Finance Digest for Week of May 30, 2005

DISPATCHES FROM THE HOUSING BUBBLE FRONT

A bane amid the housing boom: rising foreclosures.

To walk Thayer Street in northeast Philadelphia is to count, door by door, the economic devastation afflicting a working-class neighborhood. On a single block, 18 of the 42 brick rowhouses have gone into foreclosure in the past three years. There is Marciela Perez, who fell ill with cancer, lacked health insurance and stopped making mortgage payments. Barrel-chested Richard Hidalgo, who got divorced and could no longer make his monthly nut. And Mike O’Mara, a rawboned and crew-cut truck driver who took on too much debt, lost his job and fell behind on his mortgage. Cynthia Boyd 42, is barely holding on to the house she bought in Philadelphia. Boyd, who had problems making her mortgage payments after she became sick and had family problems, tried unsuccessfully to file for bankruptcy. “Mortgage companies convinced us to refinance, and each time our bill went up,” O’Mara said as he surveyed his narrow street from his shaded front porch. “You fall behind and they swoop down on you.”

Philadelphia, its suburbs and indeed much of Pennsylvania have experienced a foreclosure epidemic as low-income homeowners take on mortgage debt they cannot afford. In 2000, the Philadelphia sheriff auctioned 300 to 400 foreclosed properties a month. Now he handles more than 1,000 a month. Allegheny County, which includes Pittsburgh, had record auctions of foreclosed homes, and officials speak of a “Depression-era” problem. The foreclosures fall particularly hard on black and Latino families.

For some American homeowners, the greatest housing boom in U.S. history has delivered riches. They repeatedly tap their homes for equity and use the cash to purchase granite countertops, a BMW, even a trip to the Super Bowl. But there is a dark side – a sharp rise in foreclosures that is destroying the single greatest generator of personal wealth for most Americans. Foreclosure rates rose in 47 states in March, according to Foreclosure.com, an online foreclosure listing service. The rates in Florida, Texas and Colorado are more than twice the national average. Even in New York City and Boston, where real estate markets are white-hot, foreclosures are rising in working-class neighborhoods.

Should the nation’s housing bubbles deflate, as many economists and federal officials expect, the foreclosures could prefigure a national crisis. Americans now shoulder record levels of housing debt – more than 8% of homeowners spend at least half their income on their mortgage. State and federal regulators place much of the blame for the foreclosure problem at the feet of mortgage brokers and bankers, who have crafted ever-riskier ways for Americans with poor credit to buy homes. Interest-only and adjustable-rate mortgages account for 63% of new mortgages. But many policymakers say the rise in foreclosures leads to a larger question: Is the push to boost homeownership – successive presidential administrations have strongly promoted it – backfiring?

Hear a pop? Watch out

Now that even Alan Greenspan is talking about “froth” in real estate markets, how concerned should people be – not just about the value of their own homes, but about the entire country? After all, we just had a big stock market bust and it barely dented the economy. Outside of brokers, speculators, and a few unlucky sellers, would a real estate crash really matter to the country as a whole? In a word, yes. To understand why, first look at how pervasive the effects of real estate are throughout the economy.

Start with the so-called wealth effect. If people tend to spend more when their net worth increases, they will spend less when it decreases. Economists use this rule of thumb: a $1 change in household wealth leads to a roughly 5-cent change in consumer spending. By that measure, a 10% decline in real estate prices would knock about half a percent off the GDP. Even more significant for the economy, though, would be a collapse in home equity lending. The industry has been booming as housing prices have soared. But if prices stop rising, new borrowing against home equity will drop, and may disappear.

That is important, because home equity lending amounted to more than $200 billion last year – or nearly 2% of the economy, according to Economy.com. If all that borrowing – which freed up cash that was spent on new furniture, appliances, vacations, cars and the like – simply vanished, the effect could be large enough all by itself to send the economy into recession. But that is not all. The housing sector has even broader effects on the economy, by some estimates accounting for 25% of all activity. A decline in property values would most likely lead to declines in other industries, like construction, brokerage, banking and insurance. And these are important for future growth. Construction, for example, amounts to 4% to 5% of the economy, according to the Bureau of Economic Analysis.

Then there is banking. Because of the leverage associated with real estate, a fall in values would affect banks and other lenders. It would probably lead to tightened credit standards, less lending and higher interest rates. If lenders begin to suffer steep losses, there is always the danger of financial contagion, in which problems at one institution ripple out to others it does business with. And there is a new wild card for the economy. In 2004, adjustable-rate mortgages made up a third of new mortgage originations. No one knows what the effect of the widespread use of A.R.M.’s would be in a down market. A climb in interest rates, of course, would put downward pressure on real estate prices, but A.R.M. borrowers would feel the pinch rapidly. If those borrowers started to default, lenders would be hurt. Adding it all up, it is easy to see how a drop in real estate prices would spell trouble for the economy.

An I.M.F. compared a 14% decline in real housing prices with a 37% decline in stock market prices – roughly the same size as the post-2000 stock market fall in the U.S. The study’s findings suggest that a housing crash could cause twice the damage, and for twice as long, as the last U.S. recession. While such a large decline in housing prices might come as a shock to Americans, the I.M.F. found that similar busts happen every 20 years, on average, in the countries studied. The Yale economist Robert J. Shiller, who studies the housing market, agrees. His research leads him to believe that the I.M.F. conclusions apply directly to the U.S. economy.

Lending standards plumb new lows.

The U.S. real estate bubble continues to swell like a lava dome, supporting full-blown manias on both coasts and in quite a few cities, suburbs and towns in between. You would have to live in a place like Muncie, Indiana, or Vernon, Texas, to be unaffected by it all. In Vernon, a town of about 12,000 in the lower panhandle, a mere $50,000 still buys all the house a growing family could need. To put that in perspective, a beach dweller in the Hamptons could trade his or her property for 200 homes in Vernon, with enough left over to buy a few Wichita Falls mansions. Not that anyone from the Hamptons is yearning to relocate to the Texas scrublands. Vernon is a quiet place, one where even big deals are still done on a handshake. But you would be wrong to infer that it is a relative dearth of wheeler-dealers that has kept prices there from taking off. In fact, the town is where Charles Keating seeded his schemes. Yes, that Vernon Savings & Loan – where my wife’s grandmother kept her savings.

But I digress. For it is not Vernon’s affordable housing that we wish to discuss, but rather the vast number of barely affordable homes on inventory just about everywhere else. In Southern California, to take a particularly notorious example, the concept of “barely affordable” has been stretched to the threshold of the metaphysical. Los Angeles County’s frothy market offers dwellings that only 17% of buyers can afford at the median price. And it is even worse in Orange County, where the figure is 11%. But how, you ask, can real-estate mania be going full-bore in a region where home prices are so very high? Some would answer that it is simply a matter of all-but-insatiable demand meeting temporarily insufficient supply. No argument here. But even the most cravenous sort of demand cannot by itself cause a market to boom as Southern California real estate has. It is not the demand for housing per se that has pushed prices to extremes, however, but rather the relative ease with which home buyers can borrow money.

Most of us know, either through experience or anecdote, that home loans have never been easier to get. This is surely not because Americans have become better credit risks. In fact, the opposite is true. Personal bankruptcies have been setting new records almost monthly, the average worker has seen no real income growth in more than a decade, and household liquidity has dropped off the charts. But in response, and to an extent few could have imagined even ten years ago, mortgage lenders have compensated by becoming increasingly creative as Americans have gone deeper and deeper into hock. Thus has “creative financing” become an ironic euphemism for a process that is inherently destructive. Indeed, the erosion of mortgage lending standards has progressed to such a degree that nearly anyone not living in a cardboard box or under a highway can qualify for a loan with ease.

I recently had an e-mail conversation with someone in the mortgage business, and this is what he had to say about one lender in particular, Golden West Financial (NYSE: GDW), a firm that has always enjoyed a blue-chip reputation: “For the past ten years, Golden West has been the most admired financial firm in the U.S., according to Forbes and Fortune. It has been dominated by two of the wealthiest people in the world, Herb and Marion Sandler, husband and wife co-chairs, who have run it with an iron fist since the 1960’s and with highly conservative and principled residential mortgage lending. They have by far the lowest foreclosure rate in the industry on their loan portfolio, which is primarily invested in California.

“Their primary lending unit, World Savings, is now offering on owner-occupied homes 90% loan-to-value, no-income-verification, cash-out refinances into negatively amortizing, adjustable-rate mortgage loans. There is no liquid-reserve minimum, nor is there a stated-minimum credit score. This type of loan was not available even through the sub-prime private lending market just five years ago. Today it is being made available by the company that has built a reputation for soundness, ethics and character that makes Warren Buffet pale in comparison. Do ya think Herb and Marion know what is happening in their company? If the icons of business ethics are doing this what do you suppose the rest of the industry, comprised of mere mortals, is doing?

