There are, I know, politicians and pundits who blame the financial crisis on a "lack of regulation." Frankly, anybody who says that has failed the IQ test, or perhaps the ethics test. For all practical purposes, the American banking system is a branch of the federal government. It has been for decades.

Without government guarantees, backed by taxpayers, Fannie Mae and Freddie Mac could not have attracted the level of investor trust they did. The subprime mortgage and housing bubble wouldn't have been funded. Nor would politicians have had the leverage to pressure banks into offering bad loans. Perhaps most importantly, financial institutions would have had no reason to lavish huge campaign contributions and cushy make-work jobs on the political classes.

The banking crisis, however, is not my primary concern right now. It's happened, despite numerous warnings for years from rational economists and commentators. And it will pass. It is a structural problem, and restructuring is happening even now.

The so-called bailout will delay the emergence of new institutions, but it won't stop it. Alternative institutions are rising that will avoid many of the past mistakes. Some are likely to be offshore. Even Vladimir Putin is talking about metal-backed currencies. It is ironic evidence that others are learning the lessons our political class has forgotten.

My concern at the moment is the federal budget and ongoing deficits. This new expansion of government spending and debt is not some one-time event that markets can repair. According to the Congressional Budget Office, current annual deficits have quadrupled. Independent CBO economists forecast that they will level out in a decade to about triple pre-stimulus levels.

Frankly, I failed to predict the magnitude of these budget increases coming. I expected increases and never believed candidate Obama when he promised to cut net spending. Neither, however, did I imagine he would increase it as much as he has.

It is inevitable, however, that this level of spending will be reduced. It will happen for a variety of reasons. For one, such levels will slow the economic growth Americans are used to. It will stifle productivity and reduce income tax revenues. As it always has before, this will send the political pendulum swinging away from big government.

Incidentally, claims that the spending increases are either a "bailout" or a "stimulus" are bilge. No one has ever seriously tried to explain how spending that does not take place currently can appreciably stimulate the economy in the short run. Still, less than 24% of the stimulus will occur this year. That other 76% stimulates nothing but advocates of government spending.

So today, I want to take the time to deal in some depth with the effects all this will have on breakthrough technologies. I realize, incidentally, that some of my comments may be interpreted as partisan. They shouldn't be. I was a critic of President Bush's spending record as well, though it pales compared with current levels. And for the record, I don't think I've ever registered with either major party, even when I was working with a candidate in the last presidential campaign. He was a Republican, but he understands Federalist principles that would have limited the power of the GOP.

I would gladly vote for the sort of tax-cutting Democrat my father was. Ours was a loyalist Democratic household and my parents revered John F. Kennedy - one of America's great tax cutters. His across-the-board tax cuts were greater proportionately than those passed during the Bush administration. They were enormously successful in promoting spending and economic growth. Give me a Kennedy over a Nixon any day.

Nevertheless, I am prepared for e-mail from those who mistake my criticism of destructively high taxes for partisanship. It's not. Honestly. Economics is called the "dismal science" for a reason. And it often falls to rational economists to play the role of parent, explaining that we just can't afford all those cool toys people want right now.

The term "dismal science," by the way, was coined by a Victorian historian describing the work of Thomas Malthus. Malthus set the standard for doom and gloomers. An Anglican minister and a terrible economist, he predicted the imminent destruction of civilization, if not humanity itself, in the late 1700s. Despite our survival and amazing progress since then, others make similar predictions to this day.

I am, in fact, optimistic about the long run. The economy will not only recover. It will continue to grow exponentially when it does. That doesn't, however, mean that we don't face serious challenges in the short to medium run. This, however, is a unique time historically, with unprecedented opportunities for patient farsighted investors. Rahm Emanuel and Hillary Clinton have both said that you should never let a good crisis be wasted. Though my means of exploiting the crisis are quite different than theirs, I agree with the general sentiment.

There will, however, be delays in technology development. Because so many of the emerging breakthrough technologies today are related to health and longevity, I take those delays personally. While the economy will recover, there are people who will miss out on lifesaving therapies because new technologies are not being funded. This irritates me.

Nevertheless, we need to look at the situation clear-eyed and figure out how to profit from it. And in the process, we may help move some of these revolutionary new technologies forward. There is another Chinese proverb about crises creating opportunity, and this is no exception.

Now, to business.

The most onerous impact of excessive federal spending is the absorption of capital. When finite capital is appropriated through taxation and federal debt creation, this necessarily reduces the level of funding available for research and development.

This simple math is ignored by those who believe it's a good thing to tax the rich, the people who direct most investment capital into emerging technologies. Historically, overall economic well-being is best accomplished through the promotion of new technologies and businesses. Kennedy made that point with his famous statement that "rising tides lift all boats." Right now, the deficit is lowering the tide. Until this sapping of our R&D lifeblood is rectified, transformational technologies will face challenges.

Typically, we know, investors abandon unproven sectors for traditional stability when things get scary. This includes even venture capitalists. New data from PricewaterhouseCoopers, the National Venture Capital Association and Thomson Reuters verify that this is the case.

