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All the Way Down the Rabbit Hole?

Dear Diary,

This is the Fake Ben Bernanke writing. I've started a journal to express in private what I could never express in public, namely that the dollar and stock market are at real risk and the policy of lower interest rates might be misguided.

How far does this crisis go? The more I study the issue, the more I'm convinced we're going down - all the way down the rabbit hole. Why? Thanks to Alan Greenspan and Ben Bernanke (me, or is it?), we have just experienced one of the largest, fastest creations of excess credit in history.

That is something that hasn't happened since the 1920s.

Now the credit/asset bubble is bursting. Assets (houses, stocks, etc.) are coming down to more reasonable values relative to output and labor, but they still have a long way to fall.

The unfortunate aspect is that the debt associated with the declining assets remains. The asset prices had no fundamental reason to go up in the first place, other than cheap and available debt from the Fed (look how single family vacant housing numbers were always rising during the boom).

"The system has one chunk in it," said Michael Fascitelli, president of Vornado Realty Trust. "When you're constipated, you're not very hungry are you. Nothing goes in until something comes out. The Wall Street firms will not resume lending at the pace they did until they've cleared that big load."

The marketing side of my brain disagrees with Mr. Fascitelli's decision to use such an analogy. The intellectual side of my brain disagrees that one "chunk" is the problem. The "chunk" is in fact the entire financial system and the way in which the Fed operates.

The Fed operates by lowering interest rates and encouraging more debt assumption WHENEVER there is the slightest hint of an economic recession. It seems as if the Fed only believes in free markets when they are going up. When markets are going down, and threatening to bankrupt inefficient businesses and engage in the creative destruction, the Fed and government step in, with lower rates, mortgage freezes, tax breaks, and more.

As a result, the system becomes more and more burdened by debt. At a certain point, assets are priced too high relative to output and labor, and debt is too great relative to GDP. The only way to solve the situation is via lower asset prices and higher labor prices - in other words a combination of a recession and inflation. Contrary to current Fed thinking, under the situation they have created, BOTH a recession and inflation is the likely simultaneous outcome. Or as Mervyn King, Bank of England Governor said recently, "The Committee's current judgment is that the most likely outcome is for output growth to slow and inflation to rise, at least for a period."

To give you an idea of the size of the crisis, Robert Shiller, Yale economist and index co-founder, believes the housing cycle is very important to the business cycle. Most economic recessions are preceded by housing declines and residential construction is an important leading indicator for the economy. Shiller believes the current situation is unprecedented: there's never had been a housing boom quite like the one that ended last year.

Another example is Credit Default Swaps (CDSs). There were $28.8 trillion in CDSs outstanding as of December 2006 (according to the Bank for International Settlements). Any issues with CDSs would make the subprime crisis look like a gnat next to an elephant. That $28.8 trillion is up 107% from the previous year. Does that kind of growth indicate a credit bubble?

CDSs are essentially insurance of whether a bond/company (let's call it GM for simplicity's sake) will default on its payments. The CDSs are swaps that banks and hedge funds trade with each other. One party pays for this insurance with cash payments. The counterparty issues an insurance-like policy that pays out if (in our example) GM defaults. The counterparty must post collateral to prove it can pay this policy in the event of default. As the price of a CDS changes, more collateral may be needed (the collateral requirements are marked to market).

Most bankers I have spoken with feel this mark to market aspect means there is little risk in CDSs. I agree in principle when it comes to one contract, but I disagree in total because all the CDSs added up create massive systemic risk. Here is why:

If a recession hits and the number of defaults skyrockets, CDSs will skyrocket in price, forcing counterparties throughout the banking system to post more and more collateral SIMULTANEOUSLY. To come up with the collateral, the counterparties will need to sell other assets quickly. The more assets they sell, the more the market will go down. The effects of the sell-off and recession will become more severe, forcing more defaults, and making it such that the counterparties have to post even more collateral. In the end, any bank or hedge fund that has issued too many CDSs will be unable to come up with enough collateral and will themselves default. The original buyer of the insurance will find that their insurance company cannot pay up, so they too will incur losses from the underlying bonds they hold (which have defaulted). As Warren Buffett wrote in 2006: "Unless derivatives contracts are collateralized or guaranteed, their ultimate value also depends on the creditworthiness of the counterparties to them. In the meantime, though, before a contract is settled, the counterparties record profits and losses -often huge in amount- in their current earnings statements without so much as a penny changing hands."

And what are the chances of a recession? According to the futures markets, it is now just under 50%. A friend at a big bank who creates an index of high-yield bonds says his index's pricing indicates that the market expects 40% of his companies to default. Pimco's Bill Gross claims that "we haven't faced a downturn like this since the Depression...It does keep me up at night."

That said, I'm sleeping well at night. I know we're going to lower rates a lot! We are not paying attention to the falling dollar, the price of oil, and the price of gold. More important to us is the health of the banking system. If we have to sacrifice either the dollar or the banking system, it will be the dollar. As Richard Fisher, Federal Reserve Bank of Dallas President, said on November 29th, "we have to be very mindful of the fact that in order for capitalism...to continue to function, we have to have a healthy working financial market."

It's hard to bet against the markets, with Bernanke and friends willing to sacrifice the dollar. That's why I continue to buy gold.


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