Wealth International, Limited

Finance Digest for Week of October 29, 2007

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


Nattering naboobs of positivism.

Four leading members of the Bush administration’s economic team, including Ed Lazear, Chairman of the Council of Economic Advisors, Commerce Secretary Carlos Gutierrez, Al Hubbard, director of the National Economic Council, and Jim Nussle, director of the Office of Management and Budget, convened on a CNBC panel earlier this week and confidently forecast that the economy would avoid a recession. As they uttered their platitudes, we learned that housing sales plunged again, with national inventories of unsold homes hitting a new record high, and that Merrill Lynch disclosed nearly $8 billion in losses. Set against this backdrop of deteriorating economic news, it would have been more honest, and perhaps more effective, if the Administration team came on stage in clown makeup and oversize shoes.

The group’s most entertaining routine could be described as the “falling dollar hot potato”. It is a testament to the professionalism of CNBC host Dylan Ratigan that he was able to suppress howls of laughter while the economists scrambled to avoid any discussion of the dollar by claiming that only the President and the Secretary of the Treasury were allowed to comment. (Of course the only thing Bush or Paulson will utter on the subject is the all too familiar mantra “a strong dollar is in our national interest.”) How can the leading economic policy makers in government refuse to discuss the value of our money, which is arguably the single most important part of the economy? Why is the subject taboo? Perhaps they feel that anything they say will only inspire less confidence in the dollar? In reality, the Administration is perusing a policy of benign neglect. Break-outs in the prices of gold and silver show that the policy is not going over too well!

In addition to the dollar dance, the wacky economists also provided some laughs on a variety of other subjects. Regarding the California wildfires, the panel reassured us that the resilient U.S. economy would weather the storm, much as it did with hurricane Katrina. However, as state and federal officials promise unlimited funds to rebuild thousands of burned homes, they conveniently ignore the fact that we must put the tab on our national charge card. The ability to postpone pain by borrowing from abroad is not evidence of economic resilience but vulnerability. A truly resilient economy has ample domestic savings to cover these vicissitudes itself. America has yet to pay the costs associated with a string of natural disasters, the bills for which will likely come due much sooner than anyone seems to realize.

The Administration gang also told us that the American economy will benefit once China moves to an economy based on consumption rather than savings (in other words, more like our economy) as they will finally begin buying more of our products. Although it is true to expect that the Chinese will inevitably start spending more, it is ridiculous to assume that it will benefit the U.S. When the Chinese begin spending they will simply snap up their own abundant production and send fewer goods to America. As the Chinese reduce their savings to begin enjoying the fruits of their labor, American borrowers will lose access to their largest source of credit. The two-pronged effect on the American economy will be substantial increases in both consumer prices and interest rates – hardly the benign outcome all the President’s men expect.

None seemed too concerned about the cost of funding the war in Iraq, which on the day of this “summit” we learned is now projected to be almost $2 trillion. Their lack of concern likely reflects their belief that Americans are not the ones picking up the tab. I am sure there is a different reaction among our foreign creditors, as they contemplate the prospects of “loaning” us that much more money knowing that a declining dollar guarantees they will never be repaid in full. Perhaps the thought of loaning us endless sums to cope with natural disaster at home and man-made ones abroad will shock foreigners to their collective senses, prompting them to finally cut us off.

On housing we were once again told the problems would be contained. Such upbeat pronouncements should be wearing thin in the face of mounting evidence to the contrary. When will people begin to grasp that the trillions of dollars of mortgage loans financed by Wall Street will never be repaid in full and that the losses for lenders will be staggering?

Homeowners have lenders over a barrel, and soon all will know it. Once the government exempts forgiven mortgage debt from being treated as taxable income, defaults will become a national trend. Under normal circumstances, lenders have all the power, as 20% down payments and an ample supply of qualified buyers makes foreclosure a real threat. However, under current circumstances, it is completely empty. Lenders can not foreclose as there are no buyers and no equity. If homeowners choose not to pay, lenders really have no choice but to renegotiate the loans. Once homeowners understand this no one will make a mortgage payment until their loan is reduced to an amount more consistent with the actual value of their home.

While homeowners themselves will experience mere paper losses, those of the lenders will be all too real. However, even with less mortgage debt, homeowners will finally wake up to the fact that their home equity is gone. Without it, much like the Chinese today, Americans will consumer a whole lot less and hopefully save a whole lot more.

For a more in depth analysis of the tenuous position of the Americana economy and U.S. dollar denominated investments, read my book Crash Proof: How to Profit from the Coming Economic Collapse.

Link here.


“Breaking the buck” is unlikely ... as long as the system is not tested too severely.

In mid-August, a public panic was created when CNBC incorrectly reported that a “money market fund” run by Sentinel Group had halted redemptions. To be clear, the Sentinel fund is not a money market fund and, in fact, more closely represents a bond fund. As of June, nearly 80% of the fund’s holdings matured in eight years or longer.

The fact that the fund was paying approximately 7% vs. about 5% for money market funds is a clear indication that this was an “enhanced product” with riskier investments than those held in traditional money funds. Less than a week later, the SEC filed civil fraud charges against Sentinel Management Group. In short, the woes of this company should not be construed as applicable to money market funds.

This is not the first time the media spotlight has focused on the safety of money market funds. Certainly in the mid-‘90s there was concern, and in 2001 Business Week ran the headline “Money Market Funds Enter The Danger Zone”.

Though the security of money funds has periodically been called into question, history has seen only one instance where investors actually lost money. This occurred in 1994 when a relatively small $100 million fund paid out 96 cents on the dollar. The problems here were caused by money market derivatives. Regulations were tightened in 1995 with the goal of avoiding similar issues in the future.

The reality is that, short of a financial crisis, money market funds are very safe investments. Though they are not insured by the FDIC, they are regulated by the SEC. Money funds are required to hold only top-tier investments and to keep the average maturity under 90 days. The SEC also mandates that no more than 5% of holdings can be in any one issuer, except the U.S. government.

Allowing a money market fund to “break the buck” would absolutely be a last resort for brokerage firms, as their reputations and future business depend on investor confidence. We feel it is highly unlikely that we will see the price of any large, established money market fund fall under $1/share.

With that said, there has not been a financial crisis severe enough to truly test the system since the inception of money funds in 1970. Therefore, it is only prudent to be cautious and prepared during this tenuous time in the credit markets. When evaluating a money market fund, consider the following criteria:

Link here.
10 all-weather money market funds – link.


How are you planning to spend your retirement? If your dreams include exotic adventures, you cannot afford to wait until retirement to start exploring the world. It is time to pack your bags now – at least as far as your portfolio is concerned.

When your grandparents started saving for retirement, international investing was not much of an option. Their choices, if any, were limited to a handful of international mutual funds and big global companies with shares trading in New York. And back then, brokers and other financial advisers did not have decades of academic research to draw upon to make the case for going global.

International investing has come a long way in recent years. In 1985, there were fewer than 50 global mutual funds to choose from, with combined assets of about $8 billion, according to the Investment Company Institute. Now there are more than 800 funds, representing closer to $1 trillion. Your grandfather’s plain-vanilla global mutual fund has been replaced by a dizzying array of ETFs, ADRs, closed-end funds and specialized regional or single-country mutual funds. Getting exposure to global markets from Stockholm to Shanghai is as easy as buying shares of IBM, and as time goes by even more offerings are sure to be on the way. Discount brokers are already experimenting with ways to trade stocks listed on foreign exchanges directly from your laptop.

Trouble is, even though the current generation of investors is spoiled for choice when it comes to international markets, most folks still keep the vast majority of their money at home, just like Grandma and Grandpa did. Lots of Americans have dabbled in foreign stocks or funds, but how many have actually built truly global portfolios? My guess is very few. And during a market panic like the one we saw this summer, I would not be surprised to see more investors cutting back on international exposure, especially when it comes to “serious money” like 401(k) plans and other retirement accounts.

There are a few problems with this view. For starters, most Americans are already way too dependent on the U.S. economy. We own homes here and we work for companies that are based here. Before we invest a single dime of our savings, we are 100% exposed to the U.S. market. So if you only had 10% or 15% of your stock portfolio invested overseas before the subprime mess started to unfold and you start cutting back now, chances are you will end up with almost negligible international exposure in a holistic sense.

So how much is enough? The answer will vary depending on your circumstances, but I think you need at least 20% in international stocks to even begin making a difference. Jeremy Siegel, a professor of finance at the Wharton School, argues that at least 40% of your stock portfolio should be allocated overseas. I think you can go as high as 50% if you are not planning to retire for another 20 years or more.

This is not as far-fetched as it may seem. The U.S. represents about half of the world’s market capitalization, so by that measure, a 50% allocation overseas would be just about right. And it is hardly a new concept. European investors in Switzerland, the Netherlands and other smaller markets have long taken a global approach to investing. Try asking someone from Sweden or Belgium if they think global investing is “risky”. They might look at you like you are from outer space.

Somewhere along the line we learned to associate “foreign” with “risky”. Nigerian small-cap stocks might not be the best place to park your 401(k), but you can also lose your shirt investing in shares of a penny stock from your hometown. The real risk is keeping too much of your money at home. I am not one of those gloom and doom conspiracy theorists who think America is about to go the way of the Roman Empire. But when I look overseas, I see too many opportunities to ignore.