In the first quarter this year, US venture capital investments fell 61%. In the same quarter a year ago, venture investments were $7.74 billion. This year, the total was barely $3 billion. This is the lowest level in 12 years. Acquisitions of venture-backed companies fell by nearly half from last year. There were no venture-backed IPOs. None.

The one notable bright spot in this picture is health care services. Venture capital investment there is actually up somewhat. As I wrote on several occasions while we were waiting for the train wreck, health care is countercyclical. When times gets tough, the last thing consumers cut back on is medical services.

This is one reason that my Breakthrough Technology Alert portfolio is so heavily weighted with medical biotech today. It's not the only reason, however. It is simply true that a huge percentage of the biggest and most profitable technologies on the near horizon are medical. Significantly longer healthy life, i.e. "time," is the product they will deliver.

Economists talk about the "backward-bending demand curve." It refers to the fact that we max out on stuff. Eventually, if we get enough of something, we value additional units less. Demand for life, however, is unlike any other good or service. It is, in effect, infinite.

Regards,

Patrick Cox
for The Daily Reckoning Australia

• Kennedy and Public Service
• U.S. Government Spending $13 trillion to ‘Fix’ Problems
• Debt Backed Securities Face Deepening Trouble
• The Obama Administration’s Impact on Nuclear Energy
• President Barack Obama and Franklin Roosevelt Are Becoming Akin

Richard Layard from the London School of Economics, offered a way forward:

"We should stop the worship of money and create a more human society," he writes. "Happiness has not risen since the 1950s in the US or Britain," he points out, despite big increases in wealth. "Modern happiness research can help find answers," he believes.

"Old fashioned socialist planning is the only coherent alternative to a collapsing capitalist economy," an alert FT reader added.

Given the depth of these insights, we decided not to dive into this discussion headfirst. Instead, we will simply mock the swimmers from the bank. Brazil's president, Lula da Silva, for example, could only come up with a campaign slogan: "The future of human beings is what really matters." But who can blame them? They want a capitalism that makes people happy...fairer, gentler, greener... they want to reform it...to housebreak it...to cut its balls off so they can safely put it on a leash and introduce it to their daughters.

But they miss the point of it altogether: we can't reform capitalism; it reforms us. Capitalism punishes mistakes and rewards virtue (or good luck) - not necessarily quickly or gently...but roughly and imperfectly, like a hanging judge in a frontier town. On paper, of course, we can do better. Imagine a world where public employees are saints and geniuses who do such a swell job of allocating capital we want for nothing. But then, when we get a chance to see them in action, we find that they are bigger rascals than the capitalists themselves.

This week, under pressure from its new proprietor - the U.S. government - AIG released a list showing who had gotten more than $100 billion of its bailout money. At the top of the list of recipients was a familiar name - Goldman Sachs. In a truly astonishing co-incidence, Goldman is the firm that had been run by the very person who headed up the AIG rescue - former Treasury Secretary Hank Paulson. And what serendipity! Lloyd Bankfein - Goldman's top man now - was actually in the room with the feds when the AIG rescue plan was put together.

"...we can't reform capitalism; it reforms us. Capitalism punishes mistakes and rewards virtue (or good luck) - not necessarily quickly or gently...but roughly and imperfectly..."

In the room; in the deal. But the big scalawags ducked out of the press almost immediately. Instead, the headlines focused on the small fry. AIG paid bonuses of $450 million - some charged it was $1 billion - to its executives. These guys shouldn't get bonuses, came the popular outcry; they should get a firing squad.

You'll recall the story. The insurance giant AIG lost money on a series of gambles. For example, it gambled that it could insure the mortgage payments of people who couldn't afford to buy a house. During the bubble years, people bought houses at outrageous prices. They could borrow 80% of the purchase price from government-backed debt mongers Fannie Mae and Freddie Mac. Buyers were supposed to put up the other 20% themselves, giving lenders a margin of safety in case the transactions didn't work out as planned. But, if an insurance company would guarantee the other 20%, Fannie could cover 100% of this "enhanced" mortgage loan. AIG found that insuring this part of the loan was profitable - as long as nobody asked questions. But then the market price for the collateral dropped - by as much as 50% in some areas. Suddenly, people were walking away from their houses. Defaults on these "enhanced" loans ran at 5 times the rates on normal Fannie-backed mortgages.

An ordinary person would look at these facts and pronounce the same judgment as the capitalist market: AIG and Fannie both deserve to go broke. But give him enough higher education in the economics department, or a job in government, and the fool rushes in --with someone else's money.

In the theory of bailouts, an ailing firm is given a helping hand when it needs it. This gives it time to get back on its feet, and prevents it from dragging down its employees, lenders, investors and counterparties. But what actually happens is much simpler. Money is goes from the pocket of the person who earned it...to the pocket of someone who didn't...from the innocent bystander to the fellow who caused the accident. Capitalism takes money away from erring capitalists; the capitalism improvers give it back to them.

