Web Note
The following short story is hypothetical in nature, but is based on what was, what is, and what will be.

Meet John and Terry Wheeler, January 2003

For John and Terry Wheeler it was a dream come true. The opportunity had finally arrived. It was a chance to move out of their small apartment and finally own a home of their own. They had always dreamed of owning a home, but there was never enough money. Terry’s tips from waitressing at an upscale steakhouse had enabled the couple to build a small kitty of $5,000, but that didn’t cut it. Homes were expensive in southern California and it seemed no matter how much John and Terry brought home, housing prices moved further out of reach. That is until Terry’s aunt passed away leaving her a small inheritance. The $20,000 bequest wasn’t much, but with the drop in interest rates their realtor said that with the right financing package, they would be able to swing the deal.

In March of 2003 their dream became a reality. They purchased a small home in the suburbs for $515,000. The yard was small and the homes were close together, but they didn’t seem to care. After living in a 1,000 square foot apartment since they got married, Terry thought their new home was a palace. Thanks to the realtor’s advice of taking out a variable rate mortgage, they were able to get a 3% starter loan, which brought the payments on their $490,000 mortgage down to $2,100 a month. With property taxes and insurance, their combined incomes were able to handle the $2,500 a month outgo. Besides, John’s job as an electrician paid well and with all of the new homes being built, John was getting time and half for working overtime. Business began to pick up at the local steakhouse and on weekends Terry took home more than $500 in tips. By working three lunches a week in addition to her five nights, Terry’s income was beginning to catch up with John’s.

These were good times. With John’s overtime and the extra money Terry made working lunches, the Wheelers had enough money to buy Terry a new car. They were able to buy a brand new Ford Explorer for less than $400 a month thanks to zero percent financing. Times were so good that they even had enough money at the end of the month to put a little extra aside into savings. Terry wanted to buy furniture for the living and dining rooms with their extra earnings and the tax refund they received from the President’s tax cuts. John had his eye on a new 52 inch LCD TV for the family room. With their cash savings they were able to pay cash for the LCD TV. But the furniture was too expensive. Terry didn’t want to wait. The furniture store offered them an attractive financing package that made the purchase tempting. John was hesitant, but he found it hard to say no. After all he had gotten the new TV. How could he say no to Terry’s desire to furnish an empty living and dining room? The furniture payments wouldn’t start for another two years. When they kicked in, it would add another $360 to the monthly budget. By then they hoped they would have enough cash in the till to pay down the loan and reduce their payments.

If the overtime kept up and business at the restaurant remained strong, they would still be able to handle the additional payments when they were due. However, the overtime and weekend tips were now a necessity. Without them there would be very little left over in the budget at the end of the month. But that was a worry for another day. Right now times were good and 2003 ended up as a memorable year. A new home, a new car, new furniture, a new LCD TV – what else could a couple ask for? This was living the American dream. John felt good enough about his new job. With a major new development going in, the overtime pay would continue. That Christmas he bought Terry a set of diamond earrings on credit. Terry wanted to make this Christmas special for John. She had her eye on the home entertainment system that would be the perfect compliment to the new TV. The system cost more than $2,500, so she charged it. Terry figured that her tips would enable her to pay off the credit card within a year. That year's Christmas was one they would never forget. The $4,000 in new credit card debt would be a monthly reminder.

The Wheelers Feel the "Pinch" in 2004

2003 ended well and the couple was hopeful that 2004 would bring more of the same. John’s overtime continued and Terry still made $500 or more in tips on weekends. But in March they got a bit of a shock. Last October their mortgage payment went up by $100 a month after the bank raised their mortgage interest rate from 3% to 3.5%. They had expected an increase, but were a bit troubled after the mortgage company raised the rate another half a point. Their adjustable rate mortgage adjusted every six months, but they were assured by their realtor at the time of purchase that interest rates would remain low. They were now paying 4%, which was still less than a fixed rate mortgage, but the rate hikes had increased their monthly payments by more than $240 a month. Terry was also beginning to complain about the cost of groceries and the price of gasoline. It now cost more than $56 a week to fill the tank of her new Ford Explorer and the weekly grocery bill had risen by more than $20. Their property tax bill went up in April and they also were paying more on monthly utilities. These were all small things, but they were starting to add up. John and Terry still managed to put aside $150 a month, but it wasn’t as much as they hoped for.

The monthly credit card payments were now over $120 a month and over the last year they found themselves buying more things on credit. They bought a portable barbeque and new patio furniture in the spring. Terry really wanted a spa for the backyard. The backyard was too small for a swimming pool, but the pool company could build a nice spa and waterfall in the corner of the yard for $15,000. Their credit card balance was now over $8,000, so charging it was out of the question.

John called their realtor who suggested a home equity loan. Houses in their neighborhood had been appreciating by more than 2% a month. The realtor told John their home had appreciated by more than $100,000 over the last 15 months. John took the realtor’s advice. Their home's appreciation made John and Terry feel richer. They now had more than $125,000 in equity, which was hard for them to believe. Terry wanted to put in the spa by summer. Besides the new spa, Terry also had her eye on a new bedroom set. The furniture store had been running sales every weekend. A new bedroom set would cost more than $12,000 and John wanted another TV to fit in the armoire. John called the mortgage company, figuring they would need about $35,000 to pay for the spa, bedroom set, new plasma TV and pay off their credit cards. John found it absolutely amazing how easy it was to get credit now that they had become homeowners. Getting credit had never been this easy. Buying their new home had been the best financial decision they ever made.

During that summer John and Terry took their first vacation since their honeymoon. Carnival Cruise line was offering a package tour of the Mexican Riviera for only $2,500. It was bit expensive, but with their credit card debt paid off and their home continuing to appreciate, John felt they could afford to charge it. They came back from their vacation refreshed. Terry was pleased with some of the purchases they had made in Mexico. There were new pots for the back yard, knickknacks for the family room and beautiful silver jewelry for Terry. The purchases had set them back another $1,000, which they also put on their credit cards.

It all seemed affordable especially now since their home kept appreciating. Their combined mortgages was $525,000. That was more than the original purchase of their home. But the way John figured things, they were still ahead. A call to his realtor had reassured John that things were okay financially. Their home was now worth more than $625,000. Even though their debt balances were larger, they were still ahead by almost $100,000!

They were living the good life. John’s overtime continued and Terry still made good money at the steakhouse. The couple were thrilled with their new home. Terry loved all of her new furnishings and John was considering adding a covered patio off their family room. It would provide the shade they needed to cool the house down from the summer heat. A call to their mortgage company provided the needed cash. John got the $7,000 he needed to put in the new patio cover and Terry wanted to replace the family room Venetian blinds with wooden shutters. John asked his mortgage broker for a $22,000 loan. That would give him enough money to build the new patio cover, put in the family room shutters and pay off their credit cards.

At summer's end, their credit card balance was back over $5,000. There was always something that came up each month and there never seemed to be the extra cash around to pay for things. It became easier to charge things. John and Terry had not realized it, but charging things each month had now become a way of life. Terry complained about their grocery bills. Costs seemed to be going up everywhere and their grocery bill had gone up by more than 40% over the last three years. Her last office visit to her gynecologist cost her $80. A trip to the dentist to get her teeth cleaned cost $58. Prices were going up everywhere and it was beginning to pinch their budget. In October of 2004 the mortgage company raised their mortgage rate by another half a point to 4.5%. John complained to his mortgage company, but the broker told him that his variable rate mortgage was still cheaper than a fixed rate loan.

John was getting worried. Their mortgage payment was now over $2,500 a month. Property taxes on their new home were going up along with their mortgage payment. Taxes and insurance now added up to $600 a month. In addition to their regular mortgage, they now had a $47,000 home equity loan. This cost them an additional $200 a month. Add in the $75 minimum payment for their credit cards and it all was starting to take its toll. Making matters worse was the fact that their home equity payment went up almost every month. Not by much, but enough to irritate John. The bank told him it was because the Fed was raising interest rates. The home equity loan was tied to the prime rate. When the prime rate went up, so did John’s monthly payment. John didn’t understand economics, but he began to understand that every time he saw Alan Greenspan on TV, it meant his mortgage payments were going up.

