Wealth International, Limited

Finance Digest for Week of April 9, 2007

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


We cannot be certain that the “Smart Money” would be selling the shares of mortgage lenders, but we would not rule out the possibility. The sub-prime sector is already a huge disaster. The rest of the mortgage-lending industry might follow. It has become popular to suggest that the worst is over – that the recent implosion in the sub-prime sector is great for the surviving lenders. They will be able to buy baskets of distressed loans on the cheap, the optimists say, and that is really going to power their earnings going forward.

Maybe they are right. I am not omniscient. But I would want to have more evidence of a recovery before investing in mortgage lenders ... with my money. In fact, I think you would have a much better shot at these stocks from the short side – much, much better. Many stocks in the mortgage-lending industry are still trading up around the levels where they were trading two years ago, before all this deterioration began.

Another Smart Money “sell” might be ethanol stocks. Ethanol could be a good industry for certain individuals, or for certain producers. I do not think it is a great industry for a public shareholder. The reasons why are numerous. But I would point first to the laws of physics. A researcher at Cornell University, David Pimental, who has described corn-based ethanol production as “subsidized, unsustainable food-burning. Ethanol does not provide energy security for the future. It is not a renewable energy source.” According to his research, the energy required to produce one gallon of ethanol is actually 30% greater than the yield. Pimental may not be right. His assumptions may be erroneous. But if you are going to invest in ethanol, you would want to be certain that he is wrong. Good luck with that.

I liken U.S. ethanol production to using caviar to make cat food. You are taking imported foreign oil and dumping it into a production process that yields a “renewable resource” where the energy return on energy invested is probably no better than 1-to-1. So much for energy independence. In addition, the economics of ethanol production itself are questionable. Without the 51¢/gallon government subsidy, most ethanol producers are not making money. These economics could change with market conditions. But the more ethanol we produce, the higher the price of corn rises, the less profitable ethanol production becomes. I am not picking on the ethanol industry? I am just saying that if you sit here today and look at things that might not benefit the minority shareholders of a public company over a 5-year or a 10-year period of time, ethanol is one industry that fits the bill.

Now that we have mentioned a few Smart Money “sells”, what might be a few Smart Money “buys”?

(1) Gold, and other things that do not combust near an open flame. We are in an environment where the U.S. dollar is under pressure. I think it will continue to be under pressure as far out as we can imagine. And any asset that provides a reasonable hedge against dollar weakness seems like an okay place to be.

(2) Alternative Energies. Ex-ethanol, obviously. We are in a world where solar, wind and every other form of alternative energy provides less than 1% of total electricity production worldwide. So even knowing the drawbacks and the high-cost of some alternative energy technologies, it seems very likely that they will capture a growing share of global electricity production, even if this share remains a very small minority. 2% of the global market at some point would double the current market share. 3% would triple it. Whatever the number, the market share trend is definitely higher. And this is a long-term trend. So you might want to poke around in this area.

(3) Water. Here at the Rude Awakening, we have written probably 25 columns about water investments during the last year. Chris Mayer wrote most of them. Also, he and I produced a report on water stocks a while back. Even if you forget everything else that I have said today, do not forget what I am about to say about water stocks. I think this is an area you really want to keep an eye on. The ramifications of the current global water crisis – and it is a crisis – are far-reaching. So the investment opportunities are also far-reaching. They are not always intuitive, but they are far-reaching. Let us look at a sampling of the traditional big-picture issues of the global water crisis:

In China, water has finally become a major economic issue, rather than “just” a major health issue. Filthy water has always been a developing world “thing” that most of the world’s major economies have ignored. It has not ever been a front-burner investment idea. But finally, the water-related health issues in places like China and India have become so enormous that they have become economic issues. Polluted water, and the related health-care costs, is trimming GDP in China by 0.5% per year, or maybe even 1%. And it is getting worse and worse.

Jim Rogers, among others, believes that water is the Achilles heel of the Chinese economy. If the Chinese can not figure out a way to purify their water for the population, Rogers says, the economy will cease growing, and maybe even contract. China has become one of the world’s largest investors in water purification and infrastructure. This is a new phenomenon. We are seeing, really for the first time, urgent investment in water purification, water infrastructure, etc. Not just in the developing world, but also in the developed world.

There are several companies in Singapore that focus on purification in Asia. Chris Mayer has written about is called Hyflux Ltd. “It may sound strange to talk about a global water crisis,” Chris wrote recently, “Then again, it probably sounded strange to talk about $60 oil when it cost little more than $13 per barrel in 1999.” T. Boone Pickens just made a huge investment in water in the Southwestern U.S. Jimmy Rogers has also been talking about making water investments. This story is not yet on the front page of the newspapers, but it is a terrific long-term story. Therein lies the opportunity.

Here in the Developed World, the main water opportunities have to do with repairing aging infrastructure. We are not drinking filthy water here in the U.S., but our usage is extremely inefficient. That is true throughout the Developed World. Much of that inefficiency derives from the fact that the infrastructure is quite old. America’s water pipes are just one example. In 1980 only about 10% of America’s water pipes needed to be replaced. Today, that figure is closer to 25%, and it is on track to go to 45% by 2020. We have got to get busy replacing pipes. The dollar value of these various investment needs is in the “who knows?” category. But in general, we are looking at $1 trillion over the next decade in global infrastructure and water treatment projects, and $1 trillion domestically over the next decade. Those are both big numbers that could make a lot of profit for a lot of companies.

Water supply is also an issue, especially in places like here in the Southwest. Most of Southern California and most of the American Southwest developed and prospered based on cheap and abundant water. It is no longer cheap and abundant. Throughout California, and here in Phoenix, and in many places throughout the Southwest, access to water is becoming an enormous issue. Therefore, the one thing about which everyone agrees is that the price of water is going up. In New Mexico, an acre foot of water in the Middle Rio Grande used to cost about $1,000 in 1993. Now it costs about $5,000. The trend is pretty clear, and this is still a young trend.

Over the last year or so, Chris Mayer has identified a number of water-related investments (the seven stocks have advanced an average of 38% since his recommendation. Despite these gains, Chris is still very excited about most of the stocks on this list.):

  1. Gorman-Rupp (AMEX: GRC)
  2. Nalco Holdings (NYSE: NLC)
  3. Lindsay Corp. (NYSE: LNN)
  4. Northwest Pipe (Nasdaq: NWPX)
  5. San Jose Water (NYSE: SJW)
  6. Hyflux ltd. (OTC: HYFXF)
  7. Pico (Nasdaq: PICO)

According to Fortune, “Water promises to be to the 21st century what oil was to the 20th century: the precious commodity that determines the wealth of nations.” If that is the case, water might also be the precious commodity that determines the wealth of portfolios.

Link here. (Part I complete article here, summary here.)


“Invest for the long-term.” ... “Diversify.” ... “We are in a period of Great Moderation in volatility, so don’t panic.” You should probably ignore all these soothing platitudes. Our suggestion is to panic now and avoid the rush later. In other words, sell risk. Don’t try to diversify your risk away. Sell it! Soothing axioms barely disguise the truth that markets today are more prone to volatility than ever, and that what we have recently witnessed may be just a taste of what is to come.

“An investor’s two best friends,” writes American financial guru Ben Stein, “are time and diversification. Get the broadest possible market indexes. Spread yourself out over large and small caps. Have a large dollop of the developed foreign and a goodly chunk of the developing market. Yes, it’ll be a rocky ride in China and Brazil, but over long periods you’ll do great.” Exactly what portion of your portfolio is a dollop? How do you tell a “goodly chunk” from a “badly chunk?”

Here is our beef with diversification, as most folks use the term: The idea of diversification relies on the existence of negative correlations between sectors or asset classes. When X zigs, Y tends to zag. And diversification makes sense if some things go up while others go down. But most financial markets have become dangerously correlated. We can no longer count on bonds to go down when inflation goes up, or gold to go up when stocks go down. Inverse correlations like these used to be more more reliable. Pre-Greenspan, there were certain inter-marker relationships that made sense and that you could prove with real performance data. There were also relationships between risk and reward that seemed more logical than what passes for logic today. In the “old days”, way back in 2000, risky bonds paid much higher rates of interest than Treasury bonds. No more.

Perhaps it sounds quaint today, but the high returns that used to be available on Emerging Market bonds were the reward you received for taking a risk with your capital. If you wanted a safe savings account, you were not going to make much money in it. But if you were willing to buy Brazilian stocks or Icelandic bonds, well that was another matter entirely. You might be crazy. However, you might also be right. And you deserved a few hundred extra basis points for being crazy, brave, and correct. But over the last four years, risk premia have nearly vanished. These days, everyone is crazy, no one is brave, and many people are wrong. We say no one is brave because bravery requires some knowledge or appreciation of the nature of the risk you are taking. And no one seems to think investing in shares is all that dangerous.

It has been, as then-Federal Reserve Governor Ben Bernanke said in 2004, an era of “the Great Moderation. Such an extended period of calm probably explains investors’ bold, risk-happy behaviour,” writes Corinne Lim in Australian Financial Review. Such an extended period of calm usually precedes all hell breaking loose. Stability breeds instability, as economist Hyman Minsky famously pointed out. There has been a ton of instability-breeding going on in the last few years. We have seen the first birth-pangs of instability. But not the last.

All of this happens for a simple reason. There is too much money chasing too few assets. This imbalance causes prices to rise ... and to rise ... and to rise, creating the impression that risk is not so risky after all. But this phenomenon does not mean that risk has vanished from certain types of assets. It just means you are no longer compensated for taking it.

