Wealth International, Limited

Finance Digest for Week of December 24, 2007

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


Forget about paper money deflation, think deflation in “real money”, i.e., gold.

Among those rational enough to perceive the looming economic downturn, a heated debate has arisen that centers on whether the slowdown will be accompanied by inflation or deflation.

Those in the deflation camp believe that money supply will collapse as a natural consequence of the implosion of the biggest credit bubble in U.S. history. As loans go bad, assets, which collateralize these loans, will be sold at fire sale prices to satisfy creditors. It is also argued that a recession will reduce consumer discretionary spending, causing retailers to slash prices to move their bloated inventories. This is the way the situation played out in the 1930s and this is how many expect it to happen today.

However there are several key differences between then and now, which argue against the classic deflationary scenario. In particular, the Fed’s ability to pump liquidity into the market in the 1930s was limited by the gold backing requirements on U.S. currency. No such limitations exist today. This distinction is critical. When credit was destroyed after the Crash of 1929, the Fed was not able to simply replace it out of thin air. Today however, the Fed will likely print as much money as necessary to prevent nominal prices from collapsing. In fact, in the infamous speech that spawned his “helicopter” sobriquet, Ben Bernanke explained how the printing press can be used to stop deflation dead in its tracks.

To fully understand the way inflation and deflation affect prices, we need to differentiate between assets, such as stocks and real estate, and consumer goods, such as shoes and potato chips. If we measure prices in gold, as we did during the 1930s, both asset and consumer goods prices will fall, with the former falling faster than the latter. So in that sense the deflationist are correct. However, in terms of today’s paper dollars, this outcome is completely impossible. During deflation, money gains value, so prices naturally fall as fewer monetary units are required to buy a given quantity of goods. In the coming deflation, real money (gold) will gain considerable value, so prices will therefore fall sharply in gold terms. Paper dollars however, which have no intrinsic value at all, will lose value, not only as the Fed increases their supply, but as global demand for the currency implodes.

The way I see it there are only two possible scenarios. The more benign outcome would we be one where asset prices fall, even in terms of paper dollars, but consumer goods prices continue to rise. This would be the stagflation scenario. The more catastrophic scenario is one where asset prices hold steady or even resume their ascent, while consumer goods prices rise even faster. This of course is the hyper-inflation scenario, and is the worst possible outcome. I see no possible scenario where consumer goods prices fall in term of paper dollars.

Many mistakenly believe that when the U.S. economy falls into recession, reduced domestic demand will lead to falling consumer prices. However, what is often overlooked is the fact that as the dollar loses value, the rising relative values of foreign currencies will increase consumer demand abroad. As fewer foreign-made products are imported and more domestic-made products are exported, the result will be far fewer products available for Americans to consume. So even if the domestic money supply were to contract, the supply of goods for sale would contract even faster. Shrinking supply will be a major factor in pushing consumer prices higher in America.

In addition, since trillions of dollars now reside with our foreign creditors, even if many of these dollars are lost due to defaulted loans, those that are not will be used to buy up American consumer goods and assets. As a result of this huge influx of foreign-held dollars, the domestic dollar supply will likely rise even if the Fed were to allow the global supply of dollars to contract, forcing consumer prices even higher. In fact, a contraction in the domestic supply of consumer goods will likely coincide with an expansion of the domestic supply of money. The result will be much higher consumer prices despite the recession. So even though Americans will consume much less, they will pay much more for the privilege.

The real risk is that the Fed gets more aggressive as it realizes that the additional credit it is supplying is not flowing where it wants. If the Fed drops enough money from helicopters it will eventually reverse the nominal declines in asset prices. Unfortunately, that road leads to hyper-inflation and disaster. No matter what, even if the Fed succeeds in propping up nominal asset prices, they can do nothing to sustain their real values. Consumer goods prices will always rise faster, leaving the owners of those assets poorer no matter how high their nominal values climb.

The big problem politically is that hyper-inflation may superficially appear to be the lesser evil. If asset prices are allowed to collapse, ownership of those assets will pass to our creditors. If instead we repay our debts with debased currency, we retain ownership of our assets and shift the losses to our creditors. Since American debtors can vote in U.S. elections and foreign creditors cannot, the choice seems obvious. Of course there are some American creditors as well, but since they comprise such a small percentage of the electorate, my guess is that their losses will be seen as acceptable collateral damage.

Link here.


The forecast calls for pain.

Observers of the credit crunch that has been bedeviling financial markets since August were mostly highly relieved last week when the European Central Bank injected some $500 billion into the world’s banking system via low cost funding and the Fed followed up with $40 billion of its own. This sharply lowered the premium that interbank deposit rates have commanded for the last four months over Treasury bill rates. However in the general rejoicing that the international financial markets were not about to ruin everybody’s Christmas, one question has so far been ignored: How are the ECB and the Fed ever going to get their money back? The financial fate of the world’s taxpayers, as well as the future of the markets themselves, rests on the answer to this question.

The amounts of money involved here are pretty staggering. The British taxpayer’s cash injection into the Northern Rock scam now exceeds £25 million, with another £30 million in guarantees, which combined total has more than doubled even the Labour government’s budget deficit if accounted for properly (it is about 2.3% of Britain’s GDP, a not insignificant amount of money to pour into a wholly insignificant financial institution.) Needless to say, there seems no prospect of the taxpayer getting more than about half of this sum back.

As for the ECB’s $500 billion, that represents approximately 5% of the euro area M2 money supply. Admittedly it represents less than six months growth in M2, since that aggregate is growing at the disgracefully rapid rate of 11.2%, almost double the growth rate in nominal euro area GDP. Nevertheless an addition of 5% to the euro area’s money supply has to be inflationary, even if much of it leaks back to the U.S., which is itself pursuing an excessively expansionary monetary policy.

Unlike the much predicted but in the event mild inflation produced by the Fed’s excessively stimulatory monetary policies of 1995-2007, this additional injection of liquidity may result in a much sharper and more rapid burst of inflation. However that inflation is likely to appear, not in the euro area, blessed with a strong currency and an even trade balance, but in the U.S., whose chronic and gigantic balance of payments deficit has so far had no discernible effect.

The ECB, Fed and British bailouts involve an even a more serious problem than inflation, which is the question of repayment. The $540 million has been lent to the banks in order that they not suffer a shortage of liquidity at year-end. However, while the need for liquidity is less after January 1, the underlying condition of the assets being financed will not have changed and may even have got worse. Withdrawing $540 billion of liquidity in mid-January would thus cause the mother of all liquidity squeezes and is probably impossible. It is thus likely that the ECB and other central banks will have to roll over most of the $540 billion for an additional period. Essentially they will have locked themselves in. As with Northern Rock, taxpayers will be on the hook, only this time for $540 billion.

The extent to which this leads to actual losses depends primarily on the decline in U.S. and British house prices, and whether tighter credit conditions lead to a general decline in real estate values worldwide. The central banks of the world will certainly make every effort to avoid such an outcome, if only because with $660 billion at stake (including Northern Rock and its guarantees) they are now locked into the long term health of the real estate market.

While the loss of $660 billion in taxpayers’ money in itself is of only moderate significance to them, central bankers who lost such sums would be subject to endless ignorant interrogation, not by the media which they are used to, but by the parliamentary and congressional committees to which they are nominally responsible.

There is only one way in which central bankers can minimize the losses on $660 billion of what is effectively real estate related debt. They must cause a high level of inflation. Ordinary inflation of 5-6% will not do, because it will not sufficiently change investor psychology. To achieve their objective of sustaining real estate, central bankers must induce a state of inflationary panic, causing inflation to be high enough that investors flood into real assets, of which the most conspicuous is real estate. This will prop up the nominal prices of the assets and, by reducing the real value of the associated debt, sustain the mortgage transactions which underlie the dodgy SIVs which underlie the tottering banks whose paper the central banks are now holding. Of course, the real value of the central banks’ $660 billion in short term loans and guarantees will decline, but since that decline does not have to be reflected in the accounts, nobody will care. After all, if central banks run out of money, they can just print some more.

The ECB has in the past been fairly sound on preventing inflation, as befits its partly Bundesbank ancestry, but as can be seen from its current rate of M2 growth, it has become much sloppier since the Frenchman Jean-Claude Trichet took over from Wim Duisenberg in November 2003. Eurozone M2 money growth was 8.5% in 2005 and 9.3% in 2006, rising to 11.2% in the year to October 2007. All three figures are far above the 5-6% annual increase in Eurozone GDP, indicating that under Trichet European monetary policy has strayed far from its German roots and become thoroughly inflationary. While a rapid increase in money creation by the Fed runs the risk of a collapse in the value of the dollar, because of past profligacies, no such danger confronts the ECB – excessive monetary creation in euros, while it will cause inflation to accelerate worldwide, will domestically mostly serve to dampen the undesirable rise in the value of the euro against the dollar.

So there you have it ... a monetary forecast for 2008. Central banks are now committed to maintaining as far as possible the value of real estate, particularly housing in the U.S. and Britain, where it is showing signs of collapsing. They will thus inflate the money supply, causing retail price inflation and further commodity and energy price inflation but slowing the decline in house prices and improving the value of their locked-in holdings of bank paper and guarantees.

However, because a money supply increase by the Fed might destroy confidence in the dollar, which would force a tightening in monetary policy and prevent achievement of the central bankers’ primary objective, the loosest monetary policy will come from the ECB, with the additional money created being transmitted to the U.S. and Britain through the mechanism of the foreign exchange markets and both countries’ payments deficits.

Inflation in the eurozone will remain modest, in spite of the rapid money creation, because the euro’s appreciation will reduce the price of imports to eurozone consumers. For them, the rise in commodity and energy prices will be dampened while the prices of manufactured goods from Asia will steadily grow more competitive in the eurozone as the euro rises against Asian currencies.

