By Keith Fitz-Gerald
Investment Director
Money Morning/The Money Map Report

Seeing banks such as Wachovia Corp. (WB) get sold or Washington Mutual Inc. (WM) fail is scary for retail banking customers. But there are simple steps you can take to protect your bank assets.

A Money Morning reader recently wrote to say:

“I’m panicked. After watching the news and several banks fail, how can I know if my bank is safe? I’m retired and can’t afford to ‘lose it all’.”

With about 120 banks on the Federal Deposit Insurance Corp.’s troubled list and rumors swirling that as many as 200 more are in deep kimchee, we don’t blame you for asking – particularly since the FDIC doesn’t publish the names of the banks on its watchlist.

Credit Crisis Safety Plays

Here are three quick and easy steps you can take that may help you determine if your bank is safe or not.

1. Click over to Bankrate.com’s Safe & Sound ratings page. There you can plug in your bank’s name and see how it scores on the basis of 22 objective measures designed to gauge the capital adequacy, asset quality, profitability and liquidity of thousands of banks. If your bank doesn’t make the cut with a higher rating, then switch to one that does.
2. Use the FDIC’s electronic deposit insurance estimator to see if your assets are covered in full. With the recent signing of the bailout legislation into law, the FDIC now covers accounts up to $250,000 at any one bank in any single account or $250,000 per co-owner for joint accounts. Traditional and Roth IRAs, SEPS and other retirement accounts on deposit at an FDIC-insured bank or savings institutions are insured up to $250,000 separately from any other deposits you may have at the same institution. But this is mainly deposit accounts and doesn’t include stocks, bonds, mutual funds or life insurance policies.
3. Double-check your ownership. If a portion of your assets is uninsured, getting full coverage may just be a matter of changing ownership or spreading out your accounts to different banks. (But keep in mind, like most things the government doesn’t make this easy so that means more paperwork.) If you’ve got the big bucks, visit the Certificate of Deposit Account Registry Service, or CDARS, and learn how you can obtain full FDIC insurance on deposits up to $50 million – with a single interest rate on a single statement at a single bank. Ironically, a former U.S. Federal Reserve employee – someone who must have gotten “fed” up with the complicated FDIC insurance requirements and ownership restrictions – started this innovative service.

But what ever you do, do it quickly.

That way you won’t be one of hundreds who will probably be camped out at the front doors of the next IndyMac Bancorp Inc. (OTC: IDMC) when it hits.

[Editor’s Note: “Credit Crisis Safety Plays” is a new Money Morning series that will detail strategies that investors can use to insulate themselves and their finances from the ongoing credit crisis. The first installment explained how to make sure your bank deposits are FDIC insured. These personal finance missives will draw upon the experiences of such experts as Money Morning Investment Director Keith Fitz-Gerald.]

News and Related Story Links:

• Money Morning:
  Credit Crisis Safety Plays: How to Make Sure That Your Bank Deposits are FDIC Insured

• Money Morning:
  Banking Bailout Becomes Law With House Vote, Bush Signing

• Bankrate.com:
  Safe & Sound rating

• FDIC:
  Electronic deposit insurance estimator

• Website:
  Certificate of Deposit Account Registry Service

By Keith Fitz-Gerald
Investment Director
Money Morning/The Money Map Report

With evidence mounting by the day that the banking industry may be in deeper than it admits, many investors are wondering what the Federal Deposit Insurance Corp. (FDIC) actually does and how it will protect them.

This question becomes even more crucial now that, under the proposed banking-sector rescue legislation that was passed by the Senate Wednesday night, the individual cap on the level of government-guaranteed deposits would be raised from the current $100,000 to the new level of $250,000.

Let’s take a look at what the FDIC is and does, and outline how it’s supposed to function. There are also two steps folks can take to ensure the safety of their deposits.

The 4-1-1 on the FDIC

The FDIC is an independent government agency formed by Glass-Steagall Act of 1933, as a response to the runs on banks that took place during the Great Depression.

In 2005, the Federal Deposit Insurance Reform Act increased the amount of insurance coverage for an Individual Retirement Account (IRA).

Ostensibly, federal deposit insurance was created to protect depositors from the loss of deposits at FDIC-insured banks and savings associations. And the good news is that the FDIC has done so remarkably well over the last 75 years, that no depositor has lost a single penny of insured deposited assets.

FDIC insurance covers checking accounts, savings accounts, money market deposit accounts and certificates of deposit.

It does not, however, cover so-called "non-deposit products," such as stocks, bonds, mutual funds or life insurance, even though many of those products are offered through FDIC-insured banks.

As you might suspect, there are limits as to what is insured at any given institution. In general, deposit insurance covers:

• Single accounts owned by a single owner: $100,000
• Joint accounts with two or more owners: $100,000 per owner
• Revocable trusts: $100,000 per owner per qualifying beneficiary subject to specific limitations (check with your tax advisor or accountant)
• IRAs and select retirement accounts: $250,000

It’s important to note that the FDIC individual limit applies separately to different banks. That means if you have $100,000 in each of two separate accounts at different banks – one at each bank – you’re actually insured for the full $200,000.

Credit Crisis Safety Plays

As we mentioned, under the proposed banking-sector rescue legislation that was passed by the Senate Wednesday night, and which is supposed to head to the House of Representatives for a review and possible vote sometime today (Friday), the individual cap on the level of government-guaranteed deposits would be raised from the current $100,000 to the new level of $250,000. But that new coverage will not take effect until the bill passes the House and is then signed into law by U.S. President George W. Bush.

Until that happens, there are still a couple of "action items" worth pursuing to protect and help yourself. They are:

1. Call your bank and make sure it’s FDIC-insured. If it isn’t, consider switching to a bank that is.
2. If you’re unsure about your own assets, and whether or not they are covered, check out the FDIC’s electronic insurance estimator.

But do it sooner rather than later. There are a record 117 banks on the FDIC’s troubled list and our own estimates suggest that at present rates we could easily see that number rising to more than 200 in the next six months. That means the agency could be dumping dollars in the near term, so it’s only logical to make sure your money is covered.

[Editor's Note: "Credit Crisis Safety Plays" is a new Money Morning series that will detail strategies that investors can use to insulate themselves and their finances from the ongoing credit crisis. These personal finance missives will draw upon the experiences of such experts as Money Morning Investment Director Keith Fitz-Gerald. Next up: How to be sure that your bank is safe.]

News and Related Story Links:

• Money Morning:
  Bailout Bill Clears the Senate, Heads for (Another) House Vote.

• Wikipedia:
  Federal Deposit Insurance Corp.

• FDIC Website:
  FDIC’s electronic insurance estimator

• Wikipedia:
  The Great Depression.

• Money Morning Market Commentary:
  Since You Asked … Here’s How I Would’ve Fixed the Fiasco.

Citigroup Inc. (C) will acquire Wachovia Corp.’s  (WB) banking operations for $2.l6 billion, a deal that will restore Citi’s title as the biggest U.S. bank by assets while transforming the once-highly regarded Wachovia into an investment-management operation.