And who decides who gets the loot? Ah...as soon as you hold them up to the light, the angels' wings fall off. By and large, these are the same cherubim and seraphim - such as Hank Paulson - who were supposed to be leading...regulating...and controlling capitalism when it ran into a ditch. Not a single one raised a warning. Instead, they whooped for the free market and passed the whiskey bottle to the driver! And now, thanks to their bailouts, AIG continues writing insurance against mortgage loans. Seventy-three AIG executives continue getting $1 million bonuses. A long line of reckless counterparties goes unpunished. And Hank Paulson offers advice to Financial Times readers on how to make capitalism work better.

But that is always the problem with improving capitalism...even in the slapstick American way. The reformers promise a 'new deal,' but they've always got an ace up their sleeve somewhere.

Bill Bonner
for The Daily Reckoning Australia

• Fannie and Freddie in a Free Market Economy
• Fannie Mae and Freddie Mac Investors Have Already Lost 80% of Their Money
• What’s Going to Happen to the Mortgage Twins – Fannie and Freddie
• Let Us Explain How the Financial Industry Worked
• Feds to Buy Government Debt

Yesterday, the Dow fell 280 points, following a 289-point gain the day before.

We have a feeling the smart money is selling into this rally. Why? Because it is a bear market, and the smart money knows it...

The Daily Reckoning was right all along. At least, that's the line we're taking this morning. We said the stock market topped out in 2000 - and that it would be followed by a massive, long-term bear market. But for the past eight years, this bear market has been delayed...and disguised. It was delayed by the biggest tide of monetary and fiscal liquidity since The Flood. In a matter of months, the U.S. federal budget went from a couple hundred in surplus to several hundred in deficit - a stimulus of more than $700 billion.

Meanwhile, the Greenspan Fed cut rates to 1%...and only reluctantly increased them. In fact, they're still lower than the inflation rate - 6 years later!

This boost of cash and credit held off a serious bear market decline. But it also brought about higher levels of consumer price inflation that disguised what was really going on. Though nominal prices remain more or less in line with where they were 8 to 10 years ago, inflation has knocked their real value down 25-30%.

Who noticed? And even now, people still believe they can get rich if they just hold "stocks for the long run." What they don't realize is that the run can last longer than they can. The previous major peak in stock prices occurred in 1966. Investors then waited until 1982 - 16 years - for the next bull market to begin...and until 2000 for it to reach its apogee. Based on this arithmetic, the next bull market peak may not come until 2034.

What are we worried about? We just celebrated our 60th birthday. (About which, more below...) In 2034, we'll be 86. We'll just wait.

But if smart investors are selling stocks, what do they do with the money? Our advice has been to buy gold. From the looks of it, the smart money is not following that part of our advice. Yesterday, the price of gold fell $26 to $781.

The smart money is looking for safety. But it seems to think that it is better off in US Treasuries than in gold. Yesterday, while gold and stocks both dropped, Treasury bonds went up. The yield on the 10-year T-note fell below 3.6% (yields go down as prices go up). This makes us think the smart money is not as smart as it thinks. Our guess is that the credit of the world's biggest debtor will prove less sure than they believe. The debts and financial obligations of the U.S. government continue to rise many times faster than the growth of the economy. Under the Bush administration, they've gone up faster than ever before in the history of the nation. We doubt that they will go up any more slowly if Obama is elected. Eventually, the United States will be recognized for what it is - a subprime borrower. And eventually, U.S. Treasury bonds will be looked upon as though they were Fannie Mae shares.

*** The U.S. government has just seized the mortgage lenders - Fannie and Freddie. How much that will add to the nation's debts, we don't know. No one knows. When the question was put to the man who should know - Hank Paulson - he replied: "We didn't sit there and figure this out with a calculator."

Apparently, taking control of Mac and Mae was matter of national financial security, something you couldn't put a price tag on. But the cost will be enormous. Sooner or later, someone is bound to get out a calculator.

As USA Today figured it, taxpayers are on the hook for trillions. You'd think you'd hear them squawking, with that kind of burden hoisted on their backs. But nobody really thinks he is going to pay for the housing bailout. Instead, the costs are expected to disappear - like the smell of cigarette smoke in a teenager's room. Too bad, but the smell of debt lingers long after the money has been spent. Eventually, his mother opens the door.

"How will this end?" says Chris Mayer. "I suspect we [the U.S.] are on a path similar to that of Argentina. One day, we'll have some major Argentine-style financial crisis. We'll have Argentine inflation and a similar loss of faith in the banking system and the currency. The government will chew away and destroy a lot of wealth in the process.

"Hopefully, I won't quote myself on that someday soon. In the meantime, though, I think one of the best things an investor can do is focus on buying useful and tangible assets that ought to hold their value against a depreciating paper currency. These assets include oil and gas, metals and minerals and land and water rights. The shares of the companies that own or find these assets ought to do well. Commodities will have their day in the sun once again."

Chris is an old pro at sniffing out useful and tangible assets - just ask his subscribers. If you aren't one of the lucky few under this former banker's wing, now is the time. The door is open for one of the most exclusive opportunities Chris has ever offered his subscribers - but only for a limited time. Tonight, at midnight, this offer ends...so act now.

