First up is gold's 1.27% decline in the futures markets. We've written about this in a special note that goes out later today. If you miss that note here's the short version: don't worry. The fear that China won't buy IMF fold is a red herring. China is buying plenty of gold. But you might be surprised to find out who the seller is.

What shouldn't surprise you is that fewer Australians are taking out mortgages to buy new homes. That's what happens when prices rise, interest rates head up, and the government stops shovelling tax payer money into the market. You can only "bring forward" (steal) so much demand from the future.

The number of people taking out loans to buy new homes fell by nearly 8% in January, according to the Australian Bureau of Statistics. First home buyers fell as a percentage of new lending to 20.5%. That's down from the high of May last year of 28.5%. And here in Victoria, only 525 Victorians borrowed money to buy a new home in January (see the table on page 10).

Don't be discouraged, though. The Reserve Bank agrees with the realtors and housing industry spruikers that there is a housing shortage in Australia. RBA assistant governor Philip Lowe said in a speech in Sydney yesterday that constraints on home building are restricting the supply of homes in Australia. The shortage is one factor keeping prices up. Nothing was said about the lending boom.

Lowe said that, ''With population growth above average, and growth in the housing stock below average, it is not surprising there has been upward pressure on housing costs...If we are to build more dwellings, we need to ensure that planning guidelines and infrastructure provision can accommodate this.'"

Blah blah blah. We're not going to rehash all of this again. But if anything, Australia has already sunk too much of its national capital into housing. Maybe investors have over-invested and locked out first time buyers while also damaging affordability. Who knows?

The river of liquidity that has floated Aussie house prices higher has its source waters overseas in the wholesale borrowing by Aussie banks from foreign lenders. This is what accounts for the financial sector's massive share of Australia's net foreign debt. Another global credit squeeze (the implosion of the shadow banking system) would block off those head waters. And where would that leave Aussie housing?

This is not to say or imply that homeownership is an unworthy goal. Yale Economist Robert Shiller points out in New York Times article that home ownership can promote good citizenship, a broad sense of equality, and even a sense of personal liberty in a society. That's why in Australia and America, homeownership is THE personal financial dream.

But Shiller also points out those are cultural and not financial values. The desirability of homeownership shouldn't be confused with the financial wisdom of it. The more leveraged a housing investment it is, the more vulnerable you are to getting wiped out on falling asset price falls. This is why nearly 16 million Americans are underwater on their mortgages.

In the mortgage boom years from 2004-2004, it wasn't hard to get a loan-to-value ratio of 90% or higher with less than a 5% down payment. You didn't have any equity. But the animal spirits of the housing bull encouraged people to believe prices would just keep going up.

They didn't, of course. And instead of having equity, most of the borrowers ended up with a big mortgage and a falling asset. This is what soured so many mortgage backed securities and collateralised debt obligations. And the fact that Americans can walk away from underwater mortgages - letting the bank seize back the house, which is the collateral on the loan - in some ways made the financial gamble sensible for people. Maximum upside, zero downside.

You can't walk away from the loan in the same way in Australia. But that doesn't' mean Australians aren't gambling on higher house prices. Loan-to-value ratios are coming down as banks get more cautious (this restricts new lending as well). But they are still high. And first home buyers remain especially over-leveraged - facing higher interest rates on variable rate loans.

But you know all that. So we won't yammer on about it. We're just saying...house aren't safe as houses, no matter what the RBA says.

So what is safe? Well, as a reader pointed out yesterday, cash isn't bad. Here's one response to yesterday's essay:

Hi guys,

John Pope

It's a good point. We'll deal with it tomorrow. Although it's going to be hard to predict the future...in detail. That won't stop us from trying! Until then.

Dan Denning
for The Daily Reckoning Australia

• General Motors: A Forerunner for What’s to Come for the Broader Economy
• House Prices Always Go Structurally Higher in Australia
• Are Aussie House Prices in a Bubble?
• Aussie Housing Market Actually Leads the U.S. by Three Years
• Underlying Demand During a Housing Shortage

Monday began with jitters over the market's reaction to a raise in the U.S. discount rate. In other words, the Federal Reserve increased the rate at which select banks can borrow from it.

The so called 'discount window', was intended to be an emergency lending facility. The lender of last resort. Instead, it's become the lender of any resort. The increase in the discount rate means it won't be as cheap to borrow money from the Fed.

The relevance to you shouldn't be underestimated. Aussie banks get much of their funding from overseas, so they are affected by what happens in the global interbank market. If the increase in the discount rate is a signal that the broader interest rate is going to be raised as well, then this would affect the availability of funds and their cost.

In a debt drugged, liquidity obsessed world, a change in interest rates can go from affecting profitability to affecting solvency very quickly. And it's not just the banks that are high on cheap credit. Take a look at a listed company's balance sheet. Most of them use leverage to boost their returns.

Low interest rates encourage this.

The reason the western world economy has become particularly interest rate sensitive is because of the way it uses debt. Instead of funding an asset with debt and then paying it off with the increased revenue, more debt is used to pay off the previous borrowings as they come due. This is referred to as rolling over debt.

By doing this, a company (or government) is able to sustain a high level of leverage over time. The debt is never truly repaid.

But, if interest rates rise, then the cost of borrowing goes up. Traditionally, this would have decreased the amount of borrowing. In our modern economy more must be borrowed in order to pay off the old debt. That means companies have no choice but to accept a change in rates.

The financial market reaction to a potential increase in the more important Fed Funds Rate would not have been pleasant. However, this unpleasantness didn't eventuate, indicating that financial markets expect rates to sit tight for some time to come. Based on this, Dan Denning is a step closer to declaring victory over our Money Morning editor Kris Sayce, with several beers at stake.

Neither editor is being suspicious enough in their analysis. Let's take a trip down memory lane with a former Federal Reserve economist, Michael Belongia. What happened in the past when the discount rate was changed?

In this podcast, Mr Belongia talks about how a change in the discount rate can lead to a change in the actual interest rate without FOMC approval, or much media attention. Going behind the back of the FOMC, which is supposed to set the interest rate, is scandalous. That didn't stop it from happening regularly, according the Belongia.

He explains that the spread between the discount rate and fed funds rate should be kept constant according to Fed policy. So, if the Fed's Board changes the discount rate, then the Fed Chairman can march down to the Fed's trading desk and instruct the traders to change the Fed Funds rate to maintain the spread. This conveniently avoids the often less complicit FOMC.

Belongia's accounts are shocking to anyone who believes in the integrity of that particular institution and sickening to the sensible people who don't.

As mentioned, governments around the world are also exposed to the problem of having to roll over debt. To Senator Joyce's delight, the lucky country is no exception. Dan Denning points out that "... according to 2008 data, over $400.1 billion dollars of Aussie foreign debt - or 35.4% of the total - matures in 90-days or less. Nearly half the debt total - $514 billion - matures in one year or less."

That's a lot of debt to refinance on such a regular basis, so any change in interest rates will be felt quickly.

