Finance Digest for Week of February 20, 2006

THE SUBPRIME MORTGAGE RESET PROBLEM

The red-hot U.S. housing market may be fast approaching its date with destiny. Indeed, inside the mortgage trade, much anxiety is being focused on a looming “reset problem”. Over the next two years, monthly payments on an estimated $600 billion of mortgages to borrowers with checkered or no credit histories – the “sub-prime” market – may zoom as much as 50% higher, as the 2-year teaser rates on hybrid adjustable-rate loans expire and interest payments hit their fully indexed levels.

In the past, such resets caused little disruption. For one thing, the sub-prime market was strikingly smaller. Only $97 billion of such mortgages were originated in 1996, compared with a mammoth $628 billion last year and $540 billion in 2004, according to the trade publication Inside B&C Lending. Sub-prime loans outstanding now account for more than 10% of the total U.S. mortgage debt of $8.4 trillion. Moreover, the reset triggers on sub-prime mortgages have dramatically shortened, with the loosening in underwriting standards. During the past two years, “affordability” products, as the industry has dubbed them, have migrated from prime to sub-prime borrowers. Sub-prime borrowers used a variety of products, including (1) Hybrid ARMs, with low teaser rates in the early years, (2) IO Mortgages, which charge interest only and require no repayment or amortization of principal in their early years, (3) “Stated Income” or “No Doc” Loans, requiring no verification of a borrower’s income, (4) Option ARMs, which give borrowers the option of making smaller than normally required monthly payments, with the unpaid portion being added to principal, and (5) Piggy-Back Mortgages, in which the borrower received a first mortgage of, e.g., 80% of a home’s value, plus a credit line to cover his down payment on a new home.

Surging property values in much of the country in the past four years helped bail out many sub-prime borrowers, letting them refinance their loans as painful resets loomed. Many borrowers not only refinanced old debt at attractive teaser rates, but also sucked additional equity out of their homes with cash-out refinancings, to pay off higher-rate credit-card debt. Meanwhile, delinquency rates and credit losses remained artificially low. A tapped-out borrower always could sell his home into a soaring real-estate market to pay off his mortgage debt and regroup. But now the refi window may be closing for the sub-prime crowd. The Fed’s hikes in short-term interest rates have pushed up fully indexed ARM rates. At the same time, evidence is mounting that home-price appreciation is slowing or, in a few areas, reversing. And the secondary market in mortgage-backed securities, which provides some 90% of the liquidity in the sub-prime market, is starting to balk at the easy lending practices in this sector.

Various doomsday scenarios are being posited, while market shifts usually tend to unfold slowly enough to let players adjust. Perhaps so. But significant sticker shock impends for sub-prime borrowers. Of course, if sub-prime borrowers have enough untapped equity in their homes, they will be able to refinance their loans on somewhat similar terms and roll the dice for another two years. But Glenn Costello of Fitch Ratings estimates that at least a quarter of all sub-prime borrowers facing resets may have precious little equity left, even with the huge surge in home prices in the past two years. Many piggy-backed loans to borrow the down payment on their homes, in addition to taking on a conventional mortgage.

In recent months, mortgage underwriting standards have indeed begun to tighten, mostly at the instigation of the secondary market. Even more ominous would be new standards for “nontraditional” mortgage products that have been jointly proposed by a number of federal regulators. The regulators want lenders to qualify borrowers, based on the full payments they will incur once teaser rates expire or full principal amortization on the loans begin. The prevailing practice in the sub-prime industry, however, considers only initial monthly payment levels. “The implication of all this is that many sub-prime borrowers who took out loans in recent years may not be able to refinance unless their income increases or interest rates drop significantly,” Deutsche Bank Securities analyst Eugene Xu observes dryly. In other words, the American Dream of home ownership could turn into a Roach Motel nightmare.

Housing – just cool or going cold?

This spring, Bay Area homeowners are likely to know whether the housing market has merely paused before resuming its upward climb or has truly downshifted to the slow lane and, if so, how dramatically. Last month, the number of homes sold declined for the 10th month in a row and hit its lowest level since 2001, and price gains slowed markedly as well. Now, the question is, will the market simply cool or will it dive into negative territory?

Each housing cycle in the past has had its own set of twists and turns in which a multitude of factors comes in to play. As the current housing frenzy exhausts itself, variables ranging from interest rates and employment growth to affordability, new home supply and sellers’ willingness to part with their No. 1 asset will help determine the swiftness and magnitude of any downshift. “Making this cycle more unique … is that there’s been a big increase in homeownership since the early 1990s,” said Celia Chen, director of housing economics at Moody’s Economy.com. “We’ve brought a lot more people into the market, and it’s uncertain how these people will react in a down cycle.”

The Bay Area real estate market typically runs in cycles, forming almost a stair-step pattern of multiyear price increases followed by periods of stagnation or even mild declines. At the end of the last two major housing booms in the early 1980s and 1990s, prices in most areas did not collapse. Even amid job losses, soaring interest rates and worsening affordability, the region’s huge price gains of the late 1970s were followed in the early 1980s by relatively small declines before resuming their upward trajectory. The next cycle saw a more striking correction. The median Bay Area home price crested at $225,000 in January 1990, then dipped as low as $205,000 before climbing to $229,000 in the middle of May 1996, according to DataQuick, which releases a monthly report based on county recorder data on new sales. The drop was steeper when adjusted for inflation over the years of the downturn.

The 1990s downturn was accompanied by the crash of the aerospace industry and the loss of hundreds of thousands of jobs statewide. In Los Angeles, the then-epicenter of the defense industry, employers jettisoned nearly three-quarters of a million jobs within just a few years, sparking a rash of foreclosures and a nearly 30% plunge in home prices. Yet Bay Area real estate weathered the dot-com meltdown remarkably well, considering the area lost about 450,000 jobs in three years. “Nothing leads to big declines in house prices except job destruction,” said John Krainer, economist at the Federal Reserve Bank of San Francisco. One important factor that helped offset the steep dot-com job declines, however, were rock-bottom interest rates. As companies such as Pets.com and Webvan imploded, interest rates were steadily sinking to levels unseen in decades, providing a cushion for a housing market. In contrast, the benchmark 30-year fixed mortgage interest rate jumped north of 18% in the early 1980s, squashing demand for housing and pushing prices lower. Ken Rosen, chairman of the Fisher Center for Real Estate and Urban Economics at UC Berkeley, believes low rates and easy credit have borrowed demand from the future and guided many recent buyers into riskier loans.

Last year, about half of Bay Area home buyers took out interest-only loans, according to San Francisco’s LoanPerformance.com. The high use of interest-only loans illustrates the eroding ability of many consumers to buy ever-pricier homes, which some experts liken to a balloon that eventually hits the ceiling. According to the California Association of Realtors, only 12 percent of Bay Area households can afford the median-priced home. “We’re really shrinking the number of people who can buy in the marketplace,” said Keitaro Matsuda, senior economist at Union Bank of California. “If the market conditions weaken, that could show up more dramatically because there are so few people who can step in and play the game.”

As home prices rose at a record pace, rents have lagged far behind – a fact that alarms some economists who believe monthly prices in the two markets cannot remain far apart for too long. “There’s a disconnect between the fundamental value of the asset and the value the market is producing,” said Ed Leamer, director of the prestigious Anderson Forecast at UCLA. “It’s just like the dot-com period.”

“People ask why are home prices so high in California, and my response is: ‘Everybody in the world wants to live in California,’” said Michael Carney, real estate professor at California State Polytechnic University at Pomona. In the end, prices are likely to slow and even dip as we enter the end of this real estate cycle. But in the past, it has taken wrenching changes in the economy to seriously rein back the housing market.

Fannie Mae accounting is faulted.

An internal investigation has uncovered new evidence that senior executives of Fannie Mae, the largest buyer of American home mortgages, manipulated its accounting in the 1990’s to meet earnings projections so that top executives could receive more than $27 million in bonuses. In a 616-page report, former Senator Warren Rudman and a team of lawyers and investigators concluded after an 18-month review that Fannie Mae’s accounting practices “in virtually all of the areas that we reviewed were not consistent with” generally accepted accounting principles. The report, a humbling moment for the political and financial giant, is certain to deepen the political divide in Washington over Fannie Mae, which was created by Congress during the Depression to make home ownership more affordable.

Administration officials, some members of Congress and rival businesses said the report showed the need to strengthen oversight of Fannie Mae and limit its size. But the company’s supporters in the housing industry and elsewhere said that the report only highlighted the changes that have taken place under its new management. The findings come as Fannie Mae’s regulator considers whether to force some former executives to return bonuses. And the report will not be the final word on the scandal. The Justice Department and SEC are still investigating former executives.

Fannie Mae was run with “an attitude of arrogance”, according to the report, which catalogs how the company violated accounting principles repeatedly to show stable earnings and less volatility. But the most troubling finding was that the company, rattled by falling interest rates in 1998, improperly delayed taking nearly $200 million in expenses. That move and other, smaller accounting steps let it meet earnings goals, enabling executives – including Franklin D. Raines, then the chief executive-designate, and James A. Johnson, the chief executive – to receive the maximum amount in bonuses for that year. The report concluded that employees who held vital accounting and financial reporting jobs were “either unqualified for their positions, did not understand their roles, or failed to carry out their roles properly.” And it found that management repeatedly presented directors with information that “generally was incomplete and, at times, misleading.”