Although John and Terry were still happy, they found themselves arguing more over money. The end of each month left them in a tight spot. They stopped going out to movies every Sunday. Out of necessity they both decided it was best to stay away from the shopping malls. Terry tried to save money on groceries by using coupons and buying more household cleaning supplies at Wal-Mart. These were small changes, but they helped to balance their budget. John’s union had negotiated a pay raise and his boss still needed John to put in the overtime. They were thankful for their new home and good fortune, but by year-end they both agreed to pull in their horns at Christmas. They managed to get through the Christmas season by adding only $1,500 in new credit card debt. There wasn’t enough in checking at the end of the month to pay for discretionary luxuries. The difference was made up with credit cards. The cutbacks that John and Terry had initiated made the budget balance each month, but there was very little left for unexpected expenses – a trip to the dentist, new tires for John’s truck or simple repairs around the house or birthday, anniversary or Christmas presents.

When John and Terry added up assets and liabilities at the end of 2004 they were still on the plus side. One of their neighbors had sold their home for $650,000. It was the same model as John and Terry’s. Their realtor told them that their home might be worth a little more with the patio and spa addition. Although their mortgage and credit card balances had increased in 2004, they were able to upgrade their home with new shutters, a spa and patio. Terry was happy with the way the house looked, so John anticipated no new expenditures for 2005. If the house continued to appreciate like it had the last two years, it would more than make up for the difference in mounting credit card bills. They looked forward to the new year with all of their major expenditures now behind them. The new home construction market was still strong in San Diego. John’s only worry was Alan Greenspan’s frequent appearance on the evening news. That meant higher interest rates and John worried what would happen in March when it was time for another mortgage adjustment.

J. Gordon Grecko  – Fortune's Friend

What John and Terry could not know as they began 2005 is that approaching financial and political storms would soon impact them in a personal way. Events in Washington, a crisis on Wall Street and an escalation of the war in the Middle East would push them to the brink of insolvency. John knew that when Mr. Greenspan spoke, bad things happened to his monthly budget. He and Terry were about to find out about another man – J. Gordon Grecko – who would have an even deeper impact on their mortgage payments. Terry knew of Gordon Grecko from watching entertainment programs. Terry knew he was fabulously rich and had had many glamorous wives and well publicized divorces. Heir to a publishing fortune, Grecko had made his own fortune on Wall Street by running one of its most successful hedge funds. John and Terry knew little about what Grecko did for a living other than he was very rich and had a beautiful wife.

The only reason Terry knew his name was because Grecko was a publicity hound. Grecko found that his patrician background and the publicity helped to open doors – especially when it came to obtaining credit from investment banks. Grecko was a bright star on Wall Street and everyone wanted to rub shoulders or be in business with Grecko. Grecko made money as easily as the Fed expanded credit. Grecko could have been another trust fund brat, but he had inherited his father’s brains and ambition. He had gone to Yale and then on to Harvard for graduate school. Grecko found he had a gift with numbers and finance. After graduation there was only one outlet for his ambition and that was Wall Street.

The senior Grecko had sold the family publishing business, which freed him to pursue another ambition in politics. When the senior senator from New York retired, Grecko senior stepped into his shoes. It had been an expensive election, but easily handled by a family fortune that numbered in the billions. Grecko’s political connections were helpful in opening doors, but Grecko junior’s talent and smarts were what landed him a job on Salomon’s bond desk. By the time Grecko arrived on Wall Street, the staid and predictable bond world was pulsating with change and opportunity. There he found a man who would change his life forever. John Meriwether was a rising star at Solomon and Grecko was only too happy to become one of Meriwether’s protégés. Under Meriwether’s tutelage, Grecko learned the intricacies of bond arbitrage. Bonds trade on mathematical spreads. The riskier the bond, the wider the spread  – hence the greater the difference between a bond’s yield and a similar yield on risk free Treasuries. These rules are the bible of bond trading. They are responsible for creating a matrix of different yields and spreads on debt securities around the globe.

What Grecko learned at Solomon and from Meriwether is that bond spreads would occasionally widen in a time of crisis. But if you had the staying power to ride out the storm, spreads eventually narrowed and reverted to the mean. The key was staying power and that meant having plenty of access to credit. Access to credit was what allowed you to stay in the game. Credit was also what enabled you to turn nickels into dimes, dimes into quarters, and quarters into dollar bills.

Grecko had always been comfortable with numbers, but he learned to not trust them completely. The difference between him and the other quants on the bond desk is he had developed a knack for reading the economic tea leaves better than anyone else. It was what made Grecko's calls stand out and stand far above all of his peers. Grecko was developing his own style of trading. He preferred to make large macro bets. Once he understood the big picture, he relied on his models to refine his position. The success he was having at Solomon was also giving him the confidence to go out on his own. Eventually the bond dream team at Solomon split up. Meriwether set up his own shop at Long Term Capital Management. With his mentor gone, it was time to set sail on a new course and begin a journey that would make him both famous and infamous at its end.

Wall Street was changing rapidly during the 1990s. The Fed was creating vast sums of credit and much of it was making its way to Wall Street. Large sums of money were pouring into mutual funds. The public was coming into the market in a very big way. The catalyst had been lower interest rates, which made the returns on fixed income investments seem less attractive. Deregulation was in the air, making it easy to get into competitive businesses. Banks were becoming brokerage firms and brokerage firms were becoming banks. With governments borrowing vast sums of money, the debt markets exploded exponentially.

Grecko Makes It Big

There was also a technology and communication revolution taking place and it was revolutionizing the street. Better information, faster data feeds, and instantaneous communication moved markets at lighting speeds. There was talk of a new era and Grecko was capitalizing on it. His family name and reputation put Grecko on a first name basis with many of Silicon Valley’s CEOs. He was connected with all of the movers and shakers in the markets, whether it New York, Washington, or California. While his mentor at Solomon focused his fund on debt markets, Grecko was consumed by technology. To Grecko technology was the big picture. His hedge fund stayed focused and concentrated its holdings in the technology sector. Being well connected provided him with access to the numerous technology and Internet IPOs. His fund was making a fortune. His own net worth and reputation grew as he added additional zeros to his net worth.

Grecko was glad he stayed focused on technology. Too much money and credit were making the bond market unstable. Signs of stress were visible in Asia. Grecko unwound his bond positions at the beginning of the year and concentrated his positions mainly in technology with smaller bets in healthcare and financials. He was glad he did. The Asian tsunami finally hit the credit markets in the summer of 1997. Grecko was relieved he was out. The next year he noticed that credit spreads continued to widen and remained mostly out of the debt markets. That single decision saved his fund. Instead of debt, he had loaded up on Internets taking a sizable position in Amazon.com and AOL.

By 1999 Grecko’s own fortune made the Forbes 400 list making him one of America’s wealthiest individuals. But the market was getting too frothy for his own comfort. Some of his technology holdings would double in a month only to double again the following quarter. He began to see that the party was soon coming to an end. That summer the Fed had embarked on a series of interest rate hikes. Grecko knew that would eventually mean pain for the markets and the economy. That summer he began to quietly unload the fund's technology holdings and moved into cash and short-term bonds. It was a good call. The fund ended the year up with a 70 percent return, keeping pace with the NASDAQ and making his clients as well as himself happy and wealthier.

Grecko Makes His Millennium Mark

Grecko turned even more cautious in 2000. He stayed out of the markets even though the NASDAQ kept climbing to even greater heights. Instead he began to gradually build up his bond positions, figuring by summer the Fed would be through raising interest rates. Once again his instincts had proven to be correct. Stock prices were falling; the economy was slowing down, and a presidential election cycle was starting to heat up. Markets hate uncertainty, which is why Grecko remained out of the markets. He continued to build the fund's cash and bond positions. Grecko stayed focused on treasuries throughout all of 2000 and 2001  – a position he held until the end of 2001. After the attacks on 9/11, the Fed injected massive amounts of money into the credit markets. Greenspan was slashing interest rates with a fury never seen before. The money supply was growing at double digits. Never before had the Fed created so much money and credit out of thin air.