The press often refers to the shortening maturity of government debts. This implies governments will have to roll over debt more often. Such shortening has occurred in the U.S. and is now a major concern. Former Federal Reserve Chairman Alan Greenspan has referred to it as the "critical Achilles heel".

The "greatest financial crisis globally ever"

On Tuesday, Bloomberg reported the confession of Kingpin Alan Greenspan. At least, we consider it a confession. Low interest rates have largely been blamed for the financial crisis by those who warned of its imminence. Greenspan set those rates artificially low. Often in a cunningly deceptive way, according to Mr Belongia. Anyway, here is how Greenspan's conscience was finally cleared on Bloomberg:

Former Federal Reserve Chairman Alan Greenspan said the financial crisis was "by far" the worst in history and called the recovery from the global recession "extremely unbalanced."

The world economy has undergone "by far the greatest financial crisis globally ever."

Greenspan said that while the economy was in worse shape in the Great Depression, the recent financial crisis was potentially more harmful than that in the 1930s because "never had short-term credit literally withdrawn."

Greenspan also said "fiscal affairs are threatening this outlook" for recovery, as Congress and the White House face difficulty raising taxes or cutting spending."

So, not only is his reconciliation late, but his diagnosis is too.

Speaking of confessions, our other 'favourite' economist, former Enron adviser and Nobel Laureate Paul Krugman, has declared his ignorance publicly:

"I'm craving the chance to do some deep thinking, and I haven't been doing a lot of that."

While this fact is familiar to most, it does not excuse Krugman's behaviour. Having consistently advocated the inflation of economic bubbles, to the devastation of homeowners, employees and shareholders around the world, he now advocates a level of government debt that would make Senator Joyce faint, or pop, whichever comes first.

But best of all is this part of Krugman's article:

"I guess doing the really creative academic work does require a state of mind that's hard to maintain throughout your whole life."

Creativity! Economics and creativity? Economics is about understanding timeless principles. Perhaps this is where he went wrong - too much creativity. We have seen the results of Krugman's creative solutions, indicating he doesn't understand the economy, or wishes to indebt future generations beyond help.

Resources Comeback

RBA governor Rick Battelino explained that the resources boom has overcome an interruption known as the GFC:

... now that has passed, the underlying dynamics of the resource boom are starting to reappear...

It's hard to put a finger on exactly how much investment is going to take place, but I don't think it's unreasonable to expect mining investments to rise to 6 per cent of GDP over the next few years. That would be about twice as high as it got to in the previous boom. It's a very big boom.

It certainly is big. But so are China's resource reserves.

In an article on oilprice.com, Dave Forest of the e-letter Pierce Points, warns of the potential price reaction should China decide to begin using those reserves, or even selling them. In fact, they may have already started, with vast steel exports going to Europe.

The effect a short term fall in commodity prices could have on Aussie resource investment and development could be pivotal to the future of the Australian economy.

China itself is of course an economic basket case, as cleverly shown in this business spectator slideshow.

Nevertheless, it seems a BRIC barbeque is roasting the PIIGS and may provide demand for resources to fuel their fire. (Thanks to Daily Reckoning reader Wayne for the inspiration on that one!)

Confidence

Confidence indicators took a hit in the U.S. and Germany, while U.S. new home sales dropped to a record low. This is particularly striking, as central banks often tout these two factors as their primary focus. "Restoring confidence in the market" and "supporting house prices" are phrases that echo through the halls of the central banks on a continuous basis.

Meanwhile, the US unemployment figures are proving disastrous, let alone the unemployment itself. The American Bureau of Labour Statistics has its own numbers in such a mess that the pollster Gallup has decided to help out.

The Poll informed the BLS that "nearly 20 percent [of the 20,000 adults in the work force polled] were working part time in January because they couldn't find a full-time job or had no work at all, and that they are having trouble affording basic necessities like food, shelter and health care."

This tells a different story from the BLS estimates of below 10% unemployment.

U.S. banks continue their slide into oblivion, with 4 of the 161 bank failures since 2009 recorded last week. The outlook isn't much better. Bloomberg reports that "hundreds of banks may face insolvency as losses mount on commercial real-estate loans, according to a Feb. 10 report by the panel appointed by Congress to oversee the U.S. bailout program."

Meanwhile The Telegraph uses some spectacular phrases in an article titled "Failure to save East Europe will lead to worldwide meltdown". It even breaks the language barrier with the following: "...set off round two of our financial Götterdämmerung." Götterdämmerung roughly translates to Godly twilight, implying an age of saviourless darkness.

Next up it suggests a "Monetary Stalingrad" and Eastern Europe "blowing up right now." A more surgical approach was taken by Latvia's central bank governor, who declared the Latvian economy "clinically dead", while protesters "trashed the treasury and stormed parliament."

Needless to say, an excellent article.

Strangely enough, stock markets remain comparatively buoyant and Australia seems to be trundling along happily. Whether Mr Market has sucked in enough suckers before another crash is unclear. Daily Reckoning editors would probably be more concerned if the media was more optimistic, as this indicates complacency.

The Economic Climate

Former IMF economist Jeffrey Sachs provided some creativity of his own in a recent article:

Climate change science is a wondrous intellectual activity. Great scientific minds have learned over the course of many decades to "read" the Earth's history, in order to understand how the climate system works. They have deployed brilliant physics, biology, and instrumentation (such as satellites reading detailed features of the Earth's systems) in order to advance our understanding.

The Guardian, points out otherwise:

Scientists have been forced to withdraw a study on projected sea level rise due to global warming after finding mistakes that undermined the findings.

This article was previously put forward as proof of claims made in the infamous IPCC report. The official withdrawal included the statement that "... it's one of those things that happens. People make mistakes and mistakes happen in science."

While we are in agreement that mistakes happen, we do not agree that government policy should be based on anything quite so mistaken. This is especially so, as government policy is more often than not an inherent mistake as well.

In keeping with brilliantly balanced and fair journalism, the Guardian published the article of Jeffrey Sachs two days before the article about the withdrawal of the study. I wonder what readers think of that.

In the name of financial stability!

Dan Denning also reported on the latest government scheme to support its funding aspirations:

Yesterday's Financial Review even mentioned the possibility that a shrinking government bond market would be a problem for Australian banks. That's because a new regulation proposed by the Australian Prudential Regulatory Authority (APRA) would require a certain percentage of bank assets to be made up of high credit quality bonds. And MBS.

MBSs are Mortgage Backed Securities, those things that have a habit of blowing up when house prices fall.

Acropolis Now

According to Porter Stansberry, the publisher of Stansberry and Associates Investment Research, the Greeks have pulled off a feat that would make Sun Tzu jealous. Greek military spending has been excluded from the annual budget, because it is a "state secret". So, according to Stansberry, about 30% of the Greek governments' spending isn't even declared.

Nickolai Hubble
The Daily Reckoning Week in Review

• Hike in Fed Funds Rate Would Cause Damage to Collateral on Books of America’s Banks
• Gold Standard Doubles as the Greenspan Fed Makes Real Interest Rates Negative
• Alan Greenspan Bears Blame for Intensity of Financial Crisis
• Alan Greenspan’s “Smallish” Injections
• Federal Reserve to Withdraw its Support of U.S. Mortgage Market?

