With regard to the mother of all bailouts, my first question was:

Any future lenders will [..] ask for higher interest rates. Will they have additional conditions on top of those?
[…]
Who will finance Paulson’s plan (or any other plan of this size) and under what conditions?

Today Bush called the prime lender to the U.S. and asked for the big loan. With polite language the Chinese revealed their ‘additional condition’.

It is a nice, small but productive island Beijing wants to reunite with the fatherland for quite a while. Until now U.S. interests prevented that. But now things may have changed.

Chinese, U.S. presidents talk over phone about ties, U.S. financial turmoil
BEIJING, Sept. 22 (Xinhua) — Chinese President Hu Jintao and his U.S. counterpart George W. Bush discussed bilateral relations and the financial upheavals in the United States in a phone conversation on Monday morning Beijing time.
[…]
Bush briefed Hu on the latest development of the U.S. financial market, saying his government was well aware of the scope of the problem, and had taken and would continue to take necessary measures to stabilize the domestic and world financial markets.

Hu hoped the measures would soon take effect and lead to a gradual recovery of the financial market, which he said not only serves the interests of the United States, but also those of China, and benefits the stability of the world financial market and the sound development of the world economy.

The Chinese president also praised the good momentum of the development of the Sino-U.S. ties in recent years in various areas.

He said China is ready to work with the U.S. side to intensify dialogue, exchanges and cooperation, and properly handle issues concerning mutual interests and of major concern, particularly the Taiwan question, in a bid to push forward the sustained and steady development of the Sino-U.S. constructive and cooperative ties.

Translated from diplo-speech: "Give us Taiwan and you’ll get the loan."

Taiwan will not be the only ‘additional condition’ in this deal but for China it is the premier one.

Taiwan’s GDP is some $700 billion, about the amount the U.S. needs for the current bailout. A good deal for Beijing even if the dollar falls and the big loans never gets repaid. A war over Taiwan would be more expensive.

Bush will now have to brief Congress leaders and will need to get some consensus within the U.S. foreign policy establishment on this issue. I doubt that China is dumb enough to hand the money over without having some bi-partisan guarantee.

Such a sell out of an area of interest to finance wars is not unprecedented. Bush can finally compare himself to Napoleon.

Will the U.S. agree to the Chinese condition and sell out Taiwan for the big loan it needs?

My bet is yes.

Yours?

Estimates on the productivity advantage of granite countertops and CDS’ were too optimistic.

The Paulson plan is useless as it only tries to address the degraded value of Asset Backed Securities.

These are neither the source nor the reason for the very real threat of a total financial crash.

Credit Default Swaps of a nominal value of $65+ trillion are in real danger to implode any minute in a chain reaction that will take down half of the worlds financial infrastructure and impair the real economy for a long, long time.

There is only one possible way to avert this event:

International legislative action that immediately declares all Credit Default Swaps null and void.

Here is why:

Cont. reading: Declare All Credit Default Swaps Null And Void

The Security Exchange Commission and its equivalents in several other countries have banned short selling of financial stocks. As a result, financials rallied on Thursday and Friday.

This was an utterly dumb move that will have some bad side effects. The financial stocks did not sink because of short selling, but because those companies are in bad shape and their future profits, if any, will be small.

While the SEC measure will prohibit small investors from profiting on the downturn, big investors have a very easy way around this.

They will simply go short on complete indexes like the Dow Top 30, FTSE 100 or S&P 500 and will then go long, i.e. buy, all single stocks in that index that are not the ones they want to target. The net effect is a short position on the targeted financials only.

It will take a day or two for large hedge funds to set this up effectively and reprogram their computers to automate the process. Then the financial stocks will sink again as is appropriate.

The SEC would have to prohibit all index option trading to prevent this, but that would freeze and ruin lots of investors like pension funds that have done nothing wrong.