The report comes as Fannie Mae continues to struggle through the accounting scandal. The company has not filed an earnings statement since 2004. Later this year, it is expected to make a $11 billion restatement of its earnings going back to 2001. Still, shares of Fannie Mae rose 2.2% on Thursday amid relief that the report had concluded that many of the accounting and management problems were being resolved.

SEASONALLY MAL-ADJUSTED

The U.S. economy appears to be off to a flying start in early 2006. Incoming data have uniformly surprised on the upside. The stock market has surged in response, and the bond market has even sold off a bit. Ben Bernanke has been quick to stamp the apparent solid state of the economy with his own seal of approval in his inaugural congressional testimony as Fed Chairman – going out of the way to draw added comfort from the January stats. Who could ask for more? The simple answer is the weatherman. January was not only hot in the statistical sense but it was literally the hottest January on record insofar as U.S. climactic conditions are concerned. We have just been through the mother of all winter heat waves.

And why does this matter for the average economy-watcher? As regular users of statistics, we all traffic in the realm of seasonally-adjusted data – numbers that purportedly have been cleansed of the recurring fluctuations arising from the normal rhythm of life. The problem comes when these repetitive events do not march to the beat of the guys with the green eyeshades – your friendly Washington statisticians. That is when seasonal adjustment becomes mal-adjustment – and our ability to read signals in the economy is severely compromised. In principle, seasonal adjustment has a perfectly noble purpose – basically, to get a clean read on underlying trends in the economy. The so-called seasonal factors do not distort our measure of economic activity in any given year – they are designed to average out to “one” over every 12-month interval. Instead, the intent is basically to smooth out the typical seasonal fluctuations over the course of a “normal” year. Of course, there never seems to be a normal year – or a normal month, for that matter. January 2006 is an obvious case in point.

Last month’s deviation from climactic norms has undoubtedly had a huge distorting impact on the official seasonally-adjusted measures of many facets of economic activity. Three recent examples come to mind – each of which has had an important impact in driving recent trends in financial markets: housing starts, retail sales, and employment. For example, during last month’s heat wave, there was undoubtedly nothing close to the normal winter-related fall-off in new homebuilding. Little wonder that seasonally adjusted housing starts surprised sharply on the upside by surging some 6.8% in January. In the realm of seasonal adjustment, what goes around, comes around. That means payback time is coming. According to NOAA, the jet stream has already migrated back to its more normal position after having been pushed unusually far to the north in January. If this typical seasonal pattern holds for a couple of more weeks, prepare yourself for a reversal of much of the good news on the economy that the markets have been so thrilled about during the past few days.

Which outcome is closer to the true state of the U.S. economy – the energy-shocked, consumer-led slowdown of late 2005 or the apparent heat-seeking burst of activity in early 2006? Financial markets have voted for the latter. So has the Fed’s new Maestro. My advice is do not play with statistical fire. There may have been more truth to the weakness of the economy in late 2005 than most are willing to accept. The case for a post-housing-bubble capitulation of the American consumer remains a very real threat in 2006. But rest assured of one thing: It will be exceedingly difficult to make much of anything out of the seasonally mal-adjusted data reports of the next few months.

IN JAPAN, DAY-TRADING LIKE IT’S 1999

Yuka Yamamoto dutifully quit work to assume her expected role as suburban homemaker when she married six years ago. But she quickly grew bored at home, and when she saw a television program about online stock investing, she took $2,000 in savings and gave it a try. Today, Ms. Yamamoto says she has turned her initial investment into more than $1 million as a day trader, scanning her home computer for price movements in stocks, futures and foreign currencies that could lead to quick profits. And by writing books and holding seminars on trading strategies, she has also become a celebrity among homemakers who are investors. She says she has met thousands of other married women who now play the stock market online, many without their husbands’ full knowledge.

Having overcome the country’s sluggishness in embracing cyberspace and deregulating discount brokerage firms, day-trading has taken off in Japan, the world’s second-largest financial market, after the U.S. The number of accounts at Japan’s electronic brokerage firms reached 7.9 million last September, up from 296,941 in 1999, when the first such firm opened, according to the Japan Security Dealers Association. That is an impressive gain, even after considering that some traders hold more than one account. While Japan’s business establishment still frowns on this new, rough-and-tumble style of trading, it has exploded in popularity among many who previously played only minor roles in Japan’s corporate-dominated economy, particularly young people and women. “Day-trading is great because everyone is equal, even housewives,” said Mrs. Yamamoto, an energetic woman in her late 30’s who declined to reveal her exact age or to document her trading profits. “Success or failure depends entirely on how clever you are, and nothing else.”

Analysts say online investors are driving the soaring volume – and volatility – in Japan’s resurgent stock markets. Internet trading, which did not exist before 1999, accounted for almost 29% of all equity trades in the six months that ended last September, according to the dealers association. That more than accounts for all the increased trading during the Japanese market’s rally. The leading Japanese stock index, the Nikkei 225, has risen about 40% since August. While all the short-term money sloshing around has helped Japanese stocks snap out of their decade-long slump, it is also creating new dangers, say analysts. Many recall how a similar fad in the U.S. in the late 1990’s ended with many traders suffering substantial losses when the telecom and dot-com bubble burst. As the bull market turned, overleveraged speculators dumped their holdings, accelerating and exaggerating the decline in prices.

“The real test will come when the market goes down,” said Yukihiro Yabuki, a managing director for marketing at Matsui Securities, one of Japan’s largest online brokerage firms. “Will they abandon day-trading as soon as things get tough? Do they really understand the risks?”

Bank of Japan may soon end deflation fight, bankers head says.

The Bank of Japan’s battle against deflation is nearing an end as buoyant economic conditions support recovery, said Terunobu Maeda, the chairman of Japanese Bankers Association. Japan’s central bank, which cut the interbank overnight loan rates to near zero in March 2001, has focused on providing banks with plentiful reserves to encourage lending as it struggled to overcome deflation, a policy known as “quantitative easing”.

“The conditions for lifting the policy have been put in place objectively,” Maeda, also the president of Japan’s second- biggest lender Mizuho Financial Group Inc., said at a regular press conference in Tokyo. “Domestic and overseas demand are relatively strong and the economy grew at an annualized 5.5 percent pace in October through December.” Japan’s economy grew five times faster than the U.S. in the fourth quarter as exports climbed and growth in consumer spending doubled. Bank of Japan Governor Toshihiko Fukui said on Feb. 9 core consumer prices will show clear gains in January and after, signaling the bank is getting closer to ending its five-year deflation-fighting policy of pumping cash into the economy.

THE METHOD ACTING SCHOOL OF TRADING

You have heard the phrase, “there is a method in his madness,” which derives from the play, Hamlet. Similarly, the genius of Marlon Brando and James Dean was in their “method acting”, which asks actors to reach deep into their psyche for emotional experiences that mirror the role they are playing. People who spend time trading sometimes look mad, sometimes like geniuses. But wherever they perform, one requirement for success is that they have a method to guide them through good times and bad. That is the first requirement for becoming a successful trader, according to Bob Prechter.

Trading takes guts, even though it is often done on a small stage in front of a personal computer. But guts alone are not enough. Anyone who trades wants to be more successful, and it helps to learn from an expert. Bob Prechter won the U.S. Trading Championship in 1984, when he was named the best options trader with a 444% increase. The second-place trader had an increase of 84%. If you would like to know more about Bob’s advice for being a successful trader, we are starting a 6-part series today, excerpted from Prechter’s Perspective.

“Obtaining a method comes down to one thing”, he says, “creating parameters for making decisions for entering and exiting markets. There are two areas involved: opinion generation and money management. Money management tools are techniques to allocate and protect capital. While this step is the easiest to apply among the requirements for successful investing, it can be a huge hurdle if you have not done all the reading and studying that’s necessary to understand how the markets work and what’s going on. It is also time consuming. Most investors don’t even bother with it. So they guarantee they will lose before their first position is taken.”

THE MOGAMBO GURU HAS GOT THEM BOND MARKET BLUES

When Alan Greenspan took over the Fed in 1987, you (meaning me) could get a donut and a cup of coffee for seventy cents, plus tax, leave a nice tip, flirt in a coy manner with the waitress, and then angrily take back the tip when she cruelly laughed in your face – all from a single dollar bill. Imagine my cruel surprise when I find that the price of a stale donut and a cup of weak coffee has now risen to $1.87! I was halfway through screaming at the snotty little waitress about how she is robbing me blind with her stinking little fraud, when she pulled out her HP 12-C calculator. Stunned, I watched as she deftly calculated that this was 5.6% inflation per year for those 18 years, like that was going to make it OK with me, or something. It does not, she soon found out to her dismay.

This inflation is not the result of a good job of fighting inflation, and in fact, this is proof positive that Alan Greenspan is, without a doubt, the worst central banker America, if not the world, has ever seen. That is saying a lot, because most countries’ central banks are filled to the brim with this exact same kind of idiot. But the bond market wants an inflation-fighter? At this, The Mogambo laughs! Hahaha! What a load of crap! Hell, the bond market accepted the horrid Alan Greenspan for 18 inglorious years, and that demonic little creep exploded the monetary aggregates, created the bank financing for staggering amounts of debt, both public and private, created an impenetrable web of lies about what counts as inflation and what does not, devalued the dollar by half, and facilitated and financed the buildup of such monstrous amounts of derivatives that the total, global face-value of that whole glop of toxic waste is estimated to be somewhere between $350 and $450 trillion dollars! If this seems like a lot of money to you, then you are right! It is a lot of money! It is a hell of a lot of money, and in fact, it is 10 times as much as the entire global output of goods and services of everybody on the face of the planet, for an entire year.

