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

W.I.L. Finance Digest for Week of September 8, 2008

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


The U.S. Treasury is now in the mortgage business. The financial future of the world is crumbling, and this is the biggest step in that change.

The big news of the week is the U.S. federal government's takeover of mortgage underwriters Fannie Mae and Freddie Mac. It was really just a matter of time once the housing bubble popped that the government's "implied" guarantee of the two mortgage insurer's debts would become an actual guarantee. Now here we are.

Doug Casey has a good starting point summary of what this all means.

On Sunday, September 7, Treasury Secretary Hank Paulson, flanked by James Lockhart, the new conservator from the Federal Housing Finance Agency, announced a plan to take over the operation of Fannie Mae and Freddie Mac and to guarantee their debt. They cited what we all knew, that they did not have enough capital to continue operating. Their business is to borrow to lend for housing mortgages, and to guarantee half the country's housing mortgages, about $5.4 trillion. The equity and preferred is all but wiped out as all dividends are suspended and management and the board are fired.

This is the biggest bailout ever. If 10% of the $5 trillion of guarantees must be made good by the government, the payments would be $500 billion. That is the size of the annual U.S. defense budget. The outstanding debt of the U.S. held by the public is the size of the guaranteed mortgages. It is huge.

We from Casey Research have seen this coming for more than a year:
For one thing, at the point that falling prices leave homeowners with mortgages exceeding the value of their homes, default rates will soar. This, in turn, will put lenders that hold large amounts of mortgage debt at risk, and possibly jeopardize the solvency of Fannie Mae and Freddie Mac, since they guarantee much of this debt. If these mortgage giants faced collapse -- and they are already in well-documented trouble -- a government bailout involving hundreds of billions of dollars would be a likely next step.

"... The impending calamity -- mass housing foreclosures, failing banks, Fannie Mae and Freddie Mac in ashes, millions of personal bankruptcies -- is so dire ... most people cannot even conceive of it. And indeed it may not hit us this year, or next, but the market always corrects itself, and this time will be no exception, sooner or later.

"We have said before, and we repeat again: Rig for stormy weather."

[International Speculator (the predecessor of The Casey Report), March 2007]

A lot of the non-mainstream press saw this coming as well. All it really took was the alteration one small assumption, that housing prices always go up. We were surprised to see how many otherwise sane investors, such as some of the Forbes financial columnist were caught in the downdraft.

Unusual Aspects

The Treasury will add funding to Fannie and Freddie when their assets are less than their liabilities. The Treasury gets warrants to own 79.9% of the equity. Fannie and Freddie are allowed to expand mortgage lending through the end of 2009 but are required to wind down their $850 billion of debt at 10% per year until they are essentially out of business at only $250 billion debt.

The effect on the Credit Default Swap (CDS) market could be big: There are about $1.47 trillion of CDS on Fannie/Freddie-backed mortgages. The creation of the conservatorship is probably a credit event, triggering the payment of the insurance on the debt. But as we know, the insurers are already weak, and forcing them to pay could eliminate them as ongoing business, thus creating a cascading loss of the value of insurance on other debt they guarantee.

The "New Secure Loan Agreement" that is designed to bail out the debtors of Fannie and Freddie will also be used to bail out the Federal Home Loan Banks. $274 billion additional housing market funding was passed through the FHLB last year, and it is safe to assume there are problems there too.

Who Will Rescue the Taxpayers from Fannie and Freddie?

The U.S. Government has decided to spend an enormous amount of money to prevent the two mortgage giants from defaulting. What will be the real effects?

The rescue will not resuscitate the housing market. As much as prices have declined, they still have not come down enough to make houses affordable. (They only seemed affordable for a while because of the artificially low interest rates the Federal Reserve engineered during the housing boom through its inflationary policies.) Do not expect the rescued Fannie and Freddie to revive the housing market; the government's rescue package requires them to shrink their operations.

The rescue will not end the credit crisis that is pulling the economy into recession. Fannie and Freddie are perhaps the biggest, but certainly not the only, institutions that overcommitted to risky mortgages. Banks, insurance companies, and pension funds are holding billions in the same kind of dangerous stuff. And they still must get through another two years of interest "resets" on [variable rate] subprime mortgages created during the housing boom. As those resets occur, there will be more defaults on mortgages that borrowers can no longer afford -- or no longer want because the loan balance exceeds the value of the house.

The rescue helps keep bad decision makers in place. Managers of banks and other financial institutions that invested heavily in Fannie and Freddie paper get let off the hook. They get another chance to make more bad decisions about how to deploy trillions of dollars of capital. And the politicians who passed the laws that encouraged Fannie Mae and Freddie Mac to take all those wild risks? They are up for reelection.

Implications for the Future

The complete collapse of what was 80% of the funding of new mortgages this spring is now here. The whole structure of creating mortgage-backed securities and passing them on is gone. There will be no creating new phony tranches of sliced and diced SIV debt, and no CDO and no CDS and no AAA-rated toxic waste. We do not know what happens to $62 trillion of notional CDS derivatives, but somebody is holding a disaster. This financial crisis is far from over.

By itself, the government might be able to manage some of these problems, but the problems are not isolated: the Federal Deposit Insurance Corporation (FDIC) guarantees deposits at banks of $4.3 trillion but has only a $50 billion reserve to handle bank failures.

Interest rates are close to 50-year lows, from the Fed cutting the short-term rate, and from flight to Treasuries, which are safer than other debt. But the longer-term implication of the bailout is that more deficits will weaken the dollar and therefore higher interest rates will be required in the long term, especially for non-government-guaranteed debt, to cover inflation and increased risk.

There will be many more financial institutions in trouble: perhaps 150 banks will fail, including probably one or two big banks, like Lehman, Citi, or Merrill. FDIC is next, in our opinion, once a big commercial bank goes under.

The dollar is up in the short term on what we expect is a short covering rally, but that is not consistent with long-term implications, so we do not expect it to stay up.

Homeowners gain, as Fannie and Freddie are allowed to continue to expand in 2009. But after that, they will be looking for a newly reconstituted system beyond what is in the conservatorships that are being asked to unwind. The long term is unclear.

The U.S. Treasury is now in the mortgage business. The financial future of the world is crumbling, and this is the biggest step in that change.

Freddie, Fannie Scam Hidden in Broad Daylight

Lack of faith in financial markets overseers and regulators is not cynicism. In the parlance of securities law, it is a risk-factor disclosure.

The ultimate collapse of Fannie Mae and Freddie Mac was a scenario that anyone with a highschool education could have foreseen once housing prices started to fall. Moreover, the stark numbers that revealed this were there for all to see in the companies' financial reports. Meanwhile, auditors, managements, analysts, and regulators all said nothing, or actively lied about the companies' health. But there was no need to take their word for it. You just had to look at the numbers.

When the history is written on the collapse of Fannie Mae and Freddie Mac, it will go down in the annals of corporate scandals as one of the greatest accounting scams committed in broad daylight.

All anyone had to do to know the government-guaranteed mortgage financiers were insolvent was read their financial statements. You did not need a trained professional eye to discern this open secret, only a skeptical one.

Just last month, Fannie and Freddie said their regulatory capital was $47 billion and $37.1 billion, respectively, as of June 30. The Treasury Department now says it may have to inject as much as $200 billion of capital into the two companies. Nothing much changed at the companies in that span. They just could not get the government to keep up the ruse any longer.

To have believed those capital figures, you first needed to accept two key assertions by the companies. The first was that the mortgage-market meltdown was a temporary blip. The second was that Fannie and Freddie both would be wildly profitable for decades to come, once the blip was over.

These were not the only fairy tales Fannie and Freddie told. They are just the ones that had the biggest impact on their calculations of regulatory capital. Had Fannie and Freddie ever backed off these predictions, they would have been officially insolvent, even under the government's lax standards. Until late last week, though, nobody with any authority was willing to call them on it. That is why Fannie and Freddie were able to avoid a government takeover for so long.

By the time the government moved in, Freddie had accumulated $34.3 billion of paper losses on mortgage-related securities that it excluded from its calculations of regulatory capital. All Freddie had to do was say the losses were "temporary," and they could be kept out of the company's capital figure. It did not seem to matter how ridiculous the claim was.

Fannie played the same game. As of June 30, it had $11.2 billion of supposedly temporary losses on mortgage-related securities, which it excluded from its calculations of core capital, as the government calls it. (A better name would be "`kore kapital," like the imitation krab sticks on a sushi bar menu.)

The so-called temporary losses had the warped effect of inflating a line item on both companies' balance sheets called deferred-tax assets. The bigger the companies' losses got, the more these tax assets grew, based on the premise that someday the companies would be able to use the losses to offset future income-tax bills.

