Tuesday, September 16, 2008


We are spoiled for choice this morning, dear reader; we scarcely know where to begin... ...with yesterday’s 504 point sell-off on Wall Street? ...with the biggest bankruptcy in Wall Street history – Lehman filed chapter 11 with $613 billion in debt? ...with our old dictum: the force of a correction is equal and opposite to the deception that preceded it? ...with another look at the Big Picture...at what it means for capitalism when its biggest firms go bust? ...with the past or the future? With a look back, at how a company that survived the Civil War, the railroad bankruptcies, the Panics, WWI, the Great Depression, WWII, and the Cold War couldn’t survive the biggest financial boom in Wall Street history? Or a look ahead, at what will happen after one of the biggest dealers in the $400 trillion derivative market bites the dust? Do we take the high road – with a lofty discourse on the perils of excess leverage? Nah...let’s take the low road: We told you so! Yes, dear reader, we watch the masters of the universe go down...with a fair amount of amusement and even schadenfreude. They claimed to be the smartest people on the planet – and demanded to be paid as if they were. They said they were doing the world a big favor – “allocating capital” so efficiently we would all get rich. And, of course, no one would get richer than they. But who could complain about their billions in bonuses when we were all getting rich? Now, it turns out, they weren’t so smart, after all. Like all hustlers, they weren’t smart enough to ignore their own lies. They were the ones who packaged up all that subprime debt – mortgage loans on over-priced property to people who couldn’t pay the money back; they knew what was in that “mystery meat.” Then, they got the useful stooges at the rating companies to call it Grade A. And then, they bought it themselves! What were they thinking? Not only that, they bought it on leverage – so that if it went bad, their whole company would go belly up! And now, mothers no longer want their babies to grow up to be stockbrokers and investment bankers. Now they want them to grow up to be bankruptcy lawyers! That’s where the money is! But let’s stop gloating and try to figure out what is going on... We are in a deflationary correction. The financial industry made a fortune by flogging debt; now it is taking huge losses because its collateral is going bad, its assets are declining in value and its business is soft. Merrill Lynch was worth $86 billion in January of 2007. Now, it is selling itself to the Bank of America for $50 billion. Why the sale? Because Merrill is afraid that it could go the way of Lehman Bros. That latter firm was worth $45 billion in February 2007. Now it is worth nothing...or close to nothing. Shares traded hands yesterday at 29 cents. Goldman Sachs, meanwhile, is said to be the best firm on the Street. But even it is suffering. It is supposed to announce revenues down 73% for the 3rd quarter. The handwriting has been on the wall for a long time. Once its collateral began to go down in ’07, the bubble in the financial industry couldn’t last long. We saw what was coming down the pike and have been sending our dear readers to the Strategic Financial Survival Library for resources on how to continue to make money in the coming bust. (If you haven’t checked it out, you can get access to the Survival Library here .) Still, unlike our readers, investors are shocked; they hadn’t bothered to read the headlines. Yesterday, they sold stocks and the dollar. Oil held stead – still over $100. The euro rose...and gold jumped $26. *** Speaking of gold... This week, Barron’s interviewed some sages of finance. “In a total disaster,” said Peter Bernstein, “where there is a run on paper currency, you'll get your biggest bang for your buck in gold...if everything hits the fan, gold should be worth several thousands dollars an ounce.” Yesterday, at least some investors must have seen a total disaster headed their way. They bought gold. But let us return to the big picture. For the last 13 years, the U.S. money supply has been increasing at about 2 times the rate of GDP. This is known, to monetary sticklers, as “inflation.” But the “inflation” that most people think of is the kind you see at the gas pump and supermarket checkout counter. Nobody squawks when the sticklers’ inflation raises house and stock prices. But nobody doesn’t squawk when it raise consumer prices. The monetary inflation of the last 13 years caused only modest consumer price inflation – for many reasons often described in these daily reckonings. To wit, China was making things cheaper. Wal-Mart was selling them cheaper. And the dollars spent by consumers in America tended to end up in the pockets of investors in Asia and Arabie, not in the U.S. domestic money supply. But all good things must come to an end...especially things that are too good to be true. And now, the great bubble in credit has been popped – and everyone’s squawking. The financial industry is in decline – and will probably not recover in our lifetimes. Inflation has given way to deflation. Just look at what happened to Lehman Bros. Hardly more than a year ago, investors had an asset worth $45 billion. Now they have nothing. What happened to that $45 billion? It disappeared. In California, the average house has lost about $120,000 (we are just guessing, but probably not far off) in market value. What happened to that $120,000? It disappeared. The Chinese stock market has disappeared half of investors’ money. The oil market has disappeared nearly a third of producers’ fondest hopes for future revenues. Jobs have disappeared. Sales are disappearing. Growth rates are disappearing. Bonuses have disappeared. And it is happening all over the world. Thanks to a globalized economy, the entire globe gets to suffer a slump. But what’s really new? This is what always happens when boom turns to bust. Asset values disappear. And with them, the money supply itself contracts. People spend less freely. They lend less recklessly. More money stays tucked away for longer periods in pockets and bank accounts. Prices fall. Many assets turn out to be worthless and many people go broke. Investors buy gold to protect themselves. Gold never overstates its earnings, understates its liabilities or declares bankruptcy. When everything else goes to Hell, gold is still there...still doing its job. Of course, the feds try to prevent nature from taking her course. They counter a natural correction with further unnatural deception. They lend at lower rates than those set by willing buyers and sellers. They spend even more recklessly than usual – often going to war in order to stir up financial activity. Today, for example, the Federal Reserve honchos will meet. The bank already lends to Wall Street at less than half the rate of consumer price inflation. The betting on Wall Street is that it will lower its key interest rates again – so that it can lend to Wall Street at even better rates. That’s one reason why Merrill wants to sell itself to the Bank of America – so that it can take advantage of more of this free money. Of course, when there is a serious correction, the financial authorities also make a great show of repairing the damage, supposedly caused by greed and the lack of regulation. Typically, there are a few show trials...a few rich people are ruined and run out of town...and new programs and regulations are put in place which tend to delay recovery and make the next bust-up even worse. But among one of the feds’ tricks, one is particularly dangerous: they can print money. Yes, dear reader, when the going gets rough, the feds turn on the printing press. That’s when owning gold really pays off. More on this...as the story develops... Until tomorrow, Bill Bonner The Daily Reckoning