Maybe it's the end of the dollar carry trade (where speculators sell risk assets). Or maybe not. Whether that little thesis turns out to be correct we'll know in due time.

In the meantime, there are some other things we might learn this week. First up is the TD Securities - Melbourne Institute Inflation Gauge. This will probably show that except for food, fuel, energy, healthcare, and housing, prices in the economy are stable and inflation is contained.

One quick note about this: there is obviously plenty of inflation in the prices you pay every day. But most consumer price indices are rigged to understate inflation, as our colleague David Evans pointed out yesterday in Canberra at the Gold Standard Institute conference in Canberra. Trimmed medians...hedonic adjustments...there's quite a bit of statistical hocus pocus going on.

Inflation is evident if you just follow the money. The returns on wealth (rent, capital gains, income from bonds) are accruing to that group that's benefitted the most from low rates. Dr. Michael Hudson called them the 'financial oligarchy' in his recent trip to Australia. This group has benefitted from inflation in the form of higher asset prices. And meanwhile, the Fed and other central banks have been able to say their policies are not inflationary because consumer prices and, more importantly, wages, aren't moving up.

Duh.

Is it really a surprise that there's no inflation in wages in a world where tens of millions of workers in emerging market economies are willing to do the same work as those in Western economies, but at much lower prices? Wage deflation is the order of the decade. Maybe the century. You generally won't find inflation in consumer prices or wages. But that doesn't mean it isn't there.

So what will the Fed and the Reserve Bank do this week? The RBA meets tomorrow and everyone is expecting another rate rise. The Aussie dollar has all but priced it in. The RBA also puts out its commodity price index week and its always exciting quarterly statement on monetary policy which we just can't wait to pore over for signs of continued credit and debt growth in the Australian economy.

Westpac will also post results this week. If it follows the lead of NAB and ANZ, it will report higher-than-expected bad debts, but claim the bad debt cycle has peaked. Don't be so sure, though. And why not?

Well, over the weekend, CIT Group Inc. (NYSE:CIT), with US$71 billion in assets, filed for the fifth-largest bankruptcy in American history. CIT is the latest victim of the credit crunch, which obviously still isn't over. It's a commercial lender to small businesses that's been unable to refinance its debt. As a non-deposit taking bank holding company, it has to finance asset growth through securitisation and borrowing, both of which are still pretty hard to do these days.

CIT's Chapter 11 allows it to restructure under the protection of the courts. Bondholders might make out okay. The U.S. Treasury, though, has already lost $2.3 billion in TARP money it put into the firm. And the biggest losers are the small businesses who will no longer have financing. That's bad news for the real economy.

As deposit taking institutions, the Big Four Aussie banks are not nearly as vulnerable to this kind of crisis as CIT obviously was. But as we showed last week, Aussie banks still rely on quite a bit of short-term borrowing in the wholesale funds market abroad, borrowing money from foreigners to financing lending here. That's always going to be a weakness.

Hold everything!

Last week we warned that a result of the Fed's low rates is that U.S. banks have stocked up on U.S. Treasury bonds and notes to stabilise their balance sheets. We warned that this could put the banks at risk again, IF the value of those bonds was slashed by market forces. You'd get another bank collateral wipe-out which could, if large enough, wipe out equity. Insolvency becomes an issue again.

But don't underestimate the ability of the bond bubble to go on longer than anyone thinks. The Feds meet this week and will probably not change a thing. Its formal program to buy Treasury bonds and mortgage backed securities with newly created central bank reserves (quantitative easing) can always be extended. So should bond bears like your editor (who agrees that U.S. Treasury bonds are a great short) be wary?

Yes!

The reason is a new regulation passed by Britain's Financial Services Authority which lays out new liquidity rules for bank assets. Rolfe Winkler has the story in his blog. The short version is that the FSA may require banks to own a certain percentage of assets that can quickly be liquidated to raise cash if need be. Lower credit quality assets (junk bonds or lower rated corporate bonds) might not qualify.

What that means - if you read between the lines - is that the only assets which would meet the new liquidity requirements from the FSA are sovereign government bonds. Now maybe this does make bank assets more liquid. But we wouldn't say owning more government bonds makes bank assets any safer, or improves the capital position of the financial sector.

What it DOES do is give the government a way to force new bond issues down the throats of banks. Rather than having to find creditors among the high-saving emerging market nations, governments in the UK and the US would have a captive market in their own financial sector. The banks would gradually gorge themselves on sovereign government debt, provided Moody's or Fitch or Standard and Poor's didn't downgrade the credit ratings of the US and the UK.

It sure looks like another move toward the nationalisation of the financial sector, although in a very clever way. And the banks probably don't mind that much right now. Trading government bonds with new Fed money was a virtually risk-free trade that propped up bank profits in the first half of the year. It's a good trade.

But in the bigger picture, as Nial Ferguson and Ken Rogoff mentioned this weekend, this means that the financial crisis may soon become a sovereign debt crisis. So far, the liabilities of financial firms have been transferred to the public sector balance sheet. But this has not solved the problem. It's merely moved it to a larger stage on which it must play out.

As we mentioned in our remarks yesterday at the gold show, we believe this marks the beginning of the end of the Super Cycle in paper money. A sovereign debt crisis is the same as saying that the funding model for the fiscal welfare state is broken. Only in this case, there is no organisation large enough to bail out the fiscal welfare state. What does that mean? More on the consequences, and the opportunities tomorrow.

"This is the first time I've been in Canberra," we began our remarks yesterday. "I spent most of last night trying to figure out what it reminded me of. And then it came to me. It reminded me of Washington D.C., and not in a good way. I spent four years in college living in DC. Both cities make you feel like you've stepped onto a very orderly and sterile brothel."

Dan Denning
for The Daily Reckoning Australia

• U.S. Bonds Better than Greek or Other Sovereign Bonds
• Biggest Factor Affecting Consumer Price Inflation is Growth in Bank Credit
• It All Comes Down to Debt Again for NAB
• Everyone We Know Expects a Fairly Quick Up-move in Inflation
• Hyperinflation and the Dollar’s Monetary Destiny

"Okay."

"Why so serious? I mean, all you do every day is write about the worst-case scenario. It's depressing. Who died and made you the harbinger of financial doom? How about something positive for a change?"

"Is that code for, 'buy me another beer?'"

"No, seriously. It's not all bad all the time is it?"

We'll tell you how we answered our friend's question below. But first up, the markets. It was another red day in New York, with Dow stocks down over one percent. Tech stocks on the Nasdaq - the ones enjoying a bit of euphoria renaissance - were down 2.67%. September new home sales in the U.S. fell 3.6% from the month before. The Aussie dollar shed 1.44% against the greenback.

Is that all just noise? Or is there a melody building in the markets? The chorus chanted by Ken Henry, Wayne Swann, and most of the media is that the strong Aussie dollar, the strong market, and the strong(ish) economy are all factors of Australia's great policymaking and unique relationship to the China boom.

But the alternative tune - the one which we've been humming - is that most of the rally in stocks since March and most of the 30% rise in the Aussie dollar is a result of the carry trade. Yes, Aussie assets are relatively more attractive when the cost of capital in the U.S. is zero. But this can change in a flash when foreign speculators change their trading minds.

That's just what happened last year. Only then, it was both a dollar and yen carry trade that led to a rise in Aussie assets. Once the credit crisis set in, the yen carry got dropped and investors fled risk assets and piled right back into the greenback and U.S. Treasuries. Stocks fell, commodities fell, and the Aussie dollar plummeted to nearly 60 cents against the USD.

It doesn't have to happen that way now just because it happened that way then. But since our main job here is to question conventional wisdom and offer you an alternative explanation, that's the one we're offering you. Beware carry trades promising false permanent prosperity!

But what about today's earnings? ANZ followed up yesterday's bad debts bonanza from NAB with one of its own. ANZ reported an 11% fall in net profits (to $2.94 billion) and a 46% rise in bad debts to $3 billion. But both banks hinted that the end of the "bad debt cycle" is over and that things can only get better.

Let's take the other side of that trade. Again we'll focus on two risks: access to foreign funding and asset values on the balance sheet. ANZ sourced more of its funding from domestic savers and less from short-term whole sale funding, according to its report. Aussie savers funded 55% of ANZ new loans for the year (up from 50%) while the company reduced its reliance on short-term whole sale funding by 17% (now just 17% of all funding).

What does that mean? It means the company is making plenty of new loans (you'd want to, especially to the housing market, to prop up the value of your real estate portfolio). But it means the company is relying a lot less on short-term borrowed money from overseas in order to boost lending to Aussie homes and businesses.

