Wealth International, Limited (trustprofessionals.com) : Where There’s W.I.L., There’s A Way

W.I.L. Finance Digest for Week of March 31, 2008

This Week’s Entries : This week’s W.I.L. Offshore News Digest is here.

April 1, 2008

It seems virtually every week that we feel compelled to include Doug Nolan's commentary from PrudentBear.com's Credit Bubble Bulletin. He has for years been viewing with skepticism and alarm the insidious growth of what he calls the "leveraged speculating community", to the point where it has left no part of either the financial markets or the real goods and services economy uncontaminated by its touch. Now that the whole scheme is starting to unravel, Nolan is doing his best to track the numerous crosscurrents.

The "end of an era" characterization stems from Nolan's belief that the leveraged speculating community is down for the count, the Fed's persistant and desperate attempts to bail it out notwithstanding. With confidence in the community's members destroyed, and with the true value of the assets held widely in the community in severe question, it is destined to go through a dot-com style bust -- with deadly serious implications for everyone else.

The Fed-orchestrated 1998 rescue of Long-Term Capital Management (and the "leveraged speculating community") proved instrumental in instigating the "golden age" of Wall Street finance. [F]rom the [March 27] Wall Street Journal ... "Ten years after overseeing a hedge-fund collapse that buckled the world's financial markets, John Meriwether again is scrambling to stem losses and keep investors from jumping ship. Mr. Meriwether is best known as a founder of Long-Term Capital Management ..." Meriwether's largest hedge fund -- profitable in each year since its 1999 launch -- is down 28% y-t-d. The fund now surely faces investor redemptions, a problematic "high-water mark" (hedge funds must make up for past losses before they can again collect big performance fees) and a resulting exodus of top talent.

Again this week, we see one of Wall Street's most "elder leveraged speculators" fall into serious trouble. A strategy that had worked so nicely for almost a decade turned unworkable. While sharply reducing the risk profile and degree of leverage from the LTCM days, Meriwether's bond fund was nonetheless leveraged 14.9 to 1 ... As was the case with the Peloton fund and others, the most aggressive use of leverage had navigated to the perceived safest ("money-like") instruments -- "His funds' losing positions have included mortgage securities backed by Fannie Mae and Freddie Mac, trades tied to municipal bonds and triple-A-rated commercial mortgage-backed securities."

Understandably, most fully expect Wall Street to rebound and the leveraged speculating community to emerge from current turmoil as it did following LTCM -- albeit at a more measured pace. Some assume it is merely a case of our policymakers "playing whack a mole" until they find the requisite instrument(s) to successfully beat down the sources of financial instability.

Of course, I view things very differently, instead seeing Meriwether's predicament as emblematic of an End of an Era -- with huge ramifications for both the Financial and Economic Spheres. [I.e., monetary and "real" economies.] I would expect it will be quite some time before the marketplace (investors as well as lenders) grants Mr. Meriwether or similar leveraged strategies another shot at financial genius. Indeed, there is mounting evidence supporting the bursting hedge fund bubble thesis -- from the angle of the quality of underlying assets; from the capacity to leverage; from the ability to retain investors; and from a regulatory perspective. And keep in mind that the historic ballooning in the "leveraged speculating community" has been an absolutely instrumental -- and extraordinarily opaque -- facet of the bubble in Wall Street finance and the overall credit bubble.

I would argue forcefully that the leveraged speculating community for some years now has assumed the key role of unappreciated marginal source of demand for risk assets -- risky debt instruments financing asset inflation, in particular. Over time, Wall Street "alchemy" mastered the process of transforming virtually unlimited risky loans into perceived safe and liquid securities. A sizable -- and growing - chunk of these securities were then purchased on leverage by the rapidly expanding speculator community, in the process fueling an increasingly maladjusted U.S. Bubble Economy. We are now witnessing it all beginning to wind down. End of an Era.

It is today analytically imperative to differentiate the authorities' focus on stabilizing marketplace liquidity from the unfolding bursting of the Wall Street bubble. Our policymakers may be exerting meaningful impact on the former, yet the latter remains largely out of their control -- and certainly thus far impervious to their actions. Especially when it comes to the key marketplace for agency securities, policymaker efforts are directed at sustaining perceived "moneyness" -- through both governmental support (tacit guarantees and Fed liquidity operations) and a renewed bid for mortgages by the GSEs (Fannie, Freddie, and the FHLB). And while such efforts have important ramifications with regard to accommodating the ongoing deleveraging process (and averting credit system implosion), they are at the same time completely inadequate when it comes to generating sufficient new credit to sustain U.S. financial and economic bubbles. "Moneyness" will definitely not be retained in non-agency securitizations, especially as the economy falters.

Debt problems are accelerating and expanding from mortgages to home equity, auto, credit card, student loans, small business finance, munis and corporate credits. At the same time, Wall Street has been significantly tightening lending requirements for the leveraging of all types of debt instruments. While the focus has been on mortgage credit, recent deterioration in other types of loans -- and, importantly, the leveraged holders of large amounts of this debt -- have major consequences for credit availability throughout the Economic Sphere. Housing markets and foreclosures are obviously major issues. Not commonly recognized is the now virtually across the board tightening in credit throughout the securitization markets (consumer, student, muni, corporate, etc.), exerting more expansive headwinds upon the U.S. economy than even the tightening in mortgages (that predominantly impacted transactions and home prices).

February California median home prices declined $20,550 to $409,240. Median prices are now down $67,140 in two months and a stunning $179,730 since August. Prices are down 32% from June's high, and are now even 13% below the level from three years ago. Granted, these median prices are impacted by the dearth of sales at the upper-end. Yet it is clear that the California market is in the midst of an historic crash. The credit standing of Golden State households, businesses, and various governmental agencies now deteriorates virtually by the day. I would argue the explosion over the past three years in "private-label" mortgages, Wall Street balance sheets, hedge fund assets, and California home prices were all part of the same bubble. This bubble inflated largely outside the banking system and outside GSE finance -- and will now prove stubbornly unaffected by policy maneuvers.

Some argue rather forcefully that we are now immersed in "debt deflation". I understand the basic premise, but to examine double-digit growth in bank credit, GSE "books of business" and money fund assets provides a different perspective. To be sure, our credit system continues to provide sufficient credit to finance massive current account deficits. And it is this ongoing outflow of dollar liquidity that stokes both indomitable dollar devaluation and global credit excess. Many contend that inflationary pressures are poised to wane as the U.S. economy weakens. I will suggest that inflation dynamics will prove much more complex and uncooperative. There is further confirmation of this view -- that the bursting of the Wall Street finance bubble will have a significantly greater impact on asset prices than on general consumer pricing pressures.

The analysis gets much more challenging in the commodities markets. The simple view holds that commodities are just another Bubble waiting their turn to burst. This thinking gained greater acceptance last week, with the sharp reversal of prices and unwind of speculative positions. And it goes without saying that major speculative excess has developed throughout the commodities complex ("par for the course"). I am as well sympathetic to the view that liquidations by the leveraged speculating community could lead to some major price instability. Yet it is my sense that there really is much more to the commodities story -- and inflation, more generally -- that is not widely appreciated.

The bursting of the Wall Street finance and U.S. credit bubbles marks an End of an Era. But the start of a deflationary spiral? Importantly, these bursting bubbles are in the process of consummating the demise of the dollar as the world's functioning "reserve currency" and monetary standard. Examining global markets, I note the ongoing strength of currencies in China, Russia, Brazil, and India, for example. Considering mounting financial and economic imbalances in all these economies -- not too mention histories of less than exemplary monetary management -- I can state categorically that these are fundamentally very weak currencies. Today, however, it is all relative to the sickly dollar. In the face of rampant domestic credit growth, these currencies nonetheless attract endless global finance and appreciate.

When it comes to Ending of Eras, I am increasingly fearful that we are falling deeper into a precarious period devoid of a functioning global currency regime necessary to discipline credit excess and restrain mounting inflationary pressures. And as long as dollar liquidity inundates the world economy, domestic credit systems across the globe enjoy the extraordinary capacity to inflate domestic credit and use this new purchasing power for the benefit of their citizens and economies. And, in particular because of their enormous populations, as long as the Chinese and Indian credit systems enjoy the freedom to inflate at will there will remain significant upside pricing pressure for energy, food, and various goods and commodities in limited supply -- hedge fund speculative excess and/or bust notwithstanding

I throw this analysis out as food for thought. I am increasingly of the mind that commodities should be differentiated from U.S. financial assets when it comes to the consequences from the bursting of the Wall Street finance and leveraged speculating community bubbles. Prices will likely remain hyper-volatile but (unbubble-like) well-supported by underlying fundamental factors. Similarly, I believe general inflationary pressures may likely prove more significantly influenced by runaway global credit excesses than by the Wall Street and U.S. asset price busts. If this proves to be the case, perhaps the greater risk is a bursting of the Treasury market bubble. It may take some time, but an enormous supply of government debt is in the offing and -- let's face it -- these instruments will become only less appealing over time. It also begs the question as to the advisability of aggressive Fed rate cuts. They are having little influence on the bursting Wall Street bubbles but possibly huge effects on global inflationary forces. Little wonder the ECB is so hesitant to lower rates.

