Recession – Inflation – Deflation – Depression – Stagflation

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by Al Martin

Recession – Inflation – Deflation – Depression – Stagflation - Global Collapse…?

(8-20-07) So what did the Federal Reserve do, why did they do it -- and most importantly, what can we expect next?

Market volatility in both securities, boards and commodities futures markets continued to increase throughout the week. It was obvious when the S&P; futures began to fall sharply in the overnight session Thursday night that the Fed’s first effort at calm – by consistently injecting short-term liquidity into the markets through various types of repo agreements – simply wasn’t working. It was not restoring confidence.

The Fed had a twofold mission here. The first was to provide sufficient liquidity to, at least prevent any collapses of individual securities, or asset classes in the case of bonds, that they were able to.

By Thursday (Aug. 16), it became obvious that central banks were providing sufficient short-term liquidity to prevent the collapse of any individual class of securities or markets. However, they were not restoring any confidence. Therefore, the next thing to restore confidence actually had to be some manner of rate cut.

So there was a dramatic turnaround. Right after the Fed action Friday morning, the Dow rose to an intra-day high of 321 points before falling back. They way it was perceived by the professional trade and the way it got perceived by the retail trade (i.e., Joe Six-Pack investor) were entirely two different things.

Financial media attempted to spin what the Fed did as being wildly bullish. However, the Fed did not cut the ‘Fed fund rate,’ currently standing at 5.25%. The Fed cut the discount rate.

Joe Six Pack has to remember that the Fed sets two different rates. One’s called the Fed funds rate, the rate which they tried to maintain every day through “repo” action. By either adding or draining reserves, using repurchase agreements, they attempt to maintain the target interest rate, at the Fed funds rate, currently 5 Ľ%.

Then there is the so-called discount rate, or, using market parlance, the ‘Fed window rate’ which the Fed charges banks, primary bond dealers, and other financial institutions, for loans, in other words, to loan money against securities.

The discount rate was unusually high. We have to start out from that premise, that the Fed had been maintaining a discount rate 100 basis points above the Fed funds rate, which is already an unusually high spread. This was really done to prevent or to discourage financial institutions from continuously going to the discount window.

What the Fed did on Friday morning was to cut the discount rate 50 basis points, from 6.25 to 5.75%, in order to reduce the cost of borrowing by financial institutions, thereby increasing, or allowing them a greater operating spread in business.

This is what we believe is going to happen. You’ll hear a lot of financial media chatter. Then you’ll see Joe 6-Pack in buying his 100 shares Monday morning. And it is likely the rally will continue, at least for the first half of the session Monday. Then smart money is going to start selling again. Why? Because the Fed action was really just a half measure.

On Friday there was even a mini-run on a bank, Countrywide Bank in Southern California. Then Countrywide actually rallied. Countrywide Mortgage is now being looked at as the bell-weather stock, as it were, when it comes to sub-prime problems. Countrywide, of course, like the whole mortgage group of stocks, rallied on Friday, after being pounded terribly. The fear spread to the bank, but Countrywide’s retail banking subsidiary is tiny compared to the size of the company.

What many people believe forced the Fed action on Friday was Countrywide’s announcement that it had to draw down an $11.5-billion unsecured line of credit it had with a syndicate of banks in order to continue to stay in business. When that news came out, Countrywide Credit was initially called down $4/share.

Countrywide Credit was an excellent trading stock, by the way, on Friday. We had recommended buying it when it was called lower. After the Fed action, there was a good turnaround, and a $5 quick profit to be made in that stock Friday. These are the kind of trades we recommend.

However, I think that it was this announcement by Countrywide, which threatened to crank up the fear machines, as they’re now being called on The Street, when the markets opened Friday morning. This, in turn, precipitated the Fed action. You will notice that the Fed did not wait until its usual time to act. Rather it acted before domestic equity markets opened, which would imply that there was some sense of urgency.

‘The Street’ had been looking for the first hard and fast Fed response beyond a band-aid solution to be a cut in the discount rate. What the Street had expected was something between 50-100 basis-point cut.

The fact that the Fed only cut the discount rate by 50 points brought in fresh professional short-sellers into domestic equity markets after the initial rally. That’s what hammered them down. Because there was some disappointment that this was going to be ineffectual.

Furthermore, and contrary to what the never-ending bullish spin meisters at CNBC and Bloomberg would have you believe, the Fed did not change the rules regarding discount borrowing.

It will only continue to accept ‘high-grade securities’. It cannot, in fact, by charter, accept any mortgage-backed securities as collateral for loans through the discount window. So the problem is principally concentrated in mortgage-backed securities and junk securities like the notorious and dubious CDOs.

