(Refiles to fix typo in headline)

* U.S. stocks slump as fear of more bank failures grows

* Dollar rises versus yen after strong U.S. factory data

* Oil slips below $69 a barrel on equities, strong dollar

U.S. stocks fell sharply on Tuesday as growing concerns about the U.S. banking system and over whether a recent rally in equity markets is warranted drove investors to the relative safety of bonds and the dollar.

Oil prices fell as the economic concerns outweighed surprisingly bullish U.S. data: the manufacturing sector grew in August for the first time in 19 months, while pending home sales hits a two-year high in July.

Government bond prices on both sides of the Atlantic rose as falling stocks enhanced the allure of lower-risk safe-haven debt despite the fresh evidence supporting the view of a global economic recovery.

There are “new concerns about the health of the banking system, the number of bank failures that continues to grow by the day,” said Peter Kenny, managing director at Knight Equity Markets in Jersey City, New Jersey.

A sharp drop in bank stocks in late morning trading pulled the Dow industrials <.DJI> and the broad Standard & Poor’s 500 Index <.SPX> down 2 percent on fears of balance-sheet trouble in the U.S. financial sector.

The KBW bank index <.BKX> slipped 4.6 percent, with shares of Citigroup off 7.2 percent at $4.64 among top drags.

Three more U.S. banks failed last Friday, bringing the total to 84 so far this year, as the banking industry grapples with deteriorating loans on their books. Only 25 U.S. banks failed last year, while three failed in all of 2007.

The Federal Deposit Insurance Corp reported last week that its deposit insurance fund fell 20 percent to $10.4 billion at the end of the second quarter. Worries about the FDIC’s access to capital was also weighing on the market, Kenny said.

At 1:20 p.m. (1720 GMT), the Dow Jones industrial average <.DJI> was down 185.91 points, or 1.96 percent, at 9,310.37. The Standard & Poor’s 500 Index <.SPX> was down 21.34 points, or 2.09 percent, at 999.28. The Nasdaq Composite Index <.IXIC> was down 41.11 points, or 2.05 percent, at 1,967.95.

European equities closed sharply lower after mixed economic data, led lower by banks and commodity stocks. [ID:nL1126558]

The FTSEurofirst 300 <.FTEU3> index of top European shares ended down 1.8 percent at 954.15.

Net lending to Britons in July fell at its sharpest pace since records began in 1993, even as the number of mortgages approved rose to its highest since April 2008, Bank of England figures showed.

“The market is still overall concerned about the sustainability of the recovery,” said Orlando Green, interest rate strategist at Calyon, adding that government measures such as the cash for clunkers may have boosted the result.

“There are still doubts whether the economy can stand up by itself away from these government initiatives.”

U.S. crude oil for October delivery fell $1.21 to $68.75 per barrel, while London Brent crude dropped $1.13 to $68.52.

The dollar extended gains versus the euro to hit session highs on Tuesday as sharp losses in the U.S. stock market boosted the greenback’s safe-haven appeal.

The euro fell as low as $1.4221, and was last down 0.7 percent $1.4235 .

Copper prices slipped as investors worried about the pace of economic recovery in China, but they trimmed losses after the release of bullish U.S. manufacturing data.

The benchmark 10-year U.S. Treasury note was up 12/32 in price to yield 3.36 percent.

September Bund futures settled at 122.61, down 2 ticks from Monday, but it later traded up 23 ticks at 122.84.

A rebound in Chinese stocks <.SSEC> after Monday’s sell-off helped lift Asian shares. The MSCI index of Asia Pacific stocks traded outside Japan <.MIAPJ0000PUS> rose nearly 1 percent, while Japan’s Nikkei <.N225> closed up 0.4 percent.

Sept 1 (Reuters)

On one side is U.S. President Barack Obama and his plan to expand the authority of the Federal Reserve. In addition to its current powers, Obama plans to give the Fed regulatory authority over large financial institutions that are considered “too big to fail.”

On the other side is U.S. Rep. Ron Paul, R-TX, who has gathered 250 signatures for a proposal to audit the Federal Reserve. This audit, by Paul’s own admission is only a down payment towards his overriding goal of abolishing the central bank.

So who’s right? Should the Federal Reserve have more authority or less? And what will the outcome mean for investors?

The call for greater Fed power comes, as might be expected, from those who think the Fed has done a good job managing the financial crisis. Their view is that the Fed – by swelling its balance sheet by about $1.4 trillion and more than doubling the monetary base in less than a year – prevented deflation from taking hold in the economy and saved the banking system, which was in dire danger of collapse.

To those with this mindset, it makes sense for the Fed to act as the primary regulator of banks and investment banks that pose a systemic risk to the U.S. financial sector.

But the problem with this plan is that any potential rescues would not be carried out on the Fed’s dime, but on that of the Federal Deposit Insurance Corporation (FDIC). That means a collapse in the banking system would actually benefit the Fed by allowing the central bank toramp up its balance sheet to replace all of the banks’ losses and ensure that its chairman makes the nightly news every evening.