April 6, 2008

What are the longer term consequences of the Bear Stearns bailout -- a "dressed-up confiscation of the profits of the cautious" -- with presumably more to come? Paul Tustain points out that this socialized insurance against loss -- the Bernanke put? -- creates a moral hazzard. That that unless the system occasionally rewards caution there is no reason ever to be cautious again. Successive socializations of losses result in a plodding "command economy" that has lost its flexibility to adapt and respond.

Now that he is wearing some sort of do-good government hat, even Hank Paulson is not thinking straight. Regulate in New York and finance goes to Toronto. Regulate in London, it goes to Frankfurt or Paris -- and since Toronto, Frankfurt and Paris are run by the same nervous bureaucrat-types, we can reckon soon enough that the entire financial markets will be hosted out of Singapore and Shanghai. There they will accept the risks as well as the rewards, to their very considerable long-term benefit.

You simply cannot enjoy being the financial center of the world but start bleating for government bailout whenever asset prices dip a few percent. As Paulson is demonstrating, the regulatory price for being bailed out is far too high. We must all grow up and take a full measure of punishment. The banks must take theirs.

Let the shareholders and depositors take theirs too. Just like natural organisms, the financial system must have death to evolve into a better form. Of course, this sounds like a callous statement, but it may be the only way to avoid the moral hazard that Paulson is seemingly creating.

Paulson's plan is a dressed-up confiscation of the profits of the cautious, and a transfer of those profits straight back to unreconstructed gamblers in the worst offending banks. This is very unwise. When will they learn their lesson? If reckless behavior is continually bailed out, when will we ever see a reversion to more risk-averse times? Sometimes a sound and safe bet is the correct one.

In these difficult times, profit (or more accurately the avoidance of loss) should be benefiting those who troubled to understand the risks in the system, and avoided them. But Paulson's plan is currency creation, and a devaluation of the good quality assets owned by the cautious. He fails to understand that unless the system occasionally rewards caution there is no reason ever to be cautious again.

Where Goldman Sachs should be duly rewarded for its safer bets, Bear Stearns should be given its due punishment for its uncontrolled risk. If the stock needs to fall all the way to zero, that is how Bear's cookie should have crumbled. Instead, the company has been rescued and placed in the safe, strong arms of JP Morgan. Where is the justice?

The market works better without these rescues. Only by appropriate economic reward to the cautious, when they are right and everyone else is wrong, will caution sit well beside risk-taking in the financial system. The real threat to New York and London's continued dominance of the world's future financial system is government regulation itself.

Mr. Paulson should read F.A. Hayek's classic The Road to Serfdom, and he would understand the inevitable failure of his rescue plans. He would see how these top-down rules remove society's flexibility until one day we all wake up in a paralyzed "command" economy, where nothing can be done without official sanction.

Instead, he has forgotten what a command economy means. He should study the history of communism's economic successes. It will not take him long.

Who pays for the bailout?
April 6, 2008

Under the category of gallows-type humor is this piece by Adrian Ash.

If you are game for a laugh, I would like you -- in reading the following quotes -- to imagine the words "tax-payers' cash" wherever you see the words "government" or "central bank." Better still, imagine they spell out the words "your savings" instead. Here goes ...

About half way through the article, Ash quotes the late, great Charles Kindleberger from his classic Manias, Panics & Crashes: "The authorities feel compelled to intervene. The dominant argument against the view that panics can be cured by being left alone is that they almost never are left alone." That pretty well synopsizes things.

April 6, 2008

If the price of dinner is pinching us, why don’t the CPI numbers acknowledge it?

Everyone knows the reported inflation numbers, as measured by the CPI, of the last few years are grossly understated. The federal government's incentive is known to be to understate inflation numbers to the degree they can get away with it. Lower inflation numbers make it look like the government is doing a better job of "managing the economy". More directly, it saves on government expenditure increases tied to inflation such as Social Security.

One source of downward bias is that the "volatile" food and energy components have been stipped out of the "core" inflation numbers. This does no big harm if the "volatile" components have been fluctuating around a trendless time series. In this case stripping out the volatile components amounts to a crude smoothing device. But if the "volatility" centers around a trend which is increasing faster than the purportedly non-volatile index components, then stripping out the former is flat out fraudulent. There are other smoothing devices that could be used with the volatile components -- using moving averages and the like -- and the government statisticians know these (vastly) superior techniques darn well.

Another source of bias -- downward in practice as well, of course -- is the way the government incorporates quality increases into the inflation index. Everyone who uses a PC is aware of how much more computing power you get for your money over time. (It is amazing testament to what happens when the government keeps its hands off the market.) Let us say you can get 5 times the power for the same price as 10 years ago. Is this the equivalent to 80% deflation in PCs? There is an arcane body of economic theory concerning this question. For example, stepping around some fine points, one might say that if the consumer would have been willing to pay 5 times the price for 5 times the power, but only is charged the same (1 times the) price, then that arguably represents 80% deflation in PCs. But consumers do not value numbers-crunching power. They value the overall user experience. Today's PC does not email, browse, or word process, e.g., appreciably better than its 10 years ago counterpart did. The eye candy is nice but it is not worth 5 times as much (especially when it is slowed down by uber-bloated Windows Vista). Now try getting the government to incorporate that into the statistics.

This article from Fortune goes into a few more details.

A March CNN poll indicates that 91% of the population is concerned about inflation. I would ask a member of the remaining 9% what they are thinking -- and what levels of relative fiscal comfort allow one not to be concerned about inflation -- but I am entirely surrounded by 91-percenters. So how do we account for the discrepancy between the Federal Reserve's recent assurances that inflation is under control and the 91% of the population that is worried it is not?

There are several possibilities: The first is that we are all paranoid. We simply need reassurance from the authorities: Inflation rates are fine, nothing to see here, move along quietly. The second is that the Fed's insistence on focusing on "core" inflation -- a measure that strips energy and food from the consumer price index (CPI) because they are theoretically subject to short-term volatility -- makes inflation seem smaller than it is, or than we feel it to be when our gallon of milk that was 12% cheaper last year gets swiped across the grocery store scanner, beeping ominously like a tiny alarm bell. (While core inflation was just 2.3% in February, the CPI was 4%.) The third and most disconcerting possibility is that the CPI systemically understates inflation, in which case we are paying for it taxwise, and the government is underpaying Social Security recipients. In the words of many a UFO spotter, it is not paranoia if they are really out to get you.

The first possibility is not to be completely discounted. Thanks to financial paranoia, Bear Stearns found itself hemorrhaging cash a few weeks ago, prompting a rare but always terrifying run on the bank and the eventual sale of the firm at a price that led one anonymous observer to tape a $2 bill to the front door of Bear headquarters, a tongue-in-cheek bid for the remaining assets at a competitive rate. And while merely thinking that inflation is going up is unlikely to cause it to do so, there are certainly real-world consequences from misplaced anxieties. ...

But are nine out of ten of us really just paranoid? Or are we just irritated at the Fed's insistence that if we hold still, interest-rate cuts will not hurt a bit, when historical experience tells us the resulting inflation will hurt like hell? If we focus on core inflation, we are told, the underlying trends are not so disturbing. Take energy and food out of the basket of goods used to calculate the CPI, which is what the Fed does when it reports the numbers to Congress, and things do not look so bad. Just look at the spot on the wall, says the Fed, and ignore the giant needle.

It is true that by focusing on core inflation we can detect certain underlying trends that may be masked by the price volatility of some of the goods in the CPI basket. Post-Katrina natural-gas spikes, for instance, would have distorted long-term CPI trends, even though they were event-related outliers. It makes sense to remove such rarities when looking for underlying patterns in the natural-gas market. But does that mean the entire energy category should be removed? ... The fact is, food and energy have been going up for quite a while. At what point does a consistent trend upward stop being "price volatility" and start being a material "trend upward"? And what if some of those trends -- particularly in the energy sector -- are irreversible?

As the usually grim-and-bearish Merrill Lynch economist David Rosenberg noted recently to the firm's clients, we have seen similar sustained increases in food and energy before. In the mid-'70s. Just before the Big Recession. But they are not materially important, says the Fed. Pay no attention.

One of my favorite 91-percenters, Fusion IQ's Barry Ritholtz, puts it amusingly: "If you take everything out of the CPI basket that's going up in price, sure, you have no inflation!" ... But Ritholtz is more concerned about the third scenario, in which the CPI is not accurate in the first place. And the difference between the second and third scenario is the difference between miserable and horrible. People like Ritholtz are thinking of the 1996 Boskin Commission, which was established to determine the accuracy of the CPI. The commission concluded that the CPI overstated inflation by 1.1%, and methodologies were adjusted to reflect that. Critics of the Boskin Commission suggest that the basis upon which the CPI was revised does not account for the way people actually purchase and consume products. The commission pointed to four biases inherent in the way the CPI was determined that supposedly contribute to overstatement -- among them, a bias that does not take into account substitution of one good for another and a bias that fails to take into account increases in quality that are reflected in price increases.

