If you want to attend the presentations and discussions over the next four days, you can still do so. But you should contact conference organiser Marcus Matthews today. You can reach him via email at feketeaustralia@gmail.com. And if you're there on Sunday, be sure to say hello.

Yesterday we promised to show you how the funding model for the fiscal welfare state is blowing up. But this is going to have to wait at least another day. Don't worry though. It's not going anywhere.

Today, there is a banking story to cover. You recall that yesterday we were worried about the next banking crisis. But the lingering effects of the last one are still with us. National Australia Bank reported a 43% fall in net profit yesterday. Ouch.

Don't feel too bad for NAB. Net profit fell from $4.54 billion to $2.56 billion. But the bad and doubtful debts charge for the year grew by 53% from $2.49 billion to $3.82 billion. With $654 billion in assets and $616 billion in liabilities, the bank is sitting on $37.8 in equity. A few billion in bad debts and loan losses won't wipe out that amount of equity.

But it's worth noting that NAB's total assets are 17.3x times equity. This isn't as high as some leverage ratios in the U.S. just prior to the banking crisis in 2008. But it's not far off where NAB was at the time. And there are two further risks worth mentioning.

First, as the IMF paper on Aussie banks concluded earlier this year, Aussie banks are probably strong enough to withstand a normal shock to the balance sheet. That is, the IMF stress-tested Aussie banks for losses on their two largest loan portfolios - corporate loans and mortgages. The IMF concluded the banks were adequately capitalised to survive the shocks it tested for, but that, "The above shocks do not constitute a rigorous stress test and the results are only indicative of the health of the banking sector."

If we've learned one thing in the last two years, it's that bankers and analysts have consistently underestimated the frequency and magnitude of systemic shocks. That doesn't mean the IMF conclusions aren't to be trusted. But it means in the event of another more severe shock, the banks could face larger asset writedowns and losses than the IMF has modelled.

This brings us to the second risk worth mentioning. A bank facing bigger loan losses takes fewer risks. It reduces lending. This is how the credit crisis was transmitted from America's housing market to Australia's economy. The Aussie banks had to tighten up to prepare for losses on overseas assets.

Next time around, though, we reckon the losses - when they come - will be on domestic real estate assets. And with so much exposure to domestic real estate (mortgage loans), the assets could face a world of hurt. But even if bank asset quality doesn't crash (housing prices don't crash), an external shock affects Aussie bank liabilities.

The IMF report says that, "On the liabilities side, however, banks had sizable short-term external debt obligations, and access to offshore wholesale markets was disrupted by the Lehman Brothers collapse in September 2008." Of course the government's wholesale funding guarantee eased the pain of this shock, which is one reason why that guarantee may become permanent in all but name.

But the IMF wrote that, "A key remaining vulnerability is the roll-over risk associated with sizable short-term external debt. Banks' wholesale funding (domestic and offshore) accounts for about 50 percent of total funding, of which about 60 percent is offshore. Financial institutions short-term external debt (on a residual maturity basis) is estimated by staff at about $A 400 billion (35 percent of GDP) in March 2009."

Maybe the short-term external debt levels have improved in the last six months. We haven't checked yet. But in simple terms, it means a lot of domestic lending is funding from external funding, borrowing abroad to loan at home. If American banks again blow up on the destruction of their remaining collateral (mortgage loans and U.S. Treasury bonds) we'd predict another ice age in global credit markets.

Needless to say, as a capital importer, this would put Australia in an awfully uncomfortable spot. But hey! No one is worried about that at the moment. The Aussie dollar is being inflated by the U.S. dollar carry trade. It's a shame that the strong Aussie is going to devastate local industry and manufacturing with higher costs, but at least it obscures for now the risk that Aussie banks are reliant on foreign borrowing.

In the bigger picture, this means the investment needs of the economy can't be met by household savings alone. But that's an even bigger problem than we can address today. So we won't!

More cow bell!

And what about our theory that a U.S. dollar rally will trigger a correction in gold, oil, and stock markets and lead to a mini-rally in U.S. Treasury bonds? Bond fund king Bill Gross agrees. Writing on Pimco's website, Gross concedes, "Rage, rage, against this conclusion if you wish, but the six-month rally in risk assets -- while still continuously supported by Fed and Treasury policy makers -- is likely at its pinnacle."

Dr. Doom himself, analyst Nouriel Roubini, called the present market "The mother of all carry trades." "This asset bubble is totally inconsistent with a weaker recovery of economic and financial fundamentals," Roubini said via satellite to a conference in Cape Town, South Africa. "The risk is that we are planting the seeds of the next financial crisis."

With the S&P up nearly 65% since touching 666 in March (seriously), we'd say the seeds are already bearing fruit. But maybe it's poisoned fruit. After all, the rally has been worldwide and extremely impressive by historical standards. But it's fully consistent with previous bear market rallies. If anything, it's happened faster.

What nobody yet knows is if it IS a bear market rally...or a garden variety stock market rally that precedes a recovery in the economy. You know what we think.

There IS one notable difference between 2008 and today, though. Yesterday we mentioned that U.S. banks have loaded up on a whole other kind of super-dodgy collateral; U.S. Treasury notes and bonds. Demand for those securities may go up with a U.S. dollar rally and a reversal of the dollar carry trade. But in the longer-term, we think the banks have invited another toxic house guest on to the balance sheet.

