Wealth International, Limited

Finance Digest for Week of October 1, 2007

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


Very few people understand the “continental drift” that threatens with a fracture of the U.S. (and hence, the world) monetary system. There are two tectonic plates: one, the supply of Federal Reserve notes, and the other, the supply of electronic dollars in the form of an inverted pyramid that rests on the supply of FR deposits. The fault line between the two tectonic plates is a worrisome source of unpredictable earthquakes that could cause massive and permanent damage to the U.S. and world economy. The monetary fault line exists because of the different statutory requirements the Fed has to meet in order to increase the supply of “high-powered money”:

  1. FR notes must be collateralized by gold or by U.S. Treasury bills and Federal Agency securities. The Federal Reserve does not print FR notes (still less can it air drop them). It gets them from a government official called Federal Reserve Agent against pledging appropriate collateral.
  2. FR deposits may simply be collateralized by the note of the borrower who borrows from any of the FR banks. Thus the Fed can increase FR deposits on its own authority, without reference to the government. The banking system then builds its own pyramid of deposits upon the fractional reserve of FR deposits.

Thus there is a serious obstacle in the way of increasing the money supply by increasing the volume of FR notes in circulation, giving the lie to Chairman Ben Bernanke’s promise to air drop them from helicopters: falling interest rates. For example, if the T-Bill rate dips into negative territory, then the market value of T-Bills exceeds their face value and the Federal Reserve “cannot afford” to buy them in the open market. The shortage of eligible collateral will restrict the inflation of FR notes in circulation. By contrast, FR deposits can be created out of the thin air in unlimited quantities at the click of the mouse.

Herein lies the danger of monetary earthquake along the fault line. The outstanding issue of FR notes as of September 20, 2007 was a paltry $760 billion, which is less than 0.2% of the notional value of derivatives. Just a drop in the ocean of potential bad debt. It is possible for the tectonic plate of hand-to-hand money, the FR notes to deflate, while that of electronic dollars to go into hyperinflation. The decoupling has frightening consequences for the financial and economic future of the world.

Electronic dollars vs. the foldable kind.

Helicopter Ben has just made a most unpleasant discovery. Earlier he has promised that the Fed will not stand idly by while the dollar deflates and the economy slides into depression. If need be, he will go as far as having dollars air dropped from helicopters. The time came to make good on those promises in August when the subprime crisis erupted. To his chagrin Ben found that electronic dollars, the kind he can create instantaneously at the click of the mouse in unlimited quantities, cannot be air dropped.

For electronic dollars to work they have to trickle down through the banking system. The trouble is that when bad debt in the economy reaches critical mass, it will start playing hide-and-seek. All of a sudden banks become suspicious of one another. Is the other guy trying to pass his bad penny on to me? In extremis, one bank may refuse to take an overnight draft from the other and will insist on spot payment. A field day for Brink’s. The clearing house is idled, and armored cars run in both directions up and down Wall Street delivering FR notes and certified checks on FR deposits.

Under such circumstances electronic dollars will not trickle down. In effect they could be frozen and, ultimately, they may be demonetized altogether by the market. How awkward for Helicopter Ben.

Northern Rock is a bank headquartered in Newcastle, England. It was a high-flyer using novel ways of financing mortgages through conduits and other SIV’s (Structured Investment Vehicle, a euphemism for borrowing short, lending long through securitization), instead of using the more traditional methods of building societies through savings. Now a run on the bank has grounded the high-flier. As long queues in front of the doors of branch offices indicate, a world-wide run on banks may be in the offing. Bank runs were thought to be a pathology of the gold standard. In England they have not seen the like of it since 1931 when the bag lady of Threadneedle Street went off gold. Surprise, surprise, bank runs are now back in vogue playing havoc on the fiat money world. Depositors want to get their money. Not the electronic variety. They want money they can fold.

There is the rub. Pity Helicopter Ben. It looked so simple a couple of weeks ago. The promise of an air drop should stem any run. It sufficed to tell people that he could do it. No reason to mistrust the banks since they are backed up by air drops. Now people have different ideas. The air drop is humbug. Can’t be done. Ben is bluffing. He has no authority to run the printing presses as he sees fit. He has got to have collateral. Moreover, as calculated by Alf Field writing in “Gear Today, Gone Tomorrow” (September 6, 2007) if only 10% of the notional value of derivatives is bailed out by dropping $500 FR notes, the pile would be nearly 9000 miles high. Helicopter Ben has not reckoned that FR notes do not exist in such quantities. They will have to be printed, not to say collateralized, before they can be dropped. It is true that the Federal Reserve has an additional $225 billion in unissued and uncollateralized FR notes, just in case. However, before the air drop they have to be collateralized, and that is easier said than done. There is not enough of T-Bills and agency securities to be used as collateral.

What does it all mean?

At minimum it means that we can have inflation cum deflation. I am not referring to stagflation. I refer to the seemingly impossible phenomenon that the money supply inflates and deflates at the same time. The miracle would occur through the devolution of money. This is Alf Field’s phrase to describe the “good money is driven out by bad” syndrome – Gresham’s Law. Electronic dollars driving out FR notes. The more electronic money is created by Helcopter Ben, the more FR notes will be hoarded by banks and financial institutions while passing along electronic dollars as fast as they can. Most disturbing of all is the fact that FR notes will be hoarded by the people, too. If banks cannot trust one another, why should people trust the banks?

Devolution is the revenge of fiat money on its creator, the government. The money supply will split up tectonically into two parts. One part will continue to inflate at an accelerating pace, but the other will deflate. Try as they might, the government and the Federal Reserve will not be able to print paper money in the usual denominations fast enough, especially since the demand for FR notes is global. Regardless of statistical figures showing that the global money supply is increasing at an unprecedented rate, the hand-to-hand money supply may well be shrinking as hoarding demand for FR notes becomes voracious. The economy will be starved of hand-to-hand money. Depression follows deflation as night follows day.

Next to deflation of hand-to-hand money there will be hyperinflation as the stock of electronic money will keep exploding along with the price of assets. You will be in the same boat with the Chinese. You will be put through the tantalizing water torture: trillions of dollars floating by, all yours, but which you are not allowed to spend. The two tectonic plates will disconnect: the plate of electronic dollars from the plate of FR notes, with lots of earthquakes along the fault line. No Herculean effort on the part of the government and the Federal Reserve will be able to reunite them. At first, electronic dollars can be exchanged for FR notes but only against payment of a premium, and then, not at all.

If you think this is fantasy, think again. Look at the charts showing the collapse of the yield on T-Bills. While it may bounce back, next time around the discount rate may go negative. Impossible, you say? It routinely happened during the Great Depression of the 1930s. Negative discount rate means that the T-Bill gets an agio – the discount goes into premium even before maturity, and keeps its elevated value after. This perverse behavior is due to the fact that T-Bills are superior to FR notes in that they earn a yield while they are just as acceptable (if not more acceptable in very large amounts) as are FR notes. People will clamor for money they can fold, the kind people and financial institutions hoard, the kind foreigners have been hoarding for decades through thick and thin: FR notes. T-Bills are a substitute for the hard-to-come-by FR notes. Mature bills may stay in circulation in the interbank market, in preference to electronic dollar credits. Their supply is limited, while the supply of electronic dollars is unlimited! The (negative) T-Bill rate will be an indicator showing how the Fed is losing the fight against deflation.

The scramble down the inverted pyramid.

The grand old man of the New York Federal Reserve bank’s gold department, the last Mohican, John Exter explained the devolution of money (not his term) using the model of an inverted pyramid, delicately balanced on its apex at the bottom consisting of pure gold. The pyramid has many other layers of asset classes graded according to safety, from the safest and least prolific at bottom to the least safe and most prolific asset layer, electronic dollar credits on top. (Exter talked about FR deposits and other bank deposits built upon them as fractional reserve, before electronic dollars were invented.) In between you find, in decreasing order of safety, as you pass from the lower to the higher layer: silver, FR notes, FR deposits, T-Bills, agency paper, T-Bonds, other loans and liabilities of the banking system denominated in dollars. In times of financial crisis people scramble downwards in the pyramid trying to get to the next and nearest safer and less prolific layer underneath. But down there the pyramid gets narrower. There is not enough of the safer and less prolific kind of assets to accommodate all who want to “devolve”.

Devolution is also called “flight to safety”. An example occurred on Friday, August 31, 2007, as indicated by the sharp drop in the T-Bill rate from 4% to 3%, having been at 5% only a couple of days before. As people were scrambling to move from the higher to the lower layer in the inverted pyramid, they were pushing others below them further downwards. There was a ripple effect in the T-Bill market. The extra demand for T-Bills made bill prices rise or, what is the same to say, T-Bill rates to fall. This was panic that was never reported, still less interpreted. Yet it shows you the shape of things to come. We are going to see unprecedented leaps in the market value of T-Bills, regardless of face value! You have been warned: the dollar is not a pushover. Electronic dollars, maybe. But T-Bills (especially if you can fold them) and FR notes will have enormous staying power. Watch for the discount rate on T-Bills morphing into a premium!

