We've had decades of misallocated capital in the U.S. Instead of saving, we've been spending... way beyond our means. Rather than investing in something productive, we've been gambling, taking on ever greater risks in the hope of the big payoff. Instead of creating the clean balance sheets that support stability - at all levels, personal, corporate, and governmental - we've piled up mountains of unsustainable debt.

The tragedy is that the prudent will suffer right along with the reckless. Misallocations of capital must be unwound, one way or another, before an economy can get back on its feet. It will be no simple task, and it's made even more difficult by those who put themselves in charge of the clean-up: certain residents of Washington, D.C.

At the center of the storm are two men who propose to save the nation, and they could hardly be more different.

Secretary of the Treasury Henry Paulson is the Street's guy. The former CEO of Goldman Sachs, the most powerful and successful investment bank, he brings a Wall Street insider's perspective to the table. However committed to public service he may be, he cannot be expected to act against the interests of his friends in the banking community.

And then there's Fed Chairman Ben Bernanke, a pure academician. For better or worse, Bernanke's specialty is America's Great Depression, and he considers himself an expert on the subject. Above all else, he wants to be remembered as the guy who understood how to steer the country away from the shoals of a Second Great Depression.

There is no question that Big Ben and Hammerin' Hank are trying to navigate in unfamiliar waters. Today's economy hardly mirrors that of a decade ago, much less the conditions of the 1930s.

Back in the spring of 2007, as the initial cracks in the structure began to appear, few were expecting the broken-levee crisis that has since unfolded. Savants such as our own Doug Casey and Bud Conrad saw it coming and said so, but no one in the mainstream was listening.

What was actually happening was that the first dominoes - subprime borrowers who should never have been approved - had begun to fall. In and of themselves, they would have been little more than straws in the wind. But because of the multiplier effect of the derivatives market, their influence reached far beyond a few blown mortgages. As more and more debtors were unable to pay, mortgage-backed securities lost value. And then the securities based on the MBSs lost value. And then...

Here's where CDSs were supposed to ride to the rescue. They didn't, for the simple reason that they had long since strayed far from their original insurance intent and become primarily an instrument that gave derivatives market players access to an asset class (mortgages) without having to actually own the asset.

As MBS values were hammered by defaults on the underlying loans, buyers of CDS protection began trying to collect. That hit CDS sellers, who were being drained of cash. Further out, derivatives speculators who had bet the wrong way defaulted or went bankrupt, sending shockwaves back down the line. Slowly at first, and then with increasing speed, the capital necessary to keep the system alive started drying up.

Everyone is familiar by now with the institutions that have collapsed or been bought out or taken over by the government. The list of names is stunning: Bear Stearns, Countrywide Credit, MBIA, Fannie Mae, Freddie Mac, AIG, Lehman Brothers, Washington Mutual, Merrill Lynch, Wachovia. Wall Street has undergone a transformation unimaginable a year ago. The big investment banks are gone - bankrupted or swallowed up by someone else. Even the two that remain standing, Goldman and JP Morgan, have had to reinvent themselves as bank holding companies to save their own hides.

The movement of capital among financial institutions is based not only on integrity but on confidence. Right now, that confidence has evaporated. Banks are carrying so much paper of indeterminate value that it's impossible to price in the risk of making a loan. So they aren't lending to each other, out of fear that they'll never get their money back.

The credit market, upon which our economy depends, has seized up.

When the government finally got around to admitting that there was a problem, it was already too late for any simple fix. So Washington had only two options: stand back and let the market sort things out or take drastic, emergency action.

No one knows quite what to make of Washington's response to the credit crisis. Some are howling that it's socialism, others that it's fascism or, at best, corporatism, an unholy alliance of private enterprise and the state.

Whatever the name, there is no question that the government is boldly going where none has gone before, helping to bail out some financial institutions and seizing control of others.

The Treasury Department now has $700 billion - albeit with some strings attached - with which it can buy up toxic waste paper through the Troubled Asset Relief Program (TARP). Taking this direction, instead of making direct loans, allows the "assets" they buy to be resold somewhere down the road. And perhaps, the plan's defenders say, even at a profit. Like that's gonna happen.