International stocks have performed well in recent years, but they still offer one of the best combinations of value and growth that you can find in any asset class. U.S. stocks are trading at 16 times 2007 estimated earnings, with expected earnings growth in the 7% neighborhood. Compare this with emerging markets, where stocks trade for about 14 times earnings and offer 15% growth. Even stodgy old Europe is on course to deliver better earnings growth than the U.S. – and it is cheaper too, at 14 times earnings.

Planning for retirement involves making a lot of assumptions about the future. It is tough enough predicting what the economy and markets will do next quarter, let alone several decades from now. But there is one thing I can almost guarantee. The forces of globalization will continue to boost the importance of international markets, particularly emerging economic powers like China and India. Now is the time to make sure your retirement portfolio has a meaningful stake in these markets of the future.

Link here.

Put some money in Japan.

Academics say that the stock market is random – that there is no pattern to price movements. Now take a look at a chart, which plots a foreign exchange rate along with a price index for the global stock market. Random? Not a chance. This year these two price series have marched almost in lockstep.

When the euro appreciates against the yen, stocks tend to do well. When the euro falls, stocks tend to do badly. The correlation between daily changes in closing price in the two price series is 0.93, on a scale where 1.0 would tell you that one change is always a fixed multiple of the other. The stock price used here is the Morgan Stanley World Index, which tracks 1,869 stocks in the world’s developed markets.

What is going on? The connection starts with the weak Japanese economy. To give it a spark, the Japanese central bank keeps interest rates extremely low. These low rates have not inspired the Japanese to put capital into either machinery or houses. Instead, the capital is being swept abroad. Speculators in Europe and North America borrow in yen at those low rates, convert the yen into euros and other currencies, and invest in higher-yielding assets elsewhere. This is called the yen carry trade.

The borrowed Japanese money buys gold, stocks, bonds, you name it. But the net flow of capital is, ultimately, heavily into stocks. On days when the process moves in the forward direction, the euro is bid up, the yen is bid down, and stocks in the U.S., Europe and Australia are bid up.

I expect this flow of capital to continue. But what if it went into reverse? What if the Bank of Japan suddenly raised short-term interest rates, choking off the yen carry trade? Then folks would sell stocks globally. They would sell euros, Aussie dollars and U.S. dollars in order to buy yen and repay the loans. That would send capital flooding back into Japan – making Japanese stocks strong relative to all else.

It is noteworthy that, in two corrections this year (starting in February and July), Japanese stocks outperformed. They also outperformed when the Bank of Japan twice raised rates a hair. Overnight money in Tokyo is now priced at 0.5%.

Again, I expect the flow of capital out of Japan to continue, and I remain very bullish about non-Japanese stocks. Right now you should be particularly heavy in emerging markets, in Germany, in energy, industrials and materials. But a smart investor hedges his bets. To hedge against the possibility that yen carry trades reverse, you should also have money in Japanese stocks. At the moment I have 12% in Japan versus the world’s weighting of 10%.

If you do not want to fret over single stocks, just buy the MSCI Japan iShares (EWJ) ETF. This fixed basket of 354 stocks has a 0.54% expense ratio. Below are some individual stocks you should consider.

Link here.

Pacific Overtures

“Great Quarter, guys!” I chirped, doing my best impression of a brokerage house analyst on a conference call, “and great 6 months and great trailing 12 months.” The recipient of the flowery well wishes – for once, well deserved – was David J. Winters, founder and portfolio manager of the Wintergreen Fund. Winters and his fund starred on this page a year ago. He was an established, moneymaking mutual fund investor who had quit a big money management company, Franklin Mutual Advisers, to roll his own mutual fund. You would have thought Winters would start a hedge fund.

Certainly he has got the investment record a hotshot from Greenwich, Connecticut would envy – up an annualized 22.7% since inception, versus 15.9% for the S&P 500. The secret of his success? Finding terrific companies selling for less than they are worth. Simplicity itself.

Winters could make things as complicated as he chooses. He has no restrictions in his charter on where or how to invest. He can buy common stocks or sell them short. He can invest in distressed securities, foreign currencies or restricted securities. Think of your investment, he encouraged his shareholders in the first Wintergreen annual report, as “the antithesis of an index fund.” Unhampered and unpigeonholed, he added, the fund can be “agnostic with respect to geography, market capitalization, sector and security type.”

Winters walks in the way of Graham and Dodd. He does his own thinking. And he is deeply cynical about Wall Street. Yet he is as cheery as a growth-stock investor when the Nasdaq is flying. “We are delighted with the way things have gone,” he says, “and we think there are tremendous opportunities out there.”

He mentions a long-established and faraway conglomerate, Swire Pacific Ltd. (other-otc: SWRAY.PK). “It is family controlled,” Winters relates. “It’s essentially a Scottish conglomerate that is Hong Kong-based. We think it trades, give or take, at a 35% discount to net asset value. They have been consistent buyers of their own stock. The NAV grows, give or take, 10% to 15% [a year] over time. And they are really not promotional at all. They make no effort to encourage people to be enthusiastic owners of their stock, which we like.”

Shun Tak is also Hong Kong-listed. It owns and develops real estate in Macau, the world’s number one gambling destination – that is, not counting the Shanghai stock market. Of course, says Winters, not only are they not making any more real estate in Macau, they are also not reclaiming much. He estimates that Shun Tak, which has interests in hotels, ferry transport and investment securities, is quoted at a 20% discount to its net asset value and “it could be much bigger.”

Members of the value-investing tribe generally steer clear of China, seeing that the mainland equities markets are bubbling as if it were 1999 again. Winters understands the argument but likens himself to the conservative merchants who sold jeans and shovels to the prospectors in California during the 1849 gold rush. A lot of our companies capitalize on China’s growth, he says, “but are undervalued as opposed to trading at 100 times earnings.”

Winters has built substantial positions for his fund in the makers and marketers of cigarettes: Japan Tobacco, Imperial Tobacco Group (NYSE: ITY), Reynolds American (NYSE: RAI) and Altria (NYSE: MO). Tobacco companies can raise their prices and make the increases stick. How many other businesses can do the same?

A year ago Wintergreen fund held 25% of its assets in cash. Who knows? Winters then reflected. “We are just always waiting for that big, slow pitch in our zone,” he said. In the July-August credit fright, says Winters now, he did swing, repeatedly. But the the beaten-down banks, brokers and mortgage lenders did not tempt him (HSBC, one of Winters’ former favorites, got the heave-ho last spring).

His 2006 annual report closed with an expression of worry about excessive corporate leverage and a corresponding expression of hope for “a return of the bankruptcy cycle and opportunities to participate in the resulting restructurings.” That time has not yet come, Winters observes today. Too much money is chasing too few orphaned bonds. But, he adds cheerfully, better days – or rather, in this context, worse days – surely lie ahead.

Link here.


The solar market has been one of the fastest growing markets, and we have seen companies in this sector jumping 60%, 80% and even 100% in just a couple of short months. Renewable energy has been a hot political topic, but it has also been just as hot as an investment. We have seen tremendous growth in wind, hydro and geothermal energy production, but one of the more recent markets to catch fire has been solar. To see just how explosive this market really is, there is no need to look any further than a couple of solar module producers, Trina Solar (TSL: NYSE) and First Solar (FSLR: NASDAQ). These two companies have recently signed some major deals, and it has shown in their stock prices. These companies have seen huge run-ups in the past few months.

Let us first take a look at Trina Solar. It has recently signed contracts with a German company and three Italian companies. These contracts have TSL set to deliver solar modules that will produce approximately 88-99 megawatts of power over the next three years. Just on the news of these contracts, Trina’s stock jumped 16%, but this company was hot before these contracts even came out. TSL is up over 47% since the middle of June! But the story for First Solar is even more impressive

First Solar also produces solar modules. With the signing of its recent contracts, FSLR is set to manufacture and sell enough solar modules to create 658 megawatts of power by 2012. The total amount of solar energy produced in the U.S. amounts to approximately 400 megawatts. This is an enormous deal, and to help make good on its end, First Solar has announced the production of a manufacturing plant in Malaysia that will have an annual production of solar modules producing 120 megawatts of power. This plant is set to come online in the first half of 2009. After the news release of its most recent contracts, First Solar shares jumped 24%, but even more impressive is that it is up more than 180% since the beginning of May.

The solar market is still young, and there are still some amazing gains to be had. However, there is a completely different way to play this market and experience what might turn out to be the greatest gains of the solar rally yet to come.

Commodities are not the first things that come to mind when you think of the solar market. The whole notion of renewable energy is based on the fact that it does not use oil, coal, natural gas or other tangible assets to produce electricity. But there is big money to be made in gray gold. Gray gold, or silicon, is the base semiconductor used in the production of over 85% of solar cells. Rapid growth in the use of solar energy has led to a very large increase in the demand for silicon. The problem is that refiners are really having a hard time in keeping up with this sudden increase in demand.

The idea of substitutes is very important because it can act as a price cap for certain items. If there is a feasible substitute, there is a limit to how high the price of an item can go before consumers switch to something else. There is no reasonable substitute for silicon. That is why silicon-based semiconductors make up over 85% of the solar cell market.

The preferred form of integrated circuit is called a complementary metal-oxide semiconductor (CMOS) logic circuit. Producers use this kind of circuit because it has a much lower level of energy consumption than any other form of integrated circuit used in the solar industry. In other words, it becomes much more economical in the production of electricity when the integrated circuit consumes less energy. Silicon-based semiconductors are the only way you can make a CMOS logic circuit.

This is a very important notion, because it will allow for the price of silicon to run up as long as supply-and-demand fundamentals favor a bull market. We will be closely monitoring how this all plays out ...

