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Web Log - August, 2007

Summary

Mysterious investor bets $900 million on crash by September 21

Several readers have notified me about this event that has Wall Street buzzing. One reader even suggested that I might be the mysterious investor! Very droll.

My first reaction on reading this story was that, whoever the investor is, he might have seen my web site or, more likely, performed the same computation that I did.

Related Articles

Macroeconomics
Understanding deflation: Why there's less money in the world today than a month ago.: As the markets continue to fall, the Fed is increasingly in a big bind.... (10-Sep-07)

Alan Greenspan predicts the panic and crash of 2007: He's said this kind of thing before, but this time it's resonating.... (08-Sep-07)

Bernanke's historic experiment takes center stage: An assessment of where we are and where we're going.... (27-Aug-07)
How to compute the "real value" of the stock market. : And some additional speculations about stock market crashes. (20-Aug-2007)

Ben Bernanke's Great Historic Experiment: Bernanke doesn't believe that bubbles exist. His Fed policy will now test his core beliefs.... (18-Aug-07)

Redemptions of money market funds now fully in doubt: Wednesday is the deadline for 3Q redemption of many hedge fund shares.... (15-Aug-07)

Alan Greenspan defends his Fed policies, as people blame him for the subprime crisis: Greenspan never ceases to amaze, and he did so again on Monday.... (8-Aug-07)

Nouriel Roubini says: "Worry about systemic risk." Whoo hoo!: His arguments show what's wrong with mainstream macroeconomics.... (6-Aug-07)

Robert Shiller compares stock market to 1929: He says the recent fall was caused by "market psychology," but is puzzled why.... (20-Mar-07)

A conundrum: How increases in 'risk aversion' lead to higher stock prices: Maybe because the global financial markets are increasingly "accident-prone."... (12-Mar-07)

Pundits are suddenly talking about (gasp!) "risk aversion": Fearing full-scale panic in the mortgage loan marketplace,... (6-Mar-07)

Alan Greenspan blames the housing bubble on the fall of the Berlin Wall: Meanwhile, the stock market keeps skyrocketing and appears unstoppable to many investors.... (25-Oct-06)
System Dynamics and the Failure of Macroeconomics Theory : Mainstream macroeconomic theory, invented by Maynard Keynes in the 1930s, has failed to predict or explain anything that's happened since the bubble started, including the bubble itself. We need a new "Dynamic Macroeconomics" theory. (25-Oct-2006)

Alan Greenspan gives another harsh doom and gloom speech: Saying that "the consequences for the U.S. economy of doing nothing could be severe,"... (4-Dec-05)
Ben S. Bernanke: The man without agony : Bernanke and Greenspan are as different as night and day, despite what the pundits say. (29-Oct-2005)

Fed Chairman Alan Greenspan says that the deficit is out of control: France's Finance Minister Thierry Breton quoted Greenspan... (25-Sep-05)

Fed Governor Ben Bernanke blames America's sky-high public debt on other nations: I'm normally wary of applying specific generational archetypes to individuals, but Bernanke is acting like a Baby Boomer.... (14-Mar-05)

Greenspan's testimony further repudiates his earlier stock bubble reasoning: The Fed Chairman has now completely reversed his previous position on the stock market bubble... (17-Feb-05)
Alan Greenspan warns that global economic dangers are without historical precedent : In a speech on Friday, Greenspan buried a major change of position in a speech admitting that his assumptions about the economy for the last decade were wrong. (6-Feb-2005)

I arrived at the September 21 date by speculating that the stock market, following its peak on July 19, would follow the same path that it followed after its peak in 1929. This is purely speculative, but it's easy enough for other people to reach the same conclusion.

The news broke on August 21 that someone was making option bets that the S&P index would fall at least 35-40% by September 21. Since that time, speculation has been wild about what's going on. This mysterious person could lose $700-900 million if the market does not fall, but coul make about $2 billion if the market does fall far enough.

So we're talking about real money here. This isn't some flamboyant speculator who wants to impress his girlfriend. This is some major institution that's making a very serious and very huge bet.

There are a variety of explanations, ranging from relatively harmless to a sign of imminent war. Let's take a look at some of them:

One possibility is that it isn't one investor, but a collection of unrelated investors, all of whom share the belief that the market is due for a very big correction.

According to a web site reader: "There are both mutual funds and hedge funds with massive S&P500 exposure in the billions of dollars, if they want to protect themselves, they can sell an out of the money call, and use the money to buy an out of the money put. This insurance basically costs them nothing if the market remains somewhat flat, they get a little protection against a crash, at the expense of limited upside gains if the market climbs a lot. John Hussman of the Hussman Funds does this all the time (buying S&P500 puts as a hedge against his always net long holdings)." (Paragraph added 31-Aug)

It might be a big hedge fund caught in a liquidity crunch, needing money immediately, because their clients are trying to bail out. As I understand it, this could be someone selling "call options" now in order to get cash from market makers (the people who set these deals up), and who will have to pay quite a bit on September 21, when the options come due, if the market doesn't crash. In this scenario, the $900 million bet is actually a move of desperation.

It might be someone who believes that a market correction is due sometime this fall. If it hasn't happened by September 21, then the investor can "roll the options over" for another month or two. There are many people who believe that a big market correction is due, and so this is a reasonably rational thing to do.

It might be China, as part of a strategy either to regain some of hundreds of billions it's loaned to America, or in preparation for war.

It might be some large institution with inside knowledge about some imminent bad news that will move the market sharply down. One theory is the Osama bin Laden himself has placed the bet, expecting to make money from a planned terrorist attack on September 11.

More prosaically, it might be someone with inside knowledge of a major bankruptcy of a large corporation or financial institution. Because of the recent stock market volatility and increasing risk aversion of investors, the investor may be betting that such bad financial news will panic investors.

There's a lot of concern these days that the market is due for a major correction, mainly because it's been so long since the last major correction. Even among those who believe that these times are perfectly normal, there is an expectation of SOME kind of correction, since an occasional correction IS perfectly normal.

However, there really are a lot of people expecting a serious panic these days. One web site reader has just sent me his friend's graph comparing today's stock market with the 1987 stock market panic:

Comparison: 2007 versus Panic of 1987

Comparison: 2007 versus Panic of 1987

The Panic of 1987 was a false panic, since the market was underpriced at the time, so recovery was fairly rapid. (The market today is overpriced by a factor of about 250%, same as in 1929.)

Still, it was a panic, and the market that year followed a pattern similar to this year's pattern.

From the point of view of Generational Dynamics, the panic of 1987 was not a generational panic. If you go back through history, there are of course many small or regional recessions. But since the 1600s there have been only five major international financial crises: the 1637 Tulipomania bubble, the South Sea bubble of the 1710s-20s, the bankruptcy of the French monarchy in the 1789, the Panic of 1857, and the 1929 Wall Street crash. We're now overdue for the next one, and it might be close.

Addendum. For those interested in more details, the following is last night's options listings on http://finance.yahoo.com/q/op?s=SPY . The listing is for SPY, corresponding to the S&P 500. Notice the appearance of numerous twelve "10,000"s in the volume column. The mysterious investor has "bet" on almost every strike price from 60 to 95, which correspond to S&P 500 indexes of 600 to 950, respectively. These options are worthless unless the S&P 500 index, currently at 1460, falls into or below the 600-950 range by September 21. Also, a volume figure of 10,000 refers to 10,000 contracts of 100 shares each, or 1,000,000 shares. Since this was done for 12 different strike prices, the "bet" corresponds to 12,000,000 shares. (Paragraph added 31-Aug)

A portion of the SPY (S&P 500 SPDR) options listing for August 30, 2007. (Source: Yahoo)

A portion of the SPY (S&P 500 SPDR) options listing for August 30, 2007. (Source: Yahoo)

(31-Aug-07) Permanent Link
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Wall St. markets fall over 2% -- just because the Fed publishes some meeting minutes

Returning to anxious, panicky behavior for the first time in ten days, nervous investors drove the Dow down 280 points, or 2.1%. The Nasdaq fell 2.37%.

The market opened down slightly, fell sharply at 10:30 am when the "consumer confidence" numbers were released, and then fell even more sharply at 2 pm, when the Fed published the minutes of its August 7 policy meeting.

Consumer confidence figures fell sharply in August, after surging in July. (Source: Conference Board)

Consumer confidence figures fell sharply in August, after surging in July. (Source: Conference Board)

At 10 am, a survey firm known as The Conference Board released the results of its monthly survey measuring consumer confidence. It had surged in July, and now fell sharply in August.

The Consumer Confidence Index is really no more significant than pop psychology, but it was enough to frighten investors into driving down the market almost 100 points.

Then, at 2 pm, the Federal Reserve released the minutes of the August 7 meeting that determines future interest rate policy. Apparently it's the following paragraph that spooked investors:

"Readings on core inflation had improved modestly in recent months. However, a sustained moderation in inflation pressures had yet to be convincingly demonstrated. Moreover, the high level of resource utilization had the potential to sustain those pressures. The Committee's predominant policy concern remained the risk that inflation would fail to moderate as expected. Future policy adjustments would depend on the evolution of the outlook for both inflation and economic growth, as implied by incoming information."

In other words, the August 7 minutes (from three weeks ago) say that the Fed believes that inflation is likely to continue, which means that they don't intend to lower the Fed Funds Rate from 5.25%.

Investors and journalists had been hopin' and prayin' that the Fed would reduce interest rates. Recall that it was just about three weeks ago that CNBC's Jim Cramer became hysterical, ranting that the Fed had to reduce interest rates by a full point (to 4.25%) or millions of people would lose their homes.

So this was the second event that spooked investors on Tuesday. The market started falling rapidly, especially in the last hour of trading (3-4 pm), resulting in a total fall of Dow 280 points for the day.

When I wrote, on August 17, that "The nightmare is finally beginning," I explained that what was important was not the ups and downs in the stock market, but the attitudes and behaviors of large groups of people, in this case, large groups of investors.

Some kind of tipping point was passed on July 23, a day of high volatility that followed the July 19 stock market peak. Up to that point, bad news made the stock market contine to rise. Since then, bad news is causing the market to make sharp falls.

On that day, Ben Bernanke's Fed lowered the discount rate, a move that had very little real effect, and was mostly symbolic. Still, it seemed to relieve the anxiety and panic that investors were experiencing.

Tuesday was the first day since then that the anxiety seemed to be returning.

Because of this change in behavior, I believe that a major stock market panic and crash is coming in a matter of weeks. The only thing that can stop this from happening is a reversal of the recent change in behavior, so investors become giddy, giggly and bubbly again, as they were until July 19. I consider such a reversal to be almost impossible, and since the stock market is overvalued by a factor of about 250%, so when investors change from risk-seeking to risk-averse, a slide will continue.

We're conducting a little real-time experiment, comparing the 1929 and 2007 markets, following the respective market peaks. Let's bring the comparison up to date.

This data is taken from my Dow Jones historical page. On September 3, 1929, the market peaked at Dow 381.17. By November 15, it had fallen 40% to 228.73. This year (so far), the market peaked on July 19 at 14000.

This comparison is purely speculative, but here's an update of that table:

    1929   % of peak (381.17)
    -------------------------
    Tue 09-03 ( +0.22%) 100%              2007   % of peak (14000)
    Wed 09-04 ( -0.41%)  99%              ------------------------
    Thu 09-05 ( -2.59%)  97%              Thu 07-19 ( +0.59%) 100%
    Fri 09-06 ( +1.76%)  98%              Fri 07-20 ( -1.07%)  98%
    ------------------------              ------------------------
    Mon 09-09 ( -0.36%)  98%              Mon 07-23 ( +0.67%)  99%
    Tue 09-10 ( -2.04%)  96%              Tue 07-24 ( -1.62%)  97%
    Wed 09-11 ( +0.99%)  97%              Wed 07-25 ( +0.50%)  98%
    Thu 09-12 ( -1.23%)  96%              Thu 07-26 ( -2.26%)  96%
    Fri 09-13 ( +0.14%)  96%              Fri 07-27 ( -1.54%)  94%
    ------------------------              ------------------------
    Mon 09-16 ( +1.51%)  97%              Mon 07-30 ( +0.70%)  95%
    Tue 09-17 ( -1.04%)  96%              Tue 07-31 ( -1.10%)  94%
    Wed 09-18 ( +0.65%)  97%              Wed 08-01 ( +1.14%)  95%
    Thu 09-19 ( -0.25%)  97%              Thu 08-02 ( +0.76%)  96%
    Fri 09-20 ( -2.14%)  94%              Fri 08-03 ( -2.09%)  94%
    ------------------------              ------------------------
    Mon 09-23 ( -0.84%)  94%              Mon 08-06 ( +2.18%)  96%
    Tue 09-24 ( -1.78%)  92%              Tue 08-07 ( +0.26%)  96%
    Wed 09-25 ( -0.01%)  92%              Wed 08-08 ( +1.14%)  97%
    Thu 09-26 ( +0.96%)  93%              Thu 08-09 ( -2.83%)  94%
    Fri 09-27 ( -3.11%)  90%              Fri 08-10 ( -0.23%)  94%
    ------------------------              ------------------------
    Mon 09-30 ( -0.41%)  90%              Mon 08-13 ( -0.02%)  94%
    Tue 10-01 ( -0.26%)  89%              Tue 08-14 ( -1.57%)  93%
    Wed 10-02 ( +0.56%)  90%              Wed 08-15 ( -1.29%)  91%
    Thu 10-03 ( -4.22%)  86%              Thu 08-16 ( -0.12%)  91%
    Fri 10-04 ( -1.45%)  85%              Fri 08-17 ( +1.82%)  93%
    ------------------------              ------------------------
    Mon 10-07 ( +6.32%)  90%              Mon 08-20 ( +0.32%)  93%
    Tue 10-08 ( -0.21%)  90%              Tue 08-21 ( -0.23%)  93%
    Wed 10-09 ( +0.48%)  90%              Wed 08-22 ( +1.11%)  94%
    Thu 10-10 ( +1.79%)  92%              Thu 08-23 ( -0.00%)  94%
    Fri 10-11 ( -0.05%)  92%              Fri 08-24 ( +1.08%)  95%
    ------------------------              ------------------------
    Mon 10-14 ( -0.49%)  92%              Mon 08-27 ( -0.42%)  95%
    Tue 10-15 ( -1.06%)  91%              Tue 08-28 ( -2.10%)  93%
    Wed 10-16 ( -3.20%)  88%
    Thu 10-17 ( +1.70%)  89%
    Fri 10-18 ( -2.51%)  87%
    ------------------ -----
    Mon 10-21 ( -3.71%)  84%
    Tue 10-22 ( +1.75%)  85%
    Wed 10-23 ( -6.33%)  80%
    Thu 10-24 ( -2.09%)  78% Black Thursday
    Fri 10-25 ( +0.58%)  79%
    ------------------------
    Mon 10-28 (-13.47%)  68% Black Monday      September 10
    Tue 10-29 (-11.73%)  60%
    Wed 10-30 (+12.34%)  67%
    Thu 10-31 ( +5.82%)  71%
    Fri 11-01  (Closed)
    -----------------------
    Mon 11-04 ( -5.79%)  67%
    Tue 11-05  (Closed)
    Wed 11-06 ( -9.92%)  60%
    Thu 11-07 ( +2.61%)  62%
    Fri 11-08 ( -0.70%)  62%                   September 21
    ------------------------
    Mon 11-11 ( -6.82%)  57%
    Tue 11-12 ( -4.83%)  55%
    Wed 11-13 ( -5.27%)  52%
    Thu 11-14 ( +9.36%)  57%
    Fri 11-15 ( +5.27%)  60%
    -----------------

As you can see, we're sorta-but-not-quite following the 1929 pattern. The fall from the peak isn't as far as it was then in the pattern.

But most important, there haven't been the large downward moves, such as occurred on 10/3/1929, nor has there been the large upward move (+6.32%) that occurred on 10/7. Both of these sharp movements, a downward collapse or an "upward crash," indicate that levels of anxiety and panic are very high. And as we keep saying, the market ups and downs aren't important by themselves; it's the anxiety and panic that are important.

I've estimated that the most likely dates for a panic are in the two weeks, September 10-21. I honestly don't know whether we're still on track for those dates or not. We should have a much better idea by the end of the week.

So here's where we stand: A full-scale panic and crash MUST occur, because the market is overpriced by a factor of 250%, and it might occur next week, next month or next year. Based on the enormous change in attitudes of investors since July 23, it seems very likely to occur in the next few weeks. And based on speculative comparisons with 1929, the date range September 10-21 seems the most likely. (29-Aug-07) Permanent Link
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Bernanke's historic experiment takes center stage

An assessment of where we are and where we're going.

What was really remarkable about the past week was that "Ben Bernanke's Great Historic Experiment" has been put into full operation.

It's hard to overstate the importance of what's going on. We are now at the focal point of decades of macroeconomic theory that says that the Great Depression need not have happened, and could have been prevented by means of a minor change in Fed policy.

The next few weeks will either prove that Ben Bernanke and the macroeconomic theory that he's implementing are correct or disastrously wrong. Either way, it's truly a historic moment and will be recognized as such for decades to come.

Recall the main points of the experiment, which we'll summarize briefly:

Bernanke was greatly affected by a Great Depression "shoe factory" story when he was growing up in the 60s: People couldn't afford shoes because they were unemployed because the shoe factory had shut down. Bernanke concluded that just by providing some money to the shoe factory, the shoe factory could have provided both shoes and jobs, solving the whole problem.

Bernanke has said that he does not believe in bubbles, and that he believes that any future threat of a major downturn can be handled by the Fed by simply providing money to the economy in the proper way.

Ben "helicopter" Bernanke cartoon

Ben "helicopter" Bernanke cartoon

The adjoining graphic is a cartoon that's been circulating around the internet showing Bernanke dropping money out of a helicopter. This cartoon alludes to a 2002 speech by Bernanke, where he presumably said that dropping money out of a helicopter would solve any Great Depression by defeating deflation.

Actually, he said something very different in that speech, and I'll come back to that speech in a moment, because it tells us a great deal about where the Fed is going in the next few weeks and months.

That was the week that was

But first I want to provide a context by reviewing the extremely remarkable events of the last week.

As we've previously discussed, the Fed reduced the "discount rate" from 6.25% to 5.75% on Friday, August 17. This was done after a week of enormous volatility in the stock market, and signs of greatly increase "risk aversion" among investors and financial managers.

Lowering the discount rate means that banks can borrow money from the Fed's "discount window" at the new lower rate. Thus, the Fed "provides money to the economy" as summarized above.

What has become apparent in the meantime is that nobody wanted to borrow from the discount window, even at the lower rate. There are good reasons for this. Banks rarely use the discount window anyway, because they can borrow money from each other at a lower rate, the "Fed funds rate," which is currently set at 5.25%.

It's true that there were some well-publicized discount window withdrawals by several German banks on Monday.

However, the purpose of Bernanke's great experiment would be thwarted unless it resulted in a lot more money being injected into the economy.

Several hours after the rate cut was announced on Friday (Aug 17) morning, it was becoming clear that the new discount rate was not working as hoped, and on Friday afternoon, the New York Fed (which actually administers the discount window) spoke to the four largest US banks (Citigroup Inc., Bank of America Corp., JPMorgan Chase & Co. and Wachovia Corp.) in a conference call and essentially ordered them to borrow money from the discount window. All four did so, each borrowing the minimum amount possible ($500 million).

The Fed did a few other extraordinary things to encourage use of the discount window:

Normally funds can be borrowed from the discount window for one day only. The Fed permitted money to be borrowed for 30 days, renewable by the borrower.

It explicitly changed antitrust regulations for Citibank, so that the bank could then lend money to brokers and dealers in its subsidiary, who would then lend it to clients. So this provided a route for the Fed to lend money to investors.

The New York Fed posted on its web site an explicit statement that it would accept asset-backed commercial paper as collateral for the loans from the discount window, even when the assets were based on subprime loans. This provides a means for banks to get past immediately liquidity problem from being unable to sell expiring securities.

All of these steps were enough to provide a real shot in the arm to investors, changing their moods from panicky back to giddy, as the Dow went up 1% on Wednesday, and again on Friday.

So now the first week of Bernanke's new policy has come to an end, with results that many pundits are claiming were highly successful. Volatility has come down about halfway to previous "normal" levels, and investor "risk aversion" seems to have been quenched.

I'm being unfair to pundits if I leave it at that, however. A number of pundits have been warning that the worst is yet to come. They point to continuing and increasing problems with mortgage-based securities, as the subprime "teaser rates" continue to be reset in the millions, and they also point out that last week's market was not representative because everyone was on vacation and volume was extremely low. One worried pundit pointed out: "When the market fell, it was on very high volume; when the market recovered, it was on very low volume. This means that investors are really not yet convinced that the Fed moves are working."

(Boomer trivia: The title of this section refers to an early 1960s TV show that ran opposite Twilight Zone.)

Bernanke's 2002 speech

In a speech given on November 21, 2002, Bernanke laid out a number of Fed interventions that might take place if the economy became increasingly distressed.

I will now analyze that speech, but I must begin by saying that his reasoning is extraordinarily shallow. He says things that simply don't make sense, and which time has now shown to be completely wrong.

Still, it's a very important speech there's every reason to believe that Bernanke STILL believes almost everything he says there, and because the Fed interventions that he describes are probably going to take place in the next few months. So the speech is important because it provides something of an additional roadmap to the near future.

Let's do this in two phases.

We'll start by making a simple list of the tools that he believes that the Fed can use to inject money into the economy. Then, in the next section, we'll discuss his reasoning.

Here is a list of the tools that the Fed has:

Lower the Fed Funds rate. The most obvious one is the Fed Funds rate, currently set at 5.25%. This is the major interest rate that's always dicussed by pundits, politicians, and journalists in general. It's the rate of interest that banks charge each other for overnight loans.
However, it's not an automatic thing. Banks are free to charge each other any interest rate they like. However, if a bank has money to lend, and it can lend the money to another bank at interest rate A, or lend it to the government (the Fed) at interest rate B, then the bank will lend it at whichever rate is higher. That's just common sense. And so, the Fed can control A by controlling B. This is done by "open market operations."
To control B, you have to get banks to lend money to the government, and the way you do that is by selling short-term (overnight) Treasury bills, and let banks bid on them, applying the law of supply and demand. If a lot of bids come in, so demand is very high, then the prices of the bills go up, pushing yields down below 5.25%, so the Fed increases supply and auctions more off; if only a few bids come in, so demand is very low, then the prices of the bills go down, pushing yields above 5.25%, then the fed decreases supply, and stops auctioning. (29-Aug correction)
So the Fed auctions off exactly enough each day to keep the interest rate on the bills it sells at exactly 5.25%, or as close as possible. That's how B is controlled. Once B is set to 5.25%, then A will also return to 5.25%, to compete with the government, and so banks will loan money to each other at that rate.

Lower the Fed Discount rate. The Discount Rate is the rate at which the Fed lends money to banks through the discount window. This is the rate that was just reduced from 6.25% to 5.75%. It's the interest rate at which the Fed loans money to banks in return for collateral.

"Unlike some central banks, and barring changes to current law, the Fed is relatively restricted in its ability to buy private securities directly. However, the Fed does have broad powers to lend to the private sector indirectly via banks, through the discount window. Therefore a second policy option, complementary to operating in the markets for Treasury and agency debt, would be for the Fed to offer fixed-term loans to banks at low or zero interest, with a wide range of private assets (including, among others, corporate bonds, commercial paper, bank loans, and mortgages) deemed eligible as collateral. For example, the Fed might make 90-day or 180-day zero-interest loans to banks, taking corporate commercial paper of the same maturity as collateral. Pursued aggressively, such a program could significantly reduce liquidity and term premiums on the assets used as collateral. Reductions in these premiums would lower the cost of capital both to banks and the nonbank private sector, over and above the beneficial effect already conferred by lower interest rates on government securities."

This is the particular option that Bernanke exercised in the last week, with some variation: it's a 5.75% interest loan (not zero interest), and it's a 30-day loan. It takes as collateral some of the questionable commercial paper that's being backed by subprime mortgage loans, as described previously.
At this point, it's worthwhile to note that Bernanke is pursuing this policy for a different reason than the reason he discussed in 2002. At that time, he was concerned about deflation (as occurred in the early 1930s, and in Japan in the 1990s), and was describing asset-backed loans at zero interest rates for the purpose of combating deflation. This whole idea was based on concepts of deflation that were completely wrong, and have been proven wrong in the intervening time.
Today, Bernanke isn't concerned about defeating DEFLATION; he's concerned about increasing money liquidity in the markets, but without increasing INFLATION. There's an inherent contradiction in such policies, since increasing money liquidity should naturally increase inflation (or decrease deflation, which was his point in 2002). So he's offering discount window loans at 5.75% -- a high interest rate -- to avoid stirring inflation.
Well, if the interest rate is so high, then why lower the discount rate at all? The answer appears to be that it's all psychological. Lowering interest rates to increase liqudity and to defeat deflation makes sense; lowering them to increase liquidity but not to increase inflation really doesn't make sense.
And this is a point that we'll return to: Bernanke's 2002 speech was about avoiding a new Great Depression by controlling deflation. That's not the situation today.
So this is one of many serious problems with Bernanke's strategy.
In fact, the reason that he even lists other tools in his strategy is because he believes they'll be needed when the Discount Rate and Funds Rate go down to zero, and therefore cannot go any lower. (You know, I don't really believe this, but that's a topic for another day.)
I'll now go on and list the remaining tools that he described, because it's of interest to get the whole list down. But remember that they're all geared towards injecting liquidity by controlling deflation.

