“Stimulus only adds more DEBT and none of it is helping poor people or people on the edge.”

“The bond market is totally manipulated by the Fed and it is saying the country is broke.  All it reflects now is people speculating on the Fed.”

“Some day the real two traders are going to wake up…”

“We’ve gone through a 30 year bubble period that is now coming home to roost.  It was created by the massive leverage built up by the 1980s.”

“There has been a $32 TRILLION net gain in the top 5%; they had $8 Trillion of net worth in 1985 and now they have $40 TRILLION….and I blame the Fed for turning our financial system into a massive speculative bubble built on debt leverage.”

Is the U.S. government on the verge of a massive debt problem?  For years, the U.S. government has been able to borrow all the money that it has wanted to at extremely low interest rates.  But now many of the lending sources that the U.S. government has been depending on are drying up.  Even before this recent crisis in Japan, a number of big players were moving away from U.S. Treasuries and the U.S. Federal Reserve was having to step in to pick up the slack.  But now this debt crunch is about to get a whole lot worse.  For years, many had feared that it would be China that would start dumping U.S. government debt, but now it turns out that Japan is going to be the real problem.  Right now, Japan is the second largest foreign holder of U.S. government debt.  Japan currently holds about $882 billion in U.S. Treasury bonds and they are likely going to have to liquidate much of that in order to fund the rebuilding of their nation.  So needless to say they won’t be accumulating any more U.S. government debt.  But the U.S. government still needs to borrow a trillion and a half dollars from someone every single year.  So where in the world are they going to get it?

This is called a debt problem.  Have you ever gotten to the point where you are in debt up to your eyeballs and nobody wants to lend you any more money?

Well, the U.S. government is rapidly reaching that point.

Even before the crisis in Japan, several of the big boys had starting moving away from U.S. government debt.

PIMCO, the biggest bond fund on the entire globe, recently acknowledged that they are dumping all of their U.S. Treasuries.

So if foreign nations like Japan are not gobbling up U.S. government debt and big bond funds like PIMCO are not buying any of it, then who in the world is going to be purchasing the massive amounts of debt that the U.S. government is constantly pumping out?

Well, many of you already know that answer.

The Federal Reserve is going to step in of course.  The Federal Reserve knows that if the U.S. government cannot borrow gigantic quantities of money at super low interest rates it will go broke.  So the Federal Reserve is just going to keep buying up most new U.S. government debt.  It is just that simple.

But isn’t that a Ponzi scheme?

Of course it is.  Let’s not mince words here.  It is a total scam.

And it is a scam that cannot go on indefinitely.

The truth is that the Ponzi Scheme of the U.S. Treasury issuing bonds and the Federal Reserve buying them up cannot last forever as PIMCO’s Bill Gross noted in his March newsletter….

“Basically, the recent game plan is as simple as the Ohio State Buckeyes’ “three yards and a cloud of dust” in the 1960s. When applied to the Treasury market it translates to this: The Treasury issues bonds and the Fed buys them. What could be simpler, and who’s to worry? This Sammy Scheme as I’ve described it in recent Outlooks is as foolproof as Ponzi and Madoff until… until… well, until it isn’t.”

Gross also noted in his recent newsletter that the Federal Reserve is currently buying up about 70 percent of all new U.S. government debt.

So now that Japan is out of the picture, how high will that figure go now?

80 percent?

90 percent?

Over the past several weeks there has been all kinds of speculation about whether “quantitative easing” will be extended past June or not.

Well, whether they call it “quantitative easing” or not, the truth is that the Federal Reserve is going to have to continue to “buy” most new U.S. government debt or the system will crash.

We have gotten to the point where the U.S. federal government cannot continue to function without Federal Reserve monetization of the debt.

This is a sign that we are rapidly approaching the financial endgame.

So why doesn’t the U.S. government just stop spending so much stinking money and stop getting us all into so much debt?

Well, because there isn’t enough political will in Washington D.C. to do any real budget cuts, and if our politicians did balance the budget at this point it would crash the economy.

Just the other day, the U.S. House of Representatives passed a continuing resolution to fund the federal government that would cut 6 billion dollars from U.S. government spending.

On that exact same day, the official U.S. national debt figure rose by 72 billion dollars.

Now the debt normally does not go up that much on a typical day.  But what this example does show is the losing battle that our politicians are fighting.

On Wednesday, U.S. Treasury Secretary Timothy Geithner warned a House of Representatives appropriations subcommittee that they should not even think about not raising the debt ceiling….

“Congress has to do it. There’s no alternative.”

The truth is that the U.S. government has to keep going into more debt.  Under the current system the alternative would be to collapse the economy.

But the debt that we have already piled on to the backs of future generations is absolutely criminal.

How mad do you think future generations are going to be with us for heaping 14 trillion dollars of debt on to their shoulders?

Talk about a debt problem!

But this is what we get for allowing a private central bank to run our financial system.  This debt-based system was designed to fail from its very inception.

The man supposedly “in charge” over at the Federal Reserve, Ben Bernanke, has a track of record of incompetence that is absolutely staggering.  It is a mystery why our representatives in Washington D.C. are not howling for his resignation.

Instead, most of our politicians continue to express blind faith in our current financial system and they continue to insist that everything is going to be okay.

Well, everything is not going to be okay.  The Obama administration is projecting that the federal budget deficit for this fiscal year will be an all-time record 1.65 trillion dollars.

Of course they are also trying to convince us that budget deficits will go down in future years, but by now we should all know not to trust the rosy future projections of government officials.

After all, it was only a few short years ago that Bush administration officials were promising that we would be swimming in huge budget surpluses by now.

The truth is that the government has been lying about all of this for a long time.  For now, the Federal Reserve is just going to keep monetizing U.S. government debt for as long as it can.

This Ponzi scheme will keep on working and working and working until someday it simply doesn’t anymore.

