Crash of 2007 – Economics 101

Reading time 6,837 words, 16 to 27 minutes.

Bubbles burst. That’s the simple explanation of what’s happening in the financial world in 2007. A lengthy explanation involves an alphabet soup of terminology. I’ll try to make it as simple as possible and outline some of the things I’ve learned lately.

Until recently, most people had never heard of “Derivatives.” These are “structured financial instruments based on assets.” One type of derivative that has been around for a more than a century are Commodity Future Contracts

For example, Ma & Pa Kettle own a grain farm. They notice that in winter, the price of grain is high because there is little supply (grain doesn’t grow in winter.) They also notice that in fall, the price of grain is low because all the grain farmers are bringing their grain to market and therefore the supply is high which drives down the price. On the other side of the equation are the buyers of grain such as Kellogg’s Corn Flakes. Normally, Mr. Kellogg’s products would fluctuate in price if he buys grain in the open market throughout the year.

            Commodity futures contracts allow producers and buyers to “hedge” (protect the price) by flattening this price fluctuation. Ma & Pa Kettle can sell a contract in winter when the price of grain is high to deliver a railcar of grain in fall. A carload of grain costs $40,000 dollars in winter. For a 5% margin ($2,000) the Kettles sell a contract to deliver a carload of grain in fall when a carload normally sells for $30,000. If there’s a bumper crop of grain (high supply) the price could drop even more but the Kettles have “insurance” in the form of a commodity futures contract to protect them. On the other hand, if there’s a drought and the Kettle’s crop fails and they are unable to deliver a carload of grain, they can unload their contract any time before the delivery date and receive the value of their contract, which, in times of drought, would be quite high. Instead of going bankrupt by being unable to deliver a crop, Ma & Pa Kettle survive to farm another year.

            On the other side of the equation, Mr. Kellogg would like to keep his boxes of Corn Flakes from fluctuating in price all year because his customers get annoyed if the price of Corn Flakes keeps going up and down. In fall, when prices are low, Mr. Kellogg can buy commodity futures contracts for a 5% margin for delivery of carloads of grain throughout the year. Thus, the price of a box of cereal can be determined for a lengthy period of time, enabling Mr. Kellogg to deliver his product to the grocery stores for the quoted price to the store owner and a stable price to the customer.

            Speculators also play the commodity futures contract market. Like any investor, they can make a profit by buying low and selling high. If the price of a commodity gets too low, speculators will buy contracts which then tends to raise prices (higher demand = higher price.) If the price of a commodity gets too high, speculators will sell their contracts, which then tends to lower the price (lower demand = lower price) and the difference in price is profit for the speculators. Thus the commodity futures market benefits both producers and consumers. As well, the prospect of profits enables speculators to reduce extreme price fluctuations (this is called arbitrage).

            We’ll come back to Derivatives later but first let’s do a bit of history. Once upon a time in a Galaxy far away, there was a tropical south sea island where everyone lived happily. The weather was nice, fishing was good, fruit trees were plentiful and life was simple. People on the north side of the island were somewhat richer than the south-enders but not enough to cause problems. However, trade was inconvenient because it was based on barter. I had a pig but wanted to trade for chickens. You had goats and wanted my pig so we had to find someone who was willing to trade chickens for goats. Life was made much simpler when they adopted bright red seashells for currency. The wealth of the island consisted of things like grass huts, animals, dugout canoes, fishing nets, etc. Thus, their currency, the bright red seashells, represented the wealth of the island. Seashells were an excellent form of currency because they were durable (unlike fruit which decays) they were portable (unlike boulders which are heavy) and they were in limited supply (the tide would occasionally wash up a few new ones to replace those broken or lost.)

            One day, a freak tide washed up a beach-full of bright red seashells on the south side of the island. South-enders scooped up armloads of seashells before the tide washed most of them out to sea again. Within two weeks, the price of everything on the island had doubled. Why? The wealth of the island had not changed. There were just as many grass huts, dugout canoes and fishing nets as before. What changed was the amount of bright red seashells that represented that wealth. Why would I sell my dugout canoe to a north-ender for the usual 20 seashells if a south-ender was willing to pay twice that? The other thing that changed was that south-enders became richer than north-enders and more of the island’s wealth migrated south. The moral of the story is that money’s value is based on the wealth it represents. Doubling the amount of money does not increase wealth; it only increases inflation.