“I do not offer this as a bashing of GDW, but merely as a heads-up concerning what has happened in the mortgage lending business. Survival in the industry has now mandated that all have become corrupt. This metamorphoses at GDW has been like watching your teetotaler buddy have his first drink at the age of 30, and then immediately start showing up at happy hour every evening. The story eventually ends badly. This is also the primary reason behind the drive to allow the members of the federal home loan banks, of which GDW is one, to sell their portfolios into the [mortgage-backed securities] market. They want to be able to unload the time bombs they know they are now sitting on.”

Fed debates pricking the U.S. housing “bubble”.

If the housing market has become a bubble, as increasing numbers of economists warn, would the Federal Reserve try to deflate it? The idea runs counter to a deep-seated view at the central bank, which refused to puncture the stock market bubble of the 1990’s and continues to view its main job as preventing inflation rather than influencing the prices of stocks, bonds or real estate. “We recognized that, despite our suspicions, it was very difficult to definitively identify a bubble until after the fact,” said Alan Greenspan, the Fed chairman, in a speech two years ago. The idea that the collapse of a bubble can be softened by pricking it in advance “is almost surely an illusion.”

But many economists say the housing market poses a different challenge from the stock market. For one thing, they say, the Federal Reserve’s policies have played a much more direct role in the housing boom than they did in the technology-fueled stock bubble. “This time around, the Fed’s policies have played a part,” said Nigel Gault, a senior economist at Global Insight, an economic forecasting firm. “Its policy has been to boost the housing market and the consumer through very low interest rates.”

Others worry that the Federal Reserve has tacitly encouraged risky speculation through its role as a chief regulator of the banking industry, which has steadily relaxed lending standards and allowed home buyers to borrow more money through higher-risk loans. “The Fed chairman cleaned up the mess caused by the bursting of the technology and telecom bubbles, by creating another bubble,” wrote Edward Yardeni, chief economist at Oak Associates. “Now he has failed to stop the alarming deterioration of mortgage lending standards to stop the housing bubble.” Laurence Meyer, a former Fed governor and now a principal at Macroeconomic Advisers, said the evidence of risky lending practices was abundant.

Middleman now rich man in real estate boom.

Real estate agents in the U.S. collected $61.1 billion in commissions last year, up 43% from $42.6 billion in 2000, said Steve Murray, editor of Real Trends, a real estate industry newsletter. In the most frenzied markets, some are making sums that recall the bonanzas enjoyed by stockbrokers in the late 1990’s. In Manhattan, the best real estate agents cleared over $2 million last year, said Pamela Liebman, the chief executive of the Corcoran Group. “Everything is going for the superstars in these markets,” said Susan M. Wachter, professor of real state at the Wharton School of the University of Pennsylvania. “The market’s hot, the prices are high and if they have the Rolodex, they can just keep it going. Until, of course, it all stops, which may happen. This is the kind of industry that is cyclical.”

Is there a bubble in Florida waiting to burst?

When the nation’s expert on “irrational exuberance” in the dicey world of securities wades in to warn about housing prices, as Alan Greenspan did recently, jitters may be justified. Mr. Greenspan, the chairman of the Federal Reserve, cautioned about “a little froth in this market.” And while he did not perceive a national bubble, he did say, “It’s hard not to see that there are a lot of local bubbles.” Florida could be one of those. The state’s median price for homes hit a record $218,600 in April, a 26% increase over the same month last year. That compares with a 15.1% increase in the national median price, to $206,000, over the same period. Bubble warnings nothwithstanding, the inventory of available houses is down from a year ago, which seems like a reasonable cause for price increases. With builders in some areas unable to keep up with demand for new construction, the residential real estate game has a certain musical-chairs quality these days. Buyers may feel rushed, but they still need to look before they leap.

Some homeowners delay sale in hopes of higher profit.

Kandy Walsh owns a second home near Tucson that has appreciated $200,000 in five months, and she is ready to sell it. But not just yet. She is betting that if she waits six or 12 months more before selling the new 2,200-square-foot home in a gated golf-course community, she can make even more money. “I don’t want to sell too early,” says Walsh, a real estate broker in her 50s. “But I don’t want to get clobbered, either. But if I roll the dice (and win), it is an extraordinary opportunity to really make money.” Walsh’s strategy amounts to “market timing”, which one normally associates with nimble stock market traders.

The risk, of course, is that if the overheated market suddenly implodes and home prices take a sharp drop, a big chunk of the “paper profits” would be wiped out. This type of behavior is the latest sign of speculation in today’s frothy housing market, says Gary Kaltbaum, a money manager and host of the nationally syndicated radio show Investor’s Edge. It is a sign that a bubble mentality is forming. It is a sign many people still believe housing prices will continue to rise at a feverish pace forever. “All these signs tell me that we are in the late stages of a housing mania that is reminiscent of the dot-com stock market bubble,” Kaltbaum says. “People are paying prices that have no relation to where housing prices were in the past, in the hopes that someone will pay a higher price. And that is a definition of a frenzy.” He offers this advice to folks holding out for more money by postponing a real estate deal they can profit from today: “Don’t be a minute too late to sell, because when the market turns, you won’t be able to get out. When the tide turns, there will be no one left to buy.”

Is the housing bubble about to burst? Experts fret, but investors cash in.

Ada de Varona describes herself as a full-time school teacher and a part-time real estate investor. “In the last two years, I’ve turned over six properties,” she says. This single mom buys not to own, but to sell at a quick profit – a process called “flipping”. It is a growing practice in hot markets, like Miami, where speculators are cashing in on the tremendous run-up in prices. “There’s no guarantees in life,” says de Varona. “But I’ve never lost money. I’ve always made money. The least I’ve made on a property is $20,000.”

Such enthusiasm sounds eerily familiar to Yale professor Robert Shiller, the author of Irrational Exuberance. He thinks today’s housing market looks a lot like the stock market of the late 1990s, before the tech bubble burst. “A bubble is a time when people stretch to pay more than they otherwise would, because they have grand expectations for future price increases,” says Shiller. Real estate is a national obsession – dominating the headlines, book store shelves, and even cable TV – all showing you ways to redesign your home for maximum profit. “That’s what we saw with the dot-com bubble,” says Shiller. “The problem is that when you have this extraordinary fixation of national attention on a market, it can cause a spiking of the market, and then a reversal.”

Ada de Varona is not worried. “My real estate investing is making a lot more money than my stocks,” she says. She’s confident she can build her nest egg before the bubble springs a leak.

PLAY-Boy in a Bubble?

As anyone who reads Playboy magazine for the articles can tell you, May’s Playmate of the Month is ditching modeling to take up investment in the U.S. housing market. “My ambition in life is to have a successful career in real estate,” she explains, while posing next to a stack of books, including one titled, All About Escrow. So, it is official: the get-rich-quick seduction of the U.S. housing market is not only just “better than sex”. It is now seducing the objects of sexual desire. And why not? According to Wall Street, the greatest asset out there right now is housing. After all, from the start of 2000 to the end of 2004, home prices soared 50% versus a 17% fall in the S&P 500 stock index over the same period.

Generally, the laws of physics demand that when something goes up this much, it is time to buy an umbrella and watch for the fallout. But whether it is a Bunny in her Birthday suit or a broker in a business suit, the housing bandwagon is getting heavier by the day, thanks, in part, to professional opinions such as this one: “We see all the positive factors coming together to coincide with a powerful demographic demand for housing. The sector is red hot and nothing has happened to discourage people from thinking it will remain that way.” (New York Times)

Except that on May 24, Federal Reserve Chairman Alan Greenspan “issued the strongest warning to date about a possible bubble in real estate” with his observation of “unsustainable price gains,” building “froth”, and little, localized “bubbles”: The closest Greenspan will ever get to yelling “fire” on a crowded trading floor. Mr. Fed eventually tried to recover a reassuring tone with these closing remarks: “Prices will soon simmer down, but there is a very considerable unlikelihood of a significant decline in home prices. Any decline that does occur may only hurt those who buy right before it happens.”

Well, that is comforting, in an unsettling kind of way. Still, investors insist, “Real estate is better than a 401(k) plan.” (Washington Post) Point of fact: 25% of homes bought in 2004 were purchased as investments, up 14.4% from 2003. Continued faith in the housing sector to make one’s fortune amidst a flurry of warnings to the contrary is nothing short of phenomenal. It is, in fact, what the January 2005 Elliott Wave Financial Forecast identified as a very specific “phenomenon” that occurs during one point in a market’s trend. Contrary sign of strength OR confirmation of things to come?

Getting crushed in a housing collapse.

Ask Chuck Dannis about how it feels when a housing bubble bursts and he talks about elevators. A real estate appraiser in Texas for the past 30 years, he well remembers 1986, when crude prices dropped below $10 a barrel, mass layoffs in the oil-dependent economy followed, and the Texas real estate bubble deflated. Home prices across the Southwest fell from 10% to 20%. “You’d get on an elevator, and it would be quiet,” recalls Dannis, president of appraisal firm Crosson Dannis in Dallas and a lecturer at Southern Methodist University. “No one would talk.” “For sale” signs dotted neighborhoods, with families unable to sell simply mailing their keys to the bank and walking away from homes destined to go into foreclosure.