The catch is that if a company does not expect to have enough profits to use these assets, it is supposed to record a valuation allowance on its balance sheet to reduce their size. Freddie and Fannie did not let this requirement get in the way. They never set up any allowances.

So, as of June 30, when Freddie said it had deferred-tax assets of $18.4 billion, it supposedly envisioned about $50 billion of future taxable income that, in its judgment, would probably materialize in the face of the worst financial crisis since the Great Depression. Ditto for Fannie. It claimed to have $20.6 billion of deferred-tax assets as of June 30.

The companies' delusions did not stop there. In their financial disclosures, both companies represented that the fair-market value of their tax assets was billions of dollars more than what they were allowed to show under generally accepted accounting principles.

All of this was malarkey, of course. And it was all disclosed, even if the companies' explanations were not always clear.

Gatekeepers Doze

There were lots of gatekeepers who could have stopped this sooner and chose not to. Freddie and Fannie had boards with outside directors and audit committees, though the evidence that they did their jobs is scant.

Freddie's auditor, PricewaterhouseCoopers LLP, could have stopped it, and did not. The same is true of Fannie's auditor, Deloitte & Touche LLP.

The Securities and Exchange Commission's chairman, Christopher Cox, had other priorities. He was too busy this summer trying to prop up the companies' stock prices by chasing short sellers away from their shares.

James Lockhart, the director of the Federal Housing Finance Agency, kept telling the public this summer that Fannie and Freddie were adequately capitalized. He must have known this was a joke, assuming he had bothered to read their quarterly reports.

All the while, Ben Bernanke at the Federal Reserve and Hank Paulson at Treasury offered the same warm assurances about the companies' capital. They surely knew better, too.

Don't cry for investors who lost money on the companies' stocks either. If they did not do any research or did not understand what they owned, the people they should blame are themselves.

The reality is that investors should withhold their faith in the government officials who regulate our financial markets. That is not cynicism. In the parlance of securities law, it is a risk-factor disclosure.

The moral of this story: You are on your own, folks, and there is more where this came from.


Those who caused it should stop insisting on making things worse.

As egregious as the excesses of the previous bubble were, it is not necessary that a prolonged and painful period of repentance follow, a la the 1930s. Just getting out of the way and letting nature take its course would minimize the damage and recovery time. And who would want to get in the way? Exactly.

The federal bailouts of Bear Stearns, and now Fannie and Freddie do not bode well for avoiding a "great" depression. Nature will clearly not be allowed to take its course.

"Great Depression" is a strong term, but what exactly does it mean? Depressions are a normal part of a business cycle that are now often called recessions, downturns, or corrections. They occur in any economy where the financial markets are based on fractional-reserve banking.

Depressions only become "great" when normal to severe depressions are used as excuses for massive increases in government intervention. Murray Rothbard's America's Great Depression clearly demonstrates this phenomenon. The three great depressions in the history of the United States are the Progressive Era (1907-1922), the Great Depression (1929-1945), and the Great Stagflation (1970-1982).

The year 2008 marks the beginning of the next recession, correction, or depression. All the statistical indicators are pointing in that direction. All market indicators point in that direction as well. Ask any noneconomist and you will get that same answer. We only have to wait for the folks at the National Bureau of Economic Research to officially confirm what we already know.

The reason for the depression is the bust in the housing market -- we all know that too. Austrians reported on the housing bubble throughout the boom. Beginning in early 2003, Frank Shostak, Christopher Meyer, Lew Rockwell, Robert Blumen, Jeff Scott of Wells Fargo Bank, and others, including this author, were writing and lecturing about the housing bubble. We identified the cause of the bubble as the Federal Reserve and its inevitable consequences of a bust in the housing market and the overall economy.

Homebuilder stocks peaked in mid-2005 and it has been like watching a train wreck in slow motion ever since. When the overall stock market peaked one year ago we could finally celebrate the beginning of the correction phase of the business cycle even though most of us suspected it would be a severe one. Several mortgage dealers went bankrupt in 2007 and the increased number of foreclosures signaled that the correction was finally under way.

By late 2007 there were definite signs of major corrective forces acting in financial markets. However, whenever such corrections seemed to be ready to take place they were circumvented by government intervention. On December 12, 2007, the Fed announced the Term Auction Facility which would auction reserves at the Discount Window for a "broader range of counterparties" and against a "broader range of collateral" than open-market operations and without identifying the borrowers. This was the first extraordinary intervention.

Then in March, Paulson and Bernanke orchestrated the weekend purchase of Bear Sterns by J.P. Morgan, providing Morgan with a $30 billion, ten-year loan. This certainly was an extraordinary intervention. It also helped set a pattern of intervention that sends exactly the wrong signals to the market. Government officials at the Fed, Treasury, and elsewhere have been telling us that everything is fine in the economy and then, when bad economic news is announced, they claim that "it is not as bad as we anticipated." Then, when markets react to this misinformation, government comes in with some massive bailout in the form of a brand new, extraordinary intervention.

In July, Secretary Paulson told Congress that he saw no need for additional legislation to address problems at Fannie and Freddie and then, less than one week later, he announced that the Treasury would "backstop" the two megamortgage lenders. This essentially reversed what Treasury secretaries have been saying for decades, that they do not stand behind or guarantee the securities and debts and obligations of these government-sponsored entities.

Now an even more radical step by the Treasury has essentially nationalized Fannie and Freddie. Of course this does not help troubled homeowners or prospective buyers. It does not help homebuilders. Essentially, it hurts all those people because it puts them as taxpayers at risk for several trillion dollars in potential losses.

Most commentators think this takeover of Fannie and Freddie was the right thing to do: unfortunate, but necessary to prevent a financial crisis. This is all wrongheaded. It might delay a financial crisis, but it only makes the overall economic crisis even worse. History has well demonstrated that government intervention only lengthens the economic crisis and increases its overall cost. Just ask the Japanese about their experience.

Given the extraordinary nature of interventions that have been taken so far and the precedents that have been set, we have all the makings of the next great depression.

In the absence of all these government interventions, it is likely that the corrective phase of the business cycle would already be over and we would be in recovery mode. To be sure, housing would remain in a slump for some time to come, but restorative market forces would already be at work creating the next generation of companies and jobs.

If we want to avoid the next great depression, all such government interventions should cease. The Treasury Department should revise their recent action and turn their proposed conservatorship of Fannie and Freddie into a bankruptcy receivership that would ultimately liquidate the corporation and their liabilities. Meanwhile the Fed should announce its intent to stop Term Auction Facilities and close the discount window to all but its traditional customers. To reduce the negative impact of the recession, government should cease foreign hostilities, reduce military spending, balance the budget, and cut taxes and regulations.


This piece of work from Mike Shedlock leaves little doubt that deflation is now in force as bank credit contracts. The deflation leaves the bull market in treasuries intact, as people are willing to accept very low interest rates in order to own the only risk-free paper out there. And gold? It could rally in time; however, with so many small investors "calling the bottom" it is unlikely that a bottom is happening now. Instead gold is among those assets being liquidated in the mad scramble for cash. While gold ultimately joining treasuries and going up in price is one way that the deflation might play out, that is not a given.

The U.S. Treasury Bull market is still intact after 27 years (see chart).

Many have been stating that treasuries are in a bubble, the bond market is reacting irrationally, the treasury market is manipulated, and all sorts of other similar statements. Who wants to buy a 30 year treasury at 4.3% when "inflation" is so high? Most who believe in the treasury bubble or massive inflation point to the CPI as a reason.

I tackled the issue of the CPI in "Real Interest Rates Are High". My conclusion is that if housing was adequately represented in the CPI that the value would be sitting at 1.3% not 5.6%. The claim is based on using Case-Shiller housing index in the CPI instead of Owner's Equivalent Rent. Housing prices, not some fictional rental value obtained as if one rented a house from himself, belong in the CPI. Houses are consumer goods regardless if one buy a house every year or not. People do not buy autos or computers or fishing poles every year either.

This is not a call for the Fed to lower interest rates, it is merely an attempt to show that the treasury market is not by any means acting irrationally. I have stated before and I will restate it now, the Fed has no idea where interest rates should be and that micro-management of interest rates by the Fed is exactly what has been causing bigger asset bubble after bigger asset bubble.

Fed Has Lost Control

Please see the Fed Uncertainty Principle for more on how the very existence of the Fed distorts the economic picture so badly that it creates self-reinforcing feedback loops that eventually blow sky high.

The high real interest rates that I claim we have are a function of high demand for money but no supply. In other words, the current repo system is completely broken and the Fed has totally lost control of the system.

Every step the Fed is taking is an attempt by the Fed to regain control of the system. So far every step has failed. For more on the FASB postponement, please see "Not Practical To Tell The Truth."