            Our modern currency, the dollar, was once based on gold. Gold is also a convenient currency because it is durable, portable and in limited supply. It also had the attribute of being divisible (smaller coins) which was good for making change. Throughout history, the value of gold was fairly constant. Note that I said the value of gold, not the price of gold. For instance, it takes as many ounces of gold today to buy a typical mansion as it did 500 years ago in Venice to buy a Palazzo. Another example: in the Old Testament Babylon (600 BCE) an ounce of gold could buy 350 loaves of bread. Today (Sept. 2007), the price of a loaf of good bread is about $2.00 and the price of gold is about $700 an ounce. Divide $700 by $2.00 and you get 350 loaves of bread just like 600 BCE. This demonstrates that the value of gold doesn’t change very much over time. What’s changed is the number of dollars it takes to buy an ounce of gold.

            Several decades ago unscrupulous gangsters known as politicians took our currency off the gold standard. Until that time, currency was redeemable in gold. You could go to the bank and exchange dollars for gold coins. Government Central Banks kept gold under lock and key and the amount of currency the Mint could print was determined by how much gold the government had on reserve. This limited the amount of currency that could be printed. This also kept government fairly honest – at least as much as can be expected from elected gangsters.

            Once our currency was off the gold standard, the supply of currency and, hence, the value of currency was based on faith and the honesty of our elected gangsters. It was no longer restricted to the supply of gold. This is known as fiat currency. Governments could now print as much currency as they wanted. Throughout history, fiat currency has always collapsed from rampant inflation because government gangsters can print as much money as they want in order to bribe us to re-elect them. If you think this is cynical, keep reading and don’t forget the south sea islanders mentioned previously. On the south sea island both the amount of currency and prices doubled. Since 1913 and the creation of the U.S Federal Reserve Bank (responsible for the money supply), the U.S. dollar supply has increased many thousands of percent and the U.S. dollar has lost 98% of its purchasing power.

            In the late 1960’s, American politicians thought they could fight a short war in Vietnam without raising taxes to pay for the war. As the war dragged on and became more costly, President Richard Nixon took the U.S. off the gold reserve in order to print more money (no longer restricted by gold reserves) to pay for the war. It is no coincidence that inflation increased in the 1970’s causing Central Banks to raise interest rates to a painful 20% before inflation was brought under control.

            A bit more history: it is for good reason the 1920’s were called the “Roaring 20’s.” The economy was booming, the stock market was rising, credit was plentiful and euphoria was boundless. Investors could buy stocks on 10% margin. This is known as “Leverage.” A $10 investment could buy $100 worth of stock. Leverage is wonderful as long as the price of an asset was going up. For, instance, a 20% increase in the stock price to $120 = $20 profit which is a 200% increase on the original $10 investment.

However, leverage can be deadly when the price goes down. For instance, a 20% drop in the stock price from $100 to $80 results in a loss of $20. Not only have you lost your original investment of $10 but you also get a “margin call” from your broker telling you to pony up another $10. This is what happened in the Stock Market Crash of 1929. Investors had to sell other stocks to raise the money to cover their margin calls. Selling causes other stock prices to fall so that other investors who were leveraged lost their investments and had to sell other stocks to cover their margin calls and so on. This is the “snow-ball effect.” If you roll a snowball down a snow-covered hill, it gets bigger and bigger. After the Crash, laws were changed and regulations were put in place that severely limited the amount of stocks investors could buy on margin. These regulations today apply to the stock market. However, the do not apply to new instruments called Derivatives (more on this in a moment.)

After the Dot-bomb bubble burst in 2000 and after the scare of 9-11 in 2001, the U.S. Federal Reserve lowered interest rates to 1% in order to stimulate the economy by injecting “liquidity” into the markets. Liquidity is a term we will hear a lot in the future. The difference between money and liquidity is psychological. Money that you hide under your mattress is illiquid. It doesn’t do anything. Liquidity is money that you are willing to invest or lend or buy bonds or put into a savings account. This money flows through the markets and lubricates the economy.

