Finance Digest for Week of December 10, 2007

THE CONTINUING CRISIS: IT AIN’T OVER YET

There is a lot of uncertainty at present about the monetary crisis that has been unfolding over the past several months. Many people are saying that the crisis is over. Do not believe it, and the following essay by Doug Casey that appeared in the latest issue of his newsletter, International Speculator, explains why.

While we have already dedicated a lot of ink to the continuing crisis, a recent quieting of the markets has caused many of you to wonder if the turbulence that resulted from the credit bubble hitting the subprime pin in August represents the worst of the economic storm, or if a greater crisis is still ahead. In order to address that question, we need to quickly review what has happened to date, then try to project what the future may hold.

To understand the loud popping noise heard in August, you have to understand the simple truth that over the past decade, the U.S. has imported far more than it has exported, leaving the rest of the world with large quantities of U.S. dollars to invest on an unprecedented scale. Depending on how you slice the data, the total pile now adds up to between $7 and $8 trillion.

The trade deficit is not just the result of American gluttony. Much of the imbalance results from foreign governments intervening to keep their currencies from appreciating against the dollar. Cheaper currencies, of course, make foreign-made products less expensive and, therefore, more attractive to U.S. consumers. Consider it a gift. But as many are now learning, it is a gift that falls into the same category as the Trojan Horse.

The cycle is exacerbated by foreigners deciding to invest their freshly minted U.S. dollars back into U.S. bonds, treasuries, agencies and stocks. That constant stepping up to the buying window for U.S. paper has provided a large infusion of cash to U.S. institutions, including the Treasury, keeping the credit channels well greased and U.S. interest rates surprisingly low. Big party – everybody is happy!

And that is how things stood until subprime defaults triggered the August credit crisis, crashing the party and stealing all the silver (figuratively speaking, of course). That changed things, and in a fundamental and serious way. Slapped awake to the risk, instead of reinvesting their surplus dollars back into the U.S., foreigners began selling. In fact, August was the worst month for foreign investment in the U.S. since tracking of that data began in 1978.

Chart A shows the latest data, published October 16, for transactions in August. As you can see, there was a one-month outflow of $163 billion – quite a shocker when you consider that foreigners typically invest $100 billion a month in the U.S. And now you know why the Fed and European Central Bank intervened so quickly, throwing $300 billion into the hat in order to shore up the system.

Chart B shows purchases of U.S. equities by foreigners. This signal is so far off historical levels, it underscores just how serious the August crisis was. The same dramatic negative spikes can be seen in charts for corporate bonds and combined long-term investments.

It is hard to overstate the importance of this reversal ... a reversal we have been warning readers about for the past couple of years. Correctly, it rang alarm bells all over the world. Consider that market action as a preview of the sort of monumental dislocations that could occur if all the king’s men – central banks, big banks, small banks, financial institutions, hedge funds, etc., etc. – fail to keep Mr. Dumpty from falling off the wall.

Back to normal?

That was August. Things have settled down since then. In order to get an updated picture, our own Chief Economist Bud Conrad developed a weekly indicator of foreign purchases of U.S. debt from an important subset of foreign investment data supplied by the Fed. As you can see in Chart C, these purchases have returned to their normal range. So, is it over? Hardly. As you can see in Chart D, year after year of U.S. trade deficits have resulted in a massive amount of accumulated foreign investment in U.S. dollar-denominated instruments. This is a far bigger swamp than can be drained in a single month.

With the stakes so high, it is no surprise that a number of governments stepped in with drastic measures as the crisis emerged, even taking actions they said they would not. On that score, none has been more notable than the Bank of England which, after harrumphing about Northern Rock looking to its own affairs, went into full-on bailout mode. The tab from this single troubled financial institution is already over $36 billion, and there are plenty more like it that have been stuck with the worst of the subprime paper. No matter what your frame of reference, that is real money.

Since the crisis kicked off, we have heard about banks needing bailouts around the globe ... England, Spain, Italy, Germany, etc. There are more bailouts to come. And it will not be just banks.

Which brings us to the topic of Structured Investment Vehicles (SIVs). These are a special kind of institution set up to play the role of credit intermediary. Investment banks package up mortgages into Collateralized Debt Obligations (CDOs) and sell them to SIVs. The chain of events includes breaking the mortgage pools into slices called tranches and obtaining credit ratings. Then the SIVs use the CDOs as backing for issuing Asset-Backed Commercial Paper (ABCP). The final purchaser may not realize that the original mortgages were to relatively risky homeowners who may default.

Think of it like making sausage. You take a lot of rather unsavory cuts of leftover pig parts, mush it all together, then add a few spices before stuffing the mixture into a somewhat attractive casing and selling it off as a delectable. SIVs perform that function for portfolios of high-risk debt.

Given the nature of their products, SIVs are formed as off-balance sheet entities, often with no formal legal relationship to the banks that set them up. That avoids oversight by the Federal Reserve System, but also means that losses are not covered by FDIC or SIPC insurance. The banks like them because they do not have to show SIV debt on their books and do not have to set aside capital in reserve to cover such debt.

The SIV hits the fan.

The problem comes in when investors smell risk. Then the SIV hits the fan, or to be less colloquial, SIVs find themselves short on available credit. That is what occurred in August, when investors lost confidence in the quality of the mortgages held by the SIVs and stopped buying their securities. In the absence of buyers, prices of these securities plummeted, casting doubt on the same brand of securities already sold into the portfolios of investors and institutions worldwide.

Financial markets were roiled. For the simple reason that if institutions acknowledged that the billions of dollars in SIV-generated paper they held was worth considerably less than previously recorded, it would result in reporting large losses.

Even more troubling was the fact that, because the SIV securities are based on formulas and assumptions (e.g., guesses on the number of subprime borrowers that would actually continue to pay on their loans) and these assumptions proved to be way off the mark, holders of SIV paper were unable to determine the actual value of what they held.

There is much more to it than that. To fully appreciate the problem, we would have to get into a discussion of ratings agencies and of derivatives and other hocus pocus created by modern money magicians. Suffice to say, the very foundations of modern finance were shaken.

Even though not part of the Federal Reserve System, in recent talks with America’s largest banks, the Treasury Department proposed establishing a fund to be used to bail out troubled SIVs. The funny thing is, the plan revolves around selling shares of this sausage-gone-bad fund to the investment community. The banks said they hope to have the fund, to be called the Master Liquidity Enhancement Conduit or MLEC, ready ASAP to head off a possible collapse. At this point, it is unclear how the paper issued to start up the MLEC will be priced or whether there will even be a market for it.

What happens if the market shuns the new MLEC fund and in the end, the banks are stuck with the paper? Not to get overly deep into this single aspect of the multi-faceted crisis, but bank balance sheets would have to be reconstructed, resulting in a contraction in lending activity. Those SIVs no longer able to issue commercial paper will be seeking bank lines of credit at the same time when banks will be cutting those very lines. That would mean a call for another Fed rate cut.

All obviously bad for the U.S. dollar, which is to say, bullish for gold. MLEC has been incorrectly explained in the press. It really stands for: “More Loans, Easy Credit”. Credit derivatives innovator Charles Ponzi could not be reached for comment.

One of the sources of credit that got squeezed in August was loans made between banks. Once bankers realized how weak some of their own structures were, they lost confidence in lending to each other and the availability of credit to keep these SIVs afloat collapsed. As you can see from Chart E, since the depths of the August crisis, lending has gone back to normal too. As has been widely cheered by the money honeys on MSNBC, the sense of panic has ebbed in recent weeks, largely because the obvious distortions of August have largely subsided.

But it ain’t over yet ...

We have been forecasting a housing slowdown for more than a year, and the related subprime defaults have appeared on cue. The linkage through unexpected defaults of packages of paper sold to foreign banks was the tipping point of loss of confidence in the CDO and Collateralized Loan Obligation (CLO) paper that rocked the world and caused the collapse. Whether the problems are fixed and markets are now returning to some semblance of normalcy revolves around the question of whether the housing market is recovering. As you can see in Chart F, it is not. Chart G shows that the number of foreclosures is continuing to rise. It is akin to slow-motion cascading margin calls, the result of flat or falling home prices, anemic sales and a market struggling with the excesses of the 2004-2005 home-buying frenzy.

A key cause of this bubble bursting was overlending to people who could not afford payments on mortgages once their variable interest rates reset. Some 170 firms supplying mortgage money to the underqualified subprime borrowers have collapsed and gone out of business. There are still more resets coming – major ones – as you can see in Chart H. The money is simply not there for these subprime borrowers to refinance. And many more of these borrowers are going to default.

Because of the way their loans were packaged up and sold off, their problems will continue to overhang global credit markets for years to come. Chart I shows just how seriously the market has deteriorated for the lower-rated subprime CDOs. As you can see, the AAA-rated issues were down but have recovered, while the BBB never recovered much and look like they are getting even worse. This is further strong evidence that the credit crisis is not yet over.

What comes next?

While the situation has pulled back somewhat from the imminent crisis level, we are a long way from being out of the proverbial woods. The Fed and other central banks of the world have only limited tools available to them for “managing” the economy. Those tools are mostly limited to the relatively small sphere of overnight lending between banks and influencing short-term interest rates. Unless you count dumping dollars from helicopters. And, of course, central banks are extremely important in the psychology of markets.