There is a very good reason for every step to fail: The banking system itself is insolvent. I listed 25 reasons in "You Know The Banking System Is Unsound When...." Here are reasons 1, 24, and 25.

1.) Paulson appears on Face The Nation and says "Our banking system is a safe and a sound one." If the banking system was safe and sound, everyone would know it (or at least think it). There would be no need to say it.

24.) There is roughly $6.84 trillion in bank deposits. $2.60 trillion of that is uninsured. There is only $53 billion in FDIC insurance to cover $6.84 trillion in bank deposits. Indymac will eat up roughly $8 billion of that.

25.) Of the $6.84 trillion in bank deposits, the total cash on hand at banks is a mere $273.7 billion. Where is the rest of the loot? The answer is in off balance sheet SIVs, imploding commercial real estate deals, Alt-A liar loans, Fannie Mae and Freddie Mac bonds, toggle bonds where debt is amazingly paid back with more debt, and all sorts of other silly (and arguably fraudulent) financial wizardry schemes that have bank and brokerage firms leveraged at 30-1 or more. Those loans cannot be paid back.

What cannot be paid back will be defaulted on. If you did not know it before, you do now. The entire U.S. banking system is insolvent.

At 30 times leverage all sorts of malinvestments and financial wizardry schemes were funded. Here are some examples: Incredibly, this very situation creates a demand for fiat currency for which to pay back debts.

Inquiring minds are likely puzzled by the incredible demand for fiat currency over gold. Inquiring minds may also be puzzled by the strength of the U.S. dollar over seemingly better Euros, Canadian dollars, etc. Let's tackle currencies first.

Dollar bears and commodity bulls were warned many times. It is not manipulation schemes driving the dollar, but rather an unwinding of leveraged anti-dollar bets on a rising euro, rising commodities, etc. There was widespread belief that Europe would decouple or would at least avoid a recession that the U.S. was in. When the decoupling myth was finally shattered for good, the "Great Unwind In Gold And Silver" began.

Many are in denial still, but deflation is right here right now. The case was made in "The Future Is Frugality." Here are the key bullet points: The only question now is how long deflation lasts, not whether it gets here. For more on deflation, please see "Deflation In A Fiat Regime?"

Should Gold Sink In Deflation?

Inquiring minds are likely asking: If gold is money and money gets more valuable in deflation, then why should gold be sinking?

Even though I have stated gold will do well in deflation, I have also stated that in the initial phases of deflation gold would likely be hammered as leverage everywhere was wiped out of the system. Some of that leverage is being destroyed right now. Indeed "Commodity Hedge Fund Ospraie Shuts Down After Losses." It was not the first hedge fund to blow sky high and it will not be the last either.

Leverage being reduced creates a demand for dollars. And dollars, contrary to popular belief, are actually in relatively short supply. The apparent conundrum is in mistaking credit for dollars. And when asset prices are sinking, and leverage is 30-1 (or more) as it is with banks and brokerages and hedge funds, that credit simply cannot be paid back. Attempts to do so cause assets to be sold are ever decreasing prices.

Leveraged trades (including gold) are now being unwound for the safety of treasuries. This explains the feeble rally attempt in gold during what should be a seasonally strong period.

Gold could turn around now or it might not. I have seen many reports calling for new highs by the end of the year, a strong seasonal bounce, etc. My personal guess was a weak but playable rally. It is becoming increasingly likely that there may not be a rally at all, or if one does come it will be from a much lower level.

The fact of the matter is that everyone is guessing and bottom callers have been fueling the decline by plunging in then stopping out. Furthermore, the surge in demand for gold and silver coins is potentially a very contrarian indicator. Since when has the small retail investor gotten anything right?

Key Questions For Gold, Commodity, Energy Bulls

What if you are wrong and prices head lower? Where is your stop?

Certainly the more overweight one is, the more important the answer is. Someone with a 5-10% position in gold and otherwise high cash positions is going to feel a lot differently about this selloff than someone who went all in when gold touched 850 thinking a big bounce was coming.

Deflation Models

I had several models for how deflation might play out. Here they are. Yes, this treasury bull is extremely long in the tooth. And yes there will be a time to short treasuries. But there has not been a bull market in history, in anything, that ended with that asset class being nearly universally despised.

And make no mistake about it, treasuries are despised. Foreign central banks do not count because they are not buying treasuries to make a profit, and they are relatively unconcerned about losses.

All things considered there is genuine pent up demand for treasuries right here in the U.S. should foreign buying subside. The reason is simple. It is far better to make 3% in treasuries than to lose 30% in equities, commodities, or corporate bonds.

Potential For Deflationary Crash

At this juncture the markets are definitely in a potential deflationary crash mode. And as stated above, I believe the Fed is essentially powerless to do anything about it. The Fed cannot possibly bail out every bank, brokerage, airline, and automotive company that is in dire straits. They cannot force sovereign wealth funds to do so either.

There is little doubt the Fed will try all sorts of schemes, but all those who were 100% sure Bernanke could do something better be asking what if he does not? Those who thought gold, silver, or energy was a one way bet better be asking the exact same thing.

In the meantime, the much despised treasury bull is alive and doing fine.


Kurt Kasun agrees with the credit deflation/de facto depression scenario. Unlike Mike Shedlock above, he appears to be less convinced that the full implications of a true deflation will actually play out. He believes the dollar rally will be relatively short-lived, seeing the rally is the result of other currencies being worse rather than any virtues of the USD. And Kasun warns of a U.S. stock market crash by year's end.

Things are about to get really bad. Rotating bubbles are now becoming rotating sector recessions as the positive feedback loops, created as money and credit growth ballooned over the last 25 years, have reversed and are now becoming negative feedback loops. I expect to see those 25 years of excesses dramatically unwind over the course of the next few years. The evaporation of paper wealth will be breathtaking. A "buy on the dips" mentality has been replaced by "sell on the rallies." Declining house values will further hinder the finance sector which will impede the real economy, causing asset prices to further plunge. The tipping point for debt creation's positive impact has been reached and we can expect economic convulsions similar to what a drug addict experiences after kicking the habit "cold turkey."

"The credit crunch is morphing from an American-centered financial crisis into a global economic crisis," according to David Bowers of Absolutely Strategy. The policy of creating more money than could be put to productive use in the real economy that allowed rising asset prices would more than compensate for a lack of "real" wage gains in the real economy and for consumers to continue to borrow and spend more than they earn at an accelerating pace failed once the excess money began to flow to commodities rather than to real estate or stock prices.

Growth is now demonstrably slowing in all parts of the world. Central Banks around the world will be embarking on a campaign of lowering their interest rates. Participants in the U.S. stock market, fresh off an artificially trumped up GDP restatement (trumped up due to the stimulus package and severe understatement of the GDP deflator), will take a while to realize that gains in the dollar are due to relative underperformance of other currencies and a massive liquidity contraction. The gains will be short-lived and will result in pain and agony as those investors are lured into another bear trap that will reveal itself once much of the sidelined money comes back into the market.

The fall in commodity prices will be wrongly interpreted as a reason for the economy to rebound and for stocks to rally. While the dollar will likely continue to rise over the short term it is ultimately destined to suffer the same disastrous fate as the other fiat currencies of the world. After the sucker's rally has run its course over the next few weeks or so, the reality of an unserviceable and un-payable debt overhang will set in and the second wave of financial calamity will ensue. This time around it will be the result of the effects emanating from the negative feedback loop coming from the real economy.

Scott Bugie of Standard & Poor's writes that the second phase of credit crunch could be severe: "The credit crunch is entering a second, 'post-subprime' phase where banks' loan books deteriorate more rapidly and capital-raising efforts might become harder," says Scott Bugie, credit analyst at Standard & Poor's. "Loan book deterioration is starting to hit a wider array of financial institutions, as credit losses migrate from subprime into other sectors of household finance, such as credit cards, Alt-A and prime mortgages, and auto loans well into 2009," he says.

Other mainstream economists are have also been sounding the warning trumpets: "The U.S. is not out of the woods. I think the financial crisis is at the halfway point, perhaps. I would even go further to say the worst is to come," according to Professor Ken Rogoff who was chief economist at the IMF from 2001 to 2004 and who now teaches at Harvard. He goes on to say, "We are not just going to see mid-sized banks go under in the next few months, we are going to see a whopper, we are going to see a big one -- one of the big investment banks or big banks."