Even for those who are not staunch believers in Nobel Prize-winner James Buchanan’s public choice theory, the incentives seem to be wrong. It would make more sense to put banking system regulation firmly under the FDIC, which is responsible for paying up if anything goes wrong.

It’s not likely that an empowered Fed would impose tight restrictions on the big banks. Instead, the central bank’s governance would probably become a prime example of “regulatory capture,” by which spineless regulators exist mainly to do the bidding of the very institutions they’re supposed to be regulating.

Since the rest of us are dependent on the Fed’s monetary policy to survive economically, and need bank regulation that will keep the biggest banks from picking our pockets every few years, we don’t want the Fed to become a subsidiary of Goldman Sachs Group Inc. (NYSE:GS) – something that seems likely under the Obama proposal.

On the other hand, Paul’s bill appeals to those like myself, who believe the Fed has consistently run an over-expansionary monetary policy since the mid-1990s.

The credibility of this theory has been undermined by the fact that inflation has been kept under wraps, but this month’s consumer price index (CPI) and producer price index (PPI) figures – up 0.7% and 0.5% respectively – suggest that another surge in prices may not be far off.

As we go through the fall, the months of price declines in late 2008 that were caused by the collapse of energy and commodity prices will cause year-over-year inflation to trend higher. That, in turn, is likely to raise gold prices and Treasury interest rates, causing bond market panic and inevitably changing the public perception of the Fed’s performance.

So if the Obama administration wants to give the Fed new powers and extend Chairman Ben Bernanke’s term in office (which ends in January 2010) they had better do so quickly.

In any case, Paul’s proposal to audit the Fed would bring central bank operations more under the control of politicians, who supposedly would be able to expose unpopular goings-on and unexpected losses in the Fed’s operations. That’s why it has attracted bipartisan support.

But rather than simply auditing the Fed or abolishing it, as Paul proposes, there is a much better case for giving the central bank a new mandate, whereby its obligation to maintain monetary stability is given precedence over all other obligations.

Under the Full Employment Act of 1978, it has a dual obligation to maintain employment and monetary stability. A new mandate that prioritized monetary stability would force the Fed to follow the policies of former Federal Reserve Chairman Paul Volcker. That would mean keeping interest rates well above the rate of inflation, thereby favoring savers over borrowers.

As investors, we should thus oppose the Obama administration’s plans for the Fed, which seem likely to perpetuate the rent-seeking of Wall Street’s biggest banks. We should also be suspicious of Paul’s bill to audit the Fed, since that would bring it more closely under the control of elected politicians. History has shown that politicians cannot be trusted with the ability to create money out of thin air.

Instead, we should back plans to pass legislation that “Volckerizes” the Fed on a permanent basis, making monetary policy sound, eliminating the risk of inflation, and raising the rates we earn on all of our savings to a level that pays us adequately for providing banks and other borrowers with our money.

In the end, the ability to earn decent returns on savings and keep the result is the most important capitalist freedom of them all.

Source: Choosing Sides in the Fight for the Federal Reserve: Whom Should Wise Investors Align With?

Yesterday, the Dow lost another 131 points. Another big day down and it will be in the
7,000-range. Oil sank too – down to $62. The dollar, bonds, and gold stayed about where
they were.

Economists are still talking about an “exit strategy.” But in view of what is actually going
on in the economy, they’ll probably want to stay on this highway a lot longer. This is the
long road to ruin, of course. It may be fatal, but it is not – yet – unpopular.
Broadly, what is happening is exactly what should be happening.

The stock market rally is getting old…and may have already peaked out. The consumer is
running out of time, money and credit. He has no choice but to cut back. Savings rates are
rising fast – from zero to about 5% of disposable income.

Naturally, businesses are finding it hard to make sales. Earnings are collapsing…stock
dividends are down sharply…

…and of course, businesses try to cut expenses by lightening up on their payroll.
When the correction began, it was led by losses in the financial sector. Those losses led to
cutbacks throughout the economy. Now, it’s the cutbacks that are leading to financial
losses. The economy followed the markets; now the markets follow the economy.
Investors are realizing that their favorite companies will find it hard to prosper in this
new economic environment.

“US consumers fall behind on loans at record pace,” says a Reuters headline.
Delinquencies are going up on a wide range of household debt. Debtors have never had
such a hard time keeping up with payments. Credit card delinquencies, for example, are
running at 6.6%.

Well…duh.

And no wonder “banks get stingy on credit,” as reported in the USA Today. “Despite
massive government efforts to bolster the credit market, banks are pulling back severely
on card lending,” begins the front-page article.

Once again, we see the feds’ plans failing. They give trillions to the bankers; the
bankers cut back on consumer credit. And why shouldn’t they? They can see what the
rest of us see – the consumer can’t keep up with the debt he’s got already.

“Consumers aren’t going to be able to save the U.S. economy this time,” The
Richebacher Letter’s Rob Parenteau reminds us.

