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by Chris Martenson
Wednesday, March 26, 2008

Be careful what you believe.

A television ad for Morgan Stanley’s brokerage service flickers across the screen, showing a retired couple walking across a beach with a dog and their grandchildren.  Smiles and ease and comfort drip off the screen.  It is a happy, shiny future that they are selling.  Separately, a letter goes out from Morgan Stanley to their private clients warning of a “50% chance of a systemic crisis."  Which do you believe? 

Executive Summary

  • Keeping a wide-angle view on this developing crisis is the only way to avoid being whipsawed, and the stakes have never been higher (at least in our lifetime).
  • The US financial markets, and probably the world’s, peered over an abyss on the night of Sunday March 16, 2008, but were rescued by very unusual and concerted official actions.
  • On the “happy, shiny” side of the equation, we have the fact that stocks mysteriously went up immediately on the open after the announcement of the collapse of Bear Stearns, and have continued up since.
  • On the “Cold, Hard Facts” side of the ledger, indicating that a particularly nasty recession is already underway, here is the recent data:
  • You can choose to believe that the worst is behind us (stocks), or you can choose to believe the facts (everything else). But be sure to choose carefully, because the penalty for being wrong here will be particularly steep.  
  • Simple preparations will go a long way toward mitigating the effects of a possible systemic financial crisis.

On Sunday, March 16th, deep in the night, the US financial system, and, by extension, the world financial system, peered over the edge of an abyss.  If the Bear Stearns rescue (by the Fed & JPM together) had not happened, it is my firm conclusion that a systemic banking crisis would have ensued.  While some commentators are now saying that “the bottom is in,” with one even going so far as saying the Dow 20,000 is now a lock, I would implore you to be careful in choosing your beliefs

Here’s why.  In my economic seminars, we spend about as much time on the economic context and data that define our current reality as we do examining beliefs and asking ourselves whether the ones we hold might be of the enhancing or limiting variety.  This is important because what we believe shapes what we see, and what we see determines our actions – and therefore our future.  Holding the wrong beliefs at critical turning points can be extremely harmful.

In the book The Mind of Wall Street by Eugene Levy, a wonderful example of both a limiting and an enhancing belief are simultaneously on display when he recounts his experience during the take-over of a struggling railroad back in the 1970’s.  He made a bundle on the deal.  Here he describes the situation:

Management executives looked to the past in their assessment of the railroad.  They saw its wretched history of bankruptcy and losses, the thousands of miles of useless track, and the years of failed attempts at regulatory reform; from this they could only conclude that Milwaukee Road was a failed railroad that could never be profitable.  We looked at the same railroad and instead saw vast assets in real estate and machinery that could be sold.

The railroad executive team held limiting beliefs about their company that prevented them from seeing the value of what they held.  Because of this, they saw the wrong things and took the wrong actions, losing a ton of money as a result.  Meanwhile, Mr. Levy had an enhancing belief that allowed him to see things about the railroad that led him to a fortune.

I want to share a believe of mine with you:  I believe the stock market is being propped up by the Fed and/or US government (PPT), who are desperately afraid of allowing the stock market to signal the true state of affairs. In some ways I can understand this; I think that the authorities who are stabilizing the markets right now are quite justifiably worried about what would happen if the stock market was “allowed” to send a correct signal to a wider audience.  Because I believe that the stock market is being propped, I do not trust that it is telegraphing useful or meaningful price signals, and so I will take very different actions than someone who holds the opposite view.  I might be wrong, or the person holding the opposite view might be wrong, but one of us is making a colossal mistake.

And here’s a second belief:  The market is bigger than the authorities, and they will ultimately fail in their attempts to prop the stock market, because they are merely masking symptoms, not treating causes. If it were possible for an elevated stock market alone to cure what ails our economy, I might think differently.  But those efforts are surely misdirected.

The consumer-retrenchment genie is already out of the bottle, and intervention will only serve to exacerbate what is already a terrifying gap between the ‘official story’ (as told by the stock market), the daily lives of ordinary people, and the cold, hard facts.

Even as a possibly illegal and certainly ill-advised rescue of Bear Stearns is being revised and revisited, and the stock market keeps climbing or at least holding steady, we find that the current spate of fundamental economic news is especially worrisome, if not downright scary.  The question before you, then, is, which will you believe?  A happy, shiny stock market, or the cold, hard facts?

The ECRI and NBER say “recession is here” 

To begin with, the highly-respected Economic Cycle Research Institute (ECRI) recently said, “Now the verdict is finally in.  We have unambiguously turned onto the recession track.”   In case that wasn’t strong enough, Lakshman Achuthan, managing director at ECRI said, "[Our indicator] is exhibiting a pronounced, pervasive and persistent decline that is unambiguously recessionary," while Martin Feldstein, who heads the equally-regarded National Bureau of Economic Research, said that contraction is already under way and that it’s likely to be severe, stating, "The risks are that it could get very bad."  The ECRI leading indicator incorporates a broad array of economic signals and has a very good track record of spotting recessions.  The stock market used to do this, but seemed to lose that ability around the time of the Fed rescue of August 2007.

Now, during your average, ordinary, garden-variety recession, which this one most certainly will not be, the average decline in the stock market is 28%.  Compared to a year ago, before all this financial uncertainty was widely recognized, the S&P 500 is only down -6.6%.  So, for whatever reason, the stock market is now deeply at odds with the ECRI, the NBER, and virtually every piece of economic data.  Somebody has it very wrong.

Housing data is "the worst since the Great Depression"

This housing bubble is bursting, and with alarming speed.  It’s hard to keep up with the data, it’s coming so fast.  Sales and housing starts have been cut in half since the peak (link supplied the quote below), and it’s important to remember that “sales” include transactions in which a bank takes possession during foreclosure, so the sales numbers are misleadingly high.  Notably, foreclosures for February 2008 were reported to be running 60% higher than last February, so we might expect bank repossessions to be a significant component of the recently reported existing home sales number.

CHICAGO (MarketWatch) — Housing is in its "deepest, most rapid downswing since the Great Depression," the chief economist for the National Association of Home Builders said Tuesday, and the downward momentum on housing prices appears to be accelerating.

The NAHB’s latest forecast calls for new-home sales to drop 22% this year, bringing sales 55% under the peak reached in late 2005. Housing starts are predicted to tumble 31% in 2008, putting starts 60% off their high of three years ago.

"More and more of the country is now involved in the contraction, where six months ago it was not as widespread," said David Seiders, the NAHB’s chief economist, on a conference call with reporters. "Housing is in a major contraction mode and will be another major, heavy weight on the economy in the first quarter."

Even worse, house prices have plunged by 10.7% over the past year, according to the highly-respected Case-Shiller index, although the US government (via the OFHEO) comes to a substantially different conclusion and reports a mere 3% decline.  As always, the US government has settled on a particular methodology that manages to paint a happier, shinier picture than does a private firm whose livelihood depends on delivering useful information.  Unsurprisingly, it’s the happier, shinier number that the Fed uses when calculating how much people’s homes are worth vs. how much they owe on them. But even with this deployment, a new benchmark has been set:

NEW YORK (AP) — Americans’ percentage of equity in their homes has fallen below 50 percent for the first time on record since 1945, the Federal Reserve said Thursday.

