Finance Digest for Week of September 24, 2007

BUFFETT’S SECRET

His reputation buys him time – a luxury not granted to most money managers.

Warren Buffett has been in the news lately. But then, he usually is. Speculation abounds that he might take a position in Countrywide Financial, the hobbled mortgage lender. On the surface this would seem to be a perfect value play: Buy a solid asset while it is down. After all, the argument can be made that Countrywide, the nation’s largest mortgage company, is a strong franchise that will recover once the subprime paranoia abates. Still, it is damn risky.

Buffett has a history of such derring-do. But, as far as we know, Buffett has not yet taken the Countrywide plunge. Bank of America has. The giant bank made such a bold maneuver in late August, buying preferred convertible shares from Countrywide, equal to 16% of the common, if exercised (story here). And what do you know but Buffett this summer bought a small stake of the rescuer – 8.7 million shares of B of A. This is a safer value investment, since Bank of America is hardly in trouble. Indeed, its balance sheet is awesome. At 10 times trailing earnings, this stock, like other financials, has been beaten down lately, off $5 from its 52-week high. Plus, value types will love its nice dividend yield, 5%. Here is one case where I am happy to follow Buffett into a stock.

I submit that Buffett is not that much smarter or more capable than many people in the investment business. True, his discipline and insight are exceptional. He also has the integrity to admit mistakes, which is not the case for a lot of money managers. Yes, Buffett has had a great run. But if he started out today, with his $74 billion in equity investments, I doubt he would be exalted. It is much harder to beat the market with $74 billion than with $1 billion. Over its first 37 years under Buffett, Berkshire shares climbed 2380-fold, a compound annual return of 23%. Over the past five years the shares have been inching ahead at a 10% rate, trailing the S&P 500’s 11.8%.

Nevertheless, his godlike status, earned years ago, allows him the luxury of time. He has famously been quoted as saying that his suggested holding period for an investment is “forever”. A bit of an exaggeration on his part but indicative of the relaxed approach that he can enjoy. Berkshire reported buying 130 million ounces of silver in January 1998 at an average cost of $5.88. He apparently sold his holding at $12.50 in April 2006 when an ETF was introduced for the metal and needed to buy. His total return was 113%, with an annualized gain of 13.6%.

Pretty decent. It was not, however, an investment that I or most managers could have duplicated. Not until 2003 did his investment become profitable. Before silver turned around, his holding was down 18%, and that was before storage and other charges. If I, and most managers, held a position for five years and the position was down that much, clients would not have been very tolerant. In the current climate I often get calls around noon asking how we are doing today.

The Sage of Omaha created a stir not long ago when he bought into Burlington Northern and several other railroads. Since then Burlington has been basically flat. I have a smattering of Burlington Northern Santa Fe – a good long-term investment, but nothing to bet the house on. Berkshire’s stake is a lordly 5.9% of the Berkshire stock portfolio. Had I made a comparable percentage bet in my institutional accounts, the clients would be out for my blood.

Buffett’s retirement is secure, his kids are through college, and his tastes are not extravagant. I highly recommend his annual report. It is required reading at my firm (and readily accessible on the Web). Just do not take it as the tablets from Mount Sinai. Get into things Buffett does not have on his anointed list. Apple (136, AAPL) is a tech stock, a species he pointedly avoids. (He says he does not buy companies he does not understand. I think he is being shortsighted to shun the entire tech sector.) I also like Vornado (105, VNO), the ace office-building owner.

On Countrywide, I would be cautious. The mortgage mess may be just getting under way. I would rather be a few days late to the next rally than a few days early.

HAS BERNANKE SNOOKERED US ALL?

Is the Fed actually deflating?!

Ben the Beard has put the shuck on all of us – hard-money fanatics, Wall Street analysts, and full-time FED-watchers. He has done it in plain site. He and his accomplices have left a trail of digits, but nobody has followed the trail. Until now. And even I may have wandered off the trail.

On August 28 in “The Fed’s Next Moves”, I wrote that the Fed would not lower the FedFunds target rate until its next scheduled meeting, which was September 18. That at that meeting, it would announce a rate cut of at least 0.25 percentage point, but to be sure that bankers know the Fed means business, I though it will be .50 percentage point, matching the cut in the discount window’s rate.

At the time, a forecast of a half-point cut was considered improbable. As you know, the Fed cut the target rate by half a point. I also wrote: “This will be heralded by the financial media as a sign that it’s time to buy stocks. The increase from 1% in 2003 to 5.25% in 2006 was also seen as a signal to buy stocks. Everything is the media’s signal to buy stocks.”

Sure enough, when the announcement of the half-point cut was issued late in the day, the Dow Jones rose by 335 points. It rose almost 100 points the next day. To make myself look like a genius, I should leave it at that. But because of what has happened in the last month, I must fess up. The following paragraph, as of today, was dead wrong: “While the FED is now pumping in new reserves at a little under 6% per annum, and I expect it to continue this policy for the foreseeable future, I don’t think this will be enough to reverse the sagging economy in the next six months. But if I am wrong, then we can expect a return of accelerating price inflation.”

But Bernanke and the Federal Open Market Committee (FOMC) have done something extraordinary. They have publicly lowered the FedFunds target rate, and have forced down the actual FedFunds rate to meet the target rate, while deflating the money supply. You read it here first: “deflating”.

The only monetary indicator that reveals directly what the FOMC has done in recent weeks is the adjusted monetary base. This is the one monetary aggregate that the FOMC controls directly. It reveals what actions the FOMC has taken. The adjusted monetary base (AMB) serves as the monetary base of the fractional reserve commercial banking system. Take a look at what happened from the middle of August, when the FOMC lowered the discount window’s interest rate from 6.25% to 5.75%, until mid-September. You probably have to see it to believe it. From early July, 2007, to mid-August, it climbed rapidly. From mid-August to mid-September, it fell just as sharply. This is deflation.

The table at the bottom of the chart provides the important numbers: the rate of increase from various dates until now. From mid-September, 2006, to mid-September, 2007, the increase was 1.8% per annum. This is what it has been ever since Bernanke took over on February 1, 2006. An increase of 1.8% is tight money policy by previous FED standards. I have been hammering on this point for a year. The FED has dramatically reduced the rate of monetary inflation.

I do not think my message has penetrated the thinking of most hard-money contrarians. They keep citing M-3, which was canceled by the Fed a year ago, and which was always the most misleading of all monetary statistics. Year after year, the M-3 statistic was four times higher than the CPI. The M-3 statistic was worthless from day one. Anyone who used it to make investments lost most (or all) of his money. I have written a report on this, which provides the evidence: “Monetary Statistics”.

This tight-money policy has been reflected in the various consumer price indexes. This week, the Bureau of Labor Statistics released the figure for August. The CPI fell by a tenth of a point. That is, the economy experienced price deflation. Got that word? Deflation. I prefer to use the Median CPI, which is published by the Cleveland Federal Reserve Bank. In August, it rose 0.2%. This is what it rose every month since March. This means a 2.4% increase, year to year, which is consistent with the rise in the adjusted monetary base.

The Fed deflated from the day it announced the cut in the discount rate to the posting of the latest issue of “U.S. Financial Data”. Let me ask you a question: From what you have read in the hard-money camp, was it your perception that the FED has been inflating? The answer is “yes,” is it not?

There is an ancient slogan in the newspaper profession: “If your mother says she loves you, check it out.” I say, “If your favorite financial commentator says the FED is inflating, check it out.” This brings me to an important point: you should monitor the statistics carefully and regularly if you are investing actively. Year to year, the FED is inflating, but it may be inflating far more slowly than what you have been told. Trust, but verify.

What is going on here?

I must now begin a guessing game. The FOMC does not tell the public exactly what it is doing. It is not very clear on what it has done. But we can piece together a pattern from what we have been told.

On September 18, the FOMC announced a half point reduction in the targeted FedFunds rate. Normally, the FOMC controls the actual FedFunds rate by issuing newly created fiat money to banks in exchange for bank-held assets. These are called “repurchase agreements”. The FED accepts these from banks that want to borrow money overnight in order to meet legal reserve requirements. The banks need more money to lend out. They get this from the Fed.

This means that the Fed need not purchase T-bills to inject new money into the economy. It can purchase other assets. I believe this is mainly what the Fed is buying today. I cannot prove this, but it makes sense. It is trying to bail out banks that are in trouble and which need very short-term money. These assets are sold to the Fed at face value, not market value. But does this include sub-prime mortgages? Indeed, it does. The Reserve Banks accept performing mortgages, which could include sub-prime mortgages.

Second, we have already seen that the FED was reducing the monetary base. How could it reduce the AMB? It had to sell assets. When the Fed sells an asset, the money received from the buyer disappears – the monetary deflation side of fractional reserve banking.

Third, we know from the record that the FedFunds rate for over two months had been pushing against the targeted 5.25% rate. Often, it would exceed 5.25%. Then the rate would decline, inter-day. Look at the high-range figures. My presumption is that the Fed was intervening to supply reserves by buying repo’s. This, in and of itself, would have increased the monetary base.

Fourth, the monetary base declined. This requires an explanation. I have one. The Fed was simultaneously selling T-bills from its own account. It sold enough to more than offset its purchases of repo’s from commercial banks. The buyers need not have been American commercial banks. They could have been foreign central banks, individual investors, and funds looking for safety/liquidity. The point is, the sale by the Fed extinguished the money that came in from outside the Fed.