In 2002 Dr. Marc Faber, author of the GloomBoomDoom Report and highly-sought guest for CNBC and Bloomberg TV, wrote a book titled, Tomorrow's Gold -- Asia's Age of Discovery. Those who read the book and followed Faber's investment advice to invest in commodities and Asian and other emerging market equities have significantly outperformed those who primarily invested in U.S. stocks (tech, consumer and financials). But Faber had recently cautioned against this "short dollar trade" as it had become stretched and crowded. He presciently warned investors late last year. More recently, referring to commodities, he said "Prices have made a peak. ... Whether that is a final peak or an intermediate peak followed by higher prices, we don't know yet. It could go lower."

He echoed similar sentiments in a Bloomberg TV interview this morning. I found his most recent market commentary, issued on August 20, 2008 titled, "Contracting Global Liquidity," quite compelling. He uses several charts to demonstrate how liquidity is contracting, the dollar is strengthening, commodities are declining, and what the relationships that exist between them predict for the future. He writes:

"In sum, credit growth and liquidity are contracting, a vicious economic downturn is about to unfold (China could surprise on the downside and put additional pressure on commodity prices) and asset markets are still high by historical standards and, therefore, remain vulnerable. I would use equity rallies as a selling opportunity and further weakness in gold as a buying opportunity for long term holders with significant cash and cash flows."

Faber has an enviable track record over the long, intermediate and shorter term. Not many investment strategists can boast of getting the market right over these three terms. He is an open-minded contrarian who is not afraid to change his views. He was way in front of the investment community predicting the rise of China and commodity prices six years ago. He correctly wrote that the U.S. currency and stock markets would relatively outperform others last year. And he got the April-May S&P 500 rally to 1440 right also.

The one longer-term trend Faber appears to have the most confidence in is the "long gold/short the DJIA" trade that has been working, despite the recent pullback, since 2001. Over the intermediate term he is a looking for what can be described as nothing less than a U.S. stock market crash, perhaps by the end of this year.

Rather than the U.S. markets leading the rest of the world higher, the evidence points toward the rest of the world leading U.S. markets lower. The global slowdown had begun in earnest. The U.S. is now more dependent on world growth than the world is reliant upon the U.S. This is especially true since the U.S. consumer is seeing his credit cut off and U.S. banks and financial institutions suffer the effects of the second wave of the credit crunch. Once the relief rally has run its course and investors see that the U.S. economic rebound has not staying power and only worn out consumers trying to pay off 25 years of accumulated debt, the dollar will rejoin the ranks of the other fiat currencies and resume its decline versus the price of gold.


Behind the credit bubble, avers distressed real estate investor Christopher Grey, was a systemic deficit in character. It is easy to explain bubble dynamics in terms of human greed and herding instinct, but for all that to work you need people who will succumb to the evolving something-for-nothing zeitgeist of the time. The idea that humans as a group will resist temptation is naive, but we think Grey is saying that one still can make an individual choice to step back from the "abyss," and preserve one's soul.

“Man looks in the abyss, there’s nothing staring back at him. At that moment, man finds his character. And that is what keeps him out of the abyss.” ~~ Lou Mannheim, Wall Street, 1987

The last year has not been kind to bankers. Many of them probably feel like the whole world has turned against them. Regulators and auditors are crawling all over them. They are facing massive write downs in their portfolios. Loan defaults and foreclosures are rising at an unprecedented rate. They are forced to go begging investors all over the world for more equity capital just to survive.

By some estimates, such as those of noted economist Nouriel Roubini of NYU's Stern School of Business, banks may face over $1 trillion of losses and write downs from this credit crisis and as many as 1,000 U.S. banks will fail. Nobody knows how severe this banking crisis will be or when it will end, and there are those who say it will be resolved a lot more quickly and less painfully than expected. Regardless of what happens in the future, what can lenders and borrowers learn from this crisis so that we do not find ourselves in this mess again for a long time?

There is a lot of blame to go around. The Federal Reserve failed to properly regulate the banking system and kept interest rates way too low for way too long to avoid being criticized for the recession that was caused by the previous stock market bubble of the late 1990's.

Lenders became originators and salesmen and threw out the underwriting process because they believed there would always be a greater fool to buy even the worst loan and remove it from their balance sheet.

Borrowers believed asset prices would rise forever and did not want to be left behind while everyone else was getting rich by borrowing as much as possible to speculate. Nobody cared that it was a bubble. Everyone just wanted to get theirs.

There is a common theme to all of this. Everyone throughout the financial system was suffering from a simple lack of character. Although there were excesses in Europe and all around the world, by far the worst excesses in this credit bubble were here in America. We need to ask ourselves why this happened here so much worse than everywhere else. On this topic, the head of the Swiss central bank said recently, "What is going on in the American economy is unbelievable and shameful." What is he talking about?

I think he was talking about our financial system, which for too many years has excessively rewarded extreme risk taking, especially on Wall Street, and has failed to sufficiently punish recklessness, incompetence, and even outright dishonesty. In fact, on too many occasions, bad behavior has gone completely unpunished or even rewarded. A great example of this recently has been the enormously lavish severance packages given to Wall Street CEOs who completely destroyed the balance sheets and possibly the entire futures of their respective companies.

What does it say about the character of a financial system that pays someone $150 million for destroying a company that he was hired to lead?

With this kind of example being set in the corporate boardrooms and on Wall Street, is it any surprise that so many Americans, even those who can afford it, see no reason to continue making their mortgage payments if they no longer have equity in their homes? This credit crisis in America, at its most basic level, is a crisis of character in this country, and character begins at the top.

Alan Greenspan's and Ben Bernanke's refusal to accept responsibility for their obvious and horrendous failures of regulatory oversight and interest rate determination has trickled down to Wall Street and Main Street CEOs who gorge themselves on generous pay packages even as their companies sink into oblivion.

That same lack of character has trickled down to bankers who see no reason to honestly underwrite loans or to take responsibility for their mistakes and honestly mark assets down to current market value. Borrowers, similarly lacking in character, frequently will not even consider trying to pay back a loan unless doing so in their own best interests.

The basic concepts of responsible regulation, compensation, lending, and borrowing were largely thrown out the window for many years and this credit crisis is the inevitable and disastrous result of that reckless process.

How can we reverse this process and get our financial system back on track? Some people think government bail outs are the answer. While there is no doubt that the government must offer some assistance to save Fannie Mae and Freddie Mac and stabilize the system, this is not the answer to our problems. I believe the real answer and antidote to future crises like this is for some people at the top of our financial system to start setting an example for everyone else and take some responsibility for their mistakes.

Here are a few of specific suggestions that I think would be very helpful and send the right message to the country: I am not saying that any of these individuals are bad people. I do not know any of them personally, and I will give all of them the benefit of assuming that they are all wonderful people. However, I think they are all very high profile examples of people who made horrible errors in judgment and have failed to take responsibility for those errors.

We cannot begin to heal our financial system until people at the top start setting an example for the rest of us. How can we ask a struggling family to keep making their mortgage payments instead of walking away if the people at the top who created the system that caused this mess do not take responsibility for what they did?

Bankers are staring into the abyss. Will they find their character? I hope so.


Cheap credit leads to bankers with money burning holes in their pockets, anxious to lend to anyone who will take on more debt. This leads to the overproduction of banker-favored assets -- almost always real estate. The overproduction leads to a collapse in returns which hurts everyone in the business, including those who prudently refrained from taking on more debt at the end of the cycle. This leads to a collapse in asset values. Even the cautious businessman can go bankrupt if he has any leverage when the cycle turns. Once the collapse happens those with the cash can scoop up the depressed assets. Cash is the opposite of debt. Cash is good in a credit liquidation.

A Texan customer who came to see me a few months ago told me a story which illustrates the fine mess we are in.

In the 1980s boom his neighborhood boasted not one but two commercial real-estate developers, both of whom were building shopping malls. The one developer was cautious. He had already built two malls successfully, and by re-investing some of his profits as equity in his new project he had reduced his leverage and his risk.

Further along the avenue, however, was a more aggressive developer. He had borrowed 98% of his construction costs on artificially cheap credit; money which had been pumped into the banking system by the Fed to keep the economy steaming along.

Anyway, the experienced developer was earlier into his construction project and completed it ahead of schedule -- and he got his mall nearly fully occupied. His competitor, as well as being more highly geared, was slower to build and later to complete, so you can guess what happened next.

As the early '80s boom in Texan oil projects and real estate turned into bust, the new mall could not get any tenants, which meant there was no revenue to pay down the debt. The aggressive developer went bust, and with the local economy sagging, the near worthless debts on his empty mall were sold by the bank at just $0.18 on the dollar.

That allowed the new owners to slash the asking rents. They charged $0.04 on the original construction dollar, making a yield of 4/18 -- a healthy 22% yield on their outlay. But that rent deeply undercut the other, more cautiously built shopping mall. It was charging $0.12 on its construction-cost dollar, fully three times as much.

