Disconnection: The US Financial System Morphs Into Wonderland

Sun, Sep 14, 2008 - 11:00pm
“It would be so nice if everything made sense for a change.” – Alice (in Wonderland)

Presidential election years are always a strange brew of unusual economic events, but this year has raised the bar to an entirely new level. A series of disconnections have left many scratching their heads, but expect them to continue, at least until Election Day. Let’s look back over the last few months in “Wonderland.”

The dollar, without fundamental legs to stand on, has vaulted higher in near vertical fashion, wreaking havoc on all commodity-based assets around the world. The Fed has been forced to lend out nearly 60% of its balance sheet to keep the banks solvent. The US trade deficit is on track to be over $800 billion this year and the budget deficit could soar to $500 billion, counting small off-budget items such as the Iraq War. The credit crisis is exploding on Wall Street, while Main Street deals with a deepening recession. However in Wonderland, the dollar presses ever higher.

Precious Metals Conundrum

Physical gold and silver have grown scarce among dealers around the globe. Delivery delays and high premiums are common, from New York to London, from Dubai to Mumbai. According to Swiss bank UBS, the world’s largest gold bullion trader, “Physical demand continues at a record pace.” At the very same time, the paper prices of gold and silver have plunged, along with the stocks of the entire gold and silver mining industry. UBS notes that “huge liquidation of long positions on the Comex and OTC markets have been the major reason for the fall in gold prices.” Customers world-wide are paying large premiums for an asset that has been plunging in price. Extremely curious.

Hurricanes in the Gulf no Problem for Oil Prices?

Last Friday, Hurricane Ike barreled into the Gulf of Mexico, a massive storm 600 miles across and headed for offshore oil rigs and large refineries along the Texas coast. During the day the price of oil drifted lower, ending at just over $100 per barrel. According to Reuters, fifteen U.S. oil refineries with a total capacity of 3.861 million barrels per day are now shut down in the aftermath of Hurricane Ike, the U.S. Department of Energy said on Sunday. In addition, 30 major natural gas processing plants with a total capacity of 14.55 billion cubic feet per day are closed in the Gulf of Mexico, including plants still impacted by Hurricane Gustav.

Many rigs will need weeks, in some cases months, to get back to full production. On Monday, oil continued to drop after refineries escaped with less damage than expected, ending the day around $94.00 a barrel. If heavy damage was expected on Friday, why did the price of oil not launch higher in Friday trading?

Perception becomes Reality

Senior Energy Analyst Charles Maxwell at Weeden & Co was recently quoted in Barron’s. Maxwell, 76 years old, was asked about the expectation that oil was heading for $75 a barrel. “It is the perception that really is changing, not the true value of oil throughout the system. The perception change involves whether we are going to move into an era where oil supplies will be generous and easy to find, and therefore relatively cheap - or whether those supplies are going to be closed off for both political and geological reasons.” Maxwell, a veteran analyst since the 1960’s, thinks oil is heading for $300 a barrel. For the short term, perception becomes reality.

"In these most troubling of times, oil does not appear to make the cut as a safe enough haven," said John Kilduff, an analyst at MF Global, in a research note. So the US dollar has become the perfect safe haven for these “troubling times.” Even the White Rabbit himself would find this most curious.

Black Is White, Up Is Down

As Fannie Mae and Freddie Mac are nationalized and become wards of the state (at a cost of $300 billion or more), the Federal government's balance sheet takes on another 5 trillion dollars in debt. This is apparently great news, as the dollar continues to move up dramatically. The markets must believe this and other bailouts to come must be good for the dollar. However, without foreign capital flowing into our Treasury in much larger amounts, how will the government pay for all this largess (and the largess yet to come) short of printing massive amounts of dollars? For the moment, who cares, when up is down and black is white?

The Grand Plan in Wonderland

Even in Wonderland there is a method to this madness. Some have theorized that the Grand Plan, hatched by Treasury Secretary Paulson and Fed Chairman Bernanke, was to use the excessive leverage in the hedge fund sector and force a massive de-leveraging, crushing the commodity sector, boosting the dollar and taking the pressure off the financial sector. A key benefit was to lower the cost of gasoline to hard-pressed consumers just before the election. The plan has seemingly worked very well, however it is likely just a “holding action.” And when the hedge funds have de-leveraged and dumped their commodity positions, what next? It would seem the wildly oversold commodity sector may just rebound, perhaps violently after the de-leveraging ends. Timing is everything, and Paulson and friends just want to hold off the cracks in the dike for another six weeks.