This solved the immediate problem of supplying reserves to banks. If the FOMC bought repos of assets other than Treasury debt, this provided liquidity for assets that would not have been worth as much as the Fed loaned had they been sold into the free market. Meanwhile, the sale of Fed assets such a T-bills enabled the Fed not to increase the rate of money growth. It made the repo purchases non-inflationary.

Can this continue? Yes. Will it continue? For a while, maybe. Bernanke seems determined to avoid price inflation. There is only one way to achieve this goal: reduce the rate of monetary inflation. But a policy of monetary deflation or even slow growth does not solve the problem of the business cycle. The U.S. economy will slide relentlessly into recession.

The Fed is caught between the rock and the hard place. I believe it will inflate. But this recent decline in the AMB indicates that the FED is determined to hold off for as long as politically possible. If the Fed switches policy, this will be visible in the chart and table of the adjusted monetary base. You should monitor this weekly.

I may be incorrect in my analysis. But I can offer no other explanation of how the Fed was able to provide liquidity to the FedFunds market and reduce the adjusted monetary base at the same time. It had to sell assets.

Will the Fed reinflate?

Eventually, yes. It has always inflated since about 1938. That is what it does. That is why it exists. Can the Fed avoid a recession without reinflating seriously? I think the answer is no. Will it reinflate fast enough to avoid a recession? Again, I think the answer is no. Will it reinflate, once the economy slides into recession? I think the answer is yes. In other words, between today and the next wave of monetary inflation, we are likely to go through a recession.

You may have another scenario. You may have a wealth-protection allocation strategy that is geared for inflation: up, up, and away. If so, I wish you well, but I think you are wrong. I think Bernanke is determined not to inflate. He is willing even to sell T-bills to offset repurchase agreements. Whatever the Fed is doing to shrink the monetary base, that is what it has been doing.

I am doing my best to stick with the available facts. These facts are not consistent with what I thought the Fed would do, as recently as August 28. They are surely not consistent with what the hard-money camp is telling you the Fed has been doing.

If your mother says she loves you, check it out.

WE ARE NOT EVEN IN THE FIRST INNING OF AN EPIC BEAR MARKET

Satyajit Das is laughing. It appears I have said something very funny, but I have no idea what it was. My only clue is that the laugh sounds somewhat pitying. One of the world’s leading experts on credit derivatives, Das is the author of a 4,200-page reference work on the subject, among a half-dozen other tomes. As a developer and marketer of the exotic instruments himself over the past 30 years. He seemed like the ideal industry insider to help us get to the bottom of the recent debt crunch – and I expected him to defend and explain the practice.

I started by asking Das whether the credit crisis was in what Americans would call the “third inning”. This was pretty amusing, it seemed, judging from the laughter. So I tried again. “Second inning?” More laughter. “First?” Das, who knows as much about global money flows as anyone in the world, stopped chuckling long enough to suggest that we are actually still in the middle of the national anthem before a game destined to go into extra innings. And it will not end well for the global economy.

Das is pretty droll for a math whiz, but his message is dead serious. He thinks we are on the verge of a bear market of epic proportions. The cause? Massive levels of debt underlying the world economy system are about to unwind in a profound and persistent way. He is not sure if it will play out like the 13-year decline of 90% in Japan from 1990 to 2003 that followed the bursting of a credit bubble there, or like the 15-year flat spot in the U.S. market from 1960 to 1975. But either way, he foresees hard times as an optimistic era of too much liquidity, too much leverage and too much financial engineering slowly and inevitably deflates.

Like an ex-mobster turning state’s witness, Das has turned his back on his old pals in the derivatives biz to warn anyone who will listen – mostly banks and hedge funds that pay him consulting fees – that the jig is up. Rather than joining the crowd that blames the mess on American slobs who took on more mortgage debt than they could afford and have endangered the world by stiffing lenders, he points a finger at three parties: (1) regulators who stood by as U.S. banks developed ingenious but dangerous ways of shifting trillions of dollars of credit risk off their balance sheets and into the hands of unsophisticated foreign investors, (2) hedge and pension fund managers who gorged on high-yield debt instruments they did not understand, and (3) financial engineers who built towers of “securitized” debt with math models that were fundamentally flawed. “Defaulting middle-class U.S. homeowners are blamed, but they are merely a pawn in the game,” he says. “Those loans were invented so that hedge funds would have high-yield debt to buy.”

Das’s view sounds cynical, but it makes sense if you stop thinking about mortgages as a way for people to finance houses and think about them instead as a way for lenders to generate cash flow and create collateral during an era of a flat interest-rate curve. Although subprime U.S. loans seem like small change in the context of the multitrillion-dollar debt market, it turns out these high-yield instruments were an important part of the machine that Das calls the global “liquidity factory”. Just like a small amount of gasoline can power an entire truck given the right combination of spark plugs, pistons and transmission, subprime loans became the fuel that underlays derivative securities many, many times their size.

Here is how it worked: Banks “originated” loans, “warehoused” them on their balance sheet for a brief time, then “distributed” them to investors by packaging them into derivatives called collateralized debt obligations, or CDOs, and similar instruments. In this scheme, banks do not need to tie up as much capital, so they can put more money out on loan. The more loans that were sold, the more they could use as collateral for more loans, so credit standards were lowered to get more paper out the door – a task that was accelerated in recent years via fly-by-night brokers now accused of predatory lending practices.

Buyers of these credit risks in CDO form were insurance companies, pension funds and hedge-fund managers from Bonn to Beijing. Because money was readily available at low interest rates in Japan and the U.S., these managers leveraged up their bets by buying the CDOs with borrowed funds. So if you follow the bouncing ball, borrowed money bought borrowed money. And then because they had the blessing of credit-ratings agencies relying on mathematical models suggesting that they would rarely default, these CDOs were in turn used as collateral to do more borrowing. In this way, Das points out, credit risk moved from banks, where it was regulated and observable, to places where it was less regulated and difficult to identify.

The liquidity factory was self-perpetuating and seemingly unstoppable. As assets bought with borrowed money rose in value, players could borrow more money against them, and it thus seemed logical to borrow even more to increase returns. Bankers figured out how to strip money out of existing assets to do so, much as a homeowner might strip equity from his house to buy another house. These triple-borrowed assets were then in turn increasingly used as collateral for commercial paper – the short-term borrowings of banks and corporations – which was purchased by supposedly low-risk money market funds. According to Das’s figures, up to 53% of the $2.2 trillion commercial paper in the U.S. market is now asset-backed, with about 50% of that in mortgages.

When you add it all up, according to Das, a single dollar of “real” capital supports $20 to $30 of loans. This spiral of borrowing on an increasingly thin base of real assets, writ large and in nearly infinite variety, ultimately created a world in which derivatives outstanding earlier this year stood at $485 trillion – or eight times total global GDP. Without anyone keeping tabs on these cross-border flows and ensuring a standard of record-keeping and quality, investors increasingly did not know what they were buying or what any given security was really worth.

Now here is where the U.S. mortgage holder shows up again. As subprime loan default rates doubled, in contravention of what the models forecast, the CDOs those mortgages backed began to collapse. Because they were so hard to value, banks and funds started looking at all CDOs and other paper backed by mortgages with suspicion, and refused to accept them as collateral for the sort of short-term borrowing that underpins today’s money markets. Through late last month, according to Das, as much as $300 billion in leveraged finance loans had been “orphaned”, which means that they cannot be sold off or used as collateral.

Leverage amplifies losses on the way down just as it amplifies gains on the way up. The more an asset that is bought with borrowed money falls in value, the more you have to sell other stuff to fulfill the loan-to-value covenants. It is a vicious cycle. In this context, banks’ objective was to prevent customers from selling their derivates at a discount because they would then have to mark down the value of all the other assets in the debt chain, an event that would lead to the need to make margin calls on customers already thin on cash.

Much of the past few years’ advance in the stock market was underwritten by CDO-type instruments which go under the heading of “structured finance” – private-equity takeovers, leveraged buyouts and corporate stock buybacks ... the works. So to the extent that the structured finance market is coming undone, not only will those pillars of strength for equities be knocked away, but many recent deals that were predicated on the easy availability of money will likely also go bust, Das says. That is why he considers the current market volatility much more profound than a simple “correction” in prices. He sees it as a gigantic liquidity bubble unwinding – a process that can take a long, long time.

The problem is not the amount of money in the system but the fact that buyers are in the process of rejecting the entire new risk-transfer model and its associated leverage and counterparty risks. Lower rates will not help that. “At best,” Das says, “they help smooth the transition.”

Global financial crisis to have “far-reaching” impact, says IMF report.

The turmoil stemming from the U.S. subprime property loan market and tighter credit will have a “far-reaching” impact on the world economy, the International Monetary Fund said in its latest Global Financial Stability Report. “Downside risks have increased significantly and even if those risks fail to materialize, the implications of this period of turbulence will be significant and far-reaching.”

The IMF said that since issuing its previous report in April, “global financial stability has endured an important test” in the meltdown of the U.S. subprime mortgage sector. “Markets are recognizing the extent to which credit discipline has deteriorated in recent years – most notably in the U.S. nonprime mortgage and leveraged loan markets, but also in other related credit markets.”

FEDERAL RESERVE’S Q2 FLOW OF FUNDS REPORT ANALYZED

Confirms the enormity of ongoing credit creation.