But the Boskin critics note several reasonable exceptions to those biases. The Boskin Commission suggests that when customers substitute one good for another, the CPI should treat those goods equally. If [friend of the writer] Dana orders a hanger steak instead of his beloved filet mignon because the hanger steak is cheaper, Boskin argues that the hanger steak prices should be compared with previous filet mignon prices. It is all beef, right? But critics of the Boskin report point to areas where substitution is so price-driven that consumers are pushed out of the category altogether. What happens when the consumer gives up steak entirely and switches to chicken? (Or to use a scarier example, goes from some health insurance to no health insurance?)

Boskin also says that whatever you are paying in price increases is offset by the additional pleasure you get from better goods. To put it another way, you adjust for improvement in quality over time -- a practice called hedonic pricing. So, for example, energy price increases due to federally mandated environmental measures are offset by how much we all sit around enjoying the cleaner environment. (And there is a lot of sitting, because it is not like we can afford to go anywhere anymore.) But, as critics note, quality increases over time are also a reflection of the fact that increased production typically means lower prices, thanks to economies of scale. This may be a matter of splitting methodological hairs, but if it is not, aggressive estimates put the non-Boskinized actual inflation rate north of 7%. (The We Are All Gonna Die estimate is more like 10%, but let's not push it.)

Lest you worry about your future purchasing power, rest assured that your $600 Bush-administered tax rebate will be in the mail shortly, at which point you may be able to afford filet mignon at the Palm. On the downside, it may cost $600 by the time you get that check.

April 6, 2008

A guest editorialist in the Wall Street Journal has a few questions for the Fed. He almost sounds like Ron Paul, but in reality he is part of the management of a Washington-based money manager.

In recent months we have seen countless proposals introduced in Congress to protect borrowers from so-called predatory lending. [Last] Monday, the Treasury Department announced a major overhaul of federal regulation of the banking and securities industries.

So far the policy debate has centered on predatory lending and lax bank-regulatory supervision. Hillary Clinton and others have gone so far as to say that subprime loans were "designed to fail." While that makes for a tidy political narrative complete with a villain, it is not a very complete picture of what is happening.

With companies like Bear Stearns and Countrywide (and many others) on their knees, it is clear that events have not turned out as their managements intended. Is it possible the root cause of the credit crisis -- which has not been limited to the mortgage market -- lies not just with a few sinister CEOs, but with broader policy mistakes by intelligent and well-intentioned officials at the Federal Reserve?

How intelligent are people who stubbonly stick to well-studied but obsolete theories they know, when both history and common sense clearly indicated that something was amiss?

Mortgage lenders, home builders, real-estate speculators and millions of average people who borrowed too much were caught up in a mania. They were responding to misleading market signals that told them to write more reckless loans, build more houses and borrow as much as the bank would lend them. After all, people who did these things during the boom profited handsomely year after year.

If this all sounds strangely familiar, it is because the same kind of imprudent economic decisions and outright fraud occurred during the stock-market bubble just a few years ago. To be sure, there are many contributing factors to the recent housing and credit bubbles (and to the Nasdaq bubble), but a central ingredient in almost any mania is easy monetary policy.

The housing boom began in earnest when the Fed slashed interest rates in response to the 2001 recession, and kept rates too low for too long. The lower interest rates cut monthly mortgage payments and fueled the first wave of home-price appreciation, which began to take on a life of its own. Artificially low interest rates reduced returns on safer investments like government and corporate bonds, so investors moved funds into riskier assets (like subprime loans) to increase returns. Low interest rates also made it profitable to borrow heavily in order to invest in mortgage-backed securities and other financial assets, and leverage grew at a breathtaking clip.

Furthermore, the Fed's policy of ignoring asset bubbles on the way up but aggressively responding to cushion the blow when they inevitably collapse (widely know in financial markets as the "Greenspan put") caused investors to take on even greater risk. The adverse consequences of this loose monetary policy extend well beyond rising foreclosures and the other visible effects of the housing bust. The Fed's loose monetary policy has hurt the average American. Here is how:

Rolling asset bubbles have depressed wages by spurring unproductive investment, first in the tech and telecom sectors and more recently in housing. This has reduced the funds available for other, more productive investment that could have increased real economic output and raised wages and living standards. Austrian school economists call this "malinvestment," and it is an inevitable byproduct of credit bubbles.

Having the Austrian school -- which mainstream government and academic economists have largely ignored -- mentioned and accurately characterized in the Journal is a noteworthy event.

The stock market and housing bubbles created windfall gains for some (who sold at the right time) and windfall losses for others (who bought at the peak). Many speculated or acted irresponsibly during both bubbles, and have reaped what they sowed. But others were innocent victims of the boom-bust dynamics. For example, young families who bought their first home in Florida or California during the past few years will suffer for years to come the economic consequences of buying at the peak of a historic bubble. (Proposals in Congress to offer temporary tax credits for purchasing homes would create more arbitrary windfall gains for a few at taxpayer expense, while doing little to alter the fundamentals of the housing market.)

The boom-busts have caused massive and unnecessary employment dislocation. Responding to market signals, many workers flocked to the tech and telecom sectors in the late 1990s and the housing-related sectors in recent years, only to earn a pink slip during the bust. Not only does this cause financial and emotional hardship, the waste of human capital hurts the economy overall. A flexible labor force is one of the great strengths of the U.S. economy, but policies that cause unnecessary dislocation are economically destructive.

The Fed's loose monetary policy is causing inflation and reducing the purchasing power of Americans' paychecks. Headline inflation is well above the Fed's target, and the reduced purchasing power is readily seen in the declining value of the dollar, and rising food and energy prices.

This succinct analysis could have come from the pen of Ron Paul. He has basically presented a case for why the Fed should not exist. But do not expect the Journal to go that far.

[On April 3] the Senate Banking Committee will hold a hearing and examine the details of Bear Stearns's rescue by J.P. Morgan. This rescue was brokered by the Fed, which as part of the agreement put $29 billion in taxpayer funds at risk. Fed officials will surely receive some tough questions regarding its role in this agreement, and rightly so. Policy makers ought to question the criteria the Fed used in making its decision.

But members of the Senate Banking Committee ought to ask a broader question: Has the Fed's approach to monetary policy during the last several years served the interests of average Americans?

Has it ever?

Many will no doubt wince at the suggestion of "politicizing" monetary policy. But a sober review of monetary policy is not only sorely needed, it is Congress's responsibility. Federal law has long required the Fed to report to Congress every six months on its conduct of monetary policy. In recent years, a serious discussion of monetary policy has been almost completely absent at these semi-annual hearings, which have devolved into frivolous public relations forums where members of Congress try to get the Fed chairman to endorse their latest tax cut or spending program.

"Serious discussion" has actually been present in ample quality and quantity from Ron Paul. But he got ignored, as might be expected as long as everything is going fine, however much the insiders wanted to marginalize Paul.

... The Fed has a very difficult job. Tight monetary policy risks recession, while loose monetary policy risks inflation and asset bubbles. Some Fed officials may be beginning to reflect on whether the Fed has struck the proper balance, as well as on the larger role monetary policy has played in the current housing and credit debacle. It is time for Congress to do the same.

April 6, 2008

If anyone needs any more evidence that a recession is in the cards, we see that loan delinquency rates have risen to recession-like levels. The rates have risen to levels last seen in 1992, one year after the early 1990s U.S. recession officially ended. Unless we have already seen the worst of it, it looks like delinquency rates should easily exceed those 1992 figures going foward.

Consumers fell behind on car, credit card and home-equity loans at the highest level in 15 years, another sign the U.S. economy is slowing, according to the American Bankers Association's quarterly survey. Payments at least 30 days past due increased across all eight categories of loans tracked during the 4th quarter, the Washington-based group said ... Late loans in the quarter climbed 21 basis points to 2.65% of all accounts in a consumer-loan index created by the group. ...

Lenders including American Express Co., the 3rd-biggest credit-card network, and Capital One Financial Corp. doubled reserves for soured debt in the 4th quarter amid the worst housing slump in a quarter century. Overdue consumer loans were the highest since 1992, the ABA said, a year after a U.S. recession ended. Delinquencies are a lagging indicator that often do not peak until late in an economic slowdown.

Overdue payments will keep rising in the first half of this year as "food and gas prices remain stubbornly high and income growth is anemic," ABA chief economist James Chessen said. ... The rise in the ABA index was driven by late payments for car loans, which make up 2/3 of all consumer loans with fixed balances, Chessen said in the statement. ...

JPMorgan Chase & Co., the #3 U.S. bank, said losses from failed home-equity loans may reach $450 million in the 1st quarter and double to $900 million by the 4th quarter. Losses on the $94.8 billion portfolio may increase "substantially," the bank said February 29. JPMorgan stopped issuing subprime home-equity loans last year as defaults surged among borrowers with poor credit or high debt. The bank is taking other steps to reduce risk in lending, such as requiring home buyers put more of their own money into down payments and prove their income.

I.e., going back to what was routine practice in mortgage lending not so long ago.

AmeriCredit Corp., the lender to car buyers with blemished credit records, agreed to let its biggest investor install two board members last month after shares dropped 54% in the past year amid rising delinquencies. The investor, Leucadia National Corp., has considered signing an agreement with AmeriCredit setting ground rules for potential acquisition talks.

