I have always found that an aptitude for mathematics is an essential skill for a financial professional (or talk show host). Captain obvious, at your service!

Let's take the case of a change in value of an asset. Let's say a hypothetical house was purchased for $300,000 and the down payment was 25%, or $75,000. This results in a mortgage of $225,000. This means your debt to equity ratio was 3:1, $225,000 in debt divided by $75,000 in equity.

Now, let's say that same house declines 25% in value, as many markets around the country have. This means that the house is now worth $225,000. Your debt to equity ratio is now infinite. Your house is worth $225,000 and you owe $225,000. You nave no equity and, consequently, you have an incalculable debt to equity ratio, $225,000 in debt divided by $0 equity.

This minor mathematical inconvenience is the root of our financial situation. All typical reserve calculations are irrelevant. All coverage ratios cease to exist. All debt to equity ratios have been decimated and lending capacity reduced, in many cases, to below zero, effectively requiring debt outstanding to be recalled, when possible, and no issuance of incremental debt. This shrinks capital (debt plus equity) and makes the available capital very expensive.

What does this mean? This means that, with fractional banking (and investment banking) that the smaller the equity, the greater the leverage and the greater the effect of any change in equity. On the upside, leverage is your friend, allowing you to feel like a financial Batman.

However, on the downside, your equity disappears faster than Casper in a blizzard. With the unconscionable leverage of many, if not all, financial institutions, this means that your equity has gone from a positive to a negative. We know that a negative equity means that you MUST reduce your lending, unless, of course, you reduce your reserve requirements to $0 or 0%, in which case, there are no rules anymore so let's make up new ideas, laws and controls as we go. This results in bad policies and laws that reduce the ability to short investments and inject huge capital guarantees and cash into zombie companies and industries.

We have now arrived at this financial and economic precipice. You cannot create equity out of thin air. The Government may print more money but money is a debt; it is not equity. The only way many financial institutions can survive is for shadow equity to be created, giving the illusion of real equity. When the FED exchanges good (or relatively good) treasuries for bad Level 2 and Level 3 assets, negative equity was exchanged for positive equity. The bad equity now sits on the FED's books.

At this point, people like me would offer to buy this bad debt of a few pennies on the dollar but as long as the FED does not sell it, it looks like an even swap, treasuries for bad paper, thereby protecting the illusion of a sufficient equity base of the financial institutions.

Here is the real problem. This is nothing more than a guarantee without equity or substance. It is no different than the Department of Education backing Sallie Mae bonds, the Federal Government finally explicitly backing Fannie and Freddie or the FDIC backing IndyMac. There comes a point in time when all of the guarantees of all these institutions are finally recognized to be vapid assurances. Investors finally accept the fact that each of these guarantees will be honored but with no change in equity backing them. That will, indisputably, lead to massive inflation.

I believe that this is the real message we must take from the current market.

Buy gold, buy silver, short the market, take a closer look at puts, research ETF's that are inversely related to the market. Remember, you can make money in a market like this. Just bet on any investment that prospers during this "inconvenient asset revaluation period".

Should anyone disagree with this conclusion, call the show and take away our WWF ("World Wide Financial") tag team championship belt that was awarded (by us to us) for understanding the current situation better than any other host or team of hosts.

I hope that you win and take our belt. That means that we are wrong and we all live to fight another financial day. If we win, we really all loose.

Pop quiz.

Did anyone read the news late Friday that the new housing assistance bill passed?

Did you wonder why a bill of this "significance" and "importance" was so ill-reported?

For those of us that believe and know that deficits and debts do matter, while the bill does provide some $300B in mortgage "assistance", did you notice that the national debt ceiling was raised to $10.6T?

Essentially, our recognized national debt as nearly doubled in 7 years. Let's not forget that this amount does NOT include the now explicit guarantee of Fannie and Freddie of $12T. Nor does it include the unfunded liabilities of...who really knows...but estimates run from $40T to $60T.

First, thanks to several shy but pretty creative monks many years ago, we have a double-entry method of accounting. That means nothing is created out of thin air. For every debit there is a credit. Therefore, in order for the U.S. to spend, it must first borrow, as we have a national debt, a massive and growing deficit and no reserves. This is neither a new nor a unique thought. It is fact. If this were not true, then why track the national debt - for kicks?

If we could create wealth and "money" (in any form) out of electronic bits and bites, then why not just create a million dollars for everybody in the U.S. and eliminate poverty? BECAUSE YOU CAN'T!!!

The current postulation is that as long as we create this whole transaction in our own currency, then we can create as much "money" as we like. Unfortunately, this is partially true...but...the effect would be the ultimate end-game of "Helicopter Ben" and it would create massive inflation. That would be bad enough but we continue to import things and those things will become massively more expensive as we debase our currency. The real race is to see which country can debase their currencies faster.

If we accept this as true, and I defy anyone, anywhere to challenge this statement with even a whiff of a fact, then we must consider the burden of this deficit and why it matters. Right now, our national budget is about $3T annually (not including huge amounts of "off-budget" things such as war). Of this $3T, 1/6th or $500B is interest on our debt. The debt ceiling just increased by about $1T. Interest on this additional borrowing alone will be about $40B, at our current borrowing costs. That is a huge increase in the annual deficit, a deficit that must be financed by borrowing.

Come on, folks, this has to matter to you at some point.

