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The BIG Picture Transcript
August 25, 2007
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  Part 1
  Summer Edition with Frank Barbera
  The Big Picture with Jim and John
  Part 2
  Doug Noland, "Deflating the Credit Bubble
  Q-Calls

 Part 1

 Summer Edition with Frank Barbera

[montage of voices]

We're at a 37 year high rate of foreclosures in this country, a 10 year low on housing starts.  This is a very serious issue. 

Ben Bernanke, Hank Paulson, also Chris Dodd; there’s a lot of reassuring rhetoric. 

I think you really hit the nail on the head there.  That was practically the take away of this meeting of heavyweights –  triumvirate.  Confidence building comments, nothing really concrete emanating from this meeting. 

This is a very serious issue. 

I know we’ve been through a wild month, everybody has, but it feels a little bit more stable for a second day today.

Like Rumsfeld’s comment:  We still don't know what we don't know. 

This is a very serious issue. We're losing them because these deals they work into here and therefore ought to be worthwhile avoiding in that capacity.  This is a very serious issue. 

The government may offer some protections but not many.  You're going to have look after yourself.

This is a serious issue, the fact that we're having this higher rate of foreclosures, the fact that housing stocks are down.  If we don't deal with this through action in my view, this matter could spill over and become more serious. 

JIM:  Well, when Ben Bernanke, Hank Paulson and Chris Dodd get together to tell you it's not that bad, it really is that bad.  Hello, everyone.  I'm Jim Puplava and welcome to a shortened edition of the Financial Sense News Hour.  We were going to be on recess during our normal summer holiday, but given the events of the last couple of weeks we are coming in for a shortened edition. 

Let me tell you what's coming up on the program today.  My special guest will be Doug Noland of Credit Bubble Bulletin fame.  We will be talking about deflating the credit bubble.  Doug has identified this well in advance more than anybody, and has been writing on it for years now.  So it will be interesting to hear from Doug.  Also, we're going to have a shortened Experts Series. Joining me after the market wrap will be Frank Barbera; and then John and I will get together for a short Big Picture.  John, you can take it away from here.  [3:09]

JOHN:  And we're looking at a golden opportunity out here.  You really have to frame this picture in your own mind.  The money supply in the US is going ballistic, the Fed is injecting liquidity at amazing, blistering rates, so are the global banks out there.  And what are people doing?  They are dumping gold.  I don't quite understand this, but we'll examine that one there. 

Then look at the paradigm shift that is afloat.  You know economic world view really makes a difference on whether or not you understand what is really happening.  And the problem is none of the textbook models out there are really working.  The boom bust and the credit cycles are all very distorted.  A couple of fundamental rules of thumb:  number one, if they didn't see it coming, then they won't know what to do when it gets here; or maybe better put, don't trust those to get you out of a problem who got you into it in the first place.

JIM:  Let's head down to Wall Street where US stocks rose as better than forecast home sales and durable good orders helped the S&P 500 Index complete its best weekly gain since March.  Nucor Corp. led a rally of raw material producers and Exxon Mobil, the biggest oil producer, climbed after crude prices jumped the most this month. 

The S&P 500 was up nearly 17 points, or 1.2%, to closeout the week at 1479.  The Dow Jones industrial average up 143 points; closing out the session at 13,378.  And the NASDAQ composite added roughly about 35 points closing out the week at 2576. 

For the week, it was a good week for all major indexes most of them up over 2%.  The Dow and the S&P gained 2.3% while the NASDAQ was up 2.8%. 

Well, we had a lot of reports out on the economy.  Government reports out on Friday showed American businesses increased spending in July and the housing market showed signs of stability, adding to evidence the economy will keep growing.  The S&P 500’s 2.3% weekly advance was bolstered by the Federal Reserve surprise decision last Friday to lower the discount rate.  And according to most economists, now that the Fed is on-the-job, well, they just don't see a recession in the cards. 

Gaining the most on Friday were energy companies.  They gained 2.1% as a group, the most among 10 industries within the S&P 500 as crude oil prices rose above $71 a barrel on signs of rising economic growth.  Also durable goods orders advanced 5.9% last month according to the Commerce Department; and also in that separate report, the Commerce Department said purchases of new homes increased 2.8% to an annual pace of 870,000 exceeding the highest estimates made by economists. 

Let's turn our attention to some of the other markets.  US Treasury prices ended mixed on Friday with long dated issues recovering some of the ground lost earlier in the day after new home sales figures topped forecasts.  The benchmark 10 year note was up 5/32nds, it's yield at 4.63.  The 30 year bond was up 26/32nds and it's yield falling to 4.89.  That was just roughly about a week ago at about 5%. 

Also surprising, the 3 month T-bill which rallied earlier in the week was also lower, sending its yield up 32 basis points, up to 4.23.  When you consider on Monday of this week the yield on the three month T bill was down to 3.09%,  it's another way of saying that confidence is coming back in to the market.  At least temporarily. 

Well, the dollar rose against the yen on Friday but got hit hard against the euro and other major currencies.  In fact, it got pounded.  The dollar was up 0.3% against the yen at 116.  The Euro meanwhile was up 0.8% at around 137; and the British pound was up a half a percent back up over 2 dollars ($2.01). 

Oil had a good day on Friday, but it was down for the week.  Crude oil futures closed Friday with a gain of a dollar a barrel but still ended the week with a 1% loss.  Prices got a lift for the session from upbeat data on the US economy as well as a steep decline in gasoline inventories.  Crude for October delivery climbed $1.26 or a gain of 1.8% closing out the week at $71.09 a barrel.  Also helping to bolster confidence, Mexico's state run company PEXEX resumed offshore oil and natural gas production in Cantarell.  They had been shut down temporarily as a result of hurricane Dean.  The storm caused no serious damage to offshore platforms. (In the run up to the hurricane PEMEX had evacuated more than 18,000 workers as a precaution). 

And traders continued to digest energy data released on Wednesday that showed – US petroleum supplies showed – that crude inventory surprisingly rose for the first time in seven weeks, but gasoline supplies fell for a third week in a row.  Natural gas for September delivery finished at the day at $5.52.  Natural gas futures contracted this week by over 21%.  But taking a look at the bigger picture, the trade seems to be rotating back into energy as prices remain extremely over sold. 

Finally gold futures climbed Friday with a decline in the US dollar against major currencies.  Gold’s summer sleepy season is coming to the end with the coming of gold’s time of seasonal strength and peak demand coming from India and the Middle East, as well as the Christmas jewelry season demand.  Gold for December delivery closed at 677.50 an ounce.  It was up $9.10 on the session and it was up 1.6%.  A fairly hefty decline in the US dollar, strong crude oil, a decent showing in the Dow Jones industrial average and preseasonal physical off-take from India provided support for gold on Friday. 

The danger the financial markets are in is not fully appreciated yet by many, but with the dollar trending lower again, the message is starting to come through.  Several financial tsunamis have been seen over the last week, one from emerging assets returning to the dollar, and another with the US moving out of the dollar and back into the yen.  The carry trade is back in play.  Hence the exchange rate is not been fully noticed yet.  And on the back of what's coming, expect good things for precious metals according to many experts.  The gold market should stabilize much quicker than the financial markets are expecting. 

That's the way it looks on Wall Street.  Coming up next a conversation with Frank Barbera as we take a look at the technical view of the markets coming up right after this. 

[echoes]

Hey Frank, Frank, are you down there?  I can't see you.  It's really dark? 

FRANK:  Still can hear you.  I can hear you.  No, I know.  I’m deep. 

JIM:  How deep? 

FRANK:  I've been so deep, Jim, I haven't seen daylight in weeks.  Is everything okay?

JIM:  Everything is okay on the surface here.  I was afraid you were going so deep you were going to start hitting magma.

FRANK:  Did the money drops work, Jim?

JIM:  The money drops worked, Frank. 

FRANK:  I’ve still got dollar bills floating around down here.

JIM:  Hey, seriously, Frank, we had a nice rally this week in the market all across the board, all of the major indexes up a couple percent.  We are now in positive territory.  I think the Dow is up for the year, all of the major indexes.  Why don't we start and give our listeners your take on the stock market.  We had a meeting this week with Hank Paulson, Chris Dodd and Ben Bernanke – with the three of them getting together saying, “Hey, everything is okay.” And it's, like, “we've stabilized; the problems are behind us and it's onward and upward.”  I would suppose, technically, you're not going to subscribe to that view. 