Lowering interest rates on long term Treasury bonds. There's no easy way to do this directly, but he gives several indirect methods:
1. The Fed commits to holding the overnight rates at zero for some specified period. For example, if the Fed committed to zero interest rates for three years, then three-year bonds would effectively have a near-zero interest rate
2. The Fed buys back long-term Treasuries that it has previously sold. This increases demand, and therefore lowers the yields (interest rates).

Purchasing foreign debt. According to Bernanke, "the Fed has the authority to buy foreign government debt, as well as domestic government debt." So, if I'm a government and I have a certificate saying that someone owes me $1 billion, then I can sell that certificate to the Fed (for, say, $900 million), and then the debtor owes the $1 billion to the Fed, not to me. Meanwhile, I have $900 million in cash to loan to other people. Bernanke notes that the Fed would have to "tread carefully" in this case, however, since purchasing foreign debt has foreign policy implications.

Fiscal policy: Tax cut. The above actions are monetary policy, performed by the Fed. Bernanke also suggests fiscal policies, which are performed by acts of Congress.
This is where he made his famous statement:

"A money-financed tax cut is essentially equivalent to Milton Friedman's famous "helicopter drop" of money."

This is the one part of the speech that everyone seems to remember, but Bernanke wasn't recommending it; he was simply repeating a suggestion by Milton Friedman.

Fiscal policy: Increase spending. Money can be injected into the economy through fiscal policy by means of tax cuts or increased spending.
Fiscal + Monetary policy: Acquire assets. Here he suggests a multi-step process involving both fiscal and monetary policy. The government purchases a major asset. (I'm not sure what he has in mind -- perhaps the English might wish to sell Scotland to us.) In order to make the purchase, the government issues an IOU to the selling party. Then the Fed purchases the IOU for cash.

Now that we've listed the main tools described by Bernanke in the speech, let's move on to his assumptions and conclusions.

Incorrect assumptions about deflation

As I've said many times on this web site, mainstream macroeconomics has been wrong about everything since at least 1995. The mainstream models, which were devised in the 1970s and 1980s, did not predict or explain the dot-com bubble, and could not explain why the bubble occurred in the late 90s instead of the 1980s or 2000s, and could not explain almost anything that's happened since 2000.

It's certainly unequivocally true that no mainstream economist predicted anything that's going on today. This is all a complete shock to mainstream macroeconomics.

Bernanke's 2002 speech illuminates some of the main assumptions that mainstream macroeconomics makes, and it's easy to see from his speech that not only does Bernanke not know what he's talking about, but even HE thinks he doesn't know what he's talking about.

His discussion of deflation shows this quite forcefully, in which he says that deflation is "not a mystery":

"Deflation: Its Causes and Effects

Deflation is defined as a general decline in prices, with emphasis on the word "general." At any given time, especially in a low-inflation economy like that of our recent experience, prices of some goods and services will be falling. Price declines in a specific sector may occur because productivity is rising and costs are falling more quickly in that sector than elsewhere or because the demand for the output of that sector is weak relative to the demand for other goods and services. Sector-specific price declines, uncomfortable as they may be for producers in that sector, are generally not a problem for the economy as a whole and do not constitute deflation. Deflation per se occurs only when price declines are so widespread that broad-based indexes of prices, such as the consumer price index, register ongoing declines.

The sources of deflation are not a mystery. Deflation is in almost all cases a side effect of a collapse of aggregate demand--a drop in spending so severe that producers must cut prices on an ongoing basis in order to find buyers. Likewise, the economic effects of a deflationary episode, for the most part, are similar to those of any other sharp decline in aggregate spending--namely, recession, rising unemployment, and financial stress."

Now, you have to laugh at this. It's so ridiculously shallow that you'd think he'd be embarrassed to utter it.

He says that deflation is defined as a general decline in prices. Fine.

What are the causes? It's "a side effect of a collapse of aggregate demand -- a drop in spending so severe that producers must cut prices on an ongoing basis in order to find buyers."

In other words, deflation occurs when producers cut prices, and producers cut prices when demand for the producers' products collapses.

I think I learned that in 10th grade social studies class. Do we really need a Princeton professor of economics to recite it?

What causes the collapse of aggregate demand?? Why do people suddenly stop wanting producers' products? He doesn't answer that. Obviously he no idea whatsoever. He has absolutely no idea why deflation occurs. The above explanation is simply babbling.

In the above, he mentions "recession, rising unemployment, and financial stress" as being related, but he doesn't name them of the CAUSE of deflation. Good thing, too. He's well aware that during the Great Inflation of the 1970s, there was high inflation, recession, rising unemployment, and a great deal of financial stress.

I don't know what I find more astonishing -- the fact that Bernanke says these incredibly vacuous things, or the fact that I'm the only person who points them out. It's like that fairy tale about the King who wore no clothes, and everyone was too embarrassed to say so.

Bernanke and other economists have an extremely simplistic view of inflation and deflation. If you lower interest rates, then more money enters the economy and inflation increases; if you raise interest rates, then less money enters the economy, and inflation decreases or turns into deflation.

From the point of view of Generational Dynamics, the situation is a lot more complicated.

Economists assume that new businesses are born each decade, and die each decade, and each decade is pretty much the same as each other decade. All of their models depend on that assumption.

But that assumption is obviously wrong, as anyone can easily see. Most major businesses today were either born or completely renewed during the Great Depression. They invested heavily in research and development in the 40s and 50s, and reached their zenith in innovation and product excellence by the 60s and 70s. That's why demand was so high for American products, and why high inflation occurred: We just couldn't manufacture products fast enough to satisfy demand.

Since the 1980s, these companies have gotten older. Bureaucracy has increased, and product innovation has taken second place to protecting existing jobs and income streams. The main objective is to protect one's ass. That's why demand for American products has gotten so low, and why prices and inflation are falling.

Even though this is completely obvious, mainstream economists have no concept of it. Their flat view of time, where every decade is like every other decade, is obviously wrong, but it's the underlying assumption of every economic model, and it's why Bernanke is babbling completely nonsense.

Since 2002, the Fed funds rate has been near-zero, and by the standards of their 1970s models, inflation should have been enormous. Instead, inflation remained tame. But Americans rejected American products, and when to China for manufactured goods and to India for services.

Plans for preventing deflation

Here's what Bernanke said in his speech:

"As I have already emphasized, deflation is generally the result of low and falling aggregate demand. The basic prescription for preventing deflation is therefore straightforward, at least in principle: Use monetary and fiscal policy as needed to support aggregate spending, in a manner as nearly consistent as possible with full utilization of economic resources and low and stable inflation. In other words, the best way to get out of trouble is not to get into it in the first place. Beyond this commonsense injunction, however, there are several measures that the Fed (or any central bank) can take to reduce the risk of falling into deflation."

The phrase "use monetary and fiscal policy as needed to support aggregate spending" is what the previously described tools are all about -- inject money into the economy, to increase spending, so that people will buy American products, so that demand will go up, prices will go up, and inflation will go up. Simple huh?

He added the following:

"[As] suggested by a number of studies, when inflation is already low and the fundamentals of the economy suddenly deteriorate, the central bank should act more preemptively and more aggressively than usual in cutting rates.... By moving decisively and early, the Fed may be able to prevent the economy from slipping into deflation, with the special problems that entails."

Well, that's what the Fed did in 2002 and 2003 -- moved "premptively and aggressively" to head off deflation, and that's what's brought us to our current state today.

As I said, from the point of view of Generational Dynamics, this is all wrong.

I knew all this in 2002 and 2003, because I had already developed the first two of major measures for valuating the stock market, as described in my recent essay, "How to compute the 'real value' of the stock market." And I wrote about it in my 2003 book, Generational Dynamics, where I referred to the "crusty old bureaucracy" that formed the leadership of most American companies. I knew at that time that we were headed for a new 1930s style Great Depression, but I was wrong about one major thing: I thought that the market would continue to decline from that point on.

In fact, here's what I wrote and posted on January 3, 2003, in my "Stock market forecast for 2003." This was one of my first predictions on this web site, and it contained a number of errors. However, this was also several months before I developed the Generational Dynamics forecasting methodology, and I don't claim to have started getting everything right until then.

Still, it's interesting to see what I wrote on January 3, 2003:

"I've been listening to end-of-year economic forecasts by stock analysts on TV. There seem to be two groups of forecasts:

Those who believe that once we do our quickie, no-pain, one-to-two-week war in Iraq, the stock market will rebound to its 1999 levels, up above 11,000;

Those who believe that the stock market will be steady, in the 8000s, through the end of 2003.

If technological and economic forecasting means anything at all (and it does), then the first of these forecasts doesn't have a chance of happening.

The second forecast may come true, in the sense that the forecasted crash to below 6000 may wait a year or two.

My guess: Something will go wrong in the war against Iraq or the war against terror, something that will expose a new vulnerability. That will have two effects: The DJIA will fall, and public resolve to pursue the war against terror will increase. Even if the war goes well in 2003, the stock market will continue to fall.

My guess is that the DJIA will be in the low 7000s or lower at the end of 2003."

At least I had the good sense to call these "guesses." Since that time, I've learned to say that "Generational Dynamics tells you were you're going, but not the path you'll take to get there," and "a stock market panic and crash might occur next week, next month or next year, but it's coming with 100% certainty, and probably sooner rather than later." In other words, the prediction a stock market crash and a new 1930s style Great Depression was correct, but I was wrong in "guessing" what the DJIA would be.

What I mainly didn't foresee was the "preemptive and aggressive" policy of the Fed, described above, to move against deflation before it got started. As a result, the DJIA did NOT fall -- but not for the reason that Greenspan and Bernanke intended.

The predicted reason that the market would go up is because the low interest rates would create more aggregate demand for American products, thus pushing up prices. That may have happened marginally, but I don't know anyone who could claim that it's happened in any serious way in the intervening five years.

Instead, all that money that poured into the economy was channeled into the huge Ponzi scheme that we're living with today, creating the stock market bubble, the housing bubble and the credit bubble.

The point I want to make here is that Bernanke's speech was completely wrong in explaining what was going on and predicting what was going to happen. Greenspan and Bernanke went ahead with a policy that they didn't understand, and didn't even really claim to understand, but which they thought might work if you have sufficiently simplistic economic beliefs.

Explaining Japan's 1990s deflation

If Bernanke's discussion of deflation is shallow, his discussion of Japan is mind-bogglingly bizarre.

I actually wrote a sparse analysis of Japan in March 2003, but wasn't able to complete the picture until February of this year, when I was finally able to obtain historical data on the Tokyo Stock Exchange dating back to 1914, and wrote "Japan's real estate crash may finally end after 16 years."

In brief, Japan had a major generational stock market panic and crash in 1990, just like America in 1929. But Japan's previous major stock market crash was in 1919. So you have: Wall Street: Crash in 1929, new bubble in 1995, 66 years later; Tokyo Stock Exchange: Crash in 1919, new bubble in 1984, 65 years later.

Japan's 1980s real estate and stock market bubble was HUGE. When the market crashed in 1990, prices in Japan fell for 15 years, and only in the last year have begun to rise again.

And yet, Bernanke doesn't believe that deflation is (or should be) possible. He believes that the long deflationary collapse was based on errors by the Bank of Japan (i.e., Japan's "Fed"), and on political confusion. He doesn't EVEN MENTION the 1980s bubble.

You know, Dear Reader, you must think that I enjoy writing insulting remarks about today's political and financial leaders, but really I don't. I hate what's happening, and I hate the utter stupidity of these people in positions of leadership.

But for heaven's sake, this guy was a Professor of Economics at Princeton. How could be possibly be this stupid?

But I digress. Let's quote directly from his speech:

First, here are his reasons for saying that deflation shouldn't occur:

"The conclusion that deflation is always reversible under a fiat money system follows from basic economic reasoning. A little parable may prove useful: Today an ounce of gold sells for $300, more or less. Now suppose that a modern alchemist solves his subject's oldest problem by finding a way to produce unlimited amounts of new gold at essentially no cost. Moreover, his invention is widely publicized and scientifically verified, and he announces his intention to begin massive production of gold within days. What would happen to the price of gold? Presumably, the potentially unlimited supply of cheap gold would cause the market price of gold to plummet. Indeed, if the market for gold is to any degree efficient, the price of gold would collapse immediately after the announcement of the invention, before the alchemist had produced and marketed a single ounce of yellow metal.

What has this got to do with monetary policy? Like gold, U.S. dollars have value only to the extent that they are strictly limited in supply. But the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost. By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation."

OK, so he tells his little "parable" to say that deflation never occurs as long as you can pump as much money into the economy as you want.

Well, didn't Japan try that, and didn't it fail? Here goes:

"Japan

The claim that deflation can be ended by sufficiently strong action has no doubt led you to wonder, if that is the case, why has Japan not ended its deflation? The Japanese situation is a complex one that I cannot fully discuss today. I will just make two brief, general points.

First, as you know, Japan's economy faces some significant barriers to growth besides deflation, including massive financial problems in the banking and corporate sectors and a large overhang of government debt. Plausibly, private-sector financial problems have muted the effects of the monetary policies that have been tried in Japan, even as the heavy overhang of government debt has made Japanese policymakers more reluctant to use aggressive fiscal policies. Fortunately, the U.S. economy does not share these problems, at least not to anything like the same degree, suggesting that anti-deflationary monetary and fiscal policies would be more potent here than they have been in Japan."

Well, let's all stop and have a moment of silence. Bernanke in 2002 says that Japan had "massive financial problems in the banking and corporate sectors and a large overhang of government debt." He adds that "the U.S. economy does not share these problems."

Maybe the US economy didn't in November 2002, but it sure does today.

"Second, and more important, I believe that, when all is said and done, the failure to end deflation in Japan does not necessarily reflect any technical infeasibility of achieving that goal. Rather, it is a byproduct of a longstanding political debate about how best to address Japan's overall economic problems. As the Japanese certainly realize, both restoring banks and corporations to solvency and implementing significant structural change are necessary for Japan's long-run economic health. But in the short run, comprehensive economic reform will likely impose large costs on many, for example, in the form of unemployment or bankruptcy. As a natural result, politicians, economists, businesspeople, and the general public in Japan have sharply disagreed about competing proposals for reform. In the resulting political deadlock, strong policy actions are discouraged, and cooperation among policymakers is difficult to achieve.

In short, Japan's deflation problem is real and serious; but, in my view, political constraints, rather than a lack of policy instruments, explain why its deflation has persisted for as long as it has. Thus, I do not view the Japanese experience as evidence against the general conclusion that U.S. policymakers have the tools they need to prevent, and, if necessary, to cure a deflationary recession in the United States."

And so, he doesn't believe in bubbles, even though Japan had a huge bubble in the 1980s. He believes that deflation can be prevented, even though Japan couldn't prevent in the 1990s.

I often talk of the incredible arrogance and narcissim of people in the Baby Boomer generation, and how each one is in the center of the universe, and his words are the Golden Words of Truth, even when they change their minds or ignore any facts.

Here you see arrogance and narcissism at its height. Ben Bernanke, sitting on his grandmother's knee in the 1960s and listening to the "shoe factory" story reached some conclusions about how he was so much smarter than anyone who came before him, and even facts staring him in the face are to be ignored.

How does he explain his views in the face of clear, obvious contradictions in Japan? How does he justify his policies?

Why, it's simple. Japan's deflation was caused by politics. The people at the BOJ and the Japanese Diet were just plain stupid. They didn't know what they were doing, and they argued with each other so much that they never got things done.

And so, like any other Boomer, Bernanke has no concept of what's going on in the world. In the end, he's just like all the other Boomer politicians I talk about on this web site -- he knows how to argue and blame everyone else, be has little ability to actually get things done.

The coming weeks and months

According to a recent article, recently published Fed minutes from 2001 reveal a policy of "calculated ambiguity":

"The federal funds rate was lowered another half-point [0.5%] in late January 2001. At the March 2001 FOMC meeting, with the economy continuing to weaken, Mr. Greenspan said: "I fear that with a reduction of 75 basis points [0.75%] or even 100 basis points [1.0%] today... stock prices could still fall, leading too many observers to conclude that monetary policy is ineffective. ... If we do 50 points and stock prices fall further, as they well might today, it is the central bankers who may be perceived as intellectually inadequate, not policy itself. This is far less dangerous to the economy. ... This is one of the rare periods when in my judgment calculated ambiguity can serve a useful purpose in minimizing unthoughtful activity." The chairman proposed a 50 basis points cut in the funds rate to 5 percent, in which the committee concurred."

This 2001 policy gives some insight into Ben Bernanke's policy today.

Bernanke has received a fair amount of pundit criticism in the last week, for not going far enough. Pundits have complained that the �% reduction in the Discount Rate is too small a policy change to have any real effect, and that the Fed should be much more aggressive -- by lowering the Funds Rate � point or a full point.

In fact, as we described above, Greenspan followed a "preemptive and aggressive" policy in 2002 to head off deflation.

So we have two conflicting policies here: a "preemptive and aggressive" policy to head off problems before they start, and a "calculated ambiguity" policy that calls for a slower approach so that there's an excuse if the policy doesn't work.

My guess is that Bernanke is following a "calculated ambiguity" policy right now, and will become more aggressive only if it becomes necessary.

But here's the interesting question: As the economic situation becomes increasingly severe, how far will Bernanke go in using the tools described?

Will he go so far as to use all the tools available to him to flood the markets with money, and print so much money that inflation runs away and the dollar essentially becomes worthless?

Consumer price index (CPI) from 1870 to present, with an exponential growth trend line. The CPI is 185 in 2003, and 2010 has a trend value of 129.

Consumer price index (CPI) from 1870 to present, with an exponential growth trend line. The CPI is 185 in 2003, and 2010 has a trend value of 129.

I've been predicting since 2003 that we're in a long-term deflationary trend (like Japan in the 1990s). This is based on the adjoining graph that shows that long-term inflation is running above the exponential growth trend line and so, by the Law of Trend Reversion, must fall below the trend line for a long period of time. This means that the Consumer Price Index (CPI) has to fall 30% or more, which would indicate a great deal of deflation.

However, I've always had in the back of my mind that Greenspan, and now Bernanke, might defeat this trend by making the dollar worthless.

I actually don't believe that will happen. A policy of that type would have to be sustained for several years to have such a deleterious effect, and within a few months it would be seen to be failing.

But up to that point, we can expect to see Bernanke's Great Historic Experiment proceed with an increasingly aggressive policy of injecting money into the economy, until it becomes clear that such a policy is a total failure. (27-Aug-07) Permanent Link
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World wheat prices up 30% since May on panic buying

Wheat prices hit an all-time record high, as stocks are low, and poor weather has damaged crops in Canada, after Australia suffered a severe drought, and floods have reduced yields throughout Europe.

The latest 30% spike in wheat prices came in response to news that Canada�s crop could be reduced by roughly 20% this year after bad weather hit the world�s second-largest exporter.

Countries that rely on imported wheat, such as Japan and Taiwan, responded with panic buying, pushing the price up.

Demand for wheat is generally up, especially as China and India, as tastes become more westernized, and people demand more pasta and bread in place of traditional rice.

When I last wrote about growing food prices, in an article last month, I noted that some kind of "tipping point" appears to have been reached, and worldwide food prices are really becoming uncontrollable.

Not all agricultural product prices have spiked as much as wheat, but the general trend is to be up sharply. In general, food inflation worldwide is averaging 6-8% over a year ago.

The following graphs show the increase in prices of wheat, corn and rice, respectively, over the last 1-2 years.

(I've mentioned previously that the Wall St. Journal online has been promoting its "historical prices," that go back all of three months in most cases. Well, they must have had a historian in the commodity department, because these figures go waaaaaaaaaaaay back as far as 2005 or 2006.)

Wheat, corn and rice futures prices, 2005 or 2006 to present. (Source: WSJ)

Wheat, corn and rice futures prices, 2005 or 2006 to present. (Source: WSJ)

As you can see from the above graphs, the price of wheat has doubled in two years, corn prices have increased 40-60% in two years, and rice prices have increased about 10% in one year.

Another major source of demand for agricultural demand is the rapidly expanding use if biofuels, led by four regions: US, Brazil, Europe and China. This has increasingly diverted such crops as corn and sugar cane away from food and towards energy production.

According to a a study published in May by Canada's National Farmer's Union (NFU) (PDF), there is a global food crisis emerging.

The following graph illustrates how worldwide stocks of grains have been falling sharply since the year 2000:

World total grains, days of supply: 1960/01 - 2007/08 (Source: nfu.ca)

World total grains, days of supply: 1960/01 - 2007/08 (Source: nfu.ca)

As you can see, there were 130 days of grain supply stockpiled and available in 1986, 115 days supply in the year 2000, and 47 days supply in 2007.

What's significant is not just the lower level of supply, but the sharp downward trend that shows no sign of abating. What this shows is that increasingly we're eating more food than we produce, and that this trend is continuing and probably increasing.

According to the NFU report,

"Every six years, we�re adding to the world the equivalent of a North American population. We�re trying to feed those extra people, feed a growing livestock herd, and now, feed our cars, all from a static farmland base. No one should be surprised that food production can�t keep up. ...

[T]he converging problems of natural gas and fertilizer constraints, intensifying water shortages, climate change, farmland loss and degradation, population increases, the proliferation of livestock feeding, and an increasing push to divert food supplies into biofuels means that we are in the opening phase of an intensifying food shortage. ...

If we try to do more of the same, if we try to produce, consume, and export more food while using more fertilizer, water, and chemicals, we will only intensify our problems. Instead, we need to rethink our relation to food, farmers, production, processing, and distribution. We need to create a system focused on feeding people and creating health. We need to strengthen the food production systems around the world. Diversity, resilience, and sustainability are key."

You know, this is a VERY serious problem, much more serious than the stylish, designer, fad issue du jour, global warming, and yet everyone's completely oblivious to it.

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Food panics and riots spread around the world: The unending sharp price wheat, corn and rice prices are destabilizing nations.... (9-Apr-08)

UN World Food Program to institute food rationing: Surging food prices are causing food riots around the world.... (26-Feb-08)

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Green Revolution vs Malthus Effect: Despite the "Green Revolution," world population continues to grow faster than food production. This is one of the fundamental reasons why wars occur. (28-Jun-2004)

I get yelled at by web site readers for various things on this web site, but there's no doubt what the number 1 issue is that people get angry at me about: The obvious fact that we're running out of food relative to population, and that soon there won't be enough food in the world to feed everyone.

What I've discovered, listening to people shouting at me on this issue, is that they simply assume that there's enough food for everyone, and that there always will be, and they can't imagine it any other way. It's the same kind of obliviousness that people show toward the increasing instability of the world economy.

I've actually changed my mind about what's going on here. When I've written about this subject in the past, I ascribed the cause of this problem entirely to a statistical fact -- that population grows faster than the food supply grows. But now I see how there's a huge generational factor as well.

After WW II, there was a concerted effort to make sure that everyone would eat, because it was recognized that poverty and starvation were one of the major causes of the war. There was the Green Revolution that brought the latest agricultural technology to countries around the world, especially India. And there have been programs like the U.N. World Food Program that purchases food for needy people.

But the problem is that the population grows faster than the food supply. You can see this from the fact that food prices around the world have been increasing faster than inflation since 2000, and they've really skyrocketed since 2004.

What I believe has happened is that the "Green Revolution" ran out of steam around the mid-1990s, and population growth has been rapidly overtaking food production since then.

But there's another reason as well: The mid-1990s was the time that the dot-com bubble began, and that happened because the people who remember the Great Depression had mostly disappered (retired or died) by that time.

So the "Green Revolution" ran out of steam in the mid-1990s, and the dot-com bubble began in the mid-1990s. Up until now I hadn't related these two events, but lately I've come to believe that they're closely related.

Here are the similarities between the two:

They began at roughly the same time -- in the mid-1990s.

That was the time of the disappearance of survivors of the Great Depression -- who remembered how dangerous the abusive use of credit is, and who ALSO remembered how dangerous starvation is, since it can lead populations to war.

Thus, it was the time that the arrogant, narcissist Boomer generation took charge, driven by the bitter, enraged Generation-X. The Boomers make it their life's work to reject every bit of wisdom their parents tried to hand down, and the GenXers make it their life's work to drive the Boomers to self-destruction. Unfortunately, they both succeed.

People in these generations have the attitude that the only important thing is individual civil rights, and that everything having to do with the global economy, agriculture, and wars will take care of itself, or is someone else's problem. What they don't realize is that it's the people in the generations who survived the Great Depression and WW II who have been taking care of everything for them. With those generations gone, nobody is taking care of the important things.

The new generations are increasingly contemptuous of everything that the older generations were trying to accomplish. They use credit abusively, and they've stopped making the effort to feed the world.

In particularly, they're totally, utterly oblivious to the exponentially increasing inbalances in both the economy and the agricultural marketplaces. They think that everything will take care of itself and, if it doesn't, then someone else is to blame. The only thing that matters to them is politics and arguing.

For example, I feel I can be quite certain that if the survivors of the Great Depression and WW II were still leading the nation and the world, then no one would be talking about reassigning huge amounts of agricultural land away from production of food and to production of biofuels, just to feed a "global warming" fad. They would understand how enormously dangerous that was, when there are people starving.

As a result, the world is facing both a financial crisis and a food crisis, and few people have the vaguest idea what's going on.