When that day arrives, the U.S. government debt problem is going to unleash hell on world financial markets.

The Economic Collapse

Ten Year Bond Breakout!

Posted by Karl Denninger

Borrowing costs are going up, and this chart says they’re going up a lot – like 200 basis points within the next year or so on mortgages and 10yr Treasuries.

Key to the thesis of Bernanke (and essentially everyone else) that this “V-shaped” recovery could take hold and be sustainable – instead of being a false dawn – is the premise that mortgage rates would behave.

Bernanke’s thesis, in fact was that he could cap 30 year money at 4% or less to prevent home price devaluation.

Well, now the 10 year bond is back where it was before the collapse.  That’s good, right?  Well, not really – because it means that 30 year money (mortgages) will start backing up shortly and prices on existing Fannie and Freddie (along with other long-duration) paper will start falling.

The target on this breakout of the inverted head-and-shoulders is 6% on the ten year treasury, and approximately 7% on 30 year mortgages.  As of today’s pricing (about 5% on that same money) we can back into the home price impact quite simply; the hypothetical $200,000 house will be devalued to $161,644.55.

That is, the same payment that today pays down a $200,000 mortgage will only pay down a $161,644.55 one.

The time on the full expression of this target is one to two years hence, although it can occur sooner.  The reliability of this sort of pattern is extremely high, and remains valid conditionally even with a drop back to 3%, and is not invalidated unless the ten year were to get down to 2.03%.  Neither is likely.

The entire premise of the so-called “recovery” not only requires stabilization of the housing market but a resumption in home price appreciation.  With the cost of mortgage money nearly-certain to rise toward the 7% range over the next year this is simply impossible.

The market will not ignore this for long, once it begins to express itself in actual rates and prices – and it will. 

If you’re one of the trapped underwater homeowners who as of today has an opportunity to short-sale your house, take it – while it still is available. 

Consider that The Fed is holding a literal trillion of this paper which is likely to come under extreme valuation pressures as rates back up.

Additionally, the sentiment in the market today is positively giddy – those who claim that retail is “not in” need to look at the ISE index, which hit an all time high today.  That’s all retail call buyers – they sure are “in”, and now the shears can come out of the drawer.

Parabolic moves like this always go further than you’d expect or believe possible.  But the math always wins, and the sort of rate environment we’re seeing now is quite similar to what happened in 1987.

No, this is not predicting a 1987-style crash – at least not today or tomorrow.  But with both rates and oil headed up hard the effective tax this presents to the economy is going to hit home immediately and hard, with no evidence that this very same backup in oil is in commodities generally (look at wheat lately?)

That’s not inflation, it’s financial speculation in a blow-off top.

Real job creation and a healthier economy?  We’ll see.

What’s On The Worry List?

Today’s Breakfast with Dave is a long one, easily packing three days of work in a 19 page PDF as Rosenberg will not be writing the next two days. Here is a snip from Rosenberg called What’s On The Worry List?

• Last week’s bond auctions did not go well. It seems that Japan and China did not show much interest. The lack of bids was no better underscored than in the 7-year Treasury note auction where the median yield was 3.29% versus 3.05% a month earlier. April is a cruel month for the U.S. Treasury market, with 10-year yields rising in each of the past 4 Aprils and in 6 of the past 7, and by an average of 25 basis points.

• That, in turn, could spook the equity market since another 25bps of upside pressure could then generate a fund-flow spiral as was the case in the summer of 2007 — 3.85% (where we are now) ostensibly is a trigger point for selling of mortgage bonds. As rates rise, homeowners are less likely to pay their mortgages early, which extends the life of the mortgage and that in turn encourages mortgage investors to neutralize the duration of their portfolios by selling T-bonds and notes. We have seen this happen before and while it will likely provide a nice buying opportunity given the deflationary headwinds the economy now faces, the prospect of a spasm in the Treasury market is worth considering. Every equity market correction in the past — 1987, 1994, 1998, 2000, and 2007 — was preceded by what turned out to be a brief but significant runup in yields. See Stock Rally at Mercy of Rising Rates on page C1 of today’s WSJ). And, the more overvalued the equity market is, the more the downside risks if bonds begin to provide greater yield competition in the near-term. Jeffery Hirsch over at the Stock Trader’s Almanac is in today’s NYT predicting a 20-30% correction ahead (see Stocks Soar, But Many Ask Why on page B1) — he notes the modest number of stocks hitting new 52-week highs with every new interim peak being reached by the overall market.

• The leading indicators are all pointing to a slowdown, and this could show up in a critical data-release week in mid-April with retail sales on the 14th, industrial production on the 15th, and housing starts, as well as consumer sentiment, on the 16th. The broad money supply measures are contracting again as the Fed is no longer boosting its balance sheet at a time when both the money multiplier and money velocity are showing no signs of turning higher.

• Greece will be put to the test in April when €15 billion of bonds have to be rolled over (through the end of May).

• The Fed ceases to buy mortgage securities on Wednesday and this is happening at a time when mortgage rates have already climbed back above 5% and the housing market is showing signs of rolling over again. See Spike in Treasury Yields Jolts Mortgages on page C2 of today’s WSJ. There is also pressure from within the Fed (Plosser the latest) to soon begin to sell securities outright. One thing that is very likely on its way again is another 50bps hike on the discount rate — has anyone noticed the TED spread beginning to widen ahead of this? The banks, going forward, will not have easy access to the window and will have to rely on each other for funding.

