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SPIRALS OF DEATH
Close observers of the U.S. housing finance disaster in recent months will have noted a curious phenomenon. Companies such as Countrywide that were in late August regarded as rock solid have recently passed clearly into the danger zone, while those like Fannie Mae and Freddie Mac that were regarded as potential market saviors have come under a cloud. In Britain Northern Rock, whose September bailout was said to be modest, involving little risk to the taxpayer has now turned into an immense £25 billion ($51 billion) potential black hole – real money even in the U.S. economy, let alone in the much smaller British one. This illustrates a deeply troubling quality of the largest downturns: the tendency for the free market to turn into a death spiral, in which even sound well-run institutions are engulfed.
Death spirals are fairly rare in financial history. The Wall Street Crash of 1929 was perhaps the most virulent example. After the first downturn, the market recovered for several months. Then the collapse of the Bank of the United States in December 1930, together with the further economic damage from the Smoot-Hawley Tariff caused a further collapse in confidence and activity that was concentrated in the banking sector, as relatively solid institutions followed the Bank of the United States into bankruptcy. The Federal Reserve failed to correct for the money supply contraction caused by the bank bankruptcies, leading the U.S. economy further into the pit. The additional shove given by President Herbert Hoover’s 1932 tax increase was almost unnecessary. Only the confidence brought by a new president (albeit with equally counterproductive economic policies) brought recovery from 1933. By the time the spiral was over, more than one fourth of the banks in the U.S. had gone bankrupt and the stock market had bottomed out at 1/10th of its peak.
A second death spiral, with somewhat less dire economic consequences, occurred in Britain in 1973-74. Edward Heath’s government had removed the quantitative controls on bank lending in 1971, which resulted in an orgy of high risk lending against real estate, very similar to the recent episode in the U.S. except that most of the loans were made against commercial real estate rather than housing. When the first major real estate lender, London and County Bank, collapsed in November 1973 another more conservative house, First National Finance (FNFC), was used as the epicenter of the “lifeboat” rescue organized by the Bank of England. However, the decline in confidence and real estate values quickly sucked FNFC into the maelstrom.
The lifeboat rescue fund grew larger and larger for more than a year as the stock market declined to record low levels, 70% below its 1972 high. Homebuilders such as Northern Developments, in no way involved in the original crash but dependent on bank lending, were dragged down. So were the two most important entrepreneurial finance houses, both internationally diversified and neither significantly involved in commercial real estate lending – Jessel Securities and Slater Walker, founded by Jim Slater.
Neither Jessel nor Slater had been aggressively run – indeed Jim Slater had begun deleveraging a year before the crash, as he saw trouble coming – and no wrongdoing was proved against the head of either organization, yet by the end of 1975 both very substantial companies had gone bankrupt and neither founder played a significant further role in the British financial sector. This was a great pity. In losing Jessel and Slater Britain had lost not only their very able founders but the most aggressive entrepreneurial teams in the City of London, who might have been best able to compete against the foreign invasion when Britain deregulated the financial services sector in 1986.
The British experience of 1973-74 seems more like the current position in the U.S. National policy is currently reasonably neutral, so far avoiding the twin dangers of protectionism and tax increases which caused the medium-sized downturn of 1929-30 to turn into the Great Depression. The problem is concentrated in the property sector. However there are already worrying signs that the magic alchemy of modern finance, though such mechanisms as securitization vehicles whose funding falls apart and complex derivative securities that prove to be unsalable in a crisis, is causing the problem to metastasize. In the consumer sector, GMAC has reported problems with its automobile loan portfolio. It appears that credit card debt quality is rapidly deteriorating. In the corporate loan sector, loans to aggressive LBOs have got in trouble, and loans to hedge funds and private equity funds have been sharply cut back.
The “death spiral” characteristics of the current market are pretty clear. If Fed Chairman Ben Bernanke’s original estimate of subprime loan losses of $50-100 billion had been anywhere close to accurate, there would have been no problem. When the subprime problem first emerged in February, it appeared that it would be limited. A number of subprime lenders, relatively insignificant institutions, were forced to shut down. However the general market appeared unaffected.
August’s widening in Libor spreads, at which banks lend money to each other, should have told us that this problem would be different, and altogether more important. If leading banks were unable to assess each other’s credit quality for short term transactions then something much more serious was wrong than the collapse of a modest fringe sector of the housing finance market. The Fed’s chosen solution, dropping interest rates and pumping more money into the system, did not address the real problem and was thus useless, as it has since proved. It has only postponed the denouement for a few months and stored up further trouble with inflation.
Two factors are at play here. The first is sheer size. If, as now appears likely, the eventual losses in the home mortgage market are on the order of $1 trillion, then the subprime debacle becomes something much more than a localized meltdown. $1 trillion of losses is 7% of U.S. GDP. The market cannot absorb losses of that size without some major institutional bankruptcies or a lengthy recession. The savings and loan collapse of 1989-92 caused a major housing downturn but only a minor recession. However its cost (mostly borne by the U.S. taxpayer) of $176 billion was about 3% of 1990 U.S. GDP, only half the size of the likely current losses on mortgage loans.
The second is lack of transparency, and the blow to confidence that comes from the dawning suspicion that a large portion of the derivatives and securitization mechanisms designed in the last quarter century are faulty. The advent of FAS Rule 157, requiring banks to divide their assets into three levels according to their degree of marketability, has thrown an unwelcome spotlight on the problem. If Level 3 assets can be valued only by reference to an internal valuation model, and have been allowed to accrue value in banks’ financial statements for a decade or more (enabling hefty bonuses to their progenitors) then how do we know they are really worth anything close to what the model says, and how do we go about realizing them, in a market where confidence has vanished?
To ask those questions is to answer them. It is likely that today those assets’ book values are highly overstated. Moreover, even in banks where the mathematicians and their bosses were scrupulously, even impossibly, disinterested and intelligent, there still remains the problem that those assets are worth far less in a downturn, because their illiquidity makes them intrinsically unattractive in a market where liquidity has become once more important. Anyone who has attempted to sell venture capital positions in a bear market can attest to how rapidly and completely the value of such assets can disappear. It is perfectly possible that the true realizable value of “Level 3” holdings in a bear market is no more than 10% of their book value.
Goldman Sachs, generally regarded as insulated from the subprime mortgage problem, has $72 billion of Level 3 assets. Its capital is only $36 billion. If anything close to 90% of the Level 3 assets’ value has to be written off, Goldman Sachs is insolvent. They do not have the option of acting like Nomura Securities did recently, selling everything possible and writing the remainder down to zero, because they would be without capital. Instead they are likely to be dragged kicking and screaming, quarter by quarter, to a gradual writedown and sale of their Level 3 assets, with their true position remaining undisclosed and obfuscated by meaninglessly optimistic statements by top management. Only the bonuses will survive, paid in cash and draining liquidity from the struggling company.
That is what a death spiral looks like. The U.S. survived the Great Depression, eventually, and Britain survived the 1973-74 debacle. However the market recovered only after it had plumbed depths previously thought impossible, at which even the soundest investments were trading far below their true value. After normality returned, the financial services landscape was very different, with many large and apparently solid houses having disappeared, a generation of participants reduced to driving taxis or selling apples and a generation of investors scarred by their losses and unwilling to return to the market. Emergency infusions of money, from the Fed or the taxpayers, generally do no good, only postponing the denouement and delaying the arrival of truly bargain price levels.
Such spirals of death represent the final definitive triumph of the Bears.Link here.
Wall Street has been a, if not the, major credit inflation engine. Now it is badly hobbled.
Between June 30, 2004 and June 29, 2006, the Federal Reserve raised rates from 1% to 5.25%. During this period of significant Fed “tightening”, “money” became progressively looser. More accurately, credit and financial conditions loosened in the face of rising short-term interest rates. Today, the Fed is in the midst of another of its aggressive loosening cycles. Credit conditions are today tight, and there is the distinct possibility that they will remain taut or possibly tighten further.
The Fed receives too much credit for the “efficacy” of past easing cycles. Going all the way back to the then extraordinary rate slashing from the early-1990s (23 straight cuts!), it was actually the burgeoning power of Wall Street Finance providing the brute force behind Fed “reliquefications” and “reflations”. The evolving securitization markets and government-sponsored enterprises were the key mechanisms driving system credit expansion when the banking system was severely impaired back in 1991-92. By 1993, the blossoming leveraged speculating community had become a major force, taking highly leveraged positions in U.S. (and Mexican!) debt securities, in the process significantly augmenting system credit availability and marketplace liquidity. By the time of the “Asian Contagion” and then the Russian/LTCM crisis, leveraged speculation throughout the (global) debt markets had become a prevailing source of system credit and liquidity creation.
Having first nurtured “Wall Street finance” to buck the banking system “headwinds” early in the ‘90s, by the end of the decade Fed accommodation had fashioned the most powerful “reflationary” tool in the history of central banking. Simply tinker with rates or signal lower prospective market yields and the enterprising speculators would quickly lever up on risky debt instruments on demand. Never had it been so easy for a central bank to incite “animal spirits” and stimulate credit and liquidity. The hedge funds, Wall Street firms and, increasingly over time, myriad global financial players forged both “the Maestro’s” “genius”, the American “economic miracle”, and synchronized global asset and economic booms. In any case, the leveraged speculating community has been the force behind U.S. bubble economy dynamics including $800 billion current account deficits, negative savings rates, destabilizing asset bubbles, and so-called economic “resiliency”.