Whether it is doing this by necessity or by choice is big question. But all we want to point out is that if your economy relies on imported capital to finance investment (or consumer spending, or new mortgage lending) you're vulnerable if that capital is not forthcoming. It's great when the dollar is high and capital is flowing. But if those capital flows reverse, the banks may find themselves in a jam that even a government guarantee makes it hard to escape.

It's not just us saying this, by the way. "We need to figure out how we can become less dependent on wholesale funding to finance our economic growth," said Commonwealth Bank of Australia chairman John Schubert in last Friday's Australian Financial Review. "It is not assured that we will get the funding into the future."

No foreign funding, no continued housing boom. In fact, we'd be willing to say that a cut off from short-term wholesale foreign funding is just the sort of thing that could lead to a major correction in Aussie house values. Naturally, the government here would step into the mortgage finance market in a big way, and not just for non-bank lenders, as it's done with the Australian Office of Financial Management buying securitised residential mortgage backed securities.

The U.S. government has done everything it can to keep the mortgage credit flowing and household net worth from imploding. Australia would do the same if it had to. But like in the U.S., this means more government borrowing to prop up the property market. More debt, higher interest payments, less capital available for lending to the rest of the economy.

But let's assume for now the public sector does not enlarge again to Depression-era levels of debt. Let's assume that Aussie banks have access to overseas credit. There is still the issue of asset values. ANZ says it is leveraged about 17 to 1. With $476 billion assets, that leaves it with about $28 billion in equity (according to how it calculates both assets and equity). And like yesterday, it's fair to say that a few billion in loan losses and bad debts are hardly the sort of thing to wipe out that much equity.

That's not where the real risk is, though. The real risk is to the asset portfolio. Twenty eight billion in equity capital is just under 6% of total assets. Or, put another way, a 6% loss in assets wipes out the equity.

A six percent loss in assets? Is that possible? The IMF and APRA have stress tested Aussie banks for scenarios in which large chunks of homeowners can't pay their mortgages. They chuck in large corporate bond default rates just to make things more stressful. And after all that, they've concluded that most of the banks' assets are solid and safe and unlikely to incur mammoth losses that would jeopardise the equity capital (solvency).

And maybe they are right. But we're just saying...in a world dominated by massive credit write downs...where we have just seen six months of re-leveraging...and where house values here in Australia have managed (thus far) to escape massive deflation...is a six percent loss on assets totally unimaginable?

We can imagine it, although we don't relish it. Either way, we wouldn't buy the banks just now.

But if you're looking for the most over-valued asset class in the world - the one worth a punt for going short - it has to be U.S. government bonds. Paolo Pelligrini, the man who helped John Paulson make a mint shorting the U.S. housing market, told Bloomberg that shorting long-term U.S. debt is the "only attractive bet" going at the moment.

"I always like to think about assets that are likely to experience a breakdown; the only thing I'm pretty comfortable with right now is U.S. Treasury securities and U.S. agency mortgage-backed securities...I think that those are overpriced so they are attractive shorts."

If you're not going to short the U.S. long-term bond market any time soon, the take away from this is to look for assets that go up when U.S. bond prices fall. If U.S. bond prices fall it means U.S. interest rates go up. That might, for a bit anyway, lead to a stronger USD and a weaker AUD.

For a trader - other than cash and gold - we'd look to see which of those Aussie stocks hammered by the stronger Aussie dollar have been beaten down the most. They might be due for a quick rebound - although they will be fighting the general trend in the market. We'll ask Murray what he thinks and get back to you.

So what did we tell our drunk friend when he asked us why were so critical, sceptical, negative, and gloomy all the time?

"Relax dude. It's my job to plan for the worst case scenario. It makes me happy to have a purpose in life. If you want the best case, turn the TV on and turn your brain off. And I object to your overly negative characterisation of my work."

"Huh?"

"My work isn't negative. It only seems that way because we live in a period of wealth destruction. I wish it were a world of wealth creation. But in a world of wealth destruction, you have to focus on preserving your wealth and maybe, when you can, growing it if you've got the big picture sorted out correctly."

"But you make it sound like the end of the world every day."

"It is the end of the world every day. But it starts all over the next day. And it is just the end of the financial world as we know it. Not the end of the world world...Besides, it's a lot less scary when you face up to what is really going on and make a plan for it. Uncertainty is scarier than risk because with uncertainty, you have no idea what to expect. Risk you can at least manage."

"But how can you be so sure you're right about the big picture? Everyone else I talk to says there's no way the dollar is going down as a reserve currency and that only kooks believe that. Are you a kook?"

"Certified. But that doesn't mean I'm wrong. You can't keep adding debt forever to fund your way of life. Debts have to be repaid. And interest has to be paid on the money you've borrowed. The politicians in America keep making new promises they aim to keep with borrowed money. This borrowed money is massively interest rate sensitive. And it's in addition to a huge amount of money they've already borrowed. It's the end-game for the whole financial/fiscal/political model."

"But so what? Isn't everyone else doing the same thing?"

"Well yeah. All fiat money is a scam. It's a way for the government to run perpetual debts and steal savings through inflation. It's an immoral living arrangement in that respect. But more importantly, from a financial perspective, it's a way of funding a political arrangement. And that way of funding it - borrowing more and raising taxes on a small productive class to pay for a larger public sector - is every bit as dead as the funding model for investment banks."

"But the government bailed out the investment banks. Who is going to bail out the government?"

"No one. Nothing. It will try inflation. But that doesn't work. Printing more money to pay off your debts just destroys wealth. That's where we're headed. That's what you should plan for. Sooner, not later."

"I would like to begin my plan with another beer, if it's all the same to you."

"No worries."

Dan Denning
for The Daily Reckoning Australia

• Aussie Banks Addicted to Foreign Borrowing
• IMF Report Concludes Aussie Banks are “Very Sound”…
• A National Mortgage Bubble
• Fed Now the Middle Man in Interbank Lending Market
• Borrowing and Paying Back in a Foreign Currency

You don't need to own subprime loans to take loan losses in a credit depression. Smith said the area that concerned him most was the surge in small and mid-size businesses simply closing up shop unexpectedly. "In the real economy," he said, "there is no evidence that the world economy is yet bottoming." Commercial property looms as the big threat to the Aussie banks this year.

The bad banking result may be enough to sink shares today. But not if they follow Wall Street's lead. Both the Dow and S&P closed up over two percent. It was a strange reaction to a do-nothing statement by the Federal Reserve.

The Fed merely reaffirmed that it would be dishing out US$1.75 trillion to buy mortgage backed securities, agency debt, and U.S. Treasury bonds, bills, and notes. What it did not say is that it would be increasing its purchases of U.S. Treasury bonds and notes. This may explain part of the rally in stocks. Why?

Well, bond prices fell after the Fed said it would do nothing. The yield on the ten-year note went as high as 3.12%. That's as high as it's been since the Fed telegraphed its intention to buy Treasuries and try and force mortgage rates down. If investors can surf higher bond prices in the Fed's wake, perhaps they are happy to rotate into stocks for a bit.

The rally certainly isn't explained by the GDP figures released yesterday in the U.S. Those showed that the economy shrank at a 6.1% annualised pace in the first quarter. That was a slight improvement on the 6.4% shrinkage in the fourth quarter. But is it the sort of thing-along with yesterday's improving consumer confidence number-that hints of a recovery? More on that in a moment.

Before we forget, we're taking applications here at the Old Hat Factory. We have several new products in development and are on the hunt for a full time commodities and resource stock analyst. Experience in the industry (mining or energy) is preferred. But if you're on the financial side of things and know your way around a balance sheet and cash flow statement and are handy with spread sheets, drop us a line at dan@dailyreckoning.com.au Serious inquires only please. Now, back to the markets...

The copper market seemed to interpret the Fed's statement that things were getting less bad as a sign that things are getting better. Copper prices were up 4.5% in New York. Copper is generally a leading indicator of economic growth because of its use in new construction (housing and commercial property).

Dr. Faber might be in agreement with Dr. Copper (as copper is sometimes called for its ability to 'diagnose' the economic conditions). Dr. Marc Faber's latest letter landed in the mailbox yesterday. There were some real gems in this month's Gloom, Boom, and Doom Report. One was this quote from Charles Kettering, "Success is getting what you want, happiness is wanting what you get."

Got it?

Dr. Faber also has quite a bit to say about whether the large rallies in global stock markets since March (and earlier in some cases) constitute a recovery in the economy or just a "bear market rally." He says that, "At least in nominal terms, the global printing presses being run by the world's central banks and fiscal deficits have begun to impact asset prices positively."