To ban shorts on financials was a stupid step, an outright manipulation of the markets and a warning to all. The SEC, Fed and Treasury are quite capable to take more such steps and thereby turn the already bad situation into a even worse one.

Open Thread – Your news & views …

The Secretary of the Treasury is asking Congress for a blank check of $700,000,000,000.00 to buy up Residential and Commercial Mortgage Backed Securities of dubious value on whatever terms he wishes.

The biggest obscenity in the presented proposal is this:

Sec. 8. Review.

Decisions by the Secretary pursuant to the authority of this Act are non-reviewable and committed to agency discretion, and may not be reviewed by any court of law or any administrative agency.

I will have to more to say about the type of this bailout later on. For now only one point that is independent of the type of bailout.

Who will finance this?

Paulson also wants to lift the US national debt ceiling to $11,315,000,000,000.00. (When Bush took office, the U.S. federal debt was some $5.6 trillion and on a downtrend.) The U.S. GDP is roughly 13.5 trillion so the US government debt at that ceiling will be some 83% of US GDP. In international ranking that puts the U.S. debt to GDP ratio somewhere between Cote d’Ivoire and Sri Lanka. Still excludes from that calculation are several trillions of liabilities of Fannie & Freddie and AIG the U.S. government recently took over.

Japan is of course still worse off with a debt to GDP ratio of nearly 200%. But most of Japan’s debt is held at home as Japan is a nation of savers and has a positive currency account. It exports more than it imports. Over the last years the U.S. has imported a lot more than it exported and needs some $500 billion per year from foreigners to finance that habit. The U.S. national saving rate is somewhere near zero. It therefore needs foreigners to lend the money of any deficit.

Now Paulson wants $700 billion in emergency finance from where?

Who in this world can and will lend $700 billion for an emergency plan when the total lending to the U.S. in one year is only about $500 billion?

Did Paulson talk with China, Russia and the Saudis about this?

With this new debt
and debt to GDP ratio the U.S. does no longer deserve an AAA rating. That will have to be cut
down two or three notches.

Any future lenders will therefore ask for higher interest
rates. Will they have additional conditions on top of those?

To create some emergency plan is one effort. To find the money to proceed with it is a different point. I have yet to see the second issue discussed in any serious way. But some thoughts must go into that.

What do you think.

Who will finance Paulson’s plan (or any other plan of this size) and under what conditions?

Saakashvili’s splendid little war in early August was accompanied by a lot of propaganda. But it still it was obvious to most people that Saakashvili started the war with an artillery barrage against civilians and Russian peacekeepers. Only some 12-15 hours later Russian troops from outside South Ossetia arrived to help their besieged comrades. After two days the outcome was obvious. Georgian troops were beaten and the Russian Federation forces had won the fight.

NATO analysis, the OECD observers and ‘western’ intelligence agencies confirm this view of the events. The Georgians attacked in mass first, then the Russian Federation moved troops and beat them.

But on August 26 a new Georgian version crept up. The Georgian government started to assert that regular Russian troops rushed into South Ossetia before the Georgians attacked.

We have now undisputable judgement on who is correct here.

Cont. reading: Who Started the Georgian Five-Day-War?

So Bernanke and Paulson go to congress and say a big bailout is needed. After 90 minutes congress in principle agrees. Half a trillion is said to be the appropriate number. Markets rally as short sellers get squeezed by this news.

But there is yet nothing behind this plan. Who should be bailed out and by what means? Who should do the bailout? How is this supposed to be financed? Who has the money to finance this? Under what conditions?

The general idea now seems to be to buy up bad loans from financial institutions for a rebate and to later sell these off.

The plan involves using hundreds of billions of dollars in government funding to buy bad loans, leaving banks with more money and fewer problems, according to two sources familiar with what was said at the meeting.

But what is the correct price for buying this stuff?

