That was the day when the Dow Jones Industrial Average hit its historic peak. From there, it was all downhill – slowly but steadily at first, and then violently after last August – until the Dow bottomed (for now) on March 9 of this year. Over that span, the index lost 54% of its value.

It’s been a crushing blow to just about everyone. But it’s already being referred to as the crash. As if the unpleasantness were now all behind us. More likely, in the future it will be seen as, simply, the first crash.

Don’t believe it? In a moment you will, when you see the scariest graph of the year.

But let’s quickly recall what’s already happened. During the late, great housing boom, interest rates were at microscopic levels, while bankers were encouraged to grant home loans on little more than a wink and a nudge. In order to inflate their balance sheets, those bankers resorted to all sorts of gimmicky, adjustable rate mortgages (ARMs), whose common feature was an interest rate that would eventually reset. That is, it would balloon somewhere down the road. And those most likely to come quickly to grief were the riskiest borrowers, who held loans known as “subprime.”

“But not to worry,” borrowers were told. “Betting on ever-rising home prices is the safest wager in the whole wide world. If you have problems with cash flow when the ARM resets, your house will be worth a lot more, so you can simply sell it and walk away with a nice chunk of change in your pocket.” Uh-huh.

The bankers themselves were a little more concerned about the deterioration of their portfolios. They took out insurance in the form of credit default swaps (CDSs). These were a brand-new invention in world financial history, allowing mortgages to be sold and resold until they were leveraged 20 times over. They became the shakiest part of a huge global derivatives market, with a nominal value in the tens of trillions of dollars.

For a while, this Ponzi scheme even worked. But then, as they had to, the ARMs began resetting, and there were defaults. Then more of them. Because at the same time, the housing market was cooling off and the economy was stalling out. More and more people were trapped in a situation where they owed more on their home than they could sell it for. Many simply mailed their keys to the bank and moved on.

All of this wreaked havoc in the derivatives market. Sellers of these exotic packages could no longer establish what they were worth. Buyers couldn’t determine a fair price and so stopped buying. As the ripples spread through the world financial system, trust disappeared and liquidity dried up.

Now consider that the base cause for all that dislocation was the subprime sector. And how big is that? Not very. Subprime mortgages account for only about 15% of all home loans. Their influence has been way out of proportion to their numbers, because of derivatives. Here’s the good news: the subprime meltdown has about run its course. These loans were resetting en masse in 2007 and the first eight months of ’08. Now they’re pretty much done.

And the bad news? No one in the mainstream media seems to be asking what should be a pretty obvious question: What about loans other than subprime? Truth is, the banks didn’t just trick up their subprime loans. ARMs were the order of the day – across the board.

Now, here’s that frightening graph we referred to earlier.

Take a good, long look. You can see that from the beginning of 2007 through September of 2008, subprime loans (the gray bars above) were resetting like crazy. Those are the ones people were walking away from, sending a shockwave from defaults and foreclosures smack into the middle of the economy. Now they’re gone.

The ARM market got very quiet between December 2008 and March 2009, hitting a low that won’t be seen again until November of 2011. Small wonder a few “green shoots” have poked their heads above ground. But in April, resets began to increase and will reach an intermediate peak in June. After that, they tail off a little, going basically flat for the next ten months.

It’s not until May of 2010 that the next wave really hits. From there to October of 2011, the resets will be coming fast and furious. That’s 18 months of further turmoil in the housing market, and the beginning is still nearly a year away! (Although the months in between are likely to be no picnic, either.)

While it isn’t subprime ARMs that are resetting this time, neither are they prime loans. Those eligible for prime loans wisely tended to stay away from ARMs in the first place, as indicated by the relatively small space they take up on each bar.

No, the next to go are Alt-A’s (the white bars), Option ARMs (green) and Unsecuritized ARMs (blue). Alt-A’s are loans to the folks who are a small step up from subprime. Unsecuritized loans are a 50-50 proposition; either the borrowers were good enough that they weren’t thrown into the CDS pool, or they were so risky no one would insure them.

Those two are bad enough. But Option ARMs are the real black sheep, loans with choices on how large a payment the borrower will make. The options include interest-only or, worse, a minimum payment that is less than interest-only, leading to “negative amortization”—a loan balance that continually gets bigger, not smaller. Imagine what happens with those when the piper calls.

