Mike Whitney: Stock Market Meltdown


Richard Moore

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Stock Market Meltdown
By Mike Whitney

³Whatever is going to happen, will happen...just don¹t let it happen to you.² 
Doug Casey, Casey Research

08/04/07 "ICH " -- ---  It¹s a Bloodbath. That¹s the only way to describe it.

On Friday the Dow Jones took a 280 point nosedive on fears that that losses in 
the subprime market will spill over into the broader economy and cut into GDP. 
Ever since the two Bears Sterns hedge funds folded a couple weeks ago the stock 
market has been writhing like a drug-addict in a detox-cell. Yesterday¹s 
sell-off added to last week¹s plunge that wiped out $2.1 trillion in value from 
global equity markets. New York investment guru, Jim Rogers said that the real 
market is ³one of the biggest bubbles we¹ve ever had in credit² and that the 
subprime rout ³has a long way to go.²

We are now beginning to feel the first tremors from the massive credit expansion
which began 6 years ago at the Federal Reserve. The trillions of dollars which 
were pumped into the global economy via low interest rates and increased money 
supply have raised the nominal value of equities, but at great cost. Now, stocks
will fall sharply and businesses will fail as volatility increases and liquidity
dries up. Stagnant wages and a declining dollar have thrust the country into a 
deflationary cycle which has---up to this point---been concealed by Greenspan¹s 
³cheap money² policy. Those days are over. Economic fundamentals are taking 
hold. The market swings will get deeper and more violent as the Fed¹s massive 
credit bubble continues to unwind. Trillions of dollars of market value will 
vanish overnight. The stock market will go into a long-term swoon.

Ludwig von Mises summed it up like this:

"There is no means of avoiding the final collapse of a boom brought about by 
credit expansion. The question is only whether the crisis should come sooner as 
a result of a voluntary abandonment of further credit expansion, or later as a 
final and total catastrophe of the currency system involved." (Thanks to the 
Daily Reckoning)

It doesn¹t matter if the ³underlying economy is strong². (as Henry Paulson likes
to say) That¹s nonsense. Trillions of dollars of over-leveraged bets are quickly
unraveling which has the same effect as taking a wrecking ball down Wall Street.

This week a third Bear Stearns fund shuttered its doors and stopped investors 
from withdrawing their money. Bear¹s CFO, Sam Molinaro, described the chaos in 
the credit market as the worst he'd seen in 22 years. At the same time, American
Home Mortgage Investment Corp---the 10th-largest mortgage lender in the U.S. 
---said that ³it can't pay its creditors, potentially becoming the first big 
lender outside the subprime mortgage business to go bust². (MarketWatch)

This is big news, mainly because AHM is the first major lender OUTSIDE THE 
SUBPRIME MORTGAGE BUSINESS to go belly-up. The contagion has now spread through 
the entire mortgage industry‹Alt-A, piggyback, Interest Only, ARMs, Prime, 2-28,
Jumbo,‹the whole range of loans is now vulnerable. That means we should expect 
far more than the estimated 2 million foreclosures by year-end. This is bound to
wreak havoc in the secondary market where $1.7 trillion in toxic CDOs have 
already become the scourge of Wall Street.

Some of the country¹s biggest banks are going to take a beating when AHM goes 
under. Bank of America is on the hook for $1.3 billion, Bear Stearns $2 billion 
and Barclay¹s $1 billion. All told, AHM¹s mortgage underwriting amounted to a 
whopping $9.7 billion. (Apparently, AHM could not even come up with a measly 
$300 million to cover existing deals on mortgages! Where¹d all the money go?) 
This shows the downstream effects of these massive mortgage-lending meltdowns. 
Everybody gets hurt.

AHM¹s stock plunged 90% IN ONE DAY. Jittery investors are now bailing out at the
first sign of a downturn. Wall Street has become a bundle of nerves and the 
problems in housing have only just begun. Inventory is still building, prices 
are falling and defaults are steadily rising; all the necessary components for a
full-blown catastrophe.

AHM warned investors on Tuesday that it had stopped buying loans from a variety 
of originators. 2 other mortgage lenders announced they were going out of 
business just hours later. The lending climate has gotten worse by the day. Up 
to now, the banks have had no trouble bundling mortgages off to Wall Street 
through collateralized debt obligations (CDOs). Now everything has changed. The 
banks are buried under MORE THAN $300 BILLION worth of loans that no one wants. 
The mortgage CDO is going the way of the Dodo. Unfortunately, it has attached 
itself to many of the investment banks on its way to extinction.

And it¹s not just the banks that are in for a drubbing. The insurance companies 
and pension funds are loaded with trillions of dollars in ³toxic waste² CDOs. 
That shoe hasn¹t even dropped yet. By the end of 2008, the economy will be on 
life-support and Wall Street will look like the Baghdad morgue. American biggest
financials will be splayed out on a marble slab peering blankly into the ether.

