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Drowning in a Sea of Liquidity


US is good at creating credit; bad at paying it back.

Editor's Note: The following originally appeared on December 14, 2006 and, in light of current events, has been reprinted here for the benefit of the Minyanville community.

Everything looks great - and yet you still have that uneasy feeling. When this happens, it's always good to check your premises

I think we can all agree that the markets, from stocks to bonds to art work, are riding on a sea of liquidity, which can come from 2 sources: Income or borrowing.

Real disposable income has actually fallen over the last 5 years. With a negative savings rate and a gigantic trade deficit, it's no secret that Americans are borrowing in order to consume.

Further evidence of this fact can be seen in a total GDP credit of 3.6 times (the next highest was 2.9, in 1929; it's averaged out at approximately 1.5 times over the last decades). We also have the lowest equity levels in homes ever, the highest percentage of disposable income going to service debt ever, government budget deficits of over $300 billion, and a public debt figure approaching $9 trillion (not counting the $500 billion in war costs so far - and not including the $45 trillion in unfunded liabilities from Medicare and Social Security).

Few people really understand the ramifications of this, or the process by which the bureaucrats in Washington compound the harm all this debt will cause by creating ever more of it.

A $1 billion REPO by the Fed doesn't seem like much - until you check your premises. The Fed just did a $1.3 billion dollar coupon pass, which is like a permanent REPO; it calls up JPMorgan (JPM) and purchases its bonds with credit - credit created from nothing. They just tell JPMorgan: "We owe you money."

JPMorgan now has funds (credit) it can lend out. But because of margin requirements, it can lend out much more than $1.3 billion. In fact, it lends out about 20 times that amount.

So let's say they call up 20 regional banks and let them borrow $1 billion each. In turn, each regional bank then lends out $5 billion to various mortgage borrowers. These borrowers refinance their houses - and spend the extra cash while the equity in their homes drops.

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