*** Ouch. Lehman Bros. shares plunged to their lowest level in almost ten years yesterday, falling 45%. They reported a quarterly loss of $4 billion - their worst since going public, and second consecutive loss.

Clearly, the $7.8 billion in writedowns had a hand in pulling the investment bank down, but the execs are singing a different tune. They say that these numbers can be blamed on "attempts to shore up the company's books."

CNNMoney.com reports: "During the quarter, the company said it drastically slimmed down both its commercial and residential real estate holdings by setlling billions of dollars worth of assets as part of a multi-prong restructuring plan."

Despite this 'multi-prong' plan, which includes moving the firm's commercial real estate assets into its own separate entity and reducing its residential real estate holdings by half, fears in the marketplace have not been quelled. The question on everyone's mind: Will the bank reach the fate as Bear Stearns?

"The situation is not a pretty one," say our friends at Strategic Investment. "The big banks keep on revealing even bigger losses. Remember the knockout punch delivered by the S&L crisis in the 1980s? This is bigger. More than 2,500 banks, thrifts, credit unions and mortgage companies wrote a combined $1.5 trillion in subprime loans during the peak of the boom.

"When George W. Bush's dad threw $150 billion at the S&Ls, it helped spark a three-year recession. What happens when Washington tries to defuse a multitrillion dollar time bomb?"

Bill Bonner
for The Daily Reckoning Australia

• Fannie Mae and Freddie Mac Seized By U.S. Government
• Fannie and Freddie Are Surely Doomed
• How Much it Really Cost to Bailout Fannie Mae and Freddie Mac
• Freddie, Fannie Bailouts Leave American Taxpayers Footing the Bill
• The Two Pillars of the U.S. Mortgage Market, Fannie Mae and Freddie Mac, Wobbled Again Yesterday

This weekend's big deal was the U.S. government taking over the "government sponsored enterprises" (GSEs) Fannie Mae and Freddie Mac that guarantee trillions of dollars in mortgages. The "guarantee" is supposedly accomplished by converting bundles of mortgages from the banks and loan companies that originate them (that make the contracts with the buyers of houses) into bonds that can be sold downstream. Risk was theoretically dispersed among the holders of these bonds. This all seemed to work during the long stable period when our cheap oil economy was chugging along, and house prices maintained a consistent relationship with incomes, and people paid their mortgages dependably. The whole system ran like a reliable machine - like a Chrysler slant- six engine!

Until the cheap oil age came to an end. Then, all parts of the system shook apart. It was the end of cheap oil that catalyzed the housing collapse and, by extension, the current huge financial crisis. But the run up to it was like a bounce off a high diving board into an empty pool. The bounce came around 2001 when it became apparent that the U.S. standard-of-living could not be maintained on incomes in a post-cheap- oil economy. The trauma of 9/11 prompted a new and utterly insane consensus to form that the US standard of living could be switched over from income to massive debt. All the normal brakes against irresponsible lending and borrowing came off - embodied in Alan Greenspan's absurd statement that it was a good time to assume an adjustable rate mortgage when interest rates were at a historic low - meaning they could only be adjusted upwards. Why hold Greenspan responsible? Because he was at the apex of the authority vested with establishing norms, and he shoved our behavior into the realm of the recklessly abnormal, and he should have known better.

The public went along with it because "free money" and high living are fun. Their behavior was reinforced by other authorities - for instance, President Bush, who told Americans to go shopping after the 9/11 attacks. (They went shopping with credit cards.) Things really wobbled in 2005 - which was, coincidentally, the year of all-time world-wide peak conventional oil production - with hurricanes Katrina and Rita ripping through the Gulf of Mexico oil rigs as a dramatic highlight. (It was also the year that The Long Emergency was published.)

Since then, the U.S. economy and the financial part of it that became a nine hundred pound tail wagging a thirty-pound dog, has been held together with baling wire, duct tape, and band-aids. All the debt run up by all parties - home-owners, credit-card holders, business, banks, hedge funds, government - is not being paid back reliably, and all the leveraged arrangements that depend on it being paid back are coming apart. Thus, capital disappears. The wealth of a nation disappears. All that remains is the pretense that we are still a wealthy society

Fannie and Freddie are near the center of this black hole of debt. So far, the black hole has been "papered over" by the old stage magician's trick of diverting the audience's attention. The systemic wound that Bear Stearns represented, was covered up with a band-aid applied by the Federal Reserve's exchange of loans for worthless securities. In fact, the capital of Bear Stearns actually did disappear - a mere residue of it, a few cents on the dollar, was shifted to JP Morgan as payment for taking the wrapper off the band-aid. But, basically, the money is gone.

Now, the same thing has happened with Fannie and Freddie, except that the scale is an order of magnitude greater. This time, the U.S. Treasury Department is assuming worthless paper and paying out much larger loans to enterprises that are functionally bankrupt. The exact nature of the government's chartered "sponsorship" has always been ambiguous. Professional opinion has generally held that government backing was implied rather than explicit - but that's a ridiculous internal contradiction that went unchallenged for decades as Fannie and Freddie's Ponzi-style operation lumbered on (and their executives made off with obscene payouts). Now the government's role has suddenly been made explicit. It will probably only make things worse, since the enterprises are too big and over-scaled to work under any circumstances, let alone insolvency.

