In a report entitled "Worst-case debt scenario", the bank's asset team said state rescue packages over the last year have merely transferred private liabilities onto sagging sovereign shoulders, creating a fresh set of problems.
Overall debt is still far too high in almost all rich economies as a share of GDP (350pc in the US), whether public or private. It must be reduced by the hard slog of "deleveraging", for years.....

Until quite recently, only the odd astronomer threw around numbers in the trillions, leaving the rest of us behind with our thousands, millions and billions. We didn’t mind. We couldn’t grasp the meaning of a trillion anyway — the dictionary defines it as the number 1 followed by 12 zeroes, or 1,000,000,000,000.

But today, we can hardly pick up a newspaper without being asked to get our mind around a trillion somethings. But after those 12 zeroes the average brain stalls.

Just a few of weeks ago the White House announced that the U.S. budget deficit hit $1.42 trillion in the last fiscal year, three times the previous record. Within 10 years, the annual deficit is projected to reach $9 trillion.....

.....In case you failed to catch it in our previous articles this year, we thought we’d state it outright for our readers this month: the United States Government is on a trajectory to default on their obligations. In
its current financial condition, it will not be able to fund its forecasted budget deficits and unfunded Social Security and Medicare promises on top of its current debt obligations. This isn’t official yet, and we don’t know when the market will react to it, but there is no longer any doubt about the extent of their trajectory. There simply isn’t enough taxing power, value creation or outside capital willing to support its egregious spending.....

U.S. equities will fall “substantially” below their March lows because the global economy will weaken in 2010 and stocks are expensive, said Societe Generale SA’s Albert Edwards.

The recession will worsen as businesses and consumers reduce debt and deflation remains a “key threat” for the world in the next one to two years, said Edwards, a global strategist for the Paris-based bank. Government bonds are a poor investment because yields may drop below 2 percent in 2010, while gold is cheap, he wrote in a research report today.

“Deep down, even the fiercest equity bulls must surely be doubting themselves,” said Edwards, who is based in London. “We still see much pain to come” for stocks in 2010 and 2011.

The Standard & Poor’s 500 Index has surged 64 percent since a 12-year low on March 9 as the American government lent, spent or guaranteed more than $11 trillion to end the nation’s worst recession in seven decades. Societe Generale’s outlook contrasts with the median economist estimate in a Bloomberg survey that U.S. gross domestic product will expand 2.6 percent in 2010 and 3 percent in 2011. The nation’s economy expanded for the first time in a year during the third quarter.

Edwards was voted second-best European strategist in a 2009 Thomson Extel survey released in June. The report also named Societe Generale as the top economics and strategy research firm for a third straight year.....

Markets have bounced back. Economies are recovering. U.S. unemployment is showing signs of easing. But as the worst crisis since the Great Depression appears to be passing, we could be setting the stage for the next one.

While policy makers breathe a collective sigh of relief, they're making little progress in addressing deeper flaws that the crisis laid bare: an unwieldy banking system, unreliable financial plumbing and a global economy that encourages and depends on heavy borrowing by the U.S.

Bankers and regulators say that fixes require careful consideration. But as the darkest days of the crisis fade from memory and the world's biggest banks get back on their feet, political impetus for reform may be waning. "We're wasting the crisis," said economist Richard Portes of the London Business School.....

In his latest missive to investors (pdf link here), Eric Sprott asks if our Ponzi economy is at risk of collapse. In fiscal 2009, foreigners scooped up $698 billion of Treasuries while the Fed upped its holdings by $286 billion. But the public debt increased $1.9 trillion. So who bought all the rest? According to Treasury, “other investors” bought $510 billion, up from just $90 billion in 2008. With the Fed’s printing press turned off, the question for next year is whether “other investors” can buy more Treasuries than they did this year…

As we have seen so illustriously over the past year, all Ponzi schemes eventually fail under their own weight. The US debt scheme is no different. 2009 has been witness to spectacular government intervention in almost all levels of the economy. This support requires outside capital to facilitate, and relies heavily on the US government’s ability to raise money in the debt market. The fact that the Federal Reserve and US Treasury cannot identify the second largest buyer of treasury securities this year proves that the traditional buyers are not keeping pace with the US government’s deficit spending. It makes us wonder if it’s all just a Ponzi scheme.....

If many of us could have turned around the moment we entered 2010 and made obscene gestures at 2009, we would have.

