It's not normal to see these kinds of one-day moves. But these aren't normal times. Traders love volatility. But if you're going to trade this market, your timing had better be exquisite.

We're back on the edge of a credit abyss. Just when investors were convinced that the Gordon Brownification of the world's banking sector had put the credit crisis behind us, we have more bad news.

Brown's plan to recapitalise British banks by directly inject money into them has been widely adopted. But the money (which isn't the same as capital at all) is not going to be enough to replace the "wealth" being destroyed by debt deflation. It's sort of the opposite of bailing a flooded ship out. In order to keep asset prices from sinking, the bankers need to pump more money into the global sea of liquidity.

But even that does not keep bad debts from sinking to their intrinsic value. Reuters reports that Standard&Poor's may cut its credit rating on over US$351.7 billion worth of residential mortgage backed securities that are secured by Alt-A loans. These aren't subprime loans. They are supposedly loans made to more credit worthy borrowers. But S&P notes that losses on Alt-A loans of five-years or more with fixed interest rates will rise from 35% to 40%.

You can't make this stuff up. As we pointed out, the core of the capital in the banking system is directly tied to securities whose value is tied to the price of U.S. houses. With U.S. house prices falling, more mortgage owners are underwater. More are in default. More will be foreclosed on. The securities tied to those mortgages will need to be marked down.

Until the connection between U.S. housing values and the banking sector is severed, the credit crisis isn't going away. Merely flushing more paper money into bank coffers doesn't improve the bank's solvency. You can't fix a solvency problem with more liquidity any more than you can keep a leaky bathtub full by pouring more water into it.

Stocks now face the dual challenge of an extended global recession (bad for corporate earnings) AND the possibility that it may not be so easy to simply 'recapitalise' the banking system with funny money.

Don't forget. The Keynesian economists running the global financial system are engaged in a giant game of poker with the rest of us. They want us to believe in money backed by nothing but confidence. And they want you to believe that the government can simply increase spending (of money borrowed into existence) to stimulate business activity. If banks and consumers show their doubt by hoarding cash, then the Central Bankers will have to go "all in."

"All in" is another rate cut or two. But more than that, "All in" is direct government support of stock prices (and house prices, and corporate debt, and frankly anything which needs buying to prop up its value). How soon will Paulson, Bernanke, Trichet, Brown and the rest of this gang go "All in?" It won't be long now, at this rate.

"Perhaps what we need is to go back to the first Bretton Woods, to go back to discipline," says ECB head Jean-Claude Trichet. Sound money you say? Hmm. "It's absolutely clear that financial markets need discipline: macroeconomic discipline, monetary discipline, market discipline."

"If we don't discipline ourselves, the world will do it for us," wrote Wiliam Feather. When you don't have access to credit, you are forced to live within your means. Expenses must be lower than income. Or else. But it hasn't been that way for years. Credit has enabled us all to live well above our means. Is that era ending?

Are you witnessing the last stand of the Keynesians? Our friend Gary North wrote earlier this week, "The heart of original Keynesianism was its commitment to government deficits as a way to stimulate consumer demand. Keynes also recommended central bank monetary expansion, but the heart of his economic theory was fiscal imbalance [deficit spending]."

Governments, being inherently political animals, want to promote growth at any cost via inflation. Meanwhile, it is vogue to blame poor regulation and greed. But politicians have to paint the bankers as greedy in order to justify the huge sums of money being transferred from the taxpayer to the banking industry. As Gary writes, "In justifying this immense transfer of taxpayer wealth to the commercial banks, politicians have promised a new era of regulation. They have all blamed American regulators for not regulating the securities market.

"No one is pointing to the main culprit: expansionist Federal Reserve monetary policy under Greenspan, which was matched by central bank policy around the world. Central bankers inflated their national currencies to support the domestic export markets. They did not want the [U.S.] dollar to fall, thereby reducing imports from foreign nations."