It is interesting to note that gold, the apex of the inverted pyramid, remained relatively unaffected during the turmoil in August. Scrambling originated in the higher layers. Nevertheless, ultimately gold is going to be engulfed by the ripple effect as scrambling cascades downwards. This is inevitable. Every financial crisis in the world, however remote it may look in relation to gold, will ultimately affect gold, perhaps with a substantial lag. The U.S. Government destroyed the gold standard 35 years ago, but it could not get gold out of the system. It was not for want of trying, either, as we all know. Gold remains firmly embedded as the apex of Exter’s inverted pyramid. Incidentally, it is a lie that gold has been demonetized. Gold is still a collateral used for FR notes. What happened was that further monetization of gold was blocked by fixing the official price of gold at $42.22 per Troy ounce, and at that price nobody is offering gold to the Federal Reserve. If someone did, according to existing statutes the Federal Reserve was duty bound to monetize it. Shame on academia for spreading lies about the demonetization of gold!

Vertical devolution is not the only kind that occurs in the inverted pyramid. There are similar movements that can be described as horizontal. An example is the difference between gold in bar form and gold in bullion coin form, or silver in bar form and silver in the form of bags of junk silver coins. Franklin Sanders is an expert on horizontal devolution of silver and has a fascinating study how the discount on bags of junk silver coins may go into premium, and vice versa. There may also be differences between FR notes of older issues and FR notes of the most recent vintage. There are obvious differences between the CD’s of a multinational bank and those of an obscure country bank. The point is that movement of assets horizontally between such pockets within the same safety layer is possible and may be of significance as the crisis unfolds and deepens.

Dousing insolvency with liquidity.

In a few days during the month of August central banks of the world added between $300 and $500 billion in new liquidity in an effort to prevent credit markets from seizing up. The trouble is that all this injection of new funds was in the form of electronic credits, boosting mostly the top layer of the pyramid where there was no shortage at all. Acute shortage occurred precisely in the lower layers. This goes to show that, ultimately, central banks are pretty helpless in fighting future crises in an effort to prevent scrambling to escalate into a stampede. They think it is a crisis of scarcity whereas it is, in fact, a crisis of overabundance. They are trying to douse insolvency with liquidity.

I feel strongly that this aspect of the denouement of the fiat money era has been lost in the endless debates on the barren question whether it will be in the form of deflation or hyperinflation. Chances are that it will be neither. Rather, it will be both, simultaneously. There is a little-noticed and little-studied continental drift beween the money supply of electronic dollars and that of FR notes. The tectonic plate of electronic dollars will keep inflating at a furious pace, while that of FR notes and T-Bills will deflate because of hoarding by financial institutions and the people themselves. The Fed will be unable to convert electronic dollars into FR notes. Apart from lack of collateral, present denominations cannot be printed fast enough, physically, in times of crisis. If the Fed comes out with new denominations by adding lot more zero’s to the face value of the FR notes, Zimbabwe-style, then the market will treat the new notes the same way as it treats electronic dollars: with contempt.

Genesis of derivatives.

Alf Field (op. cit.) is talking about the “seven D’s” of the developing monetary disaster: Deficits, Dollars, Devaluations, Debts, Demographics, Derivatives, and Devolution. Let me add that the root of all evil is the double D, or DD: Delibetare Debasement. In 1933 the government of the U.S. embraced that toxic theory of John Maynard Keynes. It was put into effect piecemeal over a period of four decades. But what the Constitution and the entire judiciary system of the U.S. did not prevent, gold did. It was found that gold in the international monetary system was a stubborn stumbling block to the centralization and globalization of credit.

So gold was overthrown by President Nixon on August 15, 1971 by a stroke of the pen, as he reneged on the international gold obligations of the U.S. This had the immediate effect that foreign exchange and interest rates were destabilized. The prices of marketable goods embarked upon an endless spiral. In due course derivates markets sprang up where risks inherent in interest and forex rate variations could allegedly be hedged. The trouble with this idea, never investigated by the economic profession, was that these risks, having been artificially created, could only be shifted but never absorbed. By contrast, the price risks inherent in agricultural commodities are nature-given and, as such, can be absorbed by the speculators.

This important difference between nature-given and man-made risks is the very cause of the mushrooming proliferation of derivatives markets, at last count $500 trillion strong (or should I say weak?!). Since the risk involved in the gyration of interest and forex rates can only be shifted but cannot be cushioned, there started an infinite regression: Let us call the risk involved in the variation of long-term interest rates x. The problem of hedging risk x calls for the creation of derivatives X (e.g., futures contracts on T-Bonds). But the sellers of X have a new risk, call it y. Hedging y calls for the creation of derivatives Y (e.g., calls, puts, strips, swaps, repos). Now the sellers of Y have a new risk called z. The problem of hedging z will necessitate the creation of derivatives Z (such as options on futures and, with tongue in cheek: futures on options, options on options, etc.) And so on and so forth, ad infinitum. Thus the construction of the Tower of Babel merrily rolls along.


We have to interpret the new phenomenon, the falling tendency of the T-Bill rate. Maybe the financial media will try to put a positive spin on it, for example, that it demonstrates the newly-found strength of the dollar. However, I want to issue a warning. Just the opposite is the case. We are witnessing a sea change, tectonic decoupling, a cataclismic decline in the soundness of the international monetary system. The world’s payments system is in an advanced state of disintegration. It is the beginning of a world-wide economic depression, possibly much worse than that of the 1930’s. The falling T-Bill rate must be seen as a sign of the government of the U.S. and the Federal Reserve losing their battle against deflation. We have reached a landmark: that of the breaking up of centralized and globalized credit, the close of the dollar system.

In the words of Chief Justice Reynolds, in delivering the dissenting minority opinion on the 1935 Supreme Court decision that upheld president Roosevelt’s confiscation of the people’s gold: “Loss of reputation for honorable dealing will bring us unending humiliation. The impending legal and moral chaos is appalling.

No less appalling, we may add, is the impending financial and economic chaos.

Link here.


“History’s Greatest Credit Bubble” framework explained.

David Tice (PrudentBear.com), banking analyst Charlie Peabody (Portales Partners), and I (Doug Noland, PrudentBear.com) led a panel discussion, “End Game for Credit Bubble: Implications for Financial Markets & Wall Street Finance”, at an Argyle Executive Forum (“Alternative Thinking About Investments” in NYC). It was moderated by the wonderfully talented Kate Welling. The following is certainly not an official transcript of David and my comments but, rather, Q&A expanded in hope of providing more complete responses.

Question: For starters, why don’t you provide us a framework for the analysis behind your provocative title, “The End Game for the Credit Bubble.”?

It is our view that we are in the midst of history’s greatest credit bubble. History and sound economic theory have taught us that unconstrained credit systems are inherently unstable – and the longer excesses and imbalances are accommodated the more serious the consequences from the impairment of underlying financial and economic structures. We will begin by presenting two slides that contrast between the current conventional view and our own. We see this very much as the Clash of Incompatible Paradigms – and it is this “clash” that will remain at the epicenter of unfolding credit system instability.

The Conventional View Paradigm:
Our Paradigm – History’s Greatest Credit Bubble

Question: Can you provide a brief explanation of “Bubble Economies”, “Credit Bubbles” and some of your theory behind these concepts?

Bubble Economies are highly complex creatures. Clearly, they are dictated by financial excess – most notably a sustained inflation in the quantity of credit. Substantial bubble economies develop over an extended period of time. The momentous variety are often nurtured by the interplay of extraordinary technological and financial innovation, and are almost always perceived at the time as so-called “miracle economies”. Both credit and speculative excess play prominent roles, especially late in the cycle. Central bankers are likely to be caught confused and accommodating.

It is the nature of credit that excess begets only greater excess. Major bubbles are associated with exceptional yet generally unrecognized credit system phenomenon (“monetary disorder”). It is imperative to appreciate that Bubble Economies are as seductive as they are dangerous. Credit excess causes different strains of inflation – rising consumer, commodity, and asset prices to note the most obvious. Asset inflation is the most dangerous, as there is no constituency to stand up and demand the Fed rein it in. Furthermore, the longer asset inflation and bubbles run unchecked the greater their propensity to go to wild, destabilizing extremes – likely hamstringing policymakers in the process. By the late stage of the Credit boom, inflation effects tend to be highly divergent and inequitable.

The greatest systemic danger arises when speculative-based liquidity comes to dominate financial flows and economic development, creating a highly credit-dependent and unstable system. End of cycle market price distortions tend to create the greatest impairment to financial and economic systems. Bubbles are inevitably sustained only by ever-increasing credit and speculative excess. Any bursting bubble must be supplanted by a more pronounced one (or series of bubbles). As we are witnessing these days, the great danger associated with central banks accommodating credit and asset bubbles is that a point of acute fragility will be reached – with policymaking gravitating toward prescriptions to sustain financial excess.

Question: You have discussed in the past a concept that you refer to as “The alchemy of Wall Street finance.” Can you describe it for us and relate it to our current environment?

There are two related concepts that are fundamental to our analytical framework – how we view credit-induced booms and their inevitable busts. These are the “Alchemy of Wall Street Finance” and the “Moneyness of Credit”.

The “Alchemy of Wall Street Finance” is basically the process of transforming risky loans – loans that become increasingly risky throughout the life of the credit boom – into debt instruments that are appealing to the marketplace. As long as credit instruments enjoy robust market demand they can be created in abundance – in an extreme case fueling a runaway credit bubble with dire consequences for the financial system and real economy.