But real power to set the important interest rates, for example those associated with long-term bonds and mortgages, is beyond their reach. Consequently, the Fed has no tools at its disposal that will move the economy to lasting stability without first going through a recession, a recession it will try to stave off by inflating the currency.

Another way to look at the magnitude of the problem is to look at the dollar itself. The money supply figure in the U.S. most closely associated with the ability of people to buy things is called “Money of Zero Maturity” (MZM). This new measure from the Fed attempts to estimate the supply of currency and checking deposits at banks traditionally found in M1, but also includes newer inventions of near-money like money market funds.

As you can see in Chart J, the amount of money being pumped into the system is still growing. In fact, MZM is currently growing at 12% – obviously a level that should cause higher inflation than the government now reports. This rapid growth in money shows clearly that the government is already in the process of sacrificing the dollar in an attempt to shore up the sagging economy. On that front, Chart K shows that the dollar is still weakening. It is far from over.

There is a high cost to this approach – price inflation – that cannot be put off indefinitely. And that sets up a classic “stagflation” scenario, with a faltering economy and higher inflation at the same time.

Summing it up, the massive bubble has only let off a little air, not exploded. That leaves us with the strong possibility of further convulsions and volatility in financial markets. The continuing fall of the dollar and the continuing fall of the housing market, which has been responsible for so much consumer spending since 2000, means our frequently alluded-to rock and hard place will soon come together, and probably with even greater force than in August.

Unfortunately, the potential now exists for things to get even worse, setting into motion trends such as those previewed in August that could become epidemic. That is because while the economic scenario makes a major adjustment all but inevitable, we may soon find that politics will trump economics.

What if Hillary Clinton is elected and decides to try to beat the Bush Administration’s abysmal record on government spending? It is anyone’s guess... but none of it will be good for the already wounded U.S. economy.

And it will not be good for those who fail to prepare for what comes next.

FEDERAL RESERVE’S THIRD QUARTER “FLOW OF FUNDS” REPORT TELLS A TALE

Only the pace of the unfolding credit bust can be manipulated.

Looking at Q3’s record credit inflation, it is not easy to justify Wall Street’s call for dramatically lower interest rates. Sure, the pace of Q4 credit growth will be meaningfully slower, especially in the mortgage arena. But I believe the key insight to be drawn from the Q3 “Flow of Funds” is the recognition of the enormous scope of ongoing credit creation now required to sustain the U.S. financial and economic bubbles.

I am tempted to surmise that the “law of large numbers” has finally caught up with the Great Credit Bubble. In particular, I find it incredibly ominous that the credit system has faltered so badly in the face ongoing financial sector expansion. Things can clearly get much worse. I do not expect the Wall Street securitization machine to anytime soon to return as a major force for credit expansion. And I simply do not view recent spectacular ballooning and zealous risk intermediation in the banking, money fund, and GSE sectors as sustainable. They are clearly fraught with great risk. Messrs. Bernanke, Paulson, Bush, Frank and others will, at best, manipulate only the pace of the unfolding credit bust.

HEY, BUDDY, CAN YOU SPARE A DIME FOR THE SIV SUPERFUND?

The big bailout bluff.

$80 billion to $100 billion – those were the numbers bandied about when Treasury Secretary Hank Paulson and the heads of three major Wall Street banks first floated the idea of a “superfund” to save the banks’ off-balance sheet entities, known as structured investment funds (SIVs), that include lots of subprime-backed securities. The problem for global banks with these SIVs whose total assets now equal about $400 billion? The SIVs are now largely illiquid, thanks to the credit crunch.

However, as the weeks have dragged on, it looks like the banks will not be able to raise $80-$100 billion. The Wall Street Journal reports that the bankers are now shooting for a $50 billion superfund. Strange to see that Wall Street – which had no trouble raising money before the subprime mess and the ensuing credit crunch – is now scraping for “spare change”. Bob Prechter foresees tough times for these banks – not to mention the economy. Here is an excerpt from the October Elliott Wave Theorist, in which he explains why the superfund is a good idea for a few people but a bad idea in general.

This idea is the equivalent to trying to levitate yourself by pulling on your legs. These banks are going to offer more commercial paper to buy mortgage assets; in other words, they are going to borrow more short-term money in order to buy long-term assets from themselves! That is, if they can borrow the money in the first place. One of the casualties in the rout was the commercial paper market. Investors are realizing that it backs a lot of lousy mortgage debt, so they are backing away from investing in the commercial paper that backs the mortgages.

The last time banks colluded to hold up an entire market was October 1929. It did not work.

If you have any exposure to illiquid mortgage investments, look upon this superfund as a gift. As soon as these banks pledge to buy one of your long-term, mortgage-backed securities, sell it to them.

What collateral will these banks use to back the $80 billion [now down to $50 billion] in commercial paper they hope to sell to finance this scheme? They cannot use mortgages, because the market does not want them. Will the new commercial paper become obligations of the banks? There appears to be no other alternative. In other words, depositors’ money may end up backing this paper. One thing seems certain: the banks are digging themselves deeper into a hole. If you still have deposits in debt-laden banks despite our entreaties, you might want to take this late opportunity to move them. For suggestions on where to deposit funds for safety, see Conquer the Crash.

On July 9, the [now ex-] CEO/Chairman of Citigroup said, “When the music stops, in terms of liquidity, things will be complicated.” Now wait a minute. We keep hearing that the Fed will shore up all their debts with perpetual liquidity, so how do you explain this comment? Answer: The bankers know better. Liquidity, formerly the solution, is now the problem, and the bankers know it.

The only solution that bankers, regulators, politicians and the Fed can think of is to do more of what they did to get into the problem in the first place: create more debt. They know of no other response. They are flailing for a solution to a problem that has no solution aside from taking measures to make it worse. I still know of no better analogy to a system-wide credit binge than a person who keeps going only by gulping down amphetamines. He will collapse if he stops taking them, but if he keeps taking them he will ultimately die. Bankers always choose to ingest more speed. Their choice is to collapse now or die later. They always choose later. But they cannot avoid the inevitable result.

Speaking of the inevitable result, Bloomberg reports that a mortgage fund managed by Cheyne Capital Management Ltd. has just announced that it will fail to pay the interest immediately due on the commercial paper it issued to buy mortgages. Here is the problem: If it tried to pay the interest, it would have to sell assets to raise the money. If it were to sell assets in an illiquid market, they would fall in value, making the collateral in the fund worth less. I will bet this company cannot wait for that call from the managers of the new super fund, that is, if it owns any top-rated mortgages.

The conundrum is for the “investors” who lent money to this firm is that if they ask for their rightful interest, their principal will fall. If they do not ask for interest, they have no income. If they cannot sell the assets, in truth they have no principal.

The emperor has no clothes, but so far the stock market floats merrily unconcerned in a haze of unprecedented optimism. Someday that optimism will melt as fast as it did in the mortgage market.

THE MOTHER OF ALL BAD IDEAS

Mortgage “rescue” plan will make a bad situation worse.

Without question, the Bush administration’s mortgage rescue plan will exacerbate, not alleviate, the problems in the housing market. As the plan will sharply reduce the ability of new buyers to make purchases, it really amounts to a stay of execution and not a pardon.

Although there are mountains of uncertainty as to how the plan will be structured and implemented, there is no question that as lenders factor in the added risk of having their contracts rewritten or of being held liable for defaulting borrowers, lending standards for new loans will become increasingly severe – with higher down payments, mortgage rates, and required credit scores, lower loan to income ratios, and perhaps the death of adjustable rate loans altogether. The result will be additional downward pressure on home prices, despite the fact that in the short term fewer homes will be sold in foreclosure than what might have been without the rescue plan.

Most homes temporarily saved from foreclosure will continue to depreciate as new buyers fail to qualify for loans. As a result, lenders will be on the hook for more losses than had the foreclosures taken place sooner. Of course, as these chickens will likely come home to roost after the next election, that is a trade-off incumbent politicians will happily make.

Compounding the problem is that subprime borrowers with frozen payments on loans that exceed the values of their homes will likely choose not to pay property taxes, condo or homeowners fees, or maintain the condition of their properties. Were these properties to be sold in foreclosure now, at least their new owners would have financial incentives to maintain the value of their investments. Upside-down subprime borrowers will have no incentive to throw money down a rat hole. Why make additional payments on properties in which they have no equity and which they will likely lose to foreclosure anyway? When these homes do go into foreclosure, back taxes and other fees on dilapidated properties will inflict even greater losses on lenders.

Also, subprime borrowers with frozen resets will be unable to either borrow additional money against their homes or sell them. As rising credit card payments, higher food and energy bills, and stagnating wage growth or unemployment make even paying the frozen rates increasingly more difficult, this lack of flexibility will prove fatal. Also, the moral hazard inherent in offering help to only those who can demonstrate an inability to afford the reset rates, or restricting the bailout to borrowers with low credit scores, guarantees that borrowers will alter their circumstances to qualify for the aid. Therefore more loans will be frozen than are currently forecast.

Lost in current discussion is the fact that few subprime borrowers have any skin in the game in the first place. Having put nothing down or having extracted equity in previous refinances, most subprime borrowers will lose nothing if their homes go into foreclosure. Those who have already extracted equity have received huge windfalls from their homes and will leave their lenders holding the bag.

Also missing from the dialogue is the fact that those individuals and companies that sold these homes to subprime borrowers in the first place pocketed large sums of money they never would have received if these exotic loans were not available. Is anyone going to ask them to give some of that money back in order to compensate the lenders for their losses?