This is a concession that the big quantitative easing efforts of the Fed have found their way into bond prices and certain other sectors. Also, by trashing cash the Fed has made stocks look relatively more attractive. Dr. Faber also thinks that, "In the case of resource and mining stocks, as well as Asian equities (and, for that matter, most emerging and other stock markets around the globe), the lows that were reached between October and March of this year are likely to hold-that is, for now."

And what about Australia specifically? He did not single the country out. But he did say that, "The markets that have the highest probability of having made major longer-term lows are resource-related equities, emerging markets, and Japan."

"Conversely," he writes, "the asset market that has the highest probability of having a made a secular high (such as Japan in 1989, or the NASDAQ in March 2000) is the U.S. long-term government bond market. Despite a still-weakening economy and massive quantitative easing, long-term bond yields appear to be on the verge of breaking out on the upside."

Dr. Faber appears to be right. And we have the chart to prove it. The chart tracks the yield on 30-year U.S. bonds over the last year. We've included two moving averages (MA), a shorter-term 50-day MA and a longer-term MA of 100days. So what story does this chart tell?

Click to enlarge

Source: www.bigcharts.com

For one, you can see that when the Fed first announced its intention to buy mortgage backed securities in November of last year, it sent the 30-year yield cliff diving. And remember, because bond prices move inversely to yields, this sent 30-year bond prices up (which would have been good if you were a large holder and eager seller of those bonds like, say, China).

But at the turn of the year when the stock market swooned, thirty-year yields started creeping up again. Bond investors began doubting the Fed's resolve (or ability) to keep rates low with regular purchases (quantitative easing). The really interesting point on the chart is in Mid-March.

That's when the Fed said it would buy up to $300 billion in Treasuries. Yet from a technical perspective, this is exactly the point the short-term moving average (50 days) crossed over the longer-term moving average (100 days). In other words, when the Fed announced it would be coming into the market to buy bonds, 30-year yields experienced a bit of a technical breakout.

Now weather people began selling bonds because they thought stocks were a better bet, or for some other reason, we can't say. What we can say is that this chart may indicate the Fed's basic inability to control interest rates even with quantitative easing.

If ten-year yields keep rising too, the Fed is going to have to come back to the market with something even more jaw dropping. But will the market believe it? Or is Dr. Faber right? Has the secular bear market in long-term bonds begun at just the moment the Fed stepped in to support bond prices and try to force yields down?

We think the question is important because there is a lot of cash on the sidelines at the moment. Higher yields may suck in some cash looking for safety. But we reckon higher bond yields could just as easily trigger a bigger move into stocks. This would get a lot of people who are sitting on the fence back into the market. The rally would go even higher. And then?

That depends on the economy. And on that score, yesterday's GDP figures also revealed two important numbers. Residential investment (housing) declined at a 38% annualised pace in the first quarter of the year. It's been falling for 13 consecutive months, but this latest performance was by far the worst of the lot.

The other number that shocked was the huge decline in business investment. Business investment in equipment and software fell at a 33.8% annualised investment. Investment in non-residential structures fell 44.2%. Why does it shock?

If businesses are not investing now, where will GDP and wage growth come from later this year? We have a possible answer. But before we get to it, let's look at another chart. The chart from the excellent bloggers at www.calculatedriskblog.com shows the respective contributions of residential and business investment to U.S. GDP. So what story does this chart tell?

Click to enlarge

This chart is telling us that previous recessions, residential investment tends to recover ahead of business investment. In other words, it's telling us that households begin to spend again before businesses do. We can't quite work out why that might be (if it's actually correct, that is). It could be that at the low point of a recession, interest rates decline low enough to finally stimulate new demand for mortgages. The rates suck households in and the new housing activity stimulates the rest of the economy.

We're not saying we buy that theory. But the chart is indicating a bounce in residential investment. Our suspicion is that the bounce is re-financing activity at lower interest rates or foreclosure sales (which are doing a ripping business in California). In other words, most of the activity in the housing market is coming from market-clearing prices being reached in the most over-priced markets.

The big question is if the up-tick in home sales (and residential investment) actually stabilises house prices. If those keep falling, there could be a whole new wave of defaults and foreclosures that sweeps the U.S. market. This would have follow-on effects for the banks (more stress, loan losses, capital raisings) and for the job market (thus the economy).

It's also possible more people lose their houses anyway, even if prices stabilise. How? The economy. If the unemployment rate keeps going up, you can expect more Americans to lose their homes.

So it's a bit of chicken and an egg situation isn't it? Will housing investment lead to an economic recovery? Or will higher unemployment blow out the housing investment rebound and send us all into wave two of the Great Credit Depression?

This brings us back to the question of wage and GDP growth this year. If it's not going to come from the corporate world (still busy cutting costs and shedding jobs), is it really possible for housing to lead the American economy out of recession in 2009?

The only way we can see that happening is if the Fed is even more massively involved in supporting the mortgage backed securities market than it already is. It's committed $1.25 trillion to the market already. This backing could make it possible for millions of homeowners to refinance into new fixed rate 30-year loans this year. And if that happens, then you might see that housing-led recovery.

Don't hold your breath. Goldman Sachs reckons the U.S. government will have to raise $3.25 trillion in the debt markets this year to make up for the Federal budget deficit of $1.75 trillion and to fund the Fed's various credit-easing operations. And if the Treasury can't raise the money for the Fed on favourable terms, what do you think the Fed will do?

More on that tomorrow.

Dan Denning
for The Daily Reckoning Australia

• A Period of Credit Contraction, De-leveraging and Depression
• The Credit Depression
• Copper, the Metal with a Ph.D. in Economics
• Global Credit Shortage is Over According to European Central Bank
• 40 Years of Inflation, 80 Years of Dow/Gold

In fact, so eager are we to see whether borrowers are borrowing and lenders lending that we considered holding up publication of today's DR until the report is released at 11:30 in Canberra. But as we were late with yesterday's DR due to a server crash, we're going to push on. Full results from the housing survey in tomorrow's episode.

Also, we're going to pass on commenting about yesterday's interest rate decision by the RBA. If this were a limbo contest, the Bank could still go lower. But as it pointed out in the statement accompanying the announcement that the cash had been lowered to 3%, "There has already been a major change in both monetary and fiscal policy in Australia. Market and mortgage rates are at very low levels by historical standards and business loan rates are below recent averages."

Translation: "There. We've done our bit. Over to you economy."

So where does that leave us today? It leaves us with a lot of volatility, that's where it leaves us. "With so much economic volatility," writes Dr. Marc Faber in his latest Gloom, Boom and Doom Report, "business operators avoid making any long-term capital spending commitments as the profitability of investments is highly uncertain."

Dr. Faber was writing a fictitious history of the decline of a Great Empire. He explained how during this collapse, "the absence of any transparency and consistency in the government's interventions, and of clarity about the outlook for the economy and asset prices, had-aside from increased volatility which favoured aggressive traders and large speculators-another consequence."

Investors refrain from taking long-term positions because there are so many known unknowns and even more unknown unknowns (although we conceded it is hard to put a number on the number of unknown unknowns, given their unknown nature, if you know what we're saying).

And then the misery compounds. "The collapse in capital spending was aggravated by the existence of enormous excess capacities, which had been built during the previous years when interest rates had been artificially low. Needless to say, with consumers hibernating due to their large debt burdens, declining capital investments had an additional negative impact on the economy."

Over in the real Great Declining Empire, there is definitely some hibernating going on. People are using their credit cards a lot less. Revolving credit use (credit cards) fell by US$7.8 billion in February. That's an annual pace of 9.7%. It was the biggest monthly decline since January of 1978.

Hmm. Fear?

Even industrial strength users of credit are kicking the habit. "The Federal Reserve's requests from borrowers for loans to buy asset-backed securities fell 64 percent from last month as investors balked at visa limits and possible political efforts to tax earnings," reports Bloomberg.

The Term Asset-Backed Securities Facility (TALF) is one of the Fed's many new credit addiction programs designed to make borrowing more appealing to investors, and to thaw out the market for asset-backed securities. It's not working. Or at least it's working less well. More on the Fed's assumptions about markets and prices below.

First though, we missed an article earlier this week about an insider's view of the Australian banking industry and property prices. In an article in Monday's Age, ANZ chief economist Bob Edgar says, "The reality is the banks are still expanding their lending, and I can certainly say in respect of ANZ there has been nothing decided from a policy perspective on lending less to property...But when you go through a risk assessment you would have to be a bit of a fool wouldn't you [not] to have some anxiety about property."