Inflation will appear in the U.S., in Britain, where the pound will decline against the euro but probably remain quite strong against the dollar and in India and China, whose fairly primitive monetary systems will not be able to resist the tsunami of “hot money” investment from speculators and hedge funds.

By December 2008, U.S. and British consumer price inflation will be approaching 10% per annum, and it will be well above that level in both India and China. However there will have been no outright recession, or only a mild one. Moreover, the decline in real estate values will have been slow, and in the U.S. will appear to be turning around (but not in Britain where London house prices, currently far more inflated than in the U.S., will be adversely affected by the decline in the City of London’s revenues).

Once again, central banks will have achieved a barely acceptable short term resolution to a crisis – at the cost of a lengthy and painful long-term recession, as interest rates finally have to be raised to combat a double-digit inflation that will seem to have appeared from nowhere and embedded itself unexpectedly deeply in the economies of Britain and the U.S.

That however will be a problem for the new U.S. administration that takes office in January 2009. Trichet will still be around (his term of office extends to November 2011) but the main political headaches of reversing his excessive money creation will occur in the U.S. and Britain.

If Trichet is clever, he will move the ECB to slower money creation once U.S. and British real estate prices have stabilized. That will allow Eurozone interest rates to rise moderately, while remaining lower than the crisis rates in the Anglosphere. Then he will be able to contrast the problems in the U.S. and Britain with the favorable outlook for eurozone inflation under his Presidency of the ECB. For a French intellectual, proving such superiority to the Anglosphere is always the most satisfying outcome of all!

Link here.


As central banks continue to splash their cash over the system, so far to little effect, Ambrose Evans-Pritchard argues things are rapidly spiraling out of their control.

$20 billion here, $20 billion there, and a lush $500 billion from the European Central Bank at give-away rates for Christmas. Buckets of liquidity are being splashed over the North Atlantic banking system, so far with meager or fleeting effects.

As the credit paralysis stretches through its 5th month, a chorus of economists has begun to warn that the world’s central banks are fighting the wrong war, and perhaps risk a policy error of epochal proportions. “Liquidity doesn’t do anything in this situation,” says Anna Schwartz, the doyenne of U.S. monetarism and life-time student (with Milton Friedman) of the Great Depression. “It cannot deal with the underlying fear that lots of firms are going bankrupt. The banks and the hedge funds have not fully acknowledged who is in trouble. That is the critical issue.”

Lenders are hoarding the cash, shunning peers as if all were subprime lepers. Spreads on 3-month Euribor and Libor – the interbank rates used to price contracts and Club Med mortgages – are stuck at 80 basis points even after the latest blitz. The monetary screw has tightened by default.

York professor Peter Spencer, chief economist for the ITEM Club, says the global authorities have just weeks to get this right, or trigger disaster. “The central banks are rapidly losing control. By not cutting interest rates nearly far enough or fast enough, they are allowing the money markets to dictate policy. We are long past worrying about moral hazard,” he says. “They still have another couple of months before this starts imploding. Things are very unstable and can move incredibly fast. I don’t think the central banks are going to make a major policy error, but if they do, this could make 1929 look like a walk in the park.”

The Bank of England knows the risk. Markets director Paul Tucker says the crisis has moved beyond the collapse of mortgage securities, and is now eating into the bedrock of banking capital. “We must try to avoid the vicious circle in which tighter liquidity conditions, lower asset values, impaired capital resources, reduced credit supply, and slower aggregate demand feed back on each other,” he says. New York’s Federal Reserve chief Tim Geithner echoed the words, warning of an “adverse self-reinforcing dynamic” – banker-speak for a downward spiral. The Fed has broken decades of practice by inviting all U.S. depositary banks to its lending window, bringing dodgy mortgage securities as collateral.

Quietly, insiders are perusing an obscure paper by Fed staffers David Small and Jim Clouse. It explores what can be done under the Federal Reserve Act when all else fails. Section 13 (3) allows the Fed to take emergency action when banks become “unwilling or very reluctant to provide credit.” A vote by 5 governors can, in “exigent circumstances”, authorize the bank to lend money to anybody, and take upon itself the credit risk. This clause has not been evoked since the Slump.

Yet still the central banks shrink from seriously grasping the rate-cut nettle. Understandably so. They are caught between the Scylla of the debt crunch and the Charybdis of inflation. It is not yet certain which is the more powerful force. America’s headline CPI screamed to 4.3% in November. This may be a rogue figure, the tail effects of an oil, commodity, and food price spike. If so, the Fed missed its chance months ago to prepare the markets for such a case. It is now stymied.

This has eerie echoes of Japan in late-1990, when inflation rose to 4% on a mini price-surge across Asia. As the Bank of Japan fretted about an inflation scare, the country’s financial system tipped into the abyss. In theory, Japan had ample ammo to fight a bust. Interest rates were 6% in February 1990. In reality, the country was engulfed by the tsunami of debt deflation quicker than the bank dared to cut rates. In the end, rates fell to zero. Still it was not enough.

When a credit system implodes, it can feed on itself with lightning speed. Current rates in America (4.25%), Britain (5.5%), and the eurozone (4%) have scope to fall a long way, but this may prove less of a panacea than often assumed. The risk is a Japanese denouement across the Anglo-Saxon world and half Europe.

Post-bubble chickens come home to roost.

Bernard Connolly, global strategist at Banque AIG, said the Fed and allies had scripted a Greek tragedy by under-pricing credit long ago and seem paralyzed as post-bubble chickens now come home to roost. “The central banks are trying to dissociate financial problems from the real economy. They are pushing the world nearer and nearer to the edge of depression. We hope they will eventually be dragged kicking and screaming to do enough, but time is running out,” he said.

Glance at the more or less healthy stock markets in New York, London, and Frankfurt, and you might never know that this debate is raging. Hopes that Middle Eastern and Asian wealth funds will plug every hole lifts spirits. Glance at the debt markets and you hear a different tale. Not a single junk bond has been issued in Europe since August. Every attempt failed. Europe’s corporate bond issuance fell 66% in the third quarter. Emerging market bonds plummeted 75%.

“The kind of upheaval observed in the international money markets over the past few months has never been witnessed in history,” says Thomas Jordan, a Swiss central bank governor. “The subprime mortgage crisis hit a vital nerve of the international financial system.”

The market for asset-backed commercial paper – where Europe’s lenders from IKB to the German Doctors and Dentists borrowed through Irish-based “conduits” to play U.S. housing debt – has shrunk for 18 weeks in a row. It has shed $404 billion, or 36%. As lenders refuse to roll over credit, banks must take these wrecks back on their books. There lies the rub.

Professor Spencer says capital ratios have fallen far below the 8% minimum under Basel rules. “If they can’t raise capital, they will have to shrink balance sheets,” he said.

Tim Congdon, a banking historian at the London School of Economics, said the rot had seeped through the foundations of British lending. Average equity capital has fallen to 3.2% (nearer 2.5% sans “goodwill”), compared with 5% seven years ago. “How on earth did the Financial Services Authority let this happen?” he asks. Worse, changes pushed through by Gordon Brown in 1998 have caused the de facto cash and liquid assets ratio to collapse from post-war levels above 30% to near zero. “Brown hadn’t got a clue what he was doing.”

The risk for Britain – as property buckles – is a twin banking and fiscal squeeze. The UK budget deficit is already 3% of GDP at the peak of the economic cycle, shockingly out of line with its peers. America looks frugal by comparison. Maastricht rules may force the Government to raise taxes or slash spending into a recession. This way lies crucifixion. The UK current account deficit was 5.7% of GDP in Q2, the highest in half a century. Gordon Brown has disarmed us on every front.

In Europe, the ECB has its own distinct headache. Inflation is 3.1%, the highest since monetary union. This is already enough to set off a political storm in Germany. A Dresdner poll found that 71% of German women want the Deutschmark restored. With Brünhilde fuming about Brot prices, the ECB has to watch its step. Frankfurt cannot easily cut rates to cushion the blow as housing bubbles pop across southern Europe. It must resort to tricks instead. Hence the half trillion gush last week at rates of 70% below Euribor, a camouflaged move to help Spain.

The ECB’s little secret is that it must never allow a Northern Rock failure in the eurozone because this would expose the reality that there is no EU treasury and no EU lender of last resort behind the system. Would German taxpayers foot the bill for a Spanish bail-out in the way that Kentish men and maids must foot the bill for Newcastle’s Rock? Nobody knows. This is where eurozone solidarity stretches to snapping point. It is why the ECB has showered the system with liquidity from day one of this crisis.

Citigroup, Merrill Lynch, UBS, HSBC and others have stepped forward to reveal their losses. At some point, enough of the dirty linen will be on the line to let markets discern the shape of the debacle. We are not there yet.

Goldman Sachs caused shock last month when it predicted that total crunch losses would reach $500 billion, leading to a $2 trillion contraction in lending as bank multiples kick into reverse. This already seems humdrum. “Our counterparties are telling us that losses may reach $700 billion,” says Rob McAdie, head of credit at Barclays Capital. Where will it end? The big banks face a further $200 billion of defaults in commercial property. On it goes.

The IMF still predicts blistering global growth of 5 per cent next year. If so, markets should roar back to life in January, as though the crunch were but a nightmare. There again, the credit soufflé may be hard to raise a second time.

Link here.

A picture of paper assets, gone mad.

At the end of 2006, the financial assets of financial institutions surpassed 20% of annual GDP. Those assets had never even eclipsed 5% of GDP until the early 1990s. Even more effective at getting the point across than these dry numbers is to look at a graph of the data over time.