Once the carnage begins, will it be as bad as the subprime crisis? That’s the $64K question. Perhaps not. For one thing, subprime loans were a much larger chunk of the market when they started going south. For another, there’s been a lot of refinancing as interest rates dropped; that should help ease the default rate. And the government has massively intervened, with measures designed to prop up those who would otherwise lose their homes.

On the other hand, we’re in a severe recession, which wasn’t the case when the subprime crisis started. More people will be unable to meet payments. And the housing market has continued to decline, pressuring both marginal homeowners and banks that can’t sell foreclosed properties.

Is the stock market’s next 10/9/07 on the way? Yes. Which day will it be? That’s unknowable. It could be in a week, or not for another year.

But make no mistake about it, the second crash is coming. It can’t be prevented, no matter what desperate measures Obama and his hapless financial advisors come up with. All we can hope for is that, with a little luck, it won’t be as severe as the first one. But it will last longer. We aren’t even in the middle of the woods yet, much less on the way out.

Regards,

Doug Hornig

Source: The Unstoppable Second Mortgage Crisis

• The auditors at General Motors Corp. (GM) have raised “substantial doubt” about the carmaker’s odds of surviving without filing for bankruptcy protection. “Amid the automotive depression, GM is dependent upon the largesse and forbearance of the U.S. and foreign governments to sustain its various entities,” Standard & Poor’s equity analyst Efraim Levy said in a note for clients, Reuters reported.

• Ford Motor Co. (F) said it plans to cut about 40% of its $25.8 billion automotive debt by offering creditors cash and new shares. Despite the plan, Standard & Poor’s cut its corporate credit rating on Ford to “CC” from “CCC+” while Fitch said it will not affect the current rating of “CCC,” Reuters reported.

• Despite overall retail numbers falling in February, Wal-Mart Stores, Inc. (WMT) reported sales growth for the month that outpaced its quarterly forecast. Revenue increased 5.1% at U.S. stores open at least one year, as more customers came to the world’s largest retailer for groceries.

• Google Inc. (GOOG) has an $8.6 billion pile of cash that will only be used for “very very conservative investments,” Chief Executive Eric Schmidt said in an interview with The Wall Street Journal. The primary plan is to let the cash “pile up” as the company tries to retain its footing during the global financial crisis.

• Mortgage delinquencies rose to the highest level on records that date back to 1972, as unemployment rose to a 15-year high and real estate values tumbled, Bloomberg reported. The U.S. real estate market lost $2.4 trillion in value last year, and the percentage of loans at least a month overdue or in foreclosure increased to a seasonally adjusted 7.88%, the Mortgage Bankers Association reported yesterday (Thursday).

• Blockbuster Inc. (BBI), the top U.S. movie rental chain, said sales at stores open at least a year rose 4.4% in the fourth quarter as strong demand for electronics and video games overshadowed a slump in rentals.  Blockbuster shares jumped 23% following the news and the company said it has no plans to file for bankruptcy, as was rumored earlier this week, Reuters reported.

• Shares of Citigroup Inc. (C), once the world’s biggest bank by market value, dropped below $1 in New York trading for the first time as investors lost confidence the shares could recover after more than $37.5 billion in losses and a government rescue. Citigroup is now the 184th biggest bank by market value, behind Malaysia’s Bumiputra-Commerce Holdings Bhd, according to data compiled by Bloomberg.

• Oil fell nearly 4% yesterday (Thursday) as the deteriorating economic outlook heightened expectations that consumption would shrink further, Reuters reported. U.S. crude slipped $1.77 to settle at $43.61 a barrel, while London Brent crude fell $2.48 to $43.64. Oil prices have dropped more than $100 a barrel since last July as the economic crisis triggers the first decline in global energy use in a quarter century.

Source: Global Investment News Briefs Friday, March 6, 2009

With that in mind, I have decided to give you a feel for what some of the best people I know in the money business are thinking. Not saying, thinking.

I’m not a mind reader, although many of my former clients expected me to be, but I do have a source for great financial information that is virtually untapped.

My home is in a little area of Baltimore near the harbor that is within walking distance of most of the big brokerage and banking businesses in downtown.  As you might expect, we have more than our share of bankers, analysts, brokers and every kind of financial type living in our neighborhood.

Right in the center of our neighborhood is a bistro called Regi’s.  It’s not only the preferred watering hole; it’s a great restaurant, too.

