Wealth International, Limited

Finance Digest for Week of September 11, 2006

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


It is not unusual to hear about the virtues of hard money and the evils of the paper variety at a gold conference. However, Austrian business cycle theory is rarely cited given the audience is only interested in hot stock tips. But at the Las Vegas Hard Assets investment conference held last week, the Austrians were mentioned prominently in two separate presentations. Keynote speaker John Dizard, columnist for the Financial Times, told the gold crowd that Austrian economists believe in “free markets and evidently, bow ties.” He admitted that he was initially skeptical of the Austrian argument but has since come around. Austrian business cycle theory is based on intertemporal misallocation of resources. Excessive credit creation lowers interest rates below the natural rate, spurring malinvestment. Dizard believes the effects of the misdeeds of the worlds central bankers are about ready to be felt. No financial crisis since 1994 has been allowed to run its course without central bank intervention. These crises are needed in order to liquidate malinvestments.

The FT columnist believes Fed Chair Ben Bernanke has read the Austrians and knows deep down that they are right. But, the Fed will inflate away a portion of the massive debt build-up leading to an increase in the price of gold. However not right away. Dizard said the gold price will head up six to nine months from now and he has even delayed the release of his forthcoming book entitled Gold Now to coincide with that prediction. A couple hours after Dizard’s presentation, newsletter writer Jay Taylor made the case that John Maynard Keynes and Milton Friedman were wrong and that Ludwig von Mises was right. Inflation and depression are caused by excessive credit creation. The Austrians advocate for a gold standard while bankers and politicians hate gold.

Of course conference attendees are gold fans, but judging by the attendance our legions are not growing despite the ongoing bull market. The original gold and uranium bug James Dines described attendance as “sparse” and remembered the days when it was standing room only. “The show is not as zippy as I thought it would be,” silver guru David Morgan said during his presentation. Only a small portion of a huge hall was curtained off for Hard Assets presentations, and often speakers were forced to compete with the rumble of forklifts operating just a few feet away.

Investing in natural resources and the companies that mine the stuff has clearly not caught on with young people. One presenter referred to investing in hard assets as “geezer investing”. Investment newsletter legend and author Howard Ruff made a comeback at the conference promoting his new book, Ruff’s Little Book of Big Fortunes in Gold & Silver: A Middle Class License to Print Money. Ruff is most famous for recommending the purchase of gold at $120/oz in 1975 and more importantly recommending that people sell the yellow metal near its peak of $850/oz in 1980. “I’m a has-been that’s here now,” Ruff said, and believes that investors will earn 500% to 1,000% in gold over the next eight years, twice that in silver and a multiple of that in the right mining shares.

Virtually every speaker was positive on the precious metals and commodities markets. Although, technical analyst Ian McAvity sees the potential for a meltdown in the stock market that would take all other markets with it. Broker Ben Johnson cautioned in his workshop session that newsletter writers have to be bullish, because if they do not have any stocks to recommend they are out of business. Global Resources Investments Chairman Rick Rule said investors have a choice between being contrarians or victims. Rule sees financial services and intellectual capital for the mining industry as cheap, as well as, profitable alternative energy, micro-cap Canadian natural gas producers, and mining companies with perceived political risk. “The Congo exhibits no more political risk than California does,” Rule quipped. His company’s head office is located in Carlsbad, California.

Numerous small mining companies were at the conference to make slick PowerPoint presentations full of drill results, maps, and slides of guys in hard hats standing in front of holes in the ground in the middle of nowhere. More than a few conferees wisely used these stock hustling presentations for napping. Much more of last week’s conference was devoted to oil than in the past. Craig R. Smith, co-author of Black Gold Stranglehold was a keynote speaker and also shared the stage with University of Houston professor Dr. Michael Economides for a panel on energy’s future. Smith does not believe decaying dinosaurs created oil and gas. He thinks they are being created constantly and is brought to attainable depths by the centrifugal forces of the earth’s rotation. Refining capacity is another thing however. It has been 29 years since the last refinery was built in the U.S. Dr. Economides told the crowd that ethanol is the biggest scam ever, that it takes 1.6 gallons of gas to produce just a gallon of ethanol. He called it the dotcom of the energy business.

But the primary theme of the conference was the pitiful state of the overleveraged world economies, and the coming weakness in paper currencies. Goldmoney.com’s James Turk stressed that gold is not going up in price so much as the dollar is going down in value. Because of central banking chicanery, Turk predicts the dollar will collapse leading to $8,000 per ounce gold and $400 per ounce silver. “We are being lured into a massive debt pyramid that will eventually collapse,” Gary North wrote back in 2002, “either into deflationary depression or, more likely, into what Mises called the crack-up boom, in which the nation’s currency is destroyed by the central bank.”

It was Mises who predicted both the Great Depression and the fall of communism. Now, while but only a few notice, the Fed continues to set the stage for another of his predictions to come true: the crack-up boom and the destruction of the dollar.

Link here.


Russia is said to be keen on inviting foreign capital into its electric power generators. At first sight this conflicts with its determination to keep control over its oil and gas sectors. However, this apparent confusion in economic doctrine is explained by the Russian government’s overriding concern with security and power-political matters. What is not clear is whether an economy run in the interest of “national security” can work in the long run.

Current Russian economic policy, which seems likely to continue whether or not President Vladimir Putin is re-elected in 2008, is not a re-enactment of Soviet economic policy, even that of the “glasnost” era of 1985-91 under Soviet president Mikhail Gorbachev. The private sector is not merely tolerated on a small scale, it is an integral and vibrant part of the Russian economy, and consumer spending preferences are given an important role in spurring Russia’s economic growth. To that extent, therefore the fall of the Soviet Union and the reforms of the 1990s really achieved something. In certain sectors, notably the service sectors that had been neglected under the Communists, the Russian economy is vibrant and offers excellent growth prospects for the future. Enel, the Italian electric utility, thinks so. Earlier this year it acquired 49.5% of the Russian energy trader RosEnegoSbyt and last week it announced its intention to invest €2-4 billion ($2.5-5 billion) in the Russian power generation sector.

Nevertheless, that is not the whole story. Russia’s wish to exert its full weight in world affairs and dominate its neighbors and ideally western Europe are also not similar to the policies of the Gorbachev era, when Russia attempted to mend its relations with the West, but are a throwback to the pre-glasnost era before 1985, when the Soviet Union showed no compunction in bullying its neighbors and delighted in the fear its moves inspired. To some extent, this is a reversion to traditional Russian foreign policy. Only Russia’s smaller size and relative population, compared with the Soviet Union or the late Tsarist empire prevent Russia from casting a similar shadow over word affairs today.

In this context, Russian economic policy makes sense. Economic growth is good, even if it does not come from the traditionally favored heavy industry sectors. Tt builds Russia’s strength in world affairs as well as keeping its people docile. If free market capitalism produces economic growth it is to be welcomed. The current Russian regime has no particular hang-ups about income distribution and regards its 2001 institution of a “flat” income tax of 13% as a major policy triumph. Certain sectors, however are too important to be left to the free market, particularly if that free market consists of independent minded oligarchs such as the Yukos oil tycoon Mikhail Khodorkovsky. Imprisoning Khodorkovsky and destroying Yukos have shown other tycoons that the state is not to be denied when it wants something. The power of that state has accordingly been greatly increased.

This combination, of friendliness towards the free market combined with a determination to subordinate it to the demands of a security state, is one that has not really been tried before over a long period, although current Chinese policy is fairly similar. It bears some resemblance to Italian Fascist and German Nazi economic policy of the 1920s and 1930s, but those regimes were much more committed both rhetorically and in practice to the nostrums of socialism. The Tsars may have been moving in that direction under Pyotr Stolypin in 1905-12 (before that time, the Tsarist economy was primitive and hampered by mediaeval regulations) and Wilhelmine Germany also operated under similar assumptions, but both those regimes were a long time ago, and their eventual economic success or lack of it was lost in the horrors of the First World War.

To assess the viability of a free market economy within a powerful security state i is thus worth conducting a thought experiment, and considering what the current United States might look like under such a regime. Suppose for example that President Richard Nixon, instead of the democrat that he truly was, had been the deranged paranoiac of leftist fantasy, and had combined with the brilliant but equally paranoid CIA super-spook James Jesus Angleton to create such a regime in the U.S. What would be the economic result? ...

There may be a few readers for whom the National Security America sounds preferable to our own – most of them doubtless former senior CIA and NSA officials! Nevertheless, for the rest of us it is clear that such a society would be very much poorer than the one we have, as well as being hideously vulnerable to such risks as oil depletion and the collapse of information and telecom systems. Your investment in Russia should thus be short term, and should avoid sectors in which the government takes a particular interest.

Link here.


The Fed, which last month left interest rates unchanged for the first time in two years, is the main source of the current [stock market] optimism.” ~~ Wall Street Journal, September 5, 2006

This goes along with the glowing conclusions by David Wolf, an economist and strategist with Merrill Lynch. When the governor of the Bank of Canada did not change the administered rate earlier in August, the Financial Post headlined “Standing Pat Was the Right Call”. Strategist Wolf raved that the governor’s non-move was “Looking Like a Genius”.