Proceeding in ways never before tried, in early October the Fed announced it was opening the Commercial Paper Funding Facility. For the first time, it will buy unsecured paper. To facilitate this and to cover potential losses, the Treasury will deposit an unspecified amount at the Fed. This is in addition to the Treasury's own buying spree, and the Fannie Freddie conservatorship, and the expansion of the FDIC to cover deposits up to $250,000, a move likely to send that agency back to the Treasury for another fill-up.

All the government's actions to date have accomplished... well, precious little. For the time being, credit remains frozen. Banks are still making overnight loans to other banks, but only very selectively. The stock market, despite coming off its lows, is extremely volatile after enduring its worst crash ever. Commodities have sold off. States and municipalities are facing severe budget cuts and, in some cases, bankruptcy. Money markets are in trouble. Pensions and retirement funds are at risk. And recession, or worse, looms increasingly large on the horizon.

Nor is the crisis purely an American problem. Much of the U.S. bad paper was sold to gullible Europeans, and world economies and markets are so interconnected that if one sneezes, someone else catches a cold. Already there have been big bailouts in Germany and England. The Irish government recently announced it was guaranteeing all bank deposits, which attracted a flood of money from elsewhere in the European Union, enraged other members of the EU, and raised questions of how long that shaky confederation can endure as each country charts its own path through the economic minefield.

This is a once-in-a-lifetime event, a train to nowhere, and it will cause no end of suffering.

Since we can't stop it, we'll do the next best thing, which is to protect ourselves. That means assessing the likely fallout from the government's meddling in the market, and developing guidelines for the best way to ride out the hurricane.

Some consequences are already baked in the cake. Casey Research Chief Economist Bud Conrad has been studying the unfolding crisis for years. Based on his work, this is what we foresee:

• More financial institutions will collapse. So will many hedge funds. Money market funds are also shaky; although the government will do all it can to keep them solvent, those that invest in anything but Treasury bills are at risk.
• The economy will fall into recession. By most lights, it's already here. It won't be brief, and there is even a chance that despite all the Fed's pump priming, we could drop into a depression. For however long credit remains tight, business will be unable to function normally, and the consumer-driven economy will grind to a halt.
• The whole structured finance model under which we've been operating is broken. The packaging of mortgages and other forms of consumer debt is impossible when no one will buy the packages. The trillions of dollars of outstanding mortgage derivatives will have to be unwound somehow.
• Without debt leverage, private equity financing is dead. Raising money for business start-ups or expansion will be extremely challenging. IPOs will be few and far between. Leveraged buyouts are gone. Mergers and acquisitions will mostly be limited to distress sales.
• At best, the government will succeed at what it's trying to do, i.e., stave off a depression, by sacrificing the dollar and allowing a fairly high level of inflation. If we're lucky, it won't turn into hyperinflation.
• Interest rates are going up. On the day of the coordinated, worldwide rate cut, the Fed lowered its discount rate by 50 basis points, yet the yield on the 10-year Treasuries rose from 3.5 to 3.7%. The Fed's credibility is about shot, as it has debased its own balance sheet by swapping good debt for bad. With more than half of its reserves gone, it could itself become the subject of a Treasury Department bailout.
• It is highly likely that the era of U.S. economic dominance, when the almighty dollar served as the reserve currency of the world, is drawing to a close.

But on the bright side... Well, there is no bright side. The hole that we've dug for ourselves will take a while to climb out of, and it won't be easy. But at least you can protect yourself.

• Hell, Meet Handbasket, Part I
• Credit Crunch Is Overpowering Current Investment Banking Model
• Alan Greenspan Bears Blame for Intensity of Financial Crisis
• 1 Out of 10 American Mortgages Are Owned by Other Countries
• The Glass-Steagall Act Kept Banks in Order Until 1990

While ordinary citizens thought little about the distinctions among banks, the government did. Seventy-five years ago, as the Depression deepened, lawmakers were desperately trying to determine the causes of the crisis (read, looking for scapegoats). Some of the things they found were conflicts of interest and opportunities for fraud linked to the mixing of commercial and investment banking.