After the wreckage of the past 12 months, 2010 has to be a good year, right? Good for governments staving off financial chaos, good for households struggling to stay afloat, good for investors wondering which rules of economics and markets still apply. It really is hard to see this year outdoing the last one in the doom-and-gloom department.

Yet the Year of the Tiger might live up to its name and be a fierce one. Here are five reasons why it may come with its share of sharp teeth and "Black Swans....."

Suggestions for cover?

When I was at Rice University, so many decades ago, I played a lot of bridge. I was only mediocre, but enjoyed it. We had a professor, Dr. Culbertson, who was a bridge Life Master at an early age. He was single and lived in our college, playing bridge with us almost every night. He was a master of the "end game." He had an uncanny ability to seemingly force his opponents into no-win situations, understanding where the cards had to lie and taking advantage.

Traveling to London and on into Europe, I have some time to think away from the tyranny of the computer. Over the last year, and especially the last few months, I have written in depth about the problems we face all across the developed world. We have no good choices left, so making the correct unpleasant choice is now our most hopeful option.

As I wrote in my 2010 forecast, this year is a waiting game. There are so many choices we must make, and the paths we will take from those choices vary wildly. But make no mistake, we are coming close to the end game. Some countries and economies are closer to that point than others, but the entire developed world is lurching, in almost drunken fashion, towards our economic denouement.

Over the next several months, we are going to start to explore various aspects of the end game. Whither Japan? Are they actually, as I think, a bug in search of a windshield? What does that mean for the world? How safe is the euro? Everyone over here seems to think Germany will bail out Greece. A breakup seems unthinkable to the people I've been talking to (so far). But what about Spain? Italy? Can you spell moral hazard?

The Fed has said it will exit quantitative easing (QE) at the end of March. But what if mortgage rates rise? Where do we find $1 trillion (plus!!!) in US savings to fund the deficit, assuming foreigners buy about $400 billion? By definition, savings and foreign investment and the federal deficit must add up to zero. (We will go into that later - just take it as gospel for now.) How can we run 10% of GDP deficits if the Fed does not print money (as they did by buying Fannie and Freddie paper, which became treasuries, as I outlined last week)? That would require almost a 10% savings rate - with it all ending up in treasuries. How can that happen? Really?

McKinsey has released a very detailed report which focuses on the "final frontier" of the global credit bubble: the migration of private sector leverage over to the sovereign balance sheet, and the viability and sustainability of this process. This is not a new topic on Zero Hedge, and as Greece just experienced today, unless a country is well equipped with the dynamic duo of a reserve currency and a printing press, surging sovereign debt usually ends with just one outcome...

The McKinsey consultants have performed an in-depth empirical study tracing the history of (de)leveraging in both the developing and developed world, at both the corporate, financial institution and consumer levels, and the corresponding offset at the sovereigns. Amusingly, analysts read the "improvement" in the credit picture at various private sectors, while completely ignoring the vertical spike in new sovereign debt issuance. If you were wondering why everyone is on pins and needles every time there is a new UST auction, now you know: in the zero sum game of credit transfer, any improvement in the former is purely as a result of the largess of the later. A funding crisis in Greece, which at this point seems a certainty will likely start off the long-awaited European domino action which will begin at the FX level, and slowly migrate to default risk for all European countries. Once that happens, risk will promptly migrate away from Eurozone, and travel west over the Atlantic. In that regard, we still consider US CDS as very cheap, despite their doubling from the first time we suggested investors take a look.

Back to McKinsey - lot of pretty charts, which we suggest readers peruse at their leisure, coupled with insightful commentary.

Here is what happens to global leverage when you leave deranged money printers with aspirations for zero % cost of debt in charge of the whole show:

Kyle Bass has bet the house against Japan--his own house, that is. The Dallas hedge fund manager (no relation to the famous Bass family of Fort Worth) is so convinced the Japanese government's profligate spending will drive the nation to the brink of default that he financed his home with a five-year loan denominated in yen, which he hopes will be cheaper to pay back than dollars. Through his hedge fund, Hayman Advisors, Bass has also bought $6 million worth of securities that will jump in value if interest rates on ten-year Japanese government bonds, currently a minuscule 1.3%, rise to something more like ten-year Treasuries in the U.S. (a recent 3.4%). A former Bear Stearns trader, Bass turned $110 million into $700 million by betting against subprime debt in 2006. "Japan is the most asymmetric opportunity I have ever seen," he says, "way better than subprime."

Interactive: Is Your State A Debt Disaster?

