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By Max Frumes, Medill News Service

WASHINGTON — Bazookas, tsunamis and tortoises. Oh my.

The financial world and its regulators struggle to explain complex concepts, at times turning to metaphors that would make an English teacher cringe.

Henry Paulson, the former Treasury Department secretary, took his turn in front of the Financial Crisis Inquiry Commission on Thursday, armed with an arsenal of his own metaphors. Here’s a sample from the exchange, with the group trying to find out what went wrong and how to fix it for next time.

Subprime securitizations were scary micro-organisms: When subprime securitizations began to go bad, it created fears of all securitizations, even unrelated ones. “People use this E. coli example or mad-cow disease,” Paulson said, referring in part to the 2006 E. coli scare that created an aversion to all spinach, even the untainted. “I do think that it’s a good example because there was so much uncertainty about that. It infected, you know, so many in securitizations in terms of the investors’ concern.”

The authority to backstop Fannie Mae and Freddie Mac was a bazooka: Just before the two mortgage giants failed in 2008, Paulson said that having the authority to back them up would be like having a bazooka in a street fight — i.e., if you have enough firepower then you’ll never have to use it. “You asked us to give you a bazooka you would never have to use and then shortly thereafter you used it,” said Douglas Holtz-Eakin, FCIC commissioner. Fannie  eventually raised $7 billion. Freddie committed to raise capital, but never did.

Financial crises are toothpaste: When trying to assess whether Paulson could have stopped what led to the financial crisis, FCIC Chairman Phil Angelides asked if “the toothpaste was already out of the tube” by the time Paulson took the helm at Treasury in 2006. “Most of the toothpaste was out of the tube, and there really wasn’t the regulatory apparatus to deal with it,” the ex-secretary responded. (Alternative version: Financial crises are baked goods. “The situation was already baked” when Paulson arrived.)

Financial crises are tsunamis: Angelides implied that Paulson should have seen it coming. “Even when a tsunami comes, you have warnings ahead of time,” he said. Paulson didn’t run with this metaphor, replying that financial history didn’t predict the widespread decline in housing prices. He said he didn’t know what could have been done with such a warning. Crises happen no matter what, Paulson added, and will continue to happen.

Skin is money: In securitizing mortgages — the process of bundling the debt and selling it off — the originators didn’t have a stake in whether the mortgages were paid off or not. They didn’t have “skin in the game.” Also, market makers, or those who hold enough of a security to provide quick trading, don’t have skin in the game, critics claim. Paulson warned that it’s also important not to have too much skin in the game. “Where the big problems were, were the two or three institutions that not only had skin in the game, they had half their body in the game,” Paulson remarked.

Complex derivatives are cookies: Banks that packaged collateralized debt obligations, which are slices of other securities involving subprime mortgages, wound up suffering from their own cooking. They “choked on their own cookie.”

Bear Stearns was a wounded beast: FCIC commissioner Keith Hennessey asked if Bear Stearns was just the “slowest steer and the lion got it.” Also, Bear was referred to as the “weak deer” that served as food to short sellers, who were coordinating to bring it down. Though he did not believe that short sellers were a big cause of the crisis, Paulson said there were coordinated attacks. “It sure looked like to me some kind of coordinated action,” he added.

Unacceptable collateral is a Styrofoam tortoise: Former Rep. Bill Thomas, the FCIC’s vice chairman, chimed in with his own tortured metaphor to make a point about the role that accounting gimmicks may have played in the collapse of Lehman Brothers Holdings Inc.

In Thomas’ story, tortoises were disappearing rapidly, and some thought it had something to do with sheep. Someone suggested using Styrofoam tortoises to track their interaction with the sheep. Thomas replied that they might as well use Styrofoam sheep too, with the point being that it wasn’t an acceptable substitution — just as shaky mortgages aren’t a substitute for stable securities.

It turned out, he said, that crows were “flipping tortoises in the morning for a warm meal in the evening,” nothing to do with the sheep. Paulson said the participants got sloppy in their decisions, like those who accepted mortgages as the collateral.

The housing market is tinder: Paulson had yet another metaphor. He said subprime was only the most flammable part of the problem, “the driest tinder,” and that other parts of the housing market were flammable and eventually caught fire.

