A Very Beary Future

Undoubtedly you have heard about Bear Stearns blowing up Friday morning.

If you haven't, you've been living in a cave.

If you remember way back when I was talking about how this mess would not be over until we had a major Investment Bank either fail or be forcibly absorbed.

I never thought it would happen this quickly!

And no, this doesn't mean we're done with the mess - not even close.

The danger has been foretold the last couple of months as Treasury Auctions have gone very poorly. Thursday marked the second time in a row that bonds were auctioned and the bid-to-cover (the amount of interest) was abnormally low, with "indirect bidders" (that includes foreign governments) wanting basically none of it.

This is ominous in its implications, as the "prime dealers" have had to take most of the supply down. They are structurally short these bonds and earning basically jack and nothing, but of course they can go to the discount window (or TAF) and borrow against those bonds, although the carry isn't there for them right now.

Ben Bernanke has a "playbook" for avoiding deflationary credit collapses (read: Depressions) and he's running it. He has, unfortunately, forgotten that The United States is not the only place that foreign nations and governments can invest, that those foreigners have been given an awful lot of our money (as we have "consumed" like good little packrats) and now we need those very same governments to recycle their dollars into our treasury markets to keep real interest rates acceptably low while our government continues to spend like a drunken sailor buying votes, with the latest budget being in the hole by some $400 billion dollars.

The issue we are about to run into head-first should be obvious.

A precipitously falling currency results from a loss of confidence in a nation's monetary and fiscal policies - nothing more or less. Ben Bernanke's famous speech literally threatening to devalue the currency to any degree he sees fit is a major part of the problem. It doesn't matter whether he actually is doing it or not; what matters is whether folks believe he will.

They do.

How bad is this confidence problem?

The key item is here:

"The immediate capital infusion isn't likely to restore enough confidence in Bear to stop the exodus. Robert Sloan, a managing partner of New York-based S3 Partners LLC, a financing specialist for hedge funds, said that two of them on Friday pulled whatever money of theirs still remained in Bear's prime-brokerage operation. "Once Bear started to come out with: 'Hey, this is why we're OK, this is why we're still liquid and you should keep your assets here,' they were basically telling you to move your business," Mr. Sloan said."

Indeed.

Now how many other corners of the investment world does this infest?

Answer: ALL OF THEM

Here's the bottom line folks - right now the preservation of capital dwarfs everything else. There are precious few places you can hide with near-absolute safety; among them are:

• Treasury Direct (buy 4, 13 and 26 week T-Bills directly, in your name, from the US Government.)
• Vanguard's VMPXX Treasury money-market fund (invests only in Treasury securities)
• Fidelity's FDLXX (Ditto, but run by Fidelity)
• A bank account (up to $100,000, except in rare instances - and be careful trying to "engineer" around the $100,000 FDIC limit!)

Note that none of these are run by major investment banks or have any tie to them.

There are many people out this weekend calling Bear Stearns' near-collapse "a sign of a bottom."

Don't you believe it for a second.

Today's stock market prices reflect earnings estimates that are radically too rosy; they have absolutely not priced in a recession. While many market callers are claiming that "earnings will be fine" and "the market is cheap" the truth is that they are using earnings estimates that assume that consumers will (can) continue to spend as they did in the years of 2003-2007, extracting home equity and using it to fuel consumption.

This, as I have written since April of last year, is clearly not the case. Further, deterioration in other areas of debt performance, including Home Equity lines of credit, credit cards and auto loans, is just beginning to be recognized.

As spending contracts so will estimates - and stock prices.

Now let's talk about the "supply pressure" problem.

As I wrote yesterday the government claimed that there was no price inflation last month.

Uh huh. Tell that to my Diesel Jetta, which now costs over $50 to fill - for the first time. This doesn't affect me greatly, since the car gets 50 miles to the gallon, but think about the truckers that bring your food - and everything else - to the store.

Their fuel costs have skyrocketed by more than 30% over the last few months. Diesel was under $3/gallon as recently as last October, and in the $3.25 area as recently as the start of February. Look at this graph:

Any questions?

This is what our policymakers cause when they provoke loss of confidence. Notice that the price was quite stable up until last fall, when it began a precipitous rise northward. When did Ben Bernanke start fiddling and claiming that he needed to "inject liquidity" by the truckfull instead of performing his legitimate regulatory function?

The price of oil is not just a function of our current dollar value, it is also a function of the expected future value, because the money you get from selling us a tanker-full of oil isn't all spent in a day - it is spent over several years' time!

And for those who question whether Ben has an actual hand in this, let me quote from The Federal Reserve's own web page:

".....supervising and regulating banking institutions to ensure the safety and soundness of the nation's banking and financial system and to protect the credit rights of consumers "

Really?