Finally, it is the camel’s nose under the tent that is the most troubling. Delinquencies on auto loans are now at record highs. Is a moratorium on car payments next? Of course if the government can “require” private parties to rewrite contracts, what about the government’s obligations to repay its debts? After all, the Federal government is the biggest subprime borrower of all and it has committed the American taxpayer to the mother of all adjustable rate mortgages. With the majority of our near $10 trillion national debt financed with short-term paper, what happens when interest rates rise? Will the government extend the maturities of 1-year T-bills, tuning them into 10-year T-bonds, forcing holders of government debt to accept below market returns for extended time periods? These are real risks that will not go unnoticed by a world already saturated with depreciating U.S. dollar denominated debt.

Ostensibly, this plan is being offered in an attempt to stem the tide of foreclosures that might otherwise cause further weakness in home prices. The reality of course is that current home prices are still too high, having been a function of the lax lending standards and rampant real estate speculation that got us into this mess in the first place. Everyone seems to agree that a return to traditional lending standards is a good idea, but no one seems willing to accept a return to rational prices as a consequence. The government’s attempt to orchestrate such an outcome is doomed to failure, as it is impossible to maintain bubble prices after the bubble has burst.

The final absurdity is the Government’s attempt to portray their plan as voluntary. Of course the authorities point out that if their “suggestions” are not adopted by lenders, much more draconian legislation will surely follow. Let freedom ring.

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

THE BATTLE BETWEEN DEBT AND RECESSION

So there is to be no letup or truce in the war between debt and recession. The cannon fodder of consumer credit – the battle-weary consumers themselves – must push ahead with the Christmas offensive. The U.S., standing shoulder to shoulder with its partners in Britain, will stay in the trenches until the job is completed.

All boom, no bust! Gordon Brown – now the U.K. prime minister – has promised no less for more than 10 years. And this is no time to quit the field.

But beating the credit cycle will not be easy, even if it proves possible. Indeed, this war of attrition will take just as long as the never-ending war against terror. “Some borrowers took out loans they knew they could not afford,” said President Bush this week, before he slipped into the present tense and tried to wind back the clock. “To compound the problem, many mortgages are packaged into securities and sold to investors around the world. So when concerns about subprime loans begin to mount – began to mount – uncertainty spread to the broader financial markets.”

Out in the field, the commander in chief knows he has lost the high ground, but that “uncertainty” was never a threat. Adjustable-rate home loans made it clear, right from the get-go, what would happen in 2007-08 and beyond. They “usually begin with 7-9% rates that [then] reset to between 11-13%,” as Bloomberg explains. But that was precisely the problem. Can you imagine it? An interest rate that moves up and not down?

“What we are talking about is having these loans modified so they continue for a longer period of time at the starter rate,” said John Reich, director of the Office of Thrift Supervision, of the Hope Now initiative last week.

Will flat rates be enough to keep the big guns pounding the enemy? After 25 years of ever-cheapening credit, the bond market certainly wants rates to go down – not least after bond yields reached a half-decade high at the start of this summer. Piling into short-dated bonds, in fact, Wall Street has priced in recession already. Three-month bond yields have slumped by more than 200 basis points since mid-June, the fastest rate of decline since May 2001.

Two-year bond yields have slumped by 219 points inside six months – a 15-year record – going from 5.1% to below 3% in short order. 2001 marked the shortest and shallowest U.S. recession on record. At least 1992 got to dent housing and jobs, unwinding debt and forcing households to save and not borrow. It must never happen again!

“Uncertainty about the effects of the credit crunch, together with rising oil and food prices, seems to be affecting feelings about jobs and the future economic situation,” said Fionnuala Earley, chief economist at Nationwide – the U.K.’s biggest mortgage lender – last week. “With that in mind, it is natural that consumers would think about tightening their belts this Christmas, and this is reflected in the weaker spending index.”

But this “natural” response – cutting back spending after a record decade of credit growth – cannot be permitted. “At least two cuts” to U.K. interest rates were now needed, Earley told the Telegraph “to take the pressure off [household] finances.”

The Bank of England delivered one cut, pretending that inflation will slow just because consumer demand is receding. Put another way, and on the other side of the pond, “Policymakers appear fully engaged in stanching the financial turmoil and ensuring that the economy avoids recession,” says Mark Zandi of Economy.com for Moody’s. “The Federal Reserve has aggressively lowered interest rates in recent weeks, and Congress and the administration are working to aid the hard-pressed mortgage market. More help will be needed, but policymakers appear ready to provide whatever is necessary.”

Can whatever it takes keep recession pinned down forever and ever? There has been only one winner so far in this war waged by debt – and gold prices look set to keep winning as consumer debt pushes ahead as the economy slows. The global boom in all asset prices that now seems to be tipping over the top came thanks to one major bear market – the bear market in the value of money. Government led and central bank sanctioned, it has cut the value of U.S. dollars by 2/3 versus a gold bullion investment. It has pushed the British pound sterling to new all-time record lows and even cut the euro in half, when measured in gold.

Call it liquidity if you must, a flood now washing the ink out of the central bank promises to pay. The bubble also pushed oil, base metal, and food prices sharply higher. But even if they somehow slip back as the U.S. economy slows, the outlook for gold prices might still hold good in 2008.

Dr. Copper – the metal with a Ph.D. in forecasting economic growth or recession – has broken down even as gold prices have continued to surge, notes the Bank Credit Analyst. Comparing the two metals over the last 17 years, “The copper-gold ratio plunged when central banks fell behind the deflation curve,” the BCA says. The ratio then surged “when rates were normalized or policymakers were struggling to cool growth. ... The current breakdown in the copper-gold ratio suggests that more liquidity is needed to reflate the global financial system and keep the economic expansion on track.” And more liquidity means more money, of course.

So wheel out the big guns of debt! The last time the U.S. defeated recession, real interest rates dropped below zero. The gold market doubled in the following three years. If the Fed cuts again, down to 3.5% (Bill Gross’s forecast at Pimco) or right down to 1% (the Greenspan Fed’s answer to the 2001 dip), just how far might gold go – even without rising inflation?

The European Central Bank broke ranks last week, keeping eurozone rates on hold. But the Fed and Bank of England? Neither is charged with growing the economy. Both are supposed to avoid destroying their currencies and letting inflation run wild. But as Clive Briault, a managing director of the Financial Services Authority – the U.K.’s investment watchdog – said last week, “There is a very real prospect that conditions will worsen further, raising some important risks for consumers. If their financial plans depend on cheap and abundant credit, the absence of those conditions is likely to cause significant consumer stress.”

Stress means a slowdown, and a slowdown might now mean recession. It cannot be allowed, whatever the costs. What might that cost be to cash savers without gold?

Red Kite Metals hedge fund lost about 22% last month, as copper prices plunged.

Red Kite Metals, the hedge fund that almost tripled investors’ money in 2006, lost about 22% in November as copper prices fell, according to two investors in the fund.

Red Kite, co-founded by Michael Farmer, 62, who once ran the world’s largest copper-trading company, has tumbled about 50% this year, according to the investors, who declined to be identified because the information is private. Todd Fogarty, a New York-based spokesman for Red Kite, would not comment. Red Kite is the main fund of RK Capital Management Ltd., which had more than $1 billion under management as recently as September.

“When a large commodity hedge fund has such a big drawdown, it usually means they have a concentrated position in the market that everyone can see,” said Antoine Thioly, a fund manager at Geneva-based Modula Capital Advisers SA, which invests in hedge funds and is not a client of Red Kite. “These markets are thinly traded as it is, so basically they are stuck.”

Copper slumped 9.4 percent last month as inventories gained and traders speculated that a slowing U.S. economy will curb demand. Nickel and zinc also declined, while the London Metal Exchange Index is heading for its first annual loss since 2001.

“Trading of copper futures on the LME has increased 44 percent to 6,941 lots a day in the last 4 1/2 months,” John Kemp, an analyst at Sempra Metals Ltd. in London said in a note to clients. “There has been a marked structural change in the market. It is consistent with one or more market participants exiting a huge position, or entering one.”

VALUE’S DAY ONCE MORE

The stock market is falling, or is it the sky? At this writing the answer is debatable. Treasury yields are collapsing, the price of gold is soaring and oil keeps closing in on $100 a barrel. The U.S. dollar is under siege, Fannie Mae and Freddie Mac are on the skids and the economy-stopping word “no” is on the lips of our formerly fearless lenders.

Is anyone happy? Value investors ought to be. To their way of thinking bear markets are heaven-sent. Of all people, the disciples of Benjamin Graham and David L. Dodd understand the investment appeal of everyday low prices. They like it when stocks and bonds go on sale. They are the Wal-Mart shoppers of Wall Street.

Then again, we are talking about human beings. Not even the purest seeker after investment value is likely to enter a bear market with nothing but cash in his jeans. Falling prices do, ordinarily, spell improving valuations. But they also mean mark-to-market losses on securities purchased at previous, bull-market prices. Besides, not every value investor is immune to the panic that washes over the market in a proper liquidation. The faint of heart are likely to conceive an ardent devotion to Treasury bills just when the bargain hunting gets good.

Which brings me to Graham’s own experiences in the greatest bear market of modern times. The principal author of the value-seeker’s bible, Security Analysis, first published in 1934, is properly celebrated for his brains. But it is his heart as much as his head that ought to inspire the bargain hunter.