Our second concept, “Moneyness of Credit”, also plays a central role in boom dynamics. Contemporary “money” is really not about the government printing press or Federal Reserve issuance. It is today largely the domain of private sector credit and the marketplace’s perceptions of safety and liquidity. “Moneyness” always plays a prominent role in credit booms, due to the unbounded capacity to inflate credit instruments that are perceived as safe and liquid.

Think of it this way, a boom financed by junk bonds likely is not going to progress too far – market restraint will be imposed by limitations in demand for these risky credits. On the other hand, a boom fueled by virtually endless quantities of highly-rated agency debt, ABS, MBS, commercial paper, repos and the like – instruments the market perceives as “money-like” no matter how many are issued – has the very real potential to get out of hand.

And this gets to the heart of the issue – the dangerous state of this Wall Street Alchemy. Over the life of the boom there has been a growing disconnect between the market’s perception of “moneyness” and the actual mounting risk associated with the underlying credit instruments. Especially because of the heavy use of derivatives, sophisticated structures, and leveraging, along with credit insurance and various guarantees throughout the intermediation process – the entire risk market became highly distorted and dysfunctional.

And we would argue that the market’s perception of “moneyness” has recently changed – and we believe this to be a momentous development. The market now has serious trust issues related to ratings, pricing, liquidity, leveraging, counter-party risk, credit insurance, and sophisticated Wall Street structures in general. In short, Wall Street’s capacity to create contemporary “money” has been dramatically constrained.

Of late, the rapid growth of central bank and banking system balance sheets has taken up the slack. But this is only a temporary stop-gap. The unrecognized dilemma today is that to sustain our Bubble Economy will require continuous huge quantities of credit creation – and these loans are by nature high risk. With Wall Street’s capacity constrained, there is little alternative than the banking system turning to risky lender of last resort.

Question: So where are we today, and what are the ramifications for the current economy?

Putting it all together, a confluence of factors has created what we expect to be an ongoing highly unstable credit backdrop. In the nomenclature of economist Hyman Minsky – we have today “Acute Financial Fragility” – as opposed to previous backdrops where the U.S. system, in particular, was positioned to weather periods of turmoil relatively well. Despite dogged global central bank interventions, we still fear the potential for the credit market to seize up – with devastating economic consequences. And the combination of unusually frail financial and economic structures leaves us very fearful of a dollar crisis of confidence.

At the minimum, the bursting of the Mortgage Finance Bubble has instigated a serious tightening of mortgage credit availability, leading to escalating foreclosures, credit losses, pressures on home prices, and ongoing marketplace illiquidity for MBS and mortgage-related debt instruments. A classic real estate bust will feed on itself, ensuring further havoc throughout mortgage finance and imperiling the over-borrowed consumer sector.

Question: There is a lot of talk these days about the GSEs [e.g., Freddie Mac, Fannie Mae] – their roles in market excess, previous financial crises, and the potential for GSE liquidity to come to the market’s rescue once again. What is your view on these matters?

There is a key facet of GSE analysis that does not garner the attention it deserves – and it relates, importantly, to the stark contrast between the inherent stability of GSE obligations and the underlying instability of much of today’s debt market structures.

It is crucial to appreciate that GSE-related debt (agency debt and MBS) behaves atypically during crisis, in that finance flows aggressively to this (quasi-government) asset class during periods of market tumult. The GSEs enjoyed basically unlimited capacity to expand liabilities during previous crises – 1994, 1998, 1999, 2000, 2001/02 – and their operations played a momentous role in repeatedly boosting the credit boom. Today, the GSEs are constrained and their balance sheets will not play their typical prominent role in accommodating speculator deleveraging and system reliquefication.

When, in 2004, the scandal-plagued GSEs faltered, Wall Street was keen to snatch control. Consequently, trillions of unstable non-GSE debt instruments now permeate the system. At the same time, the GSEs are today incapable of orchestrating their typical market liquidity operations. This helps explain the difference between previous relative stability during crises versus recent Acute Fragility.

And we do not expect this dynamic to be easily reversed or even meaningfully mitigated. Central bank interventions will have minimal intermediate and long-term impact on the bursting Mortgage Finance Bubble. Liquidity today flows in abundance to gold, precious metals, crude oil, commodities and virtually any non-dollar asset market – where robust inflationary biases prevail – content to avoid Wall Street mortgage-related securities and exposures. The situation will only worsen as home price declines gather momentum and credit losses escalate.

Question: So, it is your contention that the current crisis marks a major inflection point for the Credit system?

We strongly believe so. Going forward, markets will be decidedly more cautious when it comes to ratings and liquidity. “AAA” was perceived as “always liquid” – even in the midst of financial crisis. In reality, GSE-related debt and their ballooning balance sheets played a prominent role in fostering this fateful market misperception. Yet, over the past few years, the most egregious credit excesses were in speculative leveraging of highly-rated non-GSE securitizations. This scheme is now over.

The bursting of the Mortgage Finance Bubble has ushered in a major tightening of mortgage credit, which will lead to escalating foreclosures, credit losses, home pricing pressures, and ongoing marketplace illiquidity for MBS and mortgage-related debt instruments. We see the so-called “subprime crisis” transforming over time to an expansive dislocation in “Alt-A”, jumbo and “exotic” mortgages.

There are now literally trillions – and growing – of suspect debt instruments and many multiples more in problematic derivative instruments. We suspect that the proliferation of sophisticated leveraged strategies created considerable demand for high-yielding mortgage products, and now these vehicles are trapped with losses and illiquidity. Worse yet, credit insurance and guarantees in the tens of trillions have been written and, as we expect this exposure to become a major systemic issue. In short, we see credit “insurance” as a bull market phenomenon that will not stand the test of the impending credit and economic downturns. In too many cases, credit guarantees, “insurance”, and myriad other exposures have been “written” by thinly-capitalized speculators and financial operators. They will have little wherewithal in the event of a serious credit event. This is a major evolving issue. We fear the entire Wall Street risk intermediation mechanism is at considerable risk.

Question: Can you wrap thing up with some summary comments?

To summarize, we believe the current fragile boom – one characterized by unprecedented imbalances and maladjustments – can only be sustained by ongoing massive credit creation. In an increasingly risk-averse world, this poses a colossal risk intermediation challenge. Thus far, the confluence of a highly inflationary global backdrop, extraordinary central bank interventions, and a major expansion of U.S. banking system credit has sufficed. We, however, view Fed and the U.S. banking system capabilities as constrained and aggressive actions feasible only over the short-term. Importantly, Wall Street – the main source of finance behind the past few years of “blow-off” excess – will be hard-pressed to meet challenges and new realities.

Likely, liquidity issues and faltering asset markets will instigate problematic deleveraging upon highly over-leveraged credit and economic systems. We expect significant unfolding tumult in the securitization, derivatives, and risk “insurance” marketplaces. We believe the stock market has of late benefited from a combination of complacency, misperceptions with respect to Fed capabilities, and its newfound status, by default, as favored risk asset class. We see U.S. equities, in particular, highly susceptible to unfolding detrimental financial and economic forces. We expect the economy to soon succumb to recession. California and other inflated real estate bubble markets are now poised to suffer severe price declines – residential as well as commercial. Our faltering currency is, as well, a major issue.

Link here (scroll down).


“If you understood a business perfectly and the future of the business, you would need very little in the way of a margin of safety,” said Warren Buffett at Berkshire Hathaway’s annual meeting in 1997. He had first issued his famous dictum 20 years earlier. Buffett referred to it again in 2005. “We [only] borrow money against portfolios of interest-bearing receivables whose risk characteristics we understand,” he told his shareholders. The Berkshire faithful just loved it.

Understanding where you are putting your money – knowing how it will be used and knowing the likelihood of getting it back – reduces your risk, in short. If you do not understand an investment, then the “unknown unknowns” threaten to eat you alive. Appears sound in theory, right? But does anyone outside of Gorat’s Steak House today even begin to care if it is true? “Although the dislocations, especially to short-term funding markets, have been large and in some cases unexpected,” the IMF just reported, “[the world credit crunch] hit during a period of above-average global growth.”

Moreover, added Rodrigo de Rato, the IMF’s managing director, in a Moscow press conference Tuesday, “the evolution of recent days is moving toward normalization. ... The most important financial institutions have enough capital to withstand the shock.” And amid the crisis in confidence and “state of turbulence” hitting the financial sector, “We welcome the actions of central banks to maximize liquidity.”

Trouble is, maximizing liquidity – the availability of money – is what created this mess in the first place. Failing to understand this plain fact is what led Great Britain to suffer its first genuine banking run in more than a century. Here in London, all progress in finance since 1878 just got wiped out. The City and its regulators have swapped whiskery chops and black stovepipe hats for ShockWave hair gel and pink gingham shirts, but they are no more “sophisticated” than were their Victorian forebears. And as the IMF report proves, it is not only London that is failed to grasp the risks facing global finance today.

The run on Northern Rock came thanks to the very “liquidity” that de Rato says he is glad to see pouring out of central banks once again. NRK was a top-five mortgage lender that gathered £24 billion in saving deposits but lent out £113 billion. It raised the difference by borrowing short-term funds in the money markets. Did anyone inside Northern Rock understand the risks inherent in “maximizing liquidity” so aggressively? Did the BoE or FSA grasp the dangers this high-profile bank was storing up on its balance sheet? Evidently not. And why would it?