"It was the mercantilism of central bank policy that produced the asset bubbles, especially the largest one: residential real estate. This is the ultimate carry trade: borrowed short (months or weeks) and lent long (30 years). When it popped, it removed consumer demand around the world."

The borrowed money went to consumers to buy houses. Now those are falling in price. The whole global supply chain is locking up: from finished goods consumed in America, to capital goods manufactured in China, to raw materials inputs in Australia.

Is the Keynesian answer really the way out? No. The Keynesians always confuse money with capital. What we have on our hands is a historic misallocation of capital on residential real estate. Whole economies grew up around the housing industry in many countries. Tremendous leverage was employed to buy securities related to real estate. It's all crumbling in a great destruction/deflation of value.

You don't simply prevent that by printing more money. Real capital is land, labour, an asset, or entrepreneurship that's capable of generating new wealth. The Fed's low interest rate policy-followed by global central banks everywhere-led investors and consumers and businesses to speculating on higher house prices rather than investing in real economic activity.

You don't restructure a global capital structure easily. As Roger Garrison writes, reviewing the work of the great Anti-Keynesian Friederich Hayek, "The costs of restructuring capital are easily absorbed during a policy-induced boom when credit is cheap and profit expectations are high. But after the bust, the costs of undoing the misallocations caused by unduly cheap credit take the forms of business losses, bankruptcies, and unemployment."

Gee. That sounds familiar. We are now finding out that artificially low interest rates badly skew prices and the information they normally communicate. Not only that, but the low rates have led to a disastrous global misallocation of capital in bogus assets. Houses are tulips full of copper.

"If the interest rate is held below its market, or 'natural,' rate by credit expansion," Garrison writes, "the decisions of producers will be inconsistent with the preference of consumers. The economic expansion will be unsustainable. The boom will end in a bust. Only with a market-determined rate of interest can cyclical variations be avoided."

Markets are telling us the price of money should be much higher, given the huge risks in the global economy. Global regulators are telling us that money is free, and that more of it is all we need to solve the problem. They will keep loaning and printing until the whole world is drowned in a sea of fiat money.

Who do you think is right?

Dan Denning
The Daily Reckoning Australia

• Willem Buiter Attacks Fed Policy
• RBA Buys $780 Million in Residential Mortgage-Backed Securities
• One in Four US banks Announce Unprofitable Quarter
• Rate Cut of 100 Basis Points Couldn’t Cheer Up the All Ords
• Bernanke Calls U.S. Economic Recovery “Nascent”

So the $700 billion TARP plan, at least so far, is a total failure in reflating confidence in the stock markets. Let's hope it fares better in repairing bank balance sheets. But if it doesn't, what's Plan B? More on that in moment.

Here in Australia, the local market is set to follow the global lead and head much lower. The Dow was down as much as 800 points in intraday trading. It managed to close down "just" 340 points for the day. That was good for a one-day loss of 3.3% and a close at 9,984, which is, of course, under 10,000.

You are seeing a forced, global systemic reduction in leverage. Assets bought with borrowed money are being revalued lower and sold. Against this receding tide, the Central Banks of the world are trying to decide which institutions to save and which to let go out to sea, where there will become fish food.

It's not like the bankers aren't trying to throw out life vests. The Fed announced yesterday an increase in its Term Auction Facility to US$900 billion. It is exploring ways to provide short-term, unsecured funding to corporations that can't raise money in the commercial paper market-which has gone into rigor mortis.

By the way, that means the Fed won't be collecting any collateral for prospective loans. Maybe it will accept equities as collateral. But generally, unsecured means...unsecured. That's how bad it is in the credit markets.

The Fed is also now paying interest to banks who keep reserves with the Fed overnight. It's a little confusing. But we reckon what's happening is that the banks are unwilling to lend to one another, even with borrowed Fed money. So they borrow from the Fed, deposit the money back with the Fed and earn interest, and then the Fed loans the money out to other banks.

