The stock market rallied throughout most of yesterday's trading session, then stumbled into the close. This pattern has become unnervingly familiar of late. It's true that the Dow has only dipped 2% since closing a notch above 10,000 on October 19, but the decline feels a bit worse than that. Maybe that's because so many midday rallies have turned into late-day selloffs.

Or maybe the market feels so weak because it IS so weak. Most of the broad indices like the S&P 500 and the NASDAQ Composite are down more than 5% from their recent highs. Meanwhile, former market leaders like the BKX Index of financial stocks have tumbled more than 10% from their recent highs. These corrections aren't devastating, just discomforting.

Every rational investor knows that the market recovered much more ground from its March lows than economic fundamentals warranted. But that doesn't automatically mean that the market is a "sell." Maybe it is just a "do nothing for a while." Your editors are agnostic on this topic. But almost no one else seems to be. When the stock market becomes as volatile as it has been lately, every stock market commentator from Pensacola to Pismo Beach trots out a forecast - usually based upon stock charts that show trendlines, resistance levels, Fibonacci retracement points, stochastic indicators etc.

Unfortunately, the identical price charts can yield completely opposite forecasts. Show us a trendline, and we'll show you two emphatic forecasts - one bullish, one bearish. Both forecasts will be honest and informed by experience, but only one of them will be correct.

That said, our friends over at "Penny Trends" delivered a very persuasive (and bearish) forecast yesterday, based on a very clever technical indicator:

"The market is rolling over... The transformation is amazing... Our list of exchange-traded funds (ETFs) is one of the best tools we've ever developed for determining the trends in the markets. By distilling the investment universe into just 87 'baskets' of stocks, and then ranking them by three-month performance, we get a fantastic sense of the big picture. We can tell immediately if investors are building optimism or sinking into pessimism. And we can see which individual sectors and markets are strong and which are weak by the way they react relative to one another. For example...

"A month ago, the five best-performing ETFs in the world were showing an average three-month gain of 34%, while the five worst-performing ETFs in the world were showing an average loss of just 8%. Now, the five best-performing ETFs are up an average of just 17%. The bottom five are down an average 15%. In other words, uptrends are getting weaker and downtrends are getting stronger. It means the market is probably rolling over.

"Here's another way of looking at the same thing: The 87 ETFs we monitor represent every major currency, stock market, sector, and commodity. A month ago, only eight of the ETFs on our list were showing a three-month loss. That means 79 were showing a three-month gain. Now, 22 ETFs are in negative territory and only 55 are in positive territory...another strong sign the market is rolling over."

But don't let this forecast bring you down, dear investor. Things could be worse. The stock market could be just as bad as the housing market.

"But wait just a minute!" some readers may protest. "Isn't the housing market recovering?"

Well, sort of. Prices are no longer in freefall. But a sustainable recovery still seems like a delusional hope...especially when one considers that there's a lot more pain to come in the mortgage market.

Eric Fry
for The Daily Reckoning Australia

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Contrary to popular mythology, we Californians do not live merely on love, sunshine and granola.

I mean, sure, we've all got our yoga mats, our quartz crystals and our "life coaches" (who doesn't?), but life is just so much more than "namastes" and positive energy. Life is also about building enough windmills (somewhere else) and installing enough solar panels (somewhere else) to keep our yoga studios air-conditioned.

And, yeah, I guess we need SOME crude oil, cause our Priuses cannot ALWAYS run on electricity. So I guess its fine to use crude oil if we have to, as long as we can obtain the oil in an ecologically friendly way...like getting it from somewhere else. (OMG, remember the Santa Barbara oil spill in 1969? That was a SERIOUS bummer!)

So, yes, we Californians certainly understand that we cannot break our dependence on crude oil overnight. At least not until some "next generation" process comes along that can convert text messages into jet fuel. And even if we Californians use less crude oil, someone else is bound to use more of it...like all those reckless industrialists in the Developing World. Don't they know how bad crude oil is for the environment?

But I guess there's just no reasoning with these people. So I guess we'll just have to keep finding and pumping crude oil for a long time to come.

Hmmm... I'm not sure how easy that's going to be. When I was out recycling newspapers the other day, I saw an old headline that said crude oil is becoming much harder to find...and that oil production is falling off rapidly at many of the world's largest fields.

So I did a little research and - would you believe - it's true. Crude oil is becoming much harder to find and much more expensive to produce.

Eric Fry
for The Daily Reckoning Australia

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The credit crisis seems to have exploded the traditional equilibrium between cash and debt. Of course, this "equilibrium" was no such thing, as corporate cash levels have been perilously low for years...at least in the finance sector.

But corporate chieftains are becoming attentive to danger, at least for now.

"The credit crisis seems to have put fear back in their spines," Chris remarks. "The 500 largest US companies - excluding financial firms - hold the largest cash hoard as a percentage of assets since 1960. The Wall Street Journal reports today that cash hoard is nearly $1 trillion, or about 10% of total assets. That was in the second quarter, for which we have full numbers. So far in the third quarter - with 248 of the 500 firms reporting - cash has increased to 11.1% of assets.

"Cash is the financial equivalent of a big, soft pillow," Chris continues. "It helps you sleep better at night. After the credit crisis turned small balance sheet leaks into lethal holes, executive suites around the country seem determined not to let that happen again. The Wall Street Journal highlights the case of Alcoa, the big aluminum producer. It sits on $1.1 billion in cash, up 28% from a year earlier. It cut its dividend, even though it is making money. The CFO said, 'We're just going to be extremely prudent.'