On the eve of the 1929 Crash, Graham was managing what we in the 21st century would recognize as a hedge fund. He was long $2.5 million of stocks and bonds against which he was short the same amount. In addition, however, he had $4.5 million in outright long positions, and he had incurred substantial margin debt to own it. In his posthumously published reminiscences, Benjamin Graham: The Memoirs of the Dean of Wall Street (1996), the father of value investing described his state of mind this way: “We were convinced that all of our long positions were intrinsically worth their market price.”

So Graham, by heavily leveraging himself, unwittingly transformed a conservative investment strategy into a risky one. Top to bottom, 1929-32, his fund was down by 70% – a better showing than the 87% drop in the Dow but a calamity still. The once and future investment genius sorely needed income. Where could he find it?

Why, at the offices of Forbes. Graham was a superb writer who had slummed in financial journalism in the 1920s. In his memoir he describes the “feeling of defeat and near-despair that almost overmastered me towards the end” – the end, that is, of the washout. But he did not surrender to his own great depression. Near the very end of the decline he collected himself to lay out the case for common stocks. “Is American Business Worth More Dead Than Alive?” was the theme that ran through Graham’s 3-part Forbes series in late June and early July of 1932. One third of all listed industrial stocks changed hands at less than the pro rata share of their companies’ net current assets, he pointed out. In other words the business value of those companies was being given away on the floor of the stock exchange.

When the market took flight in 1933, so did Graham, whose partnership that year earned more than 50%. Between 1929 and 1956 Graham, along with his partner, Gerald A. Newman, generated a compound annual return of 17%. Note that this sterling record incorporates the evil days of 1929-32.

What is on the equity bargain counter at what, today, is certainly not the bottom of a titanic bear market? Hutchison Telecommunications International (NYSE: HTX, 22), for one. The Hong Kong wireless company (it trades as an ADR) does a profitable international business but has been punished in the market for its February decision to auction off its money-spinning Indian subsidiary to Vodafone. Never mind that Hutchison got a tremendous price, $860 per subscriber. The stigmatized seller, excluding its cash, is now valued at just $380 per subscriber. I estimate that Hutchison changes hands at a 37% discount to the sum of its conservatively valued parts. Graham might not regard Hutchison as such an irresistible bargain. But, at least, it is an interesting relative value for these tumultuous times.

FORGET (ALMOST) ABOUT THE FED, FOCUS ON STOCK PICKS

It is possible, believe it or not, to make money in stocks without obsessing about the Fed's next rate decision or the upcoming employment report. “We don’t tune out the Fed entirely,” says Matthew Kaufler, portfolio manager for the Touchstone Value Opportunities fund. “It is just not a priority for us.” Kaufler and his co-managers use a bottom up method for selecting stocks, focusing on a company’s ability to generate and sustain a high level of cash flow.

From a shareholder’s perspective, Kaufler’s priorities seem to be very much in order. The fund has returned an average of 16% annually over the past five years, a hefty 4.6 percentage points better than the S&P 500.

That is not to say that the fund’s managers run away upon first sight of Fed Chairman Ben Bernanke. They have, in fact, “poked our heads up now and then” with great success. “If we see a contrary sign flashing red then we know we need to act. For example, we began underweighting financials 18 months ago because we believed that the credit cycle would roll over,” says Kaufler. “We may have been early, but it ended up being the right move.”

Another prescient move was the fund’s decision to invest in infrastructure stocks like the Shaw Group (SGR). “The ability to generate electricity in the U.S. has been stagnant for years but demand has increased,” says Kaufler about the forces driving the power plant provider’s business. “Think about how many appliances you plug into the wall today compared to even a decade ago ... Plus we are online constantly.”

And Kaufler loves Shaw’s international business, especially China, which is putting up power plants almost as fast as it is putting up another of Kaufler’s favorite companies – McDonald’s (MCD). “McDonald’s’ two most profitable areas are Russia and China,“ says Kaufler. “Think about the expansion possibilities in those huge markets!” As a value investor, he is also thinking about McDonald’s returning cash to shareholders via dividends and buybacks. He also likes the fact that the company is converting more of its restaurants to franchises as opposed to company stores. “It is a better model for McDonald’s to be a toll-taker collecting royalty payments than a caretaker of company stores,” says Kaufler. “It is easier to predict cash flows that way.”

And certainly much easier to predict than the Fed’s next move.

THE BLACKSTONE GROUP’S TOP VALUE STOCKS

Their stock’s performance has been awful, but their stock picks have not done so badly.

When The Blackstone Group (BX) went public this summer, the IPO dominated headlines, but since then, IPO shares of the hedge fund/private equity fund have dropped about 40%. Many of the stocks owned by Blackstone Kailix Advisors LLC, the hedge fund arm of The Blackstone Group, however, are up for the year, and several are up substantially.

Stockpickr has reviewed all the stock holdings of Blackstone Kailix Advisors and extracted the stocks with the lowest price/earnings-to-growth ratios, compiling them in the Top Blackstone Group Stocks. Not all of these stocks are up for the year, but their low PEG ratios may make them nice values.

One of the Blackstone stocks with the lowest PEG ratios is Noble (NE), a Texas-based oil and gas drilling services company with a low PEG of 0.6. The stock has a P/E ratio of 14 and a yield of 0.3%. Noble is also owned by Clough Capital, a Boston-based hedge fund with $2.1 billion under management. Clough also owns Schlumberger (SLB), which has a PEG of 1.3, and Transocean (RIG), with a PEG of 0.8.

Another Blackstone stock with a low PEG is Continental Airlines (CAL), which has a P/E of 7 and a PEG of 0.6. Continental also shows up in the portfolio of Westcore Select Fund, which specializes in mid-cap stocks. The fund, which has $2.8 billion under management, has generated an average annualized return of 17% for the past three years.

Goldman Sachs (GS), with a PEG ratio of 0.7, is another Blackstone stock. Goldman has a P/E of 9 and a yield of 0.7%. Goldman is also a favorite of Forbes columnist and money manager Ken Fisher, who also likes China Mobile (CHL), with a PEG of 1.4, and Baker Hughes (BHI), with a PEG of 1.4.

Got to Stockpickr.com for the Blackstone Stocks with the lowest PEG ratios as well as the entire Blackstone Kailix Advisors portfolio.

FINANCIAL SECTOR STOCKS HAVE ENDURED IRRATIONAL VALUATION DROPS, SAYS CONTRARIAN ANALYST

And bond insurers are the most unjustly maligned.

The financial market turmoil triggered by the subprime mess is setting new lows for financial services stocks. Banks, real estate investment trusts, brokerages and mortgage companies have endured valuation drops that defy explanation. Emotion, not reason, is driving these declines. Buying opportunities are the result, although you might wait until financial shares are cheaper still.

Fears about the economy’s health and the subprime imbroglio’s depth are primarily to blame, along with short-selling and year-end tax-related trading. Since nobody seems to know what is inside all those collateralized debt obligations and their kindred collateralized mortgage obligations – mega-investment pools that bundle subprime loans – 2007 audited results should help bolster confidence when they are released sometime in the new year. Not that all the CDO and CMO losses are behind us. More pain lies ahead.

My vote for the most unjustly maligned financial sector stocks goes to the bond insurers, which guarantee principal repayment and interest for most municipal bonds. If a muni gets insurance, it automatically receives an AAA rating. The insurers will not cover anything that is not already investment grade on its own. So the default rate for insured munis is below 0.1% yearly.

Most of the revenues the insurers will be reporting over the next five years have already been collected. When they insure a bond for 20 years, they receive the entire 20 years of premiums in advance and then report the yearly income pro rata. For what it is worth, there is a rumor that Warren Buffett, who knows a lot about insurance, is eyeing an investment in bond insurers.

The insurers’ stock performance suffers because they also write policies for those much-maligned CMOs and CDOs. The market mistakenly thinks that escalating subprime defaults will hurt them badly. Perception and reality here are far, far apart. CMOs typically have four levels of seniority, or tranches. The bond insurers cover only the most senior tranche, which is the safest one. The three junior tranches would all have to be erased before the senior tranche’s insurer loses money.

What the market fails to take into account is that the insurers have another safeguard. Should a senior tranche default, the insurer has the right to step in and make the missing interest payments to forestall a liquidation. That buys time until the housing market recovers and the CMO can find its own footing. This way, the insurer is not forced to foreclose, unless it is to its advantage.

Let us say Armageddon did occur, and CMOs and CDOs all collapsed in a mighty crash. Bond insurers’ claims-paying abilities are now rated AAA. A bond insurer without this rating is out of business. Faced with a threatened downgrade, insurers would raise additional capital or sell off some of their policies. Further, there is a political angle. These bond insurers are among the best clients of the rating agencies, since the agencies pocket a fee for reviewing every bond issue being insured. A downgrade would reflect directly on the competency of the rating agencies, something they do not need called into question right now.

The two biggest companies in the bond insurance business are MBIA (30, MBI) and Ambac Financial Group (22, ABK). Their stocks have come down from highs of $73 and $96 earlier in 2007. That has made them both value plays and income plays, as their dividend yields have risen pleasantly, to 4.6% and 3.8%. These stocks should recover smartly once the market figures out that their problems are exaggerated. And once the downgrade threat has passed, demand for bond insurance will surge.