Anxiety about what? That things might change? And not for the better?

"We are at an inflection point on property for sure," Edgar continued. "Now I'm not creating or predicting a disaster [but] ... you would be very foolish to not say that conditions going forward are going to be tighter [than] what we have had for the last decade. What I would say is property developers probably should use less of a rear-vision mirror and more of a windscreen view of their projects going forward. Think about the conditions we see ... rather than the good times."

Banks are already preparing for a property smash up, according to the Sunday Morning Telegraph. "Mortgage lenders are slashing loan ratios (LTV) in a bid to protect themselves against falling house prices. In the past fortnight, Commonwealth Bank, Bankwest, ING, Challenger, Citibank and Suncorp have all cut their maximum loans from 95 per cent to 90 per cent of the property value - and may cut further. ANZ cut its maximum loan to 90 per cent last November. The move is designed to ensure the bank can recover the loan value, if the house has to be sold in the event of a loan default."

Why do this? The banks are cutting LTV ratios now so price falls don't result negative equity for leveraged borrowers. It's also banks just being a wee bit more prudent.

Finally, an academic paper from economists at Harvard and Princeton concludes that Ben Bernanke has it all wrong. The paper-called The Pricing of Investment Grade Credit Risk during the Financial Crisis by Joshua D. Coval, Jakub W. Jurek, and Erik Stafford-concludes that, "recent credit market prices are actually highly consistent with fundamentals.

"A structural framework confirms that bonds and credit derivatives should have experienced a significant repricing in 2008 as the economic outlook darkened and volatility increased. The analysis also confirms that severe mispricing existed in the structured credit tranches prior to the crisis and that a large part of the dramatic rise in spreads has been the elimination of this mispricing.

Hmm. This means the entire Fed/Geithner effort to restore normal pricing to credit markets is based on the wrong assumption that pricing is abnormal. It's not! The assets are just not worth as much as anyone on the bank side of the ledger wants to believe.

Perhaps this is why the Times of London is reporting that the IMF will raise its estimate of losses from the bad bank assets to US$4 trillion when it releases its report on April 21st. Not that IMF forecasts have not been terribly accurate up to now. But this would represent another $3 trillion in losses on top of the $1 trillion already realised (and offset with about a trillion in new capital raisings and government injections.

Some of the other conclusions from the academic report? It concludes that, "many major US banks are now legitimately insolvent. This insolvency can no longer be viewed as an artifact of bank assets being marked to artificially depressed prices coming out of an illiquid market. It means that bank assets are being fairly priced at valuations that sum to less than bank liabilities."

The bailouts, it concludes, are just a big transfer. Even the efforts to bring buyers and sellers together in the credit markets don't work. The paper says that "any taxpayer dollars allocated to supporting these markets will simply transfer wealth to the current owners of these securities."

And finally, the friendly people from the government are only making it worse. "Policies that attempt to prevent a widespread mark-down in the value of credit-sensitive assets are likely to only delay - and perhaps even worsen - the day of reckoning."

How long can Team Obama prevent that day from dawning? And how long before investors get wise to the Fed and get out of the markets? More on that tomorrow.

Dan Denning
for The Daily Reckoning Australia

• Level 3 Assets Growing in All Five U.S. Investment Banks
• RBA Buys $780 Million in Residential Mortgage-Backed Securities
• Property Sector Has Seen the Value of its Assets Wiped Out
• BHP Billiton: The Oil Company That is Not an Oil Company
• IMF Gold Up For Sale to Pay the Bills

Meanwhile, there is not much we can tell you that you don't already know about the global rout in stocks. Wall Street is at twelve- year lows. The FTSE is at six-year lows. And here in Australia the market has opened lower than its five-year low, as you'd expect after such a wretched overnight performance on global markets.

On a side note, a large cloud of brown plane tree leaves has just blown down the street across the way. We're watching from our perch on the second floor of the Old Hat Factory. Gale force winds are blowing through Victoria today.

Back to the markets and the banks. Moody's has said that the AA1 ratings on the Commonwealth Bank, ANZ, and Westpac are no longer secure. Moody's analyst Patrick Winsbury said the Aussie banks could survive the global collapse better than most,, but that "The negative outlook reflects the potential for the deepening global economic downturn to have a protracted impact on the banks' asset quality and earnings."

If the Aussie banks are re-rated by investors (downgraded), it's exactly the sort of thing that will lead to taking out the 2003 lows in the 2,700 range. That may sound severe-wiping out all the gains of an epic resource bull market. But keep in mind the S&P barely closed above 700 overnight and dipped under that level for the first time since 1996. The Dow crashed under 7,000-a place it hasn't seen since 1997.

The chart below reminds you how vulnerable the Aussie indices are to the big four banks and the big two miners. You can see that Rio and Macquarie Group (which we included as an example of how discredited the investment banking model is now) lead the charge lower.

But over the last year, the big four and BHP have managed to fight earnings gravity. If that changes for whatever reason-like seven of Australia's top ten trading partners being in a recession-the lows will be taken out. And probably sooner rather than later.

Click to enlarge
Source: www.google.com/finance

Plain and simple: All the gains in equities since Alan Greenspan uttered his famous words about irrational exuberance have been wiped out. All that remains to know now is how irrational the downside would be. The good news is that you're seeing signs of capitulation. Investors are giving up on stocks for the long-term.

For example, we got a text message this morning from a long-time bull. He always finds reasons to disagree with our analysis. He texted early this morning after watching Wall Street's depressed closing.

"It's over."

That's not quite a buy signal. But it's not a bad sign either.

Across the world the trouble is with the banks. HSBC will slash its dividend and do a US$17.7 billion rights issue to shore up its capital. Will shareholders pony up? In the U.S., AIG reported a US$61.7 billion loss. The company guaranteed some $450 billion in credit default swaps. European banks are its big counter parties, with some $300 billion in exposure outstanding.

You can see why the U.S. government is flushing money down AIG as fast as it can. If AIG is downgraded , it triggers more losses for European banks, which already have problems on their Eastern front to begin with.

In fact, the more we think about it, the more we agree with John Robb that this is not just a stress test of financial firms. It's a stress test for national governments. Banks and governments have co-evolved to get to this point where we are today in the modern world (where interconnectedness and complexity threaten to crash the system).

The "Cash Nexus" as historian Niall Ferguson calls it is the murky relationship between fractional reserve banking, perpetual government debt, and the fiscal warfare/welfare state. That is, governments would never have the money to build powerful military machines without modern bank financing and the bond market (where banks buy and sell government debt, bridging the gap between private capital and government borrowing).

Similarly, banks could never have gotten as large without the regulatory and legal framework set up to favour them. And of course it would favour them.

A few things have changed in the last ten years. The main one is that leaders have become looters, be they political or corporate. On the political side, instead of conventional armed conflict, which had diminishing marginal returns (in addition to being really unpopular in a culture addicted to leisure) governments have gotten into all sorts of other wars, mostly against their own people (War on Poverty, War on Drugs, War on This, War on That, War on Everything, War on You.)

And for their part, the banks and even non-bank lenders figured out that if the government was going to encourage home ownership for political reasons by discouraging rigorous lending standards, then the best way to deal with the increased risk was to sell it!

Alan Greenspan called this "disaggregation" of risk. But obviously securitisation did not lower systemic risk. It heightened it. But for a little while anyway, the banks and bankers made a mint off of the government's desire to gear the entire national economy towards the goal of home ownership. This happened in Ireland, the U.K., the U.S., and Australia to name few English-speaking companies.

You'll forgive us if we don't quite have our head wrapped around the idea yet. It's a work in progress. But yes, we are suggesting that the co-evolution of the modern welfare/warfare state and the financial system has been impacted by a financial meteorite of sorts.

The co-dependency has always required a little inflation to keep it going. But lately, the last one hundred years or so, it's turned into a lot of inflation. The expansion of global money supply through fiat money and widespread credit has created an inherently unstable scale of modern living. We have a living arrangement that uses resources too quickly and too inefficiently. And now we have bumped into that fact in a rather abrupt way.

A re-localisation of the economy would be something to think about and even plan for. If the centralisation of money and power has reached its useful limits, then you'd think we'd be moving away from it. Yet in Washington, Canberra, Paris, London, Tokyo, and Berlin everyone wants government to get bigger and spend more and take a larger role in the economy.

The response to the crisis has become activist and interventionist. This, ironically, echoes the ideological response of the Bush Administration in Iraq. Meet the new boss everybody! Making the exact same strategic mistake as the old boss, only a different theatre! We'll see how that works out...

