Wealth International, Limited

Finance Digest for Week of December 31, 2007

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

Note: This is the last W.I.L. Finance Digest that uses the structure and format that has been consistently followed since its inception in January 2004: summaries of articles of the editor’s choosing, with the choice of articles and summaries extracted therefrom ideally speaking for themselves. Starting with the first Finance Digest in 2008, the format will be explicitly that of a blog, with editor comments and quotes from the article(s) under consideration freely interspersed.


Freedom Under Siege: The U.S. Constitution After 200-Plus Years, by Ron Paul, is even more important today than when it first appeared 20 years ago. America today is threatened with a severe economic crisis. The Federal Reserve Board, in an effort to prop up the stock market, has followed for a long time an “easy money” policy. As a result, the dollar’s value has sharply fallen, threatening a key element in American financial world dominance. As if this were not enough, the housing market is in very poor shape. Why are we in such a bad position? Ron Paul has the answer, and knows how we can escape from trouble.

Paul, a close student of Ludwig von Mises and Murray Rothbard, explains clearly and cogently the Austrian theory of the business cycle. In this theory lies the explanation of our present plight. As Mises, F.A. Hayek, and Rothbard have pointed out, an expansion of bank credit that lowers the monetary rate of interest below the natural rate generates an artificial boom. Businesses, responding to the new credit available, lengthen the structure of production. When the credit expansion ceases, the monetary rate of interest rises back in accord with its natural rate. The structure of production contracts. The ensuing liquidation of unsustainable investments is precisely the depression. “With credit injections, the Fed lowers interest rates causing businessmen to invest in new capital equipment. They produce goods that consumers can’t afford, and eventually they find that their plans don’t pan out. This process spreads throughout the economy and creates ever-growing waves of booms and busts.” (p. 116)

If a policy of credit expansion cannot in the long run be successful, why then do governments and central banks continually resort to it? As Paul makes clear, some people do benefit from this policy, however detrimental its overall effects. A “major reason we have a powerful central bank that maintains monopoly control over credit is that those in charge of policy are granted overwhelming political and economic power. The individuals who, behind the scenes, pull the monetary strings are very much aware of the power they have. ... Economic benefits accrue to those knowledgeable about Federal Reserve policy. [Fed Chairman] Paul Volcker once admitted to me, to my surprise before a banking committee hearing, that leaks did occur regarding secret monetary policy.” (pp. 131–32). Of course, banks earn considerable profits on the loans that a fractional reserve banking system makes possible.

Paul presents a detailed account of the genesis of the Federal Reserve System, using Austrian theory as an interpretive guideline. The notorious Jekyll Island Conference is of course a highlight of Paul’s account. He sums up with a devastating quotation from the eminent historian Gabriel Kolko: “The entire banking reform movement, at all crucial stages, was centralized in the hands of a few men who for years were linked, ideologically and personally, with one another. ... the major function, inspiration, and direction of the measure [the Federal Reserve Act] was to serve the banking community in general, and large bankers specifically.” (p.115)

The profits and power that go to the financial elite come at the expense of the general public. The expansionary policy inevitably collapses. Here, Paul perceptively notes, the consequences may extend far beyond the narrowly economic. Sharp economic downturns may generate social unrest. Groups that the public, rightly or wrongly, blames for their financial straits may find themselves at considerable risk. “In periods of significant inflation, the people are not only disturbed by the untrustworthiness of the system, they become angry at certain groups that benefit or appear to benefit from inflation.” (p.127)

How can we be rescued from this morass? Again following Mises and Rothbard, Paul defends a gold standard. Only if money is treated strictly as a commodity, immune from government manipulation, can we avoid the vagaries of the business cycle. “Money, according to Mises, must originate in the market as a useful commodity in order to function properly. The most acceptable liquid commodity always becomes money. The particular commodity has varied from culture to culture, but gold has been overwhelmingly chosen as the favorite with silver a close second.” (p.117) With a gold standard, the government has no opportunity to expand monetary credit, since the supply of money is strictly limited to the stock of gold on hand.

When Paul talks about a gold standard, he means a genuine gold standard. In particular, the pseudo-gold standard favored by the supply-siders – fortunately less influential now than in 1987 – must be rejected. “The supply-siders, as led by Jack Kemp and Arthur Laffer, have advocated a type of gold standard, but in truth it is a pseudo-gold standard. It is actually a gold price rule whereby the Federal Reserve adjusts monetary policy dependent on the gold price.” (p.140)

Paul, the foremost Misesian in politics, aptly brings out the importance of the gold standard for a free society. Lack of economic freedom leads a society to tyranny. Money free of government control is essential to a free economy: “When a society accepts irredeemable fiat money, one can be sure the fundamentals of freedom are being threatened, and it’s only a matter of time before an abusive dictatorship emerges that controls all aspects of our lives if the concept of fiat money is not rejected.” (p.118)

This is no mere theoretical speculation. According to Hayek, inflation, combined with rigid price control, was a principal component of Nazi economic policy: “There is something much worse than an open inflation and I’m [Hayek] afraid that’s what you’re headed for, a continued increase in the quantity of money with government prohibitions against price rises – ‘repressed inflation’ as I like to call it. ... Hitler followed this practice throughout his regime. Despite the colossal monetary expansion, prices remained constant because people were shot if they raised prices.” (p. 119)

Besides his expertise in Austrian economics, Paul has also studied closely the great political philosophers. John Locke emphasized the connection between individual freedom and sound money: “For Locke, the right to possess, use, and to store up money is fundamental. Like the ownership of property, it is not conferred on the individual by society, but rather civil society has been established to protect this right.” (p. 123, quoting S. Herbert Frankel)

Paul assails fiat money with a formidable variety of weapons. Not only is fiat money economically unsound, it is also out of integrity with the Constitution. Where does the Constitution grant the federal government the right to issue paper money unbacked by gold or silver? “Congress is explicitly given power to coin money in Article 1, Section A, but no similar power was given to print fiat money.” (p.100)

Throughout his career in Congress, Ron Paul has trenchantly criticized America’s interventionist foreign policy, assailing it as a gross departure from the wisdom of Washington and Jefferson. In particular, he has resolutely opposed the Bush Administration’s disastrous and immoral Iraq War. If we had a sound monetary system, aggressive wars of this sort would be rendered difficult, if not outright impossible, to undertake. If the government wanted to launch an aggressive war, it would have to obtain the money to do so through tax increases or borrowing. It could not disguise the immense costs by the use of inflation, as it does now.

In his Foreword to Freedom Under Siege, Lew Rockwell aptly remarks: “We have not seen Ron Paul’s like in Washington since the days of the Founding Fathers. ... On the economy, civil liberties, the IRS, foreign policy, the draft, and the Power Elite, he takes the hardcore libertarian position. He is the 20th century’s Thomas Jefferson.” (p. x) Ron Paul’s campaign for President offers us an unprecedented opportunity to promote freedom.

Link here.


In short, a continuation of the unfolding “worst-case-scenario”.

The year was remarkable for the unusual divergences between bursting bubbles and others continuing to inflate. This was the case both domestically and globally. As an example, the U.S. KBW Bank index sank 24.8%, while the NASDAQ 100 surged 19.9%. The AMEX oil index surged 32.8%, while the S&P 500 Homebuilding index collapsed 60%. Globally, major Chinese stock indices about doubled in price, while Japan’s Nikkei 225 fell 11%. In Europe, Britain’s FTSE mustered a 4.1% gain, while Germany’s DAX posted a 22.3% rise.

“Decoupled” Asian bubbles inflated dangerously. The Chinese Shanghai Composite surged 96.7%, inflating 2-year gains to 355%. China’s CSI 300 index, which includes stocks on the Shenzhen Stock Exchange, gained 162% this year. The Shenzhen Composite was up 420% in two years. Hong Kong’s Hang Seng index rose 37.1% this year, with 2-year gains of 81.2%.

Taiwan’s TAIEX index gained 5.7% (up 28.7% in 2 years). South Korea’s KOSPI index gained 32.3% (up 39% in 2 years). Singapore’s Straits Times index advanced 15.4%, increasing 2-year gains to 47.4% (up 156% in 5 years). Thailand’s Bangkok SET index rose 26.2% (2-year gain of 22%). Malaysia’s Kuala Lumpur Composite index rose 32%, with 2-year gains of 61.6%. Indonesia’s Jakarta index surged 52.1%, with 2-year gains of 136% and 5-year gains of 546%. The major Philippine index posted a 21.4% gain (2-year gain 75.2%). The Vietnam Stock Index gained 23.3%, increasing 2-year gains to 202%. India’s Sensex index jumped 46.6%, increasing 2-year gains to 118% and 5-year gains to 495%. The Karachi Stock Exchange 100 rose 47.1% (2-year gain of 56%).

Q4 losses (3.5%) reduced 2007 gains in Australia’s S&P/ASX index to 11.8% (2-year gain 33%). The New Zealand Exchange 50 dipped 0.5%, reducing 2-year gains to 20.7%.

Latin America certainly participated in the Global Bubble Phenomenon. Brazil’s Bovespa index surged 43.7% (2-year gain of 93%). The Mexican Bolsa rose 12.3% (2-year 68%) and Chile’s Select index 13.3% (2-year 56.8%). Argentina’s Merval gained 2.9% (2-year 40%), and Peru’s Lima General index jumped 36.0% (2-year 263%).