But there was also a pervasive change in mood, a shift that affected everyone – even those secure in their ability to remain in their homes – and which contrasted sharply with the euphoria that reigned from 1982 to 1985, says Dannis. Back then, “everyone was happy and optimistic about the future, and they’d talk to each other on elevators,” he says. But after the real estate market fell, “everyone was morose,” recalls Dannis. “It felt like there had just been a funeral.”

Dannis’s memories are worth revisiting. These are heady days for real estate. But given that home-price gains running this far ahead of inflation cannot continue forever, it is worth remembering that a real estate recession is no fun. All it would take to trigger one is sharply higher interest rates. Real estate prices have not fallen on a national basis in the past 30 years, but several regions have seen real estate recessions – most often sparked by major layoffs in a dominant industry. Almost overnight, families can wake up to find that their largest asset – the one they figured would keep on growing and provide a retirement nest egg – has dropped in value. It can hurt older folks close to retirement. It can bankrupt young people who stretched to buy their first home or speculated on rental properties. Even for homeowners who can comfortably meet their mortgage payments, it means suddenly spending less on other things. It can put a damper on the whole economy.

Market driving risky mortgages.

A recent survey by the Mortgage Bankers Association found that adjustable-rate and interest-only loans together accounted for 63% of all loan originations in the second half of 2004. Meanwhile, about a fourth of buyers nationwide are taking interest-only loans, a kind of mortgage that can have fixed-rate features but is usually adjustable, according to LoanPerformance, a San Francisco-based company that tracks loan originations. “It’s higher than we’ve ever seen in recent years and probably ever,” said Doug Duncan, chief economist of the Mortgage Bankers Association.

Lenders say they are offering what most customers want. With home prices rising so quickly, many buyers could not afford homes without using adjustable or interest-only loans, which “fit their pocketbooks and their needs a little more precisely,” said Heather McElrath, a spokeswoman for the American Bankers Association. She added that society is so mobile today that many buyers believe they will not be in their homes long-term and prefer a shorter-term time horizon to manage their money better. “We’re a society that prefers instant gratification – it’s a short-term rather than a long-term focus,” McElrath said.

Lenders are pushing adjustable mortgages to maintain a high sales volume at a time loan refinancings have plunged, said Christopher Cruz, a Silver Spring, Maryland-based mortgage lending trainer. Loan originators, either mortgage brokers who act as middlemen between consumers and lenders, or mortgage bankers, who can also fund the loans themselves, get paid only if the transactions go through – which gives them an incentive to make the loan payments as alluring as possible to the borrower.

Mudd vows to change Fannie Mae culture.

Daniel H. Mudd, the new chief executive of housing finance giant Fannie Mae, pledged to change the culture of the company in the wake of last year’s accounting scandal and set the hiring of a corporate ethics officer as one of his top priorities. Mudd yesterday told analysts that Fannie would be successful again when it “regained the trust” of its investors and customers and had become “an institution you can feel confident and comfortable investing in.”

Mudd also pledged that the company would be more transparent. He said that if an ongoing review of Fannie’s books by former senator Warren B. Rudman uncovers another accounting violation, the company will disclose it. In response to an analyst’s question about Fannie’s shrinking market share, Mudd said the company was still building its capital reserves to meet a requirement set by OFHEO. He said that until the company reaches its mandated capital target, it will continue to decrease its portfolio of mortgages, mortgage-backed securities and other assets.

The size of Fannie’s portfolio is a subject of debate, as lawmakers consider legislation to create a new, powerful regulator for Fannie. The Bush administration has proposed limiting the kinds of assets Fannie can hold for investment purposes. The House Financial Services Committee recently passed a bill that would create a new regulator but would not reduce the size of Fannie’s portfolio. The Senate Banking Committee is expected to take up similar legislation by the end of the month.

GREENSPAN’S RATE MOVES ROILING ASIAN BONDS

What kinds of shocks could shoulder-check Asia? Here is one: Damage control by the Federal Reserve, which cut interest rates too much and is now set on correcting things. Asia’s bond boom is running up against a U.S. central bank that raised its benchmark lending rate 2 percentage points since June after holding it at 1 percent for about a year. What is more, the world’s most powerful monetary authority seems poised to tighten credit conditions even further this year.

The effects of higher U.S. rates are increasingly seeping into Asian debt markets, which until recently were seeing more issuance than other economic regions. Asia’s local-currency debt markets have more than tripled in size since the region’s 1997- 1998 financial crisis. And for already-vulnerable markets like the Philippines and Indonesia, Fed rate increases are a big risk. By cutting rates to a four-decade low, Fed Chairman Alan Greenspan set the stage for a slide in global borrowing costs. Easy money meant cheaper financing for Asian governments and companies and, of course, U.S. consumers.

Yet all that is changing as Greenspan’s rate moves squeeze more and more liquidity out of the global financial system. While slow in coming, the resulting rise in Asian debt yields has picked up pace. It means companies that sold bonds are seeing their borrowing costs rise and those planning to come to market are finding the process more of a struggle. For that, the Fed deserves some blame. It may seem unfair to blame officials in Washington. After all, Asia is not the huge blip on the Fed’s radar screen it was in the late 1990s. Yet just as the U.S. central bank’s global reach was felt when rates were falling, Asia is now being roiled by the flipside of the phenomenon.

YIELD CURVES SIGNAL POSSIBILITY OF A GLOBAL RECESSION

Bond markets worldwide start to signal worrying news ahead that could lead to an investor’s stampede when they have to cover their short-term borrowings that finances long-term lending. Over the last month only the yield on 10-year notes fell 19 basis points (bp) to 4.07% while the yield on 2-year notes softened only two bp to 3.62%, reducing the spread to only 45 bp. The spread between 2 and 3-year notes amounts to no more than 5 bp based on last Thursday’s closing prices. All this flattening stems to the bigger part from the rise on the short end, while the long end continues its puzzling streak that added “conundrum” to common Fed watcher’s vocabulary. All U.S. recessions were preceded by an inverse yield curve and the point this could happen is only 4 FOMC meeting away, when one presupposes the Fed will keep its measured pace of 0.25% hikes.

European bond markets look no better. 10-year German bund yields fell 22 bp to 3.21% within a month while 3 to 5-year maturities softened only 16 bp to 2.52%, according to Bundesbank data. The picture of flattening yield curves gets repeated in most European nations and one does not need to look at a chart to see that the Japanese government bond yield curve is flat only for the reason that the short end is near zero. We know that for years already. All these markets share one common perception: Their economies are going to slow soon, as the latest OECD report from confirmed.

According to Morgan Stanley economist Ted Wieseman, the rush out of bonds may evolve into a stampede. “In an economy growing at a sustained 4%+ real rate, experiencing near-record low national savings, a corresponding record high current account gap and rising inflation, bubble seems the only reasonable way to describe real short rates of barely over 0%, real five-year rates of less than 1%, real 10-year rates of 1.6%, and real 20-year rates of less than 2%, probably 200 to 300 bp below sustainable fair-value levels depending on maturity,” writes Wieseman. This rush is likely to happen once consumers and investors are pressed into liquidating their long-end lending positions to cover their short-end borrowing. As said before, this may be only 4 FOMC meetings away which is as soon as November 1.

Currency markets will continue their battle of the two sinking ships displaying the names Euro and Dollar, it can be projected. With the meltdown on bond markets looking imminent for the reasons given above, The Prudent Investor wonders where a safe haven can be found as Switzerland just annulled its GDP growth forecast of 1.5%, Bloomberg reports. As there seems to be an asset deflation just around the corner that could also hit commodities because of slowing demand caused by the economic downturn, precious metals could outshine all other asset classes.

THE ENDURING UNFAIRNESS RELATED TO FAIRNESS OPINIONS

Rooting out conflicts of interest on Wall Street has become a full-time job for securities regulators in recent years. Thankfully, some long-needed changes have been made to research and sales practices at brokerage firms, banks and mutual fund companies. But one conflict lives brazenly on, safe from even the most assiduous reform efforts. That enduring unfairness is related to, of all things, the fairness opinion. Fairness opinions are produced by Wall Street banks and are intended to assure the directors of companies involved in a merger, acquisition or other deal that its terms are fair to shareholders.

But the opinions can be problematic, because the bank affirming the fairness of the transaction is often the same one that proposed the deal – and that stands to reap millions in fees if it goes through. When J. P. Morgan Chase paid $58 billion to acquire Bank One last July, the fairness opinion was supplied by – who else? – J. P. Morgan Chase. However laughable they may be, fairness opinions continue to be used to justify transactions and to provide legal cover for directors fearful of being sued if a deal goes bad.