FRANK:  That's correct, Jim.  I think we've seen the beginning, the sort of the opening round of a larger bear market.  If you look at what happened during the last downward thrust in terms of momentum indicators, breadth indicators, volume indicators, we saw some very serious technical damage.  The kind of downside kick off that we've seen over the last few weeks, that type of movement is never the end of a decline.  It's the inception of a decline. 

Now, that doesn't mean that you can't have a fairly sizable counter trend move which is in fact exactly what we're getting.  But at some point, this rally is very likely to peak out and the market will likely start to roll over and move down to retest those lows and I think more likely than not, actually break those lows and begin a full blown second leg down. 

So I think we're a long way from being done with stock market volatility for 2007.  I don't see the low that we put in a week ago as a low that will stand without being at the very least retested sometime in the weeks ahead. 

Now, that said, the bigger picture is bearish; the bigger picture is still a market that continues to hover near a top in the act of making what we would call a secondary top now.  That big picture is -- and fundamentally there is a very good reason:  Obviously we've all seen the credit crunch; I think those problems will continue as well. 

On the short term, the S&P does have a pretty good head of steam to the upside.  We ended on the high of the week this week, the S&P closing at 1479 – up about 17 points.  It looks like we broke through initial resistance of 1463.  That was a 50% retracement zone from the high of July 16^th at 1555.90 to the recent low of August 16^th at 1370.60.  So the next target from here short term – and we're seeing at least reasonably decent momentum confirmation – is probably the 1495 to 1500 area.  That's the zone where we made the peak on August 8th at 1503.89.  That's also a 0.618 Fibonacci retracement that comes in about 1494.  The 20 day upper band – the upper Bollinger band – we can extrapolate that forward a little bit, that will be at 1499.14 during the early stages of next week. And the 50 day average is at 1494.76 and that's dropping about 70 cents to 80 cents a day.  So you'll have a cluster of resistance points in that low 1490 to 1500 zone. 

I would expect that we’ll probably see another two-to-three days of upward movement here in the stock market – perhaps into a high around the 29^th (that would be the middle of next week) – followed by a little pull back towards 1460 into early September; and then another small retest of the highs near 1500 into maybe the first full week of September. 

From that point, I would say that you'll probably make a high, we will probably start to see the kind of serious over bought readings once again, the type of diversifications that would indicate a completed secondary high.  And at that point, I think the market could start to move on.  So I think what the Fed action has done over the last few days has given the market a little bit of breather – an interlude – but I think probably from mid-September on, the market will begin to resume the decline. 

In terms of October, I still think probably by October we'll be back down towards the 1400 area; maybe back down to those late February lows in the 1360s.  So I think that the market is generally setting itself for resumption of the decline. 

You know, Jim, one important element to watch which tells you a lot about the tenor of a stock market rally, if you go back to July 27th, the nine day RSI was at 25 (I'm just going to round it off) and the S&P was at 1459.  Through today, the nine day RSI is at 59 and the market closed at 1479.  So, so far, we've gone from near 20 to just about 60 on the nine day RSI, which in a bear market that's known as the 20/60 rule.  The traditional benchmark for RSI over bought is 70 and over sold is 30.  But in a bear market, you tend to get more oversold readings – deeper oversold readings – so the scale tends to shift down to a 20/60 scale.  And that's what we saw recently with that July 27^th low in the low 20s, with the reading of 59 today, you're getting very close to 60.  That doesn't mean you can't go up for another day or two.  You can.  But probably this rally will peak in the low 60s.

And here is the important point.  Where we were standing on July 27^th with the RSI at 24, the S&P was at 1459.  Through today, we're almost at 60 and the net gain in price on the S&P is only 20 points or only about 1.3%.  That's very, very little net gain for an RSI moving from 20 to 60 – essentially the full bear market move.  That tells you that you're basically in a weak structure.  And even though I think we could move up for another two or three days and tag that 1495, 1500 area, I tend to think that's going to be very, very strong resistance, and that within a week or two the market will be reversing and resuming the medium term decline.  So I remain negative for NASDAQ which closed at 2575.80.  The strong resistance, the 50-day average will come in next week at about 2600.70.  That 2600 area for the NASDAQ should be pretty tough to get through.  That’s sort of the equivalent of 1500 on the S&P.  [17:45]

JIM:  Frank, let's move on to the bond market because if we go back to Monday this week we had three month Treasury bill yields at almost 3.1%.  They are back up over 4%.  The 30 year treasury bonds is roughly about 4.9 right now.  What is your take on interest rates?

FRANK:  Well, I think short term interest rates definitely seem like they are going to normalize.  I continue to think we will be seeing some of the discount premium coming out of the short term end.  So in other words, if you were looking a few days ago, there was a 100% probability based on Fed Fund futures and short term interest rate futures that you would get a half point cut.  That's now been moved back to 50%, and actually less than 50%. 

I tend to think that we'll see that narrow even further, and if you look at the speech that Fed governor Lacker recently gave this week, it's not at all encouraging for anybody who thinks the Fed is going to be moving to cut interest rates in September or for that matter even October.  He threw a lot of cold water on that notion by talking about some of the entrenched inflation. 

It's also worthwhile noting that in the next three months, last year at this period of time, we did not have a hurricane season.  So the CPI numbers and the PPI numbers were unusually low in the last three-to-four months of the year.  Over the course of this year, we have already put on in the first eight months of the year, very high CPI numbers.  So if we just go through the rest of this year putting on essentially normal CPI numbers of 0.3,  0.4 per month (which has become basically the norm over the last two to three years) you're really going to be annualizing CPI at about 5 ½ to 6% rate of change.  That's a pretty high headline inflation number; and that maybe enough to handcuff the Fed for quite some time to come. 

I think that's one reason that Chairman Bernanke looked to try and calm the commercial paper market down by using the discount window instead of moving directly to the main tool of the Fed Funds.  And so far, I give him high marks for what he did, but I don't think you're going to see short term rates coming down anything like as quickly as the market is currently anticipating.  On the long end of the 10 year, we ended at 4.63 today.  We need to watch 4.70.  Any move back above the 4.70 yield level on the 10 year would target a move back up to about 4.85; and I think ultimately towards 4.90, 4.95 over the next four to five weeks. 

For me, the bond market, or the long end of the bond market, looks like it may have put in an important bottom on the Treasury yield.  So I think we could start to see long term yields begin an advance over the next few weeks, so I'd be bearish on bonds.  [20:38]

JIM:  All right, moving on, let's cover both of them at the same time.  Let's talk about the dollar and the gold market, because bullion, as I see it, has been showing unusual strength in this period. 

FRANK:  It has so far.  Gold has held fairly well.  We're up 8.80 today.  We closed at 677.20 on the December contract.  It has held up better than platinum and it has held up better than silver – both of which broke through their equivalent May and June lows.  So, so far gold has been sort of the stand out -- no doubt the benefit of a flight to quality thus far during the credit crunch.

I've been concerned over the last few weeks as to whether the yen -- the unwinding of the yen carry trade could force hedge funds to put downside pressure on gold and sell gold, what is basically as a result of a margin trade.  And I'm still not sure that we will see more of that in the weeks ahead.  So at the moment, I'm kind of reserving judgment on the gold market.  I'm sort of looking at it as a neutral condition.  Maybe a narrowing range where we seen resistance at the high end at about 682, 683.  That's a downtrending trend line from the July 24^th high at 693 and the June 18^th high at 688.  That trend line comes in at around 682, 683 early next week.  That resistance, we have pretty good support at August 16^th lows around 651.  So basically I think you're in a market that's in a fairly narrow 30 point range.  It's not a trending market.  But we're going to be watching that very closely.  You know, if gold were to strengthen through that resistance at 683, that could start to give a more bullish signal on the charts. 

Silver for September closed at about $12.  The equivalent strong resistance there was 12.25.  I still believe that silver prices could drift down towards the $10 area and retest the lows we saw back in September 2006.  So that also could be a very world class investment opportunity if we get it.  We'll just have to see how things develop.  [22:52]

JIM:  Finally, Frank, let's cover energy.  Here we are on Friday and you’ve got oil prices back over $71 dollars a barrel.  We don't have any hurricanes on the horizon as of yet, at least.  It's showing some strength here. 

