DB Commodity Index Tracking Fund (DBC) and the iShares S&P GSCI Commodity-Indexed Trust (GSG). DBC holds only six commodities: Crude oil, heating oil, aluminum, corn, wheat and gold. GSC holds a much broader collection of commodities.
4. Commodity-focused stocks. See comments on #2 above. The iShares S&P North American Natural Resources Sector Index Fund (IGE) provides broad exposure to commodity-focused stocks. Alternatively, the DWS Global Commodities Stock Fund (GCS) is a small closed-end fund that holds a similar portfolio. But GCS is selling 12% below its net asset value, which means that a buyer at the current quote controls one dollar worth of resource stocks for only 88 cents.
5. Non-Dollar Bonds – The Swiss Franc performed quite admirably during the last Great Inflation in the United States. But we are hesitant to bet on a repeat performance. Indeed we are hesitant to bet on ANY foreign currency as a way to hedge against US inflation. The Swiss economy, for example, no longer features a bunch of pocket-watch-toting gnomes guarding vaults full of gold bullion. Instead, the modern Swiss economy features pocket-watch-toting gnomes masquerading as hedge fund managers. The predictable result is that Switzerland’s two largest banks have amassed questionable derivatives exposures that exceed the GDP of the entire country. Many other bankers speaking many other languages have achieved equally enormous feats of stupidity. No one knows how these feats of stupidity will influence the values of their native currencies. Not knowing, therefore, we are disinclined to guess. But those readers who suspect that the dollar will be one of the first currencies to go down in flames, rather than one of the last, might be interested in the one of the many ETFs that hold foreign currencies. The CurrencyShares Swiss Franc Trust (FXF), for example, holds Swiss francs. Alternatively, the dollar-phobic investor could purchase the SPDR Barclays Capital International Treasury Bond ETF (BWX) that holds a basket of bonds issued by foreign governments. Its largest allocations include a 23% weighting in Japanese government bonds, 12% in Germany and 12% in Italy.
6. TIPS –No discussion of inflation hedges would be complete without mentioning TIPS, short for Treasury Inflation-Protected Securities. [To learn more about how they work, check out the November 26, 2008 edition of the Rude Awakening]. Investors may purchase a basket of TIPS by buying the iShares Barclays US Treasury Inflation Protected Securities Fund (TIP). In theory, TIPS provide a direct and reliable hedge against inflation. But like so many other seemingly brilliant ideas, TIPS work better in theory than in practice. The first risk is an overt one – deflation might persist for longer than expected (by us). In which case, the principal value of a TIP could decline below par. And even though the holder of the TIP would receive par at maturity, the interest payments that the holder would receive between now and maturity would decline in concert with the declining principal value. The second risk is a covert one: the federal government controls the calculation of the Consumer Price Index (CPI). Therefore, if the CPI, as currently constructed, were to get out of hand and produce very high inflation readings, the government’s bean counters would probably spring into action to create a “new and improved”CPI that would deliver much lower inflation readings. It has happened before.

Thus concludes our review of inflation hedges. We hope all readers will utilize the delightful deflationary interlude we are now enjoying to prepare for what may lie ahead. Hostile inflationary forces may be amassing their forces at the borders of our economy at this very moment. In short, we think it’s a good time to risk being paranoid about the threat of inflation.

Source: Inflation Gestation

But Eric says TIPs buyers must be cautious: a prolonged spell of deflation would be devastating to both prices and yields.

More from The Rude Awakening:

Everyone knows that a deflationary deep-freeze is paralyzing the global economy. Everyone also knows, therefore, that inflation is as good as dead. The sellers of stocks know it; the buyers of long-dated Treasury bonds know it; and the sellers of TIPs (Treasury Inflation-Protected bonds) know it better than anybody. When so many financial market participants are certain about anything, a forward-looking investor might want to challenge the thesis…and try to make a few bucks in the process.