I will be quite surprised if this easing cycle lives up to market expectations. Most importantly, Wall Street Finance self-destructed over the past few years. Trust will not be returning anytime soon to “structured credit products”, meaning the securitization and derivatives markets are for quite some time impotent to play their usual “reflationary” role. This has been a momentous development, one certainly compounded by our major financial institutions.
It is also worth noting that 10-year Treasury yields are today below 4%. This compares to the 6% or so when the economy headed toward recession in 2000 and the 8% or so yields when the economy succumbed to tightened credit conditions back in 1991. There is simply not much room for further “easing” today. The Wall Street firms and the hedge funds are already dangerously distended after several years of reckless speculation. Wall Street is today in extraordinarily poor position to expand and bolster system credit. More likely, there is today years worth of overhang of risk securities that will eventually be liquidated by impaired leveraged players.
The unfolding credit crisis has necessitated the sequel “Committee to Save the World Part Two”. Especially after the credit system took a turn for the worst last week, I can understand Secretary Paulson’s urgency to have institutions renegotiate mortgage terms with troubled borrowers. But not only are we too far into the mortgage bust for such efforts to pay much in the way of dividends, I am skeptical that our securitization markets have the necessary infrastructure and legal structure to equitably adjust mortgage terms on millions of loans. And it is becoming increasingly clear that a large segment of troubled loans today involved some degree of fraud at origination. Besides, there is simply not much time to sort through all the various details. Examining the startling almost $92,000 two-month drop in California median prices, it is apparent that momentum generated by the The Great Housing Bust is not to be impeded by a program to check subprime mortgage resets.
Such efforts, however, obviously have major impacts on the markets. I cannot imagine more challenging market conditions. The way I see it, there is today a great and destabilizing dichotomy. On the one hand, the credit crisis and severe impairment of key sectors in the credit system ensure major liquidity constraints, faltering asset markets, and an arduous economic adjustment period. On the other hand, years of egregious credit inflation have created an incredibly bloated financial apparatus (domestically and internationally) determined to disregard new realities.
This “system”, importantly, is especially indisposed to succumbing to boom-turned-bust dynamics. Our Wall Street dominated financial apparatus is keen on “Inflate or Die” dynamics and has no intention of relinquishing the tremendous power it has gathered over the years. This is understandable, although it certainly creates a very serious problem when it comes to the stock market refusing to adjust to rapidly deteriorating underlying fundamentals. And if market dynamics preclude an orderly stock market revaluation, expect it to come at some point violently and with great hardship. This is one aspect of the great costs associated with the Fed moving aggressively again to “reflate”. It will not work, it further subverts the market process, and only worsens an already perilous situation.Link here (scroll down).
TWO SHOCKS, ONE SOLUTION
The world’s central banks are all expending best efforts to wash away the current slump in world credit markets.
“You can either bail out the big banks with a flood of cheap money or keep a lid on inflation. You cannot do both, not according to history. And sometimes – like now – you will be hard put to achieve either.”
“The economy has been hit by two shocks,” said Andrew Sentance, a Bank of England policymaker. He was talking specifically about the British economy, but these two shocks have smacked policy wonks square in the face across the developed world. The two ugly fists – both with “hate” tattooed on the knuckles – are “financial market turbulence and a sharp rise in oil and some other commodity prices.”
“[They] are operating in opposing directions in terms of their impact on inflation,” says the Bank of England’s man. “So judging the appropriate monetary policy response will not be easy.” But who needs to judge the right response when you have got a printing press and an unlimited line of credit from taxpayers?
Growth in the European money supply hit a 28-year record in October, the central bank reported last week. The broad M3 money supply rose 12.3% from October last year, the fastest rate of growth since July 1979. November’s numbers, due out late in December, will exceed this.
Last week alone, the European Central Bank promised to supply the money markets with an extra €30 billion ($44.3 billion) in short-term funds, “another indication that the credit crisis is far from over,” as Sean O’Grady reports for The Independent in London. So far, however, no cigar. Last Wednesday, the ECB made its biggest loan of 3-month money since April 2001, as the global credit crunch pushed the interbank lending rate up to 4.74%.
The ECB’s current target rate for eurozone interest rates is 4%, and these short-term loans are designed to help ease upward pressure on the free-market rate by making easy with central bank cash. But even after last week’s record auction of €50 billion ($73.7 billion), “We didn’t see any effect on markets,” one money-market trader told Reuters. “The amount [that private banks are] needing is a lot more than the ECB is allotting.”
Resolving tensions in the financial markets is only one half of a central banker’s task, however. His other key responsibility – and central bankers are almost without fail always male, if not men – is defending “price stability”. In other words, inflation must not be allowed to rise above some target or other, decided over tea and biscuits in the hushed conference suites where politicians and central bank wonks chew the cud.
The inflation target is currently set at 2% in both Europe and the U.K. Last week, however, Germany announced that consumer price inflation in the world’s 3rd-largest economy will rise by 3% in November – the highest rate of price increases since February 1994.
“Solid anchoring of inflation expectations is all the more important in a period of turbulences associated with this market correction,” said Jean-Claude Trichet, president of the European Central Bank. That neatly sums up the head-scratcher now costing central bankers their hair the world over. You either bail out the money markets with a flood of liquidity ... or you keep a lid on inflation.
You cannot do both, not according to history. And every so often – not least when you are bruised and beaten by a fearful credit crunch on one side and a hateful oil-price shock on the other – it seems you cannot achieve either. Just ask Andrew Sentance at the Bank of England. He fessed up to an inflationary mess that looks a little like this.
The U.S. Federal Reserve, meanwhile, is also presumed to be targeting 2% annual growth in its consumer prices. But just like the ECB too, it is also pumping money into the New York credit market at a record clip. Can central bankers really have it both ways?
The Fed has been supporting the local housing market by accepting mortgage-backed bonds as collateral for new loans to the banking system. Last week, Australia’s central bank lent A$500 million (US$435 million) in a series of repurchase agreements based on mortgage-backed bonds. Sales of Australian mortgage-backed bonds sank by 94% between July and September, down to a meager A$1.8 billion – a 5-year low. Can the Reserve Bank of Australia reverse this slump? Sydney’s interbank lending rate for 3-month loans ended last week at 7.165%, just shy of an 11-year high. The RBA, however, was happy to lend for 0.24% below that market rate against mortgage-backed bonds.
Put another way, the flood of money trying to wash away the current slump in world credit markets is truly global. Think this will help ease inflation in your cost of living?Link here.
THE HAIR OF THE DOG THAT BIT US
As governments try to avoid a rerun of the 1930s, figure on seeing a rerun of the 1970s.
In our scrolling-headline world of impatience, where every thought has to fit in an SMS message, one of the hardest things to accomplish in debate is not to get people to listen to an opinion, per se, but rather to get them to pause sufficiently before receiving it, so as to check that the interpretation of the terms being employed by the expositor are consistent with those of his audience.
Advertizing execs, state propagandists, and special pleaders of all sorts are only too adept at exploiting such weaknesses. Their very art is to use the disjuncture between perceived and intended meaning as a Trojan horse and so to infiltrate all manner of false analogies, straw men, and logical non sequiturs behind the walls of their listeners’ citadels of reason.
As a consequence of such – often intentional – confusion, we can even be seduced into working backwards from a received, phoney definition, allowing it to suppress and supplant our own prior and more accurate understanding of a given word or phrase. As is the malign intent, we find that once we have deceived ourselves in this fashion, we have little hope of working forward again to unpick the tangles of error contained in the many, fair-sounding arguments proffered by those who would unduly influence our actions or sway our thinking.
In our professional life, perhaps the supreme case of the difficulty caused by a regrettable semantic debasement is the way in which the word “inflation” has come to mean not an excessive supply of money and credit – as it was classically and correctly taken to be – but only the rise in a narrow index of particular prices, as compiled (and subsequently heavily-doctored) by a given group of statistics-sifting bureaucrats.
By relaxing our guard and not insisting that our debating partner fully declare the precise boundaries of meaning implicit to the term when he employs it, we give him room to construct an entirely bogus view which implies that the absence of a frequent – though by no means an inevitable – symptom of inflation (whether a rise in the CPI index itself or in that of its emaciated “core” version, ex-food and energy costs) conclusively proves the absence of the disease itself.
Inflation proper – an unjustified and initially unwanted increase in the availability of money and credit (which we shall hereafter capitalize) – is dangerous not only because it leads to inequitable transfers of wealth, but because it leads to a needless reduction in the overall stock of that wealth (both potential and realized) by disrupting the economic decision making of both entrepreneurs and their customers, thus greatly increasing the chances that today’s seeming prosperity will be the ruin of tomorrow’s hoped-for provision.
Inflation proper is not even a zero-sum game of conman and conned, but is rather a fast-spreading pestilence which blights even that portion of the harvest which the Inflators are carrying out of the community silo as part of their ill-gotten booty. Once we resolve to view the issue exclusively in this light, not only does it strip away more veils of obfuscation than Salome doffs during dance practice, it also allows us to make a consistent whole of the opera buffa of easy money which so dominates the modern repertoire.