How much good does it really do to lower the discount rate if those financial institutions that have huge inventories of mortgage-backed and/or junk bonds that have become illiquid cannot go to the discount window and use this as collateral?

That became the attitude among professional traders by the end of the day, that the Fed is going to have to act rather expediently, possibly as early as next week, to do something more. The professional short-sellers control the markets, and they still do. That was obvious in Friday’s trade.

Short-sellers, like us – and we are professional short-sellers on InsiderIntelligence.com – 80% of all the trades we make in everything are on the short side. But short-sellers were not afraid to short rallies Friday.

What this did was it provided some temporary stability. I think more importantly to the markets is that it sent a signal that the Fed was finally prepared to get off its ass and do something. The signal itself is why the market rallied, not the action, which is oftentimes the case.

However, I would think that the Fed is going to have to act again next week or, at the very latest, the week after. This action was a half measure. In the last analysis, cutting the discount rate doesn’t help address the central problem -- the central problem being about $2 trillion of mortgage-backed and/or junk bonds, which have become illiquid. Therein lies the central problem. Lowering the discount rate, or even lowering the Fed funds rate itself, does not address the central problem. It provides lower cost and cheaper liquidity for loans, thus allowing greater spreads for financial institutions in their capacity as borrowers from the Fed. But it still doesn’t address the central problem.

Indeed, as a few intrepid souls like Jimmy Rogers pointed out on Bloomberg Friday, there is really nothing the Federal Reserve or, indeed, any central bank can do to address the core problem short of some sort of an outright bailout – that is, actually purchasing these junk securities. Or, at the very least, allowing them to be tendered against system money as collateral at or near face value.

That’s something the Fed doesn’t want to do. And the reason they don’t want to do it, by the way, is because it would be transferring enormous risk, which currently exists in the private sector, onto the back of the public.

Would the public understand? Let’s put it this way. I think the Democrats are going to be sure that the public would understand it. You saw this late-week, because this has very much become a political issue as well.

Don’t forget about the Democrats. This has split the Republican Party. What is happening in the markets, the Fed’s action, the Democrats’ call to have Fannie and Freddie and the GSE’s in general, to have their caps lifted so that they could take in junk securities and take junk inventories off the hands of primary dealers, etc. This has proven exceptionally divisive within the Republican Party.

The real factions are: Pro-Bush faction Republicans, who have a financial interest in seeing the markets fall, because they are invested in the shadowy offshore Republican pools that are short the markets and have been short, not only equity markets, but bond markets, commodity markets, and other markets in anticipation of collapse being caused by Bushonomics.

What wealthy pro-Bush faction Republican wants to support something that is going to directly hurt their personal financial interest?

Meanwhile, moderate and fiscally conservative Republicans are diametrically opposed to lifting GSE caps or having the Fed change its charter because they are opposed to any type of government bailout.

Their attitude is, and this attitude is best expressed by Senator Grassley, that this is a market problem, and the government cannot come in and artificially prop up the value of these securities by buying them at twice what they’re worth and then transferring the risk to the American taxpayer.

Also you do hear some cries within what little remains of the more grassroots-oriented Republicans who do support a bailout. But those Republicans whose districts are comprised principally of the working class, do support some sort of a bailout. Because it is working class grassroots Republicans that have been the greatest victims of Bushonomics, as we have explained in the past.

Now, the Democrats, of course, universally support a change in the Fed charter, lifting of GSE caps in a variety of measures, which would be tantamount to a government bailout. And part of that is because Democrats love government bailouts. But all you’re doing is transferring the risk to the American taxpayer.

The U.S. government and the Democrats certainly realize that the cumulative fiscal deterioration which has occurred is a result of the practice of Bushonomics II during the past 6 years which has left the U.S. Treasury and the Federal Reserve without sufficient resources to provide a bailout.

So it’s very easy for the Democrats to say, “Let’s proffer some sort of a bailout.” I think the reality in the Republican Party and one of the greatest fears they have is that it opens the door to the entire issue of the fiscal destruction of the United States government, which has occurred in the last 6 years.

If the American people, particularly wearing their hats as small shareholders, were to ever realize that the Federal Reserve and the U.S. Treasury no longer have the fiscal wherewithal to provide some sort of a market bailout for anything, there would be an enormous loss of confidence in domestic capital markets. And that’s why even the Democrats won’t push it. This is the great secret that neither Democrats nor Republicans want revealed -- what Bushonomics has done to this country.

