Wealth International, Limited

Finance Digest for Week of September 3, 2007

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


As boom turned to gloom, some gamblers with good timing made a fortune. Will they also know when to take their bets off?

Earlier this year Prem Watsa, the gunslinging chief of Fairfax Financial (NYSE: FFH), had $341 million riding on a hunch that dozens of brokers, banks and insurers could struggle paying their debts. Watsa has a history of making a killing on bearish bets. He sold half the company’s stock holdings before the 1987 crash and bought puts against the S&P 500 before the index fell in 2000. But as summer began, his latest wager had produced nothing but losses.

Then the credit markets seized up, and investors began clamoring for the Toronto insurer’s collection of credit default swaps, basically insurance against bond defaults. Prices climbed. By the end of July Fairfax’s swaps were worth $537 million, up 170% in a month.

The winners and losers from the credit crunch are still being tallied, but one thing is clear: Some smart investors won big, and suddenly. They went short on subprime mortgages or went long on market volatility or bought credit default swaps – recommended in a speech by one Fairfax-like bear last year as “the most inexpensive disaster insurance” around.

Harbinger Capital Partners, a $12 billion hedge fund in New York City, started buying credit default swaps on subprime mortgages in November, according to someone familiar with the fund. It agreed, in effect, to pay an insurance premium over the life of a mortgage pool and to receive a payout on losses of principal on that pool. But it did not own the underlying pool, so what the hedge fund was doing was more like buying fire insurance on a building it does not own and then hoping for a fire. With default swaps you do not need to wait for the fire to profit. All you need is for other people to get worried and bid up the price of insurance. Then you can sell your insurance contract at a profit. In the case of subprime mortgages, insurance coverage of the sort Harbinger was buying has tripled in price since it started buying.

Credit default swaps also helped famed value investor Baupost Group return more than 20% so far this year, according to a source close to the fund. The hedge fund’s press-shy chief, Seth Klarman, was the man pushing swaps last year in a rare public appearance. Most of the swaps, used as a hedge against distressed debt held by the Boston fund for four years now, have not been cashed out yet. Another way the fund is playing it safe: A third of its $8 billion is in cash.

Russell Abrams runs a $375 million hedge fund called Titan Capital Group that trades volatility. He made a big bet earlier this year that preternaturally calm markets would soon get a case of the jitters. One of 50 securities he targeted: Countrywide Financial. In January he began buying out-of-the-money puts. As Countrywide’s bad news broke, its share price fell, volatility soared, and premiums on the options exploded.

J. Kyle Bass, a managing partner of Hayman Capital in Dallas, expects profits to keep coming for subprime bears, too. Last year he put all $106 million of his Subprime Credit Strategy Fund into shorting mortgage bonds and claims he has already tripled the money – on paper. Just back from a trip to California’s Central Valley, the epicenter of subprime defaults, Bass says he now expects $175 billion in additional losses on subprime bonds over the next year – 20% of the total $1 trillion subprime loans outstanding.

If some bears are still hoping for worse things to come, others are switching sides on the expectation that the bottom has already been touched. New York lender Clearlake Capital was started in January to rush in where others fear to tread. In August Clearlake agreed to provide $60 million – half equity, half loan – in a deal to take software maker Compudyne private. It was able to get eight percentage points over Libor for the loan portion – nearly double, says Clearlake partner Jose Feliciano, the spread Clearlake could have demanded a few weeks earlier. In two months, Clearlake says, it has agreed to provide $500 million to a half-dozen other companies at similarly rich spreads.

Investors in distressed securities apparently agree. So far this year funds targeting such risky assets have attracted $12 billion, quadruple what they got all of last year, according to Hedge Fund Research in Chicago. Another buyer of junky debt is William Gross, manager of giant fixed-income fund Pimco. (See story below.) His fund recently put $1 billion into the High Yield Credit Default Index – in effect, selling insurance against defaults. This bet will pay off if yield premiums on junk decline or, to put it another way, if junk prices rebound.

Fairfax Chief Watsa remains bearish. He concedes that this is a risky place to be. In a recent conference call he reminded investors that, given that his gains are still on paper, there is “no certainty” he will be able to realize any of them.

Link here.


Find the ideal fund for you from among the thousands of available choices. In the report you will find both conventional metrics for analyzing funds and Forbes’s proprietary indicators for distinguishing winners from the losers and cost-efficient funds from inefficient funds.

Link here.

With blood on the floor, bond king Bill Gross is gambling again. But hardly indiscriminately.

Now, in the middle of the credit markets’ dark hour, is the time for the bond king to reclaim his crown. William H. Gross, who used to dazzle the investing world with his prescient fixed-income plays, has been a disappointment lately. This is his moment to turn things around. So he is making some risky bets.

Gross, 63, is one of those investment figures whose every utterance is quoted and parsed for meaning. As manager of storied $103 billion (assets) Pimco Total Return, the world’s largest bond fund, he has a long history of beating the Lehman Brothers Aggregate Bond Index, the benchmark of the fixed-income set. He hired Alan Greenspan, the former Federal Reserve chairman, as a Pimco consultant in May 2007, and Wall Street greeted the event as an alliance of godlike figures.

But Gross took a wrong turn. He got too conservative. Two years ago he shifted out of risky securities like corporate junk bonds and into safe stuff like Treasurys that would be lifted by Federal Reserve interest-rate cuts, sure to be made to save a flagging economy. Those Fed cuts never came. Neither, until recently, was there any evidence of a coming wave of corporate defaults. In 2006 Gross shocked his fans by lagging the index. Investors put less money into his funds. Things got so bad at one point that he took took nine days off from the office to try to regain his instincts. “It felt like abject failure,” he says. Or rather, he adds, like the Yankees when they do not make it to the World Series.

Of the five largest bond funds, Total Return has the worst 12-month record, at 4.4% (appreciation plus interest income), but the best 10-year annual tally, at 5.9%. Investors pay dearly for Gross’s services: The fund has the highest fees of the Big Five, at 0.9% of assets yearly and a 3.75% sales load (see table).

Gross is a self-effacing guy. He freely admits that his head cannot instantly conjure up numbers and stats, and he often asks underlings at meetings to refresh his memory. Still, the current crisis spells opportunity to him, and his juices are flowing. To monitor the frenzied trading in Europe, Gross is getting to his California office at 3 a.m. or so. And he is on the phone with consultant Greenspan more often lately – three times in one recent week.

He sees the current crunch as a perfect opportunity to bag some nice trophies. Until this summer, spreads between Treasurys and most bonds, even junk, were too narrow to bother taking the risk of owning them. Lately, however, they have blown out. Junk bonds, yielding on average just 2.9 percentage points over comparable Treasurys in January, are today yielding 4.5 points more, according to Merrill Lynch. This is enough, he says, to compensate him for the risk of owning this paper. It takes time, Gross says, to turn around a fund larger than the economies of 134 countries, yet he is bent on doing this.

Fortunately for him, everyone else seems to be selling, meaning good buys can be had. A self-described “curmudgeon of credit”, Gross is among the most ardent pessimists. He thinks a cumulative fall in home prices of 10% is “very possible.” And if that happens, a recession may loom. Thus Gross expects a sizable one-point drop in the Fed funds rate from 5.25%. “This is Tiger Woods walking up the 15th, and he needs a birdie,” he says. “This is why you spend so much time on the range. This is a good moment.”

And he has the firepower – an enormous cash hoard, 30% of assets. Assets are selling at discounts to those who can pay fast, now that the liquidity has evaporated. Gross once was criticized for his cash buildup. Now it is an opportunity. Gross has bought mortgages on millionaires’ homes, German government paper, Brazilian debt, foreign currencies and, yes, junk bonds. The change in junk land is especially gratifying to Gross. Before the spreads blew out, Gross likened junk investors to “prisoners in an isolation ward” for accepting without protest, even gratefully, the “thin gruel” of low-yielding issues offered up by private equity shops. My, how the world changed in such a short period.

Earlier this summer he scored a win when Cerberus Capital Management came peddling junk to back its takeover of Chrysler. Gross zeroed in on a $4 billion issue, for Chrysler’s finance arm, at the London Interbank Offered Rate of 5.4% plus 3 percentage points. No one was biting. In stepped Gross, delivering $2 billion in just three days. What he got in return: Libor plus 5 points. In recent weeks he hs also bought $50 million of Ford Credit notes at Libor plus 5.5 points.

Other recent purchases he has made at a discount include 5.85% Time Warner Cable bonds due May 2017, yielding 6.4% to maturity. He likes the company’s strong pricing power: People want their cable TV and will pay for it. He also likes refiner Valero Energy’s 6.125s, maturing in June 2017, and utility Duke Energy’s 6.45s of October 2032.

Gross has put $1 billion into the High-Yield Credit Default Index. Here he is making a bullish bet on a junk-based derivative. If junk bond prices rebound, he will make money on the index. Why should their prices firm up? Because that yield spread over Treasurys has gotten so wide, having climbed by 2 percentage points in just six weeks. If the yield spread narrows, junk prices will go up (relative to Treasury prices). A 4.5-point spread, he says, is “pretty attractive,” if the economy “muddles through.”