Can diversification save you? What does that word even mean in a world flooded with liquidity and cheap money? How is it possible to truly diversify in a market where there is so much money chasing so few assets that everything is going up? When all asset classes start moving up because of excess liquidity, negative correlations tend to disappear. X and Y move up along with A, B, C, D, E, and F. With everything rising in lock-step over the last few years, is the risk not now that everything will fall in lock-step too?

So if you would like to stay ahead of financial fashions, panic now.

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


The bears burst out of hibernation on February 27, erasing the stock markets’ year-to-date gains and raising investors’ fears that the road ahead would be rough. David W. Tice, manager of the Prudent Bear fund, has been called “a longtime prophet of doom,” but correctly predicted the tech bust. “I’m very pessimistic and very convinced that there will be very hard times – equal to the 1930s,” said David W. Tice, perhaps the most prominent bear fund manager. “This has been an incredibly long bull market,” he said, one fueled by a “credit-induced boom.” He describes the current problems in the subprime mortgage market as the “first chink in the armor” and foresees a long bear market ahead.

Investment managers and analysts generally disagree on several counts with Mr. Tice – whose Dallas-based firm manages the Prudent Bear fund and the Prudent Global Income fund. They have far more faith that the American financial and economic systems will weather any squalls and they contend that in the long term, well-structured, diversified portfolios of stocks and bonds tailored to meet individual investment goals will do well. These analysts are also wary of investors’ ability to “time the market” — to buy at the trough and sell at the peak or, in the case of bear market funds, to buy when the market is high and get out when it nears bottom.

David Kathman, a mutual fund analyst at Morningstar, said of bear market funds: “Basically most people don’t need these funds and shouldn’t be messing around with them. They are very volatile.” Mr. Kathman called Mr. Tice “a longtime prophet of doom.” Nevertheless, he added, Mr. Tice was prescient in calling the 1999 bubble in technology stocks long before most analysts did. That was the same year when Mr. Tice cited problems of “accounting intrigue” at Tyco International, then a Wall Street favorite.

On Morningstar’s Web site, Mr. Kathman describes Prudent Bear as “the best of the bear-market funds.” It stands out because of its long-term performance, posting a 5.5% annualized total return over the five years through March, the only bear market fund tracked by Morningstar with positive 5-year results. (The category’s average was a decline of 9.7%, annualized.) Prudent Bear returned 9.1% in 2006, well below the 15.8% total return of the S&P 500, but in marked contrast to most bear market funds, which lost 8.9% on average. Prudent Bear, while focused on performing well in bear markets, managed to make money in good times because Mr. Tice and his associates manage it actively. Most bear market funds are managed strictly to perform in an inverse or double-inverse relationship to popular indexes like the Dow Jones industrial average or the S.& P. 500.

Like managers of the bear market funds that correlate inversely to indexes, the Tice group shorts stock index futures — that is, it sells borrowed holdings, repaying the debt with holdings bought later, presumably when prices are lower. But unlike those inverse funds, Prudent Bear also shorts particular stocks that Mr. Tice sees as especially vulnerable, and 18 percent of the portfolio is long in stocks of precious-metals companies. The fund also has “lots of cash” and Treasury issues, Mr. Tice said. If the portfolio performs as he expects in the bear market he foresees, it could be an encore: in 2002, Prudent Bear led its category with a gain of 62.9%. Mr. Tice forecasts a 50% to 60% decline in the market over the next two years. “What we have is gross credit excess” on both the personal and national levels, he said, and credit excesses fuel the speculative manias of classic boom-bust cycles. When the credit bubble bursts, both real estate and stock prices will fall, as will consumer spending, and jobs will be lost, he said.

The international situation is also precarious, in his view. “We are dependent on Japan, China, Russia, the Middle East to buy our debt,” Tice said. His second fund, Prudent Global Income, is essentially a bet against the dollar. It is invested in foreign and American Treasury debt and in gold and gold stocks. The fund returned 8.9% in the 12 months through March, 1.6 percentage points ahead of the world bond category, which it has outperformed over the past five years, as well, with an annualized total return of 9.4%.

Despite the relatively strong long-term records of Mr. Tice’s funds, few market professionals are ready to embrace his dismal forecast. “Look at history and look at logic,” Mr. Kochis said, pointing out that over time the market’s general trend has been up. Kurt Brouwer, president of Brouwer & Janachowski, an investment advisory firm in Tiburon, Califirnia, said the problem with market timing is that “you have to be right on timing, the direction and the duration — that is very difficult. The market’s big moves up are often shortly after a downturn.”

“There are other ways to reduce volatility and yet get solid returns,” Mr. Brouwer said. Bond funds are one category that has a counterbalancing effect, he said. He also uses stock funds with a particular strategic focus to offset risk in equity funds that correlate more closely to the overall market. The strategic funds he uses include the Merger fund, which seeks steady arbitrage profits from mergers and acquisitions; the Wintergreen fund, a world stock fund that Morningstar describes as “a hedge-fund-like mutual fund with a veteran manager,” David J. Winters; and the Legg Mason Opportunity Trust, which has done very well over the long term by relying on the idiosyncratic choices of the value manager Bill Miller. “It reduces those white-knuckle times,” said Mr. Brouwer.

Geoffrey H. Bobroff, a mutual fund industry consultant based in East Greenwich, R.I., said that a market correction is “a wake-up call to investors to rethink asset allocation.” But, speaking as everyman, Mr. Bobroff cautioned: “I don’t know if this correction is a short-term bear market or long-term. If I put the hedge on now, I may have missed the opportunity.”

Link here.


Stockholders and managers of firms, whose interests lie in higher prices for what they own or manage, miss few opportunities to deride short sellers. As Holman Jenkins of the Wall Street Journal put it, “short selling is a business widely unpopular with everyone who has a stake in seeing stock prices go up.”

Regulators, whose blunders short sellers frequently reveal by discovering fraud that escaped their attention, respond similarly. That combination of interests helps explain why, at various times, short selling has been banned in many countries, including England, France and Japan. Such views are reinforced by accusations that short sellers hope for bad things to happen. Others misplace the blame for the association between short selling and falling stock prices, especially in a “crisis”. All of these attacks are misguided.

Short selling is part of the information-revealing process that Mises, Hayek, and others emphasized as the central aspect and advantage of the market process. In a world of uncertainty and change, information is the scarcest good, and short selling is an important source of additional information that would otherwise be lost. Allowing short selling increases the number of people with an incentive to discover valuable information about firms’ prospects, by providing an added mechanism to benefit from information that turns out to be negative. Negative information may not be as valuable as positive information for purposes of cheerleading, but it is much more valuable for avoiding costly errors. Much of successful investing relies upon negative information – knowing some things not to do, rather than knowing what to do.

To attack or restrict short selling is then to restrict the market’s ability to elicit and integrate all available information. Short sellers have been portrayed as heartless opportunists, benefiting from bad outcomes. But they are no different than doctors who profit from illnesses, or teachers who profit from ignorance, or locksmiths who profit from thievery. Further, revealing mistakes is a far cry from just hoping for bad outcomes (just as parenting sometimes involves deflating children’s false hopes, not to harm them, but to help them make better choices).

What is called short selling in the stock market is a common risk-management process in all sorts of businesses. A farmer who sells on a futures market when he plants, before he has produced his output, does the same thing. There is no reason why a practice commonly accepted in business is somehow harmful to those participating in the stock market. Regulatory opposition, ironically, also indicates the positive consequences of allowing short selling. Regulatory agencies are supposed to prevent fraud, questionable accounting, and other management misbehavior. However, they often fail not only to prevent, but even to detect them. Short sellers who are betting their own money on being correct often uncover what regulators miss, as they did at Worldcom, Enron, Tyco, et al, showing themselves as more effective market policemen than the official regulators.

Opposition to short selling also confuses correlation with causation. A short seller’s negative assessment does not cause a negative outcome. Selling short cannot force a stock’s price down for long, if the fundamental circumstances do not justify it. Short sellers are attacked for allegedly spreading negative rumors that sometimes turn out to be false. But false positive rumors are regularly asserted by a far larger group who benefit by pumping up stock prices, from corporate managers to brokers to financial talk show touts.

Companies often directly attack them. For instance, The Economist reported, “Not long before Tyco went bankrupt it was still buying full-page advertisements to campaign against short-selling.” Within a month of Biovail filing suit against short sellers for expressing negative opinions about it, the SEC announced an investigation which led to a settlement involving serious fraud charges. A 2004 NBER study discussed the fact that “Firms use a variety of methods to impede short selling, including legal threats, investigations, lawsuits, and various technical actions.” It revealed the high probability that firms attacking short sellers actually have something to hide: “firms taking anti-shorting actions have in the subsequent year very low abnormal returns of about -2 percent per month.”

Short sellers receive widespread condemnation. But it is undeserved. They are no more self-interested than others in financial markets. They provide a valuable counter-balance to the barrage of hype and misinformation that issues from Wall Street and corporate boardrooms on a daily basis. Maybe it is time to stop selling short selling short.

Link here.

“VINTAGE 2007”

Robust March payroll data should put to rest the view of imminent Fed rate cuts. Nonfarm Payrolls jumped a much stronger-than-expected 180,000 (consensus estimate: 130,000). The unemployment rate declined from February’s 4.5% to 4.4% and has not been lower since May 2001. Average weekly hours worked, at 33.9, has not been higher since July 2001. Average hourly earnings were up 4.0% y-o-y.