CIT Group Inc. said it will stop making new loans to U.S. students after lending costs soared. New York-based CIT, which quit originating private loans last year, said ... it would no longer make government-guaranteed student loans. At least 40 lenders ceased writing some form of student loans as the global credit-market slump drove investors from bonds backed by educational debt, according to UBS AG analysts. Sales of securities with student loans as collateral fell 65% in the first quarter, UBS wrote in an April 1 report.

Now, after the barn door has closed, lenders are pulling back, entirely in certain loan categories or else by stiffening their standards on "the 3 C's" -- capacity, character, and collateral. This will have a direct impact on markets for those goods and services which are most dependent on credit, such as housing, automobiles, and higher education.

One might well ask whether this is such a bad thing. "Redlining" has a bad reputation because of the connotation of racial discrimination. But those redlined districts where banks refused to write mortgages -- presumably almost nowhere was this the case during the recent credit mania -- had very cheap housing. Community activists complained people could not get loans to buy residences, but when they win the battle housing prices immediately rise. Now what if the whole U.S. were redlined? What if all houses had to be bought for cash out of family savings? You will begin to see how the credit-granting institutions have changed the economy's whole price level and pricing structure.

"The rise in consumer credit delinquencies is consistent with a rapidly slowing economy," Chessen said. "Stress in the housing market still dominates the story, but it is a broader tale." ...

MasterCard Inc. Chief Executive Officer Robert Selander said in a March 11 interview U.S. consumers are spending more on gasoline and food, crimping spending on luxury items. ... "What we see is a mix change in how consumers are spending," Selander said in the ... interview. "With the price of gasoline up approximately 30% from where it was a year ago, with commodities prices up and working their way into prices at the supermarkets, consumers are spending more of their money now on gas and groceries.''

April 6, 2008

This story from USA Today puts a human face on the subprime debacle. Clearly both borrower and lender in many cases were willing to overlook the high probability that the borrower would default.

Foreclosures are ripping through the rows of new homes in the flatlands where Denver turns to prairie. Every week, 10 more families here need to find someplace else to live.

Six months behind on their mortgage, Dave Evans and his wife, Suzie, packed the contents of their modest blue house here into a rented truck one day in July. The move came after weeks spent alternately crying and searching in a frenzy for somewhere to go. "At the end, it was so close we could have wound up on the streets," Dave Evans says.

Around the corner, Paul Dardano moved his wife and children into his mother's duplex after he realized his house was headed for foreclosure. Then their friends' houses here started emptying, too, as they scattered to relatives in other cities. "It just happened," Dardano's wife, Eva, says, "one after another."

For hundreds of homeowners in this mostly middle-class corner of Denver -- and an estimated 1.2 million more nationwide -- the wave of foreclosures battering U.S. financial markets is quickly unraveling the American dream. Those who have lost homes here describe seeing their lives crumble into anxiety and embarrassment. Many leave for cheap apartments or rooms with relatives, a trend that is tightening the market for affordable housing.

This small corner of [Denver] represents an extreme example of how foreclosures are transforming lives and neighborhoods. On some blocks, as many as 1/3 of the residents have lost their homes, making this one of the worst hotspots in a city that was among the first to feel the pinch of the foreclosure crisis. Many houses here remain empty, bank lockboxes on the front doors.

The foreclosure epidemic has swept so quickly through this part of Denver that in less than two years, lenders took action on 919 of the roughly 8,000 properties here, according to city records. Their owners defaulted on more than $171 million in mortgages they had used to buy their way out of apartments and into cul-de-sacs. Many were buying homes for the first time, in what seemed the most affordable of the city's new subdivisions. They paid their way with easy credit -- sometimes secured from aggressive lenders who appeared to look past the checkered credit histories and unstable jobs of some of their customers. Ultimately, many of the buyers could hot afford their mortgages.

Today, the tide of unpaid bills and lost homes is getting deeper. Denver officials say they expect 11,000 foreclosures this year, up from 7,700 last year, mirroring increases nationwide. By the time homeowners get a foreclosure notice in the mail, they most likely have fallen too far behind in their bills to ever catch up, says Sindee Wagner, a deputy in the city's Public Trustee office, which processes the filings. Almost all of those who get such notices wind up losing their homes. ...

There has been little research tracking where those who lose their homes are going, says Nicolas Retsinas, director of the Joint Center for Housing Studies at Harvard. But Colorado officials such as Kathi Williams, director of the state Division of Housing, and housing assistance groups here and in other cities say demand for low-cost apartments is soaring. In some cities, those rentals have become so scarce or hard to get into that onetime homeowners either move in with relatives or leave town.

Meanwhile, two recent surveys of local officials and service providers, including one taken informally and completed last month by the National Coalition for the Homeless, suggest widespread foreclosures are driving an increase in homelessness and demand for emergency housing. ...

As in many cities, foreclosures in Denver are now nearly ubiquitous. Every third block in the city has seen at least one in the past 1 1/2 years, city records show. Last year alone, Denver averaged one foreclosure filing for every 32 households, the product of a building boom that collided with high-risk loans and thousands of borrowers willing to stretch their finances too far to buy a house. In the first half of last year, the city had one of the nation's worst foreclosure rates.

Many neighborhoods in Denver and across the nation have largely been spared from that tide, but others have been hammered. That is especially true here, along the broad avenues of Green Valley Ranch, a remote subdivision of soft-colored houses with red-tile roofs sewn into the vast carpet of flat, open land on the city's eastern edge. As Denver's housing market boomed at the beginning of this decade, the area became a magnet for low- and middle-income families buying their first homes in the kind of brand-new neighborhood they once thought would always be beyond their reach. Some turned to more-expensive subprime loans, which charged higher interest rates to borrowers with bad credit. Others got adjustable-rate mortgages and saw their payments increase sharply after two years.

Now those houses are empty again. One belonged to Dave and Suzie Evans. Theirs was a tidy, two-story house on Orleans Street, with two bedrooms, blue siding and a stone facade. Dave Evans admits the $182,000 mortgage they took out was more than the couple could afford, even with both working. "My parents taught me not to spend more than a third of your paycheck on a house, but that went out the window," he says. They wanted to buy and fell in love with the house. For a time, it worked ...

April 6, 2008

The Pets.com of the real estate bubble.

The cyclical and capital intensive hotel business is a risky one in the best of times, for obvious reasons. Nevertheless, people anxious to get a piece of the real estate boom were willing to buy condo hotel units. Hotel operators loved the idea. They could fob off the high up-front and carrying costs onto the investors, while earning operator and other fees. With the bloom now off the real estate rose, many buyers who invested in haste are now lamenting at leisure.

For many investors, the condo hotel may go down as the Pets.com of the real estate bubble. Many buyers purchased the hotel rooms from developers hoping to get paid every time the room was rented. But condo hotels, which account for as much as 10% of all hotel rooms under construction and a much greater percentage in resort markets such as Orlando, Florida, and Las Vegas, are coming back to haunt many of the people who bought the units, the developers that constructed the buildings, and the operators hired to run the hotels. Some projects also are being brought to the attention of regulators by investors.

"It's been a very bad investment," said Moji Adekunbi, a 47-year-old engineer, who bought a $550,000 condo-hotel unit in the Signature at the MGM Grand in 2005 in Las Vegas, where one of every four hotel rooms being developed is a condo-hotel unit. Mr. Adekunbi counted on the cash flow from renting out his unit more than covering his $3,000-a-month mortgage payment, leaving him with a tidy profit. He said the developer's sales staff led him to believe that the hotel would have 94% occupancy and $350-a-night rates, Turns out, he said he is netting only between $400 and $1,800 a month before his mortgage payment. ... Making matters worse, many markets for these rooms are weak, meaning owners might lose much of their investment if they sell.

Representatives for the developer and the hotel operator said hotel-rental projections were not discussed with customers before they bought their units, and some buyers made their own assumptions about rental income. "Some people's assumptions didn't pay off, and they are trying to find someone to blame," said MGM spokesman Alan Feldman.

During the real estate boom, many Americans scrambled to buy anything they could -- office condos, warehouse condos and high-rise residential condos, which are crowding the skyline of cities such as Miami. But condo hotels were one of the most dangerous investments of them all. Hotels are risky investments in real estate because occupancy can swing with the weather or the economy. Developers loved condo hotels. "It minimized the upfront risk to the developer, and shifted it to the individual unit owners," said Mark Lunt, a lodging analyst at Ernst & Young. Many developers said they insisted that buyers regard condo hotels as vacation homes that they would use rather than income-producing investments.

Some condo-hotel buyers are happy. But other buyers are suing developers to get out of their contracts, claiming they were misled. ... Other buyers are staging revolts inside high-end hotels. At the Trump International Hotel & Tower in Las Vegas a group of condo-hotel owners are clamoring to rent out their own hotel units using their own operator because they said Trump takes too much of the rental revenue. A Trump spokesman said the company's rental agreements are competitive with other condo-hotel rental-management companies in the area.