"But there might be another reason why the bigwigs sit on all that cash," Chris reasons. "They might just not see many good opportunities to invest in right now. In other words, the piling up of cash in America's corporate treasuries may just mirror the weak economy."

But Chris suspects these corporations won't pile up cash forever. Eventually, they will start itching to launch takeover deals. In fact, Chris points out, "We are already seeing a pickup in takeovers and mergers. Just last week, CF Industries, the fertilizer company, upped its bid for rival Terra Industries. The new offer is worth $200 million more and is mostly cash. Also last week, Denbury Resources offered $50 per share for Encore Acquisition - about $15 in cash and the rest in stock."

So even though the overall market seems richly priced at current levels, Chris has been setting his sights on a handful of names that look to him like ideal takeover candidates. T3 Energy Services is one of his favorites. He believes this leading oilfield services company would make a good fit with the likes of National Oilwell Varco or Cameron Intl.

Tesco (TESO:nasdaq) would be another juicy target, Chris believes. The stock trades slightly below book value, only 11 times earnings, and also has a clean balance sheet. In today's edition of The Daily Reckoning, Chris provides a few other scintillating details about Tesco.

Eric Fry
for The Daily Reckoning Australia

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Yesterday morning, Wells Fargo posted a cosmetically pleasing profit of $3.2 billion, or double the tally from the same quarter last year. So when the opening bell sounded, exuberant investors rushed into the market and bid up the shares of WFC.

But then a very strange thing happened; the buying frenzy dissipated into a selling panic, as a variety of analysts started poking holes in Wells Fargo's "strong" report. In particular, analyst Dick Bove of Rochdale Securities, complained that the bank's entire profit for the quarter came from a $3.6 billion profit on a hedging transaction. The bank's operation's, meanwhile, produced results that ranged from mediocre to poor.

Bove slapped a "sell" recommendation on the stock, and more than one investor seemed to heed the advice. The stock slumped 7% from its high print of the day to its closing price of $28.90.

Technically oriented traders couldn't care less about WFC's income statement mumbo jumbo...but they would probably care a great deal about the textbook "outside day reversal" pattern that WFC etched onto trading screens yesterday.

This ominous pattern features a share price that exceeds both the prior day's high and the prior day's low - i.e., "outside" - and then ends the trading session on or very near the day's lows. A "textbook" reversal pattern should also feature a big surge in volume.

In other words, WFC's reversal pattern has it all! - higher high, lower low and a huge spike in volume. Yesterday's trading volume of 113 million shares doubled the average daily volume of the last four months! So if you added up all the component to yesterday's reversal patter, you would probably begin to deduce that a new bearish trend will unfold over the coming days. Incidentally, the KBW Bank Index (BKX) of 24 financial stocks also produced an outside day reversal yesterday.

This technical formation does not guarantee a selloff, of course, but it does suggest that WFC might stop going up...at least for a while. This pattern also suggests that bad news is actually bad news...which would be REALLY bad news for a stock market that relies more on hope than substance.

Regards,

Eric J. Fry,
for The Daily Reckoning Australia

P.S. Of course, not ALL banks will report dubious earnings...not all banks will see outside day reversals and suffer violent selloffs...and not all banks are deceiving shareholders and the general public about the health of their balance sheets.

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Recent history suggests this little news item should be a headline. Pension plans - like supertankers, but unlike politicians - take a lot of time to reverse direction. But once plan fiduciaries decide to proceed in a given direction - investment-wise - they typically continue down that path for years, if not decades.

This tendency provides the mother of all long-term indicators for the financial markets. Although pension plan fiduciaries tend to be VERY wrong at major, long-term turning points, they tend to be right - more or less - as markets transition from one extreme to the other.

Confused?

The principal is actually very simple: pension plans behave like long- term momentum investors. So they tend to buy into rising markets...until after those markets have peaked and begun a major decline. Conversely, fiduciaries tend to sell into falling markets until after those markets have bottomed out and begun a decisive uptrend.

In aggregate, therefore, pension fund fiduciaries tend to behave like novice investors - buying high and selling low. But since their momentum investing unfolds over such long timeframes, this group of investors tends to be very right during the middle of a big move - up or down - in any particular asset class.

The world's fourth largest pension provides a classic case in point. The California Public Employees' System (CalPERS) with $181 billion of assets at last count, ranks fourth on the list of the world's largest pensions plans. But it might rank first on the list of worst market- timers. Between 1983 and 2000 the pension giant doubled its allocation to equities...just in time for one of the stock market's worst decades ever.

During the middle of this giant bull market, CalPERS was correct to up its allocation to stocks. But by continuously upping its exposure to a rising stock market, CalPERS eventually overdid it.

In September of 2000, as the US stock market was beginning its colossal collapse from the then-record highs set earlier that year, your editor highlighted the vulnerability of CalPERS' stock-heavy portfolio. In an article entitled "Golden State Bulls," he observed, "In 1983, with a moribund Dow Jones Industrial Average hovering around 1,200, the powers that be [at CalPERS] deemed 30% to be the optimal equity weighting for the fund. But 17 years and 10,000 Dow point later, the CalPERs...investment committee now allocates a whopping 67% of assets to equity investments.

"Meanwhile," the article continued, "the fixed-income allocation has atrophied to but a shadow of its former self: from 67% back in 1983 to little more than 28% [today]...That's been a swell situation for the last few years. CalPERs - ominously referred to as the 'The System' in the fund's literature - earned a 10.5% return on its investments for the year ending June 30, 2000, marking the sixth straight year of double-digit returns."