Bass could be wrong on Japan. The island nation (and the world's second-largest economy) has defied skeptics for so long that experienced traders call betting against it "the widowmaker." But he may be right on the bigger picture. If 2008 was the year of the subprime meltdown, 2010, he thinks, will be the year entire nations start going broke.

The world has issued so much debt in the past two years fighting the Great Recession that paying it all back is going to be hell--for Americans, along with everybody else. Taxes will have to rise around the globe, hobbling job growth and economic recovery. Traders like Bass could make a lot of money betting against sovereign debt the way they shorted subprime loans at the peak of the housing bubble.

National governments will issue an estimated $4.5 trillion in debt this year, almost triple the average for mature economies over the preceding five years. The U.S. has allowed the total federal debt (including debt held by government agencies, like the Social Security fund) to balloon by 50% since 2006 to $12.3 trillion. The pain of repayment is not yet being felt, because interest rates are so low--close to 0% on short-term Treasury bills. Someday those rates are going to rise. Then the taxpayer will have the devil to pay.....

Southern European countries are trapped in an overvalued currency and suffocated by low competitiveness, a situation that will lead to the break-up of the euro bloc, according to Societe Generale SA’s top-ranked strategist Albert Edwards.

The problem for countries including Portugal, Spain and Greece “is that years of inappropriately low interest rates resulted in overheating and rapid inflation,” London-based Edwards wrote in a report today. Even if governments “could slash their fiscal deficits, the lack of competitiveness within the euro zone needs years of relative (and probably given the outlook elsewhere, absolute) deflation. Any help given to Greece merely delays the inevitable break-up of the euro zone.”

The euro has slumped 9.9 percent against the dollar since November on concern countries including Greece will struggle to tame their budget deficits. The common currency and stocks in the region dropped yesterday as European leaders closed ranks to defend Greece in a plan that investors said lacked details.....

IMAGINE THAT AFTER THE TITANIC SANK, as survivors waited in lifeboats beneath a starlit sky, an overly articulate survivor interrupted the silence with a soliloquy on why the worst was yet to come.

This image came to mind sitting in a Ritz-Carlton ballroom as Pippa Malmgren, an economist who focuses on the impact of politics and policy on financial markets, systematically demolished any sense of stability harbored by the few hundred traders and portfolio managers in her audience.

Attendees of the Chicago Board Options Exchange's Risk Management Conference may have felt proud for surviving the financial crisis of 2008 -- until Malmgren convincingly described a future of riots caused by surging food prices, energy inflation and countries struggling to pay debts.

"It's an awful human feeling to walk down the street and pass people and realize they have no idea what is coming," Malmgren, head of the Canonbury Group consultancy, hurled at the audience.

Thin, bespectacled Benn Steil, a fellow at the Council of Foreign Relations, which many call a shadow U.S. State Department, clearly knows what's coming. He turned graphs of bland economic data into gory glimpses of a financial future that could give an investor good reason to doubt anything U.S. government officials say about the economy.

All that was missing was timing. If Malmgren and Steil could have predicted when the hobgoblins will hit the financial system, the conference room would have emptied as everyone stampeded to call their offices with trading instructions and then joined together in group prayer.

Instead, attendees were left struggling with an even more pronounced inability to time investing strategies to the second part of the financial crisis. That part is expected to come when the government starts trying to pay for the rescue programs that saved the financial system from collapse.....

For once, some actually good insight from a CNBC guest. Philip Manduca, Head of Investment of the ECU Group, discusses Greece and the very severe implications of what the final outcome will look like. "Trichet said the Greeks are crooks, and they've been lying about the numbers. There is a deeply embedded corruption within the Eurozone. Combined with the endemic European socialism and there is just no way you are going to get spending cuts and tax raises and maintain a GDP that makes any sense of the percentage aspect of debt to GDP. So the whole show is wrong. This is an intractable situation, this is going to continue on and on. The onle hope for the Eurozone, and the Euro as a currency, is that sameone takes the spotlight soon, and that may be the United States." Watch the rest as Philip's perspective is spot on...Not to mention that he sees gold as the only alternative to the fiat bonfire soon to engulf the western world.

Historians cite the late second
century as the turning point of the Roman Empire, when the once-
proud, feared society began its descent into infamy.

As the ruling class was undermined by civil wars and
attacks by outsiders, the Romans’ respect for law and social
institutions began to erode. In the end, a combination of
political and economic mistakes led to the empire’s downfall.