By the end of June, NRK’s total exposure to subprime U.S. home loans represented only 0.24% of its total assets. This meant NRK was deemed safe from the chaos of failing mortgage-backed bonds relying on low-income U.S. homebuyers for repayment. The mass of British investors also mistook NRK’s tiny subprime exposure for evidence that it was safe. NRK was one of the five most popular shares bought by private U.K. investors in the last week of August. Since then, however, NRK’s stock has sunk by 75%. Pictures of anxious savers queuing outside NRK’s branches on the High Street also destroyed confidence in the BoE and the FSA – the government-mandated watchdogs supposed to understand, monitor, and cap its risky behavior. The media’s panic, shocked at the very idea that a financial firm might ever go under, then forced London’s government of amateur financial idiots to guarantee all savings for all savers wherever they bank.

Risk has been abolished, in short – a concept even the TV news anchors can grasp. So who cares that it is not true? “Whatever system is put in place to safeguard deposits following the run on Northern Rock,” says a letter to the Financial Times, “it is important that it is understandable to savers. I wonder how many savers understood the workings of the Financial Services Compensation Scheme before its recent coverage in the press?”

The British equivalent of the FDIC, this Compensation Scheme, now holds funds of just £4.4 million. Total U.K. bank deposits, on the other hand, total some £1.6 trillion. The FSCS in London was allowed to promise insurance worth £31,700 to each of Britain’s cash savers (around $64,000) – and to continue making this promise – without anyone bothering to even imagine that the policy might ever be needed. The U.K. has the Banking Code, a document setting out standards of behavior agreed upon by the vast majority of retail banks and building societies. The Code itself does not mention the word “risk” once. Nor does it talk about “safety”. The sole preoccupation, as with today’s bubble-friendly banking regulations everywhere, is with honesty in marketing. Honesty about the raw fact of banking deposits – that your money is at risk the moment you let someone else lend it out for a profit – just does not figure.

In the U.S., too, the very concept of “risk” has been long forgotten as a warning. The biggest bank in the U.S. currently offers what it calls the “Risk Free CD”. Its only claim to safety is that you can “count on the security of FDIC insurance up to $100,000 on your accounts,” says the marketing blurb. Beyond the FDIC promise, the risks to your money are no different than the risks incurred by holding your cash anywhere else. The “risk free” sticker is simply there to make its 4.75% interest rate sound unique, intriguing, perhaps even attractive.

But who outside Wall Street, the City, Frankfurt’s glass towers, or Tokyo’s Kabutocho district can understand that? Who on the inside even cares?

Link here.


Something went badly wrong in the subprime mortgage market. In fact, several things did. And now quite a few homeowners, investors and financial institutions are feeling the pain. So far, harried policy makers have understandably focused on crisis management, on getting out of this mess. But soon the nation will turn to recrimination – to good old-fashioned finger-pointing.

Finger-pointing is often decried both as mean-spirited and as a distraction from the more important task of finding remedies. I beg to differ. Until we diagnose what went wrong with subprime, we cannot even begin to devise policy changes that might protect us from a repeat performance. So here goes. Because so much went wrong, the fingers on one hand will not be enough.

Link here.

For housing, the summer of the unsold – link.
The foreclosure pickings are plentiful but not easy – link.
FHA to ban seller-financed down payment assistance – link.
Countrywide Financial CEO sold big as stock dropped – link.


The capital markets have suffered mightily in the mortgage meltdown. Mortgage-backed securities – whether backed by nasty subprime loans, slightly better Alt-A ones or even highly rated borrowings, have sunk. Junk bonds, often linked to MBSs, are hard to float. Private equity deals, frenetic not so long ago, are iffy now that high-yield funding is harder and costlier to provide.

That has introduced intense fear to stock- and fixed-income investors worldwide. Despite the Federal Reserve’s half-point reduction in mid-September, there is still a lurking suspicion that more bad news lies ahead. What will happen when all those adjustable-rate mortgages reset upward in months to come, plunging more strapped homeowners into default? Are we approaching a financial meltdown that will take everything, including the stock market, into a dizzying drop not seen since the bear market of 2000-02?

Yes, it is bad now and could take many months to unwind, hurting swarms of investors who were suckered into going for sky-high returns of MBSs without examining the ridiculously poor security behind them. Ditto some of the convoluted securities that bundle them (CDOs). The mortgage problem also could put a dent into economic growth for a while. But as all good value investors know, dire times bring opportunities. The long-term trend of the stock market is up.

Since coming to Wall Street in the late 1960s, I have been through seven such crises. Somehow, the market survived them and thrived. Look back even further to the period following the end of World War II, and you will find that pattern holding in four more market spills. Beginning with the first postwar panic, resulting from the 1948-49 Berlin blockade, stocks have tumbled only to come roaring back to new highs. The worst market break came in 1973-74, during a nasty recession and the Arab oil embargo. The most recent was the dot-com slide, which began in March 2000 and ended in late 2002. The Nasdaq Composite, heavy with tech names, still has not regained the ground lost in that crash, but the broad indexes have.

During each crisis investors felt confused, uncertain and panicky. They believed nothing in their previous experience could help them cope with the ominous new world they faced. “Sell, sell, sell,” their inner worrywarts advised. “Save your capital before it is too late.”

This almost always turned out to be a bad move. Selling in a crisis is foolish. Yes, if you had sold the S&P 500, say, a year into the bear market, in March 2001, you would have avoided another 28% decline before it hit bottom. But I do not know of anyone advising an exit in March 2001 who also switched to a bullish stance in fall 2002. And if you had sold in March 2001, and stayed out, you would have missed an opportunity. Since then the stock market has returned 46% (including dividends). On average, for each of the dozen crises, the market was up 36% one year after the low point, 44% after two years.

Today’s stock market remains solid with good fundamentals and many cheap stocks at hand. The ongoing liquidity crisis must be handled gingerly, of course. Commit your capital slowly as several more shocks must be absorbed before a broad market rally begins. Here are several stocks to look at ...

Link here.


Is the dollar going to be weak forever? Mark Farrington says now is the time to buy.

The dollar is in sad shape, sliding 29% over the past five years against the euro. A bearish outlook on the greenback seems to make sense. Forecasts of an economic slowdown in America have spooked currency traders about the health of the dollar. So has the huge level of the nation’s consumer debt. Paralleling the spendthrift habits of the consumer is the indebtedness of the economy to foreign lenders: The huge current accounts deficit, 5.5% of GDP, represents money borrowed abroad to pay for spending (and capital investment) in excess of American economic output.

The Federal Reserve in mid-September cut short-term interest rates by half a point to 4.75% to aid frozen credit markets, and that has rendered U.S. fixed-income securities – and the dollars they are denominated in – even less attractive. Some countries, such as Kuwait, are dropping their peg to the dollar.

So is the dollar on a one-way ride to the dungeon? Not according to Mark Farrington, global head of currency management at Principal Global Investors in London, which runs money for big institutions. The dollar’s decline is cyclical, not structural, says Farrington. He predicts a dollar rally in 2008. If so, a bullish take on the buck would be lucrative.

Farrington, 46, is the resident contrarian on financial panels, where the conventional wisdom is that the U.S. currency will stay weak. His optimism rests on his belief in a U.S. economy, at $13 trillion the world’s largest by far and the most flexible, will always have a currency that others will want. What will turn the trend next year is the nation’s continued expansion and an improved trade deficit, contrary to the baleful signals everyone seems to be heeding (story here). The slowdown in housing investment and the subprime mess will soon be over, he thinks.

Farrington expects the dollar to strengthen against the euro soon and even more against the yen. He estimates the dollar will steadily whittle away at the euro’s current (1.40 to the dollar) conversion rate and will be worth 1.30 by year-end and 1.25 by December 2008. One factor, he says, is that the ECB will end its tightening bias by next summer. Another: The Fed will by late 2008 resume hiking rates because of a robust labor market and inflation worries.

If you accept Farrington’s thesis, then you have several ways of betting on a dollar recovery: currency futures contracts, mutual funds and ETFs (see table, “Foreign Exchange Made Easy”). Futures are taxed oddly: No matter how long you hold your positions, they are treated as 60% long term (thus getting taxed at a mere 15%) and 40% short term (taxed up to 35%).

In lieu of making rifle-shot bets against the pound or the euro using a Chicago Mercantile Exchange futures contract, you could go long the U.S. Dollar Index, available from the ICE Futures U.S. This basket reflects the strength of the dollar against six currencies – the euro, pound, yen, Swedish krona, Swiss franc and Canadian dollar. Right now the index rests at 79, meaning a contract size of $79,000. Six years ago, when the dollar was riding high, it was 116.

A safer way is to invest in currency mutual funds. The Rydex Strengthening Dollar fund charges a yearly fee of 1.66% to make a bullish play on the buck. Less costly alternatives are the Forex ETFs. Those that have gotten a lot of attention are the PowerShares DB U.S. Dollar Bullish Fund and the PowerShares DB U.S. Dollar Bearish Fund. Both track indexes that the German bank maintains. The ETFs charge a mere 0.5% of assets yearly.

If you already own a foreign stock fund that does not hedge away its foreign-currency risk (such as Harbor International), sell it and switch to a foreign stock fund that does hedge (like Pioneer International Equity-A). With Pioneer, you own shares of companies like Toyota Motor and Royal Dutch Shell, plus potentially a short position in euros, too.

Link here.


The latest news from Goldman Sachs’s beleaguered Global Alpha is that irate investors plan to pull another $1.6 billion out of the flagship hedge fund. But angry though they may be, the investors had plenty of warning – and from a manager of the fund himself.