Any night of the week, this place is packed with some of the best minds in the money business. The real deal. Men and women who actually work in the business of packaging mortgages, putting together bond deals and doing equity offerings. They don’t write about it and no one is asking their opinion about what is going on, they are the people who are actually doing it.

Here’s what they’re saying about 2009. While the ideas aren’t specific, they are from folks who know the biz from the real inside and confirm much of what I have been thinking for sometime.

One guy creates mortgage products. He’s the only person I know who really knows what a Tranche is. Tranche is a word that has been thrown around by mortgage financial types for about 20 years, but this guy can actually explain how it affects my money. Let’s call him Ted.

Ted was the first guy who spelled out for me why congress is really responsible for this credit/mortgage/banking crisis. He was the first, and to date the only person, who nailed down the fact that congress mandated that banks, and Fannie and Freddie, accept mortgages from people who could normally never qualify for one. All of this was in the name of the “American Dream,” that quickly became the world’s nightmare.

Ted is cautiously buying equities with the expectation that we will have a lot of ups and downs before we turn the corner, but we will turn the corner in 2009. Ted is also very confident that the mortgage crisis is moving along nicely.

Sally is in the tax-free bond business. She sets up and runs deals to finance public service projects. She, like a lot of other people, knows we will survive this current garbage market. She also agrees with the majority of the pros I talk to that this is the best buying opportunity in her lifetime. She is cautious and feels we need to tread lightly, but is buying now.

Dave is in business insurance. He sets up insurance programs for small and large business. He spends most of his day talking directly to the top players in a number of industries. He thinks we are in deep trouble. He sees a complete lack of leadership in Washington, at all levels, in both parties. The result of this vacuum is that we are at best trading water and most likely sinking slowly into an extended recession with deflation most likely.

His greatest fear is not the bailouts or the amount of money the Fed has to print, or even the endless debt. His fear is that when all the loans from the bailouts are repaid, congress will just spend that, too.

On the topic of real estate, almost to the person, the response is, “what did they expect.” You give mortgages to people who cannot afford them and they default? You then sell these worthless mortgages to banks all over the world and the banks go broke because of it. You’re surprised?

Still, there is optimism about real estate. It’s a waiting game. Prices have begun to bottom in our market, the really over leveraged markets, (Nevada, Florida, California), still have a way to go. They are sitting tight and waiting out the defaults.

Overall, everyone thinks we are in the best buying market of their adult lives. No one is calling a bottom and no one is calling for a short- term top. Everyone is a cautious buyer. Everyone expects to have many ups and downs before we level off late next year.

Some are throwing around numbers in the 7000’s as a low for 2009.

The areas they like best are anywhere business spending isn’t required, necessary consumables, drugs, personal items, infrastructure construction and telecom.

Their biggest concern, how will we ever absorb all of the money being printed, and what kind of inflation risk do we run after all this new money hits the system. Even my giant-brain friends don’t have the answers to these issues.

The good news, no one is running scared, everyone is buying on the dips, everyone is confident we are doing the right things to get the economy moving again, most feel Obama was the right choice for the times. There’s a lot of money to be made but you have to get in before it gets too expensive.

That’s it. If you’ve been selling and running scared you might want to consider what the real pros are doing with their money.

Keep your eye on the horizon and your powder dry.

Source: What The Insiders See In 2009

But don’t despair. Because a trend that has long been talked about – economic decoupling – is finally starting to manifest itself as other world economies, particularly the so-called “BRIC” markets of Brazil, Russia, China and India, have continued to grow even as the U.S. economy has slowed. That means profit opportunities abound for U.S. investors, despite myriad messes on the home front that include a collapsed housing market, a mortgage crisis that turned into a five-alarm credit conflagration, and a plunging greenback that seems to have left its parachute on the airplane that it jumped from.

Some of the profit pathways to play:

• Investors can eschew the U.S. market completely, and pursue profits abroad.
• They can latch onto the U.S.-based members of the “Global Titans” club, companies with their headquarters in America that derive a hefty chunk of their profits from overseas markets.
• Or investors can ferret out U.S. investments that are either immune to some of this country’s current economic afflictions, or that are problem-plagued now, but a good bet for a turnaround later.

A Year to Forget?

Like a Dickens’ novel, 2007 was a definite “Best of Times/Worst of Times” combination for the U.S. economy. Volatility and crisis were the watchwords for much of the year. After key stock indices reached record highs in the middle of the year, the explosive emergence of the subprime mortgage debacle and related credit crunch pushed share prices into a nosedive that steepened as the year progressed.

