Saturday, December 19, 2009

Day 6: Major Default Risk In Financial System

It's amazing that one year ago, as we were celebrating Christmas, most Americans were just realizing that our financial system was insolvent.

Today most Americans believe that everything is okay.

I have to give it to Obama, Geithner and their team. They have pulled off of the greatest confidence games in world history.

How did they do it? Here’s how:

The most important part of their con was to change the accounting rules. Up until March of last year, the banks had to mark their assets to market. This means that if a loan fell in value by 20%, they had to take a loss of 20%. The same is true for the opposite side, if an asset rose in value by 20% they could book that is profit - this is what led to the gross bonuses and share price growth during the 2000’s.

Today a bank marks an asset to myth. This means they can say a piece of real estate is worth the full amount of the loan they lent it out at in 2006. This allowed them to stop taking write downs, and thus stop taking losses.

Of course the losses are still there, hidden in the balance sheets, but they do not have to show them.

In addition to this, while most of the banks have given back their TARP gift, it is now clear that they are backstopped by the government should they run into future problems. They have all become wards of the state.

Thirdly, as discussed during Day 7, they can now borrow money at 0% from the Fed and purchase treasury bonds from the government at 4%. This is an easy way for the banks to make money.

There is an unintended consequence for this action. As you’ve probably heard, it is impossible for anyone to get a loan for anything today. Someone trying to start a business or a real estate investor trying to purchase an investment cannot get a loan at any price no matter how good their credit is.

The money flows have moved toward unproductive government spending, thus stifling the growth of American business and American investment - which create real economic growth and jobs in a country.

This distortion of capital concentration leads to a weakening currency.

At some point the real losses on the balance sheet will have to surface. The banks now have $1 trillion in reserves (they had $2 billion total in 2006) to prepare for the write downs.

I do not think $1 trillion will be enough once the ship begins to break. Remember, the derivatives market is now over $600 trillion in size. This is the dark off-balance sheet world where losses must be paid with dollars in the real world.

The banks problems have only just begun.

As investors realize this they will move toward gold. The gold bull market is young.

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