Although they're oblivious to these crises, as soon as danger becomes apparent, they panic -- whether it's panic selling of stocks, panic buying of food, or a panicked attack on another nation.

When I wrote in April that "the price of food is skyrocketing in India and China," I quoted the following article from the Wall Street Journal:

"Doomsday predictions of a major food shortage in China and elsewhere have circulated for years but haven't materialized. And some economists believe the recent increase in crop demand probably can be met without severely straining the global economy. They think prices could come back down over time, especially if some countries that have more land that could be put under cultivation -- particularly Brazil -- can greatly increase production. Technological advances, such as better seed varieties, could also help boost production to keep up with demand."

This is the epitome of stupidity. The The Wall Street Journal is supposed to be a newspaper of reporters who know what's going on in the world, but more and more they seem among the most oblivious of all.

It has now been eight years that food prices have been increasing faster than inflation, and the rate of growth itself seems to be growing exponentially and uncontrollably.

This may or may not be of concern to most Americans, where only 14% of a family's budget is spent on food, but it's considerably more important in China and India, where it accounts for 33% and 46%, respectively.

I'll take a guess here: Every time that the worldwide cost of food goes up another 1% more than inflation, another few tens of millions of people in the world are thrown into poverty and undernourishment. Tens of millions isn't very much compared to the world population of 6.6 billion, but it is a lot in absolute terms, and it's far more than enough to start a war. When a man can't feed himself and his family, then he has nothing to lose and everything to gain by going to war.

This is particularly true in the huge megacities of the world, each holding 10-20 million people in vertical apartment buildings or shanties, foraging for food in garbage dumps.

The national and world economy is deteriorating so rapidly, that it now seems likely that a major financial crisis will begin in a matter of weeks, based on research on previous generational crises.

I don't have similar research on food crises, but the huge surge in food prices displayed by the graphs at the beginning of this article cannot continue for long, and there is nothing going on in the world that's going to stop it.

We're expecting a major financial crisis, but even a minor one would be a major disruption to many populations, especially those densely packed into megacities, where there's no opportunity even to grow a little food in the backyard. (25-Aug-07) Permanent Link
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Antiwar Democrats are freaking out over Bush's Vietnam - Iraq war comparison.

The same people who have been comparing Iraq to Vietnam for years are now babbling incoherently, because of President Bush's comparing the Vietnam and Iraq wars.

Thanks to the economic news, it's been a long time since I've commented on the clown circus in Washington, and this story provides an interesting opportunity.

The lead headline, in big, bold letters at the top-right of Page One of Thursday's Boston Globe was: "President compares Vietnam, Iraq wars".

Wow! That must have been some speech to make it far and away the most important news story in the world! Where's Paris Hilton when you need her?

As usual, almost everything said by both sides was completely wrong, since the Vietnam and Iraq wars have nothing in common except that they're both wars, but it's been a while since I've commented on the clown circus in Washington, so this is an opportunity.

I had expected Bush's speech to be purely political, but when I read the full text of the speech I found it to be VERY interesting because it presents a very good historical summary of the neo-conservative position. I'll get back to it later, but here are the paragraphs that seems to be drawing the most babbling from so-called antiwar Democrats:

"A columnist for The New York Times wrote ... in 1975, just as Cambodia and Vietnam were falling to the communists: "It's difficult to imagine," he said, "how their lives could be anything but better with the Americans gone." A headline on that story, date Phnom Penh, summed up the argument: "Indochina without Americans: For Most a Better Life."

The world would learn just how costly these misimpressions would be. In Cambodia, the Khmer Rouge began a murderous rule in which hundreds of thousands of Cambodians died by starvation and torture and execution. In Vietnam, former allies of the United States and government workers and intellectuals and businessmen were sent off to prison camps, where tens of thousands perished. Hundreds of thousands more fled the country on rickety boats, many of them going to their graves in the South China Sea.

Three decades later, there is a legitimate debate about how we got into the Vietnam War and how we left. ... Whatever your position is on that debate, one unmistakable legacy of Vietnam is that the price of America's withdrawal was paid by millions of innocent citizens whose agonies would add to our vocabulary new terms like "boat people," "re-education camps," and "killing fields."

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Now all of this is perfectly correct. In fact, at the time of the genocidal massacre in Cambodia, leftists like Jane Fonda and William Kunstler were cheering the massacre on because the massacre was being perpetrated by their beloved Communists. "I would never criticize anything that a Socialist government did," said Kunstler. And earlier, Fonda had visited Hanoi and sided with the Communists against America.

So President Bush is shoving all this back in their faces, as well he should. These people have been anti-American jackasses most of their lives, and still are today.

However, it isn't true that Bush has "rejected the comparison" for years, as the Globe article claimed.

Last October, President Bush compared what al-Qaeda in Iraq was doing to the Tet offensive in the Vietnam War. That comparison caused a press tizzy similar to the one going on right now, but see that article for a Generational Dynamics analysis of why that comparison fails.

Furthermore, the antiwar Democrats have been comparing the Iraq war to the Vietnam war all along.

For example, Senator Ted Kennedy compared the Iraq war to Vietnam War in a January speech demanding total withdrawal. Kennedy said the following:

"Some will disagree. Listen to this comment from a high-ranking American official.

'It became clear that if we were prepared to stay the course, we could help lay the cornerstone for a diverse and independent region.

If we faltered, the forces of chaos would smell victory, and decades of strife and aggression would stretch endlessly before us. The choice was clear. We would stay the course, and we shall stay the course.'

That's not President Bush speaking; it's Lyndon Johnson speaking, 40 years ago, ordering 100,000 more American soldiers to Vietnam."

This is an interesting comparison. What Kennedy didn't mention is the point that Bush just made: After America withdrew, there was a huge genocidal war engulfing the entire region, with millions of people killed in Vietnam, and then in the "killing fields" of Cambodia.

So the question arises: Will a similar genocide occur if America withdraws from Iraq? I've answered this question many times, and won't repeat the whole thing here; there's a good summary in the article on Ted Kennedy's speech from which I just quoted.

There are some importants to remember with the Iraq war versus Vietnam war:

During the Vietnam war, America was in a generational Awakening era, so the population fought the war half-heartedly. But it was a crisis war for the Vietnamese and Cambodians, so they fought it genocidally. The Cambodian genocide would have occurred irrespective of American involvement in the Vietnam war. Their previous crisis war was the French conquest of Indochina in 1868-1885.

The Iraq war began in 1990, with American involvement beginning in 1991, and continuing ever since. It escalated sharply in 1999 with almost daily bombing of no-fly zones. The 2003 ground war was another escalation, but if we hadn't done it, we'd still be bombing no-fly zones with completely unpredictable results. Iraq today is in a generational Awakening era, so the Iraqi people are fighting half-heartedly; America is in a Crisis era, and is not going to give anywhere nearly as easily as we did in Vietnam.

The Iraq war is NOT a civil war; it's a proxy war between America and foreigners from al-Qaeda in Iraq, as well as Iran. The Vietnam War WAS a civil war.

The defining situation in the Mideast is the coming crisis war between Jews and Arabs, and a related crisis war between Sunnis and Arabs. This war will be genocidal, it will pull in the U.S. and every other country in the region. All kinds of weapons will be used, including WMDs. The Iraqi people will try to stay out of it, but probably won't have much luck in doing so.

When you look at the long history of Vietnam from the point of view of Generational Dynamics, it's easy to see how the 1960s-70s war had to do with events that were launched centuries ago.

North and South Vietnam have had different ethnic origins, with North Vietnam (Vietnamese Kingdom) originally populated by ethnic Chinese, and South Vietnam (Champa Kingdom) populated by Polynesian settlers from Indonesia and Malaysia. These ethnic differences have resulted in one crisis war after another over the centuries.

The major one occurred in 1471, when the (North) Vietnamese invaded Champa (in the South), captured its capital of Vijaya and massacred thousands of its people, effectively ending the existence of Champa kingdom. The next crisis war, in 1545, partitioned Vietnam into North and South again, until the Tay-son rebellion of 1771-1790, resulting in a united Vietnam for the first time in 200 years.

During the Awakening era in the early 1800s, cultural development blossomed, making it the high point of literary culture in Vietnamese history. Thanks to the French, Christianity bloomed, with hundreds of thousands of Catholic conversions from Confucianism and Buddhism. However, as the unraveling era arrived (1850s-70s), Ember Tu-Duc relentlessly suppressed Christianity, sanctioning thousands of executions.

This led to the French conquest of Indochina, in a crisis war from 1865-1885.

In the Awakening era that followed, 1904 saw the formation of the Duy Tan Hoi revolutionary (anti-colonial) society. 1908 - student uprising in Hanoi. 1925 Ho Chi Minh forms the Revolutionary Youth League. (In 1920, Ho had been in France, where he took part in the founding of the French Communist Party.) During WW II, Ho formed the Viet Minh political / relief organization, for people starving to death thanks to confiscation of goods by the occupying Japanese.

Thus, what we call the Vietnam War was simply the next step, lasting from 1954-1974. First, human wave assaults defeated a French encampment at Dien Bien Phu caused French to withdraw. America sent advisors to Saigon to help the South Vietnamese. The Americans supported the South Vietnamese through the North-South civil war that finally ended with the North's victory in 1974.

The point is that almost any comparison that can be made is irrelevant unless it recognizes those long-established ethnic fault lines and previous crisis wars between North and South.

So, with that background, let's take a look at excerpts from the text of President Bush's speech. It's a very interesting summary of the neo-conservative position, and once you apply generational theory to it, you see why it's completely wrong.

"The enemy who attacked us despises freedom, and harbors resentment at the slights he believes America and Western nations have inflicted on his people. He fights to establish his rule over an entire region. And over time, he turns to a strategy of suicide attacks destined to create so much carnage that the American people will tire of the violence and give up the fight.

If this story sounds familiar, it is -- except for one thing. The enemy I have just described is not al Qaeda, and the attack is not 9/11, and the empire is not the radical caliphate envisioned by Osama bin Laden. Instead, what I've described is the war machine of Imperial Japan in the 1940s, its surprise attack on Pearl Harbor, and its attempt to impose its empire throughout East Asia.

This is a very interesting comparison, because it compares two times when America was in a generational Crisis era (WW II and today), and two enemies who were also in a Crisis eras: the Japanese then, and al-Qaeda today.

It's not surprising that the Japanese at that time and al-Qaeda today act similarly, since that's how people in Crisis eras act, especially young people when they hate a certain enemy.

"Ultimately, the United States prevailed in World War II, and we have fought two more land wars in Asia. And many in this hall were veterans of those campaigns. Yet even the most optimistic among you probably would not have foreseen that the Japanese would transform themselves into one of America's strongest and most steadfast allies, or that the South Koreans would recover from enemy invasion to raise up one of the world's most powerful economies, or that Asia would pull itself out of poverty and hopelessness as it embraced markets and freedom.

The lesson from Asia's development is that the heart's desire for liberty will not be denied. Once people even get a small taste of liberty, they're not going to rest until they're free. Today's dynamic and hopeful Asia -- a region that brings us countless benefits -- would not have been possible without America's presence and perseverance.

The view of Bush and the neocons has been that by fighting in Iraq, the country will be tranformed into a free democracy, as happened in Japan, South Korea and other Asian countries. (They would also point to Germany and Italy for the same purpose.)

I've briefly reviewed the history of Vietnam in this article, but I don't have time today to do the same for all the other countries mentioned. Each country has its own fault lines, its own hatreds, and its own blossomings. When you try to create historical analogies between different countries, it's almost impossible unless you know what you're doing.

What ties all these countries and all other countries together is generational timelines. Each country has a genocidal crisis war every 70-90 years, and Awakening eras halfway between the crisis wars.

This happens whether or not the country's government is a democracy, a monarchy, a dictatorship, or some other form of government.

However, there's another important point: Dictatorships and controlled economies don't work for long. It's easy to prove, using the mathematics of Computation and Complexity Theory, that controlled, regulated economies only work for relatively small populations. As the population grows, the number of "regulators" grows exponentially faster than the population, and so either the government regulates less or it collapses. That's why the countries of North Korea, Cuba, East Germany and Russia were all stuck in the 1950s for decades under communism. Capitalism and freedom are not so much ideologies as mathematical imperatives. (24-Aug-07) Permanent Link
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Friday's Fed move turns Wall Street from panic back to giddiness

Investors seem to have regained their old giggly confidence on Wednesday, as they pushed the market up by a little over 1% (Dow).

With respect to the countdown to September 10-21 that we've been discussing as the likely date range for a major panic, the 1% rally makes no difference at all. What is important is whether investors are getting confident enough to push the bubble up again.

On Wednesday, four major U.S. banks announced that they've taken advantage of the Fed's new bargain discount rate, and have borrowed $500 million each. One pundit on CNBC said that this marks the end of the credit crunch, since all this money is now available to lend to people. Happy days are here again. The reporters were all giddy again.

It's been a long time -- years -- since anything that's happened on Wall Street bears any real relationship to common sense. Those four loans total $2 billion, and that's a tiny fraction of the hundreds of billions of dollars in credit that was floating around just weeks ago, and even less compared to the tens of hundreds of trillions of dollars of subprime mortgage-backed securities in most organizations' portfolios. Still, it was enough to cheer up investors on Wednesday.

From the point of view of Generational Dynamics, none of this should make any difference in where we're going. Remember from the 1929 vs 2007 comparison chart that I've been posting every few days that two weeks before the 1929 crash, the Dow spiked up 6.3% That might happen again, and you can just imagine how giddy the CNBC reporters will become after that.

What we're doing is a real-time test of a theory: That the level of anxiety and panic spreads among the public at an exponential rate that is independent of historical time and place, and that therefore we can predict when a full-scale panic will occur -- sometime in the September 10-21 time frame.

So if the pundits are right, and confidence has been restored, then the test will have failed, and that would be a big surprise to me. What I expect is that the level of anxiety and panic will continue to grow exponentially, as will become apparent as soon as there appears some bad news.

So, Wednesday was such a fun, uneventful day, but we'll have to see whether that continues. (23-Aug-07) Permanent Link
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Is your bank deposit protected by the FDIC?

It turns out that the FDIC doesn't really have much money.

A web site reader sent me a link to an article by a gold dealer that makes a very important point: The Federal Deposit Insurance Corporation (FDIC) has only $50 billion of assets in its Deposit Insurance Fund.

I wanted to verify this, and finally found it on the Deposit Insurance Fund Portfolio Summary - First Quarter 2007 page of the FDIC web site. The amount in the Deposit Insurance fund, as of March 31, 2007, was $47 billion (par value) or $49.8 billion (market value).

OK, that sounds good. Now, how much money is the FDIC insuring? Well, that took a little more searching, to find "FDIC insured institutions - state totals" (Go to http://www2.fdic.gov/sod/index.asp then click on "Summary Tables" and then click on "05 State Totals."

You can check out your own state for yourself if you want, but the total for all states is $6,449,864,000,000 or $6.5 trillion in almost 9,000 institutions and 95,000 offices. So that $47 billion in the Deposit Insurance Fund won't go very far if banks start failing.

Just to take one example: Countrywide Bank depositors panicked last weekend and mobbed branch offices to get their money out. This occurred after Countrywide had drawn down its $11.5 billion credit lines, for fear that those credit lines would become unavailable. Now, that's $11.5 billion for just one institution. So your money really WOULD be safer if you took it out of the bank and stuffed it in your mattress.

Incidentally, the Bank of America announced on Wednesday that it would invest $2 billion in Countrywide to keep it afloat. (23-Aug-07) Permanent Link
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If you lose your house through foreclosure, you may face a big tax bill

The idea of "walking away" from your home, if you're going to be unable to pay the mortgage payments, has gained publicity since it was recommended by CNBC's Jim Cramer when he became hysterical.

If you're thinking of "walking away," or if you're going to be foreclosed for any other reason, a New York Times article points out that you're going to be hit with a very big tax bill.

Reason: They amount of the mortgage loan that you don't pay is treated by the IRS as taxable income to you.

There are ways to structure a foreclosure so that you don't pay a big tax bill. The article provides some ideas, but this emphasizes the point that if you're threatened with losing your home through foreclosure, you'll really need legal and tax help. (23-Aug-07) Permanent Link
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A NY Times article discusses historical price/earnings ratio.

This is an extraordinary and historic event in economic journalism.

A web site reader called my attention to an article in the NY Times that discusses the danger to the stock market illustrated by historic price/earnings ratios.

I've been discussing price/earnings ratios on this web site, most recently in my recent analysis, "How to compute the 'real value' of the stock market."

But to see it in mainstream media is incredibly startling, since "experts" and pundits and Fed governors, and professors of economics and everyone else have been completely oblivious to historical data. Most of them believe that the world was created 15 or 20 years ago, and nothing before that date mattered.

(As an aside, the web site Wall Street Journal online has started making "historical data" available. "Oh!" I thought, "That should be useful!" Well, if you try to get any of their historical data, it goes back a WHOLE THREE MONTHS! Greg Ip and the other dodos at the Journal are even worse than other journalists - and apparently believe that the world was created just three months ago.)

In the NY Times article, I find these amazing paragraphs:

"More than 70 years ago, two Columbia professors named Benjamin Graham and David L. Dodd came up with a simple investing idea that remains more influential than perhaps any other. In the wake of the stock market crash in 1929, they urged investors to focus on hard facts � like a company�s past earnings and the value of its assets � rather than trying to guess what the future would bring. A company with strong profits and a relatively low stock price was probably undervalued, they said.

Their classic 1934 textbook, �Security Analysis,� became the bible for what is now known as value investing. Warren E. Buffett took Mr. Graham�s course at Columbia Business School in the 1950s and, after working briefly for Mr. Graham�s investment firm, set out on his own to put the theories into practice. Mr. Buffett�s billions are just one part of the professors� giant legacy.

Yet somehow, one of their big ideas about how to analyze stock prices has been almost entirely forgotten. The idea essentially reminds investors to focus on long-term trends and not to get caught up in the moment. Unfortunately, when you apply it to today�s stock market, you get even more nervous about what�s going on.

Most Wall Street analysts, of course, say there is nothing to be worried about, at least not beyond the mortgage market. In an effort to calm investors after the recent volatility, analysts have been arguing that stocks are not very expensive right now. The basis for this argument is the standard measure of the market: the price-to-earnings ratio.

The article uses a different measure of price/earnings, and makes a couple of errors, so I'd like to discuss some of the points of the article.

Let's begin by displaying the graph that I used in my recent article, followed by the graph in the NY Times article:

S&P 500 Price/Earnings Ratio (P/E1) 1871-2007

S&P 500 Price/Earnings Ratio (P/E1) 1871-2007

S&P 500 Price/Earnings Ratio (P/E10) 1881-2007 (Source: nytimes.com)

S&P 500 Price/Earnings Ratio (P/E10) 1881-2007 (Source: nytimes.com)

The two graphs look almost the same, but there are slight differences because "earnings" are computed slightly differently.

The caption on the lower diagram tells the story:

A different Way of Looking at Stock Prices

"Relative to corporate earnings over the previous 10 years, stocks have been more expensive recently than at almost any other point in the last 130 years. The two exceptions are the great bull markets of the late 1920s and late 1990s. (By the more common definition of the price-to-earnings ratio, which compares stock prices to profits over the previous 12 months, stocks have been at a relatively normal level recently.)

Price-to-earnings ratio Based on average corporate profits for the previous 10 years, plotted monthly."

When you're computing the price/earnings ratio, it's easy enough to compute the "price" -- it's the current price of a stock share. But how do you compute "earnings"? The most common method is to compute the earnings per share for the preceding year; this measure of price/earnings is called P/E1. But Professor Robert J. Shiller recommends using average annual earnings for the previous ten years. This measure of price/earnings is called P/E10.

Notice that the caption above says that by the P/E1 measure, "stocks have been at a relatively normal level recently."

This is completely wrong, and it illustrates the kinds of misleading statements that are frequently made about P/E ratios.

Please note the following:

The long-term average for P/E1 is about 14, and is currently 17. Thus, stocks have NOT been "at a relatively normal level recently."
The long-term average for P/E10 is about 17, and is currently around 27.

However, the biggest error of all in the article is an error of omission: It doesn't mention the Law of Mean Reversion.

The point is that 17 (or 14) is the long-term historical AVERAGE, not the MINIMUM. So if the P/E ratio has been above average since for the last 12 years (since 1995), then it has to be below average for the next 12 years, to make the long-term average the same. I explained all this in my recent analysis.

The biggest mistake in the NY Times article is the conclusion that it draws: "Now, this one statistic does not mean that a bear market is inevitable. But it does offer a good framework for thinking about stocks."

Yes, it means that and a lot more. There's no question about it.

The NY Times article is welcome despite its errors, because it brings greater attention to these issues. It's interesting that the book that it refers to was published in 1934, just after the Wall Street crash. That's the only time when people are interested in such material -- they want to know what went wrong. The generations born later not only know nothing about P/E ratios, but don't want to know.

Within a year or two, P/E ratios will come back into fashion once more, as people try to figure out where they went wrong.

Before closing, let me call the reader's attention to the graph on the bottom of the home page of this web site, there's a graph that changes weekly showing the S&P 500 price/earnings index for the last ten years. Here's the chart as of August 17:

S&P 500 Price/Earnings ratio (P/E1) and S&P 500-stock Index as of 17-Aug-2007. (Source: MarketGauge ® by DataView, LLC)

S&P 500 Price/Earnings ratio (P/E1) and S&P 500-stock Index as of 17-Aug-2007. (Source: MarketGauge ® by DataView, LLC)

The top part of this graph shows the S&P 500 Price/Earnings ratio. Notice that the graph has been in the "stocks are expensive" region since 1995 until recently. By the Law of Mean Reversion, it will be necessary for stocks to become "inexpensive" for a similar length of time.

I've been posting this graph on my home page for almost five years. The fact that DataView LLC is providing this graph, and labeling the "expensive" and "inexpensive" regions, means that there are some people out there besides myself who know what's going on. (23-Aug-07) Permanent Link
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Deutsche Bank's CEO says that German banks are in trouble

Meanwhile, Wall Street breathed a sigh of relief on Tuesday as "nothing happened" for a change, for two days in a row.

It was just two weeks ago that the Europeans were confidently feeling that the U.S. was going to be in trouble because Americans had been so foolish about regulating mortgage-based securities, but not the Europeans.

I quoted Neil Munroe of Equifax in Europe in a BBC interview that the Europeans would be OK because European officials exercise "more control" than Americans, and that "there's more prudence here." However, I also noted that Munroe became increasingly nervous and sweaty as the interview went on.

Now we know why he was so nervous. It turns out that European banks weren't so prudent after all.

A few days ago, French firm BNP Paribas Investment Partners suspended client redemptions (translation: You can't take your money out), saying, "The complete evaporation of liquidity in certain market segments of the US securitisation market has made it impossible to value certain assets fairly regardless of their quality or credit rating."

It now turns out that several German banks are in the same boat. SachsenLB is out $23.2 billion, and IKB Deutsche Industriebank has a similar problem. In both cases, it's because of investments that were "not prudent."

Both firms issued short-term commercial paper ("You can get your money out any time you want,") but reinvested the proceeds in CDOs and other mortgage-based securities that supposedly provide higher yields over long periods of time. Now investors want their money bank, and the two firms no longer have the funds.

It also turns out that Germany's largest bank, Deutsche Bank, actually went to Ben Bernanke's Fed Discount Window to borrow money at the new improved 5.75% rate. I didn't think that Bernanke's deal was open to foreign banks, but I guess it is.

It seems that these three German banks have the same problem that BNP Paribas has, according to the CEO of Deutsche Bank:

"We sense reluctance on the part of foreign partners to extend credit to German banks. If we have a banking crisis in Germany with other countries cutting us off, then other banks will also face difficulties."

In other words, they would have liked to borrow money at the Fed Funds Rate (5.25%), but nobody's willing to lend them money any more, so they went for the Fed discount rate (5.75%) because he was desperate.

And these German banks are not private banks. They're backed by the German government, and are considered to be part of the government.

However, none of this was enough to stir much passion on Wall Street, as the markets were fairly steady all day.

The reporters and pundits at CNBC seemed visibly relieved on Tuesday, as the second relatively tame day passed. The Dow peaked at 14,000 on July 19, a day that I've heard CNBC pundits call "an almost perfect day." And several pundits said that now the worst was over. He said that July 23 was the start of the recent volatility, and that such volatility normally lasts only 4-5 weeks, and that volatility is still above normal, but was lower than the peak.

Still, there was one thing that has been causing a great deal of surprise: The collapse in yields on short-term Treasury bills. Three-month Treasury bill were paying 4.82% a month ago, 4.48% a week ago, but were paying only 2.46% on Monday, though they were back up to 3.31% on Tuesday.

This huge volatility is extremely rare. Recall that the U.S. Treasury sells 3-month Treasury bills to be redeemable for a fixed amount of money in 3 months. Different parties bid on them, for investment purposes. If many parties are bidding, it means that the prices of the Treasury bills are auctioned at higher prices, which means that the net interest rate for 3-months goes down. The higher the price, the lower the yield (and vice-versa).

So this enormous drop in yields means that a lot of people are investing in them. This is what some people call a "flight to safety," meaning that investors are putting their money into safe Treasury bonds, rather than into the stock market.

Well, volatility is not necessarily the equivalent of anxiety and panic, which is what we're watching for, but it's a sign of increasing anxiety. Still, if the pundit mentioned above is right, and everything settles down, then the real time experiment that I described in the analysis I just wrote ("How to compute the 'real value' of the stock market.") would have failed.