In becoming the latest big U.S. bank to bolster its assets by rummaging through the remains of a nearly defunct financial institution, Citi agreed to buy Wachovia’s banking operations for $1 per share. The deal gives Citi a strong retail-banking network – adding 3,300 branches and offices in 21 states – as well as $2.2 billion in deposits; but the bargain also brings City $42 billion in prospective losses from Wachovia’s $312 billion loan portfolio.  The Federal Deposit Insurance Corp. (FDIC), in exchange for $12 billion in preferred stock and warrants, will cover any losses over that $42 billion ceiling.

With the deal’s completion, Citi will have 4,300 U.S. bank offices and more than $600 billion in deposits, giving it a hefty 9.8% share of the U.S. banking market. With total assets of $2.91 trillion once the takeover is concluded, Citi will have regained its position as the No. 1 U.S. bank by assets. However, in terms of how shareholders value each bank’s stock, Citi will remain the third-largest U.S. bank, behind leader Bank of America Corp. (BAC) and second-largest bank, JP Morgan Chase & Co. Inc. (JPM), Forbes.com reported.

Wachovia will retain its brokerage and wealth-management, which include such properties as A.G. Edwards Inc. and the Evergreen Investment Management Co. LLC mutual fund family.

Wachovia’s Woes

In little more than two decades Charlotte-based Wachovia grew into the United States’ fifth-largest bank, but quickly found itself hamstrung by a series of poor decisions that cost the company three-quarters of its value in the past nine months.

The most costly decision for Wachovia was the 2006 buyout of Golden West Financial Corp. – a California-based lender that specialized in adjustable-rate mortgages (ARMs). The acquisition of Golden West made Wachovia the largest holder of option ARMs, ahead of even Washington Mutual Inc. (WM)  – the lender that was snapped up by JPMorgan Chase & Co. last week. Wachovia was confronted with more than $30 billion in losses stemming from Golden West’s option ARM portfolio, BusinessWeek reported.

Wachovia’s collapse was hastened by JPMorgan’s purchase of Washington Mutual, which raised doubts about whether or not Wachovia had adequate reserves to cover mortgage-related losses.

“The J.P. Morgan/Washington Mutual transaction raised the bar in terms of potential marks/reserves against consumer real estate for other commercial banks,” said analysts at Credit Suisse Group AG (ADR: CS), led by Todd L. Hagerman.  “Our aggressive capital-sensitivity analysis for both Bank of America Corp. and Wachovia, incorporating J.P. Morgan’s $31 billion of marks, or 20% cumulative-loss assumption, suggests a blended potential capital shortfall of $40 billion to $50 billion for Bank of America and $15 billion to $20 billion for Wachovia, under a recession-type scenario.”

The result, many believe, was a run on Wachovia that resulted in a massive outflow of deposits, and ultimately, the bank’s collapse.

“The problem must have occurred last week with their ability to continue to attract and hold deposits after the failure of Washington Mutual,” Gary Townsend of Hill- Townsend Capital in Chevy Chase, Maryland told Bloomberg. “On Thursday and Friday they must have had a large run on the bank.”

Citigroup, JPMorgan On the Hunt

Collapses, like those experienced by the likes of Wachovia and WaMu, have paved the way for greater industry consolidation, with the remaining firms salvaging what usable assets can be found amid all the carnage, in a desperate bid to bolster their own positions.

Citi broadened its base with the addition of Wachovia’s 3,300 retail-banking branches and the $2.2 billion in deposits that come along with them. Those deposits will provide Citi with a cheap, stable source of funding at a time when credit is scarce.   

Citi, already the largest U.S. bank by assets, will have $1.3 trillion in total deposits worldwide, roughly $350 billion more than JPMorgan Chase & Co.

However, JPMorgan, under the stewardship of Chief Executive Officer Jamie Dimon, has made several strong acquisitions of its own – leaving the firm well positioned to compete.

After taking over The Bear Stearns Cos. Inc. in March, Dimon moved swiftly to acquire failed Washington Mutual from the federal government. JPMorgan paid $1.9 billion to the FDIC to acquire WaMu’s $188 billion in deposits, 2,200 retail branches and a loan portfolio valued at $176 billion.

While JP Morgan immediately wrote down roughly $30 billion in mortgages and home-equity loans, the acquisition left a total of $900 billion in deposits and 5,400 branches Bloomberg reported.

“JPMorgan is putting together quite an interesting empire of assets,” Douglas Ciocca, managing director of Renaissance Financial Corp. told Bloomberg. “Jamie Dimon has the right pedigree to be able to pull something like this off, as did J.P. Morgan himself.”

JPMorgan took $18.8 billion in write-downs and credit-related losses since the beginning of 2007 – a fraction of the $55 billion taken by Citigroup.

The Evolution of Goldman Sachs and Morgan Stanley

Competition will also come from the likes of Goldman Sachs Group Inc. (GS) and Morgan Stanley (MS), which have abandoned their roles as investment banks and converted to holding companies.

Goldman Sachs, the largest and most profitable U.S. securities firm, immediately took its place behind Bank of America, JPMorgan, and Citigroup, as the fourth-largest U.S. holding company last week, and is already moving forward with plans to revamp its business model.

The Financial Times reported yesterday that Goldman was looking to spend up to $50 billion on assets from ailing U.S. banks. That’s in addition to the $150 billion of its own assets it is moving to its Utah industrial loan corporation, CIT Bank, which currently has about $20 billion in deposits and $25.7 billion in assets.

Goldman has just $8 billion in securities backed by commercial mortgages, and if it sold all of those securities today, the company would record a gain, officials told the FT. Goldman has also reduced its exposure to private equity deals from $52 billion to $8 billion.

Morgan Stanley, formerly the second-biggest U.S. securities firm, had $36 billion of deposits and three million retail accounts at the end of August. The company will also convert its Morgan Stanley Investment Bank, an industrial bank based in Utah, into a national bank.

News and Related Story Links:

• Bloomberg:
  Citigroup Agrees to Buy Wachovia’s Banking Business

• Barron’s:
  WaMu Deal May Mean More Sector Markdowns

• Money Morning:
  JPMorgan Chase Biggest U.S. Bank With Its Purchase of Failed WaMu

• Bloomberg:
  Dimon Gets Morgan’s Mantle as Buyer of Final Resort

• Money Morning:
  Goldman Sachs, Morgan Stanley Seek Fresh Start as Holding Companies

• Financial Times:
  Goldman seeks to buy up to $50bn in assets.

• Forbes.com:
  
  Citicorp to Buy Wachovia Banking Operations.

Congressional negotiators late yesterday (Thursday) reached a tentative agreement on a credit-crisis compromise that gives the Bush administration about a third of the $700 billion it has requested up front, but made sure half that outlay was subject to a congressional veto, published reports state.

Details remained sketchy late yesterday. However, this much is known. Under the plan – known as the “Troubled Assets Rescue Plan,” or TARP – U.S. Treasury Secretary Henry M. “Hank” Paulson Jr. would get an immediate $250 billion to begin bailout operations, and could obtain an additional $100 billion if needed. The final installment of $350 billion could be blocked by a Congressional vote.

TARP is designed to give lawmakers a controlling stake in the unprecedented credit-crisis bailout plan, industry sources and The Associated Press both reported. Money Morning Contributing Editor R. Shah Gilani – a former hedge-fund manager and currency trader who this week proposed an alternate plan that wouldn’t burden taxpayers with billions in federal debt – said it will be tough to evaluate TARP until all the details are known.