While December numbers have yet to be reported, better than 25% year-over-year growth pushed international reserve (central bank) assets to $6.06 trillion. Through September, China’s reserves were up 45% y-o-y to $949 billion. Russian reserves were up 56% this year to $466 billion, with India’s reserves increasing 56% to $264 billion. Brazil’s reserve assets almost doubled to $162 billion. OPEC reserves were up 36% y-o-y to $421 billion. “Sovereign Wealth Fund” was added to financial market vernacular. The dollar drifted further away from reserve currency status.

Despite the significant Q4 U.S. slowdown, 2007 will post only a modest decline from last year’s record total global debt issuance. The global IPO market enjoyed a record year approaching $275 billion. Although 2nd-half deal flow slowed sharply, global M&A activity was still 20% ahead of 2006 (according to Dealogic), led by Asia and the emerging markets.

Gold gained 31.8%, its largest annual gain since the tumultuous year 1979 (when its price doubled) and its 7th straight year of positive returns. Crude oil surged 59%. Heating oil gained 62%, gasoline 54% and natural gas 17%. Despite declining 10% from its recent high, Wheat prices inflated 77% this year. Soybeans prices rose a record 79% this year to the highest level since 1973. After gaining 80% last year, corn climbed another 16% in 2007. Cotton prices rose 20%. The CRB index inflated 16.5% this year, and the more energy-weighted Goldman Sachs Commodities index surged 40.6%. It was the year when the markets came to recognize that significantly higher energy and commodities prices were having only minimal impact on demand.

During 2007, it became clear that the Federal Reserve had lost control of inflationary forces. The year ended with import prices up 11.4% y-o-y, the Producer Price Index up 7.2% y-o-y, and the Consumer Price Index up 4.3% y-o-y. Despite a weakened economy and another year of dollar devaluation (and booming exports!), the U.S. current account deficit remained in the neighborhood of $800 billion. Coupled with huge speculative outflows seeking profits from global inflation, the world was absolutely inundated with dollar liquidity.

It was, as well, a year of shattered myths:

Indeed, the entire bullish notion of contemporary risk modeling, structuring, hedging, and financial guarantees (“credit insurance”) is now in serious jeopardy.

2007 saw the initial bursting of the Great U.S. Credit Bubble. To be sure, the enormous bubble in Wall Street-backed finance abruptly went from runaway boom to astounding bust. Much of the mortgage origination market collapsed spectacularly. 30% annualized broker/dealer balance sheet growth came to an abrupt halt during 2007’s second half. Booming “private-label” MBS issuance ground to an immediate halt. Mortgage credit availability was reduced radically, especially in subprime, “jumbos” and riskier loan categories. The booming asset-backed securities and CDO markets faltered badly. The banking system’s off-balance sheet structured “vehicles” collapsed in illiquidity – another factor forcing the major lending institutions to balloon their balance sheets. The global inter-bank lending market seized up. The hedge fund industry waited anxiously for redemption notices. Counter-party risk became a very serious systemic issue, as did speculative leveraging. The global financial system ends the year on the precipice.

Meantime, U.S. bank credit expanded almost 12% during the year, with commercial and industrial loans ballooning almost 21%. With risk embracement turning to risk aversion, the marketplace called upon the money fund complex to intermediate risk. Money fund assets expanded an unprecedented $729 billion, or 30.6%. And as liquidity disappeared for Wall Street-backed mortgages, Fannie and Freddie’s combined books of business inflated an unprecedented $600 billion (or so). The Federal Home Loan Banking system ballooned its balance sheet by more than $200 billion, in the process becoming lender of last resort to some very troubled financial institutions. Global central bankers engaged in unparalleled concerted marketplace interventions and liquidity injections, sustaining global bubbles in the process.

From the Fed’s Q3 “Flow of Funds”, total (non-financial and financial) U.S. system credit growth expanded at an annualized $4.99 trillion, sustaining the U.S. Bubble Economy but in an unsustainable manner – unsustainable in the quantity and structure of credit and risk intermediation, as well as with the nature of economic (bubble) activity. Financial sector debt expanded at an alarming 15.6% annualized pace, with bank credit, GSE, agency MBS, and money funds all expanding at double-digit rates.

Of late, the Wall Street credit crunch and severe tightening in risky debt markets have instigated recessionary forces. Many housing markets have gone from bad to worse – on the way to much worse. Florida is a mess, while California is an unfolding disaster. Some analysts have begun to recognize that U.S. asset and debt markets have not faced such precarious dynamics since the Great Depression. Meanwhile, collapsing U.S. and international interest-rates fuel myriad global bubbles and inflationary pressures. In short, 2007 has been a continuation of the unfolding “worst-case-scenario”.

Link here.


As 2007 ends, it seems that the financial world shakes every time a company reveals some new exposure to the disastrous world of subprime mortgage lending. But just how different was subprime lending from other lending in the days of easy money that prevailed until this summer? The smug confidence that nothing could go wrong, and that credit quality did not matter, could be seen in the many other markets as well.

That was particularly true in the corporate loan market. Loans were cheap, and anyone worried about losses could buy insurance for almost nothing. It was not an environment that encouraged careful lending.

“The severity of the subprime debacle may be only a prologue to the main act, a tragedy on the grand stage in the corporate credit markets,” Ted Seides, the director of investments at Protégé Partners, a hedge fund of funds, wrote in Economics & Portfolio Strategy. “Over the past decade, the exponential growth of credit derivatives has created unprecedented amounts of financial leverage on corporate credit. Similar to the growth of subprime mortgages, the rapid rise of credit products required ideal economic conditions and disconnected the assessors of risk from those bearing it.”

There are differences, and they may be critical in averting a crisis. To start, there are virtually no defaults in corporate lending now, and even if Moody’s is accurate in its forecast that defaults will quadruple in 2008, the default rate on speculative loans and bonds would still be below the long-term average. That hardly sounds like a crisis. And there is no reason to think that fraud was a big factor in the corporate loan market, as it seems to have been in subprime mortgages.

But the history of junk bonds provides a warning that defaults start to rise a few years after credit gets very easy. By that standard, says Martin Fridson of the research firm FridsonVision, a new wave of defaults is overdue. Already, even without defaults, he says, about 1/10 of high-yield bonds are trading at distress levels – levels that provide yields of at least 10 percentage points more than Treasuries.

If a recession does occur, one can easily foresee a wave of defaults in junk bonds and their bank-loan cousins, leveraged loans. With highly leveraged structures supported by some of those loans, the surprises could be greater. It is sobering to realize that the issuing of leveraged loans set a record in 2007, even though the market contracted sharply late in the year.

If 2007 was the year that many readers – not to mention financial reporters – learned what C.D.O., M.B.S. and SIV stood for, 2008 could be the year of C.D.S. and C.L.O. (For those who came in late, those abbreviations from 2007 are shorthand for collateralized debt obligations, mortgage-backed securities and structured investment vehicles. The new ones are credit default swaps and collateralized loan obligations – a special kind of C.D.O. backed by corporate loans.)

We have learned in the last month that credit insurers took big risks in backing C.D.O.’s and other exotic things. Some are scrambling to raise more capital to stay in business. One, ACA, may well go out of business. But if the credit insurers turn out to have had inadequate reserves, what are we to make of the credit default swap market? Mr. Seides calls it “an insurance market with no loss reserves”q and points out that $45 trillion in such swaps are now outstanding. That is, he notes, almost five times the U.S. national debt.

Many of those swaps cancel each other out – or will if everyone meets their obligations. The big banks say they run balanced books, in which they sell insurance to one customer and buy insurance on the same borrower from another customer. But if some customers cannot pay what they owe, this could be another shock for bank investors. As it is, financial stocks have underperformed other stocks by record amounts this year.

One of the more remarkable facts about the subprime crisis is that total losses to the financial system may be about equal to the amount of subprime loans that were issued. On the face of it, that appears absurd, since many such loans will be paid off, and those that default will not be total losses. But, Mr. Seides said in an interview, “the financial leverage placed on the underlying assets was so high” that the losses multiplied, as the profits did when times were good. “When there is more leverage” and things go wrong, “there are more losses.”

The corporate credit market is vastly larger than the subprime market, and there are plenty of dubious loans outstanding that probably could not be refinanced in the current market. If some of those companies run into problems, defaults could soar and fears about C.L.O.

valuations and C.D.S. defaults could spread long before there are large actual losses on loans.

There are other areas of potential weakness in 2008. Commercial real estate is one area where some see disaster looming. Others worry that some emerging markets could run into big problems because many borrowers there have taken out loans denominated in foreign currency and could be devastated if local currencies lose value.

It was the greatest credit party in history, made possible by a new financial architecture that moved much of the activities out of regulated institutions and into financial instruments that emphasized leverage over safety. The next year may be the one when we learn whether the subprime crisis was a relatively isolated problem in that system, or just the first indication of a systemic crisis.

Link here.


Charity’s experience with losses in a “low risk” fund is probably not atypical.

The Indiana Children’s Wish Fund, which grants wishes to children and teenagers with life-threatening illnesses, got an early Christmas gift nine days ago. Morgan Keegan, a brokerage firm in Memphis, made an undisclosed payment to the charity to settle an arbitration claim. The Wish Fund said it had lost $48,000 in a mutual fund from Morgan Keegan that had invested heavily in dicey mortgage securities.

Coming less than two months after the charity filed its claim, and as a reporter was inquiring about its status, the settlement is a rare consolation for an investor amid all the pain still being generated by the turmoil in the once-bustling mortgage securities market. Before the Wish Fund reached its settlement, its mortgage-related losses meant that nine children’s wishes would go ungranted.