Just to recap: Generational Dynamics does not chart events unless they're tied to attitudes and behaviors of large masses of people, entire generations of people. What has become apparent since July 19 is a huge change in behaviors and attitudes of large masses of investors and even ordinary people, who are mobbing banks to withdraw their money.

If this anxiety continues to grow, which is what we expect, then comparisons with previous generational panics indicate that a new generational panic and stock market crash will occur in a few weeks, most likely in the period September 10-21.

This is something that you can monitor for yourself. Make your own judgment as to whether this generational anxiety and panic is increasing. If the pundit mentioned above is right, then a panic and stock market crash must still occur, but will occur later. But if the anxiety level increases, then the stock market crash should come at roughly the expected time. (22-Aug-07) Permanent Link
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Sentinel Management files for bankruptcy

Following its announcement last week that it's clients would not be able to get their money out, Sentinel Management Corp. filed for Chapter 11 bankruptcy late Friday.

You'll recall that when I wrote about Sentinel last week, after it had halted redemptions of shares by investors, I was able to get a copy of their web site's FAQ page before the Sentinel web site went down. The FAQ included statements like the following:

"Sentinel buys only the highest quality and most liquid securities (unless specifically directed by a client to seek higher yield in somewhat lower quality issues). Sentinel will not use derivatives, options, or any other 'financial engineering' techniques to enhance the yield on its portfolios. Sentinel's objective is to achieve the highest yield consistent with preservation of principal and daily liquidity, not simply 'the highest yield'.

But apparently Sentinel did NOT buy the highest quality and most liquid securities. Perhaps they bought AAA-rated securities but, as we discussed in conjunction with the article "Anxious investors mob Countrywide Bank to withdraw their deposits," so-called collateralized debt obligations (CDOs) can be AAA-rated, but worthless. It's quite possible that Sentinel (and Countrywide) purchased these securities entirely because of their AAA rating, which meant that no further investigation was required. Of course, these CDOs are based on millions of subprime mortgage loans that many homeowners will not pay, once the low "teaser" interest rates expire.

Please read my new analysis article that I've just posted, "How to compute the 'real value' of the stock market." This article explains methods for evaluating the stock market, indicating that it's overpriced by a factor of around 250%, and speculates on schedule that will end in a stock market crash some time during the week of September 10-14 or September 17-21.

The situation with Sentinel is highly relevant to the situation. In order for the September 10-21 crash date to be met, it will be necessary for the general level of public and investor anxiety and panic to continue increasing,

Some kind of tipping point was passed about a month ago, shortly after the July 19 stock market peak. Up to that point, bad news made the stock market contine to rise. Since then, bad news is causing the market to make sharp falls.

The Sentinel bankruptcy occurred late Friday, and that may be too long ago to have any effect on investor attitudes on Monday. (Is three days too long? These days, three hours may be too long.)

As I'm writing this (around midday Asian time), the Tokyo Stock Exchange's Nikkei index is up over 4% (having fallen 5.4% on Friday). So at least the Tokyo investors don't seem too broken up about the Sentinel bankruptcy.

It's going to be an interesting week. (20-Aug-07) Permanent Link
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Anxious investors mob Countrywide Bank to withdraw their deposits.

Panic is spreading, as people wonder whether their money is safe ANYWHERE.

Anxious customers jammed the phone lines and website of Countrywide Bank and crowded its branch offices to pull out their savings because of concerns about the financial problems of the mortgage lender that owns the bank.

The bank's owner is Countrywide Financial Corp., the biggest home-loan company in the nation. Ever since the Bear Stearns debacle began in June, analysts have been expressing concern that Countrywide and other home-loan companies are going to be in financial trouble. Indeed, as of today, the Implode-o-Meter web site indicates that 128 mortgage lenders have "imploded" since December.

Thursday's panic was triggered by fears that Countrywide would declare bankruptcy and by a Thursday announcement by Countrywide that it was borrowing its entire $11.5 billion lines of credit from 40 banks. It's interesting to read Countrywide's press release:

"CALABASAS, Calif., Aug 16, 2007 ... Countrywide Financial Corporation (NYSE: CFC) announced today that it has supplemented its funding liquidity position by drawing on an $11.5 billion credit facility. ...

"As we have previously discussed, secondary market demand for non-agency mortgage-backed securities has been disrupted in recent weeks," said David Sambol, President and Chief Operating Officer. "Along with reduced liquidity in the secondary market, funding liquidity for the mortgage industry has also become constrained.

"For many years, Countrywide's liquidity management framework has focused on maintaining a diverse, multi-layered assortment of financing alternatives," said Sambol. "A primary component of this framework is a committed, unsecured credit facility of $11.5 billion provided by a syndicate of 40 of the world's largest banks. In response to widely-reported market conditions, Countrywide has elected to draw upon this entire facility to supplement its funding liquidity position. ...

"Countrywide has taken decisive steps which we believe will address the challenges arising in this environment and enable the Company to meet its funding needs and continue growing its franchise. ...

"Our objective is to navigate the difficult conditions in today's market as we complete the transition of our Bank business and funding strategy," Sambol concluded. "With these changes, we believe we are well-positioned to leverage opportunities presented by a consolidating industry."

Looking beyond the soothing words of the press release, it's not easy to discern how much trouble Countrywide is in. However, part of the reason, apparently, for Countrywide to have drawn its entire credit line is concern that the credit line will disappear soon, thanks to the ongoing liquidity crisis.

Thus, it's particularly ironic that Countrywide's bank depositors are doing EXACTLY what Countrywide is doing -- they're withdrawing their deposits out of concern that their deposit will disappear soon, thanks to the ongoing liquidity crisis.

So the panic is growing at all levels from individuals to corporations.

According to the news story:

"Worried about the stability of mortgage giant Countrywide Financial, depositors crowd branches. In Laguna Niguel, Bill Ashmore drove his Porsche Cayenne to the bank's office and waited half an hour to cash out $500,000. "It's got my wife totally freaked out," he said."

This is interesting for a couple of reasons. One is just the level of panic that it portrays.

The other is the size of the deposit -- $500,000.

People will tell you that the money that you deposit in a bank is perfectly safe, as long as it's insured by the Federal Deposit Insurance Corp. (FDIC). Even if a bank goes completely bankrupt, you'll be told, you'll be able to recover your money in time from the FDIC.

But the rules for FDIC insurance are complicated. Even if Countrywide has FDIC insured accounts, that doesn't mean that ALL its accounts are insured. And even if your account is insured, that doesn't mean that your ENTIRE account is insured. In many cases, insurance is limited to $100,000, so if you have $500,000 in the bank, then you may not be fully insured.

There are a number of resources available on the FDIC web site:

You can go to the Institution Directory page and click on "Bank Find" to get a complete report on your bank.
For example, if you type "Countrywide" into the Bank Find form, then click on "Countrywide Bank FSB," then click on "Last Financial Information" available, then click on "Generate Report," then you get a report that tells you that approximately 60% of deposited funds are insured.

You can use a calculator -- the Electronic Deposit Insurance Estimator -- that will tell you whether your particular deposits are insured.

Bob Donaldson, Post-Gazette Raymond Przybilinski, 77, outside the closed Metropolitan Savings Bank on Butler Street. (Source: Pittsburgh Post-Gazette)

Bob Donaldson, Post-Gazette Raymond Przybilinski, 77, outside the closed Metropolitan Savings Bank on Butler Street. (Source: Pittsburgh Post-Gazette)

Losing your money in a bank is a real concern.

Three weeks ago, a web site reader sent me a reference to a story about a bank collapse, and she commented "Here's the other 'sad story' of the impact."

You have to feel sorry for this guy. He grew up during the horrors of the Great Depression, and he learned his lesson -- he worked hard, saved every penny he could, and put his money -- totalling $521,000 -- into the bank.

According to the article, he transferred his money to the Metropolitan Savings Bank two years ago, when bank officials told him that his money would be insured -- safe and sound.

Now the bank has failed, with regulators citing "unsafe and unsound" operations. And it turns out that he had been misinformed. The FDIC doesn't insure his entire account, and so he loses $321,000 that he had planned to give to his kids.

A few days ago I posted an article entitled "Redemptions of money market funds now fully in doubt." I received some criticism for that, because money market funds are supposed to be completely safe. Well, are they safer than banks?

Every day that passes makes me more astounded about what's happened with CDOs (collateralized debt obligations). The sheer immensity of what's been done is so mind-boggling that it's not surprising that almost everyone is oblivious to it, because it's too incredible to believe. If this were a novel, noone would even find it credible, because so many people have been doing so many stupid and shady and fraudulent things, that you'd never believe that no one caught on.

First you had loosening standards for mortgage loans, to the point where many millions of "subprime" mortgages have been written for homeowners who will never be able to meet the payments, after the initial "teaser rates" expire.

These mortgages were combined into packages of mortgage-backed securities, but since they're so risky, they're rated BBB and BBB- by the ratings agencies.

Now here's the problem: A lot of institutions won't invest in low-rated securities. Some are forbidden by law from doing so, some by charter, and many just don't like it. They'll invest only in the lowest-risk highest-rated AAA securities. Furthermore -- and here's the big point -- once securities receive an AAA rating from the ratings agencies (S&P, Fitch, Moody's), they don't have to ask any more questions. They're considered OK.

So the financiers who were stuck with tens of millions of dollars in BBB and BBB- mortgage-based securities wanted to get rid of them, and looked for a way to increase their ratings. As I recently described, they found a way to slice and dice and repackage these securities into cascading "tranches" of securities, structured in such a way that they could get an AAA rating for most of them. These are the collateralized debt obligations or CDOs. They're restructured securities with AAA ratings, backed indirectly by high-risk subprime mortgages.

However, not all of the tranches of these CDOs are AAA rated. Some of even these are are BBB- CDOs. So the financiers repeated the same trick: They took low-rated CDOs, restructured them into "CDO-squared" securities, and got them an AAA rating as well.

In the process of all this restructuring, the value of these securities was leveraged so that what was formerly tens of millions of dollars of BBB and BBB- rated securities had been magically transformed into tens or hundreds of trillions of dollars of AAA securities.

Please re-read the preceding paragraph and let it sink it, as it has been sinking it with me these last few weeks. It's so incredible that it's almost impossible to grasp.

And since these securities had AAA ratings, every institution in the world could freely invest in them, and almost every one of them did.

Thus, these CDOs are like tens or hundreds of trillions of tiny termites that gnawed there way into the portfolios of every major institution in the world, some more than others, some less than others.

And you have no way of knowing whether your bank, your pension fund, your money market fund or your insurance company has invested heavily in these CDOs.

Because even though these CDOs have a nominal value of tens or hundreds of trillions of dollars, they're based on tens of millions of dollars worth of subprime loans, many of which won't be repaid. The result is that these CDOs aren't worth the paper they're written on.

And so I summarize: Your bank or your pension fund, etc., may have invested millions or billions of dollars in these CDOs, and they are going to suffer an almost total loss of principal on those investments.

Almost all of these institutions are keeping quiet about this, because they're scared to death of what might happen -- and the experience of Countrywide is an example. Countrywide decided to draw down its credit line, and their banks were mobbed by depositors withdrawing their money.

That's why people are panicking. There's no way to know whether you'll have anything left, or whether your bank or your money market fund or your insurance company will survive.

In my article a couple of days ago, "The nightmare is finally beginning," I reached the conclusion that we're beginning a real generational panic by watching how anxiety has increased over the more and more people, with no sign of stopping.

From the point of view of Generational Dynamics, this is the signal that I wait for, when I'm evaluating actions of countries around the world. We saw a panic begin last summer in Israel when two Israeli soldiers were kidnapped near the Lebanon border and and Israel panicked and launched the Lebanon war within four hours, with no plan and no objectives. That's how generational crisis wars begin.

Now we're seeing a similar kind of panic in the financial world, and it's affecting everyone. Here's what a web site reader wrote to me yesterday:

"It's amazing to witness this and read your comments. I've been thinking like you--nobody seems to have a clue and anybody who does (if there is anybody) is not talking. I don't watch CNBC, but the people I was talking to as the market really began to gyrate wildly at the end of last week were babbling utter nonsense too.

For example, I called my broker Friday morning. The market was back up by then. I asked for a quote on the S&P. Then I will usually make a little small talk. Anyway, this guy started babbling nonsense and was unable to stop.

It didn't make any sense. Something about a guy he knows who is worth $800 million and went to a party with Bernanke and then told him that Bernanke will have to lower interest rates. He must have babbled for 10 minutes without stopping and I listened without saying anything."

This is the kind of anxiety we're seeing everywhere, and it's leading to a full-scale generational panic.

I've posted many quotes from John Kenneth Galbraith's 1954 book, The Great Crash - 1929, but one web site reader has called my attention to one passage that had escaped my notice so far:

"Never was there a time when more people wanted more money more urgently than in those days. The word that a man had got caught by the markets was the signal for his creditors to descend on him like locusts. Many who were having trouble meeting their margin calls wanted to sell some stocks so they could hold the rest and thus salvage something from their misfortunes. But such people now found that their investment trust securities could not be sold for any appreciable sum and perhaps not at all. They were forced, as a result, to realize on their good securities. Standard stocks like Steel, General Motors, Tel and Tel were thus dumped on the market in abnormal volume, with the effect on prices that had already been fully revealed. The great investment trust boom had ended in a unique manifestation of Gresham�s Law in which the bad stocks were driving out the good."

Incidentally, note the reference to "investment trusts" in this paragraph. These were the hedge funds, the derivatives, the CDOs of 1929, and they were abused just as much. People today talk about "containing the financial crisis" to the mortgage market. But Galbraith's point was that the 1929 crisis could not be "contained" to the investment trusts.

From the point of view of Generational Dynamics, this is all very familiar. A generational stock market crash is overdue. If you go back through history, there are of course many small or regional recessions. But since the 1600s there have been only five major international financial crises: the 1637 Tulipomania bubble, the South Sea bubble of the 1710s-20s, the bankruptcy of the French monarchy in the 1789, the Panic of 1857, and the 1929 Wall Street crash. We're now overdue for the next one.

The increasing level of anxiety and panic is the measure of where we are on the road to the next crash. It now appears that the levels of anxiety and panic are going to continue to increase. If, by some miracle, they stop and fall again, then we may have a little more time.

But if, as I expect, these levels of anxiety and panic continue to increase, then I would expect to have a major stock market crash within a few weeks, or months at the most.

Thus, Countrywide's move in drawing down its credit line and Countrywide's depositors' moves in withdrawing their deposits are both quite rational moves.

What this means for you, Dear Reader, is the following: If you have been thinking of doing something to protect yourself or your family, then right now is the time to do it. (19-Aug-07) Permanent Link
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Ben Bernanke's Great Historic Experiment

Bernanke doesn't believe that bubbles exist. His Fed policy will now test his core beliefs.

The story goes that when Fed Chairman Ben Bernanke was a little boy in the 1960s, he asked his grandmother why kids didn't wear shoes during the Great Depression. "Because they didn't have any money to buy shoes," she said. Why didn't they have any money? "Because the place they were working had closed down." Where had they been working? "A shoe factory."

This made no sense to Bernanke. If someone just gave a little money to the shoe factory owners, then they could have opened the shoe factory, manufactured some shoes, sold them, and paid the workers, who could then buy shoes for their children. All it would take is a little money.

That's why Bernanke doesn't believe in bubbles. That's why he believes that the 1930s Great Depression was CAUSED by the Fed -- which could have poured some money into the economy and prevented the Great Depression completely.

Bernanke undoubtedly knows that he and the Fed are being tested right now. He must know that the liquidity crisis going on right now is very similar to the liquidity crisis that preceded the 1929 crash.

If his theory is correct, then the actions he's pursuing now will prevent a new Great Depression.

And so, the Fed and other central banks around the world have been pumping money into the financial institutions of their various countries.

But Bernanke's biggest shot so far occurred early on Friday morning.

Wall Street was set to open sharply down. The Tokyo Stock Exchange had fallen 6% the previous night, and it looked like the Dow would fall 100-200 points when the markets opened at 9:30 am. That would be the seventh straight day of losses, at a time when the Fed was already pumping money out into credit markets.

Bernanke took the next step. Early Friday morning, the Fed lowered the discount rate from 6.25% to 5.75%.

Now, let's explain. Financial institutions are permitted to borrow money from the Fed when they're in trouble, and they can do so if they're willing to pay the discount interest rate. By lowering the discount rate, the Fed presumably makes it cheaper and easier for banks and so forth to borrow money if they need it.

The Fed discount rate is not the same as the Fed funds rate, which is the rate that everyone watches closely. That one has been at 5.25% for some time, and was close to zero just a few years ago. The Fed funds rate controls interest rates on Treasury bonds, and so affects everyone. The discount rate is much more restricted, and it's a higher interest rate. Banks usually just borrow money from each other at the funds rate (5.25%), but if they're stuck, they can borrow from the Fed's "discount window," now at 5.75%.

So, the Fed took a fairly modest step in the direction of making more money available.

Well, the results were spectacular. Instead of going down, which had been expected, the Dow shot up 300 points in just the first few minutes of trading. There were some oscillations, but the Dow ended up 200 points or so by the end of the day.

So, does this prove that Bernanke's theory is right? Just lower the discount rate, and investors immediately give up their risk aversion and go back to pumping up the stock market bubble?

This I have to see.

We can expect the market to fall sharply again as soon as there's bad news.

What's wrong with Bernanke's "shoe factory" story?

When Bernanke was a kid in the 1960s, all the country's leaders were from the generations that had beaten the Depression and had beaten the Nazis. They survived by learning how to manage money and learning how to govern. There were popular books around with titles like "Think and Grow Rich" and "How to get rich in real estate." It was a "can-do" time.

At that time, if you gave money to an entrepreneur, he would indeed start a business, whether it be a shoe factory or a computer factory. The company's financials would be carefully monitored, and a successful businessman could convince the bank to lend him more money to build his business, if it was well-managed.

So Bernanke's solution would have made sense in the 1960s.

But that shoe factory solution would not have worked in the 1930s.

The leaders in the 1930s were very similar to the leaders today, who are from the Boomer generation and Generation-X. People from these generations have no idea how to govern -- as can be seen from the clown circus going on in Congress -- they have no idea how to manage money -- as can be seen from debauched use of credit in the last few years -- and they have no idea how to run a business -- as we can see from the way that manufacturing jobs have fled to China and service jobs have fled to India.

1930s leaders were just as incompetent as leaders are today. Injecting money into the economy then would have been as ineffective as doing it today.

Does anyone really believe that lowering the discount rate by �% will make any difference? Will that help anyone start a shoe factory?

Last year I wrote an article entitled "System Dynamics and the Failure of Macroeconomics Theory." That article explained what's wrong with mainstream macroeconomics, and why it had failed to explain or predict anything since the dot-com bubble began in 1995.

Mainstream macroeconomics is wrong because it assumes that people's economic attitudes and behavior are correlated to their income, their social class, and their age. So, according to their models, a white 50-year-old upper class male today would be very similar to a white 50-year-old upper class male in 1975.

But that's simply not true, as this web site has been showing for years. The mainstream models assume that when someone becomes poor he changes his behavior, but that's absurd. Income, social class and age are MUCH LESS important than the generation you're born in.

A white 50-year-old upper class male today would be very similar to a 20-year-old upper class male in 1975. That's what mainstream economists can't seem to get through their heads.

They can't understand the simplest things. Today's population is VASTLY different from the population even ten years ago, for a very simple reason: Ten years ago, there were still quite a few people around who had lived through and survived the Great Depression. Today there are almost none, and that makes all the difference in the world.

If you look at the various economics blogs these days, you'll see discussions of the concept of "moral hazard." This is the most ridiculous discussion imaginable, and shows how out of touch economists and financiers are with what's going on in the world.

The "moral hazard" concept is that if the Fed lowers interest rates to bail out people and institutions that have behaved badly, then you're essentially rewarding bad behavior, and the people and institutions will continue their bad behavior.

So let's see: People in the incompetent Boomer generation have created the dot-com bubble, the credit bubble, the housing bubble, and the stock market bubble, they signed millions of subprime mortgages that will cause them to lose their homes, and they created tens or hundreds of trillions of dollars worth of collateralized debt obligations (CDOs) whose tentacles have reached into the financial portfolios of most institutions around the world.

After all that, the economists are all sitting around worrying about whether a �% decrease in the Fed discount rate will cause Boomers to exhibit bad behavior. That's like worrying about whether a serial mass murderer is going to get a parking ticket.

And so, another day has gone by where we've seen that these so-called "experts" have ABSOLUTELY NO IDEA what's going on. The only way you can understand what's going on is to understand generational theory, and they won't even consider that. They'd rather stick to their models that are always wrong.

And so, Ben Bernanke's Great Historic Experiment will go on.

I wonder where he is tonight? Is he in bed, sleeping soundly, confident that the global economy is in good shape, thanks to his �% decrease in the Fed discount rate, and that he will prove, once and for all, that he's conquered the economic cycle, and that he'll be recognized by historians as a hero?

Or is he tossing and turning, worrying about what's going to happen tomorrow and the day after and the day after that? Is he worried that, perhaps, history will recognize him as one of its greatest failures?

I'd bet that he's tossing and turning, because he knows what we all know: He doesn't have the vaguest idea what's going on. (18-Aug-07) Permanent Link
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The nightmare is finally beginning.

After Thursday's events, there can be little doubt: A generational panic and stock market crash has begun.

When I say "Thursday's events," I don't mean the fact that the Dow went from 0 to -350 to -150 to -200 and then, in the last few minutes of the session, became positive before settling at slightly negative. That plays into it, but it's not the main factor.

I'm talking about dramatic and overwhelming changes in attitudes that have occurred in just the last two weeks.

Remember the rules about Generational Dynamics: It's not the events that matter; it's not the attitudes and behaviors of a few politicians that matter. What matters is the attitudes and behaviors of large masses of people, entire generations of people.

There was a big stock market nosedive for a while on Thursday, but a stock market nosedive happens all the time. As with everything else in generational theory, it's not the "spark" that matters, but people's reactions to the spark.

There has been an enormous change in attitudes and behaviors of the masses of investors around the world in just the last two weeks.

I made up my mind that generational panic had begun this afternoon, because of the total panic in the faces and voices of everyone who was speaking on CNBC. They were babbling total nonsense, and it was obvious they had NO IDEA what was going on.

It seems like years now, but it was just a month ago that bad economic news would push the market to a new high. That was totally irrational.

It was just a week ago that I first felt I was sensing the "smell of panic."

That smell of panic has been growing every day since then, and on Thursday it was a stench. Every little bit of bad news is enough to cause the Dow to fall 100 points almost immediately.

And all the commentators, executives, financiers, analysts and journalists who comment on the situation are baffled and desperate. It's in the eyes and voices. This sense of panic has been growing quickly the last couple of weeks, and this is what generational panic is.

As if to prove my point, the market gained about 200 points in the last few minutes of Thursday's session. When the Dow went positive, there was a huge cheer from everyone on the floor of the stock exchange, as if a soccer team had scored a goal, and if I'm not mistaken, Maria Bartiromo was so giddy that she jumped up and down like a schoolgirl.

So you have a situation where literally no one has any idea at all what's going on. NO IDEA AT ALL. All they can do is hope and pray that things go their way, and they all know in their hearts that they won't.

The panic is fully justified. Most investors are oblivious to the CDO (collateralized debt obligation) problem, but this is a huge problem as I've described several times in the past. And what we're seeing is that the worst-case scenario is turnout out to be the truth. CDOs are everywhere, in every kind of portfolio, every investment class. And they're backed by a mortgage industry that's collapsing, and bringing down everyone with them.
Think of the world economy as a huge, enormous bloated mansion made of wood, with all kinds of additions tacked on all over the place. Think of the CDOs as millions of termites that are eating away at the insides, so that another piece of the mansion falls off into the ravine almost every day, and it won't be long before the entire house falls into the ravine.
As readers know, I've been following this thing with CDOs closely, and it is BEYOND BELIEF what's happened. I remember in the 1950s hearing my teachers telling me how foolish everyone was in the 1920s. Well, people are going to look back at this time, and the acronym "CDO" will live in infamy.

Everything happening now is what happened just before the 1929 crash, as described in John Kenneth Galbraith's 1954 book, The Great Crash - 1929, which I've quoted many times on this web site: The mania for mergers and acquisitions, the drying up of liquidity, the central banks injecting funds to stave off disaster. They even had hedge funds in those days -- only, they were called "investment trusts," and they were just as abused as hedge funds are today.

There have been HUGE changes in attitudes and behaviors in just the last couple of weeks, and that's why I'm saying that the nightmare has begun. A month ago, investors ignored bad news and continued as before. Today, investors are panicking, and each new piece of bad news causes them to panic even more. This is a change that's occurring VERY RAPIDLY, and it cannot be stopped.

I want to emphasize as strongly as I can that the supposed experts have NO IDEA what's going on. You cannot understand what's going on unless you understand generational theory, and everyone I try to explain it to simply rejects it. They'd rather stick with the "experts," who have gotten EVERYTHING wrong since the 1995 bubble started, and they won't even consider generational theory and this web site, which has gotten every prediction right for the past five years.

A couple of days ago, I listed some of the really stupid things that "experts" were saying on CNBC, like "You just have to ride it out," "There's still plenty of money sitting on the sidelines waiting to come back in to the market," and "Fundamentals will soon come back in to line."