Two very different plans are cited as comparison for the current one. The Resolution Trust Corp. of the 1980s and the Reconstruction Finance Corporation of 1932. The RTC took over insolvent thrifts with real assets and slowly sold these off. The RFC gave credit to existing banks and companies. Neither form seems to fit here.

Why would the government buy those papers from the banks at all? Would it not be much better to buy the underlying assets of these papers?

If the government buys houses in foreclosure this would prop up the housing markets AND the mortgage backed papers the banks are holding. The government would then own  real value and could use it as the society finds necessary. This would help the banks as well as the communities.

The current plan looks like an attempt to do something – anything – simply so the administration and congress can say that they did something. Congress is not good in making such decisions under time pressure – remember the Patriot Act.

This emergency bailout will not have the results that people expect. Half a trillion fresh government debt will have many negative side effects. The bailout will not really help with the markets either. They will fall again as there are still many more bad loans that have not yet been acknowledged.

Sit back everyone and think again.

Russia’s invasion of Georgia has achieved – and will achieve – no enduring strategic objective. And our strategic goal now is to make clear to Russia’s leaders that their choices could put Russia on a one-way path to self-imposed isolation and international irrelevance.
Secretary Rice Addresses U.S.-Russia Relations At The German Marshall Fund, Sept 18, 2008

International irrelevance? Hmm … you really think so? Here is the response:

Russia threatened to block NATO from using its air space for operations in Afghanistan if member states did not stop "hostile" policies toward Moscow, the Kremlin’s top diplomat in Kabul said.

"(Russian air space) is still open, but if the NATO countries continue to their hostile policies with regard to Russia, definitely this issue will happen," Zamir Kabulov told BBC radio in an interview aired on Thursday.
Russia envoy warns NATO on air space to Afghanistan, Sept. 18, 2008

CHRIS Cox for VP?

Former conservative colleagues in the House of Representatives are  Christopher Cox, chairman of the Securities and Exchange Commission since 2005, boosting to be Sen. John McCain’s vice presidential running mate.

ROBERT D. NOVAK – Syndicated Columnist, March 18, 2008

Republican presidential candidate John McCain, in remarks prepared for delivery Thursday, said he thought Christopher Cox, chairman of the Securities and Exchange Commission, should be dismissed.
…
In a speech in Cedar Rapids, Iowa, Sen. McCain said the SEC allowed abusive short-selling, or bearish bets on a company’s stock, to turn "our markets into a casino."
McCain Says Cox Should Be Fired As SEC Chief Amid ‘Casino’ Markets

McCain is right that Cox should be fired. (Still unlike McCain assumes, Cox can not be simply fired on a Presidents say so.) But Cox should certainly not be fired for allowing short selling.

If you allow people to act on expected increases of a products price, like filling up the car before a Gulf hurricane hits because gas will likely be more expensive the next day, why not allow people to act on an expected decrease of a product’s price? Why should there be an asymmetry between up- and downside risk?

This is the real reason why Cox should be fired:

The events of the past year are not a mere accident, but are the results of a conscious and willful SEC decision to allow these firms to legally violate existing net capital rules that, in the past 30 years, had limited broker dealers debt-to-net capital ratio to 12-to-1.

Instead, the 2004 exemption — given only to 5 firms — allowed them to lever up 30 and even 40 to 1.

Who were the five that received this special exemption? You won’t be surprised to learn that they were Goldman, Merrill, Lehman, Bear Stearns, and Morgan Stanley.

Blaming short sellers is in vogue these days. But financial markets did not go down because of short sellers. They did and do go down because rampant fraud allowed after zealous deregulation. Something McCain and Cox both have favored and are still favoring.

Thinking about a solution to the housing mess I had been playing with this idea for a while:

Here is one government program to fix the housing crisis:  buy and destroy homes.

While I did some math on this, I never wrote about it. Now Fabius Maximus makes the argument.