At least some regulators are beginning to awaken to the conflicts that fairness opinions pose. The NASD has asked its members and the public for comments on the practices surrounding the opinions and may propose new rules related to their use. In Massachusetts, William F. Galvin, the secretary of the commonwealth, is investigating the fairness opinions supplied by Goldman Sachs and UBS, the two investment banks advising Gillette, which is the subject of a $57 billion offer from Procter & Gamble. Merrill Lynch provided the fairness opinion to Procter. Mr. Galvin said he had subpoenaed documents relating to these fairness opinions out of concern that the deal might not be, well, fair to Gillette shareholders. “In the proxy statement, Goldman was credited with bringing the deal together. When one of the fairness opinion providers brought the deal together, how objective could their opinion be?,” he asked.

As a part of his investigation, Mr. Galvin asked Rajesh K. Aggarwal, a professor at the University of Virginia who specializes in corporate governance and executive pay, to analyze the fairness opinions. Professor Aggarwal wrote in his study that the opinions were reasonable and valid but that there were “substantial discrepancies” between the public and private statements the companies have made estimating the merger’s value. For example, the companies’ public projections on the revenue and cost “synergies” they expected to achieve as a result of the merger were about $14 billion to $16 billion. But internal company documents, Professor Aggarwal said, put the estimates at $22.1 billion to $28.1 billion. In addition, he said, there seemed to be errors in the way the merger’s value synergies were calculated – mistakes that underestimate the value of the deal. He concluded that by underestimating the value of the synergies, the deal would be more beneficial to Procter & Gamble shareholders than to Gillette’s owners. Shareholders are scheduled to vote on the merger in June.

Speaking generally, Professor Aggarwal said, “There’s a sense that whatever the two parties agree to must be fair. But management has no interest whatsoever in having independent third parties looking at the details of any transactions, and boards historically weren’t going to question the judgment of management. So the issue here is the one party that doesn’t participate in the negotiations – the shareholders.”

When it comes to hiring firms that can conduct truly independent reviews of deals, directors have had few choices. But a new firm, set up by two experienced Wall Street bankers, hopes to change that. The firm, Pirie, Goldsmith & Associates of New York, offers independent fairness opinions on mergers and acquisitions, as well as on asset sales, executive compensation and other issues, said Robert S. Pirie. “To be able to look the lawyers in the eye and say, ‘We hired someone who had nothing to do with the deal, who looked at it and said in their opinion it’s fair,’ if I were a director I’d be very happy to have that,” Mr. Pirie said.

While the established Wall Street firms may snicker at the creation of such a firm, former Federal Reserve chairman Paul A. Volcker applauded the idea of an organization devoted to the issuance of unbiased fairness opinions. “If there was ever going to be a market for this kind of thing it will be now,” he said. “It strikes me that it would be very valuable. A lot of mergers are promoted for the benefit of those involved.”

And all too often, shareholders are the last on that list.

CURRENCY RIFT MAY HIT CHEAP CHINESE GOODS

Most of the toys filling the shelves at the Roseville, Michigan Wal-Mart are made in China. And that was just fine with Viola Thompson, who was shopping with her grandson Friday. Like millions of Americans, the school crossing guard is not concerned about accusations that China manipulates the value of its currency to make Chinese goods sold in the United States artificially cheap. “The way the economy is, I am all for that!” said Thompson, 51, of Detroit. “I shop Wal-Mart for the prices.”

But Congress might take the bargain out of such bargain shopping. Congress threatens to impose special taxes of up to 27.5% on everything China exports to the U.S. unless Beijing revalues its currency. The Bush administration refused Congress’s latest request for a trade case to be brought against China over its currency system, marking the third time it has refused to take the dispute to the World Trade Organization. But the administration warns China that it must take action soon or face rising protectionism in the U.S. Any penalties imposed on China could punish Wal-Mart and American consumers, too. Wal-Mart is the world’s largest retailer. Wal-Mart officials in China frequently boast that, if the retailer were a country, it would be China’s eighth-largest trading partner. Last year, Wal-Mart accounted for nearly 10% of the $197 billion in U.S. imports from China.

CHINESE SHARES FALL TO 8-YEAR LOWS

Chinese share prices closed 2.0% lower on Wednesday, hitting an 8-year low after the government said it will choose a second batch of firms to sell non-tradable state-owned shares, dealers said. They said metal, coal makers and blue chips saw heavy selling as investor confidence was further hurt and the market panicked at the sale plan of the state-owned non-tradable shares. The Shanghai A-share Index fell 22.65 points to 1,090.64 on turnover of 4.67 billion yuan ($564.01 million) while the Shenzhen A-share Index was down 6.40 points, or 2.4%, at 263.53 on turnover of 3.13 billion yuan. The benchmark Shanghai Composite Index, which covers both A and B- shares, closed down 21.55 points, or 2.0%, at an 8-year low of 1,039.19 on turnover of 4.70 billion.

“Today’s fall is significant,” said Industrial Securities analyst Yi Linming. “Investors doubted about the sale plan of the state-owned non- tradable shares and have never taken it as something positive. It (the sale plan) is positive for the market in the long-run, but now it will only add to fund-raising pressures in the short term.” Metal firms lost ground as the key market index closed at its lowest finishing level since February 1997.

DIFFICULT CHOICES AWAIT A NATION – AND WORLD – STUCK ON OIL

It is the stuff of American romance: summer, a big car, a tankful of gas and the endless highway. But that fabled love is now a troubled relationship. We can still drive where we want, if the traffic is not too bad. And we can still drive something nice, if our credit holds out. But Americans can no longer control the cost of the gasoline that enlivened the romance. To be sure, America long ago lost its energy independence and has at times lost control of prices, as it did when OPEC flexed its muscle in the 1970s. But new forces in world energy markets, unrestrained consumption epitomized by the boom in sport utility vehicles and the depletion of oil have subjected the U.S. to buffeting by forces outside its control. Call it the era of the permanent oil shock.

Just two years ago, the notion of oil rising above $40 per barrel was nearly unthinkable. Now, a consensus is developing among economists that the floor for oil prices is in the mid-$40 range, compared with the mid-$20 range that prevailed from 1985 to 2002. There are signs that oil has reached an era where it is beyond the power of any single entity to rein in prices. Beyond the U.S., which is beginning to lose its dominance as the world’s most influential oil consumer. Beyond OPEC, which seems to have lost its ability to keep up with demand. And beyond even the big oil companies, whose record profits disguise costly bottlenecks in oil exploration, refining and production. As the summer traveling season begins, drivers can be thankful for one thing: The price of gas is not as high as it could have been.

Even if the price of oil has peaked for the year, prices remain high by historical standards. And unlike previous spikes in oil prices, which were tied to wars and unrest in the Middle East, the current spike has a more fundamental cause: the inability of oil suppliers to keep up with global demand. OPEC is pumping more than 29 million barrels daily, its highest level in 25 years, and it is still barely able to keep up with global demand. Analysts at the IMF say the cartel may have only about 1.5 million barrels a day of spare capacity, compared with 5.5 million spare barrels four years ago.

Supply is so tight because demand has risen so quickly in the past few years, led by surging demand from China and India – which account for more than a third of the world’s population – along with unrestrained increases in the United States, still by far the world’s largest energy consumer. China and India have developed enough economic strength for a substantial number of their citizens to begin buying automobiles, said Raghuram Rajan, research director at the IMF. In both countries, demand for oil has doubled in 10 years.

The Bush administration’s response to the oil crisis has focused heavily on boosting supply and less on restraining demand through energy efficiency and conservation. But an Energy Department report finds that even if the Bush energy plan passes Congress, the U.S. could be importing 85% of its oil by 2025, compared with 65% now. Critics note that the bill does nothing to limit consumption – such as requiring that cars and SUVs get better gas mileage – and does little to fund projects to obtain more energy from renewable sources. Outside the administration, Set America Free, a coalition including conservatives and liberals, labor unions and environmentalists, is pressing for a reduction in the nation’s dependence on petroleum, arguing that it is a matter of national security.

Severin Borenstein, director of the University of California Energy Institute, said the energy package continues to cater to the nation’s expensive addiction to oil rather than telling the American public it needs to cut back on oil. Instead of trying to maintain low gasoline prices, Borenstein said, politicians should boost the price of gas to reflect its real costs to the society and encourage the development of more efficient transportation systems and alternative energy sources. He says the current cost of oil, as high as it is, does not reflect the true price of maintaining the supply, ranging from military operations to guarding oil fields and the unaccounted costs of environmental damage from using fossil fuels.

BANKS SCRUTINIZED IN CREDIT DEFAULT SWAPS MARKET FOR USE OF INSIDER INFORMATION

Price movements in the credit default swaps market in the past four years indicate that some banks might be using private knowledge of corporate distress to take trading positions in the market, according to the first comprehensive report of its kind. Insider trading suspicions have dogged this fast-growing market since its inception. Now researchers at London Business School say they have found statistical evidence consistent with allegations of insider trading. The authors, Viral Acharya and Timothy Johnson, stress that their conclusions are based on statistical analysis rather than firm evidence of insider trading. Nevertheless, the findings are likely to be closely scrutinized by regulators and bankers.

