The Problem with Leverage

by Larry Levin

Although today started off with very little action with no volume to speak of, it sure turned around early in the afternoon. At the end of the day, it was a great trading range with great trends. And as you know by now, I advocate following the trend.

Last week, when the S&P was trading above 900.00, I penned a missive that said the market was looking bullish and a great entry would be near 820.00. The overnight low was 828.75 followed by the uptrend continuing (so far) to 918.25. There are several degrees of trends, however. Although we believe the long term (secular) trend is down doesn't mean we shouldn't close our eyes to a cyclical reversal (trend) up. Moreover, when day trading we shouldn't close our eyes to a strong bearish trend even though the cyclical trend is up - like today!

That's about as clear as mud - right? Perhaps if you come into our live trading room I can clear it up for you. Until then, please enjoy the following great article from Bill Bonner.

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Free Bernie Madoff!

Going...going...Gono...!

And more!

The press...investors...regulators...they're all howling for Bernie Madoff's head. Of course, we wouldn't mind if they lynched him. Still, he's a hero to us. He's the Rod Blogojevich of money - showing us how the system really works. He's opened a window on the financial world...giving us all a remarkable and vivid lesson...in investing...in pyramid schemes...in the markets...and in Wall Street. As a result of such eye-opening instruction, Bernie Madoff will save more investors more money than the SEC ever will.

They'll think twice before giving money to friends to invest for them... They raise their eyebrows and their doubts when someone promises them consistent high rates of returns.

The feds are charging Madoff with running a $50 billion Ponzi scheme. Charles Ponzi took money from investors and then used their money to pay out profits to earlier investors. As long as the new money kept coming into the system, it worked like a charm. So what's the difference between Madoff's Ponzi scheme and the scheme run by Wall Street...in which all the investment houses, the rating agencies, the mortgage companies, Fannie Mae, Freddie Mac and the regulators themselves were complicit? As long as new money was coming into the system, who complained?

We'll get back to that in a minute.

First, let's look at what is happening on Wall Street now. Yesterday, the markets had a chance to connect the dots...to think more about what Ben Bernanke is up to...and what it will mean.

You'll recall that the Fed cut rates down to zero - effectively firing off all its monetary ammunition in one big salvo. Now, favored financial institutions - namely, the member banks of the Federal Reserve system - can borrow without paying any interest.

That should get things moving, right? Well, not necessarily. Credit is frozen, not because it is too expensive...but merely because lenders are afraid they won't get their money back. Asset prices are falling. So, the collateral that banks lent against is going down in price. Loans that looked solid six months ago seem dangerously leveraged today. It makes more sense just to hold onto the cash...at least it won't declare bankruptcy or defraud you.

And think about the people scammed by Bernie Madoff. How much are their loans worth? There are big names and little names on the list - including Japan's Nomura Bank and France's BNP Paribas. The big banks may be able to repay their debts. But what about the little fellows...the guys who put their entire net worth...perhaps a few million...with Madoff, in order to get his promised returns?

That's the problem with leverage. It works both coming and going. When an economy is growing...it acts like hot gas. Even a small amount quickly expands. But when a bubble springs a leak, the gas disappears. One man's loss hits the balance sheets of businesses and bankers all over town. The whole system contracts. Suddenly, the whole thing is coming down like the Hindenburg.

Which is exactly what is happening. Bloomberg reports that there is no sign of credit easing - despite the Fed's efforts to give money away. Instead, everything is slowing down...shrinking...deflating:

People aren't buying new cars. So Chrysler says it will shut down its factories for a month. What began as a sleek Le Mans auto race becomes a demolition derby. Property prices in Detroit are getting wrecked. Suppliers to the auto-industry are being banged up. Unemployment in Michigan is rising to depression levels. People can't even afford to buy the paper any more. The Detroit newspaper says that it will deliver only three times per week. There's hardly a business or a household in the Detroit area that hasn't been dented by the calamity.

Meanwhile, California announced that it will put $3.8 billion worth of projects on hold. Goldman Sachs reports that its bonuses this year will be 80% lower than the year before. Bristol Myers says it will lay off 10% of its workforce; Yale's' endowment is down 25% and Mexico's Cemex - one of the biggest suppliers of cement products in the world - says sales in this quarter are down 23%.