Well, the way it worked in 2000 was that during the summer, as short rates were still rising, the consensus was very worried about the next increase in administered rates. As we wrote then, throughout most of financial history rising rates mean that the boom is still on. The time to worry is when market rates of interest start down. Along with the usually concomitant turn to steepening of the yield curve, this indicates that demand for funds to speculate with is diminishing. After all, inversion has always been driven by the urge to speculate. So the consensus now is that the end of the Fed’s or any lesser central bank’s rate hikes is a mark of genius and is good for the stock market. This is nonsense and suggests that when an economist is elevated to the head of a central bank it gives new meaning to the concept of artificial intelligence.

First of all, at the climax of the biggest bubbles going back only to 1873, changes in administered rates by the senior central bank have followed the change in short-dated market rates of interest – usually by a few months. For example, treasury bill rates turned down in September, 2000 and the Fed dropped the administered rate in the first week of 2001. In 1929, short rates started down in June, 1929 and the Fed raised the administered rate to 6% in early August. Then that extraordinary decline started. The other irony is that academics ever since have argued that the hike caused the 1929 crash and the depression. In January, 2001 when the Nasdaq had lost over $3 trillion in market cap, op-ed pieces by different writers laid the blame on the Fed’s last rate hike.

So this is how the behavior pattern works. Fully astride the bull market, the consensus in real time celebrates the end of administered rate increases as a plus. Then, when the market is down substantially, the consensus then lays the blame on the last rate hike. Chagrin always seeks a scapegoat. On this go around, the Fed is lauded for the last of 17 rate hikes of a ¼ point each and, as quoted above, the end of this has prompted “optimism” or, in the case of the Bank of Canada’s non-move, “genius”. The next level of irony is that on the biggest booms the last rate hike has been followed by a severe contraction and the most relentless declines in short market rates, with the administered rate in close pursuit.

As the stock market began to slide in September, 2000, some within the status quo crowd discovered that they had been had. The adamant faction found encouragement with the immediately circulated notion that the Fed would lower interest rates and that would reignite the boom. The theory was that a bubble was an event created and managed by policymakers and that it could readily be turned back on by a brilliantly timed rate cut. Throughout all of recorded financial history, short-dated market rates of interest have increased during a boom and plunged during the consequent contraction. The record is that at cyclical turns (either up or down), the senior central bank lags the reversal in market rates of interest.

Beyond being merely ironical, the popular theory is a profound blunder. The first level is the unsupportable assumption that the senior central bank can and does make the major changes in interest rate direction – no, it follows. The second level of folly cannot even get the direction of major events right. Booms have never been reignited by declining rates, but contractions have always been accompanied by declining short rates for treasury bills, or equivalent, in the senior currency.

In the meantime, 3-month dealer commercial paper rates reach a high of 5.44% on July 25 as the T-Bill rate reached 5.12%. So far, the lows have been this week’s 5.29% and 4.96% respectively. More importantly, treasury curve inversion reached -10 bps on August 28 and has steepened to 0 bps. At previous cyclical peaks, and although only modest, this change has indicated that the contraction was inevitable.

Link here.


A new path to fame and fortune is attracting the best MBAs – to a new bubble. No, it is not hedge funds, which are stumbling on mediocre performance. The new destination of choice is private-equity or leveraged-buyout (LBO) firms, which not only promise magical returns. They also claim, in pitches from New York to Berlin and Beijing, to perform a capitalist public service by reforming weak companies.

To be polite, that is not quite how it works. An LBO firm raises capital from institutions and very wealthy individuals and charges them a fee of 2% of assets, plus 20% of the gains. Then the LBO finds a company that it thinks is poorly managed and undervalued, and it buys control by offering a 20 to 30% premium over the current stock price. If the purchase price is $6 billion, typically the LBO firm puts up a billion and borrows the rest (hence the “leverage”). Then the smart, young LBO guys dissect the company. They cut costs, redesign products and lay off people. If all goes according to plan, the company will prosper and they can resell their shares back to the public at a higher price, or to some other company or a rookie LBO fund at a much higher price. In the 1980s, the LBO game was high risk/high reward, and took years to play out.

The problem is that LBO firms and their investors are impatient. So, being ingenious guys, they have figured out how to get their money back faster. They can charge the acquired company hefty fees for their invaluable management guidance. Or they can have the acquired company sell a junk-bond issue – for the sole purpose of paying the LBO firm a special dividend. One example is the purchase in 2002 of Burger King by an LBO consortium for $448 million. Within 2½ years, the consortium had earned all that back by charging Burger King unspecified “professional fees” and quarterly management fees, and taking a big special dividend, for which the company had to borrow to pay. This May, the consortium sold a portion of Burger King back to the public at $17 a share, which valued its remaining investment at $1.8 billion – four times the original cost. The only problem is Burger King is not doing so great. The stock closed last week at a little over $15. But so what? The consortium has already made a bundle. After the IPO, Burger King paid it an additional $30 million for terminating the management agreement. The Burger King saga is not unusual.

Money is now pouring into private equity at the rate of $200 billion a year in the U.S. and Europe. Eventually that sum will be leveraged up to a $trillion. It has to be – otherwise the return on LBO capital would be lousy. Fortune magazine calculates that from 1976 to 2004, Kohlberg, Kravis Roberts & Company, the Tiffany of LBO firms, earned its investors a 185% return – which is pretty mediocre for a 28-year period, and would have been much lower if their money had not been leveraged by a factor of five. Private-equity returns are moving from feast to famine. I calculate that the median return for LBO funds was 16% in the period from 1986 to 1996, 8.2% in the last 10 years and only 1.6% in the last five. The big money that follows success always kills the golden goose, and the LBO goose is dying. People just do not know it … yet.

LBO mania is a big bubble, one carrying an enormous amount of pension fund and endowment money. Mind-boggling leverage on mostly cyclical companies suggests that in the next recession, the game is up. LBO investors will get burned. So will the banks and junk-bond owners. With a couple of trillion dollars of LBO debt out there a bust will not be a trivial event for the U.S. and European economies. The mood brings back unpleasant memories. There are so many amateurs, so many no-good brothers-in-law raising LBO fund money, the genre reminds me of tech in the late 1990s. Look out below.

Link here.


The U.S. nationwide housing bubble, the first in the post-World War II era, has been propelled by low mortgage rates, loose lending practices, aversion to stocks after the 2000-2002 bloodbath and conviction that house prices always rise robustly. Home prices and consumer inflation are normally closely related, but now the median price of existing houses nationwide is 35% above its usual link to the CPI, propelling the prices of these unstandardized, uneconomic, depreciating, illiquid, highly leveraged and lender whim-dependent investments well above the norms and making them vulnerable to declines at least that big.

I have been forecasting the collapse in the U.S. housing bubble for some time. Now it is happening. In July, existing home sales were down 4.1% from June and off 11.2% from a year earlier. New home sales dropped 4.3% from June and declined 21.6% from July 2005. Inventories have risen while housing starts have declined. Homebuilders, from Toll Brothers to Lennar to Pulte to Hovnanian, have lowered their full-year earnings outlooks. The National Association of Home Builders’ confidence index fell to 32 in August, the lowest point since February 1991.

I am forecasting a initial slow downdrift in house prices starting in the fourth quarter, then a sharp drop that lasts until the first quarter of 2008 and is followed by a tepid recovery. I foresee a peak-to-trough decline of 25% – a drop needed to bring prices back in line with the CPI, personal income and rents. Such a nosedive in prices will wipe out the thinly capitalized speculators, subprime borrowers and the low ends of subprime debt as well as assorted other lenders, mortgage bankers and home builders. Those folks will get the bulk of the media attention.

These unfortunates will depress national sentiment as they raise the question of who is next, in many minds. But they probably are not numerous enough or collectively important enough financially to do serious damage to the economy. Instead, the main event will feature the many people who still have jobs and are still making their monthly mortgage payments, whether they have any equity left or lost it all through earlier withdrawals and house price declines. Many of those folks have relied on their house appreciation to bridge the gaps between sluggish income growth in recent years and robust consumer spending. A move from high to no or even low rates of house appreciation would probably force many to live within their incomes.

The decline in house prices I foresee will sire consumer spending retrenchment that almost guarantees a major recession. And that is what declining stocks will anticipate. That bear market could well carry stocks below their 2002 lows. The 2003 rally and subsequent advances may well prove to be rallies in the bear market that commenced in early 2000 and will not be completed for several more years. Note that the 1982-2000 bull market lasted 17 years and eight months, and bear markets are usually one-third as long as the preceding rallies.

The housing collapse will also sever the links between a place to live and a great investment, to the ultimate advantage of rental apartments and factory-built housing. It will probably also initiate a saving spree, replacing the borrowing and spending binge of the last 25 years. The major global recession it will spawn may also initiate deflation and a further attractive rally in Treasury bond prices.

Link here.

Hard truths about housing’s “soft landing”.

Sleepless nights have set in for some house-sellers now. A year ago, the picture was much different – sellers could not wait to wake up in the morning from a good night’s sleep, wondering how many people would make bids on their homes that day. Now, though, newspapers like the Boston Globe carry stories about owners who must price their homes below their assessed values just to get a nibble.

Bob Prechter has written about what happens when a real estate mania ends and whether to invest in real estate. Here are the opening paragraphs from Chapter 16 of Bob’s business best-seller, Conquer the Crash, You Can Survive and Prosper in a Deflationary Depression.

Link here.

The real estate boom is over, now the arguing is about how long lean times will last.

Get used to it – the seller’s market is closing up shop. The days of fat, fast home value increases are gone. Pack away those flipping fantasies. “The boom is definitely over, there’s no debate about that,” said Mark Zandi, chief economist of research firm Moody’s Economy.com. “Now the question is more how hard is it going to land, if it lands at all.” The answer? Depends who you ask, and what location you are talking about. How to feel about it? Depends which side of the market you are on, and what location you are talking about.

