"Banks recover to their levels before the fall of Lehman," is a headline in this Monday's El Pais from Madrid.

"Public assistance enables the world's largest 15 financial firms to return to the capitalization they had in September 2008," the article continues. The largest of the largest, HSBC, is now judged to be worth $186 billion, according to the stock market. China's ICBC is on its heels, with a market cap of $178 billion. BNP Paribas is 7th at $87 billion.

We will overlook the compromising detail that banks actually lost money in the last quarter - more than $3 billion. And let's forget that China's major banks are sitting on mega-losses from more than eight years ago (to say nothing of the more recent losses). Western banks, too, still have billions in assets whose real worth is an open question...and subject to quick reconsideration...

El Pais goes on to report something intriguing: "The two big Spanish banks leave the crisis stronger."

Ah. What doesn't kill you makes you stronger. The world economy is recovering, or so people believe. Stocks are going up - led by the banks. But are the undead of the banking world really stronger?

Ha ha...don't make us laugh.

But the world seems to believe it. The Wall Street Journal reports that just five big financial stocks are behind the stock market's rally. Fannie Mae, Citigroup, Freddie Mac, Bank of America and AIG account for nearly a third of market's daily turnover. Seems everyone is speculating on the banks...and moving them higher.

You will recall, dear reader, the banks made a fortune during the bubble years. You may also recall that they made so much money that when the bubble years came to a close, that they were almost all broke. Without hasty action from the feds, it would have been the end of the road for every major bank on Wall Street. As it was, even with government help, none of them survived intact. They all either went bankrupt, were sold off, or got bailouts with strings attached.

What busted the banks was too much of a bad thing. They made their money by peddling debt. In order to move the stuff, they convinced clients that their products were good safe investments - even leveraged derivatives backed by subprime mortgages! Such good salesmen were they that they even convinced themselves. When the crisis came, they realized that they had been buyers of the debt...as well as sellers of it. What could they do with it...except sell it to the feds?

But the whole financial industry is coming back to life. According to El Pais, it's back...and it's better than ever.

But wait? How could that be? Hasn't the world entered the worst recession since the great depression? How could lending money be such a good business? People don't borrow in a recession.

Strategic Short Report's Dan Amoss is just as skeptical. "The banking system has no experience managing through the current 'negative home equity' environment," he tells us. "This is an environment in which mortgage rates are already about as low as they can get and consumer balance sheets are as stressed as ever. Due to the nonrecourse nature of mortgages, most borrowers have no financial incentive to keep paying. Many are choosing to mail the keys back to the lender.

"This problem will cap the upside of bank stocks for years to come, so the sector will offer lots of short selling opportunities."

Borrowing by households has fallen off a cliff. Instead of borrowing, they're paying back debt at the fastest rate since the '50s. No money to be made there.

How about commercial and business loans? Are you kidding? Businesses are cutting back too. Businesses borrow to expand...and there is no expansion going on. This is a contraction. Credit is contracting along with everything else.

Then, how could the banks make money? Let's refer to that news item again. Oh...there are the magic words: "Public assistance enables..."

The banks are making money the same way Detroit is making money...dishonestly and temporarily. Instead of doing honest deals with willing and able counterparties, the banks are pulling a fast one. Their money comes, ultimately, from the poor taxpayer...the poor sap who funds all the government's giveaways. The private sector lived far beyond its means during the bubble years. People wasted their money they didn't have on things they didn't need. Now, they try to save their money. But now the government wastes their money for them.

Speaking of which...a quick note on the Cash for Clunkers program. Numbers to be released today are expected to show a peak in sales in August caused by the feds' incentives. President Obama calls the program a showcase, proving how effective government can be at getting the economy back on the road.

But let's go back to basics. It's a sham when people waste their own money. It's a crime when they waste other peoples' money. Prosperity comes from accumulating (saving) capital...and using it to increase productive capacity. The formula is pretty simple: Save your money. Invest it in productive business. The Clunkers program encouraged people to do the opposite - consume capital, other peoples' capital.

'Nuff said.

Bill Bonner
for The Daily Reckoning Australia

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"Chinese economy bounces back," says one headline in the International Herald Tribune.

"JPMorgan profit soars despite downturn," says another.

The average reader or TV viewer will go no further. "Ah," he says to himself, "good news; the worst is over. China is a green shoot as big as the Amazon. And JPMorgan is a leader in the financial sector. If the financial sector is doing well, the whole world economy must be doing well."

But here at The Daily Reckoning, we can't help ourselves. If we see a silver lining, we look for the cloud. We see garbage...we look for the rat... We begin with the JPMorgan profit announcement, because it is the most intriguing. Let us set the stage:

In the last half century, credit has expanded faster even than dress sizes. Naturally, this has made the business of hawking credit extremely profitable. Profits in the financial sector soared to 40% of the U.S. total. And every momma wanted her baby to grow up to be an investment banker.

But then, in 2007 & 2008, the bubble in the financial sector popped. Many banks and financial institutions went broke...or had to be bailed out by the government. Instead of being the world's highest-flying industry...finance became the scene of its biggest crash.

And now, from all we've been able to detect, a fundamental shift has occurred. People are no longer eager to go deeper and deeper into debt. Instead, they are eager to pay off debt...that is, to rid themselves of finance...and to get as far away from the financial sector as possible. Savings rates, for example, have gone from zero to 7% in just the last 12 months.