With a 0.6% increase in gross domestic product (GDP) for the fourth quarter of 2007 and a first quarter that’s supposed to be flat at best, it’s clear that we’re not out of the woods, yet. Many fear that 2008 will find the United States in a recession. Other investors believe we have already experienced the first elements of a recessionary contraction.

“If I had to be bold, I’d say we began a recession in December,” Bill Gross, manager of the PIMCO Total Return Fund (PTTAX), told the Financial Times in a recent interview.

The Homeowner Blues

As 2007 progressed, many Americans experienced a growing despair as they watched their largest asset – the family home – experience a significant value decline. The United States is experiencing its worst housing recession in more than 15 years. And that domicile downturn is far from over. Consumers are being forced to watch as the housing slump siphons off the equity they’ve built up, even as it shaves the market value of their homes. Consumers with marginal credit who’d signed up for adjustable-rate loans have seen their mortgage rates “reset,” and then had to watch as their monthly mortgage payment ballooned to the point that they could no longer afford those payments.

For many, unfortunately, refinancing hasn’t been an option. The vanishing homeowners’ equity made such deals unfavorable to lenders. And with the burgeoning credit crisis that quickly became global in nature, banks and mortgage firms have slashed the available amount of refinancing loans that homeowners needed to escape their soaring mortgage payments.

Soon, the banks that had made the questionable calls on subprime loans were in trouble, too. With the housing market cooling, the homeowners who couldn’t refinance also discovered that they couldn’t sell. Homeowner defaults – loans that are 30 days or more past due – soared and started a firestorm that has swept through the global financial-services sector, singing such stalwarts as Citigroup Inc. (C), Fannie Mae (FNM), UBS AG (UBS), and others.

“It will take most of the year to work out of the housing slowdown. Currently, the inventory of unsold homes is at an eight to nine-month level. We have to get this down to a more normal level of four to five months. In order to get to this level, housing starts will remain low,” Dr. Robert Sweet, an economist at MTB Investment Advisors, the investment-advisory subsidiary of M&T Bank Corp. (MTB), said in an interview with Money Morning.

And we might be getting closer to the bottom. In fact, existing home sales rose in February, the first such increase in the past seven months. But it’s probably too soon to get excited about a full housing recovery.

“It looks like this may be a temporary pause,” Nigel Gault, chief U.S. economist at Global Insight Inc. in Lexington, Mass., told Bloomberg News after the existing homes sales report was released. “The price declines have helped, and people are still getting financing, though not on the good terms they could before.”

“We’re still a long way from a recovery in housing,” Gault said.

The Fed to the Rescue?

U.S. Federal Reserve policymakers cut the benchmark interest rate by less-than-expected three-quarters of a percentage point at their last meeting, a move that was designed to energize a badly flagging economy without causing inflation to spike or exacerbating the greenback’s decline.

When central bank policymakers reduced the key Federal Funds rate from 3% to 2.25% on March 18, it was the sixth time in seven months the closely watched benchmark had been reduced. Many analysts had been expecting a reduction of a percentage point – or even more – as such recent events as the near-collapse and subsequent Fed-led bailout of U.S. investment bank The Bear Stearns Cos. Inc. (BSC) stoked fears that the U.S. financial system was ready to seize up.

The policymaking Federal Open Market Committee (FOMC) has now cut the Fed Funds rate six times and slashed the Discount Rate for direct loans to banks eight times since August, when the subprime mortgage market collapsed and created a global credit crisis.

While the FOMC made it clear that inflation has grown as a concern, it still says that economic worries remain the biggest problem and emphasized that it was ready to act again if need be.

“Today’s policy action, combined with those taken earlier, including measures to bolster market liquidity, should help to promote moderate growth over time and to mitigate the risks to economic activity,” the FOMC said in its March 18th statement. “However, downside risks to growth remain. The committee will act in a timely manner as need to promote sustainable economic growth and price stability.”

And Goldman wasn’t alone. Morgan Stanley (MS) reported that these hard-to-value/hard-to-sell assets soared 45%, reaching $32 billion. For Lehman Brothers Holdings Inc. (LEH), the first-quarter increase was $500 million, bringing its total to $42.5 billion.