But where did the previous smelly houseguest go? You know, all those mortgage backed securities and subprime loans? Where does that risk now reside? And what happens if it comes home to roost?

According to this report by the San Francisco Federal Reserve, over 95% of all new residential mortgage lending in the U.S. is now being backed directly by the U.S. government. With the banks unable or unwilling to lend, Uncle Sam has become the sugar daddy of the U.S. mortgage market. See the chart below.

The Fed supports this market by purchasing the securitised mortgages issued by Fannie and Freddie. The Congress funds the agencies which make the loans available. But no matter how you slice it, the U.S. government is supporting the housing market. It will continue to do so as a political imperative.

But by taking on this massive liability - not that it doesn't already have its hands full - the Fed is further consigning the dollar to the scrapheap of history. Do you think foreign creditors will not realise that the U.S. is borrowing money to keep house prices elevated? Will they not notice that the U.S. is printing money to do this? And what will happen to the dollar then? And gold?

The truth is that creditors already do know this. Today's Australian Financial Review reports that overseas Chinese investment is "surging." Chinese policy makers are trying to trade dollars for tangible assets or equity in resource shares as quickly as possible. "China reported a 190% jump in overseas investment by its companies for the third quarter."

"Policymakers might be encouraging Chinese firms to invest abroad, in part to help counter pressure for the nation's currency," the article continued. "Investors are betting on the yuan to appreciate as China's growth accelerates from its weakest pace in a year."

Most currencies that are not the U.S. dollar could appreciate in the coming years. Australia's currency has already done so. Brazil is considering a tax on capital flows into the country in order to prevent investors from speculating on a further rise in its currency by buying Brazilian assets. And of course speculators have tried for years to find a way to position themselves for an appreciation in China's currency. China's capital markets are not friendly in this regard, although Hong Kong stocks remain a popular option.

The fact that countries like Australia, China, and Brazil are trying to limit currency appreciation versus the greenback shows you how unbalanced the world economy still is, how unprepared it is for the reality that America's deleveraging will take place for years. Households and businesses must save and repair balance sheets. Some other country is going to have to consume what the world produces.

In the interim, the U.S. government will increase deficit spending to make up the difference. It is the stupidity of Keynesianism to support aggregate demand when what everyone needs is a correction and a recovery. But all the Feds will succeed in doing is blowing up the balance sheet of the U.S. government in spectacular fashion. Go gold.

Mind you we still think the short-term move is a dollar rally and some profit-taking on the dollar carry trade. We asked Slipstream Trader Murray Dawes what he sees when looking at the U.S. dollar index. Murray spends most of his time finding trading opportunities in Aussie stocks. But he also knows that Aussie markets (and capital flows) are still massively affected by what's going on in America.

Murray wrote that, "If we look at this chart of the US Dollar index going back to 1985, you can see quite clearly that the 10 week moving average crossing over the 35 week moving average has been a very good indicator of the trend. There are only a few instances over that whole time period where this indicator gave a false signal."

Click to enlarge

"Therefore," Murray continues, "we should be keeping an eye on this indicator going forward to tell us whether the US Dollar index has turned back up and is ready for a counter trend rally. The short US Dollar trade is getting pretty full, as I have mentioned in the past. And there is a high correlation between the direction of the dollar and the direction of gold, oil and stocks.

"The US Dollar has taken over the Yens role of funding the carry trade and this will be the situation for as long as the Fed remains too scared to raise rates, which seems to be for the foreseeable future. So we can probably expect the dollar to weaken further over the long term, but a counter trend rally (short squeeze) may be closer than people think and this would lead to weakness in commodities and stocks.

"When should we trade this move? Well have a look at the chart again. Notice the false breaks that keep occurring when the all time lows get breached (denoted by the numbers 1,2,3). With the trend still strongly down we can expect to see either a false break of the lows around 71 reached last year or if that doesn't occur then a crossover of the 10 week/35 week moving average to confirm that the trend has changed. Trading the move before either of these are confirmed would be jumping the gun."

Murray is tracking which Aussie stocks will move if and when we see the dollar index break out. We'll keep you posted.

Dan Denning
for The Daily Reckoning Australia

• IMF Report Concludes Aussie Banks are “Very Sound”…
• The US Dollar Showing Signs of Life
• Rally in Stocks and Rise in Aussie Dollar is a Result of the Carry Trade
• A National Mortgage Bubble
• Australian Banks Must Increase Fees or Expand Loans to Remain Profitable

The 4-lane Sheik Zayed road stretching between Dubai and Abu Dhabi is, at best, a competition for speed; at worst it's a death trap. Among the UAE's claim to world's largest shopping mall, world's tallest building and world's longest metro built in "one go", is this highways claim: to one of the world's biggest automobile pile-ups.

On March 12, 2008, 25 cars traveling along the route burst into flames after piling into one another as a band of fog rolled in from the Gulf. Nearly 60 cars were in the accident altogether... 347 people were injured in the crash, 6 lost their lives.

"The crash happened because everyone was speeding despite the severe weather conditions," an Abu Dhabi traffic police officer said at the crash site, as reported by the Gulf News. "Drivers weren't leaving a safe distance between cars and this resulted in everyone hitting each other after the first crash."

A documentary short posted on YouTube capturing the 911 calls placed from motorists describes 'Foggy Tuesday' as a morning devoid of "human caution." The film also heralds the obvious bravery of the men who arrived from the Abu Dhabi fire, police and rescue crews to save those who'd become entangled in the brouhaha.

