Friday, October 3, 2008

The Bail Outs Have Begun

I don't have time this evening to go into detail on everything that has happened the past few days so I'm going to let two people who are much smarter than I explain it with articles that they wrote today.

Before you read the first one, I want to expand on the last sentence in the fifth paragraph down. It says, "But if the government pays prices that fairly factors in likely defaults, it will bankrupt the very institutions it is trying to bail out." This is important and needs to be elaborated on. If the government were to pay anything close to going market rates for these investments, other banks would have to mark similar assets they have on their balance sheets down to that price. This of course would then make it clear that they are all currently insolvent, and a new string of bankruptcies would ensue. This alone will force the government to greatly overpay for these assets. (By the government I mean you and I, it is our money they are throwing away)

http://www.financialsense.com/fsu/editorials/schiff/2008/1003.html

The second article discusses an even more important point. Foreign concerns over United States assets. Like I've been saying for a while, once the foreigners even slow down buying our worthless debt the game is over. The government's last option at that point will be to print all the money needed to cover the losses and we will be moments away from hyperinflation. There has not been any indication thus far that they would hesitate in doing this. The middle class will be annihilated as their dollars only value will be the paper they're printed on.

I want to expand on something in this second article as well. In the second paragraph he states, "credit default swap (CDS) spreads for financial institutions are rising to extreme levels as the ban on shorting of financial stock has moved the pressures on financial firms to the CDS market."
This is important to understand as well, and if you haven't read my explanation on what credit default swaps are, it's a few articles below and will help you understand what's happening.

What he means by that is that while the short selling ban is protecting the financial stocks right now, it is creating huge distortions and problems in the market at the next level. Here's why: When a financial company protects debt with CDS insurance they have ways to counter their losses if a company starts to falter. The most popular way, and what has been used in the previous weeks, has been to short the companies stocks to help offset the losses they will have to pay out to the bond holders. This is called arbitrage, and it is part of what keeps the markets running fluidly. But now, when the companies start to falter, these companies are not allowed to short the firms and make that money to offset the losses. This is going to cause tremendous pain in the derivatives market which will have catastrophic effects on the global credit markets.

When the government started their "short ban" they said it was to protect these firms from predatory hedge funds. The hedge funds are just a small portion of the shorts. The majority is coming from the derivatives market from this arbitrage. If the short ban is not lifted soon you're going to see some explosions in this secondary market that will bring a real financial crisis.

http://www.forbes.com/2008/10/01/goldman-morgan-run-oped-cx_nr_1002roubini_print.html

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