Despite these pleasing investment results from the recent past, your editor wondered aloud about the immediate future: "If the bull market of a lifetime commenced when CalPERS was wading only ankle-deep in equities (some 30%), what does it mean that the pension giant now fairly bathes in them?"

Investors did not have to wait long for the answer: The stock market stunk up the place for the next nine years. Your editor highlighted this exact risk in his article.

"A back-of-the-envelope calculation shows that if the equity component [of the CalPERS portfolio] were to merely break even [during the next six years]," he warned, "the balance of the portfolio would need to generate a 25% return to meet the [fund's] actuarial assumption. And you know, that may not happen every year."

CalPERS did not welcome your editor's pro bono investment advice. In an October 8, 2000, story in the Sacramento Bee, CalPERS spokeswoman, Patricia Macht, countered, "That's (the magazine's) back-of-the- envelope calculation. We don't manage people's money on back-of-the- envelope calculations...We're not in stocks because we make a lot of money, we're in at the level that's prudent to be."

Your editor, defending his criticism in that same Sacramento Bee story, replied, "Just because [CalPERS' equity-heavy allocation] has worked doesn't mean that it's responsible."

CalPERS would have none of this criticism...and neither would any of the giant pension's many defenders and apologists. An influential money manager, who's name your editor will mercifully withhold, ended the Sacramento Bee by scorning your editor's concerns as "dead wrong."

As it turns out, of course, your editor's concerns were "dead right." (The S&P 500 Index has produced a total return of minus 12% from the end of September 2000 to the present). But anybody can get lucky once or twice.

More to the point, CalPERS "knew better"...or it should have. It should have known that stocks sometimes go down. So it should have also known that a fund that must dispense billions of dollars every year to retirees cannot prudently allocate 70% of its portfolio to such a volatile asset class. But the investment mavens at CalPERS could not bring themselves to worry about worst-case scenarios while best-case scenarios were delivering such delightful returns.

And besides, the stewards of the giant pension fund certainly understood that - come what may - they could always cite chapter and verse of the long-term bull case for equities. They could simply remind their would-be critics that equities had outperformed bonds by a large margin over almost any timeframe during the preceding 100 years. Between 1900 and 1999, for example, US stocks gained an average of 12.9 percent a year, while bonds returned only 4.7 percent annually, according to the data from the London Business School and Credit Suisse. Armed with such rear-looking data, and lots of pretty charts, the CalPERS pension fund charged into the new century loaded for bull.

This equity-heavy allocation seemed unassailably prudent to the stewards of CalPERS, who rarely missed an opportunity to congratulate themselves for a job well done. Not content to merely draw a paycheck, without also drawing attention to himself, Michael Flaherman, then- chairman of the CalPERs investment committee, crowed in mid-2000, "Our performance is the culmination of superior investment and risk management."

No sooner had Flaherman slapped himself high-fives than the stock market Fates began conspiring to punish his unabashed hubris. Since the end of the last millennium, stocks have produced an average annualized loss of 2.3 percent, compared to an annual gain of about 6.3 percent for bonds. Not surprisingly, therefore, CalPERS' equity-heavy fund has generated a meager 2.2% average annualized (gross) return since 1999. (For some mysterious reason, CalPERS discontinued reporting its investment returns net-of-fees in 2002. All of which means that the stated return of 2.2% would actually be a much smaller number).

But now that the bear market pony has frolicking outside the barn for several years, the CalPERS investment team is slamming the barn door shut. The team is drastically reducing its allocation to equities. As of last June, CalPERS reduced its equity target from 56% to 49% - the lowest such allocation since 1993. (Including "alternative" equity assets like hedge funds, the revised equity target would be 61.4%, down from 66%).

Net-net, CalPERS is now a seller of equities...or at least not a buyer. Most of the other pension plans in the US (and in the rest of the world) will likely follow CalPERS' lead.

"Equity assets in the U.K. fell to 41 percent of holdings at the end of 2008, according to data compiled by New York-based Citigroup," Bloomberg News reports. "The last time British pension funds held so little in equities was in 1974..."

Meanwhile, Bloomberg continues, "Four of the world's seven largest pension funds...have cut their equity target allocations..." It's probably safe to assume, therefore, that "caution" is the new buzzword in the halls of most pension fund managers. So it seems highly unlikely that they will exhibit their former exuberance for equities any time soon.

Demographic trends, as well as caution, will prohibit aggressive equity allocations. In California, for example, the baby boomer retirement wave is just beginning, which means that CalPERS must begin favoring capital preservation over "long-term growth." Ditto most other pension funds on the planet.

"The number of people worldwide 65 and older may jump to 1.3 billion by 2040 from 506 million last year," Bloomberg reports. "Their proportion of the total population will double to 14 percent in the same period, according to a June report from the US Census Bureau."

"[Since] the heavy equity weightings of public pension funds in this great land of ours comprise not only the mother of all sentiment indicators, but also a monstrous overhang of stocks, what if the funds sell?" your editor wondered in his mid-2000 article. "No sane fiduciary would choose to sell stocks of course - not if he or she wished to retain a comfortably feathered nest. But demographic trend may force the hand...Probably, the looming overhang is nothing to worry about - right now. But when the overhang threatens to break loose, remember: you heard it hear first."

That moment may have arrived.

Regards,

Eric J. Fry
for The Daily Reckoning Australia

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Meanwhile, in the United States, the world's richest country, the multibillion-dollar credit contagion expands from press release to press release. We would stop the presses if only it would halt the contagion. But the financial world is not so configured.