Considering third-quarter financial market developments, it is tempting to view Q2 credit analysis as somewhat less than timely and relevant. Yet the data do provide evidence of worsening unstable dynamics – in particular, an energized Financial Sphere expanding at breakneck speed, easily outdistancing the flagging Economic Sphere. Highlights for the quarter included double-digit growth rates for both commercial bank and broker/dealer balance sheets. The ABS market continued its streak of double-digit growth, and Agency MBS posted back-to-back quarters of double-digit expansion. The Money Market Complex expanded at an almost 17% rate. Rest of World (RoW) holdings of U.S. Assets expanded double-digit rates as well.

Overall, total net borrowing in the credit markets increased at a SAAR (seasonally-adjusted and annualized rate) $3.8 trillion during Q2 to $46.6 trillion. This was down only slightly from Q1’s SAAR $3.784 trillion, and, for perspective, compares to 2006’s growth of $3.825 trillion, 2005’s $3.380 trillion, 2004’s $3.085 trillion, 2003’s $2.767 trillion, and 2002’s $2.365 trillion. Notably, corporate borrowings expanded at a 10.7% rate during the quarter, state and local governments 11.9%, and the financial sector 9.8%. Financial sector borrowings built on Q1’s brisk pace (9.7%) to the strongest rate of expansion in a year. And while recent credit market turmoil has imposed borrowing restraint, it is worth noting that first-half corporate debt growth was at the fastest pace since 1999.

Continuing a trend that became quite pronounced last year, near double-digit financial sector growth far exceeds that of the real economy. The Wall Street bubble was alive and well during Q2. The broker/dealers expanded assets at SAAR $703 billion to $3.155 trillion. Broker/dealer assets inflated $413.1 billion (nominal) during the first half, or 30.1% annualized. This expansion was second only to 2006’s full-year $615 billion growth. For perspective, broker/dealer assets increased $282 billion during 2005, $232 billion in 2004, and $278 billion in 2003 – and actually contracted $130 billion during 2002.

Wall Street “structured finance” enjoyed a booming and, perhaps, foretelling Q2. GSE Assets expanded SAAR $176 billion (to $2.923 trillion), the strongest growth in a year. Still, GSE assets were up only 1.1% y-o-y. Agency MBS expanded at a 12.3% rate during the quarter, with one-year gains of 10.8%. Asset-Backed Securities expanded SAAR $545 billion (to $4.295 trillion), down only modestly from Q1. And despite the slowest quarter in some time, the ABS market still enjoyed a 13.3% growth rate for the quarter and 18.1% growth over the past year. The ABS market has expanded 63% during the past 10 quarters, extraordinary growth that hit the wall with a thud with the homecoming of market tumult in Q3.

Interestingly, total mortgage debt (TMD) actually expanded (to $13.982 trillion) at a robust 9.0% rate, the largest expansion since Q3 2006 – suggesting that ultra-easy credit conditions endured outside of subprime. Even home mortgage debt growth accelerated, rising to a 7.7% rate from Q1’s 7.3%. Meanwhile, the commercial mortgage lending boom went to “blow-off” extremes – expanding at a 15.6% pace (vs. Q1’s 10.1%). Total mortgage debt has expanded 9.2% over the past year and 24% over two years, with commercial mortgage debt up 13.9% y-o-y and 31%. It will be fascinating to learn how dramatically mortgage debt growth slowed during Q3. Credit restraint hit all sectors.

Quite possibly, Q3 will see record banking sector asset growth, both building on Q2 momentum and taking up the slack created by the breakdown of Wall Street risk intermediation. There were some interesting happenings on the bank liability side – the new credit instruments created in the process of financing robust asset growth. One can make a strong argument that it has not been the ideal environment to aggressively expand capital markets liabilities to fund risky loan growth.

Over the past year, financial asset holdings have increased 9.9%, and real estate assets 5.1%. Total household assets have ballooned 7.9% in four quarters. With liabilities up 8.5%, household net worth has inflated 7.8%. Household Net Worth is up 17.2% in two years, certainly supporting consumer confidence and expenditures. The Rest of World (RoW) balance sheet also typically exposes credit bubble effects. This quarter’s report, unfortunately, is somewhat convoluted – and with major revisions to confuse the issue. Over the past year, RoW holdings of U.S. assets were up an unfathomable $2.659 trillion, or 20.9% (RoW liabilities up $1.172 trillion).

Second quarter numbers suggests the scope of global dollar “recycling” requirements has inflated substantially. The Federal Reserve’s aggressive rate cuts earlier this week definitely only exacerbate what is becoming an untenable outward flow of dollar liquidity from the U.S. financial system to the Rest of World (that must, at a price, be “recycled” back into U.S. assets).

We believe the current course of Fed policy is an attempt to sustain the unsustainable. The Q2 Flow of Funds report certainly confirms the enormity of ongoing credit creation, intensive risk intermediation, and Financial Sector ballooning – classic credit bubble dynamics. The bottom line is that only extreme levels of credit expansion and intermediation now sustain bloated and maladjusted financial, economic and asset market structures. As we have witnessed, any interruption in the credit creation process will almost immediately instigate financial dislocation. The Fed has chosen aggressive action in hopes of resuscitating credit excess and bubble perpetuation. A less risky strategy for our system and currency would necessitate air flowing the other direction – out of credit, asset and economic bubbles. Postponing the adjustment process at this point ensures greater future financial tumult and economic hardship.

THE TWILIGHT OF THE IDOL OF CENTRAL BANKING

Now that it has been discredited, what next?

After pretending an unwonted firmness for a few weeks, the central banks in both Britain and the U.S. have caved, accepting financial sector bailouts and, in the Fed’s case, lowering interest rates. Moral hazard has thus been made immoral certainty. Financial market participants who indulge in grossly speculative activity can be “highly confident” (in the words of the old Drexel Burnham commitment letters) that they will be bailed out by the public sector, i.e., ultimately by the taxpayer. Rarely has there been such an obvious subsidy of the overpaid by the beleaguered. It raises the question: What if anything is the point of central banks in the new world we have entered?

With the Northern Rock debacle, Britain suffered its first run on a major bank since the Overend, Gurney collapse of 1866. The Bank of England initially took the same principled (if, in that case, mistaken) line it took over Barings in 1995. As lines of withdrawing depositors spread over British TV screens, however, it was quickly overruled by the Chancellor of the Exchequer Alistair Darling.

Darling, not content with rescuing just one bank, grandly announced that all failing banks would have their deposits guaranteed by the taxpayer, thus flushing 313 years of bank supervision policy down the pan. (It will be remembered that in 1720 the Sword Blade Bank, bankers to the South Sea Company, was allowed to fail, since Sir Robert Walpole, unlike his distant successors, had a shrewd grasp of the “moral hazard” concept.) By the middle of the week the BoE was offering to lend money against dodgy home mortgage portfolios.

Meanwhile, the U.S. Fed cut interest rates, thus causing a massive Wall Street stock surge, undermining the value of the dollar, sending gold up to $740 per ounce and doing very little to help the home mortgage borrower – since long term rates rose almost as much as he had cut short term rates. Unlike Fed Chairman Ben Bernanke, the bond market fears inflation. Then their regulators allowed the overleveraged and accounting-inept housing agencies Fannie Mae and Freddie Mac to buy another $20 billion of mortgage backed securities, to the further ultimate risk of the taxpayer – Freddie promptly snapped up CIT’s $4 billion portfolio of securitized subprime junk, precisely the rubbish that puts its solvency in most jeopardy. Finally Bernanke appeared before Congress and supported legislation allowing Fannie Mae and Freddie Mac “temporarily” to guarantee “jumbo” mortgages above the current statutory limit of $417,000.

The idea that large mortgages should be effectively government guaranteed beggars belief in principle. It also supports the overbuilt high end of the housing market, bailing out borrowers who, being richer, should be more able to bear the risk of lower house prices and higher interest rates. It is a subsidy from the middle class to the rich, supporting the least productive, most energy-inefficient and least deserving sector of the U.S. economy. John Edwards, of the $400 haircuts and the 28,000 square foot home, is no doubt rejoicing at the news.

This is all very depressing. When King Philip II of Spain sat in the gloomy Escorial, counting his gold and silver hoard from the Americas, he doubtless pulled at his beard in puzzlement at where all the damn inflation was coming from. One rather hoped that modern central bankers had got beyond Philip’s limited monetary understanding. However it appears that in times of crisis, when badgered by politicians, they revert to a 16th century worldview. It is as if after the Chernobyl nuclear disaster scientists had resorted to alchemy in the hope of preventing it happening again.

It is now clear that all the intellectual advances in central banking of the last 300 years have disappeared. Gone with the wind are the concept of “moral hazard”, the idea that central banks should be independent of political control, the idea that lowering interest rates might cause inflation and the knowledge that widespread deposit guarantees and bank bailouts impose huge long run costs on taxpayers and the economy. In 1720 this would have been forgivable. Today as then it is likely to bring economic chaos in its wake.

Once the long run costs of bad policy become all too clear, policymakers will make changes, to ensure that they are not repeated. It is thus worth pondering what changes one might recommend. Regrettably, one possible change, a reversion to a Gold Standard, is not immediately practicable. Gold supplies can be increased by new discoveries by at most 1% per annum or so. Since world population is currently increasing at about that rate, any significant economic growth, requiring an increased monetary base, would become impossibly deflationary.

Theoretically, it should not be impossible under fiat money to run a central bank that does a good job. After leaving the Gold Standard in 1931, Montagu Norman did an excellent job at the Bank of England, in an exceptionally difficult period. In 1931-39 his policy provided stable prices and facilitated in Britain an economic performance that relative to its major competitors was better than any since Lord Liverpool’s time. In the U.S., Paul Volcker in 1979-87 did a brave and admirable job in spite of the Fed being an exceptionally politicized institution by central banking standards. Bundesbank presidents made the Deutschemark the most trusted currency in Europe during the half-century of its independent existence.