We will not hold you in suspense any longer...the metaphor suggested by this fantastic auto accident is a perfect fit for those studying the Dubai property bust. And like the writer of a Hollywood script, we cannot help by bring it to your attention.

Yesterday, on the recommendation of our new friend Moe, we traveled the same stretch of Sheik Zayed highway where the accident had taken place. Mohammad "Moe" Fathi Al Abrozani a Bahrainian-Qtari whose mother was an Iranian-American. Moe was born in Abu Dhabi, educated in California, lived briefly in New York and Chicago, then spent seven years in Germany. (His German is so fluent our German friends, Andre and Vereena, here in Dubai did not expect him to be Arabic when they first met him in person.)

Moe had returned to the Middle East to take part in the expansive boom attracting so much attention around the globe. He's now an executive with TwoFour54 Media, a firm set up by the government in Abu Dhabi to woo Western firms into establishing their Middle East operations in the new Media City in the UAE's capitol city. The rulers of Abu Dhabi had witnessed the efforts, successes and failures of their fellow emirate, Dubai, and have since vowed to create a modern media communications hub greater than anything now in existence.

"Why mess with visas, permits and expatriate contracts down in Dubai?" Moe asked us at dinner the other night, "when you can come to Abu Dhabi and get them all from the government free...?" One foggy morning in the year 2008, the reckless speculation that spurned much of the outrageous development projects in Dubai began to pile up on each other. Now the motionless construction sites lay in wait for assistance. In a scene familiar across the West, Abu Dhabi, the company line suggests, has "come to the rescue" of Dubai; with low cost loans; paper money and the sincerity of an assassin.

When we met up with Moe and Andre at Shakespeare's a brand-new bar in the all-new Souk Al Bahar, they were quietly puffing from sisha - the traditional water pipes bubbling with aromatic smoke. Our mission in the region was and is simple. We want to establish a presence on the ground from which we can monitor the developments and assess investment opportunities in Dubai, the UAE and across the Middle East unfiltered by the mainstream press. But here we were being asked to consider moving the infrastructure of our publishing business, our families, our lives, half way around the world to the desert. Bloomberg, CNN, Forbes are all moving and or expanding their operations in either Dubai or Abu Dhabi.

Why shouldn't we? Our friends in Abu Dhabi are apparently ready and willing to help.

Dubai and Abu Dhabi, the two leading Emirates of the UAE are relatively new to the global finance and trade... but they want you to know they have arrived in high style. This weekend, Formula One racing makes its debut in Abu Dhabi. The government had to pull workers from several of its five star seaside resort project to complete the track and facilities on time. Ferrari World, a massive theme park dedicated to the sport sits nearby. Yesterday, the Emirates Palace Hotel - the world's first seven-star hotel - Demi Moore, Hilary Swank, and last year's Oscar winner, Freida Pinto (Slumdog Millionaire) graced the opening ceremonies of the Middle East Film Festival. The Abu Dhabi sovereign wealth fund has famously leveraged their way into both of the leading football franchises in the world - FC Barcelona and Manchester United.

Still, our friend Peter Cooper recalls a time in his own family history when Dubai was nothing but a backwater of the British Empire, a port full of smugglers, nomads and thieves. His great uncle had been stationed here during World War II. At the time, the strife caused by the war left the ragtag bunch group of 7,000 residents on the edge of starvation.

Sheik Rashid, the father of modern Dubai, dredged the Creek in the 1950s establishing Dubai as a free trade port. At the time, too, the Creek dredging project was roundly criticized, as it should have been. The project cost nearly 3 times Dubai's annual GDP. But it also established Dubai as the trading center for goods coming into the Middle East. If you go down by the creek today there are Iranian Dhows - the Middle East's answer to the Chinese Junk - bringing rice, rugs and refrigerators back and forth across the Persian Gulf. Iran's ports are about a two-day drift away for these wooden ships. Kuwait and Iraq a day or two more. Bahrain, Qtar, Oman closer still. Without the fantastic success of that initial dredging project, we wouldn't be writing to you from the desert today.

"Dubai the hot spot..." has been a center of trade, smuggling and the rougher trades ever since. As the back jacket copy on a 1970s novel about gold smugglers in Dubai written by the French Connection author Robin Moore indicates: "Dubai, where adventurers play the world's most dangerous games...gold, sex, oil and war. Cold- blooded adventurers in a blistering Mideast empire where life is cheap and no price too high for pleasure." The novel is still banned here because the sheiks don't like the image it portrays.

The promise of riches, however, is part of the region's allure and what has attracted those expatriates who chosen to ride out the bust and continue to live here to this day.

The most recent gold rush, the boom in Dubai property, came on the heels of the terrorist attacks on September 11, 2001 and the same policy response that spawned a housing and consumption bubble across the United States, London and much of the West. Arabs flush with energy and trading capital brought much of that money home to the Middle East fearing a Western clamp down. At the same time, investors in dirham backed assets - the local currency which has enjoyed a US-dollar peg since November 1997 - benefited from the same era of low interest rates that soccer moms in Montgomery County, Maryland or gamblers in Las Vegas, Nevada did.