Here are some additional things I've been hearing:

"What we're seeing is hedge fund unwinding -- and that's certainly very constructive."

"This is a big buying opportunity -- stocks are very cheap now."

"We've wiped out any excess optimism - that's a good thing."

"We're finally seeing people panic, and that's always when we reach the bottom, and stocks start going up again."

"There's a lot of value out there."

"Today's theme: This is a big opportunity for investors."

"What we're seeing is 'capitulation selling' - everyone is throwing in the towel. This is a clear signal that we're near the bottom."

"The bulls are finally out of the woodwork. We have the setup for a rally, since we've been going down all week."

These are statements that were made by "experts." Keep in mind that they have no idea what they're talking about.

S&P 500 Price/Earnings Ratio (P/E1) 1871-2007

S&P 500 Price/Earnings Ratio (P/E1) 1871-2007

Over the years, I've given many reasons why a stock market crash MUST occur, using such things as exponential growth forecasting methods and mean reversion techniques with price/earnings ratios.

The above graph shows the P/E ratio index since 1871 (stock prices divided by trailing one-year earnings). If you look at it, you see that the ratio has been above average (the blue line) since 1995, and has been as low as 5 several times in the last century, most recently in 1982. If you look at the right hand side, you can see that it appears about to fall that low again. In fact it MUST do so, by the law of mean reversion. When the P/E ratio falls to 5, stock share prices will fall to 1/3rd their current value.

If you still don't believe me, then show this graph to an expert with analytical experience. Don't show it to a stock broker or other salesman -- those guys flunked 4th grade math, but they can sell ice cubes to Eskimos. Show it to the nerd in the back room. Ask him to tell you what it means for stock prices.

A few days ago I posted a chart comparing 1929 and 2007 after the stock market reached the respective peaks. This is purely speculative, but here's an update of that table:

    1929   % of peak (381.17)
    -------------------------
    Tue 09-03 ( +0.22%) 100%              2007   % of peak (14000)
    Wed 09-04 ( -0.41%)  99%              ------------------------
    Thu 09-05 ( -2.59%)  97%              Thu 07-19 ( +0.59%) 100%
    Fri 09-06 ( +1.76%)  98%              Fri 07-20 ( -1.07%)  98%
    ------------------------              ------------------------
    Mon 09-09 ( -0.36%)  98%              Mon 07-23 ( +0.67%)  99%
    Tue 09-10 ( -2.04%)  96%              Tue 07-24 ( -1.62%)  97%
    Wed 09-11 ( +0.99%)  97%              Wed 07-25 ( +0.50%)  98%
    Thu 09-12 ( -1.23%)  96%              Thu 07-26 ( -2.26%)  96%
    Fri 09-13 ( +0.14%)  96%              Fri 07-27 ( -1.54%)  94%
    ------------------------              ------------------------
    Mon 09-16 ( +1.51%)  97%              Mon 07-30 ( +0.70%)  95%
    Tue 09-17 ( -1.04%)  96%              Tue 07-31 ( -1.10%)  94%
    Wed 09-18 ( +0.65%)  97%              Wed 08-01 ( +1.14%)  95%
    Thu 09-19 ( -0.25%)  97%              Thu 08-02 ( +0.76%)  96%
    Fri 09-20 ( -2.14%)  94%              Fri 08-03 ( -2.09%)  94%
    ------------------------              ------------------------
    Mon 09-23 ( -0.84%)  94%              Mon 08-06 ( +2.18%)  96%
    Tue 09-24 ( -1.78%)  92%              Tue 08-07 ( +0.26%)  96%
    Wed 09-25 ( -0.01%)  92%              Wed 08-08 ( +1.14%)  97%
    Thu 09-26 ( +0.96%)  93%              Thu 08-09 ( -2.83%)  94%
    Fri 09-27 ( -3.11%)  90%              Fri 08-10 ( -0.23%)  94%
    ------------------------              ------------------------
    Mon 09-30 ( -0.41%)  90%              Mon 08-13 ( -0.02%)  94%
    Tue 10-01 ( -0.26%)  89%              Tue 08-14 ( -1.57%)  93%
    Wed 10-02 ( +0.56%)  90%              Wed 08-15 ( -1.29%)  91%
    Thu 10-03 ( -4.22%)  86%              Thu 08-16 ( -0.12%)  91%
    Fri 10-04 ( -1.45%)  85%
    ------------------------
    Mon 10-07 ( +6.32%)  90%
    Tue 10-08 ( -0.21%)  90%
    Wed 10-09 ( +0.48%)  90%
    Thu 10-10 ( +1.79%)  92%
    Fri 10-11 ( -0.05%)  92%
    ------------------------
    Mon 10-14 ( -0.49%)  92%
    Tue 10-15 ( -1.06%)  91%
    Wed 10-16 ( -3.20%)  88%
    Thu 10-17 ( +1.70%)  89%
    Fri 10-18 ( -2.51%)  87%
    ------------------ -----
    Mon 10-21 ( -3.71%)  84%
    Tue 10-22 ( +1.75%)  85%
    Wed 10-23 ( -6.33%)  80%
    Thu 10-24 ( -2.09%)  78% Black Thursday
    Fri 10-25 ( +0.58%)  79%
    ------------------------
    Mon 10-28 (-13.47%)  68% Black Monday
    Tue 10-29 (-11.73%)  60%
    Wed 10-30 (+12.34%)  67%
    Thu 10-31 ( +5.82%)  71%
    Fri 11-01  (Closed)
    -----------------------
    Mon 11-04 ( -5.79%)  67%
    Tue 11-05  (Closed)
    Wed 11-06 ( -9.92%)  60%
    Thu 11-07 ( +2.61%)  62%
    Fri 11-08 ( -0.70%)  62%
    ------------------------
    Mon 11-11 ( -6.82%)  57%
    Tue 11-12 ( -4.83%)  55%
    Wed 11-13 ( -5.27%)  52%
    Thu 11-14 ( +9.36%)  57%
    Fri 11-15 ( +5.27%)  60%
    -----------------

This is purely speculative, but if we continue to follow the 1929 pattern, then we should expect to see enormous swings, such as the huge swings that occurred on 10/3 and 10/7/1929, and we should expect to see a real generational panic and crash in about six weeks.

This is one of the saddest and most dreaded days of my life. This is the day that I reached the conclusion that the nightmare has now begun. We're now in the beginning stages of a classic generational panic and stock market crash. I don't think I'm going to sleep much tonight. (17-Aug-07) Permanent Link
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Redemptions of money market funds now fully in doubt

Wednesday is the deadline for 3Q redemption of many hedge fund shares.

Wall Street was running about even on Tuesday, until around 10 am. European Central Bank President Jean-Claude Trichet said that we'd gone through "a period of market nervousness" that was now ending, and "financial markets in general are going back to normal functioning." In fact, the ECB was pouring billions more into the money markets to prop them up, so everything was good. More than good. Everything was swell.

At 10 am, CNBC reported that an obscure Illinois money market firm, Sentinel Management Group Inc., had asked permission of a regulatory agency to stop redemptions -- meaning that clients would be unable to get their money back.

The market immediately fell 100 points (Dow). There were ups and downs for the rest of the day, and the Dow ended up 200 points down. Other markets in Europe and New York all ended down 1.5-2%. And as I write this (around noon, Asian time), the Asian markets are down by the same amount.

So I guess Trichet must have been wrong, huh? The "market nervousness" hasn't ended after all, and "normal functioning" hasn't returned.

I was listening to pundits today on CNBC. They don't have the vaguest idea what's going on.

"You just have to ride it out."
"Investors are nervous and irrational."
"The Fed has to cool things down -- relax all the animal spirits out there."
"The underlying economy is one of the strongest in history."
"Everyone's waiting for fundamentals to come back in line."
"There's still plenty of money sitting on the sidelines waiting to come back into the market."
"Things will be back to normal in the fall."
"It's just like 1998 or 1987 - it will pass quickly."

Sentinel is a relatively small firm, and this kind of failure would never have caused this kind of reaction a few years ago. We're finally beginning to see real generational panic -- something that no one alive today, under age 80, has seen before.

As I've been writing a lot in recent articles, everything about what's going on today happened in 1929. Anyone doubting this should order a copy of John Kenneth Galbraith's book, The Great Crash - 1929, originally written in 1954, a time when the 1929 crash was still fresh in people's minds.

Sentinel Management's web site seems to be down this evening ("Under construction," it says), but on Tuesday afternoon I did grab a copy of their FAQ (no longer available). It had some mighty interesting things in it. I'm not surprised they've taken the web site down.

Sentinel is in the business of managing disposable cash for large institutions. Suppose that you have a few million dollars lying around, and you'd like to earn some interest on it -- this is the kind of thing that Corporate CFOs do all the time. You can put the money into a bank, but banks don't pay all that much interest these days.

So you hire Sentinel to manage your money for you. Here's what the FAQ says (or said):

"Sentinel buys only the highest quality and most liquid securities (unless specifically directed by a client to seek higher yield in somewhat lower quality issues). Sentinel will not use derivatives, options, or any other 'financial engineering' techniques to enhance the yield on its portfolios. Sentinel's objective is to achieve the highest yield consistent with preservation of principal and daily liquidity, not simply 'the highest yield'.

Sentinel deals only with investment firms of the highest standing in the industry. Further, it buys from no fewer than four different dealers, both to ensure fair pricing, but also to diversify counterparty risk. ...

Finally, Sentinel's custodian, The Bank of New York, is one of the three top ranked custodians in the U.S. Its size, reputation, and concentration on custody and clearing provide additional assurance to Sentinels' clients that their liquid investments are being serviced by the highest quality professionals in the business. And because they are held in custody, these assets are protected by federal fiduciary law from any third party claims against the bank. Unlike FDIC insurance for bank deposits, there is no limit on the amount of protection this federal law can provide."

Wow! Sentinel protects your money better than the Federal government agency, the FDIC, does.

So, now let's see what Sentinel said on Tuesday, in a letter to its clients:

"As you undoubtedly know, the credit markets, along with most other markets, have experienced a liquidity crisis in the past several weeks. Investor fear has overtaken reason and has induced a period in which most securities have simply ceased to trade.

We've all read the stories about one hedge fund or another suffering losses related to subprime exposure and closing down or being rescued.

This fear, while warranted in some cases, has spilled over into the rest of the credit market and liquidity has dried up all over the street. In addition, investment banks and securities firms are stuck with LBO deals they've already entered into but cannot find buyers for the bonds so must inventory them themselves.

This liquidity crisis has caused bids to disappear from the market and makes it virtually impossible to properly price securities or to trade them.

High grade securities are trading like junk bonds as panicked investors dump names like General Electric at Tyco-like prices.

We have carefully monitored this situation for the past several weeks and have met regularly to discuss the potential impact it may have on our clients.

We had previously thought that the market would return to some semblance of order and that our clients would not join in the panic.

Unfortunately, this has not been the case. We are concerned that we cannot meet any significant redemption requests without selling securities at deep discounts to their fair value and therefore causing unnecessary losses to our clients."

"Now, how is this possible?" you may well ask. How is it possible for a company that invests in "only the highest quality and most liquid securities," a company that "will not use derivatives, options, or any other 'financial engineering' techniques" -- how is such a company in a situation where "we cannot meet any significant redemption requests without selling securities at deep discounts to their fair value and therefore causing unnecessary losses to our clients."

That IS a good question, isn't it.

Of course, Sentinel says it's not their fault: "Investor fear has overtaken reason and has induced a period in which most securities have simply ceased to trade."

But that can't be the real reason.

We've been talking about collateralized debt obligations (CDOs), based indirectly on mortgage loans. I think I'm finally getting to the point where I understand how these CDOs work, and here's a summary: You take a bunch of mortgage loans, say $100 billion worth, and break them up by rating level, with AAA being the highest rating (for the most creditworthy borrowers), and BBB- being the lowest rating (for the subprime borrowers). Each rating defines a slice or "tranche" of this group of loans.

Now the problem is that the BBB and BBB- tranches are bad news, because they're so low-rated. There are many institutions that are not even permitted to invest in such securities, even for very high returns, because it's against their charter or even against the law, depending on the type of institution. So these institutions have to get rid of the lowest-rated tranches.

But who wants to buy low-rated tranches? Not too many people. It's too risky.

So the financial geniuses of a few years ago got the idea that you can turn BBB- securities into AAA securities. You do this by taking the low-rated tranche, and break these up into low-rated to high-rated tranches. These are the CDOs. Set up the returns so that if everyone makes their mortgage payments, then all the CDO owners will get paid; but if homeowners start defaulting on their mortgages, then the lower-rated CDO tranches will get nothing, and the the upper-level tranches will get whatever money is available. Therefore, the highest rated CDOs will almost certainly get paid. So the ratings agencies (Moody's, S&P, Fitch) say, "OK, that sounds good to me. We'll rate them AAA for you."

So now you've got huge numbers of AAA-rated CDOs that are based on subprime mortgages. But of course they're "safe," because their owners get paid no matter what happens.

How do you determine the value of these CDOs? There's no market for them, so you can't price them on the market -- i.e., you can't use "mark-to-market." Instead, you write a computer program that performs some complicated algorithm that comes up with a value. That's called "mark-to-model" or, as some people are saying, "mark-to-myth."

Anyway, to make a very long story short, you now have these AAA-rated securities (CDOs). Since they're AAA rated, they can be traded like commercial paper at the safest level, and lowest risk. Since they're AAA-rated, they can be treated as almost as safe as government Treasury bonds. That's what AAA means.

So there you are. That's how these CDOs got into everyone's portfolio. Tens or hundreds of trillions of dollars worth of these are everywhere -- in the portfolios of mutual funds, investment trusts, hedge funds, savings banks, pension funds, college endowments, money market funds, insurance companies, and so forth, so everyone is at risk, not just large financial institutions.

For example, a college endowment or a pension fund might be precluded by law or by charter from investing in risky securities, but these weren't risky securities -- these were rated AAA -- the safest rating possible. So they invested in them, paying for them the price computed by somebody's computer software.

Now, hedge funds are the most vulnerable, since they're the most aggressive in investing in risky securities. That's why hedge funds have been imploding every week. But everyone else has been investing in the AAA-rated CDOs as well, and now they're turning out to be not worth the paper they're written on.

That's why Sentinel can't sell their portfolio of "the highest quality and most liquid securities," and it's not because "investor fear has overtaken reason." It's actually because investor anxiety has overtaken giddiness. Investors are panicking because they don't know how to handle the situation.

It's worthwhile to write again how this ties in to generational theory.

The crazy situation that's come about was set up by the Boomer generation that survived the Great Depression and World War II. During the 1960s, these kids rebelled against their parents, and all the values that their parents had adopted. While the survivors of the Great Depression understood the meaning and danger of credit, the Boomer generation simply rebelled, and understood nothing. This was OK as long as their parents were still alive, since their parents would take care of them.

Today, the Boomers are in charge, and their parents are gone. And the Boomers have no idea what's going on, because they never learned.

They brought about the dot-com bubble of the late 1990s, then the housing and credit and stock market bubbles of the 2000s, thinking that everything would take of itself, not realizing that their parents had been taking care of everything behind the scenes.

This is the generational cycle, the generational saeculum, on which Generational Dynamics is based.

Generational panic is a unique smell, unique feel to it, and that smell and feel have been growing in the last few months, especially since the Bear Stearns announced that its hedge funds are almost worthless.

Now Boomers are wondering what to do and what's going to happen. They're getting desperate.

Wednesday will be a very important day, because August 15 is the day that investors have to inform their hedge funds that they want to get their money out in the third quarter (September 30). Those are the rules for many hedge funds, giving the managers 45 days to raise the cash that they'll need for the redemptions.

According to the Sentinel FAQ, their rules are different:

"Sentinel clients can withdraw 100% of their cash daily. Sentinel accepts deposits of any amount daily. A cutoff time of 4:00PM (eastern time) applies for notification of intent to redeem or make deposits same day."

That's what's no longer true, until further notice, and possibly never.

Here's another interesting paragraph from the Sentinel FAQ that caught my eye:

"A margin certificate protects traders in the OTC currency and bond markets against the failure of their trading counterparty. Instead of delivering margin to the broker/dealer, where they become general liabilities of the firm, traders deposit cash into a Sentinel account at The Bank of New York, where they are held in custody as margin for the benefit of the counterparty. By terms of the certificate, the counterparty can draw on them only to satisfy amounts the client owes. The assets used as margin are thereby protected against any third party claims against the counterparty in the event of the latter's failure or illiquidity."

This paragraph refers to money that an investor gives to a broker for margin calls. The Broker or Dealer holds the money in escrow until its needed, but this paragraph points out that if the Broker goes bankrupt, then you've lost your margin money, though you may get a little of it in bankruptcy court. The Sentinel FAQ says that Sentinel provides an additional service -- holding margin funds in escrow in such a way that a bankruptcy won't put them in danger to the investor.

This means that if you still own stocks, and you own them on margin, then you could lose your margin money if the broker goes under.

But what if you sell stocks short? Several web site readers have written to me asking about this option. (This means that you're betting that the value of the stocks is going to fall, and you make money in that case.)

The problem with short sales is that you have to put a lot of money into escrow with your broker, and there are going to be a lot of bankruptcies in the next few months.

For this reason, I recommend against short sales. It's possible that you'll lose your money if stock prices go up or go down.

As I've said many times before, from the point of view of Generational Dynamics, a generational stock market crash is overdue. If you go back through history, there are of course many small or regional recessions. But since the 1600s there have been only five major international financial crises: the 1637 Tulipomania bubble, the South Sea bubble of the 1710s-20s, the bankruptcy of the French monarchy in the 1789, the Panic of 1857, and the 1929 Wall Street crash. We're now overdue for the next one. It could happen next week, next month or next year, but it will come with absolutely certainty, and will come sooner rather than later. It's now beginning to appear that it's coming very soon. (15-Aug-07) Permanent Link
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Fed pours money into Wall Street, avoiding a total rout

Every time the market fell on Friday, the Fed would "inject" more money.

When I was going to school in the 1950s, my teachers often talked about the Great Depression, and how horrible it was. The events of the last few days reminds me of one particular story that has stuck in my mind all these years, probably because the teacher was close to tears as she told it. Her story went something like this:

"Before the crash, everybody was frightened about what was going on in the stock market. Every time that things looked very bad, someone with a lot of money would step in and buy stocks, and the market would go back up briefly. Then one day no one stepped in, and the market crashed."

I don't know specifically who she was referring to, but in the 1920s there were corporations that were wealthier than the U.S. Government. (That seems strange today, but it was by design prior to the 1930s. It changed with the F.D. Roosevelt administration.)

Reading through John Kenneth Galbraith's book, The Great Crash - 1929, which I've quoted many times on this web site, one can see that everything that's happening today happened in 1929 -- the mania for mergers and acquisitions, the drying up of liquidity, the breathtaking volatility. The comparisons are really dramatic, and they put to shame all the idiots who claim "this time it's different." They even had hedge funds in those days -- only, they were called "investment trusts," and they were just as abused as hedge funds are today. Really, everything that's happening today is an almost exact repeat of 1929. I'll quote some more of that book in the next few days.

Anyway, that's what's been happening this week, with the role of savior played by the central banks of the world, including America's Federal Reserve. The stock market fell 250 points when it opened on Friday morning, and the Fed injected billions of dollars, saying that it was "providing liquidity to facilitate the orderly functioning of financial markets." When the market fell again, the Fed pumped out more money. They did this three or four times, and by the end of the day, the Fed had poured $38 billion into the financial system, after injecting $24 billion on Thursday.

Central banks in the U.S., Europe, Japan, Australia and Canada, coordinating with one another, added about $136 billion to the banking system in an attempt to avert a crisis in global credit markets. Asian and European markets fell 2-3%, on top of earlier losses, but the New York markets pretty much recovered losses, as a result of a surge in the last 20 minutes.

Nouriel Roubini posted an article on Thursday analyzing the details of what's going on. He points out that what's going on now is much worse than the "liquidity crisis" that pundits have been describing.

A "liquidity crisis" is similar to a "cash flow" problem in a corporation that, say, has the assets to pay its debts, but can't convert the assets to cash quickly enough, or roll over debts quickly enough, to meet its current obligations. It's OK in the long run, because debt is decreasing, or at least not substantially increasing. Thus, a quick infusion of cash can provide a bridge that solves a liquidity crisis.

What we today have is an "insolvency crisis," where numerous institutions are at the point where debt is increasing so rapidly that there's no hope in the long run. A quick infusion of cash can help only temporarily, because new and larger infusions are continually needed, as debt increases.

Long-time readers may recall that I frequently talk of "exponential growth of public debt" in the United States. I use this phrase all the time to make a particular point, in response to people who question why this web site can't be more specific in its predictions of dates.

The criticism that I get is usually worded something like the following: "When can you ever be wrong? If nothing happens in 2004, then you can just say it will happen in 2005, and then 2006, and then 2007, and so forth. You can always say that the crisis is coming 'soon', and so you're never wrong."

I respond to such criticisms as follows: "Public debt has been increasing exponentially, and cannot continue to do so. If public debt ever levels off and starts falling, then at that point I will have to admit that I'm 'wrong.' In the meantime, a major financial crisis is 100% certain. It might happen next week, next month, next year, or thereafter, but it's absolutely certain."

Well now you can see those warnings come to fruition. For years I've seen the stock market bubble grow, the housing and credit bubbles grow, public credit and global account imbalances grow exponentially. I could predict with certainty that it couldn't last, and that a global financial crisis MUST come. And I explained the timing by means of generational changes -- from the generation that survived the Great Depression to the generations born AFTER the Great Depression. All of these things put together meant that a return to a 1930s style Great Depression MUST happen, but I could never predict exactly when.

But now the time is close. As Roubini points out, many of today's major institutions are not just having a "liquidity" or cash flow problem, that can be solved with a temporary infusion of cash. Instead, their debts are growing exponentially, and they can only be saved by exponentially growing additional infusions of cash.

I said for five years that this day was coming with 100% certainty, and now it's finally close.

An actual liquidity crisis did occur in 1998, when a very large hedge fund, Long-Term Capital Management or LTCM, collapsed, causing a domino effect that almost bankrupt a number of other institutions. Many airheads are claiming that what's happening today is similar to the LTCM episode, and that all the Fed has to do is lower interest rates by 1% or so, and the problem will be solved.

Roubini contrasts what's happening today to what happened in 1998:

"The 1998 LTCM crisis was mostly a liquidity crisis: the US was growing then at 4% plus, the internet bubble had not burst yet, we were in the middle of the "New Economy" productivity boom, households were not financially stretched and corporations were not financially stretched with debt either. In spite of those sound and solvent fundamentals the collapse of Russia � a country then with the GDP of a country such as the Netherlands � caused a global liquidity seizure and crisis of the type experienced by credit markets in the last few weeks: sudden demand for cash liquidity, sharp increase in the 10 year swap spread, sharp increase in the VIX [volatility index] gauge of investors� risk aversion, liquidity drought in the interbank and euro-dollar market, deleveraging of highly leveraged positions, reversal of the yen carry trades. With the exception of the credit event in Russia, this was not a credit/insolvency crisis. And since it was a liquidity crisis, the Fed easing � 75bps [75 basis points = 0.75%] � was successful in restoring in a matter of weeks calm and liquidity in financial markets. Even that liquidity episode had painful credit fallout: it is not remembered by most but the entire subprime mortgage industry went bankrupt in 1998-99 following the LTCM liquidity crisis. So a liquidity shock event triggered massive credit events then."

Roubini's point is that in 1998, public debt was still well under control. From the point of view of Generational Dynamics, this is because there were still a few survivors of the 1929 crash and 1930s Great Depression, just enough people to maintain at least a little common sense in controlling debt.

However, those few remaining survivors disappeared completely in the early 2000s, and public debt reached a state of total debauchery, by new generations of Boomers and Generation-Xers who had/have no common sense whatsoever.

Roubini lists a number of institutions that are insolvent today:

Homeowners: "First, you have hundreds of thousands of US households who are insolvent on their mortgages. And this is not just a subprime problem: the same reckless lending practices used in subprime � no downpayment, no verification of income and assets, interest rate only loans, negative amortization, teaser rates � were used for near prime, Alt-A loans, hybrid prime ARMs, home equity loans, piggyback loans. More than 50% of all mortgage originations in 2005 and 2006 had this toxic waste characteristics. That is why you will have hundreds of thousands � perhaps over a million - of subprime, near prime and prime borrowers who will end up in delinquency, default and foreclosure. Lots of insolvent borrowers."

Lenders: "You also have lots of insolvent mortgage lenders � not just the 60 plus subprime ones who have already gone out of business � but also plenty of near prime and prime ones. AHM [American Home Mortgage] � that went bankrupt last week � was not exposed mostly to subprime; it was exposed to near prime and prime. Countrywide has reported sharp losses not only on subprime lending but also on prime ones. So on top of insolvent households/mortgage borrowers you have plenty of insolvent mortgage lenders, subprime and - soon enough - near prime and prime.

Home builders: "You will also have � soon enough � plenty of insolvent home builders. Many small ones have gone out of business; now it is likely that some of the larger ones will follow in the next few months. Beazer Homes � a major home builder - last week had to refute rumors of its impending insolvency; but so did AHM a few weeks before its insolvency. With orders for home builders falling 30-40% and cancellation rates above 30% more than a few home builders will become insolvent over the next year or so.