Money and credit began to flow everywhere. Interest rates fell to half century lows. For Grecko, that meant it was time to change strategies. It was an easy time to obtain credit. For his hedge fund that meant it was time to leverage up and look for bigger arbitrage opportunities. J. Gordon Grecko returned to what he had learned at the Solomon bond desk. The fund began to leverage up its portfolio. Grecko’s name, reputation and his father’s position in the Senate had the investment banks lined up at his door handing out cash. His reputation for accurate market calls had the investment banks believing Grecko printed his own money through higher returns. By the end of 2002 his fund was leveraged 20-1. By the end of 2003, leverage had increased to 30:1. The fund continued to move into higher risk positions. With interest rates falling and hedge funds multiplying like rabbits, arbitrage opportunities were getting harder to find. This made it necessary to take the fund's leverage position even higher and move even further towards the tail end of the curve. By the end of 2004, leverage in the fund was approaching 40:1. That year profits in the fund were $6.4 billion. To put that in perspective, that return was more than what Caterpillar made selling earth moving tractors and trucks. It was more than Sears made selling washers, dryers and tools. It was enough money to put Grecko’s fund on par with another cash flow machine: the energy sector. The funds profits put Grecko in the same league as big oil.

The fund made that money as a result of two decisions; a correct call that credit spreads would continue to narrow rather than widen and long-term interest rates would head down rather than up. Those two correct decisions, combined with leveraging up the balance sheet, made the fund a fortune that year. The brief hiccup in interest rates in April and May made the firm's creditors a bit nervous. Grecko reassured them. As interest rates came back down again, investment banks opened up their checkbooks and virtually gave the fund a blank check. By the end of 2004 the fund's balance sheet carried over $150 billion in debt  – debt that was tied to every major investment and money center bank on the Street.

While a few of the fund's traders were beginning to get nervous with the leverage that the fund was taking on, they had absolute confidence in their boss. The amount of leverage was sizable, but it paled by comparison to the leverage and the derivative books of the major money center banks. The growth in credit derivatives was explosive. In the last fifteen years, the derivative book at major money center banks had grown from a paltry $10 trillion to $90 trillion by the close of 2004. Interest rate contracts made up the bulk of those contracts (87%). Five commercial banks held 95% of the notional amount of derivatives in the commercial banking system. Most of these contracts were illiquid. Over 92 percent were OTC (over-the-counter) related. Only 8% were plain vanilla type contracts that traded on the major exchanges. Piedmont Bank was the largest player on the street. They insured and backed almost everybody. BankUSA was second and CitiStreet came in third. These three players accounted for 90 percent of all derivatives in the banking system. They lent to and insured everybody.

Grecko knew all the major players at each of the banks. He played golf and tennis with most of them. Each one of the banks had a major stake in Grecko’s fund either directly through credit or as counterparty to the fund's derivative plays. It was a close and chummy group. In many ways, it was incestuous. Everybody had a stake in each other's business either through credit lines or hedges. The close relationship between all of the players is what created the risk.

Grecko ended 2004 with a complete assessment of his risk aggregation, breaking down his fund's exposure according to counterparty. Theoretically, things were supposed to be hedged with everyone protected. That was theory  – not reality. Derivatives allowed you to hedge a risk, but not eliminate it completely. In essence risk was never eliminated. It was simply transferred to someone else. The hope was that that transfer of risk ended up in stronger hands. Counterparties to a derivative transaction were protected by their collateral. The collateral held up only as long as no one big failed. In the case of a failure of a major player, each one of its counterparties would attempt to sell out their positions. The problem arises when everyone sells at the same time. When everyone sells, the value of collateral backing each transaction evaporates. In the case of failure of one counterparty, the effect would be to leave the other counterparty naked; holding only one side of a contract when the other side no longer existed. When this takes place, each counterparty rushes for the exit gate at the same time. This is equivalent to a bank run. Markets can lock up and in extreme cases cease to trade at all.

The possibility of a lock up was the least of Grecko’s worries as he planned his strategy for 2005. He continued to believe that long-term rates would continue to fall and bet that that the 10-year note would fall to 3.86% by spring. By February his confidence was growing that his call was correct. The 10-year note had fallen to below 4% by the second week of February. He was also betting that risk spreads would continue to narrow. He intended to use even greater leverage to counter lower spreads. It was what he had learned from Meriwether. It was the leverage that turned the nickels and dimes into quarters. However, spreads were thinning and borrowing costs were going up with each Fed rate hike. The fund started to move further out on the risk scale shorting swap spreads. Swap rates were a fixed rate that banks, insurers, and major investors demand in exchange for paying the LIBOR rate, a short-term bank rate. The problem with LIBOR rates is that they are variable and it's difficult to determine where they will go in the future. By using derivatives Grecko had taken the fund's leverage to the extreme. With arb opportunities thinning out, the solution was more debt. The combination of debt and derivatives is what enabled the fund to turn its dimes and quarters into dollar bills. By early spring the firm’s derivative book had grown fourfold. Leverage had grown to the highest level in the firm’s history. Grecko’s firm, WedgeBook Partners, had $20 billion in equity, $150 billion in debt and controlled assets of $1.5 trillion.

Grecko's WedgeBook Partners Turned Fractions Into A Whole Lot of Money

While WedgeBook had become one of the major players on the street, their risk exposure was small in comparison to its creditors. With the average investor out of the markets buying real estate, the financial markets had become the exclusive domain of the big boys – the money center banks, hedge funds and investment banks. John Q had abandoned his mutual funds in favor of real estate investing. The retail end of business had become so slow that investment banks were laying off their staff of technical and research analysts. Nobody was interested in long-term investing anymore. The money was made by trading. Using leverage allowed you to get more bang out of each trade. It was what multiplied fractions and turned them into whole numbers. The markets had become the exclusive playground of the rich and powerful and Grecko was one of its big players.

By the end of March the fund was going further afield. WedgeBook had become a major player in the Russian debt markets. However, even there spreads had narrowed considerably. By late spring Russian sovereign debt yielded no more than 200 basis points over Treasuries.

In addition to narrowing credit spreads, short-term borrowing costs were continuing to rise. The Fed had raised the federal funds rate at its March FOMC meeting. The notes accompanying the meeting indicated that further rate hikes were on their way. This presented a problem for the fund. The yield curve was beginning to flatten. Borrowing costs were going up, while the returns offered on fixed income securities continued to fall. This impaired profits. The firm's computers were failing to find opportunities. Grecko needed an edge and a call from Piedmont provided the answer. With short-term borrowing costs rising and long-term fixed returns falling, the fund needed a cheap source of capital. Piedmont suggested selling gold bullion. Gold lease rates had fallen dramatically with one year rates no more than 20 basis points. Gold had continued to trade within a narrow $20 trading range for the last three months. The dollar was rallying, which would keep gold in check. As the stock market struggled with each new Fed rate hike, money was pouring into the Treasury market. This lowered interest rates and raised the value of the dollar. The Piedmont suggestion of selling bullion made sense. WedgeBook sold 100 tons of gold short at $420, thereby netting the fund an additional $1.3 billion.

Gold continued to trade in a very short range throughout most of the spring and the fund continued with its gold short sales. By summer WedgeBook had sold short by 500 tons and net more than $7 billion, which was redeployed into higher returning investments. By summer the firm’s portfolio was looking more exotic. It showed just how difficult the markets had become with nickels and dimes harder to come by. Almost half of the portfolio was made up of junk bonds and emerging debt. Nearly one-third consisted of interest rate swaps with the balance of the fund in everything from energy shorts, equity pairs, and foreign currencies, to long and shorts on various indexes. The most profitable trades had been the precious metal shorts. In addition to the gold short sales, the fund had also begun to accumulate a sizable short in silver. WedgeBook had sold over 20,000 contracts short silver when silver had been above $8. The precious metal shorts were accounting for most of the firm’s profits this year. By late spring and early summer the fund was printing money again. Its clients were pleased with their mid-year report, which was already showing double-digit returns.