That is what 50 years of stability looks like when it stops being stable. We all understand that the value of “paper assets” is inherently unstable, because that value is subject to very rapid up-and-down swings. So, when paper assets are a relatively small percentage of national wealth (5% or less of GDP), the economy will not be badly damaged if that small percentage fluctuates widely.

But when paper assets rapidly increase to the levels of recent years (20% or more of GDP), well, a bubble that swells ... and then deflates can wreak economic havoc. That scenario is unfolding right now in the real estate market, and among lenders who “spread around the risk” to every corner (and under every rug) in the entire financial system.

The information in this chart is NOT new. It was publicly available when the chart appeared back in January of this year. Alas, instead of seeing the danger for what it was, the media (and Wall Street) threw a party about how great it was to be in a “liquidity boom”.

Link here.


Detective Paul Krugman is on the case once again, this time in taking apart the causes for the destructive boom-and-bust Housing Bubble that is threatening to spill into financial markets in general. After analyzing just what happened, Professor Krugman says that he has found the real culprit: free market ideology. He declares:

So where were the regulators as one of the greatest financial disasters since the Great Depression unfolded? They were blinded by ideology.

This is most interesting, and Krugman goes on to explain his point:

“Fed shrugged as subprime crisis spread,” was the headline on a New York Times report on the failure of regulators to regulate. This may have been a discreet dig at Mr. Greenspan’s history as a disciple of Ayn Rand, the high priestess of unfettered capitalism known for her novel Atlas Shrugged. ...

It’s no wonder, then, that he brushed off warnings about deceptive lending practices, including those of Edward M. Gramlich, a member of the Federal Reserve board. In Mr. Greenspan’s world, predatory lending – like attempts to sell consumers poison toys and tainted seafood – just doesn’t happen. ...

Of course, now that it has all gone bad, people with ties to the financial industry are rethinking their belief in the perfection of free markets. Mr. Greenspan has come out in favor of, yes, a government bailout. “Cash is available,” he says – meaning taxpayer money – “and we should use that in larger amounts, as is necessary, to solve the problems of the stress of this.”

Given the role of conservative ideology in the mortgage disaster, it’s puzzling that Democrats haven’t been more aggressive about making the disaster an issue for the 2008 election. They should be: It’s hard to imagine a more graphic demonstration of what’s wrong with their opponents’ economic beliefs.

Now, it is one thing for a political operative to make statements like that, but quite another for someone who is nominated every year for the Nobel Prize in Economics. Of course, in this situation, I have pointed out before, Krugman long ago abandoned economics for politics, or at least “progressive” politics. Moreover, other than Ron Paul, I really do not see any free market “ideologues” running on the Republican side.

Nonetheless, because so many people are anxious to parrot whatever this “prophet” is declaring, we need to examine his claims closely. So, we ask the simple question: Did ideology create the housing bubble? Krugman offers the following comments as “proof” of his claim:

Apologists for the mortgage industry claim, as Mr. Greenspan does in his new book, that “the benefits of broadened home ownership” justified the risks of unregulated lending.

But homeownership didn’t broaden. The great bulk of dubious subprime lending took place from 2004 to 2006 – yet homeownership rates are already back down to mid-2003 levels. With millions more foreclosures likely, it’s a good bet that homeownership will be lower at the Bush administration’s end than it was at the start.

Meanwhile, during the bubble years, the mortgage industry lured millions of people into borrowing more than they could afford, and simultaneously duped investors into investing vast sums in risky assets wrongly labeled families will end up owing more than their homes are worth, and investors will suffer $400 billion or more in losses.

The keyword here is “unregulated,” as in “the risks of unregulated lending.” Now, I am no player on Wall Street, but I can assure readers that financial markets in the U.S. do not fall into the “unregulated” category. Furthermore, with mortgage lending being backed up by government-created corporations nicknamed Fannie Mae and Freddie Mac, as well as a host of regulations and policies, this hardly falls into the category of “unregulated lending.”

Nonetheless, Krugman has made his claim. To debunk it, however, we first must examine the background of mortgage lending. Contrary to Krugman’s assertions that the mortgage industry suddenly sprang up in a whirl of free market ideology, the modern industry actually has its roots from policies coming from the administration Krugman believes to be the Standard of Presidential Excellence: Franklin D. Roosevelt and his New Deal.

Official government policy was that of promoting home ownership as being “good for society.” To generate money for lending and to set up a net of protection from mortgage failures, the federal government not only de facto created the savings and loan industry (or at least the industry that existed from the 1930s to the early 1980s) and regulated it heavily, but also created corporations that would purchase mortgages in the secondary markets and bundle them into mortgage securities that could be sold in the financial markets in order to raise more cash for more mortgage lending.

This system clearly was not of free market origins, although it did attempt to engage some aspects of market mechanisms. However, market mechanisms are not the same as free markets, since in the mortgage market, government has been manipulating the strings at every turn.

Furthermore, the current crisis was born out of the policies of the Federal Reserve System, which hardly is a free market entity. In the wake of the bursting of the previous stock bubble (which resulted in the recession of 2001, which Krugman claims was caused by cuts in income tax and capital gains rates) as well as the aftermath of the 9-11 attacks, the Fed cut its own interest rates to about 1%, which clearly was not a “free market rate.” It was artificial – and unsustainable.

With interest rates being extremely low and other government agencies aggressively pushing for mortgage lending and refinancing of existing mortgages as being a means to place money in the hands of consumers (and push up consumer spending to give the illusion of prosperity), this was a train wreck waiting to happen, and it did. However, none of this came about because of “free market ideology,” contra Krugman.

In answer to Krugman’s claim that the subprime lending orgy came about because of “unregulated free markets,” I only can scratch my head. Krugman subscribes to a “populist, progressive” public agenda, and at the very heart of that agenda is the belief that consumption should not be based upon individual productivity. To put it another way, individual consumption of goods should not be related to one’s income or one’s ability to create goods in the marketplace. What happened during the Housing Bubble was completely consistent with Krugman’s “populist” beliefs.

Thus, it is completely inconsistent for Krugman to claim that there was “predatory lending” because individuals who wish to purchase houses or anything else should not be limited by their incomes, in the Progressive viewpoint. Krugman, who constantly is railing against any income “inequality,” cannot turn around and say that regulators should have been keeping people from purchasing houses they could not afford because to do so would have been anathema to so-called Progressives.

Even now, Krugman and his fellow New York Times editorialists are calling for huge bailouts of homeowners who either are facing foreclosures or who are struggling to pay their mortgages. Thus, they believe that consumers should not have to face any consequences for their choices, since they hold that government should be in the business of eradicating any consequences due to the law of scarcity. This is tantamount to believing that government itself can eliminate scarcity, which is utterly foolish.

If free market ideology actually were the order of the day, there would have been no mortgage crisis and no housing bubble. That is because in a free market system, there would have been no central bank “creating” new bank reserves out of thin air and shoving them into the credit markets. A free market would not have created entities like Freddie Mac and Fannie Mae which at best only hide the risks, as opposed to mitigating them. The Law of Scarcity still holds, no matter what people like Krugman want us to believe.

Those “unregulated lenders” against whom Krugman and other “Progressives” rail actually were operating in an arena of government-created “moral hazard”. Lenders did what lenders always do when they know that government is covering their rears: they lend without regard for the real risks they face.

You see, Paul Krugman demands that we believe the following fairy tale: Once upon a time when the financial markets were completely regulated by Wise Men operating in an arena in which they believed in the Great Powers of Government, all was well. However, when that racist Ronald Reagan managed to seize power in 1981, he cast a magic spell upon everyone in the markets in which they no longer came to believe in the Magic of Regulation, but, instead, came to believe that free markets were perfect and government always did wrong, a spell that existed for 25 years.

But now it is “government to the rescue.” Yes, all it takes is the belief – the belief – that government can eliminate the Law of Scarcity, and that wise regulators who believe in government once again can create prosperity and eliminate all poverty.

This is not a caricature of what Krugman has written. Read his columns. He constantly insists that all that is needed for government to work wonders is for people in government to believe, yes, be True Believers in the State.

As for the rest of us, I guess that we simply have become blinded by our own free-market ideologies. Yes, although the Great Depression was given that name for a very good reason, we are to believe that it really was a Golden Age because “income inequality” lessened during that time. We are to believe that FDR’s New Deal ended the depression, and that all it took was for people to Believe in Government.

The collapse of the housing bubble was inevitable, but it was not the result of free market ideology. Instead, the housing bubble was nurtured and pushed by those entities that Progressives have created for more than a century. From the Federal Reserve to Deposit Insurance to government-formed financial entities to expand individual home ownership to the vast sums of money taken in taxes – that will be spent to bail out those who engaged in bad lending practices, lenders and borrowers – we see the fingerprints of the hoary Progressive Agenda at every turn.

Krugman simply is wrong when he claims that everyone in the markets was “blinded by free market ideology.” Instead, people have been blinded by “Progressivism” in which they have been told time and again by people who should know better that government can magically eliminate the Law of Scarcity.

Link here.

Setting the records straight.

Former Sen. George Mitchell’s detailed report about steroids in baseball has now been made public. Baseball can begin the arduous task of rebuilding its image. It may be time for similar measures to be taken in the mortgage industry.

Between the years of 1998-2002, numbers in baseball reached and surpassed historical levels. The incredible boom in the power and longevity of players raised suspicions of doping and cheating and finally prompted a comprehensive and independent investigation. The increase in homeruns during this period was so swift and large that something sinister had to be going on.

The same can now be said for the mortgage lending practices that plagued our economy for the first half of this decade. Interest rates hit basement levels as housing prices skyrocketed between 2002-2005. During this housing bull, mortgage lenders began to realize that they could be cashing in on a large piece of the housing pie. Adjustable rate mortgages were being passed around like “B-12” shots in a locker room. But the lenders were not hiding in the shadows. This was going on right in front of us. Just as we saw marginal players begin to sock 50 homeruns in a season, so too have we seen single mortgage brokers pocket as much as $750,000 in a single year by relaxing their lending practices and preying on uneducated borrowers.