The U.S. today is a mirror image of the Roman Empire as it
tipped into chaos. Whether we blame our bloated government, a
greedy elite or a lethargic population, the similarities between
the two foreshadow a gruesome future.

The Roman economy grew fat from the plunder of conquered
territories and the added productivity offered by new lands. The
waning of expansionism didn’t bode well for the empire.

While the U.S. ascended quite differently, it also used its
position as a superpower to fuel economic expansion. Because the
country had the strongest military and economy in the post-World
War II era, the U.S. dollar became the de facto global reserve
currency, ensuring endless competitive advantages -- which have
vanished in the last decade.

Americans have become less productive while relying more on
social safety-net programs such as Medicare, Medicaid and Social
Security -- and now expanded health-care insurance. Worse, like
the ancient Romans, a sense of entitlement has replaced the
drive and motivation we once championed. With easy access to
abundant government handouts, it’s no wonder so many jobless
people have stopped looking for work.....

SocGen’s Albert Edwards was out with a note today which is in line with my calls for a marked slowing of the economy toward the end of this year. He indicates that the rate of change in leading indicators in the real economy and in markets is rolling over right now. Edwards writes that this suggests softness in six-to-nine months.

I like his analysis because it depends on first derivatives or the rate of change rather than absolute levels which are misleading at turning points (see Has the increase in U.S. jobless claims peaked? from March 2009 for an example of first derivatives presaging the end of recession). Remember, a recession begins from a cyclical peak in economic activity. So, the economy is rising until that point. Analysts looking at absolute levels only will miss the slowing in the rate of change.

May 5 (Bloomberg) -- Capital markets may be facing the biggest crisis in a century with governments all but powerless to ward off a sovereign debt disaster, according to Gary Jenkins at Evolution Securities Ltd.

Investors greeted plans for a 110 billion-euro ($143 billion) bailout of Greece by shunning the bonds of Europe’s debt-ridden nations on concern the aid package won’t solve the country’s deficit crisis or prevent contagion. Credit-default swaps on Greece, Spain, Portugal and Italy surged and the euro tumbled.

“The capital markets could soon be in the midst of the largest financial crisis of the last 100 years,” said London- based Jenkins, Evolution’s head of credit strategy. “With government debt itself perceived to be the problem the potential for political and economic change is much greater.....”

WASHINGTON — A widening financial crisis in Europe is threatening to put a damper on the economic recovery here and abroad just as the American economy is gathering steam.

A credit contagion that began in heavily indebted Greece spread Wednesday to Spain, whose economy is much larger than Greece's, as Standard & Poor's cut the Madrid government's credit rating, just one day after slashing Athens' bonds to "junk" status and downgrading Portugal's debt as well.

European officials pledged Wednesday to act swiftly on a hefty package of loans for Greece, but skepticism remained that Germany, the continent's strongest economic power, would ultimately agree to the plan.

Even under the rosiest scenario in which a rescue package comes through and the problem is contained, analysts say, European economic growth will slow as more countries feel pressure to raise taxes and take other tough measures to get their fiscal affairs in order.

"It'll take years of savage spending cuts, wage cuts and welfare-pension reform to eventually grow out of the debt situation," said Ruth Stroppiana, an economist in London for Moody's Economy.com, which shaved its forecast for economic growth in the European Union this year to less than 1%.

That's not good news for American businesses, which count on Europe as a major market for a broad array of goods but already have felt the winds of an economic slowdown.

Europe’s government debt crisis is starting to infect the bank funding system, driving borrowing costs higher from Asia to the U.S. and threatening to slow the global economic recovery.

The interest rate that financial companies charge each other for three month loans in dollars is the highest since August, while traders are paying record amounts to hedge against losses in European bank bonds. Yields on all types of corporate bonds rose last week by the most relative to government debt since Lehman Brothers Holdings Inc.’s bankruptcy in September 2008, according to Bank of America Merrill Lynch indexes.

European Union finance ministers pledged to stop a sovereign debt crisis from shattering confidence in the euro as they held an emergency summit over the weekend to hammer out a lending mechanism for deficit-stricken nations. The sovereign debt crisis may end up costing governments more than $1 trillion, according to credit investment firm Aladdin Capital Holdings LLC in Stamford, Connecticut, with knock-on effects on banks and corporates.

“Whether the markets completely unravel depends on whether politicians can stabilize the peripheral government market,” said James Gledhill, who helps manage about 58 billion pounds ($85 billion) as head of fixed income at Henderson Global Investors Ltd. in London. “The tail risk is the stress on banks which stops them from lending to corporates and feeds through to become a real economy problem......”

