Wealth International, Limited

Finance Digest for Week of September 12, 2005

Note:  This week’s Offshore News Digest may be found here.


There are lots of decisions to make in today’s New Financial Era. You can tell there are lots of decisions to make because of all the personal finance columnists in magazines and newspapers. There are even personal finance advisors on the radio for millions of Americans to stumble upon while looking for a classic rock station not playing Phil Collins. Given all the exposure to higher level thinking on personal finance topics, most Americans will have no trouble answering this test question: Paying off your mortgage is a.) A great thing to do with your lottery winnings, b.) Something a friend of friend said they almost did once, or c.) A stupid financial move.

If you are a savvy, New Era Financial Type, then you guessed “c”. That is the correct answer according to David Lereah, chief economist of the National Association of Realtors. In fact, not only is “c” the correct answer, it is really, really correct. That is because Mr. Lereah told the Los Angeles Times that, “If you paid your mortgage off, it means you probably did not manage your funds efficiently over the years.” In other words, you made an answer “c” – a stupid financial move. Mr. Lereah is not just an economist, he is also the author of Are You Missing the Real Estate Boom? This is a book obviously aimed at readers who would answer the title’s rhetorical question with a “yes”. Otherwise, not only would the book be a short one, it would also violate the Realtors’ Code of Perpetual Optimism.

The problem with paying off your mortgage, according to Lereah, is that it’s like having half a million dollars stuffed in your mattress, which as anyone who has ever slept on lumpy money knows, is a bad, bad thing. Still, less sophisticated people, like savers, may have trouble following this New Era thinking. What Lereah means is that, even though you have not yet sold your house for actual money that you can stuff into a mattress, a pillow case or even a scare crow, what you do have is the ability to borrow lots of money against the equity in your home. And in the New Financial Era whatever a man thinketh he can borroweth. Ergo, having a house worth half a million free and clear is hardly as valuable as having half a million dollars of borrowed money while living in the house.

But here is the real difference between the New Era borrower and the Financial Luddite: Rather than dwell on the payments or the longer mortgage associated with the new loan, the sophisticated borrower uses mind control to block out such negative thoughts and merely watches the money work, work, work in sophisticated ways – like paying for granite counter tops, or even better, a vacation home that can trigger a whole new round of wealth creation. It is no wonder that once people see how money can work for them, they might ask, “Am I missing the real estate boom?”

Fortunately, like the children of Lake Woebegone, most Americans are already well above average when it comes to financial sophistication. If paying off your mortgage is a boneheaded move, then more and more borrowers are becoming financial wizards. Admittedly we did not get this smart all by ourselves. Luckily for us mortgage lenders have taken it upon themselves to educate us about their New Era product offerings, which, by the way, keep getting more and more sophisticated.

The stupid French, along with other Old Europeans, do not understand such sophisticated finance. Dr. Kurt Richebacher made this clear in his August newsletter when he reminded readers that there are housing bubbles all over the globe, even in boring Old Europe. But there is a difference, and that difference is this: Using your home as an ATM is an Anglo-Saxon thing. That’s because the U.S. Canada, Great Britain and Australia understand the alchemy made possible by borrowing against rising home prices. In most of Europe, however, there is little interest in home equity extraction, so they continue to live their small little lives drinking water without ice, going to musty old museums and saving instead of spending more than they make.

Link here.

Home equity borrowing losing some of its luster.

For Kim and James Merly, the home equity line of credit came in very handy - it helped pay for their son’s college education, a car and renovations of two rental properties. Recently, the Fairfield, Connecticut, couple noticed their interest rate had jumped to 6% from the 4% they paid in January 2004 when they first opened the account. They decided it was time to pay off the credit line.

Homeowners nationwide have seen their home equity borrowing costs rise since the Federal Reserve began raising interest rates more than a year ago. Many, like the Merlys, now want to pay off the loans, which no longer look as attractive as they did a few years ago. The rising rates mean consumers may have to rein in their spending; home equity lines of credit have been a major source of funding for big-ticket expenditures. That could in turn have broader implications for the economy, which has grown in part because of consumer spending amid record-low borrowing costs.

Mortgage bankers like James B. Nutter Jr., of Kansas City, have found more people are coming through his door looking for ways to pay off their home equity credit lines. “With the rising rate environment, they want to get rid of it,” he said. Viale said many consumers have been surprised by the steady rise in borrowing costs. “They are shocked by the increases (in monthly payments) they are getting,” said Viale, who recommends consumers cut back on spending, create working budgets and pay down debt.

Link here.


The Jewish Federation of Metropolitan Chicago prides itself on international philanthropy and how efficiently and effectively it spends money. But these days the federation is fighting to recover more than $4 million invested in an offshore fund operated by Bayou Securities. Federal authorities say Bayou, a Stamford-based hedge fund, was a fraud. Bayou is the latest in what regulators say is a growing number of frauds involving hedge funds, which are largely unregulated and traditionally serve institutions and wealthy investors. Hedge funds profit by using unconventional techniques, such as short-selling, or betting, on falling markets to make a profit during market downturns. Hedge funds typically are active traders and can use techniques off limits to mutual funds.

In the last five years, the SEC brought 51 cases charging hedge fund advisers with defrauding investors of more than $1 billion. According to the agency, there are now about 7,000 hedge funds managing $870 billion in assets, a 260 percent jump over five years ago. “The growth in hedge funds has been accompanied by a substantial and troubling growth in the number of our hedge fund fraud enforcement cases,” the SEC said in a report last year. Regulators say they are particularly concerned about the fraud because of a growing exposure of smaller investors, pensioners and charitable organizations to hedge funds in recent years.

To attract smaller investors, some funds have offered lower minimum entry requirements. Ordinary investors also passively participate in them through their pension funds and 401(k) retirement plans, which are increasingly putting billions into hedge funds. The SEC has mandated new oversight for hedge funds, saying the move could help identify fraud earlier in some cases and deter others. The new regulation will open the funds’ books to SEC examiners starting in February and make them subject to accounting and disclosure requirements.

Those who oppose regulating hedge funds have long argued that sophisticated investors are well equipped to detect fraud. They say hedge funds have not been disproportionately involved in frauds and the government should focus its limited resources on mutual funds that serve far more investors of modest means. Hedge funds have much higher minimum investments than mutual funds. “You’re dealing with people who understand the risks involved in investing in hedge funds,” said David Friedland, director of the Hedge Fund Association and president of a hedge fund in Florida. But even sophisticated investors have fallen victim to hedge fund frauds.

Link here.

Want a hedge fund? Here is your homework.

IF you are thinking about investing in a hedge fund, how can you steer clear of the likes of the Bayou Group, the recently imploded hedge fund company and brokerage firm run by Samuel Israel III? Unfortunately, getting information about individual hedge funds is not easy. While hedge funds have generally had positive returns, experts point out that some of them can be big money losers – and that this makes the decision to invest in any single fund a very risky business. A variety of databases provide information about hedge funds, but they are by no means infallible, and in any case many of them are often unavailable to the average investor.

The collapse of Bayou is a case in point. Federal prosecutors in Manhattan sued Bayou on September 1, saying the company had defrauded investors since 1998 by misrepresenting the fund’s performance. The complaint said that Bayou had misstated its assets and that its books, which it had claimed were evaluated by independent auditors, were certified by a bogus accounting firm whose registered agent, Daniel Marino, was also the chief financial officer of Bayou.

For hedge fund investors determined to avoid such debacles, there are some free Web sites that offer data on legal and financial developments, including the sites of the SEC and the National Association of Securities Dealers. While such sites contain a wealth of information, the often do not include the most telling signs of trouble in a hedge fund. Randy Shain, the co-founder of BackTrack Reports, which researches hedge funds for institutions and some wealthy individuals, says that in the Bayou case, several red flags – including questions about Mr. Israel’s character – would not have been evident to people contemplating an investment in the fund. For example, it would have been difficult to learn from publicly available data that Mr. Israel had exaggerated his position at one hedge fund, had been charged with drunken driving, and had been accused in a lawsuit by a former employee of violating securities regulations.

A litany of problems like this is hardly typical of hedge fund managers, but it does underscore how difficult it is to vet a fund, said Charles Stevenson, a veteran hedge fund manager who now runs the Navigator Diversified Strategies fund, which is a fund of hedge funds. (A fund of funds is a group of individual hedge funds that has been assembled by a third party, an arrangement that provides diversification and, perhaps, a margin of safety.) In promotional material for the Bayou funds, Mr. Israel told investors that he had worked as the head trader at Omega Advisors, a hedge fund run by Leon Cooperman, a former Goldman Sachs partner. But Mr. Israel had misrepresented the length of his employment at Omega as well as his position there, Mr. Cooperman said in an interview. Another cautionary piece of news for Bayou investors should have been that while Omega oversees two funds of hedge funds that invest money with 25 different managers, Mr. Israel’s group was not among them. “We never invested in Sam Israel’s hedge fund nor did one trade with his securities company,” Mr. Cooperman said.

