Sunday, May 9, 2010

My Prediction on the Economy & Market (continued)

Let us continue now with our understanding of the U.S. Federal Reserve system...

The U.S. Federal Reserve Bank publishes two reports called the M1 and M2, which give the status of the U.S. money supply.  The M1 reports the total of the amount of physical currency and checking accounts in U.S. banks.  The M2 reports the total of M1 + savings and money market accounts and CDs.

Prior to 2006, the U.S. Federal Reserve Bank published the M3 report (the broadest measure of money), which included M1 + M2 and large deposits, institutional money market funds, and other large liquid assets.

As stated in my previous article, the U.S. Federal Reserve system is a fractional reserve system that allows for the expansion of the money supply via loans, thus multiplying the amount of currency in the economy based on the Federal Reserve's reserve requirements (money multiplier) -- the lower the reserve requirement, the higher the multiple created by the banking system.  The broader based M2 and M3 expound upon the effects of the money multiplier and, therefore, show just how much credit is in the banking system.

According the St. Louis Federal Reserve, the M2 has increased more than 250% since 1995 alone, while the M3 increased by the same percentage, that is, until 2006, when the Federal Reserve discontinued the measurement because it believed that the "M3 does not appear to convey any additional information about economic activity that is not already embodied in M2 and has not played a role in the monetary policy process for many years. Consequently, the Board judged that the costs of collecting the underlying data and publishing M3 outweigh the benefits."  Theorists believe that the Federal Reserve discontinued the M3 in order to mask the massive expansion in the credit market created by the Federal Reserve and its reserve requirement and lending policies.

Shadowstats continues to report the M3, based on government supplied data, as well as other government information.  It reports that the M3 now stands at about $14 trillion, up from just above $4 trillion since 1995, an increase of 350% in just 15 years time.

While the M3 rate of growth has slowed since the mortgage crisis due to much tighter lending rates and loss in credit due to foreclosures, the Federal Reserve has increased the U.S. monetary base from $400 billion to $2 trillion from 1995 to present day, with the bulk of that increase occurring from the end of 2008 to 2010, when the Federal Reserve increased the monetary base from $800 billion to $2 trillionThat's an increase of 250% in little over one year!  And that is before the money multiplier takes effect!

Just imagine what would happen to home prices or the price of gas if the lending market was as loose as it was just a few years ago.  It is also important to remember that once currency is printed, it is rarely contracted from the system.  Government likes currency in the system, so the money multiplier will have an effect on the system... it's just a matter of when.

To make matters worse, however, the Federal Reserve began buying mortgage-backed securities under the lesser known Term Asset-Backed Securities Loan Facility (TALF).  Unbeknownst to most Americans, the TALF program, which was created by the Federal Reserve on November 25, 2008, will purchase up to $1 trillion (up from originally $200 billion) of AAA asset-backed securities.  Since the facility was created by the Federal Reserve and not the U.S. Treasury department, it did not require congressional approval in order to be created.

This facility is in conjunction with the widely known $700 billion Troubled Asset Relief Program (TARP), which the U.S. Treasury Department used to bail out the banking industry and General Motors but also used to purchase collateralized debt obligations (CDOs), which were the highly illiquid, nearly impossible to value securities that the financial markets created to pool sub-par mortgages together in order to meet the AAA status of the rating agencies.  CDOs were one of the main reasons for the failure of the mortgage market.  It is widely thought that these securities will be deemed worthless, due to the lax ratings given to mortgages during the mortgage bubble.

It is my hope that these facts open your eyes to just how much power the Federal Reserve, a private institute, wields over each of us.  The data above, coupled with the information provided in "The Creature from Jekyll Island" hopefully makes you more competent than 99% of the American population regarding the U.S. banking system and alerts you to just how fragile and manipulative our banking system really is.

Now that I have discussed the banking system and its issues from the creative and lending standpoint, please allow me to address FDIC and the false sense security that the government has used to give its citizens in the U.S. banking industry.

As I stated in my previous article, the government created the Federal Deposit Insurance Corporation (FDIC), which guarantees individual bank deposits up to a specified amount-- currently $250,000 per individual account, under the Glass-Steagall Act of 1933.  The FDIC is able to guarantee this money by charging each bank a small fee to participate in the insurance program.

However, a little known fact is that the FDIC collected no premiums from 1996 to 2006, which is precisely when the housing bubble began and ended.  In order to make up for this deficit, as well as to keep from having to dramatically raise premium rates, thus effecting bank profitability, Congress granted the FDIC the authority to borrow up to $500 billion from the U.S. Treasury, up from its previous $30 billion limit.