But if Gross is a bull, he is a discriminating one. He wil not buy the debt of papermaker Weyerhaeuser or retailer Nordstrom. Sales for both companies will fall if the economy tanks, he says. As with bonds, so equities. While Gross says stocks are “not unattractive” right now, he recommends investors avoid cyclicals, especially stocks dependent on the U.S. consumer, who, he has been warning, has too much debt to keep spending. Compounding consumer woes, he says, will be $1 trillion in adjustable mortgages set to notch upward over the next year, meaning disposable income will take a hit.

But Gross is gleeful about overseas markets, especially in fast-growing developing countries. One stock he would consider buying, if he were a stock picker is Coca-Cola, trading recently at 21 times earnings. Coke gets 72% of its sales abroad.

At Pimco’s offices overlooking the Pacific there is little to suggest the fund is, as Gross puts it, in a “feeding frenzy”. Gross looks calm and somehow utterly in command. He delivers a quiet word here, a wry observation there. At another time he takes a call from Greenspan, which lasts for two hours. They talk about panic spreading to the commercial paper market, about the weak housing sector and falling auto sales. Gross’s mid-August view on Fed funds: Bernanke will hold off cutting for a bit, so as not to look like he is caving in to Wall Street. But cut he will, a percentage point within a year. That said, it may already be too late to revive an economy that Gross believes is “close to the rocks.”

Indeed, Gross has a good track record at timing his moves to Fed actions and to the dips and swells of the economy. Anticipating trouble in early 2000, he started buying Treasurys and cutting exposure to corporate bonds, right before the market cracked in March. In September 2002 he got bullish on corporates again on a hunch – correct – that a recovery was gathering strength. Gross’s miscues of the past two years are a rare happenstance. Apart from loading up on Treasurys and dumping junk early, expecting the slowdown of 2006, he bought eurodollar futures, which would rise smartly if Bernanke had cut rates.

In May came a mea culpa of sorts. Gross wrote in his monthly commentary to investors that he had underestimated the boost to the U.S. from strong growth overseas. The glass was “half full,” he declared, urging investors to exploit “globalization and all of its wondrous benefits – high growth, low inflation, accelerating profits and benign interest rates.” Investors drove Treasury prices down after Gross published this, thinking he had turned optimistic on the U.S. But they had misread him, or did not read him at all. Gross has conceded he made a “big mistake” in getting conservative so early, but he was quite clear that he still expected the U.S. was headed for trouble – thus he counseled people to look abroad. He never sold his eurodollar futures. In fact, he has bought $10 billion more in recent weeks, bringing his bet in this sphere to $45 billion.

Back at the Pimco’s offices, Gross monitors bid/ask spreads for commercial paper, which for him act as a distant early warning system. He is particularly focused on the paper issued by 10 European banks, because their economies have been doing well. If bids are not sufficiently high to suit him, he will know that trouble is brewing on the Continent. But then he concedes he is driving blind. “It’s like Where’s Waldo? You don’t know where [the trouble] is, or what it’s going to morph into,” he says. “There’s a surfeit of suspicion.”

“Everyone is selling risky assets,” he says. “We’ve been out of the market. Well, now we’re back in.”

Link here.

Some financial stocks unjustly tarnished by subprime imbroglio, says veteran value investor and mutual fund manager.

The market has gone haywire. As I write, the Dow Jones industrial average has experienced 14 triple-digit fits and starts since July 20. Subprime fears have made financial stocks even more volatile. This pinball effect is leaving many investors feeling skittish about where to put their money. During tough times like these I stay focused on the areas I know best, which keeps me calm and confident in my decisions.

This way I can concentrate on what matters most. Underlying business fundamentals. And I do not waste time worrying about things I cannot control or predict, like what sectors will be in vogue next or where interest rates are going. Warren Buffett and Charles Munger have dubbed this kind of industry-specific expertise a “circle of competence”. The circle’s size does not matter as much as recognizing its boundaries. When times get tough, fear leads people to overdiversify their investments in hopes of minimizing losses. Bad idea.

There are a number of sectors I do not buy because they are outside my circle. Maybe some people can consistently predict commodity prices. I cannot, so I do not try. Similarly, you will not see me investing in the latest and greatest technology. The rapid obsolescence scares me. On the other hand, financial stocks are one of the biggest weightings in my portfolios. As a professional investor for 25 years and an owner of an investment firm, I know this area firsthand. So for me, the real lesson behind a circle of competence is that it gives me the courage to buy and hold stocks during market dislocations and not wait for things to calm down.

City National (NYSE: CYN) is the parent of City National Bank, a premier private and commercial banking franchise in southern California. Originally established to cater to the entertainment industry, City National today has 62 offices that serve both affluent individuals and small to midsize businesses. Since it is headquartered in Los Angeles, one of the epicenters of the real estate quake, some investors are troubled by the bank’s exposure to the mortgage imbroglio. But I believe City National is in a very good spot. I like their rigorous credit process and client base of wealthy individuals, which provide important insulation from the subprime drama. For these reasons the stock has hung in there, losing only 2% in the last six months, while the KBW Bank Index, a benchmark of 24 large banks, is down 9% over the same period. I believe City National should be able to keep on withstanding headwinds. Shares trade at a 29% discount to my $104 estimate of private market value.

Very little of HCC Insurance Holdings’ (HCC) specialty insurance relates to mortgage guaranty. HCC covers an array of lines from directors’ and officers’ liability to aviation. Despite positive earnings, HCC’s stock is down 13% so far this year. Investors fret that a subprime ripple effect could severely impact the insurer’s investment portfolio. But HCC’s portfolios are conservatively invested, with the majority of its weightings in top-tier fixed-income securities, principally rated triple-A. Management refuses to compromise on underwriting standards, even when pricing is soft in the industry, as it is today. The company trades at a 32% discount to my $41 estimate of private market value.

Link here.

Closed-end fund discounts from net asset value have widened enough to make them interesting again.

At long last you can get some decent deals on closed-end funds. The operative words here are “some” and “decent”. These days only a few closed-ends are bargains. And they are not screaming bargains. They are just decent buys.

A closed-end is a fund with a fixed asset base and shares that trade like shares of stock. That share price can be higher or lower than the “net asset value” per share, the per share value of the fund’s portfolio. If the price is lower, you might have a bargain on your hands.

With this form of investment company, the fund’s shareholders have no right to redeem their shares, taking assets away. They can get out only by finding other investors willing to take fund shares off their hands. Thus the portfolio manager can invest with a freer hand, using leverage, e.g., or buying stakes that would be hard to unload on short notice. What is good about closed-ends is also what is bad. The manager has a captive audience. He can do a rotten job without having to worry about assets leaving. Proxy battles for closed-end funds are pretty rare.

About the discounts: They are wider than they were a few months ago, with quite a few in the 10-15% range. This means you buy a $100 portfolio for $85 to $90. Earlier in the decade you could find yawning discounts, at 20% to 30%. During the lengthy bull market that started in late 2002, those discounts narrowed or vanished. The median at the end of May was 1.8%. Now, with the summer market meltdown, discounts are widening again. According to Lipper researchers, the median gap has expanded to 5.7%.

If you are lucky, you buy when the discount is high and sell when it has narrowed. That narrowing gives you a capital gain that comes on top of whatever performance the fund manager delivered on your share of the portfolio. But it is unwise to assume that discounts will narrow over time. Perhaps you can hope for a narrowing if you buy the fund at a discount that is deeper than it has usually been.

Even without any narrowing of the discount, you can make a small gain from your 85-cent dollars. Suppose the net asset value is $100 per fund share, and that you bought at a 15% discount. Say the fund distributes dividends (income or capital gains) at a 10% annual rate. Your $10 dividend check is something you effectively bought for only $8.50. You made $1.50 right there. But should the fund’s expenses run to $1.50 a year per $100 of net assets, then your bargain closed-end is not a bargain at all. It is more of a break-even proposition.

So here are some guidelines to finding closed-ends:

It seems that there is no shortage of fools willing to pay a premium for a closed-end. Thus far this year there have been 33 IPOs of closed-ends. At first blush they look enticing. These newbies boast an average starting distribution yield of 9.4%. Many are using a mind-spinning array of financial tricks to get there, including covered-call strategies, jumping into high-yielding stocks just long enough to capture the dividend, then moving on or investing in total-return swaps and equity-linked notes. This all is voodoo. Take a pass on the dollar that someone wants to sell you for $1.07. Wait and buy it for 85 cents.

Link here.

You could have beaten a traditional index fund with an equal-weighted one over the past decade. So equal-weighted funds are better? No.

It is easy to track the overall stock market. Just buy an index mutual fund or ETF that follows the S&P 500 or the broader Wilshire 5000. These funds are cheap and over the last five years have beaten 72% of the actively managed funds available.

How boring. How unremunerative for the vendors of index funds. Competition has cut the price of these products to as low as a tiny 0.08% of assets per year. It is hard to make a living on that kind of fee. So, naturally, Wall Street has come up with an “enhanced” index fund. It costs a little extra, but delivers better results – supposedly. The new gimmick is the equal-weighted index. Yes, it would have beaten a traditional cap-weighted fund over the past ten years. But this outperformance is not necessarily due to the inherent superiority of the concept. The better results are probably a fluke.

A conventional index fund sizes each stock position in proportion to the market value of the target company. ExxonMobil’s market value is $463 billion. Department store chain Dillard’s is worth $2 billion. In the S&P 500, the Exxon stake is worth 337 times the Dillard’s stake. In an equal-weighted fund the two positions would be the same in value.