Inflation, then, is a monetary distemper, pure and simple. As such it tends to manifest itself as a rise in asset prices, a narcosis of risk awareness, and an increase in leverage. These, in turn, lead to the formation of misplaced, overambitious business plans and overstretched budgets, while fostering elevated levels of greed, chicanery, and the abuse of trust.
Thus, the entire hubris and nemesis which characterize both the credit-driven business cycle and its distorted reflection in that Hall of Mirrors which is high finance are the real constituents of an Inflation. In fact, by the time that one is aware of the rise in consumer prices – the “inflation”, lower case, quotation marks – which often follows from this feverish and disco-ordinated state of affairs, the street-corner card sharp is usually about to tip his hand and reveal to his victim that he is being fleeced.
Conversely, if we start with the conceit that only a certain rate of climb in a clutch of selected consumer prices constitutes “inflation”, we will unfailingly find ourselves in all sorts of trouble, for some of the most perilous of all economic conditions arise exactly when the range of end-goods prices is quiescent in the face of significantly easier monetary conditions. The reason this state of affairs is so treacherous is because we then tend to disregard the possibility that such prices, absent Inflation, would – and should – actually be falling outright. The damage is being done so insidiously, like a ship whose timbers are rotting below the waterline while we pride ourselves on the gleaming state of the paintwork up on deck.
It does to remember that neither the Boom of the late 1920s in the U.S., nor that in Japan in the 1980s would have caused today’s central bankers much lack of sleep over what they insist upon misperceiving as “inflation”, despite the undeniable evidence of Inflation posed by the frenzied chase for assets – typically channeled, then as now, into a very familiar mix of foreign bonds, real estate, IPOs, M&A, and being pyramided by means of overlaid, successively-leveraged holding operations in speculative stocks.
Again, with an ominous feeling of déja vu, each of these episodes was accompanied by the complete abandonment of prudence and thrift, follies which were justified by the thrilling delusion that participants were all engaged in breaking the bounds of the possible and in forging boldly ahead into a bright new tomorrow.
Yesterday once more.
As we have repeatedly warned, the credit cycle is the business cycle and with the first having ploughed so disastrously through the crash barrier it is inconceivable that the second can stay on the track. An Austrian maxim is that a treatment of the cycle may well start as a monetary problem, but that it always ends up as a real one. Here we would note some uncomfortable parallels with the late 1920s/early 1930s.
Though history often forgets this, Jazz Age exuberance did not just express itself in the steep rise on Wall Street, but also in the granting of copious loans by creditor America to debtor Europe and Latin America where it was used in a highly unproductive fashion to build apartment blocks and municipal swimming pools, as well as to support ailing industries and stabilize commodity prices. When this flood was suddenly staunched as the Young negotiations became bogged down in 1928, it caused the hot money to rush back home where it boosted the Dow to the unsustainable heights of 1929, in outright defiance of contemporaneous moves by the central bank to reduce the liquidity pouring into stocks.
As the credit-starved foreigner consumers were forced to draw in their horns, however, U.S. exports started to fall off and domestic output started to cool, driving a fatal wedge between soaring stock prices and faltering business performance. Furthermore, as the indebted were severely restricted in the volume of trade goods they could remit in payment of their debts – thanks to a spectacularly ill-advised tariff policy – they began to bleed gold as a consequence, tightening the monetary vice further.
At last, the strain became too much and their banks began to freeze up, culminating in the devastating 1931 collapse of Austria’s giant Creditanstalt, itself mortally weakened through having been used previously as a rescue vehicle by the government of the day. In the upheaval which followed, the UK reneged on its adherence to gold, causing incalculable losses to holders of sterling reserves and provoking a further credit squeeze. The attempt to alleviate this ushered in a disruptive round of competing currency devaluations around the globe and turned the stock market crash into a deep, worldwide depression.
If we reverse the positions of the U.S. and Eurasia and think of a gold drain then as a rush from the dollar today (conflating the current U.S. administration’s malign neglect of the world’s reserve currency with the then-British government’s pusillanimity in cutting sterling loose), we can get all the way to the Creditanstalt episode - for whose present analogue we are not lacking in likely candidates from which to choose.
Knowing this, however, and being aware that the Fed is currently headed by a Depression Era buff (albeit one who has derived all the wrong conclusions from his studies), we can fully expect that these resonances will be all too apparent to policy makers and that they will be ready to take drastic and pre-emptive action at a moment’s notice in order to avoid a full rerun of the scenario they all dread so much.
Therefore, with the scale of the credit disaster potentially so enormous, there would seem to be only one course of action open to the authorities, however misguided this will be in terms of perpetuating the cause of our woes, not expunging them.
Firstly, we should expect short term rates to be slashed in order to steepen the yield curve and ease banks’ financing costs, while simultaneously tempting dollar-shy foreigners to buy currency-hedged U.S. assets by means of cheap, short-dated loans. Secondly, a sizeable slug of the sour credit will have to be repackaged and co-opted by a government which will promptly run much larger budget deficits.
On the face of it, none of this would be of much comfort to a dollar which may presently be heavily oversold, but whose structural weakness is hardly a source of puzzlement. However, the one thing which might frustrate the bears is that any further upward pressure on the euro is likely to see to see the ECB capitulate in its own sham combat with “inflation” (and European banks may need a little yield curve help of their own, as the crisis unfolds). If this happens, the Asians will be faced with an imminent shrinkage in both their prime export markets – rather than having the one take up the slack provided by the other, as is currently the case. They will doubtless then respond in time-honored fashion by seeking ways of pumping in more of their own currency and pouring prodigious amounts of concrete as a counter.
Thus, as the Inflationary boom rolls over into a credit-led slowdown, we are likely to see a radical shift back to government as the main conduit of the renewed Inflation needed to keep the banking system afloat and individuals from taking to the streets. However, if Leviathan is to be the main deficit spender in this next round of Inflation, we can clearly expect fewer supply-side wonders to accompany its outlays.
Such an outcome means that the new Inflation is far more likely to degenerate straight into “inflation” – rising consumer goods prices – than the old one it replaces, disappointing those who automatically assume that slower growth ensures lower prices, irrespective of the prevailing monetary conditions. Keynesians – being so verbally hung up on their narrow concepts of “inflation” – never could get their heads around the concept of “stagflation”.
Financial assets could be in for a rough ride if this is the case – that is, if the intent to avoid the icy wastes of the 1930s leads us straight into the searing desert of the 1970s instead. Conversely, the experience of that latter dark decade (the first, too, after 1933) suggests that, after a further bout of liquidation by the speculative crowd, commodities might find a second wind, though with a distinct change of dynamic which means investors would be wise to de-emphasise exposures to primary inputs to industrial growth (bulk base metals) and re-orient themselves to end-consumables (foods and fuels) and anti-money “hoardables” (precious metals and diamonds).
There would be a certain grim irony to be had if things do come to this pass for, as the great Richard Cantillon well understood, nearly 300 years ago, Inflation and “inflation” are just as often enemies as friends and that paper money is ultimately a poor substitute for hard specie.Link here.
The challenge is to assess whether This Time the reversal is the Big One.
So here we are, bouncing off a 10% decline in the Dow Industrials, and the clear-eyed among us are scratching our heads. Nothing has changed, the real estate market is a submarine with its dive claxon sounding, the dislocations of surging gold and oil have everyone jittery, and just when it seems the bottom is about to drop out, we see Wall Street ignite the booster rockets and head for the sky.
How can it be? Rear-end deep in alligators, the folks who are active in the stock market strap on their party hats and announce a bottom by issuing Buy Orders? There can only be one explanation. It’s a conspiracy!
Just kidding. The truth is probably more pedestrian. No market-driven phenomenon moves in one direction forever. Each trend has a lifespan, and when it is reached the trend reverses, usually when continuing the trend seems most sure. Even the trend toward credit creation must someday reverse – otherwise we would be forced to conclude that the alchemists running the Fed, Treasury, and Wall Street had actually invented their long-desired perpetual motion machine.
Our challenge has always been to assess whether it is This Time that the reversal is the Big One. People who spend a lot of time analyzing these things could easily have concluded that any of the market tops of the past 20 years [or 27!] was the zenith of credit creation silliness. Those who acted on those assumptions were mercilessly punished by reality, however. It is truly painful to arrange ones finances to weather a storm that never arrives, watching the least informed around you reap fantastic rewards as the surreal party of credit expansion gets even more raucous.
Been there, did that, bought the t-shirt (you wouldn’t believe the price).
The stock market decline during 2000 and 2001 panicked the monied elite and they responded like so many of Pavlov’s dogs. To a Fed with only one tool, the hammer of credit creation, every problem looks like a nail. And it does not matter that the problem they faced was the result of using the hammer in the first place.
My unusual view is that the trend toward declining stock prices would have ended about where it did regardless of what the Fed did, but like most things in history that is an untestable hypothesis. Either way, what I think was the final, manic creation of credit ran its course until lenders were pushing newly created credit at any body that was still warmer than room temperature. Credit was created until the gluttony almost ruptured the stomachs of lender and borrower alike.