Both the S&P 500 and the Dow Jones Industrials finished up over 1.5%. There were two drivers of the feel good vibe. First was New York's Empire Manufacturing Survey. It concluded that "conditions" were improving.

As far as we can tell, that doesn't mean anyone actually made and sold more stuff in New York State. But it does mean the state of mind - how people feel about things - appeared to improve. Hooray! It's nice people feel better about things. But things are still pretty bad anyway.

The bigger story is that Greece hasn't been abandoned by the rest of Europe...yet. Europe could probably leave Greece behind and preserve the integrity (such as it is) of the euro as a sound currency. But 50 years of harping on about social justice and economic harmony and humane capitalism is going to make it hard for policymakers to leave Greece to its own devices.

This means the debt crisis is consolidating itself into ever fewer and larger entities...the European Union...the U.S. government...and the U.K. government to name a few. In order to save Greece, historians may write, it was necessary to destroy the Euro.

But investors don't have time machines. In the modern era of central banking, new lines of credit and public assumption of large liabilities - plus more credit creation - has always been the way out of a pinch. Below, we'll tell you why this makes the inevitable disaster that much worse.

Here in Australia, it looks like the financial crisis is receding. We have our doubts. But according to Gail Kelly and the good people at Westpac, bad debts were down even more than expected in the first quarter. That's the good news. The bad news is that, "the average cost of funding is going up."

The strategic weakness of the Australian banking sector - and perhaps the whole economy - is that it's a capital importer. That's why even when Aussie banks didn't have boatloads of U.S. subprime debt; they still faced higher capital costs when the global cost of capital went up. So what?

If Greece goes down or sovereign debt default spreads go up, it's going to make importing money into Australia more expensive. And that will probably slow credit growth in the economy. Aussie banks will get jealous of their capital and stingier with their lending. Maybe even house prices - contrary to the laws of Australian financial gravity - will fall.

And if you think that's gloomy, then you won't want to read what Albert Edwards from Societe Generale has to say about the status quo. Writing earlier this week, Edwards says, "My own view on this is that obviously we should never have got into this wholly avoidable mess in the first place. But having got here, there really is no way out that does not trigger a major market-moving upheaval."

"Ultimately economic prosperity over the past decade has been a sham: a totally unsustainable Ponzi scheme built on a mountain of private sector debt. GDP has simply been brought forward from the future and now it's payback time. The trouble is that, as the private sector debt unwinds, there is no political appetite to allow GDP to decline to its 'correct' level as this would involve a depression. So burgeoning public sector deficits and Quantitative Easing are required to maintain the fig-leaf of continued prosperity."

This what we meant above about the inevitability of the disaster that approaches. When the government "brings forward" demand for housing via the FHOG or for consumer goods via stimulus, it's stealing growth from the future in order to maintain current living standards. In our view, this just perpetuates the misallocation of resources that took place in the credit boom and keeps the money in the weak hands (the financial sector) that took so many bad risks in the first place.

A real free market punishes financial failure with bankruptcy or insolvency. By not allowing a recession to take its natural course, monetary and fiscal policy prevent the conditions for the next growth phase. What's worse, they're doubling down on the debt-backed model of prosperity and piling up more liabilities on the public sector balance sheet.

That's the stage we're at now. And one insignificant survey on manufacturing sentiment in New York State doesn't change much. And by the way, the more important news yesterday is that demand for U.S. bonds by foreign investors fell by its largest amount ever. Strong dollar?

Foreign holdings of U.S. Treasury securities fell by $53 billion December. China reduced its holdings by $34.2 billion. The end game is beginning in the Chimerica relationship of vendor financing (China buys U.S. bonds to help keep U.S. rates low so Americans can buy what China makes).

What China doesn't buy, you can get the Fed will have to monetise - unless the Congress and the President suddenly cut American spending. You can see from the chart below that Japan is now a larger holder of long-term U.S. securities than China.

Click to zoom in on Foreign Holders of Treasury Securities data

The long-term trade on this is to get the heck out of U.S. assets. Whether "risk assets" like commodity currencies or commodities are the ultimate refuge is yet to be seen. But oil, gold, and resource stocks are certainly getting a big today on greenback weakness.

Dan Denning
for The Daily Reckoning Australia

• The Story Behind China Dumping its US Treasury Debt
• The Great Correction: Awaiting Bailouts that Will Never Come
• USA Has Fives Times As Much Sovereign Debt As All the PIIGS Put Together
• 1 Out of 10 American Mortgages Are Owned by Other Countries
• China Buys its Own Gold

Your editor was eating pizza at a café on St. Kilda Road last night with a friend who works in the mainstream financial media. The owner knew our friend, but not us. And once he picked up on our accent, he had a few questions like, "What is wrong with all those people in Greece?"

We'll get back to that story in a moment. But this week's markets make for compelling reading - and the week is barely half over! In today's Daily Reckoning, we confess the things we don't know, look at the routine rigging of the global financial system, and discuss whether the People's Liberation Army of China is about to drop the big one on the United States of America.

Let's quickly dispel a rumour. There was a rumour on the Internet of secret emergency meeting in Sydney of the world's central bankers. We've been assured by sources that it was just a regularly planned retreat by the Bank of International Settlements. Rather than some extraordinary rigging of the world's financial markets, it was just regularly scheduled, ordinary rigging.

In the not so mundane world of markets, today is looking pleasant, if not totally rigged. The futures were up overnight, so Aussie stocks will probably follow New York's lead and have a big day out. The big report today is the half-year earnings for the Commonwealth Bank of Australia. And the big question: have bad debts peaked?

"Yes!", says CBA chief Ralph Norris. Last year the bank reported nearly $2 billion in charges for "bad and doubtful debts." This year, it's just $1.39 billion. The bank also reported a 13% increase in first half profit to $2.91 billion. Yep, doing it tough is the old CBA.

There's no doubt that the reduction in bad debt charges is a good sign for the banks. The "operating environment" (the real economy) appears to be less threatening. We'll see how it goes, but the rest of the market could take the CBA numbers as a sign the debt problem has well and truly peaked. A re-rating of the bank shares might take place and you'd see a mini rally.

Mind you it's not a rally we'd care to go to. There was another interesting note in the CBA's media release about the last six months. It reported a 49% increase in home loans to $1.19 billion. The CBA said the home loan growth was, "mainly as a result of increased market share and significant growth in outstanding home loan balances."

In other words, CBA had less of a bad debt problem in the last six months. But just you wait. It rode the FHOG to higher loan values and volumes and market share. If those borrowers struggle with higher interest rates or - horror of horrors - Aussie house prices grow less fast (or even fall) - we'd expect to see the bad debt problem again affect earnings growth and, ultimately, the valuations on Australian bank stocks.