The core of the housing crisis is overbuilding, which has created an excess supply of housing units (broadly defined).
…
Many vacant homes will be destroyed, the fast track to fixing this
problem.  Empty houses get vandalized, destroyed by the owners (spite
or insurance fraud), occupied by squatters or meth labs, or wrecked by
the forces of nature.  In regions with net out-migration (e.g.,
Detroit) homes remain vacant for long periods, often abandoned by their
owners (valueless but costly due to taxes and maintenance).  As anyone
familiar with the history of the South Bronx knows, empty homes acts as
an infectious blight that can devastate larger areas.  After a decade
or two, the result can look like Dresden after the bombing in 1945.

There are excess houses on the market. These houses will decay without occupation and lead to slums. This will be expensive for their owners as well as for the communities, i.e the taxpayers.

Further these excess houses depress prices and they are the reason why the decline of house prices will go much further than necessary. Without supply destruction the prices for houses will be lower after the decline than before they bubbled up because of this excess supply.

So how much would the taxpayer have to invest to get rid of them?

According to the U.S. Census Bureau there are some 130 million houses in the U.S. but only 111 million are occupied. 14.6% are not occupied.

Here are the vacancy rates for rentals and for ‘owner occupied’ units:

bigger

The graph shows how the Rental Vacancy Rate (pink, left scale) jumped from some stable 8% in the 1980s and 90s to 10%.  The vacancy rate of ‘owner occupied’ units (blue, right scale) jumped from a long term 1.7% to 2.7%. There are simply too many houses.

To bring the vacancy numbers back to normal levels the excess supply, according to my calculations some 1.1 million of rental units and some 815,000^* of ‘owner occupied’ units are excess, will have to be destroyed. (People who can not afford to own, will move back to rental units. So in reality one would destroy 1.9 million ‘owner occupied’ units and the rental excess would be diminished by people moving.)

The U.S. could easily buy the total of 1.9 million units and depose them. It could buy whole suburbs and tear them down. At a $100,000 average price per unit the current owner or mortgage holder would likely make a big loss so there would be no moral hazard.

The total price for the taxpayer would be $190 billion – i.e. small change in light of recent Treasury and Fed operations. Throw in a few billions for the current jobless craftsman who can tear those down and turn the energy wasting suburbs back into fields.

To do this will likely be cheaper than to take care of the consequences of decaying houses and a deeper fall of house prices and rents as necessary.

^* numbers corrected – see the first comment

Islamabad – Chairman of the Joint Chiefs of Staff, Admiral Mike Mullen, visited Pakistan, September 16-17.  During his visit, Admiral Mullen met with Pakistan’s Chief of Army Staff, General Ashfaq Parvez Kayani, and Prime Minister Yousuf Raza Gilani.
…
For his part, Admiral Mullen appreciated the positive role that Pakistan is playing in the War on Terror and pledged continued U.S. support to Pakistan.  In this context, Admiral Mullen reiterated the U.S. commitment to respect Pakistan’s sovereignty and to develop further U.S.-Pakistani cooperation and coordination on these critical issues that challenge the security and well-being of the people of both countries.
U.S. Embassy Press Statement, Sept. 17, 2008

At least five people have been killed in a suspected missile attack by a US drone on a village in north-west Pakistan, local officials say.

The officials said missiles hit the village of Baghar in South Waziristan, close to the Afghan border.
…
At least six people were injured in the attack, according to BBC correspondent Dilawar Khan in the neighbouring North West Frontier Province.
‘US drone’ kills five in Pakistan, BBC. Sept. 17, 2008

One might assume that Mullen was out of the loop. The Joint Chiefs have been circumvented by the White House on Iraq too. Maybe Cheney even wanted to make the point that Mullen is irrelevant.

Still, it is easy to imagine how this looks for the rest of the world. One can not trust any official U.S. voice anymore. If the top U.S. officer Mullen talks of respect for Pakistani sovereignty while his troops at the same time invade Pakistan, how should can one believe ANY official statement the U.S. makes?