But in the midst of this remarkable and historic change, we get news that at least a couple of the biggest firms in the financial sector - JPMorgan and Goldman Sachs - are making billions in profits:

"Even as it weathers the worst economic downturn in decades, JPMorgan Chase said Thursday that it had made a $2.7 billion second-quarter profit as a result of stellar trading and investment banking results."

This was essentially the same story we got from Goldman. Neither bank made its money the old fashioned way -- by lending to worthy projects; they made their dough by "trading" and "investment banking." In other words, they made billions from speculation.

Anyone who takes this as evidence of a recovering economy should work for the government. Only a government economist or a mental defective (excuse us for being redundant) could believe that genuine prosperity can be built on a foundation of speculating by large financial institutions. You can see why by asking a simple question: whom were they trading against?

Speculating is a zero-sum game. No matter who wins, the economy is not a bit better off; it has not a centime more in resources. Goldman and JPMorgan report earning, together, more than $6 billion. Who was on the other side of that trade?

There is also something fishy about the whole thing. Trading is not only a zero-sum game, it's a game of chance. Traders lose money about as often as they make it. Of course, normally, the traders at the big banks have an advantage; they are not idiots. They make money by taking it away from the amateur traders, who are idiots. But what amateur traders put up $6 billion?

Our guess: the fix is in. They are taking advantage of the feds' stimulus programs...and trading against the biggest patsy in the world, the U.S. taxpayer. How? We'll find out how, later...

Meanwhile, there is the news that China is back in business.

"Government spending pushes GDP growth to 7.9% for 2nd quarter," reports the IHT, "...fueled by a large economic stimulus package and aggressive bank lending...a surprisingly strong showing during the global economic downturn...

"...while most other major economies are contracting and suffering from the worst economic crisis in decades, China appears to have turned a corner...

"Growth in the second quarter was driven by strong auto and property sales, a rebound in manufacturing and huge infrastructure spending, which was propping up global commodity prices."

Further investigation reveals that bank lending and property speculation have gone wild. (More on this in today's essay, below...) And stocks in Shanghai are up 75% so far this year.

Now, let's try to get this straight. The world is in a slump. China sells stuff to the world. And yet, China is booming.

How could it be? Again, there's something fishy about it...as if the government were jiving the figures...as if the speculators had taken leave of their senses...and as if the whole thing were just the result of the same kind of misguided 'stimulus' that got us into trouble in the first place...

The Richebacher Letter's Rob Parenteau agrees that something isn't quite right. "Ask anyone who's done business there. Keeping a double set of books in China isn't just common, it's considered 'good strategy.' You've also got under-regulated Chinese banks hiding as much as $500 billion in bad debts - China's own version of 'subprime' loans to small businesses and Asian property speculators.

"On top of that, you've got a $40 billion tab left over from the Beijing Olympics... and a $140 billion tab for rebuilding Sichuan after their 2008 earthquake."

Boom...boom...ka-booooom!

Regards,

Bill Bonner
for The Daily Reckoning Australia

• Rising in Defense of Goldman Sachs
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The subprime collapse is one symptom of years of little regulation, under-taxing, overspending, and massive debt. One way to understand what is happening in the United States is to look at what occurred time and again in Latin America and Asia, hotbeds of financial and banking crises. What we are living through happened time and again in Brazil, Argentina, and Mexico, as well as Korea and Thailand.

If there is too much debt, people lose confidence in the banks, then credit markets, currency, and government.

For more than a decade, the international financial cop, the International Monetary Fund, forecast a hurricane was heading toward US shores. As did many heads of the Treasury and the Fed. It is, to paraphrase a great writer, a chronicle of an agony foretold. There are five basic drivers of these crises, all based on excess: high income concentration, too much debt, too much reliance on foreign money, not enough tax revenue, and reckless government spending. Time after time governments believe they are different. They are bombarded by warnings but ignore, postpone, spend even more, and crash.

Over past decades, most US wages have fared poorly. Despite stagnant wages, consumer spending and debt increased, fueled by cheap credit. Companies also went on a debt binge. Careless deregulation allowed financial cowboys to run the system. Responsible CEOs who kept some cash, maintained moderate debt, invested for the long term, got pink slips. Financial chop shops did leveraged buyouts using a company's own cash and credit. To survive, companies piled on debt.

Many politicians decided reelection depended on cutting taxes and offering more benefits. Increase Medicare, postpone Social Security reform, hire more bureaucrats, and pay for a two-front war. Debt grew to pay for this party. These were not true tax cuts, just postponed debt; now we owe more and the bill has come due with interest.

Complicating this crisis is US economic hegemony. There were few places to park a lot of money. Despite the euro, European policies on debts and deficits are not much to brag about. So foreigners have gorged on US debt. The United States continues importing more than it exports. Middle Easterners and Asians who save and invest bought dollars for decades, but some of this money is now fleeing. The dollar has dropped sharply. Gold and oil have skyrocketed. In financial crises, huge pools of capital cross borders very quickly; a few can make a great deal of money shorting the country's currency.

The United States requires a massive restructuring to address its debt, cutting back on its borrowing, spending, and wars. The bailout package is essential to keep the credit markets open. But absent sentences that include the word austerity all the bailout will accomplish is a temporary postponement. Bailout and stimulus are a stopgap.

A solution requires the country to begin to spend what it earns, reduce its mountainous debt, and address massive liabilities, restructure Social Security, pension deficits, military, and Medicare. No wonder politicians would rather spend more of your money now rather than address these problems. Because we have been spending 5 to 7 percent more each year than we earn, a forced restructuring, triggered by a currency collapse, would have the same effect on wages and purchasing power that the housing collapse had on housing prices. So let's learn from our Latin and Asian friends and act before it is too late.