The balance-sheet holdings in question are known as “Level 3″ assets. And with the smoke from the subprime-mortgage crisis still hanging over Wall Street like the fallout from a nuclear missile strike, some industry observers are worried that the difficult-to-sell Level 3 assets are little more than a crisis-in-waiting that’s standing in the wings of the U.S. financial-services sector.

And now that banks and brokerages are well into their first-quarter earnings reports, it’s clear that the amount of these tough-to-value assets are climbing on the balance sheets of such banking-sector stalwarts as Goldman, Merrill, Lehman – and others, too.

But the real question is – why?

That question has put investors back on the defensive.

Money Morning Contributing Editor Martin Hutchinson – an expert on the international debt markets – had a succinct answer.

“Level 3 assets are yet another disaster waiting to happen,” Hutchinson said in an interview.

Accounting rules require financial firms to price the assets on their balance sheets at a so-called “fair value.” As part of that, financial assets are broken down into three categories, or “levels,” based upon how liquid the assets are and, in turn, how easy they are to value, or price:

• Level 1 assets are fully liquid, and easy to price.
• Level 2 assets can be priced with the benefit of “comparable assets.”
• And Level 3 assets are completely illiquid and nearly impossible to price.

In the attempt to explain what’s happening in the market – in short, why the amount of Level 3 assets are increasing on financial-sector-firm balance sheets – two theories have emerged. And neither one bodes well for the longed-for end to the global financial crisis that was kicked off by the collapse of the subprime mortgage sector.

One of two things is occurring. Either:

1. Investment banks are reclassifying Level 2 assets as Level 3 assets, for a reason we’ll explain momentarily.
2. Or the brokerage firms are inflating their estimates for the value of Level 3 assets already on their books.

Even worse – it could be a combination of both.

Prior to the current credit mess, mortgage-backed securities were priced according to Markit’s ABX Index, which used the average weight of four series in the index to track the price of housing derivatives. But once the subprime market collapsed, the ABX Index plunged – and has yet to recover.

With the first scenario, rather than mark down its Level 2 assets to the current abysmal levels of the ABX, Goldman has decided to simply reclassify those assets as Level 3 assets, experts say. If there isn’t an actual “market” in which to sell the securities, the banks don’t have to write down the price of the assets; indeed, they can list any value they want, theoretically.

“Goldman is the one house that hasn’t had any losses,” Money Morning Contributing Editor Martin Hutchinson said in an interview. “That, in itself, is suspicious.”

This kind of thinking might seem shocking to a non-Wall Streeter, but it’s common practice in modern accounting.

In the second scenario, some experts say it’s possible the investment banks are inflating the price of the level 3 assets already on their books. Since, in theory, there is no market for a Level 3 asset, they are impossible to “mark-to-market.” Financial firms use various in-house pricing models to determine a price for these assets. The firms would likely argue stridently that the pricing models they employ are valid and can be fully justified. But the reality is that – in the end – the price they mark down in the corporate ledger is basically a made-up number.

Boosting the value of assets can staunch a bleeding balance sheet. We’ve seen the damage $300 billion worth of mark-to-market write-downs has done to the global financial sector.

After all that carnage, imagine what a reversal of this write-down hemorrhaging could mean?

“If you can make up a higher price, you can pay yourself a higher bonus,” Hutchinson said.

At the same time, firms such as Goldman also boosted the collateral they can use to secure loans, even though no one is likely buy that collateral – not at any price. But with the U.S. Federal Reserve’s new lending program, investment firms such as Goldman can use Level 3 assets to secure highly liquid U.S. Treasury loans.

The bottom line is that you just don’t know if you can trust the valuation of Level 3 assets. In a true recession, it’s possible the value of those assets could go as low as zero.

With Level 3 assets currently representing 14% of Lehman’s total assets, and 13% of Goldman’s, a recession that drops the bottom out of the market could mean billions more in additional write-downs.

“People are concerned about Level 3 [assets] because of possible write-downs, though it isn’t all necessarily losing value,” Erin Archer, a senior equity research analyst at Thrivent Financial for Lutherans, told Bloomberg News. “We aren’t out of the woods yet when it comes to write-downs and the profitability of brokers.”

Thrivent holds shares of Goldman, Morgan and Lehman among the $73 billion it has under management.

“That’s 1 out of every 33. In Nevada, it’ll be more like 1 out of 11.”

“The forecast is based on data from the Mortgage Bankers Association and the Center for Responsible Lending.”