“Total U.S. retail sales have rolled back to levels we haven’t seen since 2005. Imagine if
every single retail shop opened in the last three years shut down overnight. It’s already
that bad.

“A lot of people, from Wall Street to Washington, have a great deal invested in you
believing we can reverse that trend. But, in actuality, the freeze in consumer spending
and the consumer economy could actually take many more years to thaw.”

At least, the consumer has wised up. He’s sick of debt. He’s seen where that road leads.
What he wants is to get out of debt…to be free…to be safe.

It’s the government that remains stuck in deep illusion… The feds know that it was too
much credit that got consumers into trouble. Their solution? Give them more credit!
The banks are issuing fewer credit cards than they did last year – 38% fewer. They’re
pushing credit limits down too – the average limit on a new card is down 3% so far this
year.

Instead of passing money on to customers, the banks are using the feds’ free cash to build
up their own reserves…raise their salaries…and pass out bonuses. Makes sense. What else
could they do with it?

“Uighurs are beasts” shout crowds of Han Chinese in the remote northwest of the
country. Uighurs are the Moslem minority. Han Chinese are the majority. And, judging
from the photos, the Han want to kill the Uighurs.

One thing smart people always do is to underestimate the power of foolishness. It is
wild and reckless to stir up a race war. But that doesn’t stop people from doing it. Any
kind of war is a blow to reason and civilization. But that hasn’t made war unpopular,
even among the most reasonable and civilized people on the planet.

It was within the lifetimes of many people reading this Daily Reckoning that the most
advanced countries on earth began a war of annihilation. At the beginning of the 20th
century, high culture and science were dominated by Germans. German musicians and
composers…German poets and writers…German mathematicians, physicists, painters,
philosophers – even the German economy was a world leader, second in output only to
the United States of America.

Then, the Germans went off their heads – along with the Italians, the Russians, the
Japanese…and many others.

But the Han have it right. The Uighurs are beasts from time to time. So are the Han…the
Teutons…the Anglo-Saxons…and all the tribes on earth. Occasionally, for no apparent
reason, the masks and restraints of civilization give way to mobs…and the old beast starts
howling at the moon.

It happens in markets too. What is a bubble, if not a wild and reckless thing? A kind
of madness? A mass illusion…a foolishness, in which people leave reason and civilization
behind?

What if the United States had to pay its debt in gold?

In the old days, before the monetary reforms of the 20th century…notably, Richard
Nixon’s unilateral decision to renege on America’s promise to pay its bills in
gold…countries had to settle up with each other in the yellow metal. The system worked
well; it was reliable; it prevented bubbles. Edward Chancellor explains:

“A country had to pay for its imports or foreign investments with money gained from a
surplus on trade. If more money was sent abroad than had been earned through exports,
then gold would be packed onto ships to discharge foreign creditors. A declining stock of
bullion would induce the central bank to raise interest rates in order to attract gold from
abroad. Rising rates would produce a credit contraction, unemployment and general
economic misery. The typical nineteenth century was severe, but short-lived.”

Then came the improvements. And the Great Depression. And now we are faced with
another one.

Governments are fighting this one…just as they did the last one…but with much more
money. The cost is in the trillions – most of it in the form of public debt. How will
these debts be paid? We all expect that they will ultimately be eased by inflation – in
full or in part. But suppose the feds had to pay up in real money?

Colleague Simone Wapler compared government debt to government gold. The United
States has gold worth about $241 billion, she reports. Its official national debt is $11.5
trillion. That gives it a debt/gold ratio of 48 – meaning; the feds have 48 times as much
debt as gold.

Britain is even worse. Prime Minister, then Chancellor, Gordon Brown sold much of
England’s gold at the worse possible moment – about 10 years ago. This leaves the island
with only $9 billion worth of gold compared to $1,274 billion of government debt – a
ratio of 1 to 139. But Japan is the worst of all. It has $23 billion worth of gold and $7.3
trillion of government debt, for a ratio of 1 to 323. (Of course, Japan has vast holdings of
dollars too!)

What nation has the best gold/debt ratio? Switzerland. It has only twice as much in
government debt as it has in gold.

Source:The Long Road to Ruin

Buiter warns that the “the next big crisis … will be a crisis of state ‘overreach’ and of government failure” and that “stultifying state capitalism, initiative-numbing over-regulation and overambitious social engineering may well be the defining features of the next socio-economic system to fail.” We’ll drink to that.

What follows is the conclusion of the Den Uyl lecture Buiter gave in Amsterdam on 15 December 2008 (emphasis added). Print it out and stick it to the door of your fridge. It’s one of the best accounts we’ve read of the brave new world will be ushered in by the recent financial collapse.

Reaction follows action in politics as in physics. The inevitable result of the financial collapse and deep contraction we are going through now will be at least a decade of over-regulation in the financial sector. Popular outrage at the excesses that were permitted to range unchecked during the era of self-regulation and light-touch regulation will have to be assuaged. The ‘pound of flesh’ demanded by the body politic is likely to involve a fair amount of ‘if it moves, stop it’ type regulation. That is regrettable but politically unavoidable.