But he clearly didn’t have strongly positive feelings about either Paulson’s original plan or the revised TARP proposal put forth by congressional negotiators late yesterday.

“Commenting on what’s under the TARP [proposal] is like asking if there’s a Hell below us,” Gilani said in an interview late yesterday. “We won’t know until we get there.”

Anatomy of a Deal

The tentative plan calls for the federal government to buy the “toxic,” mortgage-backed assets of failing – or failed – financial institutions in a bid to keep the U.S. financial system from melting down. A meltdown would be the penultimate event that would sap investor confidence, setting in motion a series of irreversible events that would wipe out savings, cause a big spike in home foreclosures, and ultimately, cause a major surge in unemployment after thousands of small businesses fail and major companies resort to widespread layoffs.

The Bush administration has made concessions almost daily to demands from both the political right and left from its original three-page proposal, including agreeing to limit pay for executives of bailed-out financial institutions.

Debate has been fierce on such questions as whether to phase in the cost and whether to give taxpayers an equity stake in rescued companies. House Financial Services Committee Chairman Barney Frank, D-Mass., told The Associated Press thatboth would be included in the legislation.

While details of the plan were not immediately provided, the compromise is said to include provisions to curb executive compensation for participating companies, provide more oversight of the Treasury’s actions, and supply the government with stock warrants that let the government share in profits generated by participating Wall Street firms.

“We came to some agreements on a lot of important issues,” Frank told The Los Angeles Times. “We are on track to pass this.”

Investors Show Their Approval

U.S. stocks soared yesterday on news that Congress had reached an agreement.

After soaring as much as 300 points, the Dow Jones Industrial Average Index pared gains in late afternoon trading. But all three major U.S. indices still had solid jumps for the day, as optimism that Congress would soon pass the bailout legislation buoyed U.S. markets.

The blue-chip Dow gained 196.89 points (1.82%), to close at 11,022.06. The tech-laden Nasdaq Composite Index shot up 30.89 points (1.43%) for the day to 2,186.57. And the broader Standard & Poor’s 500 Index rose 23.40 points (1.97%), to reach 1,209.27.

All sectors were up with the energy sector’s 2.64% gain and the financial sector’s 2.32% increase some of the highest.

“Optimism lies in the hope that we’re nearing the end of the credit crisis and that Paulson’s plan will help settle things down and businesses can get back to functioning as normal,” James Gaul, a Boston-based money manager at Boston Advisors LLC, which oversees $1.8 billion, told Bloomberg News.

Financials such as JPMorgan Chase & Co. (JPM) and Bank of America Corp. (BAC) posted gains of 7% and 4%, respectively. Other stocks such as IBM Corp. (IBM), up 3% for the day, gained on hopes that the bailout plan would lead to economic recovery and reignite consumer demand. 

A Wait-And-See Saga For Commodities

Gold fell yesterday, as investors waited to see the full details of the amended bailout plan. Gold for December delivery fell $13, a decline of 1.5%, to end at $882 an ounce on the Comex division of the New York Mercantile Exchange, MarketWatch reported.

"Until the bailout proposal becomes law, investors will remain reluctant to take big positions in a number of commodity complexes," Edward Meir, a commodities analyst at futures brokerage MF Global Ltd. (MF), told MarketWatch.

But that position could quickly reverse once the proposed bailout becomes law – causing gold and other precious metals to soar in price.

The plan "will continue to undermine the value of the U.S. dollar and further support a flow of capital out of paper into hard assets, into gold and silver," said Peter Spina, president of Gold Seek LLC.

Oil got a boost on hopes that the bailout would jumpstart the U.S. economy and spur demand. Crude oil for November delivery rose $2.29, or 2.2%, to close at $108.02 a barrel on the New York Mercantile Exchange, according to MarketWatch data.

The bailout plan "is certainly driving the [oil] market higher" on hopes of a recovery in the U.S. economy, said Mark Waggoner, president of Excel Futures. “Once the initiative is passed, however, the market should revert lower to $98-$100 levels,” or even less.

Bush Backs Paulson’s Plan

President Bush addressed the nation Wednesday night and tried to explain the crippling credit crisis, and why the costly bailout plan was needed, to the American public. 

"We’re in the midst of a serious financial crisis," Bush said in a nationally televised address, MarketWatch reported. "Our entire economy is in danger," as a result of the credit crunch, he said, and inaction on the plan could result in a "long and painful recession."

The high price tag for the $700 proposed bailout has triggered fear and disbelief with many voters. But Bush did his best to reassure the nation that taxpayer funds are in good hands at the Treasury Department.

"We expect that much, if not all, of the tax dollars we invest will be paid back," Bush said.

Bush explained that the U.S. government was the only entity with the patience to hold the troubled securities until the credit markets unfreeze and return to a more normal state of operation.

Gilani, the Money Morning editor, said he’s stunned over how quickly this so-called agreement was reached.

“It’s mind-boggling to me to even attempt a compromise in only a matter of days with regard to $700 billion, as if that’s tip money,” he said. “There’s something drafty in this whole process of hasty compromise and I’m afraid that it’s going to turn into an ill wind and the worst kind of open partisan warfare after the fact.”

Rather than receiving the entire $700 billion in one lump sum, the Treasury Department will receive $250 billion immediately, with the remainder to be paid in installments. This is intended to provide more congressional oversight.

“The question is, first … do they actually need the whole $700 billion?” asked Sen. Charles Schumer, D-NY. “And, second, what kind of checkpoints are there along the road?”

A protracted dispersion of funds should give Congress opportunities to monitor the bailout’s effectiveness over the next several months, proponents of the new TARP proposal said.

But Gilani sees this “bailout installment plan” as being problematic.

“Doling out capital in installments to satisfy the market’s ravenous appetite for liquidity is like giving a starving person a nickel to buy a meal,” he said.

The new plan also includes caps on executive pay for company executives, which Paulson initially opposed. Rep. Frank on Sunday referred to lavish executive salaries and bonuses as a "perverse incentive" that encourages executives to take inappropriate or excessive risks in exchange for multi-million-dollar payouts, and therefore, part of the problem.

Paulson finally agreed yesterday, stating that “the American people are angry about executive compensation and rightfully so. We must find a way to address this in the legislation.”

The plan will likely include stock warrants that compensate the federal government, and perhaps the U.S. taxpayers, for their investment.

“Right now the price of admission [to the proposed Treasury program] is zero,” Sen. Jack Reed, D-RI, said Tuesday. “It’s not inappropriate to demand that if they benefit from this transaction in the future … that they will share that benefit with the taxpayers who made the benefits possible."

Money Morning’s Gilani can’t help but wonder if this isn’t a case of too little, too late.
“Everyone knew since at least August 2007 that we were facing an increasingly dangerous credit crisis; that was the shot across our bow,” Gilani said. “When Bear Stearns failed in March that was a direct hit and we should have declared war. To now be trying to nuke the crisis with a $700 billion-bomb of legislation just makes me more afraid of the fall-out.”

