It appears as if all the cards have now been put on the table. The United States government took a minor pause in their never ending streak of bailouts two weekends ago with their decision not to bail out Lehman Brothers. Lehman Brothers is considered a small fish in the big sea of investment banks, and if there was one to let fail it was going to have to be them.
What happened when they allowed that bankruptcy? Four days later, on Thursday, September 18, we were about six or seven minutes away from the equivalent of financial armageddon. Henry Paulson spent the night before and all that morning watching what is called the money market accounts of the world freeze up. Billions of dollars began pouring out of the accounts as people started to panic. Just before lunch time, according to many traders, we were about five trades from the Dow plummeting down to the 7-8,000 level.
Paulson immediately announced to the markets the he was injecting $105 billion into the money markets, and four hours later he released word of "The Bailout." After letting Lehman fail, the government has decided they were not very happy with the market response, and they have now decided to bail out EVERYONE all at once. Details of the bailout followed soon there after, which include immediate access to $700 Billion to purchase assets from balance sheets.
There are three steps to how this nightmare unfolds before our eyes:
The government will first begin to pour through bank's balance sheets (both domestic and foreign) and purchase all the toxic mortgages that no one will even bid for right now. Even though these assets cannot find ANY price in the open market, they feel they can come in and over pay for them and ultimately make a large profit for the tax payers. They will start this process right away buying everything in sight that may slow down the credit markets. Now, with all this toxic debt sitting on their books, what is the most important factor that will keep these assets from dropping in price?
That's right, the value of American homes, which are the underlying asset for all these debt instruments. Now how could the government figure out a way to keep home prices from falling? If only there was a way they could loosen up lending restrictions again that allowed home prices to get to these bubble values. If only there was a way they could convince banks to make crazy loans again because they could sell them into the secondary market with no repercussions like there were before. In order to do that they'd have to do something completely insane like take over Fannie and Freddie.
Oh wait, that already happened. Which brings us to step two. Over the next few years you'll start to see loan restrictions loosen closer to where they were during the bubble years. All banks will sell these loans to Fannie and Freddie who will be the only buyer left. Their portfolio will grow from about $6 Trillion to about $10 Trillion in the next two years. These loosened lending restrictions will keep home prices at a much higher level than they would be set in the free market and thus not allow all the mortgage backed securities that the government is purchasing to fall to their true price.
We may not even make it to step three, but here's what happens if we do. Even with the government artificially propping up the value of housing and the credit market our country will continue into a severe recession. The next major defaults will come in the form of auto loans and credit card loans that have also been securitized like home loans. With its new powers the government will go back again and again for additional money to "save" the economy. They will begin purchasing these assets, and helping every troubled group that may slow down the economy in any way. The total cost for "The Bailout" will end up approaching $3 Trillion.
The question a few people are asking is, "Where will this money come from?" Well, we are currently $56 Trillion in the hole, and we run about a $500 Billion to $1 Trillion deficit every year now. So it cannot come from our tax payers or from the savings of Americans because they don't have any. The first choice is to try to convince foreign countries to lend it to us. Unfortunately, as every day passes they are starting to see that lending trillions of dollars to Americans that can never pay them back poses a significant risk to their own economies. They feel this every day in dealing with the amount they lent over the past few years for subprime loans, new cars, vacations, and big screens.
The second and last choice is to print the money. This is the option that will be pursued when the foreign investments are finally cut off. We will begin to monetize all this debt and begin moving toward hyperinflation. The dollar will begin its plummet and there will be nothing to stop it. The Fed will have to raise interest rates through the roof to try to save the currency, but this will crush what little economy we have left, and have the effect of beating the dollar down into oblivion.
Foreign investors will then enter our country which will now be destroyed and laying in ruins, and they will begin to purchase our remaining assets at pennies on the dollar with their strong currencies. Real estate, performing companies, and our stocks will on be on a fire sale.
This obviously seems unfair and frightening if you're an American. You get paid in American dollars, save your money in American dollars, and thus will get wiped out with everyone else when this happens. But here is the interesting part; You don't have to save your money in American dollars. Right now, I say that because at some point the government may make it illegal, you can save your money in Euros, Yen, Swiss francs, Canadian dollars, and even something called gold.
When the boats come from overseas and everyone goes shopping on American assets, which have been annihilated, you can be one of those shoppers.