The public no longer trusts the captains of finance and the politicians and appointed officials who either actively contributed to the excesses (like Larry Summers and Timothy Geithner during the Clinton administration or Gordon Brown in the UK) or failed to warn or protest sufficiently vigorously when these excesses begin to materialise on their watch (Ben Bernanke (in public service since September 2002), Mervyn King (at the Bank of England since March 1991) and most other leading central bankers). Neither the public nor the new vintage of politicians that will take over is likely to listen to those who either actively contributed to the disaster or failed to foresee it or warn against it.

Over-regulation will harm the dynamism of the economy. How serious the damage will be is not clear. What is clear is that a lot more regulation, and regulation different from what we have had in the past, will be required to reduce the likelihood of future systemic failures and to better align private and public interests.

Buiter message is clear: the rules are going to change, whether you like it or not. Investors who fail to understand this will get badly burned as they try to make their way in the new economy.

It certainly appears as if the credit crisis is well and truly over or, at the very least, the light which most of us think we can see at the end of the tunnel is no longer that of an oncoming freight train.

No wonder equities are currently enjoying one of their best spells ever. And while equities continue to go up and up, most of us are left scratching our heads. Is this the real thing or will it go down in history as ‘just’ another bear market rally? Not so long ago, the entire financial system stared Armageddon in the face. Now, only a few months later, equity markets behave as if all the worries of yesterday have been washed away. How is that possible?

“Never in the history of the world has there been a situation so bad that the government can’t make it worse.”

-Unknown

The great bank illusion

The current bull market began in earnest in the second week of March, but what really got everyone going were the surprisingly good Q1 US bank earnings which were reported during the first half of April. Most commentators interpreted the numbers as the clearest piece of evidence yet that we are now firmly on the road to recovery.

Of course US banks made good money in Q1. The environment created for them is the equivalent of the US government reducing the cost of goods to zero for its embattled car manufacturers and then going on to buy – courtesy of the US tax payer – a couple of million cars that nobody really needs. Even Detroit would make money given those conditions!

Liquidity is trapped

The problem for the rest of us is that the banks are not sharing the candy they have been handed. Much of the liquidity created by the central banks remains trapped in the financial sector (see chart 1). Quite simply, the multiplier is not doing its job, as many banks prefer to hoard cash rather than increase lending at this juncture.

This is both good and bad news at the same time. Good because it implies that we probably do not have to worry too much about the inflationary effect of the aggressive monetary easing currently taking place; bad because it means that the economy is not going to kick back to life as quickly as everyone would like – and expect.

Meanwhile investors are growing cautiously optimistic about the GDP outlook for the second half of the year with many now forecasting modest growth – at least in the United States. Only a fool would suggest that GDP would shrink by 5-10% per quarter in perpetuity, as has been the case over the past two quarters. The economic slowdown is now decelerating and, as I pointed out last month, there are good reasons why we may see a temporary lift in economic activity later this year, but it will almost certainly prove transitory.

We are still in a bear market

The dangerous conclusion to draw from the experience of the past few weeks is that all is now well and dandy and it is time to load up on stocks again. I cannot emphasize it strongly enough: The bull market of March-April 2009 is almost certainly a bear market rally but, as one of my partners pointed out the other day, NYSE saw four 20%+ rallies between 1929 and 1932 (see chart 2). Bear market rallies can be extremely powerful and hence deceiving.

The problems are not over yet. Not by a long stretch. It will take longer than 18 months to unwind the excesses of the past 25 years. Analysts at Morgan Stanley reckon that the 15 largest banks which between them have shrunk their balance sheets by about $3,600 billion so far in this crisis, will shed another $2,000 billion in 2009¹. If you do not share my pessimism, please take a quick look at chart 3 below. The US financial sector debt load (as a % of GDP) is now 117%. In the early days of the great bull market in 1982, the same number was 22%. Households are not much better off with total household debt now at 96% of GDP vs. 47% in 1982.

Further write-offs to come

The IMF reckons that both European and US banks – but in particular the European ones – are well behind the curve in terms of recognizing their credit crunch related losses. According to the IMF, there is at least another $1,500 billion to come. So when the US banks reported surprisingly good numbers for Q1 it was certainly not because the economy had suddenly and miraculously revived itself, but because some of the oldest tricks in the book were used to gloss over much bigger problems².

As the recession bites into the lives of ordinary people, banks will face losses not only on sub-prime mortgages but on all loan products. As you can see from chart 4, sub-prime is indeed a small fraction of the total loan book for the US banking sector.

Delinquencies are on the rise

And that is precisely what is beginning to happen as illustrated in chart 5. Delinquencies are now on the rise on all mortgage products; however, whereas sub-prime started to deteriorate as early as 2007, it is only recently that delinquencies related to Alt-A and adjustable rate mortgages have taken off, and prime and jumbo loans are only now starting to suffer.