When investors buy a CDS instrument, they are taking out a form of insurance to protect themselves from the risk of corporate default. This market first emerged in the late 1990s, partly because banks wanted to reduce their own balance sheet risk. In particular, banks with large exposures to risky companies would purchase CDS instruments from other financial players to offload risk on to the rest of the market. Initially, this market was so undeveloped and opaque that it largely escaped regulatory scrutiny, particularly since CDS deals are conducted off an exchange, in private transactions.

However, a couple of years ago fund managers such as Pimco started to complain that this situation meant that banks were engaging in insider trading in CDS instruments for credits such as AT&T Wireless and Sprint. Since then, regulators and banking industry bodies have clamped down, urging banks to keep their CDS operations entirely separate from lending. Most banks now insist they have implemented effective firewalls. Nevertheless, the LBS study highlights some striking price patterns in recent years. In particular, movements of CDS instruments have predated movements in the equity market when companies are in distress, and this pattern is particularly pronounced when a distressed company has a number of close lending relations with banks.

Some academics suggest this could simply show that distressed companies are dealing with more banks. Nevertheless, the LBS researchers suspect that some information from banks' lending relationships is leaking into the CDS market, consequently making them better informed than equity players. The researchers said there was no evidence that this situation was undermining overall liquidity levels or the smooth functioning of the market. Consequently, they said it would be counterproductive for regulators to exclude banks from the market.

FEAR AND LOATHING ALONG THE HEDGE ROWS

New concerns are cropping up about some banks that may be over-reaching for a larger slice of the hedge fund market at a time when big funds are losing money. The prime brokerage business – trading, lending and other services for hedge funds – has long been dominated by Goldman Sachs Group, Morgan Stanley, and Bear Stearns. But a handful of up-and-comers, including UBS AG, Merrill Lynch, Lehman Brothers, Deutsche Bank AG, Citigroup, and Bank of America, are trying to muscle in. Some say they are slashing trading commissions and loan fees and trimming collateral requirements for margin loans made to buy more stocks, bonds, commodities and currencies. Lately, this aggressive push into the hedge fund market has also meant a rich source of anxiety as some bad trading bets in April seem to be leading to more fund losses and more margin calls.

“Demand for profitability is pushing the wannabes to be more aggressive on credit terms,” says Brad Hintz, a senior Wall Street analyst at Sanford Bernstein. “The concern is that those who are pushing into prime brokerage are either aggressively lending” or cutting trading commissions to get the business, he said. During a market disruption, when hedge fund clients are forced to sell positions, weaker credit standards could trip up some of the banks. None so far has suggested that a big problem exists. Brokerage earnings come out in mid-June and commercial bank earnings in mid-July, providing the first reading on the impact to credit portfolios.

Still, this time the Fed may be the first to know. Federal Reserve Chairman Alan Greenspan signaled that he is watching the situation. In a speech earlier this month, he said that in certain corners of the market “there are signs that competitive pressures may be eroding the protection that banks achieve through collateral requirements by reducing the initial margins that they obtain from hedge funds.”

Hedge funds, of course, have become a highly desirable customer segment for Wall Street, accounting for 10% of commodities revenue and 30% of equity trading commissions. The business will become even more attractive to commercial banks next year when new capital standards mean banks can set aside less capital against margin loans to hedge funds. Right now they have a disadvantage to the brokers in that regard. Dire talk this spring of a systemic problem with hedge funds – on the magnitude of 1998’s Long Term Capital Management crisis – has not played out in reality, many analysts say. But declines have forced many to reconsider the risks.

The S&P Hedge Fund index was down 0.26% for May as of midday Friday, 1.12% for the second quarter thus far and 1.31% for the year. Meanwhile, the S&P 500 equity index was up 3.53% for May and 1.73% so far in the quarter. It is down 0.45% for the year so far. The hedge fund index tracks a limited segment of the market, however, and may not have captured the 15% or greater declines some of the big funds have felt this year, analysts said. This kind of performance, though, is not what the rich clients of hedge funds are looking for. They want their funds to beat, not lag, the markets. They pony up big bucks in commissions and fees to the managers to make sure that happens. Now is one of the periods when they can pull their money out. It is an anxious time for hedge fund operators and those who service them. Hedge fund managers are already believed to be selling out of positions to avoid a June crunch when they may have to return cash to investors, and some may be preparing to jump back into sectors that look oversold.

NOW THAT THE FRENCH HAVE VOTED “NON”, WILL GOLD INVESTORS SOON BEGIN PANTING “OUI! OUI!”

We are hesitant to proclaim a new dollar bull market, but we have no trouble imaging a continuing euro bear market. What intrigues us, therefore, is the possibility that the euro’s prospective troubles might NOT produce a big rally in the greenback. Rather, a growing dissatisfaction with all paper currencies – euros as well as dollars – might produce a big rally in gold. We would not expect a big gold rally to begin immediately, however. The initial reaction in the gold-trading pits will be to sell gold against the rallying dollar. But we will be curious to see how long that knee-jerk response might last.

It was not so long ago, you might recall, that investors could not sell their dollars fast enough. Will such impassioned dollar-sellers quickly become impassioned dollar buyers? We doubt it. They might become hesitant dollar-buyers for a while, but not impassioned buyers. The dollar’s own shortcomings have not disappeared, even if they have receded into the background temporarily. This chart illustrates quite clearly how gold has been steadily climbing against the euro. We hold out the possibility of a similar advance against the dollar, in which case, an important new gold rally would have begun.

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CSFB LIKES GOOGLE TO $350

Far from being overpriced, shares of search engine Google (Nasdaq: GOOG) still do not reflect the company’s dominant position in Internet advertising and new businesses like Gmail and Froogle, CSFB argued in an extremely bullish note published Wednesday. The brokerage raised its price target on Google’s shares to $350, noting that its previous goal of $275 was taken out on Tuesday. CSFB said the target reflects a 12-month discounted cash flow model and comes out to an enterprise value of 30 times next year’s earnings before interest, taxes, depreciation and amortization. [Ed: I guess we can put that in the bank, then.] CSFB was an underwriter of Google’s August 2004 initial offering.

A BIT ABOUT DRILLING

“Ten years ago, a geologist couldn’t find a job,” recalls Dan Sarnecki, from the Alberta Energy & Utilities Board in Calgary, “Now, you can’t find a geologist.” But if you DO find a geologist, you do not find one cheap. Finding drilling rigs is not easy either … or cheap, which should be very good news for oil-drilling companies. “Rig day rates are rapidly escalating to record or near-record levels, taking even the largest offshore drilling contractors by surprise,” the Petroleum News reports. “Three months ago, Transocean chief executive Robert Long reported that rates for the company’s second and third generation offshore drilling rigs, for example, had moved from $50,000 per day in 2004 to around $100,000 per day. … Since then, rig rates for second and third generation offshore rigs have moved as high as $160,000 a day.”

Not surprisingly, therefore, the cost of finding and pumping a barrel of oil – including labor, equipment and seismic testing – cost a record $17.12 last year, up 43% from a year earlier, based on data compiled by Bloomberg News. But one company’s expense is another company’s revenue. And in this case, the rising costs of extracting oil from its geologic hiding places are appearing as rising revenues on the top lines of many oil services companies. First-quarter profits quadrupled, for example, at Transocean and GlobalSanteFe, two of the world’s largest offshore drilling companies.

Of course, anyone can see that rig rates are very high right now. The question is whether they will remain high...and for how long. And since there are not any 2008 issues of the Petroleum News lying around our office, we cannot say for certain how high rig rates might be in three years’ time, or even in three months’ time. But based on the evidence contained in the dog-eared pages of a couple of recent 2005 issues, the outlook for the oil-drilling industry seems promising. The current boom seems likely to have staying power, mostly because the bust that preceded it persisted for so many years. During the dark decade of sub-$20 oil, oil-drilling activity seized up like an overmatched drill bit. Very few souls dared to invest in an industry that offered such dismal economic prospects. The many years of under-investment set the stage for today’s rising rig rates. Therefore, GlobalSantaFe chief executive Jon Marshall predicts, “We may have entered a longer and more robust drilling cycle than we’ve seen in many years.”

As should be expected, rig-builders are scrambling to meet the new demand. But that effort seems unlikely to pressure rig rates any time soon. And even if shipyards supply the oil industry with lots of new rigs, the new rigs might go begging for qualified rig personnel. Happily for oil services companies, the rising costs of providing their services are rising slower than the revenues they have been receiving. Entry-level geologists at U.S. oil companies may be earning a hefty average salary of $65,600, but that is only 24% more than these “petro-nerds” earned in 1999. For perspective, rig rates have more than tripled over the same time frame.

In short, we suspect that oil-drillers will continue to enjoy brisk demand for their services for the next few years, exactly as many industry insiders predict. In which case, the shares of oil-drillers and oil-services stocks should continue performing well, especially the relatively cheap Canadian stocks. Over the last few weeks, the discount between American and Canadian oil service companies has been narrowing recently. We cannot be sure that this recent trend is indicative of future trends, but we would not rule it out. The valuation gap between the Canadian and American oil service stocks should continue closing, as no significant fundamental distinction between the two would seem to validate the “Canadian discount”. Stocks like Precision Drilling (TSE: PD) and Ensign Resource Service Group (TSE: ESI) need not continue to sell for much lower valuations than their American peers.