FRANK:  Indeed, Jim.  I think we've had a nice correction from the highs around $79.  Crude oil to me looks like it's put in an important bottom.  I would say that the next target for crude is it moved back up towards 74, 74 ½.  I really wouldn't be surprised to see crude oil retesting the highs at 78 to 79 dollars over the next few weeks.  So I'd say that looks pretty bullish. 

And also natural gas has had a disproportionate decline this week.  It looks like you did see some hedge fund unwinding, maybe a carry trade impact on a natural gas contract because the decline there was unusually steep.  To me, I think there's a good chance natural gas could strengthen.  But right now, I would not be trying to pick a low.  I think we would have to see a little bit of a trading rally first for a couple of days in natural gas, some type of retest of the lows; and then at that point any strength from there would be encouraging.  So natural gas may be bottoming, that may be an interesting trade, but it's probably going to take two or three weeks for us to get a better handle on the idea that it's actually finally bottomed out.  [24:14]

JIM:  All right, Frank.  I appreciate you coming in and filling in with me on the expert side today and giving us an update on the markets. 

FRANK:  My pleasure, Jim. 

JIM:  Have a great week kind, and Frank, as we close, if our listeners would like to find out more about your work, tell me how they can do so. 

FRANK:  They can contact me at my email address which is FrankBgst@aol.com.  Thanks a lot, Jim. 

 The Big Picture with Jim and John

JOHN:  All right, Puplava.  This better be really good.  Here I am sitting in the middle of the lake, having fun in my kayak and these two suits with sunglasses show up.  They kidnap me, blindfold me and drag me back into the studio.  What do you want?  This better be good.  This is supposed to be my time off. 

JIM:  Hey.  I'm joining you.  I've got the same two suits in my office.

JOHN:  I wonder who they work for?

JIM:  I don't know. 

JOHN:  All right.  Wonderful.  This would seem to be a golden opportunity.  I mean look at this.  The central banks are injecting liquidity at a breath taking rate.  It really is.  And it's tragic because we're all going to wind up paying for this in very short order as this affects the prices in the various countries where the money supplies have been expanded.  But the weird thing is people are dumping gold.  I don't understand this, Jim.  Explain it to me. 

JIM:  What happens, John, when there is a run on liquidity and especially when you’re margined, let's say you're heavily in debt.  What happens immediately is there is a rush to get liquid, sell off assets.  And sometimes, John, you throw the baby out with the bath water.  What happens is they sell off anything.  And so stocks initially get hit – and anything in the stock market that's liquid.  And what it was doing, well, the energy markets were doing well, so they sold off the energy stocks because the energy stocks are liquid. 

And the same thing happens with the gold market.  Even though the price of bullion, which has done remarkably well – it's held up well.  And what happens is people have to remember when you look at, for example, the gold market, it doesn't take much to drive it down.  It's a very small universe compared to the stock market.  I mean if you look at, for example, the capitalization of the HUI, which is the Amex Gold Bug Index, it's only 101 billion.  And so here you have the top mining companies in the world and if you take up their market capitalization, it doesn't even add up to Coca-Cola.  So it doesn't take much of panic selling to drive these prices down to extremes. 

And one comment that I've always made (and Frank Barbera has made this comment several times on this program) every single year in the gold market you can expect to see a 20 to 30% correction.  Whereas, let's say, in the stock market where a 5 to 10% correction might by considered normal; in the gold market, a 20 to 30% correction would be normal.  Just take a look at the graph of the HUI, which is the Amex Gold Index or XAU (the Philadelphia Gold Index).  So these pronounced swings in both directions – on the way up and on the way down. 

And the one real danger that we all have is there will be a day – there will be an event where gold will trade up 40, 50 dollars an ounce, lock limit up and you will see an explosive move in the gold stocks.  They'll move 20 to 40% in two or three days.  So before you even have a chance to react, you will have missed the most important part of the move.  And that's something that people have to be very cognizant of in the gold market: It is less liquid.  And that means that the volume of trading in the gold market is much, much smaller than in the stock market. So if money decides to move out, let's say people liquidate their shares of a gold mutual fund, and the fund manager is forced to sell off stocks and then you have huge short positions that come in, both real short positions and naked short positions (and especially in the juniors, you see a lot of naked shorting that goes on), and also there is a lot of hedging that is going on.  The fact that bullion has remained so strong, and some of the stocks have gone down, a lot of these hedge funds may be going long bullion and then hedging their long bullion position by shorting the gold equity stocks. 

But what happens is eventually you get things out of balance and there is a sort of a ratio that you can use and it's the XAU divided into the price of gold.  And if you look at this chart over a good 20, 30 year period, you will find that whenever that ratio gets down to 3, the gold market has become over bought and that whenever that ratio gets close to five, it has become oversold which is where it is today.  Now, does that mean the gold market has bottomed today or will it bottom next week?  No.  But it gets down to understanding what the gold market is, how it functions and how small movements can move these fluctuations up and down.  I mean I've been in this market for quite a long time, so these things don't bother me.  In fact, I always look forward to them because that's when I tend to do most of my buying is during these dips when I make sure that the dips are clear.  I go in.  If I buy and it dips a little more, I may buy bullion or I may switch over and buy shares. 

And I can say right now, when I look at junior market and some of the best juniors that are out there, there is one very well-positioned junior that has multiple millions of ounces.  It's selling at $14 gold in the ground.  I've seen others at 16 and $18.

So to me, from a value perspective, do you want to buy the bullion at 680, or do you want to buy gold in the ground at 14 to $20 an ounce when gold is trading at close to 680?  [30:51]

JOHN:  It brings back up a story I thought of.  I had a friend who cashed out a CD for about $10,000 and “what should I do.” And I told him, “put it in silver.” He did.  This is back when silver was just a little below $7 or something.  And very shortly we both know it went roaring up to 10 or 12.  And then his wife came running in and said, “quick get out, sell it quick quick quick quick quick.” And I said, “what are you going to do with it.”  He said, “well, we'll just put it back into money again.”

And at that point, the purchasing power would have started eroding rather rapidly because of the inflation.  And it comes down to it would seem that in this country in the west, so many people think of the paper notes they are holding in their hands is genuine money.  But in reality they are a constantly eroding storage unit.  It's like having a can of something important gasoline but there is a little hole in the bottom and people don't understand how to plug that hole and that's why they keep getting caught in those traps. 

JOHN:  Yeah.  And I think another danger here.  Unless you understand what money is, then it's going to be very hard to convince you that you ought to buy gold.  And then you're going to be frightened by these fluctuations. 

But the most important thing, whether it's a bull market in stocks or it's a bull market in commodities, all you care about when the bull market peaks is that you own as many ounces as you can if you're buying bullion; or as many shares as you can if you're buying the gold stocks.  So rather than looking at the price of your portfolio and saying, “oh my God, my gold stock is down,” or “I bought silver at $13 an ounce and now it's down at 11.97 an ounce,” the way to look at it and you say, “if I go in and buy silver this month or if I go in and buy my favorite gold stock or gold junior, I'm going to get those shares much cheaper this month than I could last month.” And that's how you accumulate. 

So you buy when you go through these corrections.  And what you don't do is sell off and then hope that you're going to get perfect timing and you're going to get in at the bottom when the gold market bottoms.  That’s because chances are psychologically – and I want you to think about this – psychologically when gold bottoms, there is blood in the streets, there will be frightening news.  People will say, “oh my God, I don't want to be in gold, the gold stocks have gone down.”  And the sentiment becomes so negative, psychologically, you're not going to buy at the bottom because you'll think it will still keep going lower.  And so when it reverses itself– which it always does, just take a look at a chart of gold stock or gold bullion or silver over the last five or six years –  it will do so just as quickly as it has dropped.  And that is the very nature of the metals market.

But I think what you have to do is keep your eye focused on the ball and on the bigger picture, we're in an inflationary environment.  You heard Frank Barbera in the first hour talking about CPI will annualize this year at 5%.  Well, take a look at what you're getting in a bond.  Bond yields are below the inflation rate, and even worse off when you factor out taxes out of the yield on interest.  So let's say you're getting 5% in a bond backed out about 40% percent for taxes, you're only earning 3% after tax.  The CPI rate is 5% officially and unofficially, if you look at the real CPI rate it's probably closer to 8 to 10%.