MBIA’s and Ambac’s own bonds are rated AA/Aa2 but yield a junk-level 8%, thanks to market leeriness (bond ratings are different from claims-paying ratings). A more liquid alternative is their preferreds. Ambac has two preferred issues with the same ratings as its bonds: Ambac 5.95% of 2-28-2103 (16, AKF) and Ambac 5.875% of 3-24-2103 (16, AKT). Both yield 9%. Since the going rate for AAs today is more like 5.4%, you have a chance to lock in a premium return on a quality company for a lifetime. An early redemption – both issues are callable at $25 – would simply hand you a windfall.

SHEIKS RAISING THEIR STAKES IN BIG BANKS

Snagging legendary banks at virtual fire sale prices.

Oil-rich nations are on their biggest shopping spree ever for financial trophies, buying into legendary banks at virtual fire sale prices. The latest giant is Switzerland’s UBS.

JPMorgan Chase, a legendary white-shoe firm managing $1.5 trillion in assets, is expected to be the next bank to climb into a Persian Gulf lifeboat over its junk mortgage losses. JPMorgan executives have held talks with Abu Dhabi’s wealthy ruling family that last month plowed $7.5 billion into a weakened Citigroup to become its biggest single shareholder. A bank spokesman said Bill Winters, co-CEO of JPMorgan’s investment bank, met with CEO Mohammed al-Shaibani of Investment Corp. of Dubai, to discuss “mutual cooperation”, but without providing details.

UBS officials, Europe’s biggest bank, said the bank will write down an additional $10 billion in junk mortgage assets, on top of nearly $4.7 billion previously written off. To help offset the loss, UBS says it is getting an infusion of about $11.5 billion – paid in Swiss francs – from undisclosed sources in the Middle East and Singapore, which is known to handle oil riches in the Far East.

Underscoring interest in battered U.S. banks, the head of strategic and private equity at Qatar Investment Authority, said, “There are tremendous opportunities for sovereign wealth groups.”

Because of the weakness in its capital structure, Citigroup may need to pair up with another bank.

You think you have got a tough job. As Citigroup (C) nears a decision on its new chief, it is becoming increasingly clear that the financial-services giant will present severe challenges for any executive. The latest development came on December 10, when one research analyst said it will take years for Citigroup to recover from its billions of dollars in losses in the credit market and that it may even need to merge with a stronger partner to mend its balance sheet.

The company’s writedowns – $6.5 billion in the third quarter and $8 billion to $11 billion in the fourth – prompted the resignation of CEO Charles O. Prince III last month. David Hendler, a senior analyst at CreditSights, now says that such writedowns may put Citi in “a precarious position in terms of capital levels.” The result, he wrote, is that “the company could have to consider options ranging from dividend cuts to major asset/business unit sales, and/or a full-scale breakup or even potentially M&A with a stronger bank.”

Balance sheet stress and vulture buyers.

More pain for banks is coming, as Reutered reports that UBS wrote off $10 billion. “UBS’s write-downs are large but conservative, and it has managed to find investors to take the risks,” analysts at Dresdner Kleinwort said in a note to clients. “However, smaller groups may not have this luxury, and there is clear evidence of balance sheet stress emerging.”

Bloomberg reports that, seeking to avert a crippling reduction of its AAA credit rating, “MBIA Gets $1 Billion From Warburg Pincus”. The insurers, led by MBIA and Ambac, are sitting on $100 billion of collateralized debt obligations backed by subprime mortgage securities. One billion dollars is peanuts, compared with their actual exposure. It took nearly all of that $1 billion just to cover 4th-quarter losses. What now? The problem sure did not go away.

Denying a CNBC rumor of an asset freeze, Bank of America is closing its Columbia Strategic Cash Portfolio, a privately placed money-market fund for institutional investors. Reuters reports: “(Columbia spokesman Jon) Goldstein denied a CNBC report that the fund had been frozen, saying that clients were being offered the option of cash redemptions or of switching their assets into other Columbia-managed funds.” I would take the cash and run.

In response to Quint Tatro’s Minyanville piece this week, “Foreign Buyers at the Ready,” Minyan Peter wrote:

“While clearly foreign wealth funds and other offshore money is piling in to ‘bail out’ the capital infirmed, I would make a point about how these capital injections are being structured. Whether it is Citi, E*Trade, or UBS, new capital is coming in as either convertible debt or convertible preferred. Why? Because in liquidation, these new investments rank ahead of common shareholders when it comes to getting paid.

“As I have written previously, on the way down, vulture investors buy converts. At the bottom they go right for the common.”

Note: Peter is a former treasurer at a major U.S. bank.

In the face of enormous losses at MBIA, with even bigger announced losses to come, the market is going giddy because MBIA received a down payment on a potential $1 billion max infusion. However, that infusion does not come close to covering MBIA’s subprime exposure.

The equity markets, in general, are acting as if all these problems are going to be solved by a one-time cash infusion from venture vultures and bailouts from oil producers. Meanwhile, the credit markets have barely budged. LIBOR is down a mere one basis point from an extremely wide spread. LIBOR is suggesting banks still do not trust lending to each other, not even overnight.

The disconnect between the credit markets and the equity markets is simply staggering. Believe what you want, but the message from the credit markets is that a wave of bank failures is coming, and/or that balance sheet stress is going to get far worse before it gets any better.

GET GREEN FROM GREEN

As long as oil prices stay high, eco-friendly stocks have a big future. ETFs to track them abound.

Now that oil is nearing $100 a barrel, we find financial service stocks in an S&L-like swoon, Caterpillar worried about flagging U.S. sales and Tyson’s food empire warning that headline inflation (escalating energy and core goods prices) will harm its profit margin.

But there are still plenty of profitable packages under this market’s tree, and ETFs specializing in environmentally conscious companies are prominent among them. As long as the global economy keeps crude prices high, I would wager that alternative energy has staying power. Outfits that provide eco-friendly services like water and waste cleanup should do well in a time when Al Gore can win the Nobel Prize.

While 2007 has been a great year for oil stocks, alternative energy has had a rockier ride. The sector took off starting in July, only to pull back in this fall’s rout. The good news here is that the autumn swoon has made green energy attractively priced. Other stocks with a green tinge were not dinged as badly.

One caveat: Not all “green” ETFs invest in green stocks. The Claymore/LGA Green ETF numbers AT&T, Bank of America, Chevron, ConocoPhillips, IBM and GE among its largest holdings. It reminds me of Fidelity Investments’ launch of a new mutual fund in 1987 called Blue Chip Growth, which contained a bevy of small- and midcap companies that were nowhere near blue chips. Fidelity lamely defended the moniker by saying these were the likely blue chips of tomorrow.

Also be forewarned that different-sounding ETFs sometimes have similar holdings, which means that owning two of them gives you no real diversification and so makes little sense. Take the Powershares Cleantech and the Powershares Wilderhill Clean Energy. Among their largest holdings are 15% allocations each to First Solar, SunPower and SunTech. They also have big positions in Cree, which makes light-emitting diodes. While this pair of ETFs has not been around for very long, their performances are indeed close over the past 12 months. Owning one of them is a good idea. I opt for Powershares Cleantech (PZD). Its companies are midsize in market capitalization, tend to be more profitable and thus have a better chance of thriving. Clean Energy’s portfolio has more companies that are small or working on unproven technology.

That said, it is smart investment strategy not to abandon traditional energy companies. Carbon-oriented fuel will be with us for some time, so in a growing global economy you should take advantage of the surging oil sector that accompanies it. Buying a market weighting (10% of your overall portfolio in traditional energy names) is prudent. It is easy. You buy equal amounts of the United States Oil Fund (USO), which lets you speculate on the price of crude oil, and the Rydex S&P Equal Weight Energy (RYE), covering the companies that drill for, refine and market the oil.

And while the headlines have been screaming about peak oil – the tipping point at which crude resources begin to dwindle irretrievably – we are also seeing signs of peak water. Today’s water shortage in Georgia is a prelude to Florida’s six years hence. Odds are the next world war will not be ignited by a quest for oil but by a thirst for something potable. Powershares Water Resource (PHO) is the only water-focused ETF.

The final piece of your eco-portfolio could be Market Vectors Environmental Services (EVX), an ETF that tracks the Amex Environmental Services Index. Here are stocks in landfills and garbage recycling, hazardous waste cleanup and water. So far in 2007 this passively managed ETF has delivered twice the return of the actively managed Fidelity Environmental Services mutual fund.

A basket of the ETFs I have mentioned here – 1/3 in the U.S. Oil Fund ETF, 1/3 in Rydex S&P Equal Weight Energy and the other 1/3 divvied equally among my alternative energy picks – would have netted a 28.7% return in the year-to-date versus the S&P 500’s 0.7% return.

TECHNOLOGY ANALYST SAYS GREENHOUSE-GAS-REDUCTION THE PLACE TO BE FOR NEXT 5 YEARS

As the price of a barrel of oil has scarily flirted with $100, investors have been pouring money into renewable power plays such as solar and wind. Solar stocks are so hot that just looking at their charts is like staring directly into the sun. But Sanford C. Bernstein & Co. technology strategist Richard Keiser, 35, says that is no reason to avoid green tech. It is one of the best long-term opportunities available to tech investors.

Keiser’s job at Bernstein is to pick big, investable growth themes in technology. He liked Internet advertising in 2005 and videogame software in 2006, both pretty good calls. Two months ago he put out a 37-page report explaining why the place to be over the next five years is in greenhouse-gas-reducing technologies. Of course, he has company in this sector, notably Al Gore.