And like all booms, the property in Dubai witnessed its excess and its pathos. An article in this week's Asian edition of Time Magazine laments the manmade island project meant to mimic all the countries on the planet. "The World is one of many architectural fantasies in Dubai that now appear to be shimmering mirages. The emirate boasts the 818m Burj Dubai, the world's tallest skyscraper; a manmade island shaped like a giant palm; a ski slope in a shopping mall; an 18-hole golf course in the middle of the desert that will slurp down 3.8 million liters of water a day. But the dozens of giant cranes that once littered the skyline are beginning to migrate elsewhere. Dubai today has the feel of a futuristic, five star ghost town blasted by sandstorms."

"The fools!" we can hear readers of Time Asia chuckle with superiority. Everyone likes to kick a gambler when he's down.

But the story remains. On our way to Abu Dhabi yesterday we passed by the free zone surrounding the new deepwater global trading port at Jebel Ali. Business Bay near Jebel Ali is the home to many of the Bubble Era development projects, 30-story towers standing side-by-side, dark windowed and tenantless.

We suspect many of these nutty projects - like the City of Arabia, which had boasted an amusement park full of life size animatronic dinosaurs as its calling card during the boom - will never find the funding to finish. More sober projects that are or are nearing completion will likely take years to find tenants. And those "investors" who bet big and large on Dubai property in 2003-08 are no doubt already wishing they never had.

But the free zone near Jebel Ali also the site of Dubai's real potential; banking and trade. Corporate tax rates in are effectively zero. You name a multinational and Moe can point to their local subsidiary. The Dubai Mall, for example, is reported to need 10,000 shoppers a day to break even but now only sports around 7,000. Why do the world's most famous brand names all have shops open and spiffy already, we couldn't help but wonder. It has to be for those fine tax rates, we couldn't help but conclude.

Among other racy themes we heard this week, Dubai is supposed to now be the world capitol of the flesh trade. And the gold price hit an all- time high early in the week after we arrived sparked by rumors the GCC would back a unified currency with gold and provide oil traders an alternative pricing unit than the US dollar...

We suspect this fantastic wreck in the desert is only one scene in a long, exhilarating drama. We're not "long" Dubai in any real investment sense. Not now anyway. But, like most onlookers to the spectacle, we struggle to avert our eyes. The story promises more exciting car chases, more steamy sex scenes and political intrigue to come...and we'd be lying if we didn't admit we're suckers for a good story. And, who knows, we may open an office of our own there.

Regards,

Addison Wiggin
for The Daily Reckoning Australia

• Qatar Relies on Natural Gas Reserves While Dubai Leans on Trade and Finance
• Arab Wealth Pours Back into Dubai
• Dubai, Built on Debt and Sand
• Is Dubai the Bubble It’s Made Out to be?
• Dubai Debt Story More Like Bear Stearns Less Like Lehman Brothers

If, on the other hand, you want to know why oil prices could double this year, or how $52 trillion in total global debt will utterly suffocate central bank attempts to resuscitate bank lending, or Ben Bernanke's secret plan to turn trillions of dollars worth of toxic assets into shareholder equity, read on!

You're still with us? Good. Now, why are oil prices lying?

Prices communicate information. The NYMEX February oil contract fell over 5% today in New York trading to $34.40. This suggests oil is falling in value, at least in the short term. And maybe that's not totally a lie.

After all, the current oil price results from two factors. First, the absence of leverage from the oil futures market leaves prices reflecting immediate supply and demand. With inventories full, the market seems well supplied (so much so that OPEC is cutting production). Second, the reality that oil demand will be flat or slightly fall this year because of the worldwide financial pandemic.

Adequate supply plus stagnant demand equals $35 oil. So why is the December 2010 oil contract trading nearly 80% higher at $61.80? What could possibly happen between now and December 2010 that would cause oil to go up 80%?

Well, for one thing you might be in the early stages of an economic recovery by then. Demand would have recovered. Shares could be higher. Everything could be fine.

But we can think of at least three reasons why the current oil price is headed much higher this year (not in 2010). First, the lower oil price is actually going to lead to lower oil production later this year and next. Oil production is declining to begin with. But the crash in prices has put the kibosh on exploration and production.

Second, as Diggers and Drillers contributor Mike Graham explains in a January article on the subject, the clear trend within the oil market is that historical exporters are exporting less oil. There are several reasons for this, which Mike gets into in his story.

One is that oil exporters are hoarding it now and waiting for higher prices later. Another is that oil exporters are consuming more of their own production, leaving less for export. And still a third reason is that the world's largest oil exporters face declining production trends thanks to...you guessed it...Peak Oil.

Yes. Peak Oil has not gone away. It's been sent to the corner while the Credit Depression hogs the stage. But Goldman Sachs oil analyst Jeffrey Currie issued a report yesterday predicting a, "swift and violent rise" in oil prices in the second half of 2009.

Currie told a conference in London that, ""Thirty dollar oil reflects the same imbalances that got us to $147 oil. The problems haven't gone away. We still believe the day of reckoning is to come." What problems?

There are still major infrastructure bottlenecks in the global oil network. Currie says that despite the big fall off in demand, "This is not 1982-1983 all over again. The supply picture's radically different...the demand picture's radically different. The key difference is that today there are no large-scale next generation projects that are going to save the world. Commodity demand is exponentially higher than it was."

This brings us to the third reason oil prices should rise later this year: the oil trade is back on. Sure, credit may still be a scarce commodity. But if you judge traders by their actions, you can see the market is setting up for a big oil back draft. As evidence, Bloomberg reports that, "Morgan Stanley hired a super tanker to store crude oil in the Gulf of Mexico, joining Citigroup Inc. and Royal Dutch Shell Plc in trying to profit from higher prices later in the year, two shipbrokers said."