Markets are driven by two emotions: fear and greed. Investors wanted to earn more than a paltry 1% a year. Since a large amount of liquidity was injected and savings and bond interest was low, investors looked for new ways to earn profits. Hence the rise of derivatives mentioned previously. There are many types of derivatives other than commodity futures contracts discussed above. There are CDS’s (Credit Default Swaps – more on this later), there are Equity (stock) based, there are Interest Rate contracts, Foreign Exchange contracts, ETF’s (Exchange traded funds) CLO’s (Collateralized Loan Obligations) CDO’s (Collateralized Debt Obligations) RMBS’s (Residential Mortgaged Backed Securities) SIV’s (Structured Investment Vehicles) to name only a few, and there are even derivatives based on weather.

Weather derivatives are not as strange as it seems. Suppose I own an Amusement Park. It relies on good weather. Few people go to an amusement park when it rains. As a form of insurance, I can sell a weather derivative. I’ll give you $1,000 if you promise to pay me $10,000 per day for every day it rains more than 10 days a month. You look at the weather history and, on average it rains 4 or 5 days a month so you calculate that the chance of more than 10 days of rain is a good risk. However, if it does rain 11 days a month you owe me $10,000 (10 times leverage on the $1,000 I gave you.) if it rains 30 days a month you owe me 20 X $10,000 = $200,000 (200 times leverage.)

Leverage of 200 is very risky. You can reduce the risk by spreading it around by creating a new derivative. Remember, the definition of derivative is a “structured financial instrument based on an asset.” Structured means it’s created. In this case the financial asset is the original weather derivative. You and other investors who purchased weather derivatives can pool all your derivatives, slice and dice them and sell them as bonds to other investors. This way, the risk is not concentrated with one investor but it is spread around so no single investor is at great risk. If it rains a lot in one part of the country, there’s probably fair weather in most other parts of the country so this reduces risk by spreading it among many investors (at least that’s the theory.) Furthermore, these bonds are now considered assets. Bondholders can go to the bank and borrow money using these bonds as collateral. This borrowed money can then be re-invested.

An interesting thing is happening here. The same dollar keeps getting re-invested. The number of derivatives keeps growing as investors borrow using derivatives as collateral and thus they leverage a 1% gain into 40% and 60% and 80% profits. This is known as a “house of cards.” If you’ve ever built a structure out of playing cards you know how precarious the structure becomes the larger it gets. Pull any one card out from a house of cards and the whole thing collapses.

Furthermore, as the global economy kept expanding the past few years, financial markets began to “monetize” debt. These structured financial instruments came to be used as a store of value and a medium of exchange i.e. money. Financial Analyst, Doug Noland, has been warning us for some time of the dangers in using financial assets and derivatives as money. Borrowing made the world richer because both the cash received and the increased debt functioned as money. However, if something sounds too good to be true ……

Most of the derivatives described above are new. Derivatives are unregulated. Derivatives are the Wild West of the financial world. No one really knows how much money is tied up in derivatives because many are sold privately (also known as OTC – Over the Counter.) Estimates vary from $400 trillion to $1,000 trillion worldwide. That’s more money than most people can imagine. A trillion is a thousand billion and a billion is a thousand million. To put this into perspective, the U.S. GDP (annual Gross Domestic Product – all the goods and services produced) is about $14 trillion. Global GDP is about $50 trillion (all dollars in U.S.) This means that derivatives outnumber the entire global GDP anywhere from 8 to 20 times. That’s a lot of money. That’s a lot of liquidity.  That’s a lot of leverage. As long as it stays liquid; so far so good. However, remember what happened to the highly leveraged stock market in 1929 when prices started to fall? Today, hedge funds suddenly realize that a stack of derivatives isn’t the same thing as a stack of dollar bills, especially since you can’t buy a loaf of bread with a derivative and especially if you try to sell derivatives and nobody wants them. When they tried to sell CDO’s based on sub-prime mortgages they found few buyers and they offered a measly 30 cents on the dollar. Oops! A more detailed explanation follows.