So if you're looking at 8 to 10% inflation, your money is losing its purchasing power, it's cut in half every seven years.  Unless you understand that concept – and where people, I think, make the greatest mistake, John, is they focus on price rather than focusing on how much will my money buy this month or this week.  If you had a favorite junior that you are accumulating and it's down – many juniors are down 40 and 50%.  They have just literally been taken out to the wood shed and trashed as if they were worthless.  And that's how you make money is you buy when prices are depressed and you keep buying.  You add to your position and you hold for the market to fully recognize that position. 

I remember I was on a plane.  This was I think 1998.  It was the front cover of BusinessWeek and it was about Richard Rainwater.  Richard Rainwater is a multi, multi billionaire.  He was an investment advisor to the Bass brothers, the famous oil family out of Texas, who made a fortune for the Bass brothers, went out on his own and they were interviewing him and he was buying – this was 1998 – and remember, the tech market was going crazy. And I think his net worth had fallen to half a billion dollars and they were saying basically, “has this guy lost his touch.”  And in the interview, they were asking him what he was doing and he was buying a health maintenance organization, an HMO stock.  He was buying heavily into real estate and he was buying oil. 

Now, John, in 1998, if you were looking at somebody buying health care, oil and real estate, what would you have thought?

JOHN:  They were crazy. 

JIM:  Yeah.  Absolutely crazy.  Why in the heck would he want to be buying oil and real estate and health care.  You know, we're in a new economy and the way to make money is to buy Amazon or AOL at 600 times earnings.  Well, needless to say, he kept on buying real estate increasing his position, he kept on buying his shares and increasing his ownership in health maintenance organizations.  He also bought very heavily in the oil, and natural gas sector.  And today he's a multi, multi billionaire rather than just being a multi-millionaire.  And that is how you make real money. 

But there is one thing.  He did a lot of research and he had the conviction of his own research.  So as prices weakened, as everybody was off chasing the latest dotcom stock or the latest tech stock, was buying stuff at incredible values.  And that's the point I want to make right now.  You can buy gold in the ground in secure places in Mexico and Canada today – especially with all of the political risks that exists in the world – at $12 an ounce, $14 an ounce, $20 an ounce when gold is selling at close to 680.  That to me is how you make money. 

But you have to have the conviction to do it and you have to be disciplined to do it.  And you have to not be shaken off by any market sell off.  That is how you build real wealth.  Forget about the price.  Forget about what the daily fluctuations are.  Start thinking of how many ounces you can accumulate.  How many shares you can accumulate because in the end, if you believe gold prices are going higher, energy prices are going higher, silver prices are going higher, what really matters in the end is how many shares you own and how many ounces you own.  [37:59] 

JOHN:  You know, from time to time, Jim, I'm invited to speak at different organizations.  And what I typically speak on is the whole concept of world views.  I guess the German expression is weltanschauung which means…first of all, if you can wrap your tongue around that? 

JIM:  I'm not going to pronounce that. 

JOHN:  I had to practice for that hours in front of the mirror.  Weltanschauung – it means “world view.”  It's a classic term that philosophers use in German.  But your world view, your financial world view actually affects how you view what is going on.  And you can present two different people with two different assumptions about the world with the same facts and they will come to different conclusions. 

And the real question is whose world really is a real world view, which really anticipates what is going on out there; because it will affect the outcome ultimately.  And right now we're looking at a situation where if you're trying to follow some of the old models and rules, the paradigms don't seem to be working.  And it's very important early on to recognize that is exactly what is happening.  Otherwise, you'll be making bad decision calls. 

JIM:  You know, that is so true, John.  I remember this was back in the 80s and in graduate school I was taught Keynesian economics.  I mean that's what you learned when you go to most colleges today.  If you learn any type of economics it's generally Keynesian.  And that pretty much is how I thought when I viewed the markets.  You know, if you come from or look at the markets or the economy from a Keynesian point of view, any time something goes wrong, you never believe government is the cause of it, but you always look for government solutions to fix it; which of course creates even further problems. 

But I think the turning point in my career was the stock market crash in 1987.  And I remember everybody trying to explain away what was going on and how it happened.  And the Keynesian arguments just weren't making a lot of sense to me.  And I discovered a book written by Rothbard and it was called What Government Has Done To Our Money and I remember reading that treatise – a small little book,  probably about 60 or 70 pages –  and that was my first exposure to Austrian economics.  And when I read Rothbard and I was looking at that and I said, “boy, this makes so much sense to me.”  And as I began to explore more and more Austrian economics, and how free markets work and how these Keynesian cycles I began to question these.  And as a result of that, John, it gave me a better understanding of how markets work.  And also, I think it gave a better predictive value in terms of where we were going. 

And a lot of people may recall that it was the Austrian economists that were predicting what might follow the inflationary expansion of the Federal Reserve policies in the 20s.  And it was only the Austrians that could explain what happened afterwards when the government came in and just literally botched things with regulation and taxation.  To the point where they took a market correction that if allowed to cleanse itself, we might have gotten by with maybe a minor recession, a bear market of small magnitude.  Instead, they turned it into the Great Depression and they also turned it into the greatest bear market in history where stocks lost 90% of their value. 

So it was only looking at these kind of events that I began to understand that if we take a look at what happened in the 90s, the US began running huge trade deficits; we began outsourcing our manufacturing base; and you know, we were telling everybody that the stock market, which began to inflate from 1995 to the year 2004, that we were in a new paradigm economy.  And all that was happening, John, was money was being created and its outlet had found its way into the stock market.  And so a lot of the rules and the ways that we look at things [didn’t apply.] I mean if we just take a look at the recession that took place in 2001, normally, as the economy has entered a recession, it heads into a recession as a result of higher interest rates. Real estate generally leads the economy into a recession, as I believe it is doing now. 

But in the 2001 recession, that didn't happen.  We went from a crash of the technology bubble to the creation of a real estate bubble.  And when the stock market bottomed in 2002 in the summer of that year, what we got was a massive amount of inflation.  And that inflation found itself in all asset markets.  It found it's way into the stock market, so the stock market began going up.  It found its way into the bond market as bond yields went down.  It found its way into the real estate market as real estate inflated.  It found its way into the commodity markets as commodities inflated.  So all assets inflated.  [43:44]

JOHN:  Even when the Fed began to take away the punch bowl by raising interest rates, we suddenly found out that the whole interest rate cycle was off as well. 

JIM:  Sure.  Because if you take a look at when the Fed began to raise interest rates in the summer of 2004 – remember, during that period of time, the 10 year Treasury note virtually went nowhere.  We were in a very, very narrow trading range throughout that entire rate raising cycle which ended in the summer of 2006.  And we're still in that narrow trading range, although at a little bit higher level.  Most technicians, will tell you that the bond market basically peaked in the summer, I think, of 2003 when the yields on the 10 Year treasury note got down to about 3% and then we've been going up. 

But during that whole rate raising cycle, the other thing is the money supply did not contract during this rate raising cycle.  It continued to expand and accelerate and that's not just here.  It was also occurring globally.  The Fed, instead of really taking away the punch bowl made sure that credit continued to flow freely into the markets.  And whatever the Fed wasn't creating through the banking system it was being created on Wall Street with structured finance with these CDOs and mortgage-backed securities – the very same issue that we're dealing with today. 

And here we are in a situation today where the Fed is talking about inflation, yet we have bond yields that are below the stated inflation rate and we have bond yields that are below the real inflation rate.  So there are a lot of distortions. A lot of the old paradigms, a lot of the old economic models, John, you can throw out the window because there is no textbook written for this.  I believe we're really in uncharted territory. 

But I believe what we are entering into is the final end game for fiat money.  And that's a very dangerous period because you get more volatility, you're going to see more inflation, inflation is  catching up with central bank policies, they were able to innate throughout the 90s as we exported our manufacturing base and as we imported cheap products.  That kept the price of real goods down, but the inflation was taking place in the asset markets. 

Remember, when money is created, it has two places to go.  It can go into the real economy that's on Main Street, and into the price on goods and services that you and I consume, or it can go into assets.  And when it goes into assets that's what we call the good kind of inflation.  That's the first response.  And that's where everybody says, “gee, aren't we living in great times.  We have low inflation rates and we have plenty of wealth being created in these asset inflations that we see.”  And that's when everybody is very favorable.  And then all of a sudden it deflates.  And I think we're getting a bit of disinflation right now.  We're seeing that with the real estate market.  I think we've seen it a bit in the stock market.  But eventually, you know, what's going to come to the fore, John, is we're going to see massive levels of reinflation.  It's going to occur globally and that's why I think we're going to begin a series when we come back in a couple of weeks and we're going to start understanding how inflations evolve.  And how we head into hyperinflation so people can protect themselves.  [47:15]

JOHN:  I'm glad you said that because as you were talking about being in uncharted territory the thought that was torquing around in my mind was okay, what if you're out sailing on the ocean and you really don't have a chart, how do you figure out how to navigate?  Because you don't have the standard reference points, so what do you do?