The Perfect Financial Storm Brews and Breaks

Returns on the fund reached their peak in early July. From that point forward it was all downhill. By the end of August, the financial and political world began to take on a life of their own. A series of events were about to unfold that would shake the markets to their very core. The collapse of WedgeBook and the near bankruptcy of its creditors would be one of those events. The other storm was in the  Middle East and an unexpected event here at home. But for now those events were far away. As summer set in, Grecko was in the mood to relax. He decided to spend a few weeks in Europe in July. August would be spent at his beachfront mansion in the Hamptons before his return to a robust schedule in the fall. Before embarking on his trip to Europe, Grecko reviewed all of the firm’s positions and felt comfortable with most of them. Credit spreads had started to widen again, but the firm's profits were large enough to provide a comfortable cushion. Gold and silver lease rates were flat and as along as they stayed that way, with the metals trading in a narrow range, Grecko had no worries. Besides, the markets were usually dull during the summer, so he anticipated no major surprises. The trouble spots that would surface by the end of the summer were barely visible on the radar. Isn’t it always this way? A bomb is dropped, a president or archduke is assassinated or jet planes fly into a building, and suddenly a tinderbox is lit, a crisis erupts and the world suddenly appears different. At the moment, volatility continued to fall and as long as it kept falling ,the financial world remained stable.

The problem no one paid attention to is that debt levels had risen to unimaginable levels. The culprit was low interest rates. Double-digit bond yields were a thing of the past. With hedge funds multiplying like viruses, the only way to earn a respectable return was through the use of leverage. Hedge funds were resorting to borrowing to inflate their returns. It wasn’t just the hedge funds. The money center banks had leveraged their balance sheets in ways that were beyond description. The money center and investment banks were the real problem. They were the ones extending the credit. They were the insurers of last resort. In the world of derivatives where risk was passed around like a hot potato, they were the ones holding the bulk of the potatoes.

The investment markets had learned from the crises of the 90’s and this new decade that if things got bad enough, the markets could always rely on the Fed. In essence it was the Fed who stood behind the banks. If troubles emerged, they could always rely on the Mr. Greenspan. The Fed chief could be counted on when it mattered most – when liquidity evaporated and markets locked up. Greenspan would keep cutting interest rates until liquidity to the system was eventually restored. In following this familiar pattern, a moral hazard had been created that permeated most of Wall Street. Its major players knew that they could continue to move further and further out on the risk curve knowing they always had the Fed as a safety net to catch them if they fell. Greenspan had opposed any form of regulation. Instead, he praised the innovation and productivity of the financial markets. His opposition led to a lack of disclosure when it came to measuring risk. While most investors might be able to distinguish basic balance sheet risk, they were ill prepared and uninformed when it came to off balance sheet debt and completely befuddled when it came to derivative risk. If debt isn’t clearly shown or has been removed from most financial statements, most investors don’t know where to find it. In the case of derivative exposure, there was a gaping hole left from deregulation that had yet to be plugged. This hole widened each year with the derivative book of money center banks expanding exponentially.

The other unrecognized problem was measuring risk itself. On Wall Street risk had been defined as volatility. It permeated most trading rooms on the Street eventually becoming the Holy Grail of finance. It was as if closing prices each day meant something other than what they were. A closing price told you nothing about company's on and off balance sheet risk. Prices couldn’t forecast a firm’s derivative risk nor disclose the risk of its counterparties. All most traders knew or cared about was what the models told them. That fact that some future trade or price would deviate from the norm was considered a statistical freak. Rogue waves were viewed as infrequent events and something that their models had statistically eliminated. The problem with most of these models was that they were based on pure mathematics that imbued an air of certainty when in reality none exists. That was where the hubris lies. Just because you haven’t seen one recently doesn’t mean one won’t appear. There would come that one day where they would appear out of nowhere, without warning, undetected, taking the markets by surprise.

That is when dangers of leverage come home to roost. If you have no debt, you can hold on to your positions. You can’t be forced to sell and you won't go broke. Leverage gives way to the same brutal dynamic. It cuts both ways. It magnifies gains on the way up as well as multiplies losses on the way down. Yet for many on the Street including Grecko, they had become immune to risk as a result of the moral hazard. What Grecko had learned in his time spent on the Solomon bond desk was that you ride your losses until they turn into gains. If you had access to capital to stay the course, you would be rewarded in the long run. Grecko had that access, which is why the amount of leverage in his fund gave him little cause for worry. That confidence would be shaken before the summer’s end. Events were about to unfold in many unexpected ways in unexpected corners of the markets and in the economy. It wasn’t just Grecko’s world that would be shaken to its core, it was also the world of John and Terry Wheeler.

To be continued.

Jim Puplava

© 2005 James J. Puplava

Reference: OCC Bank Derivatives Report, 3Qtr 2004

StagFlationary Collapse:
Prelude to "The Greater Inflation"
Part 1 of an Approaching "Perfect Storm"
by Frank Barbera

Web Note
The following analysis and charts are hypothetical in nature, but are based on what was, what is, and what may be.

It is early 2005 and for several months, new orders for production have been falling. After a modest bout of Christmas spending, sales have slowed notably in February and March. Leading polls of consumer confidence show little appetite for taking on major purchases such as autos and major appliances. Used car prices have been falling sharply as cheap and easy financing under-pin a preference among consumers for new vehicles. In recent years, credit has been relaxed so that new cars can be bought with almost no down payment and loan durations spanning 8 years. This is in sharp contrast with the 20% minimum down-payments and shorter duration loans seen only 5 years earlier. In March, the latest reports on consumer confidence begin to deteriorate significantly falling 7 points on the Conference Board Survey, with forward expectations looking out 6 months even weaker. Rumors float that several ratings agencies are close to downgrading debt ratings on one of the major U.S. Auto-Makers, citing excessive debt levels on the corporate balance sheet. Bond prices continue a rally, which began at the beginning of the year, as 10 yields fall initially below 4% despite the fact that many top notch bond pro’s wonder publicly whether bond holders are getting fair compensation for extra-ordinary risks. It is also reported in March, that the Bank of Japan and Bank of China were still buyers at the recent 10 Year Bond Auction, recycling trade dollars back into U.S. Treasuries in the name of free and unfettered global trade.

At the same time, The Federal Reserve Board seeks to continue raising interest rates, with Fed head Alan Greenspan, moving the short term lending rate from 2.75 to 3.00% in April, citing a still healthy level of growth near 3.5% GDP, in an effort to “normalize” long term rates. With inflation running at 3.5%, real interest rates are still negative and for most fed watchers, the Central Bank appears “easy” in continuing a pattern of “accommodative” monetary policy. Nevertheless, amid weaker economic data and falling long-term yields, the 10 Year-2 Year spread has narrowed from 250 basis points to only 50 basis points representing a distinct flattening in the Treasury Curve. Unlike prior expansions, where robust employment growth and rising wages trigger a flattening curve, this recovery appears atypical in that growth is slowing while the curve is flattening.

Elsewhere, a report surfaces that the IMF may sell part of its gold reserves to help with 3^rd World Debt relief sending Gold prices down toward $415. An early report of Foreign Trade Flows shows that while 84% of January’s Treasury Sales were taken up by foreign central banks, the in-flow of $61.3 Billion was still sufficient to cover January’s Trade imbalance of $56.60 Billion prompting a mild dollar rally. In the United States, personal, corporate and government debt levels are running at never before seen record levels on both an absolute and relative basis. For many consumers, credit card debt payments chew up all remaining disposable income meaning that numerous households live paycheck to paycheck. Where the Federal Government is concerned, huge and burgeoning fiscal deficits have no end in sight as lower tax rates combined with huge foreign defense related expenditures and a slowly growing economy have created a fiscal “black hole”.

On television, “reality” shows dominate the ratings with a new show debuting in which contestants “day trade” technology stocks while being deprived of food and sleep. The winner after 12 weeks gets a million dollars, or 20% of the net gains on a mythical $1,000,000 portfolio, which ever is larger. Other reality shows seek high ratings by forcing contestants into life threatening situations for the chance to win $50,000, while yet another show pits college grads against high school grads to see who can outwit and outsmart the other.

Overseas, in an economy more globally linked than ever before, growth in China continues at a rapid clip as the Chinese Industrial Revolution continues to move masses from agricultural centers to urban centers. China’ s hunger for base metals and all forms of commodities continues to support sharply higher raw materials prices from steel and molybdenum to copper and nickel. Factories hungry from raw materials are manned by a labor force working at rates 1/10^th the wages seen in developed countries.