This during the biggest confidence crisis in U.S. dominated financial markets. And no – the issues are not unrelated. The central bankers in China, Pakistan’s ally, will notice this.

Press reactions from Pakistan:

Cont. reading: Confidence in U.S. Statements

The Fed seems to run out of cash as the Treasury is selling $40 billion in fresh bonds to provide more money to the Fed. Who will buy those bonds at what rate?

The TED spread difference between Treasury rates and interbank rates is at a record high. The higher the spread, the greater the perceived credit risks in interbank lending. No one wants to lend anymore.

A money market fund yesterday ‘broke the buck’ and halted redemptions. Safe money market funds ain’t safe no more.

Tip: Don’t lend (deposit) anything to (at) any bank above what is insured ($100,000 in the U.S.).

The U.S. Securities and Exchange Commission  forbids naked short selling of financial stocks. Russia closed the stock exchange. Free markets abound …

The Fed is trying to find a buyer for Washington Mutual – the biggest Saving and Loans in the U.S.  It might have as much luck with that as with finding a buyer for AIG.

After Morgan Stanley yesterday announced ‘better than expected’ earnings, the stock fell 23% 37% 43%. Seems like no one trusts these earnings numbers these days. Why might that be?

Goldman Sachs is down 23%, Gold without the man and sachs is up $50 $80 an ounce.

Everything is, of course,  contained.

More in the comments …

The coalition supporting the government of Ukraine has dissolved and a new one will be have to be formed within 30 days or there will be new elections.

The current President Viktor Yushchenko and the Prime Minister Prime Minister Yulia Tymoshenko were both part of the ‘orange revolution’ against the allegedly manipulated election of Viktor Yanukovych for President. Yushchenko and Tymoshenko recently split over a bid to reduce presidential powers.

While Yushchenko is pro-NATO, anti-Russian and recently supported Saakashili’s splendid little war, Yulia Tymoshenko has largely moved to a neutral stand towards NATO and Russia and did not take any position on Georgia’s war. Yanukovych is pro-Russian.

In the 450 seat parliament President Yushchenko’s ‘Our Ukraine’ party has 74 seats. Prime Minister Yulia Tymoshenko’s party has 156 seats. Together that had a majority. The opposition Yanukovych’s Party of Regions has 175 seats. It should be easy to make up a new coalition with Tymoshenko and Yanukovych coming together without new elections.

But Tymoshenko as well as Yanukovych may have interest in new elections. According to a poll they both might come out with about the same percentage as in the last election while President Yushchenko’s pro-western party would fall down to 4%.

One also should also never underestimate Yushchenko’s authoritarian streak and the support he has from the U.S. anti-Russian/neocon front. A strike by the president against the parliament like Boris Yeltsin’s coup in 1993, is a distinct possibility.

But if things go along the democratic way, the Ukraine will end up with a much less ‘western’ government that is unlikely to strive for a NATO and/or EU membership. This is one consequence of the five day war in Georgia. More will follow.

by Juan Moment
lifted from a comment

From fool’s highly informative link in the Wild Ride thread :

In addition, The Fed has announced that it will take equities as collateral for loans.  "Equities" is a fancy name for stocks.

That’s right – for the first time in history, now banks can take stocks to the discount window.  Maybe even their own stocks.

The Fed has gone from taking only the highest-quality securities –
"AAA" rated debt instruments – to taking everything up to and including
the most dangerous (common stock) all at once!

Now I may be blind but I’ve read The Federal Reserve Act multiple
times and nowhere do I see where equities can be taken to the window
(or anywhere else for that matter) for Fed Credit.

If they intend to actually do this, its quite clear they don’t care
what the law says. They’re going to do it anyway, and their precedent
is that you sat back and allowed them to take equity when they bailed
out Bear Stearns, and said nothing! They will do anything they want by
citing "exigent circumstances" and claim blanket authority.