Naturally, as the recession wore on, the cautious developer watched his tenants quit his mall for those cheaper rents down the freeway. So now the cautious developer failed too.

Why? Because overcapacity -- first of credit, then of malls -- had driven the local price of rented retail space down to third of its reasonable rate of return. The total rent that could be earned on two malls was significantly less than what could have been earned on one.

I have always found it difficult to make the logical step from cheap credit -- which sounds so helpful -- to financial collapse, which seems so regularly to follow it. This story shows how the route passes through overcapacity. Yet even overcapacity was not bad news for those investors who bought the distressed mall at 18% of its construction cost.

How were they able to get such a bargain? Simple. They could raise cash when almost no one else could. That probably meant they were debt free at the end of the expansion, and had found a reliable store of ready value as the credit liquidation played itself out.

I like to think that lots of readers will one day be the opportunists in stories like this, though I also believe the credit crunch has a long way to go, which means it will not be for some considerable time. Gold certainly does not offer a 22% yield, but when other asset classes do, perhaps sellers of gold will contribute the capital which kick-starts our economies from the bottom of the coming slump.

Until then debtors, politicians, and central bankers will call us hoarders, and accuse us of destroying the economy. It is not a label that makes me feel particularly proud, but I think I can live with it.


The always erudite and educational Martin Hutchinson sees Keynesian economics rearing its ugly head again, even as it remains theoretically and historically discredited. Prepare for the economic stagnation that accompanies the practice of Keysianism.

The historical evidence could not be more clear that a small public sector is consistent with vigorous economic growth. Postwar Hong Kong is perhaps the poster child example of this. Conversely, large public sectors are strongly correlated with stagnation. Witness the "Eurosclerosis" infections among the major Western European economies in the 1970s. Or, in a still ongoing saga, the fruitless attempts by Japan to use government spending to stimulate its way out of slow growth since 1989. (If they continue this policy, any attraction we have towards the Japanese stock market will be substantially muted.)

As big a scam as Keynesianism is, it cannot compare with the scam of government itself. And government and large public sectors go together like hand and glove, absent some unusual consensus or arrangement that imposes an uncharacteristic restraint on growth.

The resignation of Japanese prime minister Yasuo Fukuda on the grounds that his "fiscal stimulus" of $18 billion was inadequate throws into sharp relief a troubling reality: That most economically counterproductive of activities, the Keynesian boost in government spending, is making a horrid comeback. Like some eldritch creature from a 1950s Saturday morning horror serial, the old charlatan John Maynard Keynes never stays dead.

Even before the Great Depression, Keynes had been seeking some way to make his mark on economics that involved overturning some part or other of the classical economic paradigm. Since the world was still primarily on a gold standard, he could not usefully invent monetarism -- in any case, he never seems to have got the hang of interest rates. Denouncing Britain's 1925 return to the Gold Standard was enjoyable, giving rise to numerous witty epigrams that went down very well with his Bloomsbury friends, but it was not sufficiently original -- too many other economists were doing the same thing.

Since the most enjoyable part of Keynes's career had been his period as a senior civil servant, it was natural that he should see economic life as best directed by a team of highly intelligent civil servants like himself. It is a well-known conceit. Sitting in a comfortable armchair one can always see how the world should be better organized, the only difficulty being how to get oneself appointed dictator with the power to organize it. Keynes faced only two problems. First, the existing economic theories postulated a government that was small in terms of the economy as a whole and pursued balanced budget policies -- so could have little effect on major economic trends. Second, the political party he supported, the Liberals, was undergoing a series of traumatic election defeats, well on its way to utter irrelevance.

Keynes's work advising Lloyd George in the run-up to the 1929 election was seminal. He discovered that politicians, particularly activist ones with little grasp of economic reality like Lloyd George, were delighted to be given a rationale for spending more of the taxpayers' money on social programs, which could be used to bribe voters. While the immediate result of Keynes's work in the May 1929 election was failure, it left the Liberals and Keynes as their chief economic adviser in a position of balance of power. For two years, he could use his powers of persuasion to advance his theories, while disparaging efforts by the Conservatives and by the cautious Labour Chancellor of the Exchequer Philip Snowden.

Keynes's dreams of power came to a sharp end in 1931, with the collapse of the Labour government. The new Chancellor of the Exchequer Neville Chamberlain thoroughly distrusted Keynes and cut him off not only from the advisory top table but from his sources of insider information which had proved so lucrative -- causing Keynes's net worth to decline by 2/3 between 1931 and 1936, even as the market was recovering.

Keynes despised the highly successful Chamberlain economic policies of public sector pay cuts and a modest tariff, which produced almost immediate economic recovery and made Britain's 1930s experience far more benign than America's. To get his revenge, he flirted with Communism and wrote the General Theory of Employment Interest and Money -- two out of the three of which he knew very little about. The book was immediately influential among left-leaning civil servants, and resulted in Keynes's readmission to the corridors of power when war broke out in 1939.

From then until the 1970s, Keynes was never out of power, in the flesh until 1946 and then in spirit. Much of Britain's postwar poverty and lack of economic growth were due to his pernicious influence, whether domestically, in ensuring that government always overspent, or internationally, in setting up the statist postwar financial system ... gave Britain 30 years of economic stagnation punctuated by balance of payments crises and left us with the World Bank and IMF, still blighting the world economy today.

The inflation and slow growth of the 1970s at last caused policymakers to question the Keynesian synthesis, and in particular its recommendation of indulging in bursts of public spending every time the economy slowed. Far from there being a neat tradeoff between unemployment and inflation, it had become clear that as Keynesian public spending was increased, economies were very likely to get both, while growth rates became ever more sluggish.

To a classically-trained economist this was not surprising. Government spending, as Nobelist James Buchanan was to point out at length through public choice theory, involves bureaucrats disposing of resources in ways that suit the bureaucrats, not the owners of the resources. Consequently, it is much less efficient than private sector spending, automatically optimized by the resources' owners. Hence diverting resources to the public sector has a substantial cost in productivity and growth, worsening the tradeoff between unemployment and inflation.

Using OECD figures for public sector size and economic growth you can run a regression for the period since 1960. You will find that more than half the differences between countries and eras in growth rates can be explained by two factors: the size of the public sector and [the public sector's] rate of growth. Very large public sectors lead to very sluggish economic growth rates, while the fastest growth rates among OECD members are in countries such as Korea and Japan before 1990 that have the smallest public sectors. Further, periods of rapid public sector growth, as in Britain in 1964-79, West Germany in 1969-76 and France in 1974-82, produce sluggish or non-existent economic growth, even if the public sector early in the period is relatively modest.

The revival of free-marketism in the 1980s and its successes, first in Britain and the U.S., and then with extraordinary results in East Asia, China and India, appeared to have doomed Keynesianism to a well-deserved irrelevance. To the extent that "stimulus" was thought necessary, it was carried out by tax cuts rather than spending increases. These proved equally politically popular and less damaging to long term growth. Unless the tax cuts had a substantial supply-side effect, as in the case of the Reagan tax package of 1981 and the U.S. dividend tax cut of 2003, this "Republican Keynesianism" however produced ever-larger budget deficits, which could only be financed through ever-looser monetary policy.

The "Washington Consensus" of the 1990s, supported even by the naturally statist World Bank and IMF, notably did not include support for Keynesian reflation. Indeed, it was largely deflationary, although in deference to its origins it generally took the existing level of public spending as a given and balanced budgets through tax increases, rather than the other way around, thus producing a ratcheting up over time in the size of governments.

In the 1990s, the last bastion of Keynesian public spending was Japan, where the collapse of the 1980s bubble produced a lengthy recession, worsened by the refusal of the Japanese banks and their regulators to recognize that most of their real estate loans were of little or no value. Stimulus package after stimulus package was introduced, largely taking the form of infrastructure projects in rural areas (popular with backbench LDP parliamentarians). The most notorious of these, in 1998, was for no less than $400 billion -- 10% of Japan's GDP. Needless to say, these packages had no positive effect. The 1998 effort indeed produced a renewed lurch into deeper recession, as free marketers would have expected. They merely increased the size of Japan's public sector, depressing the economy's efficiency and long term growth and caused its public debt to spiral to over 180% of GDP.

The futility of Keynesian public spending stimuli was demonstrated exhaustively in Japan in 1990-2001. The success of the opposite policy, cutting back the size of the public sector and allowing the private economy to expand into the economic space opened up, was shown by the government of Junichiro Koizumi after 2001. From the early months of 2003, when the new policies began to take effect, Japan resumed healthy growth. As of Koizumi's politically forced retirement in 2006, all that was needed was an increase in short term interest rates, to prevent inflation and give adequate returns to Japan's legion of savers; and continuing budgetary restraint, to reduce the deficit, start paying down the monstrous public debt and return Japan to the small-government position that had produced such remarkable economic growth before 1990.

