The Morning Gold Report: The Dominoes Continue to Fall

The demise of the 158-year-old Lehman, the fourth largest investment bank in the world, suggests that the credit crisis is far from being over. It also clarifies the much-asked question: At what point is a financial institution too big to be allowed to fail? The answer, at least with respect to investment banks, is you apparently have to be at least the third largest.

Following last week's bailout of Fannie and Freddie, the government was apparently concerned that another rescue might have an extremely negative impact on the dollar and US treasuries. This implies that the vast majority of financial institutions are vulnerable to being allowed to fail.

When the Fed and Treasury failed to provide incentives to bidders for Lehman, they pulled out of the deal. BofA shifted their focus elsewhere and ended up acquiring troubled Merrill Lynch for $50 billion.

Meanwhile, JPMorgan is apparently engaged in negotiations to buy Washington Mutual. I imagine that JPMorgan is seeking some sort of help from the government, much like the sweetheart deal they received when they took over Bear Stearns. At this point, I think we can assume the Feds aren't playing. If Lehman was allowed to fail, I don't think you can expect any preferential treatment for WaMu.

AIG is involved in rescue talks with Warren Buffet and has also sought an emergency $40 bln bridge loan from the Fed. The company has reportedly been allowed to access assets in its subsidiary companies to collateralize loans. They are also looking at selling off assets to bolster their balance sheet. Shares in AIG have been hammered today, down more than 50%.

The realization that the government can no longer be relied upon to provide direct aid to ailing financial institutions has seriously eroded risk appetite. Not surprisingly stocks are being led lower by the financial sector. Once again, money coming out of the stock market is expected to buoy the gold market.

That doesn't mean the Fed isn't going to continue to pump liquidity into the market. In fact, the total amount offered in the Fed's TSLF has been expanded to $200 bln. They have also once again lowered their standards on what they will accept as collateral for loans. As the Fed's balance sheet continues to be eroded by increasing amounts of dubious assets swapped for treasuries one has to wonder about the sustainability of the recent dollar rally.

The Fed has also suspended rules that prohibit banks from using deposits to fund investment-banking activities. For depositors at BofA -- or any other bank with an investment-banking subsidiary for that matter -- this little change should be extremely troubling.

A number of banks have also banded together to provide a $70 bln emergency loan program to help ease the credit crisis. Is the industry rallying to their own defense, or is that $70 bln really coming directly from the already wide-open discount window?

In addition, the ECB added €30 bln ($42.5 bln) in extra liquidity through a one-day money market auction. At the same time, the Bank of England pumped £5 bln ($8.9 bln) in liquidity into the system in an effort to stave off contagion.

The credit crisis seems to have an entered another new and disturbing phase, despite repeated assurances that the worst was behind us. Gold offers excellent protection against systemic risks to the global banking system as well as currency debasement as the various central banks inject massive amounts of liquidity in the hopes of preventing a total seizure of the world's credit markets.

The downside extension in oil is probably the only thing that has prevented gold from moving back to the $800 level. However, it is worth noting that the gold/oil ratio has surged beyond our objective of 8.0, suggesting further upside potential toward 10.0. This is further indication that gold is decoupling from oil as the yellow metal reclaims its historic role as a safe-haven investment.

Also, chances of a 25bp rate cut tomorrow surged to 43% in early trading, from just 8% on Friday. If the Fed lowers interest rates to stimulate the weak US economy, this will put considerable downside pressure on the dollar, which would also be supportive to gold.