Regards,

Juan Enriquez and Jorge Dominguez
for The Daily Reckoning Australia

• Latin America Has Suddenly Become Very Interesting
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• From Bubble Watch to Bust Watch

As with the weather, there were some hints of trouble here and there on Wall Street. But all in all, things could not have seemed better. Little did we know, the stormy end of 10/9/07 signaled a very large bubble that had just popped.

That was the day when the Dow Jones Industrial Average hit its historic peak. From there, it was all downhill - slowly but steadily at first, and then violently after last August - until the Dow bottomed (for now) on March 9 of this year. Over that span, the index lost 54% of its value.

It's been a crushing blow to just about everyone. But it's already being referred to as the crash. As if the unpleasantness were now all behind us. More likely, in the future it will be seen as, simply, the first crash.

Don't believe it? In a moment you will, when you see the scariest graph of the year.

But let's quickly recall what's already happened. During the late, great housing boom, interest rates were at microscopic levels, while bankers were encouraged to grant home loans on little more than a wink and a nudge. In order to inflate their balance sheets, those bankers resorted to all sorts of gimmicky, adjustable rate mortgages (ARMs), whose common feature was an interest rate that would eventually reset. That is, it would balloon somewhere down the road. And those most likely to come quickly to grief were the riskiest borrowers, who held loans known as "subprime."

"But not to worry," borrowers were told. "Betting on ever-rising home prices is the safest wager in the whole wide world. If you have problems with cash flow when the ARM resets, your house will be worth a lot more, so you can simply sell it and walk away with a nice chunk of change in your pocket." Uh-huh.

The bankers themselves were a little more concerned about the deterioration of their portfolios. They took out insurance in the form of credit default swaps (CDSs). These were a brand-new invention in world financial history, allowing mortgages to be sold and resold until they were leveraged 20 times over. They became the shakiest part of a huge global derivatives market, with a nominal value in the tens of trillions of dollars.

For a while, this Ponzi scheme even worked. But then, as they had to, the ARMs began resetting, and there were defaults. Then more of them. Because at the same time, the housing market was cooling off and the economy was stalling out. More and more people were trapped in a situation where they owed more on their home than they could sell it for. Many simply mailed their keys to the bank and moved on.

All of this wreaked havoc in the derivatives market. Sellers of these exotic packages could no longer establish what they were worth. Buyers couldn't determine a fair price and so stopped buying. As the ripples spread through the world financial system, trust disappeared and liquidity dried up.

Now consider that the base cause for all that dislocation was the subprime sector. And how big is that? Not very. Subprime mortgages account for only about 15% of all home loans. Their influence has been way out of proportion to their numbers, because of derivatives. Here's the good news: the subprime meltdown has about run its course. These loans were resetting en masse in 2007 and the first eight months of '08. Now they're pretty much done.

And the bad news? No one in the mainstream media seems to be asking what should be a pretty obvious question: What about loans other than subprime? Truth is, the banks didn't just trick up their subprime loans. ARMs were the order of the day - across the board.

Now, here's that frightening graph we referred to earlier.

Take a good, long look. You can see that from the beginning of 2007 through September of 2008, subprime loans (the gray bars above) were resetting like crazy. Those are the ones people were walking away from, sending a shockwave from defaults and foreclosures smack into the middle of the economy. Now they're gone.

The ARM market got very quiet between December 2008 and March 2009, hitting a low that won't be seen again until November of 2011. Small wonder a few "green shoots" have poked their heads above ground. But in April, resets began to increase and will reach an intermediate peak in June. After that, they tail off a little, going basically flat for the next ten months.

It's not until May of 2010 that the next wave really hits. From there to October of 2011, the resets will be coming fast and furious. That's 18 months of further turmoil in the housing market, and the beginning is still nearly a year away! (Although the months in between are likely to be no picnic, either.)

While it isn't subprime ARMs that are resetting this time, neither are they prime loans. Those eligible for prime loans wisely tended to stay away from ARMs in the first place, as indicated by the relatively small space they take up on each bar.

No, the next to go are Alt-A's (the white bars), Option ARMs (green) and Unsecuritized ARMs (blue). Alt-A's are loans to the folks who are a small step up from subprime. Unsecuritized loans are a 50-50 proposition; either the borrowers were good enough that they weren't thrown into the CDS pool, or they were so risky no one would insure them.

Those two are bad enough. But Option ARMs are the real black sheep, loans with choices on how large a payment the borrower will make. The options include interest-only or, worse, a minimum payment that is less than interest-only, leading to "negative amortization"-a loan balance that continually gets bigger, not smaller. Imagine what happens with those when the piper calls.

Once the carnage begins, will it be as bad as the subprime crisis? That's the $64K question. Perhaps not. For one thing, subprime loans were a much larger chunk of the market when they started going south. For another, there's been a lot of refinancing as interest rates dropped; that should help ease the default rate. And the government has massively intervened, with measures designed to prop up those who would otherwise lose their homes.

On the other hand, we're in a severe recession, which wasn't the case when the subprime crisis started. More people will be unable to meet payments. And the housing market has continued to decline, pressuring both marginal homeowners and banks that can't sell foreclosed properties.

Is the stock market's next 10/9/07 on the way? Yes. Which day will it be? That's unknowable. It could be in a week, or not for another year.

But make no mistake about it, the second crash is coming. It can't be prevented, no matter what desperate measures Obama and his hapless financial advisors come up with. All we can hope for is that, with a little luck, it won't be as severe as the first one. But it will last longer. We aren't even in the middle of the woods yet, much less on the way out.