The point is that the bond market accepted Greenspan and his inflation, and they are accepting of this same monstrous expansion of money and credit around the world. And did I say, accepting? Hell, they love it! They are eating this stuff up so much that 6-month CDs at banks are yielding, according to the Money Rates table in the Wall Street Journal, 4.87%, which sounds good, relatively speaking. But we poor chumps who have put our pathetic little bits of savings into CD’s are actually losing money. Out of that paltry 4.87% yield on the CD, we have to pay income taxes on the interest, probably averaging about 25%. That brings our after-tax yield down to 3.15%. Now, subtract this 3.15% net yield from the real-life inflation in all the stuff we have to pay for each year, which is almost certainly running north of 7% a year.

When you subtract the CD’s net yield (3.15%) from the rate of inflation (7%), if you do the math correctly, you will get a net loss of 3.85% a year! Hahaha! You lose almost 4% of your buying power per year! If you close your eyes, you can easily envision Greenspan’s nasty, leering face, with his demonic eyes burning into your soul, as he intones, “Welcome to fiat money hell, suckers!” The whole point of my seemingly endless ranting and raving is that the bond markets, around the world, are pricing variable debt at such premiums that all debt, regardless of length, is yielding less than the global price-inflation rate! Astonishing! The chumps of the world are eagerly lining up to buy variable debt, of every maturity out to 30 freaking years, to lock in an abnormally low, low yield that is guaranteed to, one day, rise significantly!

The Mighty Stentorian Voice Of The Mogambo (MSVOTM) cries out, “And who are these low-IQ buyers of this ridiculously overpriced debt, who are literally shoving each other out of the way in order to be the first in line to get some of this crap?” Far off in the distance you could hear a lone wolf howling softly. Finally, after what seemed an eternity of an eerie, strained silence, suddenly The Mogambo shatters the stillness and shouts the answer, “Your retirement funds, as part of some bizarre, twisted ‘hedging’ or ‘diversification’ or ‘fully-funding’ fairytale, are setting you up to suffer a huge, huge, huge freaking loss by stupidly buying these grossly over-priced, under-yielding bonds!”

Let us turn now from the horrid and ugly to the more beautiful world of gold, and how gold will save you from the depredations of the government and the banks. …

HEDGE FUNDS SEEKING RETURNS IN MAKING SMALL LOANS, AND IN OTHER ESOTERIC AREAS

In the summer of 2003, Anthony DiMartino was helping pour concrete on a construction job in Manhattan when he tripped on a cable sticking out of the ground and fell, injuring himself. While the operations on Mr. DiMartino’s back and knee were mostly covered by insurance, other bills piled up as a lawsuit against Consolidated Edison, which he says did not properly bury the cable, made its way through the courts. So Mr. DiMartino recently visited a small finance company in Brooklyn. A few days later, the company, LawCash, advanced him $6,000. What Mr. DiMartino did not know was that he had another benefactor: SageCrest, a $1 billion hedge fund in Connecticut, which has provided financing to LawCash. On the surface, LawCash looks like a risky venture for SageCrest. If Mr. DiMartino receives a settlement, LawCash will get its money back, plus 30% interest. But if there is no settlement, Mr. DiMartino will not pay back a dime.

Indeed, no collateral backs any of the advances LawCash makes. Lawsuits and claims can easily drag on for years, which means there can be a huge time lag before payment is received. And if there is no settlement, there is no repayment of the original advance or interest. Yet SageCrest is not the only hedge fund in this business. So why are hedge funds – supposedly the sophisticated money, making bold, broad bets – rushing into lending? Part of the answer is that while interest rates are low, hedge funds are able to lend money at sky-high rates. SageCrest, for example, charges LawCash 16% annually for what it borrows.

But the trend also reflects the fact that as some 8,000 hedge funds look for ways to put their billions of dollars to work, they are pushing further into uncharted territories in search of high returns. “Hedge funds seem to be sticking their nose into just about everything these days,” said Charles M. Roame, managing principal of Tiburon Strategic Advisors, a San Francisco management consultant to financial services companies. “They’re in every crazy asset class you can think of” including bottles of wine, paintings and coin collections, he said. “The esoteric-ness of the alternative investments just keeps getting more and more esoteric.”

Lending, an old and seemingly ho-hum business, is now one of the hottest new investments for hedge funds. The funds are making investments in consumer credit card debt and specialty finance companies, and are going head-to-head with banks to provide loans to small companies and even individuals. Besides hoping for a big payoff in these types of loans, hedge funds are also seeking returns that are not related to movements in the stock or even bond markets. “In the past several years, the hedge fund industry has undergone dynamic changes where managers are seeking to utilize strategies which do not correlate to traditional market gyrations,” said Ron Geffner, a lawyer at the New York law firm of Sadis & Goldberg.

Besides trading weather derivatives and complex life insurance products, some of Mr. Geffner’s clients are preparing to start hedge funds that will invest in class-action lawsuits and precious coins. The greatest activity by hedge funds has been in the credit business. Market participants say the entry of hedge funds has increased the availability of money in the market. As a result, small and midsize companies may have greater access to loans at a time when most big banks have abandoned that market. It is unclear how long this will last. While some hedge funds have long-time horizons for their investments, the majority are known for moving rapidly in and out of sectors as they seek the next great investment idea. And hedge fund investors have the ability to redeem their investments, which could force a hedge fund to exit a business sooner than it would necessarily like to raise money.

AUSTRALIAN MONEY TREES

Cheap timberland may be the world’s best long-term investment. Otto von Bismarck figured that out more than 100 years ago. His investment advisor, Gerson Bleichroder, did a fantastic job managing Bismarck’s investments, delivering Bismarck about 10% a year over 25 years  in a time of no inflation. According to a story by Barton Biggs, “Bismarck was perfectly satisfied with this return, but he always withdrew his profits and invested them in land and trees. He was convinced that investing in paper securities was a fine and quick way to get richer, but that the repository of true wealth should be land on which you could grow trees. “Bismarck’s appetite for timberland was insatiable. His theory was that … his real return from timberland would be around 4.75% per annum, because inflation at the time was virtually zero. … He thought that with very little risk, this was a spectacular compounding of wealth. Bismarck was absolutely right. Over the next half century in Germany of war, inflation, surrender, and depression, timberland held value far better than anything else.”

Thanks to a very unique Australian stock, Great Southern Plantations (GTP.AX) investors can own timberland just like Otto von Bismarck. Here is how Great Southern operates: For A$3,000, Great Southern sells individual investors in Australia the rights to the harvest of 1/3 of a hectare of timberland, 10 years into the future. The important thing here is, the Australian buyer of this investment does NOT get the land. They just get the earnings from the sale of that timber once the trees are cut. A full hectare of timberland may cost Great Southern up to A$6,000 per hectare. But remember, they are selling the timber harvested from 1/3 hectare plots for $3,000 each. So Great Southern pays A$6,000 per hectare, but receives A$9,000 per hectare from investors in the timber.

Great Southern plants eucalyptus on that hectare of land. Eucalyptus trees are ready for cutting in roughly 10 years, upon which Great Southern pays the investor his portion of the timber sale, and that investor is done. Here is where it gets good: Great Southern still owns the land. And it can “resell” that 1/3 of a hectare for A$3,000, over and over again. Great Southern sold its first chunks of timberland to small investors in 1994-95. So right now, we are just entering the time when the first plantations are maturing, whcih means they are just starting to “resell” that same land for planting – land that has an effective cost basis of nothing. In short, after one 10-year cycle of harvesting, Great Southern owns everything and someone else keeps on paying for it.

Better still, Australian tax laws encourage investment in sustainable forestry. For Australian citizens, therefore, 100% of their investment in this kind of timber deal is tax deductible. The top tax bracket in Australia is 48%, so an Australian in the top tax bracket could invest A$30,000 in one of these projects for and realize a tax savings of approximately A$15,000. Even crazier, without putting up a penny, the average investor in these projects can still receive the full tax break. Great Southern, for example, can lend investors the money to buy their interest in a plantation. Great Southern can make a A$30,000 loan to an investor, and the investor can still cut his taxes by A$15,000. (Great Southern charges 12% interest on these loans. And importantly, it sells these loans, to get rid of most of its risk.) The deal is almost irresistible to taxpayers. You save A$15,000 in taxes up front, and you get into an investment that has a good chance of making you money.

The whole thing sounds too good to be true. And it was. A lot of shady companies tried to take advantage of these tax laws by creating illegitimate tax shelters. People would “buy” into a tax scheme, only they would put no money at risk. The scheme was just to get a tax rebate check from the government without ever investing anything. In 2001-2002, the Aussie government ruled that many of these deals fraudulent. Not only did the Aussies who invested in these shady deals have to come up with back taxes on all the shady deals they has obtained a tax benefit from, they had to pay stiff penalties as well.

As you might imagine, sales of these tax-related schemes completely fell apart after this. Investors were scared off. Great Southern came out of the scandal a big winner, as none of its investors had to give back a penny in tax benefit – they were all fine. Great Southern’s competitors fell apart. The company was even able to cherry pick its competitors assets. “We would have paid more than we did for some of them,” a representative at Great Southern told me as I visited them in Perth. The thing is, the general public in Australia is still a bit skeptical of these tax-saving timberland investments, after the rulings of 2001-2002. But it is all changing fast.