Link here.


Budget deficits to the left of us, money growth to the right of us, and an oil price shock behind us, will leave only inflation in front of us! Information featured in a The New York Times article last month says it all: CPI inflation over the last 6 months of 5.0% for the U.S., 3.6% for the euro countries, and 3.1% for Britain. (Today it takes $237.14 to buy what $100 could buy in 1980) These are not wimpy numbers! Other countries are also showing what can be done when budget deficits and the money supply are cranked up and currencies are allowed to fall. A prime example of this is Venezuela and Russia. Even with all their wealth from oil, they suffer from very high consumer price inflation. Even countries that have tremendous wealth from resource sales to China – Argentina, Brazil, Indonesia, Turkey, and The Philippines – are experiencing escalating consumer price indexes.

The fueling engine causing this inflation is a combination of large world budget deficits and overly accommodative central banks, which have fostered rapid growth in money and credit. World money growth is at its boiling point. China is printing money at an annual rate of 16%; Denmark is 15+%; Australia, Britain, and Canada are over 10% and broad money growth in Europe is 8%. While the broad measure of money growth in the U.S. is only 5%, growth of total credit is double digit!

After raising short-term interest rates to 3.5%, the Federal Reserve said they were still accommodative. They really meant it! Low interest rates in the U.S., Japan, Europe and China – combined with an “anything goes money growth” philosophy – has allowed the U.S. to finance its $700 billion annual trade deficit and run an economy with negative consumer savings. The world simply has too many Dollars, Yuan, Yen and Euros that are chasing a fixed number of barrels of oil. The last thing inflation needed was Hurricane Katrina’s devastating impact on oil production.

A number of market analysts and “cheerleaders” for the stock market have called for the Federal Reserve to stop raising interest rates because Katrina may cause the economy to slow. However, when you actually take a look at the budget deficits and money and credit growth (above), if the Federal Reserve stopped raising interest rates, the dollar could crash causing inflation to run at well over 5% a year. The U.S. inflation numbers for August and September should look real ugly. While Congress seems intent to increase the budget deficit by as much as $150 billion to rebuild the south, we will watch the Federal Reserve response very closely and, like many foreign investors, be ready to dump the dollar if the Fed once again listens to the mob’s cry for easy money.

Link here.


Never in modern history has the world’s leading economic power tried to do so much with so little. A saving-short U.S. economy has long pushed the envelope in drawing on foreign capital to subsidize excess consumption. But now Washington is upping the ante as it opens the fiscal spigot to cope with post-Katrina reconstruction at the same time it is funding the ongoing war in Iraq. Could this be a tipping point for America’s shoestring economy?

The saving-investment identity, one of the cornerstones of macro analysis, frames the economics of this debate. For any economy, saving is emblematic of the willingness to defer current consumption in order to invest in the future. America’s problem is that it no longer saves. Its net national saving rate – the combined saving of individuals, businesses, and the government sector (all adjusted for depreciation) – has fallen to a record low of only 1.5% of GNP since early 2002. By contrast, this same national saving rate averaged 7.5% over the 40-year period, 1960 to 2000. Unwilling to cut back on investment, a saving-short U.S. economy has become increasingly dependent on surplus foreign saving in order to grow. That means it has had to run massive external deficits in order to import this foreign capital. A current account deficit that hit a record 6.4% of US GDP in early 2005, and that will easily pierce the 7% threshold in the months ahead, underscores how far the U.S. has had to stretch offshore in order to make ends meet. This is the essence of the shoestring economy – a United States that is lacking the saving cushion needed to fund future growth and ward off the impacts of more immediate shocks.

Unfortunately, that noose is about to get a good deal tighter. Asset-dependent consumers were running a negative personal saving rate to the tune of -0.6% of disposable personal income in July 2005. Not since the Great Depression of the early 1930s have U.S. households been stretched that far. Yet, today, few seem worried about this development. The energy shock of 2005 is likely to take the personal saving rate even further into negative territory as U.S. households defend their lifestyles in the face of rising expenses for transportation, electricity, and heating. The American consumer is on the leading edge of the shoestring economy. The government sector is in a similar position. In the politically-charged post-Katrina environment, any semblance of fiscal discipline has vanished into thin air. Nor can business sector saving be counted on as a buffer to the same degree it has been in recent years. Not only do profit margins appear to have peaked, but the combination of rising unit labor costs and higher energy-related outlays could well push the earnings share lower in the months ahead.

Global considerations could well compound the problem. Up until now the U.S. has had free and easy access to the rest of the world’s pool of surplus saving. That could be about to change. Japan and Germany – which collectively account for 56% of the world’s surplus saving – both seem to be on the cusp of sustainable recoveries in domestic demand. That would tend to draw down their current-account surpluses, thereby leaving less foreign capital available to fund America’s external deficit.

Yet “resilience” has become the mantra of consensus thinking about a post-Katrina, energy-shocked U.S. economy. Just as the U.S. survived the potentially disruptive impacts associated with the bursting of the equity bubble, the carnage of 9/11, and a series of unprecedented corporate accounting scandals, most believe it can ward off the blows this time, as well. That is certainly a possibility, but I think it is equally important to appreciate the differences between this shock and the others noted above. From a pure macro standpoint, the energy shock of 2005 is less of a psychological blow than terrorism, equity wealth destruction, and a loss of confidence in corporate leadership. Higher energy product prices are, instead, more of a direct hit on household purchasing power and business costs. And they put immediate pressure on a U.S. economy that is lacking the saving cushion needed to withstand the blow.

The macro conclusions are inescapable: A saving-short U.S. economy that runs a massive current account deficit is effectively living beyond its means. It not only relies on foreign saving to fund domestic growth, but it also lacks the capacity to invest in public goods that may be needed to safeguard its future. Lacking in domestic saving, the shoestring economy is also biased toward chronic under-investment in infrastructure – leaving itself vulnerable to “breakage”. Whether that breakage comes from within (i.e., Katrina) or from the outside (i.e., terrorism), the shoestring economy runs the risk of being unprepared to ward off such blows in a fragile and dangerous world. An energy shock exacerbates the imbalances that produce such vulnerability. This draws into serious question the resilience that financial markets now seem to be banking on.

Link here.


63-year-old Ruth Wohlforth lives in a “very, very tiny house” near New Jersey’s Atlantic coast, but her property taxes are so high she may not be able to afford to stay there much longer. With a one-bedroom, one-bath house smaller than some RVs, Wohlforth’s 2005 property tax bill for her Ocean View, N.J., home is $3,478. Compare that to the $250 tax bill she paid 30 years ago when she took over the home from her parents. With a fixed income of less than $8,000 a year from Social Security and a few bonds, her numbers do not add up.

Situations like Wohlforth’s are playing out across the country. The housing bubble, with its red-hot real estate values, has sent property taxes soaring, making taxpayers mad as hell. From Maine to California, from Texas to Minnesota, rebellious homeowners are squeezed, and politicians are scrambling to try to accommodate them. At the same time, local governments fear that trimming the taxes could cripple schools, police, fire and other essential services dependent on that revenue.

Not since 1978, when California voters revolted against high property taxes and approved Proposition 13 to slash them, has a tax issue so galvanized taxpayers. “Few types of taxation have stirred more people into anger and outrage recently than the property tax,” says Pete Sepp, spokesman for the National Taxpayers Union, a Virginia-based group that tracks taxes and works to lower them. “The taxes are driving people out of their homes,” says James Dieterle, director of AARP’s New Jersey office, which has been a leader in the state for property tax relief. “One resident whose house is paid for said her property taxes now are higher than her mortgage payments and taxes were combined.”

Link here.


Dow Theory Letters’s Richard Russell was artfully qualifying his sudden bullishness last week. He was just suggesting that “those willing to speculate” should buy Spyders, the S&P 500 tracking stock (SPY). And it may not work. (Russell played the 2003 bounce this way, too.) Russell is also making bullish noises on gold. And his comment that really got my attention was this: “You can be sure that the central banks don’t want to see an upside breakout in gold. … The primary trend of gold is bullish, however, and the primary trend is stronger than all the central banks in the world taken together. When gold’s time comes, gold will brush by the manipulations of the central banks and their friends, the gold banks.”

This suspicion of covert market manipulation by governments in alliance with favored private-sector firms has been voiced with increasing frequency by Russell and other letters. Indeed, several letters muttered about suspicious late-day rallies as detailed in our June 27, 2002, column. Of course, it is too wild an idea for most of the mainstream media. Now, two respected figures in the Canadian investment industry, John Embry and Andrew Hepburn of Toronto’s Sprott Asset Management, have published a report, “Move Over, Adam Smith: The Visible Hand of Uncle Sam”. It pieces together from published sources evidence that points to the existence of the long-rumored “Plunge Protection Team”, an informal group of U.S. government agencies, stock exchanges and large Wall Street firms.