The parallels between the actors in both these scandals are many. Whether it is homeruns or houses, ‘roids or rates, if something seems too good to be true, it probably is.

Link here.

The “unknowns” for solid home equity and healthy mortgages.

I keep hearing economists and industry insiders refer to “the unknowns” of the subprime debacle. When pressed about exactly what they do not know, they usually mutter something about “trying to identify where the bad loans really are,” and “figuring out how much it will all add up to ...”

If you like answers that state the obvious, I am sure that is very satisfying. In the broadest terms, what is not “unknown” is how the subprime debacle puts a very sharp point on the old truism about borrowing and lending: If you borrow $100,00 from the bank and cannot pay, you have a problem (millions of foreclosures). If you borrow $100 billion and cannot pay, the bank has a problem (and the collective problem for banks far exceeds $100 billion).

Now, you may be wondering, “I was neither a borrower nor a lender of subprime mortgages – are there any ‘unknowns’ that I need to know?” The thorny reply is “yes.” Homeowners with solid equity and otherwise healthy mortgages face an unknown that is disturbing indeed, namely a decline in property values. Today, I came across a sobering estimate of how quickly home equity can evaporate.

This chart (courtesy of Calculated Risk) includes data through the end of 2006. The trendline begins on the upper left, to show that U.S. owner-occupied homes with mortgages had an aggregate 36% equity. As price decline percentages increase, across the bottom, the chart line quantifies the losses in aggregate equity. (Keep in mind, equity lending and property value declines in 2007 mean that an up-to-date chart would show greater reductions in aggregate equity.)

Even most conservative estimates today assume at least a 10% reduction in property values before the subprime crisis is “over”. Those estimates have been steadily increasing ever since things went south. Aggregate equity falls to about 28% with this decline.

Link here.

This is the sound of a bubble bursting.

CAPE CORAL, FLORIDA: Two years ago, when Eric Feichthaler was elected mayor of this palm-fringed, middle-class city, he figured on spending a lot of time at ribbon-cuttings. Tens of thousands of people had moved here in recent years, turning musty flatlands into a grid of ranch homes painted in vibrant Sun Belt hues – lime green, apricot and canary yellow. Mr. Feichthaler was keen to build a new high school. He hoped to widen roads and extend the reach of the sewage system, limiting pollution from leaky septic tanks. He wanted to add parks.

Now, most of his visions have shrunk. The real estate frenzy that once filled public coffers with property taxes has over the last two years given way to a devastating bust. Rather than christening new facilities, the mayor finds himself picking through the wreckage of speculative excess and broken dreams.

Last month, the city eliminated 18 building inspector jobs and 20 other positions within its Department of Community Development. They were no longer needed because construction has all but ceased. The city recently hired a landscaping company to cut overgrown lawns surrounding hundreds of abandoned homes. “People are underwater on their houses, and they have just left,” Mr. Feichthaler says.

Waiting, scrimping, taking stock. This is the vernacular of the moment for a nation reckoning with the leftovers of a real estate boom gone sour. From the dense suburbs of northern Virginia to communities arrayed across former farmland in California, these are the days of pullback. With real estate values falling, local governments are cutting services, eliminating staff and shelving projects. Families seemingly disconnected from real estate bust are finding themselves sucked into its orbit, as neighbors lose their homes and the economy absorbs the strains of so much paper wealth wiped out so swiftly.

Southwestern Florida is in the midst of this gathering storm. It was here that housing prices multiplied first and most exuberantly, and here that the deterioration has unfolded most rapidly. As troubles spill from real estate and construction into other areas of life, this region offers what may be a foretaste of the economic pain awaiting other parts of the country.

Cape Coral is in Lee County, across the Caloosahatchee River from Fort Myers. In the county, a tidal wave of foreclosures is turning some neighborhoods into veritable ghost towns. The county school district recently scrapped plans to build seven new schools over the next two years. Real estate agents and construction workers are scrambling for other lines of work, and abandoning the area. As houses are relinquished to red ink and the elements, break-ins are skyrocketing, yet law enforcement is resigned to making do with existing staff.

Florida real estate has long been synonymous with boom and bust, but the recent cycle has packed an unusual intensity. The Internet made it possible for people ensconced in snowy Minnesota to type “cheap waterfront property” into search engines and scroll through hundreds of ads for properties here. Cape Coral beckoned speculators, retirees and snowbirds with thousands of lots, all beyond winter’s reach.

Creative finance lubricated the developing boom, making it easy for buyers to take on more mortgage debt than they could otherwise handle, driving prices skyward. Each upward burst brought more investors – some from as far as California and Europe, real estate agents say. Builders were happy to arrange construction loans, then erect houses in as little as six months. Real estate agents promised to find buyers before the houses were even finished.

By 2004, the median house price in Cape Coral and Fort Myers was $192,100, according to the Florida Association of Realtors – a jump of 70% from $112,300 just four years earlier. In 2005, the median price climbed an additional 45%, to more than $278,000. National home builders poured in, along with construction workers, roofers and electricians. But as a kingdom of real estate materialized, growth ultimately exceeded demand: investors were selling to one another, inflating prices. When the market figured this out in late 2005, it retreated with punishing speed.

“It was as if someone turned off the faucet,” said speculator Joe Carey. “It just came to a screeching halt. When it stopped, people started dumping property.” By October this year, the median house price was down to $239,000, some 14% below the peak.

While speculators may find it easy enough to pack up and move on, they are leaving behind an empire of vacant houses that will not be easily sold. More than 19,000 single-family homes and condos are now listed on the market in Lee County. Fewer than 500 sold in November, meaning that at the current rate it would take three years for the market to absorb all the houses. “Confusion abounds because nobody knows where the bottom is,” says Gerard Marino, a commercial Realtor at the Re/Max Realty Group in Fort Myers. Commercial builders are unloading properties at sharply reduced prices, sometimes even below construction costs, which further adds to the glut.

Throughout Lee County, a sense of desperation has seized the market as speculators try to unload property or lure renters. On many lawns, a fierce battle is under way for the attention of passers-by, with “for rent” signs narrowly edging out “for sale”. In Cape Coral, foreclosure filings in the first 10 months of the year reached 4,874, more than a 4-fold increase over the same period the previous year, according to RealtyTrac, an online provider of foreclosure information.

Elaine Pellegrino and her daughter, Charlene, see no way to avoid joining that list. But not anytime soon. The Pellegrinos have joined a new cohort offered up by the real estate unraveling: They are among those waiting in their own homes for the seemingly inevitable. The courts are so stuffed with foreclosures that they assume they can stay for a while.

As construction and real estate spiral downward, the unemployment rate in Lee County has jumped to 5.3% from 2.8% in the last year. With more than 1/4 of all homes vacant, residential burglaries throughout the county have surged by more than 1/3. “People that might not normally resort to crime see no other option,” says Mike Scott, the county sheriff. “People have to have money to feed their families.”

Darkened homes exert a magnetic pull. “When you have a house that’s vacant, that’s out in the middle of nowhere, that is a place where vagrants, transients, dopers break a back window and come in,” the sheriff adds.

At Grace United Methodist Church in Cape Coral, Pastor Jorge Acevedo normally starts aid drives this time of year for health clinics in places like India and Africa. This year, the church is buying Christmas presents for about 50 children in the congregation, many who are are in families suffering through job losses.

At Selling Paradise Realty, a sign seeks customers with a free list of properties facing foreclosure and “short sales”, meaning the price is less than the owner owes the bank. In late November, more than 2,600 of the 5,500 properties for sale in Cape Coral were short sales, says Bobby Mahan, the firm’s owner and broker. Most people who bought in 2004 and 2005 owe more than they paid, he says. “Greed and speculation created the monster.”

As much as anything, the short sales are responsible for the market logjam. To complete a deal, the lender holding the mortgage must be persuaded to share in the loss and write off some of what is due. “A short sale is a long and arduous process,” Mr. Mahan says. “Battling the banks is horrendous.”

People who were priced out of the earlier boom here could wind up the winners. “We had an affordable-housing crisis,” says Tammy Hall, a Lee County commissioner. “The people who were here for a fast buck are gone. You are going to see normal people go back into that housing.”

When Andrea Drewyor, 24, moved to Cape Coral from Ohio this year to take a teaching job, she found a brand-new two-bedroom waterfront duplex in a gated community with a fitness center, a swimming pool and a Jacuzzi – all for $875 a month in rent.

At night, most of the units around her are dark. The developer can moan. Not Ms. Drewyor. “I like not having a lot of people living here,” she said. “This place is awesome.”

Link here.

Bottom-fishers may find some ways to save the housing market long before politicians do.

As a hedge fund manager, Steven Persky stays in business by doing well by his clients. As a side effect, the Los Angeles financier may also contribute to the solution to the housing crisis. Persky’s firm, Dalton Investments, is raising as much as $1 billion from wealthy individuals and institutions to buy delinquent mortgages in troubled markets like Phoenix, Las Vegas and southern California. Persky figures he can pick up the distressed paper for 50 cents on the dollar.

And then what? Is he going to put defaulting homeowners out on the sidewalk? That is not his plan. He says he is going to cut deals with them to stay put while making smaller payments than they originally contracted to make. The eviction route would make sense only if there were new buyers willing to pay more than the mortgage balance for the house. (A lot more – evictions are expensive affairs.) For the kinds of mortgages Persky is looking at, such buyers are not to be found.

“A lot of defaulted mortgages need to be restructured, but this is a classic distressed investing opportunity,” Persky says. “This market will clear by investors restructuring distressed assets, not by government unilaterally changing credit terms.”