Some reader mail...

Hi Dan & all at DR,

Whilst I enjoy reading your daily ramblings, sometimes your analogies are left wanting. A case in point is your analogy of the 27th February, of the "death of a star". Whilst super nova's do indeed produce enormous explosions of galactic proportion, remnants of the stars will continue to survive, all be it, in less than bright condition.

Further more, every element in the universe heavier than iron on the periodic table, and that includes gold which you seem to bang on about constantly (excuse the pun), owes its existence to past super nova explosions. Without these heavier elements, you, me and every living thing on the planet, (and perhaps elsewhere) would not get a chance at life and living it. So your analogy is perhaps, fatally flawed. Just thought I'd mention it. Keep up the polly bashing though, love it!!!

Kindest Regards

Simon A Blane

Undergraduate student, Edith Cowan University, Perth, Australia.

Sorry about that.

Hi Dan,

You really should be careful about what you wish for. In the modern Corporate Welfare State, the rich are the greatest beneficiaries of Welfare. The Rich pay almost no tax, and the taxes that are paid by the Poor are used to create an apparatus that protects the Rich from the very people paying the taxes. Without that apparatus your 'private goods' remain so only until someone takes them by force, which of course is feudalism.

So the extreme of capitalism is feudalism, and if that is the system you want for our society, then you better prepare yourself for everything that entails; bloodshed, disappearance of the middle class, culture death and endless warfare. I thought we as a society were over that phase, but apparently not. Sigh.

Ian

See above.

Dan Denning
for The Daily Reckoning Australia

• Banks Could Face Serious Trouble from Losses on Residential and Commercial Real Estate
• Latest Energy Bull Market Won’t Be Confined to Crude Oil
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• Stress Testing the Banks
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First up is Christopher Wood, regular analyst at CLSA Asia-Pacific and writer of handy newsletter called GREED and Fear. "The ban on shorting Australian financial stocks is due to expire on 27 January," he writes. "If it is not extended, this presents a clear opportunity for absolute-return investors. GREED and Fear continues to take the view that Australian financials will be the last area of Anglo-Saxon consumer financing excess to bottom with, as in Britain and America, the seemingly inevitable involvement of taxpayer money before the end of the cycle."

"GREED and Fear also continues to recommend, as has been recommended since March 2008, that Asia-Pacific relative-return investors maintain a zero weighting in Australian financials. Australian banks, including their New Zealand subsidiaries, are characterised by high loan-deposit ratios and low loan loss provisions."

"Meanwhile, the household sector is extremely leveraged while the former high flying residential property market is weakening fast. Household debt to disposable income is still running at 156%, compared with 130% in America. While Australian residential building approvals fell by 32% year-over-year in November, with new home sales down 15% year-over-year."

"GREED and Fear hears from recent visitors to the 'Lucky Country' that there is still a state of denial, which is certainly not the case in Australia or Britain. If so, this mentality will not last. But the good news is that reluctant Australian taxpayers will be able to afford to pick up the tab. Public sector debt is only 15% of GDP."

So there you have it. From the outside looking in, Aussie banks and investors are in denial about the housing market and the impact of the asset deflation and the credit crunch on bank bottom lines. Does that sound about right to you? Or is Australia's residential property market truly immune from the Credit Depression? Discuss. Or write to us at dr@dailyreckoning.com.au.

Meanwhile, allow us to turn the podium over to Australia's Prime Minister, the Honourable Kevin Rudd. Rudd was in Adelaide, trying to bask in some of Lance Armstrong's cancer-fighting limelight. But he was preoccupied with the emerging fact that foreign lenders are turning off the supply of credit to Australia as the world banking crisis accelerates.

"When markets fail, governments must act," the Prime Minister said, apparently with a straight face. What he was referring to, according to today's Age, is the $75 billion in foreign loans owed by Aussie firms that must be rolled over in the next two years. Trouble is, foreign lenders-and really lenders everywhere-appear to be in nearly full-scale retreat from lending.

This is the trouble with having only four big banks and being a net importer of capital. You can finance your lending out of domestic savings, of course. But Aussie banks-mostly to finance the housing boom of the last ten years-borrowed overseas to lend at home. And if you can't borrow overseas? Hmm. Maybe government lending, or a government guarantee on borrowing, will work instead. We'll see. Meanwhile, back over to Rudd...

"It would be difficult for Australia's four major banks to fill the gap [between borrowing needs and foreign willingness to fund] on their own," Mr. Rudd he said. "When businesses cannot get loans and are not confident about the future, they can't or won't invest, meaning they can't create jobs and they can't grow. The Government stands ready to take whatever further action is necessary to stabilise financial markets."

Mr. Rudd could be getting a lot of action pretty soon. Between the $10 billion stimulus, bond guarantees, the expanded first home buyers grant, and various infrastructure plans, Bloomberg reckons the Rudd government has committed or spent $45 billion so far. It's probably going to take a lot more than that, especially if the government has to guarantee (or the RBA provide outright) credit to local borrowers who can't borrow internationally.

Not that the Aussie banks are being singled out. Heck, Australia's four big banks may outnumber solvent banks in the U.K. and America combined by the end of the week, if things keep going they way they're going. Bank stocks in America were absolutely hammered in Tuesday trading. Citigroup (NYSE:C) was down 20%. Bank of America (NYSE:BAC) was off 29%. And Wells Fargo (NYSE:WFC) was off 24%.

What gives? It's the sinking feeling that the world's banks still don't have enough capital and will need much, much more to offset coming losses and begin lending again in normal way. But the equity capital just keeps melting away. For example, the Royal Bank of Scotland had a market cap of £75 billion two years ago. As of yesterday, it was only 4£.5 billion pounds. And that's AFTER a taxpayer injection £32 billion!

More on what this means for Australia in just a second. And later this week, we'll get into the real heart of the problem in the banking sector, dwindling capital and mismatched liabilities and assets.

But for now, let's be clear: the banking crisis has entered a new stage in the equity markets. It has real world consequences for commodity demand and resource shares. We'll get to that in a second. But what about Australian financial shares?

Well, we won't get into any analysis of loan books or balance sheets. It is true that Australian banks did not get into the subprime mortgage game. But it is also true they did make a lot of loans to margin lending firms in the stock market and still have significant exposure to residential real estate. We asked SWARM Trader Gabriel Andre to put that all aside and tell us what was the worst looking Aussie bank stock on a technical basis.

Here's what he told his readers yesterday in a SWARM alert. His analysis included a forecast for the ASX/200. "Among the losers," Gabriel wrote, "there may have one famous banking institution. Besides the balance sheet and the macro news, we had a look today at the Aussie banks. Just on the chartist side. Only with technical indicators. And there is one chart that does not look really good. It's ANZ. Take a look at the chart below.

"The key level is at $15.5. It has been the main support of the price action during several months (points A, B, C and D) but has been cleared in November (point E) when the price went further down to a low of $12.30. The key level of $15.5 mechanically became the new resistance. Hit a few times since the beginning of the year (points F and G), the resistance has been holding firmly. The long-term resistance (red line) is also just above. The price action is therefore well capped."

"Two different momentum indicators have already turned bearish: the MACD and the Klinger oscillator, which is sensitive enough to signal short-term tops and bottoms, yet accurate enough to reflect the long-term flow of money into and out of a security. This afternoon ANZ is quoting $13.7. It should go clearly further below, especially if the ASX ban on shorting the financials will expire next week."

Maybe ASIC and the ASX will reconsider the ban on shorting financials. And maybe it will not matter anyway. Either way, stay tuned.

We wrote above that the renewed banking crisis is bad news for commodity demand and resource shares. But how so? The problem is asset deflation.

Yesterday we speculated that there could be trillion dollars more in credit-market losses related to commercial real estate, residential real estate, and corporate bonds. If that is the case, it means much lower share prices. It also means finance is going to be extremely tough to come by for mining companies, who are facing falling real demand to begin with.

Today Nouriel Roubini checked in on the issue of how much more asset deflation we face. At a conference in Dubai he said, "I've found that credit losses could peak at a level of US$3.6 trillion for U.S. institutions, half of them by banks and broker dealers...If that's true, it means the U.S. banking system is effectively insolvent because it starts with a capital of $1.4 trillion. This is a systemic banking crisis."

Now you can see why it was such a bad day for the banks. The scary fact is that Roubini's estimate could still be conservative. You still have the corporate bond market, securitised consumer loans (credit cards and loans), and GSE and Agency-backed bonds (both of which are tied to U.S. residential real estate.)