Regards,

Doug Hornig
for The Daily Reckoning Australia

• Americans Behind On Mortgage Payments
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What's changed? Well for one, rising layoffs are having an effect on the real economy. Today's papers report that mortgage delinquencies are on the rise. Delinquencies on full-documentation loans are still relatively low. Just 1.75% of full-doc loans are more than thirty days past due, according to a story in the Sydney Morning Herald.

It's the non-conforming, low doc, dare we say subprime-esque loans that are even more delinquent. Nearly twenty percent of low-doc non-conforming loans are more than thirty days past due according to ratings agency Fitch. Fitch says that lower rates haven't helped folks with non-conforming low-doc loans because borrowers can't refinance now that most of the non-traditional non-bank lenders who were making the loans a few years ago have vanished in the credit crunch or been swallowed up by the Big Four.

"Fitch expects delinquencies to deteriorate further during the March quarter and a gulf to develop throughout 2009 between struggling borrowers and those feeling relief from the Reserve Bank of Australia's five interest rate cuts since September. The key factor will be each borrower's ability to retain full employment during the economic downturn, Fitch said."

What else had changed that would cause the RBA to revise its forecast? GDP growth for Australian trading partners has fallen off a cliff. Fourth quarter GDP figures in Japan showed in contracting at a 12.1% annual pace (easily making it the Biggest Loser). American GDP shrank by 6.3% in Q4. Overnight we learned that house prices in the United States have fallen 29% from their peak and 19% in the last twelve months alone, according to the Case-Shiller index, which measures house prices in twenty U.S. cities.

Of course this could get worse later this year if the Option ARM problem we wrote about recently gets worse. The entire current round of stimuli and bailouts assumes no further deterioration in bank loan books. That's a big assumption. The only good news was that Chinese GDP expanded by 6.8% in Q4, although as the chart below shows that's a lot lower than the heady days of 2007, when GDP grew by an almost unbelievable 14%.

Source: www.worldbank.org

But March wasn't all bad, was it? Did you see that the ASX Small Ordinaries had its best month in sixteen years in March? By yesterday's close the ASX Small Ordinaries was up nearly 10% for the month. It hasn't had a big month out like that since December of 1993. The chart below tells the tale.

Small Caps Rally

Source: www.google.com/finance

The energy sub sector of the small caps was the big star in March, up 26.01%. Financials stormed home second, with a 25.29% gain. What a contrast though! Small cap rallies almost always lead broader rallies in the market. And rallies in the market tend to lead recoveries in the economy. Kris Sayce has more on why this is the case in his essay.

We're not prepared to say that one month of good small cap returns heralds a reversal of the major trend in the market. But if you're a punter, it certainly has been good news. And we have always had a soft spot in our heart (and perhaps our head) for the small cap market. It's the small businessmen who lead economies out of recessions by taking risks. This is why the entrepreneur and not the capitalist is the real protagonist of Austrian Economics.

You wouldn't think the best way to beat a recession is to take more risk. But entrepreneurs take advantage of the lack of competition in recessions to find long-term customers. What's more, you have to be a low-cost producer of anything to make it in a recession. And you have to do better with capital than competing firms or investors punish you.

It also depends on the kind of risk you're taking. There are some risks inherent to some businesses, while other risks are more general. Some businesses are more like tightropes and some are more like the trapeze. Small cap finance? Tightrope walking with no net. You might make some money. You could easily break your neck.

Small cap energy? You could break your neck if the firm's management fails to execute its business strategy. But entrepreneurial risk is a different animal entirely than being in something that is by its nature a dangerous business. Taking a punt on finance stocks in the middle of a bear market in credit seems...well...insane. Energy stocks? Not as insane, especially if you're early.

Speaking of energy, the New York Times is reporting that as many as 35 new exploration and production projects from OPEC member nations could be delayed over the coming years, thanks to the oil price crash. Don't mistake dollar strength via competitive currency devaluation with long-term oil weakness.

Yes, oil is going to be a proxy for the strength of the global economy. But over the coming years, a lot of people in the industry are saying that the oil price crash virtually locked in future shortages. The only question is how soon.

Saudi oil minister Ali al-Naimi told the Times, "I have often described unsustainably low oil prices as carrying the seeds of future spikes and volatility. In a low-price environment, the trend is often to focus on survival instead of expansion...If we place a low priority on preparing for the future, that lack of action can come back to haunt us through supply shortages and another round of high prices."

Both the International Energy Agency and the International Monetary Fund agree. IMF deputy managing director John Lipsky says, "The lower that oil prices drop now and the longer they stay low, the greater the negative impact on future supply...In other words, today's low prices could be setting the stage for another price run-up in the future."

No one is interested in the oil story from an investment angle right now. That's what makes us so interested. Industry insiders couldn't be more clear about what they think is coming. And we think that means a big move in oil and oil stocks. You can read more about it here.

Houston based oil man Matt Simmons says, "We are three, six, maybe nine months away from [an oil] price shock...We are not talking about three to five years away -- it will be much sooner...These prices now are dangerously low. The lower prices fall, the less oil will be produced and the greater the chance of an oil spike."

"Unless oil demand falls by 10% or 15% per annum, which it is not going to do, then we don't need to wait for oil demand to come back before we have a supply crunch. Within a few months, we are going to realize our visible inventories are really tight -- squeaky tight -- and what would really be inconvenient is to see a recovery in the economy."

