Crater? Implode? Tank? Plummet? Crash?

David Rosenberg is reporting that spot iron ore prices in China are "down to $70 a ton from $200 a year ago." I remember when that happened. Rio and Vale were negotiating with Baosteel to get the biggest contract price increase they could, so they were keeping supply off the market. That's when I made 40% each off DRYS and RIO. Now the demand side is gone. There's no credit, and who knows if it comes back anyway?

The government is doing the best they can. Maybe they're making things worse with guarantees. The problem with guarantees is that everything that's not guaranteed is drying up. Would it come back if the government didn't guarantee stuff and make it easier for people to avoid risk? Perhaps, but when the money market funds looked shaky, short-term T bills went negative, there's so much risk aversion. If the government isn't materially making things worse by guaranteeing too much, then it's even worse than I thought, because then there is no fix except time.

Corporate Funding is Doomed!

Yesterday, I read that Fannie and Freddie have move over $10 billion from long-term funding to short-term funding. Here's another story about how the banks won't lend long-term funds to anyone. Bloomberg is reporting that Credit Suisse and Citibanks are raising borrowing costs by tying rates to CDS. Loans used to be based on borrowers' rating and a spread over LIBOR. Now that counter parties cannot be trusted, the banks are forcing the companies to insure the bonds for them. This is the stupidest thing I've ever heard of. It guarantees that any company that has problems will quickly go into a death spiral, causing huge bank losses. It also confirms my belief that LIBOR is a worthless indicator. I refuse to check it any more or read about it. The BDI is a much better indicator of global credit and liquidity.

Back to the Stone Age!

Here's a vivid example of how much the credit crunch is affecting the real economy, and killing it quickly. From Bloomberg:

In the third quarter of 2007, Volvo AB booked 41,970 European orders for new trucks. Guess how many prospective purchases Volvo, the world's second-biggest maker of heavy rigs, received in the third quarter of this year?

Here's a clue. Picture a highway gridlocked by 41,815 abandoned trucks -- because Volvo's order book got destroyed to the tune of 99.63 percent, with customers signing up for just 155 vehicles in the three-month period, the
Gothenburg, Sweden-based company said last week.

No wonder the Baltic Dry Index is down another 4% today to 885. I think this Volvo story is confirmation that the credit crunch is destroying the real economy.

Game Theory on the Market

15 minutes to the close, the Dow Jones was up 250 points. At the close, it's down 74. What gives? Well, I said to myself, "todays close will tell us if there's any selling pressure left. If it collapses at the end, it will mean that the selling pressure's still there." A couple of weeks ago, the market would get flushed out every day at 3:00 pm. Last week, it was 3:30. This week, it's 4:50. This tells me that there's still a mountain of crap to flush out of the market. The sellers don't want to kill the rally, so they're waiting later and later in the day.

And a quick word on GM: bailout. It seems that GM will get government help in buying Chrysler in return for limits on job cuts. Rumor has it that the Treasury will buy $3 billion in preferreds from GM. That's almost market cap. Also, GMAC has applied for and gotten access to the Fed's commercial paper bailout funds. But they're not out of the woods yet. It depends on how they structure this thing, but if the bonds turn out to be safe, they should be worth $10 to $15.

Credit Crunch Continues

I realized today what I was doing without thinking about it recently. Or rather I've been thinking about it, but I haven't explicitly posted it here yet.

What I've been doing is using the Baltic Dry Index as a measure of trade, and therefore the credit crunch. LIBOR doesn't show what's really happening, because all the major banks are guaranteed by various governments now. But trade doesn't happen without letters of credit, and markets can't even begin to recover until trade can happen. The BDI was down another 5.8% today, to 925. This is much more bearish for emerging markets than for the US. Therefore my short positions in emerging markets.

Two trades: short Brazil (EWZ) at $33.71 and short oil via DUG (ultrashort oil) at $39.57

Shipping Plunges Yet Again

First, a trade: sold FXP for $172.10, a 75% gain.

Next, shipping news: Capitallinkshipping is reporting that the BDI is down to 960. Reuters reports that Brittania Bulk Shipping (DWT) is considering bankruptcy after fuel price hedges caused losses on top of charter prices that didn't cover costs. DWT is now down 98% this year. At it's peak, it was worth $390 million.

Now for the link on the Chinese attack of the dollar: "US Has Plundered World Wealth with the Dollar" - People's Daily. Unsurprisingly, a search on the People's Daily website turned up no matches. The ironic thing about this is that the Chinese Yuan is disqualified from itself being a reserve currency because of its peg to the dollar. My strategy to play this is to wait until FXP drops back down below $100 and buy again. Now that Chinese markets are in sandpaper mode, the ultrashort fund is a great way to trade on this. I was looking at Yuan ETF's, but both CNY and CYB are not marginable securities, so they would take up too much room in my portfolio.