Marketwatch

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by Adam Hewison

We owe trillions of dollars, but Crude oil is at $86 a barrel, the DOW, S&P, and NASDAQ are making new highs almost everyday and unemployment is officially at 9.7%.

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Recent history proves that the Fed’s “control” is just an illusion.

By Editorial Staff

Think back to the fall of 2007. The deflationary “liquidity crunch” that over the next year-and-a-half cuts the DJIA in half, decimates commodities, real estate and world markets is only starting. Almost no one believes that the crash is coming — to a large degree, because everyone is convinced that the U.S. Federal Reserve Bank, with Ben Bernanke at the helm, will never allow deflation to happen: It can just print money!

The excerpt you are about to read is from EWI president Robert Prechter’s October 19, 2007, Elliott Wave Theorist. If you find it insightful, read more of Bob’s writings in the free Club EWI resource, “Robert Prechter’s Most Important Writings on Deflation.” (Details below.)

You cannot pick up a newspaper, turn on financial TV or read an economist’s report without hearing that the Fed’s latest discount-rate cut is bullish because it indicates the Fed’s decision to “pump liquidity” into the system. This opinion is so completely wrong that it is hard to believe its ubiquity.

First of all, the Fed does not “decide” where it wants interest rates. All it does is follow the market. Figure 17 proves it. Wherever the T-bill rate goes, the Fed’s “target rate” for federal funds immediately follows. That’s all there is to it.

If you refuse to believe your eyes, then listen to the chairman; Alan Greenspan is very clear on this point. On September 17, a commentator on CNBC asked, “Did you keep the interest rates too low for too long in 2002-2003?” Greenspan immediately responded, “The market did.” Rates were not “too low” or the period “too long,” either, because the market, not the Fed, made the decision on the level and the time, and the market is never wrong; it is what it is. If investors in trillions of dollars worth of U.S. Treasury debt worldwide had demanded higher interest, they would have gotten it, period.

Second, falling interest rates are almost never bullish. All you have to do to understand this point is look at Figure 18.

Interest rates fell persistently through three of the greatest bear markets in history: 1929-1932 in the Dow, 1990-2003 in the Japanese Nikkei, and 2000-2002 in the NASDAQ. The only comparably deep bear market in the past 80 years in which interest rates rose took place in the 1970s when the Value Line index dropped 74%. Economists all draw upon this experience, but they ignore the others. Today’s environment of extensive investment leverage and an Everest of debt in the banking system is far more like 1929 in the U.S. and 1989 in Japan than it is like the 1970s. Why is a decline in interest rates bearish in such an environment? Because it means a decline in the demand for credit. When people want less of something, the price goes down.

The recent drop in rates indicates less borrowing, which means that the primary prop under investment prices — the expansion of credit — is weakening. That’s one reason why stock prices fell in 2000-2002 and why they are vulnerable now. This is the opposite of “pumping liquidity”; it’s a slackening in liquidity.

Elliott Wave International (EWI) is the world’s largest market forecasting firm. EWI’s 20-plus analysts provide around-the-clock forecasts of every major market in the world via the internet and proprietary web systems like Reuters and Bloomberg. EWI’s educational services include conferences, workshops, webinars, video tapes, special reports, books and one of the internet’s richest free content programs, Club EWI.

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Our friends at Elliott Wave International have just released a free 34-page eBook, Understanding the Fed. It’s the free report the Federal Reserve doesn’t want you to read!

This eye-opening free report, which represents more than 10 years of research by Robert Prechter, goes beyond the Fed’s history and government mandate; it digs into the Fed’s real motivations for being the United States’ “lender of last resort.” In this 34-page report, you’ll discover how the Fed’s actions, combined with public outrage, may ultimately lead to its demise, plus much more about its secret activities and how it affects your money.

Download your free copy of EWI’s Understanding the Fed eBook, here.

About the Publisher, Elliott Wave International
Founded in 1979 by Robert R. Prechter Jr., Elliott Wave International (EWI) is the world’s largest market forecasting firm. Its staff of full-time analysts provides 24-hour-a-day market analysis to institutional and private investors around the world.

