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

W.I.L. Finance Digest :: April 2009, Part 2

This Week’s Entries :


The current bank scandal dwarfs the 1980s savings-and-loan crisis – and could destroy the Obama presidency.

Extremely frank talk from one William Black on the current bank crisis/scandal. Black was a deputy director at the former Federal Savings and Loan Insurance Corp. during the thrift crisis of the 1980s, and now serves as an associate professor of economics and law. He does not finger the problem behind all the problems, the Federal Reserve, and his faith in the ability to implement good regulation is not shared by us. Illuminating nevertheless.

William Black calls them as he sees them, which is why we enjoy talking with him. Black, 57 years old, was a deputy director at the former Federal Savings and Loan Insurance Corp. during the thrift crisis of the 1980s, and now serves as an associate professor, teaching economics and law at the University of Missouri, Kansas City. At FSLIC, a government agency that insured S&L deposits, Black prevailed in showdowns with the powerful Democratic Speaker of the House, Jim Wright, and helped identify the infamous Keating Five, a group of U.S. senators (including Sen. John McCain, the Arizona Republican who lost his bid for the presidency in 2008) who tried to quash his attempt to close Charles Keating’s Lincoln Savings & Loan. Wright eventually resigned amid unrelated ethics charges, and the senators were reprimanded for poor judgment. Keating went to jail for securities fraud.

For Black’s provocative thoughts on the current financial crisis, read on.

Barron’s: Just how serious is this credit crisis? What is at stake here for the American taxpayer?

Black: Mopping up the savings-and-loan crisis cost $150 billion. This current crisis will probably cost a multiple of that. The scale of fraud is immense. This whole bank scandal makes Teapot Dome [of the 1920s] look like some kid’s doll set. Unless the current administration changes course pretty drastically, the scandal will destroy Barack Obama’s presidency. The Bush administration was even worse. But they are out of town. This will destroy Obama’s administration, both economically and in terms of integrity.

So you are saying Democrats as well as Republicans share the blame? No one can claim the high ground?

“We have failed bankers giving advice to failed regulators on how to deal with failed assets.”

We have failed bankers giving advice to failed regulators on how to deal with failed assets. How can it result in anything but failure? If they are going to get any truthful investigation, the Democrats picked the wrong financial team. Tim Geithner, the current Secretary of the Treasury, and Larry Summers, chairman of the National Economic Council, were important architects of the problems. Geithner especially represents a failed regulator, having presided over the bailouts of major New York banks.

So you are not a fan of the recently announced plan for the government to back private purchases of the toxic assets?

It is worse than a lie. Geithner has appropriated the language of his critics and of the forthright to support dishonesty. That is what is so appalling – numbering himself among those who convey tough medicine when he is really pandering to the interests of a select group of banks who are on a first-name basis with Washington politicians.

The current law mandates prompt corrective action, which means speedy resolution of insolvencies. He is flouting the law, in naked violation, in order to pursue the kind of favoritism that the law was designed to prevent. He has introduced the concept of capital insurance, essentially turning the U.S. taxpayer into the sucker who is going to pay for everything. He chose this path because he knew Congress would never authorize a bailout based on crony capitalism.

Geithner is mistaken when he talks about making deeply unpopular moves. Such stiff resolve to put the major banks in receivership would be appreciated in every state but Connecticut and New York. His use of language like “legacy assets” – and channeling the worst aspects of Milton Friedman – is positively Orwellian. Extreme conservatives wrongly assume that the government cannot do anything right. And they wrongly assume that the market will ultimately lead to correct actions. If cheaters prosper, cheaters will dominate. It is like Gresham’s law: Bad money drives out the good. Well, bad behavior drives out good behavior, without good enforcement.

His plan essentially perpetuates zombie banks by mispricing toxic assets that were mispriced to the borrower and mispriced by the lender, and which only served the unfaithful lending agent.

We already know from the real costs – through the cleanups of IndyMac, Bear Stearns, and Lehman – that the losses will be roughly 50 to 80 cents on the dollar. The last thing we need is a further drain on our resources and subsidies by promoting this toxic-asset market. By promoting this notion of too-big-to-fail, we are allowing a pernicious influence to remain in Washington. The truth has a resonance to it. The folks know they are being lied to.

I keep asking myself, what would we do in other avenues of life? What if every time we had a plane crash we said: “It might be divisive to investigate. We want to be forward-looking.” Nobody would fly. It would be a disaster.

We know that with planes, every time there is an accident, we look intensively, without the interference of politics. That is why we have such a safe industry.

Summarize the problem as best you can for Barron’s readers.

With most of America’s biggest banks insolvent, you have, in essence, a multitrillion dollar cover-up by publicly traded entities, which amounts to felony securities fraud on a massive scale.

These firms will ultimately have to be forced into receivership, the management and boards stripped of office, title, and compensation. First there needs to be a clearing of the air – a Pecora-style fact-finding mission conducted without fear or favor. [Ferdinand Pecora was an assistant district attorney from New York who investigated Wall Street practices in the 1930s.] Then, we need to gear up to pursue criminal cases. Two years after the market collapsed, the Federal Bureau of Investigation has 1/4 of the resources that the agency used during the savings-and-loan crisis. And the current crisis is 10 times as large.

There need to be major task forces set up, like there were in the thrift crisis. Right now, things do not look good. We are using taxpayer money via AIG to secretly bail out European banks like Société Générale, Deutsche Bank, and UBS – and even our own Goldman Sachs. To me, the single most obscene act of this scandal has been providing billions in taxpayer money via AIG to secretly bail out UBS in Switzerland, while we were simultaneously prosecuting the bank for tax fraud. The second most obscene: Goldman receiving almost $13 billion in AIG counterparty payments after advising Geithner, president of the New York Fed, and then-Treasury Secretary Henry Paulson, former Goldman Sachs honcho, on the AIG government takeover – and also receiving government bailout loans.

What, then, is staying the federal government’s hand? Have the banks become too difficult or complex to regulate?

The government is reluctant to admit the depth of the problem, because to do so would force it to put some of America’s biggest financial institutions into receivership. The people running these banks are some of the most well-connected in Washington, with easy access to legislators. Prompt corrective action is what is needed, and mandated in the law. And that is precisely what is not happening.

The savings-and-loan crisis showed that, too often, the regulators became too close to the industry, and run interference for friends by hiding the problems.

Can you explain your idea of control fraud, and how it applies to the current banking and the earlier thrift crisis?

Control fraud is when a seemingly legitimate corporation uses its power as a weapon to defraud or take something of value through deceit.

In the savings-and-loan crisis, thrifts engaged in control frauds in order to survive. Accounting trickery proved to be the weapon of choice. It is at work today with the banks, and it is their Achilles heel. You report that you are highly profitable when you engage in accounting-control fraud, not only meeting but exceeding capital requirements. These accounting frauds create huge bubbles, which in turn create large bonuses, which in turn lead to huge losses.

Why then is there so much smoke and so little action?

First, they are inundated by the problem. They are trying to investigate the major problems with severely depleted staffs. Honestly. We have lost the ability to be blunt. Now we have a situation where Treasury Secretary Geithner can speak of a $2 trillion hole in the banking system, at the same time all the major banks report they are well-capitalized. And you have seen no regulatory action against what amounts to a $2 trillion accounting fraud. The reason we do not see it – are not told about it – is that if they were honest, prompt corrective action would kick in, and they would have to deal with the problem banks.

Are there any parallels between the current crisis and the savings-and-loan crisis that give you hope?

Of course. Objectively, our case was even more hopeless in the S&L debacle than in the current crisis. If we were able to do it in such an impossible circumstance back then, we have reason for hope in the current crisis. I know how easily things can get off course and how quickly things can turn back again. The thrift crisis went through several lengthy courses and distortions before it finally was resolved under the leadership of Edwin Gray, the chairman of the Federal Home Loan Bank Board, which oversaw FSLIC.

We went through almost a decade of cover-ups by a Washington establishment intent on helping thrift owners. Back then, we had the Justice Department threatening to indict Gray, the head of a federal agency, for closing too many thrifts. Next, there were those so-called resolutions, where the regulators worked day and night – to create even bigger problems for the FSLIC. Years later, these so-called resolution deals had to be unwound at great expense by closing down even larger failures. Or how about the bill to replenish the depleted thrift-insurance fund that was blocked and delayed by then-Speaker of the House, Texas congressman Jim Wright?

You say the evidence of a breakdown in the regulatory structure comes from the fact that America avoided an earlier subprime crisis in the 1990s.

Exactly. Why had no one heard of the subprime crisis back in 1991? Because America’s regulators also faced down the crisis early. The same thing happened with bad credits being securitized in the secondary market. Remember the low-doc or no-doc mortgages done by Citibank? Well, the problem did not spread – because regulators intervened.

Obama, who is doing so well in so many other arenas, appears to be slipping because he trusts Democrats high in the party structure too much.

These Democrats want to maintain America’s preeminence in global financial capitalism at any cost. They remain wedded to the bad idea of bigness, the so-called financial supermarket – one-stop shopping for all customers – that has allowed the American financial system to paper the world with subprime debt. Even the managers of these worldwide financial conglomerates testify that they have become so sprawling as to be unmanageable.

What needs to be done?

Well, these international behemoths need to be broken down into smaller units that can be managed effectively. Maybe they can be broken up the way that the Standard Oil split up back in the early 1900s, through a simple share spinoff.

The big problem for the last decade is that we have had too much capacity in the finance sector – too many banks have represented a drain on our talent and resources. All these mergers have not taken capacity out of the system. They have created even bigger banks that concentrate risk to the taxpayer, and put off dealing with problems.

And a new seriousness must be put into regulation. We do not necessarily need new rules. We just need folks who can enforce the ones already on the books.