Foreign Currency Exchange

The Telegraph is reporting "Europe on the brink of currency crisis meltdown."

The latest data from the Bank for International Settlements shows that Western European banks hold almost all the exposure to the emerging
market bubble, now busting with spectacular effect.

They account for three-quarters of the total $4.7 trillion £2.96 trillion) in cross-border bank loans to Eastern Europe, Latin America and emerging Asia extended during the global credit boom – a sum that vastly exceeds the scale of both the US sub-prime and Alt-A debacles.

Europe has already had its first foretaste of what this may mean. Iceland’s demise has left them nursing likely losses of $74bn (£47bn). The Germans have lost $22bn.

Since this is unimaginably worse than I was expecting, I don't know what to do except respond by being extremely bearish. What kind of losses will European banks take on these loans? The best case scenario is that they swap bad debt for US Treasuries at pennies on the dollar.

Austria’s bank exposure to emerging markets is equal to 85pc of GDP
– with a heavy concentration in Hungary, Ukraine, and Serbia – all now queuing up (with Belarus) for rescue packages from the International Monetary Fund.

Exposure is 50pc of GDP for Switzerland, 25pc for Sweden, 24pc for the UK, and 23pc for Spain. The US figure is just 4pc. America is the staid old lady in this drama.

Amazingly, Spanish banks alone have lent $316bn to Latin America, almost twice the lending by all US banks combined ($172bn) to what was once the US backyard. Hence the growing doubts about the health of Spain’s financial system – already under stress from its own property crash – as
Argentina spirals towards another default, and Brazil’s currency, bonds and stocks all go into freefall.

This could bring down the Euro. Germany won't want to pay for this, and if Spain defaults, they will be thrown out. Russia is in trouble too. It seems that Central Bank foreign reserves mask enormous private sector foreign liabilities.

The markets no longer believe that the spending structure of the Russian state is viable as oil threatens to plunge below $60 a barrel. The foreign debt of the oligarchs ($530bn) has surpassed the country’s foreign reserves. Some $47bn has to be repaid over the next two months.

So much for deleveraging.

Hans Redeker, currency chief at BNP Paribas, says there is an imminent danger that East Europe’s currency pegs will be smashed unless the EU
authorities wake up to the full gravity of the threat, and that in turn will
trigger a dangerous crisis for EMU itself.

“The system is paralysed, and it is starting to look like Black Wednesday in 1992. I’m afraid this is going to have a very deflationary effect on the economy of Western Europe. It is almost guaranteed that euroland money
supply is about to implode,” he said.

A grain of comfort for British readers: UK banks have almost no exposure to the ex-Communist bloc, except in Poland – one of the less vulnerable
states.

The threat to Britain lies in emerging Asia, where banks have lent $329bn, almost as much as the Americans and Japanese combined.

It appears to me that a global Depression is inevitable.

Also, central banks around the world are more likely to wage financial warfare against each other. Just look at the anti-US rhetoric coming from China. I lost the link, but a high-ranking Chinese finance official is accusing the US of using the strong dollar to steal the world's wealth. Never mind that dollar strength is only a product of the last few months. Never mind that China is the greatest printer of money that the world has ever seen. At least the stuff we printed comes with interest. Be that as it may, I expect them to throw wrenches in the works whenever possible.

The Carnage Continues

First, a trade: my worst of the year. I closed NCC at $2.09. No point in holding it any longer, as they got a buyout from PNC worth about $2.20. No point in quibbling over pennies. I'll take my losses.



Second, my theme of foreign currency implosion continues. The government guarantees combined with the current panic are rapidly destroying the world economy. The weak get weaker, and the strong get stronger. In what I believe is happening all over the world, we have a story from Australia: Four Fund Providers Suspend Withdrawals as Redemptions Soar. Everyone is piling into "guaranteed" banks.



We have another reason that currency losses are continuing. The Herd of Lemmings are all trying to hedge their misplaced bets on US Dollar weakness by selling their local currencies at the same time. If they buy swaps, then the swap seller will sell the local currency to hedge.



But this begs the question, Why aren't US dollar reserves held by foreign central banks stabilizing these currencies? Doesn't South Korea have the third largest reserves in the world? In fact, South Korea has more US Treasuries than the Federal Reserve.


The answer is that a central bank holds reserves not because it saved, but because it printed. If it did not print, how would it then hold reserves in a foreign currency? Now, there is not one central bank that did not print more than its reserves. So, selling reserves to buy back printed money is guaranteed to make things worse. The more reserves are sold, the smaller the ratio between reserves and printed currency gets. In other words, if you have $20,000 in the bank and $30,000 in debt, your coverage is 0.67. If your debts go to $40,000 and your reserves go to $26,000 (both up 30%, as in the won's fall against the dollar) you're in trouble. Your coverage ratio has fallen to 0.65. That's bad. Now let's say you have to pay off 15% of your debt because it's due and no one will lend you any more. Now debt is $34,000 and reserves are $20,000. Now you're down to 59%. Uh - Oh. Can anyone see the vicious circle death spiral?