The U.S. economy is a consumer-based economy. The U.S. consumer is tapped out. Their credit cards are maxed out, savings are less than zero and, as long as real estate prices were rising, homeowners could borrow on the increasing equity in their homes to buy vacations and SUV’s and wide-screen TV’s. Complacency set in as people began to think prices would go up forever. However, trees don’t grow to the sky and all bubbles eventually burst. Consumers are now spending less, retail sales are down and corporate profits are declining. Is the U.S. going into a recession? The answer is definitely “yes.” Will the Canadian economy follow? Since 80% of our trade is with the U.S., the answer is also “yes.” How deep will the recession be? That depends on bursting bubbles. It also depends on a lot of other factors. Keep reading.

Compounding the problem is the sub-prime mortgage crisis. In 2003 and escalating every year after, financial institutions began to lend what became known as NINJA mortgages (No Income, No Jobs or Assets.) No money down and no credit checks meant that anyone could afford $300,000 dollar homes on ARM’s (Adjustable Rate Mortgages) known as “Teaser Loans” at 1% or 2% interest rates. After a year or two, these adjustable rate mortgages re-set to current rates. On other words, cheap mortgage payments suddenly doubled or tripled. Many low income home owners are unable to make these increased mortgage payments and the rate of foreclosures is rising. In July 2007, foreclosures were 93% higher than July, 2006. These foreclosed homes are being put up for sale at a time when real estate prices are already falling. Putting more houses on the market increases the supply of unsold homes, which drives prices even lower. Real estate agents call these sub-prime mortgages “Neutron Loans” because they destroy people but leave houses. The U.S. real estate bubble is bursting now just as the dot-bomb bubble burst seven years ago.

The sub-prime mortgage crisis is escalating because the amount of sub-prime mortgages being re-set is increasing every month. In January of this year, about $22 billion in mortgages reset. In March it was $35 billion, in June $42 billion, August $52 billion and the numbers won’t peak until March of 2008 at $110 billion a month. They won’t stop then but the dollar amounts will slowly decrease every month until the end of next year. However, these numbers are cumulative. They don’t just change from month to month; they add up to trillions of dollars and millions of homes at risk. Not every sub-prime mortgage holder will foreclose but, as the U.S. economy slides into recession and more people lose their jobs or benefits, the percentage of foreclosures will escalate. Presently about 20% of sub-primes are in arrears (more than 60 days overdue.) In another month they’ll be foreclosing. This will be a snowball effect and this is just one element in what is beginning to look like the Perfect Storm.

This is just the tip of the sub-prime mortgage iceberg. Financial institutions like banks and mortgage companies don’t like to hold risk. What they’ve done is combine a lot of different grades of mortgages into a pool and slice and dice them into bonds. They pay credit-rating agencies to rate these bonds and then they sell them to hedge funds, pension funds, mutual funds, endowments and other investors. Credit rating agencies review these bonds which consist of various grades of risk from AAA (triple A is excellent, low credit risk) down to B (high risk) and they give the bonds an AAA rating because the high risk mortgages are a small percentage and the expected defaults on the high risk is low as an overall percentage. Since this is new and uncharted territory and since they haven’t been re-sold on the market yet, the selling financial institutions use a “Mark to Model” mathematical formula to value them. This is a euphemism for a wild-ass guess. Guess what? They guessed wrong. U.S. investment bank, Bear Stearns, had two hedge funds that tried to sell some of these CDO’s (Collateralized Debt Obligations) and they received offers of about 30% of their value. “Vulture” funds offered them 5%. Both hedge funds quickly withdrew them from the market and one promptly went broke. Investors in hedge funds don’t like losing money so, to protect their reputation, Bear Stearns poured several billion dollars of their own money into the funds.

