It was the Margin Call from Hell...

“Markets in turmoil after a fund fails,” is the headline in today’s International Herald Tribune.

The price of gold has breached the important $1,000 level...and hit a new world record. And black gold too – oil – hit $110. The demand for gold coins is so strong that a local coin dealer says he is out of stock on a number of items.

The dollar fell, meanwhile...down below 100 yen, for the first time since 1995. The dollar index hit a new low of 71.94...and the euro traded above $1.56.

It took investors a while to connect the dots, but now they seem to have the picture: the Fed’s big bank bailout will not really wipe out losses...nor make Wall Street more profitable; what it will do is save the big banks from going broke – if they’re lucky – while destroying the dollar.

“We’re in the helicopter phase now,” says Howard Simons, a strategist at Bianco Research in Chicago. He’s referring to Ben Bernanke’s famous remark...that he would drop money from helicopters, if necessary, in order to avoid a deflationary meltdown. On Tuesday, Bernanke’s helicopters dropped $200 billion. By Thursday, the hedge funds were still failing. What’s worse, there are rumors that a big bank may be in big trouble.

We take a moment to explain how it works. The banks have lent a lot of money to hedge funds. The funds didn’t hedge...they gambled. As a result, many are now in trouble; they can’t repay the money.

The banks send out margin calls – asking for more cash from the hedge funds, but the funds don’t have it. This week, for example, the Carlyle Fund got the “Margin Call from Hell” from its bankers. The banks wanted $97.5 million. That didn’t seem like much a few months ago, but now money is getting hard to come by. Carlyle bet $31 for every single dollar it had in capital. With that kind of leverage, the managers stood to score a fortune if the markets went their way. But if prices went in the wrong direction, and the bets went bad, it didn’t take much bad news before the fund went broke.

So, Carlyle has gone belly up. It couldn’t make its margin call. And all over town, other fund managers are biting their nails...and refusing to pick up the phone. The bankers are pacing the room too. You know the old saying: when you owe the bank $100,000...you can’t sleep at night. But when you owe the bank $1,000,000, it’s the banker who can’t sleep. Well, a lot of bankers are now sleepless in Manhattan and London...wondering which of their clients will be able to repay...and which won’t. And the last thing the Fed wants is for some large bank to make the headlines with news that it is broke. That’s what the Fed is for, after all. It’s a banking cartel...designed to protect the banks from their own stupid mistakes.

Of course, the big mistake the banks made was lending money to people who lent money to people who lent money to people who couldn’t pay it back. The subprime mortgage lenders didn’t worry, because they sold their loans on to packagers who sold them on again – often ending up in the portfolios of highly leveraged hedge funds, to whom the banks had lent money. S&P now projects that the losses from subprime will rise to $285 billion, up about $20 billion from their last estimate. Our estimate is that the losses will top $1 trillion...and if you throw in the collateral damage, lower house prices, the bill will rise to more than $6 trillion.

Houses in Southern California lost 17.9% over the past 12 months. The median price has sunk to $408,000. In the summer, the median price was over $500,000.

As expected, by us, retail sales slumped last month. Unemployment rose to a two and a half-year high. And America’s CFOs think the country is already in recession.

But today’s big question is this: will the feds succeed?

First, there is the practical issue of how lending to impaired banks in the middle of a credit crunch actually stimulates the real economy. The presumption is that there are worthy projects – new factories, business expansions, new technological developments, new employees to be hired – just waiting for credit from the banks. Now, with their balance sheets restored (they laid their subprime-infected credits off on the Fed in return for Treasury bonds)...they’ll be able to lend again; that’s the theory.

But what new factories? Who’s hiring? What businesses are expanding? The country is in a recession, for Pete’s sake. Besides, in the late stages of a credit bubble, few people borrow to actually expand the economy. The borrowers, instead, are hedge funds and speculators – just the people the banks are now afraid of. That’s just the way a credit cycle works. At first, the borrowers are solid...with sensible plans for the money. Each dollar they borrow results, say, another 75 cents to the nation’s GDP. But as the cycle goes on, the borrowers become more and more reckless. Asset prices tend to move up quickly, so the borrowers figure they can’t lose...and the lenders figure they have nothing to worry about because the collateral is becoming more and more valuable. As credit quality declines, each additional dollar borrowed adds less and less to the real economy. By the end, it may take an extra $10 worth of credit to produce a single extra dollar of GDP.

We take it as a given, at this stage, that more lending from the Fed cannot actually improve the real economy. In fact, it makes it worse – propping up failing companies, increasing speculation, misallocating resources, and adding to debts that will have to be paid, one way or another, by somebody or another, eventually. A better question is – how much damage will the feds do to the real economy?

*** Does the rally on Wall Street indicate a new bull market? Nick Parsons, a strategist in London, notes that there have been 20 rallies of 3% or more in the last eight years. Of those, 19 took place during the bear market of 2000-2003.

*** We’re getting tired of thinking about this situation. The Fed bailout...the credit crisis...inflation/deflation...whether to move money out of the dollar immediately...the conceits, pretensions, and delusions of the financial industry...the cockamamie economics of modern central banking... Our head is spinning...

But, we can’t think of anything else...

In order to pump $200 billion into the banks’ balance sheets, the money has to come from somewhere else. In this case, it comes directly from the Fed’s balance sheet – and represents about a third of it. So, if this doesn’t do the trick, the Fed has used up a lot of money for nothing.

To the extent this is “real” money – it also represents resources that would otherwise be used elsewhere, say building bridges or feeding poor people. To the extent that it is phony money – it merely adds to the world’s supply of dollar impersonators, reducing the value of each and every one.

Either way, the real economy suffers – either from inflation...or from misallocated resources. But the two have different results. In the former case, you can expect rising prices...in the second, you have to expect some Japan-like slump, with falling prices for capital assets.

So what will we get? Probably what we’re getting now – both.

*** Our guess is that the world’s financial authorities will try to halt the drop of the dollar. It is becoming dangerous...and costly. China, Russia, Japan...and the Gulf states have huge piles of dollars. When the buck goes down, they lose billions. The Arab countries typically link their own currencies to the dollar; oil is marked to market in dollars, so they tend to be dollar-based economies whether they like it or not. But they are beginning to wonder...and beginning to look for alternatives. Meanwhile, Japan suffers as the yen rises. Not only does the country have one of the largest reserves of dollars in the world, it is also a major exporter to the US. A higher yen gives the nation a competitive disadvantage. Don’t be surprised if some coordinated buying of dollars by central banks produces a bounce in the greenback.

Bill Bonner is the President of Agora Publishing. For more on Bill Bonner, visit The Daily Reckoning.