Against the backdrop of all the gigantic numbers defining the subprime debacle, the Wish Fund’s losses look like small potatoes. The crisis has generated almost $100 billion in losses or write-offs at the world’s largest financial institutions, cost a couple of Fortune 100 chief executives their jobs, wiped out billions of dollars in stock market value and hammered the reputations of the nation’s top credit rating agencies. Reports of the devastation that foreclosures are wreaking on borrowers also bring home the effects of this remarkable financial mess.

Still, the Wish Fund’s experience is instructive because so little has emerged about the losses that investors have incurred in these securities, perhaps because few holders have wanted to disclose them. Some investors may still not know how much they have been hurt by the crisis.

As this debacle unfolds, accounts of investor losses in mortgage securities will come to light. And Wall Street’s role as the great enabler – providing capital to aggressive lenders and then selling the questionable securities to investors – will be front and center.

Richard Culley, a blind lawyer in Indianapolis, founded the Wish Fund in 1984. Since then, it has granted 1,800 wishes to children ages 3 to 18. The fund has roughly $1 million in assets and is not affiliated with the national Make-A-Wish Foundation. Local medical centers submit names for potential recipients.

The Wish Fund’s foray into mortgage securities began in June, when Terry Ceaser-Hudson, the executive director, consulted her local banker, Steve Perius, about certificates of deposit coming due in the charity’s account. She said the banker, with whom she had done business for 20 years, suggested that she invest the money in a bond fund offered by Morgan Keegan. The firm is an affiliate of her banker’s employer, Regions Bank. Ms. Ceaser-Hudson’s banker put her in contact with a Morgan Keegan broker to help her make a decision.

“I thought I was making a lateral move from the C.D.’s into this fund”q Ms. Ceaser-Hudson said. “The broker said he would put some thought into this and he had something perfect for the Wish Fund that was extremely safe.”

That broker was Christopher Herrmann, and when Ms. Ceaser-Hudson met him at her banker’s office, she quizzed him about the risks in the Regions Morgan Keegan Select Intermediate Bond fund, which he recommended. “The first thing I said to him when I sat down was, ‘I want to make sure that I understand this: You are telling me that this is as safe as a money market or C.D., because we cannot afford to lose one single penny,’” she recalled. “He said, ‘This has been good for years,’ so I thought, ‘O.K.’”

On June 26, the Wish Fund put almost $223,000 into the Morgan Keegan fund. The charity’s timing could not have been worse. That same week, two Bear Stearns hedge funds, with heavy exposure to mortgages, were collapsing. Turmoil in the mortgage market, which had been percolating since late winter, was about to explode.

At the helm of the Morgan Keegan fund was James C. Kelsoe Jr., a money manager at the brokerage firm’s asset management unit, based in Birmingham, Ala. A longtime bull on mortgage securities, Mr. Kelsoe rode that wave and earned a reputation as a hotshot money manager. As of June 30, he also oversaw six other Morgan Keegan bond funds, which included about $4.5 billion in assets.

One of Mr. Kelsoe’s major suppliers of mortgage securities was John Devaney, 37, a flashy mortgage trader and founder of United Capital Markets, a brokerage firm in Key Biscayne, Florida. During the mortgage boom, Mr. Devaney built up a net worth of $250 million, he told The New York Times in an interview early this year.

However much both men initially prospered from doing business together, some investors who wound up holding Morgan Keegan's mortgage securities were less fortunate — the Wish Fund, for example.

More than two weeks after Ms. Ceaser-Hudson invested in the Morgan Keegan fund, she received her first brokerage statement. She said she was stunned to learn that within days of its initial investment in the bond portfolio, the Wish Fund had lost $5,000. By late September, with the credit markets frozen and the net asset value of the bond fund plummeting, Ms. Ceaser-Hudson ordered the stake to be sold. She received about $174,000, representing a loss of 22% within 90 days.

On November 2, she filed an arbitration case against Morgan Keegan, contending that Mr. Herrmann’s investment recommendation was unsuitable for the Wish Fund and that he had breached his duty to it. The Morgan Keegan fund, which had assets of about $1 billion in March, is down almost 50% this year. It was weighted with risky and illiquid mortgage-related securities.

For several years, Mr. Kelsoe’s embrace of mortgage securities paid off for his clients. His fund was started in March 1999 and generated positive returns each year until 2007. Through the end of 2006, it had an average annual return of about 4.5%, after taxes. Mr. Kelsoe’s love affair with mortgage debt paralleled that of Mr. Devaney, one of those colorful and cocky Wall Street figures who appear during market booms only to sink from sight in the ensuing busts.

Living in a home on the Intracoastal Waterway, Mr. Devaney surrounded himself and his family with Renoirs and Cezannes. Outside floated his 142-foot yacht called Positive Carry, a reference to borrowing money at a lower rate than you receive on your investment. In addition to running United Capital, Mr. Devaney also oversaw United Real Estate Ventures and several hedge funds with roughly $650 million under management as of early this summer. In July, he halted redemptions in the hedge funds as the market swooned for his favorite mortgage securities.

A 2004 profile of Mr. Devaney in U.S. Credit magazine said that he considered Mr. Kelsoe one of his most valued customers. United Capital Markets, the article said, was most often a buyer of bonds from Wall Street and mortgage issuers. The firm had far fewer clients to whom it sold those securities. One of the biggest buyers was Mr. Kelsoe and his mutual funds. “I have found John to be very aggressive in his ability to find interesting trading ideas,” Mr. Kelsoe was quoted as saying of Mr. Devaney in the profile.

Thomas A. Hargett, a lawyer at Maddox Hargett – Caruso in Indianapolis, represented the Wish Fund in its arbitration claim against Morgan Keegan. He declined to discuss the settlement struck by the firm and its former client. But he did say that “at the end of the day, your everyday broker and many investment professionals did not understand the risk associated with these complex derivative mortgage investments.” The independent directors who served on the Regions Morgan Keegan mutual funds’ board also may have misjudged the risk.

Because most of the directors did not own shares in the devastated bond funds, they have not been hurt by their sharp decline. Among the six independent directors, only two owned shares in the funds as of last September.

Now that the Wish Fund’s complaint has been settled, Ms. Ceaser-Hudson can carry on the organization’s work. “What we do try to do is make every single wish a quality wish, no matter what the cost,” Ms. Ceaser-Hudson said. “We try to make it something the family and child will always remember.”

Link here.


Liquidity and credit availability are not the same thing.

The international banking sector is grappling with a grave financial crisis at a time when, paradoxically, there is an abundance of ready cash available, notably from emerging market countries. Big banks since August have slashed the amount of credit they are prepared to offer each other, anxious to avoid lending money to any institution that could be liable to huge losses because of exposure to the crisis in the U.S. housing market.

According to Jean-Francois Robin of the French bank Natixis, “It’s not that there is a lack of liquidity (in the global financial system), it’s that it is not circulating.” If the inter-bank market has seized up, there are in fact funds available. “The world’s money supply is growing at a red-hot pace – 10 to 15 percent a year,” said Jean-Herve Lorenzi of the French research group Cercle des Economistes.

Foreign exchange reserves held by emerging market powerhouses such as China and other big commodity exporters – Russia and members of the OPEC oil cartel, for example – are steadily expanding. In such countries, along with Japan and Norway, sovereign wealth funds have been created to find fruitful investment outlets for the reserves that have built up over the years.

The funds, which are said to total more than $2.8 trillion, have lately come to the rescue of some of the biggest names in global finance. The U.S. investment bank Merrill Lynch is to be recapitalized thanks to a $5.0 billion injection by the Singapore state investment fund Temasek. Morgan Stanley has been reinvigorated by the participation of the China Investment Corporation, also in the amount of $5.0 billion, while another U.S. behemoth, Citigroup, has received a $7.5 billion lifeline from the Abu Dhabi sovereign fund. Swiss banking giant UBS, which has been especially hard hit by the subprime meltdown, raised $11 billion from another Singapore fund.

But sovereign funds are not the only entities sitting on piles of cash. U.S. billionaire investor Warren Buffett announced he was buying a 60% stake in Marmon Holdings Incorporated, an industrial group owned by one of America’s richest families, for $4.5 billion. Buffett’s investment firm, Berkshire Hathaway Incorporated, will acquire the remaining 40% of Marmon over five to six years at a price to be based on the group’s future performance, the two sides said. Marmon, which has been owned by Chicago’s Pritzker family since 1953, is a manufacturing and services group with more than 125 units and whose products range from railroad tank cars to electrical wires and cables.

In addition, said Robin of Natixis, “There is lots more liquidity” held by insurers and pension funds, which manage savings worth hundreds of billions of dollars. “They have taken their capital out of risky assets,” such as stocks and bonds linked to real estate, he said. “And they have lots of money to invest in the coming months, which should help the markets get back on their feet.”

Link here.
Heckuva job, Bernanke! Is the Fed the new FEMA? – link.

Asian, Mideast funds unleash cultural revolution on Wall Street.

State-run investment funds from Asia and the Middle East are unleashing a cultural revolution on Wall Street, buying up big stakes in ailing U.S. banks, but the deals are also raising national security fears. Concerns have spiked in recent weeks as some of America’s top investment banks have sought vast cash infusions to offset multibillion dollar losses triggered by a deep housing slump and a related credit crunch.

