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Credit Markets Not in Kansas Anymore


Sooner or later, debt must be repaid.


Editor's Note: This article was collaborated on by Professor Sedacca and his business partner, Rob Roy.

My goal in this piece is to convey my thoughts for where we are, what to expect for the near-term, and then the longer term picture. This commentary/analysis relates mostly to the credit markets. I stress credit markets because it is the fabric of a debt-induced, asset-based economy. For more, read on.

Are We There Yet?

"Are we there yet?" is usually reserved for car trips when young children are in the back seat of a car, tired of driving, and wondering if they've reached the destination. In this case, however, as it regards the economy at large, the answer is "Be careful what you wish for."

I have written many times about the concept of 'Zero Hour' (recall the wonderful lyrics from Elton John in Rocket Man: "She packed my bags last night pre-flight, Zero hour nine am"). Zero Hour was the concept of Barry Banister at Legg Mason (LM) that dealt with the interplay of debt growth and GDP growth. When we are in a debt-induced, asset-based economy, "Are we there yet?" means arriving at Zero Hour, which is a scary proposition. For those unfamiliar with the concept of 'Zero Hour', it is the moment at which creation of new money no longer has an impact on GDP, or the real economy.

The data below is truly sobering. It reflects the fact that money growth is having less and less of an impact on GDP growth decade by decade. I am sorry if this bothers me, even if it goes unnoticed by the masses, but sooner or later, debt must be repaid. If not, debt goes unpaid, interest payments go unpaid and the rest of us get left "holding the bag." I don't wish to hold that bag. Do you?

Diminishing Returns from Debt-Financing by Decade 12/31/1949 - 6/30/2007

Click here to enlarge.

The concept, while complicated, can be boiled down to layman's terms rather easily. Imagine it is the holiday season, and while you have a first and second mortgage (the second one paid for your plasma TV, your second car, and a vacation to Cabo and a new boat), you have to service the debt. Just the interest cost on your debt is consuming all of your money creation (income). You are now left with several choices. Get yet another mortgage (except you can't as lending standards have become tighter), get a second job (there aren't any new jobs as the economy has slowed) or, sadly, buy less gifts. The prudent individual would simply consume less and pay the debt service. Think about it-any other choice is disastrous in the longer-term. In my mind, sadly, is that this is what the U.S. is facing now.

"Are we there yet?" Perhaps the U.S. is. If not, it is close or, at a minimum, it is on its way there. Zero Hour. How do we know we are at zero hour? We know we are because M3 has now exploded to an 18% year over year rate while the Fed has downgraded 2008 GDP growth expectations to 1.8-2.5%. Yes, money is growing at a rate ten times that of new economic output.

Click here to enlarge.
M3b from

Zero Hour defined: I wish it weren't this way. But to run away from the truth, to run away from what is reality is a disservice to my clients and to those that care about their assets.

So, okay, enough of the negative stuff, let's focus on the future. What's done is done: no matter whose fault, it doesn't really matter. All that matters is how we address the future, and how to be properly positioned to deal with what Mr. Market has in store for us.

We're off to see the Wizard?

We're off to see the Wizard, the Wonderful Wizard of Oz...
If ever, oh, ever a Wiz! there was the Wizard of Oz is one because,
Because, because, because, because, because.
Because of the wonderful things he does.

- The Wizard of Oz

Who is the wizard these days? Alan Greenspan is in retirement and on the speech circuit tour for $100,000 a pop.

Ben Bernanke? He is clearly the academic, and clearly a rather bright fellow and more straightforward. Ben still gives speeches at far-off college campuses to give us a clue as to what 'gifts' the Fed will bring to us on December 11 (the next meeting and last of the year for the FOMC).

Hank Paulson? Secretary Paulson, of Goldman Sachs (GS) fame, is now looking to 'right the ship of bad lending' and help those who were 'exploited' into exploding ARM's and such to lower their reset of their new payment level.

Think about this for a moment, and please know this is a non-political comment. Why would you, as a free market individual that was once Chairman of powerhouse Goldman Sachs, suddenly care about the new rate on a bunch of re-setting loans in the sub-prime sector? In my humble opinion, here is why. Those sub-prime loans are tied directly to the CDO's, SIVs and other exotic instruments residing on the balance sheets of Citigroup (C), UBS (UBS), and yes, oh yes, Goldman Sachs. If we make the payment structure better, who wins? A few people that will eventually default anyways? Nope. The folks that sit on the bulk of the sub-prime related paper, those "so far" untouched from the sub-prime crises. Yep. Goldman Sachs and its pals.

If you don't believe me, take a look at its balance sheets and then read the neat story of how the Fed was founded, "Creature from Jekyll Island." For what it is worth, the Fed isn't 'federal' at all... I truly respect the folks at Goldman, et al, but the truth of the matter is that we are setting a rather dangerous precedent with this mortgage reset plan. Should we reward those that took loans they couldn't afford and bail them out? Should we reward those investors and investment banks that packaged these loans and make it look like it never happened? For this writer, this investor, I think not. It is a dangerous card to play-the moral hazard card.

Continued on Page 2.

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