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March 11, 2008

Overdosed!
by Alex Wallenwein

Requiem for a Departing Economic System

Continued US Fed liquidity injections like the Fed's previous "Term Auction Facility" (TAF) and today's novel "Term Securities Lending Facility" (TSLF) will only serve to overdose the economy with exactly what ails it: too much credit. This will further boost the price of everything - and in particular, of gold and silver.

The following headline and byline appeared this morning, March 11. 2008, on MarketWatch.com:

"Fed's Latest Fix Does the Trick - Wall Street applauds as Fed intercedes, not with fresh rate cut but with a further push to inject funds into the economy."

The headline was more appropriate than the author probably realizes, at least the part abou the "fix" - but the byline should have said "Addict applauds as pusher intercedes, not with a potential cure but with a further push to inject heroin into his drug-addled veins."

It's getting kind of old to keep pointing these things out.

Those who frequently read this series of Euro vs. Dollar articles already know and understand. Those who need to know don't want to know and don't want to understand - at least thus far.

The question becomes: what is the latter group's pain threshold?

How much economic, financial, professional, and personal pain can these people endure before they may question the thus far unquestioned paradigm that credit (i.e., debt in sheep's clothing) is "good"?

Of course, the Fed's potential courses of action are limited by definition. It cannot prescribe an appropriate cure for the system because it is by nature a drug pusher, not a medical doctor. From the Fed's point of view, its action is entirely logical and consistent with its very reason for being.

The problem lies not with the Fed, but with us. It lies with you, with me, and with all investors, businessmen, professionals, and laborers who act and interact within our gloal economic system.

We have been taught from birth to regard the Fed and its equivalent in other countries as physicians, and to look to these doctors of doom for the cure for our economic ills. In our view, the central bankers are the much-revered and respected men in white coats, while those who try to point out their true "profession" are written off as maligning malcontents.

It's time for an attitude adjustment - and we are currently living it.

The poetic irony is that this attitude adjustment is being delivered to us by the very system we have helped to create and maintain. Drug addicts are never forced into chemical dependency. They always agree. It is their own decision that surrenders them to the poison of their choice.

Alright, enough with the allegorical stuff, already. What does it all mean?

At rock-bottom, the net effect of all this is summarized and highlighted by this quote from the very article quoted above: "Consumers [are] 'paying $300 million a day more for gasoline, heating oil and diesel'."

There you have it! Proof positive that the Austrians are right and Keynesians will soon find themselves being used to wipe the multi-layered floors of the global economic edifice.

At crude oil prices near $110 a barrel, $300 million a day more for hydrocarbon energy is the price we all pay for endless monetary inflation which, as predicted for years, is now resulting in massive, across the floor, price-inflation.

How the "Injection" Works:

"Primary dealers" of US treasuries, the first-line beneficiaries of this latest federal credit-dope handout, are basically the nation's largest banks and financial houses. Under this latest Fed bailout package, they get to "swap" their toxic asset-backed securities (another word for subslime-infected paper assets like CDOs, etc.) for crisp, clean US treasuries for a limited term of 28 days.

This works much like the previous two TAF (term auction facilities) injections, except this time it's US treasuries that form the basis of the injection, not outright fiat dollars.

In other words, the Fed is simply buying up all of the deadly toxic subprime mortgages that are so risky because they are so default prone. Not only that, but it is also buying along with these mortgages the debt securities they were previously used to "back up".

This time, however, it is not buying the toxic slime with freshly created electronic dollars, but with US government debt paper (treasuries) which it has previously acquired in exchange for freshly created electronic dollars.

Remember that mortgages represent rights to future cash flow. They were used to "collateralise" (i.e., back up) other debt instruments like short-term corporate debt papers called "commercial paper." This commercial paper is how the biggest corporations, including the biggest banks, finance their day-to-day operations. When these less creditworthy borrowers started bailing on their repayment obligations en masse, the entire structure began to crumble.

Picture the world trade center coming down, and you have an idea of the ultimate effect of these financial machinations.

Back to the "injection."

It is supposed to work by giving those big corporations who have bought into these subslime-backed debt obligations a way to collateralize future short-term loans (i.e., commercial paper) with something that is very liquid and that can be easily traded - namely, US treasuries instead of those nasty mortgages that nobody trusts anymore.

Now, these treasuries are actually IOUs given to the Fed by Congress to return the Fed's favor of financing Congress' profligate spending habits. They are how Congress makes the Fed's hard labor of pushing buttons to create money out of thin air all worthwhile. Keep that in mind as you read on, because it becomes important to realize this a little further down.

This swap of slime for US debt is all supposed to work like unclogging a clogged drain by injecting massive amounts of water under pressure to blow out the nasty solid stuff that keeps water from flowing through.