Keiser is your typical Bernstein boffin: smart, polite and thorough. Almost everyone he works with has an elite background. Keiser’s résumé includes a mechanical engineering degree from Carnegie Mellon, two graduate degrees from MIT, four years at Booz Allen and patents for a laptop computer design and file-management software. He came to Bernstein in 2001, the youngest analyst at the time, and two years later joined the tech strategy group run by the estimable Vadim Zlotnikov, captain of his high school math team in Brooklyn and an electrical engineering double-degree-holder from MIT.

Bernstein’s model portfolio of tech stocks, created by Zlotnikov 11 years ago, has averaged a 17.3% compound annual return, he calculates, versus 8.7% for the S&P 500. The latest version of this portfolio, which is purely theoretical – no real stocks are owned – has 30 positions, led by an 11% weighting to Microsoft and 7% to Cisco. Though its results are not audited, Bernstein does alert clients to changes in the lineup in a monthly report, where it also lists each position’s average purchase price. We checked his math to confirm veracity.

Keiser, who has led the portfolio since 2006, says that stock picking in this sector has changed a lot as technologies such as PCs and servers have become commoditized and the sector’s annual revenue growth has slowed from 18% in the late 1990s to 9% now. “In this environment you have a replacement cycle and a few growth themes,” he says. “You have to get these right to outperform.”

Keiser monitors a database of 700 companies and listens to quarterly conference calls across the entire tech landscape: software, hardware, semiconductors, Internet services and telecommunications. He also talks to venture capitalists and looks for what he calls “bottlenecks” – technologies that must grow because there is no ready alternative.

Bernstein has had some ill-timed calls. In April 2006 Keiser wrote up a positive note on videogame publishing, seeing lots of potential for profit growth given the rapid proliferation of new gaming consoles like the Xbox 360 and Nintendo Wii. But Keiser chose Electronic Arts as a long-term keeper just days before the shares lost 25% of their value on a surprising and disappointing earnings announcement. Keiser, undaunted, added more Electronic Arts to the model portfolio. The stock is now back where it was before the April 2006 call. Overall, though, the picks have been sound. Keiser singled out Google in May 2005 at $266. It is $697 now.

Now Keiser is into green tech. His latest report was a four-month study by him and his associate of the category’s spending boom. He estimates that boosting the global share of sun- and wind-made electricity from 1% today to 5% would require $1.4 trillion in spending. Of that, $100 billion would be for the intelligence – chips and controls – versus solar panels and windmill blades.

What to buy? We have compiled a roster from names mentioned in his report, some of them in his model portfolio (see table). Values here are vertiginous. But Keiser says fear of stretched price/earnings multiples often leads to missed opportunities. Witness Google in this decade and Microsoft in the 1990s. Keiser says sales growth risk is low in solar and wind. Many firms have years of demand already booked. Some of these picks are not profitable yet. Others, like Vestas and Gamesa, have double-digit earnings-per-share growth over the past three years.

FROM LOGS TO LEAD

My passion for infrastructure began at an early age, as a deeply ingrained, natural byproduct of my upbringing. My father, the former mayor of a small West Virginia town, worked relentlessly to rebuild our quaint little version of southern comfort from the ground up. For better or worse, he constantly dragged me along. My friends worked on farms. I spent my afternoons and Saturday mornings searching for water leaks. They rode John Deere tractors. I rode Caterpillar end loaders.

Around 1982, a rather substantial water leak on the south side of town brought out the picks and shovels. These calls were never routine. Municipal water leaks are tricky business. Water rarely leaks to the surface in close proximity to the broken pipe itself. More often than not, concrete roads and sidewalks force water to trickle way down the line before it is even capable of reaching the surface. Some leaks, in fact, never surface.

Meaning, you just do not dig a big hole beneath a percolating puddle. Maintenance crews check various meters and pressure gauges, trying to pinpoint their proverbial ground zero. Digging up roads is not cheap. Cities (and especially small towns) certainly do not cut into roads unless they are pretty confident they have located a problem.

Well, on that crisp spring afternoon, my dad and his crew felt confident they found their leak. And sure enough, 4 feet later, they were right. The broken pipe was no surprise. The fact that hollowed-out logs served as pipe certainly turned some heads, though. Hollowed-out tree trunks acted as the earliest means for either water or sewage conveyance. Eventually, wood construction gave way to a more durable material – lead.

According to Marc Edwards, a civil engineering professor at Virginia Tech, the U.S. has over 5 million lead pipes in its water infrastructure today. Lead is a good-quality plumbing material, from the perspective that it lasts a long time and it does not break. Unfortunately, the little that can leach from those pipes into the water is sufficient to pose a serious health concern. Edwards estimates it would cost $1 trillion to completely correct this problem.

For a quick perspective, consider that Mattel, the maker of Barney, Barbie and Dora the Explorer toys, recalled more than 9 million toys because its products were coated with lead paint. Mothers and fathers were outraged. China was vilified. Lead poisoning in young children can lead to neurological problems. But as Edwards points out, “There are no laws requiring lead testing or replacement of plumbing ... Only 10% of schools have tested their drinking water in recent years.” Meanwhile, our faucets continue to run.

Here in Baltimore, the public school system turned to bottled water. The city Health Department discovered that 10 fountains that had passed previous tests still contained unacceptably high levels of lead. After 15 years of efforts to remove the lead in its water fountains, Charm City capitulated.

We have addressed this matter before. The need for a national infrastructure overhaul remains paramount. Going forward, I believe America needs an even greater commitment to nation building. Except this time, America needs to rebuild itself.

For investors, infrastructure stocks seem promising. Currently, 73,518 of America’s 594,709 bridges maintain a “structurally deficient” classification. That is the grade the I-35W bridge in Minneapolis held just before it collapsed.

Interminable military obligations, rising prices, a declining dollar and a credit crisis with no end in sight cannot thwart our fundamental need to fix this problem. So the question is ... Will Uncle Sam start applying the Band-Aids before the next bridge begins to collapse?

INVESTMENT LANDFILL

How to avoid officially admitting a big loss, by reporting it a bit at a time.

Unless you are well informed, you are going to pay for getting investment bankers and fund managers out of the very deep hole they have recently dumped us all in. To help you avoid tumbling into this Investment Landfill, here is a plain English explanation of a nasty but clever scheme for making you pay for their mistakes.

Imagine this scene (and it should be fairly easy right now). A worried fund manager has just lost a pile of money in collateralized debt obligations (CDOs) – so much money that his bonus, his job, his department, and even his whole fund management business is at risk. In an idle chat with an investment banker he sighs that, “If only I could make a thumping great profit before the year end – then everything would be okay.”

Easy! And this is how it is done.

The USA’s Federal mortgage financiers – known generally as Fannie Mae and Freddie Mac – habitually slice up monthly mortgage payments, dividing them into the interest part and the repayment part (the principal). They routinely chop up mortgages like this, all the way through to the final payment from the home-buyer.

These slices can be recombined together to form custom-built packages of future cashflows, with interest and capital repayment elements mixed to order for the investment banks. All these slices and reconstituted packages are backed by Fannie and Freddie, so they are AAA-rated – the crucial “investment-grade” credit rating needed to make them saleable to public and private pension funds, perhaps including yours.

Imagine the investment bank buys $90 million of assorted interest-only payments, spread over 30 years. It also buys $10 million of principal – which pays no interest – due for repayment 30 years from now in 2037. The bank then repackages these two different mortgage investments in a very clever way. First, the $10 million principal pile is split down the middle. Half of it ($5 million) is mixed into the $90 million of interest payments. Let us call this “Package 1”. The other $5 million of principal is left on its own and called “Package 2”.

Both packages now have the same issuer, the same AAA credit rating, the same 30-year repayment date, and an identical amount of principal ($5 million). This becomes the face value of each package. But Package 1 also has a 30-year string of interest payments, which makes it look very much like a benchmark 30-year bond. Package 2, on the other hand, has no yield at all, and therefore it is worth a lot less today than its face value.

Simple enough, and you can easily see which half you would value more highly. So here comes the clever bit. The investment bank then folds both packages into a new trust, for which the investment bank itself acts as trustee. It writes into the trust deed that “in the event of an early partial redemption, Package 1 must be sold before Package 2.” Then almost everyone forgets about the details of the trust deed.

Our worried fund manager, the one with all those losses needing to be hidden away, now buys all of this new trust instrument. He holds it for a month or two, before his investment banker telephones to suggest a sale of half of the trust’s face value. Under the terms of the deed, all of the elements of Package 1 are now sold, including all its prospective interest receipts, at a price equivalent to the benchmark 30-year bond which it so closely resembles. All of the low-value Package 2, meanwhile, is retained within the trust – again, in keeping with the terms of the deed.

Even if the market has not moved during those two short months, this sale of Package 1 redeems 95% of the fund manager’s original investment, but it reduces the principal element in the trust by only 50% of its face value. The benchmark 30-year bond – to which the actual sale price is very close – is then used as the valuation basis for the remainder of the trust instrument, Package 2.

The worried fund manager is delighted! He has sold only half of his Trust Instrument and got nearly his whole investment back – a big profit. Moreover, what is left is now priced according to the benchmark 30-year bond, and it is allowed to float innocently up and down in line with the benchmark’s publicized value.