Congress decided to erect a "wall" between commercial and investment banking, and so passed the Banking Act of 1933, usually referred to as the Glass-Steagall Act. Glass-Steagall created the Federal Deposit Insurance Corporation (FDIC) to protect depositors in commercial banks, and it forbade commercial banks to underwrite securities or act as stockbrokers or dealers.

Glass-Steagall remained in force for six and a half decades, although various deregulatory measures and changes in exchange rules chipped away at it. Notably, in 1970 a rule excluding public companies from membership in the New York Stock Exchange was dropped. The last major private institution, Goldman Sachs, went public in 1999. This allowed investment banks to sell stock to any potential investor and greatly expand their capital base.

Over the last two decades of the 20th century, the financial industry lobbied vigorously for the repeal of Glass-Steagall and, in 1999, they got their way with the enactment of the Financial Services Modernization Act. The door was opened to consolidation in the banking industry.

With one stroke of a pen, commercial bankers could begin turning their loans into investment products. (Glass-Steagall had prevented them from selling debt-backed securities for which they were the underwriters.) And Wall Street investment banks were suddenly in the mortgage business. It would prove to be a marriage made somewhere significantly south of heaven.

We're not fans of government regulation, but a deregulated marketplace carries with it certain imperatives. It functions as it should only in the absence of both criminal and boneheaded behavior. We can erect oversights meant to prevent the former and laws to punish it after the fact. But all the regulation in the world won't do much about the latter, since both market traders and the regulation itself may be boneheaded.

The biggest factor here was the removal of Glass-Steagall prohibitions, but there were two other important tweakings.

The Commodities Futures Modernization Act of 2000 transformed the new mortgage-backed securities into a commodity, enabling them to be traded on futures exchanges with little oversight by any federal or state regulatory body.

Completing the trifecta, the Securities and Exchange Commission in 2004 waived its leverage rules. Previously, broker/dealer net-capital rules limited firms to a maximum debt-to-net-capital ratio of 12 to 1. But under the new regulations, five companies - Goldman Sachs, Merrill Lynch, Lehman Brothers, Bear Stearns, and Morgan Stanley - were granted an exemption, which they promptly used to lever up 20, 30, even 40 to 1.

Just as Congress was repealing Glass-Steagall, the tech stock bubble was inflating beyond sustainability. It would soon be pricked, ushering in a brief recession during which investors began the hunt for the next big thing.

Well, how about housing?

Back in 1977, Congress passed the Community Reinvestment Act, which had the goal of extending homeownership to the largest possible pool of Americans. Over the next 25 years, legislative supplements, a robust housing market, and aggressive government enforcement of "fairness in lending" combined to weaken bank standards of who did or didn't qualify for a loan.

But that was just the beginning. In an effort to end a recession in the new century's first years, the Greenspan Fed reduced interest rates to near nothing and poured liquidity into the financial markets. At the same time, capital that had fled the stock market was looking for action.

The commercial banks - and independent mortgagors like Countrywide Credit - were awash in cash. They started lending it, and every borrower's credentials were deemed excellent, even those with low income, bad credit, and no money for a down payment.

The perfect storm was building. But at first, boy, did things ever look rosy. The country's homeownership rate - 62.1% in 1960, rising to only 64.1% in 1994 - shot up to 68.9% by 2006.

As homeowner mania seized hold of the public imagination, people began treating their homes as ATMs. If they needed cash, they borrowed against their growing equity. Real estate speculators flipped houses like crazy. Why not, when there's no risk? Housing prices only head in one direction, up, up, up, right?

It sure looked that way. The yearly average median price of an existing home went from $23,000 in 1970, to $62,200 in 1980, to $97,300 in 1990, to $147,300 in 2000 and crested at $221,900 in 2006. Astonishingly, despite recessions in the early '80s and early '00s, there wasn't a single down year for housing in all that time.

However, in 2007 housing became the latest bubble to burst, pricked by unrealistic prices, overbuilding, and the retreat from ultra-low interest rates. Concurrently, as house prices finally began to drop, a whole bunch of those no- or low-interest loans began to reset.