What’s worse, this effectively makes The Fed a margin lender on
the equity markets! You think they don’t have a reason to interfere in
the market eh? Oh boy, now they have billions of reasons, all of them
sitting on their balance sheet! Fair and open markets? Bah!

Note carefully folks – this effectively makes The Fed LONG (that is, a "buyer") of STOCKS.

What’s even better is that they don’t eat their own losses if there are any – they’re yours!

That’s because The Federal Reserve Act says that the profits (or
losses) from The Fed flow through to the Treasury (after operating
expenses) which means that now, suddenly The Federal Government is
potentially directly exposed to losses in the stock market!

Now it has always been true that The Government "loses" when the
market goes to hell as it gets less in the way of tax receipts. But
that’s different than suffering an actual capital loss – and that is
now possible.

The implications of this tectonic shift
within the banking framework are as yet to be seen, but this lowering
of securities standards by the Feds is essentially the transfer of risk
for shonky investments in equities from the commercial money houses to
the US taxpayer, and with the risk the obligations to cover the losses.
In times when the S&P could easily fall another 20% by years end,
this will have grave consequences, possibly triggering a ruinous domino
effect throughout the US and entangled nations.

Cont. reading: The Real Tragedy

So Hank Greenberg says on CNBC that AIG is a "national treasure" and wants the Fed to loan it $70-80-90 billion. Last time I looked no nation’s treasury owned AIG, but Hank Greenberg, who was kicked out of that company three years ago over dubious accounting practices, owns 11 percent of all AIG shares.

But anyway – should the Fed or Treasury loan money to AIG?

No. There is no way AIG can survive and while such a loan would cover part of its losses it would never be repaid.

Should the Fed lower interest rates?

No. Fed interest rates at this point do not matter at all.

The overnight interest rate for interbank loans was 6% yesterday, 4% over the Fed rate while it is normally only a quarter or a half percent over the Fed rate. What is missing now is trust in the solvency of any partner in the financial markets. The need to borrow $90 billion is not simply a ‘liquidity problem’. Nobody wants to lend if their is quite a chance that the money will not come back and that there are now no longer ways to hedge such deals.

This insecure situation will continue. The Dow and S&P may rally a bit from here, AIG failure or not, and will tank again after a few days or weeks. The loan crisis – mortgages, HELOCs, car loans, credit card loans etc – which is the point of origin of the general economic crisis has not even reached its peak. That will come at the end of this year or next spring.

Only then will the system really falter and only then the rubber will really hit the road, i.e. Main Street. The really bad news will come from the big industrial companies in the 2nd quarter reports in  2009. Soon after that the Dow will see the low of the cycle and it will stay there for years to come.

Between now and then we will see lots of smaller banks fail and we will see some big ones going under. Hedge funds and private equity groups will silently close down as they will not be able to get more capital or credit. Leveraged Buy Out deals will be history. The FDIC will go bust and the taxpayer will have to carry that additional burdens. Private pension plans will be in very deep doodoo.

Next year there will be lot of talk about deflation and the Fed will use that talk as justification to inflate massively.

Does anybody remember any serious Fed talk and measures against inflation in the last 15 years? I do not. So while this whole bubble, first tech, than credit, build itself via a lax monetary policy, there never was official inflation that would have required some restrictive Fed measure. But as the bubble now finally breaks there will be serious talk about deflation and it will be used to seriously inflate and to devalue the dollar.

It is a totally dishonest scheme, but it will be the only way the U.S. will be able to repair its economy and balance sheet.

Inflation and currency devaluation is a very regressive kind of unofficial tax. It hits the poor and the middle class much stronger than the richer folks.

One can adjust fiscal policies to somewhat alleviate that effect. Increase the tax rate for income over $1 million to some 80%, over $500,000 to some 60% etc and lower regressive taxes like the sales tax.