Our friend Dan Amoss back in America calls this the oil arbitrage trade, where supply is stockpiled offshore, and thus withheld from refiners, allowing existing gasoline inventories to be worked down. Then in six to twelve months time, when crude prices have moved higher, you simply park your ship at the terminal and cash in on the difference between what you paid six months ago (today) and the new market price.

It is normal for the oil futures to be in contango, where spot prices are lower than futures prices. What's less normal is the amount of oil being stockpiled offshore. "Frontline Ltd., the world's biggest owner of supertankers, said Jan. 14 about 80 million barrels of crude oil are being stored in tankers, the most in 20 years," Bloomberg ads.

We also suspect that oil as an inflation hedge will come back into vogue later this year, which might be adding to the appeal of buying today at bargain basement prices. What's more, you can never discount (although you can never fully quantify) the geopolitical aspect of oil prices. A good general rule of thumb is the more war there is in the Middle East, the more likely oil is to go higher.

So what should you do? That's the subject of the January issue of Diggers and Drillers. More on that after we publish it for subscribers first later this week.

Next is a massive topic we are reluctant to introduce today. But we have to. There is no other way around it. It begins with a question: how much air is left in the credit bubble?

Actually, the question comes via Howard Ruff and Steve Hochberg. Let's start with Hochberg.

He's the lead analyst at Elliott Wave International. Bob Prechter's folks have been forecasting for years that the collapse of the credit bubble would lead to a general and massive deflation, including much lower gold prices. In his latest analysis, courtesy of a DR Reader, Hochberg explains:

"The systemic build up of total market credit is so large, currently about $52 trillion, that its implosion will swamp the Fed's attempts to inflate. And as CTC [Conquer the Crash] discusses, the remaining dollars that are not extinguished through bankruptcy, restructuring and write-offs, will increase in value. The thirst for cash will be insatiable relative to all other assets.

"Initially, the Fed's attempt to inflate was akin to using a garden hose to refill Lake Mead after the Hoover Dam collapsed. Over the past five months the chart shows that the Fed has graduated to a fire hose. But creating just over $2 trillion in the face of a contracting pool of $52 trillion in total credit market debt is just not going to get the job done, and the only thing getting hosed right now is us."

" Eventually credit will contract to the point whereby the income generated from economic production will be able to sustain it and at that point, yes, the U.S. dollar should indeed collapse of the weight of all the Fed's machinations and gold should soar. But before the market arrives at that point, deflation must run its course. In our opinion, there is still a long way to go."

But how far? A lot depends on the composition of that $52 trillion in credit. It can't all just vanish can it? But how much of it is securitised by relatively stable assets? And how much of it could potentially melt away under the intense heat of deflation?

This is not an easy question to answer. But it begins with knowing what you're dealing with. Specifically, you have to know who owes how much, and who owns how much. Those are two different questions. Let's deal with the first one. And we promise we'll make this as painless as possible. If you want to review this data yourself, by the way, you can find it here.

Keep in mind this data deals just with the U.S. And keep in mind it is government data. But the general question is this: how much deflation is left in the credit bubble and who stands the most to lose from it?

The Fed breaks up the total credit market debt outstanding into three categories: Domestic Nonfinancial Sectors (households, farms, nonfinancial corporations, state and local governments, and the Federal government), Financial Sectors (commercial banking, REITs, broker dealers, savings institutions, Government sponsored enterprise, Agency and GSE pools, and issuers of asset backed securities), and finally, the rest of the world.

What we find is that $32.9 trillion in credit market debt outstanding, as of the third quarter in 2008, was owed by the domestic non-financial sector. That's 63% of the $52 trillion total. Households are on the hook for most of that, with $13.9 trillion owed (or 26% of all credit market debt outstanding). That would mostly be home mortgages we reckon.

Next within the financial sector are non-financial corporate businesses with $7 trillion, non-farm corporate businesses at $3.7 trillion, state and local governments at $2.2 trillion, and the United States Federal government at $5.5 trillion.

So what does it tell us? Well it tells us that if U.S. house prices continue to fall, there is a lot of room left to deflate in the credit bubble, at least several trillion dollars. It's not hard to see this happening, given the rise in foreclosures, the prospect of even less federal funding for refinancing of mortgages, and the sudden collapse of America's banking model.

But the lack of credit for refinancing and the looming wave of Alt-A recasts this year and next is, in some sense, already old news. What also keeps us up at night is the $16 trillion in credit owed by the financial sectors. How much of that is at risk to further deflation?

You can get an idea by looking at the L2 table on page 59 of the Flow of Funds report. There is $6 trillion in corporate bonds outstanding. Nearly $5 trillion in Agency and GSE-backed securitised mortgage pools are on the books, and another $3.1 trillion in GSE debt itself. This does not include $1 trillion in "other loans and advances" which may or may not include home equity lines of credit.

We're sure you get the picture by now. There is still at least $8 trillion housing related assets owed by the financial sector. That might be kind of tough to pay off, given the falling value of the assets which securitise that debt. So who stands the most to lose if households can't pay their mortgages, corporations default on their bonds, and housing-related assets held by financial corporations continue to fall?