Despite the well-earned reputation of some Wall Street high rollers, bankers tend not to be a reckless lot, nor financial dunces. In general, they would rather deploy a large amount of capital into a safe, low-yield investment than put a small amount of capital into something with very high risk.

With the new environment, however, the game changed. Commercial bankers found themselves making loans to shakier and shakier recipients, while at the same time, the investment banks and their clients were clamoring for new investment products.

So bankers did what any conservative person would do. They hedged their bets. They bundled up their loans and sold the packages to the investment banks. The outcome was essentially the mortgage business being uprooted from the commercial banks and transplanted into the investment houses, which have far less restrictive requirements about reserve capital, far fewer limits on the buying and selling of securities, and far less regulatory oversight.

The investment banks did not set out, of course, to become landlords. They just wanted some product to sell for which there was a ready market. As capitalist ingenuity collided with profit motive, they found there was no shortage of products that could be created; the mortgage bundles were sliced, diced, and repackaged into a bewildering array of securities, like structured investment vehicles (SIVs), collateralized debt obligations (CDOs), mortgage-backed securities (MBSs), and on and on.

The extent of the slicing and dicing into what financial chefs refer to as tranches was such that the original mortgage might be tossed from buyer to buyer, or even itself split into parts. Each time a package was put together and sold, the seller stretched to get top dollar for each tranche, requiring the underlying assets to be risk-rated and then assigned real-world value. In the end, rating services had little idea what they were rating (we're being charitable here), and buyers had no idea what their purchase was really worth.

And always lurking in the background was the possibility that defaults on the mortgages supporting the entire process could have a profound ripple effect, given that these products became increasingly leveraged. Knowing this, traders invented credit default swaps (CDSs), those gnarly little creatures that morphed into Godzilla after 2004.

CDSs are an insurance policy, a way of dealing with fear, and a device for attenuating the risk inherent in trading products one may not fully understand. Those buying the protection pay an upfront amount and yearly premiums to the protection sellers, who agree in return to cover any loss to the face value of the security. The result is a private, two-party contract, devoid of regulatory oversight.

There are a bunch of nasty horseflies in this particular ointment. For one, the holder of that security (who is now "protected" by a CDS) might turn around and sell it to a third party, who might himself insure and resell it, and so on, creating an impossibly complex chain of ownership and obligation. Additionally, the CDS itself can be traded over the counter. Furthermore, any of the underlying assets might also get partitioned into different tranches, adding to the confusion. And finally, short sellers can work on just about any joint in the structure.

And here's the really big rub. Suppose the party providing the initial insurance protection - having already collected its upfront payment and premiums - doesn't have the money to pay the insured buyer when a default occurs. Or suppose the "insurer" goes bankrupt. In either instance, the buyer who thought he was protected finds himself left naked and alone.

However, that possibility seems not to have been considered as the financial world created an interlocking system of derivatives that not even a Cray supercomputer could sort out. The only certainty: it was an arrangement that depended on a robust economy and rising house prices.

Except, of course, things didn't work out that way.

When the housing slump hit, defaults in the relatively small subprime sector (less than 20% of mortgages) started a chain reaction that raced through the derivatives market, the effects compounding geometrically, until finally the world financial structure was facing collapse.

To be continued, tomorrow...

Doug Hornig

for The Daily Reckoning Australia

• Hell, Meet Handbasket, Part II
• The Glass-Steagall Act Kept Banks in Order Until 1990
• Mortgage Backed Securities Put Our Financial System at Risk
• RBA Buys $780 Million in Residential Mortgage-Backed Securities
• U.S. Fed Now Accepts Credit Card Debt as Collateral

This potential development came about because the IMF finds itself on shaky financial ground. It is facing a shortfall of about $105 million this fiscal year (ending April 30, 2007), a deficit which is projected to balloon to $185 million in 2008 and $244 million by '09.

There are any number of reasons advanced for this deteriorating balance sheet, the most common one being that many formerly cash-strapped Third World countries are experiencing enough prosperity to make early repayment of loans-Indonesia, Serbia, Uruguay and Ecuador are among those doing so this year-thereby cutting down on the interest income the IMF relies upon to cover operating expenses.