Link here.


The market may be been perfectly content to brush it aside. It was, however, a brutal week for “contemporary finance”. Merrill Lynch, a kingpin of structured credit products, shocked the marketplace with a $7.9 billion asset write-down – up significantly from the $4.5 billion amount discussed just two weeks ago. Much of the write-off related to the company’s CDO (collateralized debt obligations) portfolio, the size of which was reduced in half to $15.2 billion during the quarter. But with proxy indices of subprime and CDO exposures down between 15% and 30% since the end of the quarter, Street analysts have already warned of the possibility for an additional $4 billion hit. Merrill is not alone.

Also hit by sinking CDO fundamentals, credit insurer Ambac Financial reported a Q3 loss of $361 million – its first-ever quarter of negative earnings. The company posted a $743 million markdown on its derivative exposures, “primarily the result of unfavorable market pricing of [CDOs].” Credit insurance compatriot MBIA also reported its first loss ($36.6 million), on the back of a $352 million “mark-to-market” write-down of its “structured credit derivatives portfolio”. These two credit insurance behemoths – and the “financial guarantor” industry generally – would have been a whole lot better off these days had they stuck to insuring municipal bonds and fought off the allure of easy – “writing flood insurance during a drought” – profits guaranteeing Wall Street’s endless array of new structured credit products.

Spreads on 5-year credit default swaps written on Ambac’s debt widened by 50 bps to 300bp, according to Credit Derivatives Research. Thus, the annual cost of insuring a $10 million portfolio of Ambac’s debt over five years has risen by $50,000 to $300,000. It is worth noting that MBIA and Ambac combine for about $1.9 trillion of “net debt service outstanding” – the amount of debt securities and credit instruments they have guaranteed, at least in part, to make scheduled payments in the event of default. Throw in the trillions of credit insurance written by the mortgage guarantors and you are talking real “money”. Importantly, the marketplace is beginning to question the long-term viability of the credit insurance industry, placing many trillions of dollars of debt securities in potential market limbo.

With recent developments – including the monstrous write-down from Merrill Lynch, the implosion in the mortgage insurers, and the losses reported by the “financial guarantors” – in mind, I will revisit an excerpt from a January article by the Financial Times’ Gillian Tett:

“ ... Total issuance of CDOs ... reached $503 billion worldwide last year, 64% up from the year before. Impressive stuff for an asset class that barely existed a decade ago. But that understates the growth. For JPMorgan’s figures do not include all the private CDO deals that bankers are apparently engaged in too. Meanwhile, if you chuck index derivative portfolio numbers into the mix, the zeros get bigger: extrapolating from trends in the first nine months of last year, total CDO issuance was probably around $2,800 billion last year, a threefold increase over 2005. These startling numbers will certainly not shake the world outside investment banking. For, as I noted in last week’s column, the CDO explosion is occurring in a relatively opaque part of the financial system, beyond the sight – let alone control – of ordinary household investors, or politicians.”

Subprime and the SIVs are peanuts these days in comparison to the gigantic global CDO and credit derivatives markets. CDOs may lack transparency, trade infrequently, and operate outside of market pricing (“mark-to-model”). Nonetheless, CDO exposure now permeates the entire global financial system – exposure that regrettably mushroomed in the midst of the most reckless end-of-cycle mortgage excesses imaginable. Rumors this week had major insurance companies suffering huge CDO losses. To what extent the big insurance “conglomerates” have exposure to CDOs and other credit derivatives is unclear today, but there is no doubt that the global leveraged speculating community is knee deep in the stuff. Importantly, as goes the U.S. mortgage market, so goes the CDOs. I am not optimistic.

I do not want to place undue weight on one month’s data, but the California statewide median home price sank $58,140 over the month of September (down 4.7% y-o-y to $530,830). This was by far the largest monthly decline on record and the first year-over-year fall in over 10 years. September California sales were down 39% from a year earlier. Weakness was statewide, led by a 63% y-o-y collapse in the “High Desert”. Even San Francisco Bay Area sales dropped 46% y-o-y. Ominously, the California Association of Realtors “Unsold Inventory Index” surged to 16.6 months, almost double the level from just six months earlier and compared to 6.4 months in September 2006. As far as I am concerned, there is sufficient evidence at this point suggesting the Great California Housing Bust has begun in earnest.

We have definitely reached a critical point worthy of the question: Can “structured finance”, as we know it, survive the California and U.S. mortgage/housing busts? I do not believe so. For one, the historic nature of the credit bubble virtually ensures the collapse of the credit insurance “industry” (companies, markets, and derivative counter-parties). The mortgage insurers are now in the fight for their lives, while the “financial guarantors” today face an implosion of their “structured credit” insurance business. Worse yet, major problems in municipal finance (certainly including California state and municipalities) are festering and will emerge when the economy sinks into recession.

Returning to the vulnerable CDO market, some key dynamics are in play. With California now at the brink, uncertain but huge losses are in the pipeline for jumbo, “alt-A”, and “option-ARM” mortgages – loans that were for the most part thought sound only weeks ago. The market began to revalue the top-rated CDO tranches this week. “AAA” is not going to mean much. If things unfold as I expect, a full-fledged run from California mortgage exposure could be in the offing. And as the dimensions of this debacle come into clearer market view, the viability of the credit insurers will be cast further in doubt – with ramifications for $trillions of securities and derivatives. General credit availability would suffer mightily.

With global equities markets in melt-up mode, it might seem absurd to warn that a troubling global financial crisis is poised to worsen. But structured finance is under duress. The entire daisy-chain of liquidity agreements, securitization structures, credit insurance and guarantees, derivatives counterparty exposures and, even, the GSEs is increasingly suspect. Trust has been broken and market confidence is not far behind.

The big global equities and commodities surge over the past few months certainly has been instrumental in counteracting what would have surely been a problematic “run” from the leveraged speculating community. How long this spectacle can divert attention from the unfolding mortgage/CDO/“structured finance” debacle is an open question. I cannot think of a period when it has been more critical for stocks to rise – and rise they have. Yet I suspect recent developments will now encourage the more sophisticated players to begin reining in exposure.

The nightmare scenario – where the market abruptly comes to recognize that the leveraged speculating is hopelessly stuck in illiquid CDO, ABS, MBS, derivative and equities positions – does not seem all that outrageous or distant this week. Unfortunately, today’s Ponzi-style acute fragility (as was demonstrated this summer in subprime, asset-backed CP, SIVs and the like) and speculative dynamics dictate that he who panics first panics best. I do not expect the sophisticated players to hang around and wait for securities to be properly priced and the full extent of illiquidity and the unfolding credit debacle to be recognized. And while bubbling markets do delay the inevitable reversal of speculative flows from the leveraged speculating community, they only compound the risk of an inevitable ravaging run from illiquidity. We will see to what extent the Fed is willing to spur increasingly destabilizing global stock market speculation and dollar liquidation in false hope that lower rates can somehow mitigate structured finance under duress.

Link here (scroll down).
Financial markets remain on edge because the credit crunch has not been solved – link.


I appeared on CNBC’s Kudlow & Company with my favorite host, Larry Kudlow. I went face to face with Dr. Wayne Angell, Jim Lacamp, Dennis Kneale and Dr. Robert Shiller. I want to give you a rundown of the show because it offers pretty clear evidence that many of the same misconceptions that surrounded the inflating of the housing bubble are still around – and as such are still dangerous to your financial well being. So read on.

Angell has encouraged the Fed to move aggressively in order to revive the housing markets. Later on, I questioned him on this, asking why another rate cut would help when the September cut did not – indeed industry statistics have worsened. He just said I was wrong, but I did not really get an explanation.

The optimism from the panelists was summarized by my pal Dennis, who started by denying that there was a housing problem, and stating that the housing bogeyman is not that important, that most homeowners have benefited from the rise in home prices during this decade – and even if they sold, they would end up well. He went on to say that the recovery in stocks the previous day was testimony to the bull market. What?

Jim Lacamp expressed the bullish view that the housing market will be “ring-fenced” and will not spill over into the economy or capital markets and that the fact that the markets are where they are is proof positive of the market's strength.

From my perch, the bulls continue to ignore the ramifications of the housing market’s depression not only on the economy but the spillover and contagion in the credit markets. For example, ignored in the panel conversation was how the subprime fiasco has devastated the credit markets, as evidenced by the continued structured investment vehicle problems and the huge writeoffs of permanent capital at the leading money-center banks and investment bankers.

It is astonishing to me that the subprime/housing-induced inflection point in credit, from credit expansion to credit contraction, continues to be ignored by market and economic bulls. The ironic thing of course was that after several of the guests denied the very existence of the housing problem, the next two segments were dedicated to Countrywide Financial’s deal to renegotiate some of its adjustable-rate mortgages and the implications of Chapter 13 bankruptcy filings on homeowners whose mortgage problems have accumulated.

I have mentioned in the past that a 20% drop in home prices, as currently predicted in the Case Shiller Futures Index by 2011, means that about $4 trillion of consumer wealth will be wiped out. Another $500 billion to $1 trillion of losses looks to be taken by the financial institutions and hedge funds from the CDO mess.

That is close to the amount lost after the tech bubble – and very large in the context of a $13 trillion U.S economy (the number Larry used last night). Moreover, the financial industry’s reluctance to provide credit to homeowners provides another important economic headwind.

The housing problem ring-fenced? Not likely.

Link here.