Homeowners’ percentage of equity slipped to a revised lower 49.6% in the second quarter of 2007, the central bank reported in its quarterly U.S. Flow of Funds Accounts, and declined further to 47.9% in the fourth quarter – the third straight quarter it was under 50%. That marks the first time homeowners’ debt on their houses exceeds their equity since the Fed started tracking the data in 1945.

The Federal Reserve is in a box

That last bit of data, above, is what has the Fed running around with its hair on fire.  Sure, we can all take comfort in the “bold, decisive action” that Bernanke took to preserve confidence in the system by pouring hundreds of billions of dollars into the banking system, but that leaves out a very important observation.  Namely, that the crisis is not based on the fact that banks have run out of liquidity; that’s a symptom.   The cause of this crisis is rooted in the fact that an entirely too-large proportion of the people who took out trillions of dollars in loans lack the means or the motive to ever pay those loans back.  It is now estimated that more than 1 in 10 homes is now ‘underwater’, meaning that more is owed on the mortgage than the house is currently worth.  Currently that’s 8,800,000 homes, a number that we can reasonably expect to grow as this negative housing-price dynamic plays itself out.

So the nature of this particular crisis, like literally every single other credit-bubble fueled crisis in history, is not going to be resolved until the bad debt is wiped out or the losses are socialized.  By this I mean that the Federal Reserve would have to print enough money (out of thin air) to buy all the bad debt, as in $1 to $2 trillion dollars worth of it.  If this happened, the Fed would become the largest property holder in America, its balance sheet would be ruined, and it is highly unlikely that the dollar would survive the attempt.  Therefore, like every other credit bubble that has burst in the past, massive amounts of bad debts will simply have to be wiped away.  And the sooner that happens, the sooner we can pick ourselves up and carry on.

But is this really possible?  Can all that debt simply be defaulted upon?

Probably not.  And the primary reason is that, like everybody else, the Fed has no idea what would happen if the $615 trillion derivative tower, with all of its unknowably complicated interlocking pieces, was suddenly exposed to a rash of defaults.  The fear that this would be an extinction-level event for the banking system, meaning the complete and permanent abandonment of fractional reserve banking as a concept (or for one or two forgetful generations, whichever comes first).

I have no particular insights into the complexity of the derivative system, but I can tell you that I have spent a great deal of time trying to understand the magnitude and location of the risks, without much success.  So I draw my conclusions from two anecdotes.  The first concerns Warren Buffet’s experience in the years after he bought General Re, a fairly ordinary re-insurance company.  The company got in some trouble and the decision was made to absorb its operations and shut it down.  But after several years (and much concerted effort), Berkshire Hathaway found itself stuck with 14,384 outstanding derivative contracts and 672 outstanding counterparties of indeterminate risk and unknowable value, leading Buffet to comment that derivatives are “financial weapons of mass destruction.”   It is important to note that the difficulties Warren Buffet’s organization experienced in assessing the risk and value of a single company’s derivative portfolio was during a period of stable market conditions.

The second anecdote concerns another company with a large derivative portfolio, Fannie Mae, which found itself in an accounting scandal and was forced by the government to restate its earnings for the years 2001 to 2004.  In December of 2006, after two full years of effort by an army of 1,500 expert accountants and $1 billion dollars expended, Fannie Mae was finally able to produce an earnings statement for 2004.  The reason for the excessive cost and time?  Derivatives.  There were simply so many and they were so complex that it took 3,000 person-years of effort to determine the earnings for one single year for one company.  Again, this was during stable market conditions, without the burden of counterparty defaults and the time pressures that fast-moving market conditions can impose.

Fast forward to today.  If it takes thousands of person-years of effort to calculate the impact of derivatives on a single company, what would happen during turbulent times, especially if defaults are cascading and multiplying throughout the system and tens of thousands of companies dotting the globe are involved?  Pandemonium and a major system-threatening crisis, that’s what.

So now you know why I view the Fed’s actions not as “bold and decisive,” but rather as “necessary and forced.”  They will need to go further and begin buying mortgage debt directly, as has already been publicly suggested.  In my opinion, the Federal Reserve (let alone the Bush administration) is institutionally ill-equipped to deal with this particular crisis.  The Fed relies on government data on inflation, house prices, etc., and therefore has a faulty instrument panel.  It is as if they are flying a plane with a stuck fuel gauge and an altimeter that is off by 5,000 feet.  At night, in mountainous terrain.  But, more importantly, the Fed is a sclerotic institution whose reliance on past example (the Great Depression and Japan come to mind) is poorly suited to a modern world that spent the past ten years creating financial products light-years distant from prior experience, while the Fed snoozed along basking in the false glory that came with financial stability and recklessly low but popular interest rates.

The worst is yet to come

Someday, this financial crisis will all be yesterday’s news, but already a lot of ink is being spilled to try and convince you that the worst is already behind us.  Don’t fall for it.  Even a cursory tour of the data will convince you that the bursting of this credit bubble is just getting started and that a particularly nasty recession has just begun.  Nothing the Fed has done, or even can do, will change the fact that trillions of dollars of losses lurk within the system.  And those losses will either have to be written off or they will have to be monetized (i.e., bought by the Fed for money printed out of thin air).  Writing them off would mean the possible destruction of the banking system (and massive political upheavals).  There is a slight chance, a hope, a faith, that we can somehow print our way out of this mess by monetizing the bad debts.  However, that is a knife-edge possibility with failure on one side and the utter destruction of our currency on the other.  While the destruction of our past mistaken pile of debt would be bad for those who took leave of their senses and participated in the credit bubble, placing your faith on our authorities to ‘fix this’ could be financially ruinous.  It is well past time to protect yourself and your financial assets.  While I personally hope for a favorable outcome, I am preparing for the most likely outcome – a currency and/or systemic banking crisis.

Okay, so what should you do?  

My role as a financial commentator and futurist is to help you understand that money systems come and money systems go, and that the US dollar-based system has been, and is being, seriously mismanaged to the point where it is at risk of imploding.  This could happen either in a deflationary impulse that could ruin the entire banking system (unlikely, in my view), or in a (hyper)inflationary collapse of the currency (most likely).  Either way, the effect will be to impoverish the many.  Please don’t be among them.

As I said, I see a risk that this could happen, not a certainty, but because the cost of a systemic banking crisis would be so catastrophic, I think we should each undertake certain preparations.  The analogy I like to use is fire insurance.  We all carry it on our primary residences, not because the likelihood of a fire is high, but because the cost of one is so catastrophic.

It is my belief that by taking a few simple steps, each of us can make significant strides toward enhancing our future prospects.  I sincerely wish everybody would do so.

Let’s review a scenario and some actions that could mitigate the impact(s).

Systemic banking crisis:  50% probability over the next year

Everyone should be prepared for the possibility of a severe systemic banking crisis. You may see a higher or lower percentage probability than I do, but you’d certainly better have something higher than 0% in mind.

What this would look like is some sort of a serious warning, possibly the surprise bankruptcy of Citibank or a blow-up at a massive hedge fund.  Within 24-48 hours, the stock market would be in pretty bad shape, the dollar would be spiraling downward, and interest rates would be shooting up, as foreigners dump Treasury bonds in a frantic bid to repatriate their money while some value still remains. To stabilize the situation, the President would come on TeeVee to declare a banking holiday and state that the banking system is in a crisis and that some time will be needed to “calm things down and work out some solutions.”  During this time, banks would be closed, and it is highly likely that credit and debit cards would not work, since the interbank clearing system would be a mess.  Rules against hoarding would immediately be put in place, and talk of rationing of certain staple goods, such as gasoline, would begin.