From A$50 million in fiscal year 2002, sales at Great Southern grew to A$300 million in FY2005. Sales in FY 2006 could easily exceed A$400 million. And as financial planners that have just been added to the sales force get going, FY 2007 could see sales of A$500 million. For a company experiencing this kind of growth, you might think these shares would trade at growth-stock prices. Youwould be wrong. The consensus estimate of earnings from analysts in Australia for next year is A$0.57 cents per share. At a share price of A$3.50, that puts the P/E of Great Southern (based on analyst estimates) at about 6. Man that is cheap! Great Southern pays out a nice dividend too, in the 5% range.

The sweet spot for Great Southern really gets going in 2009, which is when the big “rollovers” start to happen with existing timberlands. Right now, Great Southern’s cash flows are not great, because they still have to use the cash coming in to buy timberlands. But by 2009, they will have about 20,000 hectares a year rolling over. At the moment, business is almost too good. Great Southern is able to sell more investment products than it has available land. So it has been borrowing money (by issuing what are basically convertible bonds) to buy chunks of land. Great Southern has used the proceeds from these convertible bonds to acquire some existing vineyards and cattle lands. They can package and sell these as investments similar to their timber deals, with returns coming to investors much quicker than with timberland, and also provides some diversification away from timberland.

The biggest concern to me with this company is that in continuously issuing convertible bonds to buy new properties they will “dilute” existing shareholders. Of course, if these borrowings create value above the cost of capital, the dilution is no problem. But there is one thing that makes me comfortable enough to recommend Great Southern: Managing Director John Young owns nearly 50 million shares of stock, out of the 300 million shares outstanding. As of the latest annual report, John owned no convertible bonds. The last thing he would do is dilute his own wealth by issuing any more convertible bonds than are absolutely necessary to run the business properly.

Looking at the valuation, Great Southern’s timberlands were independently valued in June of 2005 by the highly-respected real estate firm CB Richard Ellis at A$620 million. As of its latest balance sheet, Great Southern had about A$120 million in cash. So in just land and cash alone, you are looking at almost A$750 million in value. The stock market value of Great Southern as I write to you is A$1 billion (apx. US$750 million). Beyond the land and cash, you have got the portfolio of investor loans paying the company 12%) Great Southern’s loyal customer base (60% of the 30,000 customers in the latest year were repeat customers), and a distribution base of 5,000 financial planners. Great Southern can practically grow as fast as it wants. Since Australians are still skeptical of these tax-related things, I think the shares are a bit hated. For now, Great Southern is cheap at a forward P/E of 6 and paying a dividend yield of 5.3%. But the uptrend since 2002 is clearly in place.

All this is well and good. But it is not the important thing. The important thing is the ever-increasing pile of timberland that Great Southern gets paid every ten years to hold and increase. That is the jewel. Remember Otto von Bismarck: “Investing in paper securities was a fine and quick way to get richer, but the repository of true wealth should be land on which you could grow trees.”

ARMAGGEDDON, OR JUST ONE MORE CENTRAL BANK INSPIRED “METHODOLOGY”?

In one of the least reported epochal stories in history, broken by the Wall Street Journal on last Thursday’s obscure Page A2, the 14 Families – new nomenclature for the big 14 banks and brokers dominating the financial infrastructure, architecture, profits and bonuses of the world – snuck down to the Fed to try and do something about the coming Gotterdammerung in that new, but totally obscurant world known as credit derivatives. For a moment, let us hypothesize on who these Fabled 14 families are…

We would have to be in the writer’s head to be completely accurate, but will make some broad and identifications. Given mergers in the last dozen years, some of the beasts then extant are extinct. Nevertheless, here goes: Citi, Banc of America, JP Morgan Chase, Goldman Sachs, Smith Barney, Merrill Lynch, Lehman, Bear Stearns, Morgan Stanley, Wells Fargo, Wachovia, USBancorp, Bank of New York, and CSFB. We might back out one or two of the domestics above and throw in Deutsche and ABN/Amro. Net/net it is the compendium of the big settlers, hedge fund financiers, deal makers, etc. of Wall Street.

Do any of you find it curious that there is no further mention of this meeting in the most acidulous reading of the Friday WSJ? Searching that brave new world of the internet there is one brief Bloomberg reference to “these deals being settled in ‘cash’ to avoid a lengthy outcome.” If the average of the 57,000 loose cannons in the way of deals out there is $100 Million, peanuts in this game, then we are talking $570 trillion in possible maximum exposure. This is not the FX game or the interest game where “Notional Amount” is a minimal fraction of the whole deal. If I sell $100 million on GM and it tanks, I owe $100 million! If credit quality, truly dubiously written in today’s world, crashes, we are talking U.S. GDP Times 50-60 to sort it all out! I am interpreting what Geithner, president of the New York Fed, found a year ago! I did not create this pig but the squeals at extinction will be loud!

It has been a wondrous three years, particularly for the last 1½ since the Maestro started the baby-step parade. With what the Greenspan now Bernanke Fed put in effect, credit risk evaporated to invisibility. With durations and rates assured, your excellent credit default swap writer was only identifiable by the last basis point he was able to extract from the deal. Risk spreads shrank to levels that are still flat out incomprehensible. Iraq for 10 years at 9%. First of all, they have a war and second they do not have a government. Is this a quasi U.S. Sovereign? With shrinking long rates and spreads, asphyxiation and suffocation set in among the long term buyers, who, after all, only have to outperform an index. Mexico at 5%. Hold your nose and buy! And sell it to the sucker who needs duration and something approaching yield. What the hell, there is no credit risk. Your friendly purveyor of that product will do 40-50 basis points for a year and you can tell the boss you have a Goldman credit. The permutations and combinations are endless and there should be a bit more price/bonus in each new creation.

There could easily be a multi-hundred trillion cesspool of unreconciled credit out there in “credit default swap land”. Admittedly there is potential massive overlap reducing a total aggregate beyond ultimately terrifying! Geithner, Corrigan, Volcker and the 14 families will do everything in their power to smother this mess even at the cost of much of their capital! This one may be too big for the last great “smoothing” and get out of control! In here is a systemic crash of humongous magnitude, not only for some significant piece of the “Hedge Fund” Game, but for the 14 Families. It will cause the systemic event which contracts, not expands credit, and this whole global credit bubbble will have great difficulty dealing with any contraction or even flattening out in the rate of growth of credit!

Every New York Fed Governor has to get the 14 Families out of their latest cesspool. Poor old Volcker has to take rates into double digits to do it. Poor old Corrigan had to get them to cough up a $4 billion bail-out for their self-created monster LTCM. Neither Geithner, nor anybody else, has any idea of the real size of this steaming pile of excreta. Unlike real markets this stuff has never been exchange accounted. At September 30, when Geithner finally got the “Come to Jesus” started, there were 97,000 trades which could not be matched up. They hope to cut this by 50% by next spring! Concomitant with the Geithner crawl to the 14 Families to at least acknowledge the problem has been an astonishing exercise in Fed/Regulatory speak by perhaps the most believable of Fed Governors. Having read regulatory speak for years, I will go out on a limb and paraphrase her carefully parsed 5 page production to the banking fraternity (which includes the bulk of the 14 Families) as: “Your regulatory systems, particularly for this proliferation of new products, are woefully inadequate if not hopeless and you better get them fixed soon (or SOONER) or we will rain upon your collective heads.”

JAPAN’S BOOM MAY EXPLODE YEN-CARRY TRADE

Surprisingly strong growth in Japan is raising many eyebrows, not least those at the central bank anxious to scrap its zero-interest policy. There can be little doubt 5.5% growth between October and December pushed the Bank of Japan further in that direction. Oddly, there are few if any signs global markets are bracing for higher debt yields in Japan. Why? Japanese rates have been negligible for so long that investors take them for granted. This, after all, is the economy that has cried wolf too many times. The reason investors from New York to Singapore are not ecstatic about Japan’s recovery is the sense we have been here before – many times.

Yet Japan’s latest growth figures should make believers of some of the biggest skeptics. Not only did exports boost the economy in the fourth quarter, so did personal spending – a sign optimism is spreading to households around the nation. Rest assured the BoJ is noticing and will soon begin pulling liquidity out of Asia’s biggest economy. Once that process begins, there is no telling how aggressive the BoJ will be and what effect it will have on bond yields.

There are two reasons Japan’s rate outlook is a huge story for global markets. One, yields in the biggest government debt market will head steadily higher for the first time in more than a decade. Two, it may mean the end of the so-called yen-carry trade. “All liquidity starts in Japan, the world’s largest creditor country,” said Jesper Koll, chief economist for Japan at Merrill Lynch. “When rates go up here, rates go up everywhere.” What makes the carry trade so worrisome is that nobody really knows how big it is. For example, the BoJ has no credible intelligence on how many hedge funds, investors and companies have borrowed cheaply in ultra-low-interest-rate yen and re-invested the funds in higher-yielding assets elsewhere. Nor are the Bank for International Settlements, Federal Reserve Bank of New York or the IMF likely to know how much leverage this most popular of trades has enabled banks to build up. Ditto for regulators overseeing the dealings of portfolio mangers around the globe.

During the past decade, the yen-carry trade has become a staple for many punters. A popular form of the strategy exploits the gap between U.S. and Japanese yields. Anyone borrowing for next to nothing in yen and parking the funds in U.S. Treasuries received a twofold payoff: the 3-plus percentage-point yield difference and the dollar’s rise versus the yen. Yet as the BoJ raises rates and more investors buy into Japan’s revival, the yen is sure to rise, much to the chagrin of carry-trade aficionados. Realization the trade is moving against investors may send shockwaves through global markets. It would start slowly with speculators suddenly closing positions that are becoming more expensive: dumping Treasuries, gold, Shanghai real estate, shares in Google or whatever else they used yen borrowings to bet on. The chain reaction would accelerate once the mainstream media jumped on the story.

