Dear Trader

One year ago today, the Dow closed at its all time high - happy birthday.  This birthday party, however, is not very pleasurable.  The closing high one year ago was 14,164.  Today's close was 8,579 - a loss of 40.  Estimates of the losses for those who employ the Buy & Hold investment strategy are currently $7.5 Trillion.  There will surely be an oversold rally at some point, but this won't be over for quite a while.

Friday could turn out to be a nasty one.  Will it be a reversal day, a nothing day, or Black Friday?  If it is the latter, it will almost surely be caused by a poor auction of Lehman Brother's CDSs.

According to Reuters, the timeline for what will be a huge CDS auction tomorrow related to the Lehman bankruptcy is below.  Because there are unquestionably massive losses in these CDSs, as well as confusion about who the counter-parties are, there will definitely be surprises throughout the day.

1)     9:45 a.m.-10 a.m. Auction participants will submit bids and offers for the debt backing the credit default swaps, which will be used to determine the initial recovery rate of the swaps.

2)     10:30 a.m. Auction administrators Creditex and Markit will publish the initial recovery price and the open interest for the contracts will be published. The open interest reflects the amount of bids and offers that have been made, and will show if there are more buyers than sellers, or vice versa.

3)     12:45 p.m. -1 p.m. Participating dealers will submit limit orders for the debt on behalf of themselves and their clients to fill the open interest

4)     2 p.m. The final price of the auction will be published.

Estimates are that prices will be in the 12 to 13-cents on the dollar range, leading to payouts in the $400-billion range.

People ask me all the time when this will end.  The problem is that the healing cannot even begin, until home prices stop falling.  At the moment, house prices are still going down, which must happen.  House prices have to go down to the point where people can truly afford them, without all of the Mickey Mouse financing games/scams.  And since incomes haven't gone up in the last eight years, we can presume that housing prices shouldn't have gone up either.  How much more do houses have to fall before they are back to where they were 8 years ago?  The data I have seen suggest an additional 20%, which means we're only about half way through the decline.

I am also asked if the massive amounts of money being pumped into the system will create inflation.  The answer is yes, most likely.  Currently the markets are suffering incredible asset deflation and if the Fed can withdraw this extra liquidity, it may be able to avert run-away inflation.

The concern today is that the Fed has nearly doubled the size of its balance sheet in the past few weeks.  The Oct. 3 issue of Grant's Interest Rate Observer describes:

After a flat-footed start, [the Fed] had shown its ability to degrade its balance sheet by selling off its Treasuries and acquiring dubious mortgages. But it had not really put its back into dollar debasement. The sum total of its earning assets, i.e., Reserve Bank credit, was rising at year-over-year rates of just 3% to 4%. Where was the push to print up enough dollar bills to smother the debt crisis of 2007-8 - assuming the problem was susceptible to smothering through money printing?

Mystery solved: Reserve Bank credit is suddenly flying. It surged by $203.6 billion, to $1.135 trillion, in the banking week ended Sept. 24. And if Merrill Lynch's guess is on the mark, it has soared to $1.730 trillion in only the past few days, a near doubling since May 2007, when the latent crisis became manifest.

As Helicopter-Ben Bernanke said in November 2002 - The U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost.  Of course he went on to say that the Fed could easily avoid a Japanese style deflationary spiral by throwing those freshly minted dollars from a helicopter. 

The data above show that the U.S. dollar is getting debased on an unprecedented scale.  The printing presses are running overtime and do not come without a price - eventual inflation.

Have you ever picked up a sea shell and put it to your ear to "hear the ocean?"  Today you can put a dollar bill to your ear - and hear the Treasury running out of ink!

Today's Trading Tip:

"Did you protect your investments and positions during this downdraft!!"
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