The theoretical argument for equal weighting goes like this. When a stock gets hot, a cap-weighted fund naturally rides it up, since its stake climbs in value in lockstep with the company’s market cap. An equal-weighted fund, however, cannot be so passive. It is forced by its rules to sell off a portion of winning stakes and reinvest the money in market laggards. This rebalancing is a good thing if hot stocks have a tendency to get too hot while losers tend to get too cheap. This is a big assumption, one that may or may not be true. When Rydex launched an equal-weighted ETF four years ago, its director of portfolio management, Charles Tennes, articulated the case for equal weighting: “The quarterly rebalancing imposes a disciplined process of buy-low-sell-high.”

Standard & Poor’s did a study of hypothetical returns on an equal-weighted S&P 500 index since 1990. This index, with all stocks at 0.2% of the portfolio, would have averaged an annual return of 11.4%, compared with 9.8% for the traditional index. The Morgan Stanley Equally-Weighted S&P 500 mutual fund, debuting in 1997, has awarded investors 9% annually, or 3% better than the cap-weighted Vanguard 500. The Rydex S&P Equal Weight ETF has scored an annual 18% since 2003, 4% better than the SPDR, a cap-oriented ETF tracking the S&P 500, put out by State Street Global Advisors.

Rydex and Morgan Stanley have each been able to raise over $2 billion for their maiden efforts, and to command premium fees for these funds. The Rydex ETF costs 40 basis points (0.4% of assets annually), which is four times as much as the conventionally weighted SPDR. Morgan Stanley’s equally weighted index fund costs 63 basis points, or seven times as much as the cheapest of the index 500 funds.

Equally weighted funds are gaining in popularity, especially through ETFs. Rydex last year started nine, based on its own indexes that cover areas from health care to tech. In Britain fans of equal weighting are clamoring to modify the FTSE 100 (the largest 100 names on the London Stock Exchange) so that no company can have a weight larger than 5%.

Now look closely at the theoretical argument for equal weighting. This says, in effect, that Wall Street’s herd instincts tend to push stocks to extremes. Sometimes that is true. Not always. Google was already a hot stock in 2004, when it had doubled from its offering price to $170. The stock has since climbed to $512. Dillard’s was already a laggard in May at $40. The retailer has continued downhill to $24. While Exxon’s weight in the S&P 500 has been climbing in recent years, that does not make the stock overpriced. Exxon costs only 12 times trailing earnings.

Certainly, some Wall Street successes have been built on betting against the herd. Following a contrarian strategy was how John Neff made a long-term winner out of Vanguard Windsor. Nonetheless, momentum players have also done well. Favoring stocks with strong relative performance is the essence of the Value Line stock rating system, which has been on a mostly winning streak for the past 42 years. “The idea that a tiny company should have the same weight as Microsoft in your portfolio is dumb,” says Clifford Asness, manager of AQR Capital, an immensely successful quantitative hedge fund.

Now consider an alternative explanation for the success of equally weighted index funds: Smaller companies have been beating big ones on Wall Street. They often do so for long stretches. Then the tide reverses. In the S&P study the equal-weighted index surpassed the cap-weighted kind in 10 out of 17 years. Sure enough, in each of those 10 years, small caps beat large. If small caps finish 2007 ahead of large caps, it will be for the eighth year in a row. The longest small-cap run in history – 10 years – took place between 1974 and 1983.

A correction in small caps might already be under way. Since the S&P 500 peaked on July 19, the equally weighted funds have fallen a bit behind. Cap-weighted funds are heavier in telecom, energy and banking. The equal-weighted approach favors consumer stocks, materials companies and utilities. Each sector has its good years and its bad years. A winning streak for a sector lasting several years is not evidence that the sector is a better buy now.

The point of indexing, as Vanguard founder John Bogle has long said, is to accept the market’s return. Cap weighting represents that in its purest sense. Equal weighting is really akin to a very simple quantitative program, meant to beat the market ... just like any actively managed fund. If most actively managed funds fail to do so over a long period of time, there is a good chance that the equally weighted approach will fail as well.

Link here.

Too bad good mutual fund governance is not synonymous with good performance.

Four years ago the mutual fund world was rocked by two scandals. Some managers were letting favored investors trade fund shares after the 4 p.m. market close. Others allowed hedge funds to make quick in-and-out transactions with fund shares, thus hurting portfolio performance for the ordinary investor.

The remedy offered up was independent boards. Require that the vast majority of directors overseeing the funds be outsiders. Also mandate that the board chairmen not be part of the advisory companies like Fidelity and Vanguard that run the money and market the funds.

And lo, it all came to pass, even though there is no federal edict to do this. A postscandal S.E.C. rule ordering that boards be 75% independent and all chairmen be outsiders got struck down twice in court, in 2005 and 2006, on the ground that no cost-benefit analysis had been performed. And the SEC, under a new chief, Christopher Cox, seems in no hurry to revive the rule. No matter. Some 80% of funds have since appointed at least three out of four independent directors, and a bit more than half of firms have at least one board with an independent chairman.

Okay. So are we any better off? Well, nothing like the late-trading or market-timing scandals have recurred – thus far. Fund fees have come down a bit. Whether the independent trustees are the catalyst here remains unclear. Competition may have been the driving force. Actively managed funds are getting a lot of competition these days from passive vehicles like index funds and ETFs.

Aside from stopping hanky-panky and waste, you would think that the investors’ champions on these boards would push for better performance. If they are, they are not producing very dramatic results. We calculated composite performance for the U.S. equity funds in 12 large fund families, going back five years. Do the good guys finish first? Not exactly. There is scant connection between stewardship and results.

Our advice to investors: Pay a lot of attention to costs and turnover. Pay some to past performance, and to whether the manager who delivered those past results is still around to pick your stocks. Pay very little to who the chairman is.

Link here.


Top money managers earn such huge incomes that even when their compensation is mixed with the much lower pay of clerks, secretaries and others, the average pay in investment banking is 10 times that of all private sector jobs, new government data shows. Investment banking paid an average weekly wage of $8,367, compared with $841 for all private sector jobs. The data also showed how far ahead hedge fund managers are of other investment bankers in making money.

In Fairfield County, Connecticut, home to many hedge funds, the average pay was $23,846 a week. In Manhattan, with a much broader mix of investment banking firms and seven times the number of employees, pay was much less, averaging $16,849 a week in the first quarter of 2006. Nationally, investment banking accounted for just 0.1% of all private sector jobs, but it accounts for 1.3% of all wages. Almost 72% of all investment banking earnings were in just five counties: New York (Manhattan), Fairfield, San Francisco, Los Angeles and Cook County, Illinois, which envelops Chicago. “With steady employment totals, very handsome bonuses,” the report said, “it would seem to be an understatement to say that investment banking was thriving.”

Link here.


It is just a tiny bright shard in the vast wreckage of the real estate market. But Robert Sheridan, a veteran developer and investor of River Forest, Illinois, has his eye on a rapidly growing pile of failed condominium conversions. While almost every other speculator is bailing out of apartments-turned-condos, Sheridan is moving in. His Gibraltar REO (real estate owned, as in foreclosed and repossessed) Program has raised $50 million that will, once leveraged, let him pluck $300 million worth of failed projects. “The dominoes will begin falling soon,” says Sheridan, 79.

The numbers are with him. In 2002, says Real Capital Analytics, only 39 apartment buildings nationwide were converted, at a price of $950 million. In 2005, 823 projects brought in $30 billion. This year just 30 conversion projects tagged at $943 million. With new-construction condos, ground often will not be broken until 50% of the units are under contract. By contrast, a developer cannot sell converted condos until he owns the units, which means buying out the apartment’s landlord and renovating the apartments, a long and costly process.

Sheridan is targeting projects where developers ran out of cash 6 to 12 months ago and bowed out. Mezzanine lenders typically make high-rate (18% to 24%) loans – unsecured in many large projects – to the converter to help him cover the building’s mortgage while the property is in flux. Sometimes these lenders pour good money after bad, praying the condo climate will turn around soon. Sheridan is betting that a lot of these lenders realize their stake cannot be salvaged and will walk away, leaving the property in the hands of the mortgage lender. Then, bingo. “Banks don’t want to run a sales office or mow lawns,” he says. “That’s where we come in.”

Sheridan has been in the game for 32 years, converting buildings on New York’s Upper East Side, Chicago’s Gold Coast and Florida’s oceanfront. Now he wants to buy the Arizona condos and resell them for a 20% discount from current price tags. “People are clinging to these prices,” he says. “But there are simply no buyers there.” The global credit squeeze has made refinancing even tougher. Many senior lenders will now finance only 80% of the building’s value instead of 90%, forcing more projects into foreclosure.

Ironically, one of Sheridan’s first opportunities could be a deal he choked on as a developer: La Privada in Scottsdale, Arizona, a 350-unit luxury conversion he bought in November 2005 after selling out a nearby project in 25 days, during which prices went up 40%. Sheridan put the units on the market in early January 2006, just as the Phoenix market collapsed. Failing to rework his loans, Sheridan sold his interest to the mezzanine lender, took a $5.3 million loss and pulled out. That lender soldiered on but forfeited its investment this summer. The senior lender is foreclosing and will likely be looking for a buyer, who, of course, will want a deep discount. The search may be short.