But there is a lot about the world we don't understand. As our old friend Thom Hickling used to say when he visited us in France, "Je sais rien...I know nothing Dan. That's my motto." It's more or less our motto as well. That's why we ask a lot of questions.

And it's also why you'll find apparently contradictory statements and advice in the Daily Reckoning. Your editor thinks you should use any rallies in the market to gradually liquidate your stock portfolios. In other words, retire now before the government seizes your super assets or the market crashes.

Yet we work with experienced traders and analysts who've spent years in the markets finding great investments. We publish and sell their research and that contains buy recommendations on all sorts of Australian stocks. We publish that because fundamentally, we have no idea what will happen. It's what we're all trying to figure out.

The best strategy in that case is to surround yourself with people who are thinking hard and working hard to figure things out. And ultimately, you get to choose the ideas and editors you agree with or whose thinking you're interested in and whose track record impresses you. And even if you never take a punt on any of those publications, we'll keep reckoning every day for free! How good is that?

While we're still on the subject of debt, three cheers for Senator Barnaby Joyce! The finance spokesman for the opposition is copping it from all sides for suggesting that Australia is in hock "to our eyeballs to people overseas." He also said, "You have got to ask the question, how far into debt do you want to go? We are getting to a point where we can't repay it."

Even members of his own coalition have turned on him for suggesting Australia may not be able to repay its sovereign debts. But we say if Barnaby Joyce is fiscally incompetent, we need more men like him in government. He couldn't do much worse than the debt-first mentality of the establishment.

You can also judge a man by his enemies. In an article titled "Credit experts line up to rebuff Joyce" published by the ABC, we learn that experts from Fitch, Standard and Poor's, and Citigroup assure us that Australia is in no danger of defaulting on its sovereign debt obligations. Yes, the same people that nearly brought the global financial system to its knees and didn't see it coming are telling us there is nothing to worry about.

Irony aside, it's true that Australia's fiscal position at the sovereign level is better than a lot of other countries. As Michelle Grattan points out in today's Age, "Australian net debt is expected to peak at 9.6 per cent of GDP, or $153 billion, in 2013-14. In contrast, debt in 2014 in the US is estimated to be nearly 85 per cent of GDP. It will be nearly 92 per cent in the United Kingdom, 143.5 per cent in Japan and 93 per cent for the major advanced economies collectively."

Based on these numbers, it's looking pretty grim for the Senator isn't it? He does look a bit alarmist for warning of an imminent crisis in servicing Australia's sovereign debt. What's interesting is how vigorous the attacks on him are. What's going on there?

Well, there are certain interests in government and finance who want the debt to go higher. It's the business they're in and it supports their livelihoods and lifestyles. Some of the people criticising the Senator benefit tremendously from larger and larger government borrowing in Australia - whether it's the politicians who spend it or the bankers who arrange it or the ratings agencies who get paid to slap a triple A on it.

And in case these folks haven't noticed, the funding model for the welfare state is breaking down all over the world. It will catch up to Australia eventually. Indeed the very premise of the welfare state - that society can enjoy less risk higher standards of living through progressive taxation on a tax base that's getting smaller and less productive by the day and faces global wage deflation - is being exposed as bogus and fraudulent. That's why you should expect more measures that punish you for withdrawing your money from super or the banks - or restrict it outright.

But on this issue of debt, if only the Senator had spoken about Australia's net foreign debt as a nation, he would have made a better point. The net foreign debt is the sum total of how much Australians have borrowed from the rest of the world, minus what Australians have lent or own in equity. According to the ABS, "Net foreign debt is equal to gross foreign debt less non-equity assets such as foreign reserves held by the Reserve Bank and lending by residents of Australia to non-residents."

A simpler way of thinking about it is "how much of the world do we own and how much do we owe to the rest of the world." The facts on this matter clearly support the Senator's position. According to research published last year by the Statistics and Mapping section of the Parliament of Australia's Parliament, Australia's foreign debt was just $3 billion in 1976. According to the ABS, it's now $637.5 billion - or about 63% of GDP. That's a lot higher than the sovereign debt-to-GDP level of 9%.

Even without knowing how this compares to other countries, it's safe to say that number is alarming. Australia has $1.1 trillion in foreign assets. Half are in equities and half in debt securities. As always, there's the risk that asset values, especially equities, can fall.

On the debt side, Australia has $1.8 trillion in foreign liabilities. Nearly $700 billion of that is foreign equity ownership of Aussie stocks. The other $1.2 trillion is debt owed to foreigners by Australians. The odds are that if there's a double dip global recession this figure will increase. Domestic consumption of imports will rise with more stimulus while exports would presumably fall in a global slowdown.

But so what? Who cares if Australians firms and households borrow abroad to finance their consumption and investment? Isn't that a private or market-driven decision? Well, yes. But we think it exposes the country to several big risks.

First, the lenders might not always be so forthcoming. With massive borrowing needs in places like Japan, the US, and the UK, it's probably not safe to assume a ready supply of foreign capital. Even with a great credit rating, in a credit depression capital is going to be scarcer and the cost of it will inevitably go up.

The big risk, of course, is that you build an economy based on debt which isn't sustainable when the creditors turn you down. You have long-term liabilities you racked up when the currency was strong. But if they're denominated in foreign currencies and the Aussie crashes again (as it might in a global W shaped depression) paying back your debts gets more expensive.

Ultimately, it comes down to what you've down with your borrowed money. Have you invested in wisely? An increase in debt - or even net foreign debt as a permanent feature of Australia's economic landscape - wouldn't be so bad if it translated into an increase in productive assets. You'd be a capital importer. But you'd use it to build your asset base.

Those assets - especially capital equipment in the resource sector - would lead to higher exports, lower current account deficits (also as a % of GDP) and generally more investment led growth instead of consumption led growth. It would be a responsible use of debt.

But if the debt - as we believe the numbers show - has been taken on to finance a housing boom, or worse, to finance speculation by Aussie banks and financial firms in asset markets abroad, then it's not going to be what we call productive debt. So we'll see, won't we?

Tomorrow, we'll show you why borrowing your way to prosperity is not only a sure fire bet to national servitude, but also a recipe for political instability. Our case in point will be the United States of America and its main creditor, the People's Republic of China.

Finally, our waiter last night asked us, "What's wrong with those Greeks? Is there some sort of crisis or something? Is it like that Lehman thing you guys caused?"

"What's wrong with Greece? They can't pay their bills. Nobody wants to admit it. But they're living beyond their means. All of Europe is."

"So what will happen?"

"Probably some fake bail out. The bigger countries in Northern Europe will guarantee emergency borrowing by the Greeks. No one wants to admit that standards of living have to fall and government spending has to fall too. They're going to fight it...but it's like fighting the orbits of the planets."

"Hmm. Imagine that. Even in antiquity the Greeks were bad with money. But the Romans figured it out didn't they? They were good at collecting taxes. Not the Greeks. They had all the good ideas though."