ON MAY 2nd euro-zone governments and the IMF set out the terms of a €110 billion ($145 billion) rescue for Greece. That was far more than had previously been pledged but it was not enough to settle investors’ nerves. Stockmarkets in Europe and America slumped on May 4th and fell again the next day. Greek bonds continued to trade at distressed levels.

The poor reaction in part reflects fears that rescue money could be withheld. Its disbursal depends on brutal austerity measures. Failure to carry these out could jeopardise funding and push Greece into default. Even success would leave it with an intolerable public-debt burden.


A rescue that is painful for Greece has not given other countries much relief, either. True, only a few countries are being forced into austerity by bond markets. Most rich countries, including many in the euro zone, have seen their bond yields fall since the start of the year (see chart). But the cost of public borrowing in euro-zone countries with big budget deficits, notably Portugal and Ireland but also Spain, is going in the opposite direction.....

Spiraling debt is Uncle Sam's shock collar, and its jolt may await like an invisible pet fence.

"Nobody knows when you bump up against the limit, but you know when it happens it will really hurt," said fiscal watchdog Maya MacGuineas of the Committee for a Responsible Federal Budget.

The great uncertainty about how much debt is too much has tended to make fiscal discipline seem less urgent, rather than more. There is no obvious threshold beyond which investors will demand higher real yields for holding U.S. debt. Vague warnings from ratings agencies about the loss of America's 'AAA' status haven't added much clarity — until recently.....

For the rest of this letter, and probably next week as well, we are going to look at a paper from the Bank of International Settlements, often thought of as the central bankers' central bank. This paper was written by Stephen G. Cecchetti, M. S. Mohanty, and Fabrizio Zampolli. (http://www.bis.org/publ/work300.pdf?noframes=1)

The paper looks at fiscal policy in a number of countries and, when combined with the implications of age-related spending (public pensions and health care), determines where levels of debt in terms of GDP are going. The authors don't mince words. They write at the beginning:

"Our projections of public debt ratios lead us to conclude that the path pursued by fiscal authorities in a number of industrial countries is unsustainable. Drastic measures are necessary to check the rapid growth of current and future liabilities of governments and reduce their adverse consequences for long-term growth and monetary stability."

Drastic measures is not language you typically see in an economic paper from the BIS. But the picture they paint for the 12 countries they cover is one for which drastic measures is well-warranted. I am going to quote extensively from the paper, as I want their words to speak for themselves, and I'll add some color and explanation as needed. Also, all emphasis is mine.

"The politics of public debt vary by country. In some, seared by unpleasant experience, there is a culture of frugality. In others, however, profligate official spending is commonplace. In recent years, consolidation has been successful on a number of occasions. But fiscal restraint tends to deliver stable debt; rarely does it produce substantial reductions. And, most critically, swings from deficits to surpluses have tended to come along with either falling nominal interest rates, rising real growth, or both. Today, interest rates are exceptionally low and the growth outlook for advanced economies is modest at best. This leads us to conclude that the question is when markets will start putting pressure on governments, not if.....

Pacific Investment Management Co.’s Mohamed El-Erian and Loomis Sayles & Co.’s Dan Fuss said the European debt crisis may spread across the globe because of investor concern that governments have borrowed too much to revive their economies.

“After morphing into a regional dislocation, the Greek crisis is now going global,” El-Erian, the chief executive officer of Newport Beach, California-based Pimco, said yesterday in an e-mail. El-Erian shares the title of co-chief investment officer of Pimco with Bill Gross, who runs the world’s biggest bond fund.

U.S. stock markets fell again today after plunging by the most in a year yesterday on concerns that sovereign debt troubles in Europe will bring the global economic recovery to a halt. The Dow average dropped 1.2 percent at 11:39 a.m. It fell 3.2 percent yesterday after European Central Bank President Jean-Claude Trichet resisted pressure to take steps to fight the spreading crisis, and said the bank didn’t discuss buying government debt when policy makers met.

European stocks sank the most in 14 months as the Stoxx Europe 600 Index tumbled 3.9 percent to 237.19 at 4:47 p.m. in London. The gauge has retreated 8.7 percent this week, the biggest slump since November 2008.
Fuss, whose Loomis Sayles Bond Fund beat 96 percent of competitors in the past year, said the euro crisis had reached a “critical” point......