Investment funds: "We also have insolvent hedge funds and other funds exposed to subprime and other mortgages. A few � at Bear Stearns, in Australia, in Germany, in France � have already gone bankrupt or are near bankrupt. You can be sure that with at least of $100 billion of subprime alone losses � and most losses are still hidden given the reckless practice of mark-to-model rather than mark-to-market - many more will go belly up. In the meanwhile the CDO, CLO and LBO market have completed closed down - a �constipated owl� where �absolutely nothing moves� the way Bill Gross of Pimco put it. This is for now a liquidity crisis in these credit markets; but credit events will occur given that the underlying problem was not of of liquidity but rather one of insolvency: if you take a bunch of to-be-defaulted subprime and near prime mortgages and you repackage them into RMBS and then these RMBS are repackaged into various tranches of CDOs, the rating agencies may be using magic voodoo to turn those junk BBB- mortgages into AAA tranches of CDOs; but this is only voodoo as the underlying assets are going to be defaulted on."

Corporations: "[U]ntil recently the insolvent firms in the corporate sectors included corporations that could service their debt only by refinancing such debt payments at very low interest rates and financially favorable conditions. Many firms, under normal liquidity conditions, would have been forced into distress and debt default (either of the Chapter 7 liquidation form or Chapter 11 debt restructuring form) but were instead able to obtain out-of-court rescue and refinancing packages because of the most easy credit and liquidity conditions in bubbly markets. Now that we are observing a liquidity and credit crunch and a vast widening of credit spread you will observe a sharp increase in corporate defaults and a further risk in corporate risk spreads."

Roubini points out that normally the Fed and other central banks are the "lenders of last resort," meaning that they can intervene only when other mechanisms fail, and even then cannot provide more than a temporary solution.

He points out that the International Monetary Fund (IMF) serves as a "lender of last resort" when an entire country is having a liquidity crisis, as in the cases of Mexico, Korea, Turkey and Brazil. Those were real liquidity crises, and the injections of IMF funds worked to resolve the temporary imbalances.

But other countries -- Russia, Argentina, Ecuador -- had actual "insolvency crises," and the injection of IMF funds "only postponed the inevitable default and made the eventual crisis deeper and uglier."

He adds that "provision of liquidity during an insolvency crisis causes moral hazard as it creates expectations of investors� bailout." That's certainly what we're seeing today, as pundits and politicians increasing call for a bailout. The most talked-about example was the hysterical rant from CNBC's Jim Cramer, earlier this week.

Roubini concludes:

"Thus, while the Fed and the ECB had no option today but to provide massive liquidity in the presence of a most severe liquidity crunch and run, they should not delude themselves that this liquidity injections can resolve the deep insolvency problems of many overstretched borrowers: households, financial institutions, corporates. Insolvency/credit crises lead to financial and economic distress � hard landing of economies � and cannot be resolved with liquidity injections by a lender of last resort. And now the vicious circle of a weakening US economy � with a housing recession getting worse and a fatigued consumer being at the tipping point - and a generalized credit crunch sharply has increased the probability that the US economy will experience a hard landing. We are indeed at a "Minsky Moment" and this recent financial turmoil is the beginning of a much more serious and protracted US and global credit crunch. The risks of a systemic crisis are rising: liquidity injections and lender of last resort bail out of insolvent borrowers - however necessary and unavoidable during a liquidity panic- will not work; they will only postpone and exacerbate the eventual and unavoidable insolvencies."

I agree with everything that Roubini says, except for the indefiniteness of his conclusion: The "generalized credit crunch sharply has increased the probability that the US economy will experience a hard landing."

From the point of view of Generational Dynamics, the US will experience much more than a "hard landing," and with more than a mere "probability" -- it will experience a new 1930s style Great Depression, with 100% certainty.

From the point of view of Generational Dynamics, a generational stock market crash is overdue. If you go back through history, there are of course many small or regional recessions. But since the 1600s there have been only five major international financial crises: Tulipomania bubble (1637), South Sea Bubble (1721), French Monarchy bankruptcy (1789), Hamburg Crisis of 1857, and 1929 Wall Street crash. We're now overdue for the next one. It's beginning more and more now to appear to be coming very soon. (11-Aug-07) Permanent Link
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US and European central banks inject billions in cash to stanch market meltdown

We're beginning to see real signs of a generational panic.

The big trigger early on Thursday was an announcement by the the French group BNP Paribas Investment Partners, indicating that they were following in the footsteps of Bear Stearns. They would freeze three of their hedge funds that had invested in mortgage-backed securities.

The reaction that followed this announcement was enormous. But before getting to the details, let's step back and look at the big picture.

Let's start with this, from an e-mail message from a web site reader last week:

"My father immigrated to the U.S. from Germany in the 20s and experienced the great depression in Pennsylvania. When I was a teenager, he told me his generation would not cause another depression because of what they experienced in the 30s. My father would not borrow money - only purchased in cash. Just before his death in 1962, he commented that the current generation was making mistakes his generation had made, and another depression was inevitable. What would he have said observing uncontrolled growth of financial derivatives, and our massive, ever increasing, unrepayable national debt? Having experienced hyper-inflation in Germany, believe he would have said our national debt would be repaid in drastically cheaper dollars."

What almost no one understands is how different people are today than they were, say, ten years ago. During the 1990s, the people who survived the Great Depression were disappearing (retiring or dying), all at once. Those people were like the man described in the above paragraph. My own mother, incidentally, was exactly the same. The people who survived the Great Depression instinctively knew how dangerous credit was.

The investors of the last few years are very different. Their entire lives have been in relative luxury, with no little or no fear of homelessness, bankruptcy or starvation. They believe that they can take almost any risk with credit and get away with it.

But there's always been a little voice nagging at them -- perhaps the ghosts of their own parents or grandparents -- saying, "Be very careful. Don't go into debt. We could have another Depression at any time." And although investors scoffed at such warnings, they never completely forgot them.

So when things start looking bad, and they realize that all their assumptions are wrong, they panic, and they overreact. Today's investors are capable of panicking in a way that investors would NOT have panicked in the 1990s.

We didn't see a full-fledged panic on Thursday, but the smell of panic was definitely in the air.

First, let's quote from BNP Paribas press release:

"BNP Paribas Investment Partners temporarily suspends the calculation of the Net Asset Value of the following funds : Parvest Dynamic ABS, BNP Paribas ABS EURIBOR and BNP Paribas ABS EONIA

Paris, 9th Aug. 2007

The complete evaporation of liquidity in certain market segments of the US securitisation market has made it impossible to value certain assets fairly regardless of their quality or credit rating. The situation is such that it is no longer possible to value fairly the underlying US ABS assets in the three above-mentioned funds. We are therefore unable to calculate a reliable net asset value (�NAV�) for the funds.

In order to protect the interests and ensure the equal treatment of our investors, during these exceptional times, BNP Paribas Investment Partners has decided to temporarily suspend the calculation of the net asset value as well as subscriptions/redemptions, in strict compliance with regulations, for the following funds: ...

The valuation of these funds and the issue/redemption process will resume as soon as liquidity returns to the market allowing NAV to be calculated.

In the continued absence of liquidity, additional information on the envisaged measures will be communicated to investors in these funds within one month of today."

Note the sentence: "The complete evaporation of liquidity in certain market segments of the US securitisation market has made it impossible to value certain assets fairly regardless of their quality or credit rating."

This means that there's been a coverup going on, similar to one that occurred with Bear Stearns. The assets owned by the hedge funds are collateralized debt obligations (CDOs), or other mortgage-based credit derivatives. Since these CDOs can't be bought or sold on the open, as stocks are traded in a stock exchange, the value of these CDOs cannot be determined except by estimates (known as "mark-to-model," because the assigned value is determined by a computer software economic modeling program.)

Normally, BNP Paribas should be able to sell these CDOs to other investors, or investment firms. But the "complete evaporation of liquidity" means that nobody was willing to buy them at any reasonable price. As a result, BNP Paribas stopped investors from redeeming their shares in the hedge funds.

The hedge funds are supposed to be worth $2.2 billion, but it's possible that, like the Bear Stearns hedge funds, they'll turn out to be totally worthless, and the investors will lose everything.

The hints of panic began to show themselves quickly:

The European stock markets started falling 3-4%, as anxious investors sold their stocks. By the end of the day, they were down 2-2�%.

In a related manner, anxious lenders were refusing to lend, leading to a spike in interest rates throughout Europe.

The European Central Bank (ECB) injected a record $130.6 billion into Europe's money markets to prevent a financial system seizure. This is a standard procedure, where the ECB makes money available to banks at low interest rates, so that the banks can then lend the money to others, with the intent of solving the "evaporation of liquidity" problem.

The New York stock markets fell 3-4% at the open, and ended the day down 2�-3%.

Numerous other financial firms are reporting problems almost every day. For example, after the US markets closed on Thursday, Countrywide Financial Corp., the biggest U.S. mortgage lender, said that "unprecedented disruptions" in the home loan market may crimp its ability to lend.

The Federal Reserve pumped $24 billion into the American money markets. This was considered surprising, but not a record.

As I'm writing this (around noon, Asian time), Asian markets are down 2-4%, and the Bank of Japan is injecting money into their money markets.

This reaction by investors and central banks alike is illustrating increasing anxiety -- not yet panic, but getting closer. And the anxiety begets more anxiety: As an article in The Independent pointed out, the action by the ECB only served to spark "panic selling in stock markets around the world.

Almost everyone seems to be totally oblivious to what's going on.

A Reuters article says, "Relative value opportunities are emerging in asset classes tainted by the U.S. subprime mortgage crisis."

In other words, investors formerly would invest in anything. Now they're stopping to look at which opportunities are better than others.

This is a theme that I focus on frequently: What is the value of the stock market?

Suppose that you want to purchase a pound of apples. You go the grocery and discover that one kind of apple sells for $100 per pound, while another kind of apple sells for $200 per pound. So you focus on "relative value," and pay $100 for a pound of apples.

But do you say to yourself, "Huh? Forget relative value. BOTH of those prices are way too high."

That's the problem. Even now, investors are not thinking of "value," but only "relative value," which is ridiculous.

And then, here's another article describing investors' strategy in setting up hedge funds: "Others are so-called statistical arbitrage funds, which analyze the historical relationships between related securities and trade when those relationships get out of whack."

Now, Dear Reader, do you know what they mean by "historical relationships"? In many cases, they mean last year. The hot shots may go back as far as ten years. They never go back farther than that; everyone knows that the world didn't even exist more than ten years ago.

So these people are totally oblivious to what's coming, but the readers of this web site have a great advantage over most investors and other Very Important People, because you know something that they don't know: That a new 1930s style Great Depression is coming with absolute certainty. I said this in 2002, and said that I expected a stock market crash by the 2006-2007 time frame. We still don't know exactly when it's coming, but we know with certainty that it IS coming.

The Generational Dynamics forecasting methodology, as usual, tells you where you're going to end up, but doesn't tell you how you'll get there. In 2002, I knew nothing about CDOs or a housing bubble. All I knew was the final destination, and it's only now that we're learning the path that we'll be taking to get there.

The question is: When will a full-on generational panic occur, similar to "Black Monday" in 1929?

Let's do some speculating. Last year I wrote an article "Speculations about a stock market panic and crash," to discuss what might happen leading up to a stock market panic if one occurred at that time. That didn't happen, but let's speculate on whether we might be close to one now.

Let me repeat: This is speculation, not a prediction. We know that a generational stock market panic MUST occur, and must occur soon, but short-term predictions are impossible. Still, it's hard to resist speculating.

This data is taken from my Dow Jones historical page. On September 3, 1929, the market peaked at Dow 381.17. By November 15, it had fallen 40% to 228.73.

This year (so far), the market peaked on July 19 at 14000. In the three weeks since then, it's been following a similar pattern.

The following table compares 1929 and 2007, following the respective peaks:

    1929   % of peak (381.17)
    -------------------------
    Tue 09-03 ( +0.22%) 100%              2007   % of peak (14000)
    Wed 09-04 ( -0.41%)  99%              ------------------------
    Thu 09-05 ( -2.59%)  97%              Thu 07-19 ( +0.59%) 100%
    Fri 09-06 ( +1.76%)  98%              Fri 07-20 ( -1.07%)  98%
    ------------------------              ------------------------
    Mon 09-09 ( -0.36%)  98%              Mon 07-23 ( +0.67%)  99%
    Tue 09-10 ( -2.04%)  96%              Tue 07-24 ( -1.62%)  97%
    Wed 09-11 ( +0.99%)  97%              Wed 07-25 ( +0.50%)  98%
    Thu 09-12 ( -1.23%)  96%              Thu 07-26 ( -2.26%)  96%
    Fri 09-13 ( +0.14%)  96%              Fri 07-27 ( -1.54%)  94%
    ------------------------              ------------------------
    Mon 09-16 ( +1.51%)  97%              Mon 07-30 ( +0.70%)  95%
    Tue 09-17 ( -1.04%)  96%              Tue 07-31 ( -1.10%)  94%
    Wed 09-18 ( +0.65%)  97%              Wed 08-01 ( +1.14%)  95%
    Thu 09-19 ( -0.25%)  97%              Thu 08-02 ( +0.76%)  96%
    Fri 09-20 ( -2.14%)  94%              Fri 08-03 ( -2.09%)  94%
    ------------------------              ------------------------
    Mon 09-23 ( -0.84%)  94%              Mon 08-06 ( +2.18%)  96%
    Tue 09-24 ( -1.78%)  92%              Tue 08-07 ( +0.26%)  96%
    Wed 09-25 ( -0.01%)  92%              Wed 08-08 ( +1.14%)  97%
    Thu 09-26 ( +0.96%)  93%              Thu 08-09 ( -2.83%)  94%
    Fri 09-27 ( -3.11%)  90%
    ------------------------
    Mon 09-30 ( -0.41%)  90%
    Tue 10-01 ( -0.26%)  89%
    Wed 10-02 ( +0.56%)  90%
    Thu 10-03 ( -4.22%)  86%
    Fri 10-04 ( -1.45%)  85%
    ------------------------
    Mon 10-07 ( +6.32%)  90%
    Tue 10-08 ( -0.21%)  90%
    Wed 10-09 ( +0.48%)  90%
    Thu 10-10 ( +1.79%)  92%
    Fri 10-11 ( -0.05%)  92%
    ------------------------
    Mon 10-14 ( -0.49%)  92%
    Tue 10-15 ( -1.06%)  91%
    Wed 10-16 ( -3.20%)  88%
    Thu 10-17 ( +1.70%)  89%
    Fri 10-18 ( -2.51%)  87%
    ------------------ -----
    Mon 10-21 ( -3.71%)  84%
    Tue 10-22 ( +1.75%)  85%
    Wed 10-23 ( -6.33%)  80%
    Thu 10-24 ( -2.09%)  78% Black Thursday
    Fri 10-25 ( +0.58%)  79%
    ------------------------
    Mon 10-28 (-13.47%)  68% Black Monday
    Tue 10-29 (-11.73%)  60%
    Wed 10-30 (+12.34%)  67%
    Thu 10-31 ( +5.82%)  71%
    Fri 11-01  (Closed)
    -----------------------
    Mon 11-04 ( -5.79%)  67%
    Tue 11-05  (Closed)
    Wed 11-06 ( -9.92%)  60%
    Thu 11-07 ( +2.61%)  62%
    Fri 11-08 ( -0.70%)  62%
    ------------------------
    Mon 11-11 ( -6.82%)  57%
    Tue 11-12 ( -4.83%)  55%
    Wed 11-13 ( -5.27%)  52%
    Thu 11-14 ( +9.36%)  57%
    Fri 11-15 ( +5.27%)  60%
    -----------------

If we follow the same pattern as in 1929, then we'll continue to have enormous ups and downs, with a big panic occurring about a month from now.

Once again, this is pure speculation. Perhaps investors will have a new burst of giddiness and push the stock market up to 15,000, making the bubble even huger, and the bursting even more destructive. We'll have to wait and see. (10-Aug-07) Permanent Link
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China puts on spectacular 2008 Olympics party rehearsal - a year in advance.

It carries all the hopes and anxieties of a Sweet Sixteen coming out ball.

Computer-generated image of the National Stadium, also known as the Bird's Nest. (Source: Xinhua)

Computer-generated image of the National Stadium, also known as the Bird's Nest. (Source: Xinhua)

I've written before about how focused the Chinese are on the 2008 Beijing Games of XXIX Olympiad as the most important event of the young millennium, allowing the country to takes its place as a respected great world power.

The country has already spent enormous sums of money on construction of buildings, and everything is way ahead of schedule.

The Olympics will open on August 8 of next year (8/8/2008) -- and 8 is considered a lucky number by the Chinese.

On Wednesday, August 8 of this year, at 8 pm, China celebrated the upcoming Olympics by throwing a huge rehearsal party

Scenes from the opening of the spectacular rehearsal party. The girl on the bottom is definitely not Kerry Browne, who is male and is doing a voice-over commentary. (Source: BBC)

Scenes from the opening of the spectacular rehearsal party. The girl on the bottom is definitely not Kerry Browne, who is male and is doing a voice-over commentary. (Source: BBC)

Here is the commentary by China analyst Kerry Browne:

"This is the great coming out party. This is the moment when I think China gets much closer to being what it feels it is - a real global power, a real superpower.

I think the buildup to next year it will be fairly contradictory. On the one hand, the Chinese will make a real effort to satisfy the [Olympics] committee and the outside world that they're doing this the right way, but they'll be very, very sensitive over lots of different issues, as they get towards the end, they'll be overly sensitive sometimes, with a surprising effect.

[On the question of air pollution in Beijing:] The Chinese Communist Party can't play god - they've shifted a lot of heavy industry out of Beijing - they want to improve the air quality.

The've been very successful economically because of [their industry], but the cost is that the chinese environment is absolutely critical.

[On the question of labor reform and human rights.]

There's a Yin and Yang thing. In some ways they've responded quite quickly to claims that there's been stuff produced for the Olympics that involved bad labor practices. On the other hand, this means so much to them, that I don't think that they'll act rationally in some areas, especially when we get closer to it.

I think the problem is that they will in some ways be reasonable, in some ways they'll be over-sensitive -- it's difficult to know really how this will pan out.

I don't think they want this to be remembered as the tyrant's or dictator's olympics.

They really want this to be a showcase. The problem is the things that they can't control - the reporters, the environment - things like that - that's where they might act irrationally and do things that we don't expect and which they really can't control.

The thing to remember is that they've never really had this experience -- they've had big events like the Asian games in the early 90s, and also the UN conference in the mid 1990s. But this is by far the biggest exposure they've ever had. So in a sense having all of this attention, all of these journalists, they really have no record of having had to deal with this. That's something that they've got to learn very quickly.

I think they do learn very, very quickly, but they are going to have some rough lessons, I think. And we're going to have some lessons too when journalists do go and start picking up things that they don't want the rest of the world to know."

The thing that really caught my attention is the high state of emotion around this event. It will be very easy for things to go wrong, and when they do, someone is going to get blamed, and there are many scenarios when the people being blamed will be the Americans or the Japanese, two of China's enemies (or, more precisely, enemies-to-be, according to Generational Dynamics).

This is the kind of situation that I watch out for on this web site. When a country enters a generational Crisis era, as China is doing, then it becomes increasingly possible that some event will cause the people to panic, to miscalculate, and to start a war. That's what happened last summer when two Israeli soldiers were kidnapped near the Lebanon border and and Israel panicked and launched the Lebanon war within four hours, with no plan and no objectives. That's how generational crisis wars start.

China is a country under an enormous amount of pressure. There are internal pressures driving it to civil war, as I explained in 2005, and those pressures have gotten worse, as the divide between rich and poor has grown. There's increasing enmity with Japan. The country has been planning for war with the United States for five years, repeatedly threatening war with the US over Taiwan, and spending more and more money on massive militarization.

And now the Chinese are talking about using the economic "nuclear option" against the United States.

China's relations with Taiwan are getting increasingly tense, as generational changes in Taiwan make it more "Taiwanese" and less "Chinese" every day. Furthermore, Taiwan has parliamentary elections in the fall, and presidential elections in the spring. The Chinese are desperately hoping that the elections will bring a new pro-Chinese government to power in Taiwan, but this is extremely unlikely, in view of the generational changes that I mentioned.

So the emotional contrasts are huge and dramatic. I mentioned the analogy to a "sweet sixteen" coming out party, because the Chinese are hoping that the Olympics will solve all their problems -- their internal problems and their external problems. It's an almost certain guarantee that things will go wrong, and then anything might happen. (9-Aug-07) Permanent Link
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China threatens the economic "nuclear weapon" against the United States

As xenophobia grows in Congress, China discusses retaliation.

With China holding hundreds of billions of dollars of US Treasury bonds, some Chinese officials are now talking about using what they call the "nuclear option": Dumping all these US bonds on the market in order to cause the US dollar to crash.

The first threat was carried by Xia Bin, Finance Chief at China�s Development Research Centre, saying that Beijing's foreign reserves should be used as a �bargaining chip� in talks with the US. "Of course, China doesn�t want any undesirable phenomenon in the global financial order," he said.

The threat took further shape in an article in China Daily by He Fan, at the China Academy of Social Sciences, on Tuesday:

"Thanks to the trade surplus, China has accumulated a large sum of US dollars and its world largest foreign exchange reserve is mostly in US dollars. Such a big sum, a considerable portion of which is in the form of US treasury bonds, contributes a great deal to maintaining the position of the US dollar as an international currency.

Russia, Switzerland and several other countries have restructured their foreign exchange reserve and reduced the US dollars they hold. China is unlikely to follow suit as long as yuan's exchange rate is stable against the US dollar.

The Chinese central bank will be forced to sell US dollars once the renminbi appreciates dramatically, which might lead to a mass depreciation of the US dollar against other currencies."

In one sense, the Chinese threat is purely political.

Congress has been getting increasingly xenophobic about China, and risking a major confrontation and retaliation of some kind anyway.

Congress has been blaming America's economic problems on China. Those evil bastards lent us hundreds of billions of dollars in money, at little or no interest, then manufactured millions of products that we could buy from them, in order to make our lives more comfortable. It's not our fault that we practiced credit debauchery and went into humongous debt that we now can't pay off; it's THEIR fault, for having a "savings glut." We're just pooooooooooor, innocent victims here, taken advantage of by those nefarious people in a faraway land.

Of course, that's not how the Chinese look at it. From their point of view, they did what we wanted them to do, and they sacrificed a great deal of their own standard of living to loan money to us. And now that they've made those sacrifices, the Americans are calling them "currency manipulators."

Thus we see the xenophobia growing on both sides. Congress is moving to condemn China and pass sanctions on China, because they're nefarious currency manipulators.

China is saying, "What the hell are you talking about? We've got you by the balls. You guys don't even have any money - we've got all your money. And we're going to use it against you if you don't stop all these accusations."

Thus grows the level of xenophobia on boths sides.

There has been a lot of commentary on the internet and in news programs about this new Chinese threat. The tenor of the commentary is that neither side would ever go through with its threats, because they would hurt their own economies.

That's true, and yet that hasn't stopped people before. In 1930, Congress passed the Smoot-Hawley Tariff act, primarily targeting Japan, but theoretically "protecting" American jobs by taxing imports from any foreign nation. Economists and the Hoover Administration were dead set against this measure, saying it would hurt the American economy -- which it did do -- but the warnings were to no avail, and an infuriated Japan eventually bombed Pearl Harbor.

A web site reader said, in an e-mail message today, "This is an economic version of Mutually Assured Destruction, which some may remember was the nuclear Armageddon logic that held things together during the Cold War with the USSR."

He added that the fact that we have a close business relationship with China does not guarantee that we won't have war with China:

"The US was [economically] integrated with Germany and Japan prior to WW2. In fact, business notables from Henry Ford to Joseph Kennedy to George Bush's grandpa, Prescott, to IBM, GM, Chase Manhattan, Standard Oil, Dupont, GAF, and AT&T were all in bed with the Nazis even throughout the war. Goodyear ran the Auschwitz slave-labor rubber factory with IG Farben, Chase Manhattan Bank was selling the dental bullion from the gas chamber victims, IBM was running the databases that tracked the ID numbers tattooed onto the concentration camp prisoners, Ford and GM built tanks for the Nazis, AT&T built planes, Standard Oil shipped oil (via Panamanian flagged tankers), Dupont and GAF made the gas for the gas chambers.

So, just because almost all the clothes on your back, the computer under your fingertips, the popcorn shrimp in your mouth, the loan that paid for your house, and the money paying for both the Middle East wars and Medicare all came from China, do not assume that war between the US and China is impossible.

Every blowhard trade/job protectionist from Lou Dobbs to Hillary Clinton is putting a flame torch to the fuse of the next world war."

In fact, both sides are on the road to war. China has been planning for war with the United States for 15 years, rapidly increasingly its military capabilities, and repeatedly making specific war threats with respect to Taiwan. From the point of view of Generational Dynamics, China and the U.S. are headed for a genocidal crisis war with near mathematical certainty, and nothing can be done to stop it.

But what about this economic "nuclear option" threat? What would happen if China dumped all its US Treasury bonds on the market?

I actually wrote about this several months ago in an article entitled "Where should I put my money?"

"There are more than two trillion dollars of these long-term bonds sitting in central bank vaults around the world, especially in Japan, China and the UK. Furthermore, this amount continues to grow exponentially. As a result, "everybody" knows the U.S. Treasury will never be able to redeem all those bonds.