In terms of the market, my own prediction would be that the Fed will act to reduce the discount rate another 50 basis points, bringing it down in line with the Fed funds rate within the next 10 days, if not sooner, if nothing else, to provide a second line of psychological support to the marketplace. That will dispel a little more fear.

This is the only thing they have to do, as Treasury Secretary Paulson pointed out Friday, since they can’t change the underlying problem that is causing this in the markets, i.e., the sub-prime cum junk bond problem. The U.S. government cannot really effectuate a change in the underlying problem. All they have to do is to provide enough psychological support, enough to instigate a sufficient change in investor sentiment to prevent wholesale selling by Joe Six-Pack shareholders.

That’s exactly what the U.S. government and, indeed, all central banks that have acted to inject liquidity, have done.

The shills in financial media, and their erstwhile cousins within the retail brokerage business, will immediately say that there’s nothing on the horizon that rivals another Long Term Capital Management bailout, which of course is a lie.

Secretary Paulson said it best on Friday. We have to convince Joe Six-Pack America, wearing their hats as investors, that buying securities at 90 cents on the dollar that are actually worth 30 cents on the dollar is a good long-term investment. The way we do that is by changing marketplace sentiment and by making it appear, in the minds of Joe Six-Pack investors, that the Fed can help the problem more than it actually can. And he’s right.

You can sell this idea to Joe Six Pack, 100-share investor. You can sell a share of stock for $90 that’s actually worth $30, all day long, as long as you can convince Joe Six-Pack that it’s still worth $90. That’s all the Fed, the commercial banks, and the retail brokerage firms have to do. You saw Goldman Sachs come to the rescue of one of its own funds last week. Everyone is acting in concert to maintain the lie and thus turn around sentiment.

The problem is not getting Joe Six-Pack to buy something for $90 that’s worth $30. The whole crux of it is making Joe Six-Pack continue to believe that that is worth $90 and not what it’s really worth. It is the great facade that must be maintained.

Bushononics has ensured that great lies, market lies, and economic lies, must be maintained. The truth can never be told. It must not be told. It’s the reason why we’ve stopped telling it.

We understand, however, at AlMartinRaw.com, the reason why we stopped telling the truth about Bushonomics and the fiscal destruction of the United States, is because we’re not doing anybody any favors -- the vast bulk of the population, about 95%, is unprepared for the consequences of what the truth will ultimately do to the economy of the country and the planet. Therefore we are not doing anybody any favors by telling the truth.

Even traders are turning to jokes. Some talk about the creation of a new structured product called the Constant Obligation Leveraged Originated as Structured Oscillating Money Bridge Asset Guarantee or COLOSTOMY BAG. One trader said that what’s become commonplace in the world of structured finance, is basically full of shit. So nobody understands it, especially Joe Six-Pack, who ultimately is the retail investor, doesn’t understand it. But, of course, he’s never understood it.

What’s different this time around, with these incredibly complex hypothecated derivatized instruments, is that the people that actually put them together don’t understand them either. The people selling them don’t understand them. The firms maintaining a market in them don’t understand them. As Jimmy Rogers pointed out, herein lies the great rub and the reason why professional traders are consistently shorting rallies in both equities and bond markets.

You saw that last week and you will continue to see that. Why? Because the great rub is that nobody knows. There are trillions and trillions of artificial instruments that have been created and sold, borrowed against, hypothecated. Nobody knows who owes what to whom. Eventually, when it all unravels, it’s going to create an economic debacle on this planet never seen the likes, that’s going to make Dutch Tulip Bubble collapse look like a walk in the park.

It was also revealed that Sentinel Management Group filed for Chapter 11 bankruptcy. This was another important shoe that dropped. As we say online at InsiderIntelligence.com to our subscriber/ traders, every day we’re waiting for the next shoe to drop.

Sentinel was yet another shoe. It was a brown shoe. A lot of black shoes have been dropping. Let’s say all the black shoes that have been dropping have come from sub-prime cum junk. But this was different.

Sentinel is a money management company that manages money market funds for others. It is a U.S. futures commission merchant and it manages money market accounts, mostly for commodity firms that become illiquid.

When Sentinel asked the CFDC for permission to freeze $1 billion I money market assets, 138,000 commodity traders woke up Wednesday morning and found that their account balances were useless. This forced severe gyrations across the commodity boards because there was forced liquidation -- because the money in their account wasn’t any good anymore.

Why this was a brown shoe and not a black shoe is because it revealed yet another subsidiary yet growing problem -- the ever-falling credit rating of the commercial paper market.

The prime-3 commercial paper is issued and sold, just like U.S. Treasury bills are. They are the principal short-term instruments in this country. Either U.S. Treasury bills or commercial paper, that comes in maturity dates anywhere from 1 to 364 days.