More bad news keeps rolling in from the mortgage industry. If you simply cannot read another word about subprime mortgages, you are in luck. Prime mortgages have now joined their younger brothers and, in some respects, are now in on the fiasco.

Option adjustable-rate mortgages (ARMs) have bled into the once profitable prime mortgage industry. Once reserved for only trustworthy borrowers with good lines of credit, the lending standards became relaxed and option ARMs began to grow in popularity. It is not difficult to see why this would happen.

An option ARM is similar to the standard ARM that we are familiar with. Borrowers become attracted to an extremely low introductory, or teaser, interest rate that lasts for the first few months. These teaser rates can sometimes be as low as 2%. Of course, nothing good lasts forever, and very quickly the rates shoot up. The difference is that with option ARMs, borrowers have the choice to pay as much or as little as they want per month. The first option they can choose is the traditional way to pay on a mortgage. With this option, the borrower pays the principal and the interest every month for either a 15- or 30-year term. The principal amount of the mortgage decreases with every payment.

The second option is an interest-only payment, in which the interest is paid every month, but the principal amount remains unchanged. The third option is the minimum monthly payment. This option does not pay on the principal, nor does it fully cover the interest due. This kind of payment comes in very handy when a borrower is strapped for cash or is expecting to have an increase in income in the near future.

The problem, of course, is that it is not as simple as just delaying your payments. The amount of interest not paid is just added to the principal amount owed. This comes back to hurt borrowers in two ways. First, the rates adjust after the introductory period and then reset at a certain point, usually the 5-year mark. What happens then is that the amount of money that you owe has increased, rather than decreased, over time. Essentially, this is just adding to the price of your house. Once the rates reset, the new interest rate is calculated on the new amount owed, which is the original principal plus any unpaid interest. Borrowers find themselves in the unenviable position of having to pay more money in less time. The amount of interest owed has also risen exponentially, and many homeowners will find themselves simply unable to pay.

Countrywide Financial began to offer these kinds of loans in 2003 and is currently one of the largest lenders of option ARMs. The amount of option ARMs that Countrywide sold began to grow and grow as the loan officers realized how simple they were to sell. Commissions began to rise and Countrywide itself noticed how profitable these mortgages were.

Now, just as we have seen in the subprime sector, loose lending practices and overall foolish planning by top mortgage companies like Countrywide have led to many late payments and defaulted loans. Not quite at the level of subprime, but certainly rising, option ARMs, according to The Wall Street Journal, currently account for 41% of Countrywide’s loans. Of those option ARMs held by Countrywide, 5.7% were at least 30 days late.

Although many issues have arisen along with the popularity of option ARMs, this does not mean that they are fundamentally flawed. For many borrowers who have an unfixed income, these types of mortgages can sometimes be the smartest option. They can pay more during good months and less during less successful months. But many of the borrowers who got themselves into this mess were not set up that way. Many were simply trying to purchase a loan that they really could not afford. If blame is going to be passed around, it must then be given on both sides of the spectrum. Borrowers should certainly be much more realistic when it comes to the type of home they can afford. Lenders should also carry a moral and financial obligation to make sure that they do not push a loan on someone who will later be crushed by its growing weight.

This does not mean that the “big bad mortgage companies” should shoulder the responsibility for making sure that every lender makes a wise decision. But with stricter lending practices, and an eye to making sure that the customer is actually capable of keeping up their end of the bargain, many companies would not find themselves in this predicament.

Countrywide, which previously was one of the biggest offenders with these lax lending practices, is now leading the charge in tightening up its standards. Of the option ARMs that Countrywide lent last year, 89% of them would now not meet its new standards. Better late than never, Congress has introduced a bill that would put strict regulations on these lending practices. Critics see the bill as too little, too late. Federal regulations would merely set a regulatory floor while many state laws that currently exist are already far stricter. Many critics claim that this would only add confusion to an already muddled situation.

Under that thinking, it appears that Congress is trying to fight a fire with a squirt gun. Damage has already been done, and without the mortgage companies policing themselves, more deterioration could occur. Mortgage companies need to look out, not only for their borrowers, but for themselves in the long run by making wise and responsible decisions, instead of going after a quick buck.

Link here.


If our country’s debt problems in the private sector were simply limited to the $1.5 trillion of subprime mortgages that needed to be repaid, restructured or foreclosed, the situation might be manageable. But they are not, and it is not.

It is widely understood now that this mess was caused by a Federal Reserve that pumped up home ownership (for everyone in America) and then proceeded to cut interest rates too low for too long, and by credit market participants who threw common sense and basic loan underwriting to the wind. The orgy was effectively facilitated by Wall Street’s ability to irresponsibly underwrite loans and then look the other way. Risky mortgage securities were packaged and sold in the secondary market to suckers who bought into the theory that the housing market would only go up.

As equity extraction becomes a thing of the past, a recession seems inevitable. I predict there will be continued credit surprises – mostly on the downside – as employment weakens, jobs are lost, and bills go unpaid. As a consumer-led recession unfolds, personal income and corporate revenues will not cover many debts, and the game of always being able to refinance has ended. So, for many borrowers the game is already over. They just do not know it yet.

The credit cycle has clearly turned. Financial institutions, such as banks, have only begun to add to the massive loan loss reserves they will need to shelter from the storm of at least $2 trillion of consumer, commercial real estate, corporate, and single family mortgage loans, that could easily roll over into default. And that is not all. Loan loss reserves are also being set aside as banks brace for the stress that has begun to appear in commercial mortgages and mortgage securities.

In the world of easy money and the exponential increase of artificial liquidity and credit, there is also the “shadow world” of derivatives. A derivative allows a market participant to make money or hedge a position as if they owned a financial instrument, yet they are not required to put the asset on-balance sheet (or post the capital) the same way they would have to if the asset were on-balance sheet.

Why is this important? As Hank Paulson, Secretary of the Treasury, runs around trying to bail out the Structured Investment Vehicles (“SIVs”), it has become pretty obvious. These SIVs provided a way for huge banks, like Citibank, to hold another $400 billion of assets but conveniently keep them off-balance sheet. Up until a few weeks ago, the financial press had not even heard of a SIV. Now, suddenly, they are threatening the core of the financial system, because the loans might have to go back on-balance sheet and tie up precious equity capital.

The big players love derivatives because they allow massive off-balance sheet leverage. However, the hedge funds and mortgage companies that have all blown up recently (along with some Wall Street firms and Bear Stearns) have learned a hard lesson. Mixing massive credit losses with high leverage is a formula for quick and definitive financial death. While leverage may be positive to the bottom line on the upside, it can quickly kill on the downside.

While SIVs are continuing to rock the system, they are a mere rounding error compared to Credit Default Swaps (“CDSs”) and other major derivatives. (CDSs are the most widely traded credit product.) There are $28 trillion of CDSs outstanding – a staggering number. It is more than double the U.S. GDP, and is more than four times the total of all outstanding corporate debt. The off-balance sheet “shadow world” of credit actually dwarfs the on-balance sheet visible world.

As the Music Man says, “There is a lot of gambling going on here in River City.” In real speak this means the financial players reap all of the benefits on the upside, while the investors assume most of the risk on the downside. The “gamboling” going on is off-balance sheet and, therefore, hidden from the investor’s view.

In July and August we all learned how cruel the markets can be. When the market value (gain to one party, and loss to the other) of mortgages and mortgage derivatives spiked in value very quickly, quite a number of firms, and funds, simply failed. It was very sudden. Derivatives are by design extraordinarily leveraged, so small changes in the financial markets can affect their value in a big way. A sizable wave in the financial markets can easily be magnified and turned into a tidal wave of market losses. With the current level of credit derivatives all sitting off-balance sheet (and unnoticed like the SIV’s recently were), unsuspecting investors could wake up to discover more alarming losses amounting to a few trillion dollars that were neither anticipated nor welcome.

Finally, the financial institutions that have exposure to on-balance sheet credit risk are the Who’s Who of major hedge funds, major banks, and Wall Street investment banks. Guess who the major counterparties are in the derivatives market? Why, they are the same major players! So, while Bear Stearns has become the poster boy for all that is wrong with subprime mortgages, other firms like JP Morgan Chase, Morgan Stanley, Citibank, Merrill Lynch, and even Goldman Sachs, may have their pictures posted alongside Bear Stearns’s in the “Hall of Shame” when corporate credits turn down. Crumbling credit combined with deadly leverage can prove fatal to portfolios invested in financial stocks.

Link here.


The transition from “mark-to-myth” to “mark-to-market” to has already left its mark.

If you are a bear, you must accept that you will always be wrong in polite society, and you will continue to be wrong all the way down to the bottom of recession. That is the cross that bears must bear.

Over the last three months we have seen a rolling collapse of speculative debt and real estate across half the global economy, yet friends still come over to my desk at the Telegraph, with that maddening look of commiseration on their faces, and jab, “so when is the sky going to fall then, eh?”

Well, excuse me. The sky has fallen. The median price of U.S. houses has crashed from a peak of $262,600 in March to $211,700 in September. This is an 18% drop nationwide. Yes, the year-on-year slide is still just 4.2%, but that will soon change as the base effect catches up.

Merrill Lynch has just confessed to a $7.9 billion write down on CDO subprime debt and assorted follies, nearly double what it suggested three weeks ago. This is what happens when a bank values its CDO debt at “mark-to-market” rather than “mark-to-myth”, as some of Merrill’s rivals are still trying to do. Merrill’s Q3 loss of $3.5 billion has cut the group’s equity capital by a fifth. This has consequences. The bank’s lending multiples will have to shrink.