• April 15 looms as a critical day from a geopolitical standpoint. It is the day that the Treasury Department will issue its report concluding whether or not China is a currency manipulator. If it is viewed as such then trade sanctions are likely to ensue and very likely some bilateral tensions. This could be very good news for the bullion market (as well as the Bloomberg News report today stating that gold imports in India are surging right now — up six-fold from a year ago — as there are an expected 1 million marriages planned for April and May). Sentiment is so negative on the U.S. Treasury market it’s not even funny. Everyone seems to focus strictly on supply without realizing that the only way to predict a price is by forecasting both supply and demand

• Speaking of geopolitical risks, President Obama has allowed U.S. relations with Israel to deteriorate to such an extent, and is handling the Iran nuclear situation with such a kid-gloves approach, that disturbing columns like this are now popping up in newspapers like the NYT (Rift Exposes Larger Split In Views On Mideast — page A4), the National Post (Iran Preparing to Build Two More Secret Nuclear Sites in Mountains, Experts Say — page A8), and the WSJ (How the Next Middle East War Could Start — page A23). Even the prospect is enough to underpin the energy stocks, which are currently priced for $69/bbl on WTI.

Fear Of Missing More Rally

Although that is an impressive looking worry list, it is important to understand those are things that very few are really worried about.

For example, with mutual fund cash levels at all time record lows, it is difficult to place any credence in the widespread thesis “the market is climbing a wall of worry”.

Indeed, there is no general worry, unless you mean fear of missing more of the rally in equities. The only other widespread worry is fear of massive inflation or fear the dollar will collapse. From where I sit, neither seems very likely.

For all this talk about worries, the one thing not on anyone’s worry list is a huge market decline and the distinct possibility the market bottom is not even in. No one is worried about that. However, they should be.

Mike “Mish” Shedlock
http://globaleconomicanalysis.blogspot.com
Click Here To Scroll Thru My Recent Post List

Posted by Karl Denninger

There’s no other way to describe this:

Bad.  Actually, let’s go worse than bad and call it what it is – by any definition this is just one step off from “Failed.”

Yield was way over where it was trading at the time, as you can see here:

The more-worrying factor here is that we’ve got this “mystery” direct buyers out here again taking nearly 25% of the offered amount (who is bidding for that undisclosed?) and another 11% taken down by The Fed for the SOMA account.

Yet even with this Treasury had to pay up to get it to go and the bid-to-cover was anemic at best.

Given the Primary Dealer system we have in this country, any BTC under 2.0 is an effective fail.  To get an auction that behaves in this sort of fashion, complete with mystery direct bidders and heavy SOMA (Fed) participation, yet Treasury has to pay up in the form of a significantly higher coupon is not a good sign at all.

Remember folks, this sort of issuance isn’t a local event.  It will continue through the year, as we are on track to run record budget deficits, so the premise that “it will all be ok and this won’t start a ratchet up of rates on the long end” is perhaps more than a bit fanciful.

Rick Santelli gave the auction an “F” and I agree – there’s simply no possible way to read this as anything positive at all, and that the equity market is ignoring it (other than a quick, small spike downward on the release) likely has more to do with how tightly equities have become coupled to the dollar in the last couple of weeks than anything else.

Foreign Central Bank Treasury Holdings At The Fed Decline In January For The First Time In Years

Submitted by Tyler Durden

The last thing that the fixed income market needs now, with ever greater uncertainty out of European bond land,  is weakness where it hurts the most: the US balance sheet. Yet last Thursday’s H.4.1 report indicated something which could be more troubling than even Greece’s credit crisis morphing into a liquidity one, namely, that foreign central banks’ UST holdings at the Fed declined for the first time in over two years.

What could be precipitating this? Quite a few factors have emerged recently:

1) A seemingly endless supply of Treasuries (especially the 2,5, and 7 Y) for which the indirect take down continues to be over 50%. This alone is confusing in light of the custody decline.

2) Concerns over developed country sovereign risk: last week S&P downgraded it Japan outlook and issued a scathing report on UK sovereign and financial risk.

3) Kansas Fed’s Hoenig dissent on tightening monetary policy. This is the proverbial first shot across the Fed’s bow. Hoenig’s “believed that economic and financial conditions had changed sufficiently that the expectation of exceptionally low levels of the federal funds rate for an extended period was no longer warranted.”

4) Economic conditions have taken a decidedly bearish tone. JPM’s EASI index of economic surprises (lower means greater amount of negative surprises) just took a dramatic turn lower.

5) Flattening and outright inversion in a variety of financial corp spreads in the 5s10s bracket.

6) AAA CMBS spreads widened by 30 bps. If sovereign risk is in question, why should insolvent REITs be any better?

Regardless of which specific set of news may have precipitated the January Treasury effect, this is truly a scary observation, which however does not jive with the indirect take down continuing to be as strong as ever: if indeed the custody data is correct, then all the indirect bid data has to be taken with not just a dash of salt, but as Rosenberg says, an entire salt shaker.

by Daniel R. Amerman, CFA

Overview

About 80% of net issuance of total US Treasury and Agency debt has become an artificial market, lacking real investors, and relying on the fiction of Federal Reserve purchases with imaginary money in order to prop up prices and hold down yields.  At the same time, Treasury secretary Geithner claims to be so pleased with this non-existent market that he wants to increase the average term of Treasury borrowings.  The juxtaposition is deeply bizarre, yet passes nearly without comment in the mainstream media.  In this article we will delve beneath the façade being maintained by the government, Wall Street and the media, and will uncover the cheating of small investors in a market where most of the buyers don’t actually exist.  Finally, we will introduce the hidden opportunities within sham markets.

A “Twilight Zone” Treasury Market

When reading the financial pages, do you ever get the feeling that you’re reading the script for an episode from the old television series, “The Twilight Zone”?  Perhaps one where the normal family is inside eating dinner, getting ready to let the kids go outside and play, but what they don’t realize is that all the normal looking people they see walking past their windows are in fact zombies, and the entire town has been taken over?

I usually don’t spend too much time thinking about zombies, but this is the exact kind of feeling that I got when reading about United States Treasury Secretary Geithner’s plan to increase the duration of US treasury borrowings.  That is, he wants to take advantage of the “current low level of interest rates” to substantially increase the average term at which the Treasury borrows, so instead of an average due date of 49 months, he intends to move it out to an average of 72 months.