These are all temporary problems, though, however bad they may appear. By far my biggest concern at the moment is the enormity of the debt problem facing most OECD countries. In the March issue of the Absolute Return Letter I referred to an important study conducted by Carmen Reinhart and Kenneth Rogoff back in December of last year³ which I would like to re-visit (see chart 6).

Banking crises run and run

Reinhart and Rogoff studied every banking crisis of the past generation and made some startling observations. One in particular caught my attention. It has to do with the subsequent rise in government debt which, according to Reinhart and Rogoff, has been “… a defining characteristic of the aftermath of banking crises for over a century”. According to the authors, governments inevitably underestimate the ultimate cost of a banking crisis, because the indirect costs (such as falling tax revenue in subsequent years) end up much higher than predicted.

The IMF estimates that the cost of the current crisis to the United States will eventually reach 34% of GDP or close to $5 trillion. However, the Obama administration, through its various implicit and explicit guarantees, is already using a number close to $9 trillion⁴. And Reinhart and Rogoff’s historical average of 86% of GDP implies an ultimate cost of over $12 trillion!

The IMF is too optimistic

I have a lot of respect for all the good work being produced by the people at the IMF; however, they are sometimes too politically correct for my taste; maybe too afraid of stepping on someone’s toes. So when they go public, as they did recently, with an estimate of how much the current crisis would ultimately cost, their projection will more than likely prove hopelessly inadequate.

The true cost is important, because it has to be financed through new bond issuance, and it is my thesis that the sheer size of this tsunami will eventually overwhelm the world’s bond markets. As you can see from chart 7, using the official IMF estimates, the twelve most industrialised of the world’s G20 countries (in my book known as the Dirty Dozen) will have to issue about $10 trillion worth of new bonds to cover the cost of the current crisis.

The final cost will be enormous

However, if you (like me) believe that IMF underestimates the true cost of this crisis, Reinhart and Rogoff offer a more realistic approach (see chart 8). Using their least costly case study (Malaysia 1997) as our best case scenario, the true cost comes to $15 trillion. If one uses the average of 86% instead, the cost jumps to a whopping $33 trillion. I didn’t even bother to produce a worst case scenario – it all got too depressing!

I need to put the $33 trillion into perspective, because it is so big that it is almost incomprehensible. According to Wikipedia (see chart 9), total private wealth across the world today is about $37 trillion less the losses incurred in 2007-09, so the real number is probably closer to $30 trillion now. Total global savings (loosely adjusted for the big losses in 2008) are probably somewhere in the region of $100 trillion. In other words, financing this crisis could absorb one-third of total global savings. No wonder Gordon Brown looks tired!

Where do we find the money?

Obviously, governments may buy a portion of these bonds themselves, but they cannot afford more than a fraction of the total unless they want to challenge Mugabe as the ultimate master of illusion. Neither should investors hold out for sovereign wealth funds to do the dirty work. As is clear from chart 9, the total amount of wealth accumulated in these funds is pocket money when compared to the projected bond issuance over the next few years.

Hence it comes down to the price at which governments can attract sufficient demand from people like you and me. One of two things may happen. Either this crisis will ignite such a bout of deflation that investors will happily own government bonds yielding 2-3% or the deflation scare goes away ultimately, the global economy recovers and bond investors demand much higher yields for taking sovereign risk. I am not yet sure which scenario will prevail, but I do know that both are quite bad for equities longer term. Take your profits!

Source: The $33,000,000,000,000 Question

The stock market might bounce for a while, global currencies might stabilize for a while, but don’t be deceived, large problems remain…very large problems. And the price to fix these problems will run into the tens of trillions of dollars. That’s the kind of price tag that could ruin a national currency or two…even the world’s reserve currency.

While equities continue to go up and up, most of us are left scratching our heads. Is this the real thing or will it go down in history as ‘just’ another bear market rally? Not so long ago, the entire financial system stared Armageddon in the face. Now, only a few months later, equity markets behave as if all the worries of yesterday have been washed away.

The dangerous conclusion to draw from the experience of the past few weeks is that all is now well and dandy and it is time to load up on stocks again. I cannot emphasize it strongly enough: The bull market of March-April 2009 is almost certainly a bear market rally. As one of my partners pointed out the other day, NYSE saw four 20%+ rallies between 1929 and 1932. Bear market rallies can be extremely powerful and hence deceiving.

But the problems are not over yet. Not by a long stretch. It will take longer than 18 months to unwind the excesses of the past 25 years. Analysts at Morgan Stanley reckon that the 15 largest banks, which between them have shrunk their balance sheets by about $3.6 trillion so far in this crisis, will shed another $2 trillion in 2009. The US financial sector debt load (as a % of GDP) is now 117%. In the early days of the great bull market in 1982, the same number was 22%. Households are not much better off than the banks, with total household debt now at 96% of GDP vs. 47% in 1982.

