The War On Subprime Terror

The War On Subprime Terror

By Jon Nadler, Senior Analyst, Kitco Bullion Dealers
24 Sep 2008 at 09:11 AM

MONTREAL (ResourceInvestor.com) -- The 78-year old mogul could now be entitled to don a red cape and motivate others such as Bill Gates, Larry Ellison, or the Google Boys to follow his altruistic and patriotic example and put some of their fortune into the very economy that has enabled them to become who they are. Overseas equity and commodity markets reacted as one would expect to the news.

Plan "P" hit several speed bumps in the Senate yesterday and it is unlikely to be adopted in its current guise by lawmakers feeling the heat from those who elected them. As there is no plan "B" in the Bernanke/Paulson bag of tricks, the bailout package will have to be nipped and tucked so as to make it more palatable to those who only see it as a rescue of the firms that got the world into this mess to being with. Fannie, Freddie, Lehman, and AIG have become the targets of FBI probes intended to find possible fraud at the heart of the meltdown that shook America. At the UN yesterday, several speakers were heard taking joy in America's misfortunes and ridiculed the idea of stepping up to help it, despite the deleterious effects that a U.S. meltdown would have on their own economies as a result.

The Bush administration and candidate McCain are losing the support of some of their most vocal cheerleaders like columnist George Will and Senator Graham (S.C.). Many in the electorate see the bailout and the salesmanship it received yesterday as a replay of the hearings in which the Iraqi WMD excuse was being used to convince lawmakers to give a thumbs-up to going to war. Certainly, if one watched Mr. Paulson describe in gory detail the possible effects of the Financial WMDs that Wall Street has unleashed upon the US economy, there was no time to waste in approving the "War on Subprime Terror." Some financial writers have joined a very small start-up tinfoil hat club that believes these massive Wall Street cave-ins to have originated overseas and that they may eventually be found to bear the fingerprints of economic terrorism. As in, an economic 9/11.

New York gold trading opened the midweek session at $893 after the overnight low of $879 held and light buying emerged ahead of today's headlines. Gold remains confined within the $875-$925 channel and as participants await Mr. Bernanke's sales presentation on Capitol Hill for a second day. Traders are seen as reluctant to take significant positions before the rescue plan takes shape, but volatility will remain visible so long as the package faces legislative headwinds and uncertainty continues in other markets. The dollar was off a tad, at 76.55 on the index, while crude added just over $2 to $109 per barrel. Gold will continue to benefit from the funding squeeze that continues to chill markets but still has its buyers wondering why it has not left the $900 station in a major hurry given the current apocalyptic conditions. These are, after all, looking like the end-time scenarios which many had written about for decades.

Silver gained 20 cents to $13.48 and platinum and palladium rose as well, the former quoted at $1216 up $13 and the latter at $247, up $1 per ounce. Significant automotive news from Chrysler: it intends to bring three electric vehicle to market within two years. Makes one wonder how long such blueprints were on the shelf and why they were not brought to life earlier. In any case, cheers for American know-how and resolve. Now, if they can only apply such ingenuity to make the place independent from toxic mortgages.

At this time, we bring you excerpts from a profound piece entitled "Shock and Awe" by Minyanville's Todd Harrison. The full text is available on Marketwatch. Read it and ponder the situation as well as the possibilities...

" Sir Isaac Newton offered that for every action, there is an equal and opposite reaction. His laws were clearly created before the advent of derivatives. The free market system officially broke last week and the ramifications are profound. A new world order is upon us, one that will forever change the construct of capitalism.

We often say that to appreciate where we are, we must understand how we got here. That isn't a quick conversation or a sound bite; it's an educational evolution we must all take responsibility for. That is why we provided a contextual backdrop last week and it's precisely the reason we created Minyanville. Discussing the fragility of the financial fabric is a moot point. While the blame game percolates in political circles, the rest of us are left to stress through the mess.