The last episode Sprott thinks it has definitely traced was before the U.S. invasion of Iraq in March 2003. A U.S.-Japanese agreement to intervene to prevent any financial crisis during the war was announced by a Japanese official, perhaps because the government intervention in markets is openly admitted in Japan. The U.S. never acknowledged such an accord. Sprott does not necessarily oppose government intervention in principle – the apparent interventions after 9/11 or the 1987 crash, for instance – but says such intervention requires “the most stringent safeguards and transparency.” Instead, Sprott asserts that “what apparently started as a stopgap measure may have morphed into a serious moral hazard situation, with market manipulation an endemic feature of the U.S. stock market.”

All this raises two problems. First, possible corruption, as “… the major Wall Street firms evidently responsible for preventing plunges no longer must compete on anywhere near a level playing field.” Second, there is the matter of ultimate breakdown. “Displaying markedly low volatility, the Dow hovers comfortably above the 10,000 mark. Yet with severe trade and budget deficits, rising interest rates and stubbornly high oil prices, the reasons to be bearish on U.S. equities are numerous. Strangely, the market has an uncanny ability to maintain its footing when serious declines threaten.” If that is right, economic reality may eventually intrude and, as Russell says, “brush by” the manipulators – and the investors misled by them.

Link here.


When Hurricane Katrina began boiling into a Category 5 maelstrom in late August, few people were watching her more closely than a team of meteorologists perched 35 floors above Chicago’s Loop. These were not your typical weathermen. They were part of a low-profile energy trading operation run by a highly secretive Chicago-based hedge fund firm called Citadel Investment Group PLC. Snatched by Citadel three years ago from collapsed energy trading desks like Enron and Aquila, this pack of traders had already been profiting handsomely from the rapid run-up in oil and natural gas prices. As Katrina bore down on New Orleans, threatening to disrupt the energy markets even further, they stood to make millions more if they played their cards right.

If you have never heard of Citadel, you are not alone. Beyond the cloistered world of high finance, it might as well be invisible. But over the last several years it has grown to be one of Chicago’s most innovative and influential firms by pouncing on disruptions large and small ranging from massive hurricanes to tiny swirls in the bond markets. The firm’s founder, a 36-year-old billionaire named Kenneth Griffin, started his career trading convertible bonds from a Harvard University dorm room almost two decades ago. Having built Citadel into one of the world’s biggest multistrategy hedge funds, he is quickly emerging as one of Chicago’s most powerful executives.

By creating an institution with stability and staying power, Griffin wants to prove that a well-managed fund deserves to be taken as seriously as Goldman Sachs or Morgan Stanley. “This is the opportunity of a lifetime and I certainly don’t want to squander it,” he said recently during a rare interview. “We’re here to build one of the great merchant banks in history. We want to be to finance what Microsoft is to technology.” Like most hedge fund managers, Griffin has assiduously avoided publicity, largely so competitors will not know what he is up to. But with $12.5 billion in assets under management, Citadel has gotten too big to hide. It now employs more than 1,100 people. Whether Citadel can keep growing is an open question. After years of returns averaging better than 20%, investors say the firm is crawling along closer to 2% this year, causing some to wonder if it has gotten too big to find enough places to profitably invest its capital. If it were not for Griffin’s record, it would be easy to dismiss his sort of talk as bluster. But ever since Harvard, he has done pretty much anything he put his mind to.

Link here.

Chicago-area hedge funds take a lashing in energy markets.

A tough market made worse by Hurricane Katrina is roiling the energy desks of two big Chicago-area hedge funds, causing heavy losses and costing several traders their jobs. Both Chicago-based Citadel Investment Group LLC and Ritchie Capital Management LLC in suburban Geneva have found themselves on the losing side of big trades involving natural gas and electricity, market sources say. Neither firm would comment, but Platts Commodity News, an industry trade publication, estimated the total losses at more than $250 million. Citadel, which has $12.5 billion in assets under management, lost at least $150 million, the report said. Ritchie, with $3 billion in assets, reportedly lost more than $100 million. The exact time frame of the losses was not clear. But sources said bad positions soured further when Katrina hit the energy infrastructure near New Orleans and heavily disrupted the markets for oil and natural gas.

Scott Rose, head of energy trading at Citadel, has left the firm in the wake of the trouble. Sources said Todd Orosco and Joe Skubisz, who both traded energy at Ritchie, are departing that firm. Citadel’s chairman and founder, Kenneth Griffin, also declined to comment on the energy situation. But in an interview early this week with Platts, Griffin said that “this year, the performance of the [energy] business has not met expectations, and I’m sure that weighed on [Rose’s] mind. We have been very successful since we launched [Citadel Energy Products]. This is one of the few times when we haven’t pulled the money [to] the bottom line.”

Citadel and Ritchie, two of the nation’s most secretive and aggressive hedge funds, are both new to the energy business. Citadel formed its operation in 2002 after the Enron scandal sent the industry into turmoil. Griffin recruited traders and managers from Enron, Aquila and other troubled trading operations. Ritchie launched its two energy related funds in 2004. To the extent that they can extract information from the highly secretive organization, investors say that Citadel’s energy business has largely been profitable since it began. But like many in the natural gas market, it began encountering trouble three months ago when abnormally hot weather drove already elevated gas prices through the roof. One source close to Citadel said the prolonged price run-up disrupted any number of trades, from an arbitrage between October and January futures contracts to trades designed to take advantage of what is called the “spark spread”.

The spark spread is the relationship between the price of natural gas and the price of electricity produced from that gas. Typically, these two commodities trade in a particular range. But as the price of natural gas rose this summer and predictions of a mild winter began circulating through the markets, the opportunity arose to sell the commodity short – a bet that it would soon decline. To hedge their risk, traders bought electricity, which usually rises in price as generators use more expensive gas to produce it. This sort of strategy, known as spark spread arbitrage, lets the trader profit as the price spread between the two commodities eventually returns to normal. But as natural gas continued to rise abnormally through the hot summer, this trade and any others that involved shorting the commodity began to look increasingly untenable. When Katrina hit, things got exponentially worse.

The most vexing part, said Eric Bolling, a trader on the New York Mercantile Exchange, was that the hurricane came on a weekend when the markets were closed. The storm changed directions toward New Orleans on Saturday night and by Sunday traders were in a panic. When the markets finally opened the price of natural gas exploded, far outpacing the move in electricity. That meant anyone short gas would sustain big losses not offset by long positions in power. “What underpins this is Katrina,” Griffin told Platts. “The market really thought there was a probability that we would be oversupplied [gas] in winter, and a lot of people went short.” The losses turn up the heat on Citadel and Ritchie, highfliers who have been having difficult years in 2005.

Link here.


Adorning a conference room wall on the third floor of Citigroup’s Manhattan headquarters is an enormous wooden plaque. It bears a likeness of the company’s chairman, Sanford I. Weill, and lists every deal he engineered to create what is now the country’s largest, most profitable and most influential financial institution. The inscription beneath his image reads: “The Man Who Shattered Glass-Steagall” – a reference to the Depression-era law that hemmed in the size and powers of America’s banks for several decades, until the 1998 merger that formed Citigroup helped lead to its repeal, ushering in a new age of boundless, hazardous, high-octane finance and deal-making still struggling to sort itself out.

Down the hall from the conference room – and one floor removed from most of the senior executives who run the company – Mr. Weill, 72, maintains an office bedecked with photographs of family, presidents and foreign potentates; he will occupy this space at least until he retires next spring. Recently, Mr. Weill pondered an early exit from Citigroup to start a private-equity fund, roiling the board and prompting yet another round of speculation about turmoil at the bank, which has been whipsawed by unrest since its creation seven years ago. But last week, in a rare on-the-record interview, he said he had no intention of leaving Citigroup early – or of pursuing deals that conflict with the bank’s myriad businesses when he eventually does depart. During a wide-ranging conversation he also reflected upon his accomplishments and setbacks – from his notorious falling-out with James Dimon, his former No. 2 who is now president of J. P. Morgan Chase, to his view of Citigroup’s role in financial scandals like the WorldCom and Enron debacles.

Link here.


In 2004, everything was going according to plan for the world’s big banks. After a 3-year slump, the business they had missed – underwriting share offerings, arranging mergers and structuring corporate buyouts – seemed to be coming back. But was the resurgence for real? The issue is an important one, and not just for the banks’ profits today. In the future, it will determine how risky they are as companies.

Link here.


As prices for coal, natural gas and oil have soared, solar power has been getting perhaps its most serious look from investors since President Jimmy Carter pulled on a cardigan and asked Americans to damp their furnaces. The new interest means that the handful of domestic solar stocks has been surging, too. Over the last year, the shares of Evergreen Solar (ESLR), DayStar Technologies (DSTI), Energy Conversion Devices (ENER), and Spire (SPIR) – all small domestic companies that make equipment for converting solar power into electricity - have more than doubled in price. In August, Cypress Semiconductor said it would try to raise as much as $100 million in an initial public offering for its SunPower subsidiary.