From a macro credit perspective, persistently tight labor market conditions are no surprise. Total system credit creation remains extreme, with corporate borrowings proceeding at a record pace. With marketplace liquidity, stock prices and executive salaries still demonstrating enticing inflationary biases, there remains ample impetus for business spending, hiring and the aggressive pursuit of revenues and profits. Especially for skilled workers, labor today retains significant – and in some cases extraordinary – pricing power. And while a small percentage of households suffer mightily from the subprime debacle, a larger share of the population enjoy banner income growth. As we have witnessed repeatedly, bubbles have a powerful propensity to go to amazing extremes. The current corporate finance bubble is no exception.

Undoubtedly, mortgage problems are pervasive and festering. Considering the unprecedented degree of excess that prevailed across all income levels, property values and mortgage products throughout the protracted boom, there is every reason to expect the credit loss pathosis to eventually infect the entire mortgage industry. The much more challenging aspect of the analysis remains the timing, circumstances and ramifications of the unfolding mortgage credit bust.

I will posit that, typically, the general economy would have responded much more promptly to major housing and mortgage developments than has been the case this cycle. For one, a major housing adjustment would have in the past initiated a major slowdown in new mortgage credit and a marked slowing in total system credit (and liquidity). Over the past year or so we have witnessed something quite – one could argue radically – different. Total mortgage debt growth has remained significantly elevated, while total system credit and marketplace liquidity actually accelerated. While there have been some bouts of market nervousness, the feared deterioration in the general liquidity backdrop has not yet materialized. And instead of housing-induced consumer retrenchment, robust income growth and attendant home price resiliency have safeguarded interminable household spending excess. Rather than a general tightening of system credit, the historic expansion of Wall Street and market-based finance has, ironically, created the loosest financial conditions imaginable.

2006 mortgage loans already coming home to roost.

The “2006 Vintage” of residential mortgage loans is now recognized as being in a class by itself – recalling the 1999/2000 Vintage of telecom debt. This predicament supports a central tenet of macro credit theory: Credit losses (and maladjustment) expand in an exponential manner in the late stages of a credit boom. Invariably, the benefits of prolonging frenetic “Ponzi” financial schemes will appear much more appealing than the alternative. The fundamental backdrop in 2005 (and earlier) beckoned for a major tightening in mortgage lending standards, one that rampant marketplace liquidity ensured was delayed for a number of perilous quarters. The upshot was a year of absolutely atrocious lending that is now coming home to roost, along with ongoing excesses ensuring that the roosting process has years to run.

Examining the unfolding backdrop, one can envisage the scenario of heightened mortgage stress, intensifying downward pressure on real estate prices, unfolding debacles in California and other egregious real estate bubbles across the country, faltering corporate profits, a vicious stock market bear, serious household sector financial problems, dollar confidence issues and the bursting of the U.S. economic bubble. But this fundamental backdrop resonates within the marketplace today about as clearly as this year’s subprime meltdown did a year ago.

2007 problematic loan candidates proposed.

When it comes to “Vintage 2007”, certainly the M&A marketplace is working diligently to ensure subprime-like notoriety (infamy). Ditto the booming markets in credit “insurance” and credit “arbitrage”. In general, this year’s corporate debt issuance boom is highly suspect, especially the acutely vulnerable financial sector recklessly ballooning balance sheets with risky assets and depleting meager equity cushions through ridiculously excessive stock repurchases.

Much less distinct but definitely worth pondering is the possibility that the (by far) most problematic “Vintage 2007” debt issue will be the $1 trillion or so of additional credit the Rest of World extends this year to sustain U.S. credit and economic bubbles. Sustaining the boom will require ever larger foreign purchases of ABS, MBS, CLOs, CDOs and such – structures susceptible to waning market confidence. The U.S. current account deficit does not get the credit it deserves for its paramount role in fostering ongoing global liquidity excess. Basically, our credit system now creates and disburses $1 trillion of new IOUs – additional purchasing power – to the world each year. As long as global central banks and the leveraged speculating community step up to “recycle” much of this liquidity back to U.S. debt markets, this perpetual “money machine” works as well as subprime finance appeared to work in 2004/05. However, the insuperable credit bubble dilemma is that over time the quality of the underlying debt deteriorates progressively until – as it did recently with Wall Street and its subprime exposure – there reaches a point of recognition that risk has grown unacceptably high.

The market is dead wrong: The greatest risks reside in the core, not the perifery.

The problem for “Vintage 2007” U.S. “Ponzi” finance is that it has insidiously become acutely vulnerable to a flight away from U.S. securities markets. The entire U.S. financial sector’s debt structure is increasingly suspect. The greatest vulnerability could very well be “Vintage 2007” structured finance – CDOs, CPDOs, CDS and derivatives generally. U.S. securities markets continue to lag much of the rest of the world. Yet there is an ingrained market perception that financial tumult/crisis is invariably instigated at the periphery – that risks and excesses are greatest with the inherently fragile “emerging” markets. These markets have also tended in the past to perform as credible “canaries in the coalmine”, warning of more generalized financial turbulence. So with emerging markets again trading well and crude and commodities on the rise, complacency with respect to the general liquidity backdrop has returned with a vengeance.

Here is where the markets could have it gravely wrong: The greatest vulnerabilities associated with the most egregious (ongoing) excesses today reside not at the periphery but at the core. Indeed, current global liquidity excesses are now exacerbated by heightened excesses and flows away from the core, in the process masking heightened securities market fragility throughout the core. The confluence of $1 trillion “Ponzi” foreign-sourced funding requirements and suspect “Vintage 2007 and beyond” U.S. debt creation should keep us all on guard.

Link here.

Unicycle, bicycle, credit cycle or perpetual cycle?

The ridiculous starting phrase to this article above seems, to the author, in concert with the progression of what used to be known as, quite simply, the credit cycle. Put simply, business and consumers got frisky, the Fed raised rates/reserves, they got less frisky and the cycle restarted. We will refer to the bicycle as the point a couple of years ago when the Fed, consciously or unconsciously got the GSE’s in as augmentors of their interest rate cuts, liquidity expansions, etc. Listening to (some) of the Fed, and (most) of the regulatory entities, it would now seem they yearn for something like the old cycle. No bicycle this time as the GSE’s are still mildly unable to find reliable numbers and some politicians actually think they should concentrate on median housing for those left out of the sub-prime bubble, which was what they were created for in the first place.

How does a Perpetual cycle ensue if the Fed/Regulators etc. want a return to something new, but which brings about the result of the old cycle? We have discarded the likelihood of the old cycle coming back to life after 17 Fed rate rises not only failed to stem the bubble, but a combination of either their amplification of money supply or – more likely – a whole new money supply generation cyclic machinery inadvertently created out of the U.S. propensity to borrow to consume from virtually every other nation on earth.

If this is the case, there is a completely new set of players/machines at the helm! Even in the memory of some of the youngest is the parlous state of the rest of the world back in 1998. Now, in the aggregate, they have reserves over $5 trillion. The Fed’s balance sheet of a paltry $1.8 trillion shrinks in the shadow. The other new players, many of whom access greater or lesser parts of that $5 trillions include the hedge funds at $1.3 trillion (?) not including leverage; the private equity funds at much more than $1 trillion, depending on leverage and how you count or double count it; the mutual funds, still formidable at multi-trillions (even more if we throw in the money market fund; and the investment banks having doubled into more than $3 trillion.

All of these in the aggregate dwarf not only our fabled Fed but also the power of the rest of the central banks out there trying to realize they are operating in a different environment. (Remember though, those OTHER central banks are the guys with the $5 trillion in reserves!). Talk about conundrum. Somewhere in here it is worth mentioning that the multiple needed to grow a dollar of GDP has moved from roughly 1-1 in the process to heading for $6-to-$1 to produce the same dollar of GDP at the moment. Why and How? Credit creation that is completely outside the traditional central bank/fractional reserve commercial bank/borrower mechanism that prevailed for such a long time.

When the now renowned Greenspan took interest rates to 0%, the horde was let loose. The poor commercial banks and GSE’s were in bad stead from the dot-com/telecom disaster and had to go into shipyard for repairs, opening the door for the investment banks and the non-bank creations they had birthed to take off. The brokers (investment banks) doubled and, as past readers know, the world of hedge funds, private equity funds, ETFs, venture capital and other non-regulated lending went wild. Since the successful, valiant effort of the hedge funds to face down the SEC on registration succeeded, there have only been estimations and gross numbers to give some idea of how much credit has been created out here in the unregulated world. That $5 trillion in reserves vs. less than a trillion at the start of this run hints that the number must be at least the aggregate of the $25 trillion combined in the U.S. before government and agencies, if our hypotheses are anywhere in the ballpark.

What, if anything, will slow, halt or reverse this juggernaut (old name for battleship)? This observer, guided by mentors such as Doug Noland [writer of above article] has resisted premature pronouncement of the end, but is willing to hypothesize as such can always be dismissed as musings rather than predictions. We are willing to agree with some rather astute financial analysts who have recently observed that the credit cycle (old version) has turned. It is fairly evident from the slaughter in the world of sub-prime that the most egregious of “throughput” credit created by the alchemists on the Street has struck both the rock and the hard place.