Link here.


Remember that catchy love song that Frank Sinatra made popular in the 1960s, “The Best Is Yet To Come”?

“The best is yet to come and, babe, won’t that be fine?
You think you’ve seen the sun, but you ain’t seen it shine”q

At the risk of mixing musical metaphors and styles, it looks more like the sun has deserted us right now in the financial markets, and we are about to see “The Dark Side of the Moon”, the title of Pink Floyd’s 1973 smash album. With the subprime mortgage problems reaching farther and farther out to touch hedge funds, U.S. and European banks, mortgage companies and money-market funds, what we are going to experience sounds more like “The Worst is Yet To Come”.

That is because the financial markets must contend with more than the credit crunch brought on by rising foreclosures now. They must also deal with the repercussions from more foreclosures over the next 18 months as more adjustable-rate mortgages (whether subprime or not) reset from low teaser rates to higher interest-rate levels.

How bad can it get? Investment adviser John Mauldin recently published a month-by-month account of the dollar amount of mortgages that will be reset through 2008, and the largest reset amounts pop up in the first six months of next year. In fact, as he points out, the $197 billion of mortgage resets so far this year is “less than we will see in two months (February and March) of next year. The first six months of next year will see more than the total for 2007, or $521 billion.”

So, we have not even begun to feel the pain yet. It is bad enough for the folks who will find that they cannot keep up with the higher mortgage payments and will have to move out of their homes. But the financial markets will not be catching a break either. The antiseptic phrase used to describe the situation is “repricing risk”. That means that investors have woken up to the fact that the AAA-rated mortgage-backed securities and derivatives they invested in look more like junk bonds now. This eye-opener causes them to want higher yields from what they now see as riskier vehicles.

That new investor caution plays out this way: investment banks, hedge funds and any other entity that bought securities backed by subprime loans now find it hard to sell the darn things. The Fed can try to calm such fears all it wants by lowering the discount rate and giving banks more time to pay back loans (from overnight to 30 days), but the real problem cannot be fixed with more access to credit. The fact is nobody wants any more of that. What they really want is cash to pay off their debts, be it a mortgage or an unwinding of a securities bet.

Wall Street’s denizens are in the dark about how much their schemes depend on the ocean of liquidity created by the bull market, say Elliott Wave International’s analysts, Steve Hochberg and Pete Kendall. They are particularly struck by the image of the Grim Reaper that Business Week magazine put on its cover recently with the headline, “Death Bonds”:

“The grim reaper is the perfect visage to welcome the arriving wave of liquidation; it will wreak havoc with their work. The field’s dark fate is clear in one fund manager’s description of what caused ‘forced sales’ at another fund: ‘The models work when they look at history, but not when history is all new.’ What’s ‘new’ is that for the first time in the experience of many model makers, confidence is on the run. As they rob Peter to pay Paul, all assets will be impacted in negative ways that do not compute in their models.
Link here.
Can the mortgage crisis swallow a town? – link.
The new money pit – link.
Bad outlook for homeowners – link.


The Fed’s bubble blowing days are over.

Last week, Larry Kudlow and others strongly chastised Bernanke for his failure to read the writing on the wall and urged the Fed Chairman to quickly slash the Fed Funds rate. Methinks the pundits doth protest too much. For years, Kudlow, who practically coined the term “Goldilocks economy”, has dismissed with scorn suggestions that the American economy was anything less than ragingly healthy. If our economy is really so strong, why does he call so loudly for the artificial stimulus of a significant rate cut?

In truth, the writing has always been clearly on the wall all along. A credit bubble has been steadily inflating for at least the last six years, which in its final frenzy produced some of the most absurd mortgage funding products the world has ever seen. To anyone not dependent on the hysteria, a no-doc, no money down, negative amortization, interest only, adjustable rate jumbo mortgage was a just as clear a sign of pending catastrophe as $200 for a share of Pets.com, or 5,000 Dutch guilders for a single tulip bulb.

The one thing all bubbles have in common is that they eventually pop, and ours just did. Unlike the popping of the last bubble in 2000-2001, this one will fall directly to our economy’s bottom line. And this time the Fed can not step up to the plate with unlimited liquidity injections.

A record percentage of our GDP is comprised of consumer spending. The source of this spending was the housing bubble. Would our savings rate really be negative were it not for housing related “wealth”? Could consumers really have spent as much as they did without the benefits of temporarily low teaser rates and the ability to extract equity from their homes? How many service sector jobs are directly related to that extra spending? When the low mortgage payments and home equity disappear, so too will the spending and jobs they engendered.

With the ugly truth laid bare, many now prod Bernanke and Bush for solutions. Unfortunately there are none. Based on absurd assumptions about real estate, we simply borrowed more money than we can ever hope to pay back. There is no magic elixir we can swallow to cure what ails us. The free market is the only force that can fix this mess. Unfortunately, the fix will not be pretty. Prudent lending standards will return, guaranteeing that real estate prices collapse. This is an important connection that very few have made. There is no way the average American can afford to buy the average house at today’s prices with a mortgage he can afford. Assuming that the lax standards of 2005-2006 do not return, the only way this can happen is if real estate prices collapse, which is exactly what is happening.

The financial institutions that are calling most loudly for a bailout claim the Government must act to protect homeowners. However, the most severe losses will not be born by homeowners but by those who loaned them the money. Therefore any bailouts will ultimately go to lenders not borrowers. With plenty of available foreclosed homes on the market to rent it is unlikely that former homeowners will become homeless. The only losses for most homeowners will be psychological, as their dreams of real estate riches vanish. For some paper millionaires, the sudden realization that they are flat broke will be somewhat disheartening. For those who thought retirement was simply a function of living in a home and allowing it to appreciate, the realization that they will now have to finance their retirement the old fashioned way, by saving up, will be an eye opener. Even if misguided government bailouts enable more borrowers to keep their homes the equity they thought they had will still be gone.

In the final analysis, though it was Wall Street that served the punch, it was the Greenspan Fed that spiked it in the first place. Just as Fed policy enabled Wall Street to flood the world with worthless dot.com stocks it enabled an encore performance with subprime mortgage-backed securities. My guess is the Fed’s bubble blowing days are over. Once the inebriates sober up this time, the hangover will be so severe that no one will drink a drop of Wall Street’s punch again, meaning any more inflation the Fed creates will go strait into consumer prices.

Link here.


Earning our way should include a clear, consistent strategy for staying on the right side of the major trends in the financial markets. And, for followers of conventional economic wisdom, that means committing a few choice rules to memory, such as: Gold is the ultimate “safe-haven”. The idea being, those factors that cause stocks to fall – geopolitical unrest and economic uncertainty – trigger a rise in the demand for precious metals.

The only problem is, there is no guarantee that this notion pans out in reality. Consider the past few months, for example. Over this time, the fundamental backdrop for the U.S. Economy has been about as peppy as a funeral parlor. The whole time, gold prices have provided about as much “safety” as a roof-less bomb shelter.

In fact, gold prices took step one DOWN of a still ongoing decline on May 12, 2006, right as the mainstream “experts” were calling for $1000 per ounce gold. And, in the two weeks leading up to the yellow metal’s u-turn, our analysts stepped out on a limb with these urgent announcements: April 25, 2006: Elliott Wave Theorist “Special Report” titled “The Elliott Wave Picture In Gold: End Of A Rally.” In this publication, Bob Prechter wrote, “I have just realized that gold is at a perfect spot to end a 21-year rally.” Soon after, the May 1 Elliott Wave Financial Forecast revealed: “With a five-wave rally from the August 1999 low complete or very nearly so, we can turn our attention to the likely extent of the upcoming multi-month decline” in gold.

The long-term trend changes in gold have nothing to do with the direction of stocks OR outside factors. When it comes to staying one step in front of gold’s long-term trend changes, the real “safe haven” is objective analysis.

Link here.


In December 1999, a bushel of wheat went for $2.22 on the open market. By December 2006, prices broke $5. Now, less than a year later, a bushel sells for over $8. In fact, on September 4, “Wheat rose the maximum allowed by the Chicago Board of Trade& Wheat futures for December delivery rose 3.9 percent, to $8.055 a bushel at 9:53 a.m. in Chicago, the tenth gain in 12 sessions.” (Bloomberg)

What is driving up the prices? Most analysts say it is the age-old law of supply and demand. Countries such as India have been buying wheat in record amounts, and global supply of the commodity is expected to decline due to “unusual weather” in wheat producing nations. So, “The market’s trying to find a price that chokes off demand, and it hasn’t found it yet.” Meaning, wheat prices have room to go even higher. Does that mean you and I should get ready to create a separate entry for bread in our budgets? Only time will tell for sure, but there is a way to get some clues now.

Elliott wave analysis allows you to study price trends objectively – it lets the charts do the talking. And the charts often tell a story that is vastly different from the forecasts of conventional analysts. For example, while the supply-and-demand crowd makes it sound like wheat prices can rise indefinitely, wave analysis presents a much more cautious picture. On August 31, Elliott Wave International’s Daily Futures Junctures showed his subscribers this chart.