Remember, the hidden truth is that reserves are evidence of currency printing, not savings. Currencies with reserves have been grossly overvalued, and still are. Reserves are a sign of weakness that is not priced in, not strength.


How else do you explain this title: "Russian default risk tops Iceland as crisis deepens."

Kingsmill Bond, chief strategist at Russian investment bank Troika Dialog, said Russia's Achilles Heel is the lack of a proper rouble bond market. This had forced companies to raise half their money abroad, in foreign currencies.

"The consequence is that foreign debt repayment has had a dramatic impact. It has led to a scramble for assets and forced selling of good assets in order to raise cash to pay debt. The only way for oligarchs to raise money at present is by selling their equity," he said. Russia's "unique fragility" is that over $1 trillion of debt needs to financed from a domestic capital pool of $600bn.

What do Russia, Brazil, Mexico, and South Korea have in common? Huge dollar reserves. I rest my case.

LIBOR Coming Down

The problem with LIBOR coming down is that it's been rendered irrelevant by our "Brave New World" of government guarantees on bank debt.

Lee Adler is making the point on Radio Free Wall Street that the Fed's guarantees are severely tilted towards short-term lending. The long-term is getting crushed. Two examples of this are 30-year interest rates and high yield bonds, which are paying 14-15 points over comparably dated Treasuries.

In other words, the Treasury is sucking most of the long-term funding out of the market. Just as by guaranteeing bank debt, world governments are suffocating the non-guaranteed market. This just looks like a mess to me, and I think it will take a long time to sort out.

One of the questions this raises is, "Will there be a widening or a narrowing of the price of short-term versus long-term funding?" Well, unfortunately, I am limited in how I play this. I am only willing to take one position on this corporate bond play, and I've done that with XGM. I'm unwilling to risk more than that. Closed-end funds are being touted as an option that provides diversity and a discount to net asset value, but many funds were leveraged, and that raises my research and time costs prohibitively at this point. Maybe I'll try to Google for five minutes and see what I come up with. But I won't touch a fund that's leveraged.

New Analysis

The thought came to me: If all governments are going to guarantee their own banks, what's the difference between them?

In other words, what does it mean to say, for example, that Australia has guaranteed all debt issued by its banks? Or Korea, for that matter. Let's stick with Korea. They recently announced a $130 billion plan to shore up their banks. According to Bloomberg, "South Korea will guarantee local banks' new foreign debt taken out from yesterday to June 30, 2009." Guarantees are all well and good, but what do they mean? I suppose the Korean government is taking the risk from the banks as well as responsibility to pay for any defaults. But what would they pay with? Won, of course! And that is a problem. The won is a bit shaky. Actually, it is the worst performing currency in Asia, down 30% against the dollar this year. By guaranteeing foreign denominated debt, the government is leveraging the losses the won will take if it continues to slide. There's another thing going on here. Local businesses went from hedging their expenses to just hedging against the dollar going down to taking actual short positions on the dollar. Now they are 30% in the hole. I'm going to bet against the survival of this farce. Time to short Korean banks.

Australia's currency is down 31% this year. How good is their guarantee?

What about Brazil? or Mexico?

Again, in a way, this all goes back to commodities. If they bounce back, they'll probably carry emerging markets with them. A short on South Korea is probably safer than a short on the raw material powerhouses of Australia, Brazil, or Mexico, though. So I think I'll start there.

And while I'm on a roll, this Imarex report from Capitallinkshipping claims that China has stockpiles of 71 million tons of iron ore. Just how much of a supply is that? Well, at $150/ton that $10 billion. Sounds like a lot, but we need more info. Well, this official data puts September imports at 39 million tons. So that's almost two months of inventory. A lot, but not a whole lot. But steel prices have plunged, so future demand will bbe much weaker. It doesn't look like we're at the bottom yet.

Meanwhile, the charts show the market in a tightening pattern, predicting a sharp up or down break soon. Meanwhile there's a story from BusinessWeek that Kirk Kerkorian is leveraged up to his eyeballs and probably will be facing margin calls soon. He pledged 50 million MGM shares for $600 mil in credit from B of A. That was when MGM was worth $53. Guess what? It's worth $14. Kirk has had to put up another 50 million shares. He's only got 50 million left.

Sounds like we've got people lined up around the block waiting for more margin calls, and selling everything they can so they don't get one.

I guess I'm going to play it safe and (possibly) short the MSCI South Korea Index ETF (EWY). Maybe tomorrow. Maybe I'll watch it a little more.