A lot of people would probably disagree with Simmons that a recovery in the economy would be "inconvenient." But it doesn't look he has much to worry about anyway. In fact, the size and scope of the various plans to end the recession are nearly bigger than the economy itself in America.

"The U.S. government and the Federal Reserve have spent, lent or guaranteed $12.8 trillion, an amount that approaches the value of everything produced in the country last year, to stem the longest recession since the 1930s," reports Bloomberg. That number is up 74% since Bloomberg first researched in November of last year. It tallies up to about $42k per American.

Now do you wonder why Russia and China are getting serious about getting out of the dollar? Those commitments by the U.S. authorities are nearly 100% of US GDP (US$14.2 trillion in 2008. Investments like Hunan Valin Iron and Steel's $1.2 billion, which Treasurer Wayne Swan approved last night, make a lot of sense given the unhappy days ahead for the dollar. Tomorrow, more on the "alternative risk scenario of dollar collapse," as presented by the Economist Intelligence Unit.

Dan Denning
for The Daily Reckoning Australia

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Up on stage, our old friend Paul van Eeden is explaining why the price of gold may be overpriced.

"Gold is money," says Paul, "and almost only money." So, you can forget supply and demand. To figure out what the price of gold should be, simply look at what it will buy, in comparison to other currencies. The only time gold leaves its "theoretical value" - as measured by what it will buy - is when speculation drives it up or down beyond what it is really worth.

Paul is certainly right. Based on what it will buy, gold should be only about $800. But speculators look ahead...and so do we. And our guess is that gold is going to become a lot more interesting to speculators. It's above its current "theoretical value" because inflation rates are rising. Investors want to protect themselves. And if inflation rises further, gold will shoot up more.

But, "the real threat you face is located east of one ear and west of the other," says another old friend, Rick Rule. "The subprime economy and the problems it brought us are the result of subprime thinking. A few years ago, there were billboards in Southern California offering to loan people 125% of the value of their houses. Now I ask you, is it a good business to loan more than the collateral is worth to people who can't pay the money back so they can buy over-priced houses? No, of course not. It was subprime thinking."

Rick says that taking the food and energy out of the consumer price index is also sub-prime thinking.

"The measurement of goods and services that the government uses to describe the growth in the economy, calculate productivity and make inflation-adjustments was a total fraud," says Rick.

"Other shoes are going drop," he continues. "Credit cards, for example. They also lend money to people who often can't pay it back. Say, a guy wants to buy a big TV set and can't afford to pay for it. So, he uses his credit card, figuring that it will be easier to pay for it a year later, after paying an additional 18% interest. Then they put millions of these loans together and sell them to a pension fund.

"Or take the loans for leveraged buyouts. It seemed like a great business when sales and profits were rising. But when earnings go down, it becomes hard to service all that debt. In effect, we allowed the Wall Street tycoons to do the same thing as the moron who bought a house he couldn't afford.

"But there are still bankers out there who know what they're doing. They've got a big advantage now...they've got money and others need it. And it's always a competitive advantage when your competition is brain dead. Now there are opportunities in the financial services sector, but you really have to do some real non-sub-prime thinking to find them...and have the courage to the act upon it."

Meanwhile, back to the financial news. Moody's Economy.com:

"U.S. household finances are deteriorating rapidly under the strain of increased debt and falling home prices, threatening the health of the U.S. economy, according to a new research from Moody's Economy.com, a division of Moody's Analytics.

"Household credit quality is rapidly eroding, and overleveraged households are at the heart of the economy's problems," said Mark Zandi, Chief Economist for Moody's Economy.com. "The mounting losses on household debt are straining financial institutions and will keep the economy struggling to grow for the remainder of this year and well into 2009."

But over on Wall Street, the big banks have been staging a major rally, while gold and oil have been falling. Oil was down to $124 the last time we looked. And gold dropped $25 on Wednesday. Wall Street, meanwhile, has come back from the dead - or so it appears.

"Was that the bottom?" Everyone wants to know. Many investors think it was. And they think they can take advantage of it by buying the big banks - run by the same dumbbells who packaged sub-prime loans and sold them to their best customers...and who lost fortunes for their stockholders while paying themselves millions in bonuses.

"More subprime thinking," says Rick.

Bill Bonner
The Daily Reckoning Australia

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What the Saudis give, the Nigerians take away. There was a big oil summit in the Saudi city of Jeddah this weekend. Men in suits from 36 countries, 7 international organisations, and 25 oil companies gathered to solve the world's energy crisis, or at least look like they were doing something.

In a statement released at the end of the summit, the group said, "The transparency and regulation of financial markets should be improved through measures to capture more data on index fund activity and to examine cross-exchange interactions in the crude market."

That doesn't sound like it's going to make oil any cheaper, does it?

The trouble here is that people are divided on what's driving the oil price up. OPEC's Chakib Khelil says it's the deliberately weak U.S. dollar. He says increasing oil supply is "illogical" because oil refineries - the ones that produce refined fuels - already have plenty of supply.

The Italians, the French, and a handful of U.S. politicians are blaming "the speculators." U.S. Senator Joe Lieberman wants to make it illegal for pension funds to invest in commodities. Others blame Asian countries for subsidising consumer fuel prices, which they say prevents higher prices from discouraging demand and leading to lower oil prices.

Gee. There is a lot of blame to go around. Who's right? Well, for starters, the Saudi promise to increase oilproduction to 9.7 million barrels per day was instantly nullified by the loss of nearly 400kpd from oil production in Nigeria. Both Shell and Chevron had to shut off pipelines that were threatened by sabotage in the Niger Delta.