The nearby chart shows quite clearly that prices of long-dated Treasury bonds (as represented by the iShares 20+ Treasury Bond ETF – NYSE:TLT) have been soaring, whiles the prices of TIPs (as represented by the iShares Treasury Inflation Protected ETF – NYSE:TIP) have been falling. Most long-dated TIPs have tumbled 15% in less than two months. Evidently, investors want nothing to do with inflation protection, but will stampede to obtain DE-flation protection.

But is deflation such an utter certainty that investors should be scooping up 10-year Treasury bonds that yield a near-record-low 3.11%?  To rephrase the question, is inflation such impossibility that investors should be unloading 10-year TIPs (Treasury Inflation Protected) that currently yield 2.40%, but could produce a vastly greater return if inflation heats up?

We ask these questions, not because we believe a deflationary episode is unlikely, but rather, because we do not believe that an inflationary episode is impossible. Investors in long-dated Treasury securities seem to have convinced themselves that inflation has been “deep-sixed,” not just for the next two or three years, but for the next 10 to 20 years as well.

The cost of taking the other side of that trade has never been cheaper. But TIP-buyers beware!…The other side of the trade is not without risks. A potent deflationary trend would depress the value of TIPs, both in absolute terms and relative to conventional Treasuries.  In such a circumstance, TIP prices could fall… a lot.  At maturity, of course, the TIP-buyer would receive at least “par” for his bonds.  But no investor wants to wait a decade or more to see the return of his capital.

[To better appreciate the virtues and vices of a TIP of security, consider the following brief primer: http://www.treasurydirect.gov/indiv/products/prod_tips_glance.htm]

As noted above, the conventional 10-year Treasury bond yields 3.11%, which is 71 basis points more than the 10-year TIP yield of 2.40%. The TIP-buyer accepts yield penalties like these in exchange for the comfort of inflation protection.

But comparing current yields is only one small part of the calculus that leads an investor to either buy or shun a TIP.  The most important aspect of the comparative analysis is the “implied breakeven inflation rate.”  In other words, what would the average inflation rate need to be during the life of a given TIP to make it a better buy than a conventional Treasury of the identical maturity?

During the last decade, the implied breakeven inflation rate for a 10-year TIP has fluctuated around 2% – meaning, if the inflation rate averaged less than 2% during the life of the TIP, a conventional 10-year Treasury bond would have been a better buy.  On the other hand, if the inflation rate averaged more than 2% during the life of the TIP, the TIP would have been the better buy.

Lately, a very strange thing has happened in the TIP market: breakeven inflation rates have collapsed to all-time lows. The 10-year TIP, for example, is pricing in a razor-thin inflation rate of just 0.3% per year during the next 10 years.  I.e, if the inflation rate averages more than 0.3% per year during the next 10 years, the buyer of a 10-year TIP at today’s prices would be better off than the buyer of a conventional 10-year Treasury bond.  The inverse would also be true.

Let the reader decide, therefore, whether the average U.S. inflation rate will exceed 0.3% per year during the next decade. But before deciding, let the reader also do enough homework about the quirky world of TIP securities to avoid making unintended errors.  One of the easiest – and costliest – errors a TIP-buyer could make would be to underestimate the capital-destroying potential of a severe deflation.  If the Consumer Price Index were to decline sharply for a sustained period of time, the price of a long-dated TIP would also decline sharply.  Furthermore, the current yield provided by the TIP would decline at the same time – a deflationary double-whammy.

Thus, the TIP buyer’s world is very simple: inflation = good; deflation = bad. But therein lies the appeal of these unique securities as well.  Inflation is rarely a good thing for the value of a financial asset, but it is a good thing for a TIP.

When the central banks of the world flood the global monetary system with titanic quantities of credit and currency, an inflationary uptick does not usually trail far behind.  And when the US Federal Reserve pours so many trillions of dollars into the US financial system that an $800 billion bailout seems like nothing at all, an inflationary uptick becomes increasingly likely.

TIPs are risky, but inflation is devastating.

