The Dynamic Duo

Bernanke & Paulson speak...and the Dow sinks. What gives?

JUST WHAT'S going on here? The Dow fell 173 points in New York when Ben Bernanke and Hank Paulson went to Capitol Hill to repeat how bad things are in the housing and credit markets.

   Let's unpack what the dynamic duo said, and take a look at a few other non-trivial matters weighing heavily on stocks as well as the Gold Price right now.

   Bernanke told the US Congress critters that, "The outlook for the economy has worsened in recent months and the downside risks to growth have increased."

   Oh, yes. They have.

   "To date," he added, "the largest economic effects of the financial turmoil appear to have been on the housing market, which, as you know, has deteriorated significantly over the past two years or so."

   We're not going to spend any time reciting all the evidence that points to more woes in the US housing market. It's been well established. What's at stake now is how much longer this slow-motion crisis goes on and-the special burden of today's letter-what happens to stocks in a lower interest rate environment.

   Bank of America chief market strategist Joseph Quinlan told investors that the current financial crisis is, "one of the most vicious in financial history." A research paper from his bank says the related fall-out from the crisis has caused $8.6 trillion in stock market losses worldwide, trimming a full 14.6% from the total world market capitalisation.

   "It could take months or even years before Wall Street and others get a handle on the true cost of the US subprime meltdown and the attendant global credit crunch," Quinlan added. "While subprime loans were once thought to be relatively small in scale and contained to just one segment of the US financial sector, the opposite has become painfully evident over the past few months."

   In New York, Governor Elliott Spitzer-under what authority it is not entirely clear to your editor-has given the monoline bond insurers three to five business days to find new capital or face a break-up. Spitzer wants the mononlines to break up their business into two parts: healthy vs. toxic.

   Warren Buffet wants to buy the healthy parts, municipal bonds. And if Spitzer has to count to three one more time, they all go straight to bed without dinner.

   Why the sudden deadline? After all, we've been slouching toward insolvency for weeks now with the bond insurers. The trouble is, the ambiguity surrounding their future is now bleeding into other borrowing markets, raising borrowing costs for municipalities and leading to outright lending freezes in other markets such as the "auction-rate securities" that underpin much of America's local government borrowing.

   The gangrene is spread up the leg of the body financial, in short, and it is time to amputate. Spitzer reckons that resolution of the monoline's ultimate fate will free up lending in other markets and normal activity can resume. For a moment, let's assume he's right. What happens next?

   Well here's the thing. Banks are wary of lending. They know the Fed will keep lowering rates this year as the housing crisis unfolds. But that doesn't mean the banks will loan. What about investors?

   "Worldwide risk aversion and cash levels touched new highs in February, according to Merrill Lynch's survey of fund managers, with about 30% of respondents saying that they are hedged against further falls in equities over the next three months," according to an article at Forbes.

   Investors are sitting on the beach with a pile of cash, waiting for the "all clear" signal to get back in the water. But no one wants to dip a toe in without some convincing bottom in the equity market. Won't someone please ring a bell?

   Of course the build up of huge cash surpluses doesn't automatically mean investors will buy stocks once they regain their nerve. For now it doesn't mean they're going to push the Gold Market sharply higher, either. But it's hard to see investors going aggressively into property, or bonds, or anything else really.

   Absent even more risk aversion, the cash is going to come into play at some point.