Conditions that occurred the past five years were both unprecedented and extremely unlikely to repeat. The ability to repackage weak debt and get it rated AAA is gone, not to return until after those with burned fingers today are retired or dead.
With 13-week T-bill rates hovering around 3.25% this week and an effective Fed Funds rate at about 4.5%, it is a given that the Fed will continue its recent actions and lower its target interest rates. A trend toward lower T-bill rates (and lower Fed rates) simply implies a desire for lower risk, hardly a boon for stocks. The pundits’ obsession with the Fed Funds rate is simply another illustration of irrationality.
The world is awash in dollar credits. Either holders of dollar credits can sell them for other currency credits, a process that appears to have already occurred as the price for dollars on world markets collapsed all year long, buy commodities – hence the fantastic rallies in gold and oil in dollar terms – or they can bring all those dollar credits back here to the USA and use them to buy up all the things Americans have pawned in order to maintain their profligate spending. This latter is tantamount to a lender taking possession of depreciating assets of an insolvent borrower. At some point even a few cents on the dollar is better than nothing.
I think this is what we are seeing with the purchases of U.S. corporate assets by foreign individuals and funds. It seems to me, however, that these Sovereign Wealth Funds that are awash in dollars are the last place to expect salvation. These funds are government owned and managed. It is like giving some state bureaucracy a bunch of money and expecting them to wisely manage it. I think there is a good chance that these funds will be the last suckers to the party.
If we have excess credit drowning the world, the solution is for that credit to drain away. Among many ways for this to occur, the use of that credit to purchase assets just in time for those assets to decline hard seems like a great way to retire the Fed’s excesses. Another is default, and we are seeing that in spades among weak real estate borrowers.
None of us know for sure what exactly the future will bring. We can only make educated guesses, but the stars do seem poised to line up for an end to the long period of credit creation. Lots of nervous people are watching the recent stock market lows. If that floor is broken fear may finally overwhelm greed. Either way I doubt the market process, involving the greed and fear of billions of people, is susceptible to the petty manipulation of a few arrogant men.
In the meantime, don’t bet what you cannot afford to lose. Pull up a chair, pop some corn and get ready to watch the next phase in the Clowns’ Parade that is human history.Link here.
WITH FRIENDS LIKE THIS ECONOMY, WHO NEEDS A RECESSION ENEMY?
Garbage-in statistics from the government paint garbage-out better picture than is warranted.
The headline following the release of the GDP report last week read, “Economy best in four years”. Although mortgage bankers and construction workers may disagree, the 4.9% number is a statistical fact. The figure was ginned up by the Bureau of Economic Statistics, official number crunchers of the GDP. The 4.9% is a full percentage point higher than last month’s guestimate of Q3 growth, and the highest number since Q3 2003.
What happened to the credit crunch? Was there suddenly more credit and less crunch than the stock and bond markets let on? Did homebuyers twist their ARMs instead of the other way around? Did housing starts restart and foreclosures stall?
John Williams at Shadow Government Statistics argues that it is the numbers themselves that are the surprise, not the activity they are supposed to reflect. In fact, his website second guesses a variety of government statistics. He even corrects them as he sees fit.
Among the more amazing bits of statistical trivia to be found on his site is an explanation of government employment figures. Williams notes that of the 166,000 jobs ostensibly added in October, 102,000 came from a plug number used to estimate small business hires. And, get this, those assumptions assume that 14,000 construction and 25,000 finance jobs were created in October. Maybe if mortgage companies just assumed that workers fired in those sectors were still current on their payments they would not have so many problems.
While Williams’s site is a valuable second opinion on government data, the government’s own numbers make the Q3 real GDP figure look overly creative. The 4.9% real growth reported is the fastest in four years, housing collapse or not. But curiously, the 5.9% nominal growth is slower than the prior quarter. In fact, since Q3 2003, there have been 8 quarters showing faster nominal growth than the one just reported.
How can you have such an impressive real number and much less impressive nominal number? With a very skinny inflation rate, that’s how. In the fact, the government put inflation at 1.6% in Q3. John Williams might have a thing or two to say about that.
Whether the government numbers are real or whether they come out of a BINGO basket, spreading credit problems seem to be the real thing. One of the more curious examples of how an unwinding of years of credit excess is not so easily cured by clever Abu Dhabi investors is what is going on in municipal bond underwriting.
Credit problems in the mortgage market mean fewer government contracts in South Florida. Why? Muni bond insurers often rely on insurance from MBIA and AMBAC to reduce the interest cost of their bond issues. But guess what? These bond insurers have also insured loads of asset backed securities, including CDOs chock full of subprime stuff. If the bond insurers are hit too hard by mortgage-related losses, their ability to make good on a troubled bond issues will be impaired.
So with the viability of the bond issuers now in question, fewer muni deals are getting done. Rather than incur debt at the higher interest rate, the deals are simply being postponed. A giant airport revenue bond deal in Miami is being delayed. That means the people who build those taxiways that make it seem like you are heading toward to the gate when you are really taxiing in concentric circles, will not get a contract.
More crunch, less credit. It just the sort of thing that makes 4.9% GDP numbers so hard to come by.Link here.
THE END OF CONSUMER CREDIT AS WE KNOW IT
People will soon have to start paying for things with cash, just like in the old days.
In an article that examined the troubles brewing in Citigroup’s mortgage business, the Wall Street Journal focused on Natalie Brandon, a 51 year old married woman from Granada Hills, California, who is currently unable to make the payments on her $625,000 adjustable rate home loan from Citigroup, despite the fact that the rate will not even reset higher until June of next year.
The Journal reported that Mrs. Brandon bought the house in 1985 for just $105,000, but had chosen to refinance five times over the past seven years, borrowing more than $500,000 and spending every single penny. While this may be an extreme example of American profligacy, it is by no means unique. Unfortunately this type of behavior typifies everything that is wrong with the modern American economy.
Had this homeowner behaved responsibly, as was typical for Americans of prior generations, her current monthly mortgage payments would likely be close to $600 and the remaining balance on her loan would be about $40,000. In eight more years she would have owned her home free and clear, and would likely be on track for early retirement. Instead, after 22 years of making mortgage payments, she is now $625,000 in debt. The article stated that she had recently tried to refinance into a 6%, 40 year, fixed-rate mortgage, but it fell through. Even if she had qualified, she would have been obligated to make monthly mortgage payments of close to $4,000 until she was in her 90s.
For years, Wall Street and the media have been singing the praises of the heroic American consumer. To that end Mrs. Brandon could be portrayed as Wonder Woman. She did her part to power our consumer driven economy by borrowing and spending to her heart’s content. Her last refinance even allowed her to buy a brand new Lexus. As long as she could find a greater fool willing to loan her more money, there was no limit to what she could buy. As it turned out, Citigroup was the greatest fool, left holding the bag on a $625,000 mortgage on a house now likely worth only half that amount.
Is it any wonder that we have enjoyed such a vibrant consumer based economy when a working class couple with perhaps $60,000 per year of household income can borrow over $500,000 and buy whatever they want with the money? As the bills come due and those who have been doing all of the lending finally realize they will never be repaid, this crazy consumption binge will finally come to an end.
As the losses mount, the credit crunch will spread from mortgages to auto loans and to all forms of consumer lending. The days of Americans borrowing to consume are finally coming to a long overdue end. To Americans raised on credit cards, it will come as a shock when within a few years most will only be able to buy those goods they can afford to pay for with cash.
In the long run of course, this will be a very positive development. Borrowing to consume is a waste of savings and undermines legitimate economic growth. Money loaned to consumers is unavailable to finance capital investment. By squandering savings on consumption, a society undermines its future standard of living.
When businesses borrow to make investments, those investments generate returns which enable the principal and interest to be repaid. When individuals borrow to consume, no investment is made and the loans can only be repaid out of reduced future consumption. Consumer loans, collateralized by nothing but a promise to consume less in the future, are much more likely to end in default. As lenders finally figure this out, consumer credit will dry up, and the American economy will enter a prolonged and severe recession. Unfortunately, an economy that lives by consumer credit will die by it as well. Hopefully a more viable economy will eventually rise in its place.
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.
Is the subprime mortgage crisis infecting America’s credit-card market?
When there is blood in the water, it is only natural that dorsal fins swirl around excitedly. Now that America’s housing market is ailing, predators have their sights on the country’s credit-card market. Analysts at Goldman Sachs reckon that credit-card losses could reach $99 billion if contagion spreads from subprime mortgages to other forms of consumer credit.
Signs of strain are clearly visible. There are rises in both the charge-off and delinquency rates, which measure the share of balances that are uncollectable or more than 30 days late respectively. It is too early to panic, though. Charge-offs and delinquencies are still low. According to Moody’s, a rating agency, the third-quarter delinquency rate of 3.89% was almost a full percentage point below the historical average. The deterioration in rates can be partly explained by technical factors. A change in America’s personal-bankruptcy laws in 2005 led to an abrupt fall in bankruptcy filings, which in turn account for a big chunk of credit-card losses. The number of filings (and thus charge-off rates) would be rising again, whether or not overall conditions for borrowers were getting worse.
The industry also reports solid payment rates, which show how much of their debt consumers pay off each month. And confidence in credit-card asset-backed securities is pretty firm despite paralysis in other corners of structured finance.
