We started out on January 1, 2008 with five of the largest investment banking concerns in the US, and now we are down to two.  Bear Stearns is gone, ditto for Lehman Brothers and of course Merrill Lynch was forced into a shotgun marriage with Bank of America (which now leaves Goldman Sachs and Morgan Stanley).  And of course the long-term prospects of the last two are dubious as well.  Meaning, if we look at the ratio of leveraged debt to equity, it had been reported that Goldman Sachs has debt to equity leverage of 30, JP Morgan - 24, Lehman - 24 and Merrill Lynch - 41, which later dropped down to 31 after some restructuring prior to the Bank of America takeover.  And so, Lehman Brothers is not the only firm out there with some problems, being the point to be stressed.
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On this issue of Lehman Brothers, some people are applauding the plunge protection team of Hank and Ben for finally putting a halt to bailout initiatives, and letting the market sort itself out (but of course the large insurance company AIG has now been nationalized, with a direct takeover by the US Government).  However, is it really the case they have gotten religion all of a sudden, or is it the case that the US Federal Reserve is tapped out (and they simply could not afford it)?  In our June 1, 2008 newsletter, we commented that the US Federal Reserve is not a bottomless pit, and only had about US$700 Billion worth of Treasuries on it's books to loan out or swap out at the time, for these junk bond mortgages (and other toxic waste) being held by the various banks and brokerage firms as part of their capital base.  Earlier in the year, we know the Fed already gave out about US$400 Billion, which leaves US$300 Billion assuming they stopped this program (which they did not by the way, in fact, they expanded into even more so-called lending facility programs, concluding not much remains of the US$300 Billion either).
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It has been reported that Lehman Brothers owes close to a whopping US$700 Billion Dollars to creditors (US$670 Billion Dollars worth of debt and liabilities).  They reported US$639 Billion worth of assets in their bankruptcy filing disclosure, but what are those so-called assets comprised of?  Even more toxic junk bonds?  I think you can see where I am going with this.  Our opinion is, that the Fed simply could not afford to bail out Lehman even if they wanted to, as they are shall we say, out of cash (and it is noteworthy that the US Government directly and not the Federal Reserve took care of the US$85 Billion AIG bailout this time around).  What makes us think that the US Federal Reserve is tapped out?  Well, the September 18, 2008 edition of the Sydney Morning Herald reports that:  The US Treasury Department said it was selling $US40 billion of cash management bills - effectively new debt - at the request of the Federal Reserve to help the central bank better manage their balance sheet, as a Treasury statement put it.  Dominique Strauss-Kahn, head of the International Monetary Fund, said there could well be more trouble in what former US Treasury Secretary Robert Rubin dubbed the worst crisis since the 1930s.  However, also on September 18, Bloomberg News reports that: The U.S. Treasury said it will sell an additional $100 billion in short-term debt to aid the Federal Reserve's balance sheet, amid the biggest extension of central- bank credit to financial companies since the Great Depression.  That's US$100 Billion in New Debt for the American Taxpayers, given to the Fed to shore up their own capital (so they can in turn give it to the private financial institutions).  In other words, a tax-payer bailout of the Federal Reserve or Central Bank of the United States, which in and of itself is somewhat incredible.
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It is also reported that Morgan Stanley has US$1 Trillion worth of debt on their ledger sheet, and Merrill Lynch has $988 billion.  This of course makes us wonder how in the world Bank of America had the where with all to assume more than US$900 Billion of Merrill's debt, on top of the Countrywide takeover they are still trying to digest   In addition,  Morningstar reported that Merrill had $1.6 billion of net collateralized debt obligations exposure, $6.0 billion of Alt-A mortgage exposure, and $18.0 billion of commercial real estate mortgage exposure.  That's a whole lot of exposure if you ask me.  Someone must have Bank of America's back, and we surmise this is a back door deal instigated by the Hank and Ben dynamic duo, disguised as a stand alone private merger, when in fact it could be something else (what happened with the Countrywide deal will give you a very big clue, a hint is to take a look at the participation of US$50 Billion by the Federal Home Loan Bank of Atlanta).  Just our opinion, as the numbers do not add up, at least with the argument that Bank of America is some kind of white knight flush with plenty of cash to cover all these potential liabilities.