Better Safe than Sorry

I chickened out. I'm not going to go long here. Why? Because I'm not sure any more that credit is unfreezing. LIBOR is worthless. Why? Because it's just banks lending to more guaranteed banks. Now that most of the world's banks have government guarantees, who will deal with a bank that's not guaranteed? Without market pricing, there is no transparency. I can't see what's going on. So, I need to think about what I want to do some more. Right now, I'd rather be safe than sorry.

Gearing Up

At the close today, I will buy 10% positions in DRYS, CLF, and MOS. Why? I think we're due for a nice little bear market rally. Yesterday's 400 point rally was disappointing to some, as NYSE volume was 31% below average. While it was weak, it tells me that the forced deleveraging is over, at least for now. Also, I spoke with a professor who confirmed that the credit crunch was most likely severely impeding international trade. If that is the case, I can still bet on world governments breaking up the credit liquidity logjam even if I believe that the commodity bubble is burst and done with. It's just time for a rally.

Let's compare the Baltic Dry Index with the Intertanko VLCC spot charter rates. Tanker rates are at a much healthier $60,000/day. This is right in line with the average going back to the beginning of 2002. I use 2002 because the BDI is now at the lowest it's been since 2002, and has plunged 90% this year. Now the tanker rates plunged 90% earlier this year (briefly) as speculators manipulating the market used boats for storage and then dumped them and the oil on the market. But it bounced back quickly. We now have confirmation that oil demand is slowing sharply - down 10% yoy in the US. Who would have thought that was possible? It hasn't happened since the oil rationing of the 70's.

Bottom line: I believe that the credit crunch has created some pent-up demand for commodities and there will be a bounce. I will play these loosely, although if I feel greedy, I will try to sell when the stocks get back to their 50 day moving averages.

And a quick word on Barack Obama. If he becomes president, he will raise taxes, which could cause money and capital to flee the country. The dollar will weaken, and Treasuries will plunge at some point in his presidency. Let's hope that doesn't happen. A strong dollar for a number of years would go a long way towards redistributing wealth from the rich to the working class. Asset prices would come down along with living expenses. The important thing is to keep the capital in the country which would encourage the rich to invest in domestic industry. If capital flees the country, then they'll start bubbles and booms somewhere else, which will suck more money out.

The Wheels are Starting to Turn

LIBOR is coming down, which doesn't mean anything, now that most bank debt is guaranteed. Commercial paper rates are coming down, which doesn't mean much since the government is a week away from stepping into that market as well. Treasuries are down. As Rosenberg said, why buy Treasuries when there's guaranteed bank debt?

I think that all this money is setting the stage for a ferocious rally. Just a feeling, but I covered my AMZN short today. I am holding on to DECK for short retail exposure, short ITB for homebuilders, and short COF for consumer credit downside. However, as Rosenberg points out as well,

how can the transports be down 25% since mid-September with the oil price down 27% over the same time period? To have transports down 25% at the same time that utilities are down 20% in the same 30-day period – well, we assure you, this has never happened before after scanning data back to 1960. And in the past, when the oil price is down this much in a month, the transports are up 10%,

I am thinking of L for value, UAUA for transports, ACI for Crack-up-Boom bounceback and maybe General Mills, Kraft, or Kellog for a beaten down consumer staple which will be able to take advantage of falling commodity prices.

Well, a quick look at UAUA shows a bounce from $2.80 at the low to $12. I was thinking I would like about $8. LUV is too high as well. The food co's, KFT, K, and GIS are much too expensive with P/E's of 17 or 18.

The best values I see are MO with a div. yield of 6.6% and a PE of 5. Then there's L with a book value of $40 and $25/share in cash. As far as a crack-up-boom bounce play, I need to find out if the credit crunch is really behind the drop in the Baltic Dry Shipping Index or not. The reason I'm skeptical about this is that the oil tanker rates have not dropped as much. That leads me to think that there may be other factors involved.

Posted on Russ Winter's Actionable

This is a response to Russ's assertion that US coal companies are cheap and its time to buy. They are cheap, no doubt about that. However, I think it may be too early. See below. Nota bene: no link has been provided to Russ Winter's Actionables, as it is a subscriber-only service. See WallStreetExaminer.

Russ,
The commodity crack-up-boom was one of the great frauds in human history. Copper still trades 30% higher in Shanghai than in Singapore. Why? Because the biggest industry in the entire world, bigger than all Chinese manufacturing put together was the Chinese printing-and-laundering-through-commodities bubble. See NY Times: “when adjusted for inflation and the Chinese currency’s rise against the dollar, Chinese exports actually fell 0.5 percent in August from a year earlier, and are likely to be flat for September.” China Daily reported back in Jan. of this year that “China’s coal imports rose 34 percent to 51.02 million tons last year, according to customs statistics.” US Energy Info Admin. reports that for Q1′08, US coal exports rose 41%. Europe is the biggest buyer.