In Britain, we have had the first bank run since the City of Glasgow Bank collapsed in 1878. The Fed has cut the interest rates a half point and vastly increased the pool of eligible collateral for Discount operations. The European Central Bank has injected over €400 billion of liquidity in the biggest intervention since the euro was created.

Japan is in recession. Housing starts fell 23.4% in July and 43.4% in August. The U.S. dollar has fallen below parity with the Canadian Loonie for the first time since 1976, and to all-time lows on the global dollar index. All it will take now for a full-fledged rout is a move by the Saudi and Gulf states to break their dollar pegs, which they may have to do to prevent imported U.S. inflation causing havoc. Or for the Asian banks stop buying U.S. Treasuries – as Vietnam, Singapore, Korea, and Taiwan, have gingerly begun to do.

And for good measure, the Bank of England has just warned in its Financial Stability Report that lenders are still in serious trouble, that there is a risk of commercial property crash, and that equities are “particularly vulnerable” to a downturn. It is said there may well be a repeat of the summer crisis, “potentially on an even larger scale.”

What more do you want?

It is true that stock markets have once again decoupled from the realities of the debt markets. But they did this in the early summer, when the Bear Stearns debacle was already well under way. They caught up famously in August. Nobody I talk to in the City credit trenches believes for one moment that the crunch is safely over. Indeed, they think that we are edging back to extreme stress levels, and the longer it goes on, the worse the damage.

Blue Chip companies can borrow money, but most of them do not need to do so because they have bloated cash reserves. Once you go down the chain, the picture changes fast. The iTraxx Crossover index measuring spreads on mid to low-grade corporate debt has jumped 100 basis points or so in the last week to around 360. It costs companies 1.8% more to borrow than it did in the halcyon days of the credit bubble in February, if they can borrow at all.

The ABX indexes measuring subprime debt – those infamous CDO packages of mortgages sliced and diced, and sold to German pension funds and Japanese insurers with a lot of lipstick – are still falling to record lows. As Goldman Sachs strategist Peter Berezin put it, “It’s the summer that won’t end. We continue to learn that it pays to respect the sell-offs in ABX and housing-related credit. This has elements of the February and August sell-offs, where credit markets signaled problems.”

From a par of 100, these indexes have fallen to (depending on the vintage):
AAA grade: 90
AA: 64
A 33
BBB 21

This means that the toxic BBB tier has lost almost 80% of its value. Even the AA has lost a third. Now, remember that the total stock of subprime and Alt-A (close kin) debt issued from early 2005 to early 2007 amounts to $2 trillion. Ben Bernanke’s estimate that losses would be $100 billion looks wildly optimistic.

Not to labour the point, but 3-month Euribor rates are still at 62 basis points over the ECB’s 4% rate. This amounts to a de facto half point rise since the crunch for all those in the euro-zone with floating mortgage rates – 98% of the total in Spain, the biggest property bubble of them all.

Asset-backed security (ABS) issuance peaked at €78 billion in March, fell to €52 billion in July, €9.8 billion in August, €5.6 billion in September, and €2.5 billion in October. It has died. Banks no longer dare to hawk the stuff of fear of a humiliating rebuff. Asset-backed commercial paper in the U.S. has contracted every week since August as the lenders refuse to roll over short-term loans. Roughly 25% of the market has been closed down, cutting off almost $300 billion of funding for SIVs.

These SIVs (structured investment vehicles) are “conduits” – in City argot – that allow banks to juice profits by speculating off-the-books on high-risk debt. They borrow short (three to six months) to invest long (five years of so), making money on the interest arbitrage. Until the game blows up, of course.

Some $370 billion still needs to be rolled over, and there lies the rub. The strong suspicion is that Hank Paulson’s $75 billion SIV rescue for the big four U.S. banks is intended to cover up the problem by feeding out losses slowly, rather than allowing firesales to cause a cascade. The Bank of England warned that the Super-Siv should not be used to prop up fictitious valuations. “It seems designed to prevent price discovery,” says Bernard Connolly, global strategist for Banque AIG.

Connolly says it resembles the slippery practices at the start of the Bear Stearns debacle, when creditors quickly abandoned attempts to force CDO sales by the Bear Stearns hedge funds as soon as they realized that prices were collapsing – exposing the awful truth that hundreds of billions were falsely valued on books. Nauseating though Paulson’s scheme may be, it probably has to be done.

Connolly says the Fed-led pack of central banks have made such a mess of capitalism by blowing credit bubbles (with low rates in the late 1990s and 2003-2006) that they now have no alternative other than to relaunch the “Ponzi Scheme”, or risk depression. This will have political consequences, of course. “The looming threat on the horizon, or just over it, is that the socialization of risk will be accompanied, in many countries, by the socialization of wealth,” he said. Indeed. The investors now baying for bail-outs had better be careful what they wish for. Democracy will have its way of making them pay. One recalls the 98% tax rate on dividends in Britain in the late 1970s. Haircut now, or haircut later.

In any case, the Paulson Super-Siv has failed to calm the horses. “This rescue has back-fired. The central banks don’t want anything to do with it. There is a fear that the big four U.S. banks are trying to hide their debts,” said Hans Redeker, currency chief at BNP Paribas.

The DOW is down 500 points or so since peaking in early October, and it looks wobbly. Even so, equities have not begun to reflect the reality that the 2006-2007 credit bubble has popped and cannot be easily reflated at a time of stubborn, lingering inflation. Spare me the mantra that the “fundamentals” are sound. Credit is the ultimate fundamental.

Woe betide Wall Street if the Fed fails to slash rates dramatically over the Winter, starting on October 31. Woe betide the dollar if it does.

Link here.


The fuse is now lit. The fuel at the end of the fuse is enormous. Everyone thinks they will escape the explosion.

The credit crunch that we are experiencing right now seems to be in the front of everyone’s mind. Questions abound and solutions that actually stand a chance of working are hard to come by. A reader recently e-mailed me this question, “What prevents the Fed from sending every household $100,000?” Just five things:

  1. Lack of authority.
  2. People would use it to pay off debt.
  3. Banks do not want to be paid back with money that is worthless.
  4. The Fed will act to bail out banks, not consumers.
  5. Hyperinflation ends the game. The Fed is simply not in the business of destroying itself.

Rest assured the Fed is going to do almost everything under the sun to encourage more borrowing. That includes slashing the discount rate and the fed funds rate, loosening rules on collateral, etc. Some of those we have already seen. This is likely the first inning.

But the one thing the Fed is not going to do is send everyone $100,000 or $10,000 or even $5,000. If for some reason I am mistaken and the Fed starts sending out checks or depositing money into people’s checking accounts to a significant degree, then I am willing to eat my deflation hat. Just so we are clear on this, another piddly $300 from Congress is not enough.

Many people in government and the media misunderstand the causes of inflation. In an attempt to answer some of the questions people have, Peter Schiff wrote:

“Inflation has only one cause and that is the Federal Reserve itself. In the United States, the supply of money and credit is regulated by the Fed. Since inflation is by definition an increase in the supply of money and credit, only the Fed can create it. If the money supply were held constant, increases in some prices would be offset by decreases in others. The result would be no overall inflation. In fact, without government created expansions of the money supply, the natural tendency of prices would be to decline as technology allowed for more efficient production of goods and services. So while most regard the Fed as the primary inflation fighter, in reality it is the sole inflation creator.”

That is a near-perfect explanation. Certainly, Schiff’s definition of inflation is perfect – an increase in the supply of money and credit. Schiff did make an error, however. That error is in the phrase “only the Fed can create it.” When it comes to credit, the statement is simply wrong. Money, in the form of credit, is borrowed into existence every day. This is a systemic problem, and the Fed is clearly not in control of it.

There is an educational 5-part YouTube series on money and debt. It covers in nice cartoon animation what has happened to money over time, fractional reserve lending, how money is created today, why interest rates are so low, why we get unsolicited credit offers, and why debt is exploding. The video concludes that it is taking exponential increases in debt (money) to stave off a collapse of the entire banking system, and that this cannot go on forever.

I agree with the video that there are practical limits on how high debt can get. Unfortunately, the video’s conclusion is a bunch of socialist nonsense: Eliminate interest, let governments – and only governments – create money, and supposedly, government will then use that money wisely to build roads and bridges that will add value to society. However, it does a reasonable job of pointing out many of the problems with the current system of debt creation in a very entertaining and (for the most part) educational way.

I gave five reasons the Fed is not going to give money away. If one believes that rationale, then one must logically accept there is a practical limit to debt, at least at the consumer level.

Proof of concept is easy enough to find. Massively rising delinquencies, foreclosures, and bankruptcies should be proof enough. At the state level, it is easy to see what is going to happen. Unlike the federal government, states are required to have balanced budgets. That means one of three things:

Raising taxes headed into a consumer-led recession will not work. Cutting spending is absolutely needed, but will throw people out of work at the worst time. Postponing the problem is not solving the problem. Postponement only makes things worse. The proper solution is to let free market forces work. If that means banks fail, then banks fail. If that means the stock market collapses, the stock market collapses.

Letting (encouraging) the dollar fall to zero is not a solution, for the simple reason it does not create any jobs where they are needed, which is right here, right now. Given the amount of credit in the system versus actual cash and global wage arbitrage and slower consumer spending, it would take a mammoth effort from Congress and the Fed to forestall the inevitable once again.

Sure Thing?