The bank-compensation system also creates an environment that leads to mismanagement and fraud. No one has to tell someone they have to stretch the numbers. It is all around them. It is in the rank-or-yank performance and retention systems advocated by top business executives. Here, the top 20% get the bulk of the benefits and the bottom 10% get fired. You do not directly tell your employees you want them to lie and cheat. You set up an atmosphere of results at any cost. Rank or yank. Sooner rather than later, someone comes up with the bright idea of fudging the numbers. That is big bonuses for the folks who make the best numbers. It sends the message – making the numbers is what is most important. There is a reason that the average tenure of a chief financial officer is three years.

Compensation systems like I have just described discourage whistleblowing – the most common way that frauds are found in America – because the system draws upon the cooperation of everyone.

The basis for all regulation and white-collar crime is to take the competitive advantage away from the cheats, so the good guys can prevail. We need to get back to that.

Thanks, Bill.


Yield-seekers see opportunities among master limited partnerships.

Master Limited Partnerships are a niche investment sector which has attracted the attention of yield seekers. They have some of the attributes of a real estate investment trust: In exchange for paying out almost all of their earnings to the partners those earnings go untaxed at the company level. And as with REITs, this only makes business sense if the reinvestment needs of the business are modest, i.e., about the same as book depreciation. This would indicate that major growth must be funded externally. Favored MLP businesses include pipelines, which once built have modest maintenance capital reinvestment needs.

We are told that historically the yield spread between MLPs and 10-year Treasuries has been around 2.5 percentage points, versus today’s 6 to 8 percentage points. Treasuries yields seem ridiculously low to us, and one might posit that MLPs are selling at a historically average premium to where Treasury yields ought to be, but right now one can see why MLP yields look enticing. Also – and this has to be verified partnership by partnership – some pipeline MLPs earn per unit carrying charges based on the price of the products they transport. If the price exposure to oil and gas appeals to you, then, this is an offbeat way to gain it.

Some Master Limited Partnerships currently offer the best of both worlds: significant upside, plus juicy yields.

MLPs, as they are called, typically invest in energy assets, and they pass along to investors most of their profits – as tax-free distributions. The industry’s best bets these days are pipeline MLPs, which benefit from steady fees for the long-distance delivery of natural gas. They are less sensitive to commodity prices than oil and gas exploration and production MLPs, and their hard-to-duplicate assets are a valuable hedge against inflation.

What is more, pipeline partnerships are yielding about 10%, well above the recent 2.9% yield on 10-year Treasuries.

Barron’s last recommended MLPs in the fall (see “How to Energize Your Portfolio,” October 13, 2008), about a month before the Alerian MLP index, a measure of the 50 most prominent energy partnerships, hit a 52-week low. Although the index [ticker: AMZ] since has rebounded by 33%, including dividends, its 12-month total return is a negative 25%.

“MLPs have been a phenomenal place for investors in the past 10 years, and you get a do-over now,” says Barry Young, a UBS private-wealth adviser in Houston who invests heavily in MLPs.

MLP shares sold off amid last fall’s credit crunch, when hedge funds and Lehman Brothers, a big MLP underwriter, started dumping investments. Now value investors are coming into the market, says Jerry Swank, who heads a Dallas investment-management firm that oversees about $850 million for institutions and high-net-worth individuals, mostly concentrated in MLPs.

Swank says he is picking through the wreckage for “the most liquid names, with strong balance sheets, strong sponsors [and] stable businesses – pipeline and storage in natural gas.”

One example is Williams Pipeline Partners [WMZ], a debt-free operator of long-distance gas pipelines in the West and Northwest, with near-monopoly operations in some states. That should give the Tulsa, Oklahoma-based company pricing power. Another is Energy Transfer Equity [ETE], based in Dallas, which owns the cash-flow-distribution rights to diverse gas-pipeline, storage and processing businesses, and could benefit from new assets in the MLP structure, strengthening distributions and the shares alike.

Williams Pipeline Partners has one main asset: a 35% interest in a pipeline that transmits natural gas to the Pacific Northwest from New Mexico. It is the only interstate natural-gas pipeline providing service to Seattle, Portland, Oregon, and Boise, Idaho.

Williams Companies [WMB], which controls the other 65%, carved out the MLP in January 2008, and is likely to place more property into the structure to boost returns, says Selman Akyol, an MLP analyst at Stifel Nicolaus.

As a relative newcomer, Williams Pipeline Partners has a market capitalization of only about $367 million, and no debt. Traders could find the shares “range-bound” in coming quarters, writes Stephen Maresca, the lead MLP analyst at Morgan Stanley, if the parent partner focuses on its older MLP, Williams Partners [WPZ], which is more of a chemicals play, gathering and processing natural gas.

Williams Partners has about $1 billion of debt, and is more sensitive to fluctuations in natural-gas prices, now near $3.60 per million BTUs.

Akyol thinks that even without fresh assets from the general partner, Williams Pipeline Partners is undervalued at around $16, given a recent increase of 1.6% in the distribution per unit, which boosted the payout to 7.9%.

Assuming the payout remains steady, the stock could trade closer to $20, given the partnership’s valuable assets, he says. The shares declined 11% in the past year, compared with losses of 30% or more in many other pipeline and storage names.

“Large pipeline and transportation assets are vital infrastructure to the United States,” says Akyol. “It is hard to imagine how the economy runs without these assets, or that they will not be around in the next 20 years. For long-term investors, it will be a rewarding place.”

Analysts value MLPs primarily based on metrics related to distributions per unit, not earnings, as these partnerships do not have retained earnings. A key measure of strength is the coverage ratio, or distributable cash flow per unit divided by distributions per unit, which indicates whether an MLP has enough cash to cover its payout. Although the ratio differs for various MLP subsectors, it should be greater than one.

Stifel Nicolaus estimates Williams Pipeline Partners will have a coverage ratio of about 1.1 in 2009 and 2010, after slipping just below one in the 4th quarter of 2008. Morgan Stanley similarly thinks Energy Transfer Equity’s coverage ratio is healthy but says the partnership’s shares have been penalized wrongly for perceived risk to commodity-price exposure that could lead to cash-flow shortfalls and distribution cuts.

Energy Transfer Equity is the majority owner of Energy Transfer Partners [ETP], which has pipeline operations in Arizona, Colorado, Louisiana, New Mexico and Utah. It also owns the largest intra-state pipeline system in Texas – some 14,600 miles – and treats, processes and stores natural gas, as well as selling propane. In addition to the Texas pipeline, it has 2,700 miles of long-distance pipes – and more under construction.

ETE’s 9.3% payout could increase at three times the rate of any increase in ETP’s dividend, says Maresca, the Morgan Stanley analyst. That is because Energy Transfer Equity is expanding beyond Texas with pipelines near new sources of natural-gas production, including the rapidly expanding Haynesville Shale straddling the Texas-Louisiana border.

That pipeline, to be completed in 2011, should relieve some of the natural-gas-delivery bottlenecks and boost fee revenue. Such projects should produce strong rates of return, and new pipelines will dilute the risk associated with commodity-price fluctuations in gas processing and the propane businesses, Maresca says.

Energy Transfer Equity trades for $22 a share. If the shares hold their 9.3% current yield in the next four quarters, the stock could be worth about $29, or 32% more than the current price, according to Morgan Stanley estimates.

While pipeline plays abound, it may pay to be cautious in some cases. Steer clear of those focused on short-haul transport from production areas where oil exploration budgets have been cut. Others have liquidity problems, and their payout ratios may not hold.

TC Pipelines [TCLP] has fee-based natural-gas pipeline assets and a strong balance sheet. But the Omaha-based outfit also faces competition in the Rockies, and in the near-term volume could fall.

Another potentially interesting MLP investment, MarkWest Energy Partners [MWE], gathers, processes and transmits natural gas in Texas and Oklahoma. While it also has exposure to new natural-gas discoveries in portions of the Marcellus Shale in Appalachia, production costs there could be high, and success may take years to play out.

Shares of Western Gas Partners [WES], formed by the exploration company Anadarko Petroleum [APC] a year ago, have recovered substantially since last fall, and at around $15 reflect the value of Western Gas’s diverse gathering, treatment and pipeline-transport businesses. That price may reflect the likelihood that Anadarko will place more fee-based business into the MLP structure.

MLPS are not without risk. Historically, the yield spread between master limited partnerships and 10-year Treasuries was closer to 2.5 percentage points, not today’s 6 to 8 percentage points. When interest rates eventually start to rise, the attraction of some MLPs will diminish, especially those that have liquidity issues and are more exposed to commodity prices.

MLP investors also worry the vehicles could lose their tax-favored status, particularly with Democrats in charge of the White House and Congress. But there is no evidence, to date, that this is on the Obama administration’s agenda.

Overriding such concerns, for now, is the fact that healthy pipeline MLPs such as Williams Pipeline Partners and Energy Transfer Equity have operations that generate steady fee income – and that their general partners could add assets to the vehicles and boost their payouts further.

The search for yield has taken investors down some of the market’s more dangerous byways. Energy MLPs, particularly pipeline partnerships, offer a safer, and compelling, alternative.

The Bottom Line

Two good bets among pipeline master limited partnerships are Williams Pipeline Partners and Energy Transfer Equity. Both have strong balance sheets, healthy sponsors, solid businesses and ample cash flow.


It is only the middle innings of the great housing bust.

Alan Abelson expresses his usual doubts about the current stock market rally, and revisits the research of money management company T2 Partners. They were quite bearish on the housing market in March 2008, and still are now. They expect housing prices to decline 45%-50% from their peak, vs. being off 32% today, before bottoming in mid-2010 – which sounds like a further 20% decline to us. This is an aggregate number. Results of course will differ across markets.