“The solar market is projected to grow 35 percent a year for the next three to five years,” said Walter V. Nasdeo, managing director of Ardour Capital, an investment bank in New York that specializes in energy companies. “As these technologies get better, we’re seeing things being developed like solar panels integrated into roofing tiles. That way, they don’t look like a science project hanging on your roof.” Until recently, the economics of the solar business did not tempt many consumers or investors. Without government or utility subsidies, the $20,000 to $25,000 that it costs to buy and install a typical home solar system may be too much to be recouped in the time it takes to pay off a 30-year mortgage. But government help, combined with the recent climb in energy prices, has made solar systems more appealing.

Link here.


Indiabulls Financial Services went public last September at 19 rupees a share. Today – one year later – shares of Indiabulls closed at 225 rupees, up nearly 12-fold. That is not even a new high. Five weeks ago the shares hit 271! What is so great about Indiabulls that makes it worth 12 times what it was worth one year ago? The answer is NOTHING … except that Indiabulls just happens to trade on India’s stock exchange. Indiabulls is primarily a brokerage firm. It makes its money selling Indian stocks. The Indian stock market is hot, which makes Indiabulls look good. That is one reason for the run-up in the share price.

Not content with the stock market bubble in India, Indiabulls has been taking its profits and buying up Indian real estate, which is also red hot. Indiabulls recently purchased an 8-acre former textile mill – for an astounding $101 million dollars. And this is the second one of these it has bought in just a few months. With stocks like Indiabulls as an example, the stock market in India could not be hotter. And therein lies the problem. When a financial market cannot get any hotter, it can only cool down.

$8 billion dollars in foreign money has poured into Indian stocks in 2005 alone – and $2 billion of it arrived last month! Of course, the Indian market could go higher from here. But I feel like I have seen this movie many times in my career before: A mountain of foreign money flies in on extreme optimism … and then that mountain of foreign money – or what is left of it – leaves in disappointment and disgust. A key point is that I am not knocking the India story. It is just that the chances of foreigners making money in the stock market there over the next few years is close to zero. The hot money will get washed out, as it always does.

China, Thailand, Russia, Indonesia, and Argentina … What do these stock markets all have in common? At some point in the last few years, they have all lost over 80% of their July 1997 values in terms of U.S. dollars (based on MSCI’s indexes). These losses were not even that long ago … Argentina lost 90% of its value between 2000 and 2002. Sure, the long-term promise of emerging markets can be alluring. But my point is, promise or not, the stock markets in emerging market countries can really get obliterated. The obliteration comes when there is something that spooks the hot money. The hot money will leave India too, just like it left all the others. It always does.

Link here.


I am increasingly a limp-wristed bond bull. Since I threw in the towel on my long-standing bearishness on bonds at the end of May, yields on 10-year US Treasuries have fluctuated in a 3.88% to 4.42% range – lower than most were looking for but falling short of the 3.5% target I had thought was achievable over the next year. While I still think there is a trade or two that could push long rates lower over the next few months, I must confess that my newfound bullish conviction is starting to waver. The bond market’s bearish stars are now coming back into increasingly worrisome alignment.

The case for another downleg in long-term interest rates remains largely dependent on the possibility of a growth scare. If anything, the likelihood of disappointment on the growth front is higher than it was in late May. To the extent our downwardly-revised baseline view of global growth plays out, downside growth risks should once again dominate the financial market debate – underscoring the distinct possibility of another leg to the bond rally. Any such downleg in long rates, however, could well turn out to be the last hurrah for bonds – or at least for the U.S. piece of the global bond market. That is because the U.S. saving outlook has just taken a worrisome turn for the worse, from an already weak position.

Barring a growth scare that morphs into another deflation scare – always a possibility for a bubble-prone, low-inflation economy – that would probably be it for the great secular rally in bonds. A U.S. current account adjustment has long been the bond market’s biggest threat. With fiscal policy at a tipping point and America’s chronic saving shortfall now taking a serious turn for the worse, that threat is no longer idle conjecture. You probably will not have to wait much longer for the long-awaited correction in the bond market.

Link here.


Armed with cash from $70 a barrel oil, Russian and Middle Eastern companies are on the prowl for acquisitions abroad and more and more of this money is being invested in companies in emerging markets. While most of this money still flows into high-end real estate in Western capitals or into U.S. and European equity, oil-rich investors are increasingly focusing on cheaper assets in emerging economies. Last month Turkey agreed its biggest ever privatization deal, selling a 55% stake in Turk Telekom to a group led by Saudi Arabia’s Oger Telecom for $6.5 billion, a sale that brings in much-needed cash to bridge Ankara’s widening current account deficit. “For the first time we are seeing Middle Eastern money cruising into foreign direct investment,” said Charles Robertson, emerging markets strategist at ING in London. “The Saudi $6 billion Turk Telekom deal is the best example of FDI helping to cover a widening current account deficit which has been made worse by high oil price.”

The oil boom has created a situation where purchasing power has slowly shifted from oil consuming nations to oil exporting nations. Middle Eastern oil exporters are estimated to have netted over $1 trillion in oil revenues in the past five years. This money has been flooding from the state oil sector to banks, then to other companies which are gaining from lucrative government contracts as well as booming domestic demand for their goods and services. Traditionally, billions of dollars of Middle East oil money were used to purchase dollar assets, mainly U.S. Treasuries. But nowadays, analysts say, governments are not converting petrodollars into U.S. Treasuries straight away.

Link here.


If you have ever looked on Amazon.com for books about a certain topic, you probably know about their “Listmania!” feature. It can simplify your task by offering entire lists of books loosely categorized by subject. I knew there were several “oil crisis” books now in print, but what I was not prepared for was the Amazon list that included 25 current titles that warned of the coming oil-energy-resource shortages. One of these was a 30-year update of the Club of Rome’s famous Limits to Growth. First published at a grim juncture during the 1970s oil “crisis”, the book had claimed that the world would exhaust its known oil reserves by 1992.

The world will NOT run out of oil in coming months, years, or decades, yet these days it is clearly fashionable (again) to think otherwise. Thus the real problem has to do (again) with psychology, not resources. Psychology indeed: In the oil markets, participants are overwhelmingly convinced that prices are going higher. One survey shows this sentiment at a 10-year high, another survey puts it at a 16-year high. In one of the best-known mutual fund families, energy-related funds in 2004 held 6% of assets relative to total funds assets; this year that percentage has climbed to 40%.

Shortage fears at the pumps and in the futures markets seemed to reach a crescendo as Katrina ravaged the gulf coast states. Still, has anyone bothered to check the crude oil and unleaded gas charts since September began?

Link here.


The results of a 2003 survey published in Germany this spring showed that “more and more Germans do not want to have children.” Almost 15% of all women and 26% of men between 20 and 39 are against having kids – period. That is a large increase from the early 1990s, when only about 10% of women and 12% of men in the same age group were opposed to the idea (Deutsche Welle). Germany’s Interior Minister is troubled by such “egotistical tendencies”. The government thinks it is about the declining values: “We must strengthen the value of children, of families, and of more cooperation between the generations in Germany,” they say. The study’s authors disagree. Deutsche Welle puts it very well when they say that, “the natural and somewhat obscure longing to have a child has little to do with state subsidies and labor market structures.”

Looking at this problem from an Elliott wave perspective may offer the best explanation yet again. (Hint: social mood!) Remember, the stock market is the most sensitive indicator of social mood. When mood improves, stocks rally. When it falls, so do stocks. In our own studies, we have compared charts of the U.S. and British conception rates with bull and bear markets in the Dow and the FTSE. The charts clearly showed that birth rates respond to changes in social mood, as reflected by trends in stocks. It seems that “when aggregate feelings of friskiness, daring and confidence wax, people engage in more sexual activity with the aim of having children. When these feelings wane, so does the desire for generating offspring.”

But wait a minute – German stocks have rallied since early 2003, indicating an improving social mood, so why have the German birth rates not turned up? Well, we have also observed that at least in the U.S., conceptions tended to respond only to long-term upturns in stock prices. What could this mean for the fate of the DAX’s two-year rally?

Link here.


Off-color language crops up in TV shows and movies more frequently nowadays than it did 10 or even five years ago. And four-letter words you would never have heard uttered publicly in the 1950s and ‘60s have become more common in everyday language. Yet a word that does not sound filthy or disgusting to the ear is still the one word that should not be uttered by traders or investors. Read this question-and-answer excerpt to find out what it is. Along the way, you will also learn how Bob Prechter got started with technical analysis.

Link here.