Right now, the surest bet in the world is that when the dollar drops, the U.S. stock markets rise. How long that remains so is anyone’s guess.

There is going to come a time when borrowing dollars to invest in equities is going to blow up. Of course, the carry trade may blow up first (sinking everything in its wake). Perhaps a massive derivatives unwind sinks everything first. Then again, perhaps the trigger is something from way left field that no one is watching.

What I am certain of is this: The fuse is now lit. The structural imbalances worldwide have never been greater, and the fuel at the end of the fuse is enormous. In addition, the amount at risk increases every day.

The interesting thing is that no one knows how long the fuse is. For some inexplicable reason, everyone acts as if they can get out before the stick ignites. It is simply not possible.

Link here.


Fifty years ago, I read Walter Lord’s book on the sinking of the Titanic, A Night to Remember. Frankly, the only fact I can remember about that book is this: the lifeboats were only a little over half full. That grim fact has never left my memory. It was shocking to me then. It is shocking to me now.

I am not sure what I would have done, had I been a passenger on that ship. But as an entrepreneur, I know one thing: I would have been the first person to line up at a lifeboat. If I had been refused access to that lifeboat – “Women and children first!” – I would have headed rapidly to another lifeboat, on the assumption that the same rule did not hold for every lifeboat. That was in fact the case that night. A lot of men got into lifeboats. I would have been prepared to offer my seat to a woman or child, but once the crewman said “lower it!” I would have sat tight.

Assuming that I got on deck after all lifeboats had been lowered, I would have immediately gone to the closest side of the ship. I would have looked down to see if there were any empty seats in any visible lifeboat. Had I not seen any, I would have gone to the other side. I would have seen plenty.

With seats empty, I probably would have headed for my cabin. These seats are probably going to stay empty. Why? Because people are creatures of habit. As soon as most passengers who were left behind saw that there were no more lifeboats, they would have adjusted to the new conditions: “No exit.” They would have prepared to die. Why? Because most people in a crisis think “lifeboats”, not “empty seats”. They think of the big picture as “no lifeboats here,” rather “empty seats out there.” They see no lifeboats, so they do not go looking for empty seats.

I am an empty seat guy. If there were a commodity futures contract on the last train out, I would go long. The water would be painfully cold. But since I was going to wind up in the water anyway, I would have decided to go swimming sooner rather than later. The longer I waited, the longer I would be swimming toward departing lifeboats. Time was of the essence. The water was close to freezing. I would have grabbed my life preserver and headed for a lower deck. I would have traded time for a lesser impact. My key to survival would be to keep my senses after impact. In the water, I would have swum toward where I thought most of the lifeboats were clustered. If they had been moving away from the ship, then I would have tried to guess where they would be when I arrived.

From the groaning sound, I have concluded that the Good Ship Bubble Economy has hit a monetary iceberg. The question now is this: Is the scrape long enough so that it has punched a gaping hole in all of the watertight bulkheads?

The Fed under Greenspan lured lenders and home buyers into what have now become visible disasters. But for most of this period, 1991–2005, the policy seemed to create great wealth, in the form of rising home prices. That is a long period of success. So, when signs appeared in mid-2005 that the housing market had peaked, and some of us hard-money writers began warning about this, nobody paid attention. But the reality is here.

In every mania, a few emotion-driven people buy at the top. This now-deflating housing mania was debt-funded. You could still get jumbo loans (above $417,000) last July at fairly low rates. Today, you can’t. There is no indication that anyone will be able to do so in time for these now debt-burdened people to get out from under their upside-down mortgages. They must now make mostly interest payments for the next 15 years just to pay off the equity that they have lost in one year. They are prisoners in their McMansions.

This is the price of central bank policies designed by very smart people. They are very smart people who think that they are wiser than free markets. They aren’t.

The U.S. housing market is down – on paper – by over a trillion dollars, CBS News reports. But who knows how much? The report cited one forecast that says it will be down by another $3 trillion in a year. I think this estimate is plausible.

Median prices are down by about 4%, year to year – the first national decline since 1933. Why are prices not falling faster? Because sellers think this decline is temporary, that in a year, their homes will be worth what they were a year ago. Sellers learn slowly. Their homes will not rebound just because sellers think they are special, that they can beat the market.

In a year, there will be real fear. Sellers will not be able to sell. Inventories will be much higher. Sellers will be stuck in their homes, or worse, paying the mortgage on their now-empty houses and rent on the one in the new location. Contracts that are contingent on the sale of a home by the buyer will fall through. Reality will set in. Some sellers will run out of bargaining room. That is when you should be there with cash.

If you are seller, think “Titanic”. Lower your price now and get out while the ship is still afloat. The water will be just as cold next year. Put on a life vest and jump, before the lifeboats float out of swimming distance.

Link here.
The best one-shot investment on earth – link.


A tough cut of book.

It is commonplace nowadays in the psychologically hip circuit to divide people up into three categories, as based on a well-known experiment with rats: alphas, betas and gammas. Alphas are leaders. Betas are followers. Gammas are independent-minded dominant loners. Members of the last group often become alphas at some point in their lives, but discover that they do not like leadership that much, and return to the dominant lonerhood that they prefer. Gamma leadership tends to be of the “gang’s all here” type.

Each group has its own mindset. Alphas tend to see betas as docile, as good-enough sheep, who need to be led for their own good. Gammas are seen by alphas as oddballs, but as ones that might rate respect based upon their accomplishments.

The beta mindset is the one that is generally misunderstood in our competitive society. The idea that betas look up to alphas is a conceit generally shared by would-be alphas. If you want to find out the real attitude of the typical beta, there is no better place to do so than at work. Try being friendly to the middle-aged person that is unpromotable but well-liked. His or her views of alphas and gammas will give you an idea of what the typical beta point of view is. Chances are, you will find out that betas tend to size up alphas as people of use – a “good” leader is a useful leader. If a leader is not sufficiently attentive to the needs of the followers, then he or she is not a “good” leader. The beta view of gammas is easier to guess: They are largely pitiable deviants unless they have some extraordinary talent worth noting. Sad to say, but the typical gamma fits into the beta world as part of the entertainment. No wonder that so many gammas get into the bash-the-alpha racket.

The gamma mindset is utterly cynical regarding general society. It is in the gamma circuit where you find the maxims about the “sheeple” being asserted as fact. The typical gamma view of the alpha is that the latter is a huckster, or “humbug”. Unlike frightened or disillusioned betas, the gamma sees an alpha as largely clownish or incompetent – as a Sorcerer’s Apprentice. The damage that the alphas do is the result of their limitations catching up with them. Given the amount of gamma-coined slogans about the “deluded masses”, it is not that necessary to elaborate upon the gamma’s view of the typical beta. The gamma’s view of the alpha is the crucial mindset to remember. In a nutshell, alphas are sized up as tragic figures – impractical pragmatics whose loose moorings wind up getting the better of them. In the gamma world, alphas are often perceived as unruly slaves.

Mobs, Messiahs and Markets: Surviving the Public Spectacle in Finance and Politics is a thoroughly gamma book. Even the organization of it gives the authors’ mindsets away. Both Mr. Bonner and Ms. Rajiva are goldbugs. Both are regular columnists at LewRockwell.com, the well-known libertarian Website. Had they been alphas, they could have gotten the message across to the general public through a Goldwateresque approach. First, they would have reviewed the horrors caused by Communist and leftist humbuggery; and then showed what damage has been wrought by American delusion-chasing. Instead, the reader gets the opposite. In the part that deals with politics gone wrong, “Militant Messiahs”, the three chapters therein discuss: (1) the damage wrought by war, (2) the blunderings of U.S. foreign policy, particularly in the area of nation-building, and, (3) the horrors wrought by left-wing politicos – in that order. Further proof of the gammaeque nature of this book seems superfluous.

There is a devil figure in this book. It is the alpha that genuinely cares what the betas think of him or her. This kind of alpha inevitably winds up being a “do-gooder” – the type of person who, according to the authors, causes the most trouble in this oft-saddened modern world.

If you are the alpha type, you will undergo something rarely experienced in this day and age, despite the number of Mencken imitators currently around. You will actually feel the same way that a good, worthy, successful U.S. bourgeois felt in the 1920s when reading one of Mencken’s works. The two authors are that good at being intellectually detached from all parts of the popularity-and-leadership game.

Some may find it roundly offensive, but it would be tragic if the reader, taking umbrage, expels him- or herself from the Bonner/Rajiva School for Creative Cynics. After reading this book, you will reevaluate some of your more cherished ideas. Some will find grist for self-reflection in its material.

There is actually little investment advice in Mobs, Messiahs and Markets, largely because the authors are attacking the underlying mindset that leads to recurrent and poor investment choices. If you graduate from the Bonner/Rajiva School in good standing, then you will have the mental equipment to come up with good investment ideas of your own and/or the recognition of which commonplace ideas are the good ones. It is debatable whether or not this book has its prime value as an investment manual.

Book review here.

A satirical romp through the world’s current financial markets.

William Bonner’s latest book Mobs, Messiahs, and Markets: Surviving the Public Spectacle in Finance and Politics takes us on a satirical romp through the world’s current financial markets. Co-authored by Lila Rajiva, this book examines the history and politics of modern finance and how it has been influenced and manipulated by “money-hungry professionals” and corporate executives for less then stellar reasons.