Carl Bass is our kind of guy. Let us hasten to confess, we do not know Mr. Bass, apart from the fact that he earns his daily bread running Autodesk , which does some $2 billion a year designing and servicing software, and whose stock was a hot number until it got killed by the bear market (12-month high, 43; 12-month low, a hair under 12; current price, 19 and change). In other words, until last week Mr. Bass was, so far as we were concerned, just another corporate honcho.

What brought our attention to Mr. Bass and won him our instant esteem was an item in the latest screed by our Roundtable buddy and indefatigable tech-watcher, Fred Hickey. More specifically, it directed us to February’s conference call with analysts, occasioned by release of the company’s earnings for the final quarter of its fiscal year, ended January 31.

Mr. Bass kicked off the proceedings, as Fred noted, by telling the telephonically assembled analysts the bad news. Not only were the bum results a far cry from what he had grown accustomed to, but, he sighed, “the global economic downturn is now significantly impacting each of our major geographies and all of our business segments.” The turn for the worse, he made it clear, included emerging countries where business had been robust, like China and India. And, he added, the immediate outlook was more than a touch murky.

None of which deterred an analyst, champing at the bit for good news, from asking whether there were any regions left to exploit that so far had proved immune to the global slump. “Well,” responded Mr. Bass, “I think Antarctica has been relatively immune, maybe Greenland, as well, although not Iceland, as we all found out.”

Besides the pleasure of finding a CEO with a sense of humor and, equally important, one who does not suffer foolish questions gladly, the exchange struck us as symptomatic of the insatiable yearning of Wall Street, in general, and sell-side analysts, in particular, to uncover some sliver of bullishness beneath the dismal surface of the unvarnished truth.

That touching tendency to mistake dross for gold has been much in evidence in this spirited stock-market rally, 5 weeks running and still kicking. And it has by no means been restricted to analysts. It has infected market strategists and portfolio managers, to say nothing of economists (which is about all one can say about them without resorting to invective).

Even the most unfavorable news, from the relentless shrinkage in corporate earnings to the inexorable rise in unemployment, is all too often blithely shrugged off with the observation that “it was not as bad as expected,” while neglecting to identify by whom. Nor does it seem even passing strange to the growing ranks of wishful bulls that banks that went begging to Uncle Sam for bailouts and were rewarded with billions have magically discovered, come the earnings reporting season, that, by gum, they are suddenly remarkably solvent (or should we say, seemingly solvent; just disregard several trillion dollars’ worth of ugly stuff on their collective balance sheet, please).

We realize, of course, that Washington is on the case. And we feel for the poor, anonymous soul charged with the task of almost daily sending aloft still another trial balloon to rescue the banks. But we suppose she or he does gain a measure of satisfaction from the fact that even if the balloon goes nowhere but poof, more often than not it provides a fresh fillip to the markets.

Indeed, if anything, this whirlwind activity by the administration’s economic team, this profusion of blueprints for recovery, so many of which are rapidly discarded or revised or embroidered, by all rights should be giving widows and orphans the jitters rather than prompting them to take the plunge. For it smacks of confusion or panic or both.

Believe us, we are impressed by the vigor of the rally and it has gone much further and faster than we expected. And we think those hearty types agile enough to have played the big bounce deserve a big pat on the back. That does not mean, though, that we think it is for real or sustainable.

What would cause us to change our minds is some credible evidence that the dark forces that wrought this dreadful recession are starting to dissipate. Instead, it pains us to relate, we see rough going in the months ahead. And that suggests to these rheumy eyes a disappointed market resuming its skittish ways.

Back in March of last year, we rambled on about a piece on housing by T2 Partners, a New York money-management firm. The report weighed a ton, but its heft was made more than palatable by a profusion of easily accessible bold-face tables and charts and a lucid text happily free of equivocation. We waxed enthusiastic about the analysis (and no, we had not been drinking). It was, of course, quite bearish.

Well, the T2 folks recently issued a follow-up to that prescient analysis, again festooned with nifty graphics and graced with straight-from-the-shoulder narration. They are still bearish and still, we think, on the money. That original report, incidentally, has blossomed into a book by Whitney Tilson and Glenn Tongue, who run T2 (you will never guess how they got the name for their firm). The book is called More Mortgage Meltdown and is slated to be published next month (end of public-service announcement).

In their latest tome, the T2 pair begin with a crisp summary of why and how housing collapsed, in the process wreaking havoc on both the credit market and the economy. Among the usual culprits, most of which by now have had the cruel harsh spotlight of publicity turned mercilessly on them, Wall Street comes in for special mention and, in particular, its critical role in disseminating collateralized debt obligations and asset-backed securities, or – as they are respectively, if no longer respectfully, known – CDOs and ABSs.

Those structured monsters, note Tilson and Tongue, were a “big driver” of the surge in financial outfits’ increasingly bloated profits. To produce ABSs and CDOs, Wall Street needed “a lot of loan product,” of which mortgages proved a bountiful source. It is unfortunately quite simple to generate ever-higher volumes of mortgages. All you need do is lend at “higher loan-to-value ratios, with ultra-low teaser rates, to uncreditworthy borrowers, and do not bother to verify their income and assets.”

The only catch is that the chances of such a mortgage being paid off are just about nil, a trifling caveat that bothered neither lenders nor pushers [nor buyers] one whit. The result of that cavalier approach, as we all have reason to lament, in the end has been anything but happy: Today, mortgages securitized by Wall Street represent 16% of all mortgages, but a staggering 62% of seriously delinquent mortgages.

As for home prices, the T2 duo reckon, the unbroken monthly decline since they peaked in July 2006 will continue to make buyers hesitant and sellers desperate, while the “tsunami of foreclosures” will maintain the huge imbalance of supply over demand. In January, they point out, distressed sales accounted for a formidable 45% of all existing home sales and, they predict, there will be millions more foreclosures over the next few years.

T2 expects housing prices to decline 45%-50% from their peak (currently, prices are down 32%) before bottoming in mid-2010.

They expect housing prices to decline 45%-50% from their peak (currently, prices are down 32%) before bottoming in mid-2010. They warn that the huge overhang of unsold houses and the likelihood that sellers will come out of the woodwork at the first sign of a turn argues against a quick or vigorous rebound in prices. Nor is the economy likely to provide a tailwind, since T2 anticipates it will contract the rest of this year, stagnate next year and grow tepidly for some years after that.

The first stage of the mortgage bust featured defaulting subprime loans and their risky kin, so-called Alt-A loans. Together with an additional messy mass of Alt-A loans, the next phase will be paced by defaulting option adjustable-rate mortgages, jumbo prime loans, prime loans and home-equity lines of credit.

All told, Tilson and Tongue estimate losses suffered by financial companies from mortgage loans, further swelled by nonresidential feckless lending, will run between $2.1 trillion and $3.8 trillion. Less than half of that fearsome total has been realized. Which is why, they contend, we are only “in the middle innings of an enormous wave of defaults, foreclosures and auctions.”

We do not want to leave you with the impression that the T2 guys are cranky old perma-bears. They aren’t. At the end of their report they point out that “the stocks of some of the greatest businesses, with strong balance sheets and dominant competitive positions, are trading at their cheapest levels in years.” Nothing wrong with the companies themselves, they believe; rather, the stocks got beat up mostly because of the cruddy market and soft economy. Victims, as it were, of the bearish trends.

The names they like that fall into that not exactly overly crowded category are familiar enough: Coca-Cola, McDonald’s , Wal-Mart, Altria, ExxonMobil, Johnson & Johnson and Microsoft. That does not exhaust their portfolio picks, but those are the ones they obviously think are best suited to ride out any resurgence of the bear market.


Gary “SirChartsAlot” Dorsch documents that the U.S. is not the only government gunning the money/credit supply. Chinese M2 money supply is now 25.5% higher than a year ago – its fastest growth rate in 12 years. Beijing is encouraging much of this money into Shanghai equities and the property markets. Clearly China has learned a lot from its mentors on how to blow bubbles.

Since the historic 1987 stock market crash, the Federal Reserve has responded to every recession in the U.S. economy by slashing interest rates, and funneling massive amounts of money into the hands of Wall Street’s aristocracy – the ruling class that dominates the two political parties in Washington. The Fed’s cash injections have usually found their way into assets, including commodities, stocks, and mortgage-backed securities, and often fueling speculative binges into stratospheric heights.

But on March 12th, U.S. President Barack Obama warned a group of chief executive officers of the Business Roundtable, that the Fed “can’t continue with its policies of endless cycles of bubble and bust, and instead, must build a new foundation for future economic growth.” Obama blamed the lingering banking crisis on “reckless speculation and spending beyond our means, on bad credit, inflated home prices, and over-leveraged banks. Such activity is not the creation of lasting wealth. It is the illusion of prosperity, and it hurts us all in the end,” Obama warned.

“We cannot settle for a return to the status quo. We must put an end to the reckless speculation, spending beyond our means; bad credit, over-leveraged banks, and the absence of oversight that condemns us to bubbles that inevitably bust,” Obama added. Yet only a few days earlier, Obama exerted maximum pressure on the Financial Accounting Standards Board (FASB) to let Wall Street bankers set their own prices for toxic assets in earnings reports, regardless of market prices.

By suspending the so-called “mark to market” accounting rules, concerning the value of toxic securities they hold, FASB’s new guidance would allow American banks to value assets using their own internal “mark-to-myth” models. This is, in fact, is the creation of a loophole allowing bankers to conceal their true losses and cook their financial books. By allowing the banks to claim their assets as fundamentally sound, the ruling elite expect the panic selling in the stock market will subside, banks will start lending again, and the U.S.-economy will gradually recover.

So far, all the measures taken by Obama’s economic team in response to the financial crisis, have pointed their aim at protecting the wealth of the Wall Street aristocrats.