In other condo-hotel developments, a few buyers are talking to the SEC, alleging possible securities fraud, according to their attorneys. One issue could be whether developers sold these units as investments, which should have been registered with the SEC or other regulators. ...

April 6, 2008

Panic or depression?

William Rees-Mogg writes for Whiskey & Gunpowder and other Agora Financial publications, but is on the conventional side of the spectrum when it comes to economic analysis. Here he explains why inflation is good for avoiding a depression. Ben Bernanke probably agrees.

Irving Fisher was probably the greatest American economist, both in terms of the development of economic theory and as a teacher. In 1933, having himself misread the early stages of the Great Depression -- and virtually bankrupted himself by ill-judged speculation -- Fisher published one of his most important works. It is often referred to by its title, The Debt-Deflation Theory of Great Depressions, but is, I suspect, less often read by practicing economists. However, one can be sure that it has had considerable influence on what might be called the "economic philosophy" of the members of the Federal Reserve Board.

The peculiarity of the Great Depression of 1929-33 was that the American economy proved not to be self-stabilizing, although some other major economies of the period, including the British, did recover spontaneously in the early 1930s. Indeed, for Britain, the 1930s, with industrial expansion in automobiles and extensive building of houses, was a record decade.

However, recovery in the United States was later and weaker. When one compares Franklin Roosevelt's first term, from 1933-37, the performance of the U.S. New Deal was not as good as that of Germany, rearming under Hitler, or of the United Kingdom, building cars and houses under Stanley Baldwin and Neville Chamberlain.

This is important, because there appear to be two types of depression, one of which is much stronger and longer lasting than the other. Panics, like those of 1907 or 1987, are steep, but relatively brief; great depressions can last for a decade or more. As Irving Fisher observed -- prematurely -- "The Depression out of which we are now (I trust) emerging is an example of a debt-deflation depression of the most serious sort."

He argues, "The debts of 1929 were the greatest known, both nominally and really, up to that time. They were great enough not only to 'rock the boat,' but to start it capsizing. By March 1933, liquidation had reduced the debt about 20%, but had increased the dollar about 75%, so that the real debt -- that is, the debt as measured in terms of commodities -- was increased about 40%."

Obviously, the combination of the need for debt liquidation with falling prices means that debt has to be redeemed in money that is harder to earn. By contrast, debt can be liquidated by currency inflation, as happened in the 1970s. The relationship between the level of U.S. debt and the level of the U.S. dollar, therefore, becomes critical. Fortunately, the dollar has been very weak, allowing excess debt to be repaid in depreciating dollars. The length of the Japanese depression after 1990 must have been affected by the high relative price of the yen, so that debts in the 1990s were being repaid in terms of a high-value currency.

Fortunately, the dollar has been very weak, he writes, but many would disagree with that assessment. If a debt has gone bad the losses should be allocated efficiently and with a legal consistency. Bailing out all debtors via inflation is hardly efficient. We venture to guess that many of those most deserving of taking their losses in full are politically connected enough to have their losses transferred to the public. Inflation is this made into general policy. Having said this, since Rees-Mogg is describing what is happening, we follow what he says with interest.

Irving Fisher argues that the "big bad actors" in the Great Depression were "debt disturbances and price level disturbances." In 2008, we certainly have debt disturbances, though these are more important in the housing market than in the stock market. However, the global economy is, on balance, in an inflationary stage, with energy prices very high and the dollar weak. China is experiencing significant inflation, and commodity prices are high, if somewhat nervous.

This is a relatively favorable situation, in that the global authorities have to deal with debt and inflation, rather than debt and deflation. As inflation helps to liquidate excess debt, these conditions are more likely to generate panics than great depressions. At any rate, one can hope so.

This is in contrast to Robert Prechtor and Peter Schiff, who argue that you cannot ultimately expect to use monetary manipulation to fix a fundamental misallocation of resources. If inflation is truly a given, one would expect lenders to demand an interest rate that exceeds the inflation rate -- via indexing if necessary. In this case debt would be building in real terms no matter how much you inflate.

April 2, 2008

Does evolution explain why we hate to pay up for scarce goods?

When a certain good or service is in short supply at the current price, economic theory -- logically enough, in this case -- would have the price rise until quantity demanded falls to the supply at hand. Yet we often see instances where people object to higher prices -- as charged by scalpers, "price gougers", gas stations, etc. -- even if it means they end up with nothing, and end up clearly worse off than otherwise. Economists have tried to explain these market clearing failures within the confines of conventional theory, but it seems more plausible that the objection to raised prices is emotionally based and people fail to override the reaction with their thinking brains. This interesting article discusses why that might be the case.

Friends of mine, a husband and wife, once argued over the price of a packet of cakes bought at a convenience store. She complained that the cakes were not worth the price she had paid. He pointed out that she had bought them -- albeit grudgingly -- knowing exactly how they tasted and that, therefore, they had to be worth what she had paid. No prizes for guessing which one of them is an economist.

We economists know a lot about pricing, but we tend to be baffled by the way the human race thinks about it. ... The presentation of a pricing policy clearly matters -- something disconcerting to economists, who can translate all the pricing into mathematical equations and make the presentation go away. It seems to be acceptable to charge a higher markup for fair-trade coffee, organic bread, or lower-emissions gasoline. It is not acceptable for businesses to say, "We are such fans of exploitative coffee, pesticide-laced loaves, and dirtier gas that we are willing to discount them and accept a lower profit margin." Underneath the gloss, the pricing policies are, nevertheless, identical.

The most common puzzle of all, for an economist, is why prices so rarely rise in the face of a shortage. There was a shortage of Wii games consoles last Christmas, Xbox 360s in 2005, Playstation 2 consoles before that, and so on. To secure tickets for a hot concert, you will usually need to go to a scalper, because the regular concert promoters wouldn't dare charge a ticket price that might bring demand down to the level of supply. And when U.S. oil companies raised gasoline prices after Hurricane Katrina, there were howls of outrage -- despite the fact that the refining infrastructure was badly damaged and that it was evidently impossible to supply everyone at the customary low price.

I have previously pondered the very clever explanations economists produce to explain why prices do not rise to equalize supply and demand. Perhaps ticket prices are kept low to encourage a memorabilia-buying younger crowd. Perhaps popular restaurants like to have a waiting list for reservations because it adds to the cachet. Even I am starting to feel that these explanations sound strained. Are these side benefits really enough to outweigh the lost revenue from higher prices?

The intuitive explanation, of course, is that we irrationally object to high prices, even when the alternative is rationing, long lines, and uncertainty over whether we can buy what we really want.

That is discomfiting for economists, but we might at least take solace in the idea that even though there is no immediate logic to a belief in the just price, there is at least an evolutionary logic. David Friedman ... has argued that our ancestors would have evolved in an environment where most transactions were one-on-one bargains. A hard-wired refusal to accept something other than the customary price would, in such a setting, be an advantage. Anyone who reacts to a price rise with irrational rage turns out to be a strong negotiator.

Our stubborn preference for a just price evolved in a setting that is no longer common; but evolution does not respond quickly, which may be why we still shriek with outrage at price hikes. It would also explain why ticket scalpers still prosper.

April 6, 2008

Those with fond memories, or not-so-fond, of the "strategic metals" brief mania at the end of the 1970s might want to revisit the idea. Maybe this time there is some substance behind it.

In this issue of Whiskey I am looking at an investment opportunity in 15 elements from the periodic table. In formal scientific nomenclature, they are called the lanthanides. More commonly, they are called rare earths.

None of these elements are famous like gold or sliver. None get shipped in giant ore freighters, like iron, aluminum or copper. You sure do not learn much about these 15 elements in high-school chemistry class, unless maybe it is the school that feeds lots of kids into MIT or Caltech. In fact, the only people who really study these elements are master's- and Ph.D.-level chemists and solid-state physicists. Oh, and national leaders in places like China. But without these elements, much of the modern economy will just plain shut down. ...

[T]hese elements are critical to the modern economy, and that is not hyperbole. We are addicted to rare earths as much as we are addicted to oil, except most people do not know about the rare earth addiction. ...

These 15 elements are strategic. These elements play a critical role in petrochemicals, environmental protection, "clean" technology, electronics, automotive applications, optics, telecommunications, computing and defense. They are indispensable to a myriad of intermediate and end uses.

Really, without these 15 elements, you can say goodbye to much of modernity. There will be no more television screens and computer hard drives, fiber-optic cables, digital cameras and most medical imaging devices. You can say farewell to space launches and the satellites that do everything from show you the weather to offer global positioning down to a few inches. And the world's system for refining petroleum will break down, too. That is pretty serious. ...

These 15 elements are all metals, although usually one sees them in powdered form as oxides. They are called rare earths. But how rare are they? Well, they are scattered here and there in the Earth's crust. But you will not exactly trip over them as you stroll along the beach. It is quite rare to find these elements in deposits that are economic to mine. So that is the investment lure.

Rare earths are usually found in rock bodies called carbonatites -- for the most part non-geologists have never heard of them. And for our purposes today all we need to really know is that carbonatites are rare.

Once you find a deposit of rare earth elements in a carbonatite, it is still very difficult to mine and mill the rocks and minerals. The processing chain is long and complex. So we are dealing with rare earths in rare rock bodies that are difficult to mine, mill, and process.