Think I¹m kidding?

Already the big investment banks are taking on water. Merrill Lynch has fallen 
22% since the start of the year. Citigroup is down 16% and Lehman Bros Holdings 
has dropped 22%. According to Bloomberg News: ³The highest level of defaults in 
10 years on subprime mortgages and a $33 billion pileup of unsold bonds and 
loans for funding acquisitions are driving investors away from debt of the New 
York-based securities firms. Concerns about credit quality may get worse because
banks promised to provide $300 billion in debt for leveraged buyouts announced 
this yearŠŠBear Stearns Cos., Lehman Brothers Holdings Inc., Merrill Lynch & Co.
and Goldman Sachs Group Inc., are as good as junk.²

That¹s right---³junk².

We¹ve never seen an economic tsunami like this before. The dollar is falling, 
employment and manufacturing are weakening, new car sales are off for the 
seventh straight month, consumer spending is down to a paltry 1.3%, and oil is 
hitting new highs every day as it marches inexorably towards a $100 per barrel.

So, where¹s the silver lining?

Apart from the 2 million-plus foreclosures, and the 80 or so mortgage lenders 
who have filed for bankruptcy; a growing number of investment firms are feeling 
the pinch from the turmoil in real estate. Bear Stearns; Basis Capital Funds 
Management, Absolute Capital, IKB Deutsche Industrial Bank AG, Commerzbank AG, 
Sowood Capital Management, C-Bass, UBS-AG, Caliber Global Investment and Nomura 
Holdings Inc.‹are all either going under or have taken a major hit from the 
troubles in subprime. The list will only grow as the weeks go by. (Check out 
these graphs to understand what¹s really going on in the housing market. 

The problems in real estate are not limited to residential housing either. The 
credit crunch is now affecting deals in commercial real estate, too. Low-cost, 
low-documentation, ³covenant lite² loans are a thing of the past. Banks are 
finally stiffening their lending requirements even though the horse has already 
left the barn. Commercial mortgage-backed securities are now nearly as tainted 
as their evil-twin, residential mortgage-backed securities (RMBS). There¹s no 
market for these turkeys. The banks are returning to traditional lending 
standards and simply don¹t want to take the risk anymore.

Bataan Death March?

Leveraged Buy Outs (LBOs) have been a dependable source of market liquidity. 
But, not any more. In the last quarter, there was $57 billion in LBOs. In the 
first month of this quarter that amount dropped to less than $2 billion. That¹s 
quite a tumble. The Wall Street Journal¹s Dennis Berman summed it up like this: 
³the Street is scrambling to finance some $220 billion of leveraged buy out 
deals² (but) the ³mood has gone from Nantucket holiday to Bataan Death March².

Berman nailed it. The investment banks took great pleasure in their profligate 
lending; raking in the lavish fees for joining mega-corporations together in 
conjugal bliss. Then someone took the punch bowl. Now the banking giants are 
scratching their heads-- wondering how they can unload $220B of toxic-debt onto 
wary investors. It won¹t be easy.

³The banks and brokers are in the bull¹s eye,² said Kevin Murphy. ³There¹s 
article after article not only on subprime, but also banks sitting on leveraged 
buy out loans.² (WSJ) Credit protection on bank debt is soaring just as investor
confidence is on the wane. In fact, the VIX index (The ³fear gauge²) which 
measures market volatility--- has surged 60% in the last week alone. The 
increased volatility means that more and more investors will probably ditch the 
stock market altogether and head for the safety of US Treasuries.

But, that just presents a different set of problems. After all, what good are US
Treasuries if the dollar continues to plummet? No one will put up with 5% or 6% 
return on their investment if the dollar keeps sliding 10% to 15% per year. It 
would be wiser to one¹s move money into foreign investments where the currency 
is stable.

And, that is (presumably) why Treasury Secretary Paulson is in China today---to 
sweet talk our Communist bankers into buying more USTs to prop up the flaccid 
greenback. (Note: The Chinese are currently holding $103 billion in toxic 
US-CDOs---and are not at all happy about their decline in value.) If the Chinese
don¹t purchase more US debt, then panicky US investors will start moving their 
dollars into gold, foreign currencies and German state bonds as a hedge against 
inflation. This will further accelerate the flight of foreign capital from 
American markets and trigger a massive blow-off in the stock and bond markets. 
In fact, this process is already underway. (although it has been largely 
concealed in the business media) In truth, the big money has been fleeing the US
for the last 3 years. What passes as ³trading² on Wall Street today is just the 
endless expansion of credit via newer and more opaque debt-instruments. It¹s all
a sham. America ¹s hard assets are being sold off to at an unprecedented pace.

Credit Crunch: Whose ox gets gored?