I first read about this in a Bloomberg article, and what brought “The Twilight Zone” to mind was that the entire article was written with a straight face, so to speak.  Reading the article, one would think we actually had a free market for US treasury debt, where demand for the debt and the interest rates on that debt were in fact being determined by investors of their own free will.  

This is where the zombie army comes in, that purported vast army of investors whose investment choices are determining current interest rates for US long-term and agency debt.  They don’t really exist.  Instead, the largest buyer of net issuances of US treasury bonds, of long-term agency debt, of mortgage-backed securities, is in fact the Federal Reserve.  (Net issuances being the excess of newly issued debt over retired debt, i.e. the net amount by which government debt is growing.)  And the Federal Reserve is effectively creating money out of thin air to buy these long-term treasuries. 

Plainly put –when one branch of the government is creating money out of nothingness to buy the debt of another branch of the government – they aren’t real buyers nor investors, but a sham.  A very dangerous sham for investors, who, based upon reading the mainstream financial media, believe the financial world is anywhere close to normalcy, and that they are getting fair returns for their investments.

The Real Source Of Funding (aka The Zombie Army)

Hedge fund analyst Jon Harooni and macro analyst Ravi Tanuku, in their article “Who Is Really Lending The U.S. All This Money?” (published in the hedge fund industry periodical Absolute Return + Alpha), track down what is actually happening, the real source of these funds.

Out of nearly $2.1 Trillion of net issuance across the Treasury, Agencies and MBS markets from June 2008-9, the Federal Reserve has accounted for nearly 40% of the total demand, buying more than every foreign government combined. It is also not a stretch to say the Fed has become the entire mortgage market; it has purchased nearly $500B of MBS securities during a period where there was only $350B issued. Looking at the first seven calendar months of 2009 yields similarly startling results: of the total $1.1 Trillion of net issuance across these markets, the Fed has purchased $861B or almost 80%.  (bold emphasis mine)

http://www.absolutereturn-alpha.com/Article/2319666/Who-is-really-lending-the-US-all-this-money.html

The reason that the Federal Reserve has been taking these unprecedented steps on a massive scale is that given the huge amount of current United States government deficits, combined with the weak economy, the vast amount of spending for bailout, stimulus and so forth, there simply aren’t enough buyers for all this debt.  Moreover, in a true free market, investors would demand a far higher interest-rate level than what they’re getting right now, if they were to continue to fund a government that is spending with neither restraint nor a credible source of funding for repayment.  In a free market, we would expect those interest rates to keep rising until they are so attractive that actual investors buy up all the debt.

If this free market scenario were to happen, the US government budget deficit would skyrocket to a far higher level, because the US government would be paying higher interest rates on its borrowing (the missing free market link that is supposed to restrain governments).  There would also be high pressure on housing markets, as mortgages became unaffordable.  So the situation is that in order to fulfill its plans, the US government needs to borrow fantastic sums of money – but the lenders simply aren’t there.  As the only alternative, the Federal Reserve effectively creates the money out of thin air to fund the rest of the government.

That is an extraordinary result, which shows just what a bizarre place the financial world has become, even as the government, media and investment firms struggle to put up a façade of normalcy.

Eighty percent of the US debt market no longer exists, in terms of net new debt issuance.  There isn’t enough demand, and increasing rates to find demand would inflict punishing damage.  So artificial “Zombie” investors are created, who buy the debt with artificial money, and the façade is maintained – at least for now.

The Systemic Cheating Of Small Investors

What is the price for individuals of buying into this façade?  Of leaving the safety of their home, and joining the Zombie army of phantasmic investors, buying at current market levels?  Whether directly, or through their mutual funds or retirement accounts?

This is not an innocent process, nor is it for the greater public good. Instead, let me suggest that it is a process that deliberately takes wealth from naïve investors, particularly individual investors who believe what they read in the mainstream media, and it transfers that wealth to both Wall Street and to the federal government. This is something that I have been writing and speaking about for a long time now (my article “Fed Manipulations Subsidize Wall Street And Cheat Investors”, addressed this subject two years ago).  So it’s been happening for quite a while, but it keeps getting worse and worse, and the idea that we’re indeed in the financial “Twilight Zone” becomes increasingly difficult to deny.

The problem with systemic government interventions is that as they grow in scale, the degree of mispricing grows greater and greater.   As any bond investor knows, for a given bond with a fixed coupon, the higher that interest rates move, the lower the price of that bond goes.  Why would anyone pay 100 cents on the dollar for a bond that pays a 3% interest rate, when there are plenty of new bonds around at 6% that can be bought at “par” (100 cents on the dollar)?  Therefore, anyone who pays full value for a new bond with a rate that is below market, is getting cheated at the moment they make their purchase.

This principle is illustrated in the graph above.  The all blue bar on the left side of the graph represents the value of 10 year US Treasury bonds with a 3.50% coupon.   If 3.50% were the real market rate (in which case Fed purchases would be unnecessary), then this bond would be worth 100 cents on the dollar.  With each bar to the right, the real interest rate shown on the bottom goes up – and the market price for 3.50% ten year bonds goes down. 

For instance, if real market rates would be 6.50% without zombie investors – the free market price would be less than 80 cents on the dollar.  Meaning current purchasers who buy into a manipulated market where the other investors don’t really exist, are getting cheated out of 20 cents on the dollar, every time their fixed income fund buys a 10 year treasury bond. 

However, keeping in mind that the US government was already effectively bankrupt before the financial crisis ever hit due to Boomer retirement obligations that can’t be paid, and the government is currently spending trillions without restraint – 6.50% would be a very low free market rate for the current situation.  If the proper market were 9.50% for the world’s largest unrepentant spendthrift – every investor is getting cheated out of about 40% of the value of their investment.