Right now, almost all of the world's supply of rare earths comes from China, which is why our investment opportunity is so appropriate.

The writer leaves us hanging there, and goes on to promote his paid service. But the idea alone is worth mentioning, after an almost 30-year hibernation.

April 6, 2008

How much of gold's observed strength is just dollar weakness? Adrian Ash observes that gold is moving up against the so-called strong euro as well. To see this is so over a longer period of time than this decade, you have to graft on old deutsche mark numbers pre-2002. Do this, and one sees that gold is at a significant long-term resistance point -- its all-time high vs. the DM. Now why the price of gold in terms of deutsche marks is important is an interesting tale in itself. Hint: Think of the famous German hyperinflation of the 1920s, and the less famous currency destruction following the fall of the Third Reich.

Amid all the brouhaha over gold hitting $1,000 per ounce for three short days [in March], another milestone in this 9-year bull market went completely unnoticed. Like the media-friendly $1,000 mark, this level offers a nice round number for evening news anchors to proclaim. It even comes with an extra digit -- and it also remains to be reached and breached decisively, too.

But this level may prove much more important than $1,000 per ounce -- and for plenty more people, too -- because it shows just how strong and solid the uptrend in gold prices has been to date. Historically, it points to the underlying trends of both dollar weakness and gold strength.

Trouble is, this new level for the gold price comes in terms of a dead, defunct currency. So it speaks to ages past, rather than trying to shout above the short-term noise of talking heads on CNBC. And whispering in a voice of paper ashes, it says currencies come and go, but metal can be buried for only so long ...

That tired old warhorse of Germany's glorious inflation fighting past, the deutsche mark was finally put to sleep by the Bundesbank on New Year's Day 2002. That was the day when Germany -- along with the rest of the 12-nation eurozone -- finally swapped its currency for the euro. The new pan-continental notes and coins were to be used in cash transactions and settlement of debt, while "DM" was scratched off shop signs and the paper itself was stuffed into a blazing furnace. The new euro would rise from its ashes and bring German-style stability to the currency union's 300 million citizens. Or at least, that was plan.

Now Jean-Claude Trichet, current president of the European Central Bank, warns that eurozone inflation will stay "significantly" above 2% for the rest of 2008. Track the price of gold forward from 1999 in deutsche marks -- the last entry in the Bundesbank's list of daily Frankfurt gold fixes -- and you can see that the gold price [see chart.], a leading indicator of inflation to come, agrees.

Ask any technical analyst with a blunt #2 pencil and a shatterproof ruler. Now back at 40,000 deutsche marks per kilo, the price of gold has touched very long-term resistance. Since February 21, in fact, gold has recorded an afternoon fix in London equivalent to 40,000 deutsche marks or more on 10 separate occasions.

In the days of the Frankfurt gold fix, gold managed that feat only 15 times in total. And if you think the gold market action so far this month has been frantic, just check how violent the action was on either side of those DM peaks back in the early 1980s.

"Monetary stability is linked up with general social stability -- and with political stability," as Otmar Emminger said in his inaugural speech upon becoming president of the Bundesbank in 1977. Who could ask a bundle of notes and coins to do more?

"The German public," as the economist Rudolf Richter noted in an essay of 1999, "after losing its savings twice within 25 years (1923 and 1948), definitely wanted a stable currency. No Bonn government in its right mind would have put the Bundesbank under pressure."

Hence the West German central bank's mandate to cap consumer prices by capping the supply of money itself. Memories of the Weimar inflation that followed World War I -- plus the worthless Nazi reichsmarks piled up during World War II -- still stand in sharp contrast with the American media's obsession with the Great Depression. Where Ben Bernanke now sees soup kitchens and deflation, the central bankers working to defend the German currency in Bonn for five decades could see only runaway inflation of the money supply. Twice.

"In 1923, when Germany could no longer pay its World War I reparations," writes Mike Hewitt on his DollarDaze blog, "French and Belgian troops moved in to occupy the Ruhr, Germany's main industrial area. Without this major source of income, the government took to printing money, which resulted in hyperinflation. ... At its most severe, the monthly rate of inflation reached 3.25 billion percent, equivalent to prices doubling every 49 hours. The U.S. dollar to mark conversion rate peaked at 80 billion."

Sick of inflation yet? Come World War II, incredibly, the German people had to learn the lesson again. The Nazi state converted its debts into banknotes, pushing the volume of currency in circulation up from 11 billion reichsmarks in 1939, to more than 70 billion by the time Hitler poisoned his dog and his wife and then shot himself. The survivors were forced to use cigarettes, chocolate, canned beef, and soap as money once more -- because the government-ordained notes and coins had lost all currency thanks to the huge oversupply.

With global inflation ticking higher three decades later, the Bundesbank adopted its first money supply target in 1973. In December 1974, it began announcing the target to the public each year, and inflation was whipped. By the fall of 1978, and with inflation in the U.S. and United Kingdom lurching back towards double digits, consumer prices in West Germany were rising by barely two percent per year [see chart.] But the initial relief allowed a flirtation with looser money to creep in. By 1981, inflation had reached 6.3%, so the Bundesbank set about slashing its money supply target.

It cut the target from a maximum of 9% growth to just 5% annual growth by 1985. "Only in one year of this period, 1983, did money growth slightly exceed the target range," says Robert L. Hetzel, writing in the Economic Quarterly of March 2002. "Broad money (M3) growth fell from 10 percent in the 1970s, to six percent in the 1980s. By retaining price stability as its primary objective despite the high unemployment rates of the 1980s, the Bundesbank gained credibility for its policy of price stability."

The high unemployment rates were undoubtedly due to the stiffling German government and union interference in the economy, rather than due to some "failure" to inflate enough.

Come the end of the 1990s, the Bundesbank had whipped inflation for more than five decades. Politicians in Rome, Paris, London, Madrid, and Dublin looked to the West German model -- but refused to apply it themselves. So why not get the Germans to apply it, instead ... now that was an idea! Only thing was, that pesky money supply target kept getting in the way of growth, debt, and real estate prices. And so with inflation -- like interest rates -- sitting near or below the 2% annual target, Europe quietly did away with its limit on money supply growth.

The M3 measure of the eurozone's money supply -- the same M3 measure that the U.S. Federal Reserve stopped tracking and reporting at the start of 2006 -- was supposed to grow by no more than 4.5% per year. This initial target represented one of two "monetary pillars" supporting the entire eurozone project when the European Central Bank took over the reins of policy at the end of the 1990s. At last count, however, Europe's M3 money supply was ballooning at a nearly 3-decade record of 11.5% per year in January 2008.

So trying to hedge one's dollar exposure via the euro looks like a no-go.

What does that mean for you, me, and the rest of the world trying to defend our savings and income against the global upturn in consumer prices? All too often, short-term traders looking for quick gains in gold will point you to a very short-term connection between gold and the euro. ... It is a fact that gold and the euro often do move together against the U.S. dollar day to day. Between the start of 2007 and late March 2008, for example, the euro and gold moved in the same direction on 291 of 310 trading days, according to Reuters data ...

But the euro moved in the same direction as crude oil prices on 300 days ... And no one would claim that the euro's rise versus the dollar has stopped the price of petrol from going up on Germany's autobahns. What is more, both the euro and gold rose against the dollar on 170 trading days between January 2007 and late March 2008. So their apparent correlation is built on the plain fact that the U.S. currency has consistently lost value drip by drip and tick by tick.

On average, the dollar has lost 0.05% of its value against the euro every trading day since the start of 2007. Measured in gold, it has lost a little bit more each session, down by 0.06% on average. ... [G]old's gain over the dollar has consistently outstripped the gain for U.S. investors holding euros. All told -- and trading just shy of 40,000 deutsche marks per kilo-equivalent today -- the gold price in euros has risen by more than 24% for French and German investors since the start of last year.

Will it push higher, breaking new ground above the all-time record peak of 46,530 deutsche marks? Or might gold now turn tail, falling in the face of below-zero real dollar interest rates and a 3-decade surge in the European money supply? The long-term chart says gold faces resistance. Either that, or it us about to break into historic new territory as the world has to relearn to conquer inflation.

April 6, 2008

The deflation equation does not add up.

This article could also be subtitled "If you are not confused, you just don't understand the situation." Gary North argued a few weeks back (link below) that a look at the money supply figures showed that the Federal Reserve was actually deflating, for now anyway -- not inflating like gold and commodity prices, the weak dollar, and the Fed's apparent willingness to create new money to bail out collapsing financial institutions would lead one to think. Ed Bugos has a his own take on the data and what he observes. And deflation ain't it. He does see the Fed trying to keep the gold bugs off balance, however.

When I look at the policies that central banks are adopting today, everywhere, I see an inflationary epidemic that is feeding on itself and confirming the bull market in gold. In the U.S. -- arguably an epicenter of the modern global monetary system -- I see a central bank whose powers are constantly expanding. This progression dates back to its birth in 1913, but as recently as 1999 and 2003, parts of the Federal Reserve Act were rewritten -- granting the Fed more power to create money.