So far, all the measures taken by Obama’s economic team in response to the financial crisis, have pointed their aim at protecting the wealth of the Wall Street aristocrats. Treasury Secretary Geithner announced a scheme to enable the banks to offload their toxic assets by subsidizing hedge-funds and private-equity firms to purchase them at inflated prices, using hundreds of billions of taxpayer money to cover any losses, and insure double-digit profits for the speculators. [See graphic “Plunge Protection Team” Unleashes its Nuclear Weapons to Rescue Wall Street.]

The masters of Wall Street erupted into great euphoria and jubilation over the death of FASB #157, and Geithner’s scheme to loot taxpayer funds and offload the toxic assets of the financial oligarchs – creating illusions of new found wealth. Obama himself went a step further to reassure the Wall Street titans, by quietly killing a bill passed by the House of Representatives that would have taxed 90% of the bonuses of wealthy executives and traders at AIG and other bailed-out firms.

By obscuring the accuracy of bank balance sheets, mixed with the Fed’s zero-percent interest rate policy, and the hallucinogenic “Quantitative Easing” drug, traders are taking collective leave of their senses, succumbing to delusions of ever-expanding wealth, and actively participating in the creation of new bubbles. And by definition, market bubbles can expand much farther than most traders can imagine.

Nobody bothered to ask how Wells Fargo (WFC) could post a record $3-billion profit in the first quarter, at a time when 1 in 8 U.S.-homeowners with mortgages, are behind on their loan payments, or in the foreclosure process as job losses intensifies, and California home prices are 40% below their peak levels. Instead, operating under the illusions of “mark-to-myth” accounting, and the hallucinogenic “QE-drug,” administered by the Fed, hedge-fund traders accepted the WFC earnings report at face value, bidding its share price 30% higher.

Former Fed chief “Easy” Al Greenspan and his protégé, Ben “Bubbles” Bernanke, hold the view that deliberate bubble-bursting is something between impossible and dangerous, and thus, is best avoided. The Fed is inherently opposed to hiking interest rates, to prevent bubbles from arising in the first place. Instead, the Fed allows stock market bubbles to inflate into the stratosphere, and patiently waits for the bubbles to burst under their own weight. Afterwards, the Fed moves to cushion the meltdown, by slashing interest rates and flooding the banking system with liquidity – the infamous Bernanke/Greenspan Put.

The Fed operates under the belief that wealth in an asset-based economy is created by massively inflating the money supply and pumping-up the value of financial or tangible assets. Today, the Fed has joined the Bank of England and the Bank of Japan in printing trillions of British pounds, yen, and U.S.-dollars in part, under the radical “Quantitative Easing” framework, designed to monetize their respective government’s debt, which in part, is used to bail-out the financial aristocracy.

Central bankers inflate bubbles in order to give households a fresh sense of wealth, encouraging them to borrow and spend more, and businesses to boost investments. The strategy is built around the massive expansion of the money supply. There are generally two types of bubbles, firstly, speculative excesses fueled by irresponsible bank lending. The second type of asset bubble is one in which bank lending plays a minor or no role at all – usually related to the introduction of new technology or rapid industrialization that promises untold riches.

The Nasdaq high-tech stock bubble is an example of this second type. So was the spectacular run-up in the Shanghai red-chip index, which soared 4-fold in 2007, mirroring China’s rapid accession as the world’s 3rd largest industrial power and the biggest exporter. China’s vast manufacturing sector employs tens of millions of workers and functions as the cheap labor workshop for Asian and Western companies, and is the biggest customer for Australian and Brazilian miners.

China’s central bank said on April 12th, it will ensure massive liquidity to sustain economic growth.

But it is the first type of bubble which Beijing is busy inflating right now – with the ruling Politburo ordering its state-owned banks to lend yuan aggressively. China’s central bank said on April 12th, it will ensure massive liquidity to sustain economic growth, squashing speculation that regulators might try to restrain bank lending that could lead to bad debts and asset bubbles. Chinese banks extended 1.9 trillion yuan in local currency loans in March, bringing the first-quarter total to 4.6 trillion yuan, ($585 billion), larger in size than Beijing’s 4 trillion fiscal spending plans.

In turn, explosive lending in China has fueled the explosive expansion of the Chinese M2 money supply, now standing +25.5% higher than a year ago, its fastest growth rate in 12-years. With the blessing of Beijing, much of this money is funneled into Shanghai equities and the property markets, thereby inflating prices. The combined fiscal and monetary stimulus, equaling about 30% of China’s GDP, is widely expected to lift the local economy out of its deep slump, through the traditional strategy of inflating market bubbles and indirectly boosting household wealth.

Indeed, China’s industrial output rebounded to an annualized +8.3% growth rate in March, from a record low of +3.8% in the first two months of the year, adding to evidence that Beijing’s stimulus plans, are starting to take effect. Still, China’s factory sector is structurally dependent on exports and therefore, highly vulnerable to any downturn in foreign demand, which is beyond Beijing’s control.

In fact, the spectacular growth of China might not have been possible without the massive expansion of household debt in the United States. But this growth of debt, which sustained the U.S. economy and global demand for 15-years, is de-leveraging, and morphing into the biggest banking crisis since the 1930s. As a result, China’s vast export machine is grinding to a halt. Without the government’s stimulus measures, the predicted growth rate for China would be closer to 2% this year.

So far, some of the big the winners from China’s massive stimulus plans are skilled operators in copper futures and base metal miners. Copper stockpiling by the secretive Chinese Reserves Bureau is rumored to reach 300,000 tons this year. China’s imports of the red-metal jumped 71% to 451,400 tons in the first two months from a year ago, customs data showed. On the Shanghai Futures Exchange, copper futures are up 85% above December’s lows. Meanwhile, copper inventories in Shanghai warehouses have dropped to dangerously low levels at 18,766 tons, prompting a fresh wave of arbitrage buying in London.

China is also riding to the rescue of the American farmer. In Chicago, soybean futures have jumped 15% over the past four weeks, to $10.35/bushel, whetted by China’s voracious appetite. Beijing confirmed that it bought 3.86 million tons of soybeans in March, up +66% from a year earlier, and the 2nd highest monthly tally ever. More than half of this week’s U.S. exports, 10.4 million bushels, are headed to China. This comes at a time, when U.S. soybean stockpiles are projected to reach a 5-year low of 165 million bushels this summer.

The PBoC is engineering a vast expansion of money and credit, to bolster its economy, and taking advantage of a narrow window of opportunity – the collapse of factory-gate inflation, which is -10% lower than a year earlier. The stunning collapse of a broad array of commodity prices, including crude oil, gasoline, kerosene, diesel, base metals, food and clothing, provides the necessary cover for the PBoC’s massive money printing operations – the traditional antidote for warding off deflation.

The PBoC last cut its key one-year lending rate to 5.31% on December 22nd, still much higher in inflation-adjusted terms than those pegged by G-7 central banks. The PBoC cut rates five times since September and reduced bank reserve requirements four times. It has also abolished credit quotas, triggering a surge in bank lending in support of the government’s 4 trillion yuan fiscal stimulus package.

With its command and control over the Chinese banking network, the PBoC has demonstrated its ability to burst bubbles in the Shanghai stock market, as it did last year, hammering the red-chip index 75% below its October 2007 peak. Now, the PBoC is printing money at a feverish pace, to re-inflate the stock market, endorsed by Premier Wen Jiaboa, claiming that China’s economy is on the road to recovery. What is involved here is an attempt to equate a rising stock market with economic recovery, even as unemployment continues to rise, and exports fall.

So far, China’s lending boom and efforts to re-inflate the Shanghai red-chip bubble, has coincided with its stockpiling of copper and soybeans. The Shanghai Index closed at 2,513-points, it’s highest since August, with over thirty Shanghai-A shares soaring by their 10% daily-limit, a sign that speculators, brimming with cheap bank loans, are returning to the roulette-table. Wuhan Steel and China Cosco both leapt 10%, as strong economic data configured by Beijing’s apparatchik’s stirred optimism.

Trade data released on April 10th, was also of great interest to Nymex oil traders – China imported 16.3 million tons of crude oil in March, up 33% from February’s 11.7 million tons. According to a 3-year plan designed by the National Energy Administration, China’s stimulus plan would include building large oil and natural gas refineries, increasing its total oil refining capacity to 440 million tons by 2011, which might also be a prelude to national stock building of energy fuel.

But optimism for a Chinese-led crude oil rally, was delayed by an IEA report, predicting that world oil demand would fall 2.4 million bpd to 83.4 million bpd in 2009, the biggest annual contraction since the early 1980s. Chinese demand for crude oil is expected to fall 1% this year, the first decline in decades. By all indications however, the IEA’s estimate of future oil demand is probably off-the mark, judging by the failure of OPEC to jig the market higher.

OPEC agreed on March 15th to keep output quotas unchanged, as part of its effort to help mend the world economy. “We believe the global economy is still very weak,” noted Qatar’s Abdullah al-Attiyah on March 30th. “The crisis has not reached the bottom so we have to be very careful. We are saying that $40-to-$50 /barrel is more pragmatic for the economic crisis. We cannot do more than that – it does not mean we are going to cut production in May,” he hinted.

U.S. inventories of unsold crude oil are bloated at 361 million barrels, their highest levels since July 1993, weighing down on oil prices. U.S. oil demand in January was 989,000 bpd less a year earlier, tumbling to 19.1 million bpd. In Japan and Korea, the world’s 3d and 5th largest energy importers, crude inventories have also risen due to the worst recession since WWII. Explaining oil’s rebound from $35/barrel to around $52/barrel today, Qatar’s al-Attiyah said. “The current oil price is not related to demand and supply – it is higher mainly because of a weak U.S. dollar.”