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In any event, the next shoe to drop in all this mess will surely be the derivatives and credit default swaps market (if you can call it a market).  The value of such financial shenanigans is estimated to be about US$450 Trillion Dollars (worldwide), although we have seen estimates even higher.  One economic commentator reports that over Ninety Percent of all U.S. bank-held derivatives are concentrated in the hands of just five major U.S. banks: JP Morgan Chase, Citibank, Bank of America, Wachovia and HSBC.  In terms of Wall Street firms, it is reported that Merrill Lynch had $4.2 trillion, Morgan Stanley $7.1 trillion, and to make a point of comparison, Lehman Brothers had $729 billion.  Based upon these numbers, one could argue that the combination of Bank of America and Merrill to be an derivative implosion waiting to happen.  In addition, one can surmise that Morgan Stanley is not looking to be in the peak of health either, and in terms of their debt and derivatives exposure, their previous merger talks with Wachovia were another case of trying to put two highly leveraged firms together to make a more sound whole.  Just as with Bank of America and Merrill, we argued that a hook up of JP Morgan and Wachovia is like putting two alcoholics in a room with an open bar, praying that by some miracle they both walk out sober.  And of course, Wachovia itself has now bit the dust and is a takeover target.  However, the real question is: Are some of these other mergers producing new firms that will be just another Government bail out candidate waiting to happen?  We will have to wait and see.
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Of course, part and parcel of the problem has been that these, and other kinds of creative financial alchemy, are hidden away in so-called Off The Books ledgers or in Special Investment Vehicles, in terms of both the banks and Wall Street firms.  This means, you cannot rely upon the official financial reports filed to get a true sense of the financial condition, that is of course until these firms blow up, and then you find out after the fact.
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In regards to the also very recent government bailout of Fannie-Mae and Freddie Mac, one very telling commentary by some observers is that this was done to instill confidence in foreigners, so they will continue lending money to the US Federal Government.  Indeed, this is logical and something not talked about in the general news media.  Which is to say, the US Government currently lives on the kindness of strangers, or otherwise needs to borrow money from foreigners to stay afloat financially (and we wonder how is it they have US$85 Billion to buy AIG, when there is seemingly no money for other things).  If you look at the percentage of US Government Debt owned by foreigners, it is quite substantial.  If Fannie-Mae and Freddie-Mac were allowed to do a Lehman Brothers, considering the implied Government backing for the bonds of Fan and Fred, surely it would spook the heck out of any foreign government or sovereign wealth fund.  And where else will the United States Government borrow the money from going forward?  Surely not from the domestic market, as the savings rate of US citizens has not only turned negative awhile back, but the average citizens is in fact drowning in debt.  And they certainly are not going to borrow from US banks, who are lined up themselves with hat in hand for a bailout.
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In contrast, aside from the fact we know the governments of India, China and Japan have amassed huge amounts of US Dollar reserves over the years, the average citizen in China (as just one example) saves 25 percent of their income annually.  Government finances aside, any country where the local population is saving 10 percent, 20 percent or more of their income, is a country that has available funds to funnel into investments, and has funds available for local lending.  By contrast, any country whereby the citizenry (and the government) is spending more than they take in (and not saving), is surely on a road to disaster (or have we already now reached the disaster destination?).