Today, with progressive calls for action in the face of crisis, the Fed's tentacles are potentially reaching directly into the credit and securities markets. ... [H]eadlines are rife with news of its "sweeping" new powers under Treasury Secretary Hank Paulson's "plan". The Federal Reserve is in the midst of another historic interest rate-cutting campaign. Its official policy stance is that it recognizes the inflation risks, but worries more about growth, so it will inflate to sustain "growth".

Its message has been, more or less, that money grows on trees, which is why Ben Bernanke's moniker, "Helicopter" Ben, is catching on with the press. Gold bugs could not be more thrilled. Just recently, I wrote that we are seeing the best of all worlds for gold to shoot straight up a few hundred points.

But wait! "It's not such a sure thing." At least that is what I thought I heard ... from a voice in the wilderness. "What do you mean it is not a sure thing? Look at 'em flood the markets with liquidity. $100 billion here, a few hundred there."

As I was about to sign off, the voice continued: "No, they are not inflating. They are just creating confidence in the credit markets. Look at the 'money' numbers," said the voice. "Forget credit. Look at the level of bank reserves and the adjusted monetary base. They haven't grown since August. The Bernanke Fed is just pretending to inflate!"

Gary North has argued exactly this point. See this previous Digest entry.

Perhaps I already knew what the voice was telling me. Like the title character in Tolstoy's classic novel, The Death of Ivan Ilych, I was doing some soul searching and discovering hidden truths buried deep beneath the surface. The voice was my own, and it was telling me something I had yet to consider.

It has not escaped my attention that the narrow constituents of money supply are not expanding. I have written about it. This disinflation was first apparent as far back as 2005, under Alan Greenspan's tenure, when M1 growth hit zero percent on a year-over-year basis. He set it in motion through the rate hike campaign. The total value for U.S. M1 has not changed in three years. But our "voice" insists that Bernanke is running a different, more deflationary policy than Greenspan -- even though under Bernanke's reign, since 2005-06, the broad credit aggregates have reaccelerated and the tightening campaign abandoned, and reversed.

Clearly, the Bernanke Fed is running a different policy. But it is difficult to call it a more deflationary one [see chart.] Okay, so it has kept M1 flat, and slowed the growth in the monetary base a wee bit further (which has no doubt contributed to the crisis). And since August, the Fed has not expanded bank reserves overall, even though it has slashed its policy-setting interest rate by 300 basis points, has taken other measures to ensure short-term liquidity and talks as if it is ready to underwrite almost any insolvency.

We may point out that if the Fed wanted deflation, it would have already arrived. If, for example, Bernanke actually did nothing, the monetary base would have probably shrunk. At a minimum, the Fed is inflating just enough to replenish erosion in bank reserves and the market's confidence. The thrust of all of its actions has been to cheapen money and credit and inflate.

That is not to say there are not any deflationary forces in the system -- just not ones produced by the actions of the Federal Reserve System so far. If there is deflation in the system, stable money proves the Fed is inflating. If it were pursuing a deflationary policy, you would have seen a few more Bear Stearns by now -- and it is unlikely that the broader credit aggregates like M3 and money with zero maturity (MZM) would be expanding so furiously.

Sure, there is a run on risk, and this risk aversion is causing some asset deflation, which in turn is producing a lot of short-term liquidity. So the Fed has not had to create a lot of net new notes to push rates down, yet. Consequently, so far, it is merely underwriting a lot of the market's current confidence, rather than monetizing it. But it does not necessarily follow from stable money supplies that the Fed is deliberating a deflationary policy.

So deflation has not set in yet, but our normally credible source [probably North] is still convinced that Bernanke is secretly pursuing a policy of deflation while pretending to inflate. But from the central bank's point of view, the costs of such a policy are prohibitive. So why am I still listening to this "voice"?

Because it believes the Fed wants to hijack the gold market ... In other words, the Fed is trying to quell the rise in the gold price. A central bank's general incentive to dampen gold fever is a given, but why would it want to so bad that it would be willing to risk political suicide? Our voice explains that some of the large bullion banks still hold massive derivative short positions in gold, which they borrowed from the central banks to sell into the market in the '90s. We have not heard any of them report large losses on those positions yet.

They are potentially huge. But are they huge enough to motivate the Federal Reserve to orchestrate a deflation policy in order to save these banks from ruin? The last genuine deflation in the U.S. (1929-33) wiped out almost all the banks. Are you telling me that the gold shorts held by a few select bullion banks can cause more total pain than a deflation policy?

I doubt it, especially since the central banks are so forgiving on the terms of the gold loans. This voice is right that the Fed is not expanding narrow money. It is wrong about the Fed targeting deflation.

So is the fed targeting gold? It should be. Bernanke may well be trying to keep the monetary base stable to discourage speculation in the gold and oil markets, while at the same time boosting confidence in dollar-denominated assets. This kind of a balancing act (or "sterilized" inflation) is not foreign to the Fed's modus operandi. In fact, it was well accomplished by Bernanke's predecessor.

While the idea that the Fed is deliberating deflation in order to undermine gold makes little sense, the fact that the monetary base is not growing is relevant and deserves further monitoring. Regardless of the explanation, when the central bank is not inflating, it is not bullish for gold. I say this even though, empirically, the relationship between money (i.e., M1) growth rates and gold prices is not cut and dry.

If you bought and sold gold based on the requisite changes in M1 growth rates, you would be on the wrong side of the trade most of the time, at least since the 1980s. You would have turned bearish after 2004, missing the last $400 rally. It is important to monitor. But we live in a global world today. The effects of inflation produced by China's central bank are felt in America, and vice versa.

It is especially a bad idea to short gold. But it is a good time to pick away at values created by the "Chicken Littles" on the way up to $2,000 -- if you believe that the Fed is inflating. I am not going to tell you that gold is going to go up whether we have deflation or more inflation. I do not believe that. I believe gold prices would fall in a monetary deflation. But I do not expect one soon.

April 6, 2008

As they say, differences in opinions make markets. Our guess is that most would see the recent precious metals market downdraft as a correction. But how much of one and for how long? Jim Nelson thinks it is time to step in now. Moreover, this correction (assuming it is one) has a certain similarly to the on in November 1979, just before the gold blowoff rally to $850.

Major developments are taking place in the precious metals world. As we have noted here in Penny Sleuth, the price of gold is destined for upwards of $2,000. However, we are currently experiencing a very natural correction.

With everything in the world of finance, people get scared. Last month, gold broke the $1,000 threshold and silver broke the $20 one. So of course, weak investors got anxious. They pulled back and sold off some of those gains. As I write, it would cost you $880 for an ounce of the yellow stuff, while silver is going for $16.90 per ounce. That is 20% cheaper than it was a few weeks ago. Great. But, why should you care? Money -- and lots of it.

First, let us take a look at the last gold rally, back in the late 1970s. As you can see in the chart below, gold underwent an eerily similar correction at the end of 1978. It lasted exactly one month before it righted itself again. On October 30, 1979, the spot price for gold was $242.75. Exactly 31 days later, it had shed $50. That is a hair over 20% off its high. See the similarities?

Incidentally, this was the last time gold went below $200 -- ever.

So, the next question you may be asking is: "What happened after the last time this happened?" Oh, just the largest bull market we have ever seen in the precious metals world. In 1979, and then again in the first month of 1980, gold went from this puny little sub-$200 metal to an $850 investment. It ended up being a 340% jump from the bottom of the correction to the top in January 1980. That is nearly 4 1/2 times your money in 14 months! Now, I am not saying we are bound to repeat that this time around. But, others are ...

Honestly, it does not make a bit of a difference if you believe any of them. At current levels there are already some huge profits to be made. We have written to you about the potential juniors have right now. I am not going to bore you with any more. If you want to, you can check it out right here.

As for what you should do now -- the precious metals world is on a silver platter. (No pun intended.) Take what you like. We will continue to let you know when the best ones come along. This is something worth following for quite some time.

Huge Gains as Gold Corrects
April 6, 2008

More precious metals correction advice, this time for those who like to play it from the mining stocks side. Ed Bugos shows you how to hedge a portfolio of gold stocks against an "intermediate" correction using options.

So you own a portfolio of gold stocks and you are worried about losing some of your gains to the return of a bear market on Wall Street, or a correction in oil prices, or a temporary bounce in the U.S. dollar.

You tell yourself that these things are not fundamentally bearish for gold prices. One of them is even bullish. But you know the golds are probably due for a correction anyway, and any one of these, or other factors, is just as good an excuse as any fundamental when confronting a risk averse crowd. What do you do?

You could weather the storm. You are in it for the long term, right? The trouble is gold stocks can fall a lot during even a typical correction. Most everyone already knows that markets do not go straight up. If every dip led to higher and higher highs nobody would ever lose sleep over it. Trouble is, the company could always screw up, or one of those dips could turn into a bear market. I have seen the conviction behind many buy/hold strategies melt at the tail end of a normal correction, just because it is invariably worse than expected.

In my observations, investors are more likely to get bucked off a bull market because one of the corrections discourages them than because they took some profits by selling into strength.