Before any of this happens, here are the things you should consider doing:

Tier I actions:

  • Have 3 months of living expenses at home, in cash.  The idea here is to be able to buy things even if checks and debit and credit cards are temporarily inoperative.  What you risk here is losing the miniscule interest that your checking account is currently paying.
  • Have 1.5 months of living expenses at home in gold &/or silver. This protects against the impacts of a potential dollar crisis.  The more, the merrier, but 1.5 months is the bare minimum.
  • Make sure your bank accounts are with the safest possible banks.  Use a rating service such as Veribanc (the Blue Ribbon Report is good).  Better yet, spread your accounts across several highly-rated banks.  The idea here is that these banks will have the best chance of surviving and reopening first after a crisis.  Stay away from big banks – they have the greatest exposure to the unknowable derivative risks.
  • Do a little extra buying every time you shop, until you have at least 3 months worth of food on hand.  While the likelihood of a total shutdown of the food system is remote, not having to worry about this possibility if/when a crisis hits will free up an important part of your brain for other tasks.  This means buying extra cans, jars, and packages of food (pasta, etc) that generally will keep for ~1 to 2 years.  Buy only the foods you like to eat.  Rotate the new food behind the older food.
  • Have any medicines you can’t live without?  Begin accumulating and storing them, if this is an option.  Again, this is so that you have one less thing to worry about later on.

Tier II actions – only undertake these after Tier I actions are complete:

  • Increase your gold exposure until you have 10% (minimum) to 50% of your nest-egg socked away.  Read the Buying Gold and Silver guide in the Take Action section at PeakProsperity.com for types and tips on how to go about this.
  • Perform a self-assessment to identify your strengths and weaknesses, and the opportunities and threats that you could imagine arising during a systemic crisis. 
  • Address any critical weaknesses or threats that arise in the exercise above.
  • Develop “buy-lists” that you can follow in the early phases of a crisis. Having a plan for obtaining last minute items will not take you much time to develop now, but will be a godsend if anything comes to pass.
  • Have a plan for what you’ll do.
    • Who will you trust for news?
    • What will you do first?
    • If you and your immediate family are separated by a significant distance, will you all know where to meet and who is responsible for what?
    • Could you anticipate other family members, or even friends, moving in with you (or you with them) as a possible outcome? I f so, does this change any of your other preparations?
    • Thinking these through is just good, common sense, and it is something that all mature businesses do as a matter of course.  They call it continuity and/or disaster planning. If my local co-op bank can do it, so can you.
  • Know who your support network is.  Begin cultivating local networks of people who can help you share the load and provide support.

Tier III – only after you’re done with I and II:

  • Prepare your home.
    • Water storage. What if the power went out during the crisis?
    • Make your home more self-sufficient with respect to heating and cooling
    • Store more food (for family and neighbors…be a hero!)
  • Think about your job.  Will it be more secure/needed in the event of a financial crisis, or insecure?  Build up your cash and gold/silver reserves.  Eliminate debts, especially floating rate and secured debts.
  • What skills would be especially handy during a crisis?  Do you have them?  Is there anything you ever wanted to learn that falls under this category?

Conclusion

A bit of foresight and preparation will go a long way to mitigate the personal effects of a systemic financial crisis.  What we believe shapes what we see, and what we see determines our actions – and therefore our future.  We may not be able to change the game that the Federal Reserve is playing, but we can certainly take steps to prepare ourselves for the impact. 

The Federal Reserve Plays a Dangerous Game
PREVIEW by Chris Martenson
Wednesday, March 26, 2008

Be careful what you believe.

A television ad for Morgan Stanley’s brokerage service flickers across the screen, showing a retired couple walking across a beach with a dog and their grandchildren.  Smiles and ease and comfort drip off the screen.  It is a happy, shiny future that they are selling.  Separately, a letter goes out from Morgan Stanley to their private clients warning of a “50% chance of a systemic crisis."  Which do you believe? 

Executive Summary

  • Keeping a wide-angle view on this developing crisis is the only way to avoid being whipsawed, and the stakes have never been higher (at least in our lifetime).
  • The US financial markets, and probably the world’s, peered over an abyss on the night of Sunday March 16, 2008, but were rescued by very unusual and concerted official actions.
  • On the “happy, shiny” side of the equation, we have the fact that stocks mysteriously went up immediately on the open after the announcement of the collapse of Bear Stearns, and have continued up since.
  • On the “Cold, Hard Facts” side of the ledger, indicating that a particularly nasty recession is already underway, here is the recent data:
  • You can choose to believe that the worst is behind us (stocks), or you can choose to believe the facts (everything else). But be sure to choose carefully, because the penalty for being wrong here will be particularly steep.  
  • Simple preparations will go a long way toward mitigating the effects of a possible systemic financial crisis.

On Sunday, March 16th, deep in the night, the US financial system, and, by extension, the world financial system, peered over the edge of an abyss.  If the Bear Stearns rescue (by the Fed & JPM together) had not happened, it is my firm conclusion that a systemic banking crisis would have ensued.  While some commentators are now saying that “the bottom is in,” with one even going so far as saying the Dow 20,000 is now a lock, I would implore you to be careful in choosing your beliefs

Here’s why.  In my economic seminars, we spend about as much time on the economic context and data that define our current reality as we do examining beliefs and asking ourselves whether the ones we hold might be of the enhancing or limiting variety.  This is important because what we believe shapes what we see, and what we see determines our actions – and therefore our future.  Holding the wrong beliefs at critical turning points can be extremely harmful.

In the book The Mind of Wall Street by Eugene Levy, a wonderful example of both a limiting and an enhancing belief are simultaneously on display when he recounts his experience during the take-over of a struggling railroad back in the 1970’s.  He made a bundle on the deal.  Here he describes the situation:

Management executives looked to the past in their assessment of the railroad.  They saw its wretched history of bankruptcy and losses, the thousands of miles of useless track, and the years of failed attempts at regulatory reform; from this they could only conclude that Milwaukee Road was a failed railroad that could never be profitable.  We looked at the same railroad and instead saw vast assets in real estate and machinery that could be sold.

The railroad executive team held limiting beliefs about their company that prevented them from seeing the value of what they held.  Because of this, they saw the wrong things and took the wrong actions, losing a ton of money as a result.  Meanwhile, Mr. Levy had an enhancing belief that allowed him to see things about the railroad that led him to a fortune.

I want to share a believe of mine with you:  I believe the stock market is being propped up by the Fed and/or US government (PPT), who are desperately afraid of allowing the stock market to signal the true state of affairs. In some ways I can understand this; I think that the authorities who are stabilizing the markets right now are quite justifiably worried about what would happen if the stock market was “allowed” to send a correct signal to a wider audience.  Because I believe that the stock market is being propped, I do not trust that it is telegraphing useful or meaningful price signals, and so I will take very different actions than someone who holds the opposite view.  I might be wrong, or the person holding the opposite view might be wrong, but one of us is making a colossal mistake.

And here’s a second belief:  The market is bigger than the authorities, and they will ultimately fail in their attempts to prop the stock market, because they are merely masking symptoms, not treating causes. If it were possible for an elevated stock market alone to cure what ails our economy, I might think differently.  But those efforts are surely misdirected.

