12:17 pm Central Time

The Daily Reckoning used the word hyper-inflation yesterday.  They're not alone.
The headlines everywhere are touting...

• Inflation!
• Stagflation!
• High CPI!
• High PPI!

Ignore them. 

Headlines are misleading.  Dig beneath the surface.  The other day I was interviewed by the Pittsburgh Post-Gazette.  The reporter was astounded with my dialogue about DEFLATION.  When the article hit, I was the only one quoted in the article regarding deflating home prices, oil prices tumbling, wage growth barely creeping ahead, a recession and credit crunch that would ultimately deal a blow to high prices.  Don't get caught up in the hype.

Click here for a snapshot from a writer who reviewed the recent headlines regarding inflation.  This guy is on top of it!

Those bashing the Fed for not raising interest rates will be forced to 'about face' in 6 or 12 months.  They will eat crow.  The economy is changing rapidly and you shouldn't get caught looking in the rear view mirror.  I am told Cramer used this analogy yesterday:  "The recent CPI and PPI data is like watching a ten car pile up in your rear view mirror."

Don't get fooled.  Inflation is in the rear view mirror...or is it the side view mirror?

Good Luck.

3:59 pm Central Time

Harvard economist Kenneth Rogoff  made the headlines today with an interview of unusual clarity.  Before we look at what he said, keep in mind that Rogoff is not some kind of crackpot.  Prior to joining the Harvard faculty, he was Chief Economist for the International Monetary Fund and before that spent many years on the Federal Reserve Board staff.  People with this sort of background are not typically prone to overstatement.  If anything, they say little until they are certain of the facts.  So it was odd to read this today:

"The worst is yet to come in the U.S.," Rogoff, a Harvard University professor of economics, said in an interview in Singapore today. "The financial sector needs to shrink; I don't think simply having a couple of medium-sized banks and a couple of small banks going under is going to do the job."

"Like any shrinking industries, we are going to see the exit of some major players," Rogoff told Bloomberg, declining to name the banks he expects to fail. "We're really going to see a consolidation even among the major investment banks."

"The only way to put discipline into the system is to allow some companies to go bust," Rogoff said. "You can't just have an industry where they make giant profits or they get bailed out."

The worst is yet to come?  So far the biggest victims in the financial sector have been Bear Stearns and IndyMac Bancorp.  Rogoff expects a few more such failures.  He also thinks the government should take over Fannie Mae (FNM) and Freddie Mac (FRE) rather than try to preserve them as quasi-private corporations.

On one point, Rogoff was undeniably correct: the system will not work unless companies, including banks, are allowed to feel the pain of their mistakes.  "Heads we win, tails the taxpayers lose" is not free enterprise.  It is corporate statism.  If anything resembling free markets are to survive, the bailouts need to stop.  Now is not too soon.

4:55 pm Central Time

If any companies serve as poster children for the mortgage crisis it's Fannie Mae (FNM) and Freddie Mac (FRE).  These companies depend on the mortgage market -- that's why they started.  Ever since homeowners began defaulting on loans en masse, FNM and FRE bore the brunt of the fallout.  Because they facilitate buying and selling mortgages, they're in a precarious position in this environment.  

Today, this became more obvious.

Bloomberg reported, Fannie Mae fell -22% and Freddie Mac lost -25% after Barron's reported the Bush Administration expects a government bailout for the government-sponsored entities (GSEs).  This marks the lowest point for the GSE's in over 17 years.  Grand total losses exceed 83% for each stock since December 31, 2007.  Let's put this into real numbers for everyone:  that's like starting with a $100,000 account on January 1 and ending up with $17K at today's close.  Not a pretty picture for FNM/FRE stockholders.

What would cause such ire toward these government-backed mortgage giants? 

On July 31, Treasury Secretary Hank Paulson assured the markets he did not expect the GSE's to use the multi-billion dollar government backstop he just ushered through Congress.  Even today, he reiterated (through a spokesperson) he did not foresee FNM/FRE drawing on government financing.  Still, rumors persist.  His boss just leaked the exact opposite information, and the market believes the Bush-rumor over the Paulson-denial.        

Every month, Fannie and Freddie appear to be moving closer to $0.  Will they suffer the same fate as the Enron, Bear Stearns, or Linens 'n Things?  It looks more likely every day.  We should remember bankruptcy is part of the business.  In the words of Frank Borman, former-CEO of now-defunct Eastern Airlines: "Capitalism without bankruptcy is like Christianity without hell." 

If FNM and FRE go to zero, then they won't be the first banks, nor will it be the last to succumb.  Bondholders and preferred stockholders should be protected by the Bush Backstop, but woe to investors who bought common stock.  At that point, they would be happy to get $17,000 out of the deal.  Don't plan on it.