Look Who's Upside Down Now

| About: WMIH Corp. (WMIH)

On Thursday night, we learned Washington Mutual (NYSE:WM) with $307.2 billion in assets became the largest bank failure in U.S. history (see MarketWatch). In July, Indymac with assets of $32 billion failed. WaMu is the 14th bank or thrift to fail this year.

How bad is it? On June 30, the FDIC had just $45.2 billion to insure deposits. Bloomberg reports the final FDIC bill could top $150 billion and that is separate from the $700 billion bailout currently under debate on Capitol Hill.

To put some numbers to this banking crisis I went to the federal reserve data. The decline in the solvency of U.S. banks over the past ten months has been breathtaking.

Much like borrowing a down payment, banks borrowed $3.5 billion in January in order to meet their reserve requirements. By August, banks had borrowed $123.5 billion to meet their aggregate reserve requirement of $42.6 billion. By Sept 24, the borrowing had swelled to $158.3 billion! Not once in the 59 years before 2008, had borrowed reserves exceeded internal reserves.

The aggregate balance sheet of the U.S. banking system now resembles that of an upside-down interest-only subprime mortgage customer. Fittingly, Hank Paulson called it a "house of cards".

What now? The numbers, and their accelerating deterioration, clearly suggest the banking system is on a precipice.

The fear trade takes on new twists.

The Treasury had to pledge to protect money market funds after $133.3 billion was withdrawn over just 2 days last week. (Bloomberg)

On Thursday the US mint temporarily suspended sales of 1-ounce American Buffalo gold coins after demand exceeded supply. (FT.com)

Rapid money supply growth, and the government's need for new funds puts upside pressure on interest rates, inflation and taxes.

When the bailout is cobbled together, any market bounce is likely to be short-lived. Investors will once again focus on the U.S. economy, which is cascading into a recession. Falling durable goods orders, weak housing data, a spike in unemployment claims and GE's (NYSE:GE) profit warning represent just one day's worth of red flags.

In this environment, just like in 1990, that bailout money will be used to repair bank balance sheets via Treasury bond investments. It will not be put at risk where it could help the economy. Already the money multiplier effect has disappeared. In the 13-wk period ended Sept 15, the seasonally adjusted annualized growth in M1 was much stimulated 6.9%, but M2 barely grew at a 1.6% pace.

Investors should expect a multi-year bear market. Recession into at least mid-2009 seems to be a foregone conclusion. Asset deflation could transform into inflation if the feds tinker with the economy long enough.

Cash rich firms that can self-finance their acquisitions, like Berkshire Hathaway (NYSE:BRK.A), stand to clean up in the years ahead.

Stock position: None.