Do you see what's happened? The banks will deposit with the Fed because it's paying interest. But they will not loan to one another. So the Fed is becoming the middle man in the interbank lending market.

How this gets credit in to the hands of businesses and consumers is beyond our reckoning. Our guess is that it does not. That reminds us that the purpose of the Paulson plan was primarily to recapitalise the banks first and unlock the credit markets second. But it doesn't seem to be working, mostly because asset values continue to plunge, which further dilutes bank capital.

Bridgewater Associates reckons it knows what should be done. "Ending the credit crisis will be highly unlikely without some type of accounting accommodation," it wrote in a note to clients. "Because mark-to-market accounting on existing assets threatens bank capital today, it increases solvency concerns today, which raises funding costs and accelerates the need to sell assets today, which depresses the prices of those assets, which threatens capital and raises funding costs."

"This cycle can be broken if banks communicated an accurate or conservative assessment of the fair value of their assets in the footnotes of their financial statements, thereby telling equity and bond investors what they need to know to value the company. But if these losses were accrued over the remaining life of the assets, thereby avoiding the immediate hit to the book value of capital, the selling pressure would be reduced, which might even allow prices to rise and reverse the cycle and improve sentiment. This seems pretty obvious without any knowledge of history, but history overwhelmingly confirms the need for such a change."

In other words, don't get rid of fair-value accounting. Banks would still have to keep a record of the current market value of their assets. But they wouldn't have to revalue the assets based on that market value. That change might break the relentless cycle of asset selling, higher credit spreads, and more selling.

Then again, maybe it won't. Who knows? Maybe the Feds should bust Andrew Fastow out of Federal prison and set him loose on Wall Street's books. Remember Fastow? He was the lead account for Enron.

Along with Ken Lay and Jeffrey Skilling, Fastow set up a bunch of off-balance sheet partnerships-which he called Special Purpose Entities and named after Star Wars characters...i.e. "Chewco" and "JEDI"-to park Enron's debts and assets as far off the balance sheet as possible.

Enron went from being America's seventh-largest publicly listed company to a $31 billion bankruptcy story, which looks like small potatoes these days. But for awhile, Fastow was able to juggle the assets and debts and make it look like Enron was actually a going concern.

Here's an idea: Free Andrew Fastow! Put him in charge at the Treasury Department! You have to wonder if the Paulson Plan is any different in kind than the Enron Plan-an attempt to keep assets in escrow until they increase in value...or are simply forgotten about.

Dan Denning
The Daily Reckoning Australia

• Surge in Chinese Bank Lending in 2009 Leads to Fall in Bank Capital
• Rally in Stocks and Rise in Aussie Dollar is a Result of the Carry Trade
• The FDIC Is in Trouble
• Credit Markets Threaten Retail Banking, Bank Runs Next?
• Level 3 Assets Growing in All Five U.S. Investment Banks

Then along came the Large Hadron Collider (LHC) in Europe. For complicated reasons, you have to keep temperatures very low in a particle accelerator. Just above absolute zero, in fact. The temperature in the LHC is -271 Celsius (-456 Fahrenheit).

There are only two degrees Celsius between the temperature the LHC operates and Absolute Zero. We reckon the credit markets must be in the middle, right about -272 degrees. It's pretty frigid out there people.

Bloomberg reports that, "The market for commercial paper, short-term borrowing by businesses, suffered the biggest one-week drop on record...The amount of commercial paper outstanding fell by $94.9 billion, or 5.6 percent, during the week ended Oct. 1. " What does that kind of deep freeze look like? Take a peek...

Source: Federal Reserve

Global share markets don't look very convinced the U.S. Senate's passage of a bailout bill will purge the financial sector of the bad debts which are killing it. Perhaps it's because the Senate bill was such a joke.

If you haven't had a chance to go through the bailout bill the Senate passed, don't cheat yourself. You can find it here.

Those with advanced knowledge of American government will know that the spending bills cannot originate in the Senate. Article 1, Section Seven of that useless piece of paper (the U.S. Constitution) says: "All bills for raising revenue shall originate in the House of Representatives; but the Senate may propose or concur with amendments as on other Bills."