In fact, in some Chinese factories, it has become cheaper of late to manually haul goods around the factory floor using sweat labor, than to run conveyor belts, as conveyor belts guzzle valuable and scarce electricity. In the Financial Times, it is reported that Chinese GDP is growing at 10%, while in March, China announces the acquisition of a medium sized U.S. energy company, and a major producer of Canadian coal. In Canada, coal companies have been among the hottest stocks – many advancing by nearly a 1000% as Chinese demand strains Canadian export capacity pushing up prices to levels never before seen. In Pennsylvania, Hershey chocolate announces a 15% rise in all candy-bars, while Colgate hikes toothpaste by 15% with both companies citing higher fuel prices. Both Nestle and Procter and Gamble quickly match the price hikes.

In Winston Salem, North Carolina one of the last of America’s textile mills has just closed laying off 1500 workers. For many of these workers, the textile job has been a generational heirloom, handed down in some families for over 40 years. Strikingly, economic advisors to the President proclaim that the Ricardian principle of “Creative Destruction” is at work, with a new “modern technology” based work force replacing an outmoded manual labor force. The loss of manufacturing jobs is played down while overall job growth is applauded as healthy. One government economist notes that “afterall the Unemployment Rate has just dipped to 5.2%, a full employment condition”. Yet few economic observers note the continued shrinkage in the Labor Force Participation rate, which now ratchets down to a 17 year low, as more and more workers simply give up looking for jobs. Never before in America’s history has an economic recovery unfolded against the backdrop of a shrinking labor force. Tragically, few people seem to comprehend the altered nature of government statistics, wherein unemployed and under-utilized workers are no longer counted in the unemployment rate, which, in reality is much higher than the widely touted 5.2%. In fact, unknown to most, the “unofficial” unemployment rate stands closer to the rate seen in major European countries such as Germany and France, between 9% and 10%. At BLS, sneaky computer models mythically create jobs every month under the never discussed “Business Birth-Business Death Computer Model”, another disingenuous device never discussed by an uniformed media.

In the stock market, weaker than expected job growth along with weaker economic data is seen ironically, as a “Buy” signal. Stocks gather strength and rally to new and higher recovery highs, with bluechips pacing the advance. With Oil prices hovering near $48 per barrel, high quality energy stocks are the treatment of choice, spearheading the market rally along with makers of Consumer Staples, Basic Materials and Electric Utilities. Rotation has taken place within the stock market as high-flying tech leaders from 2003 have faltered, amid ongoing concerns of decelerating earnings growth and high valuations.

Amid ever deteriorating reports in the surplus of trade, the Dollar has taken solace from higher short-term rates, managing to extend its minor rally while at the same time pressuring Gold from $420 to $410. Gold Stocks, a leveraged bet on Gold prices, have been weak all year and are still hovering near multi-month lows with the XAU near 90. In movie theatres, a strange dichotomy persists between increasingly frightening movies and a renewed popularity in children’s animated films. On one weekends Box Office, the top movie is an X-rated Horror movie aside a “G”- rated children’s story. Meanwhile, China's Lenovo Group Ltd. announces it is seeking to acquire International Business Machines Corp.'s entire personal-computer business, that is, if the deal will clear U.S. national-security regulators.

As the first half of 2005 comes to a close, long-term interest rates have eased from 4.20% to roughly 3.75%, in the process restarting a minor wave of REFI Activity in the West and East Coast Housing Market. In San Diego, home prices hit new highs in Carlsbad, La Jolla and Rancho Santa Fe with many of the homes changing hands on no money down type deals. San Diego’s “Capital Trust Company” reports that “Interest Only” Loans - heavily laden with leverage account for 80% of all new mortgage loans. Yet, in Atlanta and Boston, prices have flattened out while in Chicago, high-end home values have actually declined. Home Building stocks attract more and more attention, continuing an incredible surge on Wall Street where they have been market leaders for the last three years. Several Wall Street brokerage houses reiterate their Buy ratings on Home Building stocks.

In Bond markets, corporate-treasury spreads and emerging market spreads have narrowed even further to record lows as the 2 year-10 year yield Curve has almost completely flattened after the Fed’s third one quarter point rate hike. In the equity markets, leading steel producers have been on rampage gaining almost 35% in the first few months of 2005, with large gains in Base Metals stocks on the back of even higher commodity prices. Both Kimberly Clark and Mead announce 12% price increases for paper products which are also on the rise relating to higher prices for wood byproducts. For the first three months of 2005, it is reported that Average Hourly Earnings were up just 1.5%, the slowest reading in 25 years. At the same time, a Time Magazine article notes record high prices for Beef, Gasoline and Cheese are squeezing consumer budgets. In Las Vegas, a burlesque style Adult Entertainment restaurant opens as the newest Hot Spot in town at the premier of a major new casino. 20/20 runs a story highlighting the love affair Americans have with gambling as Poker ranks high among new favorite past-times.

In China, relatively low rates of inflation have been heating up as overall manufacturing output has been maintained at robust levels. In May, China announces a joint venture with a leading Brazilian Iron Ore Producer and the acquisition of a major Argentine Cattle Ranch. With recent Consumer Confidence polls still showing a deteriorating trend in May, many retailing stocks have come under pressure. Whirlpool announces a second price increase in major appliances as spot metals prices continue to drive up manufacturing costs. Whirlpool also pre-announces a disappointing quarter with the stock falling sharply. Elsewhere, within the stock market, specialty retailers, department stores, leading auto-makers have all seen sales slow and stock prices recording 52 week lows. Separately, it is reported by the American Council on Consumer Interests, that Americans now work thru May in order to pay down their credit card debts which now average nearly $11,000 per household. Separately, it is reported that for 2004, aggregate wages and salaries in the U.S. rose only 2.4%, the slowest level in years and that for Americans in the lowest 20 percentile, income actually fell by nearly 2%.

Second Half 2005

In addition, within the stock market, many high-flying technology stocks have been in pronounced declines, warning of sales and revenue shortfalls. On the NASDAQ, the broadly based Advance-Decline Line is moving closer to 52 week new lows as the NASDAQ lags behind both the DJIA and S&P. Yet all is not gloomy in the stock market, the narrow index of Dow 30 Industrials has just made a new 4 year high at 11,500, and the S&P 500 is still close to 1220. A special CNBC broadcast airs featuring “The Resurgence of Commodities” while at about the same time, Gold Stocks begin to improve, with the XAU Index rallying toward 100.00 and spot Gold trading back to $450. In Peoria, Illinois, Caterpillar Inc., the world's biggest maker of earthmoving equipment, introduces a long-term plan in 2003 to expand in China. Caterpillar exports U.S.-made mining equipment to China and maintains joint ventures there to produce other equipment. The company announces it will build a facility in Qingdao to spur more product development. At the same time, the head of a major semiconductor contract manufacturer, announces that more production will be shifted away from New England and toward “lower cost facilities in Asia and Mexico.” Other semi-conductor contract equipment makers follow with similar announcements leading to a surge in total layoffs.

On the NYMEX, Crude Oil prices are still holding $44 per barrel but have weakened from levels seen earlier in the year near $50-$48 while Unleaded Gasoline prices are still firm with approach of summer driving season, trading near $1.55. With gasoline prices at near record levels, U.S. refining capacity remains strained at 95% utilization rates. In currency trading, the Dollar has been in a quite range as the rally in Treasury Bonds has enticed foreign central banks to maintain a high level of participation in U.S. Treasury auctions.

Around mid-July, second quarter earnings are announced and to the chagrin of many bulls on Wall Street, a full 52% of earnings reports fail to meet Wall Street estimates with many technology companies warning of cuts in capital spending, due to excess capacity and a “tough” pricing environment. Many tech CEO’s confirm that final demand world wide has turned very weak. At the same time, the Dow Industrial make another new high in July, this time non-confirmed by other indices like the NASDAQ and S&P. Suspiciously, financial stocks, along with transportation are all experiencing significant, if not, very sharp declines. A similar phenomena hits homebuilding stock which experience 2 months of crash like behavior. It is noted by one bond manager, that over 40% of the S&P profits now come from the “financialized” economy as CFO’s juggle funds in the arena of corporate swaps.