The banks' lines of credit and interbank lending pipelines are clogged up with subslime-solids that no longer move through the system because everyone is scared of them. This barter-injection of treasuries is supposed to replace recalcitrant, non-moving subslime with easily tradeable treasuries, giving the banks a chance to unclog their nasal passages.

The problem is that, this way, the Fed ends up with all of the nasty stuff. During the previous TAF injections it has changed its role from lender of last resort to buyer of last resort. Now, with this newly hatched plan, it has become the barterer of last resort, in effect acquiring all of the poison that it has previously caused to exist in the financial system.

How did it cause the poison to exist?

By lowering interest rates far too much for far too long, causing an unprecedented home-lending and buying boom. The lending boom led to the buying boom, which jacked up home prices beyond anything otherwise feasible, which in turn invited speculators who bought properties on near 100 percent margin, hoping to "flip" them at a higher price. Because that was so easy and so cheap, lots of people did it, driving up ome prices until the inescapable tipping point came.

That home price increase tempted mortgage lenders to go and loan (i.e., create) fiat-units to just about anybody under any conditions. The mortgages were repackaged and sold to banks and hedge funds as "asset-backing" (they represent cash flow, remember?) for other, more exotic, securities and for commercial paper.

The Drug-Pusher's Business Model

A dope pusher creates his "market" by getting as many people as possible hooked on his "product". The Fed does the same. Its product is debt, sold to unsuspecting customers under the misleading name of "credit". The Fed's market consists of borrowers large and small, individual and cirproate. Lower the rates, and more borrowers come, just like a drug pusher gives product away for free at first until they have to come back for more.

Ironically, because of the very low interest rates (i.e., cost of money), investing became somewhat of a challenge because low interest rates limit returns on money invested. That created a tremendous hunger for higher returns.

Hungry for Risk

The only way you can increase your returns in a low-interest environment is by climbing up the risk ladder. The old investment maxim goes: "the higher the risk, the higher the returns." Everybody understood that, and everybody accepted it. So far, so good.

What tripped the entire system up, however, is the "ingenuity" of the very professionals who are running the system, those who are smart (i.e., educated or trained) enough to understand it and to maneuver within it (i.e., who know how to manipulate the system to their personal or corporate advantage).

The result? Hyper-complex and super-complicated interest rate or credit derivatives, which are essentially contracts that traded over the counter without any supervision or control. These contracts were intended to limit risk by spreading it.

Well, they sure did a great job at spreading the risk. They have spread it to the far reaches of the globe, and that's precisely why the US-generated subprime mortgage mess has hit every major investment market around the world, except Asia.

What a successful drug pusher the Fed is!

Just like gang-bangers in the ghettos of the world bow down to the drug kingpin who rides by in his limousine, so does the world of investing and finance bow down to the US Fed.

The Effect on Real Money - Gold and Silver

It is easy to gauge the effectiveness of the Fed's sleight of hand by looking at the price of gold and silver. Has it slammed the metals' fiat-prices down hard? So far, no.

The metals climbed in overseas trading before the Fed announcement this morning, and afterwards merely fell back to where they began their climb. No big deal, really. Even if there will be further declines, the metals will surely rebound and continue their march through the $1000 level within days.

In fact, the price movements of precious metals will soon answer the biggest question of all that is being posed by this latest Fed move: What happens when the term of the Fed loan of treasuries expires?

As stated above, these TAF and treasuries-on-loan liquidity injections are supposedly temporary. They are limited to 28 days. What happens then?

Do the big banks have to return the treasuries the Fed so kindly loaned to them? If so, will they get their toxic subprime sludge back at that time? Or will the loans be rolled over indefinitely, only requiring principal and interest payments to be made by the banks who received them? If that is so, what happens if they threaten to default, a la Thornburg and the Carlyle Group subsidiary that almost folded last week?

Now, that's easy, duh! Another Fed injection will be made, of course, to ease their best customers' withdrawal pains.

Bartering "Prime for Slime"

But this time, and from now on, the Fed will no longer create new money to inject into the system. It will barter "prime for slime" instead: "prime" US treasury debt for "slime" subprime mortgage debt. How does it work? This is new territory for the Fed and for financial markets, so let's think it through together.

Congress gave the treasuries in question to the Fed as IOUs and as collateral for the fiat-dollars the Fed created to loan to Congress. Under the terms of these IOUs, Congress has to pay the fiat back with interest (for which Congress taxes the citizens). But now, after the Fed barters these congressional IOUs away in trade for impossible-to-sell subslime-mortgage assets, it's the banks who get to hold the treasury IOUs under an agreement with the Fed. By that agreement, they are obligated to return them later.

Does that really improve the banks position at all?

Yes, it does - to a point.

The banks are not allowed to sell or otherwise dispose of the treasuries thus obtained. They only get to hold them in their balance sheets, but that, to them, makes all the difference - supposedly at least.