Another astute analyst we follow is fairly certain of a 2008 recession. Again, we are in agreement, at least for the U.S. Happening to live in a state with the 2nd most ridiculous run-up in house prices over the last few years (California taking the crown in that race), we were perusing what goes for a local paper these days this morning. Even forewarned by our bear persuasion, we were still stunned by some data therein. The profligacy in south Florida has been amazing. With Chavez sending us floods of Venezuelans and the euro sending plenty of buyers from those countries, the real estate boom is lasting longer than anyone expected. The ultimate end of the cycle will not be pretty.

Nothing suggests any fear of central banks in the CSLUSCAD (“credit set loose by U.S. current account deficit”) gang in the quarter. Until something or some event instills some fear into this totally-free-to-roam party of high rolling deal makers driven by fee income and bonuses sufficient to lead to belief in invincibility, liquidity/money/wampum or whatever the economists want to call it will grow at the 12% rate in the U.S., the teens rate in Europe and the ridiculous 20’s, 30’s and even 40% rates seen throughout the globe.

Will inflation grow? According to John Williams of Shadow Government statistics, it already is in double figures. With rents being the owner equivalent rental income input, it is even growing in the official statistics. Will the Fed raise rates to stop it? Who cares, we are funded in yen anyhow, so the long end of the curve is dependent on the Japanese Central Bank, a pillar of strength. Will a recession occur? Almost certainly and it will truly be a conundrum for Helicopter Ben as any cut, while “Old Europe” continuing to raise rates may avalanche the dollar. Sad to say, to use the Oriental sense of the word, “We live in interesting times!”

Link here.


Is the U.S. current account deficit getting easy financing because of a lack of Asian debt issuances? It is an important question. Fitch Ratings estimates that China held $350 billion worth of U.S. Treasury securities at the end of 2006. It had an additional $230 billion in U.S. agency bonds. Large Asian holdings of U.S. debt are usually attributed to the region’s penchant for undervalued home currencies, which lead to chronic trade surpluses and a buildup of foreign reserves.

Is Asian mercantilism the dominant force behind the easy financing of the U.S. current account deficit, or is financial underdevelopment in Asia also playing a part? If the perceived Asian “savings glut” – as U.S. Federal Reserve Chairman Ben Bernanke termed it – stems from a shortage of Asian bonds, then it explains why doomsday scenarios for the U.S. currency may not materialize. “There are simply not enough Asia-outside-Japan bonds for the Asia-outside-Japan investors to purchase,” says Stephen Jen, Morgan Stanley’s global head of currency research.

Last year, when he was still the chief economist at the IMF, University of Chicago Professor Raghuram Rajan said that a scarce supply of new assets worldwide was leading to frothy valuations of existing ones. Everything from real-estate and high-risk credit to art and commodities, he said, was getting pricey. Jen has now given the global asset-shortage hypothesis a geographical twist to explain the counterintuitive flow of money from labor-surplus Asia, where it may earn a higher reward, to the developed world, where the returns are more sedate.

Along with petrodollars, Asia’s official reserves have been a cheap source for financing U.S. consumption. Starting in Q1 2004, the U.S. current account gap has remained at more than 5% of GDP, soaring to a record 7% in the final three months of 2005. For all of last year, the shortfall was 6.5%. A gradual deepening of Asian debt markets may reduce the region’s savings-investment gap and, by implication, narrow the U.S. current-account deficit. On the other hand, the impetus for bigger Asian bond markets may remain absent as long as the region continues to save more than it can invest at home.

At $830 billion, the Asian sovereign bond market is less than 10% the size of its U.S. and Japanese counterparts. The European market is 12 times as large, according to Jen. There is ample evidence that Asia’s current-account surplus – or excess savings – is keeping the region’s debt markets shallow. For example, in Hong Kong, India and South Korea, only 1% of housing loans are securitized, while in Japan and Malaysia, the ratio is between 5 percent and 6%, vs. 68% in the U.S. in 2005. What else could be causing this wide gap? “Asian savings sit in savings accounts, creating vast pools of liquidity that enable banks to offer mortgages and loans at rates with which the originators of securitized loans can’t compete,” Standard & Poor’s analyst Betty Tan said in a report last year. The corporate-bond market in China meets only 1.4% of the financial needs of companies in the fast-growing economy. If cash-rich banks are willing to throw money at companies without much of a credit analysis, where is the incentive for companies to go to a larger set of bond investors?

As for the underdeveloped market in sovereign debt, the culprit may be government savings. It appears that a liquidity glut is militating against Asia’s capacity to generate an adequate supply of financial assets that will allow it to keep its savings at home. That may well be the outcome that Asia prefers. It wants to continue giving money to the rest of the world, especially the U.S., so the latter keeps buying Asian-made goods. That is the “Revised Bretton Woods” hypothesis put forward by Michael Dooley of the University of California at Santa Cruz, and David Folkerts-Landau and Peter Garber of Deutsche Bank AG. And, in their view, too, the dollar is safe.

Link here.


A consortium of Middle Eastern investors and American buyout firms is preparing a $50 billion approach for Dow Chemical in what could be the world’s biggest ever leveraged buyout. Quoting sources close to the deal, The Sunday Express, a UK tabloid paper, said a financing package has been put in place for a break-up bid of between $52 to $58 a share and an approach valuing the company at least $50 billion could come by the end of this week. Dow’s shares closed up 35 cents at $44.47 on the New York Stock Exchange last Thursday.

At least half of the capital is being provided by investors from Saudi Arabia, Kuwait, Bahrain, Qatar, UAE and Oman, with the rest contributed by a number of U.S. buyout firms including Kohlberg Kravis Roberts, it said. Representatives of Dow Chemical and KKR were not immediately available for comment. The story follows reports in recent months that strategic changes were afoot at Dow, which has been moving toward a focus on specialty chemicals.

Analysts had said they were unsurprised at the report and expected Dow to split off its basic chemicals and plastics business as part of what it has called its “asset light” strategy, which would give it a more nimble and higher-margin profile focusing on specialty chemicals.

Link here.


POP quiz: What highly paid chief executive thought nothing of plunking down a thousand bucks for an ivory back scratcher? If you guessed L. Dennis Kozlowski, the former head of Tyco International, you are not being creative enough. The back-scratching C.E.O. is the fictitious C. Montgomery Burns of “The Simpsons” – he is the greedy owner of the nuclear power plant where Homer works. Alas, Mr. Burns is a piker compared with Mr. Kozlowski, who bought such goodies as a $15,000 dog-shaped umbrella stand.

In the world of executive compensation, fact often outstrips fiction, and even farce. That is why, when the topic is executive compensation, the word that naturally springs to mind is likely to be something like “egregious”, along with many others that are unsuitable for printing in a family newspaper. A word that does not readily leap to the tip of the tongue is “transparent”. Transparent is the word of our time, and it pops up in the context of anything from financial statements to government policies. It is somehow fitting that officials use a big, foggy word like “transparency” when what they really mean is “not lying” and “not hiding what we are really doing.” But that does not sound as nice or vague, does it?

So transparency is on the march, especially over at the S.E.C. The outrage over some of the big paychecks for corporate titans and the excesses in which they engage has spurred the S.E.C. to change its rules about how much companies have to disclose. The regulators want companies to tell us more about the nooks and crannies where they have tucked away the true value of their pay packages. But now that the disclosure forms are rolling in, experts say that if anything, the S.E.C. has achieved opacity. There is so much information that you cannot see the forest for the non-tax-qualified deferred compensation. “Most of us in the trade don’t know whether to laugh or cry,” said Brian T. Foley, an independent compensation consultant based in White Plains. “My own test is, can I read it through, or do I lose focus? I’ve been doing this for 30 years – if I lose focus, or can’t figure something out, God help the average person.”

It would be wrong to say specific companies are actively trying to conceal information, because they are paragons of corporate citizenship, and have libel lawyers. So I am not saying that at all. Really. But these forms sure are complicated, albeit in ways that almost certainly have nothing at all to do with an intent to obfuscate. The companies, after all, are simply fulfilling the rules as laid out by the S.E.C. The language that the S.E.C. itself used in the announcement of its interim final rules – or, as the S.E.C. so movingly put it, “17 CFR Parts 228 and 229 [Release Nos. 33-8765; 34-55009; File No. S7-03-06] RIN 3235-AI80 Executive Compensation Disclosure” – is not exactly transparent. The 53 pages of prose that followed does not quicken the heart.

It is not just whiners like reporters and compensation experts who say that things have gotten out of hand. Warren Buffett a few paragraphs in his 2006 Berkshire Hathaway annual report to skewer the complications of comp. In Berkshire’s portfolio of companies, Mr. Buffett writes, “I try to keep it both simple and fair.” The self-serving cycle of executive pay follows a juvenile “all the other kids have one” logic, he says, and he does not tolerate it in his shop. He also dislikes it at the 19 other corporations whose boards he has served on. At Berkshire, he writes, “I am a one-man compensation committee who determines the salaries and incentives for the C.E.O.’s of around 40 significant operating businesses.

“How much time does this aspect of my job take?” Buffett asks. “Virtually none. How many C.E.O.’s have voluntarily left us for other jobs in our 42-year history? Precisely none.” Now that is about as clear as it gets. But what does Warren know? I will bet his umbrella stand does not cost anywhere near $15,000.

Link here.


“If you asked a bunch of people sitting at a bar what the inflation rate was, you would get numbers closer to the truth than what the government says in its official numbers.” So said economist John Williams one afternoon. I made the trek to visit him, along with my publisher and friend Addison Wiggin. We wanted to meet the old fellow, whose work we hold in esteem. Truth seekers like Williams are dear, because lies are so cheap. And because not too many of us are willing to parse through thousands of pages of dry economic reports to get behind the government’s accounting alchemy. What follows is an update on some of Williams’s latest work and its investment implications.