The financial sector combined holds $37 trillion in credit market "assets." It owns $37 trillion in other people's promises to pay. Those promises, all $37 trillion of them, are on the books at face value. What's more, U.S.-chartered commercial banks (Citibank, Bank of America for example) own $8.2 trillion in credit market "assets." Life insurance companies own another $2.9 trillion. Money market mutual funds own $2.1 trillion in credit market assets, while mutual funds own $2.3 trillion.

Do you see what we're getting at? The institutions that have the most to lose from a fall in the value of their credit market "assets" also have large obligations to shareholders and pensioners. Those institutions are counting on those assets to meet their own future liabilities (which do not fluctuate in value). And households are relying on those assets to retire, or in some cases, to live month-to-month on a fixed income.

Someone is going to lose, somehow. Or everyone will.

Households win if the value of the credit they owe (their mortgage) is written down or managed lower by some new law. But investors counting on that asset (often the household itself through a pension or life insurance) don't win if the amount they are owed is arbitrarily reduced.

Either way, Prechter's group is probably right. There is more deflation ahead. A lot of it. And not just in housing.

The corporate bond market would be another place to look. Corporate defaults haven't begun to rise noticeably yet. But faced with a much slower economy and much higher borrowing costs, it's going to be tough for highly indebted firms to roll over their debt, much less take on anything new. Dividends are already being slashed here in Australia.

And where does the deflation of the $52 trillion credit bubble leave us? Well Howard Ruff reckons we get a period of serious deflation, punctuated by a period of hyperinflation. Over at Kitco, he writes that, "First, we will continue to plunge into a major deflation period which will be characterized as a 'recession,' and later in the year as a 'depression.' Deflation and inflation are always monetary phenomena."

"Second, deflation will evolve into a run-away-hyper-inflationary depression because of what government will do to try to prevent deflation, which is synonymous with depression and has overtones of the 1930s."

How will government accomplish that? More on it tomorrow. Meanwhile, and finally, some timely reader mail.

"why do your emails have to be so long winded.... they waffle on toooo [sic] much, one metaphore [sic] after another... can any one really be bothered in there busy lives readin [sic] over all that.... I actually find some of the factual input useful, but there isnt [sic] much of that... a friendly tip, cut your newsletters/emails by 80%, get to the point and lose the metaphores [sic] and long winded useless stories.... the genuine potential investors your trying to pull in wont [sic] be inpressed [sic] with such dragged out point of views...I am a member of a well known share forum, many think the same as I do... the dailyreckoning could do allot [sic] better, it has so much potential, yet your [sic] boring people..."

Zzzz. Huh? What's that? Oh yes, this free daily e-mail about world historic financial events is too long and won't impress interested investors.

First, a tip. Maybe you should spend more time on spelling and grammar. But that is beside the point.

Sure the Daily Reckoning can be long. And we're grateful that you invite us into your living room and office each day to hear what we read. We don't take your time for granted, which is why put time and effort into what we write. And some times it takes time and effort to unwind a complicated subject.

If we had more time, the DR would be shorter. And in fact, we'd like to launch a subscription-based DR later this year. It would be a shorter, more to-the-point version of the DR with action to take. But in the meantime, we don't have the time for a shorter DR! So you'll have to deal with the long one. Or watch television instead. Your choice, if you're still reading that is.

Dan Denning,
for The Daily Reckoning Australia

• Pemex and Mexican Peak Oil Equal Expensive Oil
• What is the Oil Price Telling Us?
• The Coming Oil Back Draft
• No Spike in Oil Price Following IEA “Third Oil Shock” Announcement
• Oil Prices Under $70

It doesn't get much more direct than that. The truth is, governments are trying to do the impossible. They are trying to make bad loans turn good by propping them up with extra money, money that comes from out the blue. And instead of encouraging household saving that would form the base for future productive investment, governments are encouraging more consumption and nursing along trillions in mal-investment (housing-related securities).

Debt-based consumption and the securitisation of those debts are what brought us to the point of systemic crisis in the first place. Had markets been allowed to work, the over-leveraged financial firms would have failed, a deep recession would have ensued, and consumers-cut-off from credit-would be forced to save rather than consume.

So far, though, efforts to save the system by propping up bad debts are only weakening confidence in the system itself. It's happened with surprising speed. My friend John Robb writes that it's a cascading collapse of ever larger bubbles. It starts small and grows to encompass the entire global financial system.

• Small. A belief in the US consumer. US subprime mortgages collapse. US prime mortgages and US commercial real-estate and consumer credit follow.
• Big. A belief in the Shadow Banking system. The investment banking system implodes. Hedge funds liquidate. Money markets/commercial paper seize up. Financial insurance evaporates.
• Bigger. A belief in the global banking and market system. Systemic bank failures. Global markets crunch.
• Huge. A belief in the US as a global economic power. US treasuries and the dollar crash. Numerous national bankruptcies

A critical point to realise for investor is that creating more debt and credit is not going to solve the problem. The bad debts need to be liquidated and the people who made them need to be replaced by better capitalists who can put available savings to a productive use. Yet propping up the people who got us into this mess with more money is precisely the response we are headed for. In an interview with CNBC last week, Jim Rogers predicted an 'Inflation Holocaust.'

In an effort to save their own skins and prevent consumers around the world from a very healthy and natural return to living within their means, global politicians are again making a bogus promise that everything will be fine if we just borrow more money. By doing so, they've upped the ante in the crisis and put the entire financial system-in its current form-at risk.

Will the 2003 lows on the ASX and Dow be taken out?