If all this sounds far-fetched, think back to late 1998, which offers an example of the damage a panic among carry-traders can do. In October of that year, Russia’s debt default and the implosion of Long-Term Capital Management shoulder-checked global markets. The disorienting period culminated in the yen, which had been weakening for years, surging 20% in less than two months. Since then, the wild days of 1998 have been largely forgotten. And as Japan slid back into recession and deflation, the yen-carry trade was back in favor. The global financial system is in better shape than it was in 1998. Even so, it is not clear investors are taking the risk of rising Japanese bond yields seriously enough. Once the process begins, world markets may be surprised by how quickly Japanese rates shoot higher, taking the yen – and all those who borrowed in it – along for the ride.

EMERGING MARKET CURRENCIES SLIDE ON CONTAGION FEAR

Emerging market and high-yielding currencies fell sharply in European morning trade on Wednesday as Tuesday’s sharp slide in the Icelandic krona unnerved investors. The krona tumbled 4.6% against the U.S. dollar on Tuesday, as Fitch lowered the outlook on Iceland’s country rating from “stable” to “negative”, citing an “unsustainable” current account deficit and soaring net external indebtedness. The krona continued to slide on Wednesday, falling a further 3.4% to a 15-month low of IKr68.26 to the dollar.

And the sell-off appeared to spook carry trade investors who have piled into a range of generally high-yielding emerging market currencies in the hunt for superior returns. The South African rand fell 1.3% to R6.105 against the dollar, the Turkish lira 1.3% to TL1.3325 to the dollar, the Indonesian rupiah 1%to Rp9,350 to the dollar, the Polish zloty 0.5% to 3.8094 zlotys against the euro and the Slovak koruna 0.3% to SK37.418 to the euro. The Brazilian real, backed by interest rates of 17.25%, also fell 1.9% to R$2.165 to the dollar, although there was fundamental news here, with Brazil reporting a current account deficit of $452 million in January, compared to a surplus of $802 million in the same month last year. Despite this, Goldman Sachs saw the deterioration as likely to be temporary.

Elizabeth Gruie, emerging markets currency strategist at BNP Paribas, argued that the wider sell-off was being driven by declining global liquidity, as major trading blocs raise interest rates, but she believed the move was likely to be contained. The New Zealand dollar, the highest yielding developed world currency, also continued its recent slide, falling a further 0.7% to a fresh 17-month low of $0.6576 against the greenback. Not for the first time, the sell-off was blamed on Japanese retail investors, who have hitherto been big buyers of kiwi-denominated uridashi bonds.

STUDENTS SUFFOCATE UNDER LOANS BURDEN

Tom Dillon, 19, a pre-pharmacy major at the University of Connecticut, is carrying $52,000 in student loans. And he is just getting started. When he gets his pharmacy doctorate in four years, he expects his debt to exceed $150,000. Dillon’s been drawn to pharmacy since age 5, when he found out he had epilepsy. “When I get out, I’m going to have that $150,000 weighing over me,” he says. “What I decide is going to be dependent on that debt.” And the cost of that debt is about to rise. On July 1, the rate on new federally guaranteed student loans will hit a fixed 6.8%, the highest rate since 2001. It comes as the average graduate owes $19,000. Many undergrads, though, have debt exceeding $40,000.

Those higher payments carry huge implications for this generation of college graduates. The weight of debt is forcing many to put off saving for retirement, getting married, buying homes and putting aside money for their own children’s educations. Heavy student debts may also keep young adults from starting businesses, says Diana Cantor, director of the Virginia College Savings Plan. Some graduates will refuse to risk what little money they have on entrepreneurial ventures. And securing loans will now be harder. “It’s a real crisis,” Cantor says. “You’re strapped before you get started.”

The average debt for a college graduate has soared 50% in the past decade, after inflation, according to the Project on Student Debt, a non-profit advocacy group. Just as record-low mortgage rates have eased the impact of soaring home prices, low student-loan rates have let borrowers cut their payments, softening the impact of rising debt. “Low interest rates have served as a sort of amnesty for graduates with debt,” says Robert Shireman, founder of the Project on Student Debt. “We haven’t seen what the real impact is of much higher levels of borrowing.” Now, with interest rates rising, that amnesty is about to end. The 6.8% fixed rate for Stafford loans, the most popular student loan, will replace a variable rate that used to be adjusted every July 1, based on Treasury bills. Under the old system, borrowers could consolidate their loans when rates were low. And they could lock in that low rate for the life of their loans.

Today,students who do not want to borrow at higher rates have few other options. 25 years ago, students who wanted to avoid debt could use money from part-time and summer jobs to help pay for college. But since then, college tuition has risen at twice the rate of consumer prices. Tuition has soared much faster than pay has for the kinds of low-wage jobs that students tend to hold. In 1981, a student could work full time all summer at minimum wage and earn about two-thirds of annual college costs, according to an analysis by Heather Boushey, economist for the Center for Economic and Policy Research. Today, a student earning minimum wage would have to work full time for a year to afford one year of education at a 4-year public university – and that assumes she saves every penny, Boushey concluded.

Parents, meantime, face competing demands for their money. They are trying to save for retirement just as their kids are starting college. Financial planners have long urged people not to delay retirement saving to pay for college. The idea was that students could borrow for college but that parents cannot borrow for retirement. That was an easier argument to make when debt loads – and tuition – were lower, says Amy Noel, a financial planner in Boulder, Colorado. She still believes parents should not sacrifice retirement security for their children’s education. But she lays out options for her clients. “If college is so important to you, what are you willing to give up?” Noel says. “Are you willing to work four years longer?”

Lenders note that even without the change in the law, rates on Stafford loans would have risen above 6% on July 1, because rates on the benchmark Treasury bills have risen this year. They also point out that the fixed-rate formula will protect borrowers from sharp increases in future interest rates. But if interest rates drop, borrowers with loans issued after July 1 will not be able to benefit. Graduates will still be able to extend payment periods by consolidating their loans. But that will not provide any interest-rate relief, because the loan rates will be fixed.

Borrowers can try to defer their payments. But they must prove they are suffering from economic hardship. Loan forbearance, which provides a reprieve from payments, is easier to get. But for most loans, interest will pile up during the forbearance period. That further swells the student’s debt load, and the consequences of default are worse. The loan might be turned over to a collection agency. If so, collection fees would increase the balance. The default will also be reported to credit agencies. And it will show up as a negative item on a credit report. The government can also intercept borrowers’ tax refunds, garnish wages and withhold Social Security and other federal benefits.

Erasing the loans by filing for bankruptcy is seldom an option. A 1998 law designed to reduce student loan defaults requires borrowers to prove they will fail to maintain a minimal standard of living unless their student loans are wiped out. That standard is nearly impossible to meet, says Nora Raum, a lawyer and author of Surviving Personal Bankruptcy. Students from middle-income families, meanwhile, say they are, well, caught in the middle. Their families earn too much to qualify for direct aid – but too little to pay the full tab for college. That leaves them no choice but to borrow.

Nickalous Reykdal, 22, an education major at Central Washington University, says all his friends have student loans and predicts that the higher rates will force many future graduates to spend years paying off their debts. “Their student loans will double by the time they pay them off, just on interest alone,” he says. “It makes me really worry about the future.”

THE END OF DOLLAR HEGEMONY IS INEVITABLE, SAYS RON PAUL

A hundred years ago it was called “dollar diplomacy”. After World War II, and especially after the fall of the Soviet Union in 1989, that policy evolved into “dollar hegemony”. But after all these many years of great success, our dollar dominance is coming to an end.

It has been said, rightly, that he who holds the gold makes the rules. In earlier times it was readily accepted that fair and honest trade required an exchange for something of real value. First it was simply barter of goods. Then it was discovered that gold held a universal attraction, and was a convenient substitute for more cumbersome barter transactions. Not only did gold facilitate exchange of goods and services, it served as a store of value for those who wanted to save for a rainy day.

Though money developed naturally in the marketplace, as governments grew in power they assumed monopoly control over money. Sometimes governments succeeded in guaranteeing the quality and purity of gold, but in time governments learned to outspend their revenues. New or higher taxes always incurred the disapproval of the people, so it was not long before Kings and Caesars learned how to inflate their currencies by reducing the amount of gold in each coin – always hoping their subjects would not discover the fraud. But the people always did, and they strenuously objected.

This helped pressure leaders to seek more gold by conquering other nations. The people became accustomed to living beyond their means, and enjoyed the bread and circuses. Financing extravagances by conquering foreign lands seemed a logical alternative to working harder and producing more. Besides, conquering nations not only brought home gold, they brought home slaves as well. Taxing the people in conquered territories also provided an incentive to build empires. This system of government worked well for a while, but the moral decline of the people led to an unwillingness to produce for themselves. There was a limit to the number of countries that could be sacked for their wealth, and this always brought empires to an end. When gold no longer could be obtained, their military might crumbled. In those days those who held the gold truly wrote the rules and lived well. That general rule has held fast throughout the ages. When gold was used, and the rules protected honest commerce, productive nations thrived. Whenever wealthy nations – those with powerful armies and gold – strived only for empire and easy fortunes to support welfare at home, those nations failed.