Another explanation is one Bill Bonner offered while we were away on holiday in Colorado earlier this month: the oil vigilantes. That is, professional investors used to monitor inflation via the bond market. Today, oil could be their weapon of choice in trying to combat inflationary monetary policy.

In the past, if governments started printing too much money (leading to inflation), bond vigilantes sold bonds, driving up yields and interest rates (bond prices and yields move in opposite directions). By pushing up market interest rates, the bond vigilantes could tip the economy into recession. It was a handy threat to have in your back pocket.

The bond market enforced monetary discipline by punishing governments that printed too much money. That all seemed to go out the door in the last ten years. Exactly why is a bit of mystery.

Our guess is that everyone bought the bogus line that inflation was dead (the so-called Great Moderation during which you could have growth without inflation). In a world made safe from inflation, there was no need for vigilance! The battle was won. The posts were abandoned. The defences fell into disrepair.

Instead of being vigilant about inflation, investors chased rising asset prices (and higher-yields in riskier bond markets). The easy monetary conditions created the kind of asset inflation that was simply too tempting for most people to resist. Seduced by the simultaneous rise in all asset classes (bonds, stocks, real estate, commodities), no one was especially vigilant from 2002 to June of 2007 (more on last June below).

But when the Fed cut rates from 5.25% to 2% and bailed out Bear Stearns in March, investors began to get nervous that by saving Wall Street, the Fed was dooming the rest of us to much higher prices for oil, food, and anything else priced in dollars. The need for vigilance returned, but how could investors punish the Fed for unleashing inflation and still protect their assets?

Think back to a year ago. This week is the one-year anniversary of the beginning of the subprime crisis. A year ago this week we covered the slow-motion collapse of two Bear Stearns funds, the High Grade Structured Credit Strategies Enhanced Leverage Fund and the High Grade Structured Credit Strategies Fund.

On June 22nd of last year, you could still buy a barrel of West Texas Intermediate crude for $68.85. Today-even after the big oil summit-a barrel of oil traded on NYMEX will cost you $135.02. Oil prices are up 96% since the semi-official beginning of the credit crisis.

On March 17th, when the Fed announced the Bear Stearns bailout, the oil price closed in New York at $105.75. It's up 27% since then.

When you take a step back, it's hard not to see what's going on. The worse the credit crisis gets, the higher the oil price goes. The more the Fed creates new liquidity to try and contain the damage in the credit markets, the higher the oil price goes.

Can you blame investors for wanting to own commodities? Joe Lieberman wants to ban people from doing the sensible thing. Investors see that central banks have lost control of inflation, or are even making it worse. It is not speculation to find a better store of value for your money. It's common sense. No wonder certain governments want to ban it.

Dan Denning
The Daily Reckoning Australia

• Consumer Price Inflation has Spooked Investors Everywhere
• The Confusing Big Picture in the Oil Market
• Price of Oil has Gone Up 40% and 75% of Americans Blame George W. Bush
• Price of Eggs Go Up as Oil Prices Go Up
• Look out! It’s The Bond Vigilantes!

But the trouble with recent news financial news is that the press doesn't know what to do with it. Just today, former crime buster and now New York governor Eliot Spitzer charged the feds with being "partners in crime" with predatory lenders. What do you do with an article like that? Should it go with the crime stories? Or in the Health section? Is it a matter for the police to deal with, in other words... or psychiatrists?

England was made bully prosperous by its dark, satanic mills. But now, spiders build their webs in front of the mill doors, confident of being unmolested. In the City, meanwhile, people come and go in such fury of busyness that the whole world stands back in admiration or disgust.

The City's new Jerusalem makes up one third of Britain's entire economic output... and last year accounted for nearly half of U.K. GDP growth. It pays one third of all corporation tax... contributes a surplus of nearly £20 billion to the trade balance... and there are now more finance sector workers in Britain than there are construction workers, farmers and factory workers COMBINED. So rich and important has the City become that you cannot drive through drunk without running over a millionaire. Every day, it turns over a third of the entire world's foreign exchange - more than $1 trillion.

"London has 40% of the global foreign equity market... trades 70% of all Eurobonds... and is the world's leading market for international insurance," reports the Fleet Street Letter. "Currently the business and finance sector accounts for 28% of Britain's GDP... some £306 billion per year. "That's 21 times more money contributed to the economy than the construction industry... 35 times more money than the automotive sector... 47 times more money than the pharmaceuticals industry..."

But what kind of City on a hill has the City built?

One of the great conceits of the credit expansion was that "finance" was, if not a noble trade, at least it was an honest one. Mothers wanted their babies to grow up to work for Goldman Sachs. Why not? Nothing paid better... and there was no heavy lifting. But what do they actually do 'in finance' and how come they get paid so much for it?

They 'add value' by 'allocating capital efficiently,' comes the answer. But what kind of value has actually been added to Britain's economy... or America's?

In these Daily Reckoning columns, we have made the point that the financial boom was a fraud. It was based on phony money... and produced phony growth. At the end of it, the average American is worse off than when it began. He has more debt... and a lower, real hourly wage.

In Britain, the story is very similar.

Personal debt in Britain has reached £1.3 trillion... (about $2.5 trillion) up 137% since 1993 and greater than the U.K.'s GDP for the very first time. Much of that debt is the notorious 'subprime' mortgage debt. Nearly 20% of all new U.K. mortgages written last year were either "subprime" or were "made to a homebuyer who offered no proof of income", reports the FT . Consequently, 21% more people were forcibly evicted from their homes in 2007 than 2006. The Council or Mortgage Lenders expects repossessions to jump another 50% in 2008! More than 500,000 Britons have missed a mortgage payment in the last 6 months."