JIM:  Yeah.  I mean you can study history.  I mean all governments eventually inflate themselves to oblivion.  Any empire, whether it was the Roman Empire, the Spanish Empire, the French Empire, they all come to the same conclusion.  And that has been the history of fiat currencies, they never end pleasantly.  It always a tragedy when it does end.  So what you can do is learn from these periods in the past. 

And Mark Twain said history doesn't repeat itself but it rhymes, so how this will unfold is going to be a little different, but I think the end results will always be the same.  You know, they are going to inflate away the debt when you have the massive amounts of debt levels that we have in the United States today – whether it's unfunded pension liabilities in the Social Security, Medicare and corporate pension system, or it's corporate debt itself, it's government debt, municipal debt, personal debt.  All of that, the way you get rid of it is inflate it away and then the real impact of deflation comes in. 

I've had Bob Prechter on this program and Bob is a deflationist and Bob believes that we get deflation first and then hyperinflation where I guess my views are we get hyperinflation and then what follows will be deflation.  And that's the way it has unfolded with great debtor nations.  And I think history will repeat itself here with the US.  There is too much debt here and it has to be inflated away.

John.  You're listening, you follow politics a lot closer than I do, but every politician I see of both parties other than Ron Paul is promising the voters more bailouts, more entitlements – all of this at a time where we are running up so much debt that the only way we can possibly repay back these debts is to inflate it away.  [49:31]

JOHN:  Yeah.  And I think they are promising things they can't deliver in short order ; that’s compared to say for example when we started out in the whole area of Social Security.  Ultimately that thing had to bankrupt because it was set up like a Ponzi scheme.  But that was long term.  I mean how long has it been going, 60 years now so far since FDR got it rolling 60 or 70 years, but this – if I'm estimating it right is going to bankrupt in short order.  In other words, they are going to promise, but whoever sits in the White House, and whoever sits in Congress is going to face an incredibly turbulent period of time as I see it.  We're only 437 days out from the next US election and this will go belly up faster than I think anyone else is anticipating. 

JIM:  Yeah.  I really believe that the full force of these storms aren't going to hit until somewhere between 2009 and 2010 when this really comes home to roost.  And all of these debt problems, the problems that we have with energy today, availability, peak oil, the geopolitical problems in the Middle East – I do not expect the next decade to be a pleasant one, John.  I wish I could say otherwise because as a father with three children, one to get married shortly and looking forward to grandchildren, you know, this is something that you don't like to think about.  

But you know, nonetheless, if you pick up any history book, look at any century and what have you seen?  You've seen conflict, you've seen depressions, you've seen market crashes, you've seen wars, major wars.  I mean this is nothing.  Who was it?  Solomon – there is nothing new under the sun.  We've all seen this in the past and it's the benefits of wisdom as you get older you can look back and see these things.  But every generation seems to repeat the same kind of mistakes.  [51:13]

JOHN:  But maybe that answers the question I asked earlier about charts.  You said we're out on uncharted waters.  Maybe it's not so much uncharted waters as most people aren't using these ancient charts.  If you go back to the ancient charts you actually can find out where we're probably going to wind up.  It's readily available information.  But the Keynesians right now are not looking at those charts.  They are still trying to figure it out the other way. 

JIM:  Well, you know, what was the one quote from John Maynard Keynes: in the long run we’re all dead. 

JOHN:  When somebody asked him, they said, “doesn’t this Dr.  Keynes ultimately come home to roost.  I mean somebody has to pay for all of this.”  And he said, “oh well in the long run we're all dead anyway.”  Meaning we'll let some future generation worry about that. But guess what? We're that future generation. 

JIM:  It's here.  Listen, we're going to keep the show short this week.  I want to thank everybody for listening.  We'll be back after labor day unless once again there is a financial emergency, Pearl Harbor is bombed, Krakatoa interrupts or Mt.  St.  Helens or, you know, who knows, but anyway,. 

JOHN:  And you're listening to the Financial Sense Newshour at www.financialsense.com.  Coming up in the next hour we have an interview with Doug Nolan and also we'll be taking some of your Q-line calls.  But it's only a two hour show this week.  As Jim said we were brought into the studio here kicking and screaming. 

JIM:  Tell those guys they can go away now. 

JOHN:  Actually, they want to see what we're going to say in the next hour, so maybe they will go away after that. 

JIM:  All right. 

JOHN:  We'll be back in just a second with the Financial Sense Newshour, right after this. 

 Part 2

 Doug Noland, "Deflating the Credit Bubble

JIM:  Well, it’s no secret if you turn on the news, it’s almost daily practice, we’ve either got Treasury officials, or officials from the Fed, everybody talking about the credit crunch - the crisis in lending.  In fact, there’s not a day that goes by that it doesn’t become a headline:  Companies in trouble. 

Joining me on the program this week is Doug Noland who’s been chronicling this whole process in his Credit Bubble Bulletin.

Doug, I want to take this back, and let’s go back, let’s say in the late 80s and 90s, and let’s take the way the markets used to work in lending.  Let’s say I work at Bank of America or Wells Fargo, you come in with your wife and you’re purchasing your home, I’m making a loan to you.  Let’s go back to those days, and then lead our listeners forward to how we got to where we are today and why this system is almost hanging on a precipice and how fragile it’s become.  Take us back, if you would, to the old ways.

DOUG:  Okay, Jim.  I wrote a piece some time ago where I tried to differentiate between – I said something to the effect that – the way it was and the way it is now; and drawing the differences between the traditional banking model where, as you were saying, someone would show up at the bank to get a mortgage, they would speak with the loan officer and they would demonstrate that they had character and collateral, they had a good job, and they would offer to make a 20% down payment.  And the loan officer, looking through all the data, would make the determination that yes, that the bank would lend to this borrower and be willing to hold that loan on their books until the borrower paid the loan back. 

So that was the thought process.  It was very much long term oriented; that the bank officer had to make sure that it was a good credit and had to make sure that the bank would be profitable on that loan. 

Well, that model started to change, especially in the early 90s.  And interestingly, and I don’t think it’s a coincidence, that things really started to change after the banking industry came under a lot of stress from lending excesses in the late 80s.  So we had that period where we had the bank collapses – especially in the Northeast, and California, and you had the Savings & Loan collapse – and the banking system was under so much stress that the Greenspan Fed cut interest rates dramatically and basically allowed the banks to recapitalize themselves.  So the banks were impaired in the early 90s, and this really gave an opportunity for what had already been evolving during the 80s: the evolution of Wall Street finance – specifically, the securitization market place. 

So you started to see a huge growth in the securitization markets in the 90s, and specifically 93, 94, and 95 you started to see rapid growth in the GSEs – the Government Sponsored Enterprises – in their balance sheets.  So the game started to change then, where no longer were lenders just showing up at the bank to get a mortgage they could go to various lending institutions that would make that loan and then sell it to Wall Street to be bundled in a pool of securities to be securitized as mortgage-backed securities.  So that really led to major changes in the nature of lending from the bank loan office making the judgment on the borrower to any mortgage lender that could make a loan and sell it to Wall Street. As far as he was concerned, as long as he could sell it that was a good loan to him. 

So that really – that in effect changed certainly the quality of the underlying loans in many regards but it also changed credit availability just generally because you started to see at this point just huge increases in the quantity of mortgages, mortgage dollars being created each year, and that in itself also led to housing inflation. And any time you have asset inflation with a lot of credit availability it’s going to be a self-fulfilling bubble environment and we saw that especially, you know, when the Fed cut rates again with Long Term Capital Management in 1998; and then after the Fed cut rates after the technology bust this just threw fuel on this unfolding mortgage finance bubble that, you know, the way it worked out, I just think that after the technology bubble burst we basically over the last seven years have doubled total mortgage credit for the entire country in seven years.  [5:18]

JIM:  Doug, let me stop you there because there are a lot of people that are saying that this was a good thing, because rather than a few large banks holding all of these mortgages on their balance sheets, that risk was distributed.  In other words, by packaging these loans into securities and then selling these securities to pension funds, insurance companies, mutual fund companies the risk was spread, and that’s been one reason why you’ve seen so many people on the Bubblevision come on and say, “well, you know, it’s different today, we don’t have the risk levels that we have today that we had back then.” I disagree with that assumption.  But why don’t you take a crack at it too because I don’t think you feel that way either.

