July 29, 2008

Crude breaks.  Now the Real Problem - A River of Mud.

As we expected, crude oil is still breaking downward from the 4th of July weekend high.  It is establishing its new down trend, and people have begun to focus on the real financial problems ahead.

Many positive views are being written today about MER writing down, selling, and financing the sale of a bundle of CDO's at 22 cents on the dollar.  A proper perspective of this write down is that the Federal Reserve also took an implicit write down on all the CDO's they accepted as collateral in the last 6 months.  This transaction puts a price to the multi-leveled tranches and MBO's that have languished in illiquidity jail since last summer.

The USD is now partially backed by these exotic instruments.  The Fed took these as part of the exercise to save the financial markets and banking system.  So, how do they get a value out of these and any future CDO's when the Fed "gives" them back to markets?  If you are guessing the Fed will "revalue the USD", we agree.  

Inflation will do the deed, even if the economy is dehydrating any liquidity that may begin to flow in coming months.  Many want to call this likely condition as 'stagflation', and, we have described it that way too.  But we find our outlook growing a wee bit bleaker than that. 

Few people who lived through the late 70's have forgotten the frustrating stagflation and its uncertainty.   The next version will have an ignored added feature, that is, speed of information and communication. 

The Fed model is not likely to be able to quantify the effects of any skepticism about agency/government data accuracy.  It will become obvious that the Fed will have to 'raise' the value of their new batch of underlying assets (real estate) of the CDO's.  A data dependent investor and consumer will recognize this, take immediate and potentially extreme action. 

We don't see this process of reactive behaviour slowing down once it begins.  The reactive changes of the consumer to gasoline and other energy costs are just the primer to what they will do when the Fed-driven inflation gets into their conscious daily thinking.

What we can imagine is that the inflation driven behaviour overtakes the Federal 'inflators' and then push asset prices and real values in different directions faster than the Fed can close its Pandora's box.  In the years ahead, the ragged fringe, including all conspiracy hawks, will be regarded as truth tellers.  The theory that the Big Brother cabal is in control and is trying to 'control the masses', will become a prevailing view and scare many people toward even more loony beliefs - therefore, loony acts. 

The reality is much scarier than that, in our view.  Yes, it is indeed.  Look at the two presidential candidates for leadership in a collapsing economy?  Nothing there. 

The reality is that nobody is in charge.  Nobody at the helm.   No cabal, either evil or good.  And, no one person ready or willing to grab the spinning wheel of the American economic ship.  No Lincoln, no Roosevelt, no Churchill, no Thatcher, no Reagan.  It will become a global economic decline and America will be blamed.  So, it will be America that will be required to "fix it".  America will eventually find someone to take the step forward but will it be the right person? 

The presidential election ahead holds little if any prospect of righting the economic ship.  One candidate dazzles with bloated promises of higher prosperity through higher taxes.  The other is still reading Greenspan's book.  They rival each other in two character issues - ignorance and arrogance.  Neither can go more than 5 days without showing their complete lack of competence for dealing the difficult set of years ahead.

Our view, for months, has been for a long term decline in the global securities markets and economies.  Will it become a depression or remain a recessionary contraction?  We believe it will be a depression for many people in this country and for many Third World economies too.  It will take another year to see that condition arrive, and many more years for some countries to return to recent economic levels.  By the end of next year, ugly conditions will be reaching across the economic strata of this country with no prospect of improvement.  "It gets worse every day" will be a common and helpless sentiment among us all.

A positive turn will come when it seems the worst of the worst is happening.  The cycle will be ending but few will see it that way.  A bottom for the American economy and the markets will be at the gate.  Few will believe after hearing the many bottom calls over the years.  Few will venture their capital and savings to "buy the low".  Some of the brave will step forward into the risky fog. They will pioneer a new era of the American entrepreneur. 

We are optimistic about the American people.  Always.  They will cross through this unfamiliar river of economic mud, find their way to the steep and slippery banks on the far side.  Tired, dirty and changed by the difficult crossing, they will raise a new economy built on a refreshed and rugged foundation to hand to the next generation of Americans.  That is what Americans do, and do it well, don't they.

But first, we have to get across that river of mud.

WBB