Source: Beat the Rush; Sell Treasury Bonds Now

This from Rude Awakening:

History tells us that epic panics create epic buying opportunities. Inconveniently, history does not tell us in advance how long the panics will last or how low stock prices will ultimately fall. Great buying opportunities always present themselves in hindsight. In other words, to quote Henry Ford, “History is bunk.” Financial history, in particular, is bunk.

Therefore, knowing only that we do not know how low prices will fall, we must exercise a measure of caution and prudence. That said, a cheap stock is a cheap stock, even if it is destined to become cheaper. So let’s get a little crazy. Let’s imagine that we are prepared to risk some of our precious capital. Let’s imagine that we are prepared to stare financial peril straight in the face until it buckles under the strain and runs away whimpering. Let’s imagine that we are courageous enough to buy a stock…What stock would we buy?

In the midst of one of the many recent multi-hundred-point selloffs, your editor dialed up an expert on Canadian investment trusts.  “Hey Danny, how’re you holding up?” Your editor started off.

“I’m still answering my phone,” came the reply. “But I can’t say that I’m enjoying myself.”

“Well, you’ve got plenty of company,” your editor empathized. “This is brutal. So what’s the smart money doing?”

“No idea,” Danny joked. “I haven’t seen any smart money around here for several weeks.”

“Okay, so what are YOU doing?” your editor persisted.

“Well, all of my clients are selling, so I’m thinking that I should probably be buying.”

“Are you?”

“A little,” Danny said, “but the problem is that the stocks I follow looked dirt cheap two weeks ago. And now they’re down another 30% or so. It’s unbelievable.”

“What’s causing this carnage?”

“Panic…Pure panic.”

“Understood,” your editor empathized, “but if you were making your first buys today, what would you buy? In other words, if an alien, loaded down with cash, stepped out of his spacecraft and strolled into your office, what would you tell him to buy?”

“Almost anything,” came the reply. “I’d start with Penn West (NYSE: PWE). That’s a blue chip investment trust that’s down 50% from its mid-summer high. And now it’s yielding more than 20%.” [Editor's Note: Your editor does not own Canadian investment trusts, but at least one member of his extended family owns PWE and ERF.]

“Amazing!” your editor replied. “Is this company susceptible to any credit problems?”

“Not that I know of,” Danny said. “It carries very little leverage. But look, with the benefit of hindsight, you can see how we got here. Oil is collapsing, the Canadian dollar is collapsing and to top it all off, investors are freaking out. You add it all up and you get Canadian investment trusts that yield 25%!…I mean this Canadian dollar is just hard to believe. It is down 4% just TODAY! So that brings its loss against the US dollar to more than 15% since mid-Summer. I think you could easily argue that Canada’s finances are in MUCH better shape than the U.S.’s. But the markets see it differently.”

“Yeah, these are incredible times. What else do you like?”

“I’ll give you a short list,” said Danny. “I like Baytex Energy Trust (NYSE: BTE), Provident Energy Trust (NYSE: PVX) and Enerplus Resources Fund (NYSE: ERF). All three stocks yield about 20%, which seems totally crazy. Even if you believe energy prices are going to remain depressed, these stocks are too cheap.”

“Thanks Danny. Hang in there!”

To be clear, dear investor, Danny’s “short list” of distressed investment trusts are not automatically a buy because they yield more than 20%. But as we never tire of observing here at the Rude Awakening, they are probably less of a sell. (Please remember, that oil and gas investment trusts like Penn West derive their incomes from oil and gas production. So when energy prices are tumbling, as they are currently, these trusts earn less income, which means that their dividend payouts could fall sharply).

A few days after speaking with Danny, your editor checked in with Chris Mayer, editor of Capital & Crisis. [By the way, if you missed the October 14 edition of the Rude Awakening, you almost missed Chris' examination of Atlas Pipeline Partners (NYSE: APL), a deeply depressed stock that pays a very high dividend. Click here to read the story].