The IMF reckons that both European and US banks – but in particular the European ones – are well behind the curve in terms of recognizing their credit crunch related losses. According to the IMF, there is at least another $1.5 trillion to come.

As the recession bites into the lives of ordinary people, banks will face losses not only on sub-prime mortgages but on all loan products. In fact, sub-prime is indeed a small fraction of the total loan book for the US banking sector. Prime and Alt-A mortgages, together with commercial real estate loans total about seven times the size of the subprime market.

Delinquencies are now on the rise on all mortgage products; however, whereas sub-prime started to deteriorate as early as 2007, it is only recently that delinquencies related to Alt-A mortgages have taken off, and prime and jumbo loans are only now starting to suffer.

These defaulting mortgages pose a very serious threat to the U.S. economy, but they are only part of the economic crisis worldwide. By far my biggest concern at the moment is the enormity of the debt problem facing most OECD countries. In the March issue of the Absolute Return Letter, I referred to an important study conducted by Carmen Reinhart and Kenneth Rogoff back in December of last year.

Reinhart and Rogoff studied every banking crisis of the past generation and made some startling observations. One in particular caught my attention. According to the authors, governments inevitably underestimate the ultimate cost of a banking crisis, because the indirect costs (such as falling tax revenue in subsequent years) end up much higher than predicted.

The IMF estimates that the cost of the current crisis to the United States will eventually reach 34% of GDP or close to $5 trillion. However, the Obama administration, through its various implicit and explicit guarantees, is already using a number close to $9 trillion. And Reinhart and Rogoff’s historical average of 86% of GDP implies an ultimate cost of over $12 trillion!

The true cost is important, because it has to be financed through new bond issuance, and it is my thesis that the sheer size of this tsunami will eventually overwhelm the world’s bond markets. Even using the relatively conservative IMF estimates, the twelve largest industrialized countries of the world will have to issue about $10 trillion worth of new bonds to cover the cost of the current crisis.

However, if you (like me) believe that IMF underestimates the true cost of this crisis, Reinhart and Rogoff offer a more realistic approach. Using their least costly case study (Malaysia 1997) as our best case scenario, the true cost comes to $15 trillion. If one uses the average of 86% instead, the cost jumps to a whopping $33 trillion. I didn’t even bother to produce a worst case scenario – it all got too depressing!

I need to put the $33 trillion into perspective. Total global savings (loosely adjusted for the big losses in 2008) are probably somewhere in the region of $100 trillion. In other words, financing this crisis could absorb one-third of total global savings.

Hence it comes down to the price at which governments can attract sufficient demand from people like you and me. One of two things may happen. Either this crisis will ignite such a bout of deflation that investors will happily own government bonds yielding 2-3% or the deflation scare goes away ultimately, the global economy recovers and bond investors demand much higher yields for taking sovereign risk. I am not yet sure which scenario will prevail, but I do know that both are quite bad for equities longer term.

There is a third route, of course. Governments could print money for themselves, which they could then use to purchase their own bonds. We call that process inflation…and it is already underway.

Source: He Who Borrows the Most, Wins

• U.S. Federal Reserve Chairman Ben Bernanke said the U.S. economy will begin to “turn up later this year,” contingent upon the financial sector’s continued improvement, Reuters reported. Speaking to a congressional committee, Bernanke said the housing market may be bottoming out and pointed to improving consumer spending.

• The Canadian dollar hit its highest point since November. “The market is now willing to embrace risk and move clean of the safety associated with the U.S. dollar,” Stewart Hall, an economist in Toronto at HSBC Securities, told Bloomberg. “The Canadian dollar has the potential to be a high-yielding currency if the commodity story once again gains traction and moves forward.”

• Price increases and cost-cutting measures helped Kraft Foods Inc. (NYSE: KFT) post higher-than-expected first-quarter profit. The food company also reaffirmed its 2009 earnings and revenue forecast, Reuters reported.

• South Africa’s unemployment rate jumped to 23.5% in the first quarter, as Africa’s largest economy likely slipped into recession for the first time in 17 years, Bloomberg reported. “Manufacturing and mining are under strain, and we can expect these numbers to worsen,” Fanie Joubert, an economist at Efficient Group, told Bloomberg. “We’re unlikely to see a recovery until the fourth quarter.”

• The U.S. service sector is beginning to show signs that the worst may be behind it as the Institute for Supply Management’s index of non- manufacturing businesses contracted less than forecast in April.  The index of service businesses, which make up almost 90% of the economy, rose to 43.7 from 40.8 the prior month, according to the Tempe, Arizona-based group. Readings below 50 signal contraction. Separately, a survey of chief executives found the highest level of confidence in three years, as home purchases and retail sales rose, another signal that the economic slump is abating, Bloomberg reported.

• Shares of American International Group Inc. (NYSE: AIG), once the world’s largest insurer, rallied in New York trading yesterday (Tuesday), on speculation the insurer’s first quarter loss narrowed from its record $61.7 billion net loss in the fourth quarter, Reuters reported. AIG, was rescued with a taxpayer lifeline last year after severe mortgage losses left it unable to meet collateral postings with counterparties. It currently needs to pay back about $80 billion in borrowings from the U.S. Treasury and Federal Reserve.

