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Commodities / Credit Crisis 2008 Mar 14, 2008 - 03:12 PM GMT

By: Julian_DW_Phillips

Commodities As with so many crises in history, the consequences of certain situations are not foreseen, or if they had been foreseen were downplayed to either inaction, or insufficient action. So it has been with the "sub-prime" crisis that is now a full blown liquidity crisis that is spreading like a gangrene into other aspects of the credit market. You may still wonder why this crisis is causing such a threat to the entire financial system so as to cause the Fed to 'throw money from helicopters'? The problem is essentially due to the functioning of collateral.

Banks have to keep a relatively small percentage of their capital as a base for all their lending activities. Firms that raise finance in the fixed interest market have to ensure that their assets cover such loans or top-up these if their values fall below the required levels. With the value of many of these previously 'sound' mortgage related assets falling like a stone, such collateral became inadequate to meet the legal requirements so forcing institutions to provide capital as a top-up. Then their own debt related securities dropped in values making it more difficult to effect such top-ups.

As the 'spreads' on such borrowing rose the borrowing became more and more difficult until anything to do with either a mortgage related security or the institutions that issued them or used them as collateral became unacceptable as collateral. Effectively then, the capital that such securities represented 'disappeared' to the extent that prices had dropped leading to some bankruptcies and to a contagious effect that the disappearance of further value caused as other institutions holding these companies now distressed debt, suffered the same fate. As the credit cancer spreads so the crisis grows. A look at the Weimar republic's hyperinflationary beginnings point to a similar situation. [ Subsribers contact us for a copy of our article on the subject ]

Tragically, the longer short-term expedient measures are put into place the 'contagion' will continue to spread. And each step of the spread of the disease the more likely it is to effect more and more parts of the financial system. Clearly the solution, deemed as unacceptable still, is to restore value to such securities in such a way as to convince all that the mortgage market is healthy again and likely to resume growth again. If interest rates fall to the extent that the housing market recovers, foreclosures cease on those who hold mortgage bonds, whose rates are set to climb, are moved to a healthy zone the market will recover its confidence.

Last year when we first talked about the crisis we used an illustration of a firm retrenching one worker. The confidence lost in such actions can only be restored by the employment of two workers. Such is the case in the credit markets now. For the Fed to accept mortgage-backed collateral for 28-day loans does not do it. It simply tells the market that they are providing short-term bridges for the industry, but not rectifying matters. This can only be done if interest rates fall to the point where the fear of mortgage foreclosure on the more than 1 million potential victims is halted and those mortgages regarded as sound enough to be used as solid collateral. This is not happening and such a solution goes against the grain for lenders. As such, the only likelihood of an effective solution will come up when the crisis is likely to cause systemic failure!

If the Fed does not accept such collateral as solid security for loans and be seen to be doing so the crisis will spread. This will mean a situation such as is seen in Japan, where interest rates are not far from zero. Until then it doesn't matter what the state of the economy is, 'disappearing money' will have the same effect as raising interest rates, issuing bonds by government and any move intended to drain liquidity out of the system, such as rising oil prices and Trade deficits. Doing nothing or not enough will cause the contagion to spread. The process of pumping money, not only into the U.S. monetary system, but the globe's, has to continue and grow until the crisis stops, with the Fed holding all those dubious securities.

The money has to come not just from the Fed or the European banks but from, Trade surpluses, Oil producers reinvesting back into the U.S. and Chinese and other Asian surpluses being invested back into the U.S. If this capital does not return it disappears from the U.S. economy and gives a whole new dimension to the 'liquidity crisis", with foreigners taking a proportion of ownership of the U.S. it may well not be ready for?

Add to this gangrenous problem the bleeding Trade deficit and you have a suppurating wound infecting the U.S. with a recession and unless properly handled with the transfusion of huge more amounts of additional liquidity, will lead to a depression. It is too late for academic discussions on whether it is a recession or not. It is time for action time to stop the bleeding! A healthy U.S. economy can be one where prices are forced to keep stable, but a relatively sound economy in a considerably depressed condition is disaster.

The fact that Bernanke felt obliged to ask the banks to increase lending is clear evidence that the banks have not increased credit to the degree the Fed would like them to. Effectively, the Fed can influence the cost of credit by changes in interest rates and other tools, but it cannot directly influence the supply of credit. If banks continue to be reluctant to increase the supply of credit, the financial markets will come under considerably more strain, vastly increasing the attractiveness of all hard assets, including gold.

There are rumours of the potential collapse of a large financial institution which are further exacerbating the situation, despite the injection of a further $200 billion by the Fed. To quote, "there is a de-leveraging spiral of credit removal, asset price destruction, capital debasement... ad infinitum that is occurring". But the most disturbing facet of this is that the liquidity crisis is accelerating . An rapidly accelerating inflation will counter this causing the monetary systems and currncies to embark on their own destructive dramas. This is not a gradual decay, it is one that is hampering most traditional methods of spurring growth and has to receive emergency room treatment or it will become a crisis that could take a decade or so to repair.

And what are we seeing to make us say this? The $ is dropping like a stone, the oil price is irrepressible, Asian growth is ensuring commodity prices, metals and food [supported by speculation] will stay high and higher for as far as we can see ahead. The defensive measures that are being taken, so far, are Central Banks protecting national interests through exchange rate management to retain international competitiveness with key trading blocs. Sadly this removes all obstacles to tsunami like movements of capital flowing across the globe creating systemic damage of its own.

These can only to be stopped by Capital Controls and Exchange Controls. It will be easier to stop such capital flows than impose trade barriers, harming those prevented from free trade but also those imposing them [until local production replaces imports]. Such protectionism will fragment the global economy. Moves against "speculation" may precede such moves.

Can the world cooperate sufficiently to ensure the global economy in its present state does not fragment? Only hyperinflation in isolated areas and an environment where the control of money moves into the political arena lies ahead unless the crisis is proerly tackled now .

In conclusion, we are moving to a level of decay, that sits in an inflationary environment, which could move to unforeseen and eventually exponential levels as it did in the past in Germany, but this time moving into connected nations. Such an environment will see a plethora of national Exchange and Capital Controls across the globe preventing this infection. How can gold and silver not rise far higher in such a climate?

"How can gold and silver not rise far higher in such a climate?"

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By Julian D. W. Phillips
Gold-Authentic Money

Copyright 2008 Authentic Money. All Rights Reserved.
Julian Phillips - was receiving his qualifications to join the London Stock Exchange. He was already deeply immersed in the currency turmoil engulfing world in 1970 and the Institutional Gold Markets, and writing for magazines such as "Accountancy" and the "International Currency Review" He still writes for the ICR.

What is Gold-Authentic Money all about ? Our business is GOLD! Whether it be trends, charts, reports or other factors that have bearing on the price of gold, our aim is to enable you to understand and profit from the Gold Market.

Disclaimer - This document is not and should not be construed as an offer to sell or the solicitation of an offer to purchase or subscribe for any investment. Gold-Authentic Money / Julian D. W. Phillips, have based this document on information obtained from sources it believes to be reliable but which it has not independently verified; Gold-Authentic Money / Julian D. W. Phillips make no guarantee, representation or warranty and accepts no responsibility or liability as to its accuracy or completeness. Expressions of opinion are those of Gold-Authentic Money / Julian D. W. Phillips only and are subject to change without notice.

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