Conclusion: Coal prices will plunge by the end of the year.Russ, I think you have the right idea here, but I think you’re too early.

Headline

So, I'm getting coffee today and I glance at the newspaper in the vending maching. It's the Claremont Daily Bulletin. The headline reads, "DOW Down 76 Points."

Psychologically, we are not ready for a rally. When nobody cares about the DOW anymore we will be at the bottom.

In other news, we just had the worst retail sales numbers for September in three years. Sales dropped 1.2%.

And the Great Unwind is not over. Bloomberg reports that $65 billion is still frozen in Lehman Brothers. It's $45 long and $20 billion short. But the market's dropped 20% since Lehman cratered and there are margin calls on these securities. That's just great. You get a margin call, you can't sell to salvage what you have left, and you may not even own the securities anymore! Steven Pearson at Pricewaterhouse Coopers is in charge of separating assets

held in trust on behalf of clients and those the bank held as collateral from clients that it could then loan to other investors, a practice known as rehypothecation.

``The biggest losers will be those who had the most assets rehypothecated because they're gone,'' said Pearson.

.....

``It's going to be many months and maybe beyond many months,'' he said. It could take years to unravel.''

.....

``Every second that they waste hurts,'' said Edward Chin, who runs Pride Revelation Fund, one of dozens of hedge funds in Hong Kong that used Lehman as their sole prime broker. ``We're looking at many hedge funds that will have to shut down, but they can't even shut down because they don't know what they have left. The thing is I cannot now even liquidate the fund.''

.....

``If you play the long game you can unlock value, and we can play the long game,'' said Pearson. ``If you hold a fire sale you get fire-sale prices. You don't want to be selling assets in a falling market.''

So, there you have it. Any rallies are going to be sold into for a long time.

And now comes some confirmation from Bloomberg of my idea that one of the unintended consequences of government action in the markets will be to institutionalize the credit crunch.

The discount cuts the cost of cash to 2.2 percent from 3.7 percent for General Electric Co. and from 4.7 percent for Citigroup Inc., data compiled by Bloomberg show. One possible unintended consequence: private buyers are shut out.

``The Fed can drive everybody else out of the market'' for buying commercial paper unless market yields drop, said Robert Eisenbeis, chief
monetary economist at hedge fund Cumberland Advisors Inc. in Vineland, New Jersey, who used to work at the Atlanta Fed. That could end up "`assuring that markets won't restart,'' he said.

The CPFF will be up and running by October 27th. One other thing that caught my eye is that they will only be accepting top-rated commercial paper. That might be very bad for GM. I'm getting nervous after XGM's huge runup over the past two days, and I am very tempted to sell half of my position, especially now that XGM has jumped from 15% to now about 25% of my portfolio.

And shipping rates dropped another 10%+ from yesterday. Even Bloomberg doesn't know how long it's been since rates were this low.

Commodity shipping rates plunged to the lowest in more than five years ... Traders are finding it harder to get letters of credit that guarantee payments for goods, shipping executives said.

Hmmmm... maybe some of this drop is overdone and will come back if and when credit starts moving again. DRYS has fallen 84% over the past year and its P/E is 1.04. However, shipping rates have also fallen over 80% and the question is not how much they make but can they cover their debts and survive.

Trade

I was going to take a loss today on TSO since it's bounced up 40% off last week's lows. But then I read the third quarter earnings guidance: $1.70-1.90 per share. Not bad for something trading at $10.

I was thinking about getting out of PWE, but I want $20 for it. In the meantime, I get paid to wait.

But I did find something to trade: COF. It's back up to the mid 40's and it announces earnings on Thursday. They expect $1.11; COF lost $0.21 a year ago. I think that will be tough to meet.

Baltic Dry Shipping Index

The Baltic Dry Shipping Index is now at a 3-year low. Unfortunately, the chart only goes back five years. If the 2004 low is taken out, we won't even know how long its been. Now, part of this collapse is due to overbuilding of ships. But most of the collapse is due to a much smaller global economy.

David Rosenberg has a nice chart of the S&P 500 that shows market cap is still 78% of GDP. The post WWII average is 40%. The peak was reached at 130% in 2000, just before the dot-com bust.

And one more little thing. According to the LA Business Journal, housing prices fell by 5%. In September. There are $12 trillion in mortgages out there. But the real question is, how much leverage is still on those bad loans?

So, I remain bullish over the next week or two. But I believe that the stock market will make new lows, maybe not this year, but certainly next.