Few, if any, economists are enthusiastic about current market conditions, thanks to a host of bleak figures recently released by home builders, federal agencies and the National Association of Realtors. But that is just today’s pain. What about six months from now? A year? Five years? Opinions about the future range from hopeful outlooks to doomsday predictions. “One possibility is that you get a quick return to normal, which is what the economists for the realtor groups tend to hope for,” said Edward Leamer, director of the UCLA Anderson Forecast. “But there’s nothing in the historical record that suggests that we’re going to get a return to normal anytime soon. It is a question of whether it is deep and quick or not so deep and much longer.” His prediction? “Not so deep and rather long.”

The way Zandi sees it, the market is going to weaken considerably more. “It has been correcting for about a year, and it’s got another year to go,” he said. Not surprisingly, Lawrence Yun, a senior economist for NAR, is more optimistic. He claims that the market has returned to more earthly figures after a period of unsustainable growth. Others are less willing to prognosticate an end date for the slowdown, due to a host of unknowns, including future interest rates and job markets.

Of course, real estate is a highly fragmented market. Not everyone benefited equally from the boom, and not everyone will suffer the same in a bust. Areas that were once epicenters of the boom, like Phoenix, San Diego and Las Vegas, will be among the hardest hit, Leamer said. “Wherever the party was the loudest, that’s where the hangover is going to be the greatest.”

To get a sense of how home prices will perform in various parts of the U.S., we turned to Moody’s Economy.com for historic and predicted median home prices in 15 major metropolitan areas. We looked back 10 years and forward another 10. The results show several cities, including Boston, New York and Washington, D.C., experiencing ups and downs (more precisely, downs and ups) in coming years – a boon for buyers, perhaps, but not for current owners. Other places, such as Houston and Minneapolis-St. Paul, may just keep chugging along. The company bases its forecasts on an econometric model that looks at the relationship between prices and various factors that have historically driven supply and demand in these markets. The intricate formula was proved to work when compared with actual house-price performance through the early 1990s, a period when home prices rose and then fell sharply.

Link here.

Hedge fund bets on housing bust.

A New York hedge fund is betting big time what apartment-obsessed New Yorkers have been whispering about for months – that the real estate boom is over. In July, Paulson Credit Opportunities Funds raised $147 million in equity and promptly put it to work on a leveraged $1.8 billion bet that homeowners are going to have a very difficult time paying their mortgages. The bet is concentrated on the lower end of the credit world, reckoning that the housing bubble will crack first among borrowers with the worst credit. Although a Paulson fund spokesman declined to comment, its July letter to investors made clear that when it comes to the housing market, its research team does not just see the glass as half-empty, but more likely, as broken.

According to Paulson, their bet is working nicely, the fund’s one month of operation has returned 2.87% before fees. “Most recent housing trends continue to deteriorate,” the Paulson letter said, and went on to point to a spike in housing inventory as a sign of what it called “declining fundamentals”. The letter also noted that it had hired veteran economist A. Gary Schilling to provide economic analysis for the new fund. A quick review of Schilling’s research – attached to the letter - shows that he will not be arguing with Paulson’s team about the direction of home prices. “The U.S. housing bubble is deflating, and bulls hope average house prices will not drop the 20 percent or more we foresee,” Schilling predicts. “With [house price] appreciation evaporating, refinancing will dry up and foreclosures leap.”

Link here.

More fall behind on mortgages.

More homeowners with shaky credit are falling behind on their mortgage payments, especially in such states as Ohio, Alabama, Tennessee, Michigan and West Virginia, where job losses have struck the local economies, the Mortgage Bankers Association said. The problem is the worst for those with subprime credit who pay higher-than-usual interest rates and who have adjustable loans that have been resetting to higher rates. About 12.2% of such borrowers were late paying their loans in April through June, the highest level since the end of 2003.

About 25% of all mortgages carry adjustable rates, and more than half of those loans are to subprime borrowers. As a result, delinquencies are expected to rise through next year as more adjustable-rate mortgages reset to higher rates, sending ripples through family finances and housing markets. Calls to the Homeownership Preservation Foundation, which provides free credit counseling, hit a record 2,464 in August, a 25% jump over July. More than half of the distressed callers had ARM loans.

“It’s alarming. It really is,” says Pam Canada, executive director of the NeighborWorks Homeownership Center in Sacramento. Her non-profit counseling center used to receive two or three calls a week from homeowners in financial quicksand. Now, it is 20 a week. “It’s remarkable. We used to take walk-in (clients), but we don’t do that anymore. We just can’t.”

Link here.

Lenders rally to stem foreclosures as interest rates increase.

The lending business is marshaling its forces on an unprecedented scale to get in front of what could be a flood of foreclosures. Mindful that conventional methods of reaching out to financially troubled homeowners generally do not work, lenders, investors and loan officers are joining with nonprofit counseling agencies to coax reticent borrowers to come forward so they will not lose their homes. They have also talked the Advertising Council into launching a 3-year public service campaign aimed at persuading late payers to come out from behind their locked doors and talk to impartial, third-party counselors about how they can get back on the straight and narrow. Also on tap is a syndicated Spanish-language soap opera that contains subtle hints about what to do if you cannot pay your mortgage.

It is too early to know how many owners will face the possibility of being unable to make their house payments. But 167,000 new families are entering foreclosure every three months, according to the Mortgage Bankers Association. And that could just be the proverbial tip of the iceberg. With mortgage rates climbing, millions more borrowers with pay-option and interest-only loans face the prospect of larger payments in the coming months. Even those with conventional adjustable-rate mortgages will feel the pinch. An estimated $375 billion worth of loans will adjust to higher rates this year and $1 trillion in 2007, according to PolicyLab Consulting Group, an Ithaca, N.Y., firm with expertise in housing economics. Add in higher energy costs, higher homeowners’ insurance premiums and higher taxes, and it is easy to see a disaster in the making.

Lenders and the companies that administer loans have a wide array of tools at their disposal to help troubled borrowers. Among other things, they can reduce or suspend your payments and cancel late fees, allow you to make up what you owe in small increments over 24 months, add what you owe to your loan balance and allow you to start over with a clean slate, sometimes at a lower interest rate, or extend the term of your loan. But in many instances borrowers do not reach out to their lenders. Many people believe their lenders want to take their houses away from them because they make money doing so. But lenders lose too – up to 60 cents on the dollar, in some cases. The typical cost of a foreclosure, which is a long, drawn-out legal procedure that can take months in some states, is $59,800, according to Freddie Mac.

Link here.

AmEx allows customers to charge condo down payments.

American Express will begin allowing select customers to use its credit cards to charge their condominium down payments. Currently, the service will be limited to buyers of luxury condos in Manhattan, as American Express rolls out the program with New York real-estate firm Moinian Group for one its projects under construction. Both companies say they plan to expand the service. The change will allow the customers a chance to earn reward points and frequent-flyer miles, getting one point for every dollar charged. Moinian will pay a fee to American Express for every transaction. Condo buyers will not be charged any additional fees.

Link here.

Help! Home for sale.

Travel agent Terry Likens and his partner, contractor Duane Przybilla, own a three-bedroom, four-bath townhouse in Eden Prairie, Minnesota. They would rather have a single-family house with more space and a backyard. So they want to sell – but these days, that is a problem. When they bought their home for $294,000 in June of 2004, real estate inventory was flying off the shelves, even in the relatively calm markets of the Upper Midwest.

Homeowners in the Minneapolis metro region had enjoyed steady house price increases for years – an average of 9% a year for the 4 years through June 2005, according to the Office of Federal Housing Enterprise Oversight (OFHEO). In the year since, prices grew just 4.7%. For Likens and Przybilla, the problem is not that their townhouse has been on the market so long – it has been only four weeks – it is that it has attracted almost zero interest. “The hardest part is not being able to pursue new properties,” says Likens. “We already lost the house we really wanted.”

The failure to attract any buyers is not the house’s fault – it shows well. Everything is in mint condition and Eden Prairie is less than 10 miles from downtown Minneapolis. Despite all that, only two showings of the house have taken place since it was put on the market. Likens does not think the price – $327,900 – is the problem. It was arrived at with lots of input from Mary Condon, their Coldwell Banker Burnet agent, and other area brokers. They even held an open house just for agents so they could get feedback on how much they should ask. According to Condon, Minneapolis market conditions are still decent, but the Likens/Przybilla property is in a challenging price category. “There are currently 140 similar priced homes (between $250,000-$350,000) in Eden Prairie, and there’s a 7.9 month supply of homes in this price range,” she said.

Not selling has hurt, though. Losing the house they wanted hurt even more. The alternative would have been holding two mortgages at once – an option that would have made them even more anxious to sell and could induce them to accept a really low bid. Already they do not expect to make any money on the sale, after selling expenses.

Link here.


Analyzing Fannie Mae is like driving without a road map in a foreign country full of unfamiliar traffic rules. The lack of audited financial statements (no road map) and poor understanding of traffic rules (no precedent in financial history) does not give one very much conviction about the value of an equity stake in this behemoth. So let us start with what we know about Fannie.