Chris is nervous, but excited. “I never expected to see stocks as cheap as they are today,” he said. “I had always assumed that deep value stocks became extinct sometime in the 1940s and that I would never see them during my career. But I was wrong. Deep value stocks are reappearing in parts of the stock market. The ENTIRE stock market is not cheap, of course. But many individual stocks are.”

Chris expanded upon this observation in a recent email alert to his subscribers:

“Recently, The Wall Street Journal reported a fact that shows just how extreme some valuations have become out there. According to the WSJ, nearly one out of every 10 stocks trades below the value of its per share cash holdings, “an even greater proportion than [Benjamin] Graham found in 1932.” [Graham, author of "The Intelligent Investor," is legendary among us value investors as the "Father of Value Investing."]

The year 1932 was horrific for stocks. By July 9 of that year the Dow Jones Industrial Average had collapsed 91% from its 1929 peak. So it’s hard to believe that there are more stocks trading below their cash balances now than in 1932. Amazing!

Or to put it more specifically, of the 9,194 stocks Standard & Poor’s tracks, about 876 trade below their per share cash holdings. In theory, you could drain the cash in these companies’ treasuries to buy the whole company and get everything else for free.

Loews Corp. (NYSE: L) isn’t quite that cheap, but it is VERY cheap. For starters, the stock is 40% cheaper than when I first recommended it to my subscribers. But that’s not all. At the current quote of $26 per share, Loews trades for just under 6 times earnings and has $3.5 billion of net cash — or about 30% of its market cap. If you net out that cash, Loews’ price-to-earnings ratio slips to well under 5. That’s incredibly cheap for such a well-financed company.

Even better, the company’s net asset value comes in around $40 per share. Much of that NAV is in publicly traded companies. So it’s easy to figure the values. And they are good investments on a stand-alone basis. Loews owns stakes in Boardwalk Pipelines and Diamond Offshore, both of which look like bargains. If these shares rise in value, as I expect they will, Loews’ NAV will also rise. In other words, Loews is cheap on its own merits as is, and you get its cheap portfolio, too. Loews is also a buy.

There are a lot of these kinds of opportunities out there now. At least in pockets, we have the kind of true Depression-era valuations that Ben Graham would have recognized. Old Ben Graham is more relevant now than ever because the market we are in increasingly resembles the ugliness of 1930s, when Graham plied his trade. Graham wrote in 1932, and I think it will prove true today: “In all probability, [the stock market] is wrong, as it always has been wrong in its major judgments of the future.”

Source: Soldiers of Fortune

There are “fears that the package may cost too much, drive up inflation, swell the already bloated U.S. deficit and hurt the ailing economy,” reports AP.

Eric Fry says his investment strategy is based on a simple formula: “Sell the dollar, sell the dollar and sell the dollar.” And as the buck gets whacked, so will American stocks and bonds. On the other hand, foreign assets and commodities should soar…

This from The Rude Awakening:

During the last couple of years, I have been very afraid of the stock market, and in particular I have been afraid of the financial sector. So in many, many editions of the Rude Awakening, we’ve been telling our readers just to hide as well as they can.  Mostly we have been telling them to hide out in commodities like gold and oil, and also to hide out in investments that are denominated in any currency other than the US dollar.  For the most part, these have been very good hiding places. But lately, these hiding places are starting to feel a bit like tombs. The commodity markets have been horrible.

Stocks and commodities usually move in opposite directions. But during the recent stock market selloff of late August and early September, commodities provided almost no protection whatsoever. In fact, they performed even worse than stocks.

Therefore, many of us resource investors are feeling more chagrin than satisfaction. We sidestepped the financial sector 18-wheeler, only to step in front of the commodity sector bus. But at least we’re still flinching on the pavement…unlike our bank-stock-investing counterparts. We should remember that Merrill Lynch (NYSE:MER) stock has delivered a total return of MINUS 45% during the last 10 years! Commodity prices have nearly doubled over the same timeframe. So all of us commodity investor who gravitate toward self-flagellation might want swing the whip a little more gently. These are very unusual times in the financial markets.