People tell me, "Of course they'll all be redeemed. The Treasury can print as much money as it wants, and it could redeem them all tomorrow."

But my intuition tells me that when the world is flooded with some trillions of some particular item, and that the number of trillions keeps growing exponentially, and that those trillions of items could go on the market at any time, then those items may turn out not to be very valuable.

During a crisis or a war, China or another country may put several hundred billion dollars worth of these long-term bonds on the market in order to destabilize the American economy. At that point, if you happen to have some of these bonds, they'll be worthless.

So, if you're going to buy Treasury bonds at all, the best bet is probably short-term, 6-month Treasury bonds."

China's economic "nuclear option" is a real threat, and I have no doubt that as the Clash of Civilizations war approaches, China will use it. Why wouldn't they? (9-Aug-07) Permanent Link
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Alan Greenspan defends his Fed policies, as people blame him for the subprime crisis

Greenspan never ceases to amaze, and he did so again on Monday.

Let's recall:

Greenspan was Fed Chairman from 1987 to 2005.

When the dot-com bubble began in the late 1990s, he decided to "allow" the bubble to occur.

Instead, he would deal with its aftermath by setting interest rates to near-zero when the bubble was bursting.

That was, in fact, the Fed policy after 2000, and the Fed reduced interest rates 12 times by June, 2003. That was the policy that Greenspan believed would have worked in 1929, to prevent the Great Depression of the 1930s. His successor, Ben Bernanke, believes the same thing.

In recent months, many people are blaming Greenspan's near-zero interest rate policy as the cause of the housing bubble (which is true).

You may recall that last October tried to blame the housing bubble on the fall of the Berlin Wall. (The fall of the Berlin wall led to globalization, which led to low interest rates, which led to the housing bubble. That explanation was really an act of desperation.)

Greenspan must be getting very worried, for he's now giving a new explanation in a Monday interview with the Wall Street Journal.

He now says that his interest rate cuts can't be the cause of the housing bubble, because the housing bubble got worse after interest rates were increased again. He concurs with Ben Bernanke that the REAL cause of the credit bubble and the housing bubble are the fact that other countries are saving too much -- i.e., there's a "global savings glut."

I can only roll my eyes in disbelief at this. I used to think that Greenspan had more sense than Bernanke, but I guess they're really both the same. To blame America's credit binge on other countries' savings is, well, presumptuous, to say the least.

From the point of view of Generational Dynamics, the reason for the credit binge is completely obvious although, as usual, these "experts" seem totally blind to a generational explanation, no matter how obvious it is. The credit binge came about when the risk-averse generations of people who survived the 1930s Great Depression all disappeared (retired or died), all at once, leaving behind people born after the Great Depression, with no personal memory of its horrors. The 1930s Great Depression occurred because of a similar credit binge in the 1920s, which occurred when the survivors of the Panic of 1857 all disappeared, all at once. To say, as Greenspan and Bernanke do, that the Great Depression could have been avoided by a simple policy change of near-zero interest rates is completely absurd.

And now we've seen it. Greenspan put into effect precisely the plan that was supposed to have been able to prevent the 1930s Great Depression, and it produced the housing bubble and the credit bubble and the stock market bubble.

According to Greenspan, they feared that the country would have negative inflation, or deflation, and that was because of what had happened to Japan in the 1990s.

OK, here's what happened in Japan, a brief summary of what I wrote about Japan in February. Japan had a huge real estate and Tokyo Stock Exchange (TSE) bubble in the 1980s, and the bubble burst in 1990, and prices have been falling until very recently. (It may be surprising that prices fell for about 15 years, but that's what happens when a bubble bursts, if it took many years for the bubble to expand.)

Now, it turns out that the TSE had a previous major stock market crash in 1919. Then, 65 years later, the next stock market bubble began in 1984. This parallels Wall Street: Crash in 1929, new bubble in 1995, 66 years later; Tokyo Stock Exchange: Crash in 1919, new bubble in 1984, 65 years later.

Once again, you can see Generational Dynamics in action. A new bubble occurs as soon the generation of people who lived through the last crash are gone. I've said many times on this web site that analysts, journalists, and pundits are totally blind to even the simplest generational relationships, no matter how obvious they are.

So anyway, according to the new WSJ article, Greenspan used to believe that deflation was impossible with paper currency, since the government could simply print money until it created inflation. But Japan in the 1990s proved that view wrong.

So that's why Greenspan felt it necessary to keep interests close to zero in the early 2000s -- because he feared deflation.

According to Greenspan, "We decided that in 2003 that though we judged the probability of severe deflation as small, were it to happen, its consequences were seen as devastating. So we chose to take out insurance against them, fully recognizing at the time that we were taking risks in the process. But central banks cannot avoid taking risks. Such tradeoffs are an integral part of policy. We were always confronted with choices."

However, the near-zero interest rates had unintended consequences, as he said at the time: "I don't know what it is, but we're doing some damage because this is not the way credit markets should operate."

From the point of view of Generational Dynamics, the credit markets were acting strangely because the generations of post-Depression babies were now completely in charge, and had no fear of credit. It was simply a change from a risk-averse generation to a no-fear-of-risk generation. But these people are completely oblivious to these simple explanations.

Greenspan and the Fed decided that the credit bubble was OK because of the innovation of credit derivatives, which permit large financial institutions to make "bets" on whether interest rates are going to go up or down. Greenspan believed that this removed any risk in the economy away from the ordinary investor, and concentrated the risk in large institutions that could afford it.

Instead, the new risk-seeking generations of investors found ways around the rules, and essentially bet every penny they had on these credit derivatives, especially the collateralized debt obligations (CDOs). There are now tens or hundreds of trillions of dollars worth of the CDOs in the portfolios of mutual funds, investment trusts, hedge funds, savings banks, pension funds, college endowments, money market funds, insurance companies, and so forth, so everyone is at risk, not just large financial institutions.

But here's how Greenspan sees it:

"History tells us it�s far better to have people periodically going to excess with its adverse consequences than to try to block it off in the beginning. These adverse periods are very painful but they�re inevitable if we choose to maintain a system in which people are free to take risks, a necessary condition for maximum sustainable economic growth. We have learned to move risk from the leveraged institutions which are the major lenders in this country to those far more capable of absorbing loss. It�s why our economy in recent years has developed the flexibility to absorb severe adjustments."

What does he mean by this???? What history is he talking about?

In my article last year on "System Dynamics and and the Failure of Macroeconomics Theory," I described a pivotal moment in Greenspan's history:

"Another difficult period occurred in 1994 when inflation began to increase, along with bond yields (interest rates). Alan Greenspan and the Fed took a very tough stand and tightened the money supply, stopping inflation in its tracks, but also causing bond yields to crash. This caught a number of investors by surprise. Remember when Orange County, California, went bankrupt? They blame Greenspan for that."

So that's why Greenspan decided not to deal with the dot-com bubble in the 1990s, but to deal with it later by lowering interest rates to zero.

You know, Dear Reader, It's hard to believe all this. Could it be possible that Greenspan really believes all the blithering nonsense he talks about? I can understand the Wall Street Journal reporter, Greg Ip, and his journalist colleagues not having the vaguest idea what's going on, and I've always known that Bernanke held many airhead views, but I always thought that Greenspan had a little more sense. I guess he doesn't. How could everyone be so oblivious?

Well, let me make a couple of closing points here.

Greenspan used to think that deflation was impossible, but Japan's 1990s experience proved him wrong.
I frequently make the point that mainstream macroeconomics has failed to predict or explain anything since the 1990s, and this shows it as well as any. Why did Greenspan think that deflation was impossible?

Then, in 2003, Greenspan attacked deflation by setting interest rates to zero, flooding the markets with money. Sure enough, all the money created several bubbles -- a housing bubble, a credit bubble, a stock market bubble.
But Bernanke and Greenspan evidently don't believe in bubbles. Do they even know that Japan was in a big bubble in the 1980s, leading to the bubble bursting and deflation in the 1990s? Do they even connect those two events?
Apparently not. They treat deflation as the CAUSE of the problem, rather than a SYMPTOM of the problem, with the result that they've made the bubbles much bigger, and the problems much worse.
And once again, they didn't anticipate that, since mainstream macroeconomics does predict or explain anything.

From the point of view of Generational Dynamics, the "adverse consequences" we're headed for is a new 1930s-style Great Depression.

What Alan Greenspan has done is to take responsibility for the "adverse consequences," leaving no ambiguity whatsoever. Even though he's 80 years old, he may well live to regret doing that. (8-Aug-07) Permanent Link
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Nouriel Roubini says: "Worry about systemic risk." Whoo hoo!

His arguments show what's wrong with mainstream macroeconomics.

I know I shouldn't keep picking on the same guy, after I wrote about his housing recession predictions, but he's so important, and his reasoning is so mainstream, and the mainstream reasoning is so vacuous.

Roubini provides pro and con lists of reasons whether we're having a period of "temporary economic turmoil," versus "a more severe and protracted period of financial market volatility and downturn that could end up into a systemic risk episode."

Since he's laid out the reasons pretty clearly, it's of interest to me to comment on them, as representives of current mainstream economic thinking.

As I explained at length in my comprehensive analysis of macroeconomic theory that I wrote last year, "System Dynamics and the Failure of Macroeconomics Theory," economists have been wrong about everything, at least since the start of the bubble in 1995. They didn't explain or predict the bubble or its timing. They failed to predict low inflation or high unemployment in the early 2000s. They didn't predict or explain productivity increases. They didn't predict or explain the low interest rate "conundrum." They didn't predict or explain the housing bubble. They've been consistently wrong about almost everything.

Because Roubini lays out the mainstream macroeconomics arguments in such details, it gives me an opportunity to explain again why mainstream macroeconomics is a complete failure.

"Any time there is an episode of turmoil in US and global financial markets the question in the mind of investors is whether this is a period of temporary turmoil or the beginning of a more severe and protracted period of financial market volatility and downturn that could end up into a systemic risk episode.

In the last decade only the LTCM episode in 1998 at the peak of the Asian and emerging markets financial crisis and the bust of the tech bubble in 2000-2001 - that triggered the US recession of 2001 - had systemic implications. Since then we have experienced a variety of other episodes of financial turmoil that have ended up being only temporary shocks. In these episodes of temporary turmoil investors risk aversion sharply rose for a while, volatility indices and gouges of investors risk aversion (such as the Vix, the 10 year swap spread and credit spread) sharply increased; and the financial pressures spilled over from credit/debt markets to equity markets. But in each of the most recent episodes the turmoil was transitory (a few weeks or, at most, a couple of months); once the transitory sources of the financial disturbances disappeared, calm returned to markets and investors risk aversion returned to lower levels.

This gets right to the heart of the debate going on today among mainstream economists. Start with the assertion that the surging economic problems are caused by investors' increasing risk aversion, since investors are then unwilling to buy stocks or remain in the stock market, and so stock share prices fall.

The economists' debate then is about how to get investors' risk aversion back to "normal."

Roubini refers to risk aversion returning "to lower levels." He doesn't say "to normal levels," but the unstated assumption of every pundit, as far as I can tell, is that lower levels are "normal" and today's higher level is "abnormal."

In fact, from the point of view of Generational Dynamics, it's the higher levels of risk aversion that have been abnormal. The current generations of investors have been so fearless, that they've been willing to take any risk whatsoever, making investments that would be out of the question of generations of investors who personally survived the 1930s Great Depression.

So right off the bat, we see that Roubini and other mainstream economists base their reasoning on an incorrect assumption: That the levels of risk aversion in the recent past have been "normal," when in fact they've been abnormally low.

This means that the debate on how to lower risk aversion again to "normal" levels is fundamentally wrong. There may be a way to push it down to abnormally low levels again, but that can't be more than temporary. The level MUST rise to normal levels at some point, and then the bubbles MUST burst.

"One of such episode of temporary turmoil followed 9/11 in 2001 and the collapse of Enron in late 2001. Another episode of transitory turmoil occurred in early 2003 before the US invasion of Iraq when market started to worry about the risks and consequences of the war on the economy. A more recent episode was the one that � in the spring of 2005 � followed the downgrade of GM and Ford by credit rating agencies; that downgrade caused serious but temporary pressures in the credit derivatives markets and in equity markets. Another episode occurred in the spring of 2006 when a sudden �inflation scare� in the US (worries that inflation was rising and that, therefore, the Fed was not done yet with rising the Fed Funds rate) led to a sharp downturn in US and global equity markets and serious pressures on some emerging markets currencies, equity markets and bond markets. And the final episode � before the most recent turmoil this summer � was in late February 2007 when the combination of a mini-crash in the Chinese stock market, rising worries about the fallout of the subprime crisis and a US �growth scare� affected mostly equity markets in the US.

Since most previous episodes of financial turmoil since 2001 have been temporary, the optimistic and consensus view in the markets is that the current financial turmoil will be again transitory and that risky assets � starting with equities � will recover their upward price path once investors� nervousness abates. That is certainly possible as previous episodes of turmoil since 2001 were mostly contained. But I will flesh out a number of reasons why the current episode of market turmoil may be more serious and protracted than previous ones and why we should worry now about systemic risk.

Roubini presents one side of the argument. He notes that in previous recent surges in investors' risk aversion, the risk aversion has come down as soon at the triggering event was over. Thus, the argument is that the same thing will happen soon, as soon as investors forget the Bear Stearns debacle.

However, he now proceeds to the opposite arguments: That today's environment has some fundamental differences from previous recent surges, and that "we should worry now about systemic risk."

"First, most of previous transitory episodes occurred at the time when US and other G7 monetary policy conditions were much looser than today. Starting in January 2001 the Fed aggressively cut the Fed Funds rate that fell from 6.5% to a bottom of 1% by 2004. Next, the normalization of US monetary policy brought back the Fed Funds rate to 5.25%; while at the same time monetary policy has been tightened in all G7 countries and several other emerging markets. And with inflationary pressures being still on the upper limits of many central banks� comfort zone further tightening is expected (say in the Eurozone, UK, China and many other economies). Thus, in past episodes, easy monetary conditions helped; today instead policy is tighter and on the way to further tightening.

So, his first reason "why we should worry about systemic risk" is that interest rates have been tightening. What does that have to do with systemic risk? Tightening interest rates were once thought to affect unemployment (Keynesian), and more recently have been thought to affect inflation (Monetarist). But what do they have to do with systemic risk? Roubini is just guessing.

"Second, following the brief US recession between March and November 2001, economic growth � first in the US, then in other G7 economies and emerging markets � recovered rapidly and has remained high for a number of years. But starting with the fall of 2006 the US has experienced a serious economic growth deceleration that may turn out into a hard landing (either a growth recession or an outright recession). The rest of the world is growing robustly but the clouds over US economic growth are rising. In previous episodes � like the spring of 2006 or early 2007 � we had an inflation �scare� or a �growth� scare and markets reacted sharply downward. Now, if instead of having a growth �scare� the US were to experience an actual sharp growth hard landing (say a growth recession) the financial consequences would be serious as housing, capex spending and private consumption would sharply slow down.

Next, Roubini's second reason to worry is because the American economy has been slowing down. Once again, I have to ask why this means a "systemic risk.

A growth recession is defined as "An economy in which the output of goods and services slowly expands but unemployment remains high or grows."

This gets down to the question of exactly what "systemic risk" Roubini is talking about.

I know what I've been talking about -- since 2002 -- a stock market panic and crash, and a new 1930s style Great Depression.

Roubini seems to be covering all the bases: maybe it'll simply be a deceleration of growth (a "soft landing"), or maybe it'll be a sharp slowdown in housing, capital expenditure spending, and private consumption (a "hard landing"). He's covering all the bases. That way he won't be wrong.

"Third, between 2001 and 2006 the debt, credit and financial excesses of important sectors of the economy were contained; today they are not. At the time of the 2001 recession the balance sheets of the corporate sector were weak but those of the household were relatively sound. Today, instead, after six years of excessive borrowing and two years of negative savings the balance sheets of the household sector are weak and fragile. At the same time the process of releveraging of the financial and corporate system (hedge funds, private equity, prop desks, LBO and share buyback activity) has led to significant increase in the amount of debt and leverage in the private sector. As suggested by Ed Altman � the leading academic expert of corporate distress - corporate defaults have been kept at a much lower levels (0.6%) than justified by current corporate financial fundamentals (2.5%) only because of the slosh of liquidity that allowed potentially distressed corporations to refinance their debts or do out-of-court restructuring plans. In the last few years a credit boom � if not a bubble � stimulated asset prices in a typical Minsky-style credit-driven asset bubble. The easy monetary conditions after 2001 and the continued wall of liquidity coming from highly saving and forex-accumulating emerging markets fed a US and partly global asset bubble and a credit/debt bubble. Thus, the excessive leveraging of households, some parts of the corporate sector and many financial investors is a new source of financial fragility and systemic risk."

Roubini's third reason to worry is that the "debt, credit and financial excesses of important sectors of the economy" are not "contained."

This of course is a serious problem. This web site started saying so years ago, first talking about a stock market bubble in 2002, then housing and credit bubbles in 2004 and 2005.

The sentence "In the last few years a credit boom � if not a bubble � stimulated asset prices in a typical Minsky-style credit-driven asset bubble" refers to Roubini's previous posting, about economist Hyman Minsky and his view that "periods of economic and financial stability lead to a lowering of investors� risk aversion and a process of releveraging," or excessive use of credit. This is the Minsky Credit Cycle Model.

According to Roubini, the Minsky Credit Cycle peaked with the Savings and Loan bust in the late 1980s and the dot-com bubble bust in 2000. He says that we're now at the peak of a new Minsky cycle.

Well no, he's not sure it's a bubble. Or maybe he is sure. To repeat what he says: "In the last few years a credit boom � if not a bubble � stimulated asset prices in a typical Minsky-style credit-driven asset bubble. ... fed a US and partly global asset bubble and a credit/debt bubble." Well, it looks like he's covered either way.

In his posting on the Minsky Cycle, he concludes with this: "Note also that, as Minsky - as well as more recently the BIS � have warned the deflation of such credit-driven asset bubbles is historically painful and associated with economic downturns and recessions."

What the heck is this? I've quoted Greenspan many times as saying exactly the same thing: "Any onset of increased investor caution elevates risk premiums and, as a consequence, lowers asset values and promotes the liquidation of the debt that supported higher asset prices. This is the reason that history has not dealt kindly with the aftermath of protracted periods of low risk premiums." Only Greenspan said it two years ago.

"Fourth, the housing bubble has already popped in the US and is at risk of popping in other bubbly housing markets (UK, Spain, Ireland, Australia, New Zealand, and Iceland to name a few cases). The fallout of the US housing recession has been twofold. First, spillover to other sectors of the economy (auto recession, weakness in durable goods and housing related sectors, weak capex investment of the corporate sectors, slowdown of private consumption among overstretched US households). Second, spillover to other financial markets as: a) this is not just a subprime problem but increasing a near prime and prime mortgage problem; b) there is now a liquidity and credit seizure in a variety of credit markets (LBOs, CDOs, CLOs, etc)."

The fourth reason is the one that I and many other people have been talking about for months, and has riveted the attention of investors everywhere, ever since the Bear Stearns debacle. No argument here.

"Fifth, we are now reaching a point where the distress of many and different economic agents may lead to a systemic effect. Some have argued that the growth of credit derivatives has diffused financial risks among many different agents and in a variety of countries reducing systemic risk. That is why � it is argued - the risk of one huge LTCM blowing up and causing systemic risk are limited. But the experience with previous episodes of systemic risk (the S&L crisis where hundreds of smaller financial institutions went belly up causing a credit crunch and the 1990 recession; the tech bust of 2000-2001 where hundreds of smaller tech and internet companies went belly up and triggered the 2001 recession) suggest that the LTCM type of systemic crisis (one large institution getting in trouble and taking with it most of the financial system) is the exception rather than the rule: many and different agents and institutions getting in trouble can lead to systemic effects especially after a period of asset bubbles driven by a credit/debt bubble.

And today there is a variety of economic and financial agents that are under financial pressure if not outright distress. Specifically, hundreds of thousands of subprime and near prime households will default on their mortgage and their homes will end up in foreclosure; the ability of the financial and legal system to manage such a surge in bankruptcies is severely limited. Also, over fifty subprime lenders have now gone out of business and now some of the larger lenders � see AHM and Accredited Home Lenders Holdings Co. - are also in trouble and near bankrupt; the mortgage rot is spreading from subprime to near prime and Alt-A (see Countrywide, IndyMac, etc.). Now, there are news of massive losses among major US home builders and rumors that some may be near bankruptcies. There are already half a dozen mid-sized hedge funds � between US, Australia and Europe � that have gone belly up; and every day financial institutions across the world are reporting large subprime-related losses as a lot of the RMBS and CDO were bought by foreign investors. And in a world where most investors in these illiquid instruments (RMBS, CDOs, CLOs, etc.) are marking to model rather than marking to market the extent of the eventual losses is unknown and the number of financial institutions that will go belly up is also unknown and likely to surprise on the upside. Systemic risk episodes often occur with a death through 1000 cuts rather than one single major � a� la LTCM � blow."

So Roubini's conclusion then is that we should indeed "worry about systemic risk."

I find that his summary is useful as representing the point of view of mainstream economists today.

This entire posting illustrates everything that's wrong with modern macroeconomics.

In order to illustrate the problem, I'd like to return to and expand upon an analogy that I've used before: a heat wave in New York City in November.

Here's the situation: It's New York City, and it's late November. There's been a heat wave, and now the weather has cooled off a bit, and there's a debate going on over whether winter is coming.

I'm going to mimic Roubini's arguments, pro and con. First, here are the arguments that winter is NOT coming:

"The weather has cooled off several times in the last few months. In the first week of September, the temperature fell rather sharply. In the second week of October there was another dip in the temperature. Nervous pedestrians began wearing heavy coats, but in both cases the pedestrians stopped wearing heavy coats as the temperature went up again. Today, pedestrians are starting wear heavy coats again as the temperature dips. But we believe that the pedestrian will regain his confidence, shed his heavy coat, and the temperature will rise once more, so there won't be any winter. That's what happened in September and October, and we can expect that to happen again today."

Notice the "cause and effect" confusion in this argument: Do the pedestrians' heavy coats cause the chill, or does the chill cause the heavy coats? The argument could go either way, and leaves the possibility open that either interpretation is correct.

I first wrote about this problem in September, 2004, in an article entitled "Federal Reserve congratulates itself on jawboning policy." I commented on a study by Ben Bernanke that supposedly showed that long-term interest rates have been kept low merely because the Fed SAID that they would remain low. By setting expectations, Bernanke's study claimed, the economy stayed stable, because the Fed SAID it would remain stable.

This claim was ludicrous in 2004, but now in 2007 surely even Bernanke can't believe it. But that's the same argument that by convincing people not to wear heavy coats, then the weather won't get cold.

In Roubini's argument, reflecting mainstream economic theory, the risk averseness of the investors has been increasing at the same time that market turmoil occurs. Which is cause, and which is effect? Economists really have no idea, but the hope is there that if we can only convince people to be risk-seeking again, then the market will start heating up again, and the bubble will grow again.

Now I'll mimic Roubini's arguments in the other direction:

"Things are different today than they were in September or October. First, there was a snowstorm in Minnesota last week, indicating a more widespread breakdown in the warm weather, and nothing like that happened in September or October. Furthermore, the jet stream appears to be changing course, more and more flowing from the north and less from the south. Finally, factories in China are producing more heavy coats and shipping them to the United States, including New York City, and that will bring temperatures down further. So we have good reason to worry that winter is coming."

You may think that I'm making a joke in comparing these weather arguments to Roubini's economics arguments, but I'm not. The two sets of arguments are equally invalid.

If you want to understand whether winter is coming, you have to go back farther than September or October -- you have to go back a full year or two to previous Novembers. Any attempted comparison at all between November's weather and September's weather is going to fail, because they're at different points in the seasonal cycle. The comparisons are totally irrelevant.

Similarly, if you want to understand today's economic climate, you have to go back much farther than 2003 or 2000 or the 1990s or the 1980s. Any macroeconomic model developed at those times cannot possibly be relevant to today's economy, because they're at different points in the long-term economic cycle. The comparisons are totally irrelevant.

To understand today's economic conditions, you have to compare it to the 1920s. But mainstream economists NEVER do that, because they believe that the they've totally solved the "Great Depression" problem, and that it will never happen again.

Over the years, I've given many arguments why we're headed for a major panic and stock market crash, and a new 1930s style Great Depression. But the following argument, that I've made many times, is really all by itself absolute proof: The Price/Earnings ratio since 1995 has been way above its average of around 14, and has to be around 5 for a decade to maintain its long-term average (the Law of Mean Reversion).

This argument is not exactly rocket science; it's pretty standard stuff. If Nouriel Roubini or any other mainstream economist even simply ADDRESSED these arguments, and at least TRIED to explain why this argument is wrong, the attempt might give me some pause.

But they never do. They simply ignore these arguments, and go obsessively into details on Minsky Cycles and other stuff from which you can't conclude anything.

That's one of the reasons why I've no doubt these last few years that Generational Dynamics is correct, and all of its predictions are correct: Almost no one ever bothers to address the arguments, even when the arguments are obvious.

And so, as I've said so many times before, Generational Dynamics predicts that we're headed for a new 1930s style Great Depression. It's impossible to make short term predictions, but for the reasons that I've given in numerous recent articles, the economy now appears to be deteriorating rapidly, and so the time may well be getting close. (6-Aug-07) Permanent Link
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CNBC's Jim Cramer becomes hysterical, blaming Ben Bernanke

In an interview that followed Friday's market meltdown, Cramer started screaming hysterically, at one point appearing to cry. This interview is gaining quite a bit of attention around the internet.