Fannie is a “government-sponsored enterprise” (GSE), but it is owned entirely by private stock market investors. The fact that it is “government sponsored” enters the equation if you consider the implied government guarantee backing most of the bonds issued by Fannie. Implied government backing has never been tested in a liquidity crisis – an instance when most expect the federal government would make up any potential shortfall of interest and principal payments to Fannie bondholders. So Fannie can issue bonds with a microscopic spread, or interest rate premium over Treasury bond yields. For example, if 30-year Treasury yields were 6.2%, Fannie could issue an enormous amount of 30-year bonds somewhere around 6.3%. Fannie has a structural competitive advantage over all private financial institutions in the business of providing capital for home mortgages. Just like most banks, whereby Fannie floats debt at the most competitive rates across the yield curve and invests this borrowed capital in higher-yielding assets, pocketing the spread between the rates paid by its assets and the rates paid out to its bondholders.

This spread business is fairly straightforward. As long as the small premium it pays over treasury yields does not widen dramatically, Fannie can underwrite as many mortgages as the market demands, subject to limitations imposed by its regulator, the OFHEO. This has been a license to print money for decades and was the #1 factor behind the phenomenal return of FNM stock during the 1980s and 1990s.

One would expect Fannie executives to be content with this business and not “kill the goose that lays the golden eggs,” but a combination of hubris, greed, and pressure to surpass Wall Street’s rising expectations led to an ill-conceived foray into the “credit-default swap” (CDS) business. Similar to MGIC’s business, the CDS business involves two parties – the sellers and the buyers of default risk. MGIC buys/shoulders mortgage default risk in return for a future stream of mortgage insurance premiums. Fannie’s involvement in CDS parallels MGIC’s role in private mortgage insurance, but Fannie guarantees the value of mortgage-backed securities.

The mortgage-backed security (MBS) is the vehicle that has enabled the globalization and socialization of mortgage supply and default risk. In this default insurance segment of its business, Fannie cobbles together a pool of mortgages that it purchases from mortgage brokers. These mortgages bear similar sizes and risk profiles and are bundled together to form a security that closely mirrors a bond (but includes an expected level of default and “prepayment” risk). This feat of financial engineering enables, for example, a group of Japanese retirees to finance the mortgage of a crane operator in Buffalo. Geographical boundaries and prudent lending practices at your local bank are no longer limitations to mortgage growth. The result has been the hyper growth of the mortgage business.

Is this necessarily a bad thing? Not according to Alan Greenspan and the Wall Street establishment. They argue, convincingly, that the diversification of mortgage risk makes global capital markets far more efficient and minimizes the chance of a major bank having “life-threatening” exposure to a depressed regional economy. But praise of this financial engineering ignores or minimizes the self-reinforcing cycle of aggressive lending practices leading to higher house prices, which leads to more aggressive lending, which leads to even higher house prices. Once this beast was unleashed, it took on a life of its own. Two additional factors that the cheerleaders of the MBS market ignore and minimize are human error in the pricing of risk and moral hazard. Misunderstanding the risks involved with financing a home purchase on the other side of the world can lead to an abrupt liquidity crisis when the momentum behind the housing market stalls, as it has now.

Enron was humming along nicely, raising enormous amounts of capital from “efficient markets”, which are commonly elevated to omniscient status, until the company hit a liquidity crunch in which lenders declined to continue financing its giant Ponzi scheme. The important lesson investors should take away from Enron is not how to detect an elaborate accounting fraud, but to expect that greed and fear will overwhelm the “efficient market” theory when the providers of capital underestimate their own capacity for error. Human error and the chances of underpricing default risk should not be underestimated.

The term “moral hazard” originated with the insurance industry and refers to the incentive of the insured party to increase risky behavior now that it no longer has monetary responsibility for the consequences of risk. Applied to the MBS phenomenon, one can think of mortgage brokers as the insured party. Because they do not retain and service them on their books, they approve mortgage applications that they otherwise would reject as excessively risky. In effect, institutional and international providers of capital act as insurance companies that seem unaware of how risky their agents are acting in underwriting mortgages. This disconnect will prove to be a huge problem. This does not really become obvious until housing market conditions worsen further. Then we will find out the consequences of hypergrowth in mortgage securitization.

Link here (scroll down to piece by Dan Amoss).


The timing was excellent – Anne Evers, the editor of The Gold Report wanted to interview Bob Prechter, and Bob was in the midst of publishing a new book about using the Wave Principle to forecast gold and silver over the years. The Gold Report published the interview last week on its web site and Anne graciously gave us permission to publish some excerpts from it.

TGR: Historically, gold has risen as the dollar has declined, but the correlation has not been as strong recently. Where do you believe the U.S. dollar is headed, and how do you think it will affect gold and silver?

Bob Prechter: On the contrary, I think gold and the Dollar Index have been acting pretty well in concert. The correlation is not exact, but market correlations rarely are. Gold tested its low in 2001, and the dollar topped in 2001, five months later. The dollar bottomed in December 2004, rallied and then tested its low in May 2006, the same month that gold topped. Under the Wave Principle, psychology is typically very bearish at the low of “wave 2”, which is essentially a test of the previous low. The sentiment towards the dollar in 2006 was nearly as bearish as it was in 2004 at the low, and the final surge in the gold rally was an expression of that sentiment. I think if you study the historical record, you will see that gold and the Dollar Index are generally in no stronger sync than they have been recently. All that aside, though, there is no reason why the two markets have to trend together. If the euro and other currencies were to inflate faster than the dollar, and if the psychology of the markets were such as to reflect the difference, then the Dollar Index could quite easily go up while gold was going up.

TGR: More than three years ago … you said: “We are more in debt now than in any time in the history of the country. That is setting the stage for the problems we face.” Since then, both the government and consumers have continued to dig themselves deeper and deeper into debt. Do you still believe, as you did then, that the markets and the economy are headed for a crash? And what impact will that have on the gold market?

Bob Prechter: I believe more than ever that a crash is how the debt bubble will deflate. If you plot the DJIA in terms of gold, you will see that the stock market has been crashing relentlessly since 2000 and recently hit a level equivalent to Dow 4000. In other words, if we had begun pricing the Dow in terms of gold in January 2000, it would have fallen by 2/3. It would not be sitting near its high. So the only place I am wrong about a crash is in the nominal figures. But I think that is coming, too. If I am correct that the crash will be deflationary, it will not make gold go up. People will be scrambling for dollars to pay interest and principal on those debts you mentioned.

TGR: Exchange Traded Funds are relatively new – in fact the first silver ETF was only just recently launched. How do you think these affect the gold and silver markets? Do you believe these are good investment vehicles for precious metals?

Bob Prechter: The new ETFs will have no impact on the level of pricing. But their creation does say something about market psychology. Usually – although not always – financiers create trading vehicles when a market has been hot. The only advantage I see to trading gold ETFs instead of gold futures is when a trader does not trust himself to stay off leverage. Otherwise, it is just another scorecard for the Great Asset Mania. …

Right now I think gold is in a bear market, so I am not recommending either. But generally speaking, the best time to buy gold shares is when you are bullish on the stock market along with gold. Aside from the 1970s, there is a more persistent correlation between gold stocks and the DJIA than there is between gold stocks and gold bullion. The time to own bullion over stocks is when you are bullish on gold and bearish on the stock market. … I always want to have a ready mechanism to buy gold if I think it is going to enter or extend a bull market and also to own some gold as a hedge against draconian measures by the money monopolists. In extreme monetary times, when one needs a real asset that is not an IOU and is not easily manipulated, gold is the top choice. …

I think it is vitally important that gold, silver and the DJIA peaked within the same 24-hour period in May. … I have been making the case that liquidity has been driving all the hot markets together, and that includes real estate, copper, oil, foreign currencies and junk bonds. I further contend that when deflation hits, these markets are likely to go down together. So there will be no “hedge” investment, no markets in which to get rich while other suffer as there were in the 1970s. The only refuge will be safe cash equivalents, and they are few and far between. If you want to get safe from the crash, I spelled out how to do so in Conquer the Crash. Look around. Real estate is slumping fast. Gold and silver are down from their highs. The S&P is still 15% below its 2000 high, and its rally from 2002 looks tired. The hype on oil is relentless and deafening, but its net gain for the past year is zero. Despite massive credit inflation, grain prices have been falling. I think these are warning signs of the crash I have been talking about. Gold bugs say that the Fed can inflate the economy out of any difficulty. I guess we will soon find out.

Link here.


A “disorderly” drop in the dollar is the biggest risk to world financial markets, the IMF said, urging policy makers to prepare and act quickly when asset prices slump. Investors are buying U.S. bonds under the assumption that the dollar will not slide, and a drop in the currency might turn into a rout as foreign investors and central banks move to cut losses, the global financial watchdog said. “A low-probability but potentially high-cost risk to the global financial system is that a dollar decline could become self-reinforcing and hence disorderly,” the IMF said in its Global Financial Stability Report.

Last week, IMF Managing Director Rodrigo De Rato singled out lopsided global trade and investment flows, protectionist sentiment and high energy prices as sources of concern to an otherwise benign outlook for the global economy. The IMF says the U.S. current account deficit, running at a record rate, needs to narrow. The dollar has fallen 6.8% against the euro this year. It was recently little changed at $1.2710 against the euro and fetched 117.6 yen.

Link here.

U.S. dollar “cover story”.

We are no strangers to scrutinizing the subject matter of certain magazine covers, specifically when they involve financial markets gracing the front page of popular news weeklies. Take, for example, the U.S. dollar back in late 2004/early 2005, when the bold FACE of many major magazines from The Economist to NewsWeek was clear: “Let the Dollar Drop” … “The Disappearing Dollar” … “The Incredible Shrinking Dollar”.