At 12.50% the true market price should be less than 50 cents on the dollar, and at 15.50%, it would be about 40 cents on the dollar.  Meaning investors are getting cheated out of 60 cents with each new bond they buy.  What the true market yield would be for the government to actually borrow “real” dollars, we can’t tell without a legitimate free market of actual investors.  But whatever the level, any individual who buys today at rates set by a market primarily made up of unreal investors, is getting cheated on a very real basis.

(It is a quite different story for institutional investors who borrow from the Fed at artificially low rates, to purchase bonds from the Treasury at somewhat higher artificially low rates, as covered in my previously mentioned article “Fed Manipulations Subsidize Wall Street And Cheat Investors”.)

Now the price of this manipulation after manipulation on top of manipulation is mispricing, mispricing, mispricing from the perspective of the average individual investor.  Believing what they’ve been hearing from the economics and financial community, and believing in what they’re reading in the mainstream financial media, these investors think that when they buy US treasury bonds they’re getting a fair rate of return on that treasury bond. They believe if they step up and buy a mortgage-backed security, they’re getting a fair rate on that mortgage backed security. And they believe if they purchase a stock with their 401(k) or IRA, they’re getting a fair price on that stock.

They’re not.  Instead, the Federal Reserve and US treasury are cheating small investors out of returns that should be theirs.  If someone buys a US treasury bond or a mortgage-backed security, the yield ought to be far higher in compensation for the risks that are involved right now with the US economy and the massive extraordinary government deficits.

The Next Step

Almost two years ago, in a series of public articles, I predicted not just financial disaster, but the process with which financial disaster would unfold. 

1. Using my professional background as a derivatives author and former investment banker, I explained why the subprime mortgage crisis would get much worse.
2. I explained the understandable, human reasons why the investment banking industry was creating enormous systemic risk with credit derivatives, and that the crisis would jump from mortgage derivatives to credit derivatives (i.e. AIG).
3. Long before September of 2008, I explained how Wall Street could melt down in a week or an afternoon, not from accounting losses, but from losing the short term funding that the heavily leveraged financial giants relied upon, as the extent of losses become clear to creditors during a derivatives market collapse.
4. I predicted that the government would not allow this meltdown to occur, but would instead engage in the largest bailout in financial history.
5. I projected that the bailout would necessarily reach a size that it could no longer be financed conventionally, and the Federal Reserve would resort to directly creating money without limits, to fund the massive bailout.
6. I explained why this would ultimately lead to the destruction of the dollar and of retirement savings through a massive bout of monetary inflation.

(All of these explanations were publicly published through contrarian websites and widely circulated on the Internet at that time.)

To my knowledge this accurate, step by step explanation of what would be happening and why, was absolutely unique – though for the sakes of all of us and of our families, it would have been much better if I had been entirely mistaken.

Unfortunately, it is very difficult to see any path out of this other than Step #6 – massive inflation that will destroy the value of the dollar, and conventional investment strategies along with it.  Indeed, it has already happened, and all that prevents a sudden spike in interest rates is the Fed’s 80% funding of the market for US and agency debt, in combination with China and Japan’s urgent economic need to prop up the dollar, manipulating its value through the purchases of US government debt.  Each source of funding creates ever growing instability, and that foreign investors are fleeing longer term agency debt is a sign that they are keenly aware that the end may be nigh.   

Your Choice:  Victim or Beneficiary

So what is an individual to do?

Let me suggest there are powerful reasons not to be taking your assets – particularly your retirement savings – and purchasing investments where we know that the value is being deliberately manipulated by the US government and Wall Street for their own purposes. To purchase under those conditions is to set yourself up for victim status.  I would argue that this applies as much to stocks as it does to Treasury Bonds.

There is another approach, which is to say that these fundamental unfairnesses, these fundamental manipulations, these fundamental mispricings by their very nature necessarily create arbitrage opportunities for individuals and institutions that know how to look for them.  Indeed, that is their very purpose – to effectively give “Free Money” to Wall Street in the form of huge profits with reduced risk, in order to rebuild firm capital – with much of those profits then passing directly into the bonus pools of the exceptionally politically well connected individuals involved. 

However, participating in these handouts is not your intended role.  From a traditional mainstream finance perspective, your role is to systematically take your savings and every month invest them in mispriced securities, for which you will pay the financial institutions an all-in average of about 2% in fees every year, even while the benefits of the mispricing pass to others.  As an individual, you cannot directly participate in Wall Street’s insider’s game, not unless you are bringing many millions to the table, and then it is still somewhat problematic whether you will end up as predator or prey.  However, in the process of manipulating markets, the government also necessarily did something else – and that was to leave the back door open. 

A mispriced market is a market that is rife with profit opportunities.  The trick being how to access these opportunities, when traditional personal finance strategies involve buying overpriced securities.   To find the back door, we have to leave the traditional personal finance strategies behind, and learn exactly how the system is being manipulated for the benefit of institutional insiders, through liability based bailouts.  When we clearly see those manipulations, then we have something else that opens up for us –  a veritable playground of opportunities for investment, indeed, some of the best we may find in our lifetimes.

But first we need to be able see these opportunities and that means we need to start with education.

This morning we got this from Bloomberg:

Retiree Annuities May Be Promoted by Obama Aides (Update2)

By Theo Francis

To contact the reporter on this story: Theo Francis in Washington at tfrancis14@bloomberg.net.

Jan. 8 (Bloomberg) — The Obama administration is weighing how the government can encourage workers to turn their savings into guaranteed income streams following a collapse in retiree accounts when the stock market plunged.

The U.S. Treasury and Labor Departments will ask for public comment as soon as next week on ways to promote the conversion of 401(k) savings and Individual Retirement Accounts into annuities or other steady payment streams, according to Assistant Labor Secretary Phyllis C. Borzi and Deputy Assistant Treasury Secretary Mark Iwry, who are spearheading the effort.