[Editor's Note: Contributing Editor R. Shah Gilani has toiled in the trading pits in Chicago, run trading desks in New York, operated as a broker/dealer and managed everything from hedge funds to currency accounts. In his just-completed three-part investigation of the U.S. credit crisis, Gilani was able to provide insider insights that no other financial writer or commentator could hope to match. He drew upon the experiences and network of contacts that he developed through the years to provide Money Morning readers with the "real story" of the credit crisis. It's a perspective on the near-financial meltdown that you'll find nowhere else. If you missed Gilani's investigative series, Part I appeared Friday, Part II ran Monday and Part III was published Wednesday. In his “Open Letter to U.S. Treasury Secretary Henry M. Paulson, Federal Reserve Chairman Ben S. Bernanke, members of Congress and the governor of your state,” Gilani details a bailout proposal that he believes will fix the problem quickly and effectively – at little cost to taxpayers. If you like the plan, mail the plan to the leaders of Congress or to the governor of your state.]

News and Related Story Links:

• The Los Angeles Times:
  Lawmakers reach agreement on bailout framework.

• Money Morning Investigative Research Report:
  
  Dear Hank: Here’s How to End the Credit Crisis at No Cost to Taxpayers.

• Money Morning Special Investigation of the Credit Crisis (Part I):
  The Real Reason for the Global Financial Crisis…the Story No One’s Talking About.

• Money Morning Special Investigation of the Credit Crisis (Part II):
  The Credit Crisis and the Real Story Behind the Collapse of AIG.

• Money Morning Special Investigation of the U.S. Credit Crisis (Part III):
  How Complex Securities, Wall Street Protectionism and Myopic Regulation Caused a Near-Meltdown of the U.S. Banking System.

• The Associated Press:
  Bailout money would be phased in.

• Bloomberg News:
  U.S. Stocks Advance as Congress Nears Agreement on Bank Bailout

• MarketWatch:
  Stock indexes rally on optimism for bank bailout

• MarketWatch:
  Gold pulls back as investors mull rescue plan

• MarketWatch:
  Oil futures gain 2.2% as bailout plan nears approval

• MarketWatch:
  Bush urges quick action on financial rescue plan

• Reuters:
  US STOCKS-Wall St jumps as bailout approval nears.

By Shah Gilani
Contributing Editor

Are you shell-shocked? Are you wondering what’s really going on in the market? The truth is probably more frightening than even your worst fears. And yet, you won’t hear about it anywhere else because “they” can’t tell you. “They” are the U.S. Federal Reserve and the U.S. Treasury Department, and they can’t tell you what’s really going on because there’s nothing they can do about it, except what they’ve been trying to do – add liquidity.

At the exchange rate yesterday (Wednesday), 35 trillion British Pounds was equivalent to U.S. $62 trillion (hence, the 35 trillion Pound gorilla). According to the International Swaps and Derivatives Association, $62 trillion is the notional value of credit default swaps (CDS) out there, somewhere, in the market.

This isn’t the first time Money Morning has warned readers about the dangers of credit default swaps. And it won’t be the last.

The Genesis of a Derivative Boom

In the mid-1980s, upon arriving in New York from Chicago with an extensive background trading options and futures (the original derivatives), I was offered a job at what was then Citicorp [today's Citigroup Inc. (C)]. The offer was for an entry-level post in the bank’s brand new OTC (over-the-counter, meaning not exchange traded) swaps and derivatives group. When I asked what the economic purpose of swaps was, the answer came back: “To make money for the bank.”

I declined the position.

It used to be that regulators and legislators demanded theoretical, empirical, and quantitative measures of the efficacy of new tradable instruments being proposed by exchanges. What is their purpose? How will they benefit the capital markets and the economy? And, what safeguards will accompany their introduction?

Not any more. In the early 1990s, in order to hedge their loan risks, J. P. Morgan & Co. [now JPMorgan Chase & Co. (JPM)] bankers devised credit default swaps.

A credit default swap is, essentially, an insurance contract between a protection buyer and a protection seller covering a corporation’s, or sovereign’s (the “referenced entity”), specific bond or loan. A protection buyer pays an upfront amount and yearly premiums to the protection seller to cover any loss on the face amount of the referenced bond or loan.
Typically, the insurance is for five years.

Credit default swaps are bilateral contracts, meaning they are private contracts between two parties. CDSs are subject only to the collateral and margin agreed to by contract. They are traded over-the-counter, usually by telephone. They are subject to re-sale to another party willing to enter into another contract. Most frighteningly, credit default swaps are subject to “counterparty risk.”

If the party providing the insurance protection – once it has collected its upfront payment and premiums – doesn’t have the money to pay the insured buyer in the case of a default event affecting the referenced bond or loan (think hedge funds), or if the “insurer” goes bankrupt (Bear Stearns was almost there, and American International Group Inc. (AIG) was almost there) the buyer is not covered – period. The premium payments are gone, as is the insurance against default.

Credit default swaps are not standardized instruments. In fact, they technically aren’t true securities in the classic sense of the word in that they’re not transparent, aren’t traded on any exchange, aren’t subject to present securities laws, and aren’t regulated. They are, however, at risk – all $62 trillion (the best guess by the ISDA) of them.

Fundamentally, this kind of derivative serves a real purpose – as a hedging device. The actual holders, or creditors, of outstanding corporate or sovereign loans and bonds might seek insurance to guarantee that the debts they are owed are repaid. That’s the economic purpose of insurance.

What happened, however, is that risk speculators who wanted exposure to certain asset classes, various bonds and loans, or security pools such as residential and commercial mortgage-backed securities (yes, those same subprime mortgage-backed securities that you’ve been reading about), but didn’t actually own the underlying credits, now had a means by which to speculate on them.

If you think XYZ Corp. is in trouble, and won’t be able to pay back its bondholders, you can speculate by buying, and paying premiums for, credit default swaps on their bonds, which will pay you the full face amount of the bonds if they do actually default. If, on the other hand, you think that XYZ Corp. is doing just fine, and its bonds are as good as gold, you can offer insurance to a fellow speculator, who holds the opinion opposite yours. That means you’d essentially be speculating that the bonds would not default. You’re hoping that you’ll collect, and keep, all the premiums, and never have to pay off on the insurance. It’s pure speculation.

Credit default swaps are not unlike me being able to insure your house, not with you, but with someone else entirely not connected to your house, so that if your house is washed away in the next hurricane I get paid its value. I’m speculating on an event. I’m making a bet.

The bad news is that there are even worse bets out there. There are credit default swaps written on subprime mortgage securities. It’s bad enough that these subprime mortgage pools that banks, investment banks, insurance companies, hedge funds and others bought were over-rated and ended up falling precipitously in value as foreclosures mounted on the underlying mortgages in the pools.

What’s even worse, however, is that speculators sold and bought trillions of dollars of insurance that these pools would, or wouldn’t, default! The sellers of this insurance (AIG is one example) are getting killed as defaults continue to rise with no end in sight.

And this is only where the story begins.

The Ticking Time Bomb

What is happening in both the stock and credit markets is a direct result of what’s playing out in the CDS market. The Fed could not let Bear Stearns enter bankruptcy because – and only because – the trillions of dollars of credit default swaps on its books would be wiped out. All the banks and institutions that had insurance written by Bear would not be able to say that they were insured or hedged anymore and they would have to write-down billions and billions of dollars in losses that they’ve been carrying at higher values because they could say that they were insured for those losses.