Dan Denning
for The Daily Reckoning Australia

• Corporate Debt is Just One Aspect of the National Debt Problem
• Australia to Borrow as Much as $300 billion
• Central Bankers Encourage Debt Booms That Become Debt Bombs
• Commonwealth Bank (ASX: CBA) Nearly Doubles Bad Debts Over Last Year
• RBA Buys $780 Million in Residential Mortgage-Backed Securities

The context for this week's action was a strange day on Wall Street on Friday. The U.S. dollar, at long last, rallied a bit. It scared the daylights out of everyone. The Dow and oil fell. Bond yields rose. But gold went up on Friday and finished the week up 2.7% to $1,146.80. That's right. Gold rallied with the dollar. Hmmn.

Days like Friday make investors question their conviction. They start to convince themselves that after a near 60% rally in stocks since the March lows, some kind of correction is coming. But they wonder if it's just a run-of-the-mill correction. Or is it phase two of the Depression that began in 2008?

Our focus today, though, is on the bond scam being perpetrated by money-grubbing governments. That is, our focus is on the counter-attack by national governments against rising bond yields. Between the GFC and ageing populations, the Western Welfare States know that they must increase deficit spending in the coming years. But already the gold market is telling them what global savers think of this (not much).

So how does a government fund its spending programs if global creditors begin to turn to other assets? Well, it can have its own central bank "monetise the debt." But having the central bank buy government bonds with new money is a sure-fire path to currency depreciation and higher interest rates. It simply highlights what we've been saying for five years now: the funding model for the fiscal welfare states is broken.

But lately we see that we've underestimated just how clever governments can be at squeezing new revenues out of people and forcing the market to choke down government bonds. Last month, the FT's Alphaville blog reported that the U.K.'s Financial Services Authority (FSA) is essentially guaranteeing a bond bubble by forcing banks to own sovereign bonds.

The FSA is doing this for the banks' own good, of course. With liquid government bonds on the balance sheet, the banks would have a "liquidity buffer." This should, the FSA reckons, inspire faith by market participants in the fundamental health of the banks, and prevent another collapse of public faith. Ahem.

But did you know in a September discussion paper called "APRA's prudential approach to ADI liquidity risk" that the regulator of Aussie banks is considering imposing a similar liquidity requirement on Aussie banks? It would force the banks to own assets of a certain credit calibre. And you can guess which assets would qualify.

Go on. Guess. We dare you.

Really, you can't make this stuff up. Western governments are starting to tell Western banks that the only way for banks to be sure they have sufficient liquid assets is to buy more government bonds!

And it won't be a choice. The banks should have known better than to take government money and government guarantees. It was only a matter of time before governments came up with a way to tap bank deposits to pay for massive borrowing programs.

APRA says its current policy regarding liquidity at banks, "provides little guidance as to what constitutes a liquid asset for stress-testing purposes." However, the Big Con begins, "there is an emerging international consensus amongst prudential supervisors that liquid assets should be high quality assets that can be readily sold or used as collateral in private markets, even when those markets may be under stress; as a backstop, liquid assets should also be eligible central bank collateral for normal market operations."

Here's where the intentions are laid bare. "APRA proposes to adopt this definition of liquid assets in APS 210. In most currencies, sovereign bonds will be the assets that most clearly satisfy these criteria."

APRA then expressed some mock concern that because Australia's Federal government had consistently run surpluses for the last ten years or so, it would have to work with the Reserve Bank to find some other "safe" asset like a sovereign government bond for banks to involuntarily load up on. But that was a bit rich.

After all, the Australian Federal government is piling up the debt! The Australian Office of Financial Management is selling $2.4 billion in bonds and notes this week alone. Choke on that, the Big Four. Granted, the AOFM says Australia's 2010 borrowing program of $50 billion is slightly less than Treasury expected, given Australia's improved GDP picture. But it's still a lot of debt to sell.

Of course if you're forcing banks to buy it, the sale is not as hard. Maybe we are getting ahead of ourselves, though. APRA says it won't impose the new liquidity requirements until next year, after it's had time to review responses to the idea from market participants. Right.

Incidentally, did you see that both the Commonwealth Bank and Westpac fell back on the government guarantee to raise money in the wholesale funds market last week? CBA tapped the guarantee to raise $1.36 billion in the U.S. market. Westpac, on the other hand, tapped the guarantee to raise money right here in Australia. It sold $1.1 billion worth of bonds, and apparently the local market was a little tepid without the government guarantee.

Unless the banks are using the government guarantee to borrow money which they can invest in some higher-yielding asset, you know it's not something they want to do. It costs them more to "rent" the Aussie government's AAA credit rating. And it's not something they've had to do in three months. What does that tell you?

It tells us that when you're a net capital importer, your banking system is not nearly as healthy and robust as you think. Borrowed booms are fickle.

But it's not like the Aussie Federal government or the State governments are a picture of financial health either. In today's Australian Scott Murdoch reports that, "The debt of Australia's six state governments could soon outrank the $136 billion owed by the commonwealth as the state administrations fund an ambitious infrastructure program in a bid to boost the economy.

Murdoch says state governments will float $28 billion in new debt in the next seven months, prompting us to wonder which Aussie state is the most like California, fiscally speaking of course. Queensland appears to take the cake, with a $57 billion annual deficit and projections for eight more years of deficits. New South Wales comes in second.

Yet the Keynesians, if we ever gave them breathing room in this space, might tell you that funding long-term infrastructure projects with government debt is exactly the right thing to do in a recession. The government spending makes up for shortfalls in private sector spending. And when the recession passes by, the entire state (and nation) are left with shiny new infrastructure that increases export capacity and productivity. A win win!

Maybe it will work that way. And maybe it won't. The really interesting scenario is whether state government borrowing needs begin to compete with Federal borrowing needs. The Feds can compel Aussie banks to buy government bonds, if the APRA rule passes. What can the States do to make sure their debt is purchased? Hmm. A government guarantee? Chocolates and flowers to creditors? A pretty please?

A government's inability to pay for the promises it's made is no laughing matter, especially when those promises involve an ageing population. But, "The commonwealth budget is in danger of going directly from the deficit caused by the financial crisis to one caused by ageing of the population without ever seeing a surplus," writes David Uren in today's Australian.

It would be a bitter pill to swallow. After all, Kevin Rudd has promised that strict government spending limits will put the Federal budget back into surplus sometime around 2015-2016. Ahem. But it's now looking like the deficit that was born under the GFC will grow and flourish as Australia faces the same demographic crisis as other Western nations: paying for the retirement and healthcare of the Boomers.

But wait! The IMF says that by 2014, Australia's public sector debt as a percentage of GDP will be just 27.8%. That's not worrying at all, is it? Especially when you compare it to projected levels of 108% in the U.S., 98% in Britain, 128% in Italy, and a whopping 245% in Japan.

Those countries have real problems. American and Britain have broken financial systems and massive public sector debts that are still growing. Japan and Italy are getting old, with fewer workers to support retirees. Will those governments be able to borrow what they need? Or will the bond market rebel?