Annuities generally guarantee income until the retiree’s death, and often that of a surviving spouse as well. They are designed to protect against the risk that retirees outlive their savings, a danger made clear by market losses suffered by older Americans over the last year, David Certner, legislative counsel for AARP, said in an interview.

“There’s a real desire on a lot of people’s parts to try to encourage something other than just rolling over a lump sum, to make sure this money will actually last a lifetime,” said Certner, legislative counsel for Washington-based AARP, the biggest U.S. advocacy group for retirees.

Promoting annuities may benefit companies that provide them through employers, including ING Groep NV and Prudential Financial Inc., or sell them directly to individuals, such as American International Group Inc., the insurer that has received $182.3 billion in government aid.

Balances Fall

The average 401(k) fund balance dropped 31 percent to $47,500 at the end of March 2009 from $69,200 at the end of 2007, according to a Fidelity Investments review of 11 million accounts it manages. The Standard & Poor’s 500 Index tumbled 46 percent in that period. The average balance of the Fidelity accounts recovered to $60,700 as of last Sept. 30 as the stock market rebounded.

There is “a tremendous amount of interest in the White House” in retirement-security initiatives, Borzi, who heads the Labor Department’s Employee Benefits Security Administration, said in an interview.

In addition to annuities, the inquiry will cover other approaches to guaranteeing income, including longevity insurance that would provide an income stream for retirees living beyond a certain age, she said.

“There’s been a fair amount of discussion in the literature taking the view that perhaps there ought to be more lifetime income,” Iwry, a senior adviser to Treasury Secretary Timothy Geithner, said in an interview.

Lump Sums

“The question is how to encourage it, and whether the government can and should be helpful in that regard,” Iwry said.

While traditional defined-benefit pensions were paid out as annuities, providing monthly payments for retirees and often their spouses, workers increasingly are taking advantage of options to receive lump-sum distributions.

Only 2 percent of 401(k) plan participants convert retirement savings into an annuity on retirement, according to a July 2009 report from the Retirement Security Project, a joint venture of Georgetown University’s Public Policy Institute and the Brookings Institution in Washington.

A survey of 149 companies released on Dec. 17 by employee- benefits consultant Watson Wyatt Worldwide, now part of Arlington, Va.-based Towers Watson & Co., suggested that about 22 percent of employers with retirement savings plans offered retirees the choice between an annuity and a lump-sum distribution.

Annuity Sellers

Government success in getting workers to move retirement assets into annuities may prove profitable for insurers that sell annuities, Anne Mathias, policy research director for Washington Research Group, a policy analysis unit of Concept Capital, said in an interview.

Retirement plans, including 401(k) accounts, held $3.6 trillion in assets at the end of the second quarter of 2009, while annuity investments of all kinds totaled about $2.3 trillion, according to figures from the Washington-based Investment Company Institute, a trade association for asset managers.

The top sellers of individual annuities in the U.S. include AIG, MetLife Inc., Hartford Financial Services Group Inc., Lincoln National Corp. and New York Life Insurance Co., according to figures from the American Council of Life Insurers for 2008. The top group-annuity sellers include ING, Prudential Financial, MetLife and Manulife Financial Corp.

Under Fire

Asset managers are concerned the government may go too far in encouraging annuities, said Mike McNamee, a spokesman for the Investment Company Institute. Seven in 10 U.S. households would object to a requirement that retirees convert part of their savings into annuities, according to a survey the group released today.

“Households’ views on policy changes revealed a preference to preserve retirement account features and flexibility,” the institute said in a report.

The institute also said annuities have received support from academic research and “it is unclear why individuals usually forego the annuity option” even when it is available. The survey didn’t ask about potential efforts by the government to encourage voluntary use of annuities.

Annuity sales to individuals have come under regulatory scrutiny in recent years over the size of sales commissions and whether some varieties are suitable for older investors.

Social Security

John Brennan, the former chairman of Vanguard Group, the Valley Forge, Pennsylvania-based mutual-fund company, criticized annuities today as often expensive and offering little inflation protection. Americans already benefit from “the best annuity in the world, which is Social Security,” Brennan said in an interview on Bloomberg Television.

AARP’s Certner said policy makers could avoid many of those pitfalls by encouraging the use of group annuities, which are bought by employers rather than individuals and often carry lower fees, or using approaches that provide retirement income without commercial annuities.

Adding lifetime income to 401(k) plans won’t be sufficient for many workers because they can’t, or don’t, save enough to live on in old age, and Social Security often proves inadequate as more than a safety net, said Karen Ferguson, director of the Pension Rights Center in Washington, D.C.

Senate Bill

“It’s a great idea, but how much are people really going to get out of it?” she said. A better approach would be to give employers incentives to revive defined-benefit pensions, which have languished as employers have focused on cheaper and more flexible 401(k) plans, Ferguson said.

One proposal raised by Iwry as co-author of a paper while at the Retirement Security Project, before joining the administration, has reached Congress. A bill requiring employers to report 401(k) savings both as an account balance and as a stream of income based on an annuity was introduced on Dec. 3 by Senators Jeff Bingaman, a New Mexico Democrat, Johnny Isakson, a Georgia Republican, and Herb Kohl, a Wisconsin Democrat.

On CNBC this morning, Rick Santelli from the CME had this to say:

The floor is a bit abuzz. There is published reports out that I am getting from many of my sources about something the Obama administration is going to put towards a public comment period. This is very early in the process, but it goes something like this – avg Americans were hurt big during the big givebacks in their IRAs when the credit crisis pushed stocks down. So remember how IRAs are formulated, they are thinking of changing that and allowing more of an annuity scenario. Now if you think this thru what it means is instead of a bit of your paycheck going into equities every week, it will probably be going into things like Treasuries it would be a little bit lower return but it would be safer and this is very early but you want to pay attention to any new stories coming out about this annuity conversion they are going to put out for public comment.