Before taking over Alpha, Mark Carhart was an assistant professor of finance at the University of Southern California. He had studied under Eugene Fama, a founding father of the efficient-market theory, which says investors cannot consistently beat the market. Carhart himself drew attention with a research paper warning investors against mutual funds with “hot hands”. He wrote that his analysis of 1,892 funds over 32 years showed that high repeat returns had little to do with skill, and the winning streaks did not last long anyway. Past performance is no guarantee of future results? Carhart proved it. Google his March 1997 paper, “On Persistence in Mutual Fund Performance”, and you get 22,000 hits.

If there ever was a hot hand, it was the one guiding Global Alpha. Goldman hired Carhart soon after his article appeared in the Journal of Finance, and put him and a fellow Ph.D. from the University of Chicago, Raymond Iwanowski, in charge of the fledgling Alpha. Trading on complex mathematical models, Alpha returned 21% a year in the 10 years through 2005. Goldman put many of its private banking customers into the fund.

Then, true to Carhart’s theory, hot turned cold. [Ed: Albeit after one heck of a run.] Last year Alpha lost 9%. This year, thanks partly to bad bets on the yen and the Australian dollar, it is down 33%. Assets have fallen to $6 billion from $10 billion and are expected to fall by another 25% as investors bail out in the next few weeks.

If rumors prove true that Carhart is destined to be bounced from Goldman, which declined to make him available, he can always return to academia to tilt at mutual funds again. His other papers criticized fund operators for buying up shares at year-end to artificially goose values and for ignoring failed funds in calculating overall returns. Perhaps he would want to probe whether hedge funds have similar faults. Carhart once wrote that high mutual fund expenses virtually guarantee lagging returns. Alpha’s fees: 2% of assets and 20% of profits.

Link here.

Amaranth cost hedge fund investors $6 billion. It did not cost very many employees their careers.

It has been a year since Amaranth Advisors LLC disintegrated in the biggest hedge fund collapse ever. In the blink of an eye $6 billion of its $9 billion in assets went poof. The cause was wrong bets on natural gas by Brian Hunter, a trader operating out of Calgary, Alberta.

Amaranth had 400 employees at the time. What has happened to them? Rather than being rendered radioactive, Amaranth’s former employees have been welcomed elsewhere on Wall Street like conquering heroes – in many cases with multiple job offers. One founding partner became a financial adviser at Oppenheimer & Co., where an information sheet for prospective clients prominently lists his Amaranth experience.

It is not all peaches and cream. Amaranth founder Nicholas Maounis is still overseeing the skeleton crew unwinding Amaranth’s remaining positions. He is also fending off a suit filed by the San Diego County Employees Retirement Association charging Amaranth and four executives committed fraud by boasting of a diversified portfolio that was anything but. Former risk management boss Robert W. Jones, named in the suit, is not working yet, nor is former chief operating officer Charles Winkler, who has been chastised for talking up the fund just prior to its demise.

Brian Hunter, the gas trader, tried to raise money for another commodity fund, Solengo Capital, until he was sued by the Commodity Futures Trading Commission and named in an administrative action by the Federal Energy Regulatory Commission. Hunter denies wrongdoing and has filed a complaint against the FERC.

Many Amaranth employees took big financial hits, too. “The biggest losers were Amaranth’s employees,” says former treasurer Arthur DiRocco. “A lot of them had their hearts ripped out and their wallets stolen and will take years to recover financially.”

Link here.

Merrill Lynch severs ties with former executive Kim’s hedge fund.

Merrill Lynch, the world’s largest brokerage, will not invest in the hedge fund started by former co-head of trading and investment banking Dow Kim, three people with knowledge of the matter said. The decision follows trading losses at Merrill that led to this week’s ouster of Kim’s protégé, Osman Semerci, as head of the fixed-income division.

When Kim, 44, announced in May that he would leave to start Diamond Lake Investment Group, Merrill CEO Stanley O’Neal said Merrill would “benefit from his investment expertise by forming an affiliation with Kim’s new firm.” The company severed ties instead because Kim had been responsible for the mortgage and fixed-income businesses that are now causing losses, said the people, who did not want to be identified commenting on a decision that was not public.

Link here.


The Economist reports certain trends are now moving in nuclear power’s favor. Technological advances help keep plants online and shutdowns low. And new passive safety features have the ability to shut down reactors during an emergency without human intervention. Even Homer Simpson could not accidentally cause a meltdown.

The current political climate helps the nuclear cause as well. Instead of dealing with the hostile regimes controlling most of the world’s supply of fossil fuels, we can look to allies, such as Canada and Australia, for the uranium needed for nuclear facilities. The U.S. is still the world’s largest uranium buyer – 20% of the country’s grid is nuclear powered. Japan and France have also dedicated significant resources to nuclear power (France’s power supply is already a whopping 80% nuclear). The world’s surging energy demands and the return to nuclear technology are helping to fuel the hype.

Back in 2001, uranium traded for about $6.75 per pound. After an epic 47-month price surge, the heavy metal finally took a breather this summer, peaking close to $140 per pound in June. And as uranium began to rise, speculators saw potential and moved in. Demand grew and the number of uranium companies rose from less than 12 to more than 500 today. These 500-plus companies have done quite well. Take a look at the small-cap UEX Corporation (TSX: UEX). They have mining interests in Saskatchewan, Canada. UEX got in at the right moment. Check out how they have done since the uranium run started.

In June, the uranium market began to cool. Tired of having their margins squeezed, nuclear plants stopped buying. Then the speculators began to take profits. Now, uranium trades around $85 per pound, still 13 times what it traded for only six years ago. After an unprecedented price run, one-time buyers are dumping their positions as uranium finally begins to correct. But while these fly-by-night uranium speculators are running scared, we are presented with a potentially profitable opportunity to get in on the ground floor.

Even with 500-some companies competing to provide the uranium needed to start up this new wave of nuclear plants coming online, the demand is only going to push the price of uranium back through the roof. But which ones are going to benefit the most from it?

As always, it is the small companies that are able to take advantage of this second run. It will be a lot easier for these companies to double or triple in size, which will give shareholders the chance to see huge profits. The first things to look for are reserves and location. Any mining company struggles to find the right location with plentiful reserves. And those that do are the ones that become giants like Cameco and Barrick Gold.

It is not enough to just have good locations and big reserves. The actual metals in the Earth have to be high grade. To be profitable, companies have to be able to actually mine these metals at a low cost. So the second factor after location and reserves are the grade of their reserves.

Also, to be a competitive mining company, these small-caps have to partner up with an established major miner. These partnerships give the juniors a better exposure to the best reserves and locations.

Lastly, if a company looks completely overbought and seems to be moving only on speculation, it probably means that it is completely overbought and moving only on speculation. To avoid getting in right as everyone else decides to get out, you have to do some back-of-the-envelope math to see how stable the company’s balance sheet is and when it will start to be profitable.

To find a company like this takes plenty of time and careful observance. Most people do not have that kind of time. And that is why very few get in on these companies while they are still juniors.

Link here.


Last year was the worst year for sinkholes and sewage spills in U.S. history. What caused them? I will tell you in a minute. But here is a hint: The answer will make investors in water pipe makers a lot of money.

Earlier this year, I attended Gabelli’s Second Annual Water Infrastructure Conference. Of all the presenters, Thomas Rooney, president of Insituform Technologies, had the most eye-opening story. He told attendees about the looming crisis arising from our decaying water and wastewater infrastructure – namely, leaking and breaking pipes. But more importantly, Rooney gave us some tangible evidence that shows just how bad things are getting. The most important was the record number of sinkholes and sewage spills in the U.S. last year. Leaking or breaking pipes are the biggest causes of these things in our cities.

A water pipe that leaks (or breaks) either allows dirt to get in the pipe or allows sewage to get out. If dirt gets in the pipes, then the pipes carry the dirt away. Eventually – even if the pipes carry only tiny amounts of dirt away each day – this weakens the ground above the pipes. This ground lies below – and supports–-- our roads and buildings. Sooner or later, the ground gives way, creating the gaping sinkholes that swallow up cars and houses and even lead to people’s deaths. One such sinkhole in Los Angeles was 30 feet deep and shut down a stretch of highway. Another in Grand Rapids, Michigan, cut off the water supply to residents, who then had to live under a “boil water advisory”.

Conversely, sewage may leak out. If sewage leaks out, then you have major health issues in the surrounding environment. Last year alone, more than 3.5 million people became ill from E. coli and other toxins released from over 40,000 sewage spills in the U.S., according to the EPA. More than 1.5 million people get sick in Southern California every year because of bacterial pollution in the ocean – much of it coming from broken pipes, according to a study by UCLA and Stanford. And in Hawaii last year, Waikiki Beach had to close after 40 million gallons of raw sewage flowed into the water after a water main pipe broke.

As bad as 2006 was, “This year is shaping up to be even worse,” Rooney said. “From Hawaii to New York, Alaska to North Carolina and everywhere in between, an epidemic of breaking pipes is causing unprecedented havoc.”

However, because people cannot see these things, they have a harder time believing there is something wrong. As long as water is cheap, as long as their faucets and showers provide clean water and they do not get sick after a weekend at the beach – they do not worry. What you do not see under the sink, behind the walls and under the ground are the unseen working parts of water infrastructure. These are easily forgotten old economy things – pipes and valves and other parts made from stainless steel, brass ingots, cast iron and more. When this water infrastructure breaks down – because it is old and in desperate need of repair – then those expectations will no longer hold true.