Money markets and the cost of protecting bank bonds from losses show investors are concerned Europe’s almost $1 trillion rescue plan may not be enough to contain the region’s sovereign debt crisis.

The Markit iTraxx Financial Index of credit-default swaps on European banks and insurers rose to 38 basis points more than the Markit iTraxx Europe Index tied to investment-grade companies from 31 yesterday. While the gap narrowed from 58 basis points before European leaders agreed to the rescue plan, the bank index on average has traded 10 basis points less the past three years. A measure of banks’ reluctance to lend also rose to more than three times the level from March.

The loan package for debt-laden nations including Greece is part of an attempt to stop a decline in the euro and stave off a sovereign default that would threaten recovery from the worst global recession since the 1930s. European financial companies, which hold more than 134 billion euros ($170 billion) in Greek, Portuguese and Spanish sovereign debt, are under scrutiny by investors concerned that they’re owed too much by Europe’s most- indebted countries.

“Sovereign risk hasn’t gone away in the slightest,” said Jim Reid, head of fundamental strategy in London for Deutsche Bank AG, Germany’s biggest bank. “What this package has done is massively reduce the tail risk in European markets without necessarily changing the medium- to long-term dynamics of financial markets......”

FOR weeks there have been calls for the euro zone's policymakers to get ahead of the sovereign-debt crisis, which started in Greece and was in danger of engulfing other countries with big budget deficits and poor growth prospects. In the early hours of May 10th, such a plan finally emerged. After a lengthy summit in Brussels, European finance ministers agreed on a “stabilisation fund” worth up to €500 billion ($640 billion) over three years. That sum would be supplemented by a further €220 billion or more from the IMF. In addition, the European Central Bank (ECB) said it would purchase government bonds to restore calm to “dysfunctional” markets.

The market response was euphoric. Germany’s stockmarket had risen by more than 5% when it closed on May 10th. The CAC 40, the main index in France, was up by almost 10%: big French banks are heavily exposed to Greece, so they stand to benefit from a cast-iron rescue package. The yield on ten-year Greek government bonds plunged from more than 12% to less than 8%. The yields on comparable bonds for Portugal, Spain, Italy and Ireland also fell sharply. The euro rose a bit against the dollar.

The response is a sign of how sceptical markets had previously been that Europe could respond to the deepening crisis with enough scale and speed. Even so, the rescue plan has a patched-together feel to it.....

The $1 trillion coordinated bailout to stave off a Greek debt default is fatally flawed and may well lead to another, deeper global recession.

While optimists hope the bailout will signal an end to the government debt crisis, the history of debt crises suggests it is just the end of the first act in what will be a long and drawn-out tragedy.

As part of the bailout, Greece is required to take tough medicine to get its fiscal house in order, such as cutting salaries and pensions of government workers. That’s easier said than done, given Greece’s long history of generously rewarding those who go to work.

But the story doesn’t end here. The fatal flaw in the plan is that the European nations bailing out Greece -- even Germany, where government debt has risen to about 80 percent of gross domestic product -- have similar budget problems and even less political will to take similar medicine.

Their plan appears to rest on the hope that lenders won’t notice. Eventually they will, and when that happens, a worldwide loss of faith in government debt markets is a virtual certainty.

In other words, it is hardly good news for a creditor if a hopelessly bankrupt borrower offers to take on the debts of a hopelessly bankrupt borrower......

May 19 (Bloomberg) -- Europe’s banks are facing déjà vu as fresh tremors in the debt markets threaten to shake the financial system less than two years after the collapse of Lehman Brothers Holdings Inc.

This time the concern isn’t about subprime mortgages or exotic derivatives, it’s about banks’ holdings of bonds sold by European Union governments including Greece, Portugal and Spain. Pledges of $1 trillion in EU aid have failed to shore up the euro or dispel doubts about the region’s finances.

Investors have punished the shares of European financial firms and driven up the cost of insuring against default by banks and insurers on concern measures aimed at reducing the region’s budget deficits will choke economic growth. In a worst- case scenario, government debt restructurings could erode capital and spark another credit crunch, analysts say.

“There’s a concern this may be Lehman II,” said Konrad Becker, a Munich-based banking analyst at Merck Finck & Co. “The direct risks of writedowns and loan defaults combined with indirect ones such as mistrust between banks could lead to a systemic crisis......”

Seth Klarman is worth listening to, especially when markets go mad.

Mr. Klarman is president of the Baupost Group, an investment firm in Boston that manages $22 billion. His three private partnerships have returned an annual average of around 19% since inception in 1983—and nearly 17% annually over the past decade, as stocks went nowhere.

