We are simultaneously posting a report entitled Why the Worst May Soon Be Over from Bedlam Asset Management in Britain. I apologize in advance for even bringing this article to your attention, as I do not believe it will be possible for anyone to understand it if you don't have a pretty good understanding of European (and Asian and U.S.) banking systems. In addition, the article is filled with fairly arcane references to financial products and systems that few outside of the largest financial institutions had ever heard of before September 15, 2008.

You might then ask why I would put this on our web site - surely not to torment my clients! But I have always believed I should share all the knowledge I have for those few clients who want to know everything, and the people at Bedlam Asset Management have presented the most comprehensive explanation of our situation from a global perspective. While I do not agree with every idea they present, I would say a person cannot understand much of what has been going on from a macroeconomic perspective unless you understand what they are talking about in this article.

At the very least, you can learn more about this crisis by studying the European banking system's near-collapse than you can by studying what has gone on in the U.S. This is because the Europeans bought more of our terrible mortgage-related securities than we did. Plus, their largest banks bought into the insane derivatives that nearly brought down the entire system, and they bought in very, very big. These are the financial bond "insurance" policies, or "credit default swaps," the banks sold, to the tune of $40-$70 trillion (depending on which economist is speaking) - guaranteeing that our mortgage market would never have a problem. As I have shared before, Mr. Buffett called these (five years ago), "thermonuclear weapons" that, he implied, would one day be unleashed on our financial systems.

Now Mr. Buffett knows a lot about thermonuclear weapons, as he owns one of the largest reinsurance companies in the world, and one of those weapons going off in one of our cities is his single largest financial risk. For example, he lost I believe (from memory) around $2 billion on 9/11 - I’m sure more than anyone else - for his company was a major reinsurer of the Twin Towers. So when Mr. Buffett called the ballooning derivatives market a thermonuclear weapon, I knew he meant exactly that. Of course, neither he, nor I, nor anyone had any idea when this financial bomb might go off. It might never explode, as financial circumstances change in unforeseen ways.

The answer to the question as to when it might explode would be September 15-26, in Europe. Fortunately for everyone, it did not go off, but the countdown had begun. And that bomb, the destruction of a $40-$70 trillion monster, was being accompanied by cataclysmic problems in every other area of our financial system. That sounds like a pretty big bomb to me. In fact, you could look at any one of at least four distinct problems we had that alone could nearly freeze up our credit markets.

But Europe was playing with the biggest bomb, the derivatives market/credit default swap/other insane financial engineering products market. This is, you might recall, what brought down Bear Stearns, Lehman Brothers, AIG and nearly Merrill Lynch. The people at Lehman and AIG guaranteed Chairman Bernanke that everything would fall down if they fell, due to the trillions of dollars worth of interlocked, and now nearly worthless, smorgasbord of complex financial products they all shared together. They had created a monster, and they claimed it would bite the world economy’s head off if they were allowed to go bankrupt. They gave the Fed a final warning that this would happen on the weekend of September 13-14.

But the Fed allowed Lehman Brothers to fall on September 15, which is the day the world markets went into crisis and panic. Then, in the middle of the night on Sunday, September 28, I heard that Fortis, a huge European bank, was collapsing. And then within a few days, seven of the largest banks in Europe were insolvent, including the Royal Bank of Scotland and numerous other major British banks, nearly Ireland’s entire banking system, perhaps Italy if truth were known, the entire nation of Iceland, etc. I suppose this could be a coincidence, but it sounds to me as if the people at Lehman knew they had created a weapon that would wreak financial havoc.

I was, I must admit, on "pins and needles" last Friday when Lehman Brothers' credit default swaps were "valued." This was the first one of the $40-70 trillion worth of these things to be valued to see how much money banks had lost. That was also, as I'm sure most of us will not soon forget, the day we were all wondering whether or not we would end up in a depression. The Lehman credit default swaps were initially valued at 8.625% of their original value, a loss of, it is estimated, at least $365 billion. And those are the losses from exactly one out of the large number of our largest financial institutions that were on the other end of Lehman's trades, and the trades they made with each other, etc. And the total liability when you combine all the companies is somewhere between $40-70 trillion.

But the bomb did not go off. The last ingredient had been added, which is fear and a complete lack of confidence in the financial system. And that last ingredient is the fuse. Once it is lit, things start to move fast in the banking world. Without confidence, banks basically can't exist, as in order to function they must be primarily involved in credit, which can't exist without confidence. And then when their stock prices and assets start to fall quickly, as investors no longer have any confidence in them, certain regulatory requirements/safeguards force them under in a few short days.

So the fuse was lit by last Friday. Fortunately, Britain responded like the responsible adults we always hope they will be in a crisis. They moved very quickly to take the fuse out, i.e. to restore confidence in all their major financial institutions. There is exactly one sure way to make sure the bomb wouldn't go off, and that is for the government to back the banks. In a panic, only a government has enough credibility and staying power to calm people's fears. Was there any financial company in the world you trusted implicitly last Friday? No, whereas most expect Great Britain to weather the storm.

This has been an unusual time in many, many ways. One is that, since I saw this monster rearing its head on September 8, I have felt that people would have panicked much sooner and much more if they saw everything I was seeing! While I am one who always cautions calm when people start to panic, in this case the risk was so great that a panic had to come if our entire financial system was about to collapse. Forget calm - I want that bomb defused right now.

Had Britain not removed the fuse, Europe would have taken the direct hit of this "thermonuclear weapon." Its entire financial system would have been wiped out - this week. We would have been decimated here in the U.S., but Europe was going to be annihilated.

So I have been studying Europe to get a clearer picture of how the many financial dangers we have been facing look, and how/what/who they destroy. Europe went closer to the brink than we did, and anyone who needs to protect against investment risk needs to know everything possible about the dangers they saw up close, in order to make sure we control and avoid risk should we approach that brink again.

This in no way means that you need to understand everything that has gone on from a macroeconomic perspective! That's my job, another part of which is to educate and share ideas so you get the amount of information you want and need, and we all become better investors.

Finally, please know that I do not think my analysis presented in this short report more than begins to explain the entirety of what has gone on in recent weeks. In fact, the article by Bedlam Asset Management gives a much more comprehensive analysis. I am, however, fairly confident I am following a deadly thread running through this crisis. Looked at from every angle, this has been one of the most dangerous times in economic history. I recommend we remain vigilant until we are certain it has passed.

Next week, after taking a few days off after a very long six weeks, we will be posting the results from a mathematical analysis of the risk we have been experiencing in recent weeks and months. I promise no math knowledge or ability will be required to understand it. But if you are interested in risk control, it might not put you to sleep.

Richard Morey
Secure Retirement
18 Crow Canyon Court
Suite 300
San Ramon, CA 94583
925-855-4300