For the next 30 years, Package 2 will sit on the books valued initially at perhaps 20 times what it would actually fetch on the market, if sold. Of course, it will not be sold – and neither will it receive one shred of income for between now and 2037. But the true benchmark bond will receive interest, and as the benchmark’s interest payments get paid each year, so the benchmark’s resale value will slowly fall ... and the value of Package 2 will slowly come into line.

When finally – in 2037 – the benchmark has no remaining income left to pay, the two will have the same value. Package 2, which never paid any income, will be sold at the benchmark price against which it was routinely over-valued these last 30 years, and no-one will be any the wiser!

Thus, today’s mega-loss has been converted, almost invisibly, into 30 years of miserable under-performance, which eventually deprives the unwitting investor – the end-user who buys into this scheme via the fund manager – of 90% of his money.

Think it cannot be done? This was broadly the strategy implemented by U.S. investment banks for their Japanese customers in the aftermath of Tokyo’s stock-market and real estate crash in the early 1990s. The Japanese have experienced horrible underperformance in just about all of their investments ever since.

The scam was exposed in F.I.A.S.C.O. by author Frank Partnoy, who was one of the investment bankers involved. He is now a university law professor, and Partnoy broke the mould. He left his bank because he felt ashamed – fully realizing that investors would be steadily relieved of most of their capital, while their bankers and advisers got rich on unmerited bonuses, earned by hiding huge losses for decades to come.

TOO MUCH RETAIL

The following may be so hard to believe that many will consider it urban legend. But there was a time, long ago, when there were not enough stores.

It is true. Ask anyone from the Pre-Mall Era (PME) and they will tell you that shoppers in most American towns were once limited to a Sears & Roebuck, a J.C. Penney, a local department store or two, and, maybe a Tandy Leather. Tandy Leather, for those who do not remember life without Sharper Image, was the perfect store for families who loved making their own belts. These stores are not so easy to find these days.

The point is, not so long ago – OK, a pretty long ago – America was severely under-stored. Kids relied heavily upon the Sears catalog to come up with a Christmas list and to burn off some early December energy. Otherwise, kids would beg for even more trips to Radio Shack, the brand new retailer that sold high tech toys, like the transistor radio you soldered together yourself that could almost fit into a suitcase. (Back then, Radio Shack was also part of the Tandy empire, an organization enamored with the high margins that came with having customers assemble their own products.)

But that was a long time ago. It was before Nordstrom knew your shoe size, and before there was an entire store in the mall devoted to shaving. This was so long ago, in fact, that Mr. Abercrombie and Mr. Fitch still wore their shirts.

Over time, thanks largely to the malling of America, the store shortage went away. In the process, Peter Lynch made Magellan fund investors a bundle in retail stocks by betting that consumers never met a chain they would not help expand until it cannibalized its own sales.

But the retailers did not know when to stop. According to a website that follows this sort of thing, the amount of store space per capita in the U.S. doubled between 1990 and 2005. Meanwhile, consumer spending grew at less than half that rate. After decades of new malls and new chains to go into the malls, America is now the “The most over-retailed country in the world (and) hardly needs more shopping outlets of any kind,” according to a PricewaterhouseCoopers report.

At last, according to Fortune’s Suzanne Kapner, retailers are cutting back on their expansion plans. Chicos, Starbucks, Wet Seal and Walgreens are making noises about slowing store openings. She also notes that retail analyst Richard Hastings sees return on invested capital tanking for the retailing giants Target, Kohl’s and even Wal-Mart. Already, Wal-Mart has announced that it is slashing U.S. capital expenditures from $12.2 billion last year to $8.3-9.2 billion in fiscal 2010.

The fact is, much of U.S. retailing is either slowing growth or scaling back. It would seem that all those store openings over all those years are catching up with the retail industry – just as the home equity ATM is running out of cash.

Larry Kudlow is not going to believe this, but this retrenchment could actually affect the U.S. economy. Hiring in retail, along with construction hiring, has been a boon to the economy over the past several years. Although hardly the contributor it was a couple of years ago, at least retail new hires are positive.

The same cannot be said for the year-over-year change in the construction segment where employment turned negative early this year. Together, new hires in those sectors accounted for as much 28% of employment growth during the last half-decade of credit bubble reflation. So while it makes sense that retail’s building binge would have to reverse eventually, it is also logical that years of credit excesses would affect more of the economy than just a small group of subprime lenders. Retailers and their employees look to be yet another victim.

FEAR THE FOREX MARKET ... OR AT LEAST GIVE IT SOME RESPECT

Following the siren call of quick riches will leave you on the rocks.

If you have to catch something that is going around, do whatever you can to make sure it is not the forex trading bug. Although the offers of easy riches from swapping currencies might be tempting, the vast majority of investors would do well to resist the lure. Not only is this market supremely risky, but there are other, better ways to achieve the same investment goals.

That may not be readily apparent to everyone, especially given the feeble performance of the U.S. dollar, which is down around 30% against the euro over the past five years. That has made betting against the greenback look like an appetizing one-way bet.

As the easy money of the housing market becomes a distant memory, a small industry of shops offering fast access to the forex market has sprung up like mushrooms in a dark, damp room, all hinting at the profits to be made by trading currencies. To be sure, that possibility does exist. But the truth is, an individual is much more likely to lose, according to industry experts.

“I can categorically say that Joe Average has no place in the currency markets,” says Morris Armstrong, who spent 23 years as a currency dealer and who is now a financial adviser at Armstrong Financial Strategies in Danbury, Connecticut.

More than $2 trillion of currency is bought and sold each business day across the globe, largely by very sophisticated operators with major technological advantages relative to the small investor – think huge multinational banks like Citigroup and HSBC, or national monetary authorities, such as the European Central Bank and the Bank of Japan.

Also, the forex market is volatile, Armstrong says, and he points out that “margin can do some serious damage,” especially to those without very deep pockets. Trading on margin means borrowing money to pay for a large portion of the trade. While that leverage multiplies the gains, it also exaggerates the losses. Often, leverage is offered to currency clients by brokers, but if the market moves unfavorably enough, then the entire amount of the investment can be lost quickly. So even if traders gets things right directionally or strategically, they can still lose money if the timing is wrong.

That said, experts agree some exposure to foreign currencies can be a good way to reduce the overall riskiness of a portfolio. So now that you have been warned, what can you do? Small investors might want to consider buying stocks of companies that would do well if the dollar stays weak, and perhaps even if it does not, says Jerry Miccolis, a financial adviser at Brinton Eaton Wealth Advisors. “Pick U.S. multinationals with lots of new growth potential,” he says, highlighting Coca-Cola and Procter & Gamble as prime examples.

Investors get the double benefit of growing overseas markets, enhanced by the dollar story, because much of those firms’ new business is coming from rapidly expanding emerging economies, Miccolis explains. He also like the iShares S&P Global Consumer Staples (KXI) ETF, which tracks a basket of consumer staples stocks across the globe.

A less leveraged way to gain direct currency exposure can be through foreign-denominated money market mutual funds. Roe owns the Pimco Developing Local Markets fund, which is effectively an emerging-markets money market fund.

For those who are still keen on having direct currency exposure to a single currency, ETFs might be a simple way to go. If you want to buy the Canadian dollar or Australian dollar, you can use the CurrencyShares Canadian Dollar Trust (FXC) or the CurrencyShares Australian Dollar Trust (FXA). These ETFs attempt to track the value of the underlying currencies and are not leveraged. In addition to the CurrencyShares ETFs, iPath has a similar family of single currency funds, including the iPath GBP/USD Exchange Rate ETN (GBB), which tracks the value of the British pound vs. the U.S. dollar.

MINING PROFITS FROM THE GOLD BULL

If you asked people to list their best investments since 2000, what percentage of them do you think would say gold or silver? Chances are, not many. Most would probably tell you about some technology stock that they happened to hold onto that has doubled or tripled in price from the bear market low in 2002.

Not only would gold or silver probably not enter the conversation, chances are most people would not be able to name a single gold or silver mining company. Even though gold has almost tripled and miners have risen over 600% since 2000, most people have not yet realized that precious metals have been outperforming the general market since then by leaps and bounds.

That may be about to change. The dollar index has fallen to a record low. The euro traded over 1.40 per dollar for the first time, and the Canadian dollar reached parity against the U.S. dollar for the first time in over 30 years. These events reached the front page around the country.

This time, the dollar’s decline coincided with a sharp rise in public awareness about the weakening greenback. As a result, the precious metals bull market may be entering a new phase. When the general public becomes more aware of the dollar’s bleak future, more and more people will see charts comparing the price of gold and the U.S. dollar index and ask themselves why they have not been invested in gold. Such a shift in public awareness is usually the ingredient that changes a stealth bull market – like the one we have seen so far in gold – into a raging bull market.

Every time people listen to the news, they are reminded of how stocks perform. They are reminded of interest rates and the bond market every time they get their credit card statement or check to see if it they should refinance their mortgage. They are reminded of the bull market in energy every time they fill up their gas tank. But unless they collect coins as a hobby, most people have very little regular contact with the price of gold. With the exception of a brief period at the peak in early 2006, the precious metals rally has garnered very little investor interest.

Since May 2006, fund flows out of precious metal stock funds have been huge, even though the price of gold remained near its peak. This suggests that even the investors who are aware of gold remain more interested in trading gold stocks than holding them for the long run. All the sentiment signs suggest that we have a long way to go before gold is considered a must-have, long-term buy-and-hold investment. Such sentiment extremes mark the terminal stage of all long-term bull markets.