DOUG:  I disagree completely.  Credit bubbles are very dangerous, and they’re very seductive.  Asset inflation is very seductive.  So the whole system has been seduced by this for some time now, and conventional wisdom believes a lot of things that are just incorrect.  The dynamic of a credit bubble is to sustain it so every year you need larger amounts of credit.  And certainly in the mortgage finance bubble we basically did that for a number of years where every year you have a large quantity of credit, and that’s financing home prices that are basically inflating every year.  And then you have more and more transactions, so you get a steady growth of the actual nominal number, or nominal amount of credit.  What you also get is, especially during the late phase of the credit bubble when you have the most speculation  and the greatest excesses, you get a dramatic deterioration in the quality of the loan.

So, if we had a theoretical line showing the actual risk of lending, it would go parabolic at the end of the cycle because the quantity of loans is so high, and the quality of loans is deteriorating so rapidly.  And we’ve seen evidence of this in how quickly the subprime market imploded; and now we’re seeing evidence in the jumbos, and Alt-As where the losses from these mortgages will be so much larger than anyone anticipated – just because the home prices were so inflated and the markets are so distorted.  So the whole notion that risk has been dispersed, some risk has been dispersed but the actual amount of systemic risk that has been created in the mortgage markets over the last few years is unlike anything our system has ever seen.  So there’s really no bull case to be made as far as the role of distributing the risk.

Right now, I hear some commentators suggesting it’s to our advantage that some of this risk is absorbed by the European banks. While it might be an advantage today but they’re not going to come back and continue to play this game as risk intermediators in our system.  So they’ve been burned and burned badly, and they’re going to change their behavior, and they’re not going to be major players in our asset-backed commercial paper market, and they’re not going to be major players in our CDO markets and some of these other markets that have been such a key part of the Wall Street finance which has quietly, kind of behind the scenes, been fueling our bubble economy.  There’s no good news there.

And the other aspect as far as dispersing this risk, so much of it has been dispersed to hedge funds – and I call them the leveraged speculating community – a lot of it international insurance companies and the broker-dealer community, they all have been playing this game.  And you don’t want risk to be distributed to highly leveraged players because that’s when markets get in trouble because, you know, they’re not positioned to absorb big losses.  So a lot of times, they’ll take on these positions – and I often use the analogy of writing flood insurance.  They’ll write flood insurance during the drought with the expectation that as soon as the heavy rain begins they’re going to go out and reinsure.  So they don’t plan on holding this exposure and absorbing the loss.  They plan on:  “Well, I’m smart enough to anticipate as the losses start to unfold, I’m going to dump this exposure.” So what you have is a huge distortion in the risk market place during the boom.  And as we’ve seen in the last few weeks it can unravel so quickly when there’s a panic rush to try to get out the door and dump this risk exposure that nobody wants now.  So again, I see no bull story, no good news here at all.  [9:49]

JIM:  And we might explain, that’s one of the reasons why, when you had hedge funds that with bank Paribas that went under, they were buying the same kind of securities. So a lot of this – these mortgages – have been bundled, wrapped sliced and diced in different tranches, and then sold.  It’s not just US pension funds, it’s not US insurance companies, it global financial institutions:  hedge funds in Europe, hedge funds in Asia.  It’s global in nature.  And that’s what I think is a very important aspect to understand in this whole risk process.

DOUG:  Correct, Jim.  And the numbers are huge.  Again, we doubled mortgage credit in seven years.  So the actual number of dollars of this mortgage bubble is enormous; it has spread everywhere; it’s international; it’s domestic.  It’s in the money market funds to the hedge funds to the pension funds.  It’s everywhere.

And the expectation was that most of this was so-called Triple A (AAA)– safe and liquid securities.  And now it’s like the bloom is off the rose where Triple A is not Triple A anymore.  There’s recognition that you can lose a lot of money and lose it quickly in securities that you thought were safe and liquid. 

So, so much has changed over the last few weeks. We hear a lot about the problems in the asset-backed commercial paper market, and the problems in the kind of money market fund type vehicles.  And these are very serious problems because this is about a loss of confidence: That vehicles and instruments that the market place believed were safe and liquid, now they’re finding out that they’re not safe and not liquid.  And this is a pretty dramatic turn of events for, I think, Wall Street finance generally.  [11:33]

JIM:  I wonder if you might comment.  This is out of Bloomberg today:  The Fed may avoid emergency interest rate cut on signs liquidity crisis easing.  That was story No.  4 on Bloomberg.  Story No.  14:  Commercial paper roils borrowers as more than 550 billion set to mature.  The impression you got when you were watching the newsies today, Buffett’s getting involved, he’s going come in and rescue; the Fed has go this under control. 

And I want to get to something that’s been called sort of the cockroach theory and that is, I just wonder Doug, you know, we’ve seen some of the secondary lenders go under, the intermediates go under, we’ve even seen a bank run on Countrywide last week.  They were lined up around the bank pulling their money out of the bank.  How does this not filter up the food chain to the big boys?  I just don’t see how that can be avoided.  How can you have 400 trillion in derivatives, and we know the largest owners of that are the big money center banks, and they also are lenders.  How can this not filter up the food chain?

DOUG:  Well, I think absolutely it will filter up the food chain.  I’ll make a comment.  You know, the S&P 500 is up two percent year to date, the NASDAQ  is up over 4.4%; we’re not even in an equities bear market per se, yet.  The Fed and global central bankers were forced to move and move very quickly early in this problem.  The reason they had to move early was because of the acute fragility of the whole global financial system.  You know, they’ve already added over $300 billion dollars of liquidity.  It’s basically in these circumstances unprecedented.

What this has done though is it’s given hope to the stock market that global central bankers are on the case and that they can resolve whatever liquidity issues there are out there.  So, they’ve seen it in the past.  We saw it with LTCM and the technology bubble: the Fed can step up. Even Senator Dodd said today that Bernanke was willing to go to all measures to rectify the problem.  So the stock market and conventional wisdom is that there’s a liquidity issue that’s short term and the Fed’s on the case and will resolve it. 

What they’re providing is they’re providing liquidity and market confidence to somewhat lessen the impact of this deleveraging, because right now these highly leveraged players, these hedge funds and other that had borrowed so much to buy securities on margin, they’re forced now because of losses to liquidate.  So this is a real strain on the system.  I mean, if central banks wouldn’t have intervened I think the system would have just froze.  It would have just froze up and there wouldn’t have been any transactions.  So there’s one issue here and that’s liquidity which the central banks are dealing with on a short term basis; there’s another issue that will evolve over the coming weeks and months and that’s this confidence in Wall Street structured finance.  You know, confidence in contemporary finance as we’ve known it for 20 years.  And that problem, I don’t think the central banks are going to be able to resolve.  [14:50]

JIM:  This reminds me so much of the Great Depression days when the stock market began to unravel the economy.  It was almost on a weekly basis.  You had the president, you had the Treasury Secretary, you had the head of the Federal Reserve.  Doug, just go back over the last month, and how many times have you turned on the television and it’s Paulson giving a press conference to Maria Bartiromo over whether China was going to dump its bonds.  I mean it’s almost like every other day – today you had Senator Dodd meeting with Bernanke, and next week, I think Barney Frank is going to hold hearings figuring what went wrong.  And then you’ve got the government now talking about a possible bailout.  It just seems to me we create this situation, we create the moral hazard and we’re trying to signal to the market that there will be no consequences; if you’re a leveraged hedge fund player or speculator, you don’t need to worry the Fed is on the job.  If you are a leveraged home owner there’s no need to worry the government’s on the job.

DOUG:  Well, it’s eerily like reading a history of that 1929 to 1930 period.  And everyone’s saying the economic fundamentals are sound, and it’s just a short term liquidity problem. 

Actually, Jim, I don’t fault the central banks for what they’re doing today.  I think they have no choice.  Their mandate is not to allow the credit system to freeze up; and I certainly think it was heading in that direction. 