A couple years ago, lowly valued oil-drilling stocks could not seem to find any investors. Today, investors cannot seem to find any lowly valued drilling stocks … but they can still find a few reasonably valued stocks, especially up in Canada.

BASKING IN NIRVANA: THE ASSET MANIA

I am in my final year of a forty-year banking career. I have worked in large regional banks and small community banks. I have witnessed economic and financial markets ebb and flow over the four decades of my active life in banking. During all of this time I have been an interested student of the workings of markets and economies. My experience has taught me to understand that a major determinant of economic and market trends is the human herding impulse. The herding impulse is largely an emotional response to act and behave like everyone else. It is an unconscious default decision to be part of the herd. We human animals take many actions which are not derived from our rational sides. To understand the irrational in human behavior, notice how mobs of people participate in actions which most people would not undertake individually. Most participants in economies and markets have limited financial knowledge and so defer to the decisions of the group. The impulse to imitate the group becomes increasingly insistent the longer a trend continues.

The herding tendency strengthened in the stock markets in the later 1990s as stock prices, especially of tech stocks, began their steep ascents. Some market participants offered increasingly bizarre justifications for prices which were well beyond norms when measured against earnings or, for that matter, against sales. In time, many market players became overextended by committing a large portion of their total assets to the market. Eventually, small changes in market supply/demand relationships, such as a diminution of buying resulting from the existing heavy commitments, tipped the impulse in the other direction. The herding instinct then unraveled the previous price increases in a hurry.

I believe the stock market has followed the above general description from the late 1990s to the present. It seems to me we are participants in a very long-term trend change that is taking years to play out. The general uptrend in stock averages began in 1982 and, with some price setbacks intervening, continued until 2000. The Dow Industrials first broached 10,000 in 1999 and has meandered around that level for several years. Being in the middle of this trend change obscures its outlines and veils its effects.

Following the devastation of stock values during 2000 to 2002, the mania was transferred by our Federal Reserve and willing market participants to the property markets. The Fed could not have been so ignorant as to fail to understand what they were doing. The Fed’s exceedingly low interest rates had the effects of making it unwise to save while providing an incentive to borrow. And borrow we did! During the past few years, consumer debt has increased about twice as fast as consumer incomes. Consumer debt in comparison to GDP is larger than it has been in many decades while required consumer debt payment amounts are near historical highs. In the last four years, according to Freddie Mac, consumers have taken about $700 billion of cash out of their home values during financings. Without this indulgence, abetted by the Federal Reserve, the recovery in consumer spending would have been much weaker.

I have seen these historically extreme market activities manifested among community banks. It is accepted and commonplace for community banks to make loans of 95% to 100%, and sometimes more, of market value. The Federal Reserve’s extremely easy money policy following the stock market decline has fostered these market activities and mitigated their effects. An appraiser in the market where our bank is located recently told me she has been asked several times to appraise a property at a specific value in order to be adequate to cover the loan request. A “market value” derived under such duress then confirms a spurious sale price which, in turn, becomes a “comparable” for the next appraisal.

Credit practices, which would have astonished prudent lenders fifteen years ago, have become commonplace in small town America. Homes which are for sale advertise “no money down” on the front yard for sale sign. Why do borrowers and lenders believe 100% financing is reasonable? They are assuming property prices will continue to rise because most everyone they know is assuming the same thing. The herding impulse exerts a strong pull. We are currently basking in this Nirvana of rising property prices, which facilitates the extraction of equity for consumer expenditures.

I remember other markets when professionals and investors were certain price trends would continue. In the early 1970’s the “nifty fifty” growth stocks were judged by securities analysts and other professionals to be one decision investments. You were advised to buy and hold them indefinitely because they were bound to continue to appreciate. The herd mentality was operative during that time though not commonly perceived. Most of the “nifty fifty” stocks suffered significant price declines when the S & P 500 dropped 45% in 1973 and 1974. In the early 1980’s everyone knew the surging price of oil would surpass $50 per barrel as it moved toward $100 a barrel. Market realities intervened, however, and the ensuing price decline took oil toward $10 per barrel. We learned many oil buyers were hoarding the product because of their certainty prices would continue to rise. When the herd’s mood changed to doubt and concern, the subsequent selling drove prices lower.

Today people are certain real estate will continue to appreciate. That is why they foresee little risk in property loans at 100% of cost. I believe they are mistaken, terribly mistaken. The possible washout from this herd inspired mania in properties will reverberate for many years. The U.S. economy will be exposed for what it is, a debt driven illusion of strength. Unfortunately, consumers will be financially damaged. Maybe I will be retiring in time to avoid the carnage in the consumer debt market, which seems likely to result from history’s latest rendition of an asset mania.

THE CURSE OF CHEAP CREDIT

Call it cheap credit’s revenge. We seem to have arrived at the curious juncture where the low interest rates that rescued us from the last recession might be the cause of the next – or, at any rate, might be the cause of some serious economic or financial unpleasantness. It turns out (not surprisingly) that cheap credit, when continued too long, inspires suspect and speculative borrowing. It becomes a formula for its own undoing. William Rhodes, senior vice chairman of Citigroup, puts it this way: “The speculation here is more evident than people seem to realize. … I’ve seen this movie.” The script is familiar. Too much cheap credit induces overborrowing. During the borrowing phase, the economy seems to do fine. But sooner or later the prices of things bought on credit rise to artificially high levels. Prices stop rising – and perhaps crash. Lenders and borrowers suffer losses. Their spending slows or declines, dragging down the economy.

The present recovery is built largely on cheap credit. Striving to prevent a punishing recession after the 1990s’ stock “bubble”, the Federal Reserve lowered interest rates. The federal funds rate (the rate on overnight loans between banks) dropped to 1%. That policy worked. Americans borrowed heavily, particularly for housing. The result was a construction boom and a helpful rise in home prices. The higher housing values fortified confidence and provided – through the refinancing of mortgages at lower rates – huge cash windfalls that fueled consumer spending. Now the Fed wants to preempt the perils of cheap credit, starting with old-fashioned inflation. The problem is that the Fed directly influences only the obscure federal funds rate, which is not used by ordinary borrowers. It has risen to 3% and may go higher. But the more important rates are those on long-term bonds and mortgages – and, contrary to expectations, they have not risen.

No one quite understands why. It was expected that, as the Fed squeezed the total supply of credit, all rates would rise. Theories abound to explain what has happened. Who knows? Even Fed Chairman Alan Greenspan calls the low rates on bonds and mortgages a “conundrum”. Whatever their cause, they pose twin dangers. One is that more loans may turn out to be stinkers. Borrowers may miss payments or default. The second is that cheap credit is pushing some prices to speculative (that is, unrealistic) levels. “Bubbles”, as we have learned, do ultimately pop. Consider housing, emerging markets, junk bonds, and hedge funds: Everything is interconnected. Hedge funds own mortgages, junk bonds and emerging-market bonds. Losses in one market can cause losses in others. That is normal, but will the normal trigger something more threatening? Cheap credit, once a blessing, could become a curse.

HAS THE FED LOST CONTROL OF INTEREST RATES, ASKS AUTHOR OF THE DOLLAR CRISIS

Richard Duncan is the bestselling author of The Dollar Crisis, a book that was presciently published in September 2002 and correctly predicted the downward direction of the US dollar. The book’s grim yet well argued view has led many intelligent people to stop and think about U.S. economic policy and the danger to the global economy that its twin deficits pose. A new and revised paperback edition of The Dollar Crisis was published last week and contains seven new chapters that bring the book right up to date. In the essay below, Duncan argues that the Federal Reserve may have lost control of interest rates.

Essentially, if the U.S. current account deficit continues to expand from its current level, as seems likely so long as the dollar remains at existing exchange rates, then the amount of paper dollars that foreign central banks wish to invest in U.S. government debt will continue to expand. If foreign central bank buying drives down the yield on treasury bonds, it will also push down mortgage rates, which in turn will cause the rate of increase in property prices, already the fastest in 25 years during 2004 (and the fastest ever in real, inflation-adjusted terms), to accelerate still further. This would allow yet more equity extraction which, in turn, will stimulate U.S. consumption further. Additional consumption will pull in more imports and exacerbate the U.S. current account deficit. And, a larger current account deficit will put yet more dollars in the hands of foreign central banks, who, then, will look for still more dollar-denominated assets in which to invest them. At the same time, rising house prices and booming consumption will lift U.S. tax revenues, causing the US budget deficit to shrink much more than currently expected. In other words, if the U.S. current account continues widening faster than the U.S. budget deficit, it could drive down yields on government bonds and therefore the interest rates on mortgages so low that it creates an asset bubble that the Fed could not control.