Before we get to the larger question of what will happen to the global financial system, let's return to the more immediate question of what stock markets are going to do when they open Monday (assuming they do, in fact, open for business as usual). Without a clear plan emerging (as of yet) from the G20 meeting in Washington (it followed the G7 meeting), the futures in Asia are down, although the ASX/200 futures are up 27 points as of this writing.

Where stocks go from here depends on what they are pricing in. Remember, stock markets are forward looking. The market tries to determine the current value of future earnings. There are two factors that cloud that picture right now: the credit crunch and a global recession.

The crisis in the financial sector was not successfully quarantined. Banks are not only unwilling to lend to one another, but to anyone at all. Hence the freeze in the short-term commercial paper market. Companies that relied on the money market and commercial paper market to fund payrolls and inventory now have to go straight to the local central bank. Wire service reports from the U.S. suggest General Motors may soon borrow directly from the Fed.

The earnings picture is nearly impossible to paint if the credit markets remain locked up like this. We simply don't know who can get credit from the Central Banks and who can't. Who will fail and who will survive? Who will have to cut prices or slash payrolls?

The other factor weighing on shares is the emerging fact that we are facing a synchronised global recession. If consumers are also denied access to credit, consumption must decline as savings rates rise. Unless retailers slash prices (and profit margins) we don't see how they will sustain revenues for the last quarter of 2008 and the first quarter of 2009, much less increase them.

That means stocks would have to begin factoring in a dramatic decline in consumer spending and 2009 earnings. The analysts would prefer to do this in piecemeal fashion. The market will likely do it in a few lump sums.

3,500 or Taking out the 2003 Low?

Last week we published analysis by our chartist and Swarm Trader Gabriel Andre. Gabriel said the first line of resistance for the ASX/200 would be at 4,300. That support was taken out on Friday. If the index is unable to regain it, Gabriel highlighted the next line of resistance at 3,500. That decline would be just 460 points from current levels-or 11.6% in percentage terms (one very bad day of trading or two awful days, at this rate).

Click to Enlarge

An 11.6% decline from the current levels would put Aussie stocks back at 2004 levels. You'd have to think that the big blue chip miners would start to look extremely attractive at those prices-once (and if) the banking crisis is quarantined (via nationalisation and equity stakes). Cashed-up private investors might be willing to come in from the sidelines at that point, lured by the valuations.

But we have drawn a third line on the index where the 2003 lows are. We should consider the possibility that the current crisis is going to wipe out all of the equity gains that began with the low-interest rate cycle in 2003. The March, 2003 low on the ASX was 2,715. A fall to that level form 3,960 would represent a decline of 31%.

Obviously a decline of that magnitude on top of the 40% drop from the October 2007 high is astonishing. Remember, the closing high for the ASX/200 was 6,853 on November f1st of 2008. A decline to 2,715 or below would represent a 60% fall on the index (which curiously coincides with one of Gabriel's key Fibonacci retracement levels.)

2003-2007: A Bear Market Rally

Could the market really give up 60% from its all time highs? The argument to support this retracement starts with the claim that this bear market began in 2000, not in 2007. Stocks declined for three years as the market purged the easy money created in the tech boom.

Then a host of a factors-cheap exports from China and Asia to keep down consumer price inflation in the West, low interest rates to fuel simultaneous booms in housing, shares, bonds and commodities-conspired to prevent the bear market from doing its work. Globalisation and interest rates banded together to give us a mighty, but unsustainable boom.

In essence, this view suggests that the entire rally from 2003 to 2007 was simply a rate-fuelled rally in the midst of a secular bear market. It you accept that view, then it becomes quite easy to see how the 2003 lows could be challenged. And if the view is correct, they won't just be challenged, they'll be taken out and a new low established.

For this scenario to unfold, you'd have nothing less than a global financial system reboot. It would represent the complete collapse of the global system in which American consumption, fuelled by credit, is the engine of global growth. It would also mark an emphatic end to the system whereby global exporters keep their currencies artificially cheap against the U.S. dollar in order to remain attractive to the U.S. market.

You could also expect to see a sudden and violent end to the habit of recycling trade surpluses in the U.S. stock and bond market (a form of vendor financing that no longer makes sense when your customers are broke and can't get credit.) The Treasury market would see much higher interest rates and the U.S. dollar would crash (especially against gold, oil, and commodities, giving us the 'Inflationary Holocaust' predicted by Jim Rogers).

Global Rebalancing

This series of system shocks would eventually bring about the long-anticipated "global rebalancing," where Americans save more out of necessity and the developing world eventually consumes more of its own production. On the American side, it means lower levels of consumption, more saving, paying down debt, and investment in real wealth production (infrastructure and energy rather than residential housing and shopping malls).

For the developing world, it means more investment in domestic infrastructure and the domestic economy. Savings will have to be unleased locally to finance this investment, rather than loaned to rich Western countries to finance deficit spending. And with rising per capita incomes and the beginning (yikes) of consumer credit, you'd expect to see higher rates of consumption on consumer and durable goods, all of which is resource intensive and in the long-run, very good for Australia.

But all of that is an enormous shift, a huge wealth transfer from the consumption and debt based economies of the industrialised world to commodity producers and high-savings nations in Asia. It is the Money Migration at light-speed. It creates real wealth for investors while destroying bogus balance sheet value for bankers.