The reason why people go into commercial paper, which is issued by corporations, is because it pays a higher rate than U.S. Treasuries. These are called bills. Bills implies a short-term obligation, a note a longer term obligation.

When Sentinel asked for the freeze, it was shedding light on yet another problem -- the stress that has been created in the commercial paper market because of the mortgage cum junk bond debacle, and the fact that what’s called prime-3 grade commercial paper, the lowest grade commercial paper, is becoming increasingly illiquid.

Commercial paper is continuously rolled over into its term cycle. Interest is paid out, and the paper is rolled over again.

What’s happening is more and more issuers of prime-3 grade commercial paper are unable to pay the coupon or the interest rate. Therefore, if they can’t pay the interest rate, they have to roll the paper over at a deeper discount.

But if that paper is being used to support a money market fund and a bank or a brokerage firm has to pay out that interest rate to the client, they can’t. The commercial paper market in this country is in trouble. And if the prime-3 commercial paper market collapses, which is entirely possible, it is going to weaken, and already has begun to weaken prime-1 and prime-2 commercial paper. It is the reason, for instance, that, until late-week, interest rates for U.S. Treasury bills rose sharply as people scrambled to buy them and sell commercial paper.

In conclusion, the recent market turmoil has been (certainly for traders) the greatest trading period ever. There has never been a trading period like it. Fortunes have been made and will continue to be made as long as the volatility continues. And the volatility will certainly continue because central banks, the Fed and other central bank, so-called prime banks, primary bond dealers, financial institutions, the insurance companies, pension firms can support markets, but there’s nothing they can do to address the underlying problem of bad mortgage paper and bad junk bonds.

That is something that can only end in liquidation unless some government comes along and actually says, “We are going to use 90 cents of taxpayers’ money to buy something that’s worth 30 cents.”

In essence this trading is a zero-sum game, and you’re either making money or losing money. Period

What happened last week with Sentinel, and the reason why Sentinel is a seminal event is that it demonstrated a new set of risks in marketplaces that most hadn’t considered before. And that is, when you wake up the next morning and turn your screens on to start trading again, is the firm that you’re doing business with still going to be in business? Or did it collapse the night before?

Are your money market account balances you have on deposit in that firm still any good or not? That’s more of a fear factor.

It’s a whole new factor that traders and investors have to consider that didn’t exist before. This is a whole new step down the road of global economic collapse. If the prime-3 commercial paper market collapses, which is entirely possible, and prime-1 and prime-2 paper become impeded, in terms of their liquidity, this is another different problem. (Prime-1, 2 and 3 relates to the credit-worthiness of the issuer, 1 being the best and 3 being the worst.)

If the prime-3 commercial paper market collapses, prime-1 and prime-2 paper will become increasingly illiquid. Spreads will increase. It would create enormous investor losses. For the first time, investors that have money in money market accounts, which are most of the people would start to suffer losses. And it would dramatically widen the scope of the financial debacle.

It would bring this problem to a whole new group of people, which, in itself, is dangerous. It’s why mainstream media has largely tried to ignore this or devote very little time to it. That’s being done because of political pressure out of Washington. Because you can’t let Joe Six-Pack, who owns a few hundred shares of this or a few hundred shares of that and has an IRA, 401(k) and really doesn’t know anything about the markets, you can’t ever let him know the truth.

And now we’ve got another factor that didn’t exist before. What happens if Joe Six-Pack wakes up one morning and finds out his money market account balance isn’t any good anymore? There’s no way you can hide that from him. Fear grips the soul by then -- and by then it’s too late.

* AL MARTIN is an independent economic-political analyst with 25 years of experience as a trader on NYMEX, CME, CBOT and CFTC. As a former contributor to the Presidential Council of Economic Advisors, Al Martin is considered to be a source of independent analysis for financially sophisticated and market savvy investors.

After working as a broker on Wall Street, Al Martin was involved in the so-called "Iran Contra" Affair as a fundraiser for the Bush Cabal from the covert side of government aka the US Shadow Government.

His memoir, "The Conspirators: Secrets of an Iran Contra Insider," (http://www.almartinraw.com) provides an unprecedented look at the frauds of the Bush Cabal during the Iran Contra era. His weekly column, "Behind the Scenes in the Beltway," is published weekly on Al Martin Raw.com, which also publishes a bimonthly newsletter called "Whistleblower Gazette."

Al Martin's new website "Insider Intelligence" (http://www.insiderintelligence.com) will provide a long term macro-view of world markets and how they are affected by backroom realpolitik.

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