To measure Mr. Klarman's importance as an investor, you need only see the value his rivals place upon his words. You could have earned at least a 20% average annual return since 1991—better than twice the performance of the market—merely by buying and holding Mr. Klarman's book, "Margin of Safety": Published that year at a cover price of $25, hard copies now fetch up to $2,400.

But the professorial Mr. Klarman speaks in public about as often as the Himalayan yeti. He made an exception last Tuesday, when I interviewed him in front of a standing-room-only crowd of 1,600 financial analysts at the CFA Institute annual meeting in Boston. He then made another exception, speaking with me over the phone later to clarify points that he feared had been misconstrued.

Mr. Klarman specializes in buying securities that nauseate other investors. As the credit crisis exploded, he put more than a third of his assets into high-yield bonds and mortgage-related securities. I asked him what he had meant, in a recent letter to his clients, when he compared the financial markets to a Hostess Twinkie. "There is no nutritional value," he said. "There is nothing natural in the markets. Everything is being manipulated by the government." He added, "I'm skeptical that the European bailout will work."

Some members of the audience gasped audibly when Mr. Klarman said, "The government is now in the business of giving bad advice." Later, he got more specific: "By holding interest rates at zero, the government is basically tricking the population into going long on just about every kind of security except cash, at the price of almost certainly not getting an adequate return for the risks they are running. People can't stand earning 0% on their money, so the government is forcing everyone in the investing public to speculate."

"We didn't get the value out of this crisis that we should have," Mr. Klarman told the audience. "For our parents or grandparents, it was awful to have had a Great Depression. But it was in some ways helpful to carry a Depression mentality throughout their later lives, because it meant they were thrifty with their money and prudent in their investment decisions." He added: "All we got out of this crisis was a Really Bad Couple of Weeks mentality."

You could have heard a pin drop as Mr. Klarman proclaimed, "I am more worried about the world, more broadly, than I ever have been in my career." That's because you can make good investing decisions and still end up with bad results if you reap your profits in currencies that do not hold their purchasing power, he explained.

"Will money be worth anything," asked Mr. Klarman, "if governments keep intervening anytime there's a crisis to prop things up?"

To protect against that "tail risk," said Mr. Klarman, Baupost is buying "way out-of-the-money puts on bonds"—options that have no value unless Treasury bonds plummet. "It's cheap disaster insurance for five years out," he said.

Later, I asked Mr. Klarman what he would suggest for smaller investors who share his worries.

"All the obvious hedges"—commodities and foreign currencies, for example—"are already extremely expensive," he warned.

Especially gold. "Near its all-time high, it's a very hard moment to recommend gold," said Mr. Klarman.

Mr. Klarman pointed out that his own ideas "on bottom-up opportunities in undervalued securities are more likely to be accurate than my top-down views on what's going to happen in the world at large." In other words, while you might want to insure against a disaster scenario, you shouldn't bet the ranch on it.

And, said Mr. Klarman, one of the best ways to protect against a decline in purchasing power is to buy whatever is "out of favor, loathed and despised." So forget about gold or other trendy hedges. Instead, wait patiently for markets—European stocks, perhaps—to get so cheap that they turn most investors' stomachs. Then you can pounce.

As Mr. Klarman put it, "Sometimes, when you can't figure out a good defense, the best thing to do is to go on offense."

Mervyn King, the Bank of England Governor, summed it up best: "Dealing with a banking crisis was difficult enough," he said the other week, "but at least there were public-sector balance sheets on to which the problems could be moved. Once you move into sovereign debt, there is no answer; there's no backstop."

In other words, were this a computer game, the politicians would be down to their last life. Any mistake now and it really is Game Over. Or to pick a slightly more traditional game, it is rather like a session of pass-the-parcel which is fast approaching the end of the line.

The European financial crisis may look and smell rather different to the American banking crisis of a couple of years ago, but strip away the details – the breakdown of the euro, the crumbling of the Spanish banking system to take just two – and what you are left with is the next leg of a global financial crisis. Politicians temporarily "solved" the sub-prime crisis of 2007 and 2008 by nationalising billions of pounds' worth of bank debt. While this helped reinject a little confidence into markets, the real upshot was merely to transfer that debt on to public-sector balance sheets.....

This week’s plunge in U.S. stocks triggered a technical indicator known as the Hindenburg Omen that may signal a more severe selloff, according to analysts who follow charts to predict market moves.