You'd think Australia wouldn't have much to worry about, compared to that quartet. But remember: the country is a new importer of capital. The government, like the private sector, has to borrow from foreign creditors. And foreign creditors have to want to lend Australia money. So will they?

They might, perhaps at higher interest rates. But then again, maybe they'll just come for Australia's oil and gas and its oil and gas companies. A recent report by Deloitte previewed a coming contest between independent oil companies (IOCs) and national oil companies (NOCs) owned by governments. "Over the next couple of years, IOCs will start to be faced with the dilemma of constrained access due to ongoing resource nationalisation and the growing sophistication of the NOCs."

The NOCs believe in free markets, except when it comes to maximising the value of strategic resources like oil. They do, however, like to use free markets to pursue acquisitions in foreign equity markets. "National Oil Companies (NOCs) are on the hunt," the report says.

"The are aggressively looking for corporate M&A opportunities to accomplish their three goals: bolster their market strategies; expand their reserve portfolios; and develop strategic alliances...From an economic standpoint, net consuming NOCs are seeking to gain access to sufficient reserves to fuel their countries' economic engines over the long haul."

The NOCs can meet some of their needs by making deals with each other. Evidence deals between China and Russia, China and Brazil, and China and Kazakhstan. Do you notice a pattern here?

The other method the NOCs might take is to pursue listed independent oil and gas juniors who are rich on exploration projects but capital poor. There are a few of them here in Australia. It's not a bad trade.

Deloitte writes that, "Independent oil and gas junior companies have struggled in recent months due to their higher sensitivity to oil prices and tax regime changes. After the oil price collapse of 2008, many leapt into survival mode.

"Those that succeeded in freeing up cash are now poised to implement M&A strategies designed to enhance their reserve portfolios while those that remain cash strapped, which is still the fast majority, are likely to be M&A targets."

There's an idea for investors. Don't go after the cash-rich juniors. Go after the cash-poor ones that are likely to be M&A targets and might get a bit of a premium bid from potential NOC acquirers. Hmm. We'll ask Diggers and Drillers editor Alex Cowie what he thinks of the idea and get back to you.

In the meantime, if you want a more comic perspective on China's choices in the coming years, have a look at this skit. And then ask yourself how easy it's going to be for borrowing nations to get what they ask for with no strings in the future. For Australia, you have to wonder what the strings are going to be. It depends on who's doing the lending.

If it's European and U.S. banks, the "strings" will be higher interest rates. If it's China, the "strings" might be a friendlier and more transparent policy from the Foreign Investment Review Board concerning Chinese acquisitions of Aussie companies. And if the Reserve Bank has to eventually monetise Aussie debt, the "strings" will be much higher inflation.

Dan Denning
for The Daily Reckoning Australia

• Government Sponsored Enterprise Debt and Australian Banks, a Ticking Time Bomb?
• Inflation is Evident If You Just Follow the Money
• One Year Treasury Bills to be Reissued by Bush Administration
• What Kind of Investor is Happy to Lose Money Over 90 Days?
• Is the American Government the Place to Park Your Money During Dangerous Times?

Of course there is. George Soros is picking up more shares of gold and potash producers. Mineweb reports that, "Billionaire investor George Soros' Soros Fund Management substantially raised its shares in PotashCorp as well as invested in gold ETFs during the third quarter. In Form 13F documents filed with the SEC, Soros Fund raised its PotashCorp from 1.98 million shares to 2.95 million shares with a fair market value of $266.4 million."

And while China and America bicker over currencies, Chinese firms are scrambling to buy real assets. And while Aussie banks source foreign borrowing to lend in local real estate, Aussie mining firms go begging for bits of capital that would bring world-class ore bodies (and key strategic resources) into production...by local producers and owners.

Take Moly Mines. It's aiming to operate a 10 million tonnes per annum copper and molybdenum mine at Spinifex Ridge in Western Australia. Prior to the credit crisis last year, things were going swimmingly. Molybdenum is a hardening agent used in steel-making. There aren't a lot of economic ore bodies in the world. Moly, according to the research we published in April of 2008 in Diggers and Drillers, had one of the most economic deposits.

But it all went off the rails with the credit crisis. The company couldn't secure the funding it needed to bring the project into production. And the share price fell. That made management amenable to any offer that would secure financing and rescue what was still, by all accounts, an immensely valuable and lucrative resource.

Yesterday, the Foreign Investment Review Board (FIRB) approved a $200 million investment in Moly by China's Sichuan Hanlong Group. It gives the Chinese group majority control in Moly and could see the development of the project at Spinifex Ridge begin in the middle of next year.

Good on the Chinese for finding a great project to invest in at a bargain price. The truth is, Australia has more good mineral and energy projects than the local capital markets can realistically fund (given the preference by the banks for investing in/spruikin property). BHP CEO Marius Kloppers made this point yesterday in a lecture to the Lowy Institute in Sydney.

Kloppers said there are 74 separate resource projects worth $80 billion the advanced stages of planning. Those projects need capital. "'Although clearly not simple," Kloppers said, "a part of the solution lies in continued foreign investment, meaning that both Australia and Australian companies need to be open to this kind of investment, despite its immediate and strategic implications."

What are those "immediate and strategic implications?" Well, up to now, existing Australian shareholders are being clobbered. Those who owned equity in these projects before the credit crunch have been diluted as the firms in question raised money with rights issues or institutional placements.

That's fair enough. Owning shares implies an assumption of risk. The stock market is not a savings account. But the other immediate implication is the transfer of majority ownership of these key projects to overseas owners (including the transfer of a big chunk of income from the assets).

This is what it is. And in most cases, it is not an issue of national security. The truth is, many of these projects won't get off the ground without foreign capital. They will create Australian jobs, export earnings, and share price gains for Australian investors. They will also secure key resources for foreign manufacturers.

There's no sense getting all lathered up about it. The status quo is a result of Australia's status as a net capital importer and the investment decisions made with the money Aussie banks have borrowed. The banks could have chosen to invest in Australian mines. But mining is a risky business.

Is it as risky as property? We don't think so. But the way the Australian property market is currently structured - with the government supporting prices directly through grants and indirectly through miserly land releases, and the banks channeling new lending into the market - it's a rigged game for the banks. Why wouldn't they invest in property? It's certainly in their interest.

Whether there is a national interest at stake in the mining industry is another question. You'd certainly think so, given how much government revenue is derived from royalties and exports. But most state governments and the Federal government seem happy with the current arrangement.

The large producers have an unassailable competitive position. And the smaller explorers and developers are left to their own devices to find capital for their projects. Hey...that's why they call it capitalism!

For investors with the patience to investigate the smaller fry, it's a great market. Our new editor of Diggers and Drillers, Alex Cowie, looks like an insomniac in a coffee shop when he comes to the office each morning. There are literally more good stories than he can possibly research.

The important point is that what might be a national problem - selling of mining projects to foreign investors - is an individual investor's opportunity. You always want to invest where you have an advantage. And as an Aussie resource investor looking at the mid and small caps, you DO have an advantage.