The problem I have goes back at least – we’ll start in the early 1990s, that’s when the moral hazard really began, and the Greenspan tenure was a disaster in that respect.  So I don’t know what else they should do today but to try to keep it from collapsing, because I think it really is that tenuous.  I don’t think that that they’re going to be able to resuscitate the bubble so I’m not as concerned as others are on that aspect of then trying to talk the markets up.  I think they’re just trying to keep things from imploding.  [16:58]

JIM:  Can in the end Doug, can they do that though?

DOUG:  Jim, I’ll step back and one of the points that I wanted to make, and I think that it’s important.  And I’ll throw out some numbers here, and I hope that this isn’t too confusing.  But if you look at the year period form 1998 to 2001, the GSEs expanded their balance sheets, so they increased their holdings, so if hedge funds in 98 were in trouble and need to sell securities, or even during 2001-2001 when the markets were in trouble and there was liquidation they were buying.  They increased their balance sheets $1.2 trillion over that four year period, which was amazing.  During that period the asset-backed securities market increased to $738 billion. 

Compare that to 2004 to 2006, that 3-year period, and this is after the accounting issues and the fraud at the GSEs were revealed, so the GSEs were reined in so they could not expand their balance sheets.  So over that 3-year period, 2004, 05, 06, the GSEs expanded their balance sheets by 57 billion is all.  Wall Street finance had so much momentum at that point and the mortgage market had so much momentum, in real estate prices we had bubbles everywhere, that Wall Street didn’t miss a beat without the GSEs being involved.  Structured finance took over mortgage lending and especially in the asset-backed securities market, over that 3-year period.  So the GSEs expanded 57 billion; the asset-backed securities market expanded almost $2 trillion in three years. 

This is a major problem today, because in the past when the markets started to falter and you’d have these liquidity issues and hedge fund problems and deleveraging, the hedge funds could just call Fannie and Freddie and sell them the mortgage-backed securities and everything was fine.  They would reliquify the system.  Not only were the GSEs there willing to buy these securities, the market…because the GSE growth had been so dominant, the market place, the whole system was full of GSE and GSE-related debt.  So during these types of crises the market actually loved those securities. 

You know, there’s a talk of Ponzi finance.  I’ve called the GSEs the anti-Ponzi because if there was any crisis the market gravitated towards their debt, and the GSEs could easily issue as much GSE debt as they wanted and expand and reliquify the system.  Well, now, we have a completely different dynamic in that the GSEs cannot expand their balance sheets, and at the same time, the market is full of non-GSE securities; it’s full of asset-backed securities that were put into collateralized debt obligations, these CDOs, all this sophisticated Wall Street – I call it alchemy.  And this is not stable debt.  This is a real problem.  It’s not GSE debt.  Most of it is mortgage debt during late in the cycle; it’s going to have huge issues for credit losses.  And these asset-backed securities today are not liquid.  The agency debt was very liquid; this stuff is not liquid.  So this is a huge problem in that the system is full of private-label mortgages and all of these sophisticated instruments. 

Today, people don’t trust the prices, they don’t trust the ratings, they don’t trust all these structures, they don’t trust the leverage. So this is such a different environment than we’ve seen and a much more serious crisis than the bust bursting of the technology bubble, or even Long Term Capital Management; because Long Term Capital Management is really about deleveraging.  I mean, Wall Street finance was not in jeopardy; credit losses were not a huge issue.  Today, we have these huge issues as far as, you know, credit losses, from be it subprime, Alt-A, jumbo and even, you know, leveraged loans in corporate finance generally.  So this is why it’s going to be very different for the Fed to rectify this problem because this is about private sector debt and poor quality debt structures that I don’t think the market place is going to trust much for quite some time.  [21:09]

JIM:  The thing that is appearing over and over again from the newsies is that, and especially from government officials, once again, reminiscent of 1929 and the early 30s, the economy is sound.  But Doug, for example,  take a look at just a couple of instances in, for example, Woodland Hills, you’ve got Amgen cutting back and laying off two thousand people; you’ve got Countrywide laying off people and it has decimated the Woodland Hills area of California.  Job losses are mounting all across the financial economy.  And then you also have, what about the about the elimination of jumbo loans.  I mean anything you buy in California today is almost done with a jumbo loan because the cost of real estate is still so expensive.

DOUG:  Well, I’m bearish right now obviously, and I’m nervous.  I don’t know how this plays out.  This situation with jumbo mortgages in California to me, you know, it’s a disaster.  I fear that there are a couple of dynamics that our conventional wisdom doesn’t appreciate doesn’t appreciate, and one you talked about the job losses in the financial economy.  And that’s right, I think the credit bubble itself, all this credit that we were creating was going directly and indirectly into a lot of upper end incomes; be it – the easiest examples are real estate agents and mortgage brokers, and investment bankers and attorneys and the whole support system for the asset bubbles in real estate and Wall Street securities.  So I think the economy is much more vulnerable than many believe because of the credit that was going to the upper end; and I think the upper end mortgage area is where we had the greatest excesses. 

So I think when all is said and done, subprime losses are going to be small compared to the losses we see in jumbo and Alt-A, and especially, unfortunately out in California – especially now, the inventories out there, you know better than I do, Jim, they’ve been building dramatically.  And I think people have been holding out waiting for prices to improve but now we’ve had a dramatic cutback and all the lenders are backing away from California jumbo and Alt-A.  and to me, I don’t know who’s going to finance transactions out there over the coming months – to me, it’s very disconcerting.  [23:33]

JIM:  I want to come back to something that we were talking about is how the GSEs – or Government Sponsored Entities – transformed the mortgage market.  They got in some difficulties.  Wall Street took over.  Now, Doug, when I turn on the television, and I see a government official - whether it’s a Congressman or a Senator, or somebody in government – they’re talking about bringing the GSEs back in to the picture to the rescue, expanding the loans that they can buy.  So it almost looks like they want the GSEs to reinflate the market again. 

DOUG:  Well, of course they do.  We should expect nothing less.  I mean there’s desperation out there to find buyers for mortgages.  And I think a lot of – well, I think Washington generally doesn’t understand the risk of Fannie and Freddie, so of course they would think it’s their role to step in and provide the liquidity. 

But I think we need to step back here and have the debate here and ask if we want these companies to continue to expand their total book of business right now, Jim – and that’s the mortgages that they hold on their balance sheets, plus the mortgages out in the market place that they’ve guaranteed; and that book of business is – their total exposure – is over 4 trillion dollars now.  And this is a huge problem, and I fully expect down the road these institutions to be nationalized.  And I think the US taxpayer is going to pay a huge bill for this. And so I hope there’s a real discussion and not just a discussion on the size of their balance sheets – that’s the typical discussion.  We need to decide how large we can allow these books of business to grow at risk to the taxpayer. 

To be honest, I don’t mind the GSEs if they want to play a role in affordable housing; if they wanted to try to rectify some of the problems at the lower end because of the lack of the availability of credit in subprime.  But to think that the GSEs should start doing jumbo mortgages, to try to be the buyer of last resort for California mortgages, my God, it’s hard to believe that makes sense to anyone because that’s just a potential disaster.  It’s also reminiscent of the S&L – the Savings and Loan problem that, you know, was a several billion dollar problem during the 80s that they allowed to grow to several hundred billion by the early 90s.  And definitely, the tab of the GSEs is growing rapidly right now.  [26:03]

JIM:  You know, it’s very hard, and as you mentioned, to try to forecast how all of this is going to play out other than some kind of massive reinflation effort.  But I just can’t help but believe when it does play out, Doug, that somebody at the top of the food chain is going to go under.  You can’t have 400 trillion in derivatives and all the permutations that we’ve seen in the mortgage market and sit back and believe all the guys – the big boys who are really holding all the cards at the top – are going to come out of this unscathed.  I just wonder how long before the next leg and we find out a JP Morgan, or a Goldman Sachs, or a who knows who, a Bank of America or somebody is more exposed than we are even led to believe right now.