With such a progressive tax policy the burden of inflation, which is needed to repair the national U.S. balance sheet, can be put equally on everyone.

Ratings agencies had threatened to downgrade the insurance giant’s credit rating by Monday morning, allowing counterparties to withdraw capital from their contracts with the company. One person close to the firm said that if such an event occurred, A.I.G. might survive for only 48 hours to 72 hours.
A.I.G. Allowed to Borrow Money From Subsidiaries, NYT Sept. 14

All three major agencies — Standard & Poor’s, Moody’s Investors Services and Fitch Ratings — dropped AIG’s ratings at least two notches late Monday.
AIG downgraded as it struggles to shore up books, AP, Sept. 16

Tick – tock -tick – tock – …

There is again conflict heating up between India and Pakistan. There are two well known political issues between these countries. Yesterday a major economic issue was added by India that may well lead to unrest or even war. I suspect that the U.S. has a hand in this.

One political conflict is over Kashmir, the north western state of India that has a Muslim majority and borders Pakistan. Kashmir does want independence from India, but does not want to become a part of Pakistan.

While Pakistan generally supports anti-Indian activities in Kashmir it does not want Kashmir to become independent but would like to incorporate it. Unrest is Kashmir is often a proxy war that Pakistan traditionally stokes whenever it has interior political trouble.

This time though trouble in Kashmir seems to be indigenous. The state government gave a patch of land near a Hindu temple in Kashmir to some Hindi charity. The 6 million Muslims in Kashmir protested over this in large rallies. Hindu protesters then blocked the only road connecting Kashmir with India for several weeks. This led to big losses for Kashmir fruit farmers who now plan to reopen the silk road to Pakistan.

Saturday five bombs exploded in New Delhi and killed 21 people. A group called Indian Mujahideen took responsibility and referred to the conflict in Kashmir. Some accuse Pakistan of supporting the Indian Mujahideen which I find unlikely.

While the recent conflict might not have been activated by Pakistan, India has other grievances too. Last month the Indian embassy in Kabul was bombed and India as well as the U.S. accused Pakistan’s military secret service ISI to be behind this. Pakistan feels threatened by any Indian activity in Afghanistan. (Why do the U.S. and NATO allow Indian activities in Afghanistan at all? These practically guarantee a never ending trouble with Pakistan supported Taliban.)

In a rather harsh step India yesterday added a big economic issue to the already problematic situation:

India has closed Chenab water flow and as a result the shortage in Pakistan has become more severe.

Sources told Dawn on Sunday that the water blockade by India could adversely affect the Kharif crops, particularly cotton and sugarcane which were in maturity stage and required final watering, and the sowing of Rabi crops early next month.

…
The water shortage could force Pakistan to import more wheat next year, adding to the foreign exchange pressure and worsening its balance of payments crisis.

The authorities are already estimating more than 35 per cent shortage of irrigation water during the next Rabi season following a decline in the melting of snow in Northern Areas, higher withdrawals by provinces during Kharif and increased hydropower generation.

The sources said India’s unilateral decision to stop the Chenab flows had put additional pressure on the irrigation system of Pakistan, which used to receive more than 23,000 cusecs a day until last week, but it had now been brought down to almost zero.

(Chenab is a river (map) of the Indus system that flows from Kashmir to Pakistan. Kharif is the autumn harvest and Rabi the spring harvest period. A cusec is a cubic foot of water flow per second.)

The flow of water from the rivers of the Indus system is essential for Pakistan’s electricity generation and for irrigation. Karachi already sees daily long electricity outages and the government recently raised electricity prices by 31%.

India stopping the flow of the Chenab is a violation of the Indus Water Treaty between India and Pakistan.