Technology stocks reached that pinnacle of sentiment in 1999-2000, and real estate reached that point in 2005-2006. The precious metals bull market may now just be at the dawn of its recognition by the public, which makes it unlikely gold is anywhere near an end to its bull trend.

The Amex Gold Miners Index consists of the 37 largest gold mining companies in the world. Over the past seven years, it has stair-stepped higher from a low at 180 in late 2000 to an intraday high at 1,266 in May 2006 – for a total gain of 603%. You can see the periodic consolidations outlined in black on the chart. Since May 2006, it has consolidated yet again, laying the groundwork for another sprint higher.

I have been keeping a sharp eye on miners since April. While I have anticipated a resumption of the long-term bullish trend, I have also been mindful that the correction from May 2006 was ongoing and could still produce more downside before it was completed. That downside came when the general market sold off in July and August and the miners were pulled down with it. The Amex Miners Index fell from a July high of 1,175 to an August low at 890 – a loss of 24% in one month.

However, that sharp loss in mining stocks was not accompanied by a decline in gold, and as soon as the general market stabilized, the miners quickly rebounded. The recovery was further aided by the Fed’s decision to lower the fed funds rate by 50 basis points, which led to a broad rally in miners and a breakout in gold above its May 2006 high.

The sharp sell-off in August appears to have been the washout that was needed to end the correction from May 2006, and the miners look to have now resumed their long-term uptrend. This means that mining stocks may just be the way to play this bull market.

Gold’s big drunken night out.

The gold price just closed out November at an average of $806.25 per ounce, a new record high – and the 3rd record month on the run. Not that you would know that from reading the newswires, however. And fair is fair.

The bull market has just collapsed after all. “I think you have got liquidation,” one trader said to Dow Jones as the gold market sank on Friday, November 30. “The gold bulls [are] throwing in the towel here.”

“When you see so much volatility at the top of the range, that tends to signal the end of the move,” said Richard England, a trader at Standard Bank. “I’d say the risk to the gold price is to the downside.”

“Gold’s raving rally is over,” another metals-head said.

Selling gold will give investors “an avenue to benefit from the prospect of a stabilization in the dollar,” Jim O’Neill of Goldman Sachs advised on November 29. “We would now use a short exposure in gold, expressed in U.S. dollars, to capitalize on a gradual relaxation of credit concerns in the financial sector over the coming months.”

And just how far does Goldman Sachs think the price of gold will tumble as the credit markets spark up a joint and breathe deep ahead of Christmas? The only U.S. investment bank to actually make money during the credit crunch so far (albeit on paper and marked to model) reckons you can look for a 15-20% setback, driven by a bounce in the U.S. dollar.

Something does not fit, though. “Did you see that the metals desk at Goldman Sachs just recommended gold again?” noted a leading and very experienced gold market analyst to me by e-mail. It begs the question, we agreed.

Is this a political ploy? After all, the U.S. dollar has never been worth less on the international currency markets. Treasury Secretary Henry Paulson says he believes in a “strong dollar” ... yet he has done zip to beef it up, either with higher interest rates at the Fed or a slowdown in U.S. government debt growth. And he did use to run Goldman Sachs as its CEO, you know.

“We see scope for acceleration through $770 to retest the $600-650 levels prevailing ahead of the summer,” O’Neill went on, while his colleague at Goldman Sachs in New York, Oscar Cabrera, forecast average gold prices in 2008 of $800 an ounce, up from $687 in 2007.

“We see upside risks to our forecast,” Cabrera added – meaning that the gold market looks likely to rise above even his revised targets.

Better get your story straight, Goldman! Is it time to buy, sell or move onto shorting subprime mortgage bonds that you issued last year? Conspiracy theories aside, it remains a fact that trying to ride this bull market in gold often feels like trying to get your heaviest friend home after way too much beer. At first glance, the big fella seems an immovable object. But if you just stick with him, you really will both get home, maybe sometime before dawn. The trouble is, making progress means getting your over-sauced friend up on his feet.

And that is when the trouble begins. Soon as he is up, he starts lurching from streetlamp to streetlamp, shouting at strangers and waving his fist at the cops. The big guy gets mighty quick too, sprinting first into traffic and then straight back onto the sidewalk. Anyone who gets in his way risks getting squashed under the weight of hops, malt and yeast in his belly. Slow progress still comes, however, as you steer out of the traffic and back onto the sidewalk. Given a chance, you might even get him onto the night bus in one piece.

Sobered up and back at our desks, it is not just in dollars that gold’s long-term bull market rolls on. Versus the euro, gold averaged more than €549 per ounce in November, a new 24-year record. Measured in British pounds sterling – against which gold hit 5 new all-time highs this month – gold in November averaged £389 per ounce, another record high.

Does that mean the gold versus sterling is only sure to keep climbing? No, not at all. But standing 145% above its bear market low of August 1999, gold priced in pounds gives the lie to sterling’s strength. Yes, it a 25 year high vs. the dollar this month, up there above $2.12. But it has been losing against the rest of the world’s money at the very same time, dropping more than 3% for 2007 to date.

And priced against gold, the pounds in my pocket (what few there are) have never been more worthless.

MORE DOLLAR DOOM

Protect yourselves. There are wolves at the door.

If the dollar were an animal, it might be a lamb – a fluffy, adorable little lamb ... surrounded by a pack of wolves. The dollar is simply no match for the vicious influences that threaten to devour it – influences like a Federal Reserve that promises to combat every financial crisis with ample doses of additional credit.

Over the past year, I have spoken with numerous business and financial reporters in the U.S. and Canada. These reporters range from employees of small-town newspapers to my much larger hometown chronicle, the Pittsburgh Post-Gazette. I have spoken with representatives of industry trade publications like Oil & Gas Journal, as well as reporters from the Vancouver Sun, Canada’s The Globe & Mail, the Los Angeles Times, the Associated Press and the Dow Jones Newswires. In addition to the print media, I have also been interviewed on many different radio programs.

Part of a recent interview with an Orlando, Florida radio station focused on the immense losses announced by Merrill Lynch and Citigroup, and the departures of the top managers of both firms. Merrill wrote down over $8 billion of bad financial paper. Citigroup has massive losses that may be in the vicinity of $13 billion or more. These are mind-boggling numbers, yet my view is that we are just seeing the tip of a few icebergs.

It seems that over the past few years, much of the financial industry loaded up on bad debt instruments. I will not even dignify this rotten paper by calling it some sort of “investment”, because there was and is essentially nothing to back it up. There are entire portfolios filled with subprime loans, initiated via “no documentation” loans against over-appraised buildings on the far side of the railroad tracks. In other words, these are worthless loans that will never see a dime of repayment. In many cases, these loans are evidence of economic crimes.

When the banks and investment houses acquired these bad books of business, the risk models that they used were pure guesswork. In the real world, engineering has made complicated structures like bridges and skyscrapers safer over time. But the so-called modern “financial engineering” has done nothing of the sort in the economic world. It all goes to show that just because the human mind can come up with an idea, it does not mean that people should act on it, let alone back it with their funds.

At this point, it is all but impossible to value much of what the financial houses have on their books. So the write-downs are just beginning. I believe that there are greater losses lurking in the shadows for both Merrill and Citigroup, and for many other banks and investment houses around the world. Several well-known banks in Germany, for example, are on the brink of disastrous write-downs. It is just a matter of time before these losses become public.

While on the air in Orlando, the interviewer asked what I anticipate for the U.S. economy and how the individual investor should protect himself from the coming turmoil. My reply was that I believe that the U.S. dollar is in a long state of decline. This is going to be an ongoing tragedy because so many people in the U.S. and around the world will be caught in the riptide as the value of the dollar washes away.

Do you remember when you would walk into a store and the owner might have the first dollar he ever earned in a frame, hanging on the wall behind the counter? People were proud of their money and trusted it as a long-term store of value. Not any more. Yet most people in the U.S. know only the dollar and understand only the dollar and their savings and investments are almost entirely in the dollar. So what happens when the value of the dollar just disintegrates? It is painful to think of the hardship that is coming down the road.

No one really knows how the decline of the dollar will play out. There is no modern precedent for what is about to occur as the world’s reserve currency evaporates in value. Literally billions of people rely upon the U.S. dollar as the economic rock that holds up the foundations of the world economy. Yet that rock is turning into loose sand. How does one save, let alone invest, in a world where the value of the dollar is in irreversible decline? A declining dollar is the same as the destruction of capital.

My advice is to load up on gold and other precious metals and mining shares in companies that control real ore in the ground. While you are at it, also go for the companies that own or control real energy reserves, such as oil and gas, coal, uranium and renewable energy systems.

As if on cue, last month, the British newspaper The Independent launched a story with these words:

“A new phase in the credit crunch, one of ‘$1 trillion losses,’ seems to be dawning. The crisis at Citigroup and renewed doubts about some of the world’s leading banks disquieted stock markets on both sides of the Atlantic recently, with the fractious mood set to continue.”

So there are a trillion dollars of losses yet to be booked ... and a company the size of Citigroup does not have the capital to manage itself as an ongoing entity ... and the prices for gold and oil are skyrocketing as the value of the dollar declines.

My advice is to protect yourselves. There are wolves at the door.