Though that may be a central part of the problem, the IMF should take a long look at its own bloat as well. In the past ten years, its annual budget has doubled to nearly $1 billion. As Devesh Kapur, an economist at the University of Pennsylvania, puts it, "Costs at the fund have been allowed to get out of control. It now has a bigger staff and budget than its role justifies."

Be that as it may, IMF officials determined that sources of revenue other than lending income needed to be developed. And thus the Committee to Study Sustainable Long-Term Financing was convened last May by IMF Chief Rodrigo Rato. Also known as the Crockett Committee-after Chairman Andrew Crockett, former director of the Bank for International Settlements and now President of JPMorgan Chase-it consisted of a small group of eight "eminent persons," namely: Crockett; former Fed Chair Alan Greenspan; Mohamed el-Erian, CEO of Harvard Management Co.; Tito Mboweni, governor of the South African Reserve Bank; Guillermo Ortiz, governor of the Bank of Mexico; Hamad al-Sayari, governor of the Saudi Monetary Agency; Jean-Claude Trichet, president of the European Central Bank; and Zhou Xiaochuan, governor of the People's Bank of China. The committee released its report on January 31 of this year.

During the press briefing that followed, Crockett said that the committee favored the "creation of an endowment-were it to be possible-that would provide income that could be relied upon over a period of time without having to ask members."

The "more attractive source" for this "is to use the fund's resources of gold, and so the report does suggest that it would be appropriate and possible to [...] sell a part of the fund's gold holdings, and to devote the resources obtained from that to the creation of an endowment."

The sale could be as much as 400 metric tons (12.9 million ounces), which, valuing the metal at a conservative $500/ounce (the past two years' average), would net the IMF a minimum of $6.6 billion. That amount, invested, would be expected to generate $195 million in annual income. Of course, if current prices hold for the duration of the sales period, those numbers would be substantially higher.

Crockett noted that the 400-ton figure corresponds to IMF gold that was sold and repurchased in an off-market transaction about 6 years ago. It is about 12.5% of the Fund's total holdings.

The Committee, whose recommendations have been referred to the IMF's executive committee for debate, took care to emphasize that the proposed sales should be "ring-fenced [...] to limit their market impacts." (Longtime Fed watchers chuckled at the wording, noting that such phrases are a dead giveaway of Greenspan participation.) To this end, Crockett promised the following safeguards:

"In the first instance, the amount should be limited to the 400 tonnes I mentioned without envisaging any additional sales.

"Secondly, the sales should take place within the existing Central Bank Gold Agreement [CBGA], that is to say it would not be additional to sales already programmed by central banks, but would be accommodated by reductions in the amounts of gold that central banks might sell under the [CBGA].

"And thirdly, we have emphasized that the sale should be undertaken in a very careful way in terms of their periodicity amounts and manner of sale such as not to disturb the market."

The CBGA limits signatory central banks (all of the major ones, excluding only the U.S.) to sales of 500 tons/year. In 2006, however, the banks released only about 350 tons. Thus, the IMF committee appears to be saying that it proposes taking up whatever slack exists this year, while not allowing its sales to push the amount of new gold coming to market over the pre-set 500-ton limit.

It is important to remember a couple of things here.

First, it's not the IMF's gold. The metal belongs to the depositor nations, the largest of which is the U.S. The Aamerican taxpayers own that gold, and thus have a very real interest in what happens to it.

Second, the IMF is prohibited from trading in gold. Its bylaws state that it does not "have the authority to buy gold," nor may it "engage in any other gold transactions-such as loans, leases, swaps, or use of gold as collateral."

What it can do is "accept gold in the discharge of a member's obligations" and "sell gold outright," but the latter requires "an 85% majority of total voting power." Since the U.S. controls about 17% of voting power, it can't by itself make a deal happen. But it has the absolute authority to block one.

The Crockett Committee report is not the first time the notion of IMF gold sales has been floated. It's an idea that has cropped up repeatedly in the past but has always failed, either because of American opposition or because of opposition among the more general membership, which includes many gold-producing nations that have an interest in keeping a floor under prices.