In many parts of the country, we are at that breaking point. Rooney used the analogy of the aging power grid before the big blackout in 2003. Before that, no one cared about the aging power grid. Afterward, all kinds of wheels were set in motion to correct the problem. “Most water and sewer pipes in the United States were built 60 years ago – but were meant to last 50 years,” Rooney says. “Do the math.”

Even when cities start to tackle the problem, they have little awareness of the extent of the problems. Rooney told a story about Atlanta, where his company is part of a pipe rehabilitation project. After completing work on 100 miles of pipe, the city held a celebration to mark the occasion. Rooney noted there are 15,000 miles of pipe in Atlanta. This is the problem in many cities.

Things get even worse, hard as it is to believe. Rooney’s company deals with small-diameter pipes. “A little-known secret,” Rooney said, is the fact that the large-diameter pipes – those 40-50 inches in diameter, often made of concrete – are starting to leak in Los Angeles, New York and other major cities. When these pipes go, it will be front-page news, disrupting the water supply and affecting the health of millions.

Smart investors are starting to take notice of the opportunities in water. It is endlessly fascinating to me how investment fashions and moods shift over time. At Gabelli’s first water infrastructure conference in 2006, there was a relatively small audience – maybe a couple of dozen money managers and analysts. This time, the room was full. There must have been over a hundred people at different times. Water is now heating up as a global investment topic. Investors who stick with the right water investments ought to do quite well.

Link here.


John Wasik, a Bloomberg columnist, is writing about how the “CPI’s Lie on Household Inflation Doesn’t Wash”:

Right now, the Fed is desperately trying to encourage everyone to “aim high”. It is the only way to stave off a severe consumer-led recession. But eventually, a severe recession will come whether anyone is ready for it or not. The Fed always wants to put off the inevitable. In the process, bubbles get bigger and bigger as everyone aiming high is willing to take on excessive risk, perhaps counting on the Fed’s ability to control the economy and the stock market.

If the Fed were in control, the dot-com crash would not have happened, we would not be in an even bigger housing/credit bubble than that that is now bursting, and the dollar would not be at all-time lows.

Wasik’s advice might be suitable (or not) for someone who is 20 or 30, but the closer a person is to retirement, the worse Wasik’s advice becomes. Such advice ignores the possibility of a sustained stock market downturn, a severe bear market, and/or a consumer-led recession with rising unemployment.

It took seven years for someone in a diversified basket of S&P stocks to recover from the crash of 2000-01. Treasuries did better, without the risk. Nonetheless, I salute Wasik for pointing out the sham that the CPI is. However, it is because of the debasement of the dollar and distortions in the CPI that the Fed has practically forced risk down everyone’s throat.

But one must be cognizant of herding behavior that has nearly everyone thinking exactly like he is and the Fed wants. Aim high. Shoot for the moon. Do or die. You are losing money by saving. Buy assets. Only fools save. In the long term, stocks always go up. The problem is that aiming high is synonymous with increasing risk. Up till now, risk taking has been rewarded.

But what happens when everyone does the same thing? More to the point, what happens when everyone does the same thing for 20 years or longer? Eventually, risk gets so unappreciated that various asset classes go to the moon. Consider real estate. About a year ago, the mantra was that real estate always goes up. There will never be a national housing decline, because all real estate is local.

Here is the big question: Is this more like 1994 or 1929? In other words, is this a midcycle correction or the cusp of collapse? Everyone ignores the latter possibility. Japan underwent deflation in which land prices and the stock market fell for 18 years. There was no depression. Life still went on. The same scenario can happen here too, regardless of what anyone thinks.

Essentially, the same advice given for real estate (you cannot buy too much home, home prices always go up) is now being touted for stocks. There is an amazing belief in the Fed’s ability right now to control the business cycle, as well as price stability. It is not warranted. At this stage of the cycle in a slowing economy, with rampant overcapacity, a tenuous job climate, and no real reason for businesses to expand, the odds are that aiming high is precisely the wrong thing to do.

Link here.


Generally, the “Greenspan Put” has been the notion that the Fed would flood the money markets to prevent an abysmal decline from excessive highs in the stock market. Therefore, longer term, there was no need to be concerned about overweighting the stock market – ever. Perhaps convictions about this aspect of modern portfolio theory were slightly doubted during the travails that culminated in the liquidity panic of October 2002.

It is worth noting that a few hundred years of recurring bull and bear markets suggests that central bankers are rent-seekers mainly along for the ride. And the idea that policy makers are timing such cyclical events is expedient for those who need the comfort of the ancient notion of Plato’s philosopher king, or at least in a secular priesthood, called the FMOC.

Despite evidence to the contrary, the establishment still maintains the artifice of a random walk economy, so that inspired manipulations can be written on a clean slate. The history of financial markets is an endless thread of business prosperity and subsequent recessions, bull and bear markets, as well as great financial manias and their attendant credit expansions and consequent contractions. The thread runs in the past back to the development of modern financial markets in the last half of the 1600s. This includes periods of central bank accountability and sobriety, and this generation’s remarkably reckless experiment in artificial currencies and interest rates (not to overlook artificial pricing and ratings of artificial securities).

With little change in its resolute nature, financial history will likely continue its record of euphoria and dismay. In the mid-1960s the economic establishment was absolutely convinced that they had eliminated the business cycle. But, as the saying went, “they had a bear market anyway.” Other nonsense at the time included “Operation Twist” whereby the Fed would buy enough bonds to drive interest rates from 6% back to a “normal” 3%. That operation was integral to long rates soaring to 15% – the highest ever reached in the world’s senior currency.

At the start of the Greenspan era the Fed enhanced its reputation by “ending” the 1987 crash, echoing a cliché dating back to at least 1825. A period of uncharacteristic accommodation by the Bank of England when a financial bubble was due made for a huge boom. The climax of speculation was followed late in the year (1825) by a severe liquidity crisis that ran until it naturally exhausted itself. Afterwards, senior officers at the BoE congratulated themselves in preventing the panic from running forever.

The naiveté that massive liquidations will continue unless ended by policy still remains in central banking circles. Oddly enough, the concept that only policy can prevent speculative collapses is as ardently held. Most have read Mr. Greenspan’s 1966 condemnation of Fed policy during the “Roaring Twenties”, and it is a supreme irony that during his watch the Fed and the Treasury outdid the recklessness that was part of the 1929 bubble.

This recklessness has continued, and could continue until enough asset classes become unstable enough to end the extraordinary speculation by market participants, as well as by policy makers. The key to this fascinating transition may be found in reviewing the action common to the culmination of previous eras of great asset inflations, or for that matter the end of any business cycle – the change shows up in the credit markets first. Within this, the yield curve usually provides the critical signal as it reverses from inverted to steepening. Then come the problems in credit quality spreads.

Typically the final phase of a booming stock market runs some 12 to 16 months against an inverted yield curve, and this time around inversion started in February 2006. This counted out to a potential top somewhere around June of this year. (Wilshire 5000 high was set in July.) Moreover, there is little need to worry about rising interest rates as they usually increase until the boom is exhausted, and the time for concern is when short-dated market rates of interest begin to decline. Treasury bills increased to 5.18% at the end of February and the subsequent decline was an alert to possible change.

More precision is offered by the reversal to steepening, as short rates begin to decline relative to long rates. Perhaps intense demand for short term funds by speculators drives short rates up, providing a sophisticated measure of speculative abilities. Typically, as the curve reverses to steepening it is the time when the most blatant of speculations begin to fall apart. The curve reversed by the end of May, and the rest is making a data base for history books yet to be published.

Beyond providing a rather good timing indicator there are some other interesting features of the curve. Most agree that on the near term the Fed can push short rates down for a while. Also, most agree that central bankers cannot intentionally influence the long end, which strongly suggests that changes in the curve are independent of Fed interest rate manipulations. This is confirmed by a review of the U.S. curve going back to the 1850s. As a rule, when the curve inverts and reverses to steepening, a credit contraction and business recession follows. It is worth noting that this has prevailed during a variety of monetary systems.

When the U.S. was between central banks and on the Treasury System, a fiat currency was tried until 1879 and then the gold standard prevailed. The curve actually drove the good times, or the bad. Then under the Fed, the curve has done its thing whether on a pseudo-gold standard until 1971 or a fiat currency since. There is a little more to determining the transition from the Greenspan “Put” to the Greenspan “Call”, and all that that implies.

The greatest accolade that can be bestowed upon a financial policy maker is to be compared to Alexander Hamilton, who organized the finances of the fledgling Republic in the late 1700s. The most recent “Greatest Treasury Secretary since Alexander Hamilton” was Robert Rubin, who was Bill Clinton’s economic advisor, and then Treasury Secretary from January 1995 until July 1999. Andrew Mellon served in the position from 1921 until 1932, and during the late 1920s also received the accolade. As best as can be determined, no other Treasury Secretary was so capable as to receive the accolade. The common feature has been that the ones that did were in office when a great financial bubble occurred.