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Speaking on the theme of US Government finances, how much debt or liabilities do they have really?  Similar to these off the books items mentioned for the banking and financial related companies in the US, one needs to pull back the layers of the onion to get a true picture.  The official tally of US Government Debt obligations (Treasury Bills, Bonds and Notes) is quickly approaching US$12 Trillion Dollars.  But what about these recent Fannie-Mae and Freddie-Mac deals?  Even though Hank Paulson has said these various obligations were not physically transferred onto the direct debt ledger of the government, is it not also true, that in reality, the US Government liabilities have gone up by a few Trillion Dollars more, in the least because of this deal?  What about the Social Security Trust fund, which is nothing more than a stack of IOU notes from the US Treasury?  Some day, the US Treasury must pay that all back as well, even though it does not show up as direct debt obligations on the balance sheet at the moment either.  What about the fact that the FDIC is broke, in terms of not having enough money to cover all the bank failures, or Medicare, or the so-called US Highway Trust Fund?  Based upon these things, we can easily suggest that the true amount of current financial obligations of the US Treasury, whether actually recorded as direct debt or not, possibly exceeds US$20 Trillion Dollars at present (maybe more).  Medicare of course is the wild card that could push this figure up even more so (and some have tried to do the calculations, and have come up with US$80 Trillion Dollars as a figure they project).  What is the point to be made here?
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I know some people think I enjoy writing about gloom and doom, but that is not the case.  Rather, the true trick of economic, social and political forecasting, is to try and think like a chess player.  Meaning, to think three or four moves ahead, as to where this is all going and what these events or circumstances could mean later on.  As such, while we are witnessing asset value deflation, in terms of US real estate, all of these initiatives and statistics point to eventual inflation of the money supply, meaning to turn all that debt in cash at some point in time, or by definition, devaluation of the US Dollar as a result.  In addition, these things coupled with the effects of globalization (and specifically downward pressure on labor rates and wages inside the US) point to a drastic downward spike in the US standard of living as well.  It is inevitable, regardless if the vast majority of Americans understand this or not.  The middle class in America are starting to get glimpses of it now, but as the old saying goes, they have not seen the worst of it just yet.  This mess will play itself out over years, not months, as we move from one crisis to another.
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The real problem of course is that economic crisis usually leads to social crisis, and then a knee jerk reaction from politicians.  And so, we can speculate that watching what is going on in the US financial markets, and watching the debt pile up for the US Government, would conceivably motivate foreign lenders to demand a risk premium for US securities, assuming they still want to lend.  This is the real problem for the US Federal Reserve, in terms of setting interest rates.  Foreigners outside of the US are going to want sufficient rates of interest to either compensate for the risk, and or compensate for the devaluation of the currency (inflation).  Indeed, we have already seen this happen, whereby Fannie-Mae and Freddie-Mac were being forced to borrow at 15 percent interest just before the nationalization, or excuse me, rescue program.  On the other hand, the US economy is in the proverbial toilet, and the excessive leverage and debt being carried by consumers and business (Banks, Wall Street) has been predicated on low interest rates.  After all, is that not what Alan Greenspan has trained the masses to expect?  Aside from all that, investors that purchase government bonds do so because they think they are making a conservative investment.  If the US Government continues on this nationalization and bailout roller coaster, the United States of America (the government) could end up becoming the world's largest mutual fund.  Will foreign investors want to continue lending money knowing the money is going right out the back door in the form of corporate bailouts?
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If the US Federal Reserve raises interest rates, they please the foreign lenders, but they put the US economy into further turmoil.  Indeed, this is exactly what has happened with home mortgages - no?  The teaser rates readjusted upwards and all of a sudden, no one could afford the new payments.  The same problem holds for the banking and brokerage industry, as there is no profit margin when longer-term loans are made at 5 percent, and costs to borrow exceed that (not to mention declining capital ratios, when older low interest bonds go down in value when interest rates go up, and if such bonds make up the capital reserves of a financial institution, then that firm has an operating capital problem as a result).  In terms of Wall Street, many have made the observation that a shadow banking operation has basically been created, and not to delve into an explanation, sufficient enough to say, this game was played with excessive leverage, plus predicated upon low interest rates as well for the spread.  Even though Dick Cheney would like you to believe that deficits do not matter, or living on excessive debt and borrowed money is not a problem, you had better believe the exact opposite is true.  Just ask the ex-employees of Lehman Brothers.