In the meantime, you can expect global policy makers to try and engineer some replacement for the broken system of global finance. Italian Prime Minister Silvio Berlusconi called for a new "Bretton Woods." It will involve ever greater monetary cooperation and centralisation.

It is worth noting that the G7 nations think they will be the architects of the new financial system. It has not occurred to them that perhaps the global balance of economic power is now tilting away from Europe and America toward something else entirely. More on where this leads in tomorrow's regularly scheduled Daily Reckoning.

The Best Value in the Resource Share Market

For now, suffice it to say that there IS real economic growth in Asia. And once the global economy emerges from the recession induced by the collapse of the leveraged credit bubble, demand for the resources to build the developing world will resume. Valuations in the resource sector will not be driven by speculative money hitching a ride on soaring commodities prices (the first phase of the commodity boom).

Instead, valuations will be driven by solid balance sheets, excellent projects, and good management (the second phase of the commodity boom). For Aussie resource share investors, it means it will be your best chance since 1987 to buy best-of-breed resource companies leveraged to the urbanisation, industrialisation, and infrastructure trends that are making Asia the new engine of global growth.

But how do you know where to begin your search? In light of the crisis and the appetite for helpful analysis, we've elected to publish a small section of the latest issue of Diggers and Drillers, normally available only to paid subscribers. In it, you'll find what editor Al Robinson is doing now to turn this crisis into an opportunity.

Al has selected his four favourite cash-rich Aussie companies to emerge from the crisis stronger. To protect the investment made by paid-up subscribers, you won't read about those four in this free sample. But we have given you a table of ten firms Al researched and what he found.

How to Find the Safest, Cheapest Resource Stocks During the Crisis
By Al Robinson, Diggers and Drillers

How do you know which undervalued stocks will survive the mauling in finance? You search for the ones with quality assets and cash. Cheap mining and energy companies can use cash to shield their currently-oversold mining, oil, and gold assets.The businesses survive. The cheap assets live on and rise to their real value.

That means steady, satisfying, long-term investment gains for you if you play your cards right in the next few months. I've scanned the entire resource market and laid out the ten of the most cash-greedy stocks. They have some of the most profitable assets; oil wells, coal mines, gold reserves and iron deposits. All are going on a massive sale this month.

But these ten companies are sitting on a $2.1 billion mountain of cash. That's your ticket to safety.

Ten Oversold Resource Firms, Each with a Shield of Cash

This selection includes both producers and juniors. It includes energy and mining stocks. It includes small-caps and mid-caps. It's a table with variety. But they all have big cash accounts in common. Of the resource shares in the top 300 listed Australian companies, these companies have the most liquid backing. They ooze safety compared to the rest of the market. They're getting cheaper just as fast though.

They have minimal short-term debt maturing in the next year. That's just as crucial as the cash balance itself. These companies have liquid assets unsoiled by heavy borrowing. They aren't leveraged to the credit crunch through debt exposure. They are leveraged to the resource boom through asset exposure.

All up, these 10 stocks have over $2.1 billion in cash on hand right now. Their market cap is $6.2 billion. Over 35% of the equity here is un-invested and un-spent.

Credit stretches and contracts like a length of elastic. That gives credit-based companies a wild ride up and a wild ride down. But cash doesn't stretch. It's solid. It sits there. It does nothing until you need it. That time has come.

Overall the companies above have less than $1 million in short term debt. It's insignificant. And above all, every single firm owns a quality project that the market is chronically devaluing this month.

Six are energy stocks. That's not surprising, considering the massive boom in energy company cash-flows over the last year and a bit. Oil, gas and coal assets have leapt in price. Liquidity has flowed to the companies that own them. These ones held onto it.

But the juniors have cash too - if you're brave enough. Some aren't producing yet. They've filled their wallets with clever financing methods instead. And the juniors on that list are still getting a lot of attention from important investors.

Al Robinson
The Daily Reckoning Australia

• The Australian Resource Boom Isn’t Dead Yet
• The Future of the Australian Resource Market, Two Ways the Boom Could End
• Lehman CDS Auction Hammers Australian Resource Stocks
• The Dark Underbelly of Australia’s Resource Boom: Chinese Resource Demand
• Big Australian Resource Stocks Up 24% in 2008

Banks recognize that not all their loans will be repaid. They operate on margins of safety, with reserves set aside for when things go wrong. But in the worlds of swaps, hedge funds and derivatives...slick operators can invest billions with no margins of safety...and no reserves. The result, Gross says, could be catastrophic:

"But today's banking system, as pointed out in recent Investment Outlooks , has morphed into something entirely different and inherently more risky. Our modern shadow banking system craftily dodges the reserve requirements of traditional institutions and promotes a chain letter, pyramid scheme of leverage, based in many cases on no reserve cushion whatsoever. Financial derivatives of all descriptions are involved but credit default swaps (CDS) are perhaps the most egregious offenders. While margin does flow periodically to balance both party's accounts, the conduits that hold CDS contracts are in effect non-regulated banks, much like their hedge fund brethren, with no requirements to hold reserves against a significant 'black swan' run that might break them.

"According to the Bank for International Settlements (BIS), CDS totaling $43 trillion were outstanding at year end 2007, more than half the size of the entire asset base of the global banking system. Total derivatives amount to over $500 trillion, many of them finding their way onto the balance sheets of SIVs, CDOs and other conduits of their ilk comprising the Frankensteinian levered body of shadow banks."

Bill Bonner
The Daily Reckoning Australia

• None Found