Everyone Guaranteeing Everything

If every government guarantees everything, then what good's the guarantee? Everything will be the same. In fact, that is basically what's happened. Since Ireland guaranteed all bank deposits, everyone rushed to take their money out of British banks and put it into Irish banks. So, the UK took over RBS, HBOS, and partially nationalized Barclays. That was last week. Now, over the weekend, we have France and Germany coming up with $1.8 trillion Euro-Zone proposal to guarantee all bank debt for the next five years. How will other banks compete? When US banks have to pay more for borrowing, then the US government will probably step in and do the same thing. This is ridiculous. It is unsustainable. The governments of the world are just printing money as fast as they can just to not fall farther behind.

I'm going to give this rally a little bit longer and then I will start going short again. The governments of the world have not made the fundamentals of the world economy any better. They have not made the banks any safer. All they have done is encouraged people to take their money from some banks (whether they are good or not) and put them into guaranteed banks (whether they are good or not). In the long run, this will result in the collapse of some good banks, and the multiplication of losses in some bad banks.

Trading Concerns

I have two trading concerns. The first is that I have too much long at the moment. The second is that most of my shorts are more volatile than the longs. So, if the market reverses, I'm afraid I'll get whiplashed.

It's an easy fix, though. All Ihave to do is sell FXP.

One More Thing

David Rosenberg reports that the Fed has lent banks $839 billion from the discount window in the past two weeks ending yesterday (Thursday, October 9th, 2008).

3-month LIBOR is at 4.82% and the prime rate is at 4.50%. The average rate for consumers and business is at 8.14%. Banks are borrowing all they can and lending out as little as possible.

Where Did the Money Go?

My roommate from China asked me this. Very good question. Simple answer: It was never there. It was all fake. It was all debt. Debt (or credit) is not money. If people don't think you'll pay, its worth less or even worthless.

All the money was just a giant printing scheme. OPEC and emerging markets printed money and bought what we printed, which was Treasuries and MBS. Wall Street made up new stuff with higher yields and fake safety ratings, and the rest is history.

Also, here's a philosophical question: If holding dollar-denominated reserves makes a currency more valuable, why isn't the decline in, say, the Peso offset by the rise (in Peso's) of the central bank's reserves? Again, simple answer: The reserves aren't enough to offset the printing they did. So, if they start selling T's to buy Pesos, the drop in their reserves will offset the Pesos they buy. What? Huh? Doesn't one side equal the other? No, it doesn't. Subtracting the reserves upsets the valuation ratio more than not subtracting them. Here's an analogy: if you're losing in Chess, you don't want to just trade pieces.

Credit Default Swaps

$128 billion in Lehman Brothers credit default swaps will get their final price today. According to Bloomberg, the initial price on the bonds was 9.75 cents or 25% lower than the lowest estimate. $115 billion in CDS payments will have to be made. When Lehman went bankrupt, CDS were selling for 5% +790 bips per year. Buyers will be jumping for joy - if their counterparty can pay up. I wonder how the hundreds if not thousands of CDO's that sold CDS are holding up right now.

And now for some good news: Oil under $80! Time to buy that gas guzzler you always wanted!

The Great Unwind

The great unwind continued today. The deleveraging is uncontrollable. Mutual funds have reported $72 billion in withdrawals. The Mexican government is afraid to draw down reserves, according to Bloomberg. Every time the market made a move today, the unwinders were on the sidelines selling more. At three o'clock the floodgates opened. Volume ballooned and the bottom dropped out. Spreads started to open up. If we have an opening like we closed today, they'll have to close the exchange.

However, I continue to be biased towards buying US and selling international equity, as the strong dollar gives me a little confidence.

Two trades today. I sold my bonds in the morning for a tiny loss, and I bought more XGM at $3.88, as it plunged today.

More Reasons

Another reason I think the unwind has a way to go is from a comment made by Lee Adler on Radio Free Wall Street. He said something that I think is very important, prescient, and correct. He said that all the Fed's recent actions, especially the CPFF and the Paulson plan are aimed, not at shoring up assets, but the securitizations of those assets. In other words, they are trying to stop the current deleveraging process.

Now, given this new way of looking at things, I have to sell my Teasury bonds. Although they are holding their own, we now have Russia, Korea, Brazil, Mexico, and more selling Treasury bonds to shore up their currencies.

For the past 10 years, emerging markets have printed worthless paper and used it to buy paper from the US. Now they are all trying to sell Treasuries and buy real dollars at the same time. They will then use those real dollars to buy back what they printed over the past few years.

Betting on the Break

I went out on a limb and made two trades at the close today.

The Brazil index (EWZ) I shorted at $37.00
I shorted the Canadian index (EWC) at $37.43

I am betting on the deleveraging continuing. I picked one most likely to break (Brazil) and the one hit less than most (Canada).

One of my online sources was saying that an inside source at a Canadian fund of hedge funds needs to liquidate $7 billion. And that's just losses from the last week, not including this week. We've gotten to the point where the more it falls, the more it falls. If there's a huge rally, I'll sell off a holding or two.