In light of those figures, the accompanying forecast of 41 million homes losing value because of surrounding foreclosures, with a total loss in value of $356 billion, seems awfully conservative.

One other figure that stands out, and this one’s already in the rear-view mirror: Only three states did not experience at least a 20% increase in foreclosure starts in 2007 — Alaska, Montana, and Vermont.

One out of every 33 homeowners in foreclosure? Sorta reinforces my thinking that soon foreclosure will be a perverse badge of honor.

Treasury Secretary Hank Paulson has proposed the Federal Reserve be given broad powers to regulate the financial industry. He could not have nominated a more incompetent body. The Coast Guard would do a better job.

Financial upheaval owes homage to derivatives that shrouded the massive growth in debt and leverage. This murky world inflated the incentives of those who ran the machinery over the cliff — bankers, mortgage brokers, law firms, appraisers, rating agencies, politicians, and on it goes. This is well known. Despite protestations, the parties knew they were behaving either recklessly or criminally at the time. The Federal Reserve encouraged them.

With a straight face, Hank Paulson proposes that the Fed quash future imbroglios. Yet the terracotta soldiers of Xian would bring more initiative to the assignment.

In September 1998, the Federal Reserve didn’t have the slightest idea of how the banking system functioned; it hadn’t the slightest idea of the banks’ exposure to hedge funds; nor had it the slightest idea of the leverage within the financial system. Maybe these deficiencies are excusable, although the Federal Reserve was responsible for regulating bank holding companies (the holding companies being where much of the risk was housed). It is unpardonable in the aftermath, having learned of its own deficiencies, that the Federal Reserve made no effort to improve its oversight or to warn of the dangers it had recently discovered. Instead, the Fed encouraged devious practices.

In the first three weeks of September 1998, Long-Term Capital Management (LTCM), a Greenwich, Conn., hedge fund, lost half a billion dollars per week and everyone knew it. Except, possibly, Alan Greenspan. In mid-September, the Federal Reserve chairman told the House Banking Committee that “Hedge funds [are] strongly regulated by those who lend the money.” On Sept. 21, LTCM lost $550 million. In a virtuoso rejection of every financial institution’s model, all security prices went down. This is normal. In a panic, everyone sells.

The Fed’s lackluster oversight was partly to blame. On May 2, 1998, Alan Greenspan gave a speech in which he emphasized the advantages of “private market regulation.” Greenspan explained, “Rapidly changing technology has begun to render obsolete much of the bank examination regime established in earlier decades. Bank regulators are perforce now being pressed to depend increasingly on ever more complex and sophisticated private market regulation… One of the key lessons from U.S. banking history [is] that counterparty supervision is still the first line of regulatory defense.” He also noted the Federal Reserve’s decision to supervise “risk management procedures, rather than actual portfolios.” The Fed now evaluated how banks monitored their own risks (e.g., their modeling techniques, the process used to monitor counterparties) in lieu of examining specific securities.

The Federal Open Market Committee (FOMC) held a conference call on Sept. 29, 1998. The staff and Federal Reserve governors briefed Greenspan on Long-Term Capital Management’s counterparties — the banks that lent to LTCM. He was told that none of the banks, with the exception of Bankers Trust, had an up-to-date balance sheet for LTCM. Even this was “only a small piece of [Bankers’] whole action because so much of the latter is off balance sheet.” When assets are off balance sheet, the bank’s motivation to “strongly regulate” is diminished.

The Federal Reserve chairman was at a loss: “The question is why it happened in the first place. Is it just that the lenders were dazzled by the people at LTCM and did not take a close look?” Vice Chairman William McDonough replied there “was in place a credit system that made a great deal of sense.” In the next sentence — which simply cannot have been an explanation of this sensible system — McDonough told the FOMC: “For at least some of the lenders, there was no initial margin requirement.” McDonough went on to suggest the Federal Reserve might have taken more initiative: “We do not regulate the firm. But given the number of institutions they dealt with around the world, was there a way that should have enabled us to be more aware of their overall position? One is inclined to say, ‘You bet.’ But exactly how we could have done that I am not so sure.”