And while Beijing is calling on the G-20 to replace the U.S. dollar as the world reserve currency, the Chinese central bank is simultaneously printing vast quantities of yuan. The rapid expansion of Chinese M2 is buoying gold prices in Shanghai, since the Chinese yuan has no intrinsic value whatsoever, but for the fact that it has been decreed as legal tender. Instead, Chinese traders confronted with limited choices, are bidding-up Shanghai red-chips, even at a time when industrial profits are 37% lower in Q1, compared to a year ago. Traders are intoxicated by bubble-mania, and acting out of fear of the inflationary impact of the PBoC’s printing press.

Shanghai gold traders are waiting to find out if Obama’s economic team will label Beijing as a currency manipulator, in the next semi-annual U.S. Treasury Department report. “I recognize that China’s currency manipulation and domestic subsidies give it an unfair trade advantage and has led to U.S. job losses. I am committed to tackling this problem and ensuring that all trade manipulations are addressed by the U.S. government,” Obama said rhetorically ahead of the November 4th election.

But given America’s desperate fiscal condition, Obama needs to convince China to keep investing its foreign exchange reserves in U.S. Treasuries in order to help finance the bailout of failing U.S. banks and pay for the $787 billion U.S. stimulus package. Yet China’s financial security is increasing intertwined with U.S. Treasury bonds, which are fast becoming a risky option, inflated within a bubble of gigantic proportions. It will be too late to leave the game of musical chairs, when China and Japan decide to stop buying or begin selling the U.S. Treasury bonds. Someday, Beijing might take pre-emptive action to buy gold directly from the IMF, to rebalance its portfolio.


Even after all the damage that has been caused to the global economy, the Federal Reserve neither accepts responsibility for its misdeeds, nor has any intention of modifying its errant behavior.

Martin Hutchinson lays most of the blame on for the current economic travails on the Fed; we tend to agree. He argues that Wall Street largely reacted to the perverse incentives laid out by the Fed. Fair enough, more or less, although Wall Street certainly had some say-so in the political manoeuvres which created the perverse incentives.

Never apologize, never explain seems to be the Fed’s philosophy. (Its “explanations” are so ridden with sophistry as to not be explanations worthy of the name.) It is the living embodiment of the Family Circus “Not Me” ghost, with about the same level of maturity.

The Federal Open Market Committee (FOMC) meeting on March 17-18, if it achieved nothing else, made one thing abundantly clear: Even after all the damage that has been caused to the global economy, the Federal Reserve neither accepts responsibility for its misdeeds, nor has any intention of modifying its errant behavior. A private sector institution that behaved in this way would be bust – unless it found a way of wheedling endless billions out of the unfortunate taxpayers. In monetary policy as in most human activities, there is an urgent need for accountability.

The “Great Moderation” was unadulterated hogwash.

Only two years ago, Fed Chairman Ben Bernanke was proclaiming a “Great Moderation” by which improved monetary management capability by the Fed and other central banks had caused a permanent decrease in the volatility of the global economy, with inflation remaining low while growth continued at a steady pace. The only disturbing factor was a mysterious “savings glut” in Asia, which was causing balance of payments imbalances and might conceivably prevent the capital markets from accommodating ad infinitum the worthy consumerism of the U.S. public.

As we now know, this analysis was unadulterated hogwash. Far from producing a “Great Moderation,” the Fed’s excessively lax monetary policy over the last decade has produced the most dangerous global recession since the Great Depression. Far from being the world’s chief problem, the Asian “savings glut” was the result of uncontrolled U.S. money printing and balance of payments deficits – and that glut may now be the principal factor allowing the world to escape the current troubles without repeating the experience of the 1930s.

So where is Bernanke’s apology? Or, better still, resignation?

So where is Bernanke’s apology? Or, better still, resignation? Why are we still being forced to listen to his endless predictions of deflation, something that has completely failed to appear, either in 2002 when he first predicted it or in the last few months, during which core inflation has remained resolutely positive with a tendency to accelerate? Where is the legislation threatening to tax his income at 90%, in retaliation for his role in causing this disaster? Where is the investigation of his finances by the New York state Attorney General? Where even is the beautifully modulated denunciation by President Obama?

The lack of political blowback from the Fed’s mistakes is perhaps unsurprising, but it is also dangerous. The policy-setting FOMC meeting March 18 voted to compound the Fed’s errors of over-enthusiastic money creation by buying $750 billion more credit card and mortgage debt, $100 billion more of debt of the odious and superfluous Fannie Mae and Freddie Mac, and $300 billion of Treasury bonds. With broad money supply increasing at an annual rate of more than 15% even before this latest extravaganza, all hope of monetary moderation has been lost.

The Fed’s hangover cure: Inject absolute alcohol directly into the sufferer’s veins.

The late Fed Chairman William McChesney Martin famously defined the Fed’s job as “taking away the punchbowl just as the party gets going.” Under Alan Greenspan and still more under Bernanke, the Fed “spiked” the monetary punch, thus producing a very unpleasant hangover. It now proposes to treat that hangover by injecting absolute alcohol directly into the economy’s veins.

The Fannie Mae/Freddie Mac purchases compound an old error; they limit the scope of the private sector in the mortgage market. That is the mistake that led to securitization’s takeover of that market, a development that can now be seen to have raised mortgage costs and destabilized housing. The other new debt purchases, apart from the effect of their huge size on monetary expansion, will artificially revive the securitization market, providing subsidized competition to the banking sector. Since the principal economic need in this difficult time is for the banking sector to earn profits sufficient to fund its past mistakes, these purchases are economically counterproductive.

Funding excessive budget deficits through the central bank was a favorite tactic of Weimar Germany – until the roof fell in – and banana republics everywhere. It is one of the most effective ways known to destroy the economy.

However, the most dangerous part of the FOMC’s new aggression is its purchase of Treasury bonds. Already, the Obama administration is promising to run budget deficits of more than 10% of Gross Domestic Product, far beyond any seen in previous U.S. peacetime history. The Fed now proposes to monetize those deficits, reducing their political cost to the crazed public spenders, but greatly increasing the danger of spiraling inflation. Funding excessive budget deficits through the central bank was a favorite tactic of Weimar Germany (until the roof fell in late in 1923), various Argentine governments and banana republics everywhere. It is one of the most effective ways known to destroy the economy, since to the normal “crowding out” effect of excessive state borrowing it adds the wealth-destroying effect of surplus money creation. In Third World countries whose monetary system has been competently designed by Western bureaucrats under aid grants, it is illegal.

The FOMC’s action was initially popular with the markets, and with market-oriented commentators. “Grownups in Washington won’t let the circus over ill-gotten corporate bonuses distract them from saving this economy,” wrote CBS MarketWatch.

In reality, what remains of the U.S. private sector appears well on the way to saving itself. Retail sales were up in January and February, the upward slope in unemployment claims is becoming less steep and economic statistic after statistic comes in significantly better than the forecasts, now adjusted to doom and pessimism.

The main unknown is the true condition of the banking system, but here the main need is to avoid further government meddling, whether by providing ludicrously expensive bailouts of bad loans the banks are taking care of themselves, or by imposing randomly punitive taxes on the unfortunate bankers. It seems increasingly likely that even Bank of America is working its way out of its problem, with only Citigroup and the egregiously awful AIG being true basket cases likely to need yet further infusions of taxpayer money. The healthier banks such as Wells Fargo and US Bancorp have taken to hurling insults at the Treasury Department and the Fed, an excellent sign that they are well on the way to recovery!

Once the economy has touched bottom, the private sector’s problems will be well on the way to being solved, and we will only have to deal with the disasters perpetrated by the public sector in response. Unfortunately, those disasters seem likely to be far more economically damaging than the original problem.

Once the economy has touched bottom, around the middle of this year, the private sector’s problems will be well on the way to being solved, and we will only have to deal with the disasters perpetrated by the public sector in response. Unfortunately, those disasters seem likely to be far more economically damaging than the original problem. The Congressional Budget Office believes that U.S. public debt will increase by over $7 trillion in the next decade, with the deficit remaining in the $700 billion to $800 billion range throughout. There is no equivalent body auditing monetary policy, but the inflation statistics themselves will soon tell the tale of money supply growth run riot. It is thus likely that for several years we will be forced to continue dealing with the multilayered economic crisis for which Bernanke and his predecessor Greenspan bear so much of the responsibility.

While theoretically the Fed chairman should wish to make the private economy as strong as possible through prolonged non-inflationary growth, in practice most of his day-to-day contacts are in the public sector, and his only report of significance is to the economic illiterates of Congress.

Bernanke’s term ends next January, and it is to be hoped that President Obama does not reappoint him, though on current form I hold out little hope that his successor will be much of an improvement. In any case, the incentives at the Fed are all wrong. While theoretically the Fed chairman should wish to make the private economy as strong as possible through prolonged non-inflationary growth, in practice most of his day-to-day contacts are in the public sector, and his only report of significance is to the economic illiterates of Congress.

There is a better way. When the great and wise Alexander Hamilton [one might differ on this opinion] set up the Bank of the United States, he set it up as a private sector institution. The Bank of England was also fully private until the post-war Labor government started nationalizing everything that was not nailed down. Technically, parts of the Fed are also private – the 12 Federal Reserve banks are owned by the banking system – but its incentives are entirely public-sector and in many cases counterproductive.

There are thus two possibilities. One would be make the Fed truly independent of government, and provide a remuneration system whereby members of the FOMC were properly incentivized to get it right. The Fed’s statutes must be written so that maintenance of sound money is the Fed’s preeminent goal, not shared with politicized matters such as the maintenance of full employment. A contract could be drafted providing a suitably long-term remuneration incentive, geared to inflation, economic growth and money supply growth, for the Fed chairman and for all members of the FOMC while in office. To the extent factors deviated from their target range (for example, the excessive increase in M3 money supply from 1995), remuneration would be reduced, with the reduction becoming more pronounced as the deviation was prolonged.