For the first time ever, therefore, investors consider Brazilian government bonds safer than Merrill Lynch (NYSE: MER) bonds. According to the relative pricing of credit default swaps (CDS) on Brazilian government debt versus Merrill Lynch debt, the reeling American brokerage firm is a riskier credit that the resurgent Latin American economy.

[Credit Default Swaps are a kind of insurance policy against a bond default. The greater the perceived risk of default, the more expensive the insurance - i.e. the Credit Default Swaps - would become. Declining CDS prices, therefore, would indicate declining anxiety about a potential default, whereas rising CDS prices would indicate rising anxiety about a potential default.]

Buying five years of protection against a Brazilian default used to cost much more than buying five years of protection against a Merrill Lynch default.

But now that Brazil has become as crisis-free as the U.S. financial sector has become crisis-prone, Credit Default Swap prices have flip-flopped. Merrill CDS prices have jumped above those for Brazilian government debt! In other words, CDS buyers consider a Merrill Lynch default more likely that a Brazilian default.

Maybe CDS investors have got it all wrong... or maybe the U.S. finance sector is in much deeper doo-doo than most investors believe. The "doo-doo" interpretation seems more plausible.

Credit Default Swap pricing is not necessarily indicative of future trends, but neither is it NOT indicative. For example, after presenting the following chart in the March 14, 2007 edition of the Rude Awakening ("Credit Default Swaps... and You"), we advised, "Sell the mortgage lenders... Finally, investors are beginning to recognize that the unfolding mortgage-lending crisis might be something more than a fleeting annoyance...

"Now that companies like New Century are perishing," we concluded, "and the nation's largest banks and brokerage firms are warning of possible ‘mortgage- related charge-offs' demand for Credit Default Swap protection is rife. Demand for put options on mortgage-lending stocks is also very robust. As a result, insurance ain't cheap. Then again, how often do you get the chance to buy fire insurance when you're house is already ablaze? If the bond market is as smart as she usually is, this inferno might blaze for a while longer still."

And indeed it has. The mortgage-lending conflagration has consumed hundreds of billions of dollars worth of asset values, both in the real estate market and in the mortgage-backed securities market. At the same time, the conflagration has scorched the careers of a few finance-company CEOs, torched the U.S. dollar and threatened the viability of numerous enterprises.

An updated version of Credit Default Swap pricing for Pulte Homes (NYSE: PHM), Washington Mutual and the Russian government shows that the market has become even more anxious about homebuilders and mortgage-lenders. Pulte Home Credit Default Swap cost five times more than Brazil Credit Default Swaps. A contrarian investor might infer from these pricing extremes that the time has come to buy Pulte and sell Brazil. Perhaps the contrarian would be correct.

But a chicken investor would conclude that the time has come to accept the verdict of the Credit Default Swap market and avoid stocks like Merrill Lynch and Pulte... even though they have already suffered mightily. A chicken would infer that the time has come to avoid obvious risks and play it safe.

Cluck... Cluck.

Eric Fry
for The Daily Reckoning Australia

• None Found

These four letters stand for Asset-Backed Commercial Paper. "Commercial paper" - or CP - refers to short-term corporate debt. Specifically, unsecured short-term promissory notes issued by corporations with maturities that typically range from 30 to 270 days. Asset-backed CP is that which is collateralised by an asset-backed entity - i.e. an entity that owns assets like mortgages or credit-card receivables.

The asset backed commercial paper market is struggling mightily at the moment. Almost no one will provide financing to an asset-backed entity, especially not an asset-backed entity like a "structured investment vehicle" (SIV) that is full of mortgage-backed securities (MBS).

In a perfect world, SIVs borrow short-term money in the commercial paper market, then invest the proceeds in debt instruments like mortgages, credit card receivables and collateralised debt obligations (CDOs). But as we observed in the September 24 edition of the Rude Awakening, "The borrowing part of this formula has dried up completely. The asset-backed issuers of commercial paper cannot find any lenders to finance their toxic cocktails of lousy mortgages and 'new math.'"

Since almost all the investors who comprise the free market refuse to purchase asset backed commercial paper, the Federal Reserve has stepped into the breach. In other words, the Fed is now financing the very same stuff that the world's private investors refuse to finance. What more do you need to know about the gravity of America's credit crisis?

The asset backed commercial paper market has nearly ceased functioning. In early August, ABCP outstanding totaled nearly US$1.2 trillion - representing about half of the entire commercial paper market. Since then, however, ABCP outstanding has tumbled by US$279 billion, while the other half of the CP market has remained exactly the same. In other words, traditional corporate borrowers like IBM may still tap the CP market, but not asset-backed entities.

This harsh reality becomes even more alarming when one considers that a complete CP cycle is 270 days...which means that the SIVs who effortlessly obtained 270-day commercial paper commitments last April, May or June have not yet attempted to roll over their CP in the now- hostile environment.

In all, another US$894 billion of asset backed commercial paper will mature over the next six or seven months. Who will provide that funding?...Maybe the same nameless "top tier" institution (the Fed is our guess) that just provided an US$80 billion credit line to Citigroup. Already, the Federal Reserve appears to have absorbed about US$25 billion in MBS securities via "temporary" repurchase agreements. (We realise that this stuff is as boring as heck, but that's also why it escapes scrutiny...and why it may be so important to investors, especially, dollar-based investors).