Consumers are likelier to load up on credit-card debt now that home-equity loans are drying up. But card issuers look at cash flow rather than asset values, so falling house prices do not necessarily trigger a change in borrowers’ creditworthiness. Moreover, the incentives for consumers to keep paying the mortgage decrease if properties are worth less than the value of the loan. Consequently, card debt rises higher up the list of repayment priorities.
If a sudden subprime-style meltdown in the credit-card market is improbable, the risks of a sustained downturn are much more real. If lower house prices and a contraction in credit push America into recession, the industry will undoubtedly face a grimmer future. Keep an eye out for those dorsal fins.Link here.
SUBPRIME DEBACLE TRAPS EVEN VERY CREDIT-WORTHY
One common assumption about the subprime mortgage crisis is that it revolves around borrowers with sketchy credit who could not have bought a home without paying punitively high interest rates. But it turns out that plenty of people with seemingly good credit are also caught in the subprime trap. An analysis of more than $2.5 trillion in subprime loans made since 2000 shows that as the number of subprime loans mushroomed, an increasing proportion of them went to people with credit scores high enough to often qualify for conventional loans with far better terms.
In 2005, the peak year of the subprime boom, the study says that borrowers with such credit scores got more than half – 55% – of all subprime mortgages that were ultimately packaged into securities for sale to investors, as most subprime loans are. The proportion rose even higher by the end of 2006, to 61%. The figure was 41% in 2000. Even a significant number of borrowers with top-notch credit signed up for expensive subprime loans, the analysis found. The numbers could have dramatic implications for how banks and U.S. regulators address the meltdown in subprime loans.
The surprisingly high number of subprime loans among more credit-worthy borrowers shows how far such mortgages have spread into the economy – including middle-class and wealthy communities where they once were scarce. They also affirm that thousands of borrowers took out loans – perhaps foolishly – with little or no documentation, or no down payment, or without the income to qualify for a conventional loan of the size they wanted.
The analysis also raises pointed questions about the practices of major mortgage lenders. Many borrowers whose credit scores might have qualified them for more conventional loans say they were pushed into risky subprime loans. They say lenders or brokers aggressively marketed the loans, offering easier and faster approvals – and playing down or hiding the onerous price paid over the long haul in higher interest rates or stricter repayment terms.
There is no hard-and-fast rule on what makes a loan subprime. But generally they are riskier than regular mortgages because lenders are more willing to bend traditional underwriting standards to accommodate borrowers. Rising home prices, and the growth of an industry of lenders specializing in subprime loans, led to an increase in all kinds of reasons for borrowers with good credit scores to sign up for subprime loans.
Many borrowers figured they would refinance in a few years before the rate on their loan moved higher, but falling home prices and tighter credit standards in the past year have suddenly made that unrealistic in many cases. “Brokers and agents were telling” borrowers with high credit scores for the past several years “that it was OK” to get subprime loans, “and borrowers were wanting to take on more debt,” says Mark Carrington, director, analytical sales and support at First American LoanPerformance.
Tom Pool, an assistant commissioner for the California Department of Real Estate, says his office has seen a number of cases involving “totally ignorant and unsophisticated borrowers who had good credit, but were duped into loans they had no hope of repaying.” But experienced borrowers with high credit scores are often too casual about the loan process.Link here.
JUNIOR MINING COMPANY RIPE FOR A DOUBLE
The adult pacific salmon lays several thousand eggs in small nests. The male comes along and fertilizes most of them (90%). But less than 1% makes it to adulthood. Even fewer (less than two out of 1,000) ever make it back upstream to spawn. The rest are lost to predation and the other forces of nature long before achieving success in reproduction.
The odds of finding an economically prospective ore deposit are similarly mind-boggling. And the political forces set on taxing and bootstrapping the mining business today makes those odds even longer.
A prospector might stumble upon a showing of gold in a sample he took downstream from an outcrop up the hill yonder. But statistically speaking, the odds that it will become a mine are one out of 1,000. That is, for every 1,000 mineral targets, only one will become a bona-fide mine. That does not mean you cannot make money in exploration stocks. Like the eggs of the adult pacific salmon, a good lot of them still make it into the ocean.
Unfortunately, most of them end up drowning. And I do not mean the fish. Even when someone finds a worthy deposit, there are still obstacles to actually mining it – environmental, infrastructure, political, construction and/or financial.
Still, the surest proof of the economics of any deposit is actually producing stuff. Until that moment, everything that we know about a deposit is academic. For the junior that makes it to this moment, however, it is like the salmon that grew to adulthood and made it upstream. It has survived many life cycle risks.
In the market, once a company reaches this stage, investors pile into the stock and often send it higher in a big way. The market will pay more for earnings as their prospect nears production compared with deposits in the ground. This process is often called a “re-rating”. The market re-rates the asset in light of its changing risk-reward profile as it evolves through a life cycle. The life cycle often goes like this: From an inspiration to a venture to a discovery, to development and finally to production. At each stage of its evolution, as in any business, the company’s audience expands. It makes the radar of more fund managers that have minimum criteria. Many investors are willing to pay more for a proven asset.
One such alevin that appears to have made it upstream is European Minerals (TSX: EPM), a Canadian-listed mining junior who owns the Varvarinskoye gold-copper skarn deposit in Kazakhstan. The company has spent nearly $200 million since 2004 building the mining infrastructure. Now it is nearly complete. European Minerals expects the mine’s first gold pour in December. It expects to reach full capacity by the middle of next year.
The president of Kazakhstan visited the site in September and gave it the royal A-OK. The company’s shares are in the midst of a re-rating that is not likely to end until its first full year of production. Of course, there are still risks, as the company could run into production difficulties at the starting gate.
The mine had obstacles: Relatively low grades (1 gram/ton Au and 0.25% Cu) and high strip ratios. And with gold and copper prices at record lows, the project was uneconomic. The mineral value of one ton of Varvarinskoye ore declined to less than $10. The company expected it to cost about $9 to process.
But by 2003, when the outlook for commodity prices perked up, efforts paid off. Changes to the mine plan and pit design combined with the discovery of additional gold and higher commodity prices to breathe new life into the project. Funding cheapened too. The economics of the prospect suddenly looked a lot better.
Today, it costs $12-13 to process one ton of Varvarinskoye ore, but the mineral value of that ton is now expected to fetch somewhere between $20 and $30. And the company locked that in. As part of its development financing, the company sold forward 443,000 ounces of gold, or half of its 120,000 ounces in annual production of gold over the next eight years.
One downside to hedging is that it erodes some of the advantage the company could otherwise enjoy from rising gold prices. On the other hand, it adds to a strong base of value below $1 per share for this stock, should gold prices fall. Operating this mine will cost the company $50-60 million annually. The hedge book effectively covers half of that for eight years.
I am no fan of hedging, but due to the re-rating potential of this stock, there is still plenty of upside. At current gold and copper prices, the operation could produce U.S. $80-100 million in annual net cash flows during its first three years (starting mid-2008, when the company expects the plant to be at full design capacity). Production rates decline subsequently but the mine is expected to last 17 years.
Those cash flows translate into 28-35 cents per share, or 18-23 cents per fully diluted share. The stock currently trades at less than five times those numbers. Yet the market is paying 10-20 times cashflows for established gold “producers” today – the high end of the range is usually reserved for companies that the market thinks has additional growth potential.
Ignoring growth and extrapolating prices and production costs over the life of the operation returns a discounted net asset value of somewhere between C$1.60 and C$1.90 per share based on the currently issued shares (284 million) and a 10% discount rate (which is relatively conservative).
Most producers’ shares trade at a premium to discounted long-term cashflows. Moreover, the potential for additional growth exists, even if conjectural. All this makes investing in European Minerals a timely way to benefit from higher gold prices.Link here.
A QUALITY SMALL COMPANY THAT CAN KEEP EVEN SHELL OIL WAITING
Kaydon Corp. (NYSE: KDN) is a small-cap company that sells precision-engineered products into the demanding market for energy resource exploitation, where – it is not too strong to say – design or mechanical failure is simply not an option. The company also sells components to the wind energy industry.
How is a drilling rig, whether onshore or offshore, is similar to an electricity-generating windmill farm? Both kinds of structures tend to reside in environmentally harsh and inaccessible locales. Therefore, both kinds of structures must possess the durability to resist the elements – from saltwater to blazing sun to extreme temperature to hurricane-force winds to rogue waves. Drilling rigs and windmills must both support rotating machinery for many hours per day, amidst many different kinds of conditions. And, if the critical machinery does not rotate, then both drilling rigs and windmills are worse than junk. They are junk that is costing the owner or operator a lot of money.
Day rates for the big, offshore drilling rigs can be as high as $500,000 – even more for the real behemoths. The rig lessee is paying more than $20,000 per hour, whether the rig is running or not. An operator will simply not accept downtime that is caused by mechanical failure, no matter what the explanation. So you use the very best equipment, whatever the price.