The counterparty risk that all Bear’s trading partners were exposed to was so far and wide, and so deep, that if Bear was to enter bankruptcy it would take years to sort out the risk and losses. That was an untenable option.

The Fed had to bail out Bear Stearns.

The same thing has just happened to AIG. Make no mistake about it, there’s nothing wrong with AIG’s insurance subsidiaries – absolutely nothing. In fact, the Fed just made the best trade in its history by bailing AIG out and getting equity, warrants and charging the insurance giant seven points over the benchmark London Interbank Offered Rate (LIBOR) on that $85 billion loan!

What happened to AIG is simple: AIG got greedy. AIG, as of June 30, had written $441 billion worth of swaps on corporate bonds, and worse, mortgage-backed securities. As the value of these insured-referenced entities fell, AIG had massive write-downs and additionally had to post more collateral. And when its ratings were downgraded on Monday evening, the company had to post even more collateral, which it didn’t have.

In short, what happened in one small AIG corporate subsidiary blew apart the largest insurance company in the world.

But there’s more – a lot more. These instruments are causing many of the massive write-downs at banks, investment banks and insurance companies. Knowing what all this means for hedge funds, the credit markets and the stock market is the key to understanding where this might end and how.

The rest of the story will be illuminated in the next two installments. Next up: An examination of the AIG collapse, followed by a look at how bad things could get, and what we can do to fix the problem at hand. So stay tuned.

[Editor's Note: Contributing Editor R. Shah Gilani has toiled in the trading pits in Chicago, run trading desks in New York, operated as a broker/dealer and managed everything from hedge funds to currency accounts. In his new column, "Inside Wall Street," Gilani promises to take readers on a journey through the "shadowy back alleys" of the U.S. capital markets - and to conduct us past the "velvet rope" that guards Wall Street's most-valuable secrets - in an ongoing search for the investment ideas with the biggest profit potential. If the whipsaw markets we're experiencing lead to the so-called market “Super Crash” that many analysts fear, shrewd investors won't have to worry. The reason: They will be able to capitalize on the once-in-a-lifetime profit plays that we detail in a new report. For a copy of that report - which includes a free copy of CNBC analyst Peter D. Schiff's New York Times best-seller, "Crash Proof: How to Profit from the Coming Economic Collapse" - please click here.]

News and Related Story Links:

• Wikipedia:
  Credit Default Swaps (CDS).

• Money Morning News:
  JPMorgan Raises Bear Stearns Bid.

• Wikipedia:
  
  Over-the-Counter.

• Money Morning News Analysis:
  Fed Steps in and Bails Out AIG to the Tune of $85 Billion in Taxpayer Funds.

• Wikipedia:
  
  Mortgage-Backed Securities.

• Web Site:
  
  International Swaps and Derivatives Association.

• Money Morning Market Analysis:
  Credit Default Swaps: A $50 Trillion Problem.

• Money Morning Market Analysis:
  Foreign Bondholders – and not the U.S. Mortgage Market – Drove the Fannie/Freddie Bailout.

• Wikipedia:
  London Interbank Offered Rate (LIBOR).

After zooming about 7% from mid-July to mid-August, U.S. stocks have dropped about 5% – a whipsaw-pattern decline that was punctuated by the 2.99% sell-offs in both the Dow Jones Industrial Average and Standard & Poor’s 500 Index yesterday (Thursday).

But none of that’s a surprise for Money Morning readers: Since the U.S. stock market began its now-aborted rally in the middle part of July, we’ve consistently repeated three messages:

• The market rally isn’t sustainable.
• The global credit crisis isn’t over – and the worst is likely still to come.
• And don’t be discouraged: In spite of the economic gloom, and despite the challenge of these highly volatile markets, there are still plenty of profit plays available – they’re just not where investors were expecting to find them.

Subsequent events have proven us correct on the first two points: The market rally has sputtered and stalled, and rising LIBOR (London Interbank Offered Rate) rates tell us that there are additional banking troubles to come – a development we first reported in January, and analyzed again in April, making us among the very first to recognize this as a signal that the credit crisis was worsening.

Indeed, the evidence continues to mount that what started as a mortgage-market credit crisis may actually be the biggest financial crisis to grip the global financial markets since the Great Depression.

Given that market events are playing out as we expected and historical patterns remain intact, we’re confident that our third prediction also will come true – that investors will find solid profit plays to make.  But credit-crisis investing demands a special mindset, and a careful adherence to a very specific set of guidelines

Here’s a credit crisis update:

• Legendary PIMCO manager William H. “Bill” Gross is pleading for unprecedented intervention to avoid a catastrophic “financial tsunami.” This represents a change in his tenor and may be self-motivated – at least in part – by the billions of dollars in junk debt his funds are holding, but it’s a change nonetheless. And that makes it worth noting.
• The dollar LIBOR has reached a four-month high, according to the British Bankers Association and the interbank costs of borrowing both short-term euros and dollars continue to edge higher. This suggests banks still don’t trust each other and continue to foresee higher, rather than lower, risks ahead. Remember that higher interest rates reflect higher risks.
• Primary dealers hit the U.S. Treasury with $45 billion worth of bids for only $25 billion worth of Treasuries – or nearly twice as much as the U.S. Federal Reserve was prepared to sell. This suggests that banks are still cash-strapped and that they have nowhere else to turn.
• U.S. regulators, including the Federal Deposit Insurance Corp. (FDIC), are increasingly worried enough about their own finances that they are hatching plans to raid the Treasury’s coffers at a time when the list of trouble institutions is rising at the fastest rate since the U.S. Savings & Loan Crisis.
• Banks are now borrowing primary credit to the tune of a record $18.98 billion per day from the Fed – up from $18.47 billion per day only a week ago.

So, how do we translate this insight into actions that minimize losses and position us for profits? Here are four steps to take immediately – call them rules for credit-crisis investing – that will help you avoid the stock market’s undertow:

• Don’t be rash – especially right now: Some analysts are calling for additional declines, so the temptation might be to either bail out of the markets completely, or, if you’re already on the sidelines, to stay there. Not only does market history demonstrate beyond a shadow of a doubt that this is a mistake, but bailing out provides investors who do so with an even bigger quandary (and possible risk) – when to buy back in.
• With uncertainty comes opportunity – take advantage of the turmoil by rebalancing your portfolio: Many investors have enjoyed large run-ups in their energy holdings, or have disproportionately large positions in gold, natural resource/commodity shares, or even bonds, for instance. While it feels great to sit on large gains, the problem is that you’ll miss out on the huge gains that the market rebound will bring. The reason: It’s the shares that are now classified as “downtrodden” that will generate some of the biggest gains. So it makes sense to pare down your winners and rebalance into those laggards, since they may actually represent more-promising opportunities.
• Quality rules: However, just because stocks are cheap, doesn’t mean they’re not garbage.  A key to successful credit-crisis investing is to confine new money to conservative choices with superior fundamentals, positive earnings and expanding revenue. Most of these profit plays are based overseas, with the bulk of them concentrated, not surprisingly, in Asia. Many such companies are still experiencing double-digit – or even triple-digit – growth, despite the U.S. and European slowdowns. While those shares could drift even lower in the near term, history demonstrates time and again that, over the long haul, growing companies sport higher valuations and higher share prices, drawing investors to them like fresh apple pie attracts hungry children. That intrinsic value gives such stocks strength – even during a down market.
• Make sure your foundation is strong: We call them “Base Builder” investments, because they’re strong enough to weather a rough market storm – without sacrificing upside even in a down market. Two favorites – which we’ve talked about before here in Money Morning – are the Vanguard Wellington (VWELX) mutual fund, and the Rydex Inverse S&P 500 Strategy Fund (RYURX). The former is designed to generate upside profits while providing downside protection, while the latter is about hedging, since it’s a so-called “inverse” fund that gains in value as the broad market declines.

