Thursday, September 18, 2008

Executive Summary

• The chance of a major dollar crisis is one step closer to being a reality.
• The US has thrown all fiscal caution to the wind in an effort to prop up our old way of doing things. 
• We are exchanging future US liabilities for bad current debts.
• All of this represents the bursting of the largest credit bubble in history.
• The rules have changed.  Be prudent.

This report explains the recent move by the Treasury in offering $100 billion in new debt to "help bolster the Federal Reserve balance sheet."

I focus on this because I believe it marks the beginning of the end of the US dollar.

Want to know why gold popped so hard, and the reason why I am ready to call for a major dollar wipe-out?

It is all contained in yesterday’s news that the Treasury Department is going to “help bolster the Federal Reserve balance sheet” by selling Treasury bonds and giving that cash to the Fed.  Oops.  Today (9/18/08) the announcement is that the amount of new government debt is going to be $100 billion.

Sept. 18 (Bloomberg) — 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.

Yesterday the Treasury started a special program to help finance the Fed’s portfolio with an initial $100 billion in bill auctions. The proceeds will give the central bank cash to boost liquidity in credit markets struggling from $519 billion in writedowns and losses since the start of last year.

I’m sure most of you are scratching your heads right now.  What does all this mean?  Whose balance sheet is doing what, and which money is going where?

Let me demystify this process for you.

Here’s the actual mechanism. The black arrows connote the movement of US government debt (the yellow boxes), and the green arrow shows the movement of cash. 

1. Starting in the upper left corner, the Treasury auctions off (sells) bonds into the open market to financial institutions.
2. The Treasury receives cash for those bonds.
3. The Treasury then hands this cash over to the Fed (top green arrow).
4. Separately, the Fed steps into the open market and buys bonds/bills and Mortgage Backed Securities (a.k.a. junk) from banks.
5. The Fed pays cash to the banks/institutions for these bonds.

Hang on here.  Isn’t this overly complicated?  It sure is, and that is the intent.

As in a simple math problem, we can cancel some like terms and make this all a bit easier to understand.

Here’s the simplified view with all the complexity stripped out.

Ah!  That’s better.  It means that the Treasury just shipped $100 billion of newly created US Government debt over to the Fed, to use however it likes in battling this crisis.

What does this mean?  It means that the Treasury Department is now sharing the burden of ruining its balance sheet alongside the Fed, which, truth be told, has pretty much already ruined its own balance sheet.  A year ago, the Fed had $880 billion of Treasury debt on its books, whereas now it has less than half that amount, the rest having been swapped for Mortgage Backed Securities in what I call the "Treasuries for Trash(tm)" program.  So this means that the US Taxpayer is now funding the ability of the Fed to do what it does, which is mainly to accept bad mortgage debt (and now equities too!) in exchange for safer, better Treasuries.

What else does this mean?  It means that the chance of a major dollar crisis is one step closer to being a reality, because the US has thrown all fiscal caution to the wind in an effort to prop up our old way of doing things.  It means that we are exchanging future US liabilities for bad current debts.

It means that if anybody asks you about this puzzling bit of maneuvering, you can simply say, "It’s just the Treasury Department going deeper into debt, so that the Federal Reserve doesn’t have to."

While it is possible that this will work and everything will return to normal, I am not able to give it much of a chance of actually working, due to the numbers involved and the basic facts of the case.

At bottom, all of this represents the bursting of the largest credit bubble in history.  For this all to return to normal, it will require houses to get back to their frothy levels of 2005, for credit to be as freely available as at the peak, for people to be “tapping their home equity” at the same rate as before, and for more autos to be sold than at the peak.

Unless all of that happens, and more, the credit bubble will not expand beyond its old boundaries, and we will not be able to support all of the past debts.  Therefore, we can be pretty sure that some capital destruction, and possibly quite a lot of it, is on the way.  There’s really very little that can be done about that.

My advice to you is the same as it has been for months:

• Trim your expenses as far as humanly possible.
• Don’t take on any more debt for any circumstances, unless you are speculating and can manage the risks.
• Hold gold and silver, physical only.  How much?  That depends on how many of your US-dollar-denominated holdings you’d like to be absolutely sure do not go to zero.
• Keep cash out of the bank.  Three months’ living expenses, if you can.
• Develop a sense of community and get to know the people you can count on and who will count on you.
• When you can, keep things topped off around the home.

Please, be prudent.  The rules have changed, and this is no time for status quo reactions.  Not only are tough times coming, but they literally have no historical precedent, as we’ve never had a credit bubble this large burst so suddenly.