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Washington declares war on debt crisis! Urgent Q & A

Mon, Sep 22 2008, 08:55 GMT
by Martin D. Weiss, Ph.D.

Money and Markets

In the last few hours, in a desperate attempt to ward off a catastrophic Wall Street meltdown, the government has announced three unprecedented actions:

First, President Bush, Fed Chairman Bernanke and Treasury Secretary Paulson have called on leaders of both parties in Congress to work through the weekend to develop a plan to let the government buy up bad debts from banks.

Such a plan may buy some large banks some time. But like the bailouts of Freddie Mac, Fannie Mae and AIG, it does very little to change the reality on the ground.

Millions of Americans can still not pay their mortgages. The value of millions of homes is still falling. The nation's $47 trillion debt market is still in deep trouble, and so are the countless companies, consumers and governments that depend on it.

Second, The Securities and Exchange Commission has announced a temporary ban on short selling of 799 financial stocks — an attempt to reduce the massive downward pressure on their share values.

But short selling is a major vehicle that's widely used by prudent investors to reduce their risk and hedge their investments against the very dangers that we see all around us today.

By making it more difficult for investors to hedge in those stocks, the authorities are merely compounding the problem: If investors cannot sell short financial stocks, they will sell short something else as a proxy for financial stocks, including companies in other sectors that remain vulnerable to a credit crisis and a recession.

Alternatively, if investors feel those proxy hedges are not adequate, they will simply resort to outright liquidation of their securities, making the next stock market decline that much worse. Clearly, the SEC cannot repeal the law of gravity. And no matter what they do, the government cannot stop investors from selling.

Third, early this morning, Washington moved to guarantee money market funds that invest in high risk instruments like commercial paper. This supposedly protects money fund investors from the kind of "Breaking the Buck" crisis that arose this week at Reserve Primary Fund, buying some time for a $2 trillion industry in turmoil. But alas, this, too, is a disastrous and futile gesture.

The reason: To fund the Fannie Mae, Freddie Mac, AIG and new banking bailouts, it's estimated that the U.S. Treasury will need to borrow at least $1 trillion in new money from investors in the United States and abroad.

But by guaranteeing money funds that invest in high-risk, higher-yielding instruments, the authorities are actually encouraging investors not to invest in the lower-yielding U.S. Treasuries.

Result: With this step, the U.S. government is shooting its funding operation in the foot. It's merely making it that much more difficult for the U.S. Treasury itself to raise the money it will need for each and every one of its bailout efforts.

And sure enough ...

• This morning, U.S. bond prices are collapsing, as the interest rate the U.S. Treasury has to pay on its 10-year bonds has surged by an unprecedented 39 basis points (.39 percentage points).

Bottom line: These three government bombshells do not end the credit crisis. They merely threaten to spread the plague to the one borrower who heretofore stood above the crowd of sinking debtors: The United States Government itself.

Urgent Answers toYour Urgent Questions

With each of these dramatic Wall Street disasters, unprecedented government counter-actions, and violent market reactions ... my inbox has quickly filled up with urgent questions. Here are the main ones with my response.

Q. Will these new government actions end the crisis?

A. No. It may buy a bit of time for some banks. But now that the nation's $47-trillion debt balloon and $180-trillion derivative bubble have burst, no amount of legislation can restore them. Nor can the government legislate a bull market in stocks or an end to the recession.

Q. The SEC is forbidding short sales. What impact will this have on the stock market?

A. The immediate impact is the rally you've seen so far. However, this action merely destabilizes the market further by making it more difficult for investors to hedge their risk.

Q. I own put options. How does the SEC's action affect me?

A. Put options are not short sales and are not part of the SEC's prohibition. Moreover, the SEC's action is strictly regarding a finite list of 799 financial stocks. All other stocks are not covered.

Q. Won't financial stocks rally sharply in this environment?

A. They already have rallied. But that rally is likely to be short-lived, just like every other government-inspired rally to date. Remember: The government cannot save the entire banking system, let alone the entire $47 trillion U.S. debt market.