President George W. Bush addressed the flurry of such deals during a White House press conference. “I don’t think it’s a problem,” Bush said, as he warned against a protectionist backlash which he said could harm investment flows.

Top U.S. government officials say the deals should not spark undue alarm, but do merit scrutiny. “The most obvious consideration is national security,” Robert Kimmitt, the deputy U.S. Treasury secretary, wrote in the latest edition of Foreign Affairs, a high brow journal published by the Council on Foreign Relations and read by elite policymakers. Kimmitt said national security concerns could arise from the extent of control state-run funds seek to exert over their investments, and in relation to possible intelligence-gathering.

Investments by Singapore, China and the UAE on Wall Street are so far viewed as “passive”, meaning Singapore, Beijing and Abu Dhabi’s rulers will have no control over the management and operations of the U.S. banks. The interagency Committee on Foreign Investments in the United States (CFIUS), which reviews foreign investments, has not blocked any of the deals so far.

Analysts believe more deals are likely, especially as the foreign funds are sitting on huge cash stockpiles. U.S. banks have been forced to seek cash injections because of heavy losses on mortgage investments.

Although the investment tide appears to have turned in favor of foreign funds, the money flows are not all one way. Bank of America said last month that its $3 billion investment in the China Construction Bank in 2005 had surged in value to $19 billion.

Link here.


With credit lines are all maxxed out, consumers will soon be forced to pay with cash.

The subprime mortgage crisis is merely the tip of a very large iceberg. Beneath the surface lies not only a sea of tenuous loans to prime borrowers, but also an assortment of other liabilities backed by auto loans and credit card debit. Now that home equity extractions, “zero percent auto financing” and “zero interest” credit card rollovers are much harder to come by, Americans must do without the credit lifelines that have previously kept them afloat.

Similar to the home buying market, lax lending standards in the automobile marketplace have led to gross distortions that must be painfully corrected. For years standard practice allowed millions of car buyers to trade in old cars (that were worth less then outstanding loans), and roll the balances into new low interest rate loans for new cars. Although these “E-Z” financing terms allowed many over-stretched buyers to stay current on their debts, and vendors to move bloated inventories, they immediately saddled lenders with loans that far exceeded the value of the collateral. Such a situation encourages defaults and is toxic to lenders. Vendor financing (especially with publicly traded companies focused on short-term results) compounded the problem as conflicts of interest encouraged lenders to sweep these problems under the rug.

The same phenomena also occurred with credit cards. For years, low short-term interest rates and low defaults encouraged banks to aggressively seek new customers. The competition became so intense that balance transfer wars enabled debtors to constantly stay one step ahead of default by transferring their balances to new issuers who often permitted low, or zero, interest for up to six months. When the teaser periods expired there was always another card company willing to accept a balance transfer on similarly friendly terms.

For a while at least, this high wire lending act in the auto and credit card sectors was kept aloft by repeated waves of mortgage refis in which extracted home equity was used to consolidate other consumer debts. By turning higher interest rate, non-tax-deductible consumer debt into lower rate, tax deductible mortgage debt, consumers were able to temporarily manage their debts. In addition, since home equity extractions often exceeded the amounts of other debts, the extra cash in homeowner’s pockets temporarily made higher mortgage payments more affordable. Plus with their credit cards paid off, card holders were not only free to run their balances back up again, but their improved credit scores resulted in even more credit card offers.

Because defaults were low, bonds backed by auto loans and credit card debt were rated AAA, allowing Wall Street to easily package the debt for investors. However this is all coming to an end. Lenders, burned by subprime losses are cutting back. The home equity ATM has been shutdown and credit card and auto loan delinquencies are already at record highs. In fact, to make up for losses, credit card companies have been raising their rates, thus compounding the problems for those struggling to pay. Auto lenders will no longer allow potential buyers to roll their negative auto equity into new loans.

It was inevitable that all of this debt would eventually catch up to us. Americans are now so upside down on their auto loans that new car sales will collapse. And when many loans go sour, lien holders will be stuck with substantial losses on repossessed vehicles. As the music finally stops for serial credit card balance transferors, the inability to renew low teaser rates means that fewer borrowers will be able to afford their payments.

As delinquencies continue to rise rating agencies will downgrade bonds backed by auto loans and credit card debt, inflicting subprime type losses on a much wider scale. As defaults increase and losses mount, credit will tighten like a noose around the neck of America’s consumer based economy. Just as subprime homebuyers are being shut out of the housing market, soon Americans will find that their credit is no longer good at car dealerships or department stores. American consumers that want to buy will need to be prepared to pay cash.

The bottom line is that a host of factors that temporarily allowed default risks to be underestimated and credit to be miss-priced have disappeared. As a result, Americans have simply borrowed more money then they can possibly repay. Ratings agencies once again missed the boat by feeding garbage data into computer models and blindly accepting what came out.

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

Link here.


Losses arising from America’s housing recession could triple over the next few years and they represent the greatest threat to growth in the U.S. So said Robert Shiller, Professor of Economics at Yale University and co-founder of the respected S&P Case/Shiller house-price index, who predicted that there was a very real possibility that the U.S. would be plunged into a Japan-style slump, with house prices declining for years.

“American real estate values have already lost around $1 trillion. That could easily increase 3-fold over the next few years. This is a much bigger issue than subprime. We are talking trillions of dollars’ worth of losses,” said Professor Shiller. He said that U.S. futures markets had priced in further declines in house prices in the short term, with contracts on the S&P Shiller index pointing to decreases of up to 14%. “Over the next five years, the futures contracts are pointing to losses of around 35% in some areas, such as Florida, California and Las Vegas. There is a good chance that this housing recession will go on for years.”

Professor Shiller, author of Irrational Exuberance, a phrase later used by Alan Greenspan, continued, “This is a classic bubble scenario. A few years ago house prices got very high, pushed up because of investor expectations. Americans have fuelled the myth that prices would never fall, that values could only go up. People believed the story. Now there is a very real chance of a big recession.”

He pointed out that signs at the beginning of 2007 that had indicated that some states were beginning to experience a recovery in house prices had proved to be false: “States such as Massachusetts had seen some increases at the beginning of the year. Denver also looked like it had a different path. Now all states are falling.”

Until two years ago, each of America’s 50 states had experienced a prolonged housing boom, with properties in some – such as Florida, California, Arizona and Nevada – doubling in price, fuelled by cheap credit and lax lending practices to borrowers who ordinarily would not have been able to secure a mortgage. Two years ago, the northeastern states of America became the first to slide into a recession after 17 successive interest-rate rises between June 2004 and August 2006 hit the property market.

Last week, new numbers from the S&P/Case Shiller index showed that house prices had declined in October at their fastest rate for more than six years, with homes in Miami losing 12% of their value.

Link here.

“House lust” hits home.

Down the block from my home, workmen are finishing a new house. It replaces a bungalow that had measured about 1,500 square feet. The new home has a covered front porch, two fireplaces and a finished basement. It comes in at just under 5,700 square feet. What is it with Americans and their homes?

Everyone knows the direct causes of the present housing collapse: low interest rates, lax mortgage lending, rampant speculation. But the larger force lies in Americans’ devotion to homeownership. It explains why government officials, politicians and journalists (including this one) overlooked abuses in “subprime” lending. The homeownership rate was approaching 70% in 2005, up from 64% in 1990. Great. A good cause shielded bad practices. The same complacency lulled ordinary Americans into paying ever-rising home prices. Something so embedded in the national psyche must be okay.

“House lust” is what Dan McGinn calls it in his book by the same title. McGinn documents – sympathetically, for he dotes on his own home – our housing excesses, starting with supersizing. In Sweden, Britain and Italy, new homes average under 1,000 square feet. By 2005, the average newly built U.S. home measured 2,434 square feet, and there were many that were double, triple or quadruple that. After World War II, the first mass Levittown suburbs offered 750-square-foot homes.

“We are not selling shelter,” says the president of Toll Brothers, a builder of upscale homes. “We’re selling extreme-ego, look-at-me types of homes.” In 2000, Toll Brothers’ most popular home was 3,200 square feet. By 2005, it had grown 50%. These “McMansions” often feature marble floors, sweeping staircases, vaulted ceilings, family rooms, studies, home entertainment centers and more bedrooms than people.

In a nation of abundant land – unlike Europe and Japan – our housing obsession is understandable and desirable up to a point. People who own homes take better care of them. They stabilize neighborhoods. In a world where so much seems uncontrollable, a house seems a refuge of influence and individuality. In a 2004 survey, 74% of would-be home buyers preferred a new home to an existing house. One reason is that a new house often allows buyers to select the latest gadgets and shape the design. The same impulse has driven the remodeling boom, which totaled $180 billion in 2006.

Homes are a common currency of status. As McGinn notes, many jobs in an advanced economy are highly technical and specialized. “I could tell you more about (my job),” a woman informed him at a dinner party, “but you won’t understand it, and it’s not that interesting.” By contrast, a home announces that, whatever the obscurities of your work, you have succeeded. There is a frantic competition to match or exceed friends, co-workers and (yes) parents.

Some house lust is fairly harmless. Several Web sites (zillow.com, realtor.com) provide estimated prices for homes. People can indulge their nosiness about their neighbors’, friends’, co-workers’ or relatives’ finances. They can also fantasize about their next real estate adventure by watching a cable channel (HGTV) devoted to houses, home buying and renovation.