As mid-August approaches, early reports circulate from U.S.Traveler Magazine, that overseas tourism by Americans is down, a report echoed by poor “load factors” at major U.S. Airlines. Within the Airline Industry, it is reported that high fuel costs and poor available seat miles (ASM) have resulted in even bigger losses causing three time comeback kid, U.S.Global Airways to file liquidation laying off more than 25,000 workers. At this time, Challenger Christmas Grey announces that layoffs in general, are surging and are now near a three-year high. In a seeming contradiction, mythical government employment data shows “job growth” still on the mend. Taking heart for the payroll data, economists on a Blue-Ribbon panel continue to predict strong growth ahead. Yet for many individual families, a pattern of ever higher grocery receipts is colliding with falling wages and rising anxiety centered upon job security. In late August, leading Oil tanker company, Overseas Global Shipping notes that “day rates” have weakened significantly. This report dovetails with a sharp decline in the Baltic Freight Index, which in retrospect, has now been falling quietly for the balance of the last 4 months.

In Taiwan, a meeting is held in late August announcing the opening of the ACD Bond Market (Asia Cooperation Dialogue) (http://aric.adb.org/asianbond/index.htm) where bonds will be traded from member countries including China, Korea, India, Malaysia, Thailand, Singapore and Japan. Only days later, S&P announces that a major U.S. Auto Company has been downgraded from investment grade to junk while both Fitch and Moody’s maintain the thinnest margins of investment grade ratings. At Wal-Mart, a more vocal chorus is growing within the U.S. labor force to unionize labor as in Canada, a more pronounced movement toward Unionization has been heated for many months. On the LME spot-market, robust demand for Nickel and Copper has pushed prices to new all time highs with Nickel now trading near $9.00 and Copper near $1.75. In the August report for U.S. Producer Prices, high metals prices combined with high gasoline prices produce a sharp, uptick in inflation leading Bond yields to rise from 3.85% to 4%. At the same time, economic data in the U.S. shows the biggest decline in 17 years in consumer revolving credit, as domestic spending in the U.S. continues to show signs of slowing. In a number of U.S. cities, a trend is noted of high-end restaurants closing down as fewer people are eating out. Perhaps surprising to many, the U.S. Trade Deficit for August is announced at yet another record, -- despite the slow down of U.S. final demand. As a result, the Trade Gap now lurches toward 6% of GDP, an extreme reading associated with currency devaluations on a historical basis. On the Foreign Exchange market, the August Trade number triggers a sharp break in the Dollar exchange rate with the Dollar Index breaking below medium term support at 81.00. As the Dollar breaks below 81, long-term bond yields press back toward 4.10% with credit spreads widening out for the first time in many months.

In the stock market, U.S. Base metals producers Phelps Dodge (PD) and Inco (N) are on fire, moving to new all time highs as strong spot prices continue to drive record earnings reports. However, other companies are not fairing as well. The mid-August earnings report from Procter & Gamble shows disappointing results, as PG was unable to raise prices and noted that higher raw materials costs had cut into the quarterly bottom line. With the sharp decline in PG stock, and an increasing awareness of the renewed Dollar decline, confidence in stock prices has weakened, and with it, stocks have begun to fall sharply.

By late August, the S&P 500 has fallen into negative territory for the year, trading in the 1120-1140 area, down 6% from December 2003, while NASDAQ is now down nearly 16%, trading closer to 1850. Among technology stocks, semi-conductor companies are turning in some of the worst performances as major produces like Intel sport large and bulging inventories and report shrinking gross margins. At the same time, the quarterly Federal Deficit hits new record highs with some in congress beginning to discuss a reversion to fiscal conservatism. As Gold stocks have been rising in recent days, several Wall Street brokerage houses downgrade mining blue-chips citing excessively high valuations. The shares are unaffected and continue to trend higher.

In other parts of the U.S., angry labor groups form stating that exports to China, have contributed to the loss of 2.6 million manufacturing jobs in the U.S. since March 2001 and point out that the U.S. imported a record $195 billion of goods and services from China during 2004, producing a bilateral trade deficit of about $160 billion. Area’s most affected in manufacturing have been textiles, home furniture, appliance manufacturing, and automotive. Amid increasing trade tensions, the U.S. Export-Import Bank announces that it is rejecting in a final decision, Chinese Semiconductor Manufacturer, SMI Corp’s request for a $769 million loan guarantee to buy semi-conductor equipment from Applied Materials citing multi-examples of Chinese failure to respect intellectual property rights.

As September begins, the Dollar sinks ever lower, with the Euro moving toward new multi-year highs at $1.37, the British Pound at $2.10 and the Swiss Franc at 1.06. At home in the U.S., long term interest rates are now rising steadily with the 10 year Bond yield quoted at 4.50% Adding to the surge in long term interest rates, was a new report just issued by the TICS, Treasury International Capital Data (http://www.treas.gov/tic/)

showing U.S. outflows to Foreign Stocks and Bonds hitting an 8 year high. As the Dollar cascades to new lows, Gold prices firm quickly with nearby Gold contracts notching new multi-year highs at $465, while major gold producers rally strongly from depressed level seen earlier in the year. By the end of September, the XAU, the Philadelphia Gold and Silver Index is now up for the year and trading between 108 and 110, a gain of 9% for the year. In Toronto and Vancouver, shares of emerging exploration companies are performing even better with the TSE Venture Exchange Precious Metals Index up 20% in 2005. In late September, Chinese state owned conglomerates announce the purchase the largest Iron Ore manufacturer in Brazil and a 40% equity stake in a major silver producer. China also secures ownership of a large tract of Canadian Oil leases on the Athabasca Oil Sands.

Early October brings to light new Auto Sales data, showing dismal sales with volumes falling to the lowest levels in nearly 10 years. At the same time, Ford Motor Company extends its $2,000 cash back or New Dell Computer offer which had run earlier in the year by offering to throw in 4 free tickets to Disneyland and a new Nokia Cell Phone for every new car sold. For months, O% financing has been ineffective, leaving auto makers confronted with a sales vacuum. In the credit markets, Ford, the No.2 automaker in the U.S., is written up by Forbes which states “Ford wouldn't have made any money pretax for the last two years through 2003, were it not for its financing arm.” For Ford, slower sales cause credit spreads to widen across its entire 280 billion yield curve from 350 basis points to 550 basis points. On the stock charts, auto shares have now broken down below major support levels and are now sliding toward multi-year lows. In the same report, Japanese auto makers continue to increase their market share sparking anger among anti-outsourcing labor groups with several Japanese auto makers noting severe product shortages due to halted production in South East Asia where steel and nickel are in ultra-short supply. The dismal state of the U.S. auto industry is highlighted even further when ABC News reports that in China, a long running dispute between China’s 2^nd largest Auto Maker, Shanghai Automotive and one of America’s largest car makers has been resolved by allowing Shanghai’s subsidiary ‘Cherri Corp’ to knock off cheap $12,000 copies of American designed vehicles. At home, major auto related companies are bleeding red ink and announce the closure of facilities.

As 2005 draws to a close, trade tensions between the U.S., China, and Japan and between Europe and Asia are steadily on the rise. The U.S. Dollar is plummeting toward 1.40 on the Euro and Gold is now trading above $550. Gold Stocks finish the year as the Number 1 performing sector with the XAU above 135, while the S&P and the Dow both finish the year down 12% to 15%. On Wall Street, many are reflecting back on the poor performance in January as a leading omen of a return to bear market conditions in the stock market. Retail Stocks have been the biggest losers in the 4^th quarter as chain after chain of major retailers announce store closures and falling sales.

Yet domestically, prices in the U.S. are still on the rise for a wide range of raw materials and finished goods. At the same time, wage growth continues to decline with even bullishly bias government figures reporting an obvious retrenchment. Long-term interest rates have now been rising and finish the year near 5.35%, sparked by a lower dollar, rising import prices for Asian manufactured goods, and sharply higher costs for raw materials. By December, a clear picture of oversupply has emerged in virtually all formerly high-flying Real Estate markets with housing prices actually declining 10% to 12% in numerous markets. To sell a home in most markets now takes nearly 10 months leading some homeowners to cut prices in order to close a deal. Among major banks, a downtrend in earnings is observed as successive quarterly reports are accompanied by an increasing trend of “one time” charges. Invariably, these charges relate to residential real estate now in receivership from defaulted borrowers who overextended themselves when rates were very low and housing prices very high. At the Box Office, animated movies are falling in popularity with a new genre of Horror/Sci-Fi dominating new releases.