This is why the Senate lobotomized a bill already passed by the House. The Senate took a spending bill which had already cleared the House, gutted it as clean as you'd like, and stuffed it full of new spending and tax provisions which the house will vote on tomorrow.

One of the funnier provisions of the Senate bailout bill is Section 503, an "Exemption from excise tax for certain wooden arrows designed for use by children."

Hooray! Everyone gets the shaft! And it's tax free!

According to Bloomberg, "Senators attached a provision repealing a 39-cent excise tax on wooden arrows designed for children..The provision...will save manufacturers such as Rose City Archery in Myrtle Point, Oregon, about $200,000 a year."

And we're supposed to take the Congress seriously? These are the people in charge of America? They're the same people who also just lifted the Statutory Debt limit to US$11.3 trillion.

The Law as a concept is worthy of respect. But when bad lawmakers make bad laws, they undermine the whole institution of the Law. That's what Congress and the President are doing.

It would be funny if it weren't so serious. The plan, or FrankenTARP as we are now calling it includes restriction on judicial review, a suspension of the normal rules for drafting and debating legislation in front of Congress, and allows for the President and Treasury Secretary to come back as many times as they'd like to get up to US$700 billion "at any one time."

It's effectively a down payment on the recapitalisation of the banking system. Once you've committed nearly a trillion dollars to a project, it's a little hard to walk away from isn't it? And with the other provisions about increasing deposit insurance, renegotiating mortgages, and providing relief to renters, you can see many version of this plan being resubmitted to Congress by President Obama and passing (without debate).

So what do you say? Are you ready for some massive, State-sponsored inflation? It will be very different from what Treasury Secretary Andrew Mellon told Herbert Hoover in 1931. Mellon told Hoover:

Liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate. Purge the rottenness out of the system. High costs of living and high living will come down. People will work harder, live a more moral life. Values will be adjusted, and enterprising people will pick up the wrecks from less competent people

The response of the Paulson Treasury Department on the Bernanke Fed is not "liquidate" but "monetize." They won't say that of, course. The expansion in Fed credit and the Treasury plan are supposed to be "loans." We'll see how that goes. Meanwhile, take a look at the Fed's latest statistical release.

Source: Federal Reserve

Dan Denning
The Daily Reckoning Australia

• Every Member of Congress Gets a Copy of I.O.U.S.A.
• A Bailout Bill for the Fed Should be Interesting
• U.S. House of Representatives Passes Climate Change Bill
• Congress Urged to Approve Bailout By George Bush and Warren Buffett
• Ghost of the Great Depression

The financial press will report that the big story this weekend is that the Republicans and Democrats finally agreed on the details of a bailout deal to "save" the economy from imminent collapse. But that is not the story at all. In fact, it's pretty nauseating to see the self- congratulatory smiles on the Senators and Congressmen and women who are on board with the Paulson plan. What have these morons wrought?

Well, on the face of it, the bailout deal is pretty much the program Henry Paulson asked for, with a few bells and whistles to make everyone else happy. It gives him some discretion to negotiate warrants on behalf of the U.S. taxpayer. That gives the taxpayers potential equity in financial firms. Just what we needed.

One interesting rider to the legislation is that it gives the Securities and Exchange Commission the discretion to suspend mark-to-market accounting rules. That could come in handy. If firms don't have to mark troubled assets to market for awhile, they can hang on to them and hope for things to improve. It's also possible that the suspension of the mark-to-market accounting standards is just the cover Team Paulson needs to buy the assets at the non-market (much higher) price.

Don't forget what this bailout deal is all about: recapitalising the banks. You can't do that if you pay them twenty cents on the dollar. The politicians will call it many other things. But you can imagine that behind closed doors the choice was pretty clear. Let the banks get dragged into insolvency or borrow from abroad to recapitalise them.