Regrettably Koizumi's retirement produced opportunities for backsliding. His two successors, Shinzo Abe and Fukuda, tried to maintain his policies but were less skilful than Koizumi in facing down the public spending barons. At the central bank Toshihiko Fukui, the sound-money governor chosen by Koizumi in 2003, stopped increasing interest rates in early 2007 because of an upper-house election campaign, then wimped out at a crucial meeting in August 2007, as the cheap-money faction was able to claim that the beginnings of the U.S. subprime crisis required Japan to maintain low interest rates. When Fukui's term ended in March 2008 he was replaced by an inflationist, and Japan's short term rates are now substantially negative in real terms.

With Fukuda's resignation, and the likely succession of pro-spending Taro Aso, the path is now clear for Japan to return to primitive Keynesian public spending, combining it with negative real interest rates in a poisonous combination reminiscent of 1970s Britain. This will produce one of two outcomes. If the Bank of Japan is more inflationary than the Ministry of Finance is profligate, inflation will soar, reducing the real value of Japan's government debt, but impoverishing the middle classes and producing long term stagflation. Alternatively, if Ministry of Finance profligacy wins out, inflation will not destroy the value of Japan's public debt quickly enough, and its size will spiral upwards until the country is forced into default. Not a happy future either way.

Alarmingly, the return of Keynesian deficit spending is not confined to Japan. In both Britain and the U.S., governments of opposite political persuasions have found it convenient to spend public money, while excessively low interest rates have kept the apparent cost of financing their deficits artificially low.

In both countries, the bursting of housing bubbles produced by over-expansionary monetary policies have caused governments to invent various housing bailout schemes, all of which increase public spending without providing a means to finance it. The resulting recessions, possibly accompanied in the U.S. by the advent of a leftist government, will cause demands for additional spending to spiral. The politicians will accommodate these demands, since memories of the 1970s are now dim, while the more recent memories of the (temporarily non-inflationary because of innovations in global communications) something-for-nothing possibilities of 1995-2006 will prove only too alluring.

Eventually deep recession and spiraling inflation will cause even politicians to realize they have got it wrong. By that stage however government will be taking an even larger portion of the economy than it is currently and long term growth prospects will be correspondingly depressed.

"Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back," said Keynes. One of the very few times he got it right.

Another noteable Keynes quote is: "Practical men, who believe themselves to be quite exempt from an intellectual influences, are usually the slaves of some defunct economist." One wonders if he realized that the "defunct economist" he was referring to would end up being himself, in spades.


Wood prices take a beating as U.S. housing shrinks further.

The weekly Barron's "Commodities Corner" column is a good place to start getting a fundamental education on the various markets, as a context for one's trading/capital management system. Last week we covered their piece on the platinum market. This week the lumber market gets a once-over. There are studies out there that make a good long-run case for timberland as an investment asset -- claiming it provides better average returns than stocks while being uncorrelated with financial asset returns -- but current times are undeniably tough for the primary timberland output, lumber.

It is going to be a long, cold winter for the lumber industry. It will survive, but it is not likely to thrive.

Not only is lumber suffering from the well-known woes in the housing market, but increased production threatens a delicate balance between supply and demand. The bearish outlook comes as lumber values head into their typical seasonal downtrend from late summer to fall.

This could mean that lumber prices, after bouncing off their lows in March, could fall again. [Last] Friday, the September lumber contract at the Chicago Mercantile Exchange settled at $251.20 per thousand board feet, down $1.30 for the day and 80 cents -- or 0.32% -- on the week.

Between foreclosures, available new houses and existing dwellings on the market, there is an estimated 10-to-12-month supply of houses to sell at the current rate, says Bob Book, senior lumber analyst at TJ&R Trading. With that sort of glut, the number of speculative houses expected to go into construction this fall, before the cold weather hits, will slow significantly.

Because of the housing slump and the drop in prices -- nearby CME lumber prices were as low as $185.70 in March 2008 -- some mills shuttered and others reduced capacity. Henry Spelter, economist at the U.S. Forest Service's Forest Products Laboratory, says that as of January 1, there were 969 North American (Canadian and U.S.) sawmills with a stated capacity of 77.35 billion board feet annually, down from 990 mills in June 2007. Nine of the remaining mills have closed at least for a time, and several were mothballed for some of the summer for annual maintenance and vacation.

Spelter adds that capacity-utilization during the first six months of the year also dropped. The 75% estimated utilization rate was well below the 93% average from the 2002-2006 period.

The crimps in output helped lift prices off the spring lows of about $185, but with demand still expected to decline, forecasts of increased production could send prices right back down. Output is expected to ramp up a bit now that the summer schedule is over, and now that the recent rally in the greenback versus the Canadian dollar makes it a little more profitable to restart.

Even a small rise in output could oversupply the market, says Jamie Greenough, broker and lumber-market analyst at commodities brokerage Global Futures. TJ&R's Book says mill prices could drop $60 to $65 before mills shut down again.

In the very short term, nearby CME futures could go up simply because of the futures' hefty discount to the cash market (including wholesalers), Greenough notes. But once the September contract expires, any rallies should be seen as selling opportunities.

"Given the present supply-demand implications through the winter, it would be hard to think of going long in any contract month," Greenough says.


Charles Maxwell correctly predicted the recent price spike ‐ and he sees an eventual move to around $300 a barrel.

Charley Maxwell is one of the most respected analysts in the energy business. 50 years worth of experience and making a lot of good calls will do that for you. Among the later was his prediction almost exactly four years ago that prices would be a lot higher by 2010, although his projection was for far less than the $145/barrel hit earlier this year, when conventional wisdom was that oil would at least stay below $40.

Now Maxwell tells us to expect oil to hit $250 in today's dollars by 2015. He is among those who believe we are hitting a peak in oil production, and that the world faces a major adjustment in accommodating that fact. The adjustment will be made difficult by oil not having a close substitute, especially for transportation uses.

Charles Maxwell, who began his career in the energy business in 1957 working for Mobil Oil, is no stranger to Barron's readers. In an article he penned nearly four years ago, Maxwell predicted that oil prices would move sharply higher by 2010, and then higher still. Maxwell, 76, got the timing and trend right, though his top price of $60 a barrel by 2010 proved far too low. "Oil is unique in that when it begins to disappear, there really aren't any good substitutes, which there are for so many other commodities," Maxwell says. "It's that lack of substitutes that forces the pricing mechanism to balance supply and demand."

Maxwell has worked since 1999 as senior energy analyst at Weeden & Co., an institutional brokerage firm in Greenwich, Connecticut, having started as an energy securities analyst in 1968. Oil prices came down last week, trading at around $108 a barrel, but he predicts an eventual sharp move upward -- to around $300 a barrel -- owing to a lack of available supply. Barron's caught up with Maxwell recently for his latest assessment.

Barron’s: What is your prediction for the price of oil over the long term?

Maxwell: I see it heading on an upward slope. Around that long-term line, there will be a lot of ups and downs. I thought the peak on this cycle might be somewhere around $100 a barrel, but it turned out to be a lot higher, more than $145 in early July. But like a child's blocks piled one upon another, you finally reach a point where at $145 they were beginning to sway. It had gone far beyond the fundamentals. So the questions are: "What are the fundamentals and what should the price be?" The answers depend on where you are sitting and what you own.

What is your view?

I would put the price of oil today at somewhere between $75 and $115. That implies quite a fast rise, given that we were averaging about $32 a barrel for West Texas Intermediate in 2003. However, it is perception that really is changing, not the true value of oil throughout the system. The perception change involves whether we are going to move into an era where oil supplies will be generous and easy to find and, therefore, relatively cheap -- or whether those supplies are going to be closed off for both political and geological reasons.

Which scenario do you see?

We are not going to have enough oil, and we are going to have to start a huge switch in which we make do with a number of other fuels that are not so easy to convert to our immediate energy needs, mainly for transportation.

It sounds like this comes down to not having enough supply to meet demand.

We will have enough coal supply to meet demand, but the real question there is, "Can we afford to substitute a great deal of coal given the emission problems?" The carbon footprint of coal is very high. We will be forced to use some more coal, but until we develop clean-burning coal technologies and underground gas fields to store carbon dioxide, we are going to be under very tight restrictions on its incremental use. That does not seem to be such a bad thing until you look at, say, nuclear power, which would be another big alternative, and you realize that it is being used effectively by the French, the Japanese and the Germans. But for various reasons, nuclear power has become a political football in the United States. If we committed to nuclear power today, we would not have it up and running for another 10 years or longer.