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This was not the time for the FOMC to design a regulatory apparatus, but the Greenspan Fed never did attempt to fill this gap. In retirement, Greenspan reminds his audiences that the Fed does not regulate hedge funds. True, but the Fed could have worked backward from the foundation that McDonough had suggested. (The SEC is responsible for monitoring broker-dealers. It, too, has failed miserably.) The need for adult supervision of banks was obvious when a staffer commented on the conference call, “It is something of a signature for [LTCM] to insist that if a counterparty wanted to deal with them, there would be no initial margin. Not many other firms have gotten away with that.” For this reason alone, the Fed should have geared up its watchdogs to better monitor the suicidal banking system it regulated.

Another staff member enlightened the FOMC with a frightful prospect: “The counterparties…get comfortable with zero percent margin. But from the [financial] system’s point of view, zero initial margin permits an essentially unlimited amount of leverage. There is no constraint other than the exhaustion on the part of the counterparties.” Greenspan and Bernanke fiddled with their slide rules as financial derivatives grew to 10 times the world’s GDP. In 2007, Bernanke should have known that banks, in a desperate attempt keep dancing, were borrowing at five percent to lend at four percent.

And these are only the reported job losses, and I’ve even seen estimates as high as 400,000 jobs lost!

And people with houses to sell are not going to be too happy, either, as Bill Bonner here at The Daily Reckoning reports, “So far, U.S. homeowners have lost probably about 12% of the wealth they thought they had in their houses. The total capital value of the residential housing market is about $20 trillion. So, a 12% loss is equal to about $2.4 trillion.”

Apparently, Mr. Bonner recognizes the look of horror on my face and the way I am gasping for breath at the prospect of a country with a GDP of $15 trillion losing $2.4 trillion in wealth. To make me feel better, perhaps, he added, “A few foreign housing markets have been hit harder – Ireland, Spain and Iceland, for example.” Yikes!

Back here in America, the National Association of REALTORS reports, “the median price of an existing single-family home dropped 8.7 percent in February from a year earlier, the most in four decades of record keeping.”

And it is not just first mortgages that are in trouble, as Ed Steer of GATA sent the International Herald Tribune article “U.S. Equity Loans Are Next Round In Credit Crisis”, which contains the chilling statistic “Americans owe a staggering $1.1 trillion on home equity loans – and banks are increasingly worried they may not get some of that money back.”

And they should worry, as, “In December, 5.7 percent of home equity lines of credit were delinquent or in default, up from 4.5 percent in 2006, according to Moody’s Economy.com”, and “In places like California, Nevada, Arizona and Florida, where home prices have fallen significantly, second-lien holders can be left with little or nothing once first mortgages are paid.”

To make sure that they get their money back, “many lenders are taking the extraordinary step of preventing some people from selling their homes or refinancing their mortgages unless they pay off all or part of their home equity loans first.” What makes this all the more worrisome is that “In the past, when home prices were not falling, lenders did not resort to these measures.” Cue ominous soundtrack, with wolves howling and banshees wailing.

And it won’t be happy for those guys holding stocks of the S&P500, as that index had earnings sliding again, this time to $66.18. In case you were wondering, less than 6 months ago, the earnings of the S&P500 were almost $86.00! It’s amazing that the stock market HASN’T collapsed in the face of an earnings slowdown of 23%!! Earnings are slashed by almost a quarter, but the underlying stocks haven’t sold off, but actually seem to rise? Wow!

This amazing phenomenon proves either that the government’s Plunge Protection Team exists and is massively operating to intervene in the markets, or that people are truly idiots. Or maybe delightful little fairies guard our dreams and protect us in life! Something.

Either way, the earnings yield of the S&P500 is a miniscule 4.83%, which is the lowest since sometime in ’04. Nice “growth” there, dudes!

And it won’t be happy for many shareholders at all, as Jack Willoughby in Barron’s reports, “The average U.S. diversified stock fund lost 10.11% in the opening quarter, slightly more than the Standard and Poor’s 500 index’s drop of 9.44% over the same span.”

It also looks like all the other stock funds, (big cap, low cap, high growth, blue chip) had losses, too, ranging 7% to 15% in the first quarter, with the exception of everybody’s favorite, the gold funds, which gained 5.22%, and some short funds that were up 11.93%.

And the news is not any better in bonds, and Ty Andros of TraderView.com has been looking at the gigantic bubble in bonds. He says that bond prices “have been this high, and rates this low, ONLY one other time in over 50 years, and that was the 2nd quarter 2003.”