On the institutional side, an estimate coming out of the G7 meeting put losses from sub-prime lending alone at $400 billion. So far, only $120 million has been revealed. If the estimate is correct, there is surely more subprime debt hiding in a Wall Street and City basements.

Colleague John Stepek, in the London office, puts it this way: "Our consumers are in more debt than their American counterparts. Our houses are more overvalued. We are even more dependent on a small niche area of the economy -- the City of London -- than Americans are. So we have even further to fall."

He might have added that the FTSE is already down 13% this year, while the Dow is down only 8%. And while the dollar has rallied, the pound has fallen.

Blame the City? Call in the cops to investigate?

It's true, practically all the deals made by Wall Street and the City over the last few years have a bit of Ponzi in them. As long as the volume of credit kept expanding, an investor could hope that a greater fool would buy out his positions at a higher price. Subprime mortgages, liar's loans, private equity finance, Chinese stocks, residential housing, SIVs, CDOs - they all needed more and more leverage, more and more finance, just to stay even.

Many of the new financial products, too, were based on false pretenses. Mathematicians crossed their fingers, calculated the odds based on historical prices, and then passed off the results as though they were as reliable as the periodic tables. If wheat had never traded at $10 a bushel, the $10 figure was an "outlier," not worth worrying about. What they didn't realize, or didn't admit, was that prices are neither fixed nor random - but subject to influence. By speculating on "normal" patterns, they were leaning against the very price curves they said were eternal. And when enough speculators crowded on... the price curve bent, and then collapsed under their weight. "Stability creates instability," as Hyman Minsky used to say.

But prosecutors would have a hard case. No one held a gun to investors' heads. Instead, they asked for it. he whole show was more a slapstick farce than a police thriller.

Bill Bonner
The Daily Reckoning Australia

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Oil rose $2.19 to over $95... and gold held steady.

One thing that bothers us about our dim outlook for the U.S. economy is that so many others seem to see things the same way.

Tim Bond, strategist at Barclays Capital says the "world faces a future of inflation, higher interest rates, lower house and share prices and economic volatility."

Yep, that's what we think too.

He goes on to forecast, "rising real resource prices and a degenerating ecosystem, in turn catalyzing changes to the fundamental structure of the economy."

We're not sure about that last part, but we were with him up to there.

The reason for this assessment is also the same as ours. The world is over-leveraged. People have too much debt. And there are only two ways of reducing debt - either it is actually paid down, which would mean higher savings... less spending... and less "growth" for a consumer economy. Or it could be inflated away... which would bring problems of its own - a collapse of the dollar , most likely... collapse of the bond market... and a collapse of the dollar-based world financial system. The paths are much different, but they both lead to the same place: lower living standards in America... and Britain.

Mervyn King, head man at the Bank of England, said on Wednesday that it's time to face up to a "genuine reduction in our standard of living." He went on to predict that England would most likely see a combination of lower growth... and higher inflation.

Yes, dear reader, it's our old friend stagflation... back after 25 years. And yet, he looks just the same. More than 2/3 of fund managers surveyed by Merrill Lynch say they see stagflation coming for a visit. Which worries us, because we see it too. And these are the same fund managers who were buying subprime debt and borrowing money so they could speculate on Chinese shares at 40 times earnings. Now, the managers are moving to cash. "Risk aversion hits 7-year high," says the newspaper.

Stagflation is a devilish mixture. One part slump... one part inflation... and one part who-knows-what. Of course, the feds are eager to put more inflation into the brew. If they had their druthers, the concoction would have more of a kick - with more exciting price increases and less depressing slump. And to that end, they've come up with a number of rotgut proposals. For example, there is the "stimulus package' signed into law Wednesday. You've heard about it on the news, so we won't give the details. President Bush, signing the new law, applauded the U.S. economy with such gusto - it was as if he didn't realie he had just signed a rescue measure.

"The genius of our system is that it can absorb such shocks and emerge even stronger," said the president. But if the system were so robust, why was the doctor injecting $170 billion of adrenaline? He didn't explain.

Meanwhile, the next article in the same issue of the Financial Times (yesterday's) tells us that the feds also tossed a 'lifeline... to floundering borrowers.' You wouldn't think such a resilient economy would need to give borrowers a lifeline too. With all that adrenaline in their blood, you'd think they could swim up Niagara Falls without a paddle, as they say. "Project Lifeline" is meant to replace the last project called "Hope Now Alliance," for which all hope seems to have given out. How does "Project Lifeline" work? As near as we can tell, the people who took Alan Greenspan's advice to mortgage their houses aggressively, and who now find themselves 'upside down,' with more mortgage than house, can call a toll free number and buy themselves some time.

Meanwhile the news continues to encourage us. Not because it is good, but because it is bad.

Auto loan delinquencies are at a 10-year high. "Repo lots overflow with reclaimed cars," says the USA Today.

The Wall Street Journal reports that more families are falling behind on their heating bills.

And the Guardian , in the U.K., tells us that American students are the "next victims" of the credit crunch. Poor things, they're unable to get financing to continue wasting their time in school; now they're going to have to get a job.

From subprime, to prime, to home equity, to credit cards, to car loans, to buyout financing... the whole credit structure has been hit, some parts worse than others.

Today's news, for example, also tells us that Switzerland's biggest bank has fessed up to $11 billion in subprime related losses... sending the stock to a four-year low.

