Greg’s Note: The potential bailout that looms today over Washington has sparked a great debate. The government wants to bailout the financial markets with $700 billion. Critics of free markets are saying, “I told you so,” while others are wringing their hands and shouting “moral hazard.” While both sides have a good point, will $700 billion even make a dent in the grand scheme? Lord William Rees-Mogg doesn’t think so. Send your comments on the bailout to greg@whiskeyandgunpowder.com.

Whiskey & Gunpowder
September 25, 2008
By Lord William Rees-Mogg
London, England, U.K.

The Trouble with Trillions

For about 10 years, Simon Jenkins and I were both writing columns for the London Times. Simon is still writing a column for The Sunday Times, but has shifted his weekly column to The Guardian. However, he has written something in The Sunday Times that has provoked a very interesting reply from a reader, a copy of which has been sent to me.

The reader’s letter comes from a Mr. D.P. Marchessini. I suspect that Mr. Marchessini is correct and the present credit crisis is the natural consequence of high leverage, the repeal of the Glass-Steagall Act and the creation of excessive and complex derivatives. The letter traces the sequences of events:

~~~~~~~~~~~~~Special~~~~~~~~~~~~~

John Smith “Diagnosed” with “Beta-Tester Syndrome”
…Now Eligible to Collect $70,000 per Year (Part-Time)!

This is a rather unusual story…

And for most people, February 1, 2007 was just like any other day. But for 487 “test subjects”...it was a day they will never forget.

A small group of ordinary individuals, following very specific instructions, had a chance to make more than $497 per minute.

Incredibly...this was NOT a one-time event.

On February 9, it happened again...

Read on to see of you’re eligible to receive benefits!

~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~

“In 1933, the United States passed the Glass-Steagall Act, which prohibited commercial banks from dealing in investments, and prohibited investment banks from doing commercial banking activities. This was a very sensible measure, and kept the banks in reasonable order until 1990.

“Unfortunately, in 1990, this Act was repealed — for reasons best known to the psychiatrists of the legislators. The result was that all the big Wall Street brokers became banks, as well as brokers, and the big banks started trading and speculating. This was combined with an enormous increase in “leverage” — borrowed money — by all the banks. Leverage is the ratio of a bank’s capital to its total assets.

“This used to be between five and seven times, pre-1990. But post-1990, it immediately started ballooning and, although the banks tried to keep it quiet, it was known that Merrill Lynch was more than 40 times. Goldman Sachs was 28 times, and Lehman Brothers was 30 times when it failed. Regardless what one thinks of such hair-raising tactics, the one thing that is clear is that they only work when the market is going up. Apart from their Balance Sheet, all the banks also had an enormous amount of ‘derivatives,’ which were kept off the Balance Sheet. Derivatives are an enormous cocktail of very exotic Options, on almost anything. In 1995, I was talking to someone at a dinner party, who was rich and supposedly very well connected in the financial world. I asked him what he thought the total amount of nominal value in derivatives were at that time. He said he thought perhaps $100 billion. In fact, at that time, they were $1 trillion. Today, they are $1.3 quadrillion — all off the Balance Sheet. They are also not included in any bankruptcy. Of course, this is the nominal value, and the actual amount at risk is much less. But five percent of $1.3 quadrillion is $65 trillion — still a tidy sum.”

I do not understand derivatives, certainly not at a level of $1.3 quadrillion. I am not even sure what a quadrillion is, though I assume it is 1,000 trillion. I do not feel ashamed of my inability to understand the global derivatives market, since the Sage of Omaha, Warren Buffett, himself has said that he does not understand them. What is clear is that they have been created in very large numbers. If Mr. Marchessini’s figures are correct, the gross value of derivatives is far in excess of the capacity of all the world’s governments to bail them out. Even a net value of $65 trillion is beyond the bailout potential of the major powers.

The Secretary for the Treasury, Hank Paulson, has asked Congress to authorise $700 billion as a bailout for those banks that have invested in sub-prime mortgages and other toxic assets. This is a sum one can reasonably understand. In London there are a large number of houses worth £1,000,000 or more. A thousand such houses are worth £1 billion. That is a solid reality. The $700 billion, which Secretary Paulson is asking for, is worth about £400 billion. It is therefore equivalent to about 400,000 good town houses in London.

~~~~~~~~~~~~~Special~~~~~~~~~~~~~

Better Than Gold

With gold, your assets are safe. Your money should appreciate, and you can live independent from all the market troubles of today.

But if I told you that you could do that without gold, and even make more money with just as much security, would you be interested?

I hope so, because today I have something that’s better than gold. Read on…

~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~

Plainly that would be a valuable estate, but it is conceivable. I can imagine the suburbs of London rolling out to Heathrow and the West. If one started at Canary Wharf and went on to Heathrow one could easily identify 400,000 houses worth £1 million each. If the U.S. Government chose to pledge itself for 400,000 such houses that seems reasonable. This may involve very large figures, but so does the Federal Budget.

It is the trillions that cease to be meaningful. I know several billionaires; I have certainly never met a trillionaire, let alone a quadrillionaire. If these derivatives hang over the whole banking system, then they should presumably be wound down and, over time paid off. They represent potential liabilities of the banking system, even if they are off the banks’ balance sheets. They cannot simply be consigned to a bad bank or simply be allowed to go into default. Even if Mr. Paulson gets his $700 billion, what will that do to settle the problems of quadrillions of derivatives?

Regards,
Lord William Rees-Mogg

Greg’s Endnote: Whether or not this bailout goes through, there is still a lot of financial damage left to be done. Our leaders in Washington are hard at work in front of the cameras but even they don’t have the power to get us out of this mess. So what does that mean for the average investor? What do you do now? Click here for some much-needed answers…

Whiskey & Gunpowder Special Reports

New "Backlash" Set to Rocket Oil Past $150...and Send Gas Soaring to Over $6 per Gallon

The 10 Shocking Reasons for China's Pollution Problem

Geothermal Energy: Investment in the Future

Here's One Coal Stock That's Set to Skyrocket

Investing in Exchange Traded Funds

The Real Story Behind the True Gold Bull Market

If someone forwarded you this copy, please look here to start your own subscription. Wanna let us know what you thought of today's issue? Now you can... click on this link. Whiskey & Gunpowder is a free e-mail service brought to you by a team of rebellious brigands. If you have not already done so, please click here to confirm your subscription. This will help us ensure you get every Whiskey & Gunpowder without interruption. Are you having trouble receiving your Whiskey & Gunpowder? You can ensure its arrival in your mailbox here. Please note: we sent this e-mail to maryroger@shaw.ca because you subscribed to this service. To end your Whiskey & Gunpowder e-mail subscription, click here.

Nothing in this e-mail should be considered personalized investment advice. Although our employees may answer your general customer service questions, they are not licensed under securities laws to address your particular investment situation. No communication by our employees to you should be deemed as personalized investment advice.We expressly forbid our writers from having a financial interest in any security recommended to our readers. All of our employees and agents must wait 24 hours after on-line publication or 72 hours after the mailing of a printed-only publication prior to following an initial recommendation. Any investments recommended in this letter should be made only after consulting with your investment advisor and only after reviewing the prospectus or financial statements of the company.

© 2008 Agora Financial, LLC. All Rights Reserved. Protected by copyright laws of the United States and international treaties. This newsletter may only be used pursuant to the subscription agreement and any reproduction, copying, or redistribution (electronic or otherwise, including on the World Wide Web), in whole or in part, is strictly prohibited without the express written permission of Agora Financial, LLC. 808 Saint Paul Street, Baltimore MD 21202.