As 2006 begins, a second great bear market is beginning to unfold on a global scale. In Japan and Asia stock markets are already down 20% from their early 2005 peaks. Thru the fourth quarter, the Leading Index of Economic Indicators is now down 6 months in a row. In mid-January, 4^th quarter earnings are released with only 38% of companies meeting growth expectations while once again, technology shows surprising declines in final demand. In tech-land, a number of CEO’s discuss further cuts in capital spending and perhaps idling even more “spare” capacity with several more companies contemplating shuttering “high cost” manufacturing in the U.S., while maintaining production in the 3^rd world. Several high profile CEO’s resign due to the poor performance results. 

At the same time, foreign capital continues to exit the United States, where budget deficits remain at record levels. With the Dollar continuing to slide, long-term bond yields are now approaching 6.25%, and across the entire U.S. economy corporate earnings are falling sharply. Day after day, lower dollar values, trigger higher long-term bond yields and falling stock prices. Within the stock market, Energy and Base Metals stocks two of the former bull market leaders are now locked into major downtrends and down 12% to 15% from their 2005 highs. On the LIFFE, Baltic Dry Index futures in a sign of weakening global demand close below 2,200; the lowest levels seen since early 2003 and down nearly 60% from the early 2004 peak. Within the stock market, only the Gold Stocks gain ground feeding off bad news and a weaker dollar. The XAU crosses 165 and in the process scores a new all time high.

First quarter GDP is announced with a contraction of –2%, far worse than economists had expected. In the currency markets, the Euro is now trading at 1.60 to the Dollar with the British Pound at 2.65. Within the U.S., the congress is talking up legislation that will force China to revalue the Yuan or impose import tariffs on all Chinese manufactured goods thereby “creating a more level playing field in the arena of international trade”. On television, a new reality show debuts where angry homeless people are pitted against college graduates on a deserted island to see who can obtain food and survive.

In a case of being careful about what you wish for, the China responds with a 10% Yuan revaluation and a movement to a more “open and flexible” exchange rate. Sentiment runs high that trade imbalances will improve. Around the world, capital begins to flow into Asian currencies and Asian bond markets where daily trading volume is now steadily increasing. In China, the central Bank has been diversifying its reserve dollar portfolio, once over $500 billion by making direct investments in multi-national corporations, investing and/or acquiring a large number of U.S., Canadian and South American raw materials producers. Chinese interests take-over a medium sized Uranium producer in Chile. As the Dollar continues its downward spiral now near 70 on the Dollar Index, commodity prices continue to reach new and ever higher prices in what appears to be a “manic” blow-off type market.

At major credit card companies and other financing companies, delinquency rates are now surging toward a 10 year high. At the same time, personal bankruptcies are at record highs while mortgage defaults are surging as increasing numbers of unemployed workers find rising mortgage payments impossible to meet. With long-term interest rates now pressing 7.00%, a large U.S. automaker announces a multi-billion dollar quarterly loss with the stock plummeting. At the same time, other auto-makers see their share prices collapse with an index of auto stocks now trading at a 25 year low. With collateral impaired, with credit rating agencies downgrade of a variety of auto related debt to junk status. Both companies announce plans for more plant closures and further layoffs. Treasury Junk spreads, once at an incredibly narrow 200 basis point spread, have now widened out to nearly 800 basis points with one bond manager noting a substantial drop off in liquidity in both emerging market debt and nearby corporate SWAPS. At the same time, a major government sponsored agency see its shares come under heavy selling pressure, triggering major declines in the market averages as rumors circulate that GSE mortgage players are losing billions on their derivative hedge books.

Besieged by a flurry of bad news, the Dow and the S&P join the NASDAQ in under-cutting the August 2004 lows with CNBC anchors now openly wondering when the bad news and bear market will come to an end. In the Real Estate market, residential property values in many major cities, especially former boom towns on the East and West coast are now down more than 25% from their 2005 peaks. Yet, the news does not improve as American Consumer Confidence surveys plunge toward multi-year lows. For many, the decision to buy new homes with adjustable rate mortgages has proven a major mistake with the residential real estate market now falling sharply. Easy financing deals of all kinds, from homes to appliances have disappeared. Within the realty business, it is reported that sales have slowed to a 20 year low, and several new fangled mortgage finance companies which featured “reverse amortization mortgages and sub-prime loans” have recently gone broke. Several large home-builders are now losing money due to an increasing cost of carry on large numbers of projects started near the peak of the boom. Homebuilding stocks, leaders on the upside are now pacing the bear market decline. Ironically, one Wall Street analyst notes that as the group advanced with low P/E’s right thru the top, multiples are now expanding during the decline as earnings are falling faster than prices.

At Wal-Mart, many average Americans now join picketing workers who are seeking unionized wages in what is becoming a national boycott of foreign made goods. A new organization, “Americans for ‘Made In the USA’ purchases commercial air time on the major media networks exhorting U.S. citizens to take back their manufacturing jobs. Another bill is floated in congress which proposes building a 1,000 mile wall across the Mexican border to “put U.S. workers back on the job”.

Daily headlines are filling with job losses and poor earnings reports, as many companies find themselves in a profit squeeze, caught between higher material costs and falling final demand. Kraft announces price increases on all cheese and dairy products. Several U.S. economists suggest the economy is slowing down but note that growth rates should soon increase citing the wondrous benefits of globalization. Yet in the bond market, mechanical selling has become self-reinforcing stemming from “negative convexity” issues as many over-leveraged hedge funds are now frantically trying to unwind “carry trade” positions. The unwinding of the carry trade is hurting corporate earnings in a profound manner as for many companies, financial wizardry based on credit spreads supplanted product profit margins as a key earnings driver years ago. Panicky institutional selling is now pressing up yields despite poor economic data with 10 Year Notes pressing 7.50%.

Perversely, Gold, which was once thought of as “only” an inflation hedge, is now the only asset class building momentum to the upside as prices close above $700 for the first time in 27 years. Supporting the rise in Gold prices have been a series of announcements by several smaller central banks, including the Bank of South Korea and the Bank of Taiwan which have announced plans to add on gold positions to hedge reserve depreciation in their dollar holdings. Importantly, Gold is now advancing against all forms of paper money, showing excellent relative strength versus even “defensive” currencies like the Swiss Franc and Kiwi-Dollar. On the NYSE, a narrow group of Gold stocks now show high relative strength versus all other industry groups including base metals and energy, where share prices have been falling for a number of weeks despite still high spot commodity prices. As mid-year approaches, the XAU is still the sole market leader and is closing in on 200. In Canada, a conference on Resource Investment draws nearly 12,000 people into the Civic Center in Vancouver as many smaller exploration Gold stocks are making multi-year highs. One speaker, as widely respected metals analyst, predicts that Gold will soon approach $850, its former 1980 peak.

As the second half of 2006 approaches, stock indices have fallen over 20% from the early 2005 highs, and with many decrying a new bear market, a brief, but sizeable “summer rally” ensues. However, in the technology world, over-capacity has once again become a major issue, and with the release of poor second quarter earnings, CEO’s cite sliding productivity, a competitive pricing environment and weak final demand as components for a continued squeeze on earnings. Price wars between major companies both foreign and domestic have intensified.

In Asia and much of Europe, profit margins are also under intense pressure, causing many foreign manufacturers to begin “passing thru” higher prices in order to maintain stable profits. In the past, these manufacturers would often absorb higher raw materials prices as profit margins would remain high due to strong volumes in final demand. Yet, by mid 2006, massive change is underway and at the U.S. Bureau of Statistics, a three-month decline in the Index of Lagging Economic Indicators is seen as validating the start of a recession. Also around mid-year, China makes an open bid for a major U.S. energy producer Unocal, in a deal valued over $50 billion dollars.

On the U.S. consumer spending front, higher market related interest rates have had the adverse affect of pushing up already high credit card rates, and are cutting off availability of credit through the mechanism of home equity borrowing. The Result: total consumer spending has slowed sharply, -- a trend reinforced by higher import prices coming from Asia. In the latest Trade Deficit figures, new record deficits have been recorded despite a lower dollar and a slow down in overall U.S. consumption. Strangely, the typical trade correction seen through a lower currency appears absent in this cycle owing to the fact that lower levels of imports are now being entirely offset by higher prices being passed thru on imported goods.

With much of the U.S. manufacturing sector gutted in the 1990’s and early 2000’s, dependence of foreign production now looms as a major liability, forcing up consumer prices as higher ‘pass thru’ import prices have intensified the squeeze on real wages for most Americans. Declining purchasing power now reinforces the larger slow down in consumption.

