You already know that I turned extremely bearish a few weeks ago. I am even more bearish now.

Weighing heavily on markets this week was the release of The Institute of Supply Management’s Non-Manufacturing Report on Business on Tuesday, which came in at only 44.6% for January. As the name implies, the report dealt with non-manufacturing businesses, i.e. the service industry, and is material because the service sector has been both the largest and the fastest growing component of the U.S. economy for the past sixty years. The service sector accounted for about sixty percent of U.S. output and employment in the 1950s and by the turn of the century that number grew to 80 percent. As a gauge of the health of the US economy, then, it makes sense that the service sector would be more indicative than the manufacturing sector.

So what does it mean when the ISM Non-Manufacturing (Service) Index stands at 44.6%? Without going into an excruciating explanation, let’s just say that if the index is at 50% it implies neither growth nor contraction in economic activity. A number greater than 50% implies growth and a number smaller than 50% implies contraction. So when the Service Index came in at 44.6% it was clear that the largest sector of the US economy is reporting a decline in economic activity.

What really attracted the market’s attention was a sub-index of Business Activity that came in at a very low 41.9%. The index result for the question: “Indicate how you and your management feel about the next 12 months compared to 2007” was 37%. Only 16% of respondents said they felt better while 42% said they felt worse about the economic outlook. The ISM Index is telling us is that the US economy is contracting.

Unfortunately that is not all. The financial sector is still saddled with bad debts and worthless credit default swaps. While an economic downturn is a normal occurrence, the credit problems plaguing the financial sector are not.

UBS downgraded several credit card issuers to “sell”, causing American Express shares to fall 3.7%, Capital One to fall 7.2% and Discover Financial Services to fall by 9.5%. This downgrade on consumer debt issuers is long overdue. Up until now the focus has been on mortgage debt, but the systemic problems I described on January 18th are not confined to the mortgage industry.

The problem with structured debt instruments and the credit default swaps that were layered on top of them is that they are coming back to haunt the banks that originated much of the toxic waste. Toxic waste is what low grade debt is referred to in credit markets; it’s not a term I made up.

Bond insurers are busy going bankrupt because they never had the capital to make good on the insurance products (credit default swaps) they sold and they grossly miscalculated the systemic risk in the debt market. As they go bust investors who bought the debt instruments are looking to the banks who originated the toxic waste to take it back. So the banks are trying to come up with rescue plans to save the bond insurers so that they can pretend the risks are mitigated and avoid having to buy back the debt they created.

A group of banks are trying to bailout Financial Guarantee Insurance Co., one of the bond insurers busy going under. Another group of banks is trying to save Ambac Financial Group Inc.. Yet the problems are not limited to one or two companies: there are over $46 trillion’s worth of credit default swaps and nowhere near enough capital to cope with rising default rates in mortgages and credit cards, not to mention corporate defaults, which are also rising and will be the next shoe to drop.

Credit card delinquencies are rising and that means Americans, who have been spending borrowed money to sustain their lifestyles, are going to get cut off from the juice. This week the US Federal Reserve Bank announced an abrupt slowdown in consumers’ credit card borrowing. Revolving credit, which is mostly credit card debt, grew 11.1% in October, 13.7% in November, but only 2.7% in December. In December an average of 7.6% of credit card loans were at least 60 days delinquent or had gone into default. That is up from 6.4% a year earlier.

Banks are responding to rising delinquencies by tightening credit standards for both mortgages and credit cards (and, I would assume, other loans such as auto loans as well).  That means less credit available for spending and that means less spending, which directly translates into slower economic growth. Citigroup went so far as to cancel the credit facilities of 161,000 credit card customers in the U.K, 7% of the accounts it bought for $1.13 billion less than a year ago.

I mentioned that corporate defaults will be the next shoe to drop. Recall all those billion dollar private equity deals that were done over the past few years? Those were almost all financed by issuing low-grade corporate debt (upgraded with credit default swaps, no doubt) and sold off to investors. Now the value of that debt is falling hard, making it almost impossible for banks to sell current commitments to issue new corporate debt. The banks are sitting on approximately $152 billion in loans they committed to make, but cannot sell. Many existing corporate loans are trading at a 15% to 20% discount to par value. Historically corporations whose loans trade at such steep discounts are on the verge of bankruptcy or a restructuring.

Municipal bond issues are also coming under pressure. At least six sales of tax-exempt auctions -- all insured against default -- have failed to attract sufficient interest in the past two weeks.