Repurchase Agreements, "repos" are also called Sale and Repurchase Agreements. Under these agreements, the seller (usually a bank) sells securities to a buyer (usually the Federal Reserve) for cash. But the seller (bank) agrees to re-purchase the securities from the buyer (Fed) at a later date. Typically the banks use Treasury bonds or Agency bonds as repo collateral. Lately, however, mortgage-backed securities (MBS) have become the collateral of choice.

In the early part of this year, the Fed rarely "repoed" an MBS. Weeks would pass between MBS repos. But as springtime arrived, MBS repos started popping up like so many daffodils. Just a few at first, then a few more, then eventually enough to absorb a money center bank's entire short-term liabilities...for example.

As the nearby chart clearly shows, the rolling 2-week total of "temporary" MBS repos soared from about zero in June to a whole bunch in August...and the repos are on the rise again, despite the "recovering" credit markets.

The Fed's newfound interest in MBS contrasts sharply with the utter disinterest of free market investors. The disinterest of real-world investors comes as no surprise. It is an open secret among many hedge fund managers that the institutional holders of mortgage-backed securities and derivatives have not even come close to marking their assets to market. It is also an open secret that two critical pieces of knowledge remain utterly unknown: How big is the total MBS risk? Who's holding the risk?

Until these questions receive credible (and quantifiable) answers, no one will provide financing to AB entities, except the Fed.

Could the Fed conjure up US$1 trillion worth of AB financing between now and President's Day, 2008? Maybe, but probably not without also conjuring up a dollar crisis, or a bond market crisis...or both at once. The only viable path toward recovery and normalcy requires a legitimate mark-to-market. But marking MBS and CDOs to real-world prices might clip tens of billions of dollars from bank balance sheets...and might kick a few dozen millionaire-bankers to the curb.

Unfortunately, because the millionaire-bankers still control the flow of information - and still hold meetings with the Treasury Secretary to concoct shell games - the "fantasy pricing" regime remains in effect. Merrill's US$8 billion write-down was at least a good start because it broke new ground: it acknowledged impairment of AAA-rated securities - "a level of detail that other banks have so far failed to give," analysts from the Royal Bank of Scotland politely observed.

To begin to illustrate the magnitude of the crisis, let's examine the unfolding SIV meltdown. According to professional estimates, 36 SIVs worldwide deploy about US$400 billion in capital. According to unofficial "whisper" estimates, these 36 SIVs have leveraged their capital to about US$2 trillion worth of actual exposure. [If the number is less than US$2 trillion, we'd love to hear about it. But the SIV operators are conspicuously mum on the topic. In fact, the SIV operators ain't sayin' nuthin' about nuthin'.]

And even when they do say something, they don't say anything useful. Late last week, Citigroup claimed to have "secured funding through year end for the US$80 billion in structured investment vehicles it manages..." But of course, the giant bank neglected to disclose the source of this astronomically large credit line. There aren't too many lending institutions with US$80 billion to toss around. In fact, there's only one we know of, and it's run by a guy named Ben Bernanke.

Citi also announced that its SIVs had succeeded in selling "many billions of dollars" of short-term commercial paper to "top-tier name institutions." Again, we wonder, what's the big secret? Why not just tell us which "top-tier institution" is in a position to purchase "many billions of dollars" of SIV commercial paper? Why not just tell us...unless that top-tier institution is also the one run by Ben Bernanke? We are also struck by the coincidence that US$80 billion happens to be the exact sum that the Citi-led syndicate of banks is supposed to be providing to the Super SIV.

Maybe we're way off base here, but we're not way off base in fearing non-disclosure. Any investor with more than two days of investment experience should know that non-disclosure is never good news.

Meanwhile, the SIVs that can't secure financing from the US Federal Reserve must liquidate their portfolios at "fire-sale" prices (i.e. real-world prices), or default on their debts...or both at the same time.

One week ago, the US$6.6 billion Cheyne Finance Plc became the first SIV to default on its commercial paper. A couple European SIVs are in the process of liquidating their US$15 billion portfolios. We predict others will follow in their footsteps. According to the Financial Times, "More than US$42 billion of assets in SIVs...are facing limits on their operations." But that still means about US$300 billion of SIV assets are struggling for survival. And they will likely continue to struggle, not merely because they cannot access funding, but also because their assets are deteriorating.

Just read the newspaper.

The housing bust is triggering a deepening mortgage bust, which is triggering a deepening MBS bust. And the evidence is everywhere. Last week, S&P downgraded US$23 billion worth of mortgage-backed securities that had been issued less than 9 months ago! 1,713 different securities in all; and each one from the class of 2007. Meanwhile, the housing market is trending from bad to worse. As the nearby chart clearly shows, home sales and home inventories are both heading in the wrong direction. The inventory of unsold homes nationwide totals more than 10 months worth of sales - a 23-year high.

Enter the US$80 billion Citi-Paulson "Frankenfund" - the Master Liquidity Enhancement Conduit, or MLEC - to finance the stuff no one else will touch. We are skeptical of this rescue attempt, as noted in the October 17 edition of the Rude Awakening, "Bail-Out Nation." The MLEC advances the cause of obfuscation, while preventing the price discovery that would enable the ABCP market to recover, and bring an end to the crisis.

Just yesterday, Former Chairman of the SEC, Arthur Levitt, described the Citi-Paulson MLEC scheme as "problematic."

"Transparency is the issue," said Levitt. "These [MBS] products are opaque. And our mechanism for overseeing the products, for regulating the process is virtually non existent."