The part of the plan about taking pressure off the financial sector hasn’t worked out quite as well. With the dollar soaring and commodities plunging, the financial sector has continued in its primary trend, falling off a cliff.

Wall Street Implodes

This past weekend, the Federal Reserve and Paulson frantically attempted to broker a deal to rescue Lehman Brothers, the 158 year old investment bank that was established before the Civil War. There were no takers. Lehman is basically insolvent due to its massive losses associated with its toxic real estate derivatives. This once-proud institution has been forced to file for bankruptcy. In a brief fit of good judgment, Paulson decided not to bail out Lehman by adding further public funds to the hundreds of billions already pledged.

When Bank of America passed on buying Lehman Brothers, Paulson and company pushed B of A to buy Merrill Lynch, another financial giant on the edge of bankruptcy. Curiously, Bank of America, after a few hours of due diligence, decided to overpay and buy Merrill for $29 per share, a 70% premium over the $17.05 close last Friday. When asked why he didn’t wait until Monday to get Merrill at a lower price, Bank of America CEO Ken Lewis stated “the strategic opportunity was so compelling it couldn’t wait.” Bank of America must now digest both Countrywide Financial and Merrill Lynch, while dealing with the challenges of its own balance sheet. The billions of dollars of toxic sludge that Merrill carries on its books now becomes B of A’s problem. Whatever happened to prudent banking? Just how hard did Paulson twist their arm? Perhaps Paulson would just like a weekend off once in a while.

Trillions in Liquidity Evaporate

As Merrill is swallowed, Washington Mutual, Wachovia and AIG are on cliff’s edge, ready for their turn to take the plunge. It is likely the veteran bankers in the Big Apple have never faced anything this bizarre in their careers. Two trillion dollars in liquidity has exited the US financial system this year, and three trillion world-wide. Without this vital lubrication, how does this system keep chugging ahead? The financial system has disconnected. It is ugly out there and likely to get uglier. Welcome to Wonderland.

American Taxpayer looks like the Sucker

The aftermath remains to be seen, but thus far the powerful dollar rally has not brought out a flood of new capital from abroad to rescue the banking system. It looks like the only sucker in this card game is the usual patsy, the American taxpayer. Expect higher inflation and higher interest rates in our future. Oh, and higher taxes, too.

With long-held leverage now leaving the financial system at a frantic pace, perhaps the financial “disconnections” will begin to reconnect with reality over the ensuing months. A critical inflection point may be in the offing, as world financial markets begin to exit Wonderland. However, even the Cheshire Cat’s mischievous grin will fade to a scowl when the bill from our journey to Wonderland finally comes due.

“If I had a world of my own, everything would be nonsense. Nothing would be what it is, because everything would be what it isn’t.” ;- Alice (channeling Ben Bernanke?)

Today’s Market

U.S. stocks tanked on Monday as Lehman Brothers Holdings Inc. filed for bankruptcy and insurance giant American International Group Inc. scurried to raise capital even as its market value was axed by distraught investors.

The Dow Jones Industrial Average plunged 504.48 ending at 10,917.51. The S&P 500 Index was down 58.74 to close at 1,192.96, below the July lows. The Nasdaq also was hammered, losing 81.36 to close at 2,179.91.

Treasury Secretary Henry Paulson offered reassurances in an afternoon press conference in which he called the U.S. banking system "safe and sound," while rejecting comparisons between Lehman and the March bailout of Bear Stearns.

Gold futures rose for a second day Monday, closing at near $790 an ounce, as the deepening crisis on Wall Street raised demand for the safe-haven investment. Gold for December delivery rallied $22.50, or 2.9%, to end at $787 an ounce on the Comex division of the New York Mercantile Exchange. It surged $25 in overnight electronic trading to $789.50.

Wishing you a good evening in Wonderland,

Tony Allison
Registered Representative

About the Author

Financial Consultant
tallison [at] puplava [dot] com ()