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In any event, we are already witnessing the knee jerk political reaction, and it is not admirable.  The effectual nationalization of banks, mortgage related companies, wall street brokerage firms and now insurance companies (AIG).  In addition, Congress-Woman Nancy Pelosi is now calling for a bailout of the automobile industry (and has gotten her wish with the earmarks added on the the US$600 Billion emergency funding bill passed in late September of 2008, not to be confused with the US$700 Billion bailout bill), and many would say the airlines are not far behind.  The last time I can recall a government reacting in this manner during a similar financial crisis was Germany and Italy during the 1930's Depression, whereby private corporations were sort of fused together into a special partnership with the state.  The Italians called it Fascism, but of course the Germans themselves called it National Socialism (a rose by any other name?).  Why is it that we human beings continue to repeat history, over and over again?  Of course, Americans at the moment do not have some of the other things that went along with that, such as censorship of the press, restriction of civil liberties, elimination of trade unions, monetary and exchange controls, special permission from the government to travel, etcetera.  Hopefully these other things I just mentioned will not follow.
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I know what you are thinking, that this is a crazy and alarmist statement.  But surely one can argue that we have been steadily and progressively on this road to a new flavor of National Socialism for some time now (if the German version was Bavarian Chocolate, maybe the American flavor is Rocky Road).  US corporate income tax rates are much, much lower than they are for individual citizens, and in some cases American companies pay no taxes at all simply because a vast majority of income and operations is overseas.  In other words, many US companies are more like distributors these days, at least inside the US, with all the manufacturing taking place in Taiwan, Malaysia, Mexico, etc.  In addition, US companies are allowed a tax-free pass on foreign source income, that is until they physically bring those profits back to the US, which could be never, realistically speaking.  Individual US citizens, in contrast, are theoretically taxed on ALL worldwide income and gains, and even though a certain portion of salaried income earned outside the US (from non US employment) gets a break, such US citizens still have to pony up Social Security tax payments.  In addition to all this, now there is recent legislation to even further tax Americans should they decide to expatriate (see the recent HEART Act signed into law by George Bush in June of this year, also know as the Heroes Earnings Assistance and Relief Tax  act, or Heart, which has nothing to do with the Government wanting to be your valentine).  While there are no financial penalties imposed upon US corporations that close down domestic US operation and relocate, individual citizens are now taxed on unrealized capital gains, plus some other pre-existing taxes for expatriation, for basically doing the same thing as the corporations.  And so, all these events and initiatives point to a favored collaboration between the state and corporations, at the expense of individual citizens, who do not have these same tax breaks and benefits.  In other words, just another flavor of National Socialism when you get right down to it.
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We started writing about some of these things you are now witnessing, last year in 2007.  We even went so far to use the dreaded D word (Depression, the economic kind and not the other kind requiring a psychiatrist) a few times, and of course we received some negative mail about it.  However, not talking about something is not going to make it go away.  On the contrary, it just may make the outcome even worse, if you find yourself unprepared, that is.  Once again, our goal is not be negative or alarmist, but rather realistic and as a result of that, just like the Boy-Scout motto, Be Prepared.  Why should you allow yourself to be a victim of something that is not your fault?  Why?  There is no need for you to be blind-sided, or for your family to suffer.  Absolutely none.