The other possibility would be to design de novo a purely private sector central bank, with the board of directors consisting of senior bankers. In pre-1946 London, this worked well because the bankers with high IQs tended to work for medium sized institutions. In the Wall Street of 2007, that would not have worked – as the late unlamented Treasury Secretary Hank Paulson showed, there are altogether too many confluences of interest between a Goldman Sachs and the Treasury or the Fed. However, if the behemoths are reined in because of being “too big to fail” and the brains migrate to medium sized advisory institutions, then those institutions would be ideally suited both to provide governance over the central bank and to provide its top officials.

The current unpleasantness is far more the fault of the Fed than of Wall Street, which simply responded to the perverse incentives provided by monetary mismanagement.

In either case, the separation between the Fed and the governmental apparatus must be sharply increased. Such a position, however, will be attainable only when the media, the public and at least some of the politicians have grasped one overriding truth: The current unpleasantness is far more the fault of the Fed than of Wall Street, which simply responded to the perverse incentives provided by monetary mismanagement.

All That Glitters Is Not Gold

Tanzanian Royalty rallied on the reputation of CEO James Sinclair. But the gold guru’s actions cast doubt on the exploration company’s fortunes.

Gold miners offer a leveraged play on the price of gold, and the opportunity for major gains IF a major economic discovery occurs after one buys the stock. But many, many is the slip betwixt the cup and lip in this stock sector. The industry has more than its share of charlatans, and it is one tough industry to make money in even for the competent good guys. If you chose to play the game do it with eyes open, armed with plenty of facts, and using advice from people you trust. Unless you visit the mines yourself and know what you are doing you will be relying on what others tell you to some degree or other.

Case in point, it seems, on what not to buy: Long-time gold guru James Sinclair’s company, Tanzanian Royalty. Barron’s makes an extremely solid case that the company is grossly overvaluated here. Sinclair has a brand name from having made some good calls on the metal’s price action. He tries to talk a good game, but words cannot compensate for the lack of substance. Usefully, the analysis itself is a pretty good first approximation for how to approach analyzing any precious metals miner.

Gold explorer Tanzanian Royalty Exploration has no revenue, no earnings and no proven gold, as well as some accounting issues. So why do its shares trade at a premium to peers that seem to be in much better shape?

It helps that its chairman and chief executive, James E. Sinclair, is famous for correctly forecasting gold prices, and he is very bullish on the metal on his avidly followed newsletter-style website. Over the years, Sinclair’s views on gold have been sought out by newspapers like the New York Times and on cable-TV networks like CNN. Barron’s has interviewed him and run his advertising.

So it is surprising to learn that the widely known bull on gold has been a steady seller of shares of his own gold-related company.

Tanzanian Royalty (ticker: TRE) is a small-cap Canadian outfit (including its predecessor) that has been looking for gold for a decade. None of its properties, all in Tanzania, have yet shown economically viable mineral reserves, as defined by regulators. Were it valued more like rivals with similar cash and gold reserves, its share price would be substantially lower than the current $4.05.

TRE’s market capitalization is $370 million. Some rival miners with more cash on their balance sheets than TRE and actual gold have market caps one-sixth that size.

Dubbed Mr. Gold by the media for prescient calls on gold in the late 1970s and 1980s, Sinclair ran his own precious-metals trading firm in those days. On his website and in interviews, a bullish Sinclair today says gold will trade as high as $1,650 an ounce by January 2011 and says he would wager $1 million that it will. Gold was trading at about $881 an ounce Friday.

In an interview with Barron’s last week, Sinclair disputed the view of TRE’s shares as overvalued, saying the market cap was due to its less-capital-intensive structure and the potential of its properties. Moreover, he promised that a third-party evaluation of its important Kigosi property in Tanzania would be ready in “about six months.”

While TRE puts out press releases on his share purchases, the CEO says he is not required to put out press releases on his share sales.

In addition to Sinclair’s devoted following – he is sometimes referred to as “Uncle Jim” on Yahoo!’s TRE message boards – shareholders could be speculating that he will sell TRE to a big miner. Though he was ousted as chairman of Sutton Resources in 1995, some remember that Sutton was bought by Canadian gold giant Barrick Gold (ABX) in April 1999 for its Tanzanian properties. Not everyone credits Sinclair for the deal, but some do.

There is no question that Tanzanian shares have done extremely well since Sinclair and his family became its largest stockholders in April of 2002 (as a result of a merger they ended up with about 25% of the shares, which trade on the American Stock Exchange, and on the Toronto Stock Exchange under the ticker TNX.TO). TRE shares have soared about 711% since then. That trounces the 218% rise in the metal itself over the same period, though TRE has no gold reserves. Meanwhile, the American Stock Exchange Gold Bugs Index (HUI) composed of companies involved in gold mining – many of which have gold in hand – is up much less, just 198%. Since last summer, the credit crisis has hurt the juniors, as the small prospectors are called, on worries that they will not be able to get the financing needed to develop mines. In that time, TRE has fallen less than its peers.

Yet TRE faces the same business risks that rivals do, and continued financing is among the most important. TRE’s financing is accomplished by the unusual method of private placements of its stock with CEO Sinclair, who then sells his shares into the market. ... According to Canada’s System for Electronic Disclosure by Insiders, or SEDI, his TRE stake has dropped to about 2.3 million shares as of March 12, from 3.9 million in October 2004.

Though company announcements claim he is financing TRE, ultimately the main financiers are mostly the retail shareholders who buy from Sinclair. In his interview, he repeated that he is a strong backer of the company and that he recently agreed to another $2.43 million private placement for TRE shares. But if Sinclair is unwilling or unable, for any reason, to continue these private placements, how will TRE finance its activities? With the credit crunch, the environment has become tougher for juniors dealing in speculative endeavors to get traditional financing through selling equity directly into the stock market. That is especially true for a company without any proven reserves, like TRE.

When Barron’s asked why he was selling TRE shares, Sinclair replied that it was for personal liquidity. Asked why he did not put out a press release on the stock sales, Sinclair replied, “Is it required? ... I take no salary, no options, no warrants. I have purchased more than I have sold.” But when asked to furnish that data, he refused and referred Barron’s to the SEDI Website. The selling trend shown by SEDI insider-trading records is seconded by TRE documents: Sinclair had 3.17 million shares in August 2008 and 2.88 million in January.

Sinclair has declared he will not go to the public markets to finance the company, but it is probable that TRE could not easily get an investment bank to underwrite its shares because of that lack of economically viable mineral resources.

There is little institutional interest – roughly 17% of TRE’s 89 million shares are held by mutual funds, according to Bloomberg. TRE filings report that 83% of its shareholders are American, most of them individual shareholders who, unless they are familiar with Canada’s SEDI, are perhaps unaware that Sinclair is selling shares after buying them.

These TRE shareholders might not know that Sinclair is listed as a “disciplined person” on the website of the Canadian Securities Administrators, an organization of provincial securities regulators. On July 22, 1998, Sinclair was ordered by the British Columbia Securities Commission to pay $2,000 to settle a violation of “misrepresentation” in a press release having to do with Sutton. Sinclair called it a small “misunderstanding.”

Unlike many peers, TRE does not appear to be followed by any sell-side analysts from brokers specializing in Canadian miners, so 3rd-party information is scarce. ... If analysts looked at TRE, they would find its finances are stretched. For example, as of November 30, the company had about $1.2 million in cash, not much more than the $1.17 million in salaries and fees paid to its directors for the fiscal year ended Aug. 31, 2008.

As Sinclair makes clear, TRE is a royalty company, not a mining firm. That means it will find lands with potential, then sell them off to bigger miners in exchange for royalties from mine production, if that occurs. As Sinclair noted, royalty firms need less capital than a junior miner, but $1.2 million is hardly enough. Even royalty firms must drill on properties to entice partners.

According to a TRE filing for the year ended last August 31, TRE spent $2.37 million for exploration in fiscal 2008, just $267,000 more than fiscal 2007. For the past three years TRE has spent less than $8 million in exploration and written off roughly half of that in mineral-property value. By comparison, Barrick eventually spent some $400 million to develop its Buzwagi mine in Tanzania.

On its websit–rs projects-description page, TRE often promotes its own properties in Tanzania that are near Barrick developments and continues to list Barrick as a joint-venture partner in an Itetemia prospect. Barrick says it has no JV partnership with TRE.

Sinclair disputes that TRE does not have the cash for its drilling program: “We have our own drills and team.” Sinclair also said the firm has one rig for all its properties, similar to some other companies. None of them, however, has the market cap of TRE.

Moreover, David Duval, a Vancouver-based mining technologist, says that before a gold mine can be developed, $20 million to $30 million in drilling and exploration costs are typical, depending on the property. Duval called Barron’s, saying he had done so at the behest of Sinclair and that he is a consultant to TRE. Duval is also listed as a contributor and co-founder of Sinclair’s website.

Something else that might trouble investors is that TRE has been cited by its auditor KPMG for a “pervasive material weakness” in accounting controls. In TRE’s annual report for the year ended last August 31, KPMG, gave an adverse opinion on the effectiveness of TRE’s internal controls: “The company has limited accounting personnel with expertise in generally accepted accounting principles to enable effective segregation of duties with respect to financial reporting matters and internal control over financial reporting.” The company says it is attending to that.

But the greatest risk to TRE shareholders is its lack of gold reserves. TRE has put out many positive-sounding press releases since 2002 about its properties, but it has not discovered any economically viable gold resources as defined by a National Instrument 43-101-compliant document. The document – established by Canadian authorities after the giant BRE-X Minerals fraud in 1997 – is an officially sanctioned disclosure measure of “mineralization,” or the presence of minerals like gold.