Despite the global wheat shortage scare, you see that editor Jeffrey Kennedy’s wave count implies a reversal at hand (at least, a short-term one.) Three things helped Jeffrey reach this conclusion:

  1. The overall wave count shows a completed structure at multiple degrees of trend. This chart shows that wheat’s recent rally is likely in the finishing stages of waves 5 of (5) of 5 circled – all within a larger wave III.
  2. In all markets besides commodities, the longest and strongest wave in an Elliott wave impulse if wave 3. But in commodities, it is often wave 5. The above wave count takes this peculiarity into account – as you can see, wave 5 is indeed extended.
  3. Waves within an Elliott wave pattern commonly relate to each other by a Fibonacci ratio. And as you can see in this chart, wave 5 reached 2.618 the length of wave 1 at the 771.5 level, a common Fibonacci proportion. This is often a sign that prices will not move much further.

Jeffrey also considered other clues, and concluded that a top may be close in wheat. Of course, all of these indicators are clues, not guarantees. Even so, as this example shows, the conclusions you can reach with wave analysis are much more measurable than the conventional thinking typically allows.

Link here.


True or False? Financial markets perform in the following way: First comes a major news event, such as a widely watched earnings report or unexpected weather disruption. And second, the markets react.

Answer: False as a $5.00 Gucci bag.

What really happens is altogether different. First, the markets make a meaningful move. Second, the mainstream “experts” scour the day’s headlines to find one or two events that “explain” the price action, after the fact. That is not a cause-and-effect relationship. It is a cherry picking one.

Take, for example, an August 28 story from a major financial news source titled, “Europe Gets A Reality Check”. According to the report, every major European stock index from France’s CAC 40 to Germany’s DAX spent the day in a powerful decline. As for why, the reasons were two-fold, starting with a downgrade of France’s largest bank BNP Paribas by Bear Stearns. Next came the dropping of the Barclays “bombshell”. To wit: A London Financial Times report claims that the 3rd-largest bank in the U.K. “has exposure in the hundreds of millions of dollars in failed debt funds” due to its various asset-backed funding vehicles for the U.S. sub-prime sector and troubled German Bank Sachsen LB.

The only problem is, European stocks took step one DOWN of a synchronized sell-off in mid-July, long before the FT “expose” on Barclays hit the stands. Shortly after the wheels began to turn, the August 2 Global Market Perspective stepped in to say – the “Reality Check” long since unpaid by European stocks was about to be cashed. In GMP’s own words, “In the context of European stock indexes, then, this decline should retest the June 2006 low. Thanks to the lingering memories of a strong rally, most people find it difficult to imagine markets falling sharply. So, it’s time for a reality check.”

The action since then speaks for itself.

Link here.


By now you are probably sick of the media telling you about the subprime mortgage market sucking real estate and the entire free world into the pit of despair. If your perspective depends on the mainstream media, you are in a thicket of mechanical symptoms, reasons and explanations. And most importantly, the sources that should keep your informed are themselves ignorant of the real cause of the new trend.

Why? Because so few understand the psychological progression of deflation. For example, a prominent New York Times article titled, “Why a U.S. Subprime Mortgage Crisis Is Felt Around the World,” is typical of most media coverage. The title seems to proclaim, “I am The Explainer,” but the article only retells the same tired history and lists symptom after symptom:

Do you really need to hear this litany again? Explanations of internal combustion and vapor lock do not help when you have run out of gas.

For each symptom of deflation, a different reason is proffered. An Orlando Sentinel article says the 29-month supply of condos now for sale in Orlando, and the 48,000 for sale and under construction in Miami, are due to the “bust” that followed “flipping”, “saturation”, and “overbuilding”. Even as the article gets close to the real reason for this drama – herd psychology – it wanders away. “... up to 70 percent of the condos rising in Miami were being snapped up by people who didn’t plan to hold on to them, much less live in them. That was evident from the hordes who camped overnight, fought over lottery numbers, even paid homeless men $20 and a pack of cigarettes to hold their places in long lines, all for the chance to put 20 percent deposits on condos that existed only in brochures. The frenzy for some projects was so fevered that some developers raised their prices hourly.”

Mainstream media cannot seem to pull the trigger on a comprehensive diagnosis – they just keep blaming the subprime problem. But the analysts here at Elliott Wave International make no bones about it. We see the early stages of deflation, a profoundly psychological event that destroys asset values. Our perspective on mass psychology allowed us to see it coming long before today’s symptoms began.

So what symptoms are next? The just-published Elliott Wave Financial Forecast says: “Anticipating the economic chain reaction won’t be hard, at least initially; just follow the old trail of easy money.”

Link here.


The 45% drop in earnings at Freddie Mac, for the quarter that ended in June, predating August’s intensification of the mortgage market crisis, indicates an uncomfortable reality. U.S. President Bush may attempt to hold back the tide of foreclosures by handing out yet more federal guarantees to subprime borrowers, but that will only delay the inevitable. Far from being able to assist the mortgage market by purchasing yet more mortgage backed securities, Fannie Mae and Freddie Mac are about to fight for their lives. The more interesting question is what should be done about it if they perish.

Fannie Mae and Freddie Mac were set up in 1968 and 1970 to extend the bizarre U.S. policy of having third party government-related entities guarantee home loans. Other countries do not do this. Britain had for many years a perfectly satisfactory system of building societies, mostly mutually owned, that made floating rate home loans to approximately the same percentage of the population as were homeowners in the U.S. While the British system has gone astray in recent years, it remains blessedly free of government bailouts though not of overpriced housing – in London it is prices that have reached truly gargantuan proportions, rather than the houses themselves as in the U.S.

Fannie Mae and Freddie Mac can get in financial trouble not only from accounting incompetence, although their inability to determine within a billion or two what their true profits are is fairly startling, but through market movements. In 1981-82 Fannie Mae sustained losses – $190 million in 1981 and $105 million in 1982. Those losses were made on a base of total outstanding guaranteed mortgages of $62.1 billion at December 1981, so represented 0.31% and 0.17% of outstanding assets respectively. Based on today’s (12-31-2006) asset book of $2,526 billion, Fannie would in a similarly problematic environment sustain losses totaling $12 billion, compared with its capital of $41.5 billion.

Fannie’s defenders would claim that its derivatives portfolio would prevent such losses in today’s market, but relying on Fannie’s derivatives trading skills seems optimistic. The interest rate risk on a portfolio of home mortgages is almost impossible to hedge, because prepayment rates vary wildly depending on interest rate movements and housing market conditions. All you can do is observe trends that have held good in the past and hedge against a repeat of them. There is no guarantee that such trends will repeat in the future. It is thus more than conceivable that Fannie Mae’s derivatives portfolio would magnify the institution’s losses rather than reducing them.

There is a further problem. The 1981 and 1982 losses occurred in a period of intense interest rate volatility, but did not coincide with a significant house price decline. Because inflation was so rapid during those years – 12.5% in 1980 and 8.9% in 1981, though only 3.8% in 1982 – nominal house prices dropped very little, except in pockets of industrial devastation. Fannie Mae’s credit losses were thus modest. This time around, it is already clear that house prices are dropping, and with mortgage markets tightening they are very likely to drop further, perhaps to a final low 15% below the peak nationwide and 30% below it on the coasts.

Needless to say, a 15% drop in house prices would spread mortgage losses far beyond the subprime sector, to which Fannie Mae and Freddie Mac have below-average exposure. With a total mortgage book of $2,526 billion (on and off its balance sheet) Fannie Mae would only have to incur loan losses averaging 1.64% of principal to reach insolvency. The epidemic of mortgage refinancing in 2002-05 will have reduced their capital cushion to much smaller than it might usually be. You thus do not need to imagine the Great Depression, but merely an extended period of poor housing markets, to postulate a scenario in which Fannie and Freddie expire (or more likely are bailed out by the U.S. taxpayer).

If such a bailout becomes necessary, it is to be hoped that Congress will look once again at the fundamental question: What should government’s role be in the home mortgage market, and what sort of mortgage market do we really want?

The traditional U.S. home mortgage market at its best is epitomized by the Frank Capra/Jimmy Stewart 1946 classic movie It’s a Wonderful Life. Home mortgages are made by savings and loans, which are purely local organizations. In order to get a mortgage, a borrower needs to have an account with the S&L, with a substantial amount on deposit. Jimmy Stewart, not a wealthy man, owns the local S&L, knows most of the borrowers personally, and has played a huge role in the development of his local town of Bedford Falls.

All very sweet and sentimental, you may respond, but today’s mortgage market has greatly increased efficiency, removing the barriers between borrowers and lenders, creating a liquid worldwide market in which German state banks and the People’s Bank of China can alike invest, and thereby hugely reduced the borrowing costs of the American homeowner. Is that not right?

No, actually it is not. For the earliest month for which the Federal Reserve has mortgage yield data, April 1971, the 20-year Treasury bond yielded 6.00%. 30 year fixed rate conventional mortgages yielded 7.31%, a differential of 131 basis points (1.31%). In the first month of data for the 30-year T-bond, April 1977, it yielded 7.75% while 30-year conventional fixed rate home mortgages yielded 8.67%, a differential of 92 basis points. Fannie and Freddie had only just got going in 1971 and were young in 1977. Unfortunately, pre-Fannie 1950s data is not readily available, but I am sure it would show the same general level of differentials.

And today? In July 2007, the latest month for which data is available, before the latest unpleasantness really got going, 30 year Treasuries yielded 5.11% and 30-year conventional mortgages 6.70%, a differential of 159 basis points. For February 2006, at the height of the housing boom, 30 year Treasuries yielded 4.54% and 30-year conventional fixed rate mortgages 6.25%, a differential of 169 basis points.

