This past couples of weeks have felt like an eternity when it comes to noteworthy occurrences in financial markets. We’ve marked are 10th (IndyMac) and 11th FDIC bank rescue. As a result of the escalating number of troubled banks and diminishing value of the assets that these banks hold, the FDIC has been forced to go to the U.S. Treasury for a credit line.

The recent jobless claims and ADP figures have unemployment at a multi-year high, while inflation has quietly ticked over 6% officially. Consumer spending continues to dry up while shoes continue to drop in the credit market. All in all economic indicators continue to tell us that stagflation is in our not so distant future.

Last, but most definitely not least, is the recent bailout of Fannie Mae and Freddie Mac. This marks the greatest bailout by size in our nation’s history. The aftermath has yet to shake out and find the main stream media, but signs of financial strife as a result of this market manipulation are beginning to show.

All in all, it has not been a pretty picture, but I have reason to believe that the outlook for the next 6-12 months is even more pessimistic. Fortunately for us, when there’s blood on the street, there’s opportunity to make money, and I think we are entering a period of truly fantastic profit potential. First, let’s take a look at why I carry such a pessimistic view for the near and intermediate terms.

Blood on the Street

To truly understand credit markets, we must understand one very important notion. Credit markets aren’t frozen because there is a lack of money to go around. They are frozen because there is a lack of lenders willing to lend at current rates. It is for this exact reason that regardless of monetary policy, the long term trend for interest rates is higher. Please look at this chart of the following institutions and the price they are being forced to pay for lent money:

Lehman Brothers–11-13%
Merrill Lynch–11-12%
Morgan Stanley–9-10%
Citigroup–9 ½-10 ½%
Keycorp–11-13%
National City–13-15%
Wachovia–10-12%
Zions Bancorp–13-15%
GM/GMAC–not possible
Washington Mutual–not possible
Ford–not possible

(Chart by John Mauldin)

The real scary thing is that the companies on this list have approximately one trillion dollars worth of short term debt to roll over by next summer. Of that trillion, $300 billion of which will mature before Dec. Do you think these companies can run a profitable practice with such massive debt on their balance sheets, continuing diminishing asset values (not just tier 3 either), and double digit interest rates staring them in the eye?… neither do I. There are only three options left for these guys: massive liquidity injection (private), bankruptcy, or government bailout.

Just a quick note of interest: it seems liquidity injections by the private sector are drying up. Just today Korean Development Bank ended discussions for a potential capital infusion in Lehman Brothers. I’m sure KDB has been spending time looking through Lehman’s balance books only to find out that things were less rosy than expected. As long as were discussing Lehman, the New York based bank is also the largest holder of commercial real estate backed securities. I believe that the commercial real estate sector will probably be the next major shoe to drop in the credit sector (short position should be considered).

I’m sure you’re also wondering about the bottom three companies on the list. Take that for what it is. These guys literally can’t find financing, or should I say, they can’t find public financing. It’s ironic that I decided to discuss this today, because the House of Representatives is currently meeting to discuss a potential $25 billion federal credit line for the big three (Ford, GM, and Chrysler). Unfortunately for the auto makers, it looks like they won’t receive the $50 billion they were asking for. It’s this sort of last resort socialistic tendencies that are necessary when these companies are no longer solvent

As for the fate of GM/GMAC, Ford and Washington Mutual, it’s not looking good. With Federal money, Ford and GM might be able to pull through, but with the inability to finance debt at ANY price, WaMu is facing SURE BANKRUPTCY or BAILOUT (a WaMu short position should definitely be considered as well). It is just a matter of time now. As for the auto makers, this credit line doesn’t mean they are out of the woods yet. Only time will tell.

All Signs Point to Inflation

As shoes continue to drop in the credit market and asset prices continue to fall, we are looking at a massive contraction in liquidity. Dear reader, that’s how free markets work. After decades of excess money and credit growth, markets eventually revert to the mean. Unfortunately our ‘mean’ is so far below the current level of monetary base that if allowed to revert; we would be looking at a deflationary cycle that would dwarf the great depression.

As a reaction to this contraction of liquidity, monetary authorities around the world will enter the race to inflate. I don’t care what the rhetoric is now by Trichet or anyone else claiming a hawkish stance on monetary policy. I mean, that’s how Bernanke got the nick name Helicopter Ben in the first place.

Essentially what I’m getting at is that the health of our credit market carries an inverse relationship with growth in the money supply. Think of it like this as a giant bucket that’s half filled with water. As each shoe drops in the credit market, a new leak is sprung in the bucket. Growth in the money supply is like a hose feeding the bucket. The Fed wants to keep the water level constant, but as new leaks are sprung, the Fed has to turn up the pressure on the hose.

Golden Profit Potential

As readers of mine, you know that my favorite indicator of increased hose pressure is gold. Whether it’s irony or stupidity, the gold market has continued to contract through the Fannie and Freddie bailout and the rest of the credit woes.

Some claim the contraction to be the end of a bull run; obviously I couldn’t disagree more. Others claim the bull market is intact and it is simply following the correction in oil markets. Then there are others who claim there is just a robust demand for dollars during a time of such illiquid markets.

What do I think? I think many analysts, myself included at times, are guilty of over analyzing the issues at hand. I like to call it what it is, a market that just overheated to the upside and was in need for a correction. Gold has consolidated, and in the process built itself a base sturdy enough for another strong move to the upside. Have a look at this chart:

What we have here is a 4 year monthly chart of the StreetTracks Gold ETF (GLD). When discussing big picture, or macro trends, monthly charts are usually the best way to go because they completely dismiss all of the short term noise.

This is a market that definitely overheated and has simply consolidated back to the 20 month moving average, which also happens to coincide with out trend line. It’s really as simple as that. Of course, we could apply some more in depth technical analysis to give ourselves a rough estimate at the next interim peak, but that will have to be a story for another day.

Listen, what I will do is let you in on a little secret as to how I’m playing this trend. I believe that the far out of the money spring call options are extremely undervalued at current prices. That’s all I’m going to say for now.

Nicholas Jones
Analyst, Oxbury Research