One thing this points to is a truth that is uniformly overlooked by kibitzers: that what we developed over the past decade in America was not an "information economy" or a "consumer economy" but a suburban sprawl building economy, meaning an economy dedicated to building a living arrangement with no future. The climax of the sprawl building economy occurred in absolute lockstep with the climax of peak oil. You can date it virtually to the month - May, 2005. After that, the future asserted itself and all the financial expectations bound up with sprawl-building went up in a vapor - including the value of mortgages on suburban houses. Everything that followed has been an attempt to cover up this basic reality: that the way we live in America can't continue.

The reason our energy debate is so hollow and idiotic is because we can't face this basic reality. The fantasy-du-jour among both political parties is that we can become "energy independent." By this they mean we can keep on living the way we do by means other than oil. This is just not true. We have to make profound changes in everything we do from the way we inhabit the landscape to the way we produce our food. Lately, the only change we've shown any interest in is changing what our cars run on. But that is not going to rescue us, not even a little. Our inability to talk about anything else except the cars will drag us down into poverty and turmoil.

The housing market is not coming back. Ever. In the form that we knew it. The suburban project is over. That version of the American Dream is over. We'll be a lot better off if we put aside dreaming altogether for a while and start focusing on reality instead - that part of the day when we're awake and capable of actually doing things. We've got a lot to face and a lot to do.

The government takeover of Fannie and Freddie is just another papering- over of our fundamental problem - that until we embark on new ways of being a nation, of living differently and working differently on different things, the other nations of the world will not have confidence in us, or the paper we issue, and we will not really have confidence in ourselves.

I have believed all along - and said as much in The Long Emergency - that we would not get through this crisis without passing through a period of hardship. We're entering it now. Even if the stock markets shoot up five hundred points today on the basis of the Fannie-Freddie deal (and the mistaken belief that our troubles are over), we are only at the beginning of a very painful workout. Personally, I think we're in for financial carnage before the election. The Fannie-Freddie deal may be the place where the wheels really come off.

James Howard Kunstler
for The Daily Reckoning Australia

• How Much it Really Cost to Bailout Fannie Mae and Freddie Mac
• The Two Pillars of the U.S. Mortgage Market, Fannie Mae and Freddie Mac, Wobbled Again Yesterday
• Fannie Mae and Freddie Mac Investors Have Already Lost 80% of Their Money
• Fannie and Freddie Say Goodbye to Veto
• Fannie and Freddie in a Free Market Economy

USA Today was in a blue mood on Friday. The stock market fell more than 300 points the day before, after its reporter realized that falling commodity prices were not necessarily such good news.

"Investors fear that crashing oil, coal and platinum prices signal something far more sinister: a sharp business slowdown abroad that could crimp the economy here and hamper US corporate profits."

Retail sales are weak. On Friday, we reported that unemployment is at a five-year high...and foreclosures have hit a new record.

Of course, when you sell houses to people who can't afford to pay for them, you have to expect to get some returns. And you have to expect that the folks who financed the mortgages will regret it. In the case at hand, the investors who bought shares in the mortgage twins - Mac and Mae - have already lost 80% of their money.

And yesterday, the U.S. government seized control of the mortgage giants. The New York Times reports:

"Hurricane Hank swept through the nation's capital yesterday with gale-force regulatory winds and a tidal surge of federal cash, upending two of Washington's biggest enterprises and permanently changing the landscape of housing finance in America.

"In wresting control of Fannie Mae and Freddie Mac, and in authorizing the Treasury to begin purchases of mortgage-backed securities, Secretary Henry M. Paulson Jr. has taken responsibility for assuring that low-interest loans will continue to flow into the country's hard-hit housing markets. Not since the early days of the Roosevelt administration, at the depth of the Great Depression, has the government taken such a direct role in the workings of the financial system.

"Although the details of yesterday's takeover are complex, the rationale is quite simple: to restore some semblance of normalcy to the housing market. Paulson and other policymakers think that until that happens, neither financial markets nor the wider economy will be able to regain their footing.

"Fannie and Freddie did not go gently into conservatorship. Although their access to badly needed equity capital had dried up and their borrowing costs had increased, they had hoped that they could muddle through by raising fees and demanding higher interest rates from borrowers. But that plan was cut short when Paulson, backed by Fed Chairman Ben Bernanke and their newly empowered regulator, James Lockhart, concluded that Fannie and Freddie could no longer reconcile their sometimes-conflicting obligations to shareholders and homeowners without posing additional risks to an already shaken financial system.

"Under the deal they could not refuse, Fannie and Freddie directors and top executives will lose their jobs. Shareholders will lose their dividends, voting rights and most of their ownership stake, while agreeing to pay dearly for the government's money and backing. Left unharmed will be holders of trillions of dollars in Fannie and Freddie debt - or securities backed by mortgages that Fannie and Freddie have insured against default - who will get all their money back, with interest."

