US Fed Buying Bad Debt to Halt Credit Crunch - Headlines in Disguise

By: Andy_Sutton

Scanning a newspaper or watching the news recently seem more like a covert operation with secret codes and cryptography than anything resembling factual news. In fact, more than once, I have felt compelled to dig through cereal boxes in search of one of those plastic decoder rings that were so popular when I was young.

Approximately two months ago, I co-authored a report entitled "The 2007 Credit Crisis Q&A". In that piece we made some careful observations about the state of affairs regarding the credit turmoil. Mysteriously, after a couple of weeks though, the situation seemed to drop out of the conventional media. This situation has not ended; rather, it has gotten much worse. However, the approach has been to pretend the problem doesn't exist rather than be forthright.

There appears to be a very positive correlation between this credit crisis and the fall of the dollar. The mechanism is fairly simple to understand:

• US Mortgage debt has been securitized and resold all over the world, along with agency, municipal, government, and consumer debt such as car loans and credit card debt.
• Another popular instrument is the credit default swap, which allows one to buy 'insurance' to prevent losses in the event of defaults on debt. One has to question the quality of this 'insurance'. What guarantees are there that the issuer has enough liquid assets to cover the swaps written? If the issuer's assets are compromised as well, the 'insurance' isn't worth the paper it is written on.  It is a fairly safe bet that the issuers of credit default swaps used computer modeling and issued swaps well in excess of what they have the assets to cover in the event of above-normal defaults.
• The vast majority of the above debt is dollar-denominated.
• The banks that originate the debt sell much of the debt immediately to intermediaries on Wall Street who pool the debt together with other similar debt.
• The pool is then divided into groups called tranches that are generally based on the credit-worthiness of the underlying debt.
• The tranches are securitized (broken down further and converted into salable units) and sold in the financial markets.
• The highest quality tranches get the highest credit ratings and pay the lowest rates of return.
• The lowest quality tranches get the lowest credit ratings and pay the highest rates of return.
• The originators act as conduits in that they accept the payments from the borrowers and forward it to the intermediaries who then make sure the holders of the actual securities get paid.
• If defaults in the pool occur, they will affect the lowest rated tranches first. (Hence the high rate of return)
• The holders of this debt have an expectation that the counter-party will deliver on the promise to pay.
• A certain amount of defaults are always figured into the equation. But what happens when defaults on this debt begin to run above the assumed rate?
• The value of the underlying debt is compromised.
• Players begin to seek out markets for the debt, feeling the need to get out before the rest, thereby staying ahead.
• It works for a while, but eventually more and more players figure out that something is wrong and the market for the security begins to deteriorate and dry up.
• The recent fall in the dollar began in an environment of poor fundamentals such as persistent trade deficits, ever-rising national debt, lack of real savings, and a general economic malaise caused by over-consumption and under-production.
• The dollar fall caused foreign investors in dollar-denominated debt to lose real value. To maintain liquidity and reserves, they began to sell.
• The flood of dollars into the system caused the dollar to lose more value.
• This put further downward pressure on the value of their remaining assets.
• Pinched, the foreign investors sell more of their securities, reinforcing the cycle.
• The poor fundamentals of the US economy were the trigger; the wave of unexpected defaults has been the fuel on this fire.

The US Fed has poured inflation onto the fire by attempting to keep the system liquid with periodic injections directly into the banking system; billions of dollars, totaling over $600 billion worldwide. This statement is backed only by what we actually KNOW about. What is unknown is how much, if any, additional fresh money has been thrown at this.

During this time, the gold price has gone from stagnating in the mid to upper $600 range to well over $800, and the price of oil has ramped from the lower $70's to nearly $100/barrel. If this is any indication of the amount of liquidity being thrown at this problem by the Fed and other central banks, then the American consumer is going to be under siege with rapidly rising prices in the next 6-9 months. This morning, the US government reported that prices paid for imports had risen 1.8% in October ALONE.

What can the Federal Reserve officials do about the continuing credit crunch?

Not much, really. They will probably continue buying debt of questionable worth, and investors and foreign exchange speculators worldwide will correctly interpret this activity as inflationary. This will be the motivation for continued selling of the dollar, causing its value to fall against foreign currencies, commodities, and precious metals. This scenario has been playing out now for most of the past year.

The Federal Reserve buying debt from banks keeps the banks solvent, but does not magically turn misallocations of capital (such as over-built housing) into profitable activities, and therefore does not prevent insolvencies of other institutions (including, say, your employer). The cost of this moral hazard is more inflation. The problem is exacerbated by the fact that the wanton printing of money is debasing what little real savings (underconsumption) we have left.

One possible hazard during this credit crunch is that in order to raise cash for various needs such as claims and distributions, institutions such as insurance companies and pension funds might be forced to sell assets that are not worth as much as they are listed for on the books. This might cause the demise of the institution and the impoverishment of the customer. The shocks in this instance will likely be significant as the standard practice of financial institutions has been to book the prices of these securities based on computer models as opposed to the prices actually being paid on the market.

One of the Federal Reserve's objectives will be to try to build confidence among investors to prevent panic selling. While panic selling might be harmful, lack of panic selling does not mean that all is well! The common good does not scale down, or in other words, the last one out of the markets loses. Therefore, it is in your best interests to ignore the reassurances of the Federal Reserve officials and their partners in the mainstream media. Beware of official economic statistics that run contrary to what you see with your own eyes. Do you really think that construction added 14,000 jobs and finance 25,000 while the housing market collapses? Look for sources of information that have the least conflict of interest with your own.