Translation: Its time to clear the fogged mirror, not fog it up some more. The crisis will continue deepening until the market-improvers at Treasury and the Federal Reserve abandon their price-support schemes. The crisis will deepen until MBS securities fall to the real-world prices that will attract real-world investors.

The asset backed commercial paper market will probably provide an early clue as to when that moment has arrived.

Eric Fry
for The Daily Reckoning Australia

• None Found

America, the Land of the Free, is quickly becoming the "Land of the Freebie," especially for members of the millionaire corporate elite who make multi-billion dollar mistakes... with someone else's money. This unfortunate state of affairs is jeopardizing the dollar's value, as well as its hard-won reserve-currency status.

Once upon a time, American-style capitalism resembled a bare-knuckled fistfight – a continuous "Ultimate Fighting" match in which competitors would pummel one another until a victor emerged. But modern American-style capitalism is more like "arts and crafts" time in one of Manhattan's pricey nursery schools. Every coddled kiddy's "artistic" creation – no matter how inept or ghastly it may be – elicits praise from the nursery school instructors. Indeed, every grunt elicits praise...and every boo-boo finds a Band-aid.

Outside the walls of the nursery school, capitalism is just as brutal and Darwinian as it has always been, perhaps even more so. But on the inside, the privileged kiddies never shed a tear without receiving an immediate hug and a "There, there. It's okay. It wasn't your fault... and even if it was your fault, Uncle Ben will make it all better."

As for discipline; forget it. The coddled capitalists of America's high finance never receive a slap on the wrist for any misdeed whatsoever. That would be child-abuse. Nor do they ever even receive a time-out for bad behavior. Worst case, punishment arrives in the form of multi-million dollar severance packages.

Who are these "nursery school" capitalists? They are the folks who receive millions of dollars each year to preside over public corporations and/or to speculate with the shareholders' capital.

American corporations are crawling with these leeches. Using other people's money, they engage in moronic speculations, knowing that success will multiply their net worth dramatically and that failure will produce negligible negative consequences. And sometimes even failure produces success, thanks to the Federal Reserve's well-established penchant for bailing out speculators.

Because Wall Street's privileged speculators receive continuous coddling, they never really learn to behave themselves. Thus, when the multi- millionaire, Nobel-prize winning operators of Long Term Capital Management fell down and got an "owy" in 1998, Alan Greenspan's Federal Reserve rushed to their sides with Fed bailout Band-aids aplenty and emergency doses of financial Bactine. He slashed interest rates, while also cajoling Wall Street's leading banks to provide a multi-billion dollar bailout.

Everyone called it a rescue plan for the capital markets. But the capital markets of 1998 required no rescuing. They had worked flawlessy; they had separated fools from their money.

But because the fools in question hailed from leading Wall Street institutions, and because the Wall Street institutions, themselves, stood to lose billions of dollars, LTCM would not be allowed to fail. Thus, the Fed bailout of 1998 was nothing more than government-sponsored collusion to rescue speculators from the consequences of their ill-conceived speculations.

But the Fed bailout succeeded in sparking a robust year-end rally, which made lots of people very happy...and Alan Greenspan very popular. Few folks cared that the bailout would lead directly to the largest stock market bubble of the preceding 60 years – a bubble that would produce an epic bust and erase hundreds of billions of dollars from the savings accounts of unsuspecting individual investors.

During the early years of the 21st century, the Fed continued coddling Wall Street's privileged few, by slashing short-term interest rates to unnecessarily low levels. Who benefited? Lots of banks and lots of speculators...and lots of speculating bankers.

The speculators devised numerous ways to capitalize upon ultra-cheap short- term financing. The speculators become overnight investment geniuses by borrowing short-term and speculating long-term. But the sort of genius that relies on short-term financing often perishes at maturity. Only a complete moron would borrow short-term and invest long-term, without preparing an emergency back-up plan or exit strategy – only a complete moron...or a coddled capitalist.

Fast-forward to the summer of 2007 – the financial "Summer of Love" – and we find the same playpen of privileged kiddies making the same poopies in their diapers. All the biggest banks and brokers on Wall Street found themselves on the losing side of some kind of ill-conceived loan. They found themselves on the hook for billions of dollars worth of loans that no individual of moderate intelligence would have ever issued with his own money.

Not only did Wall Street's genius bankers issue billions of dollars worth of idiotic loans, they also packaged the loans into billions of dollars worth of idiotic mortgage-backed securities (MBS). The bankers then sliced, diced and reformulated various types of mortgages into various categories (tranches) of collaterized debt obligations CDOs and other asset-backed exotica.

Why did the whiz kids go to such great lengths to repackage mortgage loans? Because it was a great way to move these things off their own companies' balance sheets, and onto someone else's. By moving the loans elsewhere, the bankers could originate new idiotic loans, create new idiotic mortgage-backed securities for public consumption...and collect hefty fees along every step of the process.

When the Wall Street bankers couldn't find any real buyers for their idiotic mortgages and MBS, they would create non-real buyers called structured investment vehicles (SIVs). These SIVs would borrow money, just like a corporation, then use the money to buy mortgage-backed securities from the Wall Street bankers who created the SIVs. The process would be something like setting up a shell company to buy your house from you.

As long as the shell company could obtain financing, it could easily buy your house, and might not even quibble about the price (but that's a topic for another day). Unfortunately, if the shell company suddenly lost access to financing, it would have no choice but to sell the house it bought from you at whatever price it could obtain.

That's exactly where we are today.