We pause for a moment to review. For a long while, we described the financial world as though it were a war - a battle between the natural forces of deflation (following a bubble)...and the unnatural forces of inflation (as the feds continue to pump up the supply of money and credit).

Early this spring, inflation had the upper hand in this war. Prices were soaring for oil, metals, food, fertilizer - and just about everything else. Commodities were going up because the go-go economies of Brazil, Russia, China and India were going so fast. And not only were their raw materials prices moving up fast, so were there internal labor costs. So, instead of exporting lower priced goods - as they had been for the last 15 years - they began to raise prices too.

Then, the gods of financial war went over to the other side. The emerging economies slowed down. Demand for commodities slumped. The price of oil dropped from a high of $147 down to $106 on Friday. Gold fell down below $800. Yesterday, it rose $2.80 - to end the day at $806. And bonds too are signaling a weaker economy. The 10-year T-Note has risen in price to yield only 3.66%.

What is behind this shift in the fortunes of war? Why are the feds losing this battle?

Well, it's not clear that they are really losing. So far, they are beating an orderly retreat. The economy is pulling back. But the feds believe they can still win. Curiously, all the shooting and casualties have encouraged investors to seek safety. They believe they've found it in the U.S. dollar. Investors expect lower inflation rates; that's why they're willing to buy U.S. bonds and notes at yields well below the current inflation rate. As long as the dollar holds, and inflation rates are under control, they figure they can continue pulling back in good order...until the U.S. consumers get back on their feet.

We don't know what will happen. But that doesn't prevent us from taking a guess - that it ain't gonna work that way - and hang on to our gold.

*** Former Federal Reserve Chairman Paul Volcker says the U.S. financial system is "broken."

At a banking conference in Calgary, he went on to predict that "Growth in the economy in this decade will be the slowest of any decade since the Great Depression, right in the middle of all this financial innovation.''

"It is the most complicated financial crisis I have ever experienced, and I have experienced a few," said Volcker. That's quite a statement from a man who, as Fed chief from 1979 to 1987, had the duty of battling down the runaway inflation of the 1970s.

At the end of last year, Short Fuse and Addison had the opportunity to sit down with Dr. Volcker in his office above Rockefeller Center in New York City for an interview for I.O.U.S.A. He told the movie crew that he felt that the United States was careening down a path it had traveled before, when inflation got the best of the country.

"With respect to the fiscal crisis looming out there in the future," he said, "We'll see whether a democracy can deal with an obvious problem that's going to be present in not too many years. The earlier we take action to deal with it the better."

Until tomorrow,

Bill Bonner
for The Daily Reckoning Australia

• Fannie and Freddie in a Free Market Economy
• What’s Going to Happen to the Mortgage Twins – Fannie and Freddie
• Fannie and Freddie Say Goodbye to Veto
• Fannie and Freddie are Finito
• GSEs Fannie Mae & Freddie Mac on Death Watch

As demonstrated below, the real cost of the bailouts will easily exceed $1.3 trillion. In fact, the real cost is likely to range between $1.3 trillion to $1.6 trillion, and is not unlikely to reach $2.5 trillion.

Between 2001 and 2007, Fannie and Freddie purchased or guaranteed $700 billion of Alt-A and subprime loans. Given the default rates on these loans - and the fact that the price of the housing that is the ultimate security of the loans will, for reasons demonstrated below, fall by at least thirty percent - this alone implies a loss for Fannie and Freddie on the order of $210 billion.

Fannie and Freddie acknowledge already-impaired loans on the balance sheet of $19 billion, which they have used creative accounting to avoid deleting from the shareholder equity account. This means that Fannie and Freddie have a maximum of $64 billion in capital remaining.

Given the inevitable losses on the Alt-A/subprime portion of their portfolio, it must be the case that if the federal government, as it is doing, guarantees Fannie and Freddie's solvency, the difference between the loss and the capital to be made up by the government (i.e., the taxpayers) must equal, not $25 billion but $147 billion.

That alone would mean that the CBO is blowing smoke with their estimated cost figures, and if you think back to the S&L cost of $160 billion, this is not a surprising result. The real picture is so much worse that it is pretty obvious the CBO is flat out inventing figures just to get the politicians through November.

The real story is simple. We have witnessed the largest asset-price bubble in US history, making the tech-stock bubble seem like an overdone weekly rally.

When you look at the graph of the Case-Shiller residential real-estate index, an index dating from 1890 to the present and an index which measures the cost of housing in comparison to other goods, the first thing you see is that the 2001 to 2006 bubble stands out like a fifty foot saguaro cactus in a patch of daisies. There simply has never been

When you know what you are looking at - the biggest bubble in history - it is scary.

To be precise, the Case-Shiller Index in its entire 110-year history had never crossed 140 until the recent bubble. In 2006, it reached 210. Every single real-estate bubble in the past has at best been followed by a fall back to at least the 110 level in the postwar era, although the bubble preceding the Great Depression witnessed a fall to 60.

What this means is that in the best-case scenario, real-estate prices have to fall in the medium to long run by almost half.