The consumer-retrenchment genie is already out of the bottle, and intervention will only serve to exacerbate what is already a terrifying gap between the ‘official story’ (as told by the stock market), the daily lives of ordinary people, and the cold, hard facts.

Even as a possibly illegal and certainly ill-advised rescue of Bear Stearns is being revised and revisited, and the stock market keeps climbing or at least holding steady, we find that the current spate of fundamental economic news is especially worrisome, if not downright scary.  The question before you, then, is, which will you believe?  A happy, shiny stock market, or the cold, hard facts?

The ECRI and NBER say “recession is here” 

To begin with, the highly-respected Economic Cycle Research Institute (ECRI) recently said, “Now the verdict is finally in.  We have unambiguously turned onto the recession track.”   In case that wasn’t strong enough, Lakshman Achuthan, managing director at ECRI said, "[Our indicator] is exhibiting a pronounced, pervasive and persistent decline that is unambiguously recessionary," while Martin Feldstein, who heads the equally-regarded National Bureau of Economic Research, said that contraction is already under way and that it’s likely to be severe, stating, "The risks are that it could get very bad."  The ECRI leading indicator incorporates a broad array of economic signals and has a very good track record of spotting recessions.  The stock market used to do this, but seemed to lose that ability around the time of the Fed rescue of August 2007.

Now, during your average, ordinary, garden-variety recession, which this one most certainly will not be, the average decline in the stock market is 28%.  Compared to a year ago, before all this financial uncertainty was widely recognized, the S&P 500 is only down -6.6%.  So, for whatever reason, the stock market is now deeply at odds with the ECRI, the NBER, and virtually every piece of economic data.  Somebody has it very wrong.

Housing data is "the worst since the Great Depression"

This housing bubble is bursting, and with alarming speed.  It’s hard to keep up with the data, it’s coming so fast.  Sales and housing starts have been cut in half since the peak (link supplied the quote below), and it’s important to remember that “sales” include transactions in which a bank takes possession during foreclosure, so the sales numbers are misleadingly high.  Notably, foreclosures for February 2008 were reported to be running 60% higher than last February, so we might expect bank repossessions to be a significant component of the recently reported existing home sales number.

CHICAGO (MarketWatch) — Housing is in its "deepest, most rapid downswing since the Great Depression," the chief economist for the National Association of Home Builders said Tuesday, and the downward momentum on housing prices appears to be accelerating.

The NAHB’s latest forecast calls for new-home sales to drop 22% this year, bringing sales 55% under the peak reached in late 2005. Housing starts are predicted to tumble 31% in 2008, putting starts 60% off their high of three years ago.

"More and more of the country is now involved in the contraction, where six months ago it was not as widespread," said David Seiders, the NAHB’s chief economist, on a conference call with reporters. "Housing is in a major contraction mode and will be another major, heavy weight on the economy in the first quarter."

Even worse, house prices have plunged by 10.7% over the past year, according to the highly-respected Case-Shiller index, although the US government (via the OFHEO) comes to a substantially different conclusion and reports a mere 3% decline.  As always, the US government has settled on a particular methodology that manages to paint a happier, shinier picture than does a private firm whose livelihood depends on delivering useful information.  Unsurprisingly, it’s the happier, shinier number that the Fed uses when calculating how much people’s homes are worth vs. how much they owe on them. But even with this deployment, a new benchmark has been set:

NEW YORK (AP) — Americans’ percentage of equity in their homes has fallen below 50 percent for the first time on record since 1945, the Federal Reserve said Thursday.

Homeowners’ percentage of equity slipped to a revised lower 49.6% in the second quarter of 2007, the central bank reported in its quarterly U.S. Flow of Funds Accounts, and declined further to 47.9% in the fourth quarter – the third straight quarter it was under 50%. That marks the first time homeowners’ debt on their houses exceeds their equity since the Fed started tracking the data in 1945.

The Federal Reserve is in a box

That last bit of data, above, is what has the Fed running around with its hair on fire.  Sure, we can all take comfort in the “bold, decisive action” that Bernanke took to preserve confidence in the system by pouring hundreds of billions of dollars into the banking system, but that leaves out a very important observation.  Namely, that the crisis is not based on the fact that banks have run out of liquidity; that’s a symptom.   The cause of this crisis is rooted in the fact that an entirely too-large proportion of the people who took out trillions of dollars in loans lack the means or the motive to ever pay those loans back.  It is now estimated that more than 1 in 10 homes is now ‘underwater’, meaning that more is owed on the mortgage than the house is currently worth.  Currently that’s 8,800,000 homes, a number that we can reasonably expect to grow as this negative housing-price dynamic plays itself out.

So the nature of this particular crisis, like literally every single other credit-bubble fueled crisis in history, is not going to be resolved until the bad debt is wiped out or the losses are socialized.  By this I mean that the Federal Reserve would have to print enough money (out of thin air) to buy all the bad debt, as in $1 to $2 trillion dollars worth of it.  If this happened, the Fed would become the largest property holder in America, its balance sheet would be ruined, and it is highly unlikely that the dollar would survive the attempt.  Therefore, like every other credit bubble that has burst in the past, massive amounts of bad debts will simply have to be wiped away.  And the sooner that happens, the sooner we can pick ourselves up and carry on.

But is this really possible?  Can all that debt simply be defaulted upon?

Probably not.  And the primary reason is that, like everybody else, the Fed has no idea what would happen if the $615 trillion derivative tower, with all of its unknowably complicated interlocking pieces, was suddenly exposed to a rash of defaults.  The fear that this would be an extinction-level event for the banking system, meaning the complete and permanent abandonment of fractional reserve banking as a concept (or for one or two forgetful generations, whichever comes first).

I have no particular insights into the complexity of the derivative system, but I can tell you that I have spent a great deal of time trying to understand the magnitude and location of the risks, without much success.  So I draw my conclusions from two anecdotes.  The first concerns Warren Buffet’s experience in the years after he bought General Re, a fairly ordinary re-insurance company.  The company got in some trouble and the decision was made to absorb its operations and shut it down.  But after several years (and much concerted effort), Berkshire Hathaway found itself stuck with 14,384 outstanding derivative contracts and 672 outstanding counterparties of indeterminate risk and unknowable value, leading Buffet to comment that derivatives are “financial weapons of mass destruction.”   It is important to note that the difficulties Warren Buffet’s organization experienced in assessing the risk and value of a single company’s derivative portfolio was during a period of stable market conditions.

The second anecdote concerns another company with a large derivative portfolio, Fannie Mae, which found itself in an accounting scandal and was forced by the government to restate its earnings for the years 2001 to 2004.  In December of 2006, after two full years of effort by an army of 1,500 expert accountants and $1 billion dollars expended, Fannie Mae was finally able to produce an earnings statement for 2004.  The reason for the excessive cost and time?  Derivatives.  There were simply so many and they were so complex that it took 3,000 person-years of effort to determine the earnings for one single year for one company.  Again, this was during stable market conditions, without the burden of counterparty defaults and the time pressures that fast-moving market conditions can impose.

Fast forward to today.  If it takes thousands of person-years of effort to calculate the impact of derivatives on a single company, what would happen during turbulent times, especially if defaults are cascading and multiplying throughout the system and tens of thousands of companies dotting the globe are involved?  Pandemonium and a major system-threatening crisis, that’s what.