Typically, SIVs borrowed short-term money in the commercial paper market, rolling over their obligations every few months. In essence, therefore, the SIVs financed their long-term mortgage assets with short-term CPO liabilities. The process worked brilliantly...until it didn't.

In mid-August, the asset-backed commercial paper (ABCP) market tumbled into a deep-freeze, thereby eliminating the SIVs' primary source of funding. What happens to an SIV that cannot borrow in the CP market, you may be wondering? Option A) It liquidates its portfolio of mortgage securities at fire-sale prices; Option B) It goes knocking on the door of its original underwriter for emergency funding.

Unfortunately, "Option A" includes the distasteful side-effect of putting real-world prices on the billions of dollars worth of illiquid securities that still carry Wall Street's fantasy prices. Replacing fantasy prices with real-world prices would force many American financial institutions to fess up to the billions of dollars of additional mark-to-market losses – losses that the institutions are pretending they have not already incurred. "Option B," therefore, seems like the lesser of two evils, but only in small doses. Large doses of "Option B" could cause serious indigestion on bank balance sheets.

Enter the beefy "Master Liquidity Enhancement Conduit," or M-LEC to save the day. This $80 billion fund-to-be, according to Bloomberg News, "will help SIVs, which own $320 billion of assets, avoid selling their holdings at fire- sale prices."

Here's how the whole thing is supposed to work: Citigroup, Bank of America, JP Morgan and a few lending institutions to be named later will kick $80 billion into a fund. The fund will buy AA- or AAA-rated SIVs. Once these SIVs become the M-LEC's property, they cease to require financing from the commercial paper market or, more importantly, from the lending institutions who are providing the $80 billion bailout. In effect, the banks are bailing out themselves.

To the skeptical observer, therefore, the M-LEC merely puts a happy face on a grim inevitability. These banks would be on the hook for billions of dollars worth of financing anyway. So while pretending to "provide liquidity to the SIV market," the M-LEC is merely a ruse...and not even a very good one.

For one thing, Goldman Sachs is conspicuously absent from the consortium of participating banks, even though former Goldman CEO, and current Treasury Secretary, Henry Paulson, brokered the deal. Presumably, Goldman demurred because it has no interest whatsoever in stepping into the SIV tar pit that has ensnared its competitors...and will continue to ensnare its competitors.

The second problem with the M-LEC ruse is that it will not commence operations for 90 days. That's an eternity in the commercial paper world where the SIVs are fighting for their survival. The 90-day lead-time reveals the insincerity – or incompetence – of the M-LEC proposal. Many, many SIVs could implode over the next 90 days - many more, in fact, than an $80 billion fund could hope to rescue.

The entire SIV market totals more than $320 billion in assets, most of which relies on financing of less than 270 days. Do the math.

The third glaring problem with the M-LEC ruse is that it will buy only AAA- or AA-rated SIVs, where the least of the problems reside. A genuine bailout fund would buy the most toxic securities first, and leave the highly rated stuff out in the marketplace to find real-world buyers. This curious aspect of the M-LEC, therefore, elicits the thought, "Gosh, maybe the banks are trying to support the prices of the highly rated stuff they haven't marked to market, rather than the lowly-rated stuff they don't own."

Net-net, the M-LEC is a joke – a very bad joke.

It is the kind of joke that attempts to rescue well-heeled speculators from the consequences of their recklessness...without providing any benefit whatsoever to the capital markets overall. The SIV world doesn't need a bailout; it needs a mark-to-market. If SIVs were reflecting their real-world pricing, instead of Wall Street's government-sponsored fantasy pricing, REAL capitalists would be lining up to purchase them or to provide financing.

The American capital markets do not need M-LECs, they do not need bailouts; they do not need rescuing...except from the "nursery school" capitalists who consider their wealth an entitlement, and who believe that their failures and their successes both deserve multi-million dollar paydays.

The "Bail-Out Nation" is costing us all dearly. Every Fed bailout undermines the dollar's value and international prestige. That's a very heavy price tag. If the "Bail-Out Nation" does not allow its coddled capitalists to fail, the U.S. dollar itself might fail.

Eric Fry
for The Daily Reckoning Australia

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Sometimes, the difference between a good boom and a bad boom is very subtle and subjective. A "bad boom," for example, might simply be a good boom that you failed to participate in. But usually, key fundamental differences differentiate the good from the bad. Bad booms tend to rely upon credit, for example, rather than earnings and savings. Therefore, when the inevitable bust occurs, credit becomes a four-letter word: Debt.

When a nation of debtors finally exhausts all its sources of additional credit, it chokes on debt. The nation of debtors can no longer sell a house to repay it creditors. Instead, the debtors must simply work to satisfy their creditors. And that's not all. Sometimes the debtors must work for cheapened money, but repay their creditors with expensive money.

Let's consider a simple illustration: A European creditor who loaned 100 euros to an American in 2001 will expect to receive 100 euros in repayment. He does not care that 100 euros will cost the American 65% more dollars than they did in 2001. But the American will care…especially if he loses access to easy credit.

Since bad booms rely upon ever-larger doses of credit to sustain themselves, what happens if credit creation lurches into reverse? Usually, the booms go bust…in a big way.

In fact, credit may be lurching into reverse right before our eyes.  The lenders are simply refusing to lend, which is why the commercial paper outstanding is plummeting. In a perfect world, asset-backed entities, known as "structured investment vehicles" (SIVs), borrow short-term money in the commercial paper market, then invest the proceeds in debt instruments like mortgages, credit card receivables and collateralised debt obligations (CDOs). But the borrowing part of this formula has dried up completely.