Sue Herrera and Tyler Mathiesen comment about (a) isn’t this the wrong time to go into treasuries since folks coming on CNBS are saying it is, and (b) people can already put their IRA monies into Treasuries if they want.

Rick responds: The difference is that it is going to be something that is going to be more of a large scale program a very simple one and more of a conversion as well. Like I said early stages, but the range of opinions is “hey it is not a bad idea” to very cynical that we are worried about who is going to buy treasuries ad infinitum.

Rick’s a pretty sharp guy and most importantly, he tells the truth.  So, what does this all mean?  We shall translate:

US Treasury To Americans:  To Prevent Treasury Market Collapse, We Will Force YOU To Buy Treasuries In Your Retirement Accounts

The U.S. Treasury and Labor Departments will ask for public comment as soon as next week on ways to promote the conversion of 401(k) savings and Individual Retirement Accounts into annuities or other steady payment streams, according to Assistant Labor Secretary Phyllis C. Borzi and Deputy Assistant Treasury Secretary Mark Iwry, who are spearheading the effort.   Business Week

In other words, Social Security Trust Fund II.   As of last month Fund I is broke.   Summary of 2009 Annual Reports Social Security Board of Trustees    The government already stole all this money, and has not been refunding it for years.  With all the deficit expenditures heaped on top of this, which have gone exponential in the last two years, Social Security ran out of money completely last year, more than 5 years ahead of the previously projected date.  This means that retiree’s checks only go out through DAILY sales of Treasuries.  So, if they sell them to YOU, perhaps you can fund the retirees.  Heh.  Talk about a Ponzi scheme that is doomed to go the way of Bernie Madoff.

 Although this proposal will be presented shortly by the administration as being a ‘frugal choice,’ maybe even the ‘patriotic choice.’  And this will actually sound good to the people who were scrambling around in 2008 trying to find a safe-haven for their retirement accounts during the stock market sell-off.   Indeed, historically speaking,, there has never been a safer asset class in which to be invested.  The problem is, this time we aren’t talking about just a stock market (equities) crash, we’re talking about a potential crash in the Treasury market.  The reality is that there is no one left to buy Treasuries and they need YOU to fund their debt.  After all, China stopped buying Treasuries (funding our debt) in October 2009, but of course no one is talking about this. 

 Press Release:  Treasury International Capital 

 Major Foreign Holders of Treasury Securities 

You see, if they force people to buy Treasuries now, at the current price, when more and more foreigners stop buying, like China did, the price goes down as the yields (interest rate) goes up.  Thus, all the people forced to buy in here will LOSE a tremendous amount of money. 

 Expect the procedure to look something like this:

Step 1 – Make this ‘option’ available
Step 2 – Listen to crickets
Step 3 – Crash stock market
Step 4 – We’re the government and we’re here to help. All your IRA are belong to us. Or of course, you can risk it in stocks if you want.

It’s step 5 they wont’ tell you about:  Treasury market crashes, after all your money has been allocated into it.  It’s exactly like herding sheep.

At this point, anyone expecting the government to be honest about their true intentions about this proposal, or anything for that matter,  is woefully misguided.

Since the biggest financial collapse in world history was built on credit related to housing, it is pretty obvious that we should be paying very close attention to that market. The reasons are complex, but a recovery must be based on the liquidation of bad debt. The sooner that happens the quicker a recovery will happen.

When we mean “liquidation of debt” we are talking about a mountain of credit built on the housing bubble. This phony bubble wealth permeated the entire economy. When home owners saw the price of their home rising, they saw it as a source of capital to use for a variety of things, but let’s face it, most people spent it.

New stores opened, malls were built, financial institutions grew, cars and boats, second homes, vacations, and restaurants all flourished. Credit card debt mushroomed. Home mortgages were increased to pull cash out for spending. Yes, some of it went to good things, like our children’s education, helping our aged parents, and paying off bills. But the reality was that our debt kept growing.

The clever lads created even more phony wealth under the guise of insurance, but as we found out, companies like AIG really had no idea how large their obligations were for credit default swaps written against almost any financial risk. And these instruments were further leveraged without understanding the magnitude of these triple-counted obligations or their relationship to housing.

It all comes back to housing as the fuel for the 70% of our economy that was consumer spending. The thought was that housing has always gone up, and if it went down, it really never went down if you averaged growth since the post-WWII-period. A drop of 10%? Never has happened. 20%? Not even a 6th deviation possibility.

My thesis has been that this was all fueled by the Fed through monetary policies that created and supported the bubble. Aided and abetted by governmental policies and financing schemes that favored housing and risky loans. This was not a “free market” phenomenon. Far, far from it.

My thesis has also been that we can’t recover until all this bad debt is liquidated, and capital generated by savings is created and ultimately invested in profitable enterprises. It would be a mistake to rekindle the bubble. But, as we know, that’s what our government is trying to do. The government creates uncertainty as it flails around with programs, spending, and debt schemes to revive the economy. As a result mark-to-market accounting is thing of the past and banks are guarding their balance sheets, corporations are sitting on a lot of cash, cutting costs, and becoming leaner, and Mr. and Mrs. America still favor savings and debt instruments over equities and spending.

The big question: is the housing market bottoming out? Because once it does, debtors and debt holders will then have a handle on how great their losses are. When the bottom is falling out, it is difficult to get lenders to lend if they are afraid their remaining cash reserves will be needed to shore up the bank because of loan losses. The holders of subprime debt find it difficult to value their assets while housing values are still dropping.

Lenders have been shepherding their cash, reducing debt obligations, and cutting back lending and new investments because they do not know how deep their hole will be until housing bottoms out. Keynes called this a “liquidity trap.” More reasonable people, especially the Austrian school economists, call this a reasonable and necessary response to uncertainty.