There will be massive opportunities on the other side of this ride. Our goal is to persist through this process of price discovery and be in a position to prosper when the eventual recovery arrives. As many issues vie for our collective mindshare, we'll break them down into five things you need to know about our current state of affairs.

Will the government bailout work?

We've long offered that the only true solution for what ails the market is debt destruction and said that this dynamic would come to a head in September when corporate credit came due. While that ultimate destination is unavoidable, the path we take to get there remains an open question. There are two alternative scenarios, neither of which is particularly pleasant to ponder.

'You're gonna need a bigger boat.' ó Police Chief Brody, 'Jaws'

The first is credit cancer that eats its way through various sectors until the body rids itself of disease. This has been in play for years and has spread from home builders to banks to technology, retail and other industry segments within our finance-based economy. The other is a car crash that causes credit to freeze as capital markets seize, price discovery permeates and social mood shifts as the magnitude and consequences of the new world order manifests throughout the financial and societal structure.

The critical diagnosis was evident for years but few policy makers paid attention until after the patient was rushed into the emergency room. After administering ad hoc drugs with hopes of masking the disease, the government is now attempting to buy the cancer and sell the car crash. If they didn't implement a comprehensive overhaul, global equity markets -- tied together with $500 trillion of derivatives -- would have experienced a cataclysmic crash.

That outcome remains within the probability spectrum -- they may have been too late -- but the likelihood has been reduced, albeit not without profound cost. Government officials are attempting to buy time, snuff out the fuse and stem contagion that has spread across the earth. Price discovery is a process rather than a point, and a multitude of factors will affect the ultimate outcome. While we can debate the merits of the proposed plan, we must remember that it introduces the possibility of regulated containment that didn't otherwise exist.

Before the patient can recover, he must be stabilized. The government initiatives will introduce a plethora of unintended consequences -- there are no quick fixes or magic pills -- but the best hope, at this stage, is to stop the bleeding before attempting to cure the cancer.

Martial law for the markets

Last Friday, the U.S. government waved the white flag and surrendered the capital market process when it banned short sales in the financials. It was a profoundly sad day for the free market system. I felt as if I lost a close friend of 17 years that I was intimately involved with. Over the weekend, I discovered there might have been more to that decision than I initially thought. There was chatter on the Beltway that we may have been the victim of economic terrorism, a coordinated short raid that originated in London and Dubai.

While the legitimacy of that remains to be seen, my source is well-respected. Further, as the goals of terrorism are economic destruction and social upheaval, it makes some sense. The stock market is the world's largest thermometer and breaking the capital market construct -- as some would say they did last week -- would effectively achieve both goals.

This is a separate conversation from the financial fabric itself, a monster created through years of experimental engineering. It simply speaks to the fact that we're vulnerable and that weakness may have been exposed from afar. Whether or not that proves true, I expect a coordinated agenda to emerge from Washington akin to what we saw after Sept. 11, 2001. During that period, the lines of distinction between bullishness and patriotism blurred and it was considered un-American to be a bear.

I will be very clear. Minyanville is as American as apple pie. We love everything this country is supposed to stand for. We love capitalism. We love small business. We love the notion that you can invest in what you believe in and be rewarded for your efforts. And we're not bears, per se, we're simply a community that is trying to navigate the cumulative imbalances and find our way to better days.

With that said and respected, a few elements of the proposed bailout seem particularly egregious. In particular, "Decisions by the Secretary pursuant to the authority of this Act are non-reviewable and committed to agency discretion, and may not be reviewed by any court of law or any administrative agency." Perhaps I'm sleep-deprived but that seems to fly in the face of the balance of powers that is the fundamental foundation of the United States of America.

We offered in February as we sat at a historic crossroads that the stakes had never been higher. The ace up the Federal Reserve's sleeve since the turn of the century had been the U.S dollar. They let the greenback devalue with hopes that a legitimate economic recovery would take the place of the credit expansion that has dominated this decade. From 2002 to 2007, the world's reserve currency declined 40% while everything measured in dollars appreciated in kind. That passed largely unnoticed by stateside players but it was --and remains -- a considerable source of stress for foreign holders of dollar-denominated assets. We called it "asset class deflation vs. dollar devaluation" and toggled between the two as policy makers pulled strings.