This did not go unnoticed. World-wide, about 50 other hedge funds have gone bankrupt for similar reasons. There are thousands of hedge funds but the number going broke keeps rising. Many banks are also in trouble. In the middle of August, western (government) Central Banks offered about $500 billion to the market. This provided a bit of confidence and stock markets temporarily stopped dropping. However, it has not solved the problem. This merely affects the “over-night” rate that banks lend to each other and they aren’t lending because much of their money is tied up in the sub-prime mortgage mess and is therefore frozen because nobody wants to be the first one to start selling them at a loss. They aren’t lending because derivatives are not transparent so the lending back doesn’t know if the collateral is good or garbage. If the borrowing bank goes bankrupt, the lending bank doesn’t want to be stuck with garbage. Central Banks announced they would do whatever was necessary (i.e. more lending) and increased the lending period from over-night to 30 days (and more if necessary.) In other words, not only are the mint’s printing presses running 24/7 they’ve now been put on steroids.

Credit rating agencies, fearing future lawsuits, said, “Oops, we’ll have to review our ratings.” This sent another shock wave through the financial world. Pension fund’s charters restrict them to investing only in AAA securities. If the bonds they own are downgraded, they’ll have to unload them. However, if they sell them, they’ll either sell at a 70% loss or be unable to find any buyers. There is a great deal of pressure on financial institutions to NOT sell because then the reduced value will be “official” and trillions of dollars of assets world-wide will be re-rated and losses will escalate. Many financial institutions are doing nothing, burying their heads in the sand and hoping the problem goes away. However, the problem is too big to go away.

Another problem that is causing concern is redemptions or rather the increasing difficulty in making them. Funds have “hard” locks (investors are locked in for years) or “soft” locks (investors make applications to withdraw funds within a month.) Funds are starting to stall even soft lock redemptions. If you want your money, send them a letter (one week) and they’ll process it (more time) then they’ll mail you an application (another week) and you fill it in and mail it back (another week) and they process it (more time) and if they decide you made a mistake they’ll mail it back (another week) and so it goes. They’re trying to stall for time. They’re reluctant to allow redemptions because they need to sell assets to raise capital for redemptions and nobody wants to buy their assets. Investors are also finding their requests for transfer to “safer” Treasury Bills are not being done and in some cases, they are being transferred to even riskier funds without their knowledge.

Another unknown risk are CDS’s (I told you I’d get around to these.) They are Credit Default Swaps, another form of derivative and another type of insurance that allows investors or banks to pass on the risk of loans defaulting. Because most of these are sold OTC (Over the Counter) they are private and no one knows how large this market is (have we heard this before?) Estimates are in the billions covering loans in the trillions. Wait a minute, how can you have billions covering trillions? Once again it’s called leverage. Once again, it’s unregulated. It’s like a 100 people taking out an insurance policy on one person’s life. If that person dies, a 100 people are lined up to collect the payout and the insurance company says “Sorry we don’t have the assets” (although they collected the premiums willingly enough.) Even if they had the assets, they’re frozen in a state of fear so they are unable to pay out. There are companies that are leveraged 150 to 180 times. Ticking time bomb, anyone?

Some people mistakenly believe that all these problems affect only the rich. After all how many ordinary people are invested in hedge funds, many of which require assets of a $1 million or more? Sorry to burst your bubble (no pun intended) but this crisis will affect everyone. About $90 billion in ordinary debt is rolled over every month. The modern business world floats on debt. Business investment in new buildings and equipment needs a liquid debt market. Applying for a credit card involves a willing financial institution. Home owners whose mortgages are expiring need to renew their mortgages and will have a much harder time finding lenders and will be faced with higher interest rates. Investment banks are shutting down their mortgage divisions and starting to lay off tens of thousand of employees. Credit card companies and other financial institutions are rapidly raising standards and penalties and cutting credit lines. And, this is only the beginning of the panic.  

Not only are we seeing the beginning of a credit crisis (funds frozen) and a debt crisis (sub-prime mortgages) but, more importantly we are seeing a crisis of confidence. Remember, fiat currencies are no longer based on gold. They are based on faith and confidence in governments to manage the money supply. When confidence is lost, currency becomes worthless. Governments first made the mistake of keeping interest rates too low (1%) for too long (more than a year) which made borrowing very cheap and increased massive amounts of liquidity. Now they’re attempting to prolong the reckoning by increasing liquidity even more. You can’t put out a fire by throwing more gasoline on it. Failure is a natural part of the business cycle and delaying the inevitable financial failures and losses only builds up the pressure so instead of a trickle, the dam will eventually burst.