So now you know why I view the Fed’s actions not as “bold and decisive,” but rather as “necessary and forced.”  They will need to go further and begin buying mortgage debt directly, as has already been publicly suggested.  In my opinion, the Federal Reserve (let alone the Bush administration) is institutionally ill-equipped to deal with this particular crisis.  The Fed relies on government data on inflation, house prices, etc., and therefore has a faulty instrument panel.  It is as if they are flying a plane with a stuck fuel gauge and an altimeter that is off by 5,000 feet.  At night, in mountainous terrain.  But, more importantly, the Fed is a sclerotic institution whose reliance on past example (the Great Depression and Japan come to mind) is poorly suited to a modern world that spent the past ten years creating financial products light-years distant from prior experience, while the Fed snoozed along basking in the false glory that came with financial stability and recklessly low but popular interest rates.

The worst is yet to come

Someday, this financial crisis will all be yesterday’s news, but already a lot of ink is being spilled to try and convince you that the worst is already behind us.  Don’t fall for it.  Even a cursory tour of the data will convince you that the bursting of this credit bubble is just getting started and that a particularly nasty recession has just begun.  Nothing the Fed has done, or even can do, will change the fact that trillions of dollars of losses lurk within the system.  And those losses will either have to be written off or they will have to be monetized (i.e., bought by the Fed for money printed out of thin air).  Writing them off would mean the possible destruction of the banking system (and massive political upheavals).  There is a slight chance, a hope, a faith, that we can somehow print our way out of this mess by monetizing the bad debts.  However, that is a knife-edge possibility with failure on one side and the utter destruction of our currency on the other.  While the destruction of our past mistaken pile of debt would be bad for those who took leave of their senses and participated in the credit bubble, placing your faith on our authorities to ‘fix this’ could be financially ruinous.  It is well past time to protect yourself and your financial assets.  While I personally hope for a favorable outcome, I am preparing for the most likely outcome – a currency and/or systemic banking crisis.

Okay, so what should you do?  

My role as a financial commentator and futurist is to help you understand that money systems come and money systems go, and that the US dollar-based system has been, and is being, seriously mismanaged to the point where it is at risk of imploding.  This could happen either in a deflationary impulse that could ruin the entire banking system (unlikely, in my view), or in a (hyper)inflationary collapse of the currency (most likely).  Either way, the effect will be to impoverish the many.  Please don’t be among them.

As I said, I see a risk that this could happen, not a certainty, but because the cost of a systemic banking crisis would be so catastrophic, I think we should each undertake certain preparations.  The analogy I like to use is fire insurance.  We all carry it on our primary residences, not because the likelihood of a fire is high, but because the cost of one is so catastrophic.

It is my belief that by taking a few simple steps, each of us can make significant strides toward enhancing our future prospects.  I sincerely wish everybody would do so.

Let’s review a scenario and some actions that could mitigate the impact(s).

Systemic banking crisis:  50% probability over the next year

Everyone should be prepared for the possibility of a severe systemic banking crisis. You may see a higher or lower percentage probability than I do, but you’d certainly better have something higher than 0% in mind.

What this would look like is some sort of a serious warning, possibly the surprise bankruptcy of Citibank or a blow-up at a massive hedge fund.  Within 24-48 hours, the stock market would be in pretty bad shape, the dollar would be spiraling downward, and interest rates would be shooting up, as foreigners dump Treasury bonds in a frantic bid to repatriate their money while some value still remains. To stabilize the situation, the President would come on TeeVee to declare a banking holiday and state that the banking system is in a crisis and that some time will be needed to “calm things down and work out some solutions.”  During this time, banks would be closed, and it is highly likely that credit and debit cards would not work, since the interbank clearing system would be a mess.  Rules against hoarding would immediately be put in place, and talk of rationing of certain staple goods, such as gasoline, would begin.

Before any of this happens, here are the things you should consider doing:

Tier I actions:

  • Have 3 months of living expenses at home, in cash.  The idea here is to be able to buy things even if checks and debit and credit cards are temporarily inoperative.  What you risk here is losing the miniscule interest that your checking account is currently paying.
  • Have 1.5 months of living expenses at home in gold &/or silver. This protects against the impacts of a potential dollar crisis.  The more, the merrier, but 1.5 months is the bare minimum.
  • Make sure your bank accounts are with the safest possible banks.  Use a rating service such as Veribanc (the Blue Ribbon Report is good).  Better yet, spread your accounts across several highly-rated banks.  The idea here is that these banks will have the best chance of surviving and reopening first after a crisis.  Stay away from big banks – they have the greatest exposure to the unknowable derivative risks.
  • Do a little extra buying every time you shop, until you have at least 3 months worth of food on hand.  While the likelihood of a total shutdown of the food system is remote, not having to worry about this possibility if/when a crisis hits will free up an important part of your brain for other tasks.  This means buying extra cans, jars, and packages of food (pasta, etc) that generally will keep for ~1 to 2 years.  Buy only the foods you like to eat.  Rotate the new food behind the older food.
  • Have any medicines you can’t live without?  Begin accumulating and storing them, if this is an option.  Again, this is so that you have one less thing to worry about later on.

Tier II actions – only undertake these after Tier I actions are complete:

  • Increase your gold exposure until you have 10% (minimum) to 50% of your nest-egg socked away.  Read the Buying Gold and Silver guide in the Take Action section at PeakProsperity.com for types and tips on how to go about this.
  • Perform a self-assessment to identify your strengths and weaknesses, and the opportunities and threats that you could imagine arising during a systemic crisis. 
  • Address any critical weaknesses or threats that arise in the exercise above.
  • Develop “buy-lists” that you can follow in the early phases of a crisis. Having a plan for obtaining last minute items will not take you much time to develop now, but will be a godsend if anything comes to pass.
  • Have a plan for what you’ll do.
    • Who will you trust for news?
    • What will you do first?
    • If you and your immediate family are separated by a significant distance, will you all know where to meet and who is responsible for what?
    • Could you anticipate other family members, or even friends, moving in with you (or you with them) as a possible outcome? I f so, does this change any of your other preparations?
    • Thinking these through is just good, common sense, and it is something that all mature businesses do as a matter of course.  They call it continuity and/or disaster planning. If my local co-op bank can do it, so can you.
  • Know who your support network is.  Begin cultivating local networks of people who can help you share the load and provide support.

Tier III – only after you’re done with I and II:

  • Prepare your home.
    • Water storage. What if the power went out during the crisis?
    • Make your home more self-sufficient with respect to heating and cooling
    • Store more food (for family and neighbors…be a hero!)
  • Think about your job.  Will it be more secure/needed in the event of a financial crisis, or insecure?  Build up your cash and gold/silver reserves.  Eliminate debts, especially floating rate and secured debts.
  • What skills would be especially handy during a crisis?  Do you have them?  Is there anything you ever wanted to learn that falls under this category?

Conclusion

A bit of foresight and preparation will go a long way to mitigate the personal effects of a systemic financial crisis.  What we believe shapes what we see, and what we see determines our actions – and therefore our future.  We may not be able to change the game that the Federal Reserve is playing, but we can certainly take steps to prepare ourselves for the impact. 

by Chris Martenson
Monday, December 10, 2007 (reprinted Saturday, March 15, 2008)

Executive Summary

  • The credit bubble collapse is just getting started.
  • Odds of a major systemic financial crisis now higher than ever.
  • Dollar collapse is underway.
  • Your opportunities to protect your assets are dwindling fast.