In a nutshell, here is the story. Government officials, mere self-interested mortals like the rest of us, want to paint the best picture possible. This, they have found, tends to win them more elections. So every administration for years and years has made little adjustments in reported figures for things such as inflation. These little adjustments, as you might imagine, always go one way. They make things look better than they otherwise might. Over time, these little adjustments start adding up. Then you get big differences between what is really happening and what the reported figures say.

Williams has gone back and reversed these adjustments. Take a look at inflation, popularly measured using the consumer price index (CPI). The official numbers tell us inflation is less than 3%. Yet calculating inflation using the same methods from before Clinton took office, Williams gets inflation closer to 6%! The latter figure is nearer to the experiences of everyday people living in this country, who have to pay for groceries, gasoline, insurance, medical bills and more.

According to Williams, the primary ill of the modern economist is that “Something like 80% of economists get their annual forecasts wrong. So to be right more often, all you have to do is go against what most economists are saying.” Most economists, because they seem to take the data at face value, have a rosy view of the U.S. economy. No mainstream economist that I know of makes the case that the U.S. is in a recession. Yet Williams does not hesitate to tack against prevailing sentiment. “We are in an inflationary recession now,” he told us.

Williams ticks off the data that confirm a recession in progress: much weaker than expected housing starts, retail sales and industrial production. Also, a weak manufacturing survey, sluggish annual growth in durable goods orders, rising new claims for unemployment insurance and anemic employment growth. Williams’s Shadow Government Statistics shows the economy shrinking now, whereas the official government numbers still show positive growth.

We will not get into all of the details. But what does an inflationary recession mean for investors? Think 1970s. Not disco and bell-bottoms, but rising prices for gasoline, groceries and gold. Think higher interest rates. As an investor, you want to stay ahead of that inflation number, to keep your purchasing power. A bond yielding 5%, which is about what a 10-year Treasury pays, looks rather inadequate against an inflation rate of nearly 6% per Williams. Tangible assets tend to do better in environments like this. In the early 1970s, commodities soared even as the economy headed into recession. So long-term investors should look to own real assets – whether oil and gas in the ground, cheap raw land, water rights, ships, rigs or what have you.

Companies that can grow at a rate higher than inflation should reward investors as well, as long as you do not pay too much for them. Companies that should be able to swim upstream and boost cash flow in a sluggish economy include certain commodity and infrastructure businesses. And do not forget about opportunities abroad. In short: Buy cheap tangible assets with growing cash flows (“tangible assets that sweat”). It has been our playbook for a few years now. That, and do not trust the government’s numbers. Ever.

Link here.


Three Rules of Work: Out of clutter, find simplicity; from discord, find harmony; in the middle of difficulty lies opportunity.” ~~ Albert Einstein

We have come to an inflection point on the investment curve and are edging ever-closer to the “point of recognition” as it pertains to real estate. And real estate is key, because in my opinion its collapse will take down all asset classes for some time. Ergo, we humbly offer real estate’s new rules:

When it comes to selling your real estate, better a year too soon than a day too late. As real estate values deflate in the U.S., it is clear that different markets will take their lumps at different times, much the same way dot.com stocks bit the dust one at a time when the NASDAQ collapsed in 2000. Some areas will buck the trend and hold up better than others. But scattered markets throughout the U.S. have already experienced the onset of real estate deflation, more communities are faced with that reality each day, and the psychology is getting damaged beyond repair. Investment manias have always ended in deflationary depressions and we have just concluded the two grandest investment manias of all time, piled one on top of the other. Ideally, you will have sold your investment real estate in 2005-06, but you still have time to come out just fine. You will be a winner if you sell now and set the cash safely aside, even if it is a week, a month or a year too soon in your area.

If you are buying real estate to hold right now, you could lose your equity and ultimately your property. At the very least, you should be taking a wait-and-see approach to buying at this point. The risk/reward ratio is completely out of whack and the snowball is just beginning to form, near the top of this enormous and steep mountain. If you cannot see the danger and are buying property, face it – you could pay dearly.

Perhaps the best metaphor is that of a runaway freight train: Why take the chance of trying to grab hold and jump on now when the train has started to pick up steam on its way to careening wildly out of control? It makes entirely more sense to wait until the train crashes through everything, then comes to a wheezing, sputtering, exhausted stop. At that point not only can you board the train safely, you can buy it for next to nothing, restore it to its former glory, and guide it prudently back to the top of the mountain.

If you are counting on the Federal Reserve to “inflate” in order to save real estate’s bacon, I believe you are making a mistake. The market will be taking it from here and the Fed will be powerless to “fix the problem.” As Robert Prechter says, in Conquer the Crash (2002), “If people and corporations are unwilling to borrow and unable to finance debt, and if banks and investors are disinclined to lend, central banks cannot force them to do so. During deflation, they cannot even induce them to do so with a zero interest rate. ... the Fed’s purported ‘control’ of borrowing, lending and interest rates ultimately depends upon an accommodating market psychology and cannot be set by decree.”

Use common sense> Once people start depending on “the government” to preserve their investments, that little voice should be telling them that they are on shaky ground. This is a multi-trillion dollar problem and much too big for any central bank or policymaker to contain, particularly if lenders pull back and ordinary folks lose their appetite to borrow more money, which is what we see taking place right now.

Forget the statistics about home values holding up. They are not. Speaking of the government, do not rely on government statistics which indicate that real estate values are hardly falling at all. Of course, that varies from market to market but for the most part, it is nonsense. That hissing sound is housing bubble deflation. Ask any honest realtor if their market is changing. People in communities across America are walking away from their upside down, nothing-down mortgages as the housing mania unwinds. I would not be surprised if many (not all) U.S. real estate markets have already experienced 20% market declines in the most recent 18 month period.

The number of sales is down considerably – in many markets 30% to 40% – so the number of people willing to buy for just-beyond-peak prices has already dropped substantially. While the “average” may hold up statistically for a time, dunderheads willing to pay that average will be fewer and further between. As hokey real estate loans move closer to extinction and more equity is required to buy, the numbers will only get worse. The market is in the process of going splat, buyers are noticing and getting skittish, the mainstream media coverage is reinforcing the psychology and the foreclosure/lending/banking crisis has just begun. The challenges we face from the real estate shakeout become more daunting each day.

If you do buy a hardship property or get an amazing deal on something right now, by all means get in and get out. I recommend waiting to purchase an even better deal later on and avoiding the exposure of being a market timer right now, but if you do find something that is a particularly good buy or needs a lot of work and can be sold for a profit, get it done quickly. Buy it, fix it, sell it.

Foreclosures are everywhere, but remain patient. The deals will get even better as the crisis unfolds. Finding foreclosures will not be difficult (heck, Yahoo! just announced an online “Foreclosure Center” to take full advantage of the developing trend). But in two or three years, as the market goes ka-phlooey, there will be so many foreclosures to choose from you will have bargaining power beyond your wildest dreams.

Do not leverage into anything. During the credit contraction/liquidity crisis portion of the post-bubble meltdown, anyone who is leveraged will get punished. So do not borrow against one property to buy another, do not buy with little or nothing down, do not use your line of credit to buy real estate, and do not take on a teaser or negative-amortization loan betting on market appreciation going forward. Look at everything with the most critical eye you can muster right now. In fact, resist your urge to use leverage to buy any investment, including stocks and precious metals. All asset categories will fall together in the coming deflationary environment – at least for a time. The term “leverage” should become passé for quite a while.

If you buy now, there may be few or no willing buyers when you decide to sell (or are forced to sell). I know this is difficult to imagine after 70 years of real estate appreciation, but the last time the U.S. experienced a post-bubble, deflationary depression (1929-1933), real estate fell almost completely out of favor and property values fell precipitously. Unfortunately, because of the bigger bubble, I expect things to be even worse this time. Unlike a stock, if the real estate market “crashes”, you are not able to simply call a broker and sell it immediately. You may find a damaged buying psychology and no buying interest, and find yourself faced with the difficult choice of taking a loss each month or walking away from your investment.

If you do buy now, the next buyer may have a lot more trouble finding a loan even IF he wants to buy it from you. The subprime and Alt-A mortgage meltdowns offer hints as to what is to come. As foreclosures mount, lenders find it more difficult to pawn their irresponsible loans off on the secondary market and stop offering those loans. Dozens of lenders caught in the crosscurrent have already gone bankrupt. As the crisis unfolds, Fannie Mae will surely change the rules of their game, too. Undoubtedly, as values continue to fall, lending practices will become increasingly more stringent. At some point buyers will likely need significantly more real (i.e., unborrowed) cash to buy property. Those few with the necessary cash will certainly demand a much lower price. Therefore, even if financing is readily available to you for the time being, you must allow for a risk premium in case the next buyer faces a different climate. Of course, once again this suggests that you should not buy now. You will come out better if you wait until money is hard to get for most everyone, and you are the only one who can come to the party with cash.

If you plan to keep any property, get a long-term, fixed rate loan. Better yet, pay down the loan balance or pay it off completely. I recommend you sell all real estate right away (except for possibly your home), but if you do keep a particularly special property, make sure you do not have a balloon payment coming due in five years and risk the chance that replacement financing is no longer available. Better to lock in your financing now – long-term at fixed interest rates – in case the worst happens and it takes 15-20 years for values to rebound to today’s levels (which is a distinct possibility), or consider using proceeds from other property sales to pay off your loan entirely. When real estate values tanked during the Great Depression in the early 1930’s, financing became difficult to get, rents fell for eighteen years and it was not until 1954 that property values got back to par.