What happens when a junk bond issuer gets into trouble? Do the bondholders put padlocks on the doors and sell the company’s machinery for scrap? Usually not. The creditors are likely to do better keeping the factory running.

Persky concedes that the housing market has a lot more pain ahead. Treasury Secretary Henry Paulson is working on an interest rate freeze with big lenders, and some politicians would go a lot beyond the Paulson plan, with moratoriums on foreclosures. In the meantime, the distressed-debt buyers are out in force. They see the mortgage fiasco as a buying opportunity as good as the one presented by junk bonds in 1990 or busted tech stocks in 2002. In 2006 private equity firms raised $18 billion for investments in distressed debt and special situations, including housing. In the first eight months of 2007 they raised another $23 billion, says Private Equity Intelligence. So far very little of this cash has been put to work. The bottom has not been found in home prices, but it has to exist somewhere. This is what the debt workout business is all about.

Bond giant Pacific Investment Management is raising $2 billion, including $20 million from its own employees, to invest in the Pimco Distressed Mortgage Fund. The firm told prospective clients it expects to earn 15% to 20% annual returns, according to the Fresno County Employees’ Retirement Association.

Goldman Sachs boss Lloyd Blankfein announced last month his firm had raised $1.8 billion to buy distressed securities like shaky mortgage-backed bonds. Fixed-income giant BlackRock is getting together a similar fund. Among private equity shops, billionaire Wilbur Ross and Marathon Asset Management are both investing in distressed subprime mortgages.

Wells Fargo, the nation’s second largest mortgage lender, is now acquiring AAA-rated jumbo mortgages, as the spread they are paying over smaller home loans (suitable for sale to Fannie Mae) quadrupled since July to 1.1 percentage points. “We’re buying with both hands,” says Chairman Richard Kovacevich.

Investment firm Gordon Brothers used its partners’ capital and leverage recently to buy 160 homes at a “significant discount” from their previous book value from a bankrupt home builder. It intends to sell them at auction. “Raw land, condos, single-family homes. To us it’s just a question of the right price for each market,” says managing director Gary Prager.

In September Morgan Stanley Real Estate set up a joint venture with Lennar Corp. that paid $525 million for 11,000 residential lots previously valued at $1.3 billion on Lennar’s books. The deal gives Lennar a 20% stake in the new venture and rights to buy back some of the properties. There is a market-clearing price for anything.

Jeffrey Gault used to run KB Homes’ urban development unit. He says he could spend his days playing golf. But with the opportunities he sees, he is out raising $350 million for LandCap, a new venture that will do deals similar to Morgan Stanley’s. “There’s a lot of competition among smart investors,” he says. “I don’t think government intervention is needed.

Link here.


Imploding market for Wall Street-backed securities not helped by central banks’ liquidity injections.

Last week was not a good week for Wall Street finance. Bear Stearns reported its first loss in its 84 year history. “Market conditions during the company’s fourth quarter continued to be very challenging as the global credit crisis that began in July continued to adversely impact global fixed income markets ... On November 14th, we announced we would take a $1.2 billion write-down on our mortgage securities inventories as a result of continuing deterioration in market conditions through the end of October. During the month of November, market conditions continued to deteriorate, which resulted in additional write-downs – bringing total mortgage related losses to $1.9 billion.”

Yet Bear’s total writedown was rather puny in comparison to Morgan Stanley’s bombshell. “During the fourth quarter, the firm recognized a total of $9.4 billion in mortgage related writedowns as a result of the continued deterioration and lack of liquidity in the market for subprime and other mortgage related securities since August 2007. Of this total, $7.8 billion represents writedowns of the firm’s U.S. subprime trading positions ...”

Morgan Stanley’s CFO: “As you are aware, over the past year our trading group decided to short the subprime market. The traders were short the lowest tranche of the subprime securities with a notional value of approximately $2.0 billion. The traders decided to cover the cost of the negative carry in the short position. To do so they went long approximately $14 billion of the super-senior AAA or BBB subprime securities we refer to as mezzanine. As the credit markets declined dramatically, the implied cumulative losses in the subprime market “ate” (unclear) into the value of the super senior AAA tranche we were notionally long. As a result, not withstanding the short position, the implied losses of the notional long generated a major net loss when the position was marked-to-market. The loss was non-linear with the decline of the relevant ABS index, given the long/short structure of this particular trade.”

Analyst question: “I know everyone is dancing around it, but I guess my question would be to help us understand how this could happen – that you could take this large of a loss? I would imagine that you have position limits and risk limits, as such. It behooves me to think that you guys could have one desk that could lose $8 billion?”

CFO: “Look, let’s be clear. One, this trade was recognized and entered into our accounts. Two, it was entered into our risk management system. It is very simple – it is simple and very painful. So I am not being glib. When these guys stress-lossed (tested) the scenario on putting on this position, they did not envisage in their stress losses that we could have this degree of defaults, right? It is fair to say that our risk management division did not stress those losses as well. It is as simple as that. There was a big fat tail risk that caught us hard, right? That is what happened. Now, with hindsight, can you catch these things? We are not unique being long these positions, right? What is unique is that this was a trade that was put on as a proprietary trade and we have learned a very expensive and, by the way, humbling lesson.”

Morgan Stanley’s stock was up 8% for the week, despite reporting the first loss in its 72 year history. Investors were apparently comforted with the news of a $5 billion equity infusion from the China Investment Corporation (controlled by the Chinese Finance Ministry).

The marketplace should be petrified with the revelation of an $8 billion loss on a single trade that was not “rogue” – nor did it apparently even circumvent risk management processes. Instead, it appears to be a “simple” case of a devastating failure in the models used to structure a highly leveraged “hedged” trade. At the heart of the issue were illiquidity and a collapse in the value of a leveraged position, in a development that is very much systemic in nature. As the CFO stated, the company is “not unique being long these positions.” Morgan Stanley is quite fortunate that they do retain a strong global franchise in what remains a period of extraordinary global credit bubble excess. They still enjoy the capacity to plug part of the hole in their equity base.

The market was rocked Thursday by the revelation of an additional $8 billion “CDO-squared” (CDOs of CDOs) exposure at troubled MBIA. The stock’s 25% pounding confirmed that MBIA has reached the point where there is scant room for error. And while the credit insurers (“financial guarantors”) are (massively) exposed to devastating model failure similar to that which has hammered Morgan Stanley, Bear Stearns, Merrill Lynch and scores of others, they lack the fundamental “franchise value” that would be enticing to investors from China, the Middle East or elsewhere.

The financial guarantors suffer today from a confluence of terminal forces. First of all, current and future credit insurer losses are unknowable. And it is not that loss estimates are difficult to reasonably quantify – it is much more a case of requiring a series of assumptions with respect to the credit cycle, market environment and economic performance on top of a bunch of guesses as to how various interrelated risk exposures will react to myriad possible scenarios. Such an exercise would require sophisticated models based on various other models, when we know full well today that even basic securities valuation modeling has broken down. Moreover, it is likely that prospects for writing profitable new business will be dismal for years to come. The market has lost trust in the insurance. At this point only a massive and highly-complex multi-government-orchestrated industry bailout would avert a collapse.

Morgan Stanley’s CFO claimed that the company was caught hard by “big fat tail risk.” I do not believe it was a case of “tail risk” at all. Devastating illiquidity and market losses were inevitable. Only the timing was unclear. Broker/dealer assets ballooned 140% in just 4 1/2 years, to $3.2 trillion. During this same period, the asset-backed securities market inflated 120% to almost $4.3 trillion. Myriad sophisticated structures, financial guarantees, liquidity agreements, and leveraging strategies were implemented to perpetuate the greatest financial bubble in history. As with all great schemes of leveraged speculation, the minute the music stops collapse ensues. Underlying acute fragility is exposed with the inevitable reversal of speculative and leverage-based market liquidity.

To keep the music playing required increasingly egregious excesses – ever greater quantities of increasingly risky loans, structures and leveraging. The credit insurers came to play a critical role in perpetuating the bubble. They could not resist the allure of easy “profits” insuring Wall Street’s creative “structured credit products”, while at the same time aggressively expanding their traditional guarantee business at the top of a historic credit cycle. The credit insurers destroyed themselves.

December 21 – Bloomberg (Darrell Preston): “State and local borrowers are discovering that buying municipal bond insurance from MBIA Inc. and Ambac Financial Group Inc. is a waste of money ... Wisconsin, California, New York City and about 300 other municipal issuers sold bonds without buying insurance in recent weeks, avoiding premiums that are as high as half a percentage point of the bond issue ...”

Wednesday S&P downgraded ACA Financial Guarantee from A to CCC. The insurance on about $69 billion of “structured credit products” is now essentially worthless, including $26 billion or so of CDO guarantees. This is one further blow to the imploding CDO marketplace and a potential tipping point for credit insurance more generally. To this point, the market has been content to assume that the larger financial guarantors were “too big to fail” – which implies too important in the marketplace to have their debt downgraded. But Fitch placed Ambac’s ratings on watch for possible downgrade. By the pricing of their credit default swaps, Ambac and MBIA this summer lost their “AAA” stature and are now quickly losing market confidence in their long-term viability.

We expect further significant and imminent weakness in “structured credit products” – certainly in the illiquid markets for CDOs and credit default swaps (CDS). Keep in mind that the economy is only now succumbing to recessionary forces, and we have yet to experience the failure of a major financial institution in the U.S. There will be many, and it is worth noting that Rescap’s CDS prices surged again this week. It is amazing to watch the massive central bank liquidity injections inflate the value of government and quasi-government backed securities, while having minimal impact on the imploding market for Wall Street-backed securities. It is impossible to rectify the damage from the bursting Bubble, and there is today literally trillions of increasingly impaired Wall Street securities overhanging the debt markets.