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The legacy of George W. Bush as President will probably go down in history along the same lines as Herbert Hoover.  Both men presided over an economy that was over leveraged, and one that experienced exponential increases in debt and borrowing that eventually had run its course.   In addition, an environment of unregulated (or deregulated as the case today) banking and financial markets, that also effected or filtered into the broader economy.  Of course, the current economic make up of the US economy has some major differences today (2008) than the situation of the 1930's.  For one thing, America's manufacturing and export base is currently gone.  Indeed, about 70 percent of the US economy is comprised of consumer spending today (not exports), and in terms of financial services and banking, this now makes up roughly one third of business economic activity (and manufacturing less than 15 percent).  In other words, the US is basically an economy no longer driven by exports, but rather is a net buyer of products from other countries, and what is left over nothing more than a somewhat cannibalistic service economy (that feeds upon internal combustion, so to speak).  American wealth therefore has flowed out to the door to China, India, Korea, Malaysia and other hubs or centers of manufacture.  Some of that money has come back in the form of loans to the US Government (purchases of Treasury Bills, Notes and Bonds) but that may cease as foreigners become nervous and uncertain about the future of the US economy.
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However, it is very, very important to understand that what really pulled the US economy out of the economic Depression of the 1930's was World War II, or better said, the result of it, and why this will not, nor cannot, be the case today.  Which is to explain, back in the 1940's, government spending on war related efforts put the domestic US factories to work at full speed, but that was driven by government deficit spending as opposed to true sales and commerce with other nations.  Of course, once the war was over, the economies of Japan and Europe were in ruin, and the US had a captive market for its manufactured products until such time the factories were rebuilt in these places (which took about a decade, and the 1950's is looked upon as a time of dynamic economic growth and nostalgia in America because it was indeed a decade of upward mobility for the average worker).  And that is what pulled the US out of it's economic malaise after WWII, meaning EXPORTS and sales of American made goods abroad.  In other words, the debt and deficit spending was paid off or put back into balance by actual business activity, sales, profits, etc.  Similarly, how did China amass so much wealth in the past decade?  The answer is exports.  The United States today, in contrast, continues to import more than it exports, and also is a net borrow from foreigners as well (whereas the US was a net creditor in the past).  In simple terms we would ask:  Where will the money come from to pay off all these current additional debts that are being incurred from bailouts?  What is the long-term plan?  We don't see one, at least not one that involves basic economic principals of growth and positive trade balances, simply because the factories are now gone with the wind.  US Politicians seem to have no plan at all, other than to drift though one problem to the next, with no long-term vision, goals or ideas, to prepare the populace for the next few decades of changes and challenges.  It is a mistake that will come back to haunt them.  China, on the other hand, has a plan and list of definable goals, which they intend to accomplish (next up on their list is to have some of the best education facilities and faculty in the world, to produce the next generation of scientists and engineers so they can begin to innovate instead of copying the technology of others).  That is why they are, and will be, a new economic and political force in the world.
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Getting back to our topic, even though it is true that social welfare and social safety programs exist today (whereas they did not in 1929, that is, until the New Deal legislation was passed in the 1930's), the real question is how to fund them.  It is fine for a government to temporarily borrow money in the short-term, or temporarily engage in deficit spending, BUT only when the game plan and opportunity exists to pay it off when the economy turns around.  We would ask the question:  What is going to turn around the US economy and where is the economic growth and government revenues going to come from to pay off all these debts incurred for bailout initiatives?  If you know the answer, you are much smarter than I am, because I cannot see it or figure it out.  Remember, there are some basic truths that apply to government and business finances, as they do to your personal finances.  You cannot borrow more than your capacity to pay back, and in addition, eventually it must be paid back.  The only difference with governments is, they have the capacity to TAX and PRINT money.  Therefore, if economic growth (exports, etc.) is not going to do it, can you guess where this money is going to come from?  Interestingly enough, it was reported in the Latin American Press that President Bush was asked that very same question, and his answer straight away was TAXES.  Funny how this was never mentioned in the domestic US press at all.