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How to find the secret indicators that let you know just how well the economy is really doing, with Mark Zandi, Moody’s, and Jim Bianco, Bianco Research.

Indicators include:

• Vehicle Miles Travelled (Department of Transportation)
• Number of Truckers (Bureau of Labor Statistics)

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Free video tutorial available to all Club EWI members

By Nico Isaac

For over ten decades, the mainstream financial world has embraced the view that external news events drive trend changes in the markets. In less than ten minutes, EWI’s senior tutorial instructor Wayne Gorman shatters that very idea into a fine dust, swept away into thin air.

In part one of his exclusive, three-part Club EWI video series “Why Use The Wave Principle,” Wayne first assesses the pitfalls of relying on macroeconomic models to forecast; namely: “An investor is lured into the market at just the worst time, when it’s time to sell, and forced out just at the best time to buy.”

As for real world examples of this happening, Wayne spans three hundred years of financial history to reveal how the most pivotal economic, political, and environmental events failed to alter the course of their respective markets. Here, the free video includes groundbreaking charts on these (and more) well known episodes:

• The S&P 500 and Enron from 2000-2002: The stock market ROSE and continued to proceed upward AFTER the largest US corporate scandal and bankruptcy ever (at the time).
• The Dow Industrials and GDP quarterly data from 1970 to early 2000s: After the release of major negative GDP numbers, the market for the most part ROSE, just the opposite of what most market analysts and investors expect.
• The Dow and profound political events over the last 80 years: In the 1930s and 1940s, a series of negative incidents — i.e. Hitler rising to power, World War II, and the Holocaust — preceded a powerful uptrend in stocks all the way into the 1960s.
• Stock market charts of the five countries most affected by the 2004 Indian Ocean Tsunami (India, Indonesia, Malaysia, Sri Lanka, and Thailand). Four out of the five ROSE after the natural disaster…

Believe it or not, we’ve only scratched the surface. In his myth-busting, free video “Why Use the Wave Principle,” Wayne Gorman presents a total of 40 charts that capture failed fundamental analysis of the world’s leading financial markets. Wayne recalls this expression from a famous, Nobel Prize winning economist:

“Economic reasoning will be of no value in cases of uncertainty.”

And he offers this response:

“But isn’t that what we have in financial markets: cases of uncertainty? We need a different type of reasoning, one that will help us to avoid the pitfalls shown on the previous charts. That’s why the Wave Principle is so important. It offers a unique perspective and a market discipline of rules and guidelines that help investors avoid buying at tops and liquidating at bottoms. It helps to explain and understand trends before they happen.”

The flaw in Economic 101, cause-and-effect theory is one of the easiest things to prove. But it’s also one of the hardest things for many investors to accept. Now is the time to do so. Watch the free “Why Use the Wave Principle” video in its entirety today at absolutely no cost. Simply sign on to join the rapidly expanding Club EWI and take advantage of the amazing educational benefits membership has to offer.

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John Lekas, senior portfolio manager for the $320 million Leader Short-Term Bond Fund, says the “real” unemployment number, or U-6, could surge as high as 25% by the middle of 2010.

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Deflation is more than just “falling prices.” Robert Prechter explains why.

By Editorial Staff
The following article is an excerpt from Elliott Wave International’s free Club EWI resource, “The Guide to Understanding Deflation. Robert Prechter’s Most Important Writings on Deflation.”

The Primary Precondition of Deflation
Deflation requires a precondition: a major societal buildup in the extension of credit. Bank credit and Elliott wave expert Hamilton Bolton, in a 1957 letter, summarized his observations this way: “In reading a history of major depressions in the U.S. from 1830 on, I was impressed with the following: (a) All were set off by a deflation of excess credit. This was the one factor in common.”

“The Fed Will Stop Deflation”
I am tired of hearing people insist that the Fed can expand credit all it wants. Sometimes an analogy clarifies a subject, so let’s try one.