The confidence crisis is also becoming apparent in the increasing number of people who no longer believe the statistics the government is trying to peddle. The employment numbers are fictitious. Consumer price indexes are fudged – see WWW.shadowstats.com for a look behind government economic reporting. M3 (money supply statistics) is no longer being released because governments don’t want people to see how massive the increase in the money supply really is because an increase in the money supply translates into an increased inflation and demands for higher wages. There’s even a report (unverified as yet) that President Bush issued an executive order (presidential decree bypassing Congress) that allows the Dept. of Homeland Security to declare secret any adverse corporate financial reports. A moment’s thought will reveal what would happen if XYZ Corporation announced to its shareholders it could not release its financial report because Homeland Security declared it a top secret. Shareholders would sell stocks in a flash. The government’s not stupid; they realize this. So what do you think they’ll do? As always, they’ll fudge the numbers. Not only can we not believe government statistics, we can’t even believe U.S. corporate financial results anymore.

Adding to the lack of confidence is Ben Bernanke, the new and untested chairman of the U.S. Federal Reserve. In a former life he was a professor. Have you ever known a professor who could find his reflection in a mirror? His claim to fame was studying the Great Depression of the 1930’s. This is like the Generals who prepare for the last war. Conditions in the 1930’s were completely different than they are now. Today, the U.S. is in worse shape than before any previous recession: real GDP is down, income growth is down, employment growth is falling and so are retail sales, savings, homeowners equity and house prices. Is there any good news? Most importantly, in the 1930’s they didn’t have enough liquidity and needed more. Today, we have too much liquidity and need less. In August, Bernanke began applying the solution that might have prevented the Great Depression of the 1930’s. He’s adding more liquidity at a time when we need less. In fairness, the liquidity the Central Banks recently injected is the Discount rate. It’s an overnight rate and the short duration usually doesn’t add to inflation. This Discount rate is the benchmark banks use to lend each other money. So fearful have banks become of lending that they were raising the interest rates that they lend each other. So, the Central banks extended the duration to 30 days “and longer if necessary.” However, it’s not enough. Banks who have the funds are afraid to lend them to other banks. The Fed is even allowing banks to move up to 30% of their capital to cover their brokerage divisions. This is what led to bank failures in the 1930’s. We never learn. The entire global economy is based on confidence (not gold) and confidence is fast disappearing.

Bernanke is also caught between a rock and a hard place. Part of the problem today is the massive amount of U.S. dollars held in foreign reserves as a result of the U.S. trade imbalance (too many imports, not enough exports.) For decades, the U.S. dollar has been the world’s “reserve currency” (it used to be gold.) In the last two years, more and more foreign governments have quietly announced they are “diversifying their reserves” which means they are no longer accepting U.S. dollars. The Chinese are sitting on 1.3 trillion U.S. dollars. They desperately want to diversify by buying real assets with their paper money. Every time they try to buy an American company, they’re slapped down. The Chinese don’t have endless patience and they aren’t afraid to use this money as a hammer. There’s an old saying “If you owe the bank thousands, you’re in trouble, if you owe them billions, they’re in trouble.”  The Chinese have a 1.3 trillion dollar hammer and one of these days they are going to use it.

The result of all this is a falling U.S. dollar (this is one reason the Canadian dollar is strengthening.) On the one hand Bernake needs to raise interest rates to increase demand for the U.S. dollar and drive its price back up. On the other hand, he needs to lower the interest rate to cushion the millions of sub-prime mortgages that are being re-set to current rates. He can’t do both at the same time. The Americans are in an election cycle. Foreign holders of U.S dollars don’t vote. American homeowners do vote. On September 18th he lowered interest rates, which will again increase the money supply and inject even more liquidity into markets already awash with liquidity. Although this may delay the inevitable, the resulting inflation will be massive but by that time the election will be over and the new President will be left holding the bag and the Republicans will say “Look what a mess he made so vote for us next time.” On both sides of the border, we’ll all be paying the price and the price may be massive inflation. 