When money gets tight; anyone who is ³over-extended² is apt to get hurt. That 
means that the maxed-out hedge fund industry will continue to get clobbered. At 
current debt-to-investment ratios, the stock market only has to fall about 10% 
for the average hedge fund to take a 50% scalping. That¹s more than enough to 
put most funds underwater for good. The carnage in Hedgistan will likely persist
into the foreseeable future.

That might not bother the robber-baron fund-managers who¹ve already extracted 
their 2% ³pound of flesh² on the front end. But it¹s a rotten deal for the 
working stiff who could lose his entire retirement in a matter of hours. He 
didn¹t realize that his investment portfolio was a crap-shoot. He probably 
thought there were laws to protect him from Wall Street scam-artists and 
flim-flam men.

It¹ll be even worse for the banks than the hedge funds. In fact, the banks are 
more exposed than anytime in history. Consider this: the banks are presently 
holding a half trillion dollars in debt (LBOs and CDOs) FOR WHICH THERE IS NO 
MARKET. Most of this debt will be dramatically downgraded since the CDOs have no
true ³mark to market² value. It¹s clear now that the rating agencies were in bed
with the investment banks. In fact, Joshua Rosner admitted as much in a recent 
New York Times editorial:

³The original models used to rate collateralized debt obligations were created 
in close cooperation with the investment banks that designed the 
securities²Š.(The agencies) ³actively advise issuers of these securities on how 
to achieve their desired ratings² (Joshua Rosner ³Stopping the Subprime Crisis² 
NY Times)

Pretty cozy deal, eh? Just tell the agency the rating you want and they tell you
how to get it.

Now we know why $1.7 trillion in CDOs are headed for the landfill.

The downgrading of CDOs has just begun and Wall Street is already in a frenzy 
over what the effects will be. Once the ratings fall, the banks will be required
to increase their reserves to cover the additional risk. For example, ³As a 
recent issue of Grant¹s explains, global commercial banks are only required to 
set aside 56 cents ($0.56) for every $100 worth of triple-A rated securities 
they hold. That¹s roughly 178 to 1 ratio. Drop that down to double-B minus, and 
the requirement skyrockets to $52 per $100 worth of securities held---a margin 
increase of more than 9,000%².

³56 cents ($0.56) for every $100 worth of triple-A rated securities²?!? Are you 
kidding me?

As Mugambo Guru says, "That is 1/18th of the 10% stock margin equity required in
1929"!! (Mugambo Guru; kitco.com)

The high-risk game the banks have been playing---of ³securitizing² the loans of 
applicants with shaky credit---is falling apart fast. There¹s no market for 
chopped up loans from over-extended homeowners with bad credit. The banks don¹t 
have the reserves to cover the loans they have on the books and the CDOs have no
fixed market value. End of story. The music has stopped and the banks can¹t find
a chair.

The public doesn¹t know anything about this looming disaster yet. How will 
people react when they drive up to their local bank and see plywood sheeting 
covering the windows?

This will happen. There will be bank failures.

The derivatives market is another area of concern. The notional value of these 
relatively untested instruments has risen to $286 trillion in 2006---up from a 
meager $63 trillion in 2000. No one has any idea of how these new ³swaps and 
options² will hold up in a slumping market or under the stress of increased 
volatility. Could they bring down the whole market?

That depends on whether they¹re backed-up by sufficient collateral to meet their
obligations. But that seems unlikely. We¹ve seen over and over again that 
nothing in this new deregulated market is ³as it seems². It¹s all stardust mixed
with snake oil. What the Wall Street hucksters call the ³new financial 
architecture of investment² is really nothing more than one overleveraged 
debt-bomb stacked atop another. Ironically, many of these same swindles were 
used in the run-up to the Great Depression. Now they¹ve resurfaced to do even 
more damage. When the crooks and con-men write the laws (deregulation) and run 
the system; the results are usually the same. The little guy always gets 
screwed. That much is certain.

At present, the stock market is running on fumes. Another 4 to 6 months of wild 
gyrations and it¹ll be over. The NASDAQ plunged 75% after the dot.com bust. How 
low will it go this time?

Keep an eye on the yen. The ongoing troubles in subprime and hedge funds are 
pushing the yen upwards which will unwind trillions of dollars of low interest, 
short term loans which are fueling the rise in stock prices. If the yen 
strengthens, traders will be forced to sell their positions and the market will 
tank. It¹s just that simple. The Dow Jones will be a Dead Duck.

So far, Japan ¹s monetary manipulations have been a real boon for Wall 
Street--enriching the investment bankers, the big-time traders and the hedge 
fund managers. They¹re the one¹s who can take advantage of the interest rate 
spread and then maximize their leverage in the stock market. It works like a 
charm in an up-market, but things can unravel quickly when the market retreats 
or starts to zigzag erratically. The recent rumblings suggest that the 
volatility will continue which will push the yen upwards and cut off the flow of
cheap credit to the stock market. When that happens, the end is nigh.