Wow! 50 years! Then, since he knows what a drudge I am about inflation, innocently asks, “How about purchasing power? Let’s use the rule of 72 to figure out what type of purchasing power losses these holders are about to face. 72 divided by inflation of (I will be kind) 9 percent.”

The results are that, “In the case of the 10-year note, it will lose half its value over the next 8 years, and in terms of the 5-year, a 31% loss of purchasing power will be seen between now and redemption time.” My God! These are staggering losses, considering the sheer tonnage of bonds that are already extant in the freaking world!

And why will bond investors face purchasing power losses? Easy! Mr. Andros says, “MZM (money with zero maturity) is expanding at 30 percent, and reconstructed M3 is running at over a 17% growth rate.” I am stunned! In short, the Federal Reserve is creating money seemingly as fast as it possibly can, which devalues all the existing currency by just that little bit more!

On the other hand, he says, “As long as they create fiat currency and credit as they are, stocks can NEVER be expected to decline for long. They will just rise to reflect their re-pricing in the currency in which they are denominated (currencies don’t float they just decline at different rates) with nominal gains to reflect the loss of purchasing power, not to be confused with REAL gains as measured in gold.”

And to prove it, look at Zimbabwe, where a single cigarette now costs over Zim$750,000; their stock market shows the biggest gains of all the stock markets in the world!

Too bad the entire capitalization of the Zimbabwe stock market is roughly equal to a used Chevrolet with bald tires! Ugh.

Until next week,

The Mogambo Guru
for The Daily Reckoning

The Mogambo Sez: If I was ever a bull on gold, silver and oil, I was but a novice, as I am much, much more so now.

And so should you be.

Editor’s Note: Richard Daughty is general partner and COO for Smith Consultant Group, serving the financial and medical communities, and the editor of The Mogambo Guru economic newsletter – an avocational exercise to heap disrespect on those who desperately deserve it.

The Mogambo Guru is quoted frequently in Barron’s , The Daily Reckoning and other fine publications. Click here to visit the Mogambo archive page .

Now, at the age of 77 Soros is making the rounds to promote his new book, “The New Paradigm for Financial Markets,” which goes on sale next month. And while he travels the media circuit he’s taking the opportunity to speak his mind on the country’s current financial crisis, which Soros considers the “biggest financial crisis” of his lifetime. Last week, he echoed the International Monetary Fund’s estimate of more than $1 trillion in losses linked to the collapse of mortgage-backed securities. However, Soros pointed out that losses so far disclosed by financial institutions are related only to the decline in value of those financial instruments.

“I think it’s a pretty accurate estimate of the loan losses,” Soros said during a conference call with reporters. “But we have not yet seen the full effect of possible recession. It only relates to the decline in the value of the various financial instruments which are held by the banks and other institutions.”

They don’t “in any way reflect possible decline in the quality of loans that they hold. These are the eventual losses yet to be seen,” he added.

Almost 50 of the world’s biggest banks have recorded a combined $232 billion in asset write-downs and credit losses since the beginning of 2007, according to Bloomberg data.

Soros described the $45 trillion market in credit swaps – which gives investors the opportunity to place bets on the likelihood that companies will default on bond payments – as the “Sword of Damocles.”

“This $45 trillion market is unregulated,” he said. “That’s more than five times the entire government bond market of the United States. It’s almost equal to the entire household wealth of the United States.”

As far as accountability is concerned, Soros blames regulators and the current U.S. administration, which he says “failed to perform their job.”

“This is a man-made crisis and it’s made by this false belief that markets correct their own excesses,” he said. “It will take much longer for the full effect of the decline in the housing market to be felt.”

He continued: “I think the situation is more serious than the authorities admit or recognize. They claim that there will be a pickup in the second half of the year. I cannot believe that.”

The IMF reports that falling home prices and rising delinquencies could mean another $565 billion in mortgage-market losses. If you toss in the losses from subprime trades that Wall Street sucked up willy nilly, the final tally runs to $945 billion.

It was the addition of smoke-and-mirror housing gains into U.S. stocks that pulled the Dow out of the doldrums and pushed U.S. blue chips to new highs in 2006 and 2007.

The loss of those gains is now breaking the collective back of U.S. Banks. The group as a whole has shed 30% over the past few months. A few leading lights, like Citigroup (C: NYSE) have nearly doubled that loss.

Thanks to the broken banks, you can expect the Dow to double its losses too — at minimum — over the next few months.

Adam Lass
Senior Editor, WaveStrength Options Weekly