At the time, the greenback had plunged over 30% from its 2001 high to land at an record low against the euro, a 12-year low against the British Pound, and a 5-year low against the Japanese Yen. And according to Wall Street, the only thing the U.S. note was physically fit for was a coffin, with everyone from Bill Gates to Alan Greenspan predicting “further decline” in the years ahead. Even the Oracle of Omaha, Warren Buffet, had boarded the dollar bear bandwagon by increasing his short position against the currency to $21.4 billion by December 31, 2004 (vs. $zero$ in 2002) In his own words, even the Federal Reserve would not be able to stave off “the day of reckoning.”

By then, glossy prints depicting the dollar’s demise were a dime a dozen – one reason we believed the persistence and force of the downtrend was over. In December 2004 our analysis was urgent: “For the first time ever, we start with the U.S. Dollar because the case for a bottom in this currency is an extraordinarily compelling one. It is a rare treat when the technical evidence confirms the waves so resoundingly. We are strongly bullish on the dollar. The upside reversal in 2005 should be measured in months, not weeks.” On December 30, the greenback came back to stage a 10-month long rally that tacked 15% onto its value before reversing south.

Flash ahead to today and we see the return of the luck stops here for the buck bears. And, in the September 8 Short Term Update, we mention that a recent Futures magazine has placed the “Incredible shrinking Dollar” on its COVER. This sign, along with a very familiar wave pattern, brings STU to one conclusion: “The movement is finally allowing us to eliminate various potentials and focus on the dominant path for the coming month, which remains” clear.

Elliott Wave International September 11 lead article.
USD: Can they answer this simple question? – link.


OK, it is clear now. For so long it did not make sense why the boards of America’s biggest corporations would risk legal sanction and public humiliation just to give their executives an even bigger payday. More than 100 companies are under investigation by the SEC for sneaky options dealings despite the fact that managements had giant compensation packages even before the alleged finagling. You would think CEOs would have been content to get rich slowly as their company’s stock rose over time, and let the compensation committee stick to routine matters like the number of ski trips allowed on the corporate jet, how many Super Bowl tickets to purchase, which side of home plate for World Series seats, etc.

But last week the light came on, and in the unlikeliest of places – a meeting of the Senate Banking Committee. It was there that SEC Chairman Christopher Cox helped the senators understand, as gently and professionally as possible, that it was Congress’s fault that CEOs and board members were behaving badly. The story goes something like this: The year 1993 was much like 2006 in that the level of CEO pay was getting embarrassing, especially compared to the salaries of say, mortals. Lawmakers’ constituents were complaining that CEOs were not accountable, and some were miffed that every dollar companies paid their leaders was deductible from the company’s tax bill. And at a time when the federal budget was under duress, was not this, if not an abomination, at least a little annoying?

So Congress felt compelled to do something, and what they did was tell companies that they could pay their honchos whatever they wanted (this is, after all, a free country, and if executives want to hand pick their boards and ignore shareholder resolutions to limit their pay, then who in the name of George Jefferson should stop them?), but they could not deduct more than $1 million per executive from their corporate tax bill. It was about that time that executives and their boards decided to align the interests of management with those of shareholders. This way everyone would be working toward a common goal, which is to make sure that their CEO is richer than your CEO. As luck would have it, the best way to ensure such an alignment is to switch some of that taxable (to the company) salary to a non-taxable (to the company) stock option program. In fact, not only were stock options a better tax deal for the company, they were not even an expense, according to the accounting rules. In those days, companies and executives could have their cake, eat it and not worry a whit about cholesterol.

But this magical dessert was too radical for the matter-of-fact bunch at the Financial Accounting Standards Board (FASB). They lacked the creativity to understand how a CEO’s boats, houses, and racehorses could be displayed in plain sight, and yet neither a fine tooth comb nor an electron microscope could find the compensation making title to those assets possible anywhere on the income statement. Silicon Valley executives issued a collective shudder at the thought of putting down on paper what they were costing the company. This was the same collective shudder that shook a lot of money out of the corporate coffers, money that just happened to land in pockets of lobbyists. These corporate liaisons who are responsible for ferrying political ideas from their corporate hosts to our representatives in Congress, suddenly saw how the something-for-nothing economy was just what America needed. Thus inspired, they worked as effectively as malaria-bearing mosquitoes, spreading their passion throughout our legislative body. Congress became so infected with the idea that they voted down FASB’s proposal to account for something as something, so the rules accounting for something as nothing remained intact.

But this is not the revelation revealed in the Senate Banking Committee. After all, tossing stock options towards executives like confetti is the prerogative of the company, as any red-blooded board member and golfing buddy of the CEO will tell you. No sir, the seeds of the scandal lie in insidious tax law. While corporations can typically deduct the $1 million salary plus stock option compensation for each executive, the option deduction is only allowable if the options are granted at-the-money. If the options have a strike price at a discount to market (in-the-money), that would be something for nothing today, rather than something for nothing tomorrow. Bottom line: Something for nothing tomorrow is tax deductible but something for nothing today is not.

And there is the revelation. Since there are penalties for granting in-the-money stock options, particularly if not disclosed to shareholders, there is suddenly a temptation to say the options were issued on a certain date in the past when the stock price was lower. This is like placing a pork chop on the coffee table and expecting the dog to just let it sit there until a human wanders by to remove it. So should the rest of America ask corporate America to have more self-control than a Golden Retriever? At least some members of the Senate Banking Committee do not think temptation can be resisted under current law, and that the law must be changed to account for this quirk of human nature. There is talk of nixing the $1 million limit on deductability, or at least raising it. This would get us back to enriching CEOs the old fashioned way. With cash.

Link here.


Whenever you add a speculative play to your portfolio, it is important to be honest about its potential. Any stock could fall to zero, but many of those speculative picks with the tempting “make-it-or-break-it” stories are the ones that could most likely break not only new 52-week lows, but also your spirit. This was the situation I found myself in last week. Shares of a small pharmaceutical company I had been following for some time were hit hard when an FDA advisory panel voted that a proposed leukemia drug should not receive federal approval. And as far as I am concerned, this is the final blow to a company that has seen its fair share of bad luck over the past couple of years. But like I said, this was an all-or-nothing deal.

Link here.


When the word “controversy” is raised among computer gaming circles, this controversial company’s name cannot be too far behind. It is still months away from releasing the next installment of the most controversial and intense releases to legions of fans, but already the anticipation is mounting, and the parental groups are lining up to protest, indirectly promoting the latest game. And it does not hurt that a multi-billionaire corporate raider just bought 800,000 shares.

By October 17, shares of one beaten down software-company are likely to come back with a vengeance when its parent-scaring subsidiary releases its long-awaited software. When it released its controversial Grand Theft Auto game in 2001, the stock ran from $4 to $10. In 2002, it ran from $22 to $23.50. In 2004, it ran from $16 to $21. And in 2005, it ran from $18 to about $22 in a month’s time. But come 10/17, RockStar Games’ Bully will be released, and could help refill the gaping bearish gap left at $16 – a possible 45% short-term return for patient shareholders.

Is any publicity good publicity? If you are Mel Gibson … uh, no. But negative publicity can put an afterburner under video game sales. I love the Grand Theft Auto games. In fact, I am one of millions that cannot wait for Bully to hit the shelves, and would not have heard about it if it were not for those groups and the media, which have a tendency to blow things way out of control. But just why are people up in arms about a game? Many are upset because they fear another Columbine-type situation – the game’s main character is a 15-year-old boy who has to defend himself against school bullies at a fictional boarding school in the U.S. while dealing with nerds, jocks, and authoritarians with weapons including baseball bats, stink bombs, and bags of marbles. According to the New York Times, “Anti-game activists claimed that it would encourage players to become bullies themselves.”

Billionaires are not dumb investors. Take Carl Icahn, who is known for buying up shares in companies and then pushing for major changes that may affect the company very positively. In recent quarters, he has bought shares of Symantec and Cigna, and now, Take-Two Interactive (TTWO: NASDAQ). According to an SEC filing, Icahn now owns a 1.1% stake in Take-Two. It is unknown how he plans to positively affect the company after its recent legal issues, SEC and FTC investigations, and a Grand Jury investigation – all of which are priced into the stock. We can assume he has a plan for where he would like to take Take-Two.

There you have it. Two great reasons to be ultra-bullish on Take-Two shares: the October 2006 release of Bully and a multi-billionaire’s purchase of 800,000 shares. Plus, as of late-July 2006, more than 44% of the 72 million share-float was short. Shorts covering en masse come holiday shopping season could send the stock screaming much higher.

Link here.


For years, investors have shrugged off the swelling trade deficit as yet another sign of the strength of the U.S. consumer. “So what if we buy a ton of imports?” they say. “At least we can.” The trade deficit should come in at about $800 billion this year. To keep things in perspective, that works out to about 6% of the massive $13 trillion U.S. economy. If you are thinking, “Big deal, 6 percent,” consider that any other country that would dare maintain such a high debt would have had its currency slaughtered by now.

Make no mistake, we are not forced to play by the rules. For many reasons – mainly because we boast most-favored-economic-nation status, hold the current title to the world’s reserve currency and buy more exports than any other country – our creditors simply look the other way. But that does not mean our creditors, who control about half the U.S. Treasury market, have relinquished control to the debtors. That would be like the proverbial inmates running the asylum.