An NI 43-101 reports whether the property has “proven” minerals – the highest measure of geological confidence – or lesser reliability, like “probable,” or “inferred,” the least strong. No miner is likely to get substantial mine-development financing without such a document, and TRE does not have one.

Instead, press releases are issued about preliminary drilling results, but no gold mines follow. For example, TRE reported October 13, 2004, a “significant gold discovery” in the Luhala property in the Lake Victoria Goldfields area. On October 19, 2005, another “significant gold discovery” was announced in the Tulawaka region. Three to four years later, there is no news of any commitments to develop these properties into gold mines, or any of Tanzanian’s leaseholds.

Sinclair is upbeat about TRE’s probability of finding economically viable gold soon: “We have discovered about four grams per ton in Kigosi. ... We are going to have an NI 43-101 on Kigosi in about six months – as soon as consultants finish their work,” he says. “It could fall apart ... [BUT] if all goes well, from the time the report is completed there will be a mine within 18 to 24 months.” ...

That sounds optimistic, since gold mines often take three or more years to build after the finding of economically viable metal.

Despite having resource prospects that do not measure up to peers’, TRE’s valuation is golden compared with many. (See table.) For example, TRE has its $1.2 million in cash, no gold reserves and its $370 million market cap. Meanwhile, rival MDN (MDN) whose market cap is $55 million, also has prospects in Africa, but $14.6 million in cash and 100,000 ounces of gold resources, according to broker Canaccord Adams. Semafo (SMF) has a market cap similar to TRE’s but also has 4.8 million ounces of gold reserves.

Another way to benchmark TRE is to look at the S&P/TSX Metals & Mining Index (STMETL) of 35 stocks, many with real revenue and cash flow. The index’s average price/book ratio is 1.35, but TRE, which is in the index, trades at about 17 times its book value of 24 cents a share.

Membership in such indexes and the International Stock Exchange Gold index (HVY) may boost TRE shares higher than they would be otherwise. In both indexes, TRE’s weightings are equivalent to companies with many times its market cap and actual gold, like Eldorado Gold (EGO), which has 7.6 million ounces of proven or probable gold.

Speaking with Barron’s, Sinclair repeatedly said that TRE’s market cap is due to its less-capital-intensive royalty structure and the value of its leaseholds. ... When it was pointed out that TRE has no NI 43-101, yet its valuation was much higher than companies with 43-101- compliant gold and actual gold, he replied: “I will come after you,” and ended the phone call.

Rising gold prices have boosted TRE’s stock value lately, but it needs to find some gold soon. Otherwise, its exploration failures so far and its dependency on Sinclair’s financing methods will catch up with the shares.

While Sinclair has had success predicting gold prices, TRE does not have a good track record of finding gold in economically viable amounts. Without Sinclair, it is likely TRE’s market cap and share price would be significantly less golden.


Jeff Bezos’s Amazon.com is winning customers with competitive prices, wide selection, reliability – and Kindle. It is winning shareholders, too.

Almost everyone is a customer of some frequency or other of Amazon.com. The service is convenient and reliable, and the prices reflect the company’s low-cost business model. Here is a very interesting piece from Barron’s on “the world’s best retailer.”

Wal-Mart is a logistics and technology company in a retailer’s clothes; Amazon.com is in many ways similar, but without the storefronts. We suspect Amazon will have to keep refining its delivery system. In the battle for customers with Wal-Mart it comes down to UPS vs. Wal-Mart’s own logistics and delivery system. Amazon’s inventory management problem looks simpler, and of course its real estate costs are hugely lower, but it is more costly to the supplier to deliver the goods piece by piece to the customer’s doorstep than to have the customer come to you and load up.

The stock, not surprisingly, is not cheap; however, the article author does make the case that if you value Amazon on its free cash flow multiple – that is the multiple of cash left for shareholders after capital spending and working capital requirements are handled – then it does not look so expensive. That is a respectable argument, but it is doubtful the current price will set a value buyer’s heart aflutter.

This may be an opportune time to add shares of Amazon.com to your shopping cart and proceed to checkout.

The stock makes sense because the retailer itself makes sense to smart shoppers. They do not waste valuable gas fighting for a parking space in a massive mall parking lot; they find prices that compete with Wal-Mart’s and flirt with the Web’s biggest bargains; and they can easily peruse a vast array of merchandise – ranging from gigantic TVs to Elmore Leonard novels to disposable razors. What is more, their purchases tend to get delivered as promised.

The many benefits of the e-tailer’s business model are even more apparent in tough times. Amazon’s highly automated and centralized operations run at a lower cost than those of traditional retailers, allowing the Seattle company to pass on significant savings to its customers. Rather than truck merchandise to thousands of stores from myriad distribution centers, Amazon picks and packs its items from computerized warehouses where they are shipped direct to a customer’s house, just the way founder Jeff Bezos envisioned.

No stores means fewer layers of expense for real estate, employees, inventory and utilities. While traditional outfits like Circuit City and Linens ‘N Things have gone belly up, and speculation mounts about the staying power of household names like Sears (ticker: SHLD), among many others, Amazon.com (AMZN) had a strong Christmas season and free cash flow that rose 16% for 2008.

“It simply has a better retail model, and it is only getting better.”

“A lot of consumers are migrating to Amazon,” says Walter Price, a veteran technology investor from Allianz Global Investors. “It simply has a better retail model, and it is only getting better.”

And Bezos has added a couple of kickers – which Price views as options on two nascent Amazon businesses that are not reflected in the share price.

The e-commerce pioneer always has been pragmatic in finding ways to leverage its operations by running portions of other companies’ businesses, from Website check-out services to logistics.

Now, Amazon is taking that a step further by providing Web services, better known these days as “cloud computing.” What is cloud computing? It is the outsourcing of information-technology and data-center operations to third parties, mostly by small- and medium-sized companies that choose not to spend their resources to deal with these tasks themselves. (The name cloud derives from the remote ether-like computer space where the outsourced operations take place.) Amazon, which has spent more than $2 billion on its systems in the last decade, has divided these services into several parts, including: Amazon Simple DB (databases), Amazon Elastic Compute Cloud (computing capacity) and Amazon Simple Storage (data storage).

Price believes these services could eventually generate hundreds of millions of dollars annually – and investors are getting them for almost nothing.

The second kicker is Kindle, a digital-reading device. Its original version was generally well received, but its recently released 2.0 edition has become a hit with consumers. Wall Street analysts estimate the company has sold 350,000 of the devices, which got a plug from Oprah Winfrey last fall. A Kindle runs $359, and it not only generates revenue but protects and promotes Amazon’s original business – selling books.

Amazon’s financial performance has not gone unnoticed.

Of course, Amazon’s financial performance has not gone unnoticed. With a forward-looking price/earnings ratio of 39, you may feel as though you are paying retail for the shares. But valuing them on a cash-flow basis is a more accurate gauge because it takes into account the company’s unusually long float period, which allows it to use the cash as working capital. At a price of 70 on [March 27], the shares sell at roughly 20 times the company’s free cash flow of $1.36 billion, or $3.18 per share, in 2008. That is less than Wal-Mart’s (WMT) free cash flow multiple of 22.6 and Costco’s (COST) 25.4.

Free cash flow multiples are a very sensible measure of value, as long as the cash flows are sustainable. We are surprised to suddenly see the idea trotted out by Barron’s after all these decades.

Allianz’s Price expects free cash flow to grow about 20% annually going forward, without taking potential revenue growth from Kindle or Web services into account. He believes the shares could crack 100 in two to three years, while Piper Jaffray research analyst Gene Munster has a more modest 12-month target of 81 for the stock.

Amazon’s business model for billing, inventory and delivery gives the company some unique financial advantages over other retailers. It can carry customer payments on the balance sheet for up to 26 days before it must pay suppliers. The float on that money can help to lower pricing and gives Amazon still more power to grab market share.

“We have a negative operating cycle,” Chief Financial Officer Tom Szkutak told investors at a recent Morgan Stanley conference. “So, as we grew, we generated cash from working capital. And we are all about maximizing profit dollars, not individual margins,” he said. (Neither Szkutak nor Bezos would talk with Barron’s.)

“It is not unreasonable to expect that revenue could double over the next three years,” says Price, barring a complete collapse of the economy. Amazon reported 2008 profit of $1.49 a diluted share – or $645 million, up 36% from the prior year – on $19.17 billion in revenue for fiscal 2008, which was up 28% from 2007.

Because of its other advantages, the e-commerce company tends to follow others’ prices without necessarily trying to beat them. “We really want to offer low prices every day ... [but breadth of] selection is very key to growth,” Szkutak told the conference. Not only does Amazon carry more product categories than ever – either through its own e-tail operations or third-party retailers on the site – it also offers more brands and styles per category.

Amazon’s strong balance sheet and wide selection stand out even more in this wretched retailing environment, where malls find themselves losing tenants, and tenants find themselves with less and less inventory. Retail sales generally stagnated in 2008 and have dropped nearly 10% for the period December 2008 through February 2009 over the same period a year earlier. With the exception of Wal-Mart, drugstores and warehouse clubs, just about every retail business is off.

After a decade of starting their online purchases by searching on Google, cybershoppers now make Amazon their default page.

That leaves Amazon to pick up the slack. More and more consumers turn to the Web for shopping, with Amazon often the first destination. After a decade of starting their online purchases by searching on Google (GOOG), cybershoppers now make Amazon their default page, knowing that its bots are crawling the Web to identify the lowest prices. Even e-Bay (EBAY), which tried to compete, recently shifted its focus back toward selling used merchandise. And with less than 10% of all retail sales done over the Internet, there is loads of upside. Price contends that U.S. online sales will account for as much as 20% of total retail sales within the next 10 years.

