The bail out of Bear Stearns has validated all the worst fears and forecasts expressed in these newsletters over the past few years. The Fed has once again verified that it will create whatever new liquidity is required to prevent any particular crisis from developing into a deflationary debt implosion.
The bail out was undertaken not because Bear Stearns was â€śtoo big to failâ€?. It was done because of something called â€śinter-connectivityâ€?.
What does this mean? It is Fed-speak for concern about the $600 Trillion notional value of derivatives outstanding, with just about every bank in the world participating to greater or lesser extent. By far the biggest player in the derivatives market is J P Morgan.
The problem with derivatives is that these are individual transactions between 2 or more parties. Often the transactions are arbitraged onwards to several other players. Everyone in the chain relies on all the other parties to meet their obligations. If one party in the chain goes bankrupt, it can cause a domino like collapse of all the other parties in the chain â€“ if the bankrupt party is a large player in derivatives. They are all â€śinter-connectedâ€?.
Bear Stearns is known to be a big player in the derivative markets and must have been a major counter party to many transactions with JP Morgan, given Morganâ€™s huge derivative positions. Hence Bear Stearns had to be rescued because of â€śinter-connectivityâ€?; to prevent a melt down in the derivative markets. It can hardly be a coincidence that the bail out was routed through J P Morgan.
Let us be clear about where this will end. It will end with the Fed and/or the US Government owning or guaranteeing all the bad debts and losses from all sources in order to preserve the existing system. It has serious implications for the value of the US Dollar, the international monetary system and for inflation. The vast quantity of new liquidity that needs to be created will almost certainly result in runaway inflation.
The initial stage of this developing crisis created a change in sentiment from "what is the return ON my investment" to "how do I get the return OF my investment".
That change in sentiment caused a rush to buy US Government bonds and short dated Treasury Bills. Holders of these assets are assured of the eventual return of their capital in nominal terms, i.e. in current US Dollars. This would be a smart move if the crisis was developing into a deflationary debt implosion. It is not a smart move in a runaway inflationary event.
The next phase in this crisis is likely to involve a further change in sentiment to "how do I protect the value of my capital in REAL terms?"
When that change of sentiment occurs, there will be a rush out of bonds into tangible assets that offer protection in real terms. The bond markets are several multiples bigger than the stock market. Consequently when this change occurs, very large amounts of money will be chasing relatively small amounts of those assets that provide protection in real terms. Expect very large and rapid gains in the precious metals, base metals and mining company shares as a consequence of the coming rush out of bonds.
We can now consign Government Bonds to the upper layers of John Exterâ€™s inverted asset pyramid that has been referred to several times in these newsletters. For ease of reference, the description the inverted pyramid is appended:
"Imagine an inverted pyramid consisting of layers of various investment asset classes where the least secure (and most prolific assets) are in the very wide top layers. The inverted pyramid then narrows down through layers of increasingly more secure assets to the small point at the base which consists of the most secure (and least prolific) assets. The theory is that in times of financial crisis investors will cause their investments to devolve downwards through the different asset layers in the inverted pyramid as they search for greater security. This move to assets representing greater security is already happening in the current crisis.
The asset in the most secure category at the tip of the inverted pyramid is gold. Platinum and silver bullion lie directly above gold. Precious metals have performed the function of protecting wealth throughout the ages. In the layer above the precious metals are base metals, uranium and the minor metals. Above them are the companies that mine and hold large deposits of metals. The least secure assets in the envisioned environment, which form the broad layers at the top of the inverted investment pyramid, will be financial and paper money assets."
Bottom line: It is time to part from your debt.
17 March 2008
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Disclosure and Disclaimer Statement: The author is not a disinterested party in that he has personal investments in gold and silver bullion, as well as in gold, silver, uranium and base metal mining shares. The author’s objective in writing this article is to interest potential investors in this subject to the point where they are encouraged to conduct their own further diligent research. Neither the information nor the opinions expressed should be construed as a solicitation to buy or sell any stock, currency or commodity. Investors are recommended to obtain the advice of a qualified investment advisor before entering into any transactions. The author has neither been paid nor received any other inducement to write this article.