Averaging each pair of observations, a typical yield premium over long dated Treasuries for 30 year home mortgages was 112 basis points in the 1970s and 164 basis points today. Effectively, government guarantees, securitization, fantastic modern analytic technology and the combined genius of Wall Street have made home mortgages 52 basis points, just over 1/2% per annum, more expensive.

Anyone who has read the newspapers over the last few years can begin to guess what the problem is. Wall Street is full of centi-millionaires and even billionaires, while the wealthier mortgage brokers also drive Lexuses. House prices in real terms are far higher than 30 years ago, and mortgages are made on an entirely impersonally, using computerized credit scoring, with everybody skimming off commissions and nobody responsible for the credit risk until the mortgage becomes a tiny part of the assets of an offshore securitization conduit of a half-asleep German bank. The above analysis shows that these people are not economically adding value, but are mere successful rent-seekers.

One might ask, if the new system is so much less efficient in delivering value to the ultimate customer, how did it drive out the old? The answer is one word: salesmanship. Anybody who has lived in a U.S. suburb with an economically attractive zipcode and no butler will recognize that excessive salesmanship is the bane of American life. This is even more true in the mortgage business. Homeowners today do not go into their local S&L, save for half a decade and request a mortgage from Jimmy Stewart. Instead they are sold a mortgage product, either directly or over the Internet, by an aggressive salesman who is paid a multiple of what Jimmy Stewart earned, or at least aspires to be. That product is then securitized by an investment bank trader who in good years is paid a LARGE multiple of what Jimmy Stewart earned. With others it is sold to a securitization vehicle of immense complexity that has been set up by Wall Street lawyers paid a HUGE multiple of what Jimmy Stewart earned. Costs have been increased at every point in the process, but aggressive salesmanship has driven Jimmy Stewart out of business.

The government has played a role too, primarily in the early stages of securitization development. Government guaranteed mortgages, originally for low income housing under the aegis of Ginnie Mae, were the first to be securitized, in 1968. It is likely that the mortgage bond market would never have achieved sufficient investor acceptance without its government guarantees. Investors would have been rightly suspicious of a package of mortgages to unknown homeowners scattered around the country, and would have demanded a yield high enough to make the transaction impossible. However, it is likely that government guarantees (or those of the “government sponsored entities” Fannie Mae and Freddie Mac) are no longer necessary except perhaps in low-income housing where an element of subsidy is involved. The FTC could rightly require Fanni, Freddie Mac, and the whoe mortgage banking industry to run corrective ad campaigns with the slogan: “Interfering unnecessarily in your home mortgage to make it 1/2% more expensive.”

Skeptics may object that technological advances at least may have made obsolete the Jimmy Stewart model of individual credit assessment and funding by personal savings. Credit scoring, by which computerized models are used to assess borrower credit quality, and money market funds, by which savings are bundled and placed through the wholesale money market. However mortgages are not credit cards. The amounts are much larger and the terms longer, so they would certainly repay an individual credit assessment, particularly if savings for down-payments were also required. Moreover, with computerized bank teller procedures and universal deposit insurance, S&Ls could today compete with money market funds at only a modest additional funding cost, and would use wholesale markets to smooth local gluts and scarcities of savings. Another new development, the interest rate swap market, can now minimize the mismatch between 30 year mortgage rates and 3 month deposit rates, which got the S&L industry in trouble in 1980-82.

If Fannie Mae and Freddie Mac go bust they should not be bailed out. They are unnecessary, as is the whole system of government guarantees. Instead legislation should establish a new system of home mortgage institutions, requiring a minimum 10% down-payment for mortgage loans and enjoying federally guaranteed deposit insurance. At the same time, a stamp duty of say 1/4% should be imposed on securitization transfers, making that market illiquid and unattractive to Wall Street and investors. The home mortgage interest deduction could also usefully be repealed, reducing the attraction of McMansion ownership to the wealthy (and making little difference to those of modest means, whose mortgage interest payments generally fall within or close to the “standard” income tax deduction).

No giant fortunes, but only moderate ones would be made from the new institutions. However they would reduce the cost of home mortgages and remove an entirely parasitic sector from the U.S. economy. Because of the down-payment requirement, they would also perform the economically essential function of increasing the U.S. savings rate.

Most important, such a system, by making “flipping” impossible and McMansion ownership more expensive would decrease house prices, bringing homeownership much more securely into the financial reach of those with moderate incomes. Homeownership would thereby increase rather than diminish overall, with only cheats, speculators and vulgar egomaniacs worse off. Time to bring back Jimmy Stewart!

Link here.


It is beginning to dawn upon people how a deflationary spiral works. As explained in Conquer the Crash, to satisfy creditors, debtors will sell all they can, even their best assets, to raise cash. That is one reason why gold and silver are not going up. When the subprime mortgage market crashed, guess what? Other bonds, including supposedly safe municipal and corporate bonds, also fell. Most commentators believe that forced liquidation is the only reason that perfectly good investments fell in price. As one report dated August 24 said, “There’s really no credit-related reason behind the decline.”

But Conquer the Crash is on record predicting that a large portion of currently outstanding corporate and municipal debt will become worthless. Every trend has to begin somewhere, and its ultimate outcomes are never evident at the start of a move. By the end of the price decline in these bonds, when a bit of glue on the back of them will aid their use as wallpaper, observers will finally postulate why the bear market started in the first place. Even if most of the recent price declines are due to forced sales, those sales in turn are decreasing the total value of investments, which in turn will curtail individuals’ and companies’ economic activity, which will lead to an economic contraction, which will stress the issuers of such bonds to the point that they will be unable to make interest payments or return principal. In other words, whether investors understand it now or not, the forced sale of bonds is itself enough reason to sell them also on the basis of default risk.

Despite my description, this process is not linear. Every step of the way seems to have an immediate causal precursor, but like credit inflation, credit deflation is in fact an intricate, interwoven process, whose initial impetus is a change in social mood from optimism toward pessimism. If you are still on the fence about this idea, ask yourself: What changed in the so-called “fundamentals” between June and August? Absolutely nothing. Interest rates did not budge; there were no indications of recession; there were no changes in bank lending policies; there were no chilling government edicts. The only thing that changed was people’s minds. One day sub-prime mortgages were a fine investment, and the next day they were toxic waste ...

Link here.


The Federal Reserve keeps thorough records of U.S. consumer credit, and most of the data goes back 30 years or longer. It is all on the Internet. Scroll through the numbers, and before long you will have what amounts to a crash course in how rapidly the debt levels have grown during just one generation.

New car loans, for instance: In June 1971, the total amount financed averaged $3,045 for 35 months, with a 13% down payment. Fast-forward to May of this year, and the amount financed averaged $27,163 for 61 months, with a 6% down payment.

But to see what real growth in the debt levels looks like, “revolving credit” (also known as credit card debt) is the place to look. The Fed’s records on revolving credit begin in January 1968. The figure for that month totaled $1.4 billion. Jump a little more than five years ahead and you come to the first month when revolving credit exceeded $10 billion – $10.2 in June 1973. Barely 11 years later came the $100 billion threshold – $106.26 in December 1984. The latest release showed that for June 2007, revolving credit stood at $903.9 billion. By next year, or no later than 2009, total revolving credit will exceed $1 trillion, assuming, of course, that the current rate of growth remains on a linear path ...

Which is not a safe assumption by any stretch. Things could turn non-linear in a matter of days. A large and “unforeseen” disruption could hit the revolving credit industry, just as the subprime disruption struck the mortgage/real estate industry. In turn, the media will say that the unforeseen problem was “unforeseeable” – which is absolute rubbish.

The subprime blow-up was foreseen by analysts who looked objectively at the data and the trends. Even so, the subprime problem is only one component of the larger debt and credit problem. The same thing can (and almost certainly will) be said about revolving credit.

Link here.


The costs of growth are often ignored in financial forums. That is why we are dedicating this week’s article to the environmental impact China’s massive industrialization places on both their own country as well as the greater global community. We hope this shows a side of China often neglected in the mainstream media.

We owe a great debt of gratitude to two individuals whose research went a long way in the development of this report. First, we would like to thank Elizabeth C. Economy, author of the essay “The Great Leap Backward? The Costs of China’s Environmental Crisis”, found in the latest issue of Foreign Affairs. We would also like to thank James Kynge, former China Bureau Chief for the Financial Times and author of the book China Shakes the World. Many other scholars, editors, and interested parties contributed to this essay without their direct knowledge.

Consider some of these costs:

According to Elizabeth Economy, “The environmental degradation and pollution cost the Chinese economy between 8 percent and 12 percent of GDP annually – water pollution costs of $35.8 billion one year, air pollution costs of $27.5 billion another, and on and on with weather disasters ($26.5 billion), acid rain ($13.3 billion), desertification ($6 billion), or crop damage from soil pollution ($2.5 billion).”

Meaning, there seems to be great economic incentive to aggressively address this catastrophic problem. And as James Kynge points out, it is not that the world lacks the resources to support China’s growth, it is simply that the world does not have enough resources to cater to 1.3 billion Chinese behaving like Americans.

Link here.