Look at the "what-if's. What if the U.S. incremental cost to borrow increases? The deficit and the debt increase. As the debt increased, the interest carry increases and the deficit increases. What if the FED needs to be re-financed by the Treasury? When the FED craps out on the last of the $1T or so of capital it has (and it has already committed $500-$600B), it must go to the Treasury and ask for more securities. The Treasury must then float these securities (borrow) and give them to the FED. What if we give away another stimulus package? Where do you think that money comes from? What if we need another mortgage bailout? What if the FDIC, with about $53B of capital (before the $8B it spent on IndyMac or the two bank failures this weekend) needs more capital? What if $300B just isn't enough to save the 3-5 million homes already in or expected to enter foreclosure within the next year?

Time for the comic relief of the chart above, thanks to our friends at The Sovereign Society. Banks have borrowed nearly $200B through January of 2008. Other borrowings have brought the total amount borrowed from the FED to $500-600B. The FED has taken instruments of completely unknown value and exchanged them for still relatively valuable Treasury securities. Yes, this is old news, but the national debt ceiling now exceeding $10T is new news. And it matters. Just like it matters to you when you have more debt than you can service.

The payoff of this column, since our entire BizRadio and Wall Street Shuffle teams are committed to giving you the tools to make a better financial decision, is that you should take inflation very seriously. In fact, the only treatment for the problems we have right now (notice I did not say "cure") is inflation. Bet on it, bank on it, invest accordingly. Bernanke is praying for it and he is pulling out all the stops to create it. He knows the alternative is massive deflation, and that is something no one wants or knows how to cure.

The U.S. is nothing more that than the collective earning and borrowing capacity of its citizens based upon the opinion of those that would lend to us. At some point, these numbers matter. It is at that point that we will really understand the term "defend the dollar".

The very uncomfortable reality is that our dollar is strong only as long as the world believes we will defend it. That defense could have been with a sound fiscal and monetary policy but it will depend, ultimately, upon the lenders' perception of our military strength and their perception of our willingness to use it.

Maybe that this the real reason Cheney said that "deficits don't matter". I respectfully disagree.

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I believe in the "End of Days" concept for the American Consumer. While I'm not sure exactly what the signs are or what the final sign will be, I can say with certainty that we are managing to leverage every valuable asset we have. When we have run out of things to borrow against, that will be the last sign. Until then, for the American Consumer, these will have to do (and these are pretty darn close to the final act):

The Seven Signs of The Financial Apocalypse of the American Consumer
1) Reverse mortgages
2) Life settlements (for the sellers)
3) Negative am, Alt-A, sub-prime, cash-back mortgages
4) Property tax loans
5) Payday loans
6) Debit cards for your 401K
7) Paying your mortgage with your credit card

I have friends in the property tax lien business. It is huge in Texas. If you cannot pay your property taxes, you can go to a firm that lends you the money at 18% interest over 48 months. They take a lien on your home. In Texas, this lien jumps to the head of the priority line, even jumping in front of your first mortgage holder.

Even people that own $3 million homes are borrowing the $90,000 of property taxes due.

You would think this is almost an entirely risk free investment, as property taxes are about 3% of the value of your home annually. A lender lends 3% of the value of your home to you and pays your taxes for you and they take a first lien.

Know what is slowing this lending practice right now?

The lack of qualified applicants!

Can you imaging? You are so concerned about the borrower paying back your puny 3% loan and worried that the property that you have taken as collateral won't sell that you won't lend 3% against the property. AND you have a first lien?

That, my friends, is truly amazing. And just a weeeee bit concerning.

Our next post will list the Seven Signs of the Financial Apocalypse of our federal government.

The big question is whether this is a permanent consumer buying shift.

If it is, this is a big problem for an economy that prides itself on being more than 70% consumer driven.

Also, as you drive through familiar neighborhoods, have you noticed browner and slightly less manicured lawns? And, in the evenings, have you noticed that many homes are dark that were previously lighted at night?

Think this has anything to do with your July power bill was up more than 50% from July of 2007? How do you think increased water prices are affecting the average American?

A better question is what do you think winter heating bills will do to consumption?

Does anyone think this is just a small problem with middle America? I have friends that have what once were considered to be great middle class jobs. They now have problems just meeting their monthly obligations. And they have no wage pricing power. And they face increased commodity costs. And their home value is declining. And their 401K's and retirement plans are shrinking.

This is not just your neighbor's problem. If the average American consumer is struggling, the nation struggles. If the nation struggles, the exporters of the world struggle. If that happens, your choice of investments, no matter where they are in the world, face challenges.

Never was there a better time to remember Will Rogers when he said that he was more concerned with the return of his investment rather than the return on his investment.

And just one more thing. In that Freddie and Fannie have contributed some $170 million dollars over the last few years to campaigns and lobbying...

Can they still do it if the U.S. Government REALLY is backing their paper now? Or if the FED REALLY makes an investment into some new class of preferred stock in either or both of these companies?

At what point does a private company become a GSE then become a ward of the country?

Can we at least stop them from now using our tax dollars and guarantees to lobby our Congress?

You heard it on "The Wall Street Shuffle" weeks before this release. And we have no inside information, just a lot of common sense...and we read everything.

NEWS ALERT
from The Wall Street Journal


July 17, 2008

J.P. Morgan Chase posted a 53% fall in net income to $2 billion, or 54 cents a share, from $4.2 billion, or $1.20 a share, a year earlier. The decline in earnings was driven partly by a higher provision for credit losses. Items related to the acquisition of Bear Stearns amounted to a net loss of $540 million. The firm beat analysts' expectations of on average 44 cents a share.

Chairman and Chief Executive Officer Jamie Dimon said, "Our expectation is for the economic environment to continue to be weak -- and to likely get weaker -- and for the capital markets to remain under stress. We remain conscious that since substantial risks still remain on our balance sheet, these factors will likely affect our business for the remainder of the year or longer."