For years, our creditors – call that the rest of the world – have increasingly extended us debt because U.S. interest rates were higher than those anywhere else. But that dynamic is changing. Growth here is slowing, and fast, which implies interest rates should be headed south, and soon. The last thing a creditor wants to hear is that your credit standing is deteriorating and you will not be able to compensate by paying higher interest rates. At the same time, interest rates outside the U.S. have risen, which means there is more than one safe option out there for cash stashers. The bottom line: Over the last year, the risk has increased that the U.S. will not be able to carry its debt load indefinitely.

In true perverse fashion, the silver lining is that the expected boom in growth outside the U.S. is coming to a premature end. Apparently the rest of the world is still susceptible to catching a cold when we sneeze. That implies that faltering demand in the U.S. will drag down interest rates abroad. In the end, our creditors may find another reason to look the other way, even if our interest rates fall – because they have no choice but to keep the U.S. economy’s lifeline afloat.

Link here.


Let us play a game. The game is called “Agree or Disagree”. To play this game, we will look at a lengthy article by Stephen Roach entitled “On the Road to Global Rebalancing”. In italics are statements by Roach. My responses are in normal print.

It was exactly six years ago when I first coined the term ‘Global Rebalancing.’ The equity bubble had burst, America was heading into recession, and an unbalanced, U.S.-centric global economy was in trouble. A rebalancing was in order, I argued at the time – and the sooner the better!” Agree.

An unbalanced world was able to buy time. With the benefit of hindsight, it is not that difficult to figure out how. Fearful of a Japanese-style deflation in the aftermath of a burst equity bubble, America’s Federal Reserve rushed to the rescue – spearheading a massive monetary easing that pushed short-term interest rates down to the unheard of 1% threshold. That prompted a seamless move from one asset bubble to another, as the property market took over where equities left off.” Agree.

Courtesy of state-of-the-art financial technologies, U.S. homeowners were quick to extract equity from an increasingly frothy housing market – and use the proceeds to fund both consumption and saving.” Violently disagree. It is pure insanity for any economist to suggest that extracting equity (borrowing against one’s home) can in any way, shape, or form “fund savings”.

Time has finally run out for an unbalanced world. Just like the demise of the equity bubble over six years ago, America’s property bubble is now in the process of bursting. Moreover, a sharp resurgence of equity markets is unlikely as corporate profit margins now come under pressure. That means the days of asset-driven support to U.S. consumption are coming to an end. For American households, that spells a return to basics – the need to draw support from income generation, rather than wealth creation. That points to a likely increase in personal saving and, as a result, less of a need for foreign saving – setting the stage for a reduction in America’s gaping current account and trade deficits.” Agree.

… [T]he non-U.S. world must move actively to embrace policies that boost private consumption. This will wean the world from excess dependence on the American consumer – tempering the damage from a U.S.-led export compression scenario.” Disagree. The pool of real funding is most likely negative. The imbalances are not because of excessive savings abroad, but because of lack of saving in the U.S. It seems silly to promote consumption bubbles elsewhere just because the consumption bubble is bursting in the U.S.

[T]he stewards of globalization – namely, G-7 finance ministers, the IMF, and the world’s major central banks – must remain committed to rebalancing. So far, so good. …” Disagree. So far, so bad is more like it. … It is a joke to suggest that anyone is serious about global rebalancing anymore than they are serious about solving trade issues. … [N]o one is serious enough to do anything more than talk while hiding under the mask of blatant protectionism.

There is no quick fix for an unbalanced world. Many harbor the false illusion that currency adjustments – namely, a significant depreciation of the U.S. dollar – could provide a shortcut to global rebalancing.” Agree.

Lulled into a false sense of complacency by America's prolonged bubble-induced consumption binge, the rest of the world is unprepared for a very different post-bubble climate.” Agree.

Yet the rebalancing of an unbalanced world is far too important and far too delicate an operation to be left to the whims of overextended markets. Policymakers around the world must rise to the occasion.” Violently disagree. The reason we are in the fix we are in is because policymakers thought they knew better than the markets. Greenspan blew bubble after bubble. The market was not concerned about Y2K, but Greenspan was. He fueled a massive bubble in dot-coms and fiber as a result. Even though consumers or housing were not tapped out, the Greenspan Fed fueled the biggest housing bubble the world has ever seen by slashing rates to 1%.

Is there any way we could possibly be more imbalanced if market forces, rather than the Fed, were attempting to control interest rate policy? Roach clearly understands the problem. His unfounded optimism as of late is based on thinking that what caused the problem is going to cure it. Sorry, Roach, your optimism and faith in central bankers everywhere is simply unfounded.

Link here.


On September 5, 2006, Chevron Corp. announced, “That it successfully completed a record-setting production test on the Jack #2 well at Walker Ridge Block 758 in the U.S. Gulf of Mexico. The Jack well was completed and tested in 7,000 feet of water, and more than 20,000 feet under the seafloor. … More than half a dozen world records for test equipment pressure, depth, and duration in deep water were set during the Jack well test.” It is the deepest successful well test drilled to date in the Gulf, at a total depth of 28,175 feet.

Absolutely, this is historic. Chevron has accomplished what until recently many observers thought was all but impossible. Chevron’s success in the deep water of the Gulf of Mexico was not, to be sure, the first deep well ever drilled in deep water. There have been other deep holes drilled in the Gulf and in other parts of the world. And there are similar efforts being conducted in the Gulf, and planned elsewhere, by other oil companies. Furthermore, the Chevron announcement is not exactly new news. The Jack #2 well was drilled in 2004, and Chevron ’ its partners spent much of the past two years evaluating and testing the prospect. But Chevron's technical teams apparently required a large amount of additional testing, data gathering, and analysis in order to determine future development plans. Thus, Chevron kept its information under wraps until last week.

Neither Chevron nor its partner companies have yet publicized detailed information on the oil quality or reservoir parameters of Jack #2. These data are considered proprietary, and certainly cost a lot of money for Chevron et al. to acquire. Neither Chevron nor its partners have described the quality of the oil or gas, sulfur content, or the oil-to-gas ratio of the reservoirs. However, the implication is that the reservoirs are oil-dominant. The Jack #2 well is remote from all existing subsea oil-gathering pipelines, so moving any oil to shore poses a major logistic problem. Early-stage figures on field development in the vicinity of Jack #2 are yielding cost estimates of $80-120 million per well drilled, plus as much as $1.3-1.5 billion for subsea facilities. Again, only deep pockets need apply.

By way of comparison, Chevron’s Tahiti project, located elsewhere in the deep water of the Gulf of Mexico, will begin producing in 2008 and carries a $3.5 billion price tag. Tahiti will produce an estimated 125,000 barrels per day, thus carrying an up-front price tag of $28,000 of capital expenditure per barrel of oil equivalent produced per day. In another Gulf of Mexico project, Chevron’s Blind Faith project will cost an estimated $1 billion and yield an estimated 30,000 barrels per day, for a capital expenditure of $33,000 per barrel of oil equivalent produced per day. This is quite a contrast to the historically adjusted cost of capital expenditure for shallow-water, shelf development in the Gulf of Mexico, which is about $1,000 per barrel of oil equivalent produced per day. In other words, deep-water development may be 30 times as expensive as shallow-water offshore development. That is what I call “oil patch sticker shock.”

All things considered, the Chevron flow test was outstanding. And timing or no, Chevron’s well is an immense achievement by the company, its partners, and the many other vendors, subtier vendors and members of the team who contributed to bringing Jack #2 to fruition. There will be other deep-water wells, of course. In all likelihood, there will be many others. But Jack #2 stands alone in one respect. Its announcement is a milestone on the pioneering trail of applying immense measures of resources to solve a great problem. Chevron’s is among the first confirmations of a significant oil discovery in a frontier exploration area, the deep-water Gulf, now that mankind has moved onto the backside of Hubbert’s curve.

The Chevron well is emblematic of the culture and industry of our modern, industrial, immensely complex, and interrelated world. Jack #2 is not just another oil well, but is instead the culmination of literally decades’ worth of fundamental research and development work by industry, academe, and government. And the Chevron well has been made possible only due to a vast array of utterly spectacular, and fairly recent, developments in numerous scientific and engineering fields, coupled with people who are willing to place big bets on very risky plays. The Chevron effort marks a leap ahead in using advanced technology to find oil, but it should not be confused with the “technology will save us” line of thinking. Like Oprah says, “Don’t go there.”

For many years, cumulative worldwide oil extraction and depletion has exceeded new oil discovery by a wide margin. Chevron has not nullified Peak Oil. Jack #2, in fact, demonstrates a key element of the Peak Oil thesis: the “easy” oil is gone. Mankind has been drilling it up, lifting it out of the ground, and burning it into heat and vapor for the past 147 years. The oil that mankind will lift from the earth in the future, on the far side of Peak Oil, will be in faraway places, in harsh climates, under excruciatingly difficult conditions, deep down, heavy, sour, and overall expensive. So welcome back to the world of Peak Oil, if perchance you ever left. Yes, by all means, break out the champagne for Chevron. Like the famous story of legendary baseball great Babe Ruth, Chevron has walked up to the plate, pointed to the distant bleachers, and smacked the ball right out of the park. And the crowd goes wild!

But remember that Babe Ruth struck out a lot more times than he hit home runs. And understand that the game we are playing, in order to fuel our oil-addicted culture, is far from over. In fact, the game that we are playing never ends.

Link here.
There’s a hole in the bottom of the sea – link.