On one side, there was the socialization of markets, nationalization by governments and potential hyperinflation. On the other, there was asset class deflation, risk aversion and the unwinding of the debt bubble. It was clear that decision makers preferred the first scenario. The "haves" would presumably fare better than the "have-nots" and wealth would be retained by a slimming margin of the society. They knew all too well that the devil of deflation knows no friends on an absolute price basis.

While on television Monday, I was asked if the spike in crude was due to confusion regarding the bailout proposal. My response was that, quite the contrary, the eye-popping commodity rally was an unintended consequence of the plan itself. That brings us full circle in this discussion. All roads ultimately lead to deflation and debt destruction, which was the natural and progressive path that sliced 25% off the commodity index and caused the dollar rally this summer. The bailout proposal reversed that course in one fell swoop and reintroduced the specter of hyperinflation. That will work until it doesn't, which is to say that the patience and appetite of foreign holders of deteriorating dollar-denominated assets is extremely strained. If they scream "Uncle Sam" and debase our currency, the caveats of a fiat currency hit home in a hurry. If they don't, the dollar will rally and asset classes of all shapes and sizes will deflate in kind.

Social mood and risk appetites shape the tape and we've drawn analogies to periods past. The stock market crash of 1929 didn't cause the Great Depression, for example, the Great Depression caused the stock market to crash. Despite numerous discussions on this topic, there is a profound difference between written words and life experience. This presented itself in real-time last week when the Reserve Primary Fund broke the buck, halted redemptions, and denied people access to what they believed were liquid and safe capital conduits. On the other side of the societal spectrum, a different scenario has taken shape.

Between the Lehman Brothers' toe tag, a shotgun wedding between Bank America and Merrill Lynch and the dressing down at Goldman Sachs and Morgan Stanley , the crisis arrived for the precious few still in a position to spend. These seemingly separate situations introduce two very important dynamics: voluntary and involuntary thrift. The former involves people who have savings but choose not to (or can't) spend it, while the latter describes people who can't afford to fill up their car and take the family to Applebee's.

Both processes are currently in play. As folks digest personal issues, it stands to reason that social tension manifests as a whole. That curbs risk appetites, which reduces spending habits, harms the economy and drives our economy deeper into recession. It's a vicious circle, akin almost to a bubble in reverse.

We flagged this unfortunate theme at the beginning of the year but again, living through it is an entirely different dilemma. The angst is palpable and tension is high as we edge toward what promises to be a very tenuous election. Indeed, anticipation of social unrest may be the catalyst for the decision to transfer troops back to the states. Beginning Oct. 1, a military army brigade will be an "on-call federal response force for natural or manmade emergencies and disasters," the first time an active unit has been given a dedicated assignment of this kind.

This is far from fun and anything but easy, but in order to get through it, we must go through it.

On the other side of prolonged period of socioeconomic malaise, an "outside-in" global recovery awaits that will reward those who have preserved capital, reduced debt and armed themselves with financial intelligence.

While opportunities will certainly present themselves, proactive preparation and lucid awareness are far more important than the next best trade. It's about:

• Building a future so our children will have a stable home.
• Winning the war, both in a literal and figurative sense.
• Seeing all sides as we edge through historic times.

Identify an appropriate horizon and synch your risk accordingly. Understand that opportunities are made up easier than losses and the ability not to trade is as important as trading ability. Remember that risk management trumps reward chasing and profiting is a privilege rather than a right. Most importantly, take the time to be mindful of the little things in life, situations that you may have once taken for granted.

It should never take something bad to make you realize you've got it good. No matter where you are, it's never too late to start.

Happy Reflection.

© Copyright 2008, Resource Investor.
The War On Subprime Terror