Regardless of whether the U.S. government reduces its budget deficit or not, it would appear that the rapidly expanding U.S. current account deficit has begun to undermine the ability of the Fed to determine the level, or even the direction, of interest rates in the U.S. If the present trend in the current account deficit is left unchecked, the investment of ever larger amounts of dollar surpluses by foreign central banks into U.S. dollar-denominated assets threatens to produce asset price bubbles and economic overheating in the U.S. over which the Fed would have no power to control. Seen from this perspective, there is little wonder that the Fed has begun to talk down the dollar. These fears may also explain why the U.S. has recently launched an aggressive campaign to force China to revalue the Yuan.

The extraordinary accumulation of dollar reserves has also begun to impact third party countries, as well. When investors diversify out of dollars and into euros, for instance, they then invest those euros in euro-denominated debt instruments and thereby push up bond prices and push down bond yields in Europe. This explains why German government bond yields are currently at a 109 year low. Soon, this could make economic management in Europe more difficult as well. Such low yields on government bonds in Europe, the U.S. and elsewhere around the world threaten the solvency of life insurance companies and corporate pension schemes, which will be unable to meet the guaranteed returns promised to policy holders and retired workers if interest rates continue falling.

The surging U.S. current account deficit is creating numerous destabilizing imbalances in the global economy. The Fed seems to have only begun to understand the full implications of this now that the current account deficit has grown so large as to undermine their ability to control U.S. interest rates. Their best hope of regaining control over the situation is to force a sharp devaluation of the dollar relative to all the Asian currencies in order to reduce the U.S. current account deficit. The U.S. has now adopted, and begun to enforce, a Weak Dollar Policy. Asia must come to terms with this fact and recognize that this policy shift poses a grave threat to its export-led model of economic growth.

GREENSPAN’S BOND CONUNDRUM RIPENS INTO AN ENIGMA

The 10-year U.S. Treasury note was a “conundrum” to Alan Greenspan in mid-February at a yield of about 4.10%. After cracking the 4% barrier this week, it looks more like Winston Churchill’s Russia: “a riddle, wrapped in a mystery, inside an enigma.” The median forecast of 62 of the finest minds in finance, surveyed by Bloomberg News in December, was for the 10-year bond to yield 4.78% by mid-year. Instead, the note pays about 3.9%, the lowest in more than a year. Barring a market crash in the next four weeks, that is quite a margin of error.

Bond mavens are now lining up to call for lower yields. Morgan Stanley Chief Economist Stephen Roach said earlier this week he is turning bullish on bonds, with a 3.5% level possible in the coming year. Bill Gross at Pacific Investment Management Co., never shy to predict an increase in value for the securities he owns, said May 18 that the 10-year rate could drop to 3% by the end of the decade. Gabe Borenstein, managing director of global investments at Investec Holdings Ltd. in New York, predicts a 10-year yield of 2.5% in the current business cycle, which has 18 months or less to run. Higher energy costs, renewed wariness among indebted consumers, and continued recycling of dollars into Treasuries by overseas investors will help drive down yields, he says.

“All of the economic forces point to a dramatic slowdown ahead which will turn into a serious recession, with almost no tools left to abort that possibility,” says Borenstein, whose firm manages $100 billion globally. David Rosenberg, chief economist for North America at Merrill Lynch in New York, published a May 4 laundry list of demographic reasons why bond yields might plummet “to levels not seen in about half a century”, as an ageing population shuns equities and shifts more of its retirement nest egg into fixed-income securities. “The combination of an ever-greater share of the population heading into retirement age and rising life expectancy will likely boost the demand for bond duration income-generating assets,” he wrote. “The typical boomers, who helped drive the equity bull market from 1982 to 2000 as they moved through the peak ‘capital growth years’ of the life cycle, are now beginning to enter ‘capital preservation’ mode for the first time.”

A March study of historical rates by Menno Middeldorp, senior economist at Rabobank Nederland in Utrecht, the Netherlands, suggests that ultra-low interest rates are the norm, rather than the exception. Middeldorp points out that most bond-market participants have not experienced low rates for long periods, which may skew expectations. “It would be shortsighted to conclude that interest rates should move higher simply because one doesn’t understand why they are below the average levels most people can remember,” he wrote.

I cannot help wondering whether we are near the point when apocryphal shoeshine boys start recommending bonds. Does it really make sense for pension funds to get paid just 4.25% for lending to the U.K. for half a century or to the U.S. for 30 years, or 4% on 30-year loans to Italy? The “this time it’s different argument” turned out badly at the turn of the decade for investors seduced by the promise of the Dow Jones Industrial Average reaching 36,000 and the Nasdaq Composite Index only ever going up. Let us hope there is a gentler, kinder solution to the bond-market puzzle.

Sell bonds … once more with feeling.

When Dallas Fed Governor, Richard Fisher, declared yesterday morning, “We are clearly in the 8th inning of a tightening cycle”q cheers seemed to erupt from the bond-investing crowd. As they rushed to buy long-dated government bonds, they seemed to imagine that the interest-rate ballgame would end decisively in the “9th inning”, perhaps with a “walk-off” rate hike by Alan Greenspan at the June FOMC meeting. But we are not so sure that inflation will slouch off the field a loser as early as June 2005. Instead, we imagine a tedious, extra-inning affair – perhaps with multiple lead-changes – after which bonds end up the loser. And even if bonds ultimately win, like in the 23rd inning, for example, the victory might still feel very much like a loss to bond investors. Net-net, we suspect 10-year Treasury bonds yielding 3.89% are better sold than bought.

We suspect we will discover, with the benefit of hindsight, that the recent spike lower in bond yields had much more to do with temporary, non-economic influences, than with underlying macro-economic trends. As we see it, three short-term factors created a temporary surge of bond buying. Two long-term factors will bring the buying to a halt, and will gradually reinstate an enduring era of bond-selling.

A cheap speculation.

Shortly after putting yesterday’s column (immediately above) to bed, futures trader Richard Morrow rang our office to announce, “I’m shorting bonds … I LOVE this trade!” “Which bonds?” we asked, “and how are you doing it? What instruments are you using to go short?” “I’m buying puts on the 10-year Treasury,” he replied breathlessly. “I don’t think I’ve ever seen bond options this cheap!”

“So how cheap are they, Richard?” we asked. “Well the implied volatility on the options is only about 5%, even though the average monthly volatility of 10-year bonds during the summer months is more than 7%. … the implied volatility of the options should be much closer to 7%, but since bond prices have been moving straight up for several weeks, put option volatility has compressed, just like you would expect. … when option volatilities fall, prices usually fall pretty soon afterwards. So I’m gonna load up on these things, but only a little at a time. I’ve only bought about 1/2 of my put option position, so far.”

“[W]hat makes you so negative on Uncle Sam’s obligations?”, we asked. “Well bonds yields seem extremely low, whether you compare them to the CPI or to the GDP growth rate or to almost any other relevant data series. The facts are as follows: First quarter GDP growth was 3.5%. The CPI over the last 12 months was 3.5%, which is close to a 10-year high. Hedge funds and Wall Street have somehow convinced themselves that interest rates are going down no matter what the data says.”

Interest rates today remind me a lot of the euro last Christmas at 136. Everyone was bullish on the Euro at 136 and they were all wrong. I would submit that a sub-4% 10-year Treasury makes less sense than a 136 euro. “Long story short,” Richard winds up, “the 10-year would be yielding between 6% and 7%, if it were trading in line with its historical relationship to the CPI, GDP and the current stage of the interest rate cycle. So that analysis makes out-of-the-money puts look awful cheap on a reward/risk ratio basis. By the way, I’m early on this trade because I’m always early on financial trades. …”

Options on futures are not for everyone, of course. Some of us might prefer a more sedate means of betting against bonds. Happily, the Rydex family of mutual funds offers an interesting alternative, the Rydex Juno Fund. This unique fund holds short positions in long-dated Treasuries. Thus, each 3/32 change in price of the long bond means approximately a one-penny move in the share price of Rydex Juno. The fund has been a very poor investment lately – falling as bond yields have been falling. But if bond yields are on the brink of reversing course, as Richard suspects, Rydex Juno may be on the verge of delivering gains to its shareholders. We have been wrong before, of course, and so has Richard. But the short side of the bond market seems like a worthwhile speculation.

FLORIDA WEB SITE COMPARES DRUG PRICES

It monitors what pharmacies charge uninsured customers for 50 common medications.

Florida consumers struggling with rising prescription drug costs have a new ally: a state Web site that lets them shop for the lowest prices. The Web site allows consumers to compare prices of 50 common medications. The prices shown are what pharmacies charge uninsured customers as reported to the state. The prices are not guaranteed and are subject to abrupt change. The state will update them each month. The Web site was unveiled by Attorney General Charlie Crist and Alan Levine, head of the state Agency for Health Care Administration. The Web site, in English and Spanish, shows that prices vary widely within counties. In some cases, drugstore chains charge different prices for the same drug in the same city.

