Oh wait. We forgot about the 'stress tests.' Remember that's the official government report of how the 19 largest U.S. banks would hold up under further loan losses or asset write downs. It's designed to give investor (and the banks) a transparent picture of how much capital the banks need to be unequivocally healthy.

Actually, it's not designed to do that at all. The 'stress tests' are a white-wash. There's no way the government would release a report to the market that said the banks were in horrible shape (insolvent) and needed billions more in capital to make up for billions of losses in residential and commercial real estate.

That means either the 'stress tests' were a bogus exercise in deception. Or, to the extent they uncovered anything legitimate, it will be leaked in the press and priced into the relevant banks shares before the tests ever hit the public. Besides, the 'stress test' began in 2007. The market's already told us what it thinks of the banks.

One more quick note on commercial real estate. Is it still 'the other shoe to drop' on the banks this year? Maybe it already dropped! The Guardian reports that, "Global sales of investment grade real estate plunged 73% to $47 million in the first quarter from a year ago, or just one-sixth of the level two years ago, according to real estate research firm Real Capital Analytics on Friday."

A 73% cliff dive is as good as a crash in our book. But that figure only refers to new sales. There is a lot of existing debt that has to be refinanced. "Making things worse," the Guardian adds, "the number of properties that need to refinance or need capital infusions is soaring. New reports of defaulted mortgages and failed commercial property companies surpassed $55 billion in the first quarter, bringing the total known distressed commercial properties to $153 billion."

This is one reason to remain suspicious of property and financial stocks this year. In fact, you can pretty much bank on the idea that these stocks will never lead the market again in the way did over the last five years. The sector that leads the market up in a credit boom never really fully recovers as the best-performing sector (think tech stocks).

One thing to watch for? The financial sector and state governments using the Federal wholesaled funding guarantee to trash the country's international credit rating. Macquarie Group used the Fed guarantee to raise $14 billion on international debt markets at the end of the financial year. The company has already set aside $200 million to pay the Feds for the use of the guarantee this year (think about that for a second, this government is 'selling' its credit rating for $200 million).

Macquarie is raising capital this way, "Mainly because Macquarie could actually save money on its deals because it did not have to rely on its lower (and therefore higher risk-rated) single "A" credit rating. Analysts have estimated Macquarie's benefit at $580 million for every $10 billion of new debt raised," reports Danny John in today's Age.

To be fair, Macquarie is also raising money from equity investors too. After announcing write downs that slashed its full year-profit in half, the company told the ASX it had sold $540 million in new equity to institutions. So here's the question...what is the bank loading up for?

By 'loading up' we mean that it's essentially re-arming itself to get back in the market...and do what? "Macquarie is already aiming to build a global stock-broking business centred on Asia, London and New York and to become significantly bigger in energy trading, specifically in oil and gas. It plans to buy new businesses and increase its existing operations with capital injections on the other side of its balance sheet."

Hmm, oil, energy, and Asia? That sounds like a strategy based on decoupling. Remember that? It was the idea that the credit crisis would hurt the U.S. and Europe but not so much the emerging market countries. But it depends on what you mean by 'hurt.'

Equity investors everywhere were 'hurt' in the last 18 months. Nowhere was safe. Nothing was decoupled. So now the question is which economies will recover first: the high-saving emerging markets with growing populations and rising incomes, or the highly-indebted industrial economies that are going even deeper into debt to bail out financial institutions (this is not a trick question.)

By the way, Western governments have been so fixated bailing out their banks they haven't noticed how Chinese banks and companies are providing critical capital to world-class mining projects. China picked up another valuable pebble when China Non-Ferrous Metal Mining Company picked up a controlling stake in the world's largest non-Chinese rare-earths producer for the paltry stake of $505 million on Friday. We'll have more on the sad strategic case of Lynas Corporation tomorrow and whether there is good news buried in the story of Aussie resource investors.

Is it fair to blame the government for leaving strategic assets hung out to dry? That's debatable, and the Treasurer still has to sign off on this deal. But obviously the government has other problems on its mind. On Friday, Treasurer Wayne Swan said government 'revenues' would be about $100 billion less than he expected with last May's budget.

What does all this lead to? We reckon the combined burden of Federal, State, and government-guaranteed bank borrowing is going to put a lot of pressure on the Aussie dollar and lead to higher interest rates. State governments are already under pressure. "Victoria may lose its prized triple-A credit rating as the State Government pushes the state deep into debt to fund new roads, railway lines, hospitals, schools and water projects, one of the big four banks has warned," today's Age reports.

The Wall Street Journal (and international investors) are on to the story too. The Journal reports that, "Australia's major states are all expected to post in the next six weeks a significant deterioration in their fiscal positions, strengthening expectations of a surge in state government bond issuance. A dramatic erosion in traditional revenues from land taxes and mining royalties will be a common theme for all states."

Dan Denning
for The Daily Reckoning Australia

• Economy Free to Recover?
• Bank Stress Test Not Stressful Enough
• Is the Macquarie Model Dead?
• House Prices Down and Aussie Market Enters Second Wave of Rebound Rally
• Australia to Borrow as Much as $300 billion

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

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

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

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

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

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

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

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

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

"It's over."

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

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

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

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

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

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

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

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

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

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

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

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

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

Some reader mail...