Stop borrowing against the equity of your home. I know this has been too easy and all-too-very tempting, especially when mortgage interest rates have been historically low and the interest is tax deductible in most cases, but this borrowing mentality got out of hand to the point that accessing your home equity became easier than getting financing on a new refrigerator. It really did feel like we were getting richer by the minute via Fed-created, artificial and short-lived value increases in our property. Alas, the rules of the game are changing. I know it will require an adjustment in thinking and old-school budgeting, but if you plan to keep your home and are fortunate enough to still have substantial equity, you must make the decision to live within your means. Pay down debt wherever you can. Safe cash will be king in the coming environment and you will be able to use that money to make money.

Do not listen to the National Association of Realtors, or anyone else in the industry whose livelihood depends on your willingness to place at-risk your hard-earned money. Listening to what these folks have to say is akin to walking into a car dealership and asking the salesman if today would be a good day to buy a car. I have been in the investment real estate business for 25 years and the N.A.R. has never taken any position other than, “Now is the best time to buy real estate!” They proclaim it in up markets, down markets, sideways markets, active markets, dead markets, high interest-rate markets, low interest-rate markets and this-little-piggy-went-to-the-market markets.

Be ready for the propaganda. They will say that “real estate values in the U.S. always go up in the long run,” (to them, “always” means since 1932. Real estate values collapsed in the U.S. after the Stock Market Crash of 1929 and also dropped an average of 70% over 16 year’q time in Japan’s very recent post-Nikkei bubble real estate deflation). The pimps will tell you authoritatively that the last time we had a downturn in the real estate market, it only lasted a few years at which point values took off again. They are right. 1990-1993 saw real estate values drop in the U.S. before the glorious run-up began. The problem is, this time it is a post-NASDAQ bubble, post-real estate and mortgage bubble-bubble long-term deflation situation, not a normal real estate down cycle. Eventually, they will tell you with great conviction that “we have reached the bottom” and they will continue to do so year after year after year forever and ever, Amen.

I may be early. I may be early wrong. Of course I believe my analysis is correct. I am in the real estate industry and obviously would not be writing this series otherwise. I am ever hopeful that “things will be different this time,” but investment manias have never ended any other way and too many obvious signs point to the stated outcome. If the Fed can somehow further-delay the bubble-on-bubble’s asset deflation and depression, terrific! I encourage you to use that stay of execution as a means of coming out whole. Can central bankers beat back deflation if the majority of people decide to stop buying and recklessly borrowing against their real estate?

Gold and silver bugs write in to say that the Fed will opt for hyperinflation over deflation, and that the precious metals will soar (and I have learned to never argue with metals bugs). I offer another opinion: That the Federal Reserve will elect to protect the dollar first (its primary legal responsibility), and take the same path it chose in the 1930’s when it raised interest rates to prop up the dollar in the face of a deflationary depression. I also say that the real estate collapse and change in psychology will be too unwieldy to prevent a massive credit contraction, and that that contraction will render the Fed impotent.

And if I am wrong, which we can all hope for, I appreciate the fact the dialogue is taking place. I have been heartened to hear from hundreds of readers who are open to the discussion and no longer blindly walking the assumed path that real estate values are guaranteed to go up and up forever. The vast majority of our readers have already taken (or are in the process of taking) a defensive posture. That was certainly not the case a year or two ago.

Some folks sold their NASDAQ stocks at the top of the curve in January of 2000. They were the ones who protected their assets and won the first game of the Asset Preservation World Series. You now have the chance to do the same thing with your real estate.

Link here.


In spite of Bernanke’s claims that problems in housing are “well contained”, most of the evidence appears to be contrary. In “Housing Slump Pinches States in Pocketbook”, The New York Times is reporting on tax shortfalls:

“‘It is the year of the housing hangover,’ said Sean M. Snaith, director of the Institute for Economic Competitiveness at the University of Central Florida.”

MarketWatch is reporting that lower U.S. corporate profits could cut into capital spending and hiring. The Chicago Tribune is reporting that, “Turmoil in the subprime mortgage sector hits some workers as hard as borrowers.”

The Orange County Register is asking, “Are Property Taxes in Subprime Soup?” Imagine you are a subprime borrower who paid taxes to New Century or some other now bankrupt subprime lender and you wake up and find that those tax escrows you made were not paid. Subprime being what it is, exactly how are you going to come up with $2,000-4,000 or more to pay tax bills you have already paid? Some borrowers have avoided escrow payments simply because they could not afford those on top of a mortgage. Where are those borrowers going to come up with the money to pay property taxes?

The Central Valley Business Times is reporting, “Unprecedented foreclosure activity”: “Foreclosure sales are now 15% of all home sales in California.” 4,796 homes out of 5,316 homes at foreclosure sales received no bid. That is a pretty stunning 90% of homes at foreclosures auctions receiving no bid. Obviously, those homes have a bigger mortgage than what they are worth.

In regards to the highly touted 180,000 March payroll numbers, there are some anomalies that need to be addressed. Judging from the enormous drop in the teenage participation rate, the latest drop in the unemployment rate is a complete fabrication of reality. While Paul Kasriel, who addressed the numbers in “An Autopsy on the March 2007 Employment Situation Report”, and I focus on different aspects of the payroll numbers, we both reach the same conclusion, expressed by Kasriel: “In sum, an autopsy of the March 2007 Employment Situation report suggests that labor market conditions are not nearly as robust as the headlines that accompanied the report.”

Now factor in the fact that 2.1 million homeowners missed a mortgage payment in 2006, according to USA Today. Does that look like containment? I suggest that the containment is spreading, even as Bernanke and others deny its existence.

Link here.

Subprime losers blame Wall Street firms.

When Buck Meyer thinks about the $300,000 he lost after he bought a subprime mortgage lender’s bonds, he does not hesitate to denounce financial titans Bear Stearns, Credit Suisse Group, JPMorgan Chase and Morgan Stanley. Like the thousands of people who snapped up American Business Financial Services’s notes yielding 10 times the going rate on Treasury bills, Meyer had no idea that the company was on the verge of bankruptcy. He wondered how something so celebrated as “a kitchen-table startup” by the Philadelphia Business Journal and so lucrative that it paid $50 million in fees to the four firms for its burgeoning credit, could default on his money. “At what point did it become a Wall Street Ponzi scheme?” said the 52-year-old Meyer, who almost wiped out the nest egg he received from selling his home in Doylestown, Pennsylvania, six years ago.

Whether Wall Street’s best and brightest were reckless in their pursuit of profits and somehow responsible for the consequences will be decided in a Philadelphia court. That is where the four top brands of finance are accused of creating an “illusion” that American Business was a safe investment, according to a lawsuit filed on behalf of Meyer and more than 20,000 other individuals who held about $600 million of the company’s bonds when it went bankrupt in 2005.

Link here.

Housing boom tied to sham mortgages.

The man was one slick fraud artist. Phillip Hill lured people to fancy cocktail parties in a $1.9 million mansion. He asked to use their names and credit histories in real estate deals, promising to make them rich. Most got $10,000 checks on the spot for signing up. By the time the scam unraveled, the credit of those participants had been ruined, hundreds of upscale properties had fallen into foreclosure and real estate prices had plummeted in some of this city’s most exclusive neighborhoods. Hill is about to go to federal prison.

Many experts have concluded that the nation’s real estate boom of recent years was fueled in part by weakened lending standards that sparked excessive demand and drove up prices. Now, some are worried that the looser standards may have permitted a boom of another kind – a big expansion of mortgage fraud. No one knows exactly how extensive the crime has become, but new data from the federal government suggest that it has jumped 10-fold since 2000. Prosecutors are finding cases all over the country in which sham transactions, based on fraudulent appraisals, led to homes changing hands at far above their real value. Mortgage lenders failed to carry out the most elementary safeguards.

In some neighborhoods, mortgage fraud became so extensive that it drove up overall home prices. That is what happened in Atlanta. Hill, 50, was convicted last month in what authorities call one of the biggest mortgage-fraud cases in U.S. history. Federal prosecutors say this kind of fraud is hardly unique to Atlanta – the lax lending standards that Hill exploited have existed throughout the country in recent years. As more of these cases come to light around the nation, the question is: How much did an epidemic of fraud contribute to the frenzied housing market of recent years?

Link here.


While the future for uranium metal looks bright, the outlook for many of the stocks is less certain. To be blunt, most of today’s uranium issues are overhyped and overpriced, exposing investors to the ever-growing risk of a pullback in share prices. This dichotomy – great commodity, so-so stocks – presents a significant investment challenge. Simply put, investors looking to profit from the outpouring of interest in yellowcake today must be far more creative than previously if they hope to uncover subsectors of the uranium space that have not already been overinflated by the hurricane wind of promotion. A tall order to be sure, but one that we have been digging deep on for several months. Below, we discuss three areas where investors can still find value largely unrecognized by the lumpeninvestoriat – the kind of potential that can lead to double- and even triple-digit gains once those beyond the leading edge of the bell curve catch on and start piling in.