No mention has been found of the accolade being awarded to Richardson, who was the Secretary at the conclusion of the mania in 1873, but the leading New York newspaper editorialized that with his abilities and the fiat currency there was nothing that could go wrong. In 1884 leading economists described the contraction as “The Great Depression”. It ended in 1895. It was still being analyzed under the dreaded term until as late as 1939. The exciting prosperity of a naturally occurring financial mania apparently makes the reputation of the man who just happens to be in office. Then there are those who stayed too long. Andrew Mellon was an outstanding banker and industrialist before taking over at Treasury and was widely praised during the good times. In not leaving the office until 1932 he became the focus of the animosity typical of the usual post-bubble recriminations. This turned to outright hostility when in the face of socialist New Dealers he advised that it would be best to liquidate the “rottenness out of the system.”

The end of the artificial prosperity of the 1920s financial mania was signaled as T-Bill rates turned down and the curve started its reversal to steepening in the early summer of 1929. It also signaled the eventual demise of Mr. Mellon’s reputation as an outstanding financial officer of the U. S. government.

As with 1929 and the 1873 examples, the tide of speculation turned with the yield curve in the early part of the summer of this year. More specifically, the curve completed the transition to steepening by the end of May, and that could be considered the time when the Greenspan “Put” became the Greenspan “Call”. What a posterity.

Link here.


Walter Bagehot, an economist and author writing in the 19th century, had the answers to the current credit crunch. In 1866, the U.K. money markets were in turmoil. The collapse of a private bank called Overend & Co. threatened to destroy the fragile trust underpinning the credit system.

The parallels with today are powerful, as ripples from the crash in the U.S. subprime mortgage market threaten to swamp parts of the financial markets. Central banks are losing control of monetary policy, as short-term money-market rates jump and long-term bond yields develop immunity to policy changes. Their sovereignty is under fire, as the crisis forces them to be reactive rather than proactive.

So what would Bagehot, who edited the Economist newspaper from 1861 until 1877, make of the current crisis? The following question-and-answer dialogue combines current questions with comments culled from his book Lombard Street, published in 1873. I reckon we have a lot to learn from a guy who died 130 years ago.

Link here.


The Bond Vigilantes ride again.

The stock market has focused on the positive implication that less expensive money will stimulate growth, while the Treasury market has fretted over inflation. Cheapening the cost of money tends to tempt sellers to lift prices, setting off inflation, which the Treasury market detests ... “Fixed-income markets, after initially rejoicing, are now feeling the wrath of the bonds vigilantes,” wrote economists at Action Economics. – Associated Press, 9-24-2007

Hello Mr. Bernanke. It is good to see you. I do not believe you know me. But I will not tell you my name. It is of no consequence. But I will tell you, Señor, of my Association. Then you will know why I wear this cape.

It is a nice black cape, do you not agree? I bought it years ago, Mr. Bernanke. Years ago, when the dollar was strong. Strong like a bull in Pamplona, able to run down all in its path. I could not afford such a cape today. You see, the dollar is weak. Weak like the mind of a Los Angeles juror. So weak, it is no longer the bull. It is the drunken tourist in front of the bull. Watch as I move this bill toward the flame of the candle, and how I use it to light my cigar. It is not a good cigar, Mr. Bernanke. I can no longer afford the good ones.

I see you are curious about my mask, Mr. Bernanke. I have not worn it for some time. I have not worn it for years. Years! The cape and the mask I have kept in my closet. Waiting there.

Señor, before you call security I will solve the riddle of my identity for you. Mr. Bernanke, I am a Vigilante. A Bond Vigilante. You may have heard of us, the Vigilantes. Or perhaps not. You have been busy. Me? I have been on vacation. A long vacation. But I must say, it was well deserved. We worked hard in those days. We did great things. We tolerated nothing. We trusted no one. We were, Mr. Bernanke, a menace to the irresponsible.

It is because of an acquaintance of yours that my vacation was so long. Oh, do not worry, it was not your predecessor, Mr. Bernanke. I will spare you the indignity of once again having to hear his name.

It was Mr. Volcker, Señor. When his work was done, my work was done also. But I cannot begrudge him. We were great rivals. The markets believed me much of the time. Believed me? They feared me, Mr. Bernanke. Feared us. The markets trembled when we raised our swords. When we dashed through the town, our capes flying behind us, our voices loud. Bond investors hid behind their Telerate machines. They cowered. Some sang hymns. Do you remember Telerate machines, Mr. Bernanke? They cowered because we told them the truth. We told them what would happen if things were not put right.

People have missed us, I think, Mr. Bernanke. They have said, “Where are the Vigilantes?” I have heard them. I have not only been on vacation, you see. I have a family. I learned some HTML programming. Did a little consulting. My cape, it remained in the closet.

You know, Mr. Bernanke, some people have questioned, if we were still alive. Some have questioned if we were ever alive. Come here, Mr. Bernanke. Feel my breath! I must share one thing with you.

You took the discount rate down last week, did you not, Mr. Bernanke? It was a bold move. A big surprise. But what is higher today, Mr. Bernanke? The 10-year Treasury bond? Yes. The 30-year fixed rate mortgage. Oh yes.

Mr. Bernanke. It is this I have to tell you about the Bond Vigilantes.

We are back.

Link here.


Gold is playing the role of a hedge for fixed income investors from abusive central bankers.

Nowadays, traders of all different stripes are betting on more rate cuts by the Federal Reserve in the months ahead. Since mid-July, the odds of a U.S. economic recession have been mounting, led by sliding home prices and the first loss of U.S. jobs in four years in August.

Historically, the U.S. economy has gone into recession seven times since 1960, and six of the downturns were foreshadowed by an inverted yield curve, when yields on 3-month T-Bills are higher than for 10-year T-Notes. In March-December 2000, at the height of the dot-com frenzy, the yield curve was inverted. More recently, the yield curve inverted between February 2006 and June 2007. The Nasdaq and S&P 500 began to implode in 2001, and an 8-month economic recession arrived in 2002. Now U.S. home prices are tumbling and threatening to drag the U.S. economy into recession in 2008.

During the three previous Fed easing campaigns, whenever the 2-year Treasury yield fell to more than -50 basis points below the fed funds target, the Fed lowered its target rate. In August 2007, the 2-year T-Note yield fell to -110 basis points below the 3-month T-Bill rate, persuading the Fed to slash the fed funds rate by a larger-than-expected 50 bp on September 18. Finally forced to choose between defending U.S. home prices or the U.S. dollar, the Bernanke Fed decided to sacrifice the greenback.

Unlike previous U.S. economic slowdowns which have worked to contain inflationary pressures in the global commodity markets, this time around, the Fed’s aggressive rate cut on 9-18 ignited big rallies in a broad spectrum of commodities to all-time highs, and lifted gold to a 28-year high. The Fed’s aggressive rate cut conveyed a sense of panic, and was not copied by any other central bank, thus knocking the U.S. dollar to 15-year lows. A weaker U.S. dollar is engraving sharply higher food and energy prices into “core” inflation.

Global bond vigilantes hooked on gold.

With booming commodity and stock markets detected in all corners of the earth, and out of control money supply fueling inflation, the global bond vigilantes should be reacting by jacking up long term interest rates. Instead, global bond yields have tumbled by anywhere from 50 to 75 basis points since mid-July, when revelations of the subprime debt crisis surfaced. While the U.S. economy is sliding towards “stagflation”, other economies are decoupling from the U.S. locomotive, and have become more “China-centric”. Therefore, Fed rate cuts are simply adding more firepower to the “commodity super cycle”.

In today’s bond markets, which are plagued by heavy intervention from central banks, it might not be possible for the bond vigilantes of yesteryear to swing the big stick and jack-up bond yields to punitive levels. Instead, bond vigilantes must operate via the gold market, in order to profit from excessive money supply growth, by simultaneously shorting government bonds and buying gold. This way, if central banks try to artificially depress bond yields with excessive money supply, the resulting inflationary pressures would ultimately show up in a higher gold price.

For example, since May 2004, the Euro M3 money supply has accelerated from a 4.9% growth rate to as high as 11.6% in August 2007. During that time, German bund prices gyrated up and down, but today, are little changed since May 2004. But when measured against the price of gold, the German 10-year bund has lost 40% of its value. Thus, gold has a very special role to play, as a hedge for fixed income investors from abusive central bankers.

The Bank of Japan has pegged its overnight loan rate at an abnormally low 0.50% since February, exporting inflation around the globe. Since October 2002, the Bank of Japan has bought ¥1.2 trillion of government bonds each month, to pump more money into the economy, and keep the yen weak in the foreign exchange market. The BoJ will monetize more than half of the government’s budget deficit this year, expected around ¥25 trillion. Such massive money pumping has led to a doubling of Tokyo gold prices from four years ago, while knocking government bond prices into a bear market.

Tokyo gold traders have not been duped by the government’s brainwashing and fuzzy math on inflation. Japan’s financial warlords paint an economy that is flirting with deflation. Few traders believe the phony statistics on inflation anymore, but they still serve to provide political cover for the Bank of Japan’s ultra low interest rate policy. Artificially low interest rates in Japan and elsewhere are providing fertile ground for speculators in global commodity and stock markets. Thus, the BoJ is exporting inflation worldwide, thru it ultra-easy low interest rate policy, via the mammoth $1.05 trillion “yen carry” trade.