Sure, you may be investing alongside the Chinese, who may be getting a better deal. But there are dozens of smaller projects across the resource spectrum that - as long as the world does not plunge into a second great manufacturing depression - make compelling investment stories.

Murray got back to us with his U.S. dollar index chart. You may recall that the other day we published a chart of the dollar index showing that the short-term and long-term moving averages were in danger of crossing. Murray, a full time technical analyst, basically said our chart looked nice but didn't communicate any useful information to traders about when to enter or exit positions affected by the dollar's decline (or rise).

Murray sent over his chart with a note that begins, "The US dollar index is still in strong downtrend. My last update (to Slipstream readers) said that we needed to keep an eye on the 10 week/35 week Moving Average as the confirmation for any change of trend. Also we needed to see a close above around 81 to confirm a re-entry into the distribution between 78 and 89 formed over the last year."

"None of these indicators are close to being confirmed. So, from a long term perspective, you have to remain bearish the dollar although entry into any short positions is highly risky at this point. Have a look at the chart and you can see that the lowest dotted blue line comes in around a price level of 73 which is close to where we are now."

Click to enlarge

"The meaning of the lower dotted blue line is just that it is an area where a false break can occur. So even though the current price action doesn't look like it is related to the distribution between 78 and 89, it still could be so beware. You can see from the other ranges that I have shown in the chart that a break through the low of the range saw a move to around that lower blue dotted line and then saw a squeeze from there. The first one saw a move all the way back to the top of the range and the second one tried to re-enter its range but ultimately failed.

"The point being, if you had sold down at the lower dotted blue line on either occasion you would have ended up in a difficult position. The market usually looks terrible at those points, but all too often you will see a reversal there which will at least move back to the bottom of the range.

"In this case that would see a move back to 79ish. And from there a re-entry into the range could see a quick move to the point of control at 84 and on to the highs at 90. I think we will see the Dollar create a low somewhere between 67 and 74 and then we will see a big short squeeze to take out traders in what has become a very overcrowded trade.

"Don't get me wrong," he concludes. "I still think the US Dollar is toilet paper, but it doesn't mean it won't buck around like a wild bronco on its way to fiat currency heaven."

Yee haw!

Dan Denning
for The Daily Reckoning Australia

• Australian Recession in the Works? Ask the Sharemarket
• The Dark Underbelly of Australia’s Resource Boom: Chinese Resource Demand
• Australian Iron Ore Shares on China’s Menu
• Trickle of Chinese Money into Australian Housing and Equities Small Compared to Growth in Bank Lending
• The Aussie Dollar as a Measure of Global Risk Appetite

"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

The Guv also said he would not be too timid about raising interest rates. He believes the threat [of global financial calamity] has passed and that the bigger threat may well be inflation. That kind of tough talk sent the Aussie dollar right up to over 92 cents against the greenback. If it weren't late fall, now might be the perfect time to take a trip to America and see how cheap things really are.

But it is a bit surprising that a Central banker would say he's not sure there WILL be another shock to the world's financial system. The last twenty years show a history of regular shocks. The economic models of economists suggest these shocks are 100-year or even 500-year events. But they just keep happening!

The Peso Crisis...the Asian Crisis...the Russian bond crisis which led to the fall of Long Term Capital Management...Bear Stearns...Iceland...Northern Rock...the entire GFC...nope! None of those could ever happen again. Especially in a world that's reducing debt where asset markets are now undervalued and house prices have dramatically corrected and banks have recapitalised.

Well, that's the story that Stevens probably believes. But you know our view. There's a lot more bad debt out there posing as assets. There are more credit write downs. Banks have a boatload of commercial real estate and residential housing assets and a thin slice of equity capital supporting them. There is still a lot of leverage in the financial system. And that leverage exposes banks to losses.

For example, today's AFR cites research from the International Monetary Fund and concludes that Aussie banks could lose as much as two percent of total loans outstanding if corporate and household defaults increase. And gee, that's not likely at all when interest rates rise quickly, is it?

According to the AFR, the IMF report does conclude Aussie banks are "very sound", but they could lose $33 billion from rising defaults. We're not sure what default rate the report assumed, but we reckon it was probably too low. Nearly everyone in the financial establishment underestimated the depth of the crisis last time, too.

The other threat is that that Aussie banks source 30% of their loan funding from international credit markets, according to the IMF. Australia's short-term external debt is about $400 billion this year, according to the AFR. Is that really a threat?

It doesn't seem like one right now. Interest rates are rising and the Aussie dollar looks like it's headed to parity against the USD. This makes Australia a popular destination for international capital flows. After all, you have heaps of foreign investors pouring in to buy Australian property. The place is a capital nirvana!

But yes, it is vulnerability. For one, it means growth in the Australian economy is not sourced from domestic savings but from borrowed foreign money, which must later be repaid. Second, it means that the income and rent from Australia's capital stock (houses, property, shares, and bonds) may not be making Australians rich or even staying in Australia.

Granted, if the Boomers are selling their houses to Chinese investors in order to finance a comfortable retirement, it should work out well for the Boomers. But their children may be renting from Chinese landlords for a long time to come. And no, we're not blaming the Chinese for this at all. It's a great move for Chinese investors. But it may not be such a great development in the capital structure of Australia.

But at the moment, you wouldn't get that sense that rising public debts and the transfer of ownership of Australia's capital assets are any worry whatsoever. Sure haven't seen much of it in the papers or on the TV shows. It's like everyone's forgotten that the more integrated the world's financial markets have become, the more they've tended toward instability. Or everyone believes whatever was wrong before has been fixed now.

One person who had his wagon fixed yesterday was Bank of America CEO Ken Lewis. America's new pay tsar (the U.S. Treasury Special Master for Compensation, Kenneth Feinberg) stripped Lewis of his 2009 salary. Don't cry for Lewis just yet. His retirement package will leave him with between US$70 and US$120 million.

But why is there even a pay master to begin with? Isn't that the job of boards of directors and shareholders? Could government charades to regulate the corporate sector get any more cosmetic? Coming soon, a pay master for your job.

Dan Denning
for The Daily Reckoning Australia

• Aussie Banks Addicted to Foreign Borrowing
• Stress Testing the Banks
• Aussie Banks are Scrambling to Raise Their Tier 1 Capital Ratios
• Bank for International Settlements Report Looks at Origins of Credit Crisis
• Gold, the Aussie Dollar, the Greenback and You

Well, a few people are concerned. Hedge fund manager Peter Thiel told the Wall Street Journal, "The recovery is not real...Deep structural problems haven't been solved and it's unclear how we will create jobs and get the economy growing again -- that's long been my thesis and it still is."

That sounds about right. But is Mr. Thiel's sentiment just sour grapes? Are the bears (your editor included) just cranky because they've missed a powerful six month rally? That's possible, but unlikely.

The real worry is that despite the pages of the calendar flipping over, not much has changed in the last year. The financial system remains fragile. The economy remains addicted to finance. And investors are valuing earnings as if everything was pre-Lehman.