What the banks hold in their balance sheets determines whether they get the kind of credit they need to finance their daily operations. Their problem is that they currently cannot finance their operations, except at a very high cost. The reason: The subslime slush on their balance sheets scares other banks away from loaning them money. The other banks (potential creditor banks) are afraid that the slime that collateralizes the debtor-banks' loans will one day completely collapse and leave them with no recourse should the debtor bank run into trouble in paying the loans back or making their interest payments on time.

So here comes the big question:

What good is all of that if the treasuries must be returned after 28 days?

Are creditor banks so stupid as to believe that a 28-day "prime for slime" swap of this nature really and truly improves the debtor-bank's balance sheet so that loaning the debtor-bank money is now justified?

Probably not.

For that reason it is safe to assume (or reasonable to speculate) that the Fed's real intention is to roll these loans over indefinitely - until the subslime mess has somehow "worked itself out."

But how? Exactly how can this mess "somehow" work itself out? The uncomfortable answer is that, in all likelihood, it cannot.

If it can, nobody can really point out exactly how, so Murphy's law dictates that we assume it cannot be worked out. As a result, the Fed "eats up" all of the slime the mortgage lenders produced and hopes that the economy will somehow right itself and work it all out.

Divine Justice?

There is a hint of divine justice in all of this. As shown above, the Fed is ultimately responsible to for the subprime mess, and now it sees itself forced to literally eat its own crap. (Bon apetit!) On top of that, the Fed no longer gets the direct benefit of the government's debt payments on the IOUs it has acquired by electronically creating new money for Congress.

One thing is for sure: This latest move smacks of utter desperation on the Fed's part. It is forced to give away that which gives it power over our Congress: the power to collect on the IOUs Congress gave the Fed. A good part of that power will soon reside in the banks that get the benefit of this latest ploy.

So what happens if these banks go under, anyway?

As we have seen, they very badly need to be able to lend to each other at low interest and with maximum confidence. Otherwise, their profit margins are shot and they can't make enough money by enslaving citizens anymore. Poor banks.

In that case, Bernie gets to recoup his treasuries on behalf of the Fed, of course, and gets to substitute the banks original subslime back onto their then already pulverized balance sheets.

End result: the Fed gets its power over Congress back, but the top banks it tried to rescue are dead. Operation successful, patient deceased.

Boy, I would hate to be in Bernie's shoes.

It is Still A "Bailout?"

Since no money is handed out to the banks, can this new TSLF ploy still be considered a bailout? Short answer: yes.

It is still a bailout because, even though no cash changes hands from the Fed to the banks, the "handout" here lies in the fictitious valuation of the subslime mess the Fed will now have to take onto its own balance sheet.

In essence, the Fed is swapping something of near ultimate value (at least in the twisted world of fiat-paper and debt-addicts) for something of at best questionable to zero value. In the process, it is simply making all value judgments regarding the subslime substance up out of thin air. In order to give the banks any "prime" (treasuries) at all, it has to artificially assign a value to the "slime" that no one else is willing to assign to it.

Therein lies the handout.

The upshot and the height of irony of it all is that, this time, the Fed actually gives something up that it owns in this lending arrangement, instead of just making up money out of nothing.

What new and uncomfortable territory this must be for Bernie. For all of his life as a Fed banker, he was able to give essentially nothing (or make what he gave up out of nothing) and receive actual value for it. Now, for the first time in the Fed's post-1971 history, it not only has to give up something of real value (treasuries), but it must give it up in return for something else that has little to zero value, namely: subslime mortgages. Hilarious!

For the Fed, that's not much fun, if you think about it - and it betrays the degree of its desperation that we alluded to earlier.

For the Fed to be willing to do this, they must know something we mortals are not allowed to learn lest a panic should ensue.

In other words, we're screwed, my dear Watson!

In less vernacular terms, this means if the Fed's gambit goes well, we get hyperinflation because (1) the demise of the oil dollar system as a result of the euro's creation and launch guarantees a flood of money coming back to the US, and (2) because continued, successive liquidity injections of this or a similar sort will be required to keep the whole thing afloat as the dollar crashes.

If the gambit goes south, we will suffer from hyper-deflation as the entire credit system collapses of its own weight while the banks implode, one by one.

The only way for regular people to counter all of this is for them to be able to answer the next question in the affirmative:

Got gold?

Alex Wallenwein
Editor, Publisher
The Euro vs Dollar Monitor

Just like driving your car, investing only makes sense if you can see where you are going. The Euro vs Dollar Monitor is your golden windshield wiper that removes the media's greasy film of financial misinformation from your investment outlook. Don't drive your investment vehicle without it!

Copyright © 2003-2008 Alex Wallenwein

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