The asset-backed issuers of commercial paper cannot find any lenders to finance their toxic cocktails of lousy mortgages and "new math".

Over the last six weeks, the (formerly) US$1.2 trillion US asset-backed commercial paper market has contracted by a whopping US$245 billion dollars. In other words, one fifth of this market has simply disappeared. Unfortunately, the SIVs still need the US$245 billion that nobody will lend them. Without the money, they must liquidate their illiquid portfolios of subprime mortgages and credit derivatives. "We're dumping all our collateral into the market and it becomes a death spiral for the assets," moans Brian McManus, head of collateralised debt obligation research at Wachovia Corp.

To avoid dumping their collateral on the market, however, some SIVs will try to "move back home" like an unemployed college grad. Where is home exactly? On the balance sheets of the biggest banks and brokerages firms in the US (we're talking about the same folks who are already reeling from overexposure to various other piles of financial compost). According to the fine print in many SIV formation documents, the underwriters who issued the SIVs must provide the financing of last resort.

So far, the slow-motion crisis in the commercial paper market is unfolding behind the veil of institutionalised obfuscation. That's because all of Wall Street wishes to keep it that way. The cold, hard truth might hold some interest for short-sellers and academics, but not for the folks who are on the hook for billions of dollars worth of mortgage-backed securities. But even a very bad boom is not so bad if an individual prepares for the bust.

Preparing would include reducing debt and diversifying savings into foreign currencies and "hard assets". But the American financial system is not merely an "SIV problem", it is also - and more importantly - a financial system problem. In addition to the US$250 billion of short- term financing that has already disappeared form the asset-back CP market, another US$300 billion will come due before Thanksgiving. It will come due, and it will probably not find willing lenders. So where will this US$550 billion of credit and/or collateral end up?

Probably not in a place that will please stock-market investors, or bond investors or stock market investors…especially, dollar-holders. Here's the problem in a nutshell. Since homeowners are defaulting in record numbers, mortgage-backed securities of all types are tumbling in value. And since the prices of mortgage securities are tumbling - and since know one knows what these things are really worth - no one wants to provide financing. And since no one wants to provide financing, hundreds of billions of dollars worth of credit drops out under the asset-backed securities market.

You get the idea. As credit disappears, therefore, SIVs and other mortgage-loaded entities must either liquidate their portfolios or obtain new financing from some other channel…or dump their portfolio back on the underwriters. And the numbers involved are extremely large. The US$500 billion that might disappear from the commercial paper market before Thanksgiving could be a very big problem…for the mortgage market, for the banking system…and especially for the US dollar.

Bad booms produce bad results. That's just the way it is. Maybe it's time to prepare for the bust.

Eric Fry
for The Daily Reckoning Australia

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If the connection between falling stocks markets and a rising yen confuses you, don't be dismayed. You have a lot of company. But the connection is not as confusing or sophisticated as it might seem. The "yen carry trade," as it is known, only seems complicated. But it's actually so simple, it's moronic.

"Speculators borrow yen at preposterously low interest rates," explains Bill Bonner. "They trade the money for other currencies - notably those of English-speaking countries - in order to place the money in higher-yielding investments. They then pocket the difference and think they are geniuses. The game works beautifully. Nothing goes wrong. That is, until something goes wrong."

Two weeks ago, as global stock and bonds were tumbling, the "EXIT" door became jam-packed...and the yen's price soared. If assets prices worldwide continue to tumble, the yen carry trade will continue to unwind. And if the carry trade unwinds, the yen will soar. Buying yen, therefore, offers a back-door hedge against falling stock and bond prices.  One simple way to buy yen is to purchase the CurrencyShares Japanese Yen ETF (NYSE: FXY).

For several years, the yen carry trade has nurtured and facilitated risk-taking throughout the world's financial markets. It has provided a seductive source of low-cost liquidity that has emboldened speculators to borrow yen at dirt-cheap rates of interest and invest the proceeds in higher-yielding investments. As long as the "higher-yielding investments" obliged with high-yields, the process worked beautifully. And it had been working very beautifully... until about four weeks ago.

But now that stocks and bonds become very volatile - or simply falling - many yen carry trades are producing losses. As the losses mount, the pain is increasing. As the pain increases, the speculators begin to sell their "high-yield" assets and repay their borrowed yen.

Obviously, the process of repaying yen requires buying yen first, then giving them to the lender. That's why the yen appreciates during times of market distress.

For example, in mid-July the yen fell to a record low against the dollar on the very same day that the Dow reached its all-time high above 14,000.

But as stocks tumbled from their all-time highs, the yen's value rocketed higher. The more stocks fell, the more the yen rose; the more the yen rose, the more stocks fell. After a while, cause became indistinguishable from effect.

The yen's recent spike might be signalling that rampant risk-taking is winding down.

"People are taking risk off the table," one currency trader told Bloomberg News, "In this environment, the yen carry trade is suffering and is going to continue to suffer." The "suffering" of the carry trade does not move us to tears.

"The big carry trade beast has started to roar," says Albert Edwards, an investment strategist with Dresdner Kleinwort, "A complete meltdown of the Yen carry trade now beckons.

"So far," Edwards continues, "the 'Great Unwind' has not seen a major reversal of Yen-funded trades. Much else has happened, but this is the elephant that has been waiting to trample its way through the global financial village and squash the villagers already dying of thirst from a liquidity drought."

Avoid the stampede; buy some yen.

Eric Fry
for The Daily Reckoning Australia

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