Even though commodity prices have retreated substantially from their all-time highs, they will rebound eventually…and then continue on to new all-time highs. (Perhaps the big bounce in gold and oil during the last couple of trading sessions is the start of something bigger). So at the risk of repeating myself, I will repeat myself anyway: I like commodities, at least for the long haul, if not also for the short haul. I like commodities because supplies are limited and demand is not. I also like commodities because they lack CEOs and executive management teams. I like commodities because greed and stupidity cannot destroy their value.

Please understand that my opinions are just that, mere opinions.  I’m not issuing any prophecies here, just a couple of guesses. And even my guesses aren’t really guesses at all; they are reactions to fear.  I am afraid that the US Federal Reserve and the U.S. Treasury have overextended themselves.  They have committed hundreds of billions of dollars to rescuing Bear Stearns, Fannie Mae (NYSE:FNM), Freddie Mac (NYSE:FRE) and AIG etc.  That’s bad enough.

What’s worse is that these governmental agencies have exposed themselves to more than $1 trillion of potential liabilities.  No one knows how large the ultimate invoice will be to clean up the American financial system.  But we investors can assume that much of the money to satisfy that invoice will roll off of printing presses.  We can assume, in other words, that the Treasury will greatly inflate the money supply in order to prevent an even more extreme credit crisis.  This process will almost certainly erode the dollar’s value.

And so we ask ourselves, “What wins when the dollar loses?” Gold, the currency of the ages, comes to mind immediately.  But we would also expect most other commodities to perform extremely well in a weak-dollar environment.  And obviously, investments that are denominated in a foreign currency should perform relatively well when the dollar weakens, at least from the perspective of an American investor.

Also, we should expect the Treasury’s multi-billion-dollar bailout packages to increase the supply of Treasury bonds. I’m not so sure these bonds will meet with eager investment demand. For one thing, whenever supply swamps demand, prices fall.  That’s economics 101.  For another thing, the traditional buyers of Treasury bonds might become much less eager to loan money to a government that is buried under a massive mound of unknown and growing liabilities. So I’m afraid the road in front of us will be very difficult for investors in American stocks and bonds.

Investors who wish to bet on falling Treasury bond prices could buy an ETF like the UltraShort Lehman 20+ Year Treasury ProShares. (AMEX: TBT; Price $68.37) This unique ETF wins when Treasury bond prices fall. Specifically, this ETF produces an investment result that corresponds to 200% of the inverse of the daily performance of the Lehman Brothers 20+ Year Treasury Index.

I think we’ve reached an important inflexion point in the American financial markets. The extinction of Bear Stearns, Lehman Bros., Fannie Mae and Freddie Mac – along with the near-death experiences of AIG, Merrill Lynch, Morgan Stanley (NYSE:MS) and Goldman Sachs (NYSE:GS) – tell us that a very important change has occurred in the financial markets. The extreme greed and institutionalized speculation that has nourished the Wall Street brokerage firms for so many years has finally been exposed as the fraud it has always been.

American-style investment banking is not a “business model,” it is a Ponzi scheme – a fraud – in which all the money flows to the people at the top, while everyone else who plays the game absorbs the losses. This massive institutionalized fraud is now over.

But investors must understand that this fraud created enormous leverage in the financial system.  And this enormous leverage created enormous liquidity which caused stock prices all around the world to soar… and therefore, caused lots of investors to feel rich and happy.  But now that all of this leverage is collapsing, the liquidity it created is draining from the financial system and causing share prices to fall sharply.  The U.S. Treasury and the Federal Reserve are trying very hard to counteract these trends by absorbing hundreds of billions of dollars worth of bad mortgages, and also pumping fresh credit into the banking system.

The Treasury and the Federal hope that these actions will restore buoyancy to the potential markets.  But we doubt it.  Instead, we suspect that these actions will only add buoyancy to the US inflation rate and, therefore, to commodity prices.