Now consider Fannie and Freddie. Just looking at their portfolios on the balance sheet without the guarantees, let us accept (for no particular reason other than a desire that the reader sleep better at night) that real-estate prices only fall by thirty percent.

Well, since Uncle Sam is now committed to "doing whatever it takes," that is a loss right there of $1 trillion. This commitment to keep financial markets open as usual is made in spite of the overwhelming evidence that what we have been taught is usual is in fact delusional, given that Fannie and Freddie own $3 trillion and change of mortgages.

The CBO is not fence-post stupid, so obviously just as in the S&L fiasco in 1988, they are outright inventing figures so that the politicians can slither into November and then announce, Whoops! our numbers were a little low.

The more realistic scenario is actually worse. Fannie and Freddie own and guarantee a total of more than $5 trillion in mortgages.

Given the long-run historically plausible equilibrium values of residential real estate as embodied in the Case-Shiller Index, that means that the taxpayer loss definitely reaches $1.3 trillion, easily ranging up to $1.6 trillion.

Unfortunately, that is the good news. The bad news is that if real-estate prices were to replicate the Great Depression (as would surely occur in the case that hedging instruments of Fannie and Freddie were to catastrophically fail due to counterparty failure - and given the absurdly low risk premiums on credit-default swaps at the height of the bubble, such an event cannot be considered unlikely) the Case-Shiller Index tells us that the loss to the taxpayers could exceed $2.5 trillion dollars.

I don't know what those people in Washington are taking to sleep at night after all their electorally driven accounting and finance exercises, but I can tell you what they will be doing to keep the government open for business: printing a whole lot of money.

Chairman Bernanke has the discount window open to any collateralization not worth the paper it is written on, so in effect he has the helicopters ready to drop hundred-dollar bills over Wall Street - as he once famously described the ultimate policy instrument of a fiat-money system.

Of course, if he does that, we will have to change his nickname from Helicopter Ben to Hyperinflation Ben, which answers the question of who picks up the tab of bailing out Fannie and Freddie: anyone owning dollars.

Produce a lot of something, and it becomes worth less. And given the losses at Fannie and Freddie, the taxpayer guarantee, and the ongoing initiation of Boomer retirement, only the inflation tax will work to pay for keeping Fannie and Freddie afloat.

Like it or not, we are about to enter interesting times, and it is too bad our supposed professional civil servants at the Congressional Budget Office have failed to tell the emperor the truth: that he is buck-naked bankrupt and getting ready to take a lot of people with him.

Our only hope is to (1) accept up front a twenty-percent fall in American living standards for a people living beyond their means for the past twenty-five years on the delusions made possible by fiat money, and (2) simultaneously discipline the creature from Jekyll Island, a.k.a. the Federal Reserve System, not to create new money just to prop up asset-price bubbles.

Regards,

Don A. Rich

for The Daily Reckoning Australia

• Fannie and Freddie Say Goodbye to Veto
• What’s Going to Happen to the Mortgage Twins – Fannie and Freddie
• Freddie and Fannie Hit Hard as Stock Falls to its Lowest Since 1995
• Fannie and Freddie in a Free Market Economy
• Fannie and Freddie are Finito

All of this has Craig James, the lead economist at ComSec, perplexed. "Something has to give unless you are going to have people in their 30s and 40s still living at home with mum and dad...The situation is unsustainable...More homes will need to be built to house our growing population."

Or maybe, as more than one reader has pointed out, we'll go back to living with our parents. Maybe this whole living arrangement of one man, one house is what's unsustainable. Houses have gotten bigger while fewer people are living in them. This is a great luxury, if you can afford it. But maybe this allocation of our collection resources is no longer economic, especially as houses are not a productive asset, but one that you consume.

Besides, for tens of thousands of years human beings lived and evolved together because we needed each other...to hunt, to defend against rival tribes, to sing, to dance, and to raid our neighbours and steal their warm pelts. Maybe life has more meaning when other people need you and you live in small groups. Maybe sitting in front of campfires with the tribe is better than sitting in front of LCDs alone.

On a statistical rather than philosophical note, the ABS also reports jobs data today. With banks raising interest rates and petrol and food prices up, the last blow the economy needs is rising unemployment. Still, you can sense the worm has turned psychologically.

Consumers will spend less because of marginally higher food and petrol prices. But they will also spend less because they are more worried and less confident that a year ago. That's not a recession. But it could take some pressure of the RBA to raise rates later this year. July CPI figures come out in a few weeks. By then, the rate picture for the rest of the year should be clear.

BIS Shrapnel's mining research unit says the next five years will be good for oil, gas, coal, and iron ore, but perhaps not as good for zinc, lead, copper, and nickel. New production for some Aussie commodities is in the pipeline. That increased supply will bring down prices for some commodities. But in others, there still hasn't been enough Aussie investment to meet growing demand.

"We didn't really do enough investment, with the benefit of hindsight, through the 1990s to gear ourselves up for maintaining strong growth in mineral output and what we're trying to do now is catch up," says BIS Adrian Hart. "The next five years will all be about increasing production to meet demand from China and other emerging economies... and once that production comes on stream that will drive weaker prices for a lot of commodities."