“Siphon the gasoline from your tanks! … Sell the stuff for whatever you can get and buy it cheaper next week!” Or, at least, that is what the financial markets seem to be saying. The wholesale price of unleaded gasoline is crashing, and eager buyers have become as scarce as Swiss baseball players. The shares of oil-refining companies are also crashing, .and eager buyers have become as scarce as – well – Puerto Rican yodelers.

Is unleaded a buy? Are oil refining stocks a buy? “Yes,” is the answer. But we have no idea when, or at what price. Over the last six weeks, the wholesale price of unleaded gasoline has tumbled from $2.35 a gallon to $1.60. Gasoline, therefore is 30% cheaper than it was just last month. This “discount pricing” offers no assurance that eager buyers will return, but it does suggest that eager sellers might take a break for a while. Therefore, contrarian investors might want to examine the possibility of nibbling on one of the many beaten-down oil-refining stocks.

But first, let us examine the main reasons why this “falling knife” could continue falling for a while. U.S. gasoline supplies are ample, gasoline demand is slipping somewhat and refining margins have imploded from their mid-summer highs. From March through June, most oil refiners were earning more than $15 a barrel to convert crude oil into gasoline and other distillates. But now they are earning less than $5 a barrel. Not surprisingly, oil refining stocks have been sinking as fast as refining margins (see graph).

But refining margins are as volatile as gasoline itself. So there are probably worse investment ideas than buying refining stocks when margins are poor, with the expectation that they will recover. Eventually. If there is any “buy” in the energy complex – and we are not at all certain that there is yet – the refining stocks may be it. However, buying refining stocks outright, in the midst of the current washout, requires more valor, or stupidity, or brilliance, than most of us investors possess. Therefore, the intrepid refining-stock bull might consider two strategies: (1) Long-dated call options (or bull spreads) on the refining stock of choice. (2) A pair trade in which one would buy a basket of refining stocks and sell short a basket of exploration and production (E&P) companies.

Even after Tuesday’s shellacking, the S&P Index of E&P stocks clings to a slim gain since late July. Over the same timeframe, however, the S&P Index of refining stocks has tumbled 30%. Admittedly, no “Absolute Law of Mean Reversion” would require these two energy-stock sectors to re-converge toward one another. But, eventually, the same falling crude oil prices that hurt the E&P companies tend to help the refining companies. Cheap crude is a good thing for a refiner, as long as gasoline prices are not also plummeting – like they are now. Net-net, the ferocious selling of unleaded gasoline seems a bit overdone, at least relative to crude oil. Likewise, the ferocious selling of refining stocks seems a bit overdone, at least relative to E&P stocks.

Coincidentally, the commercial unleaded gasoline traders have reduced their net short position to almost nothing – their smallest net short position in nearly two years. This “smart money” crowd has tended to amass its largest short position just before unleaded prices were about to fall, and its smallest short position, just before prices were about to rise. Their current miniscule short position, therefore, suggests that the selloff in unleaded is probably drawing to a close. Still not convinced that refining stocks might be a “buy”? Jim Cramer thinks they are a “sell”.

Link here (scroll down to piece by Eric J. Fry).


As is often the manner of mercurial financial backdrops, a marketplace can decide it does not care about a particular development. It may for some time ignore the development, becoming only more dismissive to the point that it appears the market will refuse to ever care – only to abruptly change course and perhaps care very intensely. The markets will now care about the phenomenon of rising U.S. labor costs, although they are not today at all clear as to why. I want to say right from the get-go that, while it is my view that income inflation has evolved into a key inflationary manifestation, my thinking is much less clear when it comes to analyzing consequences over the short, intermediate and longer-terms. And as much as I expect the markets to now follow wage and income developments with decidedly keener interest, I at the same time expect ample confusion with regard to ramifications for traditional inflation measures, the financial markets and economies.

Most conventional analysis is disappointingly superficial. With the structures of today’s financial and economic spheres virtually unrecognizable from those in place during the 1970s, analyzing current income developments in the context of a ‘70s “wage/price spiral” is likely a fruitless exercise. The Fed apparently also maintains a sanguine view of rising pay, comforted that it remains “difficult for corporations to pass along costs.” This all miss the essence of contemporary inflation dynamics.

I doubt we are on the cusp of a rapid ‘70s-style acceleration in consumer price inflation. The vast supply of contemporary output – including imports, digital media, technology, telecommunications services, medical, education, financial services and “services” generally – works to restrain rapid general price index gains. I would also be surprised if rising wage pressures put much of an immediate dent in corporate bottom lines. Rising incomes are more of an upshot of a protracted credit-induced corporate profits boom, with corporate and government sectors increasingly flush with finance – flush, that is, for as long as the credit bubble is sustained (creating the backdrop for a future profits collapse and government deficit explosion).

Perpetuating a perilous dynamic, inflation’s effects (and evils) will likely remain highly insidious. Inflation will creep and skulk. Rather than alarming jumps in measures of the general price level that would force the Fed to actually tighten financial conditions, traditional inflation indictors will offer up hope that recent price gains will prove fleeting. Certainly, the Fed and the markets expect that a housing-led economic slowdown will repress price pressures. Perhaps. But as I analyze the mosaic of credit, financial, and economic data – with a diligent study of credit creation, liquidity and speculative dynamics, and the resulting flow of finance – I come to an analytical perspective with respect to today’s income inflation much at variance with conventional thinking.

The resiliency of inflated home prices in the face of rapidly slowing sales, higher rates and bulging inventories is both a notable and major 2006 development. Stable to somewhat rising prices in many markets have supported (and been supported by) continued rapid mortgage credit growth. The housing equity “piggybank”, in particular, is bolstered by prices that have to this point stabilized at inflated levels. The year could see record equity extraction and yet another year of double-digit mortgage credit growth, with rising wages also surely helping mitigate the burden of enlarged adjustable-rate mortgage payments. And I would imagine that wage and income trends are inspiring to the energized MBS, ABS and mortgage derivatives marketplaces. Heightened income inflation is today playing a prominent role in prolonging the mortgage finance bubble.

Continued robust mortgage borrowings and huge ongoing corporate and government debt growth combine for record total system credit growth, this despite the significant decline in home sales transactions. The unrelenting massive credit expansion – pursuant to several years of an intensifying inflationary bias permeating the wages and incomes arena – readily explains today’s heightened income inflation. Credit growth, then, continues to buttress home prices, in the process bolstering the aged credit bubble and its brethren, the stock market bubble.

With market talk turning to recession – and even the occasional whisper of deflation – the Income Inflation issue is sure to get the analytical short shrift. I am certainly mindful that U.S. and global bond yields are in retreat, energy prices are in a marked decline, and commodity prices are also seemingly affirming the slowdown view. Yet, if income inflation is today underpinning housing prices, credit growth, consumption, and current account deficits, we must also recognize that this inflationary manifestations is quite likely poised to bolster U.S. and global liquidity. Instead of the much anticipated housing downturn initiating a credit slowdown and long overdue imbalance adjustment period, we could very well witness a further round of credit bubble perpetuation and liquidity over-abundance.

Especially considering the global prominence of speculation and derivative hedging strategies, I would not rule out the possibility that the decline in U.S. and international bond yields is more “technical” in nature than a fundamental response to slowing growth, waning liquidity and quiescent inflation. Indeed, a decent case can be made that the highly liquid global backdrop has again thrust a robust inflationary bias upon U.S. Treasury, agency, and MBS markets, forcing prices up and yields down. And with speculators and hedgers caught on the wrong side of bearish rate bets, one can assume that market dynamics have forced retrenchment in a number of similarly-minded speculations (certainly including the global “reflation trade”). Moreover, the good fortune so far enjoyed with respect to energy supplies this year only puts further pressure on speculators that had placed bets with inflation and potential commodities shortages in mind.

Considering the poor state of U.S. housing markets, to what extent lower mortgage and market yields stimulate the U.S. bubble economy is very much an open question. But I will suggest that lower global yields will almost certainly add fuel to already strong economies abroad. I have no desire to go out on the limb with guesses as to what extent the commodities bulls will be shaken out of their increasingly painful energy and commodities bets. But I remain very circumspect of notions of waning inflationary pressures in the U.S. or world economies.

Labor markets are a notoriously unwieldy animal to corral once let loose, and this one awhile ago slipped out the back when no one was paying attention. The Fed does apparently recognize expanding labor shortages and “sharp wage increases or wage pressures,” including workers in information technology, finance, accounting, nursing and healthcare, trucking and transportation, engineering, oil services, and other “skilled positions”. Pressures are clearly broad-based, while “salaries offered for positions that are difficult to fill have increased substantially.”

To wrap this up, it is my view that (“inflation”) expectations have changed rather dramatically. Workers in an increasing number of sectors, industries and skill levels – unlike the late-90’s boom largely isolated within the tech industry! – have come to demand more pay, while businesses are able and increasingly willing (because of expectations for ongoing profit inflation) to aptly accommodate. When it comes to “anchored inflation expectations,” the Fed should pay less heed to Treasury yields and devote more attention to salary and income trends. But I have seen no indication that the Fed appreciates the nature of, nor ramifications for, today’s income inflation.

Link here (scroll down to last subheading in page content column).