A windmill is perched, often as not, atop a 250-foot tower constructed on some remote mountaintop or in some distant prairie, far from the nearest machine shop. Its massive blades may be spinning thousands of revolutions per hour, 18 or 20 or more hours per day, every day, generating electricity that is flowing into the power grid. The wind may gust from a very low speed to powerful blasts within a matter of seconds, and then the wind may die down, and soon thereafter repeat the process all over again. So the mechanical workings of the windmill have to absorb and transmit immense stresses, with the rotating machinery gearing up and gearing down, again and again, over the very long haul. But, the windmill is almost never attended by a human maintenance worker.
So the windmill system must be designed and built to tolerate the rigors of a high-wind environment. And the customers for that electricity, the electric utilities, are under legal mandate from numerous regulatory bodies to keep their electric grid powered up. So again, the instruction to the windmill operator is, “Do not let anything break.” And not uncommonly, someone is also saying to use the very best equipment ... whatever the price.
Kaydon, of Ann Arbor, Michigan, makes that “very best equipment” for these extreme kinds of applications. Incorporated in 1983, the company is a world leader in the design and manufacture of custom-engineered, critical-performance products, to include bearing systems and components, filters and filter housings, as well as custom rings, shaft seals, linear deceleration products, specialty retaining rings, specialty balls, fuel cleansing systems, gas-phase air filtration systems and replacement media, industrial presses and metal alloy products. And this product line is far more than what you might buy down at your local auto parts dealer. These products are used by high-end, mostly high-tech, customers in a wide range of critical machine-positioning applications, instrumentation systems, material handling devices, aerospace and defense systems, security applications, high-tolerance construction efforts, electronic and even medical applications.
Kaydon generates less than 10% of its 2006 sales from the wind energy industry business segment. But the company’s sales there are growing very rapidly. As the nearby chart illustrates, Kaydon expects to quadruple its sale to the wind energy industry over the next three years.
At the current quote of $49 a share, Kaydon’s stock is selling for less than 20 times estimated 2008 earnings. There are about 28.2 million shares outstanding, giving the company a market capitalization of about $1.38 billion.
In remarks earlier this year, Kaydon’s President and CEO Brian Campbell referred to “the strength of Kaydon’s proprietary product positions and disciplined strategic direction. We believe our strong order intake during the year, combined with increased current incoming order rates and customer product availability inquiries, lay the foundation for increased operating performance in the current year.”
One of Kaydon’s strengths going forward is, as mentioned above, its sales into the wind turbine market, particularly the critical bearings components of windmills. The windmill sector of the market is growing at near breakneck speed, and the company is expanding its capacity and sales efforts in this line of business. In 2006, investment in windmill systems in the U.S. was second only to investment in new coal-fired power plants for the production of electricity Kaydon is positioning itself to serve the sweet spot of a fast-growing market.
The key problem in developing windmill systems at the present time is the availability of windmill turbines, and this puts the investment spotlight squarely on one of Kaydon’s most profitable new business lines going forward. “We would love to build more wind farms,” says John Hofmeister, president of Shell Oil Company. “We have the real estate and the permits. We certainly have the funds to construct these facilities. But our biggest problem is just the availability of windmills. We are experiencing a two- to three-year delay in delivery of windmill systems.”
Two- to three-year delays for a huge company like Shell that can pretty much buy what it wants? Sounds to me like a growth story for a precision-maker of a critical product – the kind where people say, “Use the very best equipment, whatever the price”Link here.
THE CHEAPEST BUFFETT STOCKS BASED ON BOOK VALUE
One of the favorite ratios that value investors use as an investment candidate screen for stocks is the price-to-book ratio. If the company liquidated all assets at their accounting values as stated on the balance sheet, paid off all debts, and divided what was left by the number of shares, that would be the book value per share. [Ed: Accounting for potential dilution from the exercise of outstanding options complicates the calculation slightly.] Many times the stated book value is very conservative because real estate, which may have been owned for many years, is often carried on the books at cost.
In principle, the lower the price-to-book ratio, the better. Stockpickr has reviewed the list of stocks held by Warren Buffett’s Berkshire Hathaway and sorted out the stocks with the lowest price-to-book ratios into the Best Buffett Stocks by Book.
The Buffett stock with the lowest price-to-book is Wesco Financial (WSC), which is involved in three businesses: property and casualty insurance, furniture rental and steel. It has a price-to-book of 1.1. The stock has a price-to-earnings (P/E) ratio of 32 and a yield of 0.4%. [Ed: Buffett has not historically been a fan of dividends.]
Another low P/B-ratio Buffett stock is ConocoPhillips (COP), which has a price-to-book of 1.5. ConocoPhillips has a P/E of 12.4 and a yield of 2.1%. COP is also liked by Money manager and Forbes columnist Ken Fisher.
Bank of America (BAC), another Buffett stock, has a P/B of 1.5. B of A has a P/E of 10 and a yield of 5.7%. Bank of America is favored by another Forbes columnist, the famous contrarian, David Dreman.
To see all 10 of the Warren Buffett stocks with low price-to-book ratios, check out the Best Buffett Stocks by Book at Stockpickr.com. And for his entire stockholdings, be sure to visit the Warren Buffett portfolio.Link here.
THE CHINESE DIET AND THE (HORTI) CULTURAL REVOLUTION
Many investment opportunities are being created in the process.
The popular South Beach Diet is a weight-loss program based on reducing carbohydrates, sugars and starches, while increasing proteins and fiber. Most practitioners of the South Beach Diet are overweight. Many Americans voluntarily sacrifice the pleasures of beer, pizza, nachos and doughnuts for the health benefits of lean meats, poultry and fresh veggies. In some parts of the world, however, South Beachers have a different mindset. In China, for example, the population is embracing a South Beach-type diet because they can finally afford to do so.
As China urbanizes, its diet improves. This fact might seem counter-intuitive, especially given the romantic notion Westerners have of country living. For example, Farmer Ping leaves the fresh air and pure water of the country for the pollution and crowding of the city in order to make more money. You would think that the big city diet of frozen dinners and ready-to-eat foods could never match the nutritional value of the farm-fresh victuals associated with country living. The facts, however, tell a different story. The Chinese urbanite now gets two-thirds of his nutrition from meat proteins and vegetables. Ping’s cousin back on the farm still gets two-thirds of his calories from grains.
The Chinese are eating more meat and other proteins as their wealth increases. UN data indicate that annual per capita meat consumption in China grew from 20 kilograms in 1985 to over 50 kilograms in 2000. Per capita chicken consumption has more than tripled between 1990 and 2005, but is still at only about 1/2 the average of all Asian nations and only 1/3 of the amount consumed daily in the developed world. Per capita beef consumption is up nearly 10-fold from 1990 to 2005, but still below the Asia average and less than 1/2 that of the developed world. As beef and chicken gain in popularity, pork intake has declined in relative terms, yet per capita pork consumption has nearly doubled since 1990.
In recent years, China has done a decent job of feeding 20% of the world’s population with only 10% of the world’s farmland. This may no longer be the case, as protein demands continue to grow. To create meat protein, you need grain. It takes 7 kilograms (kg.) of grain to produce 1 kg. of beef and about 2 kg. of grain to produce 1 kg. of chicken. Recent biofuel initiatives are another incremental source of grain demand. Combined, these factors are straining China’s ability to remain self-sufficient in grain production.
While grain demand rises, China’s supply of farmland shrinks. An expanding industrial base continues to encroach on tillable acres. Available arable land has receded from 130 million hectares in 1996 to 122 million hectares in 2006. Excessive use of chemical fertilizers and pesticides has contaminated nearly 25% of the country’s arable land.
China must also contend with a very limited water supply. The country’s per capita water supply is just a quarter of the global average. To that limited supply of water, add the relative inefficiency of irrigation practices. China requires two tons of water to produce one kilogram of grain – three times the water Western countries use. Moreover, a thousand tons of water can produce one ton of wheat with a market value of roughly $250. Chinese factories can create, on average, $14,000 of goods with the same amount of water. If you owned the water, whom would you want as a customer?
With cities encroaching on cropland and increasingly scarce supplies of potable water for irrigation, China will need to make some hard decisions about how to best meet consumers’ demands for more protein. One logical solution would be to import more feedstock grain. Farmers could then switch agricultural production from grains to more labor-intensive cash crops such as fruits and vegetables. Another solution would be to import more meat. As recently as 2003, imported meats accounted for only 3.5% of consumption.
As Chinese policymakers wrangle with the macro-issues of how best to acquire more meat proteins for their 1.3 billion constituents, Chinese corporations will have to figure out how best to deliver the goods. Not only are the Chinese (as well as the rest of the Asian world) eating better, they are also in a hurry to do so. According to a recent ACNielsen study, the Chinese are the second most frequent buyers of ready-to-eat meals in the world, behind only Thais and slightly ahead of Taiwanese and Malaysians. Quality control and branding will be more important to consumers should this trend continue.
When analyzing this phenomenon you can see that there are many direct and indirect ways to invest in the Asian protein demand surge. Whether it is commodity futures, stocks of companies involved, or the Chinese meat industry itself, there is money to be made. A lot of people got rich off of the South Beach diet, and now you can, too.Link here.
10 ROADBLOCKS TO PROFITABLE SHORT-SELLING
Short-selling has come back into vogue in recent months, with the major averages convulsing in response to the mortgage crisis. We have seen more downside pressure this year than at any time since the 2000-02 bear market. This decline has forced a cadre of long-only traders and investors to revisit this classic strategy.