Other effects are less innocuous. Although house prices recently exploded, they have increased only slightly faster than inflation since the 1890s, concluded a study by Yale economist Robert Shiller. The recent sharp run-up may imply years of price declines or meager increases. “Buying a bigger house isn’t an investment,” warned Wall Street Journal columnist Jonathan Clements. It is “a lifestyle choice – and it comes with a brutally large price tag.” Not only are mortgage payments higher, so are costs for utilities, furniture and repairs.

Worse, government subsidizes these supersize homes along with suburban sprawl and, just incidentally, global warming. In 2008, the tax deduction for mortgage interest payments will cost the federal government $89 billion. The savings go heavily to the upper-middle class and the wealthy – the least needy people – and encourage ever-larger homes. Even with energy-saving appliances, those homes are likely to generate more greenhouse gases than their smaller predecessors. As individuals and a society, we have overinvested in housing. We would be better off if more of our savings went into productive investments elsewhere.

Sociologically, the “housing bubble” resembles the preceding “tech bubble”. When people paid astronomical prices for profitless dot-com stocks, they doubtlessly reassured themselves that they were investing in the very essence of America – the pioneering spirit, the ability to harness new technologies. Exorbitant home prices inspired a similar logic. How could anyone go wrong buying into the American dream? It was easy.

Link here.


The Bush administration’s mortgage rescue plan will worsen, not alleviate, the problems in the housing market.

We are suffering from a home value crisis, not simply a credit crisis. If home prices were still rising, defaults would be low, investment returns would be high, borrowers would still be cashing out equity, and lenders would be showering credit on home buyers. Falling prices reverse this dynamic. A recent study by the Federal Reserve Bank of Boston found that most foreclosures result from falling home prices, not from the resetting of mortgage rates.

And if rates are frozen for some subprime mortgages, standards for most new loans will become increasingly strict. Lenders will have to factor in the added risk of having their contracts rewritten when borrowers default. Higher down payments, mortgage rates and required credit scores – along with lower loan-to-income ratios and perhaps the death of adjustable-rate loans altogether – will further push down home prices.

Whether or not their payment levels are frozen, borrowers with loans that are greater than the values of their homes will have few incentives to keep paying their mortgages or to maintain their properties. Why spend more on a home in which they have no equity and which they may lose to foreclosure anyway? Having put nothing down or having extracted equity in previous refinances, most subprime borrowers will lose nothing financially from foreclosure. In some cases the low teaser rates allowed them to pay less than what they might otherwise have paid in rent. The real losses are borne by the lenders.

Proponents suggest that a rate freeze will buttress home prices by keeping foreclosed homes off the market. But that is a stay of execution, not a pardon. Most homes temporarily saved from foreclosure will continue to depreciate as new buyers fail to qualify for loans. Lenders will be on the hook for even more losses than if the foreclosures had taken place sooner.

Everyone seems to agree that a return to traditional lending standards is a good idea, but no one seems willing to accept a return to rational prices as a consequence. While the bubble was inflating, self-serving explanations were offered for why traditional formulas of home valuation no longer applied. As it turns out, the laws are still in effect. These traditional measures, like the relationship between home prices, rents and income, indicate that prices need to fall at least 30% more nationally. The sooner this balance is achieved, the sooner lenders will again commit capital.

Link here.

The most specious business story of 2007.

The winner is “Housing Crunch” (etc.), which heads the list of all the “top business stories” list for 2007.

“Inventories of unsold homes hit the highest level since World War II and some economists predicted the largest drop in home prices since the Great Depression. The mounting defaults triggered sudden downgrades of mortgage-backed securities, which spooked credit markets, causing lenders to snap their wallets shut as banks grew too nervous to lend, even to each other. Federal Reserve moves from its emergency playbook did little to thaw lending.”

Now, that paragraph at least gets its facts right, so why am I making such a big deal about that story being “specious”? Because the “Housing Crunch” story should have been the top story of 2006. All the available evidence one year ago pointed in the direction of what the facts would be at the end of this year.

And that is why the January 2007 issue of the Elliott Wave Financial Forecast began with a Special Section titled, “2007: The Year of Financial Flameout”. That issue also included a shot of the book cover from Flipping Houses for Dummies, duly noting the irony of the book’s recent appearance just as the housing trend was heading south.

Link here.


As Berkshire Hathaway quietly moves into the business of municipal bond insurance, rivals and bond issuers question the outcome.

For Warren Buffett, timing is everything. And with credit markets tightening, prices likely to rise, and longstanding competitors on the ropes, it may be the perfect time for the überinvestor to move into the business of offering bond insurance for cities, states, and government bodies. Buffett, who has long been a big player in insurance with such companies as Geico, sees opportunity in the industry’s tumult, longtime colleague Ajit Jain told BusinessWeek.

“Our hypothesis is that the pricing is going to firm up going forward and we will reach a level we will find attractive,” says Jain, who heads Buffett’s reinsurance business in Stamford, Connecticut. “If that were to happen – and I hope it will happen – then we are in a state of readiness and we would start writing municipal bond insurance.”

Buffett’s Berkshire Hathaway Assurance (BRKB) is moving gingerly but deliberately into the business and will give longstanding players a run for their money. The company is expected to gain a license from New York state insurance authorities by year-end 2007 and, says Jain, will soon afterward seek approval to operate in California, Puerto Rico, Illinois, Texas, Florida, and Massachusetts.

Big players in the business, such as MBIA and Ambac Financial Group, have been struggling amid anxieties about potential defaults on bonds and other debts they guarantee that are backed by subprime mortgages. As a major part of their business, such outfits guarantee the bonds issued by government entities to finance public works such as schools and sewer systems. Even though their risks for government-bond defaults are small, their exposures in other areas are worrying investors and rating agencies and forcing them to seek hefty dollops of capital to preserve their high ratings.

Buffett’s entry as a rival in the business is not helping them. MBIA’s stock dropped some 16% on December December 28, closing under $19 vs. $76 per share early this year. Likewise, Ambac shed nearly 14%, to about $25, after sliding from above $96 early in the year. Such companies are scrambling to find private equity investors or other companies that can provide more than $1 billion each in capital to keep the insurers afloat.

Buffett expects that the bond guarantors will have to charge higher fees after years of pricing their policies too low. “We historically [thought] the pricing in the business did not reflect an adequate return for risk-bearers,” says Jain. “People were not realistic about the loss potential in this business.”

Even though Buffett’s outfit is planning to price its guarantees above the others, the total cost to the municipalities and other bond issuers could wind up lower with his company. Experts in the field say the issuers could save slightly on the terms they offer investors because investors will feel more comfortable with the bonds with an entity as financially strong as Berkshire Hathaway behind them. “Even if you pay a little higher of a fee, you are better off on a net basis,” says John Miller, who heads the municipal investment team at Nuveen Investments, a Chicago firm specializing in municipal bonds.

The gamble for Buffett is that bond issuers may see little reason to seek guarantees on their bonds. Because of the distress the guarantee firms are now suffering, investors are fixing virtually no additional value on guaranteed bonds compared with those without such backing. “They are trading at or near where they would if they were just independently priced, without the insurance,” says Miller.

However, industry observers believe that a special “Buffett premium” would make municipalities eager to seek out his company’s imprimatur. His move into the business is certain to draw interest from issuers and further unsettle rivals.

“I learned a long time ago ... do not bet against Warren Buffett,” says Donald Light, a senior analyst who tracks the insurance industry for Boston-based Celent, a financial advisory firm, and a shareholder in Berkshire Hathaway.

Link here.


Just how good were the good old days?

These are the glory days of the financial markets. They are bigger, richer and more powerful than they have ever been. Yet it is that very position at the heart of global economic life that makes this year’s credit squeeze a threat. Already, fairly or unfairly, a pantomime cast of predatory lenders, bankrupt bankers and teenage money managers has been lined up to take the blame. There are calls – some justified – for stricter regulation of financial markets. But before writing new rules, we should remember the financial world of 40 years ago, and where liberalization has got us.

Things have come a long way.

In the U.S. 40 years ago, commercial banking and securities trading were strictly separated by the Glass-Steagall Act, and banks were unable to expand across state boundaries. On Wall Street and in the City of London, there were fixed commissions for share trades, and a closed circle of underwriting banks. Home mortgages came from building societies or a savings and loan and there was little competition on interest rates. Banks held a lot of reserves, but before the first Basel agreement on capital adequacy, reserves often bore little relation to a bank’s risk. Exchange rates were fixed under the Bretton Woods regime and the international mobility of capital was restricted.

The liberalization of these restrictions, mainly in the 1970s and 1980s, brought great benefits. The deregulation of financial markets led to a surge of competition and innovation. The cost of trading securities has collapsed. Banks have become bigger – and so in one sense more secure – and brought the techniques of the securities business to bear on banking. As a result of liberalization, financial intermediation is cheaper, and we have a more complete and efficient set of markets.

Whereas 40 years ago many millions of young people may have wanted to borrow against their future income, in order to go to university or to buy a home, they struggled to do so. The liberalization of consumer finance has eased credit constraints on many.

With the free international movement of capital has come a surge in direct and portfolio investment across borders. Not only has capital been allocated more efficiently as a result, but foreign investment has been a channel for the transfer of technology and management skills, and so increased growth. The wave of globalization in recent decades would have traveled more slowly without financial liberalization.

But there has been a cost.

But for all this gain, there is a cost. Any relaxation in controls on banks’ capital and activities makes it easier for them to take risks – and so increase profit – in the knowledge that the state cannot afford to let them fail. There is no simple answer, but a system of bank rescues in which shareholders lose all of their money creates the right incentives. Shareholders walked away from this year’s bailouts of Northern Rock and Germany’s IKB.