Founder and president of Agora Publishing, best selling author Bonner and fellow co-author Lila Rajiva offer an interesting picture of the investing public and the powers of group-thinking and corporate manipulation. In the book they point out and try to give an explanation as to why people often throw caution to the wind and abandon all common sense and decency to follow the crowd in their investment behaviors.

Somehow, I could really relate to this book with awe and a new awareness when I reflected back to the mob mentality that consumed me and my baby boomer cohorts as we pursued the Beanie-Baby craze. Am I simplifying the theme of this book, or in my own small way relating my personal experience to the overall economic picture?

In the larger scope of the financial world, ordinary people invest billions of dollars worth of their hard-earned income with brokers, mutual fund investors and other financial advisers hoping that their life savings will turn into big-time fortunes. Mobs, Messiahs, and Markets explores the possibilities that investors are caught between the private world and the “collective” investment world and are, therefore, compromised in their decisions and recommendations. The book goes on to suggest that investments such as mutual funds, hedge funds, insurance funds and pension funds are, for the most part, counter-productive to sound investing strategies.

Book review here.


On a recent trip to California, I grabbed a copy of the Los Angeles Times that featured a page-1 photo of a massive beached whale. The poor critter was a female blue whale. The carcass was about 80 feet long and tilted the scales at nearly 100,000 pounds – making her one of the largest animals in the world.

Beached whales may have nothing to do with the world’s exhaustible supply of crude oil ... or inexhaustible supply of dollars. But I see a connection ... an ominous connection.

It is difficult to say how old she may have been, but certainly north of 50 years is a safe bet. Apparently, this whale was migrating along the coast of Southern California when a massive object, probably a cargo vessel, struck her. The death of this particular whale brought the financial world into my consciousness with a certain shocking level of reality. There is actually an old school of thought, for example, that regards the discovery of a beached whale as a sinister portent ... and so it may be.

In the 17th century, the English writer Thomas Hobbes (1588-1679) published numerous works that laid out much of the template for modern political philosophy. Among the most famous works by Hobbes was Leviathan (a fancy word for whale) – doctrine for the foundation of societies and legitimate forms of government, in which the state is portrayed as a whale-like monster.

In Leviathan, Hobbes articulates the necessity of a strong central authority to avoid the evil of discord and civil war. According to Hobbes, any abuses of power by this authority are acceptable as the price of peace. The sovereign must control civil, military, judicial and ecclesiastical powers. Hobbes argues that the sovereign has the authority to assert power over matters of faith and doctrine, and that if he does not do so he invites discord.

The use of the term “leviathan” by Hobbes was no mere random choice of words. Whales are large, beastly creatures that were reputed to swallow men whole (Jonah comes to mind). And according to Leviathan, life in the raw state of nature is “solitary, poor, nasty, brutish and short.”

So let us play a little game. Imagine that beached whales actually portend some kind of bad luck or grim event. What grim event, therefore, might the beached whale in Ventura County, California, portend? Allow us to suggest a couple of possibilities: Oil higher; dollar lower.

Oil has climbed to a record-high $92 per barrel. Why is the price rising? The Peak Oil paradigm is beginning to gain traction. I have discussed Peak Oil extensively and often in my investment letter, Outstanding Investments. U.S. Secretary of Energy and former CIA Director James Schlesinger recently noted at an international conference on the subject of energy, “The battle is over, Peak Oil is now accepted as inevitable, and the debate only becomes as to when.”

This is a remarkable statement, coming from one of the most “inside” of U.S. political insiders. One of the long-term trends you can expect to see is that oil prices will remain high. Oil supplies will be precarious and subject to disruption by weather events, natural disasters, and fourth-generation warfare aimed at “systemic disruption”. Also, new discoveries will trail consumption. Oil and natural gas in the ground, as booked reserves or realistic and exploitable resources, are more and more valuable. Oil service companies with a lock on technology and the operational skills to create technological systems for extracting hydrocarbons are also more and more valuable.

Recently, the gold price jumped to a new high as the dollar flirted with new all-time lows. Gold’s strength highlights the ongoing decline in the value of the U.S. dollar via chronic, gross and ought-to-be-criminal monetary mismanagement. For example, on September 18, the U.S. Federal Reserve cut its key federal funds interest rate by 0.5%, as if the big problem of the U.S. economy in recent years has been not enough cheap credit. The Fed rate cut, as expected, made many Wall Street traders happy and goosed the stock market indexes.

But the Fed action also caused an immediate spike in the prices for gold, silver and oil futures. So evidently, some savvy players understand that temporarily cheaper dollars are not necessarily good for the long-term health of the U.S. currency or economy, and this understanding is reflected in things with intrinsic value like precious metals and energy fuels. Even former Fed Chairman Alan Greenspan has stated that he believes that we will see double-digit interest rates at some time in the future in order to salvage the long-term value of the dollar.

So let’s get back to the beach in Ventura County. Within a few days of the whale’s discovery, the wildlife biologists had examined it and learned whatever they could discern from the necropsy. And for reasons of public health, the authorities had towed the carcass to an isolated spot on a different beach for as respectable a burial as is possible when using bulldozers. RIP, blue whale. The omen came, the omen passed. But we know an omen when we see one. Do not let this whale perish in vain, dear investor.

Beware the false prophets of the conventional media who tell you that everything is fine and that there is plenty of oil (“if only we would drill in such-and-such locale,” goes the refrain), or that the dollar is sound. You need to understand that the energy supply of the U.S. – and the rest of the developed world – is in a precarious state. We cannot just drill our way out of it.

And you need to know that the situation with the U.S. dollar is quite tenuous. We cannot just borrow and spend our way out of it. The government and monetary authorities, the “leviathan” of Thomas Hobbes, have overplayed their hands, abused their powers and are slowly but surely wrecking the long-term value of the dollar.

Sure, things may just drift along for a while like a dying cetacean hit by a cargo ship on the high seas. But sooner or later, the trends will manifest themselves and you will be glad that you have a portfolio filled with energy stocks and precious metals. As the old whalers used to say, “Thar she blows.”

Link here.


The haute financiers who brought you subprime backed derivatives are back!

Dig out your bell-bottoms and dust off your Doobie Brothers albums. This is where inflation stops hiding behind the official CPI data ... and starts eating your cash savings and income alive.

“More Fund Investment in Agricultural Markets in 2008”, says Lehman Brothers, now launching a “Pure Beta Index” to buy long-dated futures in 20 soft commodities. “Funds’ Take-up of Commodity Indexes to Rise 20%”, says the Financial Times, quoting Eric Kolts at Standard & Poor’s. Global pension fund investment in commodities will reach $160 billion, he believes, in 2008. “Energy and Commodities May Avoid Bank’q Job Ax”, adds the San Diego Union-Tribune, quoting an analyst saying that “Commodities and energy has been a massive push for everybody.” ... “Banks will look to retain expansion plans in commodities, which is seen as a growth area,” agrees a senior U.S. executive.

Across the Pond here in London comes the Wessex Gold Fund, using leverage to go long/short of gold mining equities and give itself “an additional edge versus long-only alternatives.” That edge will cost anyone making the minimum $500,000 investment – with a minimum 12-month lockup – some 1.5% in annual management fees, plus a 20% grab off any gains they might make.

Down Under in Australia, Oceanic Asset Management is launching “a stable” of commodity investment funds at the start of November, looking to nab both retail and institutional money. It is starting with a $710 million equity fund based in London, plus an offshore hedge fund in the Caymans. And UBS, meanwhile, just announced the launch of its Commodities Portfolio Algorithmic Strategy System. Nicknamed the UBS Comm-PASS, it is even geekier than it sounds ... running “a basket of strategies” on 19 different commodity futures, exposing its clients 51% to energy, and going both long/short yet again.

In short, “Burned Subprime Investors Eye Commodities for Growth”, as Reuters puts it. The impact on your cost of living should prove as dramatic as the bubble in global real estate they are now fleeing.

But the urgency of this autumn’s switch into commodities – driven by the flight from property and paper – is something else entirely. The Ph.D.s who cooked up the U.S. housing bubble are now applying their haute finance skills to gearing up the cost of natural resources. Hence the complexity of the very latest commodity offerings. Expect a side order of inflation to reach your dining table as a result very soon. “The reality is that there are still few options for investors interested in gaining access to commodities through a fund,” says John Fearon, director of Oceanic in Sydney. “The thirst for some exposure to commodities markets is growing all the time.”

This sudden thirst for – and eager slaking of – schnapps-style commodity products begins, naturally enough, with the threat of inflation. Crude oil has more than quadrupled in barely five years. Wheat prices have doubled since April of this year. Gold, that speechless seer of price inflation ahead, has shot 15% higher in the last eight weeks alone. That bodes ill for the value of cash in the bank and pay packet.

“Other commodities are major industry inputs, [so] their relative prices change with the business cycle,” found David Ranson of H.C. Wainwright in a study for the World Gold Council of November 2005. “Gold is not subject to these distortions since it is not a major input to industry. Changes in the gold price are thus a good barometer of changes in currency values – and ultimately in the absolute level of prices.”

Comparing gold with oil, for instance, between 1951-2005, Ranson found that gold’s correlation with the producer price index one year later was 0.37. Crude, on the other hand, managed a mere 0.01. For consumer price inflation 12 months hence, moves in the gold price averaged a 0.50 correlation, more than twice the correlation between oil and the CPI.