It may sound crazy, but suppose the government were to decide that the health of the nation depends upon producing Jaguar automobiles and providing them to as many people as possible. To facilitate that goal, it begins operating Jaguar plants all over the country, subsidizing production with tax money. To everyone’s delight, it offers these luxury cars for sale at 50 percent off the old price. People flock to the showrooms and buy. Later, sales slow down, so the government cuts the price in half again. More people rush in and buy. Sales again slow, so it lowers the price to $900 each. People return to the stores to buy two or three, or half a dozen. Why not? Look how cheap they are! Buyers give Jaguars to their kids and park an extra one on the lawn. Finally, the country is awash in Jaguars. Alas, sales slow again, and the government panics. It must move more Jaguars, or, according to its theory — ironically now made fact — the economy will recede. People are working three days a week just to pay their taxes so the government can keep producing more Jaguars. If Jaguars stop moving, the economy will stop. So the government begins giving Jaguars away. A few more cars move out of the showrooms, but then it ends. Nobody wants any more Jaguars. They don’t care if they’re free. They can’t find a use for them. Production of Jaguars ceases. It takes years to work through the overhanging supply of Jaguars. Tax collections collapse, the factories close, and unemployment soars. The economy is wrecked. People can’t afford to buy gasoline, so many of the Jaguars rust away to worthlessness. The number of Jaguars — at best — returns to the level it was before the program began.

The same thing can happen with credit.

It may sound crazy, but suppose the government were to decide that the health of the nation depends upon producing credit and providing it to as many people as possible. To facilitate that goal, it begins operating credit-production plants all over the country, called Federal Reserve Banks. To everyone’s delight, these banks offer the credit for sale at below market rates. People flock to the banks and buy. Later, sales slow down, so the banks cut the price again. More people rush in and buy. Sales again slow, so they lower the price to one percent. People return to the banks to buy even more credit. Why not? Look how cheap it is! Borrowers use credit to buy houses, boats and an extra Jaguar to park out on the lawn. Finally, the country is awash in credit. Alas, sales slow again, and the banks panic. They must move more credit, or, according to its theory — ironically now made fact — the economy will recede. People are working three days a week just to pay the interest on their debt to the banks so the banks can keep offering more credit. If credit stops moving, the economy will stop. So the banks begin giving credit away, at zero percent interest. A few more loans move through the tellers’ windows, but then it ends. Nobody wants any more credit. They don’t care if it’s free. They can’t find a use for it. Production of credit ceases. It takes years to work through the overhanging supply of credit. Interest payments collapse, banks close, and unemployment soars. The economy is wrecked. People can’t afford to pay interest on their debts, so many bonds deteriorate to worthlessness. The value of credit — at best — returns to the level it was before the program began.

Jaguars, anyone?

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By Editorial Staff
Government debt is no longer just a problem for emerging countries. Portugal, Spain, France and Greece (as we have seen in recent weeks) are living in fear of credit default. Consequently, the value of their credit default swaps is skyrocketing.

The following is an excerpt from the February issue of Global Market Perspective. For a limited time, you can visit Elliott Wave International to download the rest of the 100+ page issue free.

High levels of global debt are both financially debilitating and deflationary because they commit scarce cash to servicing interest payments. Up until now, most sovereign credit defaults occurred in emerging-market countries, such as Argentina and Russia. The deflationary tide, however, is starting to lap up against more developed Eurozone economies.

The chart shows the value of credit default swaps — an instrument similar to an insurance contract that pays holders (if they are lucky) in the event of default — for Greece, Portugal, Spain and France. In recent weeks these contracts have soared, with credit-default swaps on Greece’s and Portugal’s debt already surpassing the January-March 2009 extremes established in the latter part of Primary degree 1 down.

Obviously, the market is growing more skeptical that Greece can pay its debts, so the cost of protecting against default is rising fast. Greece’s budget deficit is 12.7% of gross domestic product, and Portugal faces a budget shortfall that’s more than twice the European Union’s limit. Traders are now buying default protection on sovereign debt at a rate of more than five times that of specific company bonds. “Greece’s neighbors would ‘step in’ to prevent a debt default to avoid ‘a problem for the whole of Europe,’” a Tokyo-based bondsalesman says. Maybe so, but who will step in to bail out Portugal, Spain, the next sovereign default or the one thereafter?

The world is running out of money to service its mounting debts, and this chart simply depicts the front edge of the next great wave of credit contraction, which will sweep into more established countries throughout Europe and eventually to the United States.

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