The market signal, named for a German zeppelin that caught fire and crashed more than seven decades ago, occurs when an unusually high number of companies in the New York Stock Exchange reach 52-week highs and lows. The indicator last occurred in October 2008, according to UBS AG.

The Standard & Poor’s 500 Index yesterday completed the biggest three-day decline since July 1, after an unexpected increase in unemployment claims added to evidence an economic recovery is weakening. The benchmark gauge for U.S. stocks has dropped 3.4 percent so far this week as Federal Reserve policy makers said growth “is likely to be more modest” than they previously forecast.

The indicator may suggest “a savage equity downturn is imminent,” said Albert Edwards, a London-based strategist at Societe Generale SA, who has told investors to favor bonds over stocks for more than a decade......

Albert Edwards, whose opinion, of all macro economists, is among the most respected by Zero Hedge staff, has just thrown down the gauntlet. In his just released piece he mocks the Black Knight, compares the market to a Polish dude with a bullet stucj in his head, makes fun of koolaid drinking permabulls, and sets his estimate for the S&P... at 450.

Investors cannot move for the weight of broker research comparing the current conjuncture in the US with Japan a decade ago. While bond markets at least, move to discount deflation, most sell-side analysts still say the current situation is unlike Japan a decade ago. They are right. Things now in the US are much, much worse than Japan a decade ago.

Equity investors are in for a rude shock. The global economy is sliding back into recession and they are still not even aware that these events will trigger another leg down in valuations, the third major bear market since the equity valuation bubble burst.

This lack of awareness reminds me of reports this week that a 35 year old Polish man hadn?t noticed for five years that he had a bullet lodged in his head. Like the equity market in 2000, the Polish man had been partying too hard to notice that he had been shot. The BBC report the police as saying "He told us he remembered having a sore head, but that he wasn't really one for going to the doctor."

As the equity bloodbath of the last decade enters its final, even bloodier phase, investors continued optimism also reminds me of the Black Knight in Monty Python & the Holy Grail - link. Despite being grievously wounded by King Arthur, the Black Knight makes light of his injuries which he dismisses as a flesh wound. The vast bulk of the investment industry fails to appreciate that we are locked in a structural bear market and about to enter Act III.
In case anyone needs a graphic summary of all that was just said, the chart below summarizes it best:

A fresh somber mood returned to the markets in a dramatic way last week with the latest FOMC decision unsettling the markets as well as the ongoing crisis in Europe. As a result, markets are now looking for broader solutions as the annual IMF meetings take place, with a number of policymakers suggesting that the November G20 will be a major event.

Some allude to the success of the London G20 in the Spring of 2009 as a key event that helped the global recovery back then and look to November for a repeat. Whether the markets will accept the luxury of six weeks grace remains to be seen. I can only believe that, in the interim, policymakers will have to feed markets with hope as to what might arrive in November, and then not disappoint.

Against this background, investors are increasingly nervous about any and all of their strategies. This week, some more of the recognized winners of post-crisis markets suffered especially badly, notably gold. As I shall discuss below, the large correction in gold will force many to rethink the relevance of the safe haven concept, just as the weakness of the Swiss Franc since late August will have. In my judgment, all financial investments have a relevant valuation about which investors need to be aware. Any thoughts about persistent safe havens (other than perhaps cash under your mattress) are dangerous. At the same time, the ongoing structural changes in the world economy and markets will result in investors searching for new and alternative investments as well as benchmarks.....

(Reuters) - Three months ago, with the Federal Reserve nearing the end of its second major stimulus program and inflation pressures on the rise, Albert Edwards' bond market view stood out from the crowd.

Societe Generale's famously bearish analyst, in contrast to most, did not see 10-year Treasury yields rising above 3 percent just because the Fed was going to stop buying bonds. Instead, he predicted they would fall below 2 percent.

So far, Edwards -- who predicted the Asian financial crisis of 1997-98, the U.S. housing implosion and who sees China's economy suffering a hard landing -- has been closer than most on his debt call. Last week, yields tested their record low of 2.04 percent.

Investors, however, should hope he's not as accurate on his next call: Edwards sees Treasury yields falling further because, he says, the economy will weaken. He is targeting benchmark rates at around 1.50 percent in the next six months.

Be sure to lock in a low-rate mortgage while you can, though. After that, says Edwards, a period of hyper inflation will push bond yields into double digits and send the S&P 500 stock index tumbling to 400, only a third of its current value.....