• Several Wall Street traders and mutual funds, including Fidelity Investments and General Electric Co. (NYSE: GE), oppose bringing back the so-called “uptick rule,” which may deter U.S. regulators from resurrecting the provision, Bloomberg reported.  At a public meeting in Washington, several executives from companies that blame short-sellers for driving down share prices said they prefer an alternative to the uptick. The Securities and Exchange Commission scrapped the almost 70-year-old uptick provision in July 2007 after studies determined it wasn’t relevant in markets dominated by fast-paced electronic trading. SEC Chairman Mary Schapiro said any new rules will uphold the benefits of short-selling while restricting market abuses.

• Chile’s peso firmed to a seven-month high yesterday (Tuesday) on dollar weakness and better-than-expected domestic growth data. “The main elements that influenced the peso…were the fall of the dollar against the euro, and also the economic data, which was negative, but better-than-expected,” one currency trader in Santiago told Reuters. The peso is now up 12.2% against the dollar year to date after slumping 22.3% in 2008.

Source: Investment News Briefs Wednesday, May 6, 2009

]]> http://www.contrarianprofits.com/articles/investment-news-briefs-wednesday-may-6-2009/16296/feed 0 http://www.contrarianprofits.com/articles/washington%e2%80%99s-lies-will-only-delay-the-recovery/16010 http://www.contrarianprofits.com/articles/washington%e2%80%99s-lies-will-only-delay-the-recovery/16010#comments Wed, 29 Apr 2009 17:06:53 +0000 Contrarian Profits http://www.contrarianprofits.com/?p=16010 The dogs in the street know Washington is going to have to come up with more cash to plug the gaping holes in banks’ balance sheets. Of course, our Orwellian government doesn’t want us to think that major banks such as Citigroup and Bank of America are insolvent.
Instead, we are to believe the “doublethink” that banks are simultaneously profitable and in need of billions of dollars in fresh capital. (Tax dollars, of course. Private investors, for some strange reason, aren’t so keen to invest in these zombies.) And so confident are the Washington bureaucrats in the power of their propaganda that they really expert us to believe that this extra capital is not need because banks are insolvent, but because…

So far, American taxpayers have shoveled out almost $600 billion in Troubled Asset Relief Program (TARP) funding to prime the economic pump and get the banks lending – and people spending – again.

Yet a report by The Wall Street Journal shows the banks are lending less money than they did five months ago. And further research shows no matter how much TARP money the government pumps into the U.S. banking system, American consumers may just not be ready to drink from the trough – a sobering reality that could doom the chances of a quick economic rebound.

Meanwhile, the banks’ perceived reluctance to lend – coupled with their lavish spending on bonuses and management perks, has the the Obama administration on the defensive, sensitive to skepticism about the government’s ability to revitalize the banking system.

Bank Lending Still Anemic

Despite government pronouncements to the contrary, pumping billions of dollars into the financial sector has not had the desired result, meaning lending hasn’t accelerated. In fact, according to the recent Wall Street Journal analysis, initial loans and refinancing outlays at the nation’s big banks dropped by 23% from October to February.

According to the data, 19 financial institutions made or refinanced a total of $226.3 billion worth of loans in October. That figure plummeted to $174.2 billion for February, The Journal reported.  In fact, the total dollar amount of new loans declined in three of the four months the U.S. government has reported the data, and all but three of the 19 largest TARP recipients originated fewer loans in February than they did in October.

For its part, government officials say the current situation could have been a whole lot worse without TARP funding.

Just last week, the U.S. Treasury Department praised “the relatively steady overall lending levels.” Without those capital injections, “lending would have suffered a far smaller total volume of loan originations in February than January,” the Treasury Department said.

But bank executives defended their lending levels by saying the reason behind a decline in new loans, refinancing deals and modifications of troubled loans is the lack of demand from consumers and businesses – and not the banks’ willingness to lend.

JPMorgan Chase & Co. (JPM) showed one of the biggest lending declines, dropping from $61.2 billion in October to $39.7 billion in February – a drop of 35%.  But JP Morgan executives explained the bank made more than $151 million in loans in the first quarter, “despite the fact that loan demand has dropped dramatically.”

Commercial lending slid by about 40% and may have been depressed by a partial thawing of the bond markets, where some corporations raise money instead of borrowing it from banks. About $70 billion of corporate bonds were issued in February, up from $21.4 billion in October, according to Thomson Reuters.

The figures show that consumer loans, especially mortgage refinancings, account for a large portion of bank lending. Nearly half of February’s lending went to consumers, up from about one-quarter in October.

But excluding mortgage refinancings, consumer lending dropped by about one-third between October and February. And because the United States has accounted for one-third of total growth in global consumption since 1990, any change in U.S. consumer behavior has profound implications, not just for the United States, but for the worldwide economy.

