Fed Gives Financial System No Doc Loan

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Indexes in Europe and America soared overnight. It was powerful one-two combination from Central Banks that sent the Dow up to its fourth-highest percentage gain ever of 12%. With a stiff right jab, governments stepped forward with plans to buy equity and directly inject capital into tottering banks and financial stocks. It’s a direct capital infusion designed to save the banks.

Direct government ownership of the banks gives the stock market the impression that corner has been turned in the financial crisis. This doesn’t mean stocks are out of trouble. They still have to factor in a recession-or how badly the financial crisis has already bled over into the real economy. But shares seem to think that the worst of the financial crisis is over.

There is every reason to doubt that nationalisation of the banking sector will work. It does nothing to arrest falling global residential real estate problems, the core of the rot in the system. But the British and Europeans moved toward direct recapitalisation over the weekend. And the Wall Street Journal is reporting the U.S. Treasury will take preferred equity stakes it at least nine U.S. financial firms.

Good, bad, or otherwise, the market is clearly treating this as a turnaround point. More on how long this rally could last and how high it could go in a moment, including how to trade it.

But don’t forget the second punch the authorities landed. It was the haymaker. In an announcement released at two in the morning in New York, the Fed announced that it and other central banks would be providing unlimited liquidity to anyone who wanted it, more or less.

Specifically, it said that participants to its new lending program, “will be able to borrow any amount they wish against the appropriate collateral in each jurisdiction.” This is like a giant no-money down, NO DOC loan to the entire global financial system. If the Fed could talk, you can imagine it saying, “If you don’t think we can fight debt deflation with credit creation, watch this.”

In poker terms, the Fed is not yet “all in.” “All in” would be direct purchases by the Central Bank of stocks, bonds, CDOs, and houses. But this is a giant gamble that it can turn the tide in the markets by making unlimited funds available to practically anyone who wants them, provided you have a pulse and a bank account.

This kind of lending is no different in principle from the no-doc lending that fuelled the mortgage bubble boom. You know, the one that preceded the house price crash. At least with housing the loans were secured with an actual asset, the house itself. Here, the massive program to expand government lending will accept any sort of collateral, or even none at all.

It is, in effect, a giant bet by the backers of fiat money that investors prefer inflation to insolvency. Because let’s face it, unlimited liquidity does nothing to improve the solvency of troubled financial firms. Liquidity is not wealth. Not even money is wealth.

The Fed and its gang of central bankers have unleashed the ‘inflationary holocaust’ that Jim Rogers warned of earlier this weekend. They are going to try and beat a deflationary depression with an enormous and unprecedented expansion in direct government lending and/or outright purchases of securities. Will it work?

They will not succeed at reinflating the housing bubble. But all the new money will have to go somewhere. We reckon that investors who can read the tea leaves will get back into deeply oversold energy and resource stocks as inflation hedges. These stocks represent good fundamental value. They’re technically attractive. And the inflation created by the unlimited borrowing facility should be impressive.

It’s an historic moment. The Fed must think it’s done what its counterparts in the Depression did not: prevent the transmission of the crisis from the financial markets to the real economy. True, consumer sentiment has already been affected. House prices are still falling. Spending will slow.

But by quarantining the banking sector and injecting new capital into it, the authorities hope the financial crisis will have ended with the steep falls in share markets-and not translate into a fundamental contraction in global economic activity. The share market will ultimately decide how bad it thinks the economy will be in the next year.

The optimistic view is that it already HAS decided and stocks are clear to rally from here. But keep in mind, earnings analysts have yet to downgrade their expectations for the next two quarters. When they do, shares could head lower. In fact, we believe the market (here and in the U.S.) will eventually test the 2003 lows. But it may not happen just net.

Please remember what the job of the Bear is. His aim is to destroy your capital. But he can only do so if you’re willing to stay in the market and keep your capital at risk. In the last week, fear and panic were so prevalent that there were no buyers in the market. Capital fled, indices fell and the marketplace was deserted of bulls.

The Bear’s job now is to sucker you back in, to make you think the worst is over and that this is a rally you can’t afford to miss. He does that by giving you a rally that seems convincing. A rally you can’t resist. But take a look at the two charts below.

The Crash of ’29: 49% in less than a month

Chart: http://www.dailyreckoning.com.au/images/20081014dra.gif

A 52% Rally and then an 86% Fall

Chart: http://www.dailyreckoning.com.au/images/20081014drb.gif

After the ’29 Crash the bear got clever. Between November of 1929 and April of 1930, the market zoomed up 52% in just five months. It didn’t make a new high. But the price action was surely enough to sucker many investors back in, believing the worst was over. It wasn’t. Over the next two years, stocks fully priced in the debt deflation in the economy and fell 86%.

This is precisely the scenario the Fed wants to prevent. It’s willing to risk a hyperinflationary melt-up in order to avoid prolonged debt deflation. We just don’t know, historically, what the result will be. So how should you handle it?

Be ready for a strong rally in Aussie stocks that could carry through past more interest rate cuts from the RBA this month and the U.S. election in November. It may even last through the end of this year and into early next. We don’t expect stocks to make a new high. But a similar rally to the post-’29 crash would put the All Ords at about the same level they were in May of this year.

Chart: http://www.dailyreckoning.com.au/images/20081014drc.gif

Is it tradeable? You bet. Earlier today, Swarm Trader Gabriel Andre put out his first two trades. We knew the market was building toward a big rally, given how oversold the indexes where in the short term. But the timing couldn’t have been better. The Swarm triggers are buzzing. We’ll have more to report tomorrow.

[Editor’s Note: It’s not too late to get into the Swarm Trader, but only 89 out of the original 300 trading spots are left so you have to be quick. Find out more here.]

Finally, are you getting a little depressed? It’s been pretty relentless in the markets the last month. More than one reader has written in, thanking us for the coverage of the crisis, but opting out. That is, a lot of investors are deciding that it’s time to turn their back on markets and focus on quality of life.

As investors, we think that’s a sure sign of capitulation and bound to create some great opportunities. But the point is well taken. Money is not wealth, as we said above. There are many other ways to measure wealth. Quality of life is just one.

“I smil’d to my self at the sight of this money, O drug! said I aloud, what are thou good for? Thou are not worth to me,” said Robinson Crusoe, on finding a pile of notes and coins in his beached ship. He found that of all the things he could salvage from the ship, the money-the medium of exchange-was the least valuable. He wasn’t going to be doing any exchanging for awhile.

Instead, he measured his “wealth” in those possessions which might improve his quality of life on his Island of Despair…a comfortable hammock, a roof that didn’t leak, a good shovel, dry gun powder, a trusty and faithful dog to keep him company.

Of course, you don’t measure wealth entirely in terms of possessions either. You can measure it in terms of your physical or spiritual health, the quality of your friendships, or your relationship with your spouse and family.

Not that we have anything useful to say about how to increase your wealth in those ways. Every dog we try to pet wants to bite us. But it’s a good thing to remember…that you don’t want the markets to master you and dictate the decisions you can make in life. The exact opposite, in fact. You want to use markets to help grow and protect your wealth, so you can live the life you’d like.

Dan Denning
for The Daily Reckoning Australia

Dan Denning
Dan Denning examines the geopolitical and economic events that can affect your investments domestically. He raises the questions you need to answer, in order to survive financially in these turbulent times.
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Comments

  1. Thanks Dan
    With a renewed sense of perspective I pat my wife and daughter and hugged and kissed the cat.

    Darren Barnett
    October 18, 2008
    Reply

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