Link here (scroll down).


On last month’s 12th Forbes cruise for investors, guests got these 2008 stock picks from our expert panel.

Ken Fisher is the founder and CEO of Fisher Investments, which manages $46 billion across 20,000+ private accounts. Fisher said, “Most see a global recession or slowdown in 2008. I don’t, not with strong earnings yields relative to low Treasury yields around the world today. Before others figure out the good news, you’ll want to be in on these economic turnaround stocks: Flextronics International (FLEX) , Manpower (MAN), Allianz (AZ), Cascade (CAE), Union Pacific (UNP).”

Brian Wesbury is the chief economist for First Trust Advisors, which manages $36 billion for private and institutional accounts. Wesbury said, “Our model shows U.S. stocks to be 25% undervalued even when we use a higher 6% yield for the ten-year Treasury bond.” (As this column went to press, the yield was 4.1%.) Wesbury thinks the U.S. and the global economy are in a long boom, fueled by tech-led productivity, easy money and tax competition. He likes chip manufacturers and aerospace parts suppliers: Sigma Designs (SIGM), Nvidia (NVDA), Precision Castparts (PCP), Parker Hannifin (PH), Hasbro (HAS).

Stephen Biggar is the global director of equity research for Standard & Poor’s. He recommended any of the 149 five-star stocks within the 1,550 companies covered by S&P. Pressed to name just five stocks, Biggar offered us this broad midcap mix: Carlisle Companies (CSL), CVS Caremark (CVS), Hologic (HOLX), Manitowoc Company (MTW), Triumph Group (TGI).

Charles Payne is CEO of Wall Street Strategies, a firm that develops stock selection services for professional traders and institutional investors. Payne is a frequent guest market analyst on Fox News and Fox Business News. He shared these picks: Diana Shipping (DSX), MEMC Electronic Materials (WFR), Evergreen Solar (ESLR), VimpelCom (VIP), Guess (GES).

Vahan Janjigian is Vice President and Executive Director of the Forbes Investors Advisory Institute. He is the editor of the Forbes Growth Investor and the Special Situation Survey, investment newsletters that have produced 5-year annualized returns of 15.3% and 26.6%, respectively, according to the independent Hulbert Financial Digest. Janjigian is also the host of MoneyMasters with Vahan Janjigian, an Internet video program available on Forbes.com and iTunes, and is the coauthor and editor of the Forbes Stock Market Course, as well. Although Janjigian is an economic and market bear, he likes these stocks: Johnson & Johnson (JNJ), DRS Technologies (DRS), Rock-Tenn Company, Class A shares (RKT), Trinity Industries (TRN), Avnet (AVT).

Link here.


Weightings with a value twist.

Growing up, Jonathan (Jono) Steinberg, 43, was best known as “Saul’s kid.” Saul Steinberg is the corporate raider who, while Jonathan was in school, made headlines by greenmailing Disney, Quaker State and others. Those aborted takeovers left Saul with a Forbes 400 fortune – and a reputation as a Wall Street extortionist.

For the past 10 years Steinberg has been researching how to break out – by reinventing index funds. His company, WisdomTree, is the vendor of index vehicles that throw out the old way of weighting indexes, via market capitalization, and instead rank stocks by dividends and earnings, which gives the new indexes a value tilt. Thus General Electric, with an $11.6 billion dividend paid out in 2007, gets almost the same weighting as Bank of America, at $10.6 billion. Under the cap system GE gets twice the weighting.

Steinberg’s ETFs mimic all the best characteristics of traditional index funds: rock-bottom expenses, high liquidity and massive diversification. By doing this, Steinberg says, WisdomTree funds will produce better returns with less volatility. Index funds hold $1.1 trillion of investors’ money, thanks to their hard-earned reputation as the benchmark investment that no stock fund can reliably beat. To show the world he could improve on that, Steinberg won over no less than Wharton professor Jeremy Siegel. Four years ago Steinberg called Siegel and told him about research he had done on indexes weighted by dividends paid. Siegel was so intrigued by this idea that he ran tests and, wowed by the results, signed on as an investor, adviser and pitchman.

At the same time, Steinberg enlisted a second key backer – hedge fund honcho Michael Steinhardt. On first meeting the younger Steinberg, Steinhardt admits he “couldn’t help being slightly wary, in light of Saul, [who] was not the most popular guy in town.” Yet, after hearing Jono’s pitch, he commissioned his own back tests and says he was so impressed that he came out of retirement to invest in WisdomTree and become its chairman. Today Steinhardt owns 34.2% of it, Steinberg 3.8% and Siegel 2%.

Here is WisdomTree’ theory: Traditional market-cap indexes reinforce the unwisdom of crowds, forcing index owners to make oversize weightings to glamour stocks, the ones trading at high multiples of their dividends or earnings. By limiting exposure to both bubbles and panics, a value-weighted index can outperform domestic indexes by 1.25% annually, according to the back tests. Overseas, the outperformance will be double or triple that, predicts Siegel.

Siegel says a dividend-weighted model, blending the two types of equity investing – index funds and Warren Buffett-style stock picking that focused on those with solid fundamentals – had always appealed to him. Until Jono, Siegel says, “No one had ever said, ‘Hey, is there something in between that might be better?’”

In the 1970s Goldman Sachs created an index weighted by earnings but dropped it after a few years. To Steinberg that aborted experiment had less to do with the index’s performance and more to do with Goldman’s desire to sell higher-fee investments.

Since mid-2006 WisdomTree has introduced 39 different flavors of spiced-up funds and attracted $4.6 billion in assets. Its biggest funds are international and have outperformed indexes substantially. (Big holdings in Europe: HSBC and BP.) The domestic funds have lagged, however, hurt recently by an overabundance of dividend-paying financial stocks, which have been hammered by the subprime mortgage implosion. Also, since WisdomTree ETFs have a value flavor, the 2007 ascendance of growth stocks has not helped.

Siegel says that it is going to take decades to develop a record that can validate WisdomTree’s theories, since the prophesied improvements are so small relative to larger market swings. But many investing experts remain thoroughly unconvinced. John Bogle, the father of traditional index funds and founder of Vanguard, has dismissed WisdomTree’s claim to have beaten his brainchild.

Noted finance professor Eugene Fama argues WisdomTree has simply found a way of repackaging the “value premium”, the well-established tendency of value stocks to outperform. Fama also believes in a value focus – he backs Dimensional Fund Advisors, which follows that creed and manages $154 billion in assets – except he thinks a better way to get value is to buy stocks with low price/book ratios.

Since WisdomTree’s ETFs debuted, Steinberg voluntarily stayed in the background, while Siegel and Steinhardt became the firm’s public face, appearing in its ads. “Up until this point he had tried a number of different things, and none of them really worked out,” says Steinhardt. “This is his shot at the golden ring.”

Link here.


Opportunities in beaten-down bank stocks.

Thomas Jefferson once said that banks are more dangerous than standing armies. Certainly with Chairman Alan Greenspan at the helm of the Federal Reserve this was the case. Under his leadership the Fed was instrumental in creating two bubbles. The dot-com bubble of 1995-99 was followed by a grand loosening of credit that resulted in a second bubble, the housing mania of 2001-05. Still, when a bubble implodes there are always good opportunities for folks who have the courage to take risks.

The credit crisis has been devastating to financial stocks. Banks, hedge funds and real estate investment trusts have incurred at least 800 publicly revealed writedowns of debt securities in the past year. Investors are running in fear from securities backed by, or in any way related to, mortgages or high-yield bonds. Both stocks and fixed-income securities have been knocked down to levels that are cheap even with worst-case assumptions about future defaults.

You have to choose carefully here because many finance stocks will not come back for a long time, if ever. Avoid highly leveraged REITs or subprime-heavy institutions like Countrywide Financial. Stay away from smaller banks, too. Their disclosure of problem assets is likely to be slower than that of their larger brethren. Also shun large brokerage houses for a while. They likely have more writeoffs ahead, given their commitments to private equity firms.

The safest plays are among the big banks. Most of this group have taken large reserves against their losses in the various mortgage areas, hoping that the market would reward them for their candor. Wall Street’s response, however, has usually been to punish the reserve-takers with further cuts in their stock prices.

Perhaps investors are spooked by memories of the 1990-91 crisis in the financial sector, when real estate losses were so huge that investors questioned the ability of some commercial banks to survive without additions to their capital bases. At the same time, scores of savings and loans were collapsing from ill-considered forays into junk bond buying and construction lending.

The story is very different today. Losses are towering, yet Tier I capital – the core measure of a bank’s financial strength, chiefly shareholders’ equity – is not threatened, as was true 17 years ago. While most large banks had lousy third quarters, the worst may well be over. Bank of America, Wachovia, Citigroup, KeyCorp and JPM organ Chase are five that should show good appreciation with time. While you wait for a stock market recovery, all pay above-market yields. Bank of America, KeyCorp and Wachovia pay 6% or better.

The following two stocks are more volatile but also provide the prospect of significantly better returns. Washington Mutual (NYSE: WM) has been knocked down 69% from its 12-month high because of larger mortgage writeoffs than have been seen at its peers. Many investors believe more bad news is coming, although the company has released a detailed account of problems, arguing that most are known. The dividend has been cut to 4% but likely will increase again once the current troubles are over. After all the pain, WaMu can still meet capital requirements and ride out the squall. Following stiff charges, the bank should make $1.00 a share this year and 34 cents in 2008, with earnings moving up sharply after that. This is down from 2006’s $3.64, but not a wipeout. It trades at 15 times estimated 2007 earnings.