(Originally printed on 12-10-2007. Uncannily good predictions and recommendations, all of which I still stand by.)

The Great Credit Bubble, for which you can thank Alan Greenspan, is now in the process of bursting. While the US media implacably attempts to assure everyone that it is well contained or almost over, nothing could be further from the truth. As one financial commentator recently put it, "the good news is that the subprime crisis has been contained…to the planet earth."

The odds of a major systemic financial collapse are now higher than ever.

If you’ve seen the Crash Course (formerly the End of Money seminar), you know I’ve been concerned for a number of years about the toxic witch’s brew of poor-quality loans and unfathomably risky derivatives that are poisoning our financial body. Part of my concern stems from the fact that no matter how hard I try, I cannot understand how the derivatives markets work.

I’ve been unable to discover the most basic answers to the most basic questions, such as “how much capital is actually backing these things?” and “who’s holding the bag?” Wall Street and its ever-compliant financial propaganda services organizations (CNBC, WSJ, et al.) have maintained all along that these new products have completely eliminated risk by spreading it so thin that it has literally disappeared. I do not believe in financial alchemy, and I do not believe this version of ‘reality,’ because it makes no sense at all. Just as it made no sense to finance 19 houses to a part-time hairdresser in Las Vegas with subprime, negative amortization loans (true story), it makes no sense that this level of malinvestment could simply ‘disappear’.

The rest of my concern centers on the fact that 3,800 paper currencies in the past have all gone to money heaven due to the exact same formula of mismanagement that our fiscal and monetary authorities are applying to the US dollar. A few key warning signs would be, (1) bailing out the poor decisions of big banks by flooding the markets with hundreds of billions of dollars of public money/credit, and (2) conducting a pair of very expensive wars “off budget,” while (3) expanding your total monetary base at an astounding, banana-republic double digit percentage rate (as we discussed last time).

I won’t be disappointed if you tend to believe proclamations from the titans of Wall Street more than you would from some random guy named Chris. However, before you place too much faith on the possibility that those guys on Wall Street “must know what they are doing,” I would ask you to consider these facts:

Exhibit A:

Out of all the toxic subprime mortgages ever issued, the subprime loans with highest rates of default were made in the first 6 months of 2007 .

 src=

While you and I and everybody else had figured out that the subprime jig was up in 2005 or 2006, the Wall Street machinery couldn’t figure out how to stop what it was doing even as late as July of 2007. Titans or nitwits? You be the judge.

Exhibit B:

Rather than admit they made a bunch of really stupid loans, Wall Street banks first went straight to the US Treasury to mediate a bailout, and, when that proved to be too slow a course of action, simply hid the extent of their losses by massively abusing an obscure accounting gimmick .

Nov. 7 (Bloomberg) Banks may be forced to write down as much as $64 billion on collateralized debt obligations of securities backed by subprime assets, from about $15 billion so far, Citigroup analysts led by Matt King in London wrote in a report e-mailed today. The data exclude Citigroup’s own projected writedowns.

Under FASB terminology, Level 1 means mark-to-market, where an asset’s worth is based on a real price. Level 2 is mark-to-model, an estimate based on observable inputs which is used when no quoted prices are available. Level 3 values are based on “unobservable” inputs reflecting companies’ “own assumptions” about the way assets would be priced.

In other words, these so-called “Level 3” assets are balance-sheet entries that company management value at whatever they say they’re worth. This is like your drunk uncle claiming to be a millionaire because he said he found a lottery ticket in the gutter on the way home last night, but he won’t let anybody see it. The value of these so-called assets is entirely in the eye of the beholder, or bank management in this case, who has decided that they are ‘worth’ every penny that they paid for them and that’s how much they are going to continue insisting they are worth, thank you very much.

Exhibit C:

As the subprime derivative debacle was unfolding, what do you suppose was the response of Wall Street? If you guessed “doubling down,” you are a winner!

Nov. 22 (Bloomberg) — The market for derivatives grew at the fastest pace in at least nine years to $516 trillion in the first half of 2007, the Bank for International Settlements said.

Credit-default swaps, contracts designed to protect investors against default and used to speculate on credit quality, led the increase, expanding 49 percent to cover a notional $43 trillion of debt in the six months ended June 30, the BIS said in a report published late yesterday.

Wow. Wowowowowow. This is shocking. First, because of how hard it is to set new records for the “fastest pace” at the same time that you are setting records for the total amount. This would be like a weightlifter setting a new world record by adding 700 pounds to the old record. Second, because the specific types of derivatives that expanded the fastest were those designed to speculate on credit quality – the very area that is most at risk right now. So we now know that even as the credit debacle was so completely obvious that people returning from year-long wilderness solos knew something was wrong, Wall Street and Hedge Funds were busy accelerating the pace at which they continued to pursue these broken bets on shaky mortgages. Rather than sound fiscal prudence, this appears to be a last desperate grab for what few chips remained on the table.

It is possible that each individual transaction made a lot of sense to the hedge fund managers, but to outsiders like us they look foolish collectively. Why? Because when everybody is hedged, nobody is. Hedging is a zero-sum game. For somebody to win, somebody has to lose. So while all these smarty-pants were busy ‘hedging their risk away,’ nobody seems to have taken stock of the fact that the assets they were hedging were themselves seriously impaired and were going to result in massive losses for somebody. In short, it is impossible to hedge a failed system.

So, there are three perfectly good reasons to suspect that the captains of Wall Street are rather mortal after all and possibly even less competent than the average soul. I could give you forty more, but in the interest of time, I won’t, except to offer the best explanation I’ve ever read on how the derivative market works (PDF) and the human mechanisms at play that allowed all this to get so out of hand. This article will be well worth your time.

Systemic Banking Crisis?

If you own a house, odds are you carry fire insurance. Not because the chance of a house fire is particularly large, but because the cost of a house fire is catastrophic. You carry fire insurance because you have rightly calculated that (small chance) x (a big cost) = unacceptable risk. So you offset that risk with insurance.

Now I want you to seriously consider what the cost to you would be if there were the equivalent of a house fire in the banking system. I’m talking about a major system ‘freeze’ where banks close, huge losses spread throughout the system, electronic interbank transfers become impossible (ATMs, credit cards, electronic funds transfers, wires, and all the rest simply stop), and many banks and brokerages simultaneously go out of business. I’d imagine the impact to you would be quite large. So the next question is, what can/should mature, responsible adults do to insure themselves against such an outcome? How much time, energy and money should one dedicate to insuring one’s financial house?

When I started giving The End of Money seminar three years ago, I had put the possibility of this sort of event at about 15% to 20% over the next 5-10 years. It turns out that I was a raging optimist compared to some financial professionals such as this guy:

Nov. 13 (Bloomberg) — There’s a greater than 50 percent probability that the financial system "will come to a grinding halt" because of losses from mortgages, Gregory Peters, head of credit strategy at Morgan Stanley, said.

This is serious business especially now that the head of credit strategy at a major Wall Street bank is openly writing about it to their main clients. In fact, there are now many respected economists and financial professionals who are calling for a generalized systemic financial meltdown or a severe stock market decline. Even if you have no assets in the larger speculative financial markets (stocks and bonds), or have already taken steps to protect them by getting them out, you are still at risk if your assets are sitting in a risky bank. The possibility of massive bank failures is now a stark reality and it is my opinion that several are already insolvent, just not publicly (yet).