This week we get what promises to be another round of mystifying data out of the Mortgage Bankers Association. Several months after the end of every quarter, the MBA releases its latest statistics on home defaults and foreclosures. In a word, every last report in recent memory has been downright encouraging. Therein lies the confusion. The Federal Reserve is anguishing over the deterioration in lending standards, and with good reason. Some of the mortgages being written today make the high-octane junk written just before the savings and loan crisis look as harmless as a newborn 30-year fixed-rate loan. Down payments are passé. Principal payments can be forgone for 15 years. Heck, even payments are optional. Household debt has never before even flirted with its current record levels. Moreover, it has been growing at a faster pace than household assets, which also have been skyrocketing thanks to the speculative frenzy juicing home prices.

That is just half the mystery. Owning a home has never been as expensive as it is today. Property taxes, utilities, any kind of home service, maintenance, wildly long commutes to wherever you work from the developing hinterlands – they have never been as costly to the average Joe and Josephine. Paul Kasriel, chief economist at the Northern Trust Co., notes that households’ required principal and interest payments are at a record 13.4% of after-tax income, despite interest rates being at 40-year lows. But housing is still surging.

As long as banks keep on loosening their standards, it is conceivable that households’ habits will worsen, not improve. Why would banks do this? Because their livelihoods depend on the addicts remaining addicted. A record 61% of bank credit is mortgage-related. I guess the MBA data had better remain encouraging. If defaults even start to tick up, the banking system would be “crippled”, Mr. Kasriel writes. And just in case you cannot picture “crippled”, Mr. Kasriel suggests you look at 1990s Japan. The crippled banking system there killed the economy.

Link here.


Over the past five years, the majority of asset-classes have gone up due to record-low interest rates. Will the boom continue in some assets, whilst the other sectors deflate and correct? In order to answer the above questions, we first need to examine history. The last commodities bull market peaked in 1980 when inflation fears were widespread and interest-rates were soaring. Throughout the late 70’s, the public exchanged cash for whatever tangible assets they could get their hands on. As a result, commodity prices went through the roof! Gold prices went up over 20 times, oil prices went up from $1.50 per barrel to $40 per barrel, and sugar prices went up 45 times! All this was happening in the 70’s because people lost faith in cash and bought hard tangible assets. During the same period, the U.S. economy was in a recession, Britain had to be bailed out by the IMF and financial assets were depressed.

It is interesting to note that in 1980-81, U.S. Treasury bonds were being termed as “Certificates of Confiscation”! At the same time, U.S. stocks were selling under 10 times earnings while yielding over six percent! Since the entire world was convinced that cash would continue to lose its value through inflation, nobody was interested in bonds and all the money was going into commodities. In order to contain these inflation fears and to make cash attractive, the Federal Reserve raised interest rates very aggressively. At the peak in 1981, the Fed Funds rate was as high as 19%! Back then, bonds were extremely depressed and (in hindsight) they turned out to be a great investment. Bonds entered a bull-market in 1981 and over the next 24 years, bond investors made a fortune!

If you were to look at the Fed Funds rate since 1956, you would see that interest rates soared up until 1981, and since then they have been falling. This trend has obviously provided a boost to financial assets such as stocks and bonds. It is worth noting that interest rates are now close to a record low and may be bottoming out. In fact, I am of the view that in five to 10 years time, interest rates will be significantly higher than where they are today. This will obviously put immense pressure on the bond bull market, which is now over 20 years old! In the near future, I expect inflationary fears to escalate, as commodities, led by oil, will continue to march forward. To put it simply, I expect tangible assets to, once again, appreciate over the coming years.

Link here (scroll down to piece by Puru Saxena).


If only The Wall Street Journal would produce a “Weekly Reader” version, we might be reading sentences like these in upcoming editions. We might also be reading sentences like, “See Oil Prices! … See Prices Fall!” Energy demand worldwide is falling. So says the International Energy Agency, and so says the weight of anecdotal evidence worldwide. Because energy prices have been climbing to very high levels – and staying at very high levels – the world’s energy consumers are beginning to trim their consumption. Falling energy prices would seem, therefore, like a likely and enduring consequence. Net-net, the recent selloff in crude oil, unleaded gas, energy stocks and almost everything else related to the energy complex may be both justified and enduring. At a minimum, we investors should consider this possibility. (For the record, we still love oil stocks, but we are a little leery of buying them at this very moment).

The International Energy Agency’s (IEA) estimates of global oil demand topped out in March and have been ratcheting lower ever since. Rising oil prices are clearly to blame for the falloff in demand. Energy demand seems likely to fall even more, as many Asian countries raise the price of government-subsidized oil products. Since oil prices have more than tripled since the end of November, many Asian governments are feeling the heat to reduce subsidies and relax price controls. They simply cannot afford to suppress the true cost of energy products. The State-owned Indian Oil Corporation, for example, is losing almost $12 million per day. To the extent that countries like India and China migrate fuel prices toward global levels, the more that demand growth in these two countries might slow. And the more that demand might slow, the lower the price of gasoline might become in place like, say, New York City.

Link here.


In his testimony to Congress on July 20, 2005, Mr. Greenspan declared it quite likely that the world is currently experiencing a global savings glut. Agreeing with Ben Bernanke, he mentioned this glut as one of the factors behind the so-called interest conundrum, i.e., declining long-term rates despite rising short-term rates. Having read a lot from the Fed’s luminaries, their inability to distinguish between rampant global credit excess and a global savings glut does not surprise us. In this view, the Federal Reserve has come to the rescue of a world where excessive saving is threatening depression by eliminating savings.

Attracted by superior rates of return on U.S. assets, investors around the world have been scrambling to pour their excessive savings into direct investments, stocks, bonds and real estate in the United States, in this way financing the resulting huge U.S. trade deficit. While this explanation may seem to make sense, there is one big snag: Not one word of it is true. First of all, in reality, private foreign investors have drastically curbed their investments in the U.S. According to the Bank for International Settlement – the international organization of the world’s central banks – Asian central banks financed 75% of the U.S. current account deficit in 2004.

First, private capital flows into the U.S. have slumped. Without the massive interventions by the Asian central banks, the dollar would have collapsed long ago. Second, the dollars with which these central banks have been buying U.S. Treasury and agency bonds have definitely nothing to do with Asian savings. Evidently, the central banks are recycling the dollars, no more, no less, which they receive from U.S. trade and capital flows. These dollars have come into the central banks’ possession through their interventions in the currency markets, to prevent a rise of their currencies against the dollar. To speak of a global savings glut as a possible cause of the surprisingly low U.S. long rates in the face of these blatant facts is truly the height of insolence and absurdity. That this opinion comes from the leading figures of the Federal Reserve is more than shocking.

True, Asian countries have very high savings rates. For China, it is reported to be as high as 45% of disposable income. But this does not necessarily imply an existing savings surplus be lent to America. The bulk of available savings in China domestically is locked up in an even higher domestic investment ratio. Looking at the global financial system, a straightforward fact to see is that central banks have been amassing foreign exchange reserves at an accelerating pace since the early 1970s. Rising in several large waves, their main source is plainly the soaring U.S. trade deficits.

Having no use for dollars in general, the first dollar recipients in the surplus countries sell them to their banks against their own currencies. These banks, in turn, found ready dollar buyers in firms and investors around the world, wanting to acquire direct investments or other assets in the U.S., at least until 2000. Since then, though, capital inflows on private accounts into the U.S. have drastically receded, while U.S. trade deficits have exploded. In order to prevent a rise of their currencies against the dollar, central banks had to step in as buyers of last resort.

Buying dollars, the central banks credit the commercial banks in their country with interest-free deposits. Now, the critical point to see is that the banks, on their part, regard these deposits as their liquid reserves to be used for profitable lending or investment. Inundated with liquid reserves by the dollar buying of their central bank, the commercial banks in these countries embark on faster credit expansion. Our focus in particular is on China. As in the U.S., the resulting credit deluge is boosting components out of proportion to the whole economy. In China, however, the specific components are real estate and manufacturing investment, while in the U.S., it is consumer-spending excess. What the Asian central banks truly recycle is the U.S. credit excess. But in flooding their banking system through the dollar purchases with liquid reserves, they transplant the virus of credit excess to their own economies.

For U.S. policymakers and economists, this is a reasonable and sustainable division of labor. The U.S. economy runs on wealth creation through asset inflation with a high rate of consumption, while China and Asia run on wealth creation through saving and investment with a high rate of investment. We are fearful of this development, because it affects more or less all industrialized countries with high wage levels. In this way, overconsuming America is force-feeding the rapid mutation of China’s backward economy into a first-class manufacturing power. We are wondering what is worse for the whole world, China’s further rapid manufacturing growth or a disastrous hard landing. Observing the same monetary and economic follies as in the late 1980s in Japan, we consider the second possibility highly probable.