If the Federal Reserve is successful in restoring confidence, find out if economic fundamentals have really changed for the better, and decide if there has really been enough time for an economic recovery. If not, call their bluff, and do not be lured into their trap. The only reason this entire system has not already collapsed is due to the confidence that people have in the system itself, the value of the dollar, and the ability of the Fed to 'control' the business cycle.

What can the rest of us do to protect ourselves?

Prepare for the possibility of high inflation, rising interest rates, or both at the same time.

Prepare for rapidly changing prices (volatility)--up, down, and oscillating!. It is easier to invest when you have a strong trend in place. Falling US dollars and rising petroleum will be two of your strongest, long-term trends.

Prepare for the possibility of war against Iran. That would cause an oil shock to which the global economies would have little resilience at this point. The fact that an oil shock would be devastating for us would not necessarily constitute a counter-incentive to those planning the attack, who have probably positioned themselves for massive profits. The authors have a public version of a report about preparing for an oil shock at http://www.mutuallyassuredsurvival.com/wiki/tiki-download_file.php?fileId=23

Above all, stay out of debt and keep plenty of cash on hand; don't tie up all or even most of your money.

The problem with debt is that in a credit crunch, it's harder to repay it, and harder to sell assets (especially if one's hand is forced) without taking a loss. Learn to live on less, and put the difference into inflation-hedged savings .

Maintaining high liquidity is a problem, because cash is losing value due to inflation. It is a lose-lose situation! Keep in mind that once a currency is in a trend, it tends to stay in that trend for years. The best you can do to defend yourself from simultaneous illiquidity, recession, and inflation, is to save in cash and near-cash assets, denominated in something stronger than the $US, and balance with some inflation hedges. The euro is already significantly appreciated, and the British economy is weak for many of the same reasons as the US economy. Try a ‘basket' of several currencies.  Countries that have the implicit backing of resources or strong economies and/or favorable balances of trade are preferable. Examples would be Canada, Australia, and some of the Nordic nations including Sweden(Krona) and Norway(Krone) as well as Switzerland (Franc).

Commodities, including and especially fuels, and precious metals are good inflation hedges. Commodities futures positions are risky for small investors; instead try a commodities fund. Whenever possible, take physical delivery of your investments whether they be precious metals or stocks. You will have to pay for the actual stock certificate, but it is worth it especially if you're a long-term investor.  The problem with futures contracts is that they are risky, and depending on circumstances there may be a good deal of counterparty risk.  What happens if for example, the price of gold skyrockets and the holder of your contract is unable to deliver due to supply constraints? Take delivery.

Look for bargains on any significant pullbacks. A good time to buy commodities or precious metals is after a recession is announced, when commodities and precious metals usually fall in price. We don't know if prices actually will fall or not, because inflationary expectations are now fairly high . If prices of precious metals and commodities do fall around the start of a recession, it is fairly safe to buy with part of your investment money (always keep some cash), because any recession is likely to be inflationary, that is, stagflation . The talking heads in the media will try to convince you otherwise, and the economic central planners might try to take down the price of gold through both “trash-talking” and short selling. Take only positions that you can hold onto indefinitely, and don't be rash or impatient. Another strategy is to set aside a specific quantity of cash each month and make your purchases, no matter what the price (“dollar-cost averaging”). This will ensure accumulation over time. The fundamentals support higher prices so minor fluctuations can be ignored as ‘noise'. The trend is your friend.

Real estate is usually considered a good inflation hedge, but we suggest waiting for bargains until after the credit crunch is over. We think it is still too early to jump back in. Instead, keep your powder dry and patiently wait for opportunities. The media has been promoting the idea that there are real bargains now. Before buying, figure out the return on investment if you bought the place and rented it out. If it's still low, or if it would be hard to find good renters due to high unemployment, it's not a bargain yet.

Because foreigners bought US assets that are now falling in price, and because a US recession will probably hurt their sales, economies worldwide are likely to at least slow down, and perhaps join the USA in a recession. If that happens, there may be bargains in Asian stocks for those able to evaluate them, or those willing to buy indices. Plan carefully, be patient, and keep cash reserves.

We wish our readers a safe and profitable journey through this adventure.

The information in this article is based on conditions at the time it was written. This article is for information purposes only and does not constitute advice to buy or sell securities.

For those individuals who are interested in specific companies and recommendations, please contact us. Due to a growing number of requests, we are going to begin offering, among other services, a paid newsletter that will profile specific recommendations on companies and industries. For a nominal fee, subscribers will receive a monthly newsletter that will discuss current issues in personal finance, investment, macroeconomics and related strategies designed to navigate today's difficult financial landscape. All interested parties should visit www.my2centsonline.com for forthcoming information or email us at info@my2censtonline.com Tomorrow's investments…Today

Atash is the editor of www.mutuallyassuredsurvival.com/ , which offers its visitors a wiki of personal and financial survival techniques for surviving perils of the 21st century , a library of sustainable technologies suitable for self-sufficiency, a news and commentary blog , reports, fiction, and numerous forums .

By Andy Sutton and Atash Hagmahani
http://www.my2centsonline.com

Andy Sutton holds a MBA with Honors in Economics from Moravian College and is a member of Omicron Delta Epsilon International Honor Society in Economics. He currently provides financial planning services to a growing book of clients using a conservative approach aimed at accumulating high quality, income producing assets while providing protection against a falling dollar.

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