The establishment functionaries try to make the sow’s ear banking system into a silk purse with a PR campaign headed up by those who own huge amounts of dollars and hate to see their investments lose value too rapidly.
This is, to put it politely, a difficult and unenviable task.  The U.S. and European central banks are trying to add liquidity to the banking systems in these parts of the world as the banks have large and partially unmanageable problems.  The only real solution to these problems is to continue to debase the U.S. dollar by adding liquidity and bailing out bankrupt financial institutions.  In our opinion, it is fairly obvious that any dollar rallies will be temporary.  Commodities will once again return to investment popularity especially gold and foods.


We have to remember that providing liquidity alone is not the goal…getting institutions to lend between one another and re-establishing confidence is equally important.  Many have likened the situation of giving people liquidity to lend to others when they are afraid of not being repaid to ‘pushing on a string’.  It does not work.  Pulling a string is easy, pushing on a string to move an object at the other end is impossible.  In short, this is the problem.

If the central bankers and banks are not successful in the next year or two, we will be forced to shift our economic predictions from expecting more inflation to expecting a deflationary depression.  One does not know if they will be successful, however, it is a sure bet that they will keep trying very hard to re-liquefy the banking system.  To a politician or a political functionary, the prospect of a deflation or depression is totally unattractive; they know they will be removed from office in disgrace.


When hundreds of billions (or more) of dollars of mortgage loans are not repaid it creates a crisis for the  pensions funds, banks, insurance companies, mutual funds, savers and other  institutions and individuals who own those mortgages or the securities formed by gathering these mortgages together.

The owners/investors in the mortgages paid good money for an income stream to be paid to them in the form of interest payments and eventual loan repayments.  If these payments are not forthcoming and the loans have to be foreclosed, the mortgage holders then own real estate.  In many cases, the real estate may not pay any income and may have big maintenance and tax expenses.  At the very least, the investment ceases to be a source of income, and possibly becomes an expense.

The bank, insurance company, pension fund, or whoever owns the defaulted mortgages or foreclosed properties becomes a much more conservative investor and lender.  They have been hurt and they are more cautious about lending in the future.


Lending is necessary for any type of business to continue in a country, so it is imperative that lending not dry up for the commercial sector of the economy.  All business activity needs lending in order for economic activity to take place.

Without lending, business activity of all types (not just home building, home re-sales, and new commercial construction) falls dramatically.  Currently, many banks and others have stopped lending because they do not trust that they will be repaid by other banks, and by borrowers who are not financial institutions.  This has huge negative repercussions for the economy of any country.  This trend must be reversed as soon as possible.


To solve the problem the banking system must be re-liquefied so that loans can go to companies for raw materials, inventory, payroll, and other business transactions…and for real estate transactions as well.  For this to happen, banks must trust that they will be repaid.

A key component to the success of whether a re-liquefaction of the real estate sector (especially the residential real estate sector) will be successful is the behavior of Fannie Mae and Freddie Mac.  Not only do they have to be rescued by the federal government, they have to be managed aggressively, like they were in the past.  If the new management is a bunch of conservative bureaucrats who are afraid to lend and are unwilling to grow their portfolio of government guaranteed loans, the mortgage liquidity system will continue to contract.

The behaviors of Fannie and Freddie are partially responsible for the lack of discipline in the real estate and mortgage markets these past several years, but it is imperative that they continue to function.  They are now a big part of the solution.

Fannie and Freddie must buy debt from loan originators…and soon…while continuing to make liquidity available to the residential real estate sector, making secondary loans, buying paper and acting as a risk manager.  We fear that if they are too conservative, there will be a depression in the U.S. real estate market which may spread to the general economy.  This depression could easily spread to Europe and the rest of the world, and the resulting global economic contraction will not be pleasant.  So it is hard to overstate the importance of their role in providing liquidity to the mortgage market.

As rude as it can be to say we told you so, please excuse us this time.  In April 2005, I wrote the following, and it was published on with respect to the economic risk associated with Fannie Mae.

“My very close friend, who is a senior mortgage banker, tells me the mortgage banking community is very concerned about the Fannie Mae situation.  Jim Sinclair and I have warned about this and so have others.  The first part of the enclosed newsletters gives some insight about how bad many derivatives Fannie has and how little they know about their positions.  If this unwinds, the real estate market could take a huge hit.  In my opinion, the fact that Fannie Mae has been allowed to do all of these financial manipulations is a scandal in itself.”

In our letters, we have warned many times in the past several years about the dangers of derivatives to the banking system and to the economy in general.  Most did not listen to us.  Please start listening now.

While the ability to borrow money is fundamental to economic expansion, economic growth does not require unregulated, unchecked, financial engineering, and derivative creation.

Let us fervently hope that the global financial leaders will be able to engender confidence and re-establish the banking system of the world of a firm footing.


1) U.S. investment managers to become more like those in Europe and Asia.

2) Increased use of non-U.S. stocks and non-U.S. currencies and bonds.  Much more use of commodity related stocks and ETF’s.

3) Today, the U.S. stock markets make up about 34% of the world market capitalization down from about 50% in 1997.

These trends are due to:
1) Growth of Chinese, Indian, Brazilian, Russian, Middle Eastern economies, and the development of larger, more sophisticated and more liquid stock, bond and commodities markets in these and other fast growing countries.

2) The weak European and U.S. banking systems are encouraging Asian and Latin investors to keep their assets in markets and banks in their home regions.  They are further encouraging wise investors everywhere to own more gold and food resources which can maintain buying power when the local currency depreciates as a result of bad management by government officials.

3) Growth of the investment management industry world wide.  This is due to creation of new wealth in the Middle East, Europe, Latin America, and Asia.  These new customers/investors are not from traditional markets of Europe and U.S., and have new perspectives on opportunity and investment.  An important perspective is the experience which comes from living in small or formerly small countries where diversification of holdings outside of your country and the holding of gold and other time tested stores of value is ingrained investment wisdom.  For example, almost all of those who escaped the Nazis with money did so by having gold, diamonds or other stores of value located outside of Nazi territory.  For millennia, refugees have bought their way to freedom with gems and gold.  This is old wisdom and it has never been more important than it is today.

4) Creation of new instruments, ETFs and derivatives to allow easier exposure to commodities, currencies, and packages of stocks that allow for easier buying and short selling individual companies.

Thanks for listening.

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