Central Banks of the world are geared to reacting to economic downturns, not financial market volatility. They are reactive not proactive. They rely on historical data i.e. last month’s or last quarter’s statistics to make decisions (and those numbers are fudged.) In early August, Ben Bernanke was telling us “economic fundamentals were still strong” while the worlds financial markets were crumbling under his feet. Historically, it takes the U.S. Federal Reserve 4 to 12 months to react to changes in the economy. And then it takes from 6 to 18 months for changes in interest rates to work their way through the economy and have their intended affect. To Bernanke’s credit, he actually anticipated the worsening economic situation with his recent .5% interest rate cut. However, the market anticipated only a .25% cut and by doubling that he shows signs of panic (maybe he knows that the situation is even worse than imagined) and he again stokes the flames of inflation.

Meanwhile billions of dollars in equity buy-outs are on hold (including the Chrysler buy-out) and about $270 billion in commercial paper in the U.S. alone is waiting for funds to unfreeze. Lenders are afraid to lend. And, the numbers keep increasing every month. Normally, about $90 billion dollars of debt are rolled over every month and to stop it is to stop the economy from functioning. Behind the scenes, governments are probably buying assets and stocks in a vain attempt to cushion falling prices but there is a limit to how much unwanted, illiquid assets they can buy. Central Banks can’t buy junk without destroying Treasury Bonds and their currencies. Bottom line: we cannot rely on the very governments who created the problem with their easy money, low rates and liquidity to solve the very problem with more liquidity. The problem is not lack of liquidity; the problem is solvency. Many financial institutions are insolvent. As we’ve seen, Central Banks keep adding fuel to the fire hoping to revive the beast. If all the massive leverage and credit outstanding begins to unwind, then no amount of government tinkering will make much difference.

Bubble, bubble, bubble! We have the U.S. housing bubble that is bursting, we have a U.S. dollar bubble, we have a global debt bubble, a global stock market bubble and a global derivative bubble. Add to that a credit crisis, a sub-prime mortgage crisis and a confidence crisis. Never before in history have we had such precarious conditions. Even before the Great Depression, things weren’t this bad. Most of this is below the radar of the mass media. Most of this is too complicated for lame-brained reporters to understand. Instead they give us media junkie O.J. Simpson and Lindsay Lohan’s latest rehab story.

So what can you do to prepare for disaster? Sad to say, not much. At the very least you’ll know the license number of the truck that will run you over. You can start to do all the things your mother told you and that you’ve neglected to do: reduce or eliminate your credit card debt, reduce or pay off your mortgage, pay off loans, spend less and use the savings to help reduce your debts. Quit smoking, lose weight and exercise more to improve your health in order to better weather the stress that’s coming. If it looks like we have inflation in the future you can lock in your mortgage for as long a period as you can. It will take many years of high interest rates to wring inflation out of the system so you don’t want to have to renew your mortgage when interest rates are high. In the early 1980’s mortgage rates topped out above 18%.

Knowledge is power and just knowing all this will reduce stress and anxiety. In a deflationary recession, cash is king. In an inflationary recession cash is worth less but the less debt you owe, the better because interest rates on debt will rise. But cash is worth nothing if you can’t get your hands on it. Get your money out of Mutual Funds (many are tied into sub-prime mortgages and are ticking time bombs) and especially get out of Money Market Funds and put it into savings accounts or GIC’s. Just because a fund is with a bank or credit union does not mean it’s insured like a savings account. Some are but many aren’t and some are insured for only a fractional amount. Savings and GIC’s pay less interest but they’re a lot safer. Keep some cash at home too.

If Funds are delaying redemptions then banks might also slow down or limit withdrawals in future. It already started in England with a “run” on Northern Rock Bank with investors lined up around the block to withdraw funds. It stopped only when the Bank of England stepped in to guarantee deposits. Sure, your bank deposit is guaranteed by the Canadian Government but how long are you going to have to deal with government bureaucrats and red tape before you get your cash? Debit cards won’t work and you’ll still need to buy groceries, gas and beer. Start by withdrawing a couple hundred dollars then take a $100 a month to build up a small cash reserve to be used in emergencies. Eventually, the confidence crisis will spread to the U.S. especially (starting October) when banks start releasing their dismal 3rd quarter financial results and then it will spread to Canada. Banks operate on a “fractional reserve” structure: that is they are required to keep only a small fraction of their deposits in cash. Governments don’t have enough money to guarantee ALL deposits.