Almost every day there is a new technology that could change the world as we know it. But we all know that only one in a thousand actually do. Here we have that one.

In a time of war and political criticism of troop protection (see this successful 2006 campaign ad), there is a breakthrough that is sure to become standard in every piece of body armor used in the military, not to mention in civilian life. An amazing new use of nanotechnology will soon be deployed on the battlefield to save lives. It should also have police and security applications, not to mention a variety of consumer possibilities.

ScienCentral News reports that two research teams – one at the University of Delaware, the other at the U.S. Army Research Lab – have perfected this unique material. It combines nanoparticles and a special liquid. Under normal conditions, it is flexible and soft. It is lightweight and basically unnoticeable when worn. However, under sudden impact it momentarily becomes solid. This happens almost instantly, about a millisecond following impact. Not only that, but the scientists have figured out how to impregnate materials such as Kevlar with it, vastly improving the protective properties. Currently, Kevlar is reasonably effective against bullets but useless against something such as a knife, or shrapnel from a roadside bomb.

The new material gives resistance to projectiles and defends against sharp weapons. The key benefit of the special liquid is that it spreads the force over a much wider area, thereby dispersing it. It only adds 20% to the weight of a garment.

I foresee this technology having multiple civilian applications, including a possible additional layer of protection during car crashes. It may also be used to strengthen tires, perhaps helping to prevent blowouts. Especially exciting is the possibility of finally having suitable bodily protection for motorcycle riders and bicyclists who are presently at the mercy of the least competent car driver on the road.

A company named Armor Holdings, a subsidiary of BAE Systems (LSE: BA.L), has acquired rights to the technology. It will release the first products sometime this year. Unfortunately, BAE is too large a company for our investment purposes. But in development of technology like this, there are almost always smaller companies that make good money off of it.

Link here.


On July 24, Westinghouse Electric signed a deal to build four nuclear reactors in eastern China. The price tag on the deal is $8 billion. This is just one tiny piece of the puzzle. China plans to spend approximately $50 billion to build 30 nuclear reactors by 2020. This will increase its nuclear energy production by 40 gigawatts. That is basically enough power to supply all of Spain with electricity. The growth in the nuclear market has resulted in a very large increase in the demand for yellowcake.

I am not talking about the cake your grandmother brings to your birthday party, either. I am talking about refined uranium. The price of uranium has seen a kind of growth second to no other commodity, equity index, or virtually any other investment vehicle available. From 2003 to the present, the spot price of uranium went from $7 to $130 per pound without declining once. And I am here to tell you that this amazing price run is not over yet, not even close. In fact, this market is just barely starting to catch the public eye, but once it becomes mainstream, the uranium market will really take off.

Uranium is the perfect case study for discussing the notion of a supercycle. A commodities supercycle refers to the extended periods of time when either supply exceeds demand, followed by demand exceeding supply, or vice versa. This cycle extends of a period of several years.

Most of the demand for uranium came from the U.S.’s and the USSR’s amassing nuclear warheads. After the fallout of the Cold War, and the incidents at Three Mile Island and Chernobyl, the demand for uranium plummeted. Nuclear power plants that were planned for production were canceled at a very rapid pace. And to add further downward pressure, much of the demand that was still left was fulfilled by recycling old Soviet warheads, which is a process that goes on today.

For all of these reasons, the spot price of uranium slumped to a low of $6.50 per pound. This drove the majority of uranium miners out of the market. Supply continued to greatly exceeded demand, fueled by a couple of extraneous factors.

Let us fast-forward to 2003. The green energy movement is starting to take hold of the media, public, and Washington alike. Geopolitical tensions are making it essential that nations secure energy resources and become less dependent on politically unstable regions – especially the Middle East.

So nuclear energy is back. But there are very few uranium mines still in production, and exploration efforts are essentially nonexistent. It was around 2003 that we began to transition from excess supply to excess demand. Time to get the shovels digging, the leach operations running, and the mills churning ... easier said than done, for these processes take time. And there are many obstacles. Operating capital could dry up. There could be a failure to obtain permits. What if there is no uranium on your property?

Even if everything goes well, you are talking at least six years until a mine becomes operational from initial exploration, and it is for this reason that there is a long period of time during which demand exceeds supply. This shortage will always show up in price, and that is exactly what we have and will continue to see.

The theory of commodity supercycles clearly explains why supply has lagged behind demand and will continue to do so over the coming years. But there is another story behind the supply shortage in uranium. Uranium deposits often occur in geologically fragile areas. Uranium mines are susceptible to disruptions. This is a risk with any mine, but the risk is higher with most uranium mines. In the last eight months two major mines – Cameco’s Cigar Lake operation and Energy Resources of Australia’s Ranger mine – have been flooded, which caused significant delays in future production.

The impact of Cameco’s flood is very significant on the market. Cigar Lake had the world’s largest undeveloped high-grade uranium deposit. The proven and probable reserves are estimated at 226.3 million pounds of U3O8, with an average 21% grade. It is very easy to see the significance of delaying this planned production from the market. The flooding at the Ranger mine was not a result of geological instability, but a result of Mother Nature. Tropical Cyclone George was the cause of the flooding at the Ranger mine. Energy Resources of Australia’s planned production was revised down to 7.5 million pounds of uranium – a four million pound decline, or 4% of total world production.

Situations like these are unable to predict and carry devastating implications for the supply of U3O8. Remember that these two incidents occurred within the past eight months. Although one cannot say when or where, you can bet that we have not seen the end of scenarios like the above-mentioned ones.

The demand side finishes the bullish picture for uranium. The main catalyst is the move to green energy. Nuclear power plants have no carbon emissions. The growth of nuclear power is just beginning, but planned production is expected to greatly increase the demand for uranium. Here is a list of the amount of power plants planned for production: U.S., 34; China, 40-plus; Russia, 42; S. Korea, 11; and many others. That is combined with the 448 nuclear power plants currently in production.

The end result of this is an annual rate of consumption currently running at 188 million pounds of U3O8 per year, compared with an annual mine production of 100 million pounds of U3O8 per year. The difference is made up in excess ore pilings and old Soviet warheads being converted into nuclear fuel.

The uranium market is very transparent. This makes the supply and demand fundamentals extremely easy to read and interpret. Supply disruptions have increased the shortages of available uranium for delivery. Junior and intermediate miners are all racing to get production online, but the general public has trouble understanding the time and money it takes into turning these properties into profitable ventures. The use of nuclear energy as an alternative to carbon-based fuel sources has really set into place the emergences of a fantastic bull market.

There is going to be an innovative way to play this market. In mid August a nuclear energy ETF was released here in the U.S. The ticker is NLR. It follows the DAXglobal Nuclear Energy Index. This is an ETF that invests in the following fields: uranium mining, uranium enrichment, uranium storage, nuclear power plant builders, nuclear fuel transportation, nuclear equipment and generation. This is really exciting stuff and its price will very likely jump, being that it is one of a kind here in the U.S. Given a good buy price, this one is a safe and potentially highly profitable way to play the uranium market.

Link here.


No matter how the markets move, there is still money to be made in uncertain or dangerous times, whether you are talking about the stock markets or society as a whole. After all, someone needs to be there to pick up the pieces.

Two years after Hurricane Katrina battered the Gulf Coast, the government, private enterprise and charities continue to pour billions into cleanup efforts. As of last summer, the federal government alone shelled out $3.6 billion to cart off nearly 100 million cubic yards of debris from the area. And cleanup efforts continue to this very day.

Many companies have been making money hand over fist, while at the same time rebuilding New Orleans and other areas that got blasted. Home Solutions of America (NASDAQ: HSOA) is a company that is currently in a very heated battle with a short seller that has been slandering the company in the news this past year. But you may also know of this company as one of the leading restoration companies in the rebuilding of New Orleans.

A disaster like Katrina leaves hundreds of thousands and, sometimes, even millions out of their homes. And it is not easy to think about making money off of it, but you should not see it that way. Even in disasters like this, the companies that help people can also bring investors huge profits. Take a look at what happened to Home Solutions’ stock price when they were rewarded with New Orleans restoration contracts.

Of course, there is even more work to be done after the debris is swept under the rug. Hazardous and toxic wastes from mining operations, industry and the like are routinely leaked onto agricultural land, city streets and residential neighborhoods during flooding. In fact, this type of cleanup is almost always necessary whenever flooding occurs.

Link here.


“The rule is that financial operations do not lend themselves to innovation. ... The world of finance hails the invention of the wheel over and over again, often in a slightly more unstable version. All financial innovation involves, in one form or another, the creation of debt secured in greater or lesser adequacy by real assets. ... All crises have involved debt that, in one fashion or another, has become dangerously out of scale in relation to the underlying means of payment.” ~~ John Kenneth Galbraith, A Short History of Financial Euphoria (1993 Edition)

Ponzi Economy

As risk and fear (of future risk) make an inconvenient reappearance on the stage of the hitherto irrationally exuberant credit markets, many observers are wondering if we have arrived at the dreaded Minsky Moment.