Today the principles are the same, but the process is quite different. Gold no longer is the currency of the realm; paper is. The truth now is: “He who prints the money makes the rules” – at least for the time being. Although gold is not used, the goals are the same: compel foreign countries to produce and subsidize the country with military superiority and control over the monetary printing presses. Since printing paper money is nothing short of counterfeiting, the issuer of the international currency must always be the country with the military might to guarantee control over the system. This magnificent scheme seems the perfect system for obtaining perpetual wealth for the country that issues the de facto world currency. The one problem, however, is that such a system destroys the character of the counterfeiting nation’s people – just as was the case when gold was the currency and it was obtained by conquering other nations. And this destroys the incentive to save and produce, while encouraging debt and runaway welfare. The pressure at home to inflate the currency comes from the corporate welfare recipients, as well as those who demand handouts as compensation for their needs and perceived injuries by others. In both cases personal responsibility for one’s actions is rejected.

When paper money is rejected, or when gold runs out, wealth and political stability are lost. The country then must go from living beyond its means to living beneath its means, until the economic and political systems adjust to the new rules – rules no longer written by those who ran the now defunct printing press.

Congress created the Federal Reserve System in 1913. Between then and 1971 the principle of sound money was systematically undermined. Between 1913 and 1971, the Federal Reserve found it much easier to expand the money supply at will for financing war or manipulating the economy with little resistance from Congress – while benefiting the special interests that influence government. Dollar dominance got a huge boost after World War II. We were spared the destruction that so many other nations suffered, and our coffers were filled with the world’s gold. But the world chose not to return to the discipline of the gold standard, and the politicians applauded. Printing money to pay the bills was a lot more popular than taxing or restraining unnecessary spending. In spite of the short-term benefits, imbalances were institutionalized for decades to come.

The U.S. did exactly what many predicted she would do. She printed more dollars for which there was no gold backing. But the world was content to accept those dollars for more than 25 years with little question – until the French and others in the late 1960s demanded we fulfill our promise to pay one ounce of gold for each $35 they delivered to the U.S. Treasury. This resulted in a huge gold drain. It all ended on August 15, 1971, when Nixon closed the gold window and refused to pay out any of our remaining 280 million ounces of gold. In essence, we declared our insolvency and everyone recognized some other monetary system had to be devised in order to bring stability to the markets. Amazingly, a new system was devised which allowed the U.S. to operate the printing presses for the world reserve currency with no restraints placed on it – not even a pretense of gold convertibility, none whatsoever! Though the new policy was even more deeply flawed, it nevertheless opened the door for dollar hegemony to spread.

Realizing the world was embarking on something new and mind boggling, elite money managers, with especially strong support from U.S. authorities, struck an agreement with OPEC to price oil in U.S. dollars exclusively for all worldwide transactions. This gave the dollar a special place among world currencies and in essence “backed” the dollar with oil. In return, the U.S. promised to protect the various oil-rich kingdoms in the Persian Gulf against threat of invasion or domestic coup. This arrangement helped ignite the radical Islamic movement among those who resented our influence in the region. The arrangement gave the dollar artificial strength, with tremendous financial benefits for the U.S. It allowed us to export our monetary inflation by buying oil and other goods at a great discount as dollar influence flourished.

During the 1970s the dollar nearly collapsed, as oil prices surged and gold skyrocketed to $800 an ounce. By 1979 interest rates of 21% were required to rescue the system. The pressure on the dollar in the 1970s, in spite of the benefits accrued to it, reflected reckless budget deficits and monetary inflation during the 1960s. The markets were not fooled by LBJ’s claim that we could afford both “guns and butter”. Once again the dollar was rescued, and this ushered in the age of true dollar hegemony lasting from the early 1980s to the present. With tremendous cooperation coming from the central banks and international commercial banks, the dollar was accepted as if it were gold.

Fed Chair Alan Greenspan, on several occasions before the House Banking Committee, answered my challenges to him about his previously held favorable views on gold by claiming that he and other central bankers had gotten paper money – i.e., the dollar system – to respond as if it were gold. Each time I strongly disagreed, and pointed out that if they had achieved such a feat they would have defied centuries of economic history regarding the need for money to be something of real value. He smugly and confidently concurred with this. In recent years central banks and various financial institutions, all with vested interests in maintaining a workable fiat dollar standard, were not secretive about selling and loaning large amounts of gold to the market even while decreasing gold prices raised serious questions about the wisdom of such a policy. They never admitted to gold price fixing, but the evidence is abundant that they believed if the gold price fell it would convey a sense of confidence to the market, confidence that they indeed had achieved amazing success in turning paper into gold. The effort between 1980 and 2000 to fool the market as to the true value of the dollar proved unsuccessful. In the past 5 years the dollar has been devalued in terms of gold by more than 50%. You just can’t fool all the people all the time.

Even with all the shortcomings of the fiat monetary system, dollar influence thrived. The results seemed beneficial, but gross distortions built into the system remained. And true to form, Washington politicians are only too anxious to solve the problems cropping up with window dressing, while failing to understand and deal with the underlying flawed policy. Protectionism, fixing exchange rates, punitive tariffs, politically motivated sanctions, corporate subsidies, international trade management, price controls, interest rate and wage controls, super-nationalist sentiments, threats of force, and even war are resorted to – all to solve the problems artificially created by deeply flawed monetary and economic systems.

In the short run, the issuer of a fiat reserve currency can accrue great economic benefits. In the long run, it poses a threat to the country issuing the world currency. In this case that is the U.S. As long as foreign countries take our dollars in return for real goods, we come out ahead. This is a benefit many in Congress fail to recognize, as they bash China for maintaining a positive trade balance with us. Foreign countries accumulate our dollars due to their high savings rates, and graciously loan them back to us at low interest rates to finance our excessive consumption. It sounds like a great deal for everyone, except the time will come when our dollars – due to their depreciation – will be received less enthusiastically or even be rejected by foreign countries. That could create a whole new ballgame and force us to pay a price for living beyond our means and our production. The shift in sentiment regarding the dollar has already started, but the worst is yet to come.

The agreement with OPEC in the 1970s to price oil in dollars has provided tremendous artificial strength to the dollar as the preeminent reserve currency. The artificial demand for our dollar, along with our military might, places us in the unique position to “rule” the world without productive work or savings, and without limits on consumer spending or deficits. The problem is, it cannot last. Price inflation is raising its ugly head, and the NASDAQ bubble – generated by easy money – has burst. The housing bubble likewise created is deflating. Gold prices have doubled, and federal spending is out of sight with zero political will to rein it in. A $2 trillion war is raging, and plans are being laid to expand the war into Iran and possibly Syria. The only restraining force will be the world’s rejection of the dollar. It is bound to come and create conditions worse than 1979-1980, which required 21% interest rates to correct. But everything possible will be done to protect the dollar in the meantime. We have a shared interest with those who hold our dollars to keep the whole charade going.

Most importantly, the dollar/oil relationship has to be maintained to keep the dollar as a preeminent currency. Any attack on this relationship will be forcefully challenged – as it already has been. In November 2000 Saddam Hussein demanded euros for his oil. I doubt it was the only reason, but it may well have played a significant role in our motivation to wage war. In 2001, Venezuela’s ambassador to Russia spoke of Venezuela switching to the euro for all their oil sales. Within a year there was a coup attempt against Chavez, reportedly with assistance from our CIA. After these attempts to nudge the Euro toward replacing the dollar as the world’s reserve currency were met with resistance, the sharp fall of the dollar against the Euro was reversed. These events may well have played a significant role in maintaining dollar dominance. Now, Iran, another member of the “axis of evil”, has announced her plans to initiate an oil bourse in March of this year. Guess what, the oil sales will be priced euros, not dollars.

Now, more than ever, the dollar hegemony – its dominance as the world reserve currency – is required to finance our huge war expenditures. This $2 trillion never-ending war must be paid for, one way or another. Dollar hegemony provides the vehicle to do just that. For the most part the true victims are not aware of how they pay the bills. The license to create money out of thin air allows the bills to be paid through price inflation. American citizens, as well as average citizens of Japan, China, and other countries suffer from price inflation, which represents the “tax” that pays the bills for our military adventures. That is until the fraud is discovered. Everything possible is done to prevent the fraud of the monetary system from being exposed to the masses who suffer from it. If oil markets replace dollars with euros, it would in time curtail our ability to continue to print, without restraint, the world’s reserve currency.

It is an unbelievable benefit to us to import valuable goods and export depreciating dollars. The exporting countries have become addicted to our purchases for their economic growth. This dependency makes them allies in continuing the fraud, and their participation keeps the dollar’s value artificially high. If this system were workable long term, American citizens would never have to work again. We too could enjoy “bread and circuses” just as the Romans did, but their gold finally ran out and the inability of Rome to continue to plunder conquered nations brought an end to her empire. The same thing will happen to us if we do not change our ways.

Ironically, dollar superiority depends on our strong military, and our strong military depends on the dollar. As long as foreign recipients take our dollars for real goods and are willing to finance our extravagant consumption and militarism, the status quo will continue regardless of how huge our foreign debt and current account deficit become. But real threats come from our political adversaries who are incapable of confronting us militarily, yet are not bashful about confronting us economically. That is why we see the new challenge from Iran being taken so seriously.

Using force to compel people to accept money without real value can only work in the short run. It ultimately leads to economic dislocation, both domestic and international, and always ends with a price to be paid. The economic law that honest exchange demands only things of real value as currency cannot be repealed. The chaos that one day will ensue from our 35-year experiment with worldwide fiat money will require a return to money of real value. We will know that day is approaching when oil-producing countries demand gold, or its equivalent, for their oil rather than dollars or euros. The sooner the better.