The current move in gold, leaping above $750 per ounce this month, was kick-started by the world’s biggest central bank – the U.S. Fed – cutting the price of dollars borrowed by the world’s biggest commercial banks. The Fed cut its “discount” rate by 0.5% on August 17, back when gold was trading nearly $100 per ounce below current prices. When unlimited money supply growth crashes into rising demand for limited-supply essentials – such as natural gas, copper, soybeans, and cocoa – the result is sure to be price inflation as violent as the monetary inflation that preceded it.

Add a sudden wall of money from Wall Street, the City, Frankfurt, Paris, and Tokyo – all seeking a growth market to replace the can’t-lose gamble of home loan trading and credit – and the surge in basic resource prices will only accelerate. Now add a little pixie dust, plus a dollop of leverage, and voila! One 1970s-style inflation – or worse – cooked to order.

“There has been hedge fund interest” in cobalt, for instance, says Nick French – a cobalt dealer at SFP Metals in London – but not because the hedge funds foresee rising demand for hip replacements, loudspeaker magnets, jet turbine engines, or other of the metal’s major end uses. Instead, “If you can push the price of cobalt up to $40 per pound from $20,” says French, “then the share price of a cobalt mining company will double.” Credit Suisse now offers a cobalt contract settled in cash, but backed by physical metal.

But futures contracts, based – like everything else offered to investors by the high finance industry – on credit, are only the start of it. “An army of structured credit experts is studying products such as collateralized commodity obligations, or CCOs,” reports Reuters, “tied to the performance of a portfolio of underlying commodities, such as precious metals or energy prices.”

My guess is – and at least I will confess it is just guesswork – that the Reuters journalist and most likely the bulk of investors about to start buying CCOs have no idea quite what these products are. All they will see, instead, is a steady stream of potential income. Provided, of course, that the CCOs pay out at maturity.

Bond managers and fixed-income traders whacked by the collapse of mortgage-backed debt can now put commodities into their portfolios – and just in time, too, for the runaway inflation about to hit thanks to monetary oversupply and heavily geared financial buying. The magic of finance has turned consumable lumps of natural resources into a stream of income ... without the bother of digging the earth or planting a crop.

But don’t feel left out! The global finance industry is more than willing to help you gear up, too. Morningstar, for example – the U.S. mutual fund rating service – just launched a series of commodity indexes applying basic momentum theory to go long or short when prices break the 12-month average. “It cannot be long before exchange-traded securities will allow retail investors to take part in the action,” says John Authers in the Financial Times.

Macquarie Bank in Australia, meanwhile, is now advising you delay making any commodity stock purchases. Lend your money to them on a “Hi-Note” instead for 30, 90, or 180 days. Earn a “high yield” in the meantime, but nominate now the purchase price you will pay – of between 85-100% of the current share value – when the note matures. High income, eh, with a cut-price mining-stock future thrown in for free? Sounds too good to be true, no?

It may be worth recalling that when Refco, the U.S. commodities and derivatives brokerage, went bust in late 2005, Jim Rogers’s Raw Material Fund was owed more than $362 million, according to court filings. I am not saying that any of the banks or brokerages now brainstorming clever new ways to gear up commodity profits is acting fraudulently or illegally today. Refco, on the other hand, was accused by Rogers of seeking to “brazenly violate the funds’ instructions and deceitfully divert the funds’ assets to an insolvent, unregulated entity.”

But making the right call in commodities – and betting they are only set to rise from here – will not guarantee you turn a profit. Not if you rely on somebody else making the trades or making good on a credit-based promise. Simply buy and sell the physical asset yourself, and at least any profits you make – and losses you suffer – will be yours to regret alone.

Link here.


Some of what makes a great investor is baked-in natural talent, beyond imitation, in the same way countless hours of golf practice will not turn you into Tiger Woods. But some things you can copy. In fact, a few things are very easy to copy. Three of them include discipline in the price you pay for an investment, keeping your turnover low, and focusing on your best ideas.

What follows is some shoptalk gathered at a recent investment conference in Hollywood, California, that reinforces these three principles. Let’s start with lessons from the Great Depression.

The Great Depression was a terrible time to own stocks. During the entire span from 1929 to 1939, stocks delivered a negative return. Small-cap stocks were hit the hardest, losing more than 5% a year on average. Bonds were the only place to hide, scratching out a relatively robust 4.7% per year. Or maybe not ... Two great investors, Robert Rodriguez and Steve Romick, both money managers at First Pacific Advisors (FPA), show that a little discipline – a little attention to prices paid – would have given you good returns, even in the Great Depression.

They show that waiting just two years – until 1931, instead of 1929 – turns negative returns to positive ones. Suddenly, small-caps beat out the alternatives. Between the market lows of 1931 and 1939, small-cap stocks outpaced bonds. And if you factor in the deflation that occurred during the 1930s (as opposed to the inflation that we all know), small-caps delivered an even more impressive result. Because the 1930s were a deflationary time, a dollar in 1939 bought more than a dollar in 1929. If you factor that in, the real return on small-cap stocks was 9.2% annually during the Great Depression.

Rodriguez and Romick are not market-timers. They are stock-pickers. They buy stocks when they are cheap. They hold onto them. So their basic message is simply this: Stick with buying cheap stocks. You can still earn good returns even in a lousy market. If you could buy all small-cap stocks and get a 9% annual real return during the Great Depression, think what a stock-picker could have done by just sticking with the cheapest stocks in a friendlier investment environment.

Stock-pickers are a minority these days. As James Montier, a researcher at Dresdner Kleinwort, recently observed, “Stock-picking has become a minority occupation. But if no one else wants to be a stock picker, then this is, most likely, where the opportunity lies.”

The second part of Rodriquez and Romick’s presentation had to do with patience. Investors, as a group, are not patient. They flip stocks too often. They sell when prices fall and buy when prices rise. The fund flows into (and out of) Rodriguez’s own fund offers a classic example of how most investors behave. The FPA Capital Fund, run by Rodriguez, has been one of the best mutual funds in the business for about two decades. Through 2005, in fact, it was the best-performing mutual fund over the past 20 years, beating the market by a sizable margin.

In 2006, the fund slipped a bit and lagged the market. Despite Rodriguez’s 2-decade-long performance history, some investors actually pulled money out of the fund. The fund lost 8.6% of its money under management to redemptions in Q1 2007 alone. When the fund lagged the market in 1999, it lost 15% of its assets due to redemptions. In 2000, it lost a whopping 25% of its assets from redemptions. The fund then beat the market by 35 points in 2001.

The FPA Capital Fund’s experience illustrates a classic case of investor impatience. There are several studies out there that show the average investor actually earns returns less than what mutual funds report. Why? Because the average investor tends to take his money out at bottoms and invest it near tops.

The typical investor trades too much. Again, Montier, commenting on empirical research exploring the link between turnover and performance, wrote, “Unsurprisingly, those funds with the highest turnover deliver the worst performance, while those funds with the lowest turnover do the least damage to net risk-adjusted returns.”

So the lessons to take from Rodriguez and Romick’s presentation are twofold: First, pay attention to the price you pay and you can make good returns, even in a bad market. Second, do not chase past returns. Be patient with your investments and give them time to bear fruit.

Finally, focus on your best ideas. Zeke Ashton is on nobody’s list of great investors – yet. But he is a rising young star. His presentation brought home another trait that successful investors have: They tend to focus their money on their best ideas.

Research supports the idea that the best-performing investors concentrate on their best ideas. The average mutual fund owns 128 stocks. Among the top 25% of all funds, the average is only 63 stocks. The bottom 75% own over 140 stocks. As Ashton said, “The goal for all investors should be to get the most value out of your best ideas without risking significant capital loss if you are wrong.”

What makes a great investor is endlessly fascinating to me. I love to study how great investors play the game. Doing so also helps reinforce good investing habits. Sometimes, these habits are relatively easy to copy. Pay attention to price, trade less, and focus on your best ideas.

Link here.


Federal Reserve Chairman Ben Bernanke is “a nut” and interest-rate cuts by the central bank are harming the U.S. economy by fueling inflation, investor Jim Rogers said. “Bernanke loves printing money,” Rogers said in an interview in New York. “This man is a nut. The dollar is collapsing, commodities are going through the roof, which means inflation’s going through the roof. These people are leading us to terrible problems down the line.”

Rogers also said he is selling short shares of Citigroup, the biggest U.S. bank, and Fannie Mae, the largest provider of money for U.S. home loans. Investors should buy commodities and the Chinese currency, Rogers said.

The Fed this week cut its benchmark interest rate by a quarter point to 4.5%. Policy makers have now lowered their target rate for overnight loans between banks by 0.75 percentage point in six weeks, the most aggressive easing since the economy was emerging from its last recession in 2001.

Financial shares in the S&P 500 Index have tumbled 14% as a group this year after a collapse in the subprime mortgage market prompted a surge in borrowing costs and forced banks to write down the value of some debt securities. Rogers said financial companies may be forced to write off “tens of billions of dollars more.” Citigroup tumbled to the lowest since April 2003 in New York Stock Exchange composite trading this week.

Rogers, who predicted the start of the global commodities rally in 1999, is betting that prices for oil and agricultural commodities will continue to rise. “Oil prices are going to go higher because nobody has discovered any gigantic oil fields for over 40 years,” said Rogers, who sees prices climbing as high as $150 a barrel. “There’s just no oil out there.”

Rogers also said he is buying currencies including the Chinese renminbi, the Swiss franc and the Japanese yen. China’s currency is “bound to double, or triple or quadruple over the next 10 or 20 years,” he said. “It’s got to be one of the best investments around right now.”

Link here.
Previous Finance Digest Home Next
Back to top