The American People: ³We¹re not a dumb as you think²

It¹s always refreshing to find out that the majority of Americans seem to have a
grasp of what is really going on behind the fake headlines. For example, The 
Wall Street Journal/NBC conducted a poll this week which shows that two-thirds 
of Americans believe that ³the economy is either in a recession now or will be 
in the next year.² That matches up pretty well with the 71% of Americans who now
feel the Iraq War ³was a mistake². Americans are clearly downbeat in their 
outlook on the economy and haven¹t been taken in by the daily infusions of happy
talk about ³low inflation² and ³sustained growth² from toothy TV pundits. In 
fact, the mood of the country regarding the economy is downright gloomy. ³Only 
19% of Americans say things in the nation are headed in the right direction, 
while 67% say the country is off on the wrong track². Iraq , of course, is the 
number one reason for the pessimism, but the dissatisfaction runs much deeper 
than just that.

³Only 16% expressed substantial confidence in the financial industry²‹³18% in 
the energy or pharmaceutical industries²‹³17% in large corporations and 11% in 
health-insurance companies². Only 18% of the people have confidence in the 
corporate media and only 16% in the federal government.

These are encouraging numbers. They show that the vast majority of people have 
lost confidence in the system and its institutions. They also illustrate the 
limits of propaganda. People are not as easily indoctrinated as many believe. 
Eventually the ³bewildered herd² catches on and sees through the lies and 

The American people know intuitively that something is fundamentally wrong with 
the economy. They just don¹t know the details or the extent of the damage. 
Decades of neoliberal policies have inflated the currency, broadened the wealth 
gap, and destroyed manufacturing. Workers can no longer buy the things they 
produce because wages have stagnated through a stealth campaign of inflation 
which originated at the Federal Reserve. When wages shrink, prices eventually 
fall from overcapacity and the economy slips into a deflationary cycle. This 
downward spiral ultimately ends in depression. So far, that's been avoided 
because of the Fed¹s massive expansion of cheap credit. But that won¹t last.

Economic policy is not ³accidental². The Fed¹s policies were designed to create 
a crisis, and that crisis was intended to coincide with the activation of a 
nation-wide police-state. It is foolish to think that Greenspan or his fellows 
did not grasp the implications of the system they put in place. These are very 
smart men and very shrewd economists. They knew exactly what they were doing. 
They all understand the effects of low interest rates and expanded money supply.
And, they¹re also all familiar with Ludwig von Mises, who said:

"There is no means of avoiding the final collapse of a boom brought about by 
credit expansion.²

A crash is unavoidable because the policies were designed to create a crash. 
It¹s that simple.

The Federal Reserve is a central player in a carefully considered plan to shift 
the nation¹s wealth from one class to another. And they have succeeded. Nearly 4
million American jobs have been sent overseas, the country has increased the 
national debt by $3 trillion dollars, and foreign investors own $4.5 trillion in
US dollar-backed assets. While the Fed has been carrying out its economic 
strategy; the Bush administration has deployed the military around the world to 
conduct a global resource war. These are two wheels on the same axel. The goal 
is to maintain control of the global economic system by seizing the remaining 
energy resources in Eurasia and the Middle East and by integrating potential 
rivals into the American-led economic model under the direction of the Central 
Bank. All of the leading candidates‹Democrat and Republican---belong to 
secretive organizations which ascribe to the same basic principles of global 
rule (new world order) and permanent US hegemony. There¹s no quantifiable 
difference between any of them.

The impending economic crisis is part of a much broader scheme to remake the 
political system from the ground-up so it better meets the needs of ruling 
elite. After the crash, public assets will be sold at firesale prices to the 
highest bidder. Public lands will be auctioned off. Basic services will be 
privatized. Democracy will be shelved.

The unsupervised expansion of credit through interest rate manipulation is the 
fast-track to tyranny. Thomas Jefferson fully understood this. He said:

³If the American people ever allow private banks to control the issue of our 
currency, first by inflation, then by deflation, the banks and the corporations 
that will grow up will deprive the people of all property until their children 
wake up homeless on the continent their fathers conquered.²

We are now in the first phase of Greenspan¹s Depression. The stock market is 
headed for the doldrums and the economy will quickly follow. Many more mortgage 
lenders, hedge funds and investment banks will be carried out feet first.

As the disaster unfolds, we should try to focus on where the troubles began and 
keep in mind Jefferson ¹s injunction:

³The issuing of power should be taken from the banks and restored to the people 
to whom it properly belongs.²

Rep. Ron Paul is the only presidential candidate who supports abolishing the 
Federal Reserve.

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