Does that include allowing their "regulated" banks to lend money to clients who are levered up 32:1 or more, as Carlyle was, along with other similar funds who have unknown and unknowable amounts of credit derivative risk?

Does it include providing loans against Fannie and Freddie securities, as announced Tuesday, when those GSEs have balance sheet gearing of some two hundred to one against their book, with an equity position of some forty basis points (0.4%) compared to their allegedly "AAA" securities, many of which are contaminated by manifestly-unsafe mortgages?

Does it include near-absolute secrecy via the TAF, so that investors cannot tell who is solvent and who is not, and we find out who has problems the same way that investors in Bear Stearns did - with their CEO on national television just two days before they blew up saying that everything is perfectly fine?

Ben Bernanke thinks he can "control interest rates" and thereby assuage what is wrong with our economy. He cannot, because the problem was that he, along with his predecessor Alan Greenspan, sat by and refused to perform their regulatory function while these institutions and their customers engaged in manifestly unsound and unsustainable behavior.

We face the worst credit environment in 100 years not because of external events but because our own government and its agencies, including but not limited to Congress, The President himself, bank overseers such as OCC and OTS and The Federal Reserve have stuck their heads in the sand and allowed firms to operate with no mark-to-market, no clean balance sheets and no supervision! Instead, every financial "crisis" is met with more liquidity, which is precisely the same thing as giving a drunk who starts to have DTs another bottle of whiskey!

Unfortunately The Drunk (that's us and our insane idea, both privately and in the government, that we can spend beyond our means of production indefinitely) is now having a SEVERE case of DTs.

Ben's "solution" is not another bottle of whiskey but a whole new barrel!

This weekend we learned that Canada has joined the party, as 20 of their Assset-Backed Commercial Paper trusts have now blown up and will seek bankruptcy protection.

The orgy of cheap credit was NOT limited to the United States and neither will the consequences of its implosion be.

There will be more "sticksaves" and "interventions." Count on it. Count on them coming as soon as Monday. If you are a "Bearish" trader you are faced with the most volatile markets we have seen since the 2000-2003 recession, and this is very likely to be far worse in terms of its impact economically, as the credit orgy that prevented the 2000-03 recession from running its course is much larger than the previous one was.

Don't think for a minute that our government can engineer another credit orgy. All the good collateral has been pledged; houses are encumbered, commercial real estate is encumbered, and all the good securities are too.

It is time for us to face the music.

I am updating expectations for this Bear Market; I no longer believe 1070 on the SPX will hold, and have now moved to the camp that sees the potential for the S&P to retrace all of the 2003-2007 Bull Market's gains, taking us back to around 800 on the SPX.

I also believe that this economic downturn will be called "over" later in the year yet prove in 2009 to be far worse than originally expected, with the potential for an outright depression ensuing in the 2009-2010 timeframe. If we elect a Democratic President, and I believe we are nearly certain to do so, the odds of this go from 30% to 75% overnight as the Democrats are guaranteed to spend even more in a clear vote-buying attempt, just as George Bush and Congress are doing now with their $150 billion "stimulus" package.

Many Boomers had their retirement portfolios utterly destroyed in the 2000-2003 bear market, and have just recently gotten back on their feet. If you are one of them and haven't protected yourself, please do so now.

The reality of the situation is best summed up by this article from The Wall Street Journal:

"The U.S. is at the receiving end of a massive margin call: Across the economy, wary lenders are demanding that borrowers put up more collateral or sell assets to reduce debts.

The unfolding financial crisis -- one that began with bad bets on securities backed by subprime mortgages, then sparked a tightening of credit between big banks -- appears to be broadening further. For years, the U.S. economy has been borrowing from cash-rich lenders from Asia to the Middle East. American firms and households have enjoyed readily available credit at easy terms, even for risky bets. No longer."

Yes, this includes you, Mr. and Ms. American Consumer, and if you're unable, you will be forced into bankruptcy.

You've been warned.

Want to act instead?

Sign the petition at http://financialpetition.org that references the letter I have recently faxed to The President and various members of Congress at http://www.denninger.net/letters/open-letter.pdf.

Or, if you'd like, create your own letter, or make a phone call or three to Congress and The President.

The contraction in home prices among other forms of financial "leverage" will continue until balance has been restored. We are far better served to take our medicine now and admit who is and who is not bankrupt than to continue to try to hide the damage from both the public and investors.

The choice is ours - we either act now or the market will do it for us, and the latter will be far more painful and prolonged than if we self-administer an honest look at our financial condition - both individually and as a nation.

What you saw Friday with Bear Stearns is just the latest - and strongest - warning about what we face if we do not "take our medicine" now.