Our modern banking system is called a fractional reserve banking system. What that means is that commercial banks don’t have to keep all the money deposited with them in reserve, since most people never draw all the money out of their accounts. According to banking rules banks only have to keep a fraction of the deposits on reserve, hence the name fractional reserve banking system. Broadly, the reserve requirement for most banks is 10% of deposits.

At the end of each business day every bank has to calculate its reserve requirement and ensure that it has sufficient cash in its vaults or on deposit at the Federal Reserve Bank to cover its reserve requirement. Those banks that have a shortfall borrow from a bank with a surplus in the overnight market at an interest rate (called the overnight rate) set by the Fed. This, incidentally, is the interest rate that the Fed can change and that is so widely published in the media. If a bank cannot borrow from other commercial banks it can borrow from the Fed directly at what is called the Discount Window, usually at a much higher interest rate, to discourage banks from using the Discount Window.

Historically banks typically only borrowed at the Discount Window when they were in trouble and other banks refused to lend them money. And when the Fed made a loan at the Discount Window it required high-quality collateral, such Government issued bonds.

Then, in December, when banks were having trouble coming up with their required reserves and were unwilling to make loans to each other (either because they did not trust each other’s credit worthiness or because they did not have excess reserves) the Fed enacted emergency measures. They reduced the Discount interest rate to make it less onerous to borrow at the Discount Window, started accepting a wider range of collateral (including mortgage backed securities) and increased the term of the loans beyond just a single day. These were very drastic measures to try and restore liquidity to the banking system. It was necessary because the banks, in aggregate, had to borrow 36% of their reserve requirements from the Fed. John Williams of shadowstats.com  reported that the last time that banks had to borrow such a high percentage of their reserves was in March 1933, when they had to borrow 46%. That time President Roosevelt declared a bank holiday and closed the banks.

Now pay attention: the latest report by the Federal Reserve shows that at the end of January banks had to borrow more than 100% of their reserve requirements (here is the link to the Fed’s release: http://www.federalreserve.gov/releases/h3/Current/). I knew something big was wrong on January 18th when President Bush called for an immediate stimulus package, but I did not know what. Bernanke, Mishkin, Volcker and Greenspan all made dire speeches; they probably already knew that the banking sector had zero reserves left.

Bush, in response, suggested that the government mail checks out to US residents. Today the Senate passed its version of an economic stimulus package that would see more than 135 million households receive checks from the government totaling approximately $150 billion. The government hopes that people will spend the money thereby stimulating economic activity but, at a minimum, it should help the banks with their reserve requirements.

When current Federal Reserve Chairman, Ben Bernanke, said there would never be another depression because he would throw money out of helicopters if necessary, he meant it. At least he is keeping his promise.

You always have to keep in mind that the Federal Reserve Bank was not created to protect the value of the dollar, or the economy, or the good people of America. Its only purpose is to protect the banks. After all, the banks themselves own the Federal Reserve Bank. So don’t let the fact that commercial banks have no more money scare you too much. If necessary the Federal Reserve Bank can just create money and give it to them.

Finally, the new budget for the US government, which will be released on Monday, is expected to top $3 trillion. This is going to be interesting. During the 1990s the budget deficit turned into a surplus, not because of good management in the White House, but because an economic boom and stock market bubble greatly increased the government’s tax receipts. Now, with the War against Terrorism and economic stimulus packages, the government’s expenses are growing rapidly while the economic downturn and falling stock prices mean tax receipts are going to fall. Whatever the budget deficit is going to be, the actual fiscal deficit will be much greater. Remember, the budget is just numbers on a spreadsheet and entirely meaningless. The real number to pay attention to is the fiscal deficit -- this is how much money the government is really short, and how much it has to borrow.

We find ourselves in a period of falling economic activity, rising inflation as the government tries to stimulate economic growth by mailing money to anyone with an address, a falling US dollar as the trillions of dollars that overseas investors hold start reflecting their intrinsic value, and rising interest rates (even though interest rates are currently falling).

Most of the consumer and corporate debt in the US is far below AAA; it is just a matter of time before the US Government’s debt gets downgraded and the interest cost increases. It will take substantially more money just to service the debt so as interest rates rise the government’s debt is going to explode.

It also means much more pain for US consumers who are saddled with debt. Many were gambling that rising asset prices will outstrip their debt obligations, but double digit monetary inflation without double digit price inflation is not sustainable for too long. Monetary inflation in the US is running at over 15%. Since we know the government is going to add to that by writing checks and the Fed will do its part when it bails out the banks we can be sure that price inflation will follow. As will higher interest rates.