What will be the U.S. position this time around? We'll have to wait and see, but if the past is prologue, there will be stiff opposition. The final decision on whether to veto or not rests with Congress, where Democrats in the past have fought IMF gold sales on the grounds that they would hurt impoverished nations. Sen. Harry Reid voted against them as minority whip, and might be expected to be consistent now that he's majority leader. Or perhaps not, depending on which way present political winds are blowing.

While the IMF's announced motive seems to make fiscal sense-provided one accepts that it has any need to be as big and meddlesome as it is-gold bugs immediately began looking for the story behind the story.

If the Gold Anti-Trust Action Committee (GATA) is correct in their contention that the American government has acted deliberately, in concert with the major central banks, to suppress the price of gold in order to mask the dollar's inherent weakness (an effort in which Mr. Greenspan is alleged to have been a willing participant), then the IMF proposal plays right into such a conspiracy. Its hidden meaning could be that the IMF must help out with gold sales, because the CBGA signatories have become reluctant to part with enough of their reserves to keep a lid on prices and, in fact, may be pleased with the appreciation of their assets. Yearly sales boosted to the full 500 tons, thanks to IMF participation, should contribute to further price suppression. It'd be no great shocker if the IMF were doing the U.S.' bidding.

In addition, it's possible that some depositors, holding dollars and nervous about their decline, are making noise about getting their gold back. Propping up the buck through gold sales could be viewed as an aid to easing their fears.

Then there's the China factor. Analyst Michael Kosares, writing on USAgold.com, says that, "There is no doubt in my mind that China would like to see the IMF sell all its 3,217 tonnes of gold, particularly if China might become a primary recipient. Without any fanfare China would happily write the check for all 3,217 tonnes. Otherwise, I can't imagine why the Chinese central bank might have been included on this IMF committee, unless it was to demonstrate that the system is at least trying to get them some gold."

Whatever the case, the most interesting part is what happens next. Not an easy call, given that neither the IMF nor the international gold trade are particularly transparent.

Many analysts, though, feel that the proposal will never fly. For example, Julian Phillips of GoldForecaster.com writes: "Should the member nations of the IMF find themselves in disagreement with a decision of the IMF to sell their gold, the possibility of this gold being returned to them is there. But should this option be used, the damage to the IMF of such a position [a minority objecting to the majority] would produce disunity in the global monetary system, which could prove extremely disruptive. [I] expect that the mere possibility of such a disruption, of itself, would persuade the majority not to sell any gold, but at best to revalue it."

Even if a sale does come about, will it matter?

Many feel that the IMF's actions are not liable to have much impact on gold, arguing that the distortions of the CBGA, even at maximum 500-ton strength, have already been fully factored into the current price and its trend line.

This is not to say that there couldn't be a short-term downdraught. Sure there could be, especially as the IMF sales are formally announced. Some holders of gold, maybe a significant number, can be expected to sell into the news.

But with countries such as China, Russia and the nations of the Middle East itching to add to their reserves, even a large dump of physical metal onto the market is certain to be absorbed in short order.

Nor will countries be the only buyers. Beverly Hills investments manager Kenneth Gerbino wrote in 2005 about a similar IMF sales speculation, saying that any additional supply "would surely be snapped up by the bullion banks and mining companies that are 'short' somewhere between 10,000 and 12,000 tonnes, according to some very savvy analysts." There's no reason to think that's changed much in the interim.

Gerbino could have been writing about the IMF when he concluded, "Central bankers will most likely continue, as usual, to scare the price of gold down from time to time by statements of gold sales. But they are all too keenly aware of the growing number of people who realize that the gold, not paper and ink, is the real stable monetary element."

Finally, it is important to keep the relatively miniscule amount of gold sales we are talking about in perspective. In an era where over $1 trillion in derivatives trade globally each day, $6.6 billion in sales is just not that much money when compared to potential investor demand once the U.S. dollar goes into the free fall that Doug Casey, among others, now believe is imminent.

In other words, if IMF sales do happen, and if they depress gold's price, that's a buying opportunity... for bullion and especially for the high-quality junior exploration stocks that pack the most punch in a rising gold market.

Regards,

Doug Hornig
for The Daily Reckoning Australia

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