With all the talk about a savings glut, we feel obliged to make some remarks about the subject. From the macro perspective, “saving” provides the physical resources for the production of capital goods in that consumers abstain with part of their income from consumption. Of course, this also involves money flows, but saving’s decisive distinguishing feature is the partial abstention from current consumption to make real resources available for the production of capital goods. It is ludicrous, therefore, when American economists claim that rising asset prices, increasing consumption, should by counted as saving. When we read decades ago that Mr. Greenspan, long before he became Fed chairman, had expressed precisely this view, he was once and for all finished for us as a serious economist.

The world economy seems to be flooded with liquidity. But there are two diametrically different kinds of liquidity: earned liquidity and borrowed liquidity. The former comes from surplus income or savings; the latter comes from credit and debt creation. In a country with virtually zero savings like the U.S., any liquidity essentially arises from debt creation. This is really fake liquidity depending on permanent, prodigious borrowing facilities, presently the housing bubble. Once this bubble evaporates or bursts, the U.S. economy loses its chief liquidity source – with disastrous effects on asset prices.

The consensus expects that the U.S. economy has the “soft spot” behind it and will surprise positively. We expect shocking economic weakness. All asset prices are in danger, including bonds.

Link here.


Whether ‘tis nobler in the mind to suffer the slings and arrows of outrageous fortune, or to take arms against a sea of troubles, and by opposing end them?” – Hamlet, William Shakespeare

Hamlet – a tragedy of inaction. How appropriate. In this second line of this play’s most memorable monologue, which begins, “To be or not to be,” we see Hamlet questioning whether or not to take action. Should he suffer in solitude from the hidden truth that he is privy to, or should he confront the situation, deal with the consequences, and bring true resolution to Denmark, his country? Perhaps, Greenspan and other government officials thought it nobler that our country should take no radical action and suffer the slings and arrows of outrageous fortune. Yet what we need is what we have needed all along. We need the resolve to take the necessary actions to set our economy on a sustainable path. That was always going to be difficult; now, it looks as though it will be so even more.

If I started at the beginning, I would end up with a novel the size of War and Peace, which neither of us would read. So, I will start somewhere in the middle, though I am quite sure where we will end. After coming off the final remnant of the gold standard in 1971, with the whole world now on fiat currencies, we were free to inflate. And so, we did. We began inflating and we began our journey to becoming the world’s greatest debtor nation.

Thus began the great bull market in credit. From 1982 to 2000, the Dow went from 875 to 11,722, our trade deficit expanded from $24 billion to $378 billion, and the household mortgage borrowing rate increased from $47.6 billion to $368 billion. As the boom turned to bust in 2000, Greenspan, a good Keynesian (“the remedy for the boom is not a higher rate of interest, but a lower one”), stepped in and cut rates from 6.5% in 2001 to 1% in 2003, flooding the economy with credit. As well, the Greenspan Fed flooded the money supply. From 2000 to 2005, the money supply has grown from $6.6 trillion to $9.8 trillion, the trade deficit has doubled from $378 billion to an annualized $685 billion,, and the household mortgage borrowing rate has more than doubled from $368 billion to $801 billion.

My point in all this is to show the reader that we are nearing an endpoint. If we extrapolate theses numbers, we see an accelerating rate of the growth that is evidence of the fact that our economy is on an unsustainable, parabolic trajectory. We have “printed” more and more money in increasingly shorter timeframes and have engaged in exceedingly riskier investment transactions to try to keep the party going just a little longer. Even in the last five years, we have traded the consequences of a popping stock bubble for multiple bubbles that now look ready to pop.

As you try to find a point of reference to assign meaning to these numbers, consider them against the backdrop of what will be one of our largest problems – the housing and real estate mania. Naturally, these lower interest rates caused most of us to desire to buy a house or buy a bigger one. The law of supply and demand combined with an increasing supply of dollars and produced rising house prices. Most of us thought something like, “If the prices of houses are rising and interest rates are so low, we’d be foolish not to buy now so we can lock in a low rate and start growing our equity.”

Against an economic topography of job losses followed by abysmal job and wage growth, rather than selling their houses and/or lowering their standards of living, many Americans applied for home equity loans. Banks, burgeoning with cash from the above-mentioned monetary stimulus, were happy to oblige. So, lending standards were relaxed, and we saw the growth of no-money-down loans and “re-financing” offered with no employment documentation, unheard of in prior years. Risk continued to increase. Soon, the cost of housing priced itself beyond the ability for the average wage earner to afford a purchase. So, we emphasized Adjustable Rate Mortgages (ARMs), with lower initial rates, so those who wanted to, could buy. After all, rates were coming down and “homeowners might have saved tens of thousands of dollars had they held adjustable-rate mortgages rather than fixed-rate mortgages during the past decade,” said Greenspan on February 23, 2004.

It is odd that he should say that then. Greenspan is often oblique and always measured and specific in his words, exercising caution for their effects. Yet Greenspan made this statement after he had lowered rates to 1% in June 2003, and just a short while before he began raising interest rates, “at a pace that is likely to be measured,” in June 2004. No caveat. No further explanation of where we were in the rate cycle. Just a clumsy, blanket statement. Oh, well. I guess we all make mistakes.

Interestingly, as measured by a Fannie Mae report on the contents of purchase loans backing mortgage-backed securities, ARMs have grown from 18% to 72% from 2001 to 2005. Of course with ARMs, if interest rates climb, the borrowers must pay an upward adjusted rate, increasing their aggregate mortgage payments, and correspondingly straining their cash flows further. Risk continued to increase. Housing prices continued to rise. However, more and more houses were being bought as investments. Consider that 23% of all homes purchased in 2004 were for investment, while another 13% were vacation homes. In addition, there was a record of 2.82 million second home sales in 2004, up 16.3% from 2.42 million 2003.

The main problems with houses as investments, is that one has to pay the mortgage until the prices rises enough to sell it for a profit. Rents cratered, as everyone wanted to, and could, buy a home. Interest-only ARMs allowed for an even smaller payment. Now, someone with very little cash flow could purchase a home and meet the monthly mortgage requirements. Interest-only ARMs grew from 3% to 50.9% from 2001 to 2005. Risk continued to increase. Against a backdrop of increasingly manic credit creation, it did not matter if you did not have a job and flipped houses and condos for a living. Sub-prime interest-only ARMs increased from 0 to 23.5% from 2001 to 2005. Risk continued to increase.

Now, in August 2005, Greenspan observes that “America’s economic imbalances, most notably the large current account deficit and the housing boom,” could end in “more-wrenching changes in output, incomes, and employment.” He then goes on to say that, “The rising prices of stocks, bonds and, more recently, of homes, have engendered a large increase in the market value of claims which, when converted to cash, are a source of purchasing power.” Greenspan then warns, “Such an increase in market value is too often viewed by market participants as structural and permanent. But what they perceive as newly abundant liquidity can readily disappear.”

Greenspan has recently spoken of an interest rate conundrum. I have a conundrum of my own. How is it that our Fed Chairman makes a passing comment that people could have saved ten’s of thousands of dollars if they had used ARMs and later downplays the possibility of a housing bubble. He then goes on to remark that interest rates increases have been forecasts for so long that anyone who has not prepared for them is basically stupid and to warn of a housing bubble that could sap all the equity from homeowners and leave them heavily indebted. Is this negligence or something worse? And for those who took out adjustable rate mortgages (ARMs), they had best hope that interest rates remain low. According to Deutsche Bank’s analysis, by 2007 “$1 trillion of the nation’s mortgage debt – or about 12 percent of it – [will be] switching to adjustable payments.”

So, how will this end? It does not really matter what I think. Instead, I would rather offer excerpts from Chapter II of the IMF report titled, “When Bubbles Burst”, which offers a historical perspective on “macroeconomic and financial after-effects of the bursting of asset price bubbles.” This is the sea of troubles against which we must take action. At this point we see that we will be hit by the storm. It is unavoidable. If our country and our leaders will not take appropriate action, how should we prepare? As I wrote at the beginning, this is going to be difficult. Each day the cost of inaction grows greater.

As for Greenspan, in 1966 he wrote, “The excess credit which the Fed pumped into the economy spilled over into the stock market – triggering a fantastic speculative boom. Belatedly, Federal Reserve officials attempted to sop up the excess reserves and finally succeeded in breaking the boom. But it was too late: by 1929 the speculative imbalances had become so overwhelming that the attempt precipitated a sharp retrenching and a consequent demoralizing of business confidence. As a result, the American economy collapsed.” How expedient it has become for Greenspan to wander so far from his own words.

Link here.


I have recently made the case that the Fed needs to pause in its “measured tightening” cycle, for at least the September Fed meeting, until we can see the full effects of Katrina and the oil shock upon the U.S. economy. We will really not know all that much by September 20th, and given the Fed emphasis upon approaching central bank policy as a task of risk management, that seems the prudent thing to do.

Pausing for 40 days, until the November meeting, though, would not suddenly send the economy into a dangerous spasm of inflation. If the economy adjusts, and oil refineries and shipping come back online in good order by then, as it most likely will, then they can continue their tightening cycle with no danger to the economy. But if we do find problems, the downside risk seems, to me, to be too great.