And so it goes...day after day. Cutting back...reducing...downsizing....

And you can imagine what this does to markets. Stocks shot up Tuesday on news of the rate cut. Wednesday, investors had time to reconsider; the Dow fell 100 points.

Oil slid below $40 yesterday; a Goldman report says it will fall to $30 before it reaches a bottom.

But it is in the currency and gold markets where the real action is taking place. The dollar fell hard yesterday, its biggest drop in 10 years. The euro rose to $1.43.

*** Now that Bernanke has run out of conventional weapons, investors are beginning to guess what happens next. In short: he's gonna drop the big one. He's going to go nuclear. He's not going to stick with Keynes and Freidman, in other words; he's gonna go Gono.

Yes, the Fed says it will now use "alternative" means of getting some juice in the economy. It will buy Treasury debt itself. This is what is known as "monetizing the debt," or turning an increase in U.S. debt into an increase in the amount of currency in circulation. It's a swell trick. If it works, Bernanke will be able to keep the rate of consumer price inflation above zero. He will probably try to get it well above zero - so as to encourage people to spend their money now, rather than wait for lower prices. The spending is supposed to be the magic that gets the consumer economy going again.

We can look ahead and see that the Fed's policy of going Gono - effectively printing money - will be disastrous. We can guess, too, that gold will probably be the main - perhaps the only - beneficiary. The price of an ounce of gold rose $25 yesterday...putting it solidly in positive territory for the year. It could easily go over $2,000 before this crisis is over.

But we don't know exactly how...or when...it will happen. Right now, day after day, the dirty laundry from La Bubble Epoque is being unfolded...we never know what awful surprises we will find. Stay tuned.

*** The latest reports say Madoff promised investors steady 13% returns. How could he do that? Of course, he couldn't. Stocks have gone nowhere for the last 10 years. The average rate of return? Zero. Promising 13% was clearly a flimflam. But investors must have guessed that he was swindling his retail trading customers in order to deliver steady, above-market returns to his investment accounts. They may not have understood how it worked, but maybe they didn't want to.

Nobody is as easy to scam as a scammer...and Madoff scammed them all. Bravo!

Of course, Madoff should get the gallows; we don't dispute it. But, often, there's not a lot of distance between the hanged man and mob that is lynching him. The people who most want to see Bernie swing are the people who invested money with him. Most were very sophisticated investors. They knew perfectly well that there is no magic way to transform a zero-return market into a 13% return market. If they were to get 13%, they knew they had to take a big risk. In this case, the risk was that Bernie Madoff was lying.

And what about the bubble economy itself? Wasn't it nothing more than a giant pyramid scheme with a huge, huge risk attached? It promised speculators enormous profits, but how could it deliver? It paid out money from new participants to the old participants. Without new money and credit the thing would implode.

As former Citigroup CEO, Chuck Prince, put it: as long as the music was playing, they had to dance. But didn't they know the music would stop...leaving them in an awkward and embarrassing position? Wasn't it as obvious to them as it was to us?

And what about the investors? Weren't they trying to get something for nothing out of the whole bubble economy? And the rating agencies? They must have known that sub-prime debt was dangerous. Even we knew it. Why did they give it Triple A ratings? And what about the SEC? It has thousands of smart analysts, accountants and investigators. How could they all be so stupid as to miss the biggest investment bubble in all history...right under their noses? And what about Alan Greenspan, who actually encouraged households to take out sub-prime mortgage loans?

Weren't they all in on the scam? Weren't they all complicit?

Bernie Madoff should hang. But SEC chairman Christopher Cox and former Fed chief Alan Greenspan should hang with him.

---Bill Bonner
The Daily Reckoning


Previous Day's Trading Room Results:

Trade Date: 12/17/08

E-Mini S&P Trades*
(before fees and commissions):


1) VA buy @ 8:50am at 901.00 = b/e (1 lot)

2) Engf buy (jumped) @ 9:50am at 907.50 = -.25 (1 lot)

3) Algorithm positions (25)...combined daily total...+21.50

ZB (30 Year Bond) Trades*
(before fees and commissions):


1) No trades today.



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