#1: Basement-hosted deposits. Every uranium investor is probably already aware of the flooding problems at the Cigar Lake mine in northern Saskatchewan. The mine, which was slated to produce 16% of world mined uranium supply, was plunged into doubt in October 2006 after water began gushing into the underground workings. The problem is that the Cigar Lake ore is hosted in sandstone, a rock type through which water flows easily. But not all deposits in Saskatchewan’s prolific Athabasca Basin are sandstone-hosted. Some uranium occurs in so-called “basement” rocks – more competent, drier layers beneath the sandstone. The problem is that many basement deposits are deep, which increases mining costs.

But it is a lesser-known fact that more accessible basement ores are found outside of the Athabasca Basin proper. In these outlying areas, the sandstone that once covered the basement has been eroded, making deposits easier to get at. But while basement deposits are extremely prospective, they have been largely ignored by investors. Therein lies the opportunity. Many companies with prospective basement deposits have none of this upside factored into their share price, meaning we can take a low-cost ride on the potential of such plays.

#2: Low grade makes a comeback. For years, low uranium prices meant that exploration companies searched mainly for high-grade ores – the type of deposits that allow a profit even during downturns in the market. But with prices rising, the industry is now realizing that lower-grade deposits may be important sources of yellowcake. One of the world’s largest uranium mines – Rossing, Namibia – works a bulk tonnage target at grades less than 0.1% U3O8. Where might another such a mega-deposit be found? Perhaps very close to home. The province of Quebec has long been known to host so-called pegmatite uranium deposits – similar to the geology of Rossing.

A few explorers have been catching our attention with potentially high-impact targets in this region. For example, Uracan Resources (URC.TSX-V) has assembled a prospective land package in southern Quebec, with trenching yielding results of 0.2% U3O8 over as much as 40 meters. The company will be drilling aggressively in 2007 to prove up a resource, which shows signs of being sizeable.

And the coming year may see the discovery of a completely new Rossing-type deposit in northern Quebec. Quebec experts Azimut Exploration (AZM.TSX-V) along with partner Northwestern Mineral Ventures (NWT.TSX-V) spotted the potential in the area a few years ago, confirming their hypothesis through sampling in 2006 at the North Rae project which yielded assays of up to 0.5% U3O8 – 10 times the average grade at the Rossing deposit. And like Rossing, the North Rae mineralized system appears to extend over several tens of kilometers, giving it potential for huge ore reserves. We will be paying very close attention to the progress of the drill program.

#3: Go where no company has gone before. The recent uranium boom has led the new crop of explorers to nearly every country on the planet. Wherever there are available yellowcake deposits, junior companies have lined up to stake land. The key word is available. While many nations are open to uranium exploration, there are several localities where authorities have been less inviting. Two of the most significant among the later are India and Brazil. Both have known deposits of significant scale, yet officials in these countries have not been granting exploration licenses. Yet. In recent conversations with Indian government officials, we have learned that the country may soon be opening up to exploration, with talks already underway with several companies already well positioned to lead the charge into India’s high-grade basins.

Another emerging district we are keeping an eye on is the African island of Madagascar. Although the nation’s geology is extremely prospective for uranium, the country was effectively closed to exploration for much of the past century due to an oppressive dictatorship. But with the changes in that country’s government over the last decade, we are starting to see permits being granted. Already a number of companies have accumulated significant land packages and we expect the news to start flowing sooner rather than later.

Link here (scroll down to piece by Doug Casey).


CNBC and other stock market tabloids are notorious for making simplistic linkages between the stock market and gross domestic product. They tell us that any event that stimulates GDP growth inevitably drives stock prices up, and any event that hurts GDP growth pushes stocks down. Since the largest share of GDP is consumption, consumer demand becomes the all-important figure driving growth. When the consumer gets too excited, the Fed must step in to cool them down with interest-rate hikes. When the consumer is not spending, Fed interest-rate cuts stimulate demand.

The tragedy currently occurring in Zimbabwe completely contradicts this sort of logic. Zimbabwe is in the middle of an economic disintegration, with GDP declining for the 7th consecutive year, half of what it was in 2000. Ever since President Mugabe’s disastrous land-reform campaign (an entire article in itself), the country’s farming, tourism, and gold sectors have collapsed. Unemployment is said to be near 80%.

Yet something odd is happening. The Zimbabwe Stock Exchange (the ZSE) is the best performing stock exchange in the world, with the key Zimbabwe Industrials Index up some 595% since the beginning of the year and 12,000% over 12 months. This jump in share prices is far in excess of increases in consumer prices. While the country is crumbling, the Zimbabwean share speculator is keeping up much better than the typical Zimbabwean on the street.

CNBC logic fails to explain the coincidence of a rising ZSE and collapsing GDP because it entirely ignores the monetary side of the economy. At this point Austrian economics makes its contribution to our story. According to Austrian Business Cycle Theory (ABCT), the peak-trough-peak pattern that economies demonstrate is not their natural state, but one created by excess growth in money supply and credit. New money is not simply parachuted to everyone equally and at the same time – it is sluiced into the economy at certain initial “entry points”. From these entry points, a number of initial goods are bought by recipients of new money causing a rise in price for these initial goods relative to other goods.

Because entrepreneurs react to this observed but unjustified change in the structure of prices by investing their capital, misallocation occurs. As money-supply growth continues and prices become more contorted, more and more ventures are undertaken that would not be undertaken in a regime without money-supply growth. When, for whatever the reason, money supply finally contracts, the artificial strength in prices that encouraged unprofitable ventures is removed, prices collapse, and large numbers of ventures go bankrupt. Thus we have the recession part of the business cycle, the simultaneous failure of many firms at the same time.

If money enters the economy at certain points, it is likely that a nation’s stock market will become a prime beneficiary of any monetary expansion. Fresh money enters the economy first through banks and other financial entities who may invest it in shares, or lend it to others who buy shares. Thus stock prices rise relative to prices of things like food and clothes and will outperform as long as this monetary process is allowed to continue.

This is what we are seeing in Zimbabwe. With the country suffering from Mugabe’s catastrophic policies, increasingly the only means for the government to fund itself has been money-supply growth. This has only exacerbated the economy’s problems. The flood of new money that authorities have created has caused the existing value of money in circulation to plummet, i.e., the prices of all sorts of goods to explode, some rising more than others. As prices become more misaligned, basic decision-making abilities of normal Zimbabweans are impaired and the day-to-day functioning of the economy deteriorates. Perversely, all of this has forced the government to issue even more currency to make up for budget shortfalls and to buy support. At last measure, the country’s CPI was rising at a rate of 1,729% a year.

The ZSE is growing some three times faster than consumer prices. This relative outperformance versus general prices is a result of stocks being a chief entry point for the flood of newly created money. Keep Zimbabwean dollars in your pocket, and they have already lost a chunk of their value by the next day. Putting money in the bank, where rates are pithy, is not much better. Investing in government bonds is the equivalent of financial suicide. Converting wealth into foreign currency is difficult; hard currency is scarce, and strict rules limit exchangeability.

As for capital improvements, there is little incentive on the part of companies to invest in their already-losing enterprises since economic prospects look so bleak. Very few havens exist for people to hide their wealth from the evils created by Mugabe’s policies. Like compressed air looking for an exit, money is pouring into shares of ZSE-listed firms. It is the only place to go.

Our Zimbabwe example, though extreme, demonstrates how changes in stock prices can be driven by monetary conditions, and not changes in GDP. New money gets spent or invested. In Zimbabwe’s case, because there are no alternatives, it is stocks that are benefiting. Though western central banks have not been printing nearly as fast as their Zimbabwe counterpart, they do have a long history of increasing the money supply. It forces one to ask how much of the growth in Western stock markets over the preceding 25 years has been created by a vastly increasing money supply, and how much is due to actual wealth creation. Perhaps stock prices have increased faster than goods prices for the last 25 years because, as in Zimbabwe, Western stock markets have become one of the principal entry points for newly printed currency.

Link here (scroll down to piece by John Paul Koning).


Takeover bids are generally thoroughly benign economic events. They are after all the principal process by which Joseph Schumpeter’s process of “creative destruction” takes place. Without them, with corporate governance currently weak as in Britain and the U.S. there would be no power to compel entrenched management to downsize itself, even when it was obvious that the company’s technology was no longer dominant. Nevertheless, at the top of a bull market one may reach a point at which the dangers of future destruction in a takeover outweigh any possible creativity. In the recent frenzy of takeovers backed by private equity and hedge funds, we appear to have reached that point.

There are certainly companies which could do with a good management shake-up. However the companies which get taken over are not necessarily those which need the shake-up. In the tech sector, for example, the two titans, Microsoft and Google, may be losing their way. In Google’s case, the company’s insouciance about copyright, attempting to seize the print and video contents of the world’s libraries cost-free and turn them into a Google advertising platform, is clearly running into a brick wall in the case of its expensive acquisition of YouTube. It may well be, in spite of the company’s current market capitalization of $147 billion, that its business will degenerate eventually to its origin in a clever search engine that sells advertising, in which case it will undoubtedly be commoditized out of any exceptional profitability.

In Microsoft’s case, it is rapidly becoming clear that the company’s major new products, the Xbox 360 and Vista, are inadequate to the job they have been sent into the market to do. In the Xbox 360’s case, Microsoft benefited considerably in 2006 from having its product in the market a year before its two competitors, Nintendo’s Wii and Sony's Playstation 3, but is now beginning to suffer as its product is significantly technologically behind its two competitors. At least, it is becoming clear that Microsoft is nowhere near establishing the position of dominance it had hoped for.

