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Originally sent as an email to family and friends August 13, 2007. I’m posting this because I’m tired of hearing the refrain, “Who could have seen this coming?” I’m not the only one.

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Earlier this summer I sold most of my stocks and three weeks ago I bailed completely out of the stock market. I’m sitting on 100% cash waiting for the dust to settle. It may be a while.

Some of you may have heard about the U.S. sub-prime mortgage scandal where sub-prime mortgages are pooled with other grades of mortgages, sliced and diced, declared as AAA grade and sold as CDO’s – Collateralized Debt Obligations to investors, mutual funds, hedge funds, pension funds, etc. They were over-valued and now cannot be sold except at a deep discount.

Many people think this is an American problem. It’s not. It’s a global problem. Most financial institutions world-wide are exposed. Thursday, a French bank panicked and froze three of its hedge funds to prevent investors from cashing out. This spread the panic world-wide and caused Central Banks to flood markets with about 300 billion dollars of liquidity and soothing words.

However, we are in a liquidity bubble. There’s too much cash chasing riskier and riskier investments. For instance, derivatives which are financial instruments based on financial assets leveraged as much as 180 to 1 have exploded in size the last few years. Derivatives are new and unregulated and their total size is unknown. Estimates range from 400 trillion to 1,000 trillion dollars. Compare this to the total global Gross Domestic Product of about 50 trillion dollars and you’ll see these risky investments (a house of cards built on sand) are 8 to 20 times the money generated annually by the whole world.

Many derivatives are based on these CDO’s and much of them are frozen because financial institutions would suffer enormous loses if they were sold. No one wants to be the first one to remove a card from this house of cards because then the whole thing will crash. In other words, all the money in the world multiplied by anywhere from 8 to 20 is frozen and useless. Little money is available for mortgage renewals and new mortgages. Little money is available for business loans. Economies cannot function like this. Central Banks released 300 billion dollars last Thursday and Friday but this is only a temporary measure. All the money in the world isn’t enough to solve the problem. The problem is too much liquidity. Creating more liquidity adds to the problem, it doesn’t solve it. You cannot put out a fire by pouring more gasoline on it. Now everyone is waiting for the other shoe to drop.

The only thing safe right now is cash and cash-based instruments like treasury notes, GIC’s and savings accounts (assuming your financial institution survives.) Gold and silver is good, too because they’ve been used as money for over 5,000 years. Everything else will be worthless.

I hope I’m wrong. Govern yourself accordingly.

Gerold