These three successes were achieved with very different legal and financial structures. They shared only one common feature: exceptional independence from political pressure. In Norman’s case his prestige – he was Governor for 24 years – was huge and in 1931-39 his political counterpart Neville Chamberlain was both capable and sympathetic to his policies. In Volcker’s case, the alternative policy of sloppy inflationism had been wholly discredited by failure. In the Bundesbank’s case the institutional structure worked well.

Independence is not merely statutory. It must be accepted by the political and banking system. In Britain, the incoming Labour government made the BoE nominally independent in 1997, but emasculated it in the following year by removing its banking supervision powers and transferring them to the Financial Services Authority. Why, given its lack of responsibility for Northern Rock’s operations, the Bank should be expected to bail it out is an interesting question. The system is a horrid mess. A free marketer might suggest privatizing the BoE and returning it to its pre-1946 corporate form, but in today’s world that would doubtless result only in its being bought by Dubai, China or Gazprom. Not an improvement.

The U.S. had two perfectly good central banks in the two Banks of the United States, but on both occasions populist pressure led to their winding up. The Fed is a messy compromise, typical of Progressive legislation in that it has been given several internally contradictory mandates, and is constrained by an altogether excessive level of political control.

While the Bundesbank worked fine, the European Central Bank appears to work rather less well. In theory, it should be exceptionally independent since the various political factions pulling at it should be impossible to unite across Europe’s strong national borders. In practice, it appears to be frightened of stirring up political opposition. Its conflicts are likely to become sharper in the future. The Euro in the next few years will be perpetually overvalued against the rest of the world’s currencies, so deflation in the Euro zone is almost inevitable. It appears impossible to create a monetary policy that avoids harsh deflation in some European countries such as Italy without causing idiotic housing booms in other countries such as Spain and Ireland.

Logically, we have now arrived at a position where no central bank can be trusted against the twin temptations of the gigantic financial services industry and the gigantic public sector. On the other hand, unraveling a century of “progress” and returning to a pure Gold Standard may be economically damaging as well as politically impossible. Setting up a Supervisory Committee of top economists is also unlikely to help much. A feature of the U.S. monetary expansion and bubble creation since 1995 was the support for Greenspan’s folly by the world’s leading monetary economist, the late Milton Friedman. The only solution is to find another Paul Volcker or Montagu Norman, but those do not grow on trees.

Rather than try to adapt a fiat money system to remove its deficiencies, it may be simpler to adapt a Gold Standard to remove its excessive deflation. The best way to do this might be that dusty staple of 1890s politics, bimetallism. If gold and silver were both coined, at a fixed ratio between them, new discoveries of both would increase the world’s money supply, giving it more flexibility than a pure Gold Standard. A World Monetary Conference could be held once a decade, to make modest adjustments to the coinage ratio between the two metals or if necessary to debase the coinage slightly.

Such a mechanism would give just sufficient flexibility to avoid excessive deflation. More important, it would provide an automatic check on central bank money creation, thereby preventing asset and stock market bubbles of more than modest size and duration. If such a system had been in effect in the late 1990s, for example, a money flow out of the U.S. at the time of the LTCM crisis would have brought the bubble to a halt 18 months earlier than it did, even if such a flow had not occurred earlier, at the time of Greenspan’s “irrational exuberance” speech. After 2001, a bimetallic standard would have prevented Greenspan from lowering interest crates so far, thus preventing the housing bubble, while the capital inflow in 2001-02, at the time of the strong dollar, would have avoided deflation.

A new monetary system will be demanded in the next few years, after the excessive inflation and moral hazard of the present system have caused the inevitable major crash. At that point, a bimetallic quasi-Gold Standard should be the alternative to work for against the statist and inflationary nostrums that will doubtless be proposed.

FROM PRIME TO SUBPRIME, AMERICA’S HOME-MORTGAGE MELTDOWN HAS JUST BEGUN

Having been in the credit profession for the past 23 years, I have observed several cycles involving the loosening and then the inevitable tightening of credit-underwriting standards. Of course, the Federal Reserve stands at the epicenter of such cycles. While money and credit are flowing like beer at an Irish pub on St. Patrick’s Day, everyone ends up looking like an attractive credit risk. When it appeared that the U.S. economy was heading into a recession, after the collapse of the dot-com and telecom bubbles, the Fed opened up the taps and encouraged one and all to imbibe its tasty, low-cost credit – with the most popular “flavor” being the mortgage loan. At this point, mortgage lenders merely became bartenders serving anyone who walked in the door. To reach this nadir in mortgage-lending standards, it is inescapable that the “Five Cs” of credit were ignored regardless if a mortgage loan was deemed prime, Alt-A, or subprime. This is exactly why the home-mortgage meltdown has just begun.

One aspect of my job entails analyzing personal financial statements. 20 years ago, without a doubt, households had much healthier financial conditions. Back then, in proportion to household net worth, savings were much higher and debt levels (especially automobile, credit card, and mortgage debts) were dramatically lower. It is alarmingly common, today, to see households with well under $10,000 in savings yet half-a-million dollars in mortgage debt – not to mention thousands of dollars in credit card debt and tens-of-thousands of dollars in automobile debt. Such households are literally one or two missed paychecks away from being destitute. Yet, amazingly, the heads of such households are considered to be prime-level borrowers (as long as there is adequate income to cover monthly debt service and expenses). What has happened, in the sphere of personal-credit underwriting, is that risk parameters have been redefined with the word “prime” having been defined downwards.

America’s unfolding mortgage-debt crisis did not emerge in a vacuum. When Alan Greenspan’s Federal Reserve pounded the federal funds rate down to 1%, in June of 2003, it is crucial to understand that such a low rate materialized due to the Fed’s aggressive creation of money and credit. In other words, America’s monetary central planner “knew” that massive inflation was needed to “rescue” the economy from the above-mentioned dot-com and telecom implosions. Housing was specifically targeted by the Federal Reserve to serve as “... a key channel of monetary policy transmission.” With this colossal inflation of the money supply, I would argue that a hyperreality surfaced in the housing market – with corresponding bubbles emerging in consumer electronics and automobiles. During such episodes of heavy inflation, people tend to lose their sense of value including suspending any fear of debt.

In his remarkable piece, Hyperinflation and Hyperreality: Thomas Mann in Light of Austrian Economics, Dr. Paul Cantor masterfully describes how central banking brings about such a destructive hyperreality:

If modernity is characterized by a loss of the sense of the real, this fact is connected to what has happened to money in the twentieth century. Everything threatens to become unreal once money ceases to be real. I said that a strong sense of counterfeit reality prevails in Disorder and Early Sorrow. That fact is ultimately to be traced to the biggest counterfeiter of them all – the government and its printing presses. Hyperinflation occurs when a government starts printing all the money it wants, that is to say, when the government becomes a counterfeiter. Inflation is that moment when as a result of government action the distinction between real money and fake money begins to dissolve. That is why inflation has such a corrosive effect on society. Money is one of the primary measures of value in any society, perhaps the primary one, the principal repository of value. As such, money is a central source of stability, continuity, and coherence in any community. Hence to tamper with the basic money supply is to tamper with a community’s sense of value. By making money worthless, inflation threatens to undermine and dissolve all sense of value in a society.

To be sure, when the federal funds rate declined to the surreal level of 1%, lenders and borrowers behaved as if they were transacting with Monopoly money.

In addition to dealing with the psychologically corrosive affects of inflation, mortgage lenders have become interwoven into what James Grant deems “mortgage socialism”. Since FDR’s New Deal, a veritable alphabet soup of governmental and quasi-governmental entities has served to intervene in America’s mortgage market to slake Uncle Sam’s thirst for putting Americans into homes regardless of creditworthiness. As the housing bubble was expanding, the private sector aggressively jumped into the mortgage-lending fray with an eye toward profiting from securitizing and selling bundles of mortgage loans in the form of mortgage-backed securities (MBSs). A most important aspect of these MBSs is that they are not backed by the full faith and credit of the U.S. Government. However, and this is critical, these private brands of mortgage-backed securities were created by bundling mortgage loans that were originated using the same low underwriting standards as prescribed by Uncle Sam’s socialized mortgage-credit hawkers. To compete in this arena, it was essential to drop lending standards down to the lowest common denominator. Yet, even if there were a few “old-school” credit managers expressing concern, top management – at the private firms producing these MBS products – did not heed such apprehensions because most of the mortgage loans were not being retained as they were being securitized and sold for a profit. Hence, shoddy credit underwriting became the problem of the MBS purchasers.

In an April 8, 2005 speech, Alan Greenspan gushed about how technology has streamlined credit underwriting and made credit more accessible to all Americans. Like a true socialist (really, what else is a monetary central planner), Greenspan celebrated credit egalitarianism in the speech. Lately, Alan Greenspan certainly has not been cheering about subprime mortgages. I wonder why not?

Old-school credit managers, undoubtedly, are still familiar with the Five Cs of credit – character, capacity, capital, collateral, conditions. And when it comes to lending large sums of money related to home mortgages, each and every one of these “Cs" is important to the credit-underwriting process. Alas, such old-fashioned underwriting is not conducive to rapid-paced credit creation – beloved by the MBS peddlers – and most certainly goes against the egalitarian spirit of mortgage socialism.

