With all the talk about the end of the Great Recession, I continually ask myself the following questions: Am I just being a pessimist for believing in a deflationary depression? Am I a fool to fight those who make the rules (Congress, the Fed and the Treasury)?
Based on the number of similar inquiries we see, many Elliott Wave International's readers ask themselves the same questions. So, let’s address a key point that most mainstream analysts seem to have missed: It's not the strongest link in the chain that matters -- it’s the weakest, and sometimes also the least visible.
For instance, take the commercial paper market, which is debt maturing in 9 months or less. It was not on the investment public's radar screens prior to 2008, and it still isn't. Yet this market is likely the most important one in terms of keeping the entire financial system liquid. Why? Because most large banks fund their high leverage with very short-term loans.
Lehman Brothers and Bear Stearns each had an entire department dedicated to making calls to lenders each morning to negotiate the terms of their 24-hour loans -- so they could, in turn, continue to hold assets and loan money. And they were not the first to learn that borrowing short and lending long can destroy a company. The same mismatch in assets and liabilities was integral in the following failures, because short-term funding often disappears when the appetite for risk wanes:
1931 -- New York’s Bank of the United States 1974 -- Herstatt Bank, Germany
1984 -- Continental Illinois 1988 -- First Republic of Texas
1989 -- LTCB of Japan 1991 -- Southeast Bank of Miami
1997 -- Credit Lyonnais 1998 -- LTCM
This chart ("Commercial Paper Outstanding, Weekly, Seasonally Adjusted") shows that presently the issuance of financial and non-financial commercial paper is now back at 2006 levels.
Citigroup, GE, UBS, Prudential, Rabobank, ING and Societe Gernerale -- all have substantial commercial paper borrowing. But if funding for it dries up, won’t the Fed just expand its commercial paper intervention, you may argue? Probably. But they won't prevent a panic -- the banking failures of '08-'09 proved that those who run banks have not learned how to do that.
During a panic, the weakest institutions are at risk first, but once a panic begins to wash over larger and larger players, well-run banks find that they can’t swim against the tide either. Even if JP Morgan Chase (arguably the strongest bank) hadn't acquired Bear Stearns (arguably the weakest), its losses were estimated to be in the billions, because JP Morgan Chase had massive exposure to similar markets. After the Lehman bankruptcy, AIG’s naked short exposure put the solvency of its counter-parties (Goldman, JP Morgan, etc.) at risk, sort of like when a bookie can’t afford to pay out a big winner.
And that's why I don't think I'm a fool to keep fighting those who make the rules: The Fed and Treasury can only respond to a crisis. They didn’t anticipate commercial paper problems in '08-'09, and they won’t anticipate the soon-to-be-encountered ones either. Yes, they will intervene, but first the problems must be acute enough to get them to act.
And here is reason that I don't think that I'm a pessimist for believing that the "Great Recession" was just a warm-up and we are headed toward a full-blown deflationary depression: When the weakest links in the financial arena fail, the whole chain will break, causing a wholesale collapse that will eventually be called a true depression.
A chance reading of a book on technical analysis and the Austrian school of economics eventually led Jason Farkas, CMT, to Elliott Wave International. Prior to joining EWI Jason worked for 14 years as a futures, options and equity trader. Jason has been tutored by some of the best investment minds, including legendary trader Dick Diamond. You can read Jason's Weekly Insights regularly in EWI's intensive Currency and Interest Rates Specialty Services.