I expect more currencies than Iceland and Russia to break. What they will learn is that their stash of Treasuries is worthless when they try to get real dollars for them to support their currency. I need to think about this idea more, and the ramifications of it, but it's bearish for world stock markets.

What Do You Do

What do you do when you don't know what to do? The future is too uncertain to make any firm predictions short-term. However, I still think I have a pretty good picture of the longer-term landscape. The coming theme will be, surprise, surprise, Deflation!

Starting with this theme, I will try to sell out of any bounces and hold onto my shorts for the short-term. If we get a 1987-style crash where the bid-ask spreads gap out, I will try to pick up some names cheap. I am partial towards companies that will benefit from a strong dollar and commodity inflation. I also like OZN at these levels, but I don't want to go over 50% exposure. If my exposure drops below that, I'll find something to buy. General Cable or WalMart or something.

Everything Breaking Down Again

We are now in Day 6 of the unrelenting stock market drop. Part of me is looking out there and saying, "Look at all the unwinds that are occurring. I need to sell." And the other part is saying, "When people are unwinding, I need to buy." The VIX is at 57.

The problem I have is that I have no idea where we are in this unwind. However, it looks more and more clear to me that there won't be much of a bounceback in the deflation that we appear headed into.

I should have bought more of those Treasury bonds:

Oct. 8 (Bloomberg) -- The U.S. Treasury said it will sell more debt to meet demand for government securities and alleviate ``protracted shortages,'' said Karthik Ramanathan, the department's head of debt management.

One strategy I was thinking of the other day would be to short the safest stocks out there: WMT, JNJ, MCD, K. If the market crashes, they will fall too. If the market recovers, the upside is limited.

The Problem

... with the Fed's alphabet soup is that it is institutionalizing the credit crunch. Let's take the Fed's announcement that it will pay banks interest on reserves. The problem is not that Ben can't print. The problem is that the banks don't want the money. If they wanted the money, the Fed wouldn't be lending at 1.35%. Printing more money for the banks that have reserves won't make them lend.

I don't know what will, but it will probably take a lot of time for confidence to be restored.

Fear and Hilarity

Here's a gem of a quote from Bill Gross. "We are to the point of fearing fear itself'' (Bloomberg). The Fed is now buying commercial paper. This is huuuuuuge. The Fed's printing so much money, they might as well just buy everything. The only thing I'm interested in here is, "how much?" but they don't answer that.

Buy the Fed can print as much as they want and the dollar will still go up. Iceland, the little country that decided to engineer great wealth through financial innovation got frozen into one of their famous glaciers. People are buying anything imported to the stores in a panic because their currency is worthless and they don't have any Euros to buy anything with. How could this happen? Well, here are some more detail from Bloomberg. I think they speak for themselves.

The global credit crunch has crippled Iceland's biggest banks, which have racked up foreign debts equivalent to as much as 12 times the size of the economy. The nation's current account gap swelled to the equivalent of 34
percent of gross domestic product in the second quarter, mainly because of the cost of debt payments.

``The commercial bank model there has failed,'' said Sunil Kapadia, an
economist at UBS Ltd. in London. ``For such a leveraged economy as Iceland, it was clear this was going to happen, but the pace has been surprising.''

About 90 percent of the external debt was generated by the three biggest banks, Kaupthing Bank hf, Landsbanki Islands hf and Glitnir Bank hf. The
government took control of Landsbanki today, following the nationalization of Glitnir on Sept. 29. It also loaned 500 million euros to Kaupthing and guaranteed domestic deposits.

Hmmmm... 12 times the economy, you say?

Iceland says they won't default, but they will have to if they don't get a rescue.

Deleveraging

Today's market action shows that the deleveraging of the hedge funds is still happening. This deleveraging seems to me to have spread from more speculative crack-up-boom plays to less speculative stocks, such as PWE and TSO. Does this mean that the bottom will be in soon? Or does it mean that the spread will force further deleveraging? In my mind that is getting more likely. But we shall see. I consider myself very lucky to have delevered with my sales today with a 0.5% loss. On the other hand, I want to kick myself for not cashing in big-time here.

More on the Fed

The rate paid on excess balances will be set initially as the lowest targeted federal funds rate for each reserve maintenance period less 75 basis points. Paying interest on excess balances should help to establish a lower bound on the federal funds rate.

From the Federal Reserve. While they say that paying interest puts a floor under the Fed Funds rate (for what reason, I don't know), I believe that the opposite is true. The Fed Funds rate will fall, making the interest rate worthless, unless they keep it at 1.25%. Actually, though, the actual rate the auctions are being done at are almost 0%. Case in point is today's open market operations. Cash was auctioned for Treasuries at a weighted average rate of 0.36%.