Hi Dan & all at DR,

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

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

Kindest Regards

Simon A Blane

Undergraduate student, Edith Cowan University, Perth, Australia.

Sorry about that.

Hi Dan,

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

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

Ian

See above.

Dan Denning
for The Daily Reckoning Australia

• Banks Could Face Serious Trouble from Losses on Residential and Commercial Real Estate
• Latest Energy Bull Market Won’t Be Confined to Crude Oil
• The Trouble With a Sovereign Debt Crisis
• Stress Testing the Banks
• The Glass-Steagall Act Kept Banks in Order Until 1990

Remember this is nothing fancy. Bill is preparing for world depression by ruthlessly cutting back on discretionary expenses. As far as we know, he is still letting people buy him drinks. We're also trying to scrounge up a few copies of I.O.U.S.A. from our mates in the States to raffle off.

As for the rest of the affair, canapés will be on offer. But you're on your own to fill up your stomach after that. Filling up your mind will come from the scintillating conversation to be had with other DR readers. If you haven't already RSVPd, please do so by sending us a note at dr@dailyreckoning.com.au.

And now to a world full of stuff no one wants. Selling stuff you bought with borrowed money is a process that's mostly been confined to the financial markets in 2008. But now we see the behaviour migrating into the economy. At the household level, a collective sense of thrift is beginning to set in. People are selling what they don't need to raise cash.

But let's start with the financial news first. Macquarie Group (ASX:MQG) told investors yesterday that its profit fell by 43%, thanks to write downs in assets. It was the first time since going public twelve years ago the "Millionaire Factory" has reported an earnings decline. Still, the $604 million profit number was higher than what analysts were expecting ($594 million) and the stock finished up over 16.5% on the day.

In the revenue results and write downs you can see how the decline and fall of the investment banking model has hit Australian shores. MQG reported a 13% decline in fee and commission income (to a paltry $2.2 billion). Trading income fell by 14% to $722 million. The big one was the 43% decline in income from asset and equity investments.

There were some strange assets in the back rooms of the Factory. The company took over a billion dollars in write downs on its Italian mortgages and fund management assets. It did not, however, take any write downs on Macquarie Airports or Macquarie Infrastructure Group. Hmmn.

Picture the good ship Macquarie Group as something like a Noah's Ark/Pirate Ship full of a menagerie of debt-financed assets. Under Captain Allan Moss as CEO, Australia's version of Goldman Sachs sailed the high-seas of global finance, buying assets with borrowed money, bundling them into funds, and then charging retail investors fees to invest in the funds. It's the sort of business those Somali pirates who hijack oil tankers should look into. Far more lucrative.

Twelve years of collective booty and swag gave the Factory quite a collection of eccentric and fee-generating assets. Some of those assets are not ageing so well. But you'll note the company chose not to mark down the value of its infrastructure or airport funds, the two big ones.

It claims the current market value of those assets isn't what they are really worth. The book value is more accurate. In the meantime, it is throwing other less attractive assets overboard. Deck chairs...Italian mortgages...extra chickens...everything must go!

There's no doubt that asset values are likely to fall more next year and that revenues will continue to fall too. Still, the company says it will sell $15 billion in assets and then set sail, on the lookout for more acquisitions again. Garn!

It's looking to sell its margin lending book. And new CEO Nick Moore said it will securitise its motor vehicle loan book, move it off the balance sheet, and sell it off. Thus the liquidation continues in the financial world. Loss-making assets are written down or thrown overboard at...er...fire sale prices.

What's really happening, mixed metaphors aside, is that the Millionaire Factory model is giving way to deleveraging reality. In a world with falling asset values and tighter bank credit, it's harder (and much less profitable) to build a cleverly constructed portfolio of assets and generate fee income from operating them.

In the post-credit crunch world (or post-Deluvian, if you accept the nautical metaphor), you have to focus on cash, not debt. One example would be Cash Converters, a sort of Main Street Macquarie, without the debt, and substituting Italian loafers for Italian mortgages. Cash Converters buys low and sells high. It's the perfect business for the first world depression.

Cash Converters helps people turn lazy assets (guitars, mobiles, stereos, old harmonicas) into cash. And what is that but the liquidation of the consumer spending boom? Of course, most stuff isn't worth as much people think it is. When you own something, you tend to think it's worth more than everyone else.

Then you try and auction it on eBay or take it to a pawn shop or Cash Converters. There, you find that it's worth a lot less than you believed in your heart. Such is life, as Ben Cousins and Ned Kelly might say. Kris Sayce at the Australian Small Cap Investigator (whom we often call the Ned Kelly of the Old Hat Factory) has been looking at Cash Converters as an example of what he calls "Main Street Stocks."

We'll let you know what he's up to...but we think it has something to do with companies that actually do more business in a recession and increase both revenues and earnings-without relying on debt. If you have your own suggestions for "Main Street Stocks," let us know at dr@dailyreckoning.com.au

Dan Denning
for the Daily Reckoning Australia

• Is the Macquarie Model Dead?
• Were the Government’s Stress Tests a Bogus Exercise in Deception?
• Commonwealth Bank (ASX: CBA) Nearly Doubles Bad Debts Over Last Year
• Credit Markets Threaten Retail Banking, Bank Runs Next?
• AUD Price of Gold a Measure of Gold’s Strength Against Other Currencies