Regrettably, when the Fed targeted housing to reflate the U.S. economy with enormous doses of money and credit, America’s creeping credit socialism was given fertile ground to grow into a monstrous housing bubble. Mortgage lenders irresponsibly said “yes” to just about any borrower while Alan Greenspan cheered them on. It is no wonder why I have seen the most debt-laden, maladjusted personal financial statements in my entire career. The toxic combination of mind-numbing inflation and credit socialism has crippled household finances from coast to coast. Therefore, do not believe the talking heads who claim that the mortgage mess is limited to the subprime stratum. As the housing bubble continues to implode, the financial fallout will result in nothing short of an international economic disaster. The Federal Reserve’s September 18, 2007 0.5% cut in the fed funds rate will not do anything to head off America’s looming household-insolvency crisis.

S&P/Case-Shiller home price index down 3.9% in July vs. a year earlier.

Home prices in 20 U.S. metropolitan areas fell the most on record in July, indicating the threat to consumer spending was rising even before credit markets seized up in August, a private survey showed. Values dropped 3.9% in the 12 months through July, steeper than the 3.4% decrease in June, according to the S&P/Case-Shiller home-price index. The index declined in January for the first time since the group started the measure in 2001, and has receded every month since then.

Stricter lending standards and reduced demand are prolonging the housing slump, now entering its third year. Prices may continue to fall as homes stay on the market longer, economists said. The housing slump “doesn’t seem like it will go away any time soon,” said Michael Gregory, a senior economist at BMO Capital Markets in Toronto, who forecast the index to drop 4.1%. The group’s 10-city composite index, which has a longer history, dropped 4.5% in the 12 months ended in July.

Robert Shiller, chief economist at MacroMarkets LLC and a professor at Yale University, and Karl Case, an economics professor at Wellesley College, created the home-price index based on research from the 1980s. The index is a composite of transactions in 20 metropolitan regions. 15 cities showed a year-over-year decline in prices, led by a 9.7% decrease in Detroit. The area showing the biggest gain was Seattle, where prices rose 6.9%.

ANOTHER PRICKLY HEDGE STORY

This time the culprit is tiny U.S. stocks, not subprime loans.

After another torrid week for hedge funds, which saw investors locked out of seven funds run by Absolute Capital Management due to the discovery of unreported illiquid investments, calls are mounting again for intensified surveillance of the often murky sector. In the absence of regulation or even a code of conduct for hedge fund managers, investors in the funds concerned, which had been run by Florian Homm, who resigned during the week citing differences of management philosophy, were effectively trusting the managers of the funds, which is a rather shaky basis for investment, it might be thought.

Absolute, which has about $3 billion under management, said that the problems applied to about $500 million of assets, and suspended redemptions after investors tried to reclaim 100 million of their money. Absolute said it had been surprised to learn that the funds had put money into the shares of small, micro-cap U.S. companies which can only be traded in small volumes. “The preliminary results of this review indicate that seven of the eight Absolute Capital equity funds contain quoted investments which the board believes are not immediately realizable at their stated values due to their illiquid nature,” said the company. Its shares collapsed on London’s AIM.

The company said that exposure to the micro-cap stocks varies from nothing in one fund, Absolute Large Cap, to 40-45% in the $342 million Absolute Octane fund. It would like investors to agree to move the illiquid investments into a separate “sidepocket”, which would be wound down over time, to avoid a fire sale of the microcap holdings. Jonathan Treacher, chief executive, who has only been in the job for a few weeks, said that the alternative is liquidation in the Cayman Islands, where the funds are registered.

Surprisingly, German Finance minister Peer Steinbrueck did not take the opportunity to make the case for more hedge fund regulation. He even tried to calm jittery investors by stating that his initiative along with French Finance minister Christine Lagarde to improve transparency in financial markets would not involve regulation as such. Germany failed to get the G8 to impose a Code of Conduct on hedge funds at a June summit.

Peer Steinbrueck has said he wants the outlines of a code of conduct in place by the end of this year, and he may yet get it. Jean-Claude Trichet, president of the European Central Bank, has said that a voluntary code could cover risk management within hedge funds and the exchange of information between funds and their bankers and between funds and their investors. And EU finance ministers, while agreeing not to regulate hedge funds, have spoken in favor of a code of conduct to guide their behavior. New French President Sarkozy has consistently spoken out against hedge funds: “We didn’t create the euro to have capitalism without ethics or morals,” he said, “these aggressive [hedge] funds ... buy up a company, sell it off in pieces, sack 25% of the staff in the meantime, collect 25% profit and create zero wealth.”

The U.S., Japan, Britain, and Canada remain opposed to any interference in the workings of the markets. “Central banks and other regulators should resist the temptation to devise ad hoc rules for each new type of financial instrument or institution,” said Fed chairman Ben Bernanke in May.

GROWTH STRATEGY

In a sharp market decline high-growth, small-company stocks normally drop even more than the broader market does. And in a market rally they shoot higher than the rest. Small-value stocks, typically bolstered by asset-rich balance sheets, usually do not fluctuate so radically. But this downdraft is different.

Small value has been hit the hardest. Since the market peak in mid-July the Russell 2000 Value Index has fallen 8%, versus 6% for the Russell 2000 Growth Index. Sure, a shift toward growth was long overdue. From when technology stocks went bust in 2000 until the end of 2006, value performed very well. That is a long and unsustainable cycle.

The best strategy, then, is to find small-growth names that have held up well in this tough market. They likely will perform even better once the market recovers. My firm looks for profitable small companies with high revenue and earnings growth, particularly those that Wall Street analysts ignore. Here are four of my favorites. Their trailing P/E multiples are on the high end, but so are our expected rates of earnings growth. Their businesses are doing very well. ...

HEALTH CARE REITS OFFER DECENT YIELDS, GROWTH

Real estate investment trusts have cooled off as fast as the sport of condo flipping. Thus far this year equity trusts – collections of properties that shunt you nice dividends from their rental incomes – are down 8% in total return (price and dividend), while the S&P 500 has managed to eke out a 4% gain. But the real dogs in the REIT kennel are health care REITs, off 10.5%. Only residential and self-storage REITs are performing worse.

Why are health REITs out of favor? For political reasons. Health REITs, which make up 7% of the REIT sector, rely on government reimbursements from Medicaid and Medicare at hospitals and long-term acute care centers. If the government cuts funding, the health REITs run the risk of going bankrupt, as happened in the late 1990s. The Clinton Administration sliced Medicare payouts, and that shuttered a lot of nursing homes.

But for many health REITs the risk is overstated. Congress is flummoxed on what to do about the health issue, so do not expect policy changes soon. And cuts in Medicare and Medicaid are rare, since the elderly are a powerful bloc on the Washington scene. Moreover, many health REITs are moving away from hospital-type properties and into assisted living, where residents pay out of their own pockets, and into medical office buildings, which operate much like traditional offices.

REITs in general are thought to be at risk of weakening rental streams in a recession. But health REITs are better insulated from an economic slump than, for instance, office REITs. They own hospitals, nursing homes, assisted-living complexes and medical office buildings. Demand for these has little to do with the economy. And the health trusts pay nice dividends, with yields averaging 6%, against 4.1% for apartment REITs and 4.2% for office REITs.

“These are definitely defensive REITs,” says James Sullivan, an analyst at Green Street Advisors, the real estate research firm. “During downturns, they are a great place to be.” With Green Street’s help, we have compiled a list of health REITs with robust projected earnings (see table).

Sullivan expects the REITs to benefit from an aging population. By 2010 there will be 6 million people in the U.S. over the age of 85. 25% of them will need to live in nursing or assisted-living homes at some point. With their stocks down, health care REITs are cheap in comparison with the estimated liquidating value of their assets.

INVESTING IN PEAK FOOD

Not only do I subscribe to the Peak Oil theory, I am experiencing it first hand. As I write this, I am only a few short minutes from the border of Russia at my home in Estonia, the small Baltic country with the big heart and the taxes to match it. Taxes are a big problem here, but the bigger one is heating fuels. With winter right around the corner and crude oil hitting record highs of almost $83, prices here are surging. Our natural gas and heating oil bills here are going to be three times as much this year and basically that will break the bank for many in this tiny country. The problem is just getting worse as Russia tightens the screws on its natural resources in the region.

Now, Peak Oil may be very familiar to you as a Whiskey reader, but another peak phenomenon may not – Peak Food. Russia recently announced it may curtail wheat exports due to low global stockpiles and that has sent wheat to above $9, driving everything from bread to pasta exponentially higher. The worst could be yet to come. Peak Oil is here. Peak Food will be here soon, too.

There have been few markets in my almost 20 years of trading that have been as exciting as the grain markets have been over the past two years. In my opinion, the best is yet to come. In the commodities world, energy, metals, and stock indexes have been the most active futures contracts – and the most talked about – for years. But like so many things in the commodities industry, that is changing too. Oil and gold commentary still rolls off the lips of the various business news channel anchors. But nowadays, in the same breath, you may hear them talking about corn, wheat, or even soybeans. Why the sudden change?

The big push by individual speculators, hedge funds, and others into the agriculture sector in such a short time has been unprecedented. A great deal of this move is a direct result of the ethanol boom and the record corn prices it has helped to generate.

The modern commodities markets owe their success to the original grain markets that started it all. Back only a couple of decades ago, there was no such thing as an energy futures market or a stock market index. In fact, the grain markets were the first organized futures contracts when many of the exchanges started trading. As the markets developed, grains took a bit of a backseat and the financial and energy commodities seemed to take the lead. Now with the emergence of the electronic trading market and the ethanol boom, grain futures are soaring. The global demand for agricultural and soft commodities is so significant that these markets are not only important, they are vital for price discovery once again.