Freddie Mac (NYSE: FRE)has also been badly hit, dropping to 12-year lows. In the current housing debacle, which may well turn out to be the worst since the Great Depression, investors are frightened that the mortgage giant may be understating losses. Many skeptics question its accounting, given its past bookkeeping scandal, and fear that default rates will rise significantly. Not helping is Freddie’s surprise Q3 loss of $2 billion and its decision to cut the dividend. Federal regulators are making the company raise more capital, an expensive proposition. A panic puts a magnifying lens on risks, making them look much bigger than they are. Prime examples are Freddie and its sister agency, Fannie Mae. Freddie yields 3.1%.

For all my recommendations in this column, I advise acquiring positions gradually. Who knows how close we are to the bottom of this very jumpy market? Still, those who buy bank stocks should be well rewarded over the next couple of years.

Link here.

Top financial sector short-squeeze plays.

The stocks in the financial sector have been the hardest hit during the last couple of months. Many of them have also been heavily shorted. Often a heavily shorted stock proves to be oversold and can spike up especially quickly due to the short-sellers covering their bearish positions on any rise in stock price.

The metric used to examine such a potential short squeeze is the short ratio. Also known as the days-to-cover ratio, this is the number of days it would take the short-sellers to cover their positions based on the stock’s current trading volume. Stockpickr has reviewed the financial sector stocks and extracted those with the highest short ratios and compiled them in a portfolio called the Top Financial Short-Squeezes.

One of the stocks with the highest short ratios is Consolidated Tomoka Land (CTO), a land sales company with a short ratio of 45.1. In its most recent quarterly report in late October, the Florida-based company reported earnings of 37 cents a share, down from 42 cents in the same quarter last year. The stock has a price-to-earnings (P/E) ratio of 44 and pays a small yield of 0.5%. Consolidated Tomoka Land is owned by the Wintergreen Fund, which is run by David Winters and has generated a one-year return of more than 32%. Wintergreen also owns HSBC Holdings (HBC), which has a short ratio of 1.5, Weyerhaeuser (WY), with a short ratio of 3.7, and Reynolds American (RAI), with a 17.7 short ratio.

Another financial stock with a high short ratio is TrustCo Bank Corp. NY (TRST), which has a short ratio of 34.8. TrustCo Bank also reported a drop in earnings when it posted quarterly results in October. The bank holding company earned $10.6 million, or 14 cents a share, down from $11.2 million, or 15 cents a share, in the third quarter a year ago. The stock has a P/E of 19 and a yield of 6.6%.

TrustCo Bank also shows up in the Top Short-Squeeze Bank Stocks, a Stockpickr portfolio that also includes such stocks as First Commonwealth Financial (FCF), with a short ratio of 18.3, F.N.B. Corp (FNB), at an 18.2 short ratio, and First Citizens Banc (FCZA), with a 4.8 short ratio.

Corus Bankshares (CORS) is another stock with a high short ratio, at 32.2. This Chicago-based bank holding company recently completed a 2 million-share repurchase program it launched in April 2004. A new 5 million-share repurchase program was authorized in late October. The stock has a P/E of 4 and a high yield of 9%. Corus is owned by Markel, is an insurance company that is sometimes referred to as a “mini-Berkshire Hathaway”. Markel also owns Fairfax Financial Holdings (FFH), with a 6.5 short ratio, CarMax (KMX), with a 10.5 short ratio, and General Electric (GE), with a short ratio of 1.2.

The list of the top financial sector stocks with the highest short ratios, Top Financial Short-Squeezes, is available at Stockpickr.com.

Link here.


Despite what some people might think or say, rules and guidelines are actually quite helpful in life. Just ask a commodities trader. For example, what would a commodities trader think was coming next for the market you see in this chart?

Well, if that commodities trader uses the Elliott Wave Principle, he or she could look at it and give you several answers – including the one that Daily Futures Junctures editor Jeffrey Kennedy gave his readers on December 17 using this very market.

Because the Wave Principle states that the basic pattern is a 5-wave impulse followed by a 3-wave correction – in an UP or DOWN market – Jeffrey knows that this particular market will eventually end its second wave corrective advance and embark on a continued decline in a third wave. But even more helpful, because of the Wave Principle’s guidelines, Jeffrey knows two probable price points where that turn will occur. Corrective waves – such as this wave 2 – most often retrace 0.618% or 0.382% of the motive waves they follow. In this case, the market has already retraced 0.382% of the wave 1 move that began in November.

Now, just because the market has reached the first of the probable turning points does not mean that it will turn down from here. But a significant number of second waves do, in fact, end after retracing 0.382% of the first wave. That is why, “If the November selloff in [this market] has more to go, and I believe it does,” says Jeffrey in the December 17 Daily Futures Junctures, “the current area [this market] is trading is an excellent place for the larger downtrend to resume.”

Who says rules and guidelines are a bad thing?

Link here.


Exchange-traded funds have been on a tear for the past two years as providers went on a land grab to stake a claim in as many unique investment ideas as possible. But some people think there could be a long-overdue shakeout in 2008 as more and more new products compete for investor attention – and an increasingly limited pool of seed capital.

ETFs are baskets of securities that track indices. They trade on an exchange like stocks. So far in 2007, 283 new funds have launched according to Morningstar, an 83% surge over last year, when 155 funds hit the market. And the 155 launches in 2006 were themselves a 75% increase over 2005.

Assets under management are also up more than 40% this year over 2006. But the growth has been concentrated in a relatively small number of large funds. Many of the new funds hitting the market are niche products tracking narrow sectors of the market that have failed to capture investors’ imaginations.

This brought us such innovative – or, depending on your perspective, wacky – funds as the FocusShares ISE-Revere Wal-Mart Supplier Index Fund (WSI), which holds companies that derive a large portion of their revenues from sales to Wal-Mart, and the Claymore/Robb Report Global Luxury Index ETF (ROB), which tracks companies whose primary business is the provision of global luxury goods and services. It would not be shocking to see firms liquidate and close some of their least successful funds.

“A lot of ETF launches we have seen are focused on extremely narrow slices of the market,” says Morningstar analyst Dan Lefkovitz. “The industry seems to be repeating the mistakes of mutual funds during the tech bubble.”

Another dark cloud on the horizon is the decline of specialists, the elite floor traders on the New York and American stock exchanges that make a market in ETFs. Specialists play a key role in providing seed capital to launch ETFs. They also keep ETF share prices in line with the value of their holdings: When demand pushes prices above net asset value, they buy the constituent stocks and create new shares; conversely, when prices fall below NAV, specialists break some up into their constituent stocks and sell the individual securities.

But these firms are becoming less willing to fund start-ups that they believe are unlikely to attract significant assets. They are also less willing to put their capital to work making a market in smaller ETFs. So products that fail to catch on can become illiquid. Some ETFs are moving their primary listings to electronic trading platforms, such as the Nasdaq and the NYSE Arca, but this could also result in fund prices moving out of line with their holdings, as well as bigger bid-ask spreads.

According to IndexUniverse, there were 445 ETFs and exchange-traded notes in registration as of December 18. If all those products came to market next year, the total number of offerings would increase by another 67%.

There are a number of additional narrowly focused products in the pipeline, with names like the IndexIQ Customer Loyalty Leaders, the IndexIQ Effective Worldforce Leaders and the AirShares EU Carbon Allowances ETF. Other funds in the pipeline will offer investors ways to invest in more foreign markets such as Turkey, Israel, Canada and India. Commodities and fixed income will also continue to be growth areas, as will ETFs that offer a way to short stocks, both here and abroad.

But next year’s biggest potential launch would be the first ETFs that are actively managed. PowerShares Capital Management, a unit of Invesco, has registered three and it expects to launch them in the first quarter of 2008. All of the ETFs currently available in the U.S. passively track indices, but if the S.E.C. signs off on actively managed portfolios, it would open up a whole new investment arena.

Link here.


You cannot have missed the profusion of exchange-traded funds the past few years. You can now buy a basket of stocks representing just about any broad index or industry group, and get it in bullish or bearish (short-sale) versions. Bonds and preferred stocks have mostly missed the ETF revolution – until very recently.

Several of the newly minted bond ETFs have me humming the Etta James blues song, “At Last”. Yes, at last, we have bond ETFs that can add diversification, value and maybe a little zing to your portfolio. The largest and most prolific ETF issuers are Barclays Global Investors, State Street Global Advisors, PowerShares and Vanguard. All but Vanguard have recently launched ETFs for municipal bonds, both nationwide and state-specific for New York and California. The one-state funds make sense for the unfortunates who live in either of those tax-grabbing locales.

Expense ratios are low for bond ETFs, between 0.2% and 0.3% of assets per year. Compare that to the average 1.1% for open-end muni mutual funds or 1.2% for closed-ends. As with equity ETFs, the bond ones are traded throughout the day and can be used in short sales. They all track indexes. They rarely trade at noticeable premiums or discounts to their net asset value, a big issue with actively managed closed-end funds.

The Barclays entry, iShares S&P National Municipal Bond (MUB) follows the performance of the Standard & Poor’s Municipal Bond Index, which has minimum maturities of a month. State Street’s SPDR Lehman Municipal Bond (TFI) has the Lehman Brothers Municipal Index, covering those with terms of at least one year. PowerShares Insured National Muni Bond (PZA) uses the Merrill Lynch Insured Municipal Index – as the name implies, consisting solely of insured bonds (the Lehman index, e.g., has only 46% of its bonds insured).

Since these are so new, you might want to wait a quarter or two before diving in. Study their income distribution, bid/ask spreads, trading volumes and total returns. Also check out how well they track their benchmarks. The iShares offering contains 54 munis while the full S&P index has 3,069. Note: Vanguard has yet to be heard from. When this discounter gets around to offering a muni ETF, you can count on a bare-bones expense ratio.

Now for a mea culpa: My one preferred stock recommendation in 2007 could not have been worse if I tried. Countrywide 7% Preferred (CFC B), now $14, was going for $24 when I suggested it in the July 23 issue. Dump it. So rather than try to cherry-pick preferred shares for yield, I would rather go with a financial ETF.