On top of that, Amazon is grabbing a greater share of online commerce as consumers realize that it is routinely price-competitive, delivers in a timely fashion, and now has arguably the greatest selection of merchandise assembled in one place – albeit in cyberspace – including Wal-Mart.

“E-commerce now starts and ends with Amazon, and eventually it will show up with higher sales,” Price says. “As they get more volume, their costs relative to their prices should come down, which should improve their profits over time,” he says.

Amazon is also growing overseas. It now ships in six foreign countries, including Germany, Japan and China. For the fourth quarter, international sales of $3.07 billion were 46% of total revenue.

“Amazon’s logistics is its secret sauce.”

Lower shipping costs also improve the customer’s experience. In the early days, Bezos would goose sales with free-shipping promotions. Now he has implemented a “Prime Program” designed to keep shipping costs down while spurring more sales. For $79 a year, Amazon customers get guaranteed “all-you-can-eat” free shipping on 2-day deliveries for most merchandise (excluding bulky items like furniture). Or they can pay $3.99 extra for one-day delivery. Only Amazon can afford to offer those terms and still make a profit because of its huge volume and efficient inventory and shipping operations. “Amazon’s logistics is its secret sauce,” Price says.

One of the reasons Piper’s Munster upgraded Amazon to a Buy in early March was a survey his firm conducted that showed 81% of Amazon’s customers are satisfied with the retailer, compared to 71% for eBay. More important, 94% of the respondents said they would recommend the e-tailer to a friend. That score, he says, is reminiscent of Apple’s (AAPL) tally earlier this decade before the iPod, as well as Netflix’s (NFLX) rating prior to its breakthrough. In both cases the scores presaged big runs in the stocks to record highs.

“It’s a leading indicator,” says Munster.

Goldman Sachs analyst James Mitchell was impressed by Amazon’s 15% increase in year-over-year gross profit and 9% jump year-over-year in operating profit. The fact that it could grow profitably during one of the worst holiday shopping seasons ever meant Amazon was not just “buying” revenue via discounted pricing, noted Mitchell.

Majestic Research predicts Amazon is on track to at least meet expectations on revenue for its first quarter (ending March 31), adding that sales have begun to accelerate and could actually exceed Street estimates for the quarter.

After spending billions to build the technology that drives its retail operation, Amazon, at its heart, is a tech company.

After spending billions to build the technology that drives its retail operation, Amazon, at its heart, is a tech company. As a result, it is always looking for ways to leverage operations, which is why it is pioneering areas like cloud computing. Tech researcher Gartner Research forecasts that, industry wide, this category will reach $56.3 billion in revenue in 2009, a 21.3% gain over 2008. The market is projected to reach $150 billion in 2013.

The notion of trusting your entire enterprise-computing needs to someone else is controversial and meets with resistance by big corporations. But small- to medium-sized companies, especially start-up software developers, embrace the trend. Adam Selipsky, a vice president of Web Services at Amazon, told trade publication Intelligent Enterprise that there are three reasons for companies to switch to its cloud: efficiency, economics and performance.

Start-up software companies are among Amazon’s biggest Web services clients. They can develop code and deliver software using Amazon’s delivery infrastructure, paying only for the computing power they use and leaving the data center headaches to Amazon. This allows start-ups to build their businesses without a lot of upfront cost – which is especially attractive during this period of tight capital.

Amazon is not competing with Nordstrom (JWN) or Sears in this marketplace. It is going up against the likes of IBM (IBM), Google, and Microsoft (MSFT). But Price thinks Amazon has an edge over Google, because Amazon’s systems use computer languages that are more open and flexible. Plus, the company is already geared toward handling outsourcing in other parts of its operations, so adding data-center services is just a natural extension, Price argues.

Tech Crunch, an online-technology publication, estimates that 60,000 corporate customers are using Amazon Web Services. Amazon would not confirm that number.

Kindle is another example of Amazon’s technology prowess. The electronic book reader is arguably superior to a similar gadget developed by Japanese consumer-electronics giant Sony (SNE). It even has prompted comparisons to Apple’s iPod and iTunes. Kindle allows people to carry entire libraries of digital books on one device, and it focuses their selections on Amazon’s list of offerings.

It also provides potential growth from the device itself. That will not provide a huge boost to sales in the short term, but the Kindle could improve margins, says JPMorgan Chase analyst Imran Khan. For the iPod, Apple has to pay for intellectual-property rights on songs and movies; and Amazon must pay book publishers for its digital content. But both “playback” devices are proprietary.

According to some analysts, it is not a stretch to see Kindle’s estimated 350,000 unit sales hitting one million this year. Goldman’s Mitchell, for one, predicts Amazon may double or triple Kindle sales in 2009 based on demand built not only by the Oprah endorsement, but by an increasingly broad range of book titles, and sales to overseas markets such as Germany and Japan.

If Amazon can build a big Kindle user base, it could raise barriers to entry in the eBook market.

If Amazon can build a big Kindle user base, it could raise barriers to entry in the eBook market, lower per-book marketing costs, reduce fulfillment costs, and increase revenue – all of which would lead to higher margins, Khan argues.

Needless to say, fulfillment costs on a digital download are a lot lower than those on a book delivered via an overnight shipper. Fulfillment costs took an 8.3% bite out of Amazon’s revenue last fiscal year, whereas the cost of delivering an eBook would account for about 2% to 3% of total revenue. Khan more conservatively forecasts Amazon to sell another 500,000 Kindles in 2009, adding $63 million in fiscal 2009 revenue, or two cents earnings per share. He predicts Amazon will sell 12 million eBook downloads during the fiscal year. Every two million book downloads equals about a penny a share in annual earnings, Khan says.

There is more than a comparison with Apple; there is compatibility. The Kindle reader application is now available for the Apple iPhone, which will expand Kindle’s reach beyond avid book readers. Another potential boon: schools and colleges, if Amazon successfully taps the textbook market.

Amazon is hardly immune from the crash in consumer spending.

Of course, there are risks. Just last week the company said it would close three distribution centers, laying off or transferring 210 workers, to fine-tune its business. And whenever investors pay up for growth, there is always the chance that revenue can disappoint. Amazon is hardly immune from the crash in consumer spending. If it gets much worse, the company will surely suffer. As it becomes a more global entity, foreign-currency swings can have a negative impact on revenue, too.

During the dot-com boom, shopping over the Internet was an exotic experiment. Today, Bezos’s Amazon has created an experience that is often more satisfying than shopping at an understaffed mall store with depleted inventories. With more selection, less hassle and faster checkout, and with competitive pricing thrown in, you have the world’s best retailer – albeit one whose shares trade at a technology multiple.


A New Way to Quantify Fear

Move over, VIX.

The new way makes a lot of sense to us. It measures investors’ willingness to buy insurance against losses, as opposed to measuring pure volatility as the VIX does.

THE SCENE: A midtown Manhattan restaurant. Two old friends meet for lunch to discuss market events.

Barron’s: It must be hard having your efficacy questioned, especially as you have not been behaving as expected lately.

VIX, the famed volatility index: It is not easy being the most successful options-sentiment indicator ever created.

Do you have a perception problem?

VIX: I see just fine.

Then you won’t mind getting new competition Monday, when the Credit Suisse Fear Barometer – the CSFB – is unveiled.

VIX: C’est la guerre.

The markets are warlike, and yet New York is like a small town. How funny that CSFB’s creators, Dennis Davitt and Edward K. Tom – who run Credit Suisse’s equity-derivatives trading and strategy, respectively – chose the same restaurant. (VIX magnanimously rises to invite his adversaries to dine.)

VIX: We were just discussing the new CSFB. Can you elaborate?

Tom: Our indicator answers a simple question. If an investor will forgo upside returns above 10%, what is the deductible before a Standard & Poor’s 500 portfolio can be fully insured?

VIX: You mean selling an out-of-the-money index call and buying an out-of-the-money put to hedge a stock portfolio?

Davitt: Exactly. VIX was not designed to measure fear. VIX measures 30-day market expectations for volatility, which is associated with, but not always correlated to, fear.

VIX: Say it, Double-D.

Tom: CSFB quantifies fear by measuring “zero-premium collars” that expire in three months, rather than VIX’s 30 days.

Davitt: Here is another major difference. Say there is a massive Standard & Poor’s 500 call bid. That indicates investor confidence, but the bid could cause call implied volatility to increase, making VIX rise, not fall.

But upside and downside risk is elemental. That is why zero-cost collars are always packed with information. So what is CSFB saying, and how do we use it?

Tom: Say, for example, the S&P is at 855, and CSFB is at 13.68%. [If SPX changes, that percent changes.] That means if you are long the Standard & Poor’s 500, you can initiate a zero-cost collar by selling a July 940 Standard & Poor’s call that is 10% out-of-the-money, and buying a July 738 put that is 13.68% out-of-the-money. This implies investors are expressing relatively low levels of downside fear for the next three months.

OK, but 13.68% still seems random.

Tom: Think of 13.68% (or any CSFB level) as an insurance deductible. It is how much the put is out-of-the-money. The market has to drop 13.68% before it kicks in.

So if CSFB registers a high level like 20%, investors are afraid, and insurance is more expensive. If CSFB is low, insurance is cheap, and investors are not.

Davitt: Right. We backcast CSFB to 1998. It is ranged from an October 2008 low of 10.5% to a March 2007 high of 30%.

VIX: Interesting ... However, I am ubiquitous.

Davitt: We have desk real estate, too. Enter “CSFB Index Go” on Bloomberg.

Well, who would have ever thought there’d be a bull market for fear?