$700 Billion Bailout, Death of I-Banks, 4 Rules of Trading, and More!

  That $700 billion figure, mind you, was guesstimated by the same folks who announced in July 2007 that they thought subprime losses could total a staggering $50-100 billion.

So you can expect the $700 billion to be like a “starter wife” — a temporary convenience while planning for an upgrade.

  Let’s scribble on the back of our proverbial envelope for a moment:

$700 billion bailout package for Wall Street
$438 billion projected deficit in the federal budget for FY 2008
$200 billion for Fannie Mae and Freddie Mac
$150 billion in rebate checks under the guise of “stimulus”
$85 billion for AIG
$29 billion for Bear Stearns

Hmnn… $1,602 billion…. that’s quite a bill for the year… not to mention the nearly $1.6 trillion in Treasury swaps and short-term paper the Federal Reserve has lent out during its auction facilities.

Who’s going to pay for all this?

The national debt ceiling will have to be raised for the second time in as many months to accommodate the request… this time to $11.3 trillion… boosting the national debt to over 70% of GDP. The highest the national debt got during the Great Depression was 44% of GDP.

“The actions taken and promised,” writes the inimitable John Williams , “will increase money supply growth and ultimately add upside pressure to inflation.  
 
“Deposits wiped out by failed banks, or cash taken out of banks and put under a mattress, contract the money supply. It is in such areas that the various systemic-supportive actions by the Fed and the Treasury have been aimed (such as the guarantee program to back money market funds), in addition to efforts to prop the equity market (such as banning short selling of certain financial stocks). Other efforts, such as the bailout and takeover of AIG and the proposed $700 billion package, will have the effect of increasing money…
 
“To the extent the $700 billion being designated to buy illiquid assets from financial institutions may help to stabilize balance sheets, aided banks presumably will resume lending money in a more normal fashion. Freeing up lending is Treasury Secretary Paulson’s expressed reason for putting forth the finance package, and the renewed bank lending will expand money growth in a very traditional manner.
 
“In saving the system, the cost to the American public from this effort — aside from rapidly expanding federal debt — is inflation. My outlook for double-digit inflation, as reported by the government, remains in place for early 2009.”

  Sure enough, the dollar’s decline has been swift and steady since we spoke last. The dollar index is 2 full points below Friday’s high, around 77 as we write. Think a $700 billion bailout affects the value of a nation’s currency? Uh… yeah.
 
As such, the euro has soared a nickel from Friday’s low, to about $1.46. The pound is up about 5 cents too, at $1.84. The yen is weaker, as the return of market optimism has reignited the carry trade. One greenback can get you around 106 yen today.

 As the dollar goes down, oil goes up. Light sweet crude has rallied $3 today due to little more than exceptional dollar weakness. Add in a weekend rally, and crude is back to $108. But gasoline prices around the U.S. are down for their fifth day in a row. A gallon of the cheap stuff goes for $3.73 today, about 33% higher than this time last year.

  Gold is rallying again today. It gained about $20 over the weekend, and popped up another $20 in New York trading. As we write, it’s back to $900 an ounce.

  For all the drama last week, the government’s actions have staved off disaster on the NYSE… for now.

If you were sleeping off a hangover all week last week, when you woke this morning and… yawn, stretch… checked the major indexes…. you wouldn’t have missed a thing.

  “You cannot be a lazy thinker and thrive in these markets,” notes Dan Amoss. “You must think through every scenario and make every financial decision in the context of this rapidly changing global financial system. For now, I’m making decisions with the following criteria:

1. Hold stocks that are cheap relative to earnings potential. These tend to be concentrated in industries that help deliver what people need regardless of the banking system: food, water, energy, and related infrastructure.
 
2. Short stocks that are expensive relative to balance sheet quality and earnings potential — preferably those that deliver what households will be quick to cut out of their budgets or those in danger of bankruptcy.
 
3. Assume that credit will remain tight throughout the banking system, and that the fiscal and monetary authorities will react to this with all manner of stimulus programs.
 
4. The era of debt- and asset-fueled consumption is waning rapidly. Consumption will be funded primarily out of income, as it should have always been.”

The worst of market volatility might be behind us… for a while, anyway. Check out the “Volatility Index” tracked in Chicago pits:

The VIX shot as high as 42 last Thursday, by far, the high point of the “credit crisis.” Option trading uncertainty hadn’t been that high in about 10 years, when Long-Term Capital Management blew up. Then, and when the VIX spiked to similar levels during the tech bust, the proceeding months were much more stable.

  It’s Monday, so naturally, we look to see which bank bit the dust over the weekend. This time it was West Virginia’s Ameribank. That’s the 12th failure this year. There are around 8,400 FDIC-insured institutions left.

  Late last night, the Federal Reserve agreed to let the two remaining independent investment banks on Wall Street dodge the crisis by becoming traditional bank holding companies.

Goldman Sachs and Morgan Stanley will alter their business models and begin accepting applications for checking and savings accounts, safety deposit boxes… that sort of thing.

The move gives both banks carte blanche access to emergency loans at the Fed discount window and protection for its customers under the FDIC. They’ll also be able to tap directly into “savings” deposited into customer accounts to cover losses made in their investment banking divisions. Such bank deposits kept Bank of America and Citi afloat this year, while Lehman and Bear bit the dust.

As depository institutions, they’ll also be subjecting themselves to greater oversight and regulation.

  Essentially… the gilded age of investment banking is over. We can’t wait to get our offer in the mail for a free coffee maker upon opening a checking account with Goldman Sachs.

  “Who will want to be a shareholder in anything like an investment bank, anyway?” asks Byron King. “We’re setting a precedent. When Wall Street institutions fail, the shareholders lose. OK, so be it.

“But in the future, who or what is going to offer up new investment capital? Let me put it a different way. The U.S. economy — as well as the economies of the rest of the world — needs large amounts of new investment. The global economy needs everything from energy and water systems to manufacturing plants to agricultural improvements to public improvements like roads, bridges, schools, etc. Where will the money come from?

“There is only so much money anyone can raise through private placements. And commercial banks are not known for their willingness to fund anything that looks overly speculative. Government — at least in the U.S. — tends to be the worst sort of entity to pick economic winners and losers. So without the investment banks, how will big projects raise capital?”

  “Am I crazy?” asks a reader. “Was not the cause of our current financial crisis a direct result of Greenspan and the Fed dropping the overnight rate to 1% forever and flooding the market with oodles of liquidity? But now the solution to this crisis is to leave the rate at 2% or less forever and flood the market with oodles of liquidity.

“The next time I catch a cold, you won’t find me lying around feeling miserable. By God, I am going out to find someone to give me the flu.”

The 5 responds: If you ask the Maestro himself, as we did for our film I.O.U.S.A., he’ll tell you the demand for capital in the Eastern Bloc countries after the fall of the Berlin Wall and the high demand for U.S. Treasuries in the emerging Asian economies were the root causes of low interest rates in the West throughout the 1990s and early in this century.

Still, even if you grant him this trespass, your point is taken. The consequences of low interest rates over such a long period of time have been one bubble after another, each larger and more destructive to the “real economy” than the last. By what measure of sanity do they think artificially low interest rates will save the financial system this time?

It’s either them or us… but one thing is for sure: We’re so far apart on this that someone’s got to be crazy. Still, keep in mind… opportunity, in a situation like this, is born of crazy.

Cheers,

Addison Wiggin
The 5 Min. Forecast

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