News and Related Story Notes:

• Money Morning Market News:
  Weak Labor Market and Slowing Retail Sales Put U.S. Stocks in a Tailspin.

• Money Morning Market Analysis:
  
  Why Today’s Bull Market is Tomorrow’s Bear Trap.

• Money Morning Economic Analysis:
  The Three Signs That the Credit Crisis Has Yet to Hit Bottom.

• Money Morning Investigative Series:
  
  Outlook 2008: Seven Ways to Profit From the U.S. Dollar’s Doldrums.

• Money Morning Market Analysis:
  LIBOR Sends Another Shaky Signal to the Global Financial Markets.

• Wikipedia:
  
  London Interbank Offered Rate.

• Wikipedia:
  The Great Depression.

• Money Morning Market Commentary:
  
  FDIC Quandary Could Stick U.S. Taxpayers With the Tab for the U.S. Credit Crisis.

• Wikipedia:
  
  Savings and Loan Crisis.

• British Bankers’ Association:
  Web Site.

"Have we seen the worst from the financial sector?"

The question – a very good one – came from an audience member following my global investing presentation at the Agora Wealth Symposium in Vancouver, British Columbia. During my entire time there, the interest in the ongoing credit crisis was intense.

I took a deep breath and launched into my three-point response.

First, I’m encouraged by what I see lately but still believe there is a fair distance to travel before all the skeletons are cleaned out of the financial sector’s closet.

There is a growing body of data that suggests banks have recognized only a fraction of the overall potential losses – approximately $50 billion to $75 billion so far on subprime debt alone. And a variety of estimates suggest that total subprime losses may be more than $300 billion before we’re through.

And that figure, incidentally, doesn’t include the additional losses from secondary-prime mortgage loans, auto loans, credit card balances, student loans and the other credit-related flotsam and jetsam floating around in the debt markets.

That suggests that the hundreds of billions of dollars in emergency capital infusions from the world’s central bankers we’ve seen to date may only be a fraction of what’s ultimately needed by the time fully leveraged figures are thrown into the mix.

Second, liquidity conditions now may actually be worse than when the entire credit-crisis mess began to unravel this time last year. For example, the benchmark London Interbank Offered Rate (LIBOR) remains higher than so-called "policy rates" and U.S. Treasuries of comparable maturities (Please see accompanying chart).

This suggests that banks still don’t trust each other and therefore are keeping so-called "Interbank" borrowing rates high in order to reflect what they perceive to be the added risk of doing business. We’ve been warning investors to watch out for this since as far back as April, and have generally been preaching caution since the credit crisis began last year.

In other words, the fact that Libor-Treasury spreads are wider today than they were a year ago suggests that the banks really don’t know who continues to hold the toxic debt instruments the entire world has come to fear – despite a recent earnings parade of CEOs making claims to the contrary.

The upshot: Many institutions are hoarding cash – something you’d hardly expect to see if the credit crisis were really on the mend.

Third, judging from recent reports, it’s beginning to dawn on financial regulators that this crisis was never about a lack of liquidity in the first place, which is something I suggested in an open letter to U.S. Federal Reserve Chairman Ben S. Bernanke some time ago.

Instead, this crisis is about three things:

• Too much liquidity.
• Fundamental structural problems in the credit industry, including the almost-total lack of regulation.
• And the lack of transparency of complex financial instruments for which there is no public market, making them tough to value and nearly impossible to trade.

It is becoming clearer by the day that – partly because of these three factors – a good deal of money has been made fraudulently, if not illegally.

Granted recent changes surrounding the "mark-to-market" accounting of so-called "Level 3" assets are a step in the right direction. But what few people realize is that, in the short-term, these new requirements could involve the immediate recognition of even larger losses than we’ve seen to date.

The reason is that many of the firms involved – think Merrill Lynch & Co. Inc. (MER), Lehman Brothers Holdings Inc. (LEH) and Citigroup Inc. (C), for example – will no longer be able to hide their losses in Level 3 assets, as they have in the past.

As you might expect, there’s a counterargument to this, and it’s a highly popular one on Wall Street – especially inside the CEO set, whose members desperately want to stop the financial hemorrhaging their firms are enduring. They claim they’re "selling" risky assets and "de-leveraging" their balance sheets.

But here’s what they are not telling you.

Even though these folks are technically "selling" assets – particularly the distressed "Level 3" assets I mentioned a bit earlier – what they are really doing is assigning the upside to hedge funds, private equity firms, and sovereign wealth funds in exchange for cash.

But here’s the kicker: The banks actually are holding onto the downside liability in the event the underlying securities go bad. That brings us back to the start of this commentary, when I said that I expect more securities to go bad.

No matter how you look at it, these financial institutions are playing a vicious shell game, hoping all the while that they’re not the loser who is taken to the cleaners when he picks up the wrong shell.

Where this goes from bad to worse is that at the same time they’re playing more fancy accounting tricks, these firms continue to pony up to the Fed’s private backdoor lending window for sweetheart financing. After all, they can’t get the financing anywhere else.

That means that every taxpayer in this country is involuntarily being put in the bailout business.

As for whether or not we’re near the end of the credit crisis as a whole, it depends on whom you ask.

When this crisis started a year ago, I was asked a similar question and answered it by saying that we would not even begin to approach the end of the line until the total losses exceeded $1 trillion.

My audience chuckled politely.

Fast-forward 12 months, and nobody’s laughing anymore – especially when I say that I’m now raising my industry loss estimate to nearly $2 trillion.

Increasingly, other analysts are embracing a similar viewpoint. UBS AG (UBS) raised it’s estimate of the total cost of the credit crisis to $600 billion, while noted hedge fund manager John Paulson suggested $1.3 trillion is not unthinkable. Meanwhile, in a report issued last May, the International Monetary Fund (IMF) projected the bailout costs at $1 trillion.

All of this leads us to a single conclusion: At least for now, this is a "recovery" in name only.

News and Related Story Links:

• Money Morning Market Analysis:
  LIBOR Sends Another Shaky Signal to the Global Financial Markets.

• Wikipedia:
  London Interbank Offered Rate.

• Money Morning Financial Analysis:
  How Will We Know the Credit Crisis and Banking Fiasco Are Truly Over?

• Money Morning Special Report:
  Dear Ben: To Save the U.S. Economy, Here Are the Moves You Need to Make Now.

• Money Morning Financial Commentary:
  Why Mark-to-Market is Bad News for Shareholders.

• Money Morning Analysis:
  Rising Tide of Level 3 Assets a "Disaster Waiting to Happen."

• Fairmark.com:
  Mark-to-Market Accounting.