But quibbling over trillions is not the point. The point is that if there is more asset deflation to come, it is extremely hard to find any positive argument for continuing to own, much less buying, all but very specific types of commodity-related investments. And just what would those investments be?

We turn to the late Harry Browne for the answer. In the early 1970s, Harry wrote a book called "How to Prepare for the Coming Devaluation." Harry's book was an investment primer on how to live in a world with massive, deliberate debasement of national currencies. Naturally, the strategy favoured "stuff" over "paper." But not just any stuff.

It was-and still is-a radically simple asset allocation model. Harry said that roughly 25% of your assets should be in gold (combination of bullion, coins, and equities), 25% in foreign bonds, 25% in U.S. Treasury bonds, and 25% in growth stocks.

Investing: once complicated, now simple!

Would that model hold up well today? Well, we'd be wary of having money in the bond market. That's one thing that's changed since Harry wrote his book in the 1970s. And we'd probably add more energy investments, given our subscription to the Peak Oil theory of declining global oil production. But his observation that simpler is better when preparing for inflation is spot on.

An actively managed portfolio with a weighting of 60% to 70% of your assets in stocks does not look like a financial survival strategy for the next five or ten years. You want a more permanent portfolio that takes into account the macroeconomic and monetary events that influence share prices.

Harry's big call was to buy gold and silver. And as you know, that worked pretty well. Buying gold has also been Bill Bonner's trade of the decade since 2000. It's working out pretty well too.

But did you know that there's a fund that's traded since 1996 which essentially imitates Harry Browne's investment strategy? It's called the Permanent Portfolio and trades under the symbol PRPFX. Note that we are not recommending you buy the fund.

What we are recommending is that you pay close attention to its strategy. "Designed to provide growth at low risk," the home page says, "the primary goal of Permanent Portfolio is to preserve and increase the real long-term purchasing power of each shareholder's investment, regardless of economic climate. "

It does this with a portfolio consisting of gold, silver, Swiss Francs, real estate, U.S. Treasury bonds, and aggressive growth stocks. Take a look at how the fund has done since its inception versus the S&P.

As you can see, the Permanent Portfolio got clobbered during the tech boom. It's relatively low allocation to growth stocks had it underperforming. Then, starting with the great Greenspan reflation of 2003, it roughly tracked the S&P 500, while still slightly underperforming. However, since late last year, it's held up much better than the S&P 500 as the financial crisis decimated stocks.

By the way, here's how the fund's assets were allocated at the end of last year:

Gold: 20%

Silver" 5%

Swiss Franc Assets: 10%

U.S. and Foreign Real Estate and Natural Resource Stocks: 15%

Aggressive Growth Stocks: 15%

U.S. Treasury Bills, Bonds and Other Dollar Assets: 35%

We might have fewer U.S. dollar bonds and more growth stocks in there too, but what's killed the Permanent Portfolio in the last six months is its exposure to commercial real estate through its REITs. We mentioned last week that we thought arable farm land would be an increasingly valuable asset in the coming years. So if we were going to make this union of asset classes even more perfect, we would strip out the REITs and backfill some agriculture and land investments.

But the rest? It looks pretty sound for a world where you face more asset deflation prior to rampant, government-backed inflation. The 80% up figure translates to about six percent a year since its inception, which is just about the historic return for common stocks (if you include reinvested dividends).

One other item to note about this. The Austrian School's analysis of the credit cycle is what informed Harry's strategy. Like today, he understood that changes in the money supply would affect the real economy and the stock market. The credit cycle and the business cycle are inextricably bound together.

But that didn't mean there isn't a prime place in Austrian theory for the role of the entrepreneur. In fact, the great Austrian economist Joseph Schumpeter pointed this out in his early work, The Theory of Economic Development. Schumpeter pointed out that the aim of all economic production is to satisfy human wants.

In Schumpeter's world, the entrepreneur is more important than the capitalist because it's the entrepreneur who has the vision to challenge conventional ways of doing business and take risks (albeit with someone else's money.) In Schumpeter's vision of capitalism, "the gales of creative destruction" are unleashed by single-minded entrepreneurs who bring change. And not just change you can believe in, but profitable change!

Or as Schumpeter writes in The Theory of Economic Development, "Entrepreneurial profit ... is the expression of the value of what the entrepreneur contributes to production." This is why Schumpeter's kind of capitalism is inherently moral and ethical. It is based on production which consumers find valuable and exchange which they enter into voluntarily.

There is no compulsion or arbitrary setting of prices or government-mandated production or lending. If the idea of the entrepreneur contributes to the production of some good or service people want more of than what's already available (or if it's entirely new) he profits. And sometimes enormously so.

That is one good thing we can say about the world we live in and one big reason why growth stocks should remain part of your asset allocation strategy. In medicine and energy, the world faces huge challenges and enormous entrepreneurial opportunities. It's going to present investors with great chances to share profits from innovative firms.

With great volatility you also get a lot of innovation. As much as we focus on value destruction here in the Daily Reckoning, there are a lot of wealth creation stores to be pursued too!

But we'll have to save the story of creative destruction for tomorrow! In tomorrow's edition, we tackle the issue of fair value versus market value in the U.S. mortgage market. And we'll have more on AGMOIL, the next trade of the decade involving a portfolio of agriculture, precious metals, and oil. Until then!

Dan Denning

for The Daily Reckoning Australia

• The Problem With a Well-Diversified Portfolio
• Australia Presents Investors With Great Portfolio of Energy Choices
• Equity Asset Allocation and Portfolio Rebalancing Left Out of Superannuation Review
• Banks or BHP?
• A Time to Liquidate Your Entire Share Portfolio

True, a big barrel of West Texas Intermediate crude oil might be hard to fit under a Christmas tree. And it's probably a fire hazard. But it also makes an excellent end table or lectern. However, we would wait for the post-Christmas sale, or maybe even until 2009, for a lower price.

Speaking of Christmas, just a reminder that our third annual Doomer's Ball is tomorrow night. The location is BLVD Bar, located at 6 Queensbridge Square on Southbank in Melbourne, from 6:30 p.m. until later. There will signs directing to the right room and even be a red carpet, we hear. If you've RSVPd, there will be a check in desk where you can pick up a name badge at your ticket for a free drink . See you then!

Today's AFR reports that Australia has a funding gap. The credit crisis is causing foreign banks to pull up stakes, pack up their cash, and head back to wherever they've come from. The AFR reckons about $50 billion in lending will have to be replaced by Aussie banks.

Those banks, by the way, may not be so keen to make new loans. ANZ boss Mike Smith was in Melbourne Friday swinging the axe. Eight hundred heads toppled from their shoulders by the time he was done. If the banks do as good a job deleveraging their balance sheets, things might start to look better in 2009.

You'd expect job losses and a bad year for stocks to impact consumer confidence and spending habits. You'd be right. Australia had a $20 billion current account deficit in March, according to David Uren in today's Australian. That was seven percent of Aussie GDP and pretty remarkable for a country in the middle of an export boom.

Now, though, consumers are rolling back their spending ways. The weaker Aussie dollar makes imports more expensive. The current account deficit has halved to 3.2% of GDP. This probably isn't great news for retailers. But if household's rebuild their balance sheets on savings, it's not a bad development.

Over the long run, in fact, an increase in the savings rate increases the amount of credit banks can lend to businesses. Household savings are the source of bank deposits. And in a fractional reserve banking system, every new dollar deposited is multiplied into ten dollars that can be lent. If the banks are lending, that is.

Christmas has come early for Leighton Holdings (ASX:LEI). Dubai's Department of Civil Aviation awarded Leighton's Middle East operation a $1.3 billion airport contract. At $21.31, Leighton is not selling for much above its 52-week low of $18.68. It trades at just 10 times earnings. Is it a buy?

That depends on whether you think countries like Dubai are going to keep building and spending. Dubai has the money, generated from the oil trade. And it's in the middle of an ambitious project to turn oil money into the capital stock of a new economy, via tourism, finance, and trade. But it could also be just another example of the credit bubble.

Take away Western demand fuelled by credit, and the world needs less oil. Ironically, this actually accelerates the rate of depletion in global oil fields. How? When a good falls in price, people tend to use more of it. The cheaper it is, the more you use it. But wait. There's more.

While cheaper oil prices in 2009 accelerate the depletion rate by encouraging more use (and lulling us all into a false sense of oil security) they also discourage smaller firms from going out and finding more. The majors are always looking for oil. They have to constantly replenish reserves to match production, or the stock price falls. But what about all the other searchers and explorers. Will they keep looking for oil with the price at $40?