Most of the bad guys who created this mess are gone…although not yet in prison where they belong. And most of the American regulatory agencies are eager to change the rules of the game. These two developments are very helpful. But the process of repairing and reforming the American financial system could be painful. The U.S. Treasury will absolutely, positively increase the money supply to rescue the financial system…Which means investors must try to protect themselves against an almost certain inflation.

So what’s an investor to do?

Sell American stocks, bonds and currencies; buy foreign stocks, bonds and currencies. And, of course, buy commodities.

Source: To France with Love

This from Rude Awakening:

I just loaned $283 to AIG…I and every other American. The funny thing is no one asked our permission. The Federal Reserve simply took our money and handed it to a group of individuals who have demonstrated the ability to lose billions of dollars faster than almost anyone on the planet.

I would rather have tossed the money in a wishing well… not only for the wishes, but also because the wishing well will repay the loan sooner. The Fed’s $85 billion ‘investment’ in AIG is just the latest chapter of the American financial tragedy – a sordid tale that begins with the extreme greed of a few and ends with the widespread suffering of the many.

The Fed did what it had to do. It protected the millions of individuals and institutions who relied on the insurance policies of one of the world’s largest insurance companies. But let’s hope the tragedy does not end with an $85 billion bailout. Let’s hope our sordid story contains a few more tragic chapters, like ones that feature tales of AIG’s executive officers shedding tears of remorse on their prison dungarees.

Retribution cannot return the billions of dollars that innocent individuals have lost, but it can compensate somewhat for all of our $283 loans. To quote John Lennon, “You may say I’m a dreamer, but I’m not the only one.”

Source: Did You Notice…? AIG-Whiz!

“The Rude Awakening’s editorial director Eric Fry thinks Hank was way off the mark. Eric says financial stocks will by a buy one day, but he doesn’t believe we are looking at a bottom now.

In the second part of The End of Peak Greed, Eric says investors are better off putting their money into companies that are making the world go around than betting on financials, which are sending it not a tailspin.

But recent dismal results from the financial sector show us still that the bottom may not be in. Almost no one can buy a house these days. But almost everyone is eager to buy the shares of the companies that can’t sell the houses that nobody can buy. And I think that’s about all you need to know about the financial sector and the housing sector to know that we’re probably not at the bottom yet.

These financial stocks will be a buy one day, there’s no question about it. And maybe they are right now. I am not arrogant enough to say that I know. I mean, maybe this is the greatest buying opportunity of all time in the finance sector. It could be. And I mean that genuinely. But I don’t believe it is.

Any investor who is tempted to bottom-fish in the financial sector, should take a look at this chart:

It compares the Nikkei Index to the Topix Japanese Banking Index. You can see that the Topix Banking Index is down 80% from its high in 1989. That’s a very, very long time. Not only that, the index rallied around 40% to 60% seven times during that period. Seven different times investors believed that this index was recovering. And seven times, it did not.

One of the reasons is that during a period of de-leveraging, such as Japan suffered, equity disappears. Equity struggles. A lot of good things can happen to businesses; a lot of good things can happen to individuals; credit can flow again. It doesn’t mean equity is going to recover. Equity suffers. It goes away.

These things will be a buy someday. It’s just that I prefer to miss the first 20% of the upside. And I’d rather buy into something where I can see at least a sign of a rebound. So why not invest in the companies that are making the world go around, and are performing well, instead of the companies that are making the world go into a tailspin?t

Addison Wiggan and Ian Mathias in Agora’s 5 Min. Forecast are equally skeptical about U.S. banks’ financial health. This from yesterday’s edition:

Here’s another worrisome new trend in the financial sector: Two sovereign wealth funds just took a pass at purchasing a gigantic stake in Lehman Brothers. Rumors abound this morning that Lehman has been offering to sell 50% of itself to state-owned banks in China and South Korea. Both foreign investors balked at the last minute.

P.S. Read on here for the first part of Eric’s post on the U.S. financial sector: Avoid Bottom Fishing for Financials: It’s Way Too Risky

Source: The End of Peak Greed, Part II