BoJ chief Fukui is a stalwart ally of the “Plunge Protection Team” headed by the dynamic duo of U.S. Treasury chief Henry Paulson and Bernanke. By putting a lid on 10-year Japanese bond yields at 2.00%, Fukui also put a ceiling on the U.S. 10-year T-Note yield at 5.25% in July, sparing further damage to the U.S. housing market. With Fukui pumping ¥1.2 trillion into the Tokyo money markets each month, Mr. Bernanke can run the U.S. money printing presses at full speed, with little fear of a collapse of the U.S. Treasury bond market.

U.S. economy headed for the “stagflation” trap.

It would be especially difficult to forecast the direction of U.S. Treasury yields, if the world’s largest economy gets snared in the “stagflation” trap, with a weakening economy accompanied by higher inflation. On the one hand, a weaker economy could encourage the Bernanke Fed to slash the fed funds rate, and anchor yields at lower levels. On the other hand, an easier Fed policy can crush the U.S. dollar and trigger higher inflation, especially in the global commodity markets.

Since mid-July, U.S. 10-year T-Notes have rallied strongly, lowering the yield from as high as 5.25% in July to 4.50% today. Yet when measured against the price of gold, T-Notes actually fell from 41 cents on the dollar to as low as 37.5 cents. Investors seeking shelter from the global sub-prime mortgage crisis were much better off buying an ounce of gold, rather than the U.S. Treasury’s IOU’s.

U.S. Treasury yields are no longer a reliable indicator about inflation expectations. Instead, the Treasury bond market is simply a parking lot for foreign central banks that peg their currencies to the greenback, and want to earn some interest on their dollar reserves. But if the U.S. dollar remains chronically weak, one has to wonder if dollar pegs in China and the Persian Gulf might unhinge.

If China began dumping some of its $408 billion position in T-Bonds, the Fed could buy large sums of bonds from China and set a floor under the market, but it would have to turn up the printing presses to accomplish that feat. That could send the price of gold soaring, once Beijing finally relents to a significant dollar devaluation against the Chinese yuan. Such as scenario is unlikely any time soon under Paulson’s watch, but could happen if the protectionist bent Democrats capture the White House and Capitol Hill in 2008.

The latest downturn in U.S. T-Notes, when measured in “hard money” terms, extends an unrelenting bear market that has prevailed since 2003, when the T-Note to Gold ratio peaked at 87-cents. Nevertheless, on September 20th, Bernanke said the Fed would remain vigilant on inflation. “We will continue to pay very close attention to the inflation rate. It is an important part of our mandate and I agree that an economy cannot grow in a healthy, stable way when inflation is out of control, and we will certainly make sure that does not happen,” he told lawmakers on Capital Hill.

Link here.


Fed Chairman Ben S. Bernanke should add the 9th-century Sufi legend “Appointment in Samarra” to his reading list. In that tale, a merchant’s servant sees the hooded figure of Death in the marketplace and tries to escape by riding to far-off Samarra – only to discover the Grim Reaper has a date with him there the following day. Could a similar fate await Bernanke? His half-point cut in short-term interest rates was designed to avoid a recession, but it may have bought him only a postponement of the inevitable. ...

Link here.


Senator and presidential candidate Barack Obama has proposed that the income ceiling on social security contributions be abolished, in order to balance the system. His solution ignores the much greater Medicare deficit and fails to address the central problem: the system needs balancing because we are living longer without working longer. If we are to enjoy the benefits of modern medicine, we need within a generation to adjust our society to the 50 year career.

During the “holiday from history” of the 1990s it was fashionable to suppose that early retirement could be the lot of all. Savings would be invested in profitable dot-coms, the Dow Jones Industrials would soar beyond 36,000 and the middle class could retire at 50, secure in the knowledge that their dot-com millions would support them for however many decades remained. This idea encouraged the nation’s brightest and most expensively educated students to devote themselves unreservedly to their careers on graduation, working 90-hour weeks and destroying their private lives, in the hope that any ethical depredations they committed in the hope of quick gains could be returned to society after they had retired at 48. This life-pattern is additionally damaging when the executives concerned are women, since it pressurizes them during their fertile years, making them postpone child-bearing until it is too late.

Needless to say, in an age when a young adult can expect to live into their late 80s, a system that encourages them to devote only 25% of their life to productive activity is hopelessly unsound actuarially.

If Social Security and Medicare are to be funded, we need an economic, social and tax system that discourages early retirement. At the top end of the ability scale, we need 50 years’ production out of our best and brightest, not 20. At the bottom end, we need the less productive to continue to support themselves by their own work for as long as possible, ideally with an employer providing health insurance, so that the drain on the state system of their retirement is minimized. The actuarial problems of the social security and Medicare systems could be eliminated by raising their eligibility ages over a period of time.

If the younger generation is going to have to work till 70, work patterns must be redesigned to accommodate its needs. The 1990s assumption that early retirement was to become increasingly prevalent must be reversed, so that proper accommodation is made for older workers. Companies will have to rework their career paths also, moving them a long way back towards the gerontocracies of the U.S. 1920s or Japan today. If it is difficult for a 65 year old employee to be accepted in a junior role by a 35-40 year old boss, it follows that successful companies will need correspondingly fewer 35-40 year old bosses.

The effect of a move back to older workers will be far greater in some sectors than in others. In retailing or automobile manufacturing, for example, much of the workforce is already at or near retirement age. In investment banking and consulting, on the other hand, the effect will be enormous, moving both industries back towards their patterns of 50 years ago. Companies will pay consultants for their experience, rightly presuming that the latest analytical techniques may add little value to their business, while in investment banking the focus will move back towards client service and long term relationships and away from the attempt to make a quick buck on the trading desk. Other changes will be a reduction in the resources devoted to travel and the hours worked by the top practitioners, It will become obvious to the industries themselves, rather than merely to their outside observers, that 90-hour weeks and excessive travel add far less value than is brought by experience in the field concerned.

A further restructuring will have to take place in education. It is already counterproductive to concentrate education at the beginning of the working life. Over a couple of decades skills rust and, more important, become obsolete. This is particularly the case in fast moving technological sectors such as IT and biotech, where a degree that is 20 years old is almost worthless. The obsolescence factor will become much more severe when careers stretch half a century.

Successful careers will thus include periods of intellectual refreshment, probably accounting for 1 year in every 10 of the career. Human resources departments and headhunters will themselves need to be retrained, to eliminate their current ageism and recognize that an executive with 30 years experience in another field and retraining into their own is not the equivalent of a raw college recruit. It needs to be more difficult to retire at 48 and easier to find a new job at 62.

The current paradigm of a world of ever-accelerating instability, aggression that short-circuits ethics and thirst for short term returns will go, for actuarial as much as for market reasons. It will not be missed.

Link here.


A mild-mannered economist by day, I am an avid fan of gambling and all its devices. I am here to inform Ron Paul fans that “the market” – the gambling website Intrade.com – says his chances of winning the GOP nomination are now 6.1%. In contrast, McCain’s chances are 5.4%, and Huckabee’s a meager 3.2%. Beyond the fact that Ron Paul is now in 4th place – and being ahead of McCain, is now surely a “real” candidate – is his meteoric rise since late May. Just look at this chart from Intrade.

To make sense of all this, let me briefly explain how Intrade works. It is fashioned after a futures market, where participants can buy or sell contracts contingent on future events. In the case of the 2008.GOP.NOM.PAUL contract, the buyer (as of October 2) pays $6.10 for a contract entitling him to a $100 payoff if Ron Paul gets the Republican nomination. In contrast, the seller of this contract receives $6.10, but might have to pay out the $100 if Paul gets the nomination. If Ron Paul does not get nominated, then the buyer of the contract is out his $6.10 and the seller gets to pocket the $6.10.

There are imperfections due to transaction costs and other frictions, but the probabilities of all the possible outcomes should sum to approximately 100%. Otherwise there would be pure arbitrage opportunities. For example, if the sum of the contract prices totaled only $98, then someone could buy one of each, and be guaranteed a profit of $2, since one of the contracts would “hit”. On the other hand, if the contracts summed to $103, then someone could sell one of each, earning $103, and then only have to pay out $100 when one of them hit – thus netting a guaranteed profit of $3.

People with inside information stand to profit by trading in this market. If a technician at a health clinic comes across a very disturbing heart exam for McCain, that person could rush out and sell contracts on McCain’s nomination – and thereby push down the price of a McCain contract.

The arbitrage element and the fact that people with inside information can trade on it leads economists to loosely say that “the market” assigns a “probability of” (right now) 6.1% to a Ron Paul nomination. Purists could raise all sorts of objections to that type of talk, but you get the idea.

Before closing, let me stress two final points. First, this is not some small-time contract that four hicks (who like to spam Fox voting schemes) are trading back and forth. When last I checked, the volume was over 63,000 Ron Paul contracts being transacted. (So if this is manipulation, it is very very expensive.)

Second, Ron has gotten much higher than 6.1% in various straw polls and other surveys, so what is the big deal? But Intrade contract is not asking, “Which candidate do you want to be nominated?” It is asking, “Which candidate do you predict will be nominated?” And I think it is incredibly encouraging – for lovers of liberty, that is – that Ron Paul has broken through the 6% mark, and is now in 4th place. The three front-runners are only a gaffe away from forfeiting their position, just as McCain did with his immigration photo op with Ted Kennedy.

The pundits are still dismissing Ron Paul as a fringe candidate who is not “serious”. Well, there is a lot of actual money on the table saying that he is indeed a contender for the GOP nomination.

Link here.
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