The simple facts of the matter are that the global population is exploding and exponential increases in demand from countries like China and India are straining a system that is already overloaded by demand and has been taxed by weather problems globally. The wheat crop has been hit especially hard this year as droughts, floods, disease, and even frost have taken their toll. Wheat has risen to $9 a bushel, and $10 is entirely possible later this year. Meanwhile, the soybean complex is also soaring, as pent-up demand, especially from China, is keeping this market very well supported.

It is important to realize that not only do we have exponentially higher demand for soybeans from a growing world population, but we also have the increased feed demands of a growing cattle population in answer to more demand for beef. Soybeans are also a victim/beneficiary of the biofuel boom. Combine all of these factors and throw in a little disease and bad weather and you have a recipe for a very hungry world, indeed ... and much higher prices.

This has been an incredible year for agricultural commodities, and many “experts” have been telling me for the last year that I was crazy to buy these commodities at such high levels. Of course, they started telling me that when corn was at $2.20 a bushel and wheat at $5.50. Today, corn is trading solidly over $3.50 and wheat is trading close to $9. The bad news for wheat supplies just keeps rolling in. In the latest round of bad news, Australia slashed its harvest forecast 31% because of dry weather. Wheat is surging as importers line up to buy whatever wheat they can. Global inventories are heading for a 26-year low. Soybeans have outperformed expectations, too, as global demand has put a solid floor underneath prices.

Is all the bad news priced into the grain markets at this point, and have we finally seen the top for the grain rally? Think again. The biggest disaster for the grains may just be getting started. According to my sources at farms in Minnesota and Iowa, diseases may be setting in, and this could be devastating to the wheat, bean, and corn crops.

Corn could be hit hard after a long summer, and hot and dry conditions and hail affected corn yields in Minnesota. The weather conditions favor the development of a disease called ear rot. Reports of ear rot have been coming in from several different areas, and the quality of grain that comes off these affected fields will almost certainly be reduced. Meanwhile, things over in the bean patch are not faring much better. According to reports, early defoliation and death in patches of soybeans has occurred recently in fields across Minnesota.

Bean and grain prices are very high already – some of the prices we have been seeing for the agricultural commodities in the last few years are nothing short of astounding. It is important to recognize, though, that demand has also been astounding. Demand is almost certain to outstrip supply, especially in wheat and soybeans. So even though we are seeing record prices, they may climb further as we head into winter. Therefore, some exposure to the agriculture sector in your portfolio seems like a prudent idea.

Clearly, the agricultural bull market is far from over, but that is not to say that we will not see some extreme volatility. Overall, though, the indications are pretty clear that staple commodities like grains are going to be more in demand and less in supply as time goes on. So my forecast for the grain markets is as follows: Higher, but volatile.

The really nice thing about commodities trading is that it is just as easy to bet on falling prices as on rising prices. So when the time does come, as it does in every market, we will be just as eager to go short and try to profit on the downside. For now, though, the trend is our friend and the trend is up.

What is next for the grains and soft commodities?

As I told my readers in the beginning of the year, the grains start out as a supply-and-demand market, and then a weather market and then go back to supply-and-demand when we actually get to harvest. Right now, all those wild swings you are seeing in soybeans and wheat are based on weather, more or less. We had hot, dry weather, and beans rallied hard. Then some rain came, and the beans fell dramatically, and then recovered a little. This pattern will most likely continue all the way until harvest.

My readers grabbed half profits on their soybean options pretty much at the high of the move. Nice! We still have plenty of time on these, and as I said, it is a weather market. And even though it is autumn now, the heat has not gone away from many parts of the country. I continue to look for any value play in the grains that may be another good addition to the Resource portfolio, but there are few bargains out there anymore.

The soft commodities, specifically sugar, are showing some good support here at these levels. Funds have come back in, and as oil prices were trading close to $76, it helped sugar, too. Keep a close eye on oil. It could be a major mover for all the commodities, as we are getting back up to the record high, and that could have a ripple effect. What that will do, I am not sure.

A STERLING PLAY ON THE COLLAPSING U.S. INFRASTRUCTURE

As everyone knows by now, the housing market is in a bad state. The NAHB/Wells Fargo Housing Market Index (HMI) is hitting new lows every month. But people forget that not everything in the “construction” sector is housing related. In fact, many other types of construction markets are flourishing or will be soon.

I wrote back in June: “In about 13 years, 90% of urban interstates will be at or exceeding capacity, according to the American Association of State Highway and Transportation Officials’ February 2007 report.” But urban interstates are not the only thing that needs upgraded. As we have seen this summer, a lot of old infrastructure is at a tipping point. The New York City steam-pipe burst in July ... the Minneapolis bridge collapse in the beginning of August. These are just the early signs of a complete breakdown across the country.

The American Society of Civil Engineers (ASCE) conducts a study every two years grading (A-F) various infrastructure problems in the U.S. The most recent one in 2005 declared that the overall American infrastructure received a D. This report included 15 areas that were graded, but I want to focus on four of them today: roads, bridges, transit, and wastewater. Of these four, three received a D grade and only one, bridges, got a C. That is right, the one that has had the most public criticism because of the I-35 disaster. So what does any of these mean to us? The report also evaluated how much it would cost to bring the overall ratings up to an adequate level. It concluded that it will cost $1.6 trillion over the next five years!

That is a lot of money in only five years. So, I quickly realized that there have to be some amazing opportunities that will come out of this. I recognized two immediate things: (1) the entire construction industry as a whole has recently taken some serious hits due to the housing bust, and (2) because of the bubble that preceded the bust, most of the construction companies out there have spread into the residential business. So, I had to look for companies that are staying 100% out of residential construction. That is when I happened upon a beauty, Sterling Construction Company (STRL: NASDAQ).

Sterling specializes in the initial construction and the rebuilding of both transportation and water infrastructures. They have road, highway, bridge and lightrail projects in key locations in certain cities in Texas. They also build (and rebuild) water infrastructure projects like water, wastewater and storm drainage systems. Their largest customer is the Texas Department of Transportation (TxDOT), which will ultimately be the recipient of that state’s share of the $1.6 trillion. This year, TxDOT has awarded Sterling with contracts for concrete paving, feeder road reconstruction, installation of a major storm sewer system, construction of a bridge, major storm drainage systems and water line work.

Companies like this are not always a sure bet when looking to invest. This particular company does have excellent numbers – 18% revenue growth and trading at 90% of its sales – but the construction business is a very cutthroat one. With so many residential construction crews out there looking for work, you can bet that this infrastructure market will soon be flooded. That is why the smart money is betting on the companies in various niche markets that cannot easily be invaded by new companies. Ones like water-pipe manufacturers, or pre-cast concrete companies.

FLYING HIGH ON THE WINGS OF GOOGLE

A wise man once said, “Obvious prospects for physical growth in a business do not translate into obvious profits for investors.” The author of this quote is Benjamin Graham, mentor to Warren Buffett. Graham understood investing. He stressed knowing a company’s intrinsic value. He focused on the business, not the stock.

Graham often shunned the term “investor”. Most so-called investors were truly nothing more than speculators. They were individuals looking for a “shortcut” to superior returns. He understood that most investors lacked patience. They lacked discipline. They lacked the basic tools needed to succeed. In essence, Graham understood human nature.

He called attention to the airline industry. The 1940s and ‘50s gave birth to commercial air transportation. Everyone knew the potential. It did not take fancy analysts in pinstripe suits to forecast enormous passenger growth rates. Before long, airline stocks were “it”. Cocktail parties offered the sound analysis. Soon, every portfolio needed Pan Am. But even simple puzzles have many pieces. Profits require much more than double-digit growth rates. Fuel costs and fierce competition crippled industry margins. Labor disputes added fuel to the fire.

Passenger growth rates, indeed, proved true. But the business never offered significant returns. As Graham wrote, “In 1970, for example, despite a new high in traffic figures, the airlines sustained a loss of some $200 million for their shareholders.” And that is the point of the opening quote. A great growth story does not inevitably equate to a great business. What was it that English entrepreneur Sir Richard Branson said? “If I was a businessman, or saw myself as a businessman, I would have never gone into the airline business.”

Good point. So take this. Yesterday, they offered you Pan Am. Today, they are serving up Google. Same suits ... same premise. “Growths rates and more growth rates,” they scream. Everyone uses Google. Maybe they do. So what?

“Everyone” used to use Yahoo. That is until Google came along. And within a lunch break, everyone switched to Google. It did not cost much. It did not take Madison Avenue. In fact, it cost nothing. Google may make a great growth story. But does it make a great business? I will let you decide.

INVESTING IN THE BANKING INDUSTRY

Banks are power-hungry, money-hoarding machines. They own your house and your car. They may even own your degree. Banks are filled with pale, gray-haired men in pinstriped suits – the masters who sit in leather chairs behind large oak doors pulling the proverbial strings. But I would argue there is no better financial mainstay than owning a great, growing bank. Most investors shy away from this sector. The financial statements are hard to read. The products are boring.

Headline: HSBC launches a revolutionary global climate change index. The benchmark index will track 300 global companies from industries such as alternative energy, recycling, water management and so on. That is great ... a great big yawn.