Al and Gabriel (the dynamic duo from Diggers and Drillers) concluded that at least one Aussie coal producer was sitting smack dab at a perfect buying price this morning. They are putting out a special buy alert on it. Coal stocks are falling, along with nearly everything else. But coal prices are still looking pretty bullish long-term, making this a great time to be selectively brave, providing you can get the right entry price.

New mines and factories are probably better long-term investments for Australia than new houses. Business investment creates incomes and jobs. Consumer investment in housing creates huge home loans that many people will never pay off if they've bought at inflated prices.

The two pillars of the U.S. mortgage market, Fannie Mae and Freddie Mac, wobbled again yesterday. The U.S. market shuddered. It shows you how important mortgage finance has become to the whole U.S. financial system, and how precarious things are today.

Shares in Freddie were down 24% yesterday while Fannie's shares fell 13%. Investors are now convinced that the firms are going to have to raise new capital and that existing shareholders face massive dilution.

"The solution to pollution is dilution," is an old phrase explaining how the negative effects from a given event can be muted if you disperse them widely enough. Think of waving your hands to disperse the smoke over a hung of burning meat loaf.

Alan Greenspan basically believed the same thing by saying that derivatives allowed for "disaggregated credit risk." Instead of one or two institutions bearing all the risk, everybody owned a little bit. This was supposed to be better global risk management.

Today though, people are beginning to wonder if it was all an elaborately worded hoax. The trouble is that Fannie Mae and Freddie Mac may not have enough capital to cover losses on the mortgages they own and have guaranteed. A bank's capital is basically its cushion against future losses. If the losses greatly exceed the available capital, you're not sitting on a cushion. You're sitting on a black hole.

Fannie and Freddie have trillions of dollars in assets. But remember, a bank's assets are someone else's liability-a loan is a promise to pay. The trouble for Fannie and Freddie is that combined, they own or have guaranteed over US$5.3 trillion in debt and securitised mortgages. Their capital, on the other hand, is slender by comparison, with Fannie having US$38.8 billion in capital and Freddie US$16.3 billion.

Many of Fannie and Freddie's assets are held in off-balance sheet vehicles. That means the banks don't have to boost capital to protect against asset losses since the assets aren't official. They are more like illegitimate children that are maintained in a second home, technically existing but not officially acknowledged. Yesterday's big hubbub was based on what would happen if the GSEs had to move those assets on to the balance sheet (move the kids from the mistress into the household with the wife and kids from the Christmas cards). Near- panic ensued.

The longer-term and not at all trivial or amusing question is how fundamentally sound are the assets owned and guaranteed by the GSEs? The GSEs have a lot of subprime debt that was issued late in the game to the riskiest borrowers. They say they can hold to maturity and don't have any need to sell it.

But what about the soundness of the rest of their portfolios? According to the credit market action yesterday, the answer is that those portfolios appear "increasingly less sound, or at least much riskier." Fannie sold US$3 billion worth of bonds this week to finance its mortgage operations.

Those two-year maturity bonds were priced at a 3.27% yield-which is nearly three quarters of a percentage (74 basis points) higher than what U.S. Treasury notes of the same duration pay. Both yields, by the way, are probably still less than the rate of actual U.S. inflation, hence negative real interest.

"You wanna borrow money Fannie? You're gonna pay." That's what the market's telling us. That spread between Fannie notes and U.S. Treasuries is the biggest since 2000. And the cost of insuring Fannie and Freddie debt against default has gone up too.

We will not ruin your day by discussing credit default swaps in detail. But think of it this way, when you get in a car accident, your insurance premiums go up. Rising credit default swap rates are the market's way of telling us it thinks Fannie and Freddie are more likely to get in an accident, so the cost of insuring their bonds against default has gone up.

All of this is enough to make the market-and anyone who owns debt guaranteed by the GSEs-very very nervous. Incidentally, we've asked APRA if anyone in Australia keeps track of which Australian banks own GSE debt and how much. So far, no luck. If things get worse, we'll find out the hard way.

Finally, for those of you who have questions about the note we sent out yesterday regarding our small cap letter, we'll do our best to respond. There were a lot of inquiries. In Daily Reckoning terms, we'd say we're looking for "positive black swans"-low probability buy high magnitude investment returns from game-changing disruptive technologies (especially in energy).

By the way, of course it wasn't hard to guess which company we were talking about in our letter. As you may have guessed by now, we're not trying to conceal anything. We're trying to be as transparent as possible.

What we are trying to show you is an example of how think as long- term investors and the kinds of investment ideas we aim to produce each month. If that looks interesting to you, great. If not, no worries. You'll still get our free Daily Reckoning every day, for what it's worth.

Dan Denning
The Daily Reckoning Australia

• How Much it Really Cost to Bailout Fannie Mae and Freddie Mac
• What’s Going to Happen to the Mortgage Twins – Fannie and Freddie
• Fannie and Freddie Say Goodbye to Veto
• Fannie Mae and Freddie Mac Seized By U.S. Government
• Fannie Mae and Freddie Mac Investors Have Already Lost 80% of Their Money