These sorts of crises always start at the edges and work in. First it was the shakier mortgage broker ‘bucket shops’ that began going under in late 2006. Then larger and seemingly firmer mortgage outfits began going under. Now more than 190 mortgage brokers, including most of the ‘top ten’, have gone bankrupt. And today not only is the very largest of them all (Countrywide Financial Corp) rumored to be a strong candidate for bankruptcy, the unthinkable seems to be unfolding before our very eyes. Both Fannie Mae and Freddie Mac, collectively holding several trillions of dollars worth of US mortgages and an even larger portfolio of associated interest rate derivatives, appear to be in some serious trouble . If either, or both, of these companies goes bust, it is highly unlikely (to me) that both the US banking system and the dollar could survive the event.

I am now putting out my strongest warning ever.

If you do not already own gold and/or silver, your time is running out. My best guess would be that once the world’s paper markets implode, the price of gold and silver will skyrocket to unimaginable and unreachable heights, if you can even locate any to buy. Get some.

By the time it is completely obvious that this is the right thing to do, you will find it difficult either due to price, availability, or both. Luckily, the world’s central banks are still capping the price of gold and silver, offering you a wonderful subsidy, which is really quite nice of them. Why do I advocate gold and silver? Simple. Because they are among the very few money-like assets that you can own (hold) that are not simultaneously somebody else’s liability. Consider that a bond (your asset) is the liability of a corporation or government. Even your checking account is your bank’s liability. A house owned free and clear would certainly qualify as a valuable asset, but a house is not very “money like.” When you go through the list (stocks, bonds, annuities, money-market accounts, etc), there is virtually no paper asset that you can identify that is not somebody else’s liability. Even a cash dollar is the liability of the Federal Reserve. But when you own physical precious metals (not mining shares or other paper claims), that’s the long and the short of it. It’s yours. Period.

Next, in order to protect from the possibility of a general banking ‘holiday’ (freeze), every family should have somewhere between one and six months worth of living expenses on hand in the form of cold, hard cash. You know, the bits of paper that work even if the ATMs and credit card readers do not. To be clear, I am not talking about cash in your checking account, I am talking about cash out of the bank and in your hands. Katrina, a natural storm, taught this lesson and we now need to apply that learning to the potential arrival of an economic storm.

Unfortunately, not very many people will be able to do this because the total cash available is a very small percentage of total deposits (~5%). Your bank will look at you funny when you take cash out, mainly because they do not have very much on hand at any given moment. If you plan to cash out more than a few thousand dollars, I highly recommend that you give your bank advance warning and thereby avoid the awkward social moment that will result when they have to tell you that they don’t actually have that much on hand. One thing to remember is that if you take out $10,000.00 or more of cash your bank is required to report you to the federal government via a SAR (Suspicious Activity Report). So the banks appreciate amounts smaller than that as it cuts down on the paperwork.

I would maintain a cash balance until we see clear signs that the evolving credit crisis is getting better, not worse. Given the latest data, which all point to a serious erosion of the credit markets, this could be awhile.

All that’s really happening here is that the long-awaited credit bust is finally upon us. It is important to remember that historically, bubbles have always deflated over approximately the same amount of time as they took to inflate. This means we are looking at a potential end to this crisis somewhere in the range of 2012 to 2020, depending on where you mark the beginning. In the meantime, there will be plenty of false dawns and countertrend rallies that will siphon even more wealth from the unwary.

Don’t be among them.

Uh Oh.
PREVIEW by Chris Martenson
Monday, December 10, 2007 (reprinted Saturday, March 15, 2008)

Executive Summary

  • The credit bubble collapse is just getting started.
  • Odds of a major systemic financial crisis now higher than ever.
  • Dollar collapse is underway.
  • Your opportunities to protect your assets are dwindling fast.

(Originally printed on 12-10-2007. Uncannily good predictions and recommendations, all of which I still stand by.)

The Great Credit Bubble, for which you can thank Alan Greenspan, is now in the process of bursting. While the US media implacably attempts to assure everyone that it is well contained or almost over, nothing could be further from the truth. As one financial commentator recently put it, "the good news is that the subprime crisis has been contained…to the planet earth."

The odds of a major systemic financial collapse are now higher than ever.

If you’ve seen the Crash Course (formerly the End of Money seminar), you know I’ve been concerned for a number of years about the toxic witch’s brew of poor-quality loans and unfathomably risky derivatives that are poisoning our financial body. Part of my concern stems from the fact that no matter how hard I try, I cannot understand how the derivatives markets work.

I’ve been unable to discover the most basic answers to the most basic questions, such as “how much capital is actually backing these things?” and “who’s holding the bag?” Wall Street and its ever-compliant financial propaganda services organizations (CNBC, WSJ, et al.) have maintained all along that these new products have completely eliminated risk by spreading it so thin that it has literally disappeared. I do not believe in financial alchemy, and I do not believe this version of ‘reality,’ because it makes no sense at all. Just as it made no sense to finance 19 houses to a part-time hairdresser in Las Vegas with subprime, negative amortization loans (true story), it makes no sense that this level of malinvestment could simply ‘disappear’.

The rest of my concern centers on the fact that 3,800 paper currencies in the past have all gone to money heaven due to the exact same formula of mismanagement that our fiscal and monetary authorities are applying to the US dollar. A few key warning signs would be, (1) bailing out the poor decisions of big banks by flooding the markets with hundreds of billions of dollars of public money/credit, and (2) conducting a pair of very expensive wars “off budget,” while (3) expanding your total monetary base at an astounding, banana-republic double digit percentage rate (as we discussed last time).

I won’t be disappointed if you tend to believe proclamations from the titans of Wall Street more than you would from some random guy named Chris. However, before you place too much faith on the possibility that those guys on Wall Street “must know what they are doing,” I would ask you to consider these facts:

Exhibit A:

Out of all the toxic subprime mortgages ever issued, the subprime loans with highest rates of default were made in the first 6 months of 2007 .

 src=

While you and I and everybody else had figured out that the subprime jig was up in 2005 or 2006, the Wall Street machinery couldn’t figure out how to stop what it was doing even as late as July of 2007. Titans or nitwits? You be the judge.

Exhibit B:

Rather than admit they made a bunch of really stupid loans, Wall Street banks first went straight to the US Treasury to mediate a bailout, and, when that proved to be too slow a course of action, simply hid the extent of their losses by massively abusing an obscure accounting gimmick .

Nov. 7 (Bloomberg) Banks may be forced to write down as much as $64 billion on collateralized debt obligations of securities backed by subprime assets, from about $15 billion so far, Citigroup analysts led by Matt King in London wrote in a report e-mailed today. The data exclude Citigroup’s own projected writedowns.

Under FASB terminology, Level 1 means mark-to-market, where an asset’s worth is based on a real price. Level 2 is mark-to-model, an estimate based on observable inputs which is used when no quoted prices are available. Level 3 values are based on “unobservable” inputs reflecting companies’ “own assumptions” about the way assets would be priced.