Goldcorp, one of the world's largest miners today, has already seen three corrections of 40-50% on the way up to $45 from its $3 (split-adjusted) share price back in early 2001. That is a 15-bagger! And it is not over. Goldcorp will see a few more like corrections, and maybe one that is even larger, on its way to $150. Hardly anyone who bought at $3 will still be aboard, and even fewer will sell the top.

However, there are ways to improve your long-term returns and reduce the impact of market volatility on your portfolio without ever having to trade in and out of your shares, and risk getting bucked off the bull too early. Options! ...

April 6, 2008

While the DJIA has more or less held in nominal terms since 2000, it has crashed when measured in gold. Bob Prechtor reviews previously made points on this (with a few sour grapes thrown in).

When the Dow Jones Industrial Average shoots up nearly 400 points in one day, as it did this week on April 1, it hardly seems credible to talk about a market crash. But the truth is that the Dow has been crashing -- down 72% -- since the top eight years ago. How so? Measure the Dow in terms of the price of gold rather than dollars, and you not only see the steep rise of the Real Dow, you also see its precipitous decline. This is a crash that no one is talking about, which has driven Bob Prechter to call it the "silent crash" ... Read the [March 14 Elliott Wave Theorist] excerpt below to find out more about how the Dow in real money has crashed to a new low.

There is so much to talk about, I hardly know where to start. I could write 20 pages about the debt implosion, the machinations of the Fed and the tragi-comedy that surrounds them. But these topics are all over the Internet, and it is more useful to be ahead of topics that will mesmerize people later. Conquer the Crash anticipated the things happening now in the credit markets and even the heat that the Fed chairman is taking. The Elliott Wave Theorist has already explained in detail why the ultimate result of the Fed's moves will be deflation, and no, the recent "surprise" short-term-lending measures do not change that position. Also, you can bet that when investors are focused on one thing, they are either wrong or behind the curve. So let us talk about things that people are not talking about and some others which they might be discussing heatedly four years from now.

The Dow in Real Money Has Crashed to a New Low

The chart below updates our ongoing Dow/gold chart, the one that shows the trends of the stock market priced in ounces of gold, i.e. real money. The "Year 2000" edition of At the Crest of the Tidal Wave included a long-term bearish forecast for this chart, and unlike our outlook for the nominal Dow, this one has been on track the whole decade. As the chart shows, in recent months the real value of U.S. stock shares has plummeted for the 5th time since 1999, reaching another new low. It is now down a stunning 72% in fewer than 9 years. Had we been smart enough to short the S&P and go long gold simultaneously to simulate a short sale in real money, we could be retired by now.

Trying to call the nominal Dow, on the other hand, has been a frustrating exercise. One day it will do what the ratio in the chart has been doing. At the moment, our super-aggressive short sale issued at the peak in July 2007 is ahead 250 S&P points. But the market has yet to confirm the final top with a serious price smash, so I am not yet presuming we will keep these gains.

If the nominal Dow had been priced in honest money since its January 2000 top, it would be selling today at 3400. And the bears would have been properly rewarded for having the guts to go against the historically large one-way crowd that was bullish in 1999-2000. Thanks to the Federal Reserve System, however, no one who would normally be succeeding is being rewarded. Bulls think their stocks are holding up, but they are crashing in value. Short sellers should be rich by now, but they are not, thanks to the banking system's raging credit engine, which has allowed leveraged investors to keep nominal stock prices up even as values collapse. Even people who do not care about the stock market, the poor schlubs who are simply savers, are losing purchasing power with every passing month.

So dollar-credit creation from nothing robs from almost everyone. The primary winners in the U.S. fiat-money-monopoly scheme are Congress and the President, who can spend money without collecting it. That is why they created the Fed in the first place. Bankers also gain, because they have the legal privilege of draining off a percentage of the population's production every year. Ironically, even these institutions get hurt in the end.

Will this situation change? Will deflation bring the whole house of cards to ruin? I think so, and this March issue of The Elliott Wave Theorist will explain more reasons why.

April 6, 2008

Chris Mayer, a value investor by inclination, recently attended an investment management conference and came back with some insights he deemed worth sharing. In particular he addresses an issue that comes up for all stock market investors from time to time, including value investors. Namely, sure stocks do well in the "long run", and value investors figure that value is value no matter what Mr. Market is doing. But -- geesh -- would it not be worth trying to avoid those 20% downdrafts that hit from time to time ... even the cheap value stocks?

The short answer is that you should skip spending time trying to time the market. Peter Lynch once said that if you spent 15 minutes a year on economic analysis, you have spent 10 minutes too many. "I also spend 15 minutes a year on where the stock market is going," he added. And: "The quest to get the timing right is what trips up most investors," conference speaker Richard Pzena said. Anyone who has been investing in the stock market long enough understands of what they speak. Which is not to excuse not doing one's homework on understanding and conservatively valuing the company of interest.

I love the process of investing -- all the thinking about the craft itself and the fun of rummaging around looking for interesting stuff to buy. So naturally, when I get a chance to hear successful investors chat, I go out of my way to grab a seat. You never stop learning.

I headed up to Manhattan recently with Dan Amoss, who writes the new (and red-hot) Strategic Short Report. We met in Baltimore and caught a train north to attend the 2008 Columbia Investment Management Conference. There, an all-star cast of successful investors assembled to speak about this crazy craft we all find irresistible -- and to offer some ideas.

Richard Pzena's opening talk was the most interesting to me. In part, because what he had to say was timely, yet full of timeless wisdom. His title: "Surviving the Cycles of Investing." Good topic, considering the nasty spill the market took to open 2008. And with the cloud of recession thick in the air, investors seem awfully full of worry. Pzena had some soothing words.

Pzena says there were only eight years in the last 40 when you would have been down 20% using a simple value approach. (For purposes of his discussion, he used a simple value strategy of buying stocks only in the lowest quartile of the market ranked by price to book. But the point applies to all us cost-conscious investors.) We just suffered through one of them -- with the S&P 500 and Dow Jones industrial average dropping 20% from top to trough.

One obvious conclusion from looking at the data, if you are a value-minded sort like me, is to shrug off the bad times and say, "Who cares?" It is no accident that most people can name the big bottoms -- 1974, 1982, 1990, etc. It is because they are relatively infrequent. Plus, the long-term return on value stocks over the full 40 years more than made up for them.

"The problem is," as Pzena says, "when you're losing 20 percent, it doesn't feel very good." You start to question what you are doing. You start to wonder, "Can I avoid those 20 percent down periods? Should I avoid them?"

To the first, Pzena rolls out the shopworn, but tested wisdom that trying to predict exactly when these downdrafts will happen is impossible. And selling after the market has already taken its tumble is a sure loser. Therefore, "riding through them is the smarter thing to do," he advises. "The quest to get the timing right is what trips up most investors," Pzena says. The best investors buy value when it is offered and do not worry about timing the market or fretting about recessions.

Many investors think that with a recession looming, or already here, it may be best to sit on the sidelines. One problem with this is that economic health is extremely difficult to gauge. It is not as if you can slap on a pair of latex gloves and say to the economy, "Turn left and cough." It is possible we will not know we were in a recession for sure until it is over.

But even so, recessions tend to be good times for investors who buy value. Pzena had examples. From January-December 1969, we had a momentum market. A momentum market is one in which people focus on getting the next piece of information. Quarterly earnings reports and recent price action dominate. This kind of market can be difficult for value guys, who think longer term.

However, Pzena points out that a recession began in December 1969 and lasted through January 1971. Stocks flipped to a value market from January 1971 to August 1977. The timing of that flip coincided with the beginning of a recession. The same holds true for all recession cycles of the last 40 years, according to Pzena. ...

"As people worry about a recession, what do they do? They put their money in what's working." That means momentum stocks, or stocks that have gone up. They worry about what the recession will impact. This is where we are now. The thing is, as Pzena discussed, recessions bode well for investors looking to pick up bargains. As you get into the recession, though, people start to think about valuation again. Momentum stuff starts to not make sense.

Are we in a recession now? Pzena did not hesitate to make a guess. "Anecdotally, yes," opined Pzena. "Toward the end of 2007, we had, at least, a major slowdown." The market is, once again, offering attractive bargains. Pzena points to price-to-book indicators. Right before 2007, there was a narrow gap between the lowest quartile by price to book and the S&P 500. Meaning, the cheapest price-to-book stocks were trading at a small discount compared with the rest of the market. Now that gap has reversed. The gap is now wide, Pzena says.

So parts of the market look attractive again. But what about those ugly headlines, you say? "This is why value works," Pzena says. "Because when you see your list, you want to throw up." It is what gets you the pricing you want.

The savvy group at the conference was excited about the opportunities the market has given them. They are not alone. Several great funds long closed to investors are now open again for new investors. These include the Tweedy Browne Global Value Fund, the Longleaf Partners Fund, the First Eagle Global and Overseas funds, the Third Avenue International Value Fund and the First Pacific Crescent Fund. They are open because they have more ideas than they have money. They want to buy.

I would give these funds a look, because they do not tend to stay open for long. The opening of these funds, captained by investors with long track records of success, is also an indicator that the smart money is buying.

Fair enough. We would also recommend looking at an older Finance Digest posting, here.