Consumer credit liberalization also leads to a trade-off. Subprime mortgages made home ownership possible for hundreds of thousands of people who would otherwise have been tenants. Yet incompetent and fraudulent misuse of subprime mortgages has caused tens of thousands of those people to lose their homes as well as a shock to the financial markets. Regulation should be directed at the misuse and mis-selling of these products and not at the products themselves.

The greatest effect of financial liberalization, however, has been to bind markets more closely together. A shock in the U.S. mortgage market really can affect the availability of credit for a European consumer. To those consumers this is hard to explain, and feels like a threat, yet while the scope for financial shocks is now greater, there is little evidence that they have increased in frequency or in magnitude. Financial regulation, especially on bank liquidity and consumer lending, should be tweaked in response to the credit squeeze. But its liberal direction, which has brought great benefits, must remain.

[Editor: Totally missing in the discussion is that whenever banks are willing to lend against a given class of assets – houses, education, cars, consumer goods, whatever – those assets go up in price. This benefits certain sellers and hurts certain buyers. Invariably it adds to the revenues and profits of the financial sector – which must come from somewhere.]

Link here.


Start with the fact that Starbucks does not have a truly decisive competitive advantage over its local competitors.

The first time Herb Hyman spoke with the rep from Starbucks, in 1991, the life of his small business flashed before his eyes. For three decades, Hyman’s handful of Coffee Bean & Tea Leaf stores had been filling the caffeine needs of Los Angeles locals and the Hollywood elite. But when the word came down that the rising Seattle coffee juggernaut was plotting its raid on Los Angeles, Hyman feared his life’s work would be trampled underfoot. Starbucks even promised as much. “They just flat-out said, ‘If you don’t sell out to us, we are going to surround your stores,’” Hyman recalled. “And lo and behold, that’s what happened – and it was the best thing that ever happened to us.”

Ever since Starbucks blanketed every functioning community in America with its cafes, the one effect of its expansion that has steamed people the most has been the widely assumed dying-off of mom and pop coffeehouses. Our cities once overflowed with charming independent coffee shops, the popular thinking goes, until the corporate steamroller known as Starbucks came through and crushed them all, perhaps tossing the victims a complimentary Alanis Morrisette CD to ease the psychic pain. How could momma and poppa coffee hope to survive? But Hyman did not misspeak – and neither did the dozens of other coffeehouse owners I have interviewed. Strange as it sounds, the best way to boost sales at your independently owned coffeehouse may just be to have Starbucks move in next-door.

That is certainly how it worked out for Hyman. Soon after declining Starbucks’s buyout offer, Starbucks was opening up next to one of his stores. But instead of panicking, he decided to call his friend Jim Stewart, founder of the Seattle’s Best Coffee chain, to find out what really happens when a Starbucks opens nearby. “You are going to love it,” Stewart reported. “They’ll do all of your marketing for you, and your sales will soar.” The prediction came true: Each new Starbucks store created a local buzz, drawing new converts to the latte-drinking fold. When the lines at Starbucks grew beyond the point of reason, these converts started venturing out – and ... Look! There was another coffeehouse right next-door! Hyman’s new neighbor boosted his sales so much that he decided to turn the tactic around and start targeting Starbucks. “We bought a Chinese restaurant right next to one of their stores and converted it, and by God, it was doing $1 million a year right away,” he said. Hyman is not the only one who has experienced this Starbucks reverse jinx.

Now, lest we get carried away with the happy civic results of Starbucks’s global expansion, I hasten to point out that the company is not exactly thrilled to have this effect on its local competitors’ sales. Starbucks is actually trying to be ruthless in its store placements. It wants those independents out of the way, and it frequently succeeds at displacing them through other means, such as buying a mom and pop’s lease or intimidating them into selling out. Beyond the frothy drinks and the touchy-feely decor, Starbucks runs on considerable competitive fire. As much as independent coffeehouse owners generally enjoy having a Starbucks close at hand, most of them seem to have a story or two of someone from the company trying to undercut them. And occasionally a new Starbucks will hurt a mom and pop – even drive them out of business.

But closures have been the exception, not the rule. In its predatory store placement strategy, Starbucks has been about as lethal a killer as a fluffy bunny rabbit. Business for independently owned coffee shops has been nothing less than exceptional as of late. According to recent figures from the Specialty Coffee Association of America, 57% of the nation’s coffeehouses are still mom and pops. Just over the 5-year period from 2000 to 2005 – long after Starbucks supposedly obliterated indie cafes – the number of mom and pops grew 40%, to nearly 14,000 coffeehouses. (Starbucks, I might add, tripled in size over that same time period. Good times all around.) So much for the sharp decline in locally owned coffee shops. And prepare yourself for some bona fide solid investment advice: The failure rate for new coffeehouses is a mere 10%, according to the market research firm Mintel, which means the vast majority of cafes stay afloat no matter where Starbucks drops its stores. Compare that to the restaurant business, where failure is the norm.

But why is Starbucks amplifying the mom and pops’ business? It is actually pretty simple. In contrast to so-called “downtown killers” like Home Depot or Wal-Mart, Starbucks does not enjoy the kinds of competitive advantages that cut down its local rivals’ sales. Wal-Mart offers lower prices and a wider array of goods than its small-town rivals, so it acts like a black hole on local consumers, sucking in virtually all of their business. Starbucks, on the other hand, is often more expensive than the local coffeehouse, and it offers a very limited menu. You will never see discounts or punch cards at Starbucks, nor will you see unique, localized fare (or, let’s be honest, fare that does not make your tongue feel like it is dying). A new Starbucks does not prevent customers from visiting independents in the same way Wal-Mart does – especially since coffee addicts need a fix every day, yet they do not always need to hit the same place for it. When Starbucks opens a store next to a mom and pop, it creates a sort of coffee nexus where people can go whenever they think “coffee”. Local consumers might have a formative experience with a Java Chip Frappuccino, but chances are they will branch out to the cheaper, less crowded, and often higher-quality independent cafe later on. So when Starbucks blitzed Omaha with six new stores in 2002, for instance, business at all coffeehouses in town immediately went up as much as 25%.

The key for independent coffeehouse owners who want to thrive with a Starbucks next-door is that they do not try to imitate Starbucks. There is no way to beat Starbucks at being Starbucks. The locally owned cafes that offer their own unique spin on the coffeehouse experience – and, crucially, a quality brew – are the ones that give the Seattle behemoth fits. Serve an appetizing enough cappuccino, and you can even follow Hyman’s lead and take aim at almighty Starbucks, where automated espresso machines now pull consistently middling shots at the touch of a button – no employee craftsmanship required.

After all, if Starbucks can make a profit by putting its stores right across the street from each other, as it so often does, why could a unique, well-run mom and pop not do even better next-door? And given America’s continuing thirst for exorbitantly priced gourmet coffee drinks, there is a lot of cash out there for the taking. As coffee consultant Dan Cox explained, “You can’t do better than a cup of coffee for profit. It’s insanity. A cup of coffee costs 16 cents. Once you add in labor and overhead, you are still charging a 400% markup – not bad! Where else can you do that?” Until Americans decide they need to pay four bucks a pop every morning for a custom-baked, designer-toast experience, probably nowhere.

Link here.


A friend of mine – a forex trader with 13 years of experience – once told me this: “I rarely trade in December. Many traders are off on vacations; others have already made their profits for the year and are sitting tight, refusing to take any risk in the remaining weeks. As a result, the forex markets thin out, making it easier for big players to push the prices around. Trading a trendless market is very difficult, so come December, I scale way back.”

This December has been no exception. The exchange rate between the U.S. dollar and the euro dipped close to $1.43 in mid-December, but on December 28 it stands near $1.47, right where it was at the start of the month. Which means that over the past four weeks, the EUR/USD has covered close to 400 pips in both directions. Talk about volatility.

If you ask me, that is all the more reason to fall back on Elliott wave analysis this time of year. Prices may swing more than normal, but wave patterns in the markets remain intact. Case in point: Our Currency Specialty Service has long believed that the recent dollar rally was a correction – meaning that the buck would give back all the gains. Which it did, but that is just half the story.

The other half is that not even the December 27 assassination news from Pakistan was able to stop the dollar latest slide. Despite the renewed turmoil in a nuclear-armed country in an already unstable part of the world, traders did not buy dollars. They dumped them instead and “bought just about everything else, including the lowly yen,” in the words of the CSS editor, Jim Martens.

“That reaction is interesting,” continues Jim. “The reaction to a sudden and unexpected event typically reveals what investors are really thinking. Historically, in uncertain times the reaction is to buy dollars: the dollar represents stability. But that was not the reaction. This is an example of the general feeling toward the dollar. I think the reaction to sell dollars speaks volumes.”

Recent volatility may well persist into the new year. It is a time for caution. Caution means knowing exactly where your risk is – and few methods show you that as precisely as Elliott wave does.

Link here.


The Japanese public has dubbed 2007 the “Year of Deception”. Expected Japanese GDP growth for the year has been revised down from 2.1% to 1.3% and the stock market has fallen by 10%. I will return to whether the Japanese are right later, but the concept itself appears more generally applicable. There has in recent years been an excessively snake-oil-salesman quality to the policies and promises of politicians, monetary authorities and financial intermediaries.