If the banks have any money left over, they can just leave it at the Fed for a 100% guaranteed 1.25%. I think this is a disaster.

Look out Below!

With the DOW down below 10K, and just about everything I'm long on down double digits, I'm thinking maybe I'm not such a good value investor. Also, here's news from Bloomberg that doesn't give me a lot of confidence:

Implementing part of last week's emergency legislation to shore up the financial industry, the Fed said today it will begin paying interest on the cash reserves banks hold at the central bank. The step should give Fed officials greater power to inject cash into banks without interfering with their benchmark interest rate, which stands at 2 percent.

This is very bad news. Banks will hoard cash at the Fed, rather than lending it out to companies or consumers or each other. I believe that the Fed knows this. Then why would they do it anyway? Because they must think that the banks are so undercapitalized that this is the only way to recapitalize them. But it won't work. Collateral values are based on the availability of credit, and the lack of credit will impair collateral values far faster than it will improve banks' balance sheets.

I'm thinking that I want to take some profits. DUG is up to $52. However, I will then be unhedged, and have too much long exposure on my portfolio. Studies have been done on trading psychology, and it appears that people usually tend to take profits too quickly, and hold losses too long. I don't want to make both mistakes, so if I take a profit on DUG, I think I'll have to take my licks on probably both ACI and CLF. As I write, the DOW is now down 541.

Fear

Am I afraid of being long in these markets? You betcha! But I'd rather act against fear than with it. Everyone else is afraid too, and probably more afraid than I am. I believe that I'm making the right bet with what I know, even if it goes against me. It's like Texas Hold-Em. You play your hand and your opponent, but sometimes the river goes against you.

CDS Haven't Been Settled

The Financial Times reports that:

The "auction season" starts tomorrow, when the International Swaps and Derivatives Association has scheduled an auction for Tembec, a Canadian forest products company. This is followed by Fannie Mae and Freddie Mac
auctions on October 6. Then, Lehman is settled on October 10, and Washington Mutual is scheduled for October 23.

* * * * * * *

The recovery value will be set by auction. Usually, the bond that
is eligible for the auction that trades at the lowest price - the so-called
cheapest-to-deliver - is the one that sets the overall recovery value for the
credit derivatives.

Apparently, CDS are settled by auction. So, counterparties don't know what their exposure is. There are about $500 billion just on Fannie and Freddie. Who holds this? How much do they owe? Who are the winners on this? Who are the losers? Here's a preview based on the Lehman bonds.

Lehman's bonds have been trading between 15 and 19 cents on the dollar, meaning investors who wrote protection on a Lehman default will have to
pay out between 81 and 85 cents on the dollar, a relatively high pay-out.

Again, I may be contrarian in thinking that the market's oversold. However, I think all the cash hoarding is bullish short-term. Everyone's as prepared as they're going to be for this. On the other hand, fear and panic can become a self-fulfilling prophecy.

Patience

Update

Well, the world's financial system survived the end of the quarter. There were no new announcements of major bankruptcies today.

There were a couple of interesting things in the news, though. Here is a story from Bloomberg about money sent back to Mexico. Remittances plunged year over year by 12.2% in August. This can't be good for the Peso.

Mosaic plunged 20% after hours after disappointing analysts. POT is down 10% along with it. The scary thing for bottom fishing is that MOS was down 59% from the high, and is now down 64%. Where is the floor under this company? The P/E is down to 11.9 times. The market seems to be pricing negative growth for the future despite earnings growth of 285%.

This may happen. The Baltic Dry Index is down to the lowest level in almost 3 years. I think that some of the drop is due to recent deliveries of large numbers of boats. Unfortunately, I don't know exactly how many boats have been delivered. However, I continue to think that short-term (next couple of months) that the sell-off in commodity stocks is overdone.

Alt-A Worse than Subprime

According to Standard & Poors, Alt-A delinquencies for 2005-2007 are rising faster than subprime delinquencies. See ResearchRecap.

Up to My Eyeballs

I just bought some more stuff: ACI and XGM. It seems to me that these stocks are pricing in a depression. Also, Al told me yesterday that the auto sales numbers are being understated immensely. The auto dealers are having trouble getting credit. They get the cars from the manufacture free for one month. Then they pay 2% per month on the car. What they're doing is selling the car, and not reporting the sale. They pocket the money, and then they pay the 2% per month because it's cheaper than the funding they can get from the banks. There are two ways of looking at this. The first way is that if the dealers go bankrupt, the manufacturer loses the money on the sale and the merchandise. The other way to look at this is that the sales numbers are really much higher than reported, especially for Ford. I think about 20% of GM's dealers are company owned, so their numbers should also be much better. If there's any kind of bounce, I think the bonds will do very well. If they don't they have the $25 billion government bailout to back them up. I take this as a sign that the government won't let them default.