Fractional Naked Shorting

Every dollar-denominated loan can be viewed functionally as a partial naked short position in FRNs (Federal Reserve Notes, 1.e. cash). The extent of the naked short is the inverse of the reserve ratio, so at 10% reserve, the position is written as 90% naked short. The entry is created where the bank shorts notional dollars into existence where none existed before. The Fed is a mechanism for supporting those naked shorts against margin calls that would otherwise happen in the real world - that's what a bank run really is, a margin call by lenders (depositors).

The continued existence of this naked shorting depends utterly on the willingness of the lenders to accept repayment in virtual instead of real dollars. Wire transfers, checks and book entries are all dollar substitutes, not actual dollars. An entire massive infrastructure has been erected to push people towards the conclusion that these are actually identical to FRNs. Banks will freely exchange your book entry with them for cash - until they can't anymore. The FDIC exists to guarantee that you will get cash for that book entry or other cash substitute. The Fed holds stocks of FRNs which it can exchange on a limited basis to commercial banks in danger of running out.

The scale of the pyramid scheme can be measured by the ratio of actual cash to virtual cash. Total cash in circulation (real cash) is $923 billion per the H.4.1 release dated December 10. The amount of virtual cash is the total credit outstanding, which is $52.6 TRILLION as of September 30 per the Z.1 release also dated December 10. In other words, each one dollar of cash is supporting nearly 57 dollars of credit. Through the mechanism of this gigantic naked short position, the value of the underlying security - the US dollar has been driven down to a huge extent. In fact, the short ratio can also be expressed as 98%. Not coincidentally, that is also the extent to which the US dollar's purchasing power has been reduced since the advent of the Federal Reserve.

This gives you some idea of the extent to which the value of the supply of dollars has been diluted by all of the substitutes that have been introduced into the system. If the dollar were a drug, it would be so heavily cut as to have no discernible effect. It also explains the desperation with which the financial world is attempting to save "the system" - by which they mean the machine that issues dollar substitutes and convinces you to accept them. There are sufficient dollars to cover less than 2% of domestic debt outstanding. That takes no account of the naked short positions of foreign banks. The bankers are short 57 dollars for each dollar that actually exists. You can well imagine what would happen if such a short position were to be squeezed to any significant extent.

One can justify banking to the extent than it increases productive capacity and therefore ultimately wealth. The increase in the pool of dollar substitutes will have minimal inflationary impact as that growth will be counter-balanced by an increase in the pool of goods those dollars can buy. This is a social good and one of the few philosophical reasons to support banking. Of course we are long past the point at which such banking was the norm, or even a large minority of credit activity.

Over Extended

We note with some amusement all of the talk about cash "on the sidelines" as if it's ready to pour into the stock market at the drop of a hat and take us to new highs. Nobody wants to admit that this is the cash that doesn't really exist. That fact was recognized by the market last year and earlier this year but has been obscured by a massive campaign of deception, propaganda and guarantees from Washington and Wall Street. Because the current mutant economic system depends on citizens digging themselves ever deeper into debt slavery, anything which causes them to save instead of borrow and spend is seen as the enemy and this includes the truth.

Much of the "cash" is in banks and money market mutual funds, both of which invest in debt that has become extremely dubious. The truth is that none of the "assets" (loans) that are backing the "cash" have gotten better and most have gotten significantly worse over the last 3-4 months. Credit card default rates now stand at a record high (again) for the fourth straight month. Auto loans are nearly as bad. 12% of all mortgages are now either in foreclosure, default or delinquent - but in any case they are not being paid. Commercial mortgages are quite bad now on the way to much worse and the State of California is so broke it is issuing IOUs instead of checks.

So what is going on here? The government-banker campaign has succeeded in getting one important group of people to dig themselves deeper into debt - speculators. If you look at the NYSE margin data, you will see that the ratio of margin debt to credit balances in margin accounts is at the highest it has been in a long time - 1.61. One can think of this as the ratio of margin actually used to unencumbered cash balances in those same accounts and so it measures the willingness of brokerage account holders to take on leverage as a percentage of their portfolios. The last time the ratio was this high was July 2007, just before the crisis began with the first round of emergency Fed intervention. Slightly lower levels were seen at the absolute top in October 2007 and again in September 2008, just before the largest leg of the stock market crash.

The latest data is from May and we await the June report with anticipation. The recent data show the speed with which a wildly speculative spirit has returned to stocks despite the small gains relative to the preceding decline. The fact that so many speculators have already leveraged up so heavily means that much of the fuel has already been burned off, leaving the market in a very vulnerable and over-extended position. These speculators have set themselves up for more crushing losses - note how much smaller both the margin and credit balances are than at any time in the recent past. Any significant decline at this point holds the potential to become self-sustaining as heavily leveraged positions become unsustainable in the face of the decline and subsequent margin call. In fact a cascade of margin calls could easily result.

Stocks are being bought but not by the cash on the sidelines. It appears that existing speculators margining themselves deeper into debt are the key driver of the bear market rally. The fact that they have used nearly all of their firepower and exposed themselves to potential forced selling is hardly bullish.