In other words, these so-called “Level 3” assets are balance-sheet entries that company management value at whatever they say they’re worth. This is like your drunk uncle claiming to be a millionaire because he said he found a lottery ticket in the gutter on the way home last night, but he won’t let anybody see it. The value of these so-called assets is entirely in the eye of the beholder, or bank management in this case, who has decided that they are ‘worth’ every penny that they paid for them and that’s how much they are going to continue insisting they are worth, thank you very much.

Exhibit C:

As the subprime derivative debacle was unfolding, what do you suppose was the response of Wall Street? If you guessed “doubling down,” you are a winner!

Nov. 22 (Bloomberg) — The market for derivatives grew at the fastest pace in at least nine years to $516 trillion in the first half of 2007, the Bank for International Settlements said.

Credit-default swaps, contracts designed to protect investors against default and used to speculate on credit quality, led the increase, expanding 49 percent to cover a notional $43 trillion of debt in the six months ended June 30, the BIS said in a report published late yesterday.

Wow. Wowowowowow. This is shocking. First, because of how hard it is to set new records for the “fastest pace” at the same time that you are setting records for the total amount. This would be like a weightlifter setting a new world record by adding 700 pounds to the old record. Second, because the specific types of derivatives that expanded the fastest were those designed to speculate on credit quality – the very area that is most at risk right now. So we now know that even as the credit debacle was so completely obvious that people returning from year-long wilderness solos knew something was wrong, Wall Street and Hedge Funds were busy accelerating the pace at which they continued to pursue these broken bets on shaky mortgages. Rather than sound fiscal prudence, this appears to be a last desperate grab for what few chips remained on the table.

It is possible that each individual transaction made a lot of sense to the hedge fund managers, but to outsiders like us they look foolish collectively. Why? Because when everybody is hedged, nobody is. Hedging is a zero-sum game. For somebody to win, somebody has to lose. So while all these smarty-pants were busy ‘hedging their risk away,’ nobody seems to have taken stock of the fact that the assets they were hedging were themselves seriously impaired and were going to result in massive losses for somebody. In short, it is impossible to hedge a failed system.

So, there are three perfectly good reasons to suspect that the captains of Wall Street are rather mortal after all and possibly even less competent than the average soul. I could give you forty more, but in the interest of time, I won’t, except to offer the best explanation I’ve ever read on how the derivative market works (PDF) and the human mechanisms at play that allowed all this to get so out of hand. This article will be well worth your time.

Systemic Banking Crisis?

If you own a house, odds are you carry fire insurance. Not because the chance of a house fire is particularly large, but because the cost of a house fire is catastrophic. You carry fire insurance because you have rightly calculated that (small chance) x (a big cost) = unacceptable risk. So you offset that risk with insurance.

Now I want you to seriously consider what the cost to you would be if there were the equivalent of a house fire in the banking system. I’m talking about a major system ‘freeze’ where banks close, huge losses spread throughout the system, electronic interbank transfers become impossible (ATMs, credit cards, electronic funds transfers, wires, and all the rest simply stop), and many banks and brokerages simultaneously go out of business. I’d imagine the impact to you would be quite large. So the next question is, what can/should mature, responsible adults do to insure themselves against such an outcome? How much time, energy and money should one dedicate to insuring one’s financial house?

When I started giving The End of Money seminar three years ago, I had put the possibility of this sort of event at about 15% to 20% over the next 5-10 years. It turns out that I was a raging optimist compared to some financial professionals such as this guy:

Nov. 13 (Bloomberg) — There’s a greater than 50 percent probability that the financial system "will come to a grinding halt" because of losses from mortgages, Gregory Peters, head of credit strategy at Morgan Stanley, said.

This is serious business especially now that the head of credit strategy at a major Wall Street bank is openly writing about it to their main clients. In fact, there are now many respected economists and financial professionals who are calling for a generalized systemic financial meltdown or a severe stock market decline. Even if you have no assets in the larger speculative financial markets (stocks and bonds), or have already taken steps to protect them by getting them out, you are still at risk if your assets are sitting in a risky bank. The possibility of massive bank failures is now a stark reality and it is my opinion that several are already insolvent, just not publicly (yet).

These sorts of crises always start at the edges and work in. First it was the shakier mortgage broker ‘bucket shops’ that began going under in late 2006. Then larger and seemingly firmer mortgage outfits began going under. Now more than 190 mortgage brokers, including most of the ‘top ten’, have gone bankrupt. And today not only is the very largest of them all (Countrywide Financial Corp) rumored to be a strong candidate for bankruptcy, the unthinkable seems to be unfolding before our very eyes. Both Fannie Mae and Freddie Mac, collectively holding several trillions of dollars worth of US mortgages and an even larger portfolio of associated interest rate derivatives, appear to be in some serious trouble . If either, or both, of these companies goes bust, it is highly unlikely (to me) that both the US banking system and the dollar could survive the event.

I am now putting out my strongest warning ever.

If you do not already own gold and/or silver, your time is running out. My best guess would be that once the world’s paper markets implode, the price of gold and silver will skyrocket to unimaginable and unreachable heights, if you can even locate any to buy. Get some.

By the time it is completely obvious that this is the right thing to do, you will find it difficult either due to price, availability, or both. Luckily, the world’s central banks are still capping the price of gold and silver, offering you a wonderful subsidy, which is really quite nice of them. Why do I advocate gold and silver? Simple. Because they are among the very few money-like assets that you can own (hold) that are not simultaneously somebody else’s liability. Consider that a bond (your asset) is the liability of a corporation or government. Even your checking account is your bank’s liability. A house owned free and clear would certainly qualify as a valuable asset, but a house is not very “money like.” When you go through the list (stocks, bonds, annuities, money-market accounts, etc), there is virtually no paper asset that you can identify that is not somebody else’s liability. Even a cash dollar is the liability of the Federal Reserve. But when you own physical precious metals (not mining shares or other paper claims), that’s the long and the short of it. It’s yours. Period.

Next, in order to protect from the possibility of a general banking ‘holiday’ (freeze), every family should have somewhere between one and six months worth of living expenses on hand in the form of cold, hard cash. You know, the bits of paper that work even if the ATMs and credit card readers do not. To be clear, I am not talking about cash in your checking account, I am talking about cash out of the bank and in your hands. Katrina, a natural storm, taught this lesson and we now need to apply that learning to the potential arrival of an economic storm.

Unfortunately, not very many people will be able to do this because the total cash available is a very small percentage of total deposits (~5%). Your bank will look at you funny when you take cash out, mainly because they do not have very much on hand at any given moment. If you plan to cash out more than a few thousand dollars, I highly recommend that you give your bank advance warning and thereby avoid the awkward social moment that will result when they have to tell you that they don’t actually have that much on hand. One thing to remember is that if you take out $10,000.00 or more of cash your bank is required to report you to the federal government via a SAR (Suspicious Activity Report). So the banks appreciate amounts smaller than that as it cuts down on the paperwork.

I would maintain a cash balance until we see clear signs that the evolving credit crisis is getting better, not worse. Given the latest data, which all point to a serious erosion of the credit markets, this could be awhile.

All that’s really happening here is that the long-awaited credit bust is finally upon us. It is important to remember that historically, bubbles have always deflated over approximately the same amount of time as they took to inflate. This means we are looking at a potential end to this crisis somewhere in the range of 2012 to 2020, depending on where you mark the beginning. In the meantime, there will be plenty of false dawns and countertrend rallies that will siphon even more wealth from the unwary.

Don’t be among them.

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