In the U.S. for example, the country’s economic policymaking since 1995 has involved not just a “Year of Deception” but a decade of it. In examining the record, one is tempted to quote Mary McCarthy’s verdict on Lillian Hellman’s autobiography: “Every word she writes is a lie, including ‘and’ and ‘the.’” Some examples:

In 1996, the Bureau of Labor Statistics adopted “hedonic pricing” by which price statistics were “corrected” for improvements in quality. There were two problems with this. First, it counted quality improvement in the tech sector by raw processing power, which experience has shown to be plain wrong: Functionality of tech equipment rises at best logarithmically with processing power. Second, it did not include the additional costs imposed on consumers by companies as a result of such innovations as automated telephone answering systems, which hugely increase the time and effort expended in conducting necessary consumer transactions. The result of hedonic pricing was to reduce consumer price increases by close to 1% per annum, producing an entirely spurious decline in reported inflation and a corresponding increase in “real” GDP growth.

The second deception chronologically, though in many respects the most important, was Fed Chairman Alan Greenspan’s “recognition” in 1997 that a new era of faster productivity growth had dawned, so higher stock prices and lower interest rates were justified. Part of this “acceleration” was just random fluctuation (much of which was eliminated in later statistical revisions), part was the result of increasing capital intensiveness in the U.S. economy, caused by lower real interest rates and part was the effect of hedonic pricing, which artificially inflated GDP growth, and hence productivity. The reality, when you look at the series over a long term, was that well over 100% of any rise in productivity in the late 1990s can be explained by these factors. The “miracle” was a mirage and lower interest rates and higher stock prices were wholly unjustified, inevitably leading to huge misallocations of capital.

As the bubble intensified, in 1999-2000, the Fed moved to the pretense that it was impossible to know when a bubble was taking place, so monetary authorities could not burst it. One may well in that case ask what is the point of having a monetary authority. An automatic system, whether a “gold standard” or a fixed monetary growth rule, would cause interest rates to rise in a bubble, thus deflating it automatically. Of course a monetary authority can deflate a bubble. It has happened many times. The Greenspan/Bernanke Fed, however, has been a thoroughly political institution that does not want to incur the temporary unpopularity from doing so.

Connected with the last point is the monetary authorities’ obfuscation of the monetary basis, both domestic and international, of their job. From 1993, the Fed abandoned the entirely sound Paul Volcker-era practice of money supply targeting, which had successfully brought inflation down with only moderate pain. Allegedly, in the new world of technology, monetary aggregates were no longer accurate enough to steer policy by. It is no coincidence that immediately after this change, the Fed embarked on its program of reckless expansion of M3, by almost 10% per annum for a decade when nominal GDP was growing at only 5-6%.

The Bundesbank and initially the European Central Bank resisted this laxity, but since Jean-Claude Trichet took over the ECB in November 2003 that too has been printing money supply, in its case M2, as if its Directors were paid by the banknote. Then in March 2006 the Fed compounded this error by the unparalleled arrogance of ceasing to report M3, presumably hoping that by this means its monetary misdeeds would go unnoticed.

In 1999-2000, Wall Street sold dot-com and telecom stocks to investors on the basis of non-existent earnings. They were aided in this by corporate top management, which proceeded to pay itself vast sums by means of stock options, while pretending these had no cost to shareholders. Again, deception.

In the political arena, one may note the “bait and switch” tactic of the George W. Bush administration in foreign policy. Bush came to office promising to pursue a “modest” foreign policy, avoiding expansionist Democrat “nation building”. Needless to say, the 9-11 attacks, similar in kind albeit larger in scale to a myriad terrorist attacks in Europe, were used as an excuse for a U-turn, inaugurating a foreign policy that would have fulfilled Woodrow Wilson’s wildest power fantasies. What is clear is that a single act by a small group of fanatics caused a complete reversal of the program on which Bush had been elected.

On public spending, too, the electorate can reasonably claim to have been sold a false bill of goods. The Republican Congresses elected after 1994 initially pursued an admirably tight fiscal policy. However after Newt Gingrich was replaced as Speaker of the House of Representatives by Dennis Hastert in December 1998, Hastert and Tom DeLay proceeded to go hog-wild at the public trough, using it for innumerable corrupt pork-barrel schemes, to which Bush joined fatuous and counterproductive public spending boondoggles like the “No Child Left Behind Act”. It is little wonder Hastert and DeLay were thrown out in 2006. The electorate reasonably felt that if it wanted wasteful public spending and inventive new social programs, it could get them from the Democrats, traditionally expert in such matters.

After the stock market bubble burst in 2000, the Fed cut interest rates viciously, decimating the income of U.S. savers and thereby causing a savings dearth and a huge balance of payments deficit. The Fed justified this by claiming to see a “deflation” for which there was no evidence whatever, as retail prices continued rising gently, stock prices remained overvalued by historical standards and house prices were soaring. Once again, deception was used to justify a mistaken policy.

In housing, the modern finance market has been built on deception. Instead of assessing a credit risk and making a loan, the modern housing financier merely collects a fee and passes the risk off to some unknown investor, preferably a foreign bank. Needless to say, this has resulted in a substantial percentage of housing loans being entirely fraudulent. It is increasingly becoming clear that a large proportion of modern finance rests on similar deceptions, with asset-backed commercial paper, securitization in general, and much of the derivatives market resting solely on aggressive obfuscation of economic reality in pursuit of fees.

To return to the Fed (no rest for the wicked), its recent activities have rested on two further deceptions. First, it pretends loudly that “core” inflation, stripping out food and energy, is all it needs to worry about. This is economically nonsense, and it knows it to be so. When the economy is overheating, food and energy prices are the first to rise, providing valuable signals of inflation in general. Second, the Fed and the ECB have now decided that the inevitable illiquidity in the interbank market following exposure of the banking system’s defalcations in housing and elsewhere can be cured by cutting interest rates aggressively and pumping $600 billion of taxpayer money into the banking system. Needless to say, such activities do not restore a systemic confidence that has proved itself unjustified. They simply prop up the stock market and cause an increase in inflationary pressure, pushing oil prices up over 30% in four months. Again, it is quite literally a confidence trick, which will be exposed during 2008.

Turning, finally, to Japan, whose people came up with the “year of deception” line, one is puzzled to find where the deception lies. Yes, economic growth in 2007 will be 1.3% compared with the 2.1% projected, but that is a modest difference, caused partly by the fiscal tightening in Japan’s 2007 budget, which was both essential to fiscal stability and in the long run economically beneficial as it reduces the burden of Japan’s excessive government debt.

There is a certain amount of deception in the monetary area. The Bank of Japan has kept its key interest rate at 0.5%, on the pretence that deflation is rampant. In reality, with energy and commodity prices having increased so rapidly, Japan is now suffering significant inflation, so its short term rates are negative in real terms. For the health of the economy, and the income of Japan’s numerous hard-saving retirees, Japan’s short term interest rates should be increased to a more normal 2.5-3% as soon as possible. Nevertheless, it does not appear that the damage done by this mistake has yet been severe, so one can hope it will promptly be corrected.

A third example of alleged “deception” is the loss of 50 million pension records by the Japanese government. However, the responsible minister resigned, as is proper, and Britain shortly thereafter, by losing 25 million social security records of its own, proved that this was not a Japanese problem, but a universal problem of placing excessive reliance on computer systems managed by incompetent government bureaucracies. One can also ask oneself where there is more risk of serious identity theft: In a country with almost no immigration and a well-established domestic criminal class that helpfully identifies itself by means of tattoos, or a country that has completely lost control of its borders, and sold most of the prime real estate in its capital to the Russian mafia.

Naturally, a primary reason the Japanese investor class regards 2007 as a “year of deception"”is that the Tokyo stock market has dropped 10%, the only large market to have done so. However, in a year of a major international financial crisis, in which several medium sized banks have collapsed and $600 billion in emergency funds has been pumped into the interbank market, it may reasonably be questioned why any of the world’s stock markets should have risen. It appears that the Tokyo stock market is currently the only major market in the world that is NOT ruled by deception!

Link here.


Why did a number of equity hedge funds suffer big losses in August 2007 – and what do those losses say about systemic risk?

Last August was a bad month for the hedge-fund industry. According to fund tracker Barclay Hedge Ltd., about 75% of the 2,600 or so hedge funds that reported results for the month showed a loss, of about 1.4% on average. The week of August 6 was particularly cruel to quantitative equity hedge funds. A number of prominent “quants”, managed by the likes of Goldman Sachs and Renaissance Technologies, suffered losses reportedly ranging from 5% to more than 30%.

What happened to the quants? The question forms the title of a recent article by two researchers from the Massachusetts Institute of Technology – Amir E. Khandani, a graduate student, and Andrew W. Lo, a well-known professor of finance at MIT’s Sloan School of Management and founder and chief scientific officer of AlphaSimplex Group, a hedge fund. Like a pair of detectives, working with indirect clues (hedge funds are famously secretive) and an investment simulation, Khandani and Lo set out to discover why the quants lost so much money.

Their conclusions, they stress, must be regarded as speculative, since the people who know what happened – the hedge-fund managers – are not talking. Still, Khandani and Lo’s diagnosis is entirely plausible, and raises disturbing questions about systemic risk in the hedge-fund industry.

Systemic risk here refers to the possibility that huge, correlated losses can rapidly occur among funds, as in a banking panic. Such correlated losses may be triggered by a single event – such as the near-collapse in August 1998 of the hedge fund Long-Term Capital Management (LTCM), which briefly menaced the stability of the global financial system.