Headline: Apple launches its latest GlactoPod. Apple calls the boy wonder Optimus Prime. People cheer. They line the streets in fervid anticipation. Confetti falls from the sky. Hooray for Apple! Hip, hip, hooray! God bless Steve Jobs. Oh, yeah – backdating – who cares? Give me Optimus.

But as famed value investor Christopher Browne points out: “Banks are the one growth stock I would love to own. The average person views banks as stodgy, old economy relics. But what would we do without ATMs, debit cards or credit cards?”

And what banks have a chance to grow? The big banks. The days of the small-town bank have come and gone. Banking success will rest on international institutions. It rests on the ability to deliver global products at a local price. So it should come as no surprise that the world’s elite sovereign wealth funds (SWFs) are taking aim at the financial sector. They are buying banks, securities houses and asset managers. And they are taking more than a “symbolic” stake. SWFs have invested an estimated $35 billion since 2006. The Financial Times reports these investments cover companies such as Barclays, Blackstone, Carlyle, Deutsche Bank, London Stock Exchange, NASDAQ and HSBC. See this list of the top 20 SWF investments in western banks and financials since the beginning of last year.

SWFs are thinking long term. They built fortunes on natural resources ... resources with limited life spans. It is time to invest for the next generation. Investors looking for similar stability should look in similar places. They should look at banks. International institutions, in particular, are the way to go. Here is why:

1. Income: They offer solid dividend income.
2. Diversification: International banks derive revenues from multiple countries worldwide. This offers great currency diversification.
3. Longevity: Banking is not going anywhere. Politicians come and go. Banking houses usually stay much longer than the empire they helped build.

Banking is the one industry that weathers time, financial meltdowns, empire collapse, wars, etc. It is the one business that all other businesses depend on. It’s no secret. He who owns the bank owns the world.

NEW TO THE GOLD MARKET?

If you are looking to buy gold today, please let me stop you and advise a cold bath. I mean, have you thought about why? It is just a lump of metal. Why would anyone ever want to buy gold at today’s prices?

After all, gold does not pay you an income. So it can compete only with cash in the bank (provided it is safe) or government bonds (provided they pay) when inflation rises faster than interest rates. That is what happened when gold rose 8-fold for U.S. citizens in the late 1970s. It doubled in price when this happened again – and inflation beat interest rates – in 2003-2006. Nor can gold compete with stock market shares when the economy is growing and real revenues rise. It remains the most unproductive of assets, an inert metal with few industrial uses.

That means gold has no future profits to promise you. But for the very same reason, it also means gold does not rely on consumer spending, new business investment or clever balance sheet gimmicks for its value. Gold is simply a rare precious metal that people all over the world have used to store wealth for more than 5,000 years. And right now, that simplicity is gold’s unique appeal.

Buying gold is as far as you can get from today’s complex and exotic debt markets. They are making headlines for all the worst reasons today, as banking stocks plunge, mortgage bonds slip into default, and losses pile up at hedge funds. Gold, on the other hand, is recording near 3-decade highs, and it still does not owe anything to anyone. In our current financial marketplace, that makes gold rarer still. Gold’s lack of “default risk” also sets it apart from the mountain of debt built up by Western consumers and their governments.

Compared with this epidemic of debt, very few people own gold. Fewer still own it outright, in their name alone. However, the global derivatives market of financial promises has doubled in three years, to stand above $415 trillion – more than eight times the value of the entire world economy!

Last month, it was mortgage-backed bonds and the complex contracts they have spawned that froze the interbank lending markets completely. Much of the betting has turned out to be worthless, and the fear remains that the worst losses have yet to show up. Of course, gold might also lose value. But unlike a mortgage-backed bond, it can never go to zero, not according to 5,000 years of world history. And so far in this global credit crunch, the gold market’s response shows that its “safe haven” status has only grown stronger. In a nutshell, that is why the gold price has now shot to a 27-year high. But is today, right at the top of the chart, the right time for you to buy gold?

Six weeks ago would have been better. Gold has risen 10% since then against the dollar, pound sterling, and euro. Buying gold six years ago would have been better still. Since 2001, gold has very nearly doubled against the world’s five major currencies. For Japanese gold buyers, it has risen 3-fold in terms of the yen. But very few early investors appear to be selling just yet, and many respected analysts agree with their logic – that the real trouble in world finance has barely begun.

Buying gold now could prove a wise decision if this crisis gets worse before the world’s debt problem is cured. Buying gold does not come without risks, however. The gold market remains highly volatile over short-term periods of time, twice as volatile as U.S. stock markets, in fact. And even if the bull market starting in early 2000 runs for another seven years from here, you must expect sharp and severe pullbacks in the meantime.

“Gold rose 600% in the [first half of the] 1970s,” as Jim Rogers, world-famous commodities trader and best-selling author of Adventure Capitalist, put it recently. “Then gold went down nearly every month for two years. Most people gave up.” You cannot blame investors who quit the gold market between 1975-1977 for putting their money elsewhere. The gold price fell very nearly in half! But that is simply “what happens in bull markets,” as Jim Rogers says, and between 1977-1980, “gold went up another 850%.”

Fast-forward to gold’s current bull market, and it enjoyed another huge surge before May 2006, rising by $230 per ounce in only six months. That spring, and for the first time in more than two decades, gold began making headlines at last – and the price promptly slumped by one-fifth. There is no reason to think a sharp pullback will not happen again.

There is every reason to wish that you'd bought back at $575 per ounce in October last year, rather than $730 today. Ask your financial adviser, and he or she should warn you that after six years, gold’s bull market could soon burn itself out. Your adviser should then point to the 1980s and ‘90s and show you how gold just kept sinking, year upon year upon year. Any U.S. investor or saver who bought gold in January 1980 suffered a 70% loss over the next 20 years. They still will not be even today!

So don’t think it cannot happen. Be sure to accept responsibility for your decision if you do choose to buy gold. That way, you will sleep better at night – which is the #1 reason people ever buy gold in the first place. To buy peace of mind, a defense against the bad things that happen when credit and money start to crumble.

“DON’T GET JOE MAD”

Now is the time to hold a little cash.

In April, a group of Penn State football players were involved in an off-campus fight. The local constabulary arrived on the scene and made a number of arrests. The information from the police blotter found its way into the news media and was broadcast far and wide. Coach Joe Paterno heard about it and was not pleased. As former Nittany Lion linebacker and Pittsburgh Steelers great Jack Ham once said, “Don’t get Joe mad.”

From Coach Paterno’s perspective, the football program at Penn State had a black eye. The transgressions of the few had embarrassed the many. Coach Paterno determined that as punishment for some of the team members getting into a fight, the entire team would have to help clean up the Penn State football stadium after every game of the 2007 season. And Penn State’s football coliseum, Beaver Stadium, is no diminutive structure. It seats almost 110,000 oft-crazed fans of the Blue and White.

It is a shame that more of the monetary policymakers in the U.S. have never played football for Joe Paterno. I am inclined to think that they might have learned something from the guy, even if they never had to clean up Beaver Stadium.

I will not bore you by rehashing the monetary policy mess that the U.S. Federal Reserve has made of the U.S. dollar over the past 94 years, let alone in the past decade or even the last year. The central bank’s never-ending overexpansion of credit and liquidity has far exceeded the underlying needs of the U.S. economy. Thus, not only have we been living in credit bubbles of one sort or another for several decades, we have learned to live with a consistent and persistent realm of monetary inflation. The slow but sure erosion of the purchasing power of the dollar over time is simply one more fact of life.

Thus, the first rule of making money in our economy is to structure your portfolio, not to lose it. Even if you are 100% in cash stuffed in a mattress, you have made a certain investment decision and condemned yourself to lose purchasing power over time as inflation robs you. Of course, if you play the stock markets, on any given day, stocks can go up or down, responding to one piece of news or another, to this trend or that. But at the end of the day, you have to ask yourself what you should do about the long-term erosion in value of the dollar. I recommend investments in the energy and natural resource sectors, where the basic resource commodities support their own forms of long-term value.

This spring, my colleague Kevin Kerr and I went over all of the precious metals stocks in the Outstanding Investments portfolio. We thought then (and still think) that, long term, we think that gold and silver will keep on rising in price, just as they have been doing for the past five years or so. We believe that precious metals, as with oil and natural gas and most other commodities, are in a long-term bull cycle.

On occasion, readers send us e-mail asking why the precious metals have not broken out into new highs during the past couple of months. We think that the answer is that the dollar is declining in value slowly, and not simply falling off of a cliff. But the long-term answer is also to be patient. It always nice and reassuring to buy a stock and watch the share price move upward almost immediately afterward. But when it comes to the monetary future – and the fate of the U.S. dollar – we are in no hurry to see a precipitous decline. We believe that the decline of the dollar is inevitable. The demise just may or may not be imminent. In the meanwhile, consider this “your” time to accumulate precious metals shares at relatively low prices, setting your portfolio up for the long-term rise.

We have received numerous inquiries along the lines of “What about cash?” Readers want to know what we think about selling off some part of the portfolio and just keeping cash in an account, if not under the mattress or in a coffee can buried in the backyard. On the later, we can think of quite a few more secure places to store your savings. Then again, as long as you remember where the coffee can is buried, it never hurts to have some hidden treasure out in the backyard. And as for cash generally, let me quote colleague Eric Fry: “You can’t take advantage of a fire sale if you’re inside the warehouse when it burns down.” When things go up in smoke, you want to be outside the warehouse with your pockets full of cash. You also want to be holding a list of all the assets you want to own when the smoke clears.