It is not yet altogether clear that Mississippi’s shipping will be back up in time for the fall harvest. Any other shocks (we are still in the middle of hurricane season) at this delicate time could be of real concern. Patience, at least for 40 days and 40 nights, is called for. Even God took that long to get things back to normal when things needed cleaning up.

Post Katrina, we have had three Fed governors speak. Frankly, they still seemed to be tied to the party line of the potential for a return of inflation. It is easy to see inflation as a potential problem. The serious rise in housing prices, and Fed concern about them, is well documented. The Fed is getting ready to pump massive amounts of money into the economy. Coffee is up seven percent and sugar up 30% due to delivery and shipping problems. The materials needed to rebuild, like copper, aluminum, and timber will be in large demand. As oil rises, shipping prices for products are going to rise. If Yellen is right, and price increases imposed by increased costs “stick”, one can readily argue that we could see a surge in inflation. And with inflation near the top level of what the Fed is comfortable with, should the Fed not act preemptively to make sure inflation does not come back? The short answer is no. There are forces, which combined with Katrina, could change those trends. Let us look at some of them.

Those smart guys at Cumberland Advisors, looking at how much pressure the consumer is under, think the Fed might come to a full stop, as they are concerned the economy will roll into a recession if the Fed continues on its current path. Increased energy prices are going to take a toll on consumer spending, but it is not just energy. Increased interest rate costs on mortgages, the new Alternative Minimum Tax and Katrina all make this worse. They put a pencil to the problem to give us an estimate of the cost and the potential hit to consumer spending.

Martin Barnes at the Bank Credit Analyst, says, “The current 11% year-on-year gain in real house prices compares to a 50 year average of only two percent. The current growth is three standard deviations above its mean, and historically, this has broadly been a mean reverting series. The odds are high that the growth in real house prices will fall below zero in the next few years.” Recent data suggests that the housing prices may be under some pressure. There is a very close correlation between housing prices, consumer confidence, and consumer spending. Any decrease in consumer spending will be in addition to the decrease noted by Cumberland. All of this suggests that it is time to be cautious.

Link here (scroll down to piece by John Mauldin).


It’s frightening… It’s difficult… It’s harrowing … and it’s very, very profitable. I am talking about “distressed investing”, also known as “vulture investing”. It is the ultimate expression of contrarian investing. It requires buying the stocks or bonds of companies that are in deep financial distress, often in bankruptcy, with the expectation that they will emerge from bankruptcy a new and improved – and debt-free – corporation.

The recent Kmart saga provides a text-book example. Once a giant among retailers, Kmart struggled for decades to compete with the likes of its more agile competitors, namely Wal-Mart and Target. Years of futility finally brought the old retailing icon to its knees. In January 2002, Kmart became the largest retailer ever to file for bankruptcy. Left for dead by most investors, a few savvy money managers detected signs of life within the comatose retailer. Martin Whitman, manager of the Third Avenue Value Fund, was one of them. Whitman has a long history of investing in distressed companies, going back to the 1970s. In the 1980s, he found a pot of gold in the bankrupt securities of Anglo Energy (now Nabors Industries). Whitman’s cost basis in Nabors is around 40 cents on a stock that today trades north of $60!

So what did Whitman see in Kmart? For one thing, he saw a company with $25 billion in revenues selling in the market for about $1 billion. Plus, Kmart owned a lot of real estate. So the risk of loss, he estimated, was low and the potential profit was enormous. He bought some of the company’s debt for pennies on the dollar. No other Kmart shopper has ever walked away with such a bargain! Eventually, Kmart emerged from bankruptcy. Much of the debt converted to new stock, leaving the new post-bankruptcy Kmart free of its heavy debt load. Not long after emerging from bankruptcy, Kmart and Sears agreed to merge, creating Sears Holdings. Whitman made a 13-fold return on his Kmart investment in about three years.

Investing in distressed situations is analytically complex. The securities are usually illiquid and the process itself is highly uncertain and tedious. Few investors are willing, and even fewer are capable enough, to dredge through the muck. Therein lies the opportunity. Seth Klarman, the astute and successful investor behind the Baupost Group, covers investing in financially distressed and bankrupt companies in his book, Margin of Safety. “The popular media image of a bankrupt company is a rusting hulk of a factory viewed from beyond a padlocked gate,” he writes. “Although this is sometimes the unfortunate reality, far more often the bankrupt enterprise continues in business under court protection from its creditors … a company that files for bankruptcy has usually reached rock bottom and in many cases begins to recover.”

The shelter of bankruptcy allows a company to get back into financial health. Once in bankruptcy, companies can void leases, nullify long-term contracts and even terminate prior labor agreements. Prior debts are restructured or swapped for new stock in the reorganized company. The new post-bankruptcy company frequently emerges as a low-cost competitor, since it has shed many of its prior high-cost commitments. (Imagine how strong your personal balance sheet would look if you could simply erase all the numbers on the liability side of the ledger!) Plus, bankrupt companies frequently build up cash – another source of value. Bankrupt companies also usually have substantial net operating losses carryforwards, or NOLs, which result from prior losses. NOLs can be used to offset future taxable income – a valuable asset in any market.

One very unique virtue of vulture investing is that it tends to excel during times of financial trouble. In this sense it is countercyclical. The ‘70s recession, for example, created opportunities in real estate, particularly in distressed real estate investment trusts (REITS). The U.S. economy will continuously produce distressed companies, like a pride of lions produces gazelle carcasses. As long as there are mistakes, recessions, bubbles and busts, there will be tasty corporate carrion for vulture investors.

Link here.


The flood waters are receding and the pumping of New Orleans is proceeding, which means it is time to start the Great Public Finance Debate of 2005. There are a lot of things to argue about in the municipal bond market – negotiated versus auction sale, are interest rate swaps useful or a rip-off. But the Great Debate now concerns whether and how the bonds sold by issuers in Louisiana and Mississippi should be bailed out.

It is a big question. You may have read the other week that the rating companies put almost $10 billion in bonds on notice for a possible downgrade. Remember that they only concern themselves with debt they rate. Plenty of small municipalities sell bonds without any rating at all. Issuers in Louisiana and Mississippi have sold 3,612 separate bond issues totaling $48.6 billion since 1995, according to Thomson Financial. That amount includes bonds sold by the states themselves and their localities and authorities, and includes general obligation and revenue bonds, insured and uninsured. The Katrina problem may be a lot larger than the $10 billion cited by the rating companies.

Some of these issuers are going to have difficulty making their debt service payments. Let us say some bonds are backed by a hotel tax. If the hotels are not open, then the hotel tax paying those bonds is not collected. Or say some bonds are to be repaid by a special sales tax. If nobody is making purchases, then there are no special sales taxes collected. Which brings us to the crux of the big question: Is it appropriate for the state or federal government to ensure that municipal debt in this catastrophic, once-in-a-century instance, does not default?

Yes. If dozens of municipal bond issuers in Louisiana and Mississippi default on their loans, it will make it that much harder to attract investors to municipal bonds as an asset class. This will drive borrowing costs up at a time these issuers will need the municipal market to borrow money to rebuild, and make it more costly for issuers everywhere to borrow.

No. It is the bondholders who would be bailed out, not the issuers, and investors in bonds, just like investors in other securities, know there is risk to everything.

Link here.


Sometime around 1600 B.C., the Egyptians created the image of a serpent devouring its own tail. A few millennia later, the Greeks gave the serpent a name, “Ouroboros”. Today, a descendant of this curious mythological serpent seems to have taken up residence in the natural resource sector. Soaring commodity prices are taking a big bite out of the profit margins of the very same companies that produce the stuff.

For more than four years, most natural resource companies have been enjoying brisk demand for their products … and rising prices. Unfortunately, rising commodity prices are causing production costs to increase sharply for the commodity companies themselves, thereby eating into their profits. We should not be surprised, therefore, if profit growth at many resource companies begins to slow down, or grinds to a halt completely.

As a case in point, the nation’s third-largest steelmaker recently shocked its shareholders by announcing a loss for the quarter, instead of the anticipated profit. The culprit: rising costs for natural gas and scrap metal. The stock dropped sharply on the news. BHP, the world’s third-largest iron ore exporter, is also griping about rising costs. The company is spending about 34% more money than last year to produce iron ore, and about 28% more to extract oil. Rio Tinto Group, the world’s No. 3 miner, last month reported a 7.7% rise in expenses in the 12 months ended June 30. Meanwhile, the price of materials and parts used in open-pit coal mining, such as steel and tires, jumped more than 5% last quarter alone. That is the biggest one-quarter increase in almost five years.