Did a similar event spark the hedge-fund losses last August? Khandani and Lo believe so. Sometime on August 7 or 8, they theorize, one or more sizable quantitative equity market-neutral portfolios were suddenly unwound. The liquidation had a significant, if temporary, impact on equity prices. That caused other quants – many of them equity long/short funds, which hold stocks in both long and short positions – to cut their own losses and sell. What Khandani and Lo call the “perfect financial storm” ended on August 10, when the liquidations ceased and returns climbed sharply.

The steep drop and rebound, they note, were consistent with a “liquidity event” such as a portfolio sell-off. To test their theory, Khandani and Lo simulated an equity long/short strategy for the week of August 6, leveraged approximately 8-to-1. Sure enough, a fund using the test strategy would have lost more than 27% of its assets between August 7 and 9, and gained about 24% on August 10.

Link here.


Is the credit market or the equity market telling the truth?

Although maybe it always seems this way, but it sure feels to us as if we are entering 2008 with some of the most pressing issues for the financial markets and real economy we have faced in quite some time. Very important fundamental issues that for now remain very unresolved. Here is a very short list of highlight topics:

These are but four very meaningful issues whose ultimate resolution we believe will importantly shape investment outcomes in the year ahead. Although we could clearly spend well more than an entire discussion on each, we thought we would highlight perhaps one of the most meaningful near term macro issues front and center as we tip toe into 2008. That is the current dichotomy we see between investor behavior in the equity markets and the credit markets. Point blank, despite a multiplicity of global central bankers firing hoped for monetary “fixit” bullets directly into the global investment crowd on almost a continuous basis since last summer, credit markets remain in a good bit of distress. For now, credit markets are essentially voting that the global central banking cavalry will indeed continue charging into the valley of death, but will not be able to return to health the already and still-to-be-financially-wounded with any type of immediacy. Alternatively, with each central banking action, or even mere hint of action, equity markets rally in the pattern of many a yesterday, implicitly conveying to us the message that in the Fed and global central bankers equity investors continue to trust to remedy any and all problems.

So as we stand back and gaze at this all too apparent behavioral dichotomy in the aggregate financial markets, we ask one very simple question. Just which is the so-called truly efficient market here, the credit market or the equity market? Which is properly discounting future economic and financial market outcomes in current price? For the dichotomy in behavioral response strongly suggests that both credit market and equity investors cannot be correct simultaneously. Hopefully by correctly identifying the true misinformed or misguided investment market participants of the moment, we can then better properly position investment structure and manage investment risk as we move into 2008.

So for now, this glaring divergence between credit and equity markets prompts us to continue to point to probably the most important issue of the moment – real Fed and global central banker ability to change the current dynamics of the credit markets, and hence the economy. Non-bank credit creation has been ground zero for macro credit market largesse over the last decade-plus and remains largely the locus of current credit market turmoil. Can Fed and global central bank actions act to repair non-bank financial sector balance sheets and spark credit cycle acceleration anew? Yes or no? In very simple terms, this is the issue of the moment, the issue over which global credit markets seem quite concerned.

The asset-backed security markets have been the primary vehicle by which non-banking sector credit creation has mushroomed, and now that at least a meaningful portion of this mushroom cloud has turned toxic, where to from here? From maybe $250 billion in outstanding asset-backed securities in 1990, we are now looking at a $4.3 trillion market. Quite interesting, and as you see in the chart, current cycle annual rate of change in ABS growth peaked in late 2005. At the exact time the now clear-in-hindsight U.S. residential real estate cycle of a lifetime topped out. Oh well, it is not called the asset-backed securities market just for laughs, right?

This chart will give you a sense for relative magnitude or importance of the asset-backed markets. It delineates the fact that over the last 18 years, the asset-backed market’s girth has grown from roughly 4% of GDP to over 30% today. The asset-backed markets made up roughly 9% of total U.S. financial sector leverage in 1990. That has grown to a 27% level today. Asset-backed markets important to the U.S. economy vis-a-vis the greater expansion of the credit cycle over the last 1 1/2 decades? No, not important, simply crucial.

But thanks to data from the Fed, we can see just how fast “confidence” in asset-backed paper is evaporating. Cutting to the bottom line, the most important point of what you see here is the continued deterioration in asset-backed commercial paper (ABCP) outstanding. Yes, the very same vehicles financing far too many CDO and SIV ventures. Since the peak in ABCP outstanding last summer, it has been a literally uninterrupted 20-week deterioration in ABCP outstanding. Total ABCP outstanding now rests at a level last seen in Q3 2005. Fed discount and Funds rate cuts have done absolutely nothing to stop this contraction. Not a good thing for CDO and SIV collateral values. The further the contraction in ABCP, the more investment risk banks and other sponsors of these vehicles will accept back on their own balances sheets, or be scrambling for alternative financing. Citi announced a few weeks back a returning of $40+ billion of prior off-balance sheet paper right back on balance sheet. If you were wondering why, wonder no more. Likewise, the less availability of ABCP to fund CDO and SIV vehicles on an ongoing basis, the more volatility in assumed asset values of these securities. Simply wonderful for a credit market already knee deep in uncertainty. And coming just at the time audit teams will be descending upon the institutions who only wish they had stopped “dancing” (thank you Charlie Prince) just a bit earlier.

As we stand here today, we have four discount rate cuts and three Fed Funds rate cuts under our collective belts, but in many respects credit market conditions are worse today than before the Fed and global central banking friends began their current monetary easing cycle adventure. The basic credit market problem of the moment is not liquidity per se, it is solvency and ongoing deterioration of collateral values underpinning mountains of in-place leverage originally built on faulty forward collateral value growth assumptions. So will Fed Funds rate cut #4 be the silver bullet to change current credit market circumstances? Or will yet another rate cut ultimately prove as truly ineffective as the last three, heightening in investor perceptions the thought that the Fed is quickly burning through precious monetary ammunition while completely missing the most important target – the credit markets? We are all going to find out in relatively short order.

What is important as we move ahead? U.S. credit spreads – corporate and high yield relative to Treasuries. Treasury swap spreads themselves. LIBOR relative to Fed Funds. But we will leave you with one we would suggest keeping an eye upon for a multiplicity of reasons – the TED spread. In days gone by, this was indeed a very widely quoted and followed relationship, but has fallen by the wayside a bit after the Chicago Merc dropped T-bill futures sometime back (originally a key data point in the calculation). So here is a bastardized version using the spread between 3-month Eurodollar rates and the 3-month T-bill yield. The TED spread is conceptually a measure of credit risk. It is a measure of emotional credit market fear. Academically, the 3-month T-bill is considered the risk free rate and 3-month Eurodollar yields reflect credit risk of corporate borrowers. When this spread is trending higher, it is telling us the credit markets are pricing in heightened systemic credit risk as a very simple message.

The chart only shows 2007 TED spreads, in the interest of brevity. You are going to have to trust us when we tell you that the TED spread in the summer was as high as anything seen since the 1987 equity market “hiccup”, and prior to that one need venture back to the very mean twin recessions of the early 1980’s to find these levels. You get the picture, or can at least imagine it. We are looking at credit market fear.

We have seen the TED spread drop recently, and this is in direct response to the recently announced global central banker TAF (term auction facility). If rate cuts will not do the trick in restoring credit market confidence, then more liquidity will, right? But there is much more than meets the eye here. First, the new TAF allows institutions to borrow below discount window rates, easing a bit of pain as well as perceptual embarrassment. Second, collateral for borrowing under this facility can be accomplished with lesser quality assets than is required in repo land. How nice of the Fed to absorb and ultimately socially redistribute (among taxpayers) increased risk. But lastly, we are convinced this vehicle was aimed at getting LIBOR rates down. Why? As you already know, LIBOR is a key index rate for so much non-banking system floating rate credit created over the last half decade to decade. Just keep in mind how many adjustable rate mortgages resetting in the next 12 months are indexed to LIBOR.

The dichotomy between credit market messages of the moment and the equity markets rallying on the perceived belief that further Fed rate cuts and liquidity largesse are some type of panacea that will make credit market issues simply go away is glaring. It is the credit markets that are the key, not the equity markets. Unless the Fed and global central banking comrades in arms can truly influence what is most certainly continued deterioration in credit markets up to the present, they are truly pushing on a string. Unless the Fed can change the trajectory of spread widening, it is a very good bet that at some point equity investors will wake up to this realization of impotence and begin to price that into equities.

Does that mean the world is about to come to an end for the equity market? Far from it. It means that sector and geographically specific equity exposure, in addition to a well thought out risk management game plan, is key to successful investment outcomes in the year ahead. For our money, we continue to watch and respect the messages of the credit markets. Near term, the equity market may be for show, but the credit markets are for dough.

Without intentionally trying to sound melodramatic, there are no easy answers here. For even if fear in the credit markets can be mitigated to an extent ahead by the Fed and their global central banking brethren, that will surely come with a price tag – further monetary inflation. Moreover, stabilizing the credit markets is one thing, but to return to the domestic and in part global economic expansion party on the back of the secular credit cycle horse that brought us in the first place, meaningful non-banking system credit reacceleration is a must. Hard to imagine that happening when so many credit market “investors” globally (banks, institutions, hedge outfits, municipalities, etc.) have already so badly been burned by so few (U.S. investment banks and rating agencies) who have pocketed so much in fees along the way. Misplaced trust in the credit markets is a funny thing. It is usually only restored with higher rates, not lower.

Link here.
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