It is possible that the U.S. has a hand in this and asked India to close the flow. Bush has quite some leverage with New Delhi through the recent nuclear deal. On Friday Syed Saleem Shahzad wrote about the conflict between the U.S. and Pakistan over alleged Taliban support and reminded us:

In this delicate situation, the balance could be tipped by India, on US instigation, mobilizing forces on the Line of Control that separates the Indian- and Pakistan-administered sections of Kashmir, as happened in December 2001. And as happened then, Pakistan will be left with no option but to surrender to America’s will in both letter and spirit.

Instead of war at the Line of Control between Kashmir and Pakistan, the threat to Pakistan this time is famine and/or financial ruin. It might fold under this threat or it might get violent over this breach of the international treaty on the river flow.

The new Pakistani president Zardari is visiting London this week and then New York. He will be offered some water. He will also be asked to give the U.S. a free hand to hunt Taliban in Pakistan’s tribal eastern areas and to stop firing at U.S. helicopters over Pakistan.

It will be difficult for Zardari to reject the drink.

Wow. I did not expect the pulling of the plug for today, but it happened:

Bloomberg headlines:

• Bank of America Said to Reach $44 Billion Deal to Buy Merrill
• Lehman Said to Prepare Bankruptcy as Buyers Withdraw (Update1)
• Wall Street Firms Set Up $70 Billion Fund to Provide Liquidity
• AIG Seeks $40 Billion Fed Bridge Loan, Times Says
• Asian Stocks, U.S. Futures, Dollar Tumble on Lehman Bankruptcy

Two broker dealers and one insurance company practically gone. It is going to be a dark Monday for a lot of 401k holders.

When will the other broker-dealers, Morgan Stanley, Goldman Sachs, JP Morgan and Citigroup go down the drain? How can BofA survive swallowing Merrill? Remember, they already picked up a bankrupt Countrywide. Did they have so many counterparty risk with Merrill that they had to buy it?

I expect the Fed to lower interest rates this week (Tuesday?) to 1.75 or even 1.5%. The dollar will then go down again, commodities will go up.

This blog lives off comments.

Please feed it with news & views.

Open thread …

The Fed and the Treasury urge major banks to rescue Lehman Brothers.

The majors, Goldman Sachs, JPMorgan, Morgan Stanley, Citigroup, Merrill Lynch and Royal Bank of Scotland all are in trouble themselves. They do not have the capital to take on more risk and would have problems to raise additional capital under favorable conditions.

If they are willing to take on Lehman at all, they will demand that the Fed or the Treasury take over billions of the risk as the Fed did in March when Bear Sterns was sold of to JP Morgan.

But the Fed has lost $30 billion on that deal and already committed half of its balance sheet to support the financial markets. The Treasury needs to put up some $200+ billion for Freddie and Fannie and much more when more of F&F’s ‘assets’ turn out to be worthless.

To get someone, anyone to buy in to Lehman is a game of chicken and the deadline is Sunday noon when the markets in Asia open. All potential buyers want the taxpayer to take the risk and the Fed and the Treasury fear the consequences of guaranteeing such.

I expect that comrades Paulson and Bernanke of the United Socialist State Republic of America (USSRA) will lose the chicken game and will again commit double digit billions of U.S. taxpayer money to bail out the capitalists and to socialize their losses.

They will find a way to obfuscate the guarantees they will give. That may well work as the media are busy to discuss campaign trivia.

Next weekend the story will repeat with Washington Mutual, two weeks from now American International Group will need rescue. That is going to be a real biggy. It is a major insurance company with a $1 trillion dollar balance sheet and endangered counterparties. Merrill Lynch may hold out a few weeks longer, but I expect it to eventually fail too.

Meanwhile many more smaller banks will go bankrupt and the Federal Deposit Insurance Corp (FDIC) will have to commit its assets to pay out the insured accounts. FDIC is likely to run out of money before the year is over and the government will be obligated to cover all further FDIC insurance losses.

I am curious where this ends. The financial system now deleverages and deflates in unprecedented ways and size. The Fed and the Treasury can only slow down the process, but there is no way to stop it.

What might the end state of this process look like?