Over in the agricultural sector, the news is even worse: production costs are soaring while product prices are tumbling. The price of corn, at $2.07 a bushel, languishes just a few pennies-a-bushel above 17-year lows. But meanwhile, the price of diesel fuel has rocketed 65% over the last year. Farmers are caught in a “cost-price squeeze”, says Rick Tolman of the Corn Growers Association. Wages are also rising throughout the mining sector. “Mining companies are running short of the workers they need to expand production and to capitalize on today’s sky-high commodity prices,” Bloomberg News reports. Down in Australia, many geologists are demanding – and receiving – A$200,000 a year, or about four times the historic average wage for a geologist.

The same serpent that is eating away at the resource sector’s profits, may also be gnawing away at the investment prospects of many emerging markets. Since resource stocks wield a sizeable influence over many emerging markets, the fortunes of these two investment sectors are closely aligned. The iShares MSCI Emerging Market Index ETF (NYSE: EEM) and the iShares Goldman Sachs Natural Resources Index ETF (NYSE: IGE) tend to track each other very closely, as the nearby chart illustrates.

The “eternal cycle of renewal” may seem like a majestic and sublime concept, but that does not mean than any one of us should volunteer to be the tail.

Link here.


It is funny how much comfort people can derive from something as transparent as a bubble. Now that home prices in some markets are showing signs of moderating, lamentations are rising from all sides about the many bad things that may happen as a result. These include bankruptcies, foreclosures, bank failures, unemployment and recession. Unfortunately, all of this hand-wringing tends to distract from the essential truth about soaring home prices, which is that they are a bad thing. So before you become carried away with mourning, let me break the news: the housing bubble never loved you. The bubble is not even your friend. In fact, the very best thing you can say about the passing of this particular bubble is “good riddance”.

What is so bad about skyrocketing home prices? Almost everything. First, they make life awfully difficult for people who are not already homeowners and do little for people who are, because selling one inflated house only to buy another affords little profit. It is true that mounting home equity makes for a nice piggy bank, but it probably also suppresses other kinds of saving and encourages excessive debt. And it has helped addict global producers to American consumerism, because it gives Americans the confidence – and in many cases the wherewithal – to spend some of the inflated value of their homes. But bubbles are not very durable. Would it not be better if Asian and European domestic demand could pick up some of the slack?

Sky-high home prices also divert too much capital into home building from potentially more productive uses. And these prices fuel risky, not especially useful speculation in residential real estate. Then there is the matter of sprawl: all those new homes will mean more driving, more fossil-fuel consumption and more pollution. Excessive home prices divert human capital as well. The National Association of Realtors had 1.1 million members at the end of 2004, up from 766,560 in 2000. It is hard to believe that such an increase would have occurred if there had been no housing bubble.

Finally, would it not be better for society, and safer for our financial system, if people could buy a home without resorting to the kinds of loans – with deferred amortization, for example, or scant down payments – that are risky for borrowers and lenders alike? Al Mansell, president of the Realtors’ association, noted recently that the median down payment by first-time home buyers was just 3%, down from 10% in the early 1980’s. He added that a quarter of first-time buyers who did make down payments used gifts from their parents. But more than 4 out of 10 put down no money at all.

But if inflated home prices are bad, is not the end of a housing bubble worse? Not necessarily. There is always pain associated with market adjustments. But as the economist Herbert Stein once dryly observed, if something cannot go on, it will stop. The Federal Reserve, through its monetary policy of low interest rates, has propped up real estate prices for years. Other government policies, from zoning to building codes, are doing likewise. Even Hurricane Katrina may play a role; by diverting huge amounts of construction material to New Orleans and the Gulf Coast, it could drive up the costs of new homes across the country. My sense, though, is that home prices appear determined to fall, at least where they are most inflated. And having them fall sooner imposes lower costs than having them fall later, while delivering immediate benefits.

If prices moderate, maybe we will not gobble up open space as quickly. Lower prices will clearly deter some speculators, who will put their money to work elsewhere. And some of those real estate brokers will find something else useful to do. Best of all, people at dinner parties and soccer games will have to find something more interesting to talk about. That alone makes the end of the housing bubble a good excuse to break out the Champagne.

Link here.


The nation’s newspapers and TV blabbermouths have been in full-throated yelp against inactivity. In the wake of the New Orleans inundation, they surf for sound bites. In those crucial hours, local officials “did nothing,” they say. Federal officials, too, including the highest official, were nowhere to be seen, doing nothing. Nothing. Nada. Zilch. The null category gets no respect. The hollowness of it is repulsive. The emptiness of it is unbearable. Even nature is said to abhor a vacuum. The poor man who has nothing to say is a pariah. He is like the investment advisor with nothing to recommend, save cash. He will get no work as a hedge fund manager; he will not drive a fancy car, nor live in a beach palace at the Hamptons.

And pity the poor renters. While everyone else has been getting rich, the renters have been left behind, stranded … like people who showed up too late at an airline counter in Duluth just before a snow-storm, doomed to spend a weekend there. Imagine the conversations between husband and wife: “You did nothing! This was the biggest housing price boom in American history, and we missed it. Now, we’ll never be able to afford to buy a decent house.”

How could the poor husband know that house prices would rise? Of course, he could not; but his wife nevertheless holds him responsible, as if he not only saw the train coming, but intentionally failed to get on board. No, dear reader, inactivity is almost always unpardonable. But here, nevertheless, we say a kind word for it, maybe two. First, we point out that doing nothing is usually the best course of action, especially in public affairs and investments. Second, we deny the possibility of “doing nothing” in any case. Since the entire world nurses a prejudice against inaction, the burden of proof is clearly on us. So, let us bend to our work like a field hand, knowing that our labors will be many, our rewards few.

In public affairs, as in private ones, there is a powerful compulsion to “do something”. The problem on the Eastern Front was not really caused by inaction, but by Hitler’s desire to “do something”. After the invasion and capitulation of France; and after the Battle of Britain, he found himself with time on his hands. Western Europe was buttoned up, from Poland to Spain; he was master of all and everyone. Only Britain held out. But he had not the means to invade Britain, so his eyes wandered across the map – as Napoleon’s had done many years before – and saw Russia. He would have been much better off staying home. Then, Stalin’s generals could have continued to bounce their mistresses on their knees, and hand out candy at birthday parties. Inaction would have begotten more inaction, in other words. And the world might have been a better place.

And now we read in the news that the administration and Congress have finally sprung to action on the bayous. They are going to spend more than $50 billion! That the money will be almost certainly squandered seems to trouble no one. That every penny of the money could otherwise be better spent by the people who earned it, bothers neither conservative nor liberal. The impulse to “do something” is so powerful, no one wants to stand against it. But our beat here at The Daily Reckoning is money. Are you ever better off doing nothing with your money? The answer falls in our lap like a ripe cocktail hostess: Of course.

Warren Buffett holds billions in cash. He is probably the best investor who has ever lived. If he cannot find anything better to do with his money than to leave it in cash – effectively doing nothing with it – how can the average lumpeninvestor expect to do better? Is this the time to buy stocks? Probably not. Stocks are still relatively expensive. The idea is to buy low and sell high later. Is it time to buy bonds? Again, probably not. Bonds are expensive, too; yields are low. Will they become even more expensive? Will yields go even lower? Maybe. But we cannot predict the future. At today’s prices, you are not likely to make money in bonds, especially corporate and junk bonds. It is better to do nothing.

But there is always real estate, isn’t there? Since 2001, investors have made such rapid advances in the property market they would have made blitzkrieg warfare proponents Guderian or Rommel envious. But it is still sunshine for America’s house buyers. Should you join them while the getting is still good? Or should you do nothing? “Do nothing,” is our advice. Most houses are too expensive. You will get more for your money as a renter. Most likely, you will be able to buy later … at better prices.

“You are either long or short,” said our old friend Mark Hulbert, 20 years ago. “There is no such thing as a hold.” What Hulbert was describing was the impossibility of inaction in the investment world. You may like to do nothing, but you cannot. If you do not buy stocks, you buy something else. “Nothing” cannot exist; it has no meaning. If you have money, you must have it in some form. You must be “long” something. You may be “long” cash, as Buffett is, but that is just as much a something as being “long” property or stocks. The real question is not whether you will do something or nothing, but: What will you do? When all major asset classes are expensive, the sensible thing to do is nothing. But since you cannot do nothing, our advice is to do as little as possible.

The trouble with cash is that it is much more something than nothing. Dollars are a gamble. They are IOUs issued by the world’s biggest debtor. Despite nearly a hundred years of decline, the dollar is still expensive in our view. That is, they still buy something, but that they will buy less in the future is practically assured. Buffett hedges this gamble by buying foreign currencies. But it is still a gamble. A more perfect “nothing” is gold. It is a sort of anti-asset. It pays no interest. It issues no press releases. It offers no guidance on quarterly earnings; it has no earnings. It does no mergers, no acquisitions and it never restructures. It hires no celebrity CEOs. It offers no discounts. It makes no excuses. But it is the thing that goes up when other assets, including dollars, go down. Gold is as close to “nothing” as you can get. Buy it.

Link here (scroll down to piece by Bill Bonner).
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