Paulson downplays Stock Market worries - Despite Yen carry trade warnings

By: Mike_Whitney

Hank Paulson is sweating bullets right now.

In fact, a shrewd investor could probably make a fortune just figuring out what type of high-blood pressure medication he's on and then betting the farm on the manufacturer.

Last week the stock market bull plopped down on an I.E.D. and wound up in intensive-care sucking food from a straw and drifting in and out of consciousness. That put Paulson on the road to South Korea, Japan and China where he'll meet up with his foreign counterparts to strategize on the deteriorating state of world markets. It's a daunting task. The sudden rise in the yen has set off a brushfire that's swept through the global system clearing out the dead-wood and sending panicky fund managers out onto the streets.

Paulson downplayed worries that the roiling markets were reason for concern. Before leaving for Japan he confidently proclaimed that the global economy was “as strong as I've seen in a lifetime. All the economies are growing, inflation is low, and liquidity is high.”

That may be, but today's market is built on an ocean of red ink and any upward movement in the yen is likely to send listing indexes to Davy Jones locker.

Glub, glub!

This is the most over-extended, over-leveraged, debt-plagued stock market in the history of the world; a sudden gust from Tokyo or Beijing and down-it-goes like a straw house in a wind-tunnel. That's what happened last week when the yen lurched upward and Wall Street suddenly plummeted 416 points. That's why Paulson quickly tossed his toothbrush and an extra pair of astronaut diapers in his duffle-bag and scampered off to the Far East.

For years, savvy investors have borrowed trillions through the Yen Carry Trade (YCT) at nearly zero percent scarfing up US government debt (paying 4.25%) or maximizing their leverage in other riskier funds or derivatives. It's created a daisy-chain of debt (similar to fractional banking) which will inevitably be broken by disruptions in the money supply and a decrease in liquidity. When interest rates go up; money gets tighter, and equity bubbles come crashing to earth. That's what's happening right now, although Paulson and his fellow-pranksters at the Federal Reserve think they can keep the balls in the air a bit longer.

Chris Laird of prudentsquirrel.com summarizes the state of the current stock market like this:

“Up to now (even still), speculators could borrow and leverage to the hilt – the Yen carry trade made that what appeared to be a relatively riskless endeavor. The amount of leverage in financial markets is at historic highs, and people did worry about that. First one investor puts up some capital, then, funds leverage that among themselves multiplying that leverage several times. Then multiply in derivatives that have infected every financial vehicle. I have stated you can consider markets at 50 to 1 leverage at the price margins” chris laird.

$9 (50% discount)

I've been hearing the same shocking news from analysts who've studied this issue for more than a decade, Steven Williams who sent me this e mail just yesterday:

“Without regulation or oversight of any kind, traders will always find ways to maximize profits... a path of least resistance. The yen carry trade (YCT) for a very long time was a zero risk opportunity. Buy cash at zero interest and use it to purchase higher paying interest securities, also zero risk, such as US Treasuries or other country treasuries & notes.

When the cost of money is zero, the leverage is virtually unlimited. I am surprised if the YCT is only 50:1. When the YCT was generating substantial profits, those gains were used to leverage into even more YCT trades, and those gains into more YCT, and so on, and so on”.

This is a classic pyramid scheme, the only difference being that Wall Street's survival depends on ever-increasing infusions of debt which masquerades as investment.

Williams further reinforces the 50 to 1 ratio (of debt to real investment) citing a report that he wrote on a major brokerage (which will remain nameless) He says:

“Several years ago I wrote about the massive notional derivative position held by (nameless brokerage). At the time they held $32 Trillion and the ratio was 50:1 to their assets. In other words, if they were to suffer a mere 2% across the board notional loss to their derivative book, the company as a functional corporation would cease to exist. I did a follow up article for Gold-Eagle called "Derivative Dangers". The latest from the US Comptroller of the Currency report on Bank-held derivatives shows (the same brokerage house) holding $58 trillion with $1.1 trillion in assets, so the ratio is still 50:1. Long-Term Capital Management was apparently leveraged 50:1 before it collapsed.”

This illustrates how brittle the present market really is and how susceptible it is to the slightest interest rate fluctuations half-way around the world.

When interest rates go up, (as they must to curtail inflation) then the hairline fractures in Wall Street's Crystal Palace quickly turn into gaping cracks that threaten the whole fragile edifice. That's why we expect a global liquidity crisis, because there's not enough fiat-currency in the world to fill the black hole of debt created by the maxed-out hedge funds and derivatives markets.

(Shaky derivatives are equally hazardous. As Chris Laird notes: “The Yen carry since has grown to incredible levels. And leverage in every market has also grown to incredible levels, and then add on top of that the explosion of the derivatives business – formerly at only $20 trillion about 1990, that is now, in my estimation over a $quadrillion in value (1000 trillion).”)

So what does Hank “Houdini” Paulson have up his sleeve? What can he possibly do to forestall the inevitable collapse? He's already been undercut by his former colleagues at Goldman Sachs who warned that “dead bodies” are likely to surface from last weeks meltdown. Jim O'Neill, G-Sachs chief global economist said:

“There has been an amazing amount of leverage on currency markets that has nothing to do with real economic activity. I think there are going to be dead bodies around when this is over…Our concern is that the repricing of risk we are seeing could spread to the credit markets. This is potentially more difficult to deal with, and needs watching.”

By “dead bodies” O'Neill means that there may be over-exposed hedge funds that have already given up the ghost and are being gingerly tossed on the meat-wagon. Clearly, the market-shakedown has triggered a massive liquidation that threatens to sweep through other asset markets.

There's nothing Paulson can really do. The (market) pendulum-swings are bound to get broader and more destructive; generating a series of crises which will put the market in a downward spiral and bring out the bears. This is unavoidable. If the Secretary of the Treasury is hoping for a “soft landing” he'd better think again. After all, we're talking about trillions of dollars here, not billions. There's not much the Federal Reserve can do either, except pump more money through the normal channels into the flagging market. (re: The Plunge Protection Team)

But the Fed is currently trapped between the two millwheels of dwindling foreign investment and a real estate market which is slowly grinding into dust. The best they can do is dispatch their doe-eyed professor, Gentle Ben Bernanke, to Capital Hill to sooth frayed nerves while the printing presses keep pumping out crisp 100 dollar bills. It's a pretty grim performance.

It's all up to G-Sachs' wunderkind, Hank Paulson. He's our man at the tiller our last best hope. The future of the faltering American economy now rests on his bony shoulders. He'll need to rebuild investor confidence in Wall Street while placating the jittery public. He'll have to sweet-talk China into loosening up its currency while coordinating with foreign Central banks to shore up the markets. And, he'll have to anticipate the next unforeseen disaster that could expose the over-leveraged stock market and bring it down in a heap.

It's a “tall order” and well-nigh impossible. If I was Paulson, I'd keep the high-blood-pressure medication in one drawer and Dr. Kevorkian's phone number in the other.

By Mike Whitney

Email: fergiewhitney@msn.com

Mike is a well respected freelance writer living in Washington state, interested in politics and economics from a libertarian perspective.

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