In America, Barrack Obama is already busy spending money America doesn't have. And he hasn't even officially taken office yet. Impressive. Obama is dusting off construction plans for bridges, highways, and schools that he says are "shovel ready." That means all the blue prints and plans are drawn up. They just need men, machines, and money.

America doesn't have the money. But that has never stopped anyone with a can-do attitude. Obama says we can't worry about the deficit in the short term. Right. It doesn't look like anyone has been worried about the deficit in America for a long time.

Dig a hole. Fill it up. We're not sure where we heard that. Maybe it's a Buddhist way of dealing with stress, and realising...something. But we get the feeling a lot of holes are about to be dug across the world. And most of it will be paid for with borrowed money.

But who will be doing the lending? So many new government bonds are going to hit the market in the next year from the U.K. and the U.S. that you wonder if the world's creditor nations aren't starting to get a bit nervous. What happens if they balk? Interest rates should rise.

That's not happening yet. Just the opposite. "Yields on two-, 10- and 30-year securities fell to the lowest levels since the Treasury began regular sales of the debt," reports Bloomberg. And get this. The yield on three month T-bills is a sparkling 0.01%.

Hear that sound? It's the sound of the bond bubble stretching to historic levels. Cover your ears.

Dan Denning
for The Daily Reckoning Australia

• Unemployment Set to Rise by Christmas
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Is it a big deal if you're an investor? That depends on whether you believe the banks are a buy. If one bank is buying another bank, then at least one bank thinks banks are a buy. But why? And is what's good for one bank good for the investor?

The question, as always, is where earnings growth is going to come from? In that light, the Westpac move is all about growing the loan book through acquisition. Growing the loan book means putting more Australian in debt. We'll get that in a minute. But let's take a quick look at the details first.

First, if you exclude non-recurring items, cash profits at Australia's big five banks grew by just 1.1% in the first half of 2008 compared to the year before. During the biggest credit crunch of the last thirty years, that's not awful. But it's not good either. By the way, all the data that follows, unless otherwise indicated, is taken from the KPMG survey "Major Banks: Half Year 2007/08." It's an excellent read. Seriously.

Aussie banks didn't face massive losses from bad housing loans (although at least one bank, ANZ (ASX: ANZ), took big losses on loans to stock brokers). So what ate into profitability? The "net interest margin" declined for all five banks in the first half of '08. The interest margin is the difference between what Aussie banks pay to borrow and what they pay out interest on deposits.

The credit crunch has raised the cost of "wholesale borrowing." ANZ's interest margin decline from 2.24% to 1.99%, Commonwealth Bank's (ASX: CBA) from 2.22% to 2.17%, NAB's (ASX: NAB) from 2.33% to 2.18%, Westpac's from 2.25% to 2.05%, and St. George's from 2.07% to 1.92%.

So here's the question, dear reader: if you're making less money lending money because the cost of money has gone up, how do you make more money? You make it up on volume.

Despite the decline in net interest margins, total net interest income actually increased by 9.8% in the first half to $17.6 billion. The banks managed that by growing assets by 19.9% in the first half compared to '07. Growing assets by that much is an accomplishment during a bear market in credit. How did the banks do it?

The banks grew their lending portfolios by 16.1% in the last twelve months ended March. Consumer lending (housing, credit cards, personal loans) grew by 11.2%. Business lending grew by 24.5%. Total bank assets in Australia now exceed $2 trillion.

Now THAT's how you grow your way out of a credit crisis. You lend more. It could, of course, be troublesome if you look at bank assets as other people's liabilities. Debt levels are already high at the household level. For banks to grow assets, household debt levels would have to grow even more and business borrowings would have to rise as well.

The trouble with growing your assets to drive your earnings is that you take increased credit risks to do it. This was the problem for the Government Sponsored Enterprises in the States and led to massive blow outs in their balance sheets (the regulators came in late to restrict the growth in balance sheet assets).

Eager to drive earnings and please shareholders (and make some money on stock options tied to earnings growth) bank managers in the States grew the balance sheet with little to no regard for asset quality. That is one simple explanation for how a mortgage lending bubble gets started.

Here in Australia, if banks are going to continue growing assets, the housing boom will have to keep booming. This is problematic too, with housing already so unaffordable. For example, the Australian Bureau of Statistics reported today that the number of home-loan approvals fell by 6.1% in March.

Higher interest rates are discouraging demand for housing loans. Yet the banks have to loan more to make up for declining margins. But the more they loan, the bigger the risk they take that the loans will be non-or under-performing.

Is there any way out for the banks? Well, they could hope for an increase in net interest margins. This would lead to a decline in the cost of borrowing money. The banks could leave the interest rates they pay on deposits fixed, and benefit from the lower cost of funding. An end to the global bear market in credit would help, then.

Of course, there's another way banks can grow earning without growing loan volumes. You know it well! Fees!

If profitability on loans is declining (and it is), the banks could make it up charging you more fees (not that they would ever do that). The growth rate in bank fees has actually declined, if you peruse the data from the Reserve Bank. But bank fees, as you can see from the chart below, contributed nearly ten billion to bank's income in 2008-basically half of a full year's profit.

Source: Reserve Bank Statistical Tables, Domestic Banking Fee Income, Table F6

There's consolation in that massive income from fees if you're a bank shareholder getting a dividend and some capital appreciation. But if the worldwide model of growing asset values through debt is under massive attack in the U.K. and the U.S., then why would it be terribly different in Australia?

Unless margins improve, banks will either have to raise fees to continue earnings growth, or expand the loan book. With rising interest rates, expanding the loan book is going to be hard to do, even if that's what you want to do. Westpac must know this and decided to take a short cut to balance sheet expansion: acquisition. Does this mean organic growth is dead? Hmmn.

Dan Denning
The Daily Reckoning Australia

• Banks or BHP?
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• FDIC Wants Banks to Make More Loans to their Business Customers
• In Europe, Banks Borrow Money and Lend it Back to the Government
• Big Australian Resource Stocks Up 24% in 2008

Is everyone living in fantasy land around here?

Local stocks got a boost yesterday (especially the financial shares) by insurance giant QBE's $7.4 billion bid for IAG. Meanwhile, the Age reports that ANZ (ASX: ANZ) was loaning money to a Melbourne broker with a similar business model to Opes Prime at the same time Opes was imploding.

"ANZ offered as much as $1.5 billion to companies associated with stock lender Chimaera Capital during February as pressure mounted on two other bank clients with similar business models," reports Marc Moncrief in today's Age. Hmm. That's an interesting business decision.

When something is not quite right with a business, it sometimes shows up in the chart before it shows up in the paper. Don't ask us precisely how this happens. But it is one of the great benefits of market pricing.

Though not perfect, the market price reflects the collected knowledge of all the buyers and sellers in a market. An efficient market-and not all markets are efficient, and even efficient markets are not always efficient-will tell you more about what's going on with a business than any one person can tell you. All you have to do is look at the price and the chart.

Our chart guy sits about four feet away. We asked him to take a look at the financials and ANZ and tell us what he saw.

"They all have been hammered since October 2007," Gabriel Andre writes. "The whole sector has fallen lower as the figures of losses generated by the credit and financial crisis were revealed. In the US and in Europe, several banks and financial institutions have already collapsed." And locally?

"In Australia, banks were obviously less exposed to the subprime risks but also face the growing mistrust of the world financial system. The ASX financial stocks are therefore in a painful configuration. Fundamentally, no recently released or coming news or data are potentially supportive for this sector. However technically, investors can take advantage of rebounds and countertrends."

Gabriel makes a good a point. In terms of improving business conditions, it's hard to think of a good reason why bank earnings will go up in 2008. But large blue chip shares have large institutional investors. These investors often look for attractive entry points in which to establish long-term positions.

That doesn't mean it's a good idea, mind you. But there's a plodding method to their investment madness, and the chart informs that method. Gabriel used our new charting software to take a look at ANZ.

"The stock recently failed to rebound beyond the 61.8% Fibonacci retracement of the fall between the high of February 4 at 27.5 and the low of March 11 at 19.5. The price came back around the 20 level. However the short-term seems to be oversold. The Stochastic Oscillator is at its lower levels and the %K line is rising above the %D line, which are bullish signals as they detect turning points. The next main resistance is the 61.8% retracement at 24.5, whereas the main support is at 19.5, the low posted in March."

