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Markets: Death Spiral?
New York: November 12, 2007
By John R. Stephenson

Banks are in survival mode. October U.S. retail sales are at or near recession levels. Hardly a day goes by without some indication that the global imbalances are unwinding. The days of never-ending American consumption may be behind us for good, as consumers retrench while their home values plummet. Once revered financial institutions have become pariahs, as the subprime creations they spawned have led to global financial chaos.

The U.S. dollar is in free fall. Citigroup, Bear Stearns and Merrill Lynch are all experiencing regime change. These once-admired U.S. investment banks are now considered radioactive as it has become apparent that their greed, and little else, was behind the massive write-downs that financial institutions globally have been experiencing. The Chinese are talking about diversifying their massive foreign exchange reserves out of U.S. dollar holdings and into those of a "stable" currency.

Figure 1: Citigroup Stock is Getting Hammered!

Source: BigCharts.com

The U.S. housing crisis has quickly become a credit crisis and is now threatening to become a crisis of confidence. If that happens, things could get ugly in a hurry as consumption makes up more than 72 per cent of the American economy.

This year, financial institutions around the world began to discover that they owned hundreds of billions of U.S. mortgage-backed bonds that had serious problems. As the housing market in the U.S. slowed and homeowners began to default on their mortgages, the value of these mortgage-backed bonds began to plummet. Wall Street firms that had used massive amounts of leverage were suddenly on the hook for huge sums of money and the credit crisis that we have been witnessing took full flight.

For years, much of what we took as gospel from Wall Street was in fact garbage. The brilliant idea that the geniuses on the Street cooked up was to package up a bunch of risky loans (subprime mortgages) made to people once living in trailer homes and to flog these loans to unsuspecting investors. Of course, they had wonderful theoretical models that showed exactly what these bonds were worth. The only problem was that the assumptions that these models were based upon were faulty. The mortgages were, in fact, far riskier than anyone realized and when push came to shove and the homeowners started to default on their mortgages much faster than the models had predicted, all of a sudden investors panicked. And why not! The wizards on Wall Street had sold investors a bill of goods.

Panic ensued. What exactly are these paper assets worth? When will the bloodbath end? Why is there write-down after write-down for these Wall Street investment banks and where was the senior leadership of these firms when the shit hit the fan? The answers by and large just weren't very good. The first casualty of the meltdown has been the stock valuations of Wall Street investment banks that not only created these financial monsters but also leveraged themselves to do so. The other casualty was the U.S. dollar. All of a sudden the U.S. has gone from an investment safe haven to a risky banana republic in the time that it takes for you to say "toxic debt."

The last and most serious casualty is global confidence in the U.S. financial system. When investors are confident that they will get their money back and a reasonable return for the risks they take, they take the plunge and invest. But the subprime mess has proved one thing — that the geniuses on Wall Street aren't so smart. Not only that, they might be crooks.

That's the mental calculus that investors around the globe are doing. The U.S. has lots of problems with no end in sight. The current account deficit (exports minus imports) is a massive 7 per cent of GDP. Just to balance the books on the U.S. current account deficit, America needs to receive some $2 billion a day in positive investment flows. But how is that possible when investors don't think the bonds, stocks etc. are worth the paper they are printed on? So far, investors have been shunning U.S. investments most notably the stocks of U.S. financial institutions and corporate debt of all types. Only U.S. treasuries are able to find bidders since they are the "safest" of all U.S. debt instruments.

As the liquidation sale continues in the U.S., the stock market continues to only sputter. The rallying call on the markets is "save our ship and lower interest rates." So far, the Fed has obliged and the elixir of easy money has been enough to keep the stock market from tumbling too far too fast. But eventually, the markets will correct.

The U.S. media, anxious for a Democratic victory, will do everything possible to play up rather than play down the current mess. The U.S. consumer is starting to do what people do when things get bad — they hunker down. And so they should, with a negative savings rate they can ill afford to continue to spend as the value of their principal asset (their house) falls. But even a four to five percent positive change in the U.S. savings rate can lead to a recession in the U.S. Things will likely get worse before they get better. The U.S. dollar will continue to fall.

So what's a savvy investor to do? For starters, don't commit any more capital to the stock market. Think about diversifying out of U.S. holdings into the stocks of commodity producers that are linked to cash flows of the global economy rather than the excesses of the U.S. economy. Buy gold and gold producing companies since gold is an asset that is nobody's liability. What's the beauty of a fire sale? If you have cash, you can pick up some pretty good bargains once the dust starts to settle.

StephensonFiles is a division of Stephenson & Company Inc. an investment research and asset management firm which publishes research reports and commentary from time to time on securities and trends in the marketplace. The opinions and information contained herein are based upon sources which we believe to be reliable, but Stephenson & Company makes no representation as to their timeliness, accuracy or completeness. Mr. Stephenson writes a regular commentary on the markets and individual securities and the opinions expressed in this commentary are his own. This report is not an offer to sell or a solicitation of an offer to buy any security. Nothing in this article constitutes individual investment, legal or tax advice. Investments involve risk and an investor may incur profits and losses. We, our affiliates, and any officer, director or stockholder or any member of their families may have a position in and may from time to time purchase or sell any securities discussed in our articles. At the time of writing this article, Mr. Stephenson may or may not have had an investment position in the securities mentioned in this article
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