There is total detachment from the bad news that is pouring out of the economy. For several years, the booming housing market has made the difference between recession and recovery for the U.S. economy. Zooming house valuations provided private households with the collateral that allowed them to replace the missing income growth with a borrowing binge. But as the housing market is sagging, this major source of higher consumer spending is plainly drying up, and most obviously and importantly, income growth is by no means catching up. In 2005, real disposable incomes of private households in the U.S. increased $93.8 billion, or 1.2%, while their debts grew $1.2 trillion, or 11.7%. Total consumer spending on goods, services and new housing accounted for 92% of real GDP growth.

The U.S. economy’s recovery from the recession in 2001 has been its slowest in the whole postwar period, and in addition, it has been of a most unusual pattern. Real GDP rose by 11.7% over the four years to 2005. Within this aggregate, residential building soared by 35.6%. Consumption gained 13.4% and government spending 10%. The big laggard in domestic spending was business nonresidential investment, up only 3.6%. Net exports year for year were increasingly negative.

Most economic data have softened, with the downtrend accelerating. In the face of this fact, it could not be doubted that Mr. Ben Bernanke and most others in the Federal Reserve were anxious to stop their rate hikes. In question was only whether they would dare to do so in view of the high and rising inflation rates. They dared. They even disappointed those who had predicted the combination of a declared “pause” with hawkish remarks about fighting inflation. During the first seven months of 2006 the CPI has risen at a 4.8% seasonally adjusted annual rate, compared with an increase of 3.4% for all of 2005.

It is, of course, perfectly true that monetary tightening impacts the economy and its inflation rates with a pretty long delay. The trouble in the U.S. case is that there never was any monetary tightening. There were many small rate hikes, and the Greenspan Fed had probably hoped that the higher costs of borrowing would exert some restraint on credit demand. But it was a vain hope. The fact is that the credit expansion has sharply accelerated during these two years of rate hikes instead of decelerating. Over the two years of so-called monetary tightening, the flow of new credit has effectively accelerated by 56%. Over the whole period of rate hikes, it had steadily accelerated from quarter to quarter. Borrowers and lenders, apparently, simply adjusted to the higher rates, trusting that there would never be serious tightening.

True monetary tightening would have to show first of all in declining “excess reserves” of banks relative to their reserve requirements. These have remained at an elevated level during the rate-hike years of 2004-05. In 1991, when the Fed tightened, credit expansion slowed sharply. A sharp slowdown in credit expansion in 2000 also happened. Yet this still represented very strong credit growth in comparison with the years until 1997.

Like all central banks, the Federal Reserve has two levers at its disposal to stimulate or to retard credit and money creation. The big lever is its open market operations, buying or selling government bonds, thereby increasing the banking system’s liquid reserves. The little lever consists of altering its short-term interest rate, the federal funds rate, thereby influencing the costs of credit.

It is most important to distinguish between the two instruments. True monetary tightening has to show inexorably in a slower credit expansion throughout the financial system. There is one sure way for a central bank to enforce this, and that is by curtailing bank reserves through selling government bonds. he other lever at its disposal, as pointed out, is to influence credit costs. But the influence of the central bank on credit costs begins and ends with altering its short-term federal funds rate. During the past two years, the Fed has raised its federal funds rate from 1% to 5.25%. But long-term rates hardly budged.

Monetary tightening has one purpose – to curb credit expansion fueling the excess spending in the economy and the markets. By this measure, Greenspan’s monetary tightening since 2004 has been a sheer farce. During these two years, he presided over a sharply accelerating credit boom, for which the reason is also obvious. To equate rising short-term rates automatically with monetary tightening can, therefore, be a gross mistake.

It can be argued that rate hikes in the past have generally worked. Yes, but the central bankers of the past never forgot to tighten bank reserves. But this time, the diametric opposite has happened. There was reserve easing. Money and credit, moreover, only became significantly more expensive at the short end. All the time, there was nothing in this to slow the housing bubble and the associated borrowing binge. Rising house prices easily offset the effect of rising short-term rates.

Does this mean that the economy can continue to grow as before? Not at all. All excesses, if not stopped, are sure to exhaust themselves over time. That is no less true for economies than for the human body. In our view, the housing bubble is finished not because credit has become tight, but because the borrowing excesses are running against natural barriers. One such natural barrier is the affordability of housing and the limited number of greater fools who are able and willing to pay these inflated prices. Affordability is way down, units offered for sale are way up and price appreciation has all but stopped. It is a radical change in the market situation, which, however, has so far impacted economic activity only moderately.

Present American folklore has it that a protracted slump in house prices is impossible. Let us say for many people it is unthinkable. And that is precisely one reason why this housing bubble could go to such unprecedented excess. The little historical knowledge we have about bursting housing bubbles is from a study published by the IMF in April 2003. An important theme running through its analysis is that housing price busts were associated with more severe macroeconomic developments than equity price busts. Coupled with the fact that housing price booms were more likely (than equity price booms) to be followed by busts, the implication is that housing price booms present significant risks.

Link here.


This is the safest way to make money. It is safer than bonds, safer than stocks and far safer than speculating in options or futures. If you invested only in this vehicle, you would be better off than 90% of your neighbors, co-workers and poker buddies. Personally, I swear by it. It is one of the best ways to safely grow wealthy – no matter what happens to the stock market. Since the beginning of 2006, the S&P 500 is up 5.6%. Not bad. But you could be sitting on gains of at least five times that large. And you would have had to assume 33% less risk.

This “magic” investment vehicle I am talking about is none other than your boring, ignored and misunderstood 401(k) account. Roll your eyes if you wish. But hear me out … This past Saturday, I was at a football game with three friends. All are in their mid- to late 20s. All have solid jobs. And all are smart guys. But one of them, Randy, has never contributed to his 401(k) plan. Never! While drinking a few beers in the parking lot, we tried to explain to Randy why he is the biggest moron ever. I went first: “Look, Randy, over the course of the year, the funds I have invested in for my 401(k) are up only 1.9%. That sounds puny considering the market is up about 5%. But because of the matching system my employer has, my real returns are above 30%. … My 401(k) gives me a chance to take some calculated risks with very little downside. For instance, I can invest in emerging markets, metals and smaller-capitalization stocks and never have to worry. Thanks to my employer’s matching system, it would take a massive downturn in the markets for me to lose any money. And more than likely, I am going to make quite a bit – even if the market stumbles a bit, like it did earlier this year.”

Link here.


Today, as I write this article, a financial storm continues to build. Still, most people do not want to be bothered with the details. With such pretty pie charts predicting fair winds, they feel secure aboard the “USS Stocks for the Long Term,” chanting the “Buy-n-Hold” mantra should they ever feel a tinge of concern. Yet, when this modern marvel collides with the iceberg of science and history, the pain will cause them to begin searching for what went wrong. Understandably, they want their lives to go as normal. Unfortunately, the thinly disguised marketing materials most investors (and advisors) look to for guidance carry a heavy consequence which will affect many for the rest of their lives.

“Please, Proceed to the Nearest Exit,” will be a short series of articles, which will show that to “buy and hold” without an exit strategy is dangerous, reckless, and naive. This series should also make it very apparent that the “money game” is not a gentlemen’s sport. In reality, it is more like engaging in hand-to-hand combat. If you doubt this and do not understand how dirty the money game is yet, just save this article and read it again later. The bear is once again rap tap tapping on our chamber door.

But first, I must diffuse the “few bad apples” argument. In his book, The Pied Pipers of Wall Street: How Analysts Sell You Down the River, Benjamin Mark Cole notes that when it comes to Wall Street Analysts’ recommendations, the word “sell” is rarely, if ever, heard. “Of 33,169 ‘buy,’ ‘sell,’ and ‘hold’ recommendations made by brokerage analysts in 1999, only 125 were pure sells. That means just 0.3 percent of recommendations were ‘sells,’ according to data put together by Zacks Investment Research. There were another 224 recommendations, or 0.7 percent, that could be interpreted as ‘sells,’ such as rankings with such tepid language as ‘market underperformer.’”

If you are thinking, “Yeah, but surely this all changed after the Crash of 2000 (to 2002),” that would be understandable. From 2000 to 2002, the S&P 500 lost 50%, the NASDAQ lost over 75%, and the Dow lost about 35%. Still, these two charts (here and here), produced in September of 2005 in Alan Newman’s Stock Market Crosscurrents, show that while insiders sold 6.7 million shares and bought 7520 shares (a ratio of 929 to 1) analysts’ sell recommendations came in at only 4%. So why would analysts issue so many buy and hold recommendations and so few sell recommendations while industry insiders flee their own companies’ stocks? Two words – “Investment Banking”.

In May of 1975, Wall Street said goodbye to fixed commission rates, regulated by the New York Stock Exchange, and said hello to the competition. And of course, this had an unintended effect. You see, while investors won the battle to transact at lower costs, they lost the war on solid research. A 1997 study by the Securities Industry Association (SIA) revealed that in the 1960s, when the commissions were fixed, they amounted to approximately 60% of the industry’s revenues. By 1997, commissions comprised only 16% of revenues. Though Wall Street widened the spread (between the bid and the ask) and pocketed it to make up for lost commission revenue, they also found their way into the lucrative world of investment banking. Brokerages also made a great deal of money in mergers and acquisitions. As such, this area of Wall Street has also seen stellar growth.

So what happened to the few analysts that dared defy the institutional banking interests issuing negative reports? I could list dozens of examples from any number of books, but for the sake of time, we will just look at one. … While I would like to believe that the industry and the regulators could do something to change this situation to benefit the investors, market history tells me it is far more likely that the pain brought about by a bear market will produce the needed effect.

Link here.
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