• The Wall Street Journal:
  Trader Made Billions on Subprime: John Paulson Bet Big on Drop in Housing Values.

How will we know the credit crisis and banking fiasco are truly over?

We won’t.

But there’s a damn good indicator that will show us the way – the London Interbank Offer Rate, usually referred to as LIBOR.

And right now LIBOR tells us that this financial mess still has room to run.

As indicators go, recent developments have demonstrated that the LIBOR system is arguably corrupt. Until now, LIBOR always has been constructed by industry insiders – with little in the way of oversight or regulation. It drives billions of dollars of trades and transactions a day. And it’s publicly available at 11:30 a.m. (London time) each business day.

Now regulatory authorities are investigating the entire LIBOR process, and that makes it as close to insider information as we’re going to get.

LIBOR is calculated entirely using data provided by insiders from 16 banks and reflects the daily borrowing rate in U.S. dollars, European euros and Japanese yen that banks extend to their best customers – each other.

Theoretically, it’s a measure of what the banks must charge for money and that’s how the rest of the world uses the LIBOR rate.

But as we’ve hinted, there’s a far darker side and, as usual, we’ll tell you about it even though other insiders won’t.

Interest rates are not really a cost of borrowing – even though that’s how they are portrayed to the public. To insiders, interest rates are a measure of risk. So even though banks and financial institutions use the daily LIBOR rate to “price” billions of dollars worth of financial instruments, what these institutions are really doing when they post their LIBOR rates is to look at each other’s credit quality and assign a risk premium.

Thus, if LIBOR rates are rising, one way to interpret that fact is to conclude that the risk of doing business with other financial institutions is going up to. That creates an incentive for banks to “fib” when they submit information on the rates at which deposits were being offered.

That’s because – as my colleague Martin Hutchinson noted way back on April 18 – “any whisper of trouble over a bank makes other banks’ dealers not want to place money with them.”

This is true even when the financial markets are healthy and in good shape. But it’s even truer when – as now – the markets are rattled and facing severe inflationary pressures.

Story continues below…

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Here’s why: The higher the LIBOR rate goes, the greater the risk of perceived default and the poorer the credit quality associated with the 16 banking heavyweights that submit the rates used to calculate LIBOR. What’s more, those negative perceptions work their way through the balance of the world’s financial system as a giant cascade of interlinked financial instruments.

If this doesn’t make sense, think of it this way: What happens with LIBOR is not any different from what happens with rates assigned to home mortgages and credit cards – just on a far larger scale. If you’re a good credit risk, you get low rates. If you’re a bad credit risk, or are a high-risk borrower, you must pay higher interest rates because banks and other potential creditors view you as more likely to default on your obligations.

The bottom line is that LIBOR can actually be viewed as a kind of leading indicator.

In fact, I suggested as much back on May 8, when I correctly warned readers that the dollar rally under way at the time was nothing more than a “head fake of legendary proportions.” At that point, the consensus view was that the dollar was finally emerging from a decline that had taken it down to record lows against key world currencies.

But when I noted that LIBOR was rising in concert with the dollar’s embryonic rebound, it was clear to me that something was rotten in Denmark – or, in this case, London. Given that realization, I was able to conclude that the dollar’s strength was nothing more than a temporary aberration and that the greenback would resume its decline once the inevitable new round of problems emanated from the financial-services sector.

And that’s exactly what happened.

Since Money Morning published my “head fake” prediction, the “dollar rally” sputtered and died and the greenback resumed its downward spiral. And the catalyst for that dour turnabout was just what I’d predicted – a whole new round of financial write-downs and headlines about banks and investment banks facing major problems. Indeed, just this week there’s been bad news surrounding Lehman Brothers Holdings Inc. (LEH), which wrote down another $3.7 billion in mortgage-backed assets.

So what’s LIBOR telling us now?

That’s simple. First, it’s telling us that this mess is far from over. And second (and potentially even worse), it’s making it very clear that inflationary worries are escalating.

It’s also clear to me that the distrust between banks is growing. The three-month LIBOR rate recently jumped 10 basis points to reach 2.79%, representing the biggest LIBOR increase since August and the highest LIBOR level since April 30.

Which is why it would seem that there are more financial shenanigans to come. Indeed, I feel a bit like the announcer on the old Batman TV series, asking in my best, scene-setting baritone voice:

“Could it be that we’ll see another round of financial house cleaning in the next 90 days? Or are there additional credit-induced write-downs and earnings disappointments headed our way? To find out… tune in next week at the same Bat Time, and the same Bat Channel…”

LIBOR seems to be telling us that there’s enough drama for several more episodes.

[Editor's note: Since this article was prepared, word has escaped from London that the biggest banks in England may be preparing to swap nearly £90 billion pounds sterling worth of mortgage-backed assets for U.S Treasury Bills with the Bank England. And, judging from how globally linked banks are these days, where there's smoke, odds are good that there's fire, too. That means we could see everything from higher interest rates globally to increasing defaults and heightened personal consumer financial trauma. Although that will create fear in the market place, it's important to note that with fear, comes opportunity.]

News and Related Story Links:

• Money Morning Investigative Report:
  LIBOR Sends Another Shaky Signal to the Global Financial Markets.

• Money Morning Financial Commentary:
  A Currency Conundrum: Beware of the U.S. Dollar’s “Head Fake” Rally.

• Money Morning News:
  Lehman Brothers Raises Capital After $2.8 Billion Quarterly Loss.

• Wikipedia:
  Batman TV Series.

If you think the credit crunch is hitting the United States and United Kingdom hard, spare a thought for Iceland.

Banks all over the world have spent much of the past few years devouring cheap money, but Iceland’s taken the whole thing to quite an extreme. Its big players – Landsbanki Islands HF and Kaupthing Bank – have been on an extraordinary borrowing spree, sucking in vast quantities of cash to fund lending and acquisitions across Europe and the United Kingdom.

The result? This tiny country – home to a mere 300,000 people – has somehow created a financial system nine times the size of its gross domestic product (GDP).

And a nasty hangover.

Now, the cheap credit that fueled the binge has all but disappeared, and the banks – as well as the economy – are in trouble. The stock market has tanked, inflation has soared, and the Icelandic krona has fallen 26% against the euro this year. House prices, which had doubled since 2001, are now falling.

According to the Icelandic Central Bank, the economy will contract by 2.5% next year and 1.5% in 2010.

"We are still likely to see a fairly sharp slowdown in the Icelandic economy in the coming quarters and the most likely scenario is for negative GDP growth in Iceland in 2008 and 2009," says Lars Christensen, chief analyst at Danske Bank A/S.

Lucky then that the Alka Seltzer is on its way.

On Friday, the Nordic central banks extended an emergency loan facility worth
$2.36 billion (€1.5 billion) to their island neighbor designed to shore up the krona, give the Iceland Central Bank some credibility as the lender of the last resort to the banks (which have been under huge speculative pressure from many of the world’s big hedge funds), and jump start the economy.

"In times of uncertainty and turmoil, the central banks have a responsibility to cooperate to attain their overall objectives," said Swedish Riksbank Governor Stefan Ingves. "The swap agreement is aimed at supporting (Iceland) in its task of safeguarding macroeconomic and financial stability."