The Fed and the federal government have been flogging this liquidity trap issue without let up and basically credit is still drying up. A 0.25% Fed Funds rate is basically a negative rate and they still can’t get banks to lend. The Fed’s balance sheet is at a record high. They have bought $850 million of mortgage backed securities. They are injecting cash into lenders. They have basically suspended mark-to-market accounting.

In Q3, the FDIC reported that bank lending still contracted by 3%:

Loans and leases held by U.S. commercial banks have declined for 10 straight months, falling to $6.7 trillion as of Oct. 28 from $7.2 trillion at the end of 2008, according to a separate statistical release from the Fed.

 

Commercial and industrial loans have dropped to $1.37 trillion from $1.6 trillion, commercial real-estate loans have declined to $1.66 trillion from $1.72 trillion, and consumer loans have fallen to $847 billion from $857 billion at the end of last year.

What do banks do? They have decided they would rather hold Treasury paper instead of make loans. This chart shows what’s been happening. No wonder T-rates have stayed so low despite massive deficit financing.

This is what makes Bernanke, Geithner, and Summers lose sleep at night. “It’s supposed to work, dammit!” Maybe this is why Summers is always falling asleep. No matter what they’ve tried, they can’t get banks to lend. I think they are very worried about this and while they say the economy is recovering nicely, they are crossing their fingers at the same time.

Back to housing.

I have been saying that I think the housing market is finding a bottom. I thought that low prices and rising affordability was the main driver of the housing market. If this were so, then housing prices would reflect real market valuations and this would finally bring about the liquidation of assets and debt wastefully invested during the prior artificial credit cycle. Lenders would know where they stood financially and would liquidate bad assets and rebuild their balance sheets. No more waiting around wondering what the Fed or the government would do to save housing.

I was wrong.

The housing market I now believe is being sustained almost entirely by the Fed and the federal government. This rekindling of the housing bubble is counterproductive and will hinder a real recovery of the economy because an artificially backed market will delay the necessary liquidation of the prior cycle’s malinvestment of capital.

Here is why I changed my mind:

First, 59% of new home buyers are relying on government-backed FHA, the Veterans Administration, and the Department of Agriculture loans. Most of these sales are driven by the first-time home buyers tax credit. The tax credit program has been extended through April, 2010.

Second, existing home sales are being driven by the tax credit and by foreclosure and short sales. Existing home sales are up 10.1%. Distressed sales — mainly foreclosures and short sales — accounted for 30% of transactions in the third quarter. And. according to the NAR, home sales are being driven by first time home buyers trying to make the previous November deadline.

This will have a negative impact on future sales. Like Cash for Clunkers, these government-driven sales may just be eating into sales that would have occurred in 2010. Many economists are referring to this phenomenon as “payback.”

Third, mortgage rates are now at 30 year lows. Another Fed related gift to home buyers. The average 30-year mortgage rate was 4.95% in October, down from 5.06% in September, according to Freddie Mac. Today, Freddie said the rate was down to 4.7%.

But … home prices are still falling. The S&P/Case-Shiller index of prices fell 8.9% for the July-through-September period from a year earlier. That was an improvement from the 14.7% drop in the second quarter and the 19% decline in the first three months of 2009. Median prices of existing homes fell in 123 of 153 metropolitan areas during the third quarter compared with a year earlier. The national median price was $177,900, down 11.2% from the third quarter of 2008. [Don't ask me to explain the disparity. Case-Shiller and NAR measure this differently.] Last month the median price for an existing home was $173,100, down 7.1% from $186,400 in October 2008.

Thus, despite record interference in the housing market by the government, home prices are still falling. There are several reasons why it is likely that home prices will continue to fall.

Almost 25% of home owners are upside down with their mortgages. Nearly 10.7 million households had negative equity in their homes in the third quarter, according to First American CoreLogic. This shadow market is huge:

Home prices have fallen so far that 5.3 million U.S. households are tied to mortgages that are at least 20% higher than their home’s value, the First American report said. More than 520,000 of these borrowers have received a notice of default, according to First American. …

 

But negative equity “is an outstanding risk hanging over the mortgage market,” said Mark Fleming, chief economist of First American Core Logic. “It lowers homeowners’ mobility because they can’t sell, even if they want to move to get a new job.” Borrowers who owe more than 120% of their home’s value, he said, were more likely to default.

 

Mortgage troubles are not limited to the unemployed. About 588,000 borrowers defaulted on mortgages last year even though they could afford to pay — more than double the number in 2007, according to a study by Experian and consulting firm Oliver Wyman. “The American consumer has had a long-held taboo against walking away from the home, and this crisis seems to be eroding that,” the study said.

This overhang will continue to drive prices down. There is no way the Feds can force lenders to modify enough loans to make a serious dent in this overhang. It’s imply too big. Eventually the losses from forced modifications will mount and the FHA or any other agency will not be able to pay off their guarantees to lender. Nor should they try.

Mark Zandi, who correctly predicted a crisis in the housing market, but not the Crash, said on Wednesday, “The housing crash is not over.” He said the lull in foreclosure sales for the past few months, due to the government’s pressure on lenders to modify loans, has resulting in higher prices. He expects Case-Shiller to bottom by Q3 2010 with an overall price decline of 38% (now at 32%).

“Foreclosure sales will increase, and home prices will resume their decline by early 2010 as mortgage servicers figure out who will not qualify for a modification,” he said.

 

Zandi said 7.5 million foreclosure sales will have taken place between 2006 and 2011. The majority of these sales, however, have not emerged yet, with 4.8 million foreclosure sales expected between 2009 and 2011.

What this means is that the housing supply, now down to a 7+ months supply, will rise again, and prices will continue to decline. We haven’t seen the bottom yet.