In certain economic circles, it becomes clear that over the last few years, the industrialization of China and the full affects of globalization including development in Southeast Asia, Latin America and India, not only prevented wage increases for taking hold in many U.S. manufacturing and services businesses, but by creating far ranging outsourcing alternatives, crippled domestic job creation and with it, any chance of a genuine self-reinforcing economic recovery. By mid-to late 2006, slumping final demand in the U.S., stemming from an over-indebted, savings deprived, U.S. consumer is causing a high tide to roll in on the sea of global trade.

Asian producers realize that while higher prices will maintain current profitability, there is also a dawning realization that high prices have a limit, as they progressively reduce final demand. In Asia, lower overseas revenues result from higher pass thru pricing and translate into less capital available for the recycling of dollars back into American bond markets. Consequently, U.S. interest rates maintain a strong upward trajectory exacerbating declines in residential real estate and corporate profits.

In Washington, a new bill is introduced calling for 40% tariff on all Chinese imported goods should China fail to immediately allow the Yuan to move to a full floating rate mechanism, as trade figures continue to deteriorate despite China’s 10% adjustment. With growing bi-partisan support, the bill also criticizes China for patent piracy and multiple failures to protect and uphold U.S. intellectual property rights. At the same time, congressional sentiment steps up to block the formerly announced Chinese take-over of Unocal – citing regulatory issues. In Beijing, the burgeoning anti-Asian sentiment breeds resentment leading to a strong counter-statement criticizing the U.S. policies and condemning U.S. fiscal mismanagement. By late 2006, the National Bureau of Economic Statistics announces that a recession has not only begun, but has been in effect for the last 5 quarters dating back to the middle of 2005.

A bitterly cold winter in 2006, presses up Natural Gas prices which act as yet another dampening affect on consumer demand. By early 2007, bond traders are focused on U.S. Asia relations and almost exclusively upon the reports dealing with net inflows of foreign capital. At this time, large and unwavering twin deficits continue to pressure the Dollar forcing interest rates to move higher. Major residential Real Estate prices are now down by 40% in many markets sparking disbelief among commentators and fears of impaired bank loan portfolios. By now, stocks have already broken below their 2002 summer lows and led by a declining NASDAQ, more than 85% of all issues are now below their 200 day moving average. Gold prices are surging again, and closely approach $850. Within the market, even the once strong sectors of Energy and Base Metals are down 25% to 30% as money managers with big losses in technology and small cap sectors see these large and liquid holdings as a source of funds.

In April another discouraging TICS report is released, into an already extremely anxious bond market. The data show an even larger than expected outflow of foreign dollars leaving U.S. capital markets. Long-term rates shoot skyward with the Dollar Index breaking down below 60, plunging to yet another series of new all-time lows. At this point, 10 year Bonds are now yielding almost 9% and a full fledged currency crisis is afoot. At home, many economists now urge the Federal Reserve to push up short-term interest rates despite the “recession” in order to stabilize the Dollar where stability is seen to be of paramount importance. Around Fannie Mae, rumors swirl of massive hedge-book related losses wiping out all of the companies equity and triggering a massive sell off in GSE debt. It is feared that several large hedge funds are also in dire straits offloading bonds into every rally.

On the Comex, Gold is in a runaway advance, now seen as the only currency which cannot be devalued. Gold Stocks are exploding in parabolic fashion with developmental “non-producing” companies leading the advance as ‘hot money’ justifies even higher valuations for these stocks based on the idea that in future years, even higher gold prices will accrue a greater premium to their undeveloped assets. The XAU hits 265.00 and on the Canadian Exchange, daily volume now exceeds NASDAQ volume, with many junior mining companies up over 1000% in the last 12 months while exhibiting huge percentage swings on a daily basis.

For the Bond market, higher Gold prices, and shrinking foreign demand continue to leave prices locked in a steep downtrend. Forced liquidation of over-leveraged hedge funds is exacerbating the decline with long term yields now spiking toward 10% and then 11%. As rates spike, shares of a major auto company collapse under $2.00 on news it will be filing for bankruptcy protection. Headlines dominate the news as mass firings are announced at a number of companies and financial institutions which are upside-down on their loan portfolios. Gold Stocks come off the high with a serious “correction” as the XAU pulls back to 225 from 265.

Seeing the sharp rise in long term yields and collapse of major automakers, heavy margin related selling begins to unfold in the stock market with the Dow sliding over 200 points, 6 days in 7. At 5,500 many fundamentalists believe that the Dow is looking cheap as price to dividend yields are moving closer to historical means. On the flip side, the XAU is now once again rallying moving back up toward its former high near 260, up nearly 300% in two years. Yet, selling pressures abound in the stock market and when rumors of a major derivatives problem at a major bank hit the floor, sellers panic and deluge the market. Soon after, news hits the wires, that foreigners are withdrawing massive amounts of capital from U.S. Banks, a that several large hedge funds are in trouble. The Dow spirals lower, collapsing over 1,000 points in a single day. As the great crash develops during the course of the day, sellers are in full control and are seeking to remove capital from risk at any cost.

Stocks of all types are sold off furiously and even with Gold prices moving up toward $1,500 an ounce, gold stocks are sold off with reckless abandon as the XAU collapses by 100 points; down nearly 36% in a single day. At just over 4,000, the Dow and other blue-chip stock indices are now down 70% from their 2005 highs. For the S&P 500 and NASDAQ, 1993-1994 levels have been revisited with the S&P index closing near 350, while the NASDAQ finished below 700. NASDAQ is now down 75% from its 2005 high and an amazing 87% from its secular peak in March 2000.

As stocks of all types collapse, bond traders recognize the tremendous deflationary affects inherent in a falling market, rationalizing that a negative wealth affect will completely dampen consumer spending and at the same time, import price inflation. Commodity prices are collapsing with copper, nickel, zinc, crude oil and natural gas all down substantially from their 2005 highs and the CRB near 230, its early 2003 low. Adding to the bearish overall tone is the further collapse of Residential property markets where some area’s now report no bidders, and home values down over 60% from the 2005 all time highs. In many areas, homeowners with no equity have simply walked away their properties handing back the keys and filing personal bankruptcy. As a result, while stocks crash and commodity prices tumble, bond prices rally sharply in a historic “flight to quality” move sending long term yields down to 7.80%. Nevertheless, great damage has been done, as losses from the surge in interest rates are now feared in the hundreds of billions of dollars, dwarfing the Savings and Loan Crisis of the early 1980s.

As the market collapses throughout the day, the financial crisis becomes the only news story seen on T.V. Around the world, nervous individuals head for their local banks and begin withdrawing funds. A massive bank run develops as ordinary individuals succumb to the fear of a building financial panic. At gas stations and supermarkets, supplies and shelves are almost empty, as individuals have rushed to spend money on food and gasoline. As the smoke clears for the first great stock crash of the new millennium, the stock exchange is closed, and a national bank holiday is declared. Declining asset values have impaired banking system finances with a major derivative crisis now dominating the headlines. In many foreign countries, markets and banks are also closed as the derivatives crisis has caused the global financial system to seize up. Shortly, it is announced that Federal Reserve, the White House, and the entire G-10 committee will be meeting non-stop during the banking holiday in order to broker a global “bail out” arrangement. As the ministers arrive in Washington, there is a hostile atmosphere, rife with protectionism.

Amid growing threats of riots, after 3 days, limited ATM service is restored allowing individuals to withdraw up to $100 to meet short-term needs while banks remain otherwise closed. On Day 10, amid great anxiety, the President, Fed Chair and a panel of G-7 representatives announce that the Bank Holiday is over. To stabilize the Dollar and stimulate domestic savings, U.S. short-term interest rates have been hiked by 5% full percentage points such that the Fed Funds Rate now stands at 7%. In addition, several new international bank mergers are announced, with a large Japanese bank acquiring a major U.S. Bank, and a large European Bank acquiring a second U.S. Bank. Insolvent hedge funds are unwound and merged by the Federal Reserve. It is announced that markets will soon be reopened and that the IMF Reserve Fund will be used if necessary to stabilize global financial markets by ensuring market liquidity.

Frank Barbera

© 2005 James J. Puplava
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