Much Dreaded EU Membership

Iceland’s financial rut has raised a pretty uncomfortable question for Icelanders: Can they really go it alone in the global market place or should they begin to think the unthinkable and join the European Union?

With fishing accounting for over 40% of exports, Iceland has long had reason to very firmly oppose membership in the EU.  Just ask any fisherman up and down the west coast of Ireland what he thinks of the EU, and the opening of Irish waters to big Spanish tankers. Magnify his fury by 10, and you’ll get a good idea of what Icelanders, a traditionally independent lot, think of the EU.

But with the economy destabilizing and the currency all over the place, support for the idea is growing. A poll published in April by the Icelandic daily Fréttabladid showed that 68% of Icelanders would be willing to open membership negotiations with the EU, up from 55% in February. EU membership would mean that the Icelandic central banks would lose the power to set interest rates. But that may well be a perfectly fair price to pay for a more stable currency.

"What we need in the long run is economic stability, which I doubt we can guarantee in the long run with our current currency," Foreign Minister Ingibjörg Sólrún Gísladóttir told the Wall Street Journal.

Gísladóttir also leads the Social Democratic Alliance party, the only major party that supports membership in the European Union.

The majority of durable goods, for example cars and washing machines, are imported into Iceland. So given that the currency has been taking a beating, Icelanders are now paying much more for the goods they import.

Inflation rose to an annualized rate of 11.8% in April, the highest level since September 1990. And over the past three months, consumer prices are up 6.4%. That’s equivalent to an annual inflation rate of 28%.

Using the Euro would mean offering up a decent chunk of sovereignty at the EU’s altar. But then, given that interest rates in Iceland are running at 15.5% and 4% in the Eurozone, membership might also offer suffering Icelanders what they really need right now.

How Long Can Iceland Hold Out?

If any struggling small-sized economy can hold out against the financial storm, it’s Iceland.

The country is extremely energy efficient. The piping hot water that comes out of the spigot comes directly from the country’s wealth of hot springs. 

Its population enjoys nearly free hydroelectric power by harnessing the flow of its natural and manmade waterfalls.

Geothermal power, created by steam under the earth’s surface, is so cheap that Reykjavik actually has some heated sidewalks in the wintertime.

And since the country is relatively small – both in size and population – the need for oil for cars isn’t nearly as big as other similarly sized European nations. 

The International Monetary Fund ranks the icy island the fourth most affluent country in the world, Vanity Fair reported in its May issue.

But with its banks losing money fast, that status is in jeopardy. Public sentiment is leaning toward falling into the arms of the EU, should the need arise.

Given how much is at stake, the issue will be treated cautiously.

"This is a long-term issue for the politicians to decide," Arnór Sighvatsson, the Central Bank of Iceland’s chief economist, told the Wall Street Journal.

News and Related Story Links:

• MoneyWeek:
  Why Iceland is suffering a nasty financial hangover

• Wall Street Journal:
  Iceland Debates Switching to Euro

• MoneyWeek:
  Why Iceland’s market is melting

• Vanity Fair:
  The Next President’s First Task [A Manifesto]

For those holding out hope that the American economy can miraculously avoid a long and deep recession, consumer credit is often viewed as the wonder drug that can cure all manner of economic ills. As such, last week’s report showing that consumer credit grew by $15 billion was widely heralded as proof of America’s economic strength and resilience.

The reality is very different, however: We’re already suffering from the after-effects of too much debt, meaning that our salvation cannot be found in more of the same.

Death by a Thousand Charge Slips

Credit card debt, which now stands at whopping $957 billion nationally (approximately $3,000 for every U.S. citizen) has, in recent years, taken on a different role in the life of American consumers.

In the past, credit cards were used primarily to purchase big-ticket items, enabling consumers to spread the costs out over many months, making goods a bit more affordable.

Now, however, charge cards are increasingly being used to bridge the gap between cost of living and the diminishing purchasing power of Americans who have been taxed mercilessly by inflation. By buying with available credit instead of unavailable cash, consumers are not simply postponing the pain of higher prices, but compounding it by packing interest expenses into the costs of everyday purchases. In addition, as home equity credit is now unavailable to fund large purchases, many consumers are turning to non-deductible, higher-cost credit card debt as their last remaining lifeline. As such, credit card debt compounds steadily, and for many borrowers, becomes increasingly impossible to pay down.

Story continues below…

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The statistics tell the tale. According to Equifax Inc. (EFX) a credit card analysis firm, people have been buying more with their credit cards but paying down less. As a result, average balances jumped nearly 9% in 2007 and delinquency rates recently hit a four-year high of 4.5%.

Also, the reliance on credit cards is preventing some of the market’s salutary forces from working. With credit always an option, domestic demand remains strong – despite rising prices.  Absent the option of putting more costly gasoline on their credit cards, Americans might have actually been forced to cut back on their fuel consumption, taking some of the upward pressure off gas prices. 

It should be painfully obvious that expanded consumer credit is actually evidence of deterioration – not improvement. Unfortunately, when it comes to understanding the economy, there is little common sense on display.  By going even deeper into debt just to make ends meet, American consumers are digging themselves, and our entire economy, into an ever-deeper economic hole and laying the foundation for the next major credit debacle. It’s fitting that just as both U.S. Treasury Secretary Henry M. Paulson and JP Morgan Chase & Co. (JPM) Chief Executive Officer Jamie Dimon declared that the worst of the crisis has past, we are on the verge of kicking this credit mess into a much-higher gear.

My guess is that many Americans continue to run up massive credit card debt because they have little intention of ever paying it off.  Since many who are underwater on their home loans, and behind on their auto and student loans, too, see bankruptcy as a foregone conclusion, they see no reason not to just go ahead and pile on as much debt as possible while the taps remain open.

Those choking on credit-card debt may also be taking cheer from the gathering government campaign to bail out over-leveraged homeowners. The sheer numbers of consumers who are afflicted with spiraling monthly payments will make credit card relief a potent political issue for crusading congressional and presidential candidates. After all, there are few fundamental differences between those who borrowed too much to buy houses and those who made the same mistake with consumer goods.

If the government bails out the former, then why not the latter, as well?   In fact, one reason some homeowners have such large mortgages is that they consolidated their credit card debts into their mortgages each time they refinanced.  Why should renters be forced to pay off their credit card debts while homeowners get to have their debts forgiven? 

It’s certainly a fair question.

But it may also be moot. Soon, as credit-card delinquencies rise – and losses on pools of securitized credit card debt mount – those supplying the credit will finally get wise to the fact they will never get their money back.  As a result, the market for such debt will dry up even more quickly than did the market for subprime mortgages. Credit cards will therefore be much harder to come by and will have much lower limits then they do today.  Limited to only the cash in their wallets, Americans finally will be forced to dramatically curtail their spending, and the recession will finally gather serious momentum.

[Editor's Note: For a more-detailed analysis of the nation's financial problems, and the inherent dangers they pose for both the U.S. economy and for dollar-denominated investments, click here to download Schiff's new financial-research report, "The Collapsing Dollar: The Powerful Case for Investing in Foreign Securities." The report is free of charge].

News and Related Story Links:

• Euro Pacific Capital Inc. Special Research Report:
  The Collapsing Dollar: The Powerful Case for Investing in Foreign Securities.

• The BBC:
  Paulson sees end of credit crunch.