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If you think this all just negative commentary, just stop for a moment and think about it.  How much lower would American wages have to be for US made products to be price competitive with the Chinese, Indians, Koreans and so on (assuming Americans were still manufacturing cell phones, computers, televisions sets, blenders, car batteries, washing machines, children's toys, and so on)?  How much lower would the US Dollar have to fall, for the exchange rates to accomplish the same thing?  What will be the game plan to reverse the negative trade balance currently effecting the US economy?  Exports of corn?  Walt Disney animated films?  How much of a reduction in the standard of living would American citizens have to accept to be placed on par with these other nations, in terms of being competitive for labor costs, etc.?  Today, a global pharmaceutical company can hire a well educated and well qualified graduate in India with a PHD in pharmacology for about the wages of a American waitress in Starbucks or Applebee's.  Perhaps a slight exaggeration, but not by much I can assure you.  That is who the American or European worker is competing with, plain and simple, and that is why the jobs and factories are not coming back. 
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There are a few things we can be assured of as a result of these ever increasing bailout and other debts incurred by the national US government:  the devaluation of the US Dollar is one of them, higher taxes is yet another.  But before that happens in earnest, the paper debt of the US Government will shoot up exponentially at first, and then the liquidation or conversion of that debt into cash later on (or exchanged for other assets).  This is what you are currently seeing, and take note that the US Debt Ceiling authorized by the politicians just shot up past the US$11 Trillion Dollar level, and it will continue to go up (and by the way, this represents a 7 percent increase in the debt ceiling).  However, in tandem with this, you will see foreigners increase their exchange of US Dollars and US Government Debt Securities for hard assets (buildings in New York, Toll Roads in Pennsylvania, maybe even the stock of private US companies held by the US Government as part of these Nationalization plans - in other words, a redemption of US Government Bonds for stock in US companies, instead of cash?).  Why?  Because the foreigners see where this is going and they do not want to hold onto a devaluing currency either.  
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And if you think this is an emergency plan thought up one weekend on a whim (the US$700 Billion boondoggle), you are being naive.  Our contention is, these guys knew exactly what was going on, knew exactly where all this would lead, and know exactly what the outcome will be in the future.  They also know what they are now doing is highly, highly inflationary and that average middle class citizen will suffer because of it.  The folks at PIMCO know it, as one of the senior staff of the company publicly made the comment that now is not the time to be worried about inflation.  Who mentioned that all this would lead to higher inflation?  He did, or he brought it up, which means a clear understanding of the outcome of what is being done.  And I will take this one step further still.  If you factor in the comments and proposals made by Bernanke during the recent Congressional Hearings on the US$700 Billion bailout, the conclusion can only be that this is a travesty and a con job of the highest magnitude being committed against the tax-payers.  If you bother to read and understand what these guys had proposed, it should make the hairs on the back of your neck stand up.  And the sad part of it is, the vast majority of the American public either does not understand it, or does not care.  However, it is interesting that polls indicated about 80 or 90 percent (depending upon which poll you use) of the American public were opposed to this US$700 Billion bailout. 
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In any event, you should realize how bad this mess really is.  If you recall from the information above, we suggested that the US Federal Reserve Bank depleted their capital of US$700 Billion worth of Treasury Bonds by swapping it for junk bonds with the banks in a effort to stem the tide.  Then, in September the US Treasury arranged for an emergency deposit of US$100 Billion Dollars worth of the new T-Bills to the Federal Reserve to bolster their balance sheet.  What you just witnessed, without even realizing it,  was a tax-payer funded bailout of the Federal Reserve, and why commentators have now suggested that Bernanke works for the US Treasury, instead of the other way around.  However, it is also very interesting to note that the US Federal Reserve now has roughly some figure starting at US$400 Billion, and approaching US$700 Billion Dollars worth of illiquid junk bonds on its balance sheet, as its operating capital.  Ergo, what is a US Federal Reserve Note really worth these days if its backed by junk?
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In any event, you are a living witness to history.  You can tell your children and your grand-children that you were there, you survived it, and recall the tale regarding what you did to protect the family's assets, while everyone else walked around in a stupefied daze.
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In closing, we leave you with the words of Mr. Hank Paulson's testimony to Congress on September 23, 2008 at 11:41 AM (yes, it is even time stamped):  You ask me about taxpayers being on the hook? Guess what, they are already on the hook.
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