Increased Savings Rate Could Slow Rebound

Consumer spending is the engine of the U.S. economy, accounting for about 70% of gross domestic product (GDP). And in the go-go days of the early 21st century, U.S. consumer spending was in full swing.

U.S. households nearly doubled their outstanding debt to $13.8 trillion between 2000 and 2007, according to the McKinsey Institute. During that unprecedented period, personal consumption accounted for 77% of real U.S. GDP growth and personal liabilities reached an astounding 138% of disposable income.

But a shift occurred as the global financial crisis worsened at the end of 2008: U.S. households reduced their outstanding debt for the first time since World War II by curtailing spending and reducing borrowing.

In fact, recently released U.S. Federal Reserve data shows that outstanding consumer credit dropped from $2.95 trillion to $2.56 trillion in January.

But as consumer spending and borrowing plunged in recent months, the saving rate has rebounded, reaching 5% in January. And each extra point in the savings rate means more than $100 billion less in spending a year, according to a recent McKinsey study.

In fact, the study found that if consumers continue to reduce debt, the increased savings rate would result in $535 billion less consumption a year, a potentially serious drag on a nascent economic recovery.

Banks and Obama Still Not Out of the Woods

Looming over all this is the possibility that banks may need more government assistance in the near future in order to keep lending – even at the current depressed levels.

JPMorgan analyst Matthew Jozoff predicts banks could suffer another $400 billion in losses as a result of continuing credit deterioration, which could force policymakers to deploy yet another round of capital infusions.

Obama administration officials acknowledge that they may still have to ask Congress for more money in the future. Beyond the 19 big banks, which are defined as those with more than $100 billion in assets, the Treasury has also injected capital into hundreds of regional and community banks.

The most immediate expense may come in the next several weeks, when federal bank regulators complete “stress tests” on the nation’s 19 largest banks.  The tests are expected to show that at least several major institutions will need to increase their capital cushions by billions of dollars.

That could include Bank of America Corp. (BAC), a bank that many experts say probably should have been liquidated long ago.

In order to avoid another capital infusion, the government might elect to take equity in return for previous loans.  Converting the loans into common stock would increase the capital of big banks by more than $100 billion and give the government a large equity stake in return.

Of course, converting those loans into common shares would turn the government into the bank’s biggest shareholder – a move some critics see as a back door to nationalization. The move would also serve to further dilute the holdings of existing shareholders.

While the option appears to be a quick and easy way to avoid a confrontation with congressional leaders who are wary of putting more money into the banks, the administration would no doubt be heavily criticized for displaying such “socialist” tendencies.

[Editor's Note: In this second installment of a two-part look at whether the credit crisis continues to crimp financing for companies and consumers, Money Morning takes a look at bank lending. In Part I earlier this week, we studied venture-capital-investment trends.]

Source: A Look at Liquidity: The Real Reason Banks Aren’t Lending

Gold was at $919/921 an ounce at 1242 GMT, down from $937.15 late in New York on Monday, when it fell more than 1 percent as investors moved away from safe-haven investments.

World stocks hit five-week highs on Monday as investors pocketed riskier assets on growing optimism that a U.S. plan to purge toxic assets from the balance sheet of banks could ease the misery of the financial sector.

“Sentiment (on gold) is a bit weaker off a perceived improvement in other forms of asset classes,” said Michael Khosrowpour, an analyst at Triland Metals, pointing to overnight gains in stock markets and gains in the dollar.

The U.S. plan helped boost Japan’s Nikkei average to a 2-1/2 month closing high on Tuesday. But European stocks dipped, breaking a three-day winning streak after euro zone and UK macro data showed job losses and higher inflation.

Traders said markets were watching out for testimony before Congress by Fed Chairman Ben Bernanke and U.S. Treasury Secretary Geithner at 1400 GMT.

Analysts said fears of inflation fanned by the Federal Reserve’s plans to buy long-dated U.S. Treasuries still lingered even if they had eased a little.

“Gold will probably continue to follow inflation expectations in the near term although remains vulnerable to improved risk asset sentiment,” UBS said in a note.

Analysts also said a higher dollar was putting pressure on gold prices.

Gold is often viewed as an alternative to holding the dollar, and often falls when the dollar rises because it makes metals priced in the U.S. currency more expensive for holders of other currencies.

Bullion has recovered ground from a six-week low of $882.90 marked on March 18 but still has some way to go before approaching the 11-month high above $1,000 reached in February.

It soared to an all-time peak of $1,030.80 in March 2008.

Receding interest in gold was also evident in the holdings of gold-backed exchange traded funds.

The world’s largest gold-backed ETF, the SPDR Gold Trust , said its holdings nudged down about a third of a tonne to 1,114.29 tonnes on March 23 from a record high 1,114.60 tonnes.

Silver was at $13.36/13.42 from $13.63, platinum was at $1,109/1,119 from $1,121, and palladium was at $203/208 versus $207.5.

March 24 (Reuters)