Does the tight oil supply, coupled with a lack of enough viable alternatives, make the U.S. vulnerable in terms of having enough energy supply?

It does, probably between about 2010 and 2025, thanks to a lack of sufficient power to drive our economy on an upward course. We have not yet seen declining energy supply at a time of growing GDP. So for the moment, we will need more power to drive the world economy higher.

What has been constraining the supply of global energy, oil in particular?

There are several factors, one being resource nationalism. The Russians are the classic example. They are not against us, but they simply want to develop their own supplies in their own way, on their own timetable, with their own money and with their own methods. Another example is Iraq. I said once to a junior minister of that country that Iraq would be producing 9 million barrels a day with the full development of reserves that most of us think are here, as against the 2 1/2 million barrels a day they were producing at the time. And he said to me, "Could we do that? Yes. Would we do that? No." He said, "I predict you will never see more than 6 million barrels a day coming from Iraq, ever" [to preserve the supply].

Another constraint is political instability in various places, including Nigeria. There is also refining, which is probably one of the easier constraints to solve. The world is using a great deal more lighter crudes, and we are actually producing more of the heavier crudes. We have to continue to change the refining system to handle the heavier crudes in order to give us the lighter products.

What other constraints exist?

Many countries, for political reasons, do not want to allow oil companies to come in and do business. They do not like us, the U.S. in particular. Venezuela is an example where they do allow you to come in, but under terms that are so harsh that companies don't. The remaining constraint relates to geology, although it is not the primary issue today. It is the geopolitical and the instability issues that are stopping the biggest part of the development.

How would you sum up the geological issue?

The easy places to find the oil have been, in most cases, tested, proven and produced. This occurred in the continental U.S. in the 1920s and 1930s and, on a worldwide basis, in the 1960s and 1970s. Now we are looking for oil in places like the Arctic of Russia or the Arctic of Alaska, where costs are much higher. It is not only more difficult to operate in those places, but it is a long way to transport the oil. There may be a great deal of oil under Antarctica, but, because it is a land mass, unlike the North Pole, which is water, we cannot see through the ice sheets that cover Antarctica. So we do not know where to drill there.

There is also the issue of existing fields that are diminishing. The classic example is that in 1985, the North Sea produced 2 1/2 million barrels a day from nine fields, compared with about 1.7 million barrels today from nearly 100 fields. We are running desperately on a treadmill on which it is very difficult to stay up, because they are not finding as many new fields as old fields are being depleted.

At some point, does it not come down to lowering consumption or tapping alternative sources of energy?

Right, and we will probably do both. Ten years ago, 40% of the world's energy was in oil, versus 39% in 2006. It should reach 38% in the next five years -- and 37% three years after that. So oil is slowing, and I expect it will stop its growth around 2015, at which point the supply begins a slow retreat.

Then what?

We will either have to reduce our economic growth around the world, which has all kinds of political and social repercussions attached to it, or we will have to find a substitute for oil. But it turns out that oil is a remarkable type of energy, as it does not spoil when you keep it overnight in a warm dish. It transports easily. It stores easily. It is very fluid. You can pump it across long distances. Oil has been the basis on which we have made a remarkable economic expansion, and now we may be tested by something a lot more serious, which is a coming shortage of oil and a need to start using other forms of fuels, which are not naturally the ones that we have developed.

Where does natural gas fit in?

Its supply should last another 40 or 50 years before it runs into the same problems of peaking that we have in oil. Natural gas has a very low carbon footprint, meaning it is a cleaner type of energy, and it has wonderful petrochemical adaptability. But it does not help at the moment to solve our principal problem, namely oil supply, particularly for transportation uses.

The dependence of the U.S. on foreign oil has grown significantly. Where do you see that going?

Dr. M. King Hubbert, the great geophysicist for Shell who gave his name to the Hubbert's Peak, said that we would reach the limit of domestic production of oil in the continental United States in the early 1970s. That, he said, would touch off a major change in the way we lived, the way we drove, where we lived, and so forth. But when we actually got there -- and he was correct that it was the peak of American oil in November 1970 -- the transformation to the use of foreign imported oil was almost seamless. There was no great change in people's habits. He thought the American public would never be stupid enough to fall for the concept of foreigners continuing to give us all the oil that we wanted.

Could you elaborate on why you see the price of oil going much higher?

The price is eventually the only thing that will slow down the use of oil; the rising price tells us that we do not have enough of it. So, we are now beginning a bitter, bitter competition for fuels that will see the price continue to rise to these ridiculous levels.

How high do you think the price of oil will go from here?

We will see $300 a barrel -- or roughly $250 in today's dollars -- because oil supply will be so short. If you want that oil, that is what you will have to pay for it. That will be in 2015, after the peak of oil [supply]. But even earlier, around 2010, more than 50% of the non-OPEC world will have peaked in its production of oil so the dependence on OPEC will become extreme. That will give OPEC a chance, I am afraid, to lift prices rather more quickly on us than they are doing today.

What concerns you the most about such high oil prices, assuming that turns out to be the case?

One thing is that people are going to be asked to change much faster than they are willing to.

What is on the horizon over the next two years?

Supply and demand will be equal temporarily. There are three or four Saudi oil fields coming on stream, but there will not be any more low-sulfur crude fields coming on after the end of 2010. There is also the recession, which takes away some demand, but oil prices will remain high.

Where do you see energy investment opportunities right now?

The tar sands, particularly those in western Canada, will be one area where the oil industry will continue. That includes companies like EnCana (ECA), which is on my buy list. It is an integrated energy companies with big exposure to natural gas. It has a deep asset base, huge North American land holdings and a disciplined management team. My target price, which is for the next 18 months to two years, is $112, compared with around $67 recently.

Any other investment themes?

I see other types of opportunities developing in energy, although not in the traditional areas. It is going to be a lot easier in the next 10 years to reduce demand than it is going to be finding new supplies to substitute for oil. That is a very big principle. It will require increasing amounts of energy, particularly electricity, to run the new world.

Can you be more specific on companies?

There are going to be so many new companies and so many new technologies that it boggles my mind at the thought of identifying all of them. There are going to be a lot of new industries coming in and wonderful opportunities in the stock market. But the old names in energy that I have covered for years will not be what they were. Most of the oil companies will be swallowed up by the larger ones. Then the larger ones will be broken up into trusts or new corporations. I do not think the oil industry can go on as it is now.

What kind of world can we expect to live in with all of these changes?

It will be a little simpler. Your friends are going to be a little closer to you than they were before. Your vacations are going to be a little closer to home. You are going to have lower temperatures in the house. We will drive smaller cars with less horsepower, but they will get 60 to 80 miles to the gallon, enabling us to stretch gasoline supplies a lot further. There are going to be thousands of new adjustments leading to new investment opportunities. But the adjustment to that rising oil price, which could take as long as 20 years, will be a very harsh social experience -- not only for our society, but for every society.

Thanks very much, Charley.


It has been 10 years since the most famous hedge-fund collapse ever. But have investors taken this event to heart?

Mark Hulbert's Hulbert Financial Digest is probably the best known of the investment newsletter tracking services. He was a pioneer in bringing rigorous tracking to an arena notorious for promotional claims which are highly divergent from the results a subscriber could have obtained following a letter's advice in real time. We respect the job he has done in the now almost 30 years since he introduced his service.

In this article Hulbert notes the almost total lack of attention paid to the 10th anniversary of the collapse of Long Term Capital Management. Hulbert thinks the speed with which collective amnesia about the event set in, an event which could have collapsed the entire financial system absent a typical Greenspan-Fed injection of eau d'hair-of-the-dog, is unusual. Hindsight is always 20-20, but we, on the other hand, cannot elicit much in the way of astonishment. The Fed intervention/paper-over resulted in the crisis being very short-lived, and occurred in the context of the advanced stages of a very vigorous mania. The 1973-74 bear market with which Hulbert compares the LTCM crack up was, in contrast, a grindingly tortuous affair which started several years after the 1960s mania had peaked. The recovery from 1973-74 was also halting; the market did not set a decisive new high until 1983. Amnesia around l'affaire LTCM derives from there being very little pain to forget.

One thing Hulbert certainly has a valid point on: The stock market selloff associated with LTCM was sharp, as was the recovery which followed. But one might have thought that investors would have absorbed some lessons with regard to the dangers of the high levels of leverage and of "the chutzpah and arrogance implicit in such aggressive bets." As we know, if such lessons were absorbed they were not acted on. "By 2005 and 2006, many hedge funds were investing heavily in various complex derivatives whose implicit leverage made LTCM look conservative by comparison. But, except for an increasingly few voices in the wilderness warning that risk had not actually disappeared, the market as a whole did not seem to care or even to notice."