So there are times to be fully invested. And there are times to hold more cash in anticipation of buying opportunities. Now just may be one of those times to have some cash in an account, ready to pounce on buying opportunities. For example, in the past month and a half, the oil service sector went through some significant declines, along with much of the rest of the stock market. And for a few brief moments – and I do mean “brief” – you could have snapped up many other great companies at real discounts. But you had to have some cash, and you had to be ready to make the move. If you delayed because you did not have the cash, let alone because you were on vacation at the shore, you missed the chance.

But just because this particular buying opportunity occurred in August and now the opportunity has passed, does it mean that nothing like it will ever happen again? Not at all. The summer sell-off was triggered by crises in the subprime lending sectors, when the value of risk was re-priced dramatically downward. This fundamental problem spilled over like a bursting dam into the rest of the financial world. People sold what they had to sell to cover positions and meet margins. They did not necessarily sell what they wanted to sell. So a lot of great companies went on short-term fire sales.

Looking forward, have the subprime lending problems gone away? Not at all. In fact, the next year may well reveal even more rot within the financial sector, as millions more mortgages have the potential to go bad. It is quite possible that hundreds more large banks, financial institutions, hedge funds and other overleveraged groups will have to bail out of their untenable positions. So the point is it will be quite beneficial to hold some amount of cash going forward. How much? That depends on how well you sleep at night. You should amass enough cash that you can wake up refreshed each day. Then watch the news for the next market meltdown. Sooner or later, it will occur. And when it does, buy gold miners and oil service companies.

HOW TO PREPARE FOR A CRASH

Not everyone cares to prepare for a financial environment that will be different from the current bullish one. Just as surely, most people do not want to think about an economic recession. But recent follies in the credit and debt markets have turned some people’s minds to the strong possibility of a U.S. recession. For instance, here is a lead from a recent story in the Financial Times, “The R-word Surfaces on Wall Street”:

The R-word is usually avoided by Wall Street’s economists. It tends to be a conversation-stopper when investment bank clients are told to prepare for the worst.

“It is like looking a client in the eye and telling them that their child is ugly,” says David Rosenberg, chief economist at Merrill Lynch. “It is not what people want to hear.”

If this is what people think about using the word, “recession”, just think how unwilling they are to talk about a depression. But Bob Prechter has written a whole book, Conquer the Crash, You Can Survive and Prosper in a Deflationary Depression, about how to prepare for a deflationary depression, and now – while the stock market’s sun is shining, and people are making financial hay – now might be just the right time to read about how to prepare for a deflationary depression.

The ultimate effect of deflation is to reduce the supply of money and credit. Your goal is to make sure that it does not reduce the supply of your money and credit. The ultimate effect of depression is financial ruin. Your goal is to make sure that it does not ruin you.

Many investment advisors speak as if making money by investing is easy. It is not. What is easy is losing money, which is exactly what most investors do. They might make money for a while, but they lose eventually. Just keeping what you have over a lifetime of investing can be an achievement. That is what this book is designed to help you do, in perhaps the single most difficult financial environment that exists.

Protecting your liquid wealth against a deflationary crash and depression is pretty easy once you know what to do. Protecting your other assets and ensuring your livelihood can be serious challenges. Knowing how to proceed used to be the most difficult part of your task, because almost no one writes about the issue. This book remedies that situation.

Preparing To Take the Right Actions

In a crash and depression, we will see stocks going down 90% and more, mutual funds collapsing, massive layoffs, high unemployment, corporate and municipal bankruptcies, bank and insurance company failures and ultimately financial and political crises. The average person, who has no inkling of the risks in the financial system, will be shocked that such things could happen, despite the fact that they have happened repeatedly throughout history.

Being unprepared will leave you vulnerable to a major disruption in your life. Being prepared will allow you to make exceptional profits both in the crash and in the ensuing recovery. For now, you should focus on making sure that you do not become a zombie-eyed victim of the depression.

The best news of all is that this depression should be relatively brief, though it will seem like an eternity while it is in force. The longest depression on record in the United States lasted three years and five months, from September 1929 to February 1933. The longest sustained stock market decline in U.S. history lasted seven years, from 1835 to 1842, and featured two depressions in close proximity. As the expected trend change is of one larger degree than those, it should be a commensurately large setback, but it should still be brief relative to the duration of the preceding advance.

WELCOME TO SUBPRIME NATION

Caught between two prefixes.

That is how Stephen Roach, the Morgan Stanley economist, put it, explaining why the fall of the dollar is bad news. In its simplest form, a weaker dollar means it takes more dollars to buy things on the open market. This year, for example, Americans will probably buy about $2.5 trillion worth of goods from overseas. They would get a lot more for their money if the dollar were stronger. Specifically, if the dollar were still worth what it was in 2002, they would get 20% more. In other words, the dollar has lost 20% of its value – against most foreign currencies – in the last five years.

Against other things, also imported from overseas, the dollar has lost even more value. Zinc has gone up 60% in the last year alone. Nickel is up 125%. Over the last five years, oil has risen 158%. Wheat is 126% more expensive. The dollar fell again yesterday – to another record low against the euro. You now have to pony up $1.41 to buy a single euro.

Americans who think Bernanke’s easy money policy is going to save the economy need to think harder. Lower interest rates are supposed to make credit more abundant. But more credit, we argue, is just what the U.S. economy does not need.

In the next 18 months, about 2.5 million households are supposed to be affected by mortgage rate adjustments. The total of the mortgages is about $350 billion. First think about this: If the dollar were still worth what was worth five years ago, Americans could save about $500 billion on their foreign purchases – in one single year! The value of all U.S. assets is about, say, $50 trillion. A 20% cut is equivalent to a loss of wealth equal to $12.5 trillion ... it is almost as if every single publicly traded company in the U.S. had gone broke. Fed rate cuts are supposed to avoid a recession, so Americans do not get poorer. But the lower dollar makes them poorer anyway.

Now, consider this: Most of those subprime mortgages will be adjusted, not based on the Fed funds rate, but on the London InterBank lending rate. And long-term mortgage rates are not the same as the short-term rates. When the Fed cuts rates, it signals to lenders that inflation will increase. This pushes up rates on long-term loans, such as mortgages. When the Fed announced its cut last week, long-term rates actually rose almost as much as the Fed’s half of a percentage point cut. Now, according to the Financial Times, the typical subprime mortgage will be reset to a rate around 10% – a huge increase in monthly expenses for the poor homeowner. And the effects (as we have seen) will be felt throughout the global economy.

Meanwhile, so many negative indicators are coming into headquarters that we feel we need to call in an exorcist. Is a recession on its way? It looks to us as though it has already begun. While the value of Americans’ number one asset is going down, their living expenses are going up. And it looks to us as though they are going to go up a lot more. Why?

Remember, there’s a war of prefixes going on. There is no doubt that we are living in a “flationary” world. But what kind of “flation”? “In” or “de”? Each time we approach the question, we hesitate. Now we can give you a definitive answer: Both.

The “flation” in the housing market clearly needs a “de” in front of it. And so does the entire subprime U.S. economy. Yes, a subprime economy. Like the subprime homeowner, the whole U.S. economy has too much debt, and a lifestyle it cannot really afford. The Fed’s grand gesture (offering more credit) looks good on TV, but it does not make the debt go away. It cannot really stop the inevitable deflation of U.S. financial assets. And it actually increases pressure on the typical household, because it forces up prices.

Last week, retailers’ sales fell 1%. Consumers would like to spend. But where will they get the money? Tax receipts are down. August employment numbers showed that jobs are disappearing. And there are 1.3 million real estate agents in the country whose incomes must be falling.

Meanwhile, over on the “in” side of the “flationary” battlefield, the forces of rising prices are gaining firepower too. Commodities will be “skyrocketing”, says our old friend Jim Rogers – because now the world has turned. All those millions of people in Asia, who were willing to work for such low wages, are now becoming consumers. What does a consumer consume? Nickel ... copper ... wheat ... soybeans.

“Inflation lurking on global horizon,” says a headline in the International Herald Tribune. “Globalization,” says the article, “is clawing back some of the benefits it delivered to Europe and the United Sates over the past decade, and higher prices are an increasingly likely result.”

The world turns, and turns, and turns again. The poor subprime nation had it so good for so long. What a pity the world turns. Now, it seems to be at the twilight of a magnificent – if preposterous – era, in which Americans could spend money they did not have on things they did not need and not have to worry about what happened next. But now we find out. And we find ourselves in the worst possible situation – squeezed between the two prefixes. Deflation is taking the oomph out of our economy and the value out of our assets. Inflation, meanwhile, is increasing the cost of everything we buy.

When globalization was just getting going it was a great thing for the rich countries. They could outsource manufacturing and other labor-intensive industries. Now, the Asians have a little change in their pockets and they are getting uppity. They want to buy OUR oil, our wheat, our nickel, our copper, and our beef. So prices are rising – OUR prices.

And now, get this, Chinese producers say their labor costs are rising too. “This development,” reports the IHT, “a long-time coming in China, has picked up as coastal regions full of cheap workers begin to experience labor shortages.” Those millions of Asian schleppers and bussers, whom we were nice enough to employ in unheated sweatshops at $1 an hour, now want more money! The cheek.

The dollar is going down – along with the value of almost all U.S.-centric, domestic, dollar-priced assets. Stocks. Bonds. Wages. Houses. That is where the “de” in deflation comes from. But it could be worse. In fact, it is worse. There is the other kind of “flation” too. Now, Americans will have to pay more for everything – energy, food, housing ...