But short-selling’s popularity can be a contrary signal, because bad things will happen when that side of the market gets overcrowded. This is especially true after amateur shorts apply the same methods they use in their stockpicking, but in reverse. In other words, they chase downward momentum without an understanding of the considerable risk.
Despite the threat of unexpected squeezes, short-selling could be the hottest game in town in 2008. Just keep in mind that it is still not easy to make money selling first and buying later. In fact, most readers will stare at falling prices for hours, and then enter their sales at exactly the wrong time. This is one of the great truths of this trading methodology.
I have compiled 10 of the most common roadblocks to profitable short-selling. Review the list and understand why this practice can cause so much pain and suffering, when misapplied. Also, remember that a downtrend makes short-selling even tougher at times, because it is harder to find your edge against other traders playing the same game.
HO CHI MINH-STYLE CAPITALISM
Another bubble candidate.
“This is a good time to be a financial journalist in Vietnam,” confided Le Tan Phuoc, chief executive officer of Searefico, a publicly held company that specializes in industrial air-conditioning systems. We were in the midst of a 9-course Chinese lunch at the glistening New World Hotel Saigon in Ho Chi Minh City. Le continued, “They are all making money in the stock market. See, they get information from their friends and people they know in government, or in the companies, and then they trade before everybody else knows about it.” I stifled a spit-take and nodded sagely.
As a connoisseur of bubbles, I am always on the lookout for signs of unsustainable economic trends at home and abroad. A recent trip to Vietnam and Cambodia provided food for thought. Having embraced the free market in 1986, the country of 85 million is rushing headlong into the global economy. Everywhere you go in Hanoi and Ho Chi Minh City, somebody is selling something. Women wearing bamboo hats squat on the sidewalk, selling tangerines, bananas, live eels, a single fish. The energy is palpable. Jogging in the September 23 Park in Ho Chi Minh City, I weaved through groups of women exercising with fans, mixed groups playing badminton without nets, a group of teens playing hacky sack with a shuttlecock. Such bourgeois pursuits evidently meet with the approval of the ubiquitous Ho Chi Minh, who looks down on modern Vietnam from the currency, from walls in corporate boardrooms, government offices, and stores. Set against a red background, he is always smiling, grandfatherly, with white hair and a wispy white beard. As I completed my circuit in the park, I looked up to see another huge image of a smiling grandfatherly figure, with white hair and a wispy white beard set against a red background: Col. Sanders on a gigantic KFC billboard.
Vietnam seems on the boil, like the pots at the ubiquitous pho stands. For the last few years, the economy has grown at an 8% clip. Through the first three quarters of 2007, domestic private-sector investment was up 28%, and foreign direct investment rose 38%. Earlier this year, Vietnam formally joined the World Trade Organization. The stock market is booming. At the end of 2005, according to the World Bank, 41 firms with a combined market capitalization of $1 billion were listed. At the end of September, the Vietnam markets claimed 206 listed firms with a combined capitalization of $22 billion. The percentage of citizens living on less than $2 a day has fallen from 63.5% in 2000 to about 33% this year.
The recent history is at once inspiring and bewildering – yet another former Communist country wholeheartedly embracing Western-style capitalism, providing the U.S. with a source of cheap labor and a new potential market for growth. But as shown by the blasé attitude toward insider trading, Vietnam’s free-market capitalism is a somewhat different creature than the U.S. version. And the differences are enough to give a visitor pause about the sustainability of Vietnam’s boom.
The checks and balances that help U.S. markets function well (the subprime debacle notwithstanding) are not yet in place. Many of the publicly held companies are controlled in part by the government. The financial press is free, we were told, but journalists generally have to clear information with the government and the companies before they run it.
In the U.S., booms in infrastructures – telegraph, railroad, Internet – helped lay the foundation for long-term growth by creating platforms for new types of businesses. In Vietnam, the process seems to be reversed. Investment is pouring into new banks, factories, and hotels, but not into crucial infrastructure like roads, ports, and power systems. The telephone and electric poles look like twigs surrounded by mounds of angel hair pasta. On one Nike factory assembly line, contractors were experimenting with customization, which offers U.S. customers the ability to design their own shoes and receive them within several days. But given the traffic and the state of the roads, it struck me that it would take at least that long simply to get from the factory to the port. In Hanoi, Vu Xuan Hong, a member of Vietnam’s National Assembly, conceded that the roads are “terrible” – one of the only times one of our interlocutors betrayed even a hint of bitterness about the devastating damage inflicted on the country by the U.S. and its allies. Vu blamed the sad state of Vietnam’s infrastructure in part on land mines and bombings. “Infrastructure is not well,” he said, while slyly alluding to this summer’s Minneapolis bridge disaster.
The traffic certainly does not seem sustainable. There is very little in the way of public transportation in Vietnam. It is difficult to describe the volume and relentless flow of motorbikes in the country’s cities. Crossing the street is like wading into a river and swimming across. Your pace slows instantly, and the current morphs around you at the last minute.
There was another factor in Vietnam that was certainly unsustainable and that was clearly contributing to bubblelike conditions. As if to emphasize Vietnam’s emergence from the dark decades of deprivation into the sunlight of prosperity, we were practically buried in food. The 9-course Chinese lunch, which came after a tremendous all-you-can-eat breakfast buffet, was followed by an 8-course Vietnamese dinner. Before I left on the trip, I dipped into Tim O’Brien’s Vietnam chronicle The Things They Carried. The narrative of this group’s journey to Vietnam would be more aptly titled The Things They Ate.Link here.
Keep your cheap suits and greasy food, China, says Vietnam.
It is tempting to view Vietnam as a mini-China. Both are populous Asian countries whose single-party governments are engineering a headlong rush into free-market capitalism (of a fashion). But Vietnam does not regard China, with whom it shares a border and a long, complicated history, as an older brother to emulate. Rather, it sees it as a regional bully, a harsh competitor, and – surprise! – a source of cheap, junky merchandise. In Vietnam, from school kids to government officials, China-bashing is very much in vogue.
One of the prerequisites of a true consumer economy is snob appeal, the ability and willingness of shoppers to draw invidious distinctions between classes of products and brands. Vietnam is clearly well on its way. Everywhere I went, I encountered high-level slagging of all things Chinese-made. Le Dang Doanh, an economist and former president of the Central Institute for Economic Management, spoke about imported Chinese-made clothes the way a bespoke-suit-wearing Wall Street banker might talk about Wal-Mart overalls. Chinese-made clothes, he said, are for the “buffalo boys” – country kids seen riding water buffaloes to work in the fields. And for those in the know, status matters. Our fixer and guide, Ha Tran, described her mortification when, upon returning from the U.S. with clothes bought from Old Navy as presents, she discovered that they were made not in America, but in Vietnam.
For American visitors, who tend to view Vietnamese history through the lens of our disastrous 20-year involvement, it is surprising how little the war defines collective memory and attitudes toward Americans and American goods. It could be that our hosts were simply being polite. Or it could be a function of the extreme youth of Vietnam. About 40% of the population was born after the fall of Saigon. There are memorials and monuments, to be sure, but they are unobtrusive, like the small cement statue in Hanoi that marks the spot where John McCain was shot down in Truch Buch Lake in 1967. At the War Remnants Museum in Ho Chi Minh City, where the propagandistic exhibits include a chilling photograph of two American soldiers water-boarding a prisoner, the crowd was roughly divided between tourists and Vietnamese school kids gleefully posing on captured American tanks. Yet the Vietnamese politicians, businesspeople, and kids we met seemed to regard the U.S. as one in a list of imperial powers the country had fended off in its long quest for independence. No hard feelings. The regime has decided that it is moving forward economically, that it needs capital and investment, and that it would much rather throw in its lot with the U.S., Japan, and Europe than with China.
In our travels, we heard repeated stories of how Vietnamese brands and consumers had fought off cheap Chinese imports by improving quality and focusing on brands. In urban clothing stores, consumers are far more likely to find domestically made clothes than Chinese ones. Last summer, a Vietnamese company signed a deal with Perry Ellis to license its Manhattan line of clothes for the domestic market.
In the 1990s, said a senior trade official, cheap Chinese beer flooded the market. But Vietnamese brands like 333, Saigon, and Tiger Beer (foreign-owned but brewed domestically) took marketing cues from Western beer companies and began advertising on television. As they did so, better-off consumers grew more sophisticated. Today, “there is no Chinese [brand] in the market to compare.”
The arrival of cheap Chinese motorbikes a few years ago forced Japanese firms to cut prices significantly. But Vietnamese consumers with disposable income now look beyond price. The trade official said he bought a Chinese-made motorbike for his daughter, but she sold it after a year and purchased a Japanese-made one instead. At Le Quy Don High School, a magnet public school in Ho Chi Minh City, we chatted with students. (Most disconcerting flat-Earth moment: the unanimous roar of approval that arose when we asked if they liked Hannah Montana.) “The goods imported to Vietnam from China are not really good,” Bang Thanh, a 16-year-old wearing stylish sunglasses, told me. “The Honda motorbikes they make there and bring in are no good.”