CNBC's Jim Cramer screams at the lovely anchor Erin Burnett as she tries to interview him. (Source: CNBC)

CNBC's Jim Cramer screams at the lovely anchor Erin Burnett as she tries to interview him. (Source: CNBC)

Most people think he's going crazy, but I actually sympathize with him. I've written about how this whole thing is affecting me, and how much I'm dreading what's coming, while everyone else is oblivious to it. So even though it's possible that Cramer was acting, my feeling was that he was being honest.

Cramer says that he's spoken to the heads of numerous organizations and gotten a picture of total desperation throughout the country, as millions of people are going to lose their homes. The purpose of his tirade is to beg Fed Chairman Ben Bernanke to lower interest rates, to solve the problem. Of course this is completely wrong, since it won't have any effect whatsoever on the problem, but I'll discuss this after you've had a chance to view the video:

Here's a transcript of the last few minutes of the interview:

"Lovely Erin Burnett: It's not Ben Bernanke and the rate that matters.

Angry Jim Cramer: It's the rate. It's entirely the rate. We're going to spend billions in Iraq to build homes. We have thousands of people losing their homes right now. 14 million people took a mortgage in the last three years. 7 million of them took teaser rates or took piggy-back rates. They will lose their homes. This is crazy.

[[At this point, he's screaming at the top of his lungs.]]

I'm sorry to be so upset about it, but you have to see what they're saying to me, off the record, before I come in here, every night and every day. And what I hear from these blowhard managers who act like ... Call someone, for heaven's sake. Go call someone.

I worked at fixed income. This is not the time to be complacent.

Sometimes I wish I didn't know anybody, so I could just sit here and say, 'You know what? Just go buy some Washington Mutual. Take that yield.' Unfortunately, I know too many people, and I'm too darn old

Erin: You are 62.

Cramer: I've been around for too long. I mean, look, I gotta tell you ... He has got to listen ...

[[At this point, he's practically in tears.]]

He's gotta call someone. Bernanke's gotta call someone. No, they're not calling anybody. And Bill Poole? Bill Poole? There was a President named Hoover, and no one thinks much of him now, the Great Engineer.

I'll leave here, and I'll get another ten calls from the trading desk, saying Cramer, would you please speak up?"

There's a reference to Bill Poole for this reason: Poole is President of the Federal Reserve Bank of St. Louis, and is a colleague of Ben Bernanke.

In recent speeches, Poole has said two things that distress Cramer: First, he said that inflation is "moderating just a bit," and indicated that there's no need to lower interest rates just yet; and second, he said that he doesn't expect losses from defaults on subprime mortgages to spread beyond the real estate industry. "The damage, I think, is going to remain primarily in the real estate sector. We do not have a bank involvement and therefore bank lending for the normal sort of economic projects is alive and well."

This, of course, has already been shown to be disastrously wrong, which is why Cramer is contemptuous of him.

Cramer is making the same point that I have: That a major economic crisis is growing, and almost everyone is oblivious to it, including the Fed governors. However, we differ on what can be done about it.

From Cramer's point of the view, the solution is simple: The Fed can lower interest rates 1%. That will reduce mortgage interest rates, and will cause the housing bubble to start growing again.

From the point of view of Generational Dynamics, nothing could be further from the truth. The economic crisis is coming about because investors and everyone else are turning highly risk-averse, after two decades of increasing willingness to take huge risks.

The coming financial panic and crash is caused by huge generational changes that are taking place. The original 1990s stock market bubble was caused by a new young generation with no fear of any financial crisis. Now that they've seen what can happen, especially in the case of Bear Stearns, then they're close to panicking, and that's what will trigger the crash. Nothing can be done to stop this, certainly not a small change in the interest rate.

Earlier this week, Jim Cramer had another controversial interview, in which he said that If your home is worth significantly less than the amount of your mortgage loan, then you have nothing to lose by just walking away and defaulting on your mortgage.

A web site reader has asked me the following question:

"You mentioned that in essence there is no effective consequence to a person simply walking away from their home, i.e., defaulting on their mortgage (which was taken on the premise that the market would keep going up, etc.). Is that in fact true...no legal consequences?"

Now, I'm not a lawyer, and I'm not giving any legal advice. I'm simply telling you what I believe to be the case, and if any actual lawyer reads this and believes that I'm wrong, he should write to me and let me know.

What I believe to be the case is this: A mortgage loan is a secured loan that permits the bank (or lender) to foreclose and take back the home used as security for the loan. The bank can then sell or auction off the home for whatever it can get, and since the former homeowner has no control over that sale, he's not responsible if the bank gets less money than expected. Therefore (and as specified by consumer protection laws), the former homeowner is not required to repay the amount that the bank lost. Now there may be exceptions to this; perhaps you might have to pay a fee; or perhaps the bank can sue you if it can prove that you defrauded them, or that you purposely damaged the house. But as a general rule, you can "walk away" and not suffer major legal consequences, as far as I know.

That doesn't mean there are no consequences. One is that you'll lose your home. Another is that the foreclosure will be on your credit record for many years, and you may have difficulty obtaining credit or another home mortgage.

If you, Dear Reader, are facing this situation, then you should consider other options before "walking away." Since it's extremely expensive for the bank if you walk away, they may be willing to accept terms highly favorable to you. This is increasingly true as mortgage foreclosures have been surging, and banks are increasingly stuck with owning large inventories of foreclosed homes.

So, for example, they may be willing to substantially reduce the monthly payments by renegotiating the terms of the loan, perhaps even cutting them in half for a few years. They may consider that option preferable to having you walk away.

Another possibility is to allow you to sell the home as a "short sale." Normally, if you sell your home, then you have to repay the mortgage loan in full. But if the value of your home has fallen, then you will owe the bank a lot of money. If you think you can sell your home, you might get the bank to agree to a "short sale," which means that you'll sell it for whatever you can get for it, and the bank won't require you to make up the difference in the mortgage loan.

The advantage to you of negotiating a short sale instead of walking away is that you can demand that the short sale not go on your credit record. This might make a big difference to you in the future.

If you'd like to consider these options, then there are two things you can do. First, google the words "mortgage foreclosure," and start reading. There's plenty of information online.

Second, consult a lawyer before you do anything drastic. You should ask the lawyer for a free initial consultation, so that you can decide what to do. If you're going to go into a tough negotiation for reduced payments or a short sale, you'd be wise to have an expert doing the negotiating for you. (5-Aug-07) Permanent Link
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Stock markets continue fall as subprime "contagion" spreads

The Dow Industrials fell almost 300 points on Friday on a steady stream of bad news.

The immediate trigger appears to have been an admission by chief financial officer that the US credit markets were the worst in decades. "These times are pretty significant," he said on a telephone conference call with investors. "I've been out here for 22 years, and this is as bad as I've seen it in the fixed-income markets."

Bear Stearns, which now has two worthless hedge funds and a third one in trouble, had its rating downgraded by S&P from "stable" to "negative." The conference call was meant to calm jitters, but it did the opposite, as it was the perceived trigger for an additional 200 point drop on Friday afternoon.

American Home Mortgage, whose stock fell 90% on Tuesday has laid off 7,000 workers and is now expected to file for bankruptcy. Chief executive Michael Strauss said: "Unfortunately, the market conditions in both the secondary mortgage market as well as the national real estate market have deteriorated to the point that we have no realistic alternative."

Pundit David Johnson on PBS Marketplace on Friday said, "This has been a bizarre week that at no point felt good. It's the subprime stuff. This has the potential to be much wider spread than just the housing market -- deals that won't get funded -- the solvency of the big financial companies - the Lehman Brothers and the Goldman Sach's and Bear Stearns -- all those stocks have been killed in last couple of days. ... We don't know how bad things are. You don't know -- how many hedge funds are in trouble, if it will have an impact on the average joe - how heavily impacted the housing market is, and whether the Fed's gonna have to walk in and do somehting. It's the uncertainty that drives you up a tree. ...How many times gave you seen the stock market do 2 billion shares a day in the summertime? Everyone's supposed to be on vacation."

That's the way things are going as investors are close to panic -- fearing a big "correction" that cause the market to fall before they got out, but also fearing a rally that could catch them barefoot out of the market.

The worry is about "contagion." At first, only a tiny portion of the housing market was going to be affected, the subprime mortgage market. But now it's clear that the "contagion" has spread to Alt-A mortgage loans and even the least risky mortgages. The reason has nothing to do with the mortgage loans themselves: If your home is worth significantly less than the amount of your mortgage loan, then you have nothing to lose by just walking away and defaulting on your mortgage.

Next, as Bob Johnson's remarks indicate, the "contagion" may have spread to the big financial firms. How many of them will go under?

A pundit on CNBC on Friday afternoon -- I didn't catch his name -- made a very interesting point. He said that many banks and financial institutions are heavily invested in mortgage-based securities, but they don't want to even investigate it, because to do so would create a market in these securities, and then by mark-to-market rules, more portfolios would have to be revalued.

In other words, other financial institutions are doing a cover-up for exactly the same reason that Bear Stearns covered-up its asset values in June. The cover-up didn't last long, of course, as the firm soon had to announce that its hedge funds are worthless. According to this pundit, there are other financial institutions doing exactly the same thing.

Index price of low-quality ABX-HE-BBB- 07-1 credit derivatives and high-quality ABX-HE-AAA 07-1 credit derivatives from Jan 19 to Aug 3, 2007 (Source: Markit.com)

Index price of low-quality ABX-HE-BBB- 07-1 credit derivatives and high-quality ABX-HE-AAA 07-1 credit derivatives from Jan 19 to Aug 3, 2007 (Source: Markit.com)

This certainly wouldn't be a surprise, since all these institutions wanted to get in on the gravy train when liquidity was flying high. In fact, banks around the world invested in these termite-infested securities.

The graphic has the latest values of the ABX index for low-quality and high-quality credit derivative securities. As you can see, these indexes are in free fall, and it makes no difference whether you're talking about subprime mortgages or high-quality mortgages.

What this graph does is that it serves as a proxy for the values of securities portfolios in banks that invested in mortgage derivatives -- and that's most of them.

This past week, for example, two major German firms announced that their hedge funds are in trouble.

The Europeans, of course, are hoping and praying and hoping and praying that the "subprime contagion" won't reach them.

This brings me to the words of Neil Munroe of Equifax in Europe, speaking on the BBC on Friday morning (ET). According to him, things are bad in the US, but the Europeans have been much more prudent and controlled:

"I think the problem is contained in the US because of the activity. I think in other parts of Europe there is a much, much stricter regime about some of the underwriting criteria that people can use. There is more control.

In the UK there's the FSA, and in Germany and other countries, there are similar organizations that will be controlling that. There's more prudence here I think. There's more respect. ..

I think there's going to be a couple of weeks where [the market is] going to be a bit sensitive. I think it will [stabilize]. I think it has to [stabilize]. I think people will realize that it's an isolated incident, albeit a very big one in the US. I think that when people understand that this is a global funding issue, and not a consumer issue, then I think the market will settle."

I've only quoted a few paragraphs out of this guy's interview, but I noticed one interesting thing. At the start of the interview, he was speaking very slowly and confidently. By the end of the interview, he was speaking faster, his voice had a higher pitch, and, if you look at the last paragraph, he was beginning every sentence with "I think." This guy is one nervous nellie.

And well he should be. We mentioned the German hedge funds above, but that isn't the main problem. Recall what I wrote in July 2004, in an article entitled, "Real estate is in an overpriced bubble all over the world": "Residential properties in countries around the world, including America, Australia, the United Kingdom, China, South Korea, Spain, the Netherlands, and South Africa, are overpriced by 50% or more."

You have the same situation around the world: A housing bubble that's bursting; and banks and financial organizations heavily invested in collateralized debt obligations (CDOs) whose values are based on the graphic shown above.

You should understand this, dear reader, if you don't understand it yet: This is going on right now. And I'm not making any of this stuff up. The values of securities in the portfolios of mutual funds, investment trusts, hedge funds, savings banks, pension funds, college endowments, money market funds, insurance companies, and so forth, are already crashing. That's what the above graph shows.

The panic has already begun, even if "the contagion" hasn't yet hit the stock market. But if Bear Stearns alone could trigger a stock market fall, then imagine what will happen when a number of other institutions are forced to revalue their portfolios by mark-to-market rules, something that they're desperately trying to avoid now, in the hope that the market will move back into super-bubble territory again.

What should you expect in the next few weeks?

An online correspondent has reminded me that in past major stock market crashes, the market fell 10-20% before the real crash occurred.

Assuming that history repeats itself, the Dow will fall to around 11,000-12,000. If a crash is going to occur now, it will occur around that time, in a few weeks. If you'd like to analyze this some more, take a look at the article that I wrote last year, "Speculations about a stock market panic and crash"

From the point of view of Generational Dynamics, it's always impossible to make short-term predictions. What we know is this: A generational stock market crisis is overdue (the last one was in 1929), but we don't know for certain whether it will occur next week, next month, next year, or even later.

However, we also know that we're seeing a pattern that's typical of immediate pre-crash periods. Now, I've been fooled before, so nothing is certain. But with the incredible collapse of the ABX index, and the knowledge that more and more lenders are "imploding" every week, there is reason to believe (but not certainty) that the crash has already begun slowly and the fall is accelerating. (4-Aug-07) Permanent Link
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Still tilting at windmills, the UN will send "peacekeepers" to Darfur

What "peace" is there to keep in this massive crisis civil war?

The United Nations Security Council passed a resolution to deploy an international force of 26,000 peacekeepers to Darfur, with a mandate to stop the massacres of civilians that have killed hundreds of thousands of people and created millions of refugees.

The resolution is considered to be a major foreign policy victory for Gordon Brown, who has just replaced Tony Blair as Britain's Prime Minister.

This must be the most popular war in the world. Everyone (or almost everyone) was in favor of 2003 invasion of Iraq when they thought it would be easy, but not it's being described as the greatest crime in the history of the world.

But the Darfur war is different. This is a wonderful war, something that's worth intervening in. And besides, it'll be easy, won't it?

In 2004, so-called "peace activist" Jesse Jackson called for sending American troops to Darfur. He was against the Iraq war, presumably because that's a "bad" war, but he was all gung-ho about charging into the middle of the Darfur civil war, I guess because that would be a "good" war.

And Democratic Senator Joe Biden, who may well be the stupidest person in the Senate, wants to move troops from Iraq to Darfur civil war. He was on Meet the Press a few weeks ago, with a long harangue about how "incompetent" Bush was because he sent too few troops into Iraq, and he said over and over that the surge is a failure because "All the troops in the world cannot settle a civil war." And then he goes on to claim that we should send 2500 troops into Darfur to "end the carnage" and "stop the bleeding."

So he's criticizing Bush for sending too few troops into the Iraq war, which is NOT a civil war, but wants to send 2500 troops into Darfur, which IS a civil war involving millions of people.

What is it about the Darfur civil war that makes everyone so stupid?

Reuters published a "Fact Box" on the Darfur war a couple of days ago. It begins:

"Rebels in Sudan's western Darfur region took up arms against the government in February 2003, saying Khartoum discriminated against non-Arab farmers there.

Khartoum mobilized proxy Arab militia to help quell the revolt. Some militiamen, known locally as Janjaweed, pillaged and burned villages and killed civilians. The government has called the Janjaweed outlaws and denied supporting them."

Now that doesn't convey what happened at all. I went to a lot of trouble over many months to dig out this history of this war, and I summarized the history a few weeks ago.

I won't repeat it all here, but it's important to understand that this war began as a series of land disputes in the 1970s, with low-level violence increasing over time. The Janjaweed militias were formed in the 1990s as a kind of people force to settle these disputed.

Darfur - southwest region of Sudan (Source: BBC)

Darfur - southwest region of Sudan (Source: BBC)

What makes the Darfur war extremely fascinating from the point of view of Generational Dynamics is two events:

In April, 2002, some young men of one Darfur village complained to the Sudan authorities that the Janjaweed militias were harassing them. But instead of getting, help, the young men were jailed.

I keep talking on this web site about how tiny events can have huge effects, provided that they take place at the time of certain generational changes, and this was one of those times. The Darfurians were infuriated by the action by the government.

Now, the event that Reuters identifies as the start of the war occurred on February 26, 2003, when those young men attacked a police station to take back their lost weapons from the time of the arrest.

This triggered PANIC in Sudanese in Khartoum, and that soon escalated into the fighting we're talking about now. That's what happens to all countries in generational Crisis eras. That's what happened last summer when two Israeli soldiers were kidnapped near the Lebanon border and and Israel panicked and launched the Lebanon war within four hours, with no plan and no objectives. That's how generational crisis wars start.

When all the fuss over Darfur started in June, 2004, I wrote that "the UN is completely irrelevant" By this I meant that UN peacekeepers could no more stop this crisis civil war than UN peacekeepers could stop a tsunami.

This new UN attempt appears to be something of a joke. First off, there's no peace for the peacekeepers to keep. Second, it will take many months to form the 26,000 man force. Third, the peacekeepers are not authorized to fight, so they'll have to stand and watch the genocide occur.

Actually, that's what happened in 1995 with the Srebrenica massacre. To this day, the Europeans are still in shock that they "allowed" this to happen, right in their own backyard.

And the fourth reason that the UN resolution is a joke is because it will do no good under any circumstances. As I've said before, a crisis civil war cannot be stopped any more than a tsunami can be stopped. A crisis civil war is an elemental force of nature.

But fortunately, all is not lost. Gordon Brown can now brag about his brilliant political victory. President Bush can claim some credit too. In fact, there's enough credit to around for all the Security Council members and their leaders to enjoy. They can brag about how they accomplished stuff. They can point to it when it's re-election time. It's a total victory to everyone except those being killed in Darfur.

This evening, a web site reader sent me an e-mail message with a link to a Slate article, "Getting Comfy With Genocide."

The author, Ron Rosenbaum, argues that "there seems to be an emerging consensus, or at least an unspoken shared assumption, that genocide is not the exception but the rule in human affairs. The past century, from the Armenians to the Jews to the Rwandans, from Bosnia to the Congo to Darfur, certainly makes it seem that way."

In fact, from the point of view of Generational Dynamics, genocide IS the rule in human affairs.

The article says,

"One aspect of the shift is a new "realism" about genocide that reflects the way the world has come to tolerate it: We now tacitly concede that in practice, we can't or won't do much more than deplore it and learn to live with it.

Another�more troubling�trend is toward what we might call "defining genocide down": redefining genocide to refer to lesser episodes of killing and thus lessening the power of the word to shock.

One has to admire the honesty of Barack Obama, who argued in the recent Democratic YouTube debate that even if rapid withdrawal of troops from Iraq might lead to genocide, he'd favor going ahead and getting the troops out. He wasn't saying he was happy about the possibility�he was just expressing the view that the word genocide shouldn't freeze all discourse: He wouldn't let it be a deal-breaker.

Some were shocked by this remark. Others agreed that fear of a future genocide should not inhibit efforts to stop the current killing. ...

In other words, let's get real. Let's not pretend we care about the possibility of future genocide in Iraq if we do little or nothing about it where it's already happening now [in Congo and Darfur]."

So it's interesting that the author appears to be endorsing a major principle of Generational Dynamics, even though he probably knows nothing about Generational Dynamics. (3-Aug-07) Permanent Link
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Bear Stearns announces that another of its hedge funds is in danger

American Home Mortgage fell 90%, leading Tuesday's market bloodbath.

A third Bear Stearns hedge fund may be in danger of collapsing, following its recent announcement that its two major hedge funds are almost worthless.

Now, Bear Stearns has suspended redemptions on another hedge fund, meaning that investors will no longer be permitted to sell their shares and get their money.

The first two hedge funds were heavily invested in CDOs (collateralized debt obligations) related to subprime mortgages. Subprime mortgage loans are the riskiest group, given to home purchasers with poor credit ratings. Furthermore, these two hedge funds were heavily leveraged (similar to buying stocks on margin), meaning that a small drop in the value of the CDOs in its portfolio would be multiplied several times over. (In case you're wondering why anyone would do that, it's because a small increase in the value of the CDOs would be multiplied many times over, as well.)

But this third hedge fund is NOT leveraged, according to the investment firm. Furthermore, its securities are NOT related to subprime mortgage loans, but rather to higher rated Alt-A and prime mortgages. Alt-A mortgage loans are given to home purchasers who have good credit ratings, but are unable to document their incomes (if they're self-employed, for example), and prime mortgage loans are given to the most creditworthy borrowers.

The fact that this hedge fund is also in trouble shows how the contagion is spreading. (Think of my analogy the other day of termites destroying a house from within.) It's NOT just subprime mortgages; it's NOT just leveraged hedge funds. Everything is vulnerable.

Financial pundit Jim Cramer explained that there's no distinction between prime and subprime, because the value of real estate is falling. Here's a partial transcript of Jim Cramer's controversial interview, where he recommends that people "walk away" from their homes, and default on their mortgages:

"This [New York's financial district] is the only area of the country - this square mile - where real estate is up year on year. It's down year on year everywhere else. It's really remarkable. The real issue is the 2/28 mortgage loan -- you're going to hear a lot about this -- the first two years low interest rates, almost no interest rates, almost undocumented. They all reset -- the big bulge of reset will be October of this year to February of next year. Most the of the people who took these mortgages can't pay them.

[[Just to explain: the 2/28 mortgage is the ARM (adjustable rate mortgage) where you pay a teaser rate for 2 years, and then the interest rate adjusts so that for the next 28 years your monthly payment is several times higher.]]

I'm looking for 100% default on the 2/28. The bears are looking for 50% -- I'm saying that they're foolish and way too optimistic.

Now where are these 2/28 loans concentrated? Largely in Florida, in Phoenix, in Las Vegas, in the southland of California, the northern part, Sacramento, but most importantly the "inland empire."

We need to plow over the inland empire, because there are too many homes, and the homebuilders have too much inventory, and the people who have made these loans - I think that everything that was written from May 2006 to the end of the year is worthless.

[[I.e., he's saying that every mortgage loan granted from May to Dec of last year is worthless.]]

By the way, I'm not distinguishing any more between subprime and prime. That's a meaningless distinction. When your house drops 20% in value, then it doesn't matter if you're subprime or prime. It's better to walk away, even if you're wealthy.

You don't want to lose your credit card, and you don't want to lose your car. Your house is fungible. It's smart to walk away. You see the economic decision now weighs on walking away from your home. It's actually a good thing.

I know that sounds a little bit counter-intuitive. But if your house declines 20% in value, it's really important to sell it, to walk away from it. ...

There's no area of the country that's doing well. There's a small area in Baltimore that's probably about a mile or two square that's doing well. And south of Manhattan in NY is doing well. ...

All the major homebuilders have indicated that other than a little bit of square feet in Baltimore, and the south of Manhattan, there are no areas that are appreciating in this country. None.

What's so odd is that the average home appreciated 1% in 2006. I'm calling for a dramatic decline in home values, based again on the number of homes that continue to be built, and the inability to seell, and now the new found end of the 2/28, the end of all of these products that made it -- the teaser rates are gone.

Now, once again I'm going to emphasize -- if the Federal Reserve were to cut interest rates by one full point, what you would have is that things would just reverse dramatically, and everything would go up in value. So it really is just a stroke of the pen for the Fed.

[[The above paragraph is total nonsense. Reducing interest rates 1% would have no effect, and may cause investors to panic further.]]

But until then we're going to be in what I now believe is a total crisis.

The only guys writing honestly about it are Moodys.com, but I also find that duplicitous, since Moody's was so far behind on the mortgages.

[[He's referring to "Moody's joins S&P in downgrading mortgage-based securities."]]

As usual, Cramer is being dramatic and controversial, but his reasoning makes sense:

Housing inventories are so high, that house values are going to fall dramatically before long.

The 2/28 ARMs (adjustable rate mortgages) were sold to homeowners on the basis of the low teaser monthly payments. These payments are going to reset in bulk in the last half of this year, and many people will be unable to make the monthly payments, so they will default.

So he gives this advice: If you're going to default on your mortgage anyway, you might as well walk away and default right now, and save money.

He predicts that 100% of these mortgages will end up in defaults. His reasoning is that it makes no sense to continue making payments on a house, even if you can afford it, if the value of house has fallen so much that it's worth less than the value of the mortgage loan.

Now, this reasoning actually makes sense. Of course, the figure won't be 100%. There are many people who love their homes and are willing to pay the increased mortgage rates; there are many people who will stay out of a sense of moral obligation. But his logic makes sense that if your home value is far less than the amount of the mortgage loan -- and that's going to happen widely by the end of the year -- then forgetting moral obligations and as a purely financial decision, it makes sense to walk away.

The biggest financial news in the last couple of days is what's happened to American Home Mortgage Investments. American Home does not deal in subprime mortgages, but even so, the value of the company's assets has been dropping like a stone.

American Home had promised last month to pay a dividend to its stockholders, but suddenly reversed itself late on Friday of last week. Then, on Monday, the company announced that it didn't have the money to meet its margin calls. This caused investors to panic, and the value of the stock fell from $10.47 per share to $1.04 per share.

The market as a whole followed suit, and the market fell 1-1.5% on Tuesday. As of this writing, around noon in Asia, the Asian markets are down 2-3%.

The market is following a very ominous pattern. (1-Aug-07) Permanent Link
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