It amounts to both a wealth transfer and a power transfer. The national penalty for wasting all that capital on a fraudulent housing boom is America's increased dependence on foreign borrowers. The remaining financial institutions not forced out of business have had to partner up with non-U.S. investors, who will now own a piece of future U.S. financial earnings.

Let's not get ahead of ourselves either. When a company goes public, it has to stage a road-show and sell itself to investors. Congress may agree to the concept of borrowing US$700 billion for its nifty bailout deal. But now Hank Paulson has to go out and actually raise that money. And who do you think he will be asking? That's right...China, Japan, Saudi Arabia etc.

There's no guarantee the money will be forthcoming. If it can't be raised abroad (which gives non-U.S. investors a call on future U.S. tax revenues via interest), then the Fed will have to create new money for it. Either way, the people in Washington should realise they are selling their nation into indebted-servitude. But then, they've been doing it for years.

Share markets will probably rally on the news of the bailout deal. And it does seem to close out at least one chapter of the credit crisis. Other things will have to happen, of course. Banks will have to lend. Spreads between inter-bank lending rates and the Fed target rate will have to come down. And the markets must dodge further disaster from the Alt-A mortgage sector and, ye gads, commercial real estate. But how much the banks stand to lose from those developments is not on anyone's radar yet.

What's happening here in Australia? Well, the share market will probably get some relief this week. Are there any buyers out there? We'll find out soon enough.

But now there are rumblings about the Aussie housing market. "Sydney house prices could fall by as much as 30 per cent in the next two years," reports News.com.au "Morgan Stanley chief equity strategist Gerard Minack said prices could fall by as much as 25-30 per cent in the next two or three years if Australia fell into recession, and by 10 per cent or more if we have a soft economic landing."

Ouch. And it's not just Minack. "The International Monetary Fund recently said Australian property was among the most overvalued in the world. It said at least 25 per cent of the increase in value over the past decade could not be justified, leaving the market ripe for a correction."

A bear market in shares and a bear market in property at the same time? That is not the sort of thing to boost consumer confidence or spending. And with business spending falling off a cliff due to the credit crunch, who does that leave to carry the spending burden?

Well, it could be that the economy doesn't need more spending right now. Perhaps it needs more investing. But the Prime Minister is having none of it. The Daily Telegraph reports that Kevin Rudd has already outlined quite a few "nation building" projects to be financed from the $20 billion "Building Australia" fund.

Australia paid off its government debt in 2006. But maybe Rudd feels left out from the great government debt binges in the U.K. and U.S. For twelve years, the Australian government has been a net creditor, with surpluses exceeding government borrowing. It now appears prepared to borrow again.

You can have an interesting economic argument about whether government should borrow to build national infrastructure assets. But it's no wonder people are so comfortable and used to being in debt. It's a way of life in the Western world.

It wasn't just Wall Street greed that led to the crisis. That is what the politicians want everyone to believe as they draft a. But the very same Washington politicians encouraged Fannie Mae and Freddie Mac to extend the dream of homeownership to as many people as possible, regardless of whether they could afford it. And when warned by regulators that the Government Sponsored Enterprises posed a risk to the financial system, Congress hid behind the idea of home ownership.

Now they want to blame it all on the lenders. There is plenty of blame to go around, although no one seems willing to accept any. Instead, we want to pretend that borrowing doesn't have consequences and that wasted money can be instantly replenished with the bailout deal. It's juvenile thinking.

Perhaps that is why the American government is now in the position of asking for allowance money from China the way a 15-year old asks for extra money on the weekend. Let's hope China says yes. Maybe they'll extend our curfew too.

Dan Denning
The Daily Reckoning Australia

• Australia’s Response to the U.S. Bailout Plan
• Level 3 Assets Growing in All Five U.S. Investment Banks
• China’s Economy is Now Freer and More Competitive than the United States
• Keynesians Believe Governments Have to Manage Economy in Macro-Economic Way
• Obama’s New Stimulus Program