DOUG:  Well, all the major – we’ll call them – money center banks, they are hugely exposed to the unfolding crisis.  The over-the-counter derivatives market – this is just a market between the different players. It can be the major banks, the Wall Street firms, the hedge funds.  This is all built on trust and agreements amongst themselves.  I’m very much worried the whole derivative market could just seize up in serious concerns about counterparty risk.  And someone, let’s say they have a stock portfolio and they’ve hedged it in the derivatives market, but then all of a sudden they worry that their counterparty, whoever wrote them that insurance may not be able to pay on it.  That can be the case in the equities market, and the currencies markets.  Certainly the derivatives market is a huge accident waiting to happen.  I think credit insurance and credit derivatives – it’s the upside of the credit cycle, that’s the only time it makes sense.  Now we’re going into the downside of the credit cycle, so I think there’s huge problems in credit derivatives, and in all the credit insurance.  So any time you have problems in that area, the major institutions are so actively involved in all these markets that it’s just different to see how this plays out impacting almost all the major players in the financial system, as far as I can see.  [28:26]

JIM:  What’s the expression – we are really moving in uncharted  waters.  We have fiat currencies today that are global – nothing is backed by gold, so there is no limitation in terms of the amount of money and credit that central banks can create.  And we just keep coming up, Doug, with just permutations of this whole structured finance situation and yet you have markets today that are – it’s almost like you feel you're on the decks of the Titanic, and you're navigating at full speed through icebergs, and nobody thinks that the ship can sink.

DOUG:  There’s a lot of complacency.  I’ll make a point about the dynamic today.  There are two aspects in my mind as far as this inflation – credit inflation. The central banks right now will aggressively expand their balance sheets.  I expect it won’t be too long until they’ve intervened – let’s call it a trillion dollars worth.  A lot of this will be simply shifting securities from the leveraged players that are impaired to the central banks.  There’s a lot of complacency – there’s confidence – that the central banks will step up and do this to keep the system from freezing up.  Well, that’s one aspect of it.

The other aspect of it is we still have a global bubble economy that to keep this global bubble economy sustained you need enormous on going credit creation.  So even if the central banks add a trillion dollars of liquidity to help out this deleveraging we still have this issue of how are we going to generate the trillions of additional credit going forward to keep incomes levitated, to keep corporation  earnings levitated, to keep asset prices levitated, to keep the global economy chugging along. 

The problem today is that central banks – again, I can see how they can intervene and create liquidity, it’s much more different for me to see how they can jump and rectify this breakdown that we’re seeing in private sector credit creation, especially in risk intermediation.  I mean Wall Street finance has been all about transforming risky loans through this alchemy of finance and very perceived safe and liquid securities.  Well, that whole mechanism is breaking down now because there’s recognition that they can’t transform all this risk into perceived safe and liquid securities.  They know the market place now knows they’re not safe; they know they’re not liquid.  So I’m not going to get all excited as far as projecting hyperinflation by just watching the central bank balance sheets because I think that won’t necessarily give us the clues as far as how this will play out.  We have to see somehow can the private sector continue to generate enough credit to sustain these bubble economies.  And that’s where I don’t think that the private credit system can do it right now.  And that’s why it’s rather hard for me not to be rather gloomy on the prospects, you know, for the US economy now going forward.

The global economy may be something of a different story because we have credit bubbles all over the world.  Like the Chinese bubble right now is pretty much oblivious to what’s going on in the US and in Europe.  You can see a scenario where, you know, you have serious credit breakdown but let’s say Chinese demand keeps energy and resource prices higher than one would expect.  So I’m going to be watching this very carefully because we’re going to see some very unusual dynamics as far as liquidity and inflation effects between different asset classes and different types of price levels throughout the economy.  [32:13]

JIM:  And Doug, if you were looking at, in terms of key barometers or benchmarks, markers to watch, in terms of how this unfolds, what would that be?

DOUG:  Well, I want to watch weekly issuance of junk bonds, investment grade debt, asset-backed securities, CDOs -- collateralized debt obligations – and I want to watch bank credit.  Right now, the market’s seized up and we’re not creating sufficient credit.  And if that continues for many more weeks then we’ve got a serious problem.  So, you know, the stock market may rally, credit spreads may narrow, but I want to see the nuts and bolts.  I want to see the credit being created.  I want to see someone step up and say we’re going to lend jumbo loans in California.  And I’m also going to be watching the California real estate market very closely, especially prices; because there’s situation now where I think where if prices take a leg down.  Generally, I remember in the early 90s how this worked where as soon as the foreclosures jumped and the banks got nervous and started dumping the properties; and in individual neighborhoods that would lead to rather rapid price declines.  If we start to see rapid price declines, and some panic in the California housing market then I think the momentum for the downside of the credit cycle will pick up rapidly and with major economic impact.  [33:42]

JIM:  I tell you, Doug, I mean it’s amazing the times that we live in.  I was watching CNBC today with Dodd talking about resurrecting the GSEs and just see all of this unfolding.  It’s amazing that we just don’t learn.

DOUG:  Well, of course we’re going to do this.  I mean of course they’re going to do it.  We would expect nothing less from them.  Of course they don’t learn.  They’re not going to give up on this.  They’re not just going to say, “this was the greatest bubble in history and now it’s going to implode.”  They’re going to do everything they can to keep it from imploding.  We’ll see.  But it’s a disaster.  I can’t believe what a disaster this is.

JIM:  Yeah.  I’m looking at “commercial paper roils market.”  First Magnus mortgage lender files for bankruptcy after investors flee.

DOUG:  I wrote a – I think it was two or three weeks ago something about I feel like I did after 9/11 where you see this tragedy and you know the world is different, you just don’t know how it’s going to play out.  But you just know something terrible has happened, and there’s going to be a huge price to pay for it.  That’s the only thing I can compare it to is how I felt after 9/11.  [34:51]

JIM:  It’s almost like there’s something that’s unfolding here, and I think that – I’m just sniffing it.  And I think they’re not letting on that this is working its way up the food chain.  I mean I don’t think I’ve ever seen Hank Paulson on TV as much.  What’s next?  They make him a commentator.

DOUG:  I mean Europeans wouldn't have interfered so aggressively if it wasn’t a disaster.  I mean this is confirmation that things are as fragile as we thought.  I don’t think Bernanke wanted to go so quickly.  I think he wanted air to come out of the stock market.  I think the central banks were forced into this because the whole thing was just going to implode in a matter of a couple of days.  I think it was that bad.  I really think it was that bad.  And now it’s just a big confidence game where they’ve got to convince everyone that they’re fine but clearly they’re not fine.  In the stock market maybe they can get through expiration because there are so many puts out there if this market starts to get hit it’s going to come unglued.  [35:44]

JIM:  I personally think that these guys are, let’s put it this way, the fire department is working full time at the Fed and the Treasury.  And to watch this on television and the complacency I think more than anything else, Doug, what surprises me is, “oh, this will be over in a day or two.  you know, no big problem.  Let’s go back and buy the home builders and the financials.”

DOUG:  A buying opportunity.

JIM:  Yeah, a buying opportunity.  It is absolutely insane.  And, you know the other thing you have to wonder, I mean this doesn’t take rocket science but if you take a look at the lending practices – the no-doc loans, no-money down, piggy-back loans, adjustable-rate loans with a reset in two years, negative amortization loans, interest only loans – what was in the minds of people starting a hedge fund at Bear Stearns, leveraging 10 or 15 times to one, and buying this stuff and thinking it wasn’t going to implode.

DOUG:  Well, the market came to believe that Triple A meant liquidity and safety; that’s why they leveraged 10 to 1 because they assumed it was liquid and safe.  But clearly Triple A doesn’t mean anything anymore.  But the most egregious leveraging and speculation was in the perceived safest instruments, like the Bear Stearns hedge funds.  you know, how can you lose, it’s all liquid, Triple A mortgage-backed.  [37:04]

JIM:  Wow, just absolutely amazing.  Well, Doug, as we close, if our listeners would like to find out more about your work and the things that you do, tell them how they could do so.

DOUG:  Well, we have our website here, www.prudentbear.com , and my article is Credit Bubble Bulletin we have – we try to highlight a lot of important news stories, or what we think are relevant news stories.  And we have a lot of articles that people write and submit to us.  So hopefully it’s a place where people can come and see the other side of the story.  We definitely – we don’t subscribe to conventional wisdom, we try to see the other side of the story; and hopefully some of the things that we write will bring a little bit more clarity to an environment I don’t think conventional wisdom can shed much light on right now.  [37:55]

JIM:  Well, I want to give my congratulations to you for just following and documenting this whole process in terms of how it’s been built and unfolding.  You do just a yeoman’s work in this area, Doug.  And that’s one o