As for Vista, it is a disaster. Microsoft’s decision to construct Vista by add-on, without removing the redundancies and bugs that had bedeviled its previous software, is reminiscent of the Detroit of the late 1960s, which gave the world such triumphs as the Ford Pinto, of the exploding gas-tank. Vista, which is exceptionally sluggish to load and causes all sorts of backward-compatibility problems with its predecessor operating systems is an excess of costs, with few benefits, imposed on consumers who may now have an alternative available in the modernized and strengthened Linux. Further, Microsoft’s announcement that it will no longer wait five years to launch a new operating system, but will in the future impose the huge harassments of system transfer on its customers every two years is likely to make its operating systems history within the next half-decade. Vista will not even be remembered with the faint nostalgia of the Ford Edsel, which was at least attractive.

Were it a conventional manufacturing company, Microsoft would be ripe for takeover, or even descent into bankruptcy. However with $34 billion in cash, a market capitalization of $280 billion and a strong friendly shareholder in Bill Gates and his family foundation, Microsoft is not remotely vulnerable to such a takeover. Blackstone, Carlyle and KKR can reluctantly put away their spreadsheets.

At the end of a long bull market with an excess of liquidity, such as we have enjoyed or in some cases suffered for the last 12 years, two factors prevent takeovers from fulfilling their creative function and maximize the likelihood of their causing destruction. First, fashionable shares have been bid up to astronomical prices. Thus even when as in the case of Google and Microsoft they have major operating weaknesses, they are priced not on the basis of their weaknesses but on the memory of their previous strengths – or in Google’s case, their previous hype – thus making any health-giving asset-stripping or break-up exercise impossibly expensive. Dead technology companies such as Polaroid and Xerox frequently linger decades beyond their last real success, earning below average returns but always priced on memory, so never vulnerable to the Schumpeteran process.

Conversely, 12 years of liquidity leads to an accumulation of money in the wrong places, whether in dozy conglomerates in the late 1960s, in semi-fraudulent investment trusts in the 1920s or in hedge funds and private equity funds today. This “silly money” has to find something to do. Its shareholders will not tolerate inaction. Since badly run tech companies are off the table because of their overvaluation, and all the badly run non-tech companies have been snapped up long ago, the only remaining victims are well run non-tech companies.

“Silly money” conglomerates or private equity funds buy these, often assisted by promising to overpay existing management, giving it a huge conflict of interest in the takeover process. They then load up the companies’ balance sheets with unwarranted leverage, and discover that since the companies were well run in the first place and has management that (other than those overpaid by the acquirer) is eminently employable elsewhere, interference by the acquirers inevitably causes operations and financial results to deteriorate alarmingly. Since late in the market cycle the next recession is at most a couple of years away, most of these deals go wrong, resulting in bankruptcy and emergency break-up of previously well-run companies, destroying immense value in the economy and creating nothing.

There are innumerable examples of this. Nelson Peltz, for example, has a 30 year record in acquisition that is wholly undistinguished by any example of operating improvements he has made. It is thus unimaginable that Cadbury-Schweppes, a company that has been formidably well run since Cadbury and Schweppes merged in 1969 – or indeed since they were founded, in 1824 and 1783 – has anything to learn from Peltz. Instead of creating value, Peltz has merely forced an entirely unnecessary de-merger of the confectionary and beverages businesses, which cannot be justified on the spurious basis of unlocking stock market value, but will simply destroy synergies built up over 40 years, cost hundreds of millions in legal, accountancy and IT fees and enrich the undeserving.

The rumored attempt by KKR on the Canadian telecommunications conglomerate BCE is another example. Such a takeover would have little chance of creating value and every chance of destroying it. Fortunately the Canadian government appears to have means whereby a takeover can be blocked, so the rumors have died down. TXU Energy, the former Texas Utilities, also seems to have achieved a reprieve through delay. The announcement by the Texas Utilities Commission of a 6-month review of all power company buyouts has delayed the acquisition, and if Texas utility customers are lucky will have done so beyond the collapse of the KKR’s capability to finance it. With KKR incapable of generating improvements in a well run utility company, a business in which they have little experience, they would load Texas electricity customers with long term brownouts, excessive charges or, most probably, both.

Finally there is Boots, subject to a $20 billion buyout by KKR with neither side alleging any ineptitude in a well run British drugstore chain that has been in business since 1849. KKR has no special expertise in running British drug stores. It will simply load the company with debt and force the closure of hundreds of Boots stores that have served their local communities well for a century or more. Rationalization is frequently necessary and even desirable, but in this case the profits of rationalization if any will go entirely to fly-by-night Americans and the costs of Boots corporate failure will fall on its British customers and employees.

Franz Muenterfering, Vice Chancellor of Germany, described private equity companies as “swarms of locusts, which pounce on companies, strip them bare and move on.” He produced a “locust list” of 12 prime offenders and recommended that private equity managers should be forced to wear a yellow locust-shaped patch on their suits. In normal markets, one would dismiss Muenterfering’s remarks as the ravings of a deranged socialist fruitcake. In today’s markets, there is no question that he has a point. Governments should react by finding ways to block private equity transactions, not forever but for a moratorium of six months or a year until the bubble has burst and financing for disreputable short-term operators is no longer available. Maybe even the EU could make itself useful for once and pass a 12 month cool-off directive mandatory on its members. A great deal of job loss, value destruction and human misery would thereby be avoided.

Link here.


In the credit derivatives market, certain instruments are exposed to what is known as “cliff risk”. This ominous sounding phrase describes a situation where the last in a series of adverse developments obliterates the value of what was only recently viewed as a triple-A-rated security. Up until that point, however, rating agencies, investors, and bankers assume that circumstances will eventually right themselves and that the principal will be paid in full, in spite of whatever bad news might have come along beforehand.

This latter way of thinking is not confined to the nether world of complex securities with tongue-twisting names like CDOs-squared. In many respects, it describes a point-of-view that permeates many aspects of modern financial life. Increasingly, Americans have taken it for granted that good times beget more of the same and they have acted accordingly. If bad news comes along, the damage is absorbed. Unlike with some toxic derivatives, however, many believe that if circumstances do manage to take a turn for the worse, something can always be done about it.

The massive build-up of public and private debts, unfunded pension promises, and other obligations underscores this perspective. Rather than coming to terms with untenable liabilities taken on because of past miscalculations, the mindset has been “don’t worry about it now.” If financial problems do not disappear of their own accord, they can be restructured, rolled over, refinanced, or even renamed. One way or another, the thinking goes, the situation will be resolved, because there are any number of options that are readily available.

This mindset probably explains why we have not seen the type of response to a growing list of negatives that wizened old-timers would have expected. In the past, significant trade deficits and other unstable imbalances, myriad signs of a looming recession, talk of a subprime meltdown-inspired credit crunch, and the inevitability of down cycles following periods of historically high profit-margins and overextended uptrends would have had money managers scrambling to batten down the hatches by now.

Instead, mutual fund cash levels are near record lows, margin debt and leverage-based speculation are at euphoric extremes, and risk spreads reflect an extraordinary degree of complacency. Nowadays, many would probably argue that it makes little sense to worry or even plan ahead for disaster, because there are numerous escape routes available if things do actually come to a head. Liquid markets, electronic trading and other modern technology, innovative financial products, hedging and stop-losses, and an unfailingly supportive Federal Reserve are seemingly permanent fixtures of today’s financial landscape that will no doubt counteract any unwelcome adversity.

At the same time, the belief exists that there is still big money to be made from taking out-sized risks, and incentives remain heavily skewed to the upside. Practically speaking, current performance is all that matters, with nary a thought given to longer-term returns – or concerns. What might be lost through aggressively geared-up bets on repeated rolls of the dice seems to pale in comparison to what can be realized if everything goes exactly according to plan.

Many Americans have adopted a somewhat similar perspective in their day-to-day financial lives. In fact, the mantra seems to be: “Why be defensive at all?” With a support system supposedly in place that can theoretically postpone the day of reckoning more-or-less indefinitely, the rational response is to push the envelope to its extremes. Combine that with the constant bullish squawking and tom-tom thumping by banks and other financial institutions, retailers, policymakers, politicians, and the media, and it adds up a siren song of short-sightedness and self-indulgence that is hard to resist.

Governments at all levels are in the same thrall. How else can you explain politicians who talk, talk, talk about fiscal responsibility, but who continue to advocate ever-escalating spending and borrowing nonetheless? Many have drunk the Kool-Aid that says we can grow our way out of each and every mess. In that delusory state, they carry on as before.

Corporate America is also mired in the here and now, with little apparent trepidation about any challenges that lie ahead. Managers seem mainly focused on slashing costs and paring back investment, instead of longer-term planning, when they are not feathering their nests, of course. Corporate policies, including executive compensation plans, are strongly aligned with short-term performance goals. Even in economically sensitive industries, borrowing levels are going up while reserves are kept to a minimum. You would have thought the best and the brightest would know better.

Yet everywhere you look, people are unwilling or unable to stop what they have been doing, especially in recent years, because it seems to have worked so far and for so long and everyone else is playing along, too. Many economic and financial squalls have passed without causing serious disruptions, at least in the aggregate, and it is hard to refute the optimists when they argue that the times are as good as they have every been.

And yet, one day, as is likely to happen ever more frequently with CDOs-Squared and other toxic New Age monstrosities, the “event” that really matters will come along. A paradigm-killer that sets in motion a chain reaction that completely undermines the apparently never-ending stability that everyone has gotten used to. By then, people will realize very quickly that America, once viewed as the world’s foremost economic superpower, is nothing more than a cliff-risk nation.

Link here.
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