That was technical speak. Not French. Gabriel brings a different perspective to our ruminations, as well as a different language. We are thinking of starting a new e-letter based only on looking at the market from a technical perspective. It would cover the All Ordinaries, the ASX/200, and sectors, as well as particular stocks. Let us know what you think of the idea by writing to us at dr@dailyreckoning.com.au

On the issue of "risky borrowers" being the only ones affected by the credit crunch, doesn't this depend on what version of reality you choose to acknowledge? True, the credit crunch hasn't resulted in massive sub-prime losses for Aussie banks. But indirectly, the bear market in credit has caused massive trouble for Aussie banks and shares.

Who needs a sub-prime housing boom when boutique brokerages flog securities lending on clients and leverage up share market returns? America's housing boom was a borrowed (and bogus) boom. How much of the out-performance of the Aussie share market in the last three years (relative to the S&P 500) has been result of investors buying shares with money they didn't have?

You can't get something for nothing, whether it's the house of your dreams or share market gains. There's always a price be paid, a reality check, always a day of reckoning.

Here's something to watch for in the futures markets: increased margin requirements. Regulators shattered the Hunt brothers in the Silver market in the early 1980s by raising margins so much that all but the most cashed-up speculators had to flee their long positions. When the highly-leveraged buyers left the market, the futures price collapsed.

Could the same thing happen today with wheat, corn, soy, and rice? Regulators could easily raise margin requirements in these markets. But it's not as clear that that action would lead to lower prices, or more importantly cheaper and more abundant food for the world's six billion people. The futures markets are much deeper and more liquid these days. Market manipulation by regulation may be harder to achieve, especially when it flies in competes with the forces of physical reality.

And besides, it would only work if you assume global food prices are rising as a result of financial speculation. That is obviously not the case. Exporters are hoarding crops, shopping for higher prices (or being forced by governments to sell product into the local market to satisfy the crowds in the streets.) The fundamental problem is in the allocation of global resources. We have a lot of people on this old furry ball, and we're all starting to wonder if we cooked enough food for our dinner party.

Speaking of regulatory plans that gleefully ignore physical reality, Kevin Rudd's new plan to have petrol stations report their prices at the end of the day to the government is absurd. He's assuming that better pricing information will lead petrol stations to keep prices lower than they otherwise might. This assumes the problem in the petrol market is too little information and price gouging, rather than too little refined fuel for growing global demand.

It's true that the more incomplete information is in a market, the larger profit margins are for sellers. This is why websites that allow consumers to compare prices have flourished. That's a valuable service, and leads to competitive pricing. When prices are transparent, producers most compete.

There's probably a petrol station (or a dozen) that raises prices because consumers can't easily compare prices. But you have to wonder if more transparent pricing will lower prices...or raise them. Retailers forced to report prices lose the flexibility of raising or lowering prices in response to wholesale prices (market forces).

So what will they do? They will go for price certainty and keep prices at the high end. Our prediction: the system will go national and petrol prices will go up, not down.

Anytime you hear the world "unfair" in a discussion of prices you know you've departed the realm of reason for the realm of political fantasy land. Prices are what they are, all things being equal, because they reflect supply and demand.

Fuel prices are not unfairly high. They are inconveniently high. But the life of convenience made possible by cheap fuel is ending, ladies and gentlemen. Wishing it was otherwise-or running to the Big Nanny State Momma for relief-is not going to change reality.

Of course crude oil prices are going up. They traded as high as $114 in New York. Refiners pay for crude oil to turn it into petrol. If their prices are going up, why wouldn't petrol go up? And why wouldn't petrol prices go up when crude oil production is peaking in places like Russia?

Global demand is growing. The supply of cheap stuff is not. Put that on your 2020 agenda Mr. Rudd. And take a serious look at generating base load electricity from geothermal and using more plug-in hybrid cars to reduce reliance in imported refined fuels.

You'd think Rudd would have learned a thing or two from John Howard's mistakes. Howard promised to keep interest rates low and they went up anyway. He made a promise that was beyond his control to keep. Rudd promised an investigation into lower petrol prices. He has about as much influence over this as he does over the price of tea in China.

But politicians are fond of making promise they know they can't keep. They can't help it. They are pathological over promisers, eager to please and be liked. They believe-based on their exalted opinion of their own intellects-that they know how things should be and have the power to make them that way. Morons, but dangerous morons.

Price controls never work. They exacerbate shortages and lead to higher prices. Even a career diplomat can figure that out. What we need to do is listen to what price signals are telling us. They are telling us that there isn't enough cheap oil to meet growing demand.

We either find more oil and pay what it takes to find it, or we reduce consumption and look for substitutes. Prices don't lie. We just don't always like what they say.

Dan Denning
The Daily Reckoning Australia

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Now, ad one healthy dose of as-yet undefined impropriety. Mix together vigorously and what do you get? A big fat mess where the retail investor doesn't own his shares but does owe the lender and the lender faces receivership by HIS lenders. More below.

But first, the share market's worst fourth quarter in 20 years is probably going to end on one of the sourest notes yet, and also one of the most bizarre. The trouble with the last few years of the share market boom-as we are learning one failed firm at a time-is that it was based on borrowed money. Borrowed money has to be paid back. Or, in some cases, seized.

Take the case of Opes Prime, the Melbourne-based broker currently causing so much strife in the share market. The company was in the "equity financing and securities lending" business. On the retail end, Opes was basically a margin lender to clients, only instead of posting cash as collateral against the loan, the client puts up his entire portfolio as collateral.

When we say "puts up," however, we are not doing justice to what an Australian Master Securities Lending Agreement (AMSLA) actually stipulates. In exchange for the margin loan, the retail client actually surrenders legal title to his or her shares. The broker owns them, whether the client knows it or not.

With legal title to a diversity of shares on the Australian market, Opes then tuned around and lent those securities to professional borrowers. The borrowers might be, say, hedge funds looking to short the Australian market.

No one is quite sure how the whole thing went pear-shaped. But certainly it did. And now Opes secured creditors-ANZ and Merrill Lynch, the ones who financed the margin loans to retail clients-are seizing the collateral of its unsecured creditors (the share portfolios of its retail investors, put up as margin for loans) and ruthlessly selling them (sometimes at below market prices).

"ANZ and investment bank Merrill Lynch, which together provided Opes with $1 billion to fund its margin lending business, are selling shares held on behalf of Opes clients to recoup their money," according to today's Australian.

"ANZ, which is owed $650million, yesterday distanced itself from Friday's aggressive share selling, which forced stocks such as the Hedley pubs group sharply lower. Merrill Lynch, which last week held $500 million of shares as security for its $350million exposure to Opes, is believed to have already sold $300million of stock."

It gets worse. To bulk up its securities lending business, Opes had agreements with super funds. Why would a super fund surrender ownership of its shares to a securities lender? Good question.

The answer might be: to earn a fee or two on shares which would otherwise just sit in the fund's account for years, doing nothing. But now ANZ and Merrill Lynch own those shares.

"This raises the prospect of super funds and the custodian companies who hold shares on their behalf facing significant losses if they are unable to recover the shares loaned to the failed stock broking firm," according to Adele Ferguson and Michael Sainsbury in today's Australian.

Yes. That's bad. Opes 1,200 private clients face up to $300 million in losses. After the banks get their money back, whatever's left will go to unsecured creditors.

It sounds confusing. But it's almost like the business was designed to fail. Opes borrows from big banks based on the value of equity collateral from retail clients. But it then lends that collateral to short sellers, the very people who believe the collateral should be worth less, and sell it short to make it so.

Opes must have been hoping its business model was immune to fluctuations in the value of the equity collateral itself. It made money as a lender both ways, lending cash to retail clients and securities to institutional clients. ANZ and Merrill Lynch apparently didn't see the value in the model.

The flaw in the model is glaringly basic: too much leverage. Or, if you prefer to put it in common sense terms, the flaw is that you can get something for nothing. Opes thought it would take lazy equity-shares that were sitting around doing no work-and lend them out.

Like so much financial engineering of the past ten years, this kind of activity created no real economic value. All it did was encourage people to rack up big liabilities. You take on leverage because you think you can boost your return with borrowed money and use the gains to repay the loan. It stops working when asset prices fall. The trouble, after the whole affair goes kaboom!, is that the liability remains.

We were going to go in depth into the Reserve Bank's financial stability report last week. But gee, it's pretty obvious there's some major instability in Australia's financial markets. In the age of leverage (or deleveraging), it looks like it's going to be tough for banks and financial stocks to increase earnings.

But at least there's no subprime crisis in Australia, right? Or is there?

Dan Denning
The Daily Reckoning Australia

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