If you have spare cash (yeah, right!) buy gold coins. Gold has nowhere to go but up in an inflation. Less cash will buy silver coins (poor man’s gold.) Silver is presently undervalued compared to gold so it’s at bargain prices. Silver also has the benefit of lower value. It will be difficult to make change from a one ounce Gold coin selling at $2,400. This is not so far-fetched. In 1981 gold sold for more than $850. Adjusted for inflation, that would be $2,400 today. Proportionately, an ounce of silver would sell for less than $150 (today it’s around $13.)

It’s too early to know whether the recession will be inflationary or deflationary. Massive liquidity causes inflation but, on the other hand, the mass liquidation of financial assets causes prices and income to drop and that will be deflationary. However, the inflationary Depression in Germany in the 1920’s was just a devastating as the deflationary Great Depression of the 1930’s. In Indonesia, during the Asian Crisis less than ten years ago, they had both inflation and deflation. This is known as Stagflation. Imports became more expensive (inflation) and yet domestic assets such as real estate plunged in value (deflation.) It’s too soon to tell which scenario we’ll face but a recession is inevitable. Let’s hope it just a recession and not a Greater Depression.

If you haven’t started a food storage program, why not? It’s not just for economic turmoil. The government even recommends it. Having several weeks or months of food stored will see you through power-outages, storms, ice-storms, earthquakes and epidemics (we’re long overdue for another Spanish Flu epidemic, we barely escaped SARS and bird flu is just around the corner.) Buy face masks (disposable particulate respirators) now while they are available (they’ll be sold out in a crisis.) Grocery stores keep only about 3 days of food in inventory. A panic situation will empty store shelves in hours. You don’t need an expensive food storage program. Dried beans, peas and other lentils last indefinitely as does salt and sugar. Buy canned goods when they’re on sale. Note the best-before date (canned lasts 2 – 3 years) and rotate them to keep them fresh. There’s lots of info available on the internet.

On the bright side, Canada is a great country to be in especially in times of trouble. We’re a lot more stable, civilized and less violent than the U.S. Many of the financial newsletters I read are advising Americans to get their money (and themselves) out of the U.S. before currency controls limit the amount of money that can be taken out of the country and before gold is once again confiscated by the U.S. government (like it was in the 1933.) At the height of the Great Depression, unemployment was estimated to be 25%. On another bright side, this means that 75% of people still had jobs. There will be tremendous bargains to be had. Stocks will be cheap, bankruptcies will create liquidations and thus, great buying opportunities (again, you’ll need cash to take advantage) and bicycling and gardening will become more than just a hobby.

How much time will we have? As one wag said “predictions are hard to make, especially about the future.” It could be weeks or months and it may not happen until after the U.S. election in November 2008 but, I wouldn’t count on it being delayed that long because it’s unfolding at a rapid rate (you’d never know it from the ass media.) It won’t be years. Every day more holes in the financial system are uncovered causing more panic in the financial world. Expect to hear many soothing words from politicians and the media. They will try to downplay the problem to avoid panic. However, the longer it takes, the harder it will crash and the more pieces we’ll have to pick up. We will be watching this slow-motion train wreck for many years. However, life will go on. It always does.  

Gerold
Sept 2007. Updated Oct 2007.
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Disclaimer: I’m not an investment advisor and these articles are for commentary only. For specific advice you should consult your own investment professional.

Your comments are WELCOME! Lengthy comments may time-out before you’re finished so consider doing them in a word doc first then copy and paste to “Leave a Reply” below.

About gerold

I have a bit of financial experience having invested in stocks in the 1960s & 70s, commodities in the 80s & commercial real estate in the 90s (I sold in 2005.) I am appalled at our rapidly deteriorating global condition so I've written articles for family, friends & colleagues since 2007; warning them and doing my best to explain what's happening, what we can expect in the future and what you can do to prepare and mitigate the worst of the economic, social, political and nuclear fallout. As a public service in 2010 I decided to create a blog accessible to a larger number of people because I believe that knowledge not shared is wasted.
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