Of course, national pride – and not simply a rising sense of consumer sophistication – filters into the resentment of all things Chinese. The Vietnamese are fiercely proud of their local industries and products, especially their food. One day, we met for lunch with young Vietnamese businesspeople at the Chinese restaurant in the New World Hotel in Ho Chi Minh City. The sumptuous, multicourse meal was delicious, several orders of magnitude better than Empire Szechuan. But the executive seated to my left was not impressed: “Chinese food is too oily.”Link here.
THIS MAY NOT BE 1929, BUT IT IS THE BIGGEST MESS SINCE
The financial house of cards is about to come crashing down.
It was Charles Mackay, the 19th-century Scottish journalist, who observed that men go mad in herds but only come to their senses one by one. We are only at the beginning of the financial world coming to its senses after the bursting of the biggest credit bubble the world has ever seen. Everyone seems to acknowledge now that there will be lots of mortgage foreclosures and that house prices will fall nationally for the first time since the Great Depression. Some lenders and hedge funds have failed, while some banks have taken painful write-offs and fired executives. There is even a growing recognition that a recession is over the horizon.
But let me assure you, you ain’t seen nothing, yet.
What is important to understand is that this is not just a mortgage or housing crisis. The financial giants that originated, packaged, rated and insured all those subprime mortgages were the same ones, run by the same executives, with the same fee incentives, using the same financial technologies and risk-management systems, who originated, packaged, rated and insured home-equity loans, commercial real estate loans, credit card loans and loans to finance corporate buyouts.
It is highly unlikely that these organizations did a significantly better job with those other lines of business than they did with mortgages. But the extent of those misjudgments will be revealed only once the economy has slowed, as it surely will.
At the center of this still-unfolding disaster is the Collateralized Debt Obligation, or CDO. CDOs are not new – they were at the center of a boom and bust in manufacturing housing loans in the early 2000s. But in the past several years, the CDO market has exploded, fueling not only a mortgage boom but expansion of all manner of credit. By one estimate, the face value of outstanding CDOs is nearly $2 trillion.
Let us begin with the mortgage-backed CDO. Almost everyone knows that most mortgages are no longer held by banks until they are paid off. They are packaged with other mortgages and sold to investors much like a bond. In the simple version, each investor owned a small percentage of the entire pool and got the same yield as all the other investors. Then someone figured out that you could do a bigger business by selling them off in tranches corresponding to different levels of credit risk. Under this arrangement, if any of the mortgages in the pool defaulted, the riskiest tranche would absorb all the losses until its entire investment was wiped out, followed by the next riskiest, and the next.
Mortgage debt could then be divided among classes of investors. The riskiest tranches – those with the lowest credit ratings – were sold to hedge funds and junk bond funds whose investors wanted the higher yields that went with the higher risk. The safest ones, offering lower yields and Treasury-like AAA ratings, were snapped up by risk-averse pension funds and money market funds. The least sought-after tranches were those in the middle, the “mezzanine” tranches, which offered middling yields for supposedly moderate risks.
At this point the banks got the bright idea of buying up a bunch of mezzanine tranches from various pools. Then, using fancy computer models, they convinced themselves and the rating agencies that by repeating the same “tranching” process, they could use these mezzanine-rated assets to create a new set of securities – some of them junk, some mezzanine, but the bulk of them with the AAA ratings more investors desired.
It was a marvelous piece of financial alchemy, one that made Wall Street banks and the ratings agencies billions of dollars in fees. And because so much borrowed money was used – in buying the original mortgages, buying the tranches for the CDOs and then in buying the tranches of the CDOs – the whole thing was so highly leveraged that the returns, at least on paper, were very attractive. No wonder they were snatched up by British hedge funds, German savings banks, oil-rich Norwegian villages and Florida pension funds.
What we know now, of course, is that the investment banks and ratings agencies underestimated the risk that mortgage defaults would rise so dramatically that even AAA investments could lose their value. One analysis, by Eidesis Capital, a fund specializing in CDOs, estimates that, of the CDOs issued during the peak years of 2006-07, investors in all but the AAA tranches will lose all their money, and even the AAA will suffer losses of 6 to 31%.
And looking across the sector, J.P. Morgan’s CDO analysts estimate that there will be at least $300 billion in eventual credit losses, the bulk of which is still hidden from public view. That includes at least $30 billion in additional write-downs at major banks and investment houses, and much more at hedge funds that, for the most part, remain in a state of denial.
As part of the unwinding process, the rating agencies are in the midst of a massive and embarrassing downgrading process that will force many banks, pension funds and money market funds to sell their CDO holdings into a market so bereft of buyers that, in one recent transaction, a desperate E-Trade was able to get only 27 cents on the dollar for its highly rated portfolio.
Meanwhile, banks that are forced to hold on to their CDO assets will be required to set aside much more of their own capital as a financial cushion. That will sharply reduce the money they have available for making new loans.
It does not stop there. CDO losses now threaten the AAA ratings of a number of insurance companies that bought CDO paper or insured against CDO losses. And because some of those insurers also have provided insurance to investors in tax-exempt bonds, states and municipalities have decided to pull back on new bond offerings because investors have become skittish.
If all this sounds like a financial house of cards, that is because it is. And it is about to come crashing down, with serious consequences not only for banks and investors but for the economy as a whole.
That is why banks are husbanding their cash and why the outstanding stock of bank loans and commercial paper is shrinking dramatically. It is why Treasury officials are working overtime on schemes to stem the tide of mortgage foreclosures and provide a new vehicle to buy up CDO assets. It is why state and federal budget officials are anticipating sharp decreases in tax revenue next year. And it is why the Federal Reserve is now willing to toss aside concerns about inflation, the dollar and bailing out Wall Street, and move aggressively to cut interest rates and pump additional funds directly into the banking system.
This may not be 1929. But it is a good bet that it is way more serious than the junk bond crisis of 1987, the S&L crisis of 1990 or the bursting of the tech bubble in 2001.Link here.
A useful X-ray into stock market fashion ebbs and flows.
Martin Sosnoff is an old hand at the investing game. He published a book in 1975 called Humble on Wall Street, a sort of punchy memoir recounting the sanity-trying bear market in stocks of the five years or so preceding the book’s publication.
He had a lot of success managing money in the happy market before things turned ugly in 1973-74. “Stocks we had went from 10 times earnings to six times earnings,” Sosnoff reflects. “There I was, Ahab, tangled in my own harpoon whale lines and being carried down to the depths by the malevolent great white whale. Of what did it avail that all my earnings projections were uncannily accurate? We were buried just the same.”
All of which is to say there is nothing quite like the right stock at the right time. One interesting guidepost to look at is the longer-term market cycles of what is in fashion and what is not.
One of my favorite charts is a conceptual portrait of market history – stretching back to 1977. Take a look at “The Tree Rings of Markets Past”. This chart marks off the booms and busts of various sectors. You see fat eras of plenty, bulging like swollen rivers after a rain, and you see thin areas of hardship, like parched desert sands.
The chart shows you the market capitalization share of the S&P 500 by sector. The S&P is broken down into 10 sectors, as you can see. Market capitalization is the value of the sector in the marketplace. As stocks rise, market caps swell. You can see what has been popular.
In 1980, the energy sector was hot and grew to represent nearly one-third of the S&P 500. It collapsed thereafter, and energy sector investors took a beating. you recall how badly mauled investors in technology were as the bubble popped.
The S&P 500 Index maintainers are always adding and subtracting names from it, so it is not a true representation of what these sectors did. But the chart still manages to capture the spirit of the past rather well. I love it for all that perspective it gives in one glance. And because it shows how great tides shift in the market. Now unfolding is another great shift.
You can see how financials have come to represent a sizable piece of the S&P 500. Today, they make up over 21% of the whole. Financials have enjoyed a long stretch of prosperity. If the past is any guide, you want to avoid the dominant sector. Even absent any knowledge about the market’s tree rings, you would want to avoid most financials now. With cracks in the mortgage business giving way, the financials are under significant pressure for the first time in a while.
As John Hussman of Hussman Funds shows, financial stocks have many marks against them, generally speaking. Bank reserves against loan losses sit at a 32-year low. Yet overall net charge-offs are up 50% from a year ago. “[R]ising charge-offs and loan loss reserves are likely to bite deeply into earnings,” writes Hussman.
Historically, the best time to buy financial stocks is when the group trades for about book value. As Hussman point out, “Currently, the typical multiples are two and often three times that level.” Most financials, he says, “are only ‘cheap’ based on comparisons with very recent norms and on the assumption that the high profitability levels of recent years will be sustained indefinitely.”
The energy sector, on the other hand, is far from danger levels. As recently as July 2004, energy was sitting there at only 6% and change. It has expanded since by a sizable margin. Yet it is still less than 10% of the S&P 500 – far from bubble levels.
If avoiding the fattest sectors proved helpful, then perhaps giving the skinny sectors a good look might be a good idea. In that vein, note the squeezing of basic materials so tightly it barely registers on the chart. That is all the companies that do the dirty work and bring up metals like copper, nickel and zinc – stuff that we need to build pipelines and power grids and more.
Nothing lasts forever. Things will not always stay bad and cannot possibly stay good. This is some of the most elementary investment thinking but is painfully true. If you can keep an open mind and remain patient, the goldmine you missed years ago may be right in front of your face before you know it.Link here.
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