From December 2008 to March 2009, the deposit insurance fund reserves fell from a projected $55.2 (a reserve ratio of 1.25%) billion to just $13 billion (a 0.27% reserve ratio).  In fact, it was reported less than six months later that the total insurance reserves reached a staggeringly low $684.1 million.  Bank failure rates had increased so dramatically during that time that the FDIC was forced to revise its estimated cost of bank failure over the next four years to $100 billion from $70 billion and required insured banks to prepay $45 billion in premiums in order to replenish the fund.  In effect, the fund was admitting that it was insolvent, even though the fund is required to keep a balance equivalent to 1.15% of insured deposits.

According to a Reuters article, the FDIC expects 2010 to be the height of bank foreclosures created because the real estate/mortgage bubble.  Last year, 140 banks failed.  In 2008 that number was 25.  And in 2007, just 3 banks failed.

To date, 68 banks have failed this year-- double the rate of last year.  According to a CBS Marketwatch article in February of this year, Gerard Cassidy, a banking analyst at RBC Capital Markets, who was one of the first analysts to warn of the bank failure situation in 2008, stated that "if the average bank that fails in 2010 has $1 billion in assets and it costs the FDIC 28% of those assets to shut it down, that means failures could cost $49 billion to $56 billion this year."

Using our data above, this could render the deposit insurance funds insolvent, especially if Mr. Cassidy's projections wind up being optimistic.  Granted, the fund is able to borrow up to $500 billion of tax payer money in order to replenish its coffers; however, given what we know about the Fed's excessive monetary base creation and the CDO purchase programs by TARP and TALF, I believe it is safe to assume that the U.S. will be borrowing money for a long time to come and, in turn, devaluing our currency at break neck speed.

Before I dive into my thesis, please allow me to show you just how big of an issue our overspending has become...

In 2009 the U.S. gross domestic product, or our country's total economic output for the year, was between $14.2 and $14.4 trillion, depending on who is calculating the total.  Our total output for the year was approximately 25% of the world's output; however, our total amount of external debt held in 2009 was $12.2 trillion, or about 94% of our GDP.  While that is only roughly 23% of the world's external debt and other Western nations, such as the United Kingdom, are in much worse fiscal shape than we are in, our debt last year equaled our entire economic output for the year!

When you consider that our estimated national debt is supposed to rise $1 trillion per year over the next six years (2010 included)-- meaning that our external debt could be, conservatively, $18 trillion-- and our GDP, which is estimated to be equal to roughly the same amount, will in almost all likelihood grow much, much slower than the estimated 7% annual compound interest rate suggested by the government (it hasn't grown at or above 7% since 1959), our country's fiscal survival appears very grim. 

Greece has recently experienced a debt crisis in which the premium of its bond rates over the historically stable German Bund have increased close to 100% during the course of 2010.  As of the most recent data point in the CIA World Factbook, Greece's external debt as a percentage of GDP was 153%.  Ironically, Germany's was 185%.  The U.K.'s, incidentally, is a mere 365%.  This looks like peanuts compared to our 94%; however, keep in mind that the government's estimated 7% year-over-year GDP growth rate is drastically inflated, which leaves us, therefore, right in the eye of this hurricane, especially considering our propensity to spend and our ever-increasing appetite for entitlement (social) programs.

As the U.S. dollar continues to be the dominant currency of choice regarding world payments and is still considered a generally "safe" investment, we will probably stay in the eye of the storm longer than most.  However, let me share a statistic that will, hopefully, prevent you from resting on your laurels.

Entitlement programs, such as Social Security, Medicare, Medicaid and now health care reform, are issues and problems that our politicians have, honestly, no desire to talk about due to their polarizing nature.  However, it is precisely these entitlement programs that are destined to be the demise of our magnificent nation unless they are dramatically cut and reformed.  None of these programs have ever been paid for and their massive increase in our nation's debt is absolutely and unequivocally staggering.

Many U.S. citizens are unaware that these entitlement programs are listed under a heading called "unfunded liabilities" in one of our nation's two accounting books.  Yes, the government uses more than one accounting book.  It helps to mask the country's real problems to its citizens, you see.  Of course, maintaining two sets of books is very illegal for corporations or citizens to do.

What it is that government is hiding is the tiny fact that our current unfunded liabilities is $108 trillion or $351,189 per citizen or 750% of our estimated 2010 GDP!

So, you see, our country's finances are in a heap of trouble-- seemingly, much more so than that of Greece, although, admittedly, I do not know the position of its unfunded liabilities.  Luckily for us, however, Europe is leading us into this massive sovereign debt crisis.  It is my belief that the dollar will strengthen for quite a while as Europe struggles but that we will also follow in Europe's footsteps.  After all, our government has followed in Europe's economic and social policies, which have created similar (or worse) fiscal problems... why will our outcome, therefore, be any different?

In my next article, I will tell you why I believe this to be true, how you can prepare yourself for the volatile period to come and how you can able to profit from it.  Until then, friends, be sure to stay abreast of the market and stay liquid, unless you feel comfortable shorting or wading into the derivatives market.

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