The $700B plan to restore confidence to the US financial system collapsed Monday, as the House of Representatives rejected the proposal by a vote of 228 to 205.  The financial system is in jeopardy.  The world needs to restore solidity to financial capitalism, and time is of the essence.

It’s essential that partisans on both sides of the political spectrum set aside their “principles” and come to agreement on Paulson’s plan.  Banks’ balance sheets are crammed with toxic assets, credit is severely constrained, and the health of the entire financial system is at stake.  Think I’m exaggerating?  Think again.  Just this past week, Washington Mutual (WM) was sold to JPMorgan (JPM) in a bankruptcy fire-sale, and Wachovia (WB) was acquired in an emergency deal brokered by the Fed.  The best way to stop the rot is to approve Paulson’s $700B bailout, and as quickly as possible.

I’ve been swamped with MBA work, so I haven’t had much time to post to my blog.  But with recent awe-inspiring market fireworks, I view a divergence from statistics and finance as a welcomed event.

By now you’ve all heard the news: the US government took control of Fannie Mae (FNM) and Freddie Mac (FRE).  Miraculously, just a few days after Bill Gross, Director at PIMCO, pleaded for a housing bailout in his September Investment Outlook, Treasury Secretary Henry Paulson colluded with Wall Street moguls to formulate a government take over.  The deal was finalized over the first weekend in September.

A lot has gone wrong this past year.  And just when you thought things couldn’t get much worse, it now appears that there’s more trouble on the horizon.  Fortunately, there is one ray of light among the storm clouds.

After years of excess, the current account and fiscal deficits have created a never-before-seen debt burden in the US – and it appears about to get worse.  Fannie Mae (FNM) and Freddie Mac (FRE) are on the rocks, and it seems to be only a matter of time before the government is forced to formulate a bail-out.  The debt burden in the US is sure to become increasingly ominous as problems with Fannie Mae and Freddie Mac make their way onto the government’s balance sheet.  Even the latest glimpse of optimism, the rally in financials off the July 28th lows, seems to have ended.

This week marks the one year anniversary of the credit crunch, which officially kicked off during the first full week in August when American Home Mortgage shut its doors after an incredibly precipitous decline in its stock.  The result?  This past year’s Fed action has been filled with enough drama to rival the latest season of “Days of Our Lives.”  The Fed slashed interest rates, rolled out a new Fed discount lending program, dramatically rescued Bear Stearns (BSC) in the nick of time, and took swift action with Fannie (FNM) and Freddie (FRE) to avert a financial panic.  Whew!

Soap operas and the financial markets have provided plenty of entertainment, but unfortunately there doesn’t seem to be any sign of relief on either front.  Could Mr. Bernanke be secretly directing the Fed by following NBC’s appetite for cheesy soap operas?  It certainly appears that way.

The commodities bull has been running free for quite some time. Just a few weeks ago, I can recall market punters hyping $200 oil by year’s end and betting on the rising demand for metals in the developing world.  But it seems the euphoria surrounding commodities has changed in a matter of just a few weeks.  If commodities continue to falter, there’s a chance that economies reliant on commodity exports could see their currencies (Brazilian Real, Australian Dollar, et al) slide soon thereafter.

For the better part of this year, it seemed that commodities could only advance. Even in the face of a severe credit crunch and a declining stock market, commodities have rallied.  Using the Deutsche Bank Liquid Commodity Index as a benchmark, commodities have risen by over 40% in the first six months of this year versus a decline of 12% on the S&P (see chart).

In my last post I made clear that due to increased demand and a lack of excess capacity, I expect oil prices (and commodity prices in general) to stay high. That being said, I think there’s a strong chance that we could see a pullback in the short term. Such an easing will not come from political rhetoric. Instead, prices will ameliorate when the symbiotic relationship between supply and demand turns favorable. Such a trend is beginning to take place.

Politicians are touting numerous so-called “solutions” to help ease the pain. Mr. McCain, for example, wishes to suspend the tax on petrol and open up the artice wildlife refuge for drilling. These ideas may seem appealing, at least on an artificial level, but after delving into these “solutions” it’s clear that, if implemented, there will be little to no positive short-run effect on energy prices. The development of deep-sea drilling rigs, after all, takes nearly 10 years before oil can be extracted. And placating the burden of high petrol via a tax reduction is counter-productive -- a lower price will just lead to increased consumption. These are not “solutions;” the free-market mechanism of demand destruction is.

It’s certainly been a tough week for mortgage behemoths Fannie Mae (FNM) and Freddie Mac (FRE). The share prices of these Government Sponsored Enterprises (GSEs) were halved last week in the wake of comments by former St. Louis Federal Reserve President, William Poole, who suggested that the two GSEs were “technically insolvent.” Market punters have jumped on the bandwagon and are now shorting every last share they can get their hands on.

In a free market, Fannie and Freddie would stand little chance, but it seems as though the Fed is willing to come to the rescue…for a second time this year. If the orchestrated bailout of Bear Stearns wasn’t exciting enough, the dynamic duo (Bernanke and Paulson) appear prepared to entertain yet again. It seems as though a fully-fledged bailout of Fannie and Freddie could be in the works.

Originally published on June 25, 2008

No, I'm not referring to Microsoft's (MSFT) new operating system. Let me explain.

For years, China pegged its currency to the dollar, thereby manipulating traditional economic theory. My classical economics textbook states that:

Currencies of economies with large current-account deficits should depreciate relative to those of countries with surpluses. A currency depreciation will stimulate exports and throttle imports, thereby helping to restore balance to trade gaps.