This month marks the 10th anniversary of the collapse of hedge fund Long Term Capital Management (LTCM). Given how momentous an event it was at the time, I would have thought that this anniversary would have already received widespread notice. After all, many then worried openly about the potential for LTCM's demise to bring down the entire financial system, something that is eerily similar to the discussion that accompanied the troubles in recent months at Bear Stearns, Fannie Mae and Freddie Mac.

Yet, curiously, this month's anniversary has received precious little attention. Just an oversight by overworked and harried financial commentators?

Perhaps. But unlikely.

I believe that it is more a case of the collective forgetfulness that recurs like clockwork at certain stages of the market cycle.

It is this forgetting that enables a new bull market to emerge from the ashes of the previous bear market. That is because those who too acutely recall the casualties of the previous decline will be too scared to venture back into the market. As these amnesiacs start earning sizable profits, more and more erstwhile skeptics are seduced into forgetting as well.

Gradually, anxieties about a bear market recede further and further into the collective unconscious. Those who nevertheless persist in recalling that previous bear market, and in reminding everyone about market risks, are considered increasingly anachronistic and old-fashioned.

Does this process sound familiar? It should, because that is exactly what happened between 2002 and 2007. An increasing number of investors and investment managers over this period began constructing their portfolios on the implicit assumption that risk was so small as to be statistically insignificant. The last year's bear market, of course, has reacquainted them with a very lively awareness of the risk that was always there.

By no means am I the first commentator to note this psychological element of the market's cycle, and in particular to the crucial role that forgetting plays.

The classic portrayal of the cycle belongs to Adam Smith, the pseudonymous author in the late 1960s of the famous book The Money Game. Smith introduced the notion of a "Kids Market," one in which the investors making the most money are those too young to remember the last bear market.

"Memory can get in the way of such a jolly market," Smith wrote. He referred to this memory as "that malaise that comes with the instantly gone, flickering feeling of déjà vu: We have all been here before."

Smith created a fictional character called The Great Winfield, who only hired investment managers who were not yet 30 years of age: "The strength of my kids is that they are too young to remember anything bad, and they are making so much money that they feel invincible," Winfield is quoted as saying. "Now you know and I know that one day the orchestra will stop playing and the wind will rattle through the broken window panes, and the anticipation of this freezes us."

So, to that extent, what has happened in recent years has adhered to a long-established cycle.

There is one feature of the post-LTCM cycle that strikes me as unique, however: How quickly this cycle appears to be playing itself out in the modern era -- how quickly we collectively can forget, in other words.

Contrast recent experience with the years following the 1973-74 bear market, for example, an event that investors quite understandably found to be incredibly traumatic. Their trauma lived on for years thereafter.

When I started tracking investment newsletters in 1980, for example, and throughout that decade and even into the early 1990s, newsletter editors had a very lively sense of the risks inherent in the stock market. They formed the veritable wall of worry that the bull market climbed.

In other words, the memory of that bear market remained fresh and widespread for nearly two decades. It was not until the go-go years of the 1990s were in full swing that those memories finally in large part gave way to forgetting.

Contrast that lengthy process of forgetting with what happened in the wake of LTCM's demise, just 10 short years ago. We might have guessed that it would take years for investors to forget the dangers of the high levels of leverage and of the chutzpah and arrogance implicit in such aggressive bets.

But it did not. By 2005 and 2006, many hedge funds were investing heavily in various complex derivatives whose implicit leverage made LTCM look conservative by comparison. But, except for an increasingly few voices in the wilderness warning that risk had not actually disappeared, the market as a whole did not seem to care or even to notice.

Where does the current stock market stand in relation to this cycle of remembering and forgetting? Or, to ask this question another way, is the current market a "Kids Market?"

To come up with some clues, I turned to the investment newsletters tracked by the Hulbert Financial Digest. I considered first those newsletters that have been around since the 1973-74 bear market. On average, the graybeards who edit these newsletters are almost entirely out of stocks. In contrast, the newsletters on the Hulbert Financial Digest's monitored list that have been published for less than 10 years are, on average, 62% invested in U.S. equities.

Another clue is provided by the list of newsletters with the best returns in recent months. The top 10 for year-to-date performance, for example, do not include even one service that was published in the 1973-74 bear market. And just two are edited by the same adviser who was also editing the newsletter during the 1987 stock market crash.

Both clues suggest to me that we may be about to enter another Kids Market. At a minimum, there already exists a large group of advisers and investors who either are eager and willing to forget past market traumas, or who are simply too young to remember them. Whether or not a new bull market is already underway, however, depends in no small part on how many other investors they can persuade to join them.

If they succeed, you will feel an increasingly strong urge in coming months to forget about the past. But, as Long Term Capital Management should have taught us all 10 years ago, risk never really disappears.


Which companies are most esteemed by investors?

Markets make opinions, and almost surely a rising stock price leads to investor esteem of the company so blessed. But investors are not totally short-term oriented. In Barron's 4th annual survey of "professional investors" ranking the world's most respected companies, past favorite Johnson & Johnson once again topped the competition. J&J "perennially wins kudos for its strong and deep management, a culture that focuses on long-term business objectives, and attentiveness to generating shareholder value."

Proctor & Gamble, Toyota, Nestle and Coca-Cola also garnered high rankings. General Electric dropped to 11th place in this year's survey, after placing 2nd in 2006 and 5th last year, apparently a victim of this year's surprising first quarter earnings decline. "[GE CEO] Immelt blew it with the earnings miss," said one investor. This leads one to wonder how much "professional investors" esteem requires the deliver the predictable earnings so beloved by analysts. The failure of a company's "earnings guidance" is clearly a major sin.

Microsoft had vaulted to 6th place last year from #22 in 2006, but now is back to #21. One New York money manager said the company trades at its lowest multiple of free cash flow ever because of its "willingness to overpay for Yahoo!" and its seeming penchant for entering low-return businesses. Sounds reasonable to us. Apple is #4 this year on account of its reputation as an innovator. Google jumped to #6 from 22 -- notwithstanding the stock's descent to around 450 from above 700. Wal-Mart moved up to #7 from 21, reflecting its low-cost delivery system and steady performance in a tough consumer economy.

Commodity-related companies received generally elevated reviews in this year's survey, while financial-services firms suffered a major bout of disrespect -- a predictable result of recent trends. "[T]he disdain for the [financial services] industry evident in this year's ranking has intensified after months of headlines detailing banks' and brokerages' dearth of fear and surfeit of greed, manifested in lax risk controls, excessive debt levels and opaque balance sheets." Nothing new here, but all that was overlooked on the way up. "No surprise, again, Citigroup wallows near the bottom of this year's list, in the company of deeply distrusted, state-influenced Russian and Chinese oligopolies." I.e., state-influenced oligopolies like Citigroup.

All in all an interesting summary of conventional wisdom regarding the world's major companies. Some of it looks rather reactive. Those that consistently are held in high regard year after year, however, have usually earned it, poseurs like GE notwithstanding.

Talking with the senior portfolio manager of American Century Investments, Jeff Tyler.

American Century's LiveStrong Portfolios and Vanguard's Target Retirement Funds were the only two target-date fund groups to receive a recent overall A grade by Target Date Analytics, a financial-planning consultancy. Target-date funds reset the asset mix -- usually stocks, bonds and cash -- in portfolios aimed to achieve a particular financial goal by a specific time for an investor, e.g., retirement or a child's college entrance.

Tyler, 50, attributes American Century's performance to his willingness to spread the risk beyond bread-and-butter equity classes, into such areas as real estate, emerging markets and a greater exposure to international holdings in general. "I'm far less sensitive to regional distinctions and company-size distinctions compared to what they do and who they serve," Tyler says. He thinks that stock premiums are going through a compression cycle right now -- which means that he orients towards holding fewer equities, especially over shorter time horizons.

We like this: Tyler says that rather than using cookie-cutter asset-allocation models, American Century is trying to build diversified portfolios that meet the stated goal: providing high probability that the investor will be able to finance an entire retirement on schedule. "At the end of the day, it is Joe Six-Pack who is the investor," Tyler says. "He doesn't have a consultant helping him out. He has to rely on himself. ... Real people invest in these funds. This isn't just an academic exercise."

Sounds like someone who has not allowed himself to be backed into a corner by the consultants and rating services.

Time to Get In on This Outsourcer

Cognizant Technologies, a big outsourcer to financial-services providers has been tarred along with its clients -- unfairly thinks Barron's. At $28 its stock is trading about $20 off its high. With 20%+ top line and bottom line growth, 18% operating margins, and selling at 15 times 2009 estimated earnings, the argument is that the stock is cheap. It does not look overpriced for a company with such margins and growth rate, and is certainly worth tracking.