Q. Is this the signal to jump back into stocks?

A. For stocks that are vulnerable to a credit crisis and an economic decline, this is a signal to SELL. And for those who are looking for a hedge or profit opportunity for the next big decline, this is an ideal opportunity to get started.

Q. I have put options based on your recommendations. What should I do?

A. We see this rally as an opportunity to add more. If you subscribe to our services that recommend put options, stand by. We will send you new alerts early next week.

Q. What about inverse ETFs? How does this affect them?

A. Our strategy is unchanged: If you own them, hold. If you don't own any, you could soon have a good opportunity to buy to prepare for the next decline. The best time to start hedging strategies is precisely at a time like this — when the government stimulates temporary, artificial rallies in the market, prior to the next major decline.

However, due to the SEC's new rules against short selling, issuers of inverse ETFs may have to make adjustments to their investment strategies. We will provide more information on this aspect as soon as it is available, probably early next week.

Q. Based on your recommendations, I was planning to move out of a bank that you said is unsafe. Should I forget about doing that now?

A. No. Do not assume your institution will benefit from the new government rescues. If anything, when the government starts borrowing the money it needs to fund its bailouts, it will only serve to drive all interest rates higher, making the mortgage and banking crisis that much worse. In the final analysis, uninsured bank depositors will still lose money; insured depositors will still suffer serious inconveniences; and shareholder value could still be wiped out.

Q. You are saying the U.S. Treasury is taking on too much risk. So why should I buy Treasury bills?

A. The additional risk the Treasury is taking will be reflected in Treasury bonds, which are likely to fall in price and rise in yield. It will not have more than a tiny affect on short-term Treasury bills, which barely fluctuate in price and mature in less than one year. Plus, if you stick primarily with 3-month Treasury bills or equivalent, you should be able to roll over those bills at higher yields as interest rates rise.

Q. Gold surged $130 in just 24 hours. Is it too late to buy?

A: Larry has been recommending gold for many months. And on the day BEFORE gold's $130 surge, he sent out a new flash alert to his Real Wealth subscribers to add substantially to their gold holdings. He continues to recommend buying on any temporary dips.

Q. I follow some of the services put out by your other editors, and they don't always agree with you on each market. What gives?

A. I don't tell our analysts what to write or what to think. Each follows an independent strategy based on his or her research and analysis. However, I am pleased to note that all have recommended prudent steps to take out partial profits on a timely basis as well as hedges to help protect you from downside risk.

Q. Can the government continue bailing out everyone forever? Where is the limit? And how can I know when that limit is being reached?

A. Contrary to popular belief, the government's resources are NOT unlimited. Brace yourself for the day in the not-too-distant future when the government finds it increasingly difficult to borrow the money it needs to fund its bailouts. This occurred at least once before, in February of 1980, when the U.S. Treasury could not find buyers for its Treasury bonds. And it was forced to dramatically reverse its monetary and fiscal policy in order to restore its borrowing power.

When that happens again, it will signal that the government has reached the limit in its ability to save the financial system and stimulate the economy.

Q. It sounds like you're saying we should abandon everything and run for the hills. Is that an accurate reading of your views?

A. No. For every weak bank, there are several strong banks; and for every company that's likely to fail, there are many that have the wherewithal to survive. These companies cannot prevent a very painful and traumatic decline. But once the economy and markets hit rock bottom, they can play a constructive role in the subsequent recovery.

Q. Everyone seems to be in favor of the government's rescues. They say that, no matter how rash they may be, the alternative is worse. But you don't seem to agree with that view. Why not?

A. Because the rescues are vastly premature. Before the government can play a constructive role in a recovery, the bad debts and weakest links in our economy need to be liquidated. By intervening now, the government is merely preventing that natural process from progressing. It is spreading the pain to more sectors, prolonging the crisis and weakening our nation's future recovery powers. The sooner it abandons or limits its rescues, the sooner we can put this crisis behind us and move on to a true recovery in the American economy.

In the meantime, however, regardless of how this crisis unfolds in the weeks ahead, the Weiss publications give you all the tools you need to keep your money safe and grow your wealth.

Published on  Mon, Sep 22 2008, 08:59 GMT