If you want to target the financial sector on the theory that it has seen the worst of its subprime writeoffs, here is an ETF for you. The PowerShares Financial Preferred (PGF) fund tracks the Wachovia Hybrid & Preferred Securities Index, a market-cap-weighted index of straight preferreds from 30 financial companies. At present the ETF yields 6.8% with an annual expense of just 0.7%. Payouts are qualified dividend income, meaning they are federally taxed at a 15% maximum rate (through 2010).

If you buy now, you are getting the benefit of a buyer’s market for bank preferreds. Banks are issuing high-paying preferreds in order to shore up their capital and satisfy regulatory requirements. In November Freddie Mac issued an 8.375% preferred; last January an equivalent Freddie preferred yielded 5.57%. You might want to wait on the PowerShares ETF, though. An upcoming spate of high-yielding preferred issues may depress share prices. There should be good buying opportunities in the first quarter of 2008.

If you are adventurous, try the PowerShares Emerging Markets Sovereign Debt (PCY) ETF, issued in October. Emerging markets are volatile and sometimes unpredictable, but that is where the growth is. The bonds in this basket are sovereign debts, presumably safer than these countries’ corporate bonds. This dollar-denominated ETF tracks the Deutsche Bank Emerging Markets U.S. Dollar Balanced Index. The largest holdings include government debt from South Africa, Uruguay, Ukraine, Peru, Poland and Hungry. The expense ratio is 0.5%, a third the average for open-end emerging markets debt funds.

Link here.


As the mutual-fund world awaits year-end results, many people naturally are watching to see which managers will continue their streaks of consecutive years beating the S&P 500. But that is not the only type of streak people are watching – a more effective tool, many experts say, is to compare each fund to its own benchmark index.

The theory goes that different asset classes can enjoy eras of outperformance, leading to distortions. The S&P 500 is a U.S-centric large-cap company index, so when small stocks, foreign stocks or sectors such as energy or financials perform particularly well, there are a lot of those types of funds that beat the S&P 500.

When funds are compared with their own benchmarks – a small-cap growth-stock fund would, in this case, be measured against a small-cap growth-stock index – it would be easier to measure the true outperformers in a given fund class. Last year, 12 funds could boast 8-year streaks – the longest current active length, going back to 1999 – beating their benchmark indexes; six large-blend funds, five large-growth funds, and one small-growth fund. This year, eight of those 12 funds were ahead of their comparable indexes for the year as of November 30, putting them on track for nine consecutive years of outperformance.

Here is a sneak peek at which funds look likely to retain their membership in this exclusive club, thanks to Morningstar’s Mark Komissarouk, who came up with these results as of November 30 using Morningstar data. Of course, there could be changes before the end of the year, particularly given the high volatility of the past few months.

In the large blend category, five funds are still going strong. Two, Russell LifePoints Equity Growth Strategy and T. Rowe Price Spectrum Growth, are funds that invest in other mutual funds. Three others that invest directly in stocks – American Funds Fundamental Investors, Hartford Capital Appreciation HLS and Target Growth Allocation – also seem, at least for now, to be in position to keep their streaks alive.

Fundamental Investors’ top holdings include Suncor Energy (SU) and Microsoft (MSFT). Hartford Capital Appreciation’s include Google (GOOG) and Companhia Vale Do Rio Doce (RIO). Target Growth Allocation’s include AT&T (T) and Cisco (CSCO). However, it looks as though Cambiar Opportunity will finish under the Russell 1000 benchmark this year.

The large growth category gets a little interesting. Only two funds from the five remaining are in position to stay up: Amana Growth, a fund that complies with the Islamic principles of Sharia, and American Funds New Economy. Amana Growthwts top holdings include Apple (AAPL) and Potash (POT). New Economy’s include Google and Schlumberger (SLB).

Three funds from that group – American Funds Growth Fund of America (a huge fund with more than $200 billion in assets), Fidelity Capital Appreciation and Vanguard Morgan Growth – look to be finishing under the Russell 1000 Growth index this year. But there is a surprise in the category, too. Natixis U.S. Diversified shows up, but it was not there last year. How did that happen? The fund’s investment portfolio changed enough that Morningstar reclassified the fund from “mid-cap growth” to “large-cap growth”. It had not had the streak beating the Russell Midcap Growth index, but had beaten the Russell 1000 Growth metric. Natixis’s top holdings include Intel (INTC) and McDonalds’ (MCD).

Rounding out the list, Turner Emerging Growth is the lone non-large-cap fund with a benchmark-beating streak going back to 1999. It actually fits into the small growth category. The fund’s top holdings include Decker Outdoor (DECK) and Oceaneering International (OII).

No value-oriented funds show up on the streaks list until it gets down to a mere 3-year streak, which itself is owned by only one value fund: Eaton Vance Dividend Builder. That large-cap value fund has beaten the Russell 1000 Value index since 2004. Dividend Builder’s top holdings include AT&T and Constellation Energy (CEG).

Link here.


World’s currencies a bizarre race to the bottom.

On December 19, we learned that the British government’s guarantee to bail out Northern Rock’s creditors is worth a staggering £100 billion. That is £5,000 [$10,000] per British household. This week, the European Central Bank made $500 billion available through money market operations. And only last week, $110 billion of new money was created by central bank loans with artificially low rates and reduced-quality security. This is money creation on an epic scale.

Why is this happening now? Here is my theory: December 31 is a major day on the financial calendar. If you take a sample of bonds, you will find that a disproportionate number of them are due for interest and/or redemption on December 31. Redeeming bonds is very cash intensive, and cash is not freely available in the banking system right now. So it seems likely that some frantic finance directors will be working long hours to find the cash that will enable them to avoid a default next week.

If that is right, the festive season could see the announcement of some nasty shocks. June 30 will not be much fun, either, for the same reasons. The credit crunch is deepening, and will continue doing so until at least next summer.

For those of us who like to take responsibility for ourselves (it is called freedom, by the way), it is getting just a little tiresome that money creation is diluting our savings and making us pay – again – for the excesses of the buy-now-think-later generation. Some of us would prefer to see the government react with a shrug and a sympathetic “bad luck” to the losers in the next financial train wreck. But it is not the mood of the nation. Politicians have begun one of their competitive caring phases, and they are rescuing victims everywhere. Every clapped-out bank, every busted pension scheme, every industrial zombie, and absolutely every government department will be nurtured in the warm embrace of the public purse.

This causes a natural backlash. Issuing new money reduces depositors’ returns, prompting savers to switch to better stores of wealth. This capital flight should be easy to spot, but modern economic statistics can obscure it. You see, the main way economists measure economic health is by counting the money spent in the economy, and now that savers are dumping currency (and buying better wealth stores), the effect is tough to distinguish from the economist’s beloved GDP growth. Our healthy GDP figures are a distortion, and the economy is not making a steady booming noise, but an ominous hissing – the noise of savers abandoning the currency.

You can see this at the key entry points to the real economy:

  1. Oil is multiplying in price.
  2. All the grains are multiplying in price.
  3. All the base metals are multiplying in price.
  4. Gold is multiplying in price.
  5. Producer prices are through the roof.

In spite of this, the monetary authorities are racing to issue more money, and economists are clamoring for cuts in interest rates. They are caught ‘twixt the devil and the deep blue sea, because although they could address these serious inflationary indicators, doing so risks the revenge of a giant economic threat – a rout in the housing market. And that would mean depression.

So it looks increasingly likely that low rates are staying, and the hot global investment money, sucked in by Britain’s recent and comparatively high interest rates, is about to quit Britain and send the currency into a tailspin. This produces higher prices for imported goods. At the same time, our public finances are in a serious mess, and the biggest contributor to our service-based economy – London – is the main victim of current turbulence. And please do not ask about the trade figures, because they are just ugly.

It is becoming genuinely possible that people will refuse to hold sterling for more than a fleeting moment. Inflation could turn so severe that the “hyper” prefix is justified.

I know – it is too far-fetched to be believable. Or is it? For 150 years, the values of Western currencies have stayed way above purchasing power parity levels with Asia. Being a developed country is what drove this premium, as money flowed down a one-way street to our advanced economies. These were the only places where sophisticated products could be built or bought.

Today, things are different. You could measure circuit board production in two factories in Indonesia and in Britain and get the output per worker priced in local currency. Multiply both by their conversion rate into U.S. dollars and the British factory seems to have produced 5 to 7 times more U.S. dollar-denominated output. So our GDP looks good, but only through the distorting lens of a Western currency conversion. There is another way to measure that same output: Simply count the circuit boards. Do that and you will see there is no material difference in productivity between a British and an Indonesian worker. Perhaps the root cause of Western currency premium has evaporated, and the anomaly is now that sterling really is 5-7 times overvalued against Asian money.

You could switch to euros. But looking at the EU’s policy, it is creating as much money as the Bank of England. And the U.S. Federal Reserve is doing it too, while all of Asia is battling to hold down its currencies so that its exports can continue apace. It is a bizarre race to the bottom for the world’s currencies. It is time to sidestep the financial consequences of this largesse. What can we savers do?

If you are as bothered as I am, currency should be struck off your Christmas list and replaced with something more reliably rare. I think gold could soon look so highly priced in sterling that many of us will be too frightened to buy it. But it is not there yet, so perhaps buy just a little now, and if it makes you a small profit, it will be easier to buy a little more next month. If that makes you a profit too, allow yourself to build a proper stash. I am not sure we will ever again be able to buy it for much under £400 per ounce.

I have just instructed my bank to transfer all my remaining cash deposits to BullionVault to buy gold, and I look forward to spending 2008 long gold and completely sterling free.

Link here.
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