I have rarely been so convinced that the next broader market move is down," says Benjamin Bornstein of Prospero Capital Management in Chicago. "The problem is that governments do not create income or wealth, and current stimulus equates to a future tax liability. That will become a major concern in mid-2010 when the stimulus is done."

By the way, on that subject, the International Monetary Fund agrees. Are you listening Kevin Rudd? The IMF reckons that less than half of the nearly $4 trillion in losses since 2007 have been realised by financial institutions. It says those institutions have to worry about rebuilding capital, stabilising earnings, and borrowing money without a government guarantee.

The Fund also warned that government stimulus programs make life harder for banks because government borrowing sucks away capital from the private sector. "Since all credit providers can buy sovereign debt, sovereign issuance will effectively compete with - and possibly crowd out - private sector credit needs."

Just to recap, government borrowing draws away capital from businesses that might use it to invest in productive projects that generate a real return. What you get in return is higher debt, probably higher interest rates, and people who've never really had to earn a paycheck or meet a payroll deciding how to allocate capital. And you still think it's a good idea?

But let's pretend that government monetary and fiscal policy is not actually making the recession worse and a profitable recovery less likely. For today, let's take up the subject of Aussie banks and the outlook for their earnings. We said that bank capital cushions may still not be large enough to protect them from falling asset values. So having literally rolled up our sleeves, let's get to it.

You might have seen the headline in yesterday's Australian Financial Review, "Cash rich banks ready for growth opportunities." The article claims that Aussie banks are carrying about $6 billion in "surplus capital" which gives them scope, "for expansion and putting them on track to return to record profits in 2010."

Is that so?

It's true that Aussie banks have raised nearly $24 billion in new capital through the equity and debt markets in the last year. And it's true that the big four banks held aside $12.6 billion in provisions for loan losses as of June 30th. But no one knows if that's enough to cushion the banks from another wave of losses.

The consensus view is that since the unemployment rate has (officially) stayed around 6%, loan losses will be less than expected. But we have yet to see any correlation between the Aussie unemployment rate and bank losses. It sounds a bit like saying that because the sky is blue, peanut butter sandwiches taste better.

Aussie banks have booked most of their losses so far on overseas investments related to the implosion in U.S. housing and housing related debt securities. But the future solvency of the banks is dependent on the value of their local loan portfolios. And that brings it down to whether commercial real estate prices and residential housing prices in Australia are really going to escape global deleveraging without declines of at least 20%.

Our view, as you know, is that they can't. If the commercial real estate and housing markets experience large falls, the Aussie banks will be in big trouble, just like banks in Europe and America were when faced with assets that suddenly plummeted in value. In fact, these falling asset values are still taking a hacksaw to the equity of smaller regional banks in the States.

Of course the big banks are not allowed to fail in America. And maybe the very big banks will never be allowed to fail in Australia. But that does not make them a good investment. If you think that other people's mortgages (what the bank calls its assets) are stable and not vulnerable to deleveraging, then we've wasted your time today.

We promise to make up for it tomorrow by telling you why gold stocks are horrible investments but world-class speculations. It's the antidote to Ponzi finance.

Dan Denning
for The Daily Reckoning Australia

• Australian Banks Must Increase Fees or Expand Loans to Remain Profitable
• One in Four US banks Announce Unprofitable Quarter
• IMF Report Concludes Aussie Banks are “Very Sound”…
• Australia’s Currency and its Economy Will Benefit from China’s Stimulus Package
• Biggest Factor Affecting Consumer Price Inflation is Growth in Bank Credit

This brings us to a quick point about the Aussie property market. A frequent complaint in the e-mail box is that house prices are a local and not national phenomenon. If that's right, then it doesn't make any sense to talk about a national property bubble...because there can't be one, can there!?

Well...no. Australia's mortgage finance market is becoming more and more national each day. This makes for a national mortgage bubble, regardless of varying property prices locally. The growth of the mortgage market becomes crucial to the growth of bank earnings, making lenders less cautious and more likely to drive up prices by lending to increasingly marginal borrowers. This explains (along with the FHB grant) why suburbs that had lower median prices two years ago have seen the fastest house price growth rates in the last year.

One of the features of the late-stage property bubble in the U.S. was the acquisition of local and non-bank lenders by money-center banks and Wall Street brokerages. It was so profitable to originate mortgage loans (since they could be sold in the securitisation market thanks to credit default insurance sold by AIG), that Wall Street and large U.S. banks went out and bought non-traditional lenders (those who sourced their mortgage funding by borrowing rather than from deposits).

The result was a huge explosion in loans which drove up prices. Late in the game, Wall Street and the banks were forced to buy up most of the mortgages they had securitised. This put the risk of falling house prices right back on bank balance sheets. Falling house prices reduced the value of bonds made up of bundles of mortgages, bonds the banks now owned. The result was last year's earnings catastrophe for financial stocks.

And not just for financial stocks! After the banks and Wall Street shut off the mortgage spigot in 2007, Congress forced Fannie Mae and Freddie Mac to resume lending and buying mortgages in the secondary market. The result has been more huge losses.

Those losses are so large, in fact, that they account for nearly half the spending increase in U.S. Federal spending this year. We learned yesterday that the U.S. budget deficit was $181 billion for the month of July and $1.3 trillion for the fiscal year (which ends in October). The deficit grew because tax revenues are falling while spending is rising (bad maths).

If you can believe it, U.S. spending is up $530 billion over this time last year. One cause is stimulus money being doled out to cronies. But the Congressional Budget Office reckons that more than half the increase in spending comes from the money Congress has allocated to Fannie Mae and Freddie Mac.

So the U.S. taxpayer (or the Chinese saver) is directly subsidising the U.S. mortgage market. We'd argue that this is what happens when the nation's financial system becomes a vehicle for channeling capital into rising house prices. It's a giant national bet that leaves the banks and government finances increasingly at risk.

Here in Australia, figures from the Australian Bureau of Statistics show that the big banks account for 92% of all mortgages. As University of New South Wales Associate Professor Frank Zumbo told a Senate inquiry yesterday, this has virtually eliminated competition in the mortgage market, giving a very few institutions nearly full pricing power.

But the bigger risk, we reckon, is that Australia's banks will become increasingly reliant on rising house prices to spur demand for new mortgages. That's the process that contributes to earnings and keeps the balance sheet ticking along. The loans made to mortgagees go on the balance sheet as assets. They are funded from money borrowed abroad, which goes on the balance sheet as a liability.

The trouble here is that assets can change in value while liabilities do not. The debt has to be repaid, even if house prices fall. Australia's banks are gambling with the capital structure of the entire nation, sinking more and more borrowed money into residential housing. It's the biggest and riskiest bet yet.

Dan Denning
for The Daily Reckoning Australia

• National Australia Bank Hasn’t Hit Bottom Yet
• Federal Reserve to Withdraw its Support of U.S. Mortgage Market?
• New Default Wave Hits Mortgage Industry
• Mortgage Bubble and More at Stake Between Australia and China
• Underwater Homeowners Continue Making Mortgage Payments