A TREND CONTINUES UNTIL IT DOESN’T … NOW LET US CONSIDER CHINA

In the 1860’s, a mathematician warned that, if something was not done about the growing horse population in London, the streets would be eight feet deep in horse droppings by 1940. As we know, that did not happen. There are many other examples of trends that unexpectedly ended. It is risky to push trends far into the future. Something unexpected almost always turns up to stop them.

At this time, there are those who are pushing current trends to the year 2050. They are as likely as their predecessors to be hilariously wrong. A favorite trend is the growth of China. Some predict that China will be the largest economy in the world by 2050, and our grandchildren will be working as gardeners and nannies in China. Others predict that China will implode well before 2050. I smile slightly at the “gardener and nanny” prediction. As they say, trees don’t grow to the sky. I laugh loudly at the implosion prediction. Today, I will address the implosion prediction.

It is often stated that, in the last ten years, 200 million people have moved from the countryside to the industrialized east China cities. Some are saying that, when China experiences a serious recession and must reduce payrolls, there will be widespread riots that will destroy the Government and break up China. Then, there is the precarious position of the banking system. Based on extensive reading and personal observations, I am convinced that even severe depression is unlikely to destroy the Chinese Government or lead to the breakup of China. Neither will a banking collapse. When these people lose their jobs during a recession/depression, many of them will gladly go back home to the country and wait there for the recession to end. Don’t expect them to bring down the Government or tear the country apart.

I remember the 1930’s in the U.S. The unemployment rate was around 25%, with many people working part time, including my father. Millions of people were impoverished and bitter, thinking that they had been had. Nevertheless, riots that did occur never threatened to bring down the Government or tear apart the country. One safety valve was the ability to return to the soil, a safety valve that China still has and we do not, except for the “guest workers” from South America. During the 1930’s, people were also disenchanted with war, vowed to never let it happen again, and hated the “merchants of death”. However, when the country was finessed into World War II, most people marched off to war without complaint. People will take an awful lot before they tear down the Government – particularly if they see fat paychecks or a no-money-down house in their future.

Some say that when recession comes and Chinese workers cannot afford the luxuries that American television claims all are entitled to the resulting dissatisfaction will be enough to cause revolt. In answer to that, some say that a worldwide depression is on the way. If that happens, the American example, built on smoke, mirrors, and lies, is likely to collapse long before the Chinese think of revolting. The Fannie Mae and General Motors cases suggest the collapse of the dream could be just around the corner.

As far as the Chinese banks are concerned, the largest ones are Government controlled. As long as they remain out of the clutches of foreign interests, they will not collapse. If necessary, the Chinese Government could drop Yuan from helicopters. After all, the Chinese Government has a printing press, too. In fact, the Chinese invented the printing press. While we are thinking of financial matters, there are those who are telling the Chinese that they must release the peg to the U.S. dollar to “level the playing field”. Those people assume that the Yuan will increase in value relative to the U.S. dollar if that is done. Why? If the Chinese Government tries to solve the banking problem through inflation, the Yuan could decrease in value.

Another issue is the huge Chinese investment in the dollar. Some say that China cannot afford depreciation of the dollar. They say that evaporation of hundreds of billions of Chinese-owned dollars would cause hate, discontent, and hardship in China. So what? It would be a small price to pay for what China has gained. What China has gained is the transfer of significant manufacturing capacity from the U.S. and Europe to China, a quick leap into the 21st century, the training of more skilled workers and professional people than exist in any other country, and considerable technical know-how. There is even a claim that China may build the next generation of nuclear power plant and export it to the world – even to the U.S. If China should lose a few hundred billion dollars through dollar devaluation, that loss would be less that the cost of a few B2’s and their maintenance. It appears that China has won an economic war at a tiny fraction of the cost of a hot war. Eat your hearts out, you war mongers.

It seems to me that there are an awful lot of sloppy analyses, lies, and optimistic hopes out there. Not only that, but writers continually repeat other writer’s thoughts to avoid thinking for themselves. I hope that I have helped some to see past the slobs, liars, hopers, and lazy thinkers.

SAVING BACKLASH

The United States continues to struggle mightily with globalization. China bashing is on the rise in Washington once again, even as the national unemployment rate falls below 5%. There is a political firestorm over a proposed acquisition by Dubai Ports World of a UK operator of five East Coast container terminals in the U.S. This backlash and the protectionist debate it has spawned reflect the dangerous mixture of macro and politics. America’s saving shortfall has triggered a classic political blame game. Ever-complacent financial markets could care less.

Notwithstanding the understandable concerns over matters of national security in a post 9/11 world, there is a very simple and extremely powerful macro point that is being overlooked in this debate: America no longer has the internal wherewithal to fund the rapid growth of its economy. Suffering from the greatest domestic saving shortfall in modern history, the U.S. is increasingly dependent on surplus foreign saving to fill the void. The net national saving rate – the combined saving of individuals, businesses, and the government sector after adjusting for depreciation – fell into negative territory to the tune of -1.3% of national income in late 2005. That means America does not save enough even to cover the replacement of its worn-out capital stock. This is a first for the U.S. in the modern post-World War II era – and I believe a first for any hegemonic power over a much longer sweep of world history.

Faced with a shortfall of domestic saving, countries basically have two choices – to curtail economic growth or to borrow from the rest of the world. The first option just does not cut it in the land of abundance. America, in general, and its consumers, in particular, treat rapid economic growth as an entitlement. That leaves the U.S. with little choice other than to pursue the second option – drawing heavily on the pool of surplus global saving as the means to fund economic growth. Once the U.S. started consuming beyond its means, it left itself beholden to external funding and production. And that is how China and Dubai have entered America’s macro equation.

That underscores a key attribute of the saving-short, deficit nation: It has no choice other than to run current account deficits in order to attract the requisite foreign capital. And in the case of the U.S., where external funding needs are so massive – now closing in on $800 billion per year – most of the current account imbalance shows up in the form of a huge trade deficit. With that external funding imperative comes key geopolitical tradeoffs. Thanks to China, America actually got a rather extraordinary deal for its trade deficit dollar in 2005 – a net balance of some $200 billion of low-cost, high-quality Chinese goods that expanded the purchasing power of U.S. consumers. If, however, Washington politicians now choose to close down trade with China by imposing high tariffs or forcing a major Chinese currency revaluation – precisely the tact of a bipartisan coalition – those actions could well backfire. Absent the China supply line, the trade deficit for a saving-short U.S. economy would not shrink as the politicians seem to imply. Instead, due to America’s outsize external funding needs, the trade deficit would remain large and merely gravitate to a higher-cost producer – imposing the functional equivalent of a tax on the American consumer.

The current political boil raises a critical question: Can the U.S. select its lenders and dictate the terms of its external financing program? The simple answer to the first part of the question is, “yes” – targeted protectionism can, indeed, redirect the sources of external commerce. Such actions would do nothing, however, to address the basic problem. America’s trade deficit and concomitant capital surplus will simply shift elsewhere in the world. As long as the U.S. economy is locked on a subpar domestic saving path, it is hooked increasingly on the “kindness of strangers” to provide the sustenance of its economic growth – both in terms of capital as well as goods.

There is an even darker side to the recent outbreak of protectionist backlash in the U.S. – the crass politics of scapegoatting. It stems from the ongoing angst of middle-class American workers – an undercurrent of discontent that has not been tempered by a sub-5% unemployment rate. A U.S. labor market that was once trapped in a jobless recovery is now mired in a wageless recovery – an extraordinary stagnation of real wages even in the face of strong productivity growth. At the same time, the U.S. is suffering from a record trade deficit, whose largest bilateral piece is with China. Bingo.

But who is really to blame in all this? At the end of the day, America’s saving shortfall – the origin of destabilizing capital and trade flows – is a by-product of conscious choices made by the U.S. body politic. The Federal budget deficit, which has accounted for the bulk of the plunge in national saving over the past six years, is made in Washington – not in Beijing. The negative personal saving rate is an outgrowth of pro-consumption tax policies – again made in Washington. The longer the U.S. avoids the heavy lifting of fixing its saving shortfall, the greater the risks that America’s current-account funding problem will end in tears. In the end, the answer to the question posed above is “no” – the U.S. cannot carefully select its lenders as well as dictate the terms of its massive external financing program. The harder the protectionist push, the greater the risks of a financial market backlash that hits the dollar and U.S. real interest rates.

STOCK GRANTS TAKING PLACE OF OPTIONS

Many high-tech companies that routinely doled out stock options to employees are switching to stock grants that may help them better manage their bottom line. The new incentives, called restricted stock units, are part of Intel and several other tech companies’ response to new accounting rules that require companies to record expenses associated with granting stock options to employees. Stock options were white-hot during the pre-Internet bubble days when Microsoft’s generosity with options turned its early employees into “Microsoft millionaires”. But even the software giant now has turned to restricted stock as a preferred way to reward employees, and employers across the country are considering doing the same.

Stock options are particularly common in high-tech companies, which use them to attract and retain employees. The restricted stock units, or RSUs, are actual grants of stock that can be cashed in whenever the employee reaches certain performance or length-of-service goals. Previously, companies disclosed options in footnotes to their financial statements but did not need to calculate the impact on earnings. For years, the high-tech industry, including Intel, fought the new rules, arguing that rank-and-file workers would lose out and that techniques for valuing options remain imprecise. But supporters of the new rules, known as the Financial Accounting Standards Board’s Statement No. 123R, argued that when employees exercised their stock options, it diminished stock values for the company’s other shareholders. Expensing options would give shareholders a truer picture of their stock, they argued.