DEEP SECRET REVEALED, OLD ADVICE REMAINS GOOD

The cat is out of the bag: Now we know the identity of one of the most famous anonymous people in recent U.S. history. It is almost as good as learning what was recorded in that infamous 18-minute gap of the Watergate tapes – tape recordings that former President Richard Nixon made of conversations in the Oval Office. But since we cannot get that, we will have to settle for the solution to the mystery of who “Deep Throat” was. Deep Throat was the code name given by Washington Post editors to the high-level informant whom reporter Bob Woodward spoke with clandestinely as he and Carl Bernstein reported the Watergate story. The Post won a Pulitzer prize for their reporting.

Woodward himself often referred to his anonymous source as “my friend” and used the initials “M.F.” in his notes. Turns out the initials actually stood for Mark Felt, a top official at the F.B.I. who had served under J. Edgar Hoover and whom Nixon passed over for the top F.B.I. job after Hoover died. 33 years after Woodward and Felt met in underground parking garages to discuss details of the story, it is time to reminisce about the players in that twisted plot that led to the downfall of a president. Famously, Woodward and Bernstein unraveled the story behind the story by following one of many pieces of advice they gleaned from Deep Throat.

Specifically, Felt told Woodward that the way to get the whole story behind the break-ins at the Democratic offices housed in the Watergate Hotel in Washington, D.C., was to follow the money trail. That rule of thumb has entered our collective conscience, and there is a good reason why: money is potent, people cannot ignore it, and it often motivates behavior. So now that the story behind the Watergate story has been revealed, we all know a secret that we did not know days ago. But the real secret to the Watergate reporting was revealed long ago – follow the money trail to get the story behind the story.

FLY THE FRIENDLY ASIAN SKIES

“Airline service is getting worse because more people are flying at a time when carriers have slashed their work forces,” according to Dean Headley, a co-author of a study on the airline industry and associate professor at Wichita State University. According to Headley, the U.S. airline system is being taxed because more planes and more people are flying than at any time since the 9/11 terrorist attacks. However, the aviation infrastructure – runways, airport slots, and air traffic control systems – is essentially the same as it was in the delay-plagued era just before the terrorist attacks, while employment at the seven largest carriers was down 12% in January 2004 compared to a year earlier. Ontime performance worsened in 2004, with 78.3% of flights arriving on time, down from 82% in 2003. (That 78.3% figure surprised me, since on a recent trip to the U.S. not a single flight I boarded was on time.)

In the meantime, U.S. airlines have piled up huge losses and the market capitalization of AMR Corp. has declined to $1.6 billion, Delta to $509 million, UAL to $116 billion, and Northwest to $486 million. By comparison, Southwest Airlines has a market capitalization of $11.5 billion and Jet Blue of $2 billion, while FedEx alone has, at $26 billion, a larger market value than all of the U.S. passenger carriers combined!

Across the Pacific Ocean, in India, an airline started in 1993 by a former travel agent, Mr. Naresh Goyal, recently went public, commanding a 45% share of the Indian airline market and having, following its IPO, a market value of $2.8 billion. Jet Airways is known for its impeccable service standards and punctual arrivals and departures, but it will face increasing competition from a dozen or so new low-cost airlines that have either already begun servicing or will soon start to service the Indian passenger airline market, which is growing by approximately 25% per annum. What is remarkable is that Jet Airways, with a market capitalization of $2.8 billion, has only 42 aircrafts, compared to 71 for America’s Jet Blue and more than 1,000 for AMR Corp., the world’s largest carrier, with revenues in 2004 of $18.6 billion.

Now, I am not suggesting to invest in Jet Airways – at its current price, it is probably overvalued – but it is nevertheless interesting that, in Asia, airlines seem to manage not only to make money, but also to provide excellent services, while in the U.S., the airline industry has not only lost billions of dollars in the last few years, but also offers poor services. Not that conditions are far better in Europe: Air France is by far the world’s worst airline, while the once proud Swissair, which in the 1960s and 1970s was frequently voted as the world’s best airline, has been taken over (fortunately) by Germany’s Lufthansa following massive losses caused by its management’s complete incompetence. Still, of the 10 airports that were voted the best in the world, Europe managed to have three. All the other ranks among the best 10 airports were won by Asian airports. Not surprisingly, the U.S. had none!

In Asia, air traffic is exploding everywhere, with the number of passengers growing at 20-25% annual rates in countries such as China and India, and with numerous new airports taking the bulk of the traffic increase. The point I really wish to make is that in Asia, markets for goods and services are expanding rapidly because they are not saturated and they are becoming more and more affordable to the masses, as a result of personal income gains and price declines arising from huge capital investments. The problem in the U.S. and in Western Europe is that markets are largely saturated and real incomes are hardly growing, which has several consequences in terms of economic growth and the profitability of the corporate sector.

YOU WANNA BE A CENTRAL BANKER? THINK AGAIN

Central bankers around the globe probably are not sleeping well this week, and events in Thailand are to blame. There, the former central bank governor, Rerngchai Marakanond, was ordered to repay 186 billion baht ($4.58 billion) of the money he spent defending the baht ahead of the 1997 Asian crisis. It sets a bizarre precedent for the world’s monetary authorities, especially since one can argue Rerngchai was merely doing his job. If holding civil servants or government officials so gratuitously accountable for a mistake spreads, who in their right mind would take such jobs?

Sure, hindsight shows the futility of Thailand’s battle with speculators. The billions Rerngchai tossed at markets in May and June 1997 would have been better spent elsewhere. And Thailand’s 65 million people have every right to know who, or what, was to blame for a crisis that forced them to go hat-in-hand to the IMF for a $17 billion bailout. Yet naming a scapegoat will not get Thailand closer to understanding the events of the 1990s – or how to avoid similar meltdowns.

As culpable as Rerngchai may be, a currency peg – which Thailand had until July 1997 – is a political device. It is a policy of the finance ministry that is carried out by the central bank. The blame for Thailand’s crisis goes to poor transparency, dodgy corporate governance, negligible public accountability and cushy ties between government, banks and businesses. Incompetent or not, Rerngchai was part of a system that came crashing down across Asia. All this week’s court ruling is likely to do is have other central bankers biting their nails, worrying if they will be next.

It sure does make you wonder which current and former central bank bigwigs should hire lawyers. What if, for example, British officials turned on former Bank of England Governor Eddie George? After all, financier George Soros made more than $1 billion speculating on the pound in 1992, thanks largely to the central bank’s efforts to stop its fall. Come to think of it, maybe the homebuilders and farmers who sent former Fed Chairman Paul Volcker hate mail in the early 1980s for raising U.S. interest rates to 20% could just sue the man. Or maybe we will see the flipside of that coin: Fed Chairman Al Greenspan demanding 5% of the upside in U.S. house prices because his easy-money policies fueled a housing bubble.

THE MINUTEMAN PROJECT: WHY NOW?

The Minuteman Project is gaining momentum. The small group of private citizens that has been patrolling a portion of the Arizona-Mexico border in search of illegal immigrants since early April now has at least five times as many members as it had at inception. And it is considering opening additional chapters in other states that border Mexico. The Project’s founding members describe themselves as “patriotic Americans of diverse racial and ethnic backgrounds. The Minuteman Project is not a call to arms, but a call to voices seeking a peaceful and respectable resolve to the chaotic neglect by our governments charged with applying U.S. immigration law.” “It’s basically like a neighborhood watch,” says the organizer of the Odessa, TX chapter (oaoa.com).

To their credit, the Minutemen have kept up with their intention of “seeking a peaceful and respectable resolve” to the “U.S. immigration problem.” So far, there have been no reports of violence or abuse during their citizens’ arrests of illegal aliens crossing from Mexico. Regardless, the Minuteman Project remains mired in controversy. Popular opinions are clearly divided, and even members of the same political parties are not always on the same page: President Bush calls the group “vigilantes”, while California governor Arnold Schwarzenegger says “they’ve done a terrific job.”

Whether you are for or against the Minuteman Project, most of us seem to have a clear opinion about it. But you know us Elliotticians – we want to understand how social events can be interpreted from an Elliott wave point of view. So for us, the real question is not whether or not the Minuteman Project is good or bad. Our question is: Why did the Project appear in the first place, and why now?

The strength of the Wave Principle is in its universality. Not only does it help you understand trends in the financial markets, but in society, too – because ultimately, both the markets and the society are governed by the same mass psychology. The Principle simply allows you to track and forecast “waves” of mass psychology, be they in the financial markets or in society at large. Over the years, we have observed that the stock market is the leading indicator of social change. Which means that by watching the trend in stocks, you can foresee social trends. We have also noticed that positive social trends are prevalent in bull markets and negative ones dominate in bear market times.

The broad sell-offs in stocks that began back in 2000 marked the beginning of the latest U.S. bear market. Which prompted Bob Prechter two years ago to make this forecast about the coming changes in our society: “Suspicion or hatred of foreigners will increase around the globe. The U.S. will increase restrictions on immigration&xenophobic entities will organize and openly pursue their agendas.” Immigration restrictions, xenophobia and societal polarization are bear market traits. From an Elliott wave perspective, the emergence of the Minuteman Project is fitting. The change in cultural expression that we predicted is coming to pass.