Hyman Minsky was the American economist who authored the Instability Hypothesis ... the counter-intuitive notion that stability leads to instability. And how does an economy go from “stability heaven” to “instability hell”? As always, “The road to hell is paved with good intentions.” To boost growth, central banks cut rates and increase liquidity. Lower cost and higher supply of money leads to a predictable outcome – a borrowing binge. As the credit spigot spews liquidity, the entire economy enjoys luxuriant growth. Consumers go on a spending spree. Corporations expand operations, hire people and bid up wages. And, as incomes and spending rise, so do government revenues. All three parts of the economy – the consumer, business, and government sectors bloom like a plant getting plentiful water, nutrients, and sunshine. Concomitantly, we get another phenomenon – asset (read real estate, stocks) prices skyrocket. For some reason, economists call that “wealth creation” rather than inflation! Now you have the “virtuous” cycle fully cranked up. More borrowing, more spending, more asset price inflation ... leading to more borrowing. With abundant liquidity, credit quality looks great – you can always borrow (no need to rob) from Peter to pay Paul – and this emboldens the lenders to lend even more money. With “wealth” growing, unemployment low, and incomes rising, consumers continue to confidently borrow, spend, and speculate in the asset markets.

Minsky postulated that “stability” of this kind leads to some undesirable consequences. One is that it changes the nature of borrowers. In any economy you have three kinds of borrowers: (1) Hedge – where both the principal and interest are repaid out of current income (think “traditional” fully amortizing 15-30 year mortgages). (2) Speculative – where only interest is paid (think “interest only” mortgages). And (3) Ponzi – where the payment does not even cover the interest (think negative amortizing “payment option” ARMs). Of course, Minsky’s choice of labels for each kind of borrower reflected a value judgement – that for stability, you need “hedge” borrowing, that “speculative” borrowing is undesirable and that “Ponzi” borrowing should be entirely avoided. Ponzi, of course, refers to the notorious Charles Ponzi (1882-1949) who was convicted of running a fraudulent investment scheme where initial investors got outsize “returns” by distributing the capital received from subsequent investors. Quite unusual for a “dismal scientist”, Minsky dared to call a spade a spade, and characterized negative amortization borrowing or lending as “Ponzi Fraud”.

So, let us take a look at the kind of lending and borrowing that has been going on over the last quarter century in our economy. Surely, it is no news that debt has been exploding for all sectors of the economy (see figure). The message from the table is clear. All three sectors have been increasing their debt loads in relation to their underlying capacity to service it. In Minsky’s terminology, all three sectors have been operating as Ponzi units. Note that the most highly leveraged, and therefore the most vulnerable, sector is the consumer.

Financial Innovation

Galbraith, the American economist we quoted at the beginning of this essay, upon much study of financial euphoria followed by the inevitable crisis, came to a stark conclusion – financial innovation is a chimera: “The world of finance hails the invention of the wheel over and over again, often in a slightly more unstable form ...” Understandably, Wall Street leaders and financial engineers will disagree vehemently with this assessment and dismiss Galbraith as a “left-wing fuddy-duddy” who was incapable of appreciating the wonders of modern finance. You can trade not only the traditional assets such as stocks, bonds, commodities, and currencies, but derivatives of a bewildering variety. Not only can you buy and sell mortgages but also CDOs based upon them and if that is not enough, CDOs squared and cubed!! If mutual funds are too stodgy for you, you can “invest” in funds of funds, indices, hedge funds, private equity funds, and so on. And you can trade these assets 24/7 globally/

Yes, but what does that prove? It only shows that the globally legalized gambling casino called the “financial markets” has created a plethora of “gaming” opportunities, and it is open to its “patrons” 24/7 globally. The American legalized gambling industry does not call itself by that name. That would be an inconvenient truth. So they euphemize. If you go to Las Vegas and play craps, you are not gambling, you are just entertaining yourself ... it’s harmless, like watching movies or eating out!

Similarly, the financial services industry positions its activities as “investing” and the gamblers, you and I, as “investors”. Of course the beauty here is that it gets to do this speculation with OPM (Other People’s Money). The philosophy is “Heads I win, tails you lose.” For hedge funds the typical pricing is 2/20. The fund manager, on top of the 2% annually he gets on your investment (which grows if the fund does well), gets 20% of your gains but 0% of your losses. Of course, “investments” are a skilled game of chance – like blackjack or poker rather than slot machines. And the fund managers are supposed to possess this rare skill in abundance, for which they get paid the big bucks. Never mind that most of them do not beat the indices or, that Bear Stearns, the self-professed mortgage expert, managed to lose the bulk of the value of investments in a couple of their hedge funds.

So yes, look behind the dazzle and the hype of this veritable explosion of investment vehicles, and you find the same eternal verities, all of which involve:

  1. A claim over an income-producing (one hopes!) asset
  2. Leverage

A brief look at today’s new-fangled “assets” serves to support Galbraith’s assertion that they are just the same “wheel” but often more unstable. Take mortgages, for example. The traditional 20% down 15/30 year fixed-rate mortgage (FRM) is simply a loan that enables the consumer to purchase a home. So is the 0% down, stated income/assets adjustable-rate mortgage (ARM). No less a celebrity than the maestro himself, Sir Alan Greenspan, hailed the creation of ARMs as a great financial innovation, urging homeowners to save money by going for ARMs rather than FRMs. Today, with ARMs resetting higher, home sales plummeting, and home values falling, record numbers of homeowners face foreclosure as they increasingly find themselves in the “can’t pay, can’t refinance, can’t sell” box. (Greenspan either had no foresight or he possessed a sadistic disposition – neither attribute is especially flattering for a Fed Head!). Who can argue against the proposition that this innovation was simply a reinvention of the same old wheel, but in a highly unstable form?

Wheels about to come off?

Galbraith asserts that financial crises happen when “... the debt becomes dangerously out of balance with respect to the underlying means of repayment.” The key question is, “How can we tell when the tipping point is reached?”

Clearly, the path that the U.S. economy has been on for the last 25 years is unsustainable. A simple reductio ad absurdum argument clearly demonstrates that debt to income ratios cannot increase to a point where the debt servicing burden exhausts all of the disposable income for consumers, because that would imply that consumer spending (70% of the economy) would go to zero. Obviously the tipping point is reached well before that.

  1. After a prolonged period of stability and prosperity (think mid-late 1990s, and 2003-06), fueled by a rapid increase in consumer debt, asset (stocks, real estate) values rise steeply.
  2. While much of the money goes into asset inflation, some does spill over to cause goods and services inflation, which causes the central bank to raise borrowing costs and cut supply.
  3. This crimps the borrow-and-spend dynamic. It also cuts off the “oxygen supply” to investors who are speculating in the asset markets with borrowed money.
  4. If economic actors are, in the Minsky classification, “hedge” units, they have some cushion to weather the credit crunch. For example, fixed-rate mortgage holders are not affected by rising interest rates.

However, if several participants have become “Ponzi” units, they face default. The conditions for a system wide banking crisis are:

  1. Debt-servicing burden squeeze or shock. A squeeze may result from higher fixed expenses, e.g., energy costs. A shock could arise from an ARM reset or job loss.
  2. Asset price deflation – falling values for real estate, stocks, etc.
  3. Rapidly rising credit write-offs – due to both increasing default frequency as well as severity (due to falling value of collateral).
  4. If sufficiently severe, this leads to a big drain on bank capital with the result that no money is available for new lending (a la Japan in the 1990s), i.e., a credit crisis.

Even a cursory look at the current U.S. economic situation reveals that conditions are ripe for a crisis. There are several reasons why the probability of a systemic seizure is high and rising.

  1. The housing market is in a deep recession. As inventories rise, price drops will accelerate.
  2. Mortgage credit is drying up for several critical segments (Sub-Prime, Alt-A)
  3. Defaults are already at record levels, and will rise exponentially as record numbers of ARMs reset over the next two years.
  4. Consumer spending growth has slowed to a crawl (1.7% in Q2 2007) and is set to fall further.
  5. Corporate profits have peaked and are set to fall as consumer spending hits a wall and financial service firms’ profits decline due to market turmoil, slow asset growth, thin margins, and rising credit write-offs.
  6. Corporations will respond to the lower profits with cutbacks and layoffs. Unemployment will rise and consumer incomes will fall. This will lead to more defaults and lower spending.

So what may be the ray of sunshine in this gloom and doom scenario? The Fed, following its well-publicized playbook, will cut and cut aggressively as an economic recession begins later this year or early next year. The critical questions are, “Will it be in time and will it be enough?” While this medicine has worked in the past, there are several key differences this time around.

  1. The debt burden is much higher.
  2. It is a housing and consumer led recession (rather than corporate capital spending driven as in 2000).
  3. House prices are deflating nationally for the first time since the Great Depression.
  4. A consumer and corporate credit crunch has developed prior to the recession.
  5. Mortgage defaults are at record levels already. Usually, they peak a couple of years after the recession.
  6. Funding for private equity, corporate buybacks, hedge funds etc. is drying up.

The bottom line is, can the Fed, by lowering rates, get more money in the hands of consumers and businesses? It looks like the answer is NO because borrowers will not see lower rates due to rising risk premiums. In fact, due to the new lending regulations, for many consumers, money will simply not be available regardless of rates (think subprime). Moreover, due to the weak dollar (which will fall further when the Fed lowers rates), inflation may remain high. Also, long-term rates may not fall as foreign central banks diversify out of the U.S. Dollar to protect the value of their portfolios.

So, it seems we have arrived at the “Galbraith Moment”. The wheels of the U.S. economy are about to come off as our debts have become dangerously out of proportion to the underlying means for repayment.

Link here.
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