Restricted stock has several advantages over stock options, experts say. It has a clear value, namely the stock price, regardless of whether it zooms or plummets. Options, on the other hand, become worthless if the stock price falls below the option’s exercise price. When the Internet bubble burst, scores of companies whose stock failed to rise left their employees with worthless options. Company accountants also have an easier time putting a value on restricted stock. Valuing options takes complex mathematical models that factor in potential stock prices and estimates of how many and when employees actually might exercise their options.

Restricted stock takes some flexibility away from employees. They receive the stock when it vests, typically after four years, and must pay taxes then whether they sell the stock or not. With options, employees can decide when to take the stock and pay taxes. Options are still a popular incentive with senior executives, and some companies appear to be accommodating them. But Deloitte & Touche is seeing an overall reduction in the volume of options being issued, managing partner Michelle Kerrick said. “The people who suffer are the lower-level employees, because companies are still motivated to retain the high-level executives,” she said. “That’s one of the biggest pitfalls.” The firm also has seen companies eliminating their employee stock-purchase plans, Kerrick said. The plans, which offer discounts on company stock, now trigger the compensation expense, she said.

The big picture, though, goes beyond financial reporting and tax consequences. “Compensation policies are to be driven by the nature of the business and its philosophy on how to compensate employees for their past services and how to provide incentives for the future,” said Sanjay Gupta, accounting professor at Arizona State University. After-tax costs are a secondary consideration, he said.

GROWTH IN FAMILIES’ WEALTH STALLS AS HIGHER HOUSE VALUES ARE OFFSET BY BORROWING

Americans may feel much richer because of soaring home prices, but they are not. U.S. families’ wealth stagnated during the economy’s recession and recovery from 2001 through 2004, as lackluster wage growth, sagging stock prices and rising debt levels offset the gains from higher home values, the Federal Reserve reported in its latest Survey of Consumer Finances. Home prices did jump nearly 27% during the survey period, and the share of households owning homes rose to 69.1% in 2004, the report said. That made Americans feel good. And it did help boost the total value of families’ assets, such as homes, autos, stocks, bonds and other investments. But wealth, or net worth, measures the value of a household’s assets minus its debts, such as mortgages, car loans, student loans and credit card balances. And debt climbed steadily during the survey period, as the Fed slashed interest rates to stimulate borrowing and spending in rocky economic times.

After totaling up both sides of the ledger, the median net worth of American households rose just 1.5% over the three years measured, to $93,100, according to the Fed’s report, which is compiled every three years to provide a portrait of family finances. By comparison, median family wealth rose 10.3% in the previous survey period, from 1998 through 2001, and shot up 17.4% from 1995 to 1998, during an economic boom that pushed up stock prices and wages. The only weaker gain in wealth recorded by the Fed was in its first such survey, for 1989 to 1992, when median household net worth dropped 5.2% during a period that included the recession of 1990-91. And the wealth gap grew in the latest survey. Median household net worth rose 4% for the richest 10% of Americans and fell 11% for the poorest 20% of Americans, the survey showed.

“Home appreciation was offset by lousy wage growth and debt accumulation,” said Jared Bernstein, senior economist at the Economic Policy Institute, a think tank focused on labor issues. Median family incomes rose just 1.6% from 2001 through 2004, to $43,200, the report said. That marked the weakest results since a 6.9% drop in the 1989 to 1992 period. Income growth was held back in from 2001 to 2004, largely because of a 6.2% fall in median wages, the largest source of family income, the report said. Investment income also declined, as interests rates, stock prices and dividends fell through much of the survey period.

The survey’s findings reflect how households coped financially with the economic turmoil of that period, which coincided with President Bush’s first term, a recession, terrorist attacks, accounting scandals, and wars in Iraq and Afghanistan. Businesses slashed millions of jobs and cut back sharply on investment in plants, software and equipment from 2001 through early 2003 while Bush and Congress cut taxes and the Fed lowered interest rates to keep the economy going. Consumers responded enthusiastically, borrowing cheaply to pay for houses, cars and other goods and services. They succeeded in pumping up economic growth to a strong 4.1% in 2003 and 3.8% in 2004. One welcomed result was the hot housing market. The median value of a principal residence rose to $160,000 in 2004, up 22% from 2001. But consumers revived the economy at a cost – by accepting a bigger debt burden and by devoting more of their income to pay interest on the debt.

Borrowing has accelerated since 2004. Total household debt grew to a record $11.4 trillion in last year’s third quarter, which ended Sept. 30, shooting up at the fastest rate since 1985, according to a separate Fed report. The Fed’s findings on wealth and income growth are particularly disappointing, Bernstein said, when compared with the economy’s 11.6% growth in productivity, or output per hour of work, during the same period.

A WORLD IN DEBT

By the opening of the 21st century, Americans were already spending more than they earned. Each day brought more new debt than real new wealth. Yet, between 2002 and 2005, every quarter showed growth in GDP. Americans mistook this growth for progress. They knew they had the world’s best economy, its best system of government, and its finest culture. They could not imagine that they were growing poorer. Supply-sider Jude Wanniski admitted that real growth came almost to a halt: “In the United States, my own work shows that between 1945 and 1971, when the dollar was fixed to gold at $35 oz under the 1944 Bretton Woods arrangement, the real economy in the US grew by 4 percent per year. From 1971 when the dollar was floated to 2004, real growth of the US economy has only a pitiful 0.3 percent per year.”

The growth, such as it is, in the American economy, has come about by virtue of increased emphasis on the present tense. Americans came to despise the past and neglect the future. The lessons of the dead and the desires of the unborn were both ignored. Instead, all that seemed to matter was consumption in the here and now. F. A. Hayek, explained the consequences: “The economy in its entirety must continue to decline so long as more is being consumed than produced, and some part of consumption therefore takes place at the expense of the existing capital stock.”

Without a theory, F. A. Hayek might have said, the facts are as mute. But by now, both facts and theories had become blabbermouths. The trouble is that the facts had been corrupted so they no longer told the truth. And the old theories that might have been used to interpret the facts had been abandoned in favor of new, more convenient delusions. Americans could now run up as much debt as they wanted, said the new theorists. The American economy may or may not have “grown” in 2005. But if traditional, time-tested theories about how wealth and poverty are correct, thank God it is not growing more. Every step it takes, it moves deeper into debt and closer to bankruptcy.

IMPERIAL DECLINE

We woke up this morning wondering how things could go so wrong. Maybe it was something we ate. We were thinking of the economy and the war on terror, but one thought slipped into another like a bad dream. We probably began dreaming of being shipwrecked with buxom cheerleaders, and then it slid into a nightmare of globalization, serfdom and the decline and fall of empires. The economy looks so healthy, so new, so high-tech, but people still get poor the old-fashioned way: by spending more than they make. Yet, for some reason not quite clear to us, they actually think they are getting rich by doing it. The post-war, post-modern generation has come to believe that it can get rich without effort, automatically. This is “progress”, and have Americans not always believed in progress? Only, today they cannot imagine any vision of progress that does not include more money. So, why not spend today what they believe is guaranteed to them tomorrow?

But, across the broad, sunny Pacific, two billion people who have just entered the world economy, may put a twist into that comfortable story. The newcomers might still lack the skills and tools to be very competitive, but that is changing – and changing fast. The spending spree in America gives the foreigners piles of dollars to spend. The Middle Kingdom alone is expected to have more than $1 trillion in foreign reserves by the end of this year – and they spend it on new plants and equipment. The new globalized capital markets are rapidly bringing both cash and technology to the place that will earn it the highest rate of return. Fifty years ago, that place was America. Now, it is Asia. Let the Asians do the sweating. Americans will do the thinking! The only question is, what will they think about? Most likely, it will be about how they will refinance their house, borrowing from Asian savers, in order to continue buying gadgets and gizmos, manufactured by Asian producers.

As they borrow more and more, these poor Sons of Liberty chain themselves to more and more debt. Not just theirs, but the nation’s. $2.5 trillion in debt has been added to the federal government’s burden during the George W. Bush years. No president in American history has ever done more damage to the nation’s finances. Nor is this the sort of debt that will be paid off by the debtors. It is debt that will be carried forward, refinanced, and refinanced again, so that generations not yet in the womb will be shackled to millions of dollars worth of it before they even begin to toddle. We recall a passage from Exodus, sent to us recently by a friend: “The Lord … who forgives iniquity, transgression and sin; yet He will by no means leave the guilty unpunished, visiting the iniquity of fathers on the children and on the grandchildren to the third and fourth generations.” Oh, my … what kind of parents are we?

Even serfs in the Dark Ages were only required to labor one day in five for their lords and masters. But future citizens in the Land of the Free will not have it so easy. They will have to work up to every other day just to pay their taxes – and service a debt incurred by strangers who died years before them. All of this laboring will be merely for cheap bread and expensive circuses.

And of all the expensive circuses staged by the Bush administration, one of the most expensive is the War on Terror. We say “circus” because we are always looking on the bright side. And in so many ways, this war is one for the record books. It is already the longest war in U.S. history. Neither the American Revolution, nor World War I, nor America’s involvement in World War II went on for so long. It is also the first war in American history to be financed almost exclusively with borrowed money. The federal budget was tight enough before the war was announced, but since then, the total of federal deficits roughly equals the cost of the war. The present generation may be fighting the war, but the generations to come will be paying for it.