Bill Bonner
The Daily Reckoning Australia

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There's a man at the Fed who's confused. And now investors, they feel quite abused.

You get the idea. The Dow fell 173 points in New York when Ben Bernanke and Hank Paulson went to Capitol Hill to repeat how bad things are in the housing and credit markets. Australian stocks have opened down to begin the day. So let's unpack what the dynamic duo said, and take a look at a few other non-trivial matters.

Bernanke told the Congress critters that, "The outlook for the economy has worsened in recent months and the downside risks to growth have increased." Yes. They have. "To date," he added, "the largest economic effects of the financial turmoil appear to have been on the housing market, which, as you know, has deteriorated significantly over the past two years or so."

We're not going to spend any time reciting all the evidence that points to more woes in the housing market. It's been well established. What's at stake now is how much longer this slow-motion crisis goes on and-the special burden of today's letter-what happens to stocks in a lower interest rate environment.

Bank of America chief market strategist Joseph Quinlan told investors that the current financial crisis is, "one of the most vicious in financial history." A research paper from his bank says the related fall-out from the crisis has caused $8.6 trillion in stock market losses worldwide, trimming a full 14.6% from the total world market capitalisation.

"It could take months or even years before Wall Street and others get a handle on the true cost of the US subprime meltdown and the attendant global credit crunch," Quinlan added. "While subprime loans were once thought to be relatively small in scale and contained to just one segment of the US financial sector, the opposite has become painfully evident over the past few months."

In New York, Governor Elliott Spitzer-under what authority it is not entirely clear to your editor-has given the monoline bond insurers three to five business days to find new capital or face a break-up. Spitzer wants the mononlines to break up their business into two parts: healthy toxic (Warren Buffet wants to buy the healthy parts, municipal bonds).

And if he has to count to three one more time, they all go straight to bed without dinner.

Why the sudden deadline? After all, we've been slouching toward insolvency for weeks now with the bond insurers. The trouble is, the ambiguity surrounding their future is now bleeding into other borrowing markets, raising borrowing costs for municipalities and leading to outright lending freezes in other markets (like the auction-rate securities we mentioned yesterday.

The gangrene is spread up the leg of the body financial. It is time to amputate. Spitzer reckons that resolution of the monoline's ultimate fate will free up lending in other markets and normal activity can resume. For a moment, let's assume he's right. What happens next?

Well here's the thing. Banks are wary of lending. They know the Fed will keep lowering rates this year as the housing crisis unfolds. But that doesn't mean the banks will loan. What about investors?

"Worldwide risk aversion and cash levels touched new highs in February, according to Merrill Lynch's survey of fund managers, with about 30 pct of respondents saying that they are hedged against further falls in equities over the next three months," according to an article at Forbes.

Investors are sitting on the beach with a pile of cash, waiting for the "all clear" signal to get back in the water. But no one wants to dip a toe in without some convincing bottom in the equity market. Won't someone please ring a bell?

All other things being equal, the chart below suggests to us that investors are going to wait until the Dow retests it 2007 low near 11,500 before bulling their way back into stocks. In reality, a decline below 12,000 would probably clear out a lot of sellers. But markets tend to overshoot on the downside, especially volatile markets. And this one is volatile.

And the All Ords?

The 52-week low for it is at 5,222, or 7.5% below where it trades at right now (5,645). A real cathartic correction would probably take us down to around 5,000 and just under…and at that point, anyone in cash would probably go all in.

Of course the build up of huge cash surpluses doesn't automatically mean investors will buy stocks once they regain their nerve. But it's hard to see investors going aggressively into property, or bonds, or anything else really. Absent even more risk aversion, the cash is going to come into play at some point.

We're still of the opinion that 2008 is going to be the year of the trading range. But today we admit the possibility that while the credit market continues to deflate and struggle and banks continue to mark down and shed assets, lower interest rates and huge cash balances may translate into higher stock prices.

The worst is probably NOT behind us. But as Businessweek reports, "For all the doomsaying, corporate cash abounds. According to Moody's Investors Service a record $1.6 trillion in cash sits on the books of non-financial U.S. companies, $600 billion more than was there five years ago."

Moody's hasn't been earning any gold stars for its foresight lately. But $1.6 trillion is a lot of cash. "The stars have aligned for corporations to start shelling out. Assets are in play or just plain cheaper than they were months ago; buyout shops are overextended and actually backing out of deals; debt is vexingly hard to score. Snooze, and some Beijing banker or Gulf sheikh will beat you to the punch."

There is a perception among some investors that the U.S. dollar is actually undervalued, making U.S. assets (and possible U.S. equities) undervalued too. We do not share this perception. But the idea is gathering steam. So watch for the cash. It could be on the move soon.

Yesterday we mentioned that aluminium might be the first metal to become a casualty of higher coal prices. Coal shortages (and high prices) in South Africa and China have a direct impact on companies that run aluminium smelters. Reuters reports that Eskom, South Africa's main supplier, is considering buying back power it previously committed to supplying the aluminium industry. It would affect BHP's smelters at Bayside and Hillside and the Mozal smelter in Mozambique.

Meanwhile, aluminium rallied yesterday by 4% in trading on the London Metals Exchange. It's a seven month high for "solid electricity" and the biggest one-day gain since late 2006. Chinalco said its smelting capacity would be reduced by storms. Couple that with Eskom's plan to buy back power promised to BHP smelters and you see a hiccup in aluminium production that no one planned for, hence the higher prices.

Dan Denning
The Daily Reckoning Australia

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