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IF EVERYONE KNOWS IT, SOMEONE IS WRONG
In June 2004, I attended a meeting with a personal trust committee of a New York bank. A trust officer opened the discussion with an unqualified forecast: “Ten-year Treasuries are yielding 4.73% this morning, but yields are going higher.” Then he added, “Everybody knows that.”
This anecdote provides insight into what the subprime crisis is all about. Too many investors, including professionals, fool themselves into thinking they know where the market is going, and why. In most cases, they are merely extrapolating from the recent past – just like the trust officer, who failed to report that the yield on 10-year Treasuries had already risen by 140 basis points (1.4 percentage points) over the previous 12 months.
“Everybody knows bond yields are going higher” could not possibly be a correct forecast. If everyone knew that rates were going higher, why would any investor have been buying those bonds at 4.73%? The obvious decision would be to wait for the expected higher yields to materialize. Yet some investors at that moment must have been buying bonds to yield 4.73%, or the market would have been trading higher or lower than that level. Those transactions were hard evidence that somebody thought bond yields were more likely to fall than to rise. What actually happened? Bond yields fell. Yields on 10-year Treasuries touched bottom at 4.00% in June 2005 and did not return to 4.73% until April 2006, nearly two years after “everybody” knew that bond yields were headed higher.
In this instance, few investors fell into the trap the trust officer had set for himself. But there are occasions when many people think the way he did and agree about what the future holds. Then big trouble always lies ahead.
The subprime disaster is a classic example. It may even turn out to be the paradigm against which all other episodes of near-unanimity will be measured. The fallout from the high degree of agreement about the outlook for stock prices and economic growth in the dot-com boom of the 1990s was child’s play when compared with what is happening to the global economy as the subprime boom slowly unwinds itself.
The process that led to the current crisis developed from a simple, intoxicating notion – that home prices “could only go up.” If the prices could only climb, then all bets supported by that assumption were riskless, no matter how thinly hedged, no matter how fancy or complex, no matter how dubious the party taking the opposite side of the bet. Home prices that could only go up would bail out everyone – buyers, lenders, vendors of tricky paper and derivatives, the rating agencies and, most important, home buyers themselves. The only losers in this environment were families who sold their homes, kindly providing the rest of society with a miraculous windfall.
Without such a rosy outlook for prices, home buyers would never have taken the risk of signing mortgages with awesome jumps in interest rates only two or three years in. Lenders would never have taken the risk of writing mortgages for buyers lacking proper credit checks and normal down payments. Investors would never have taken the risk of buying so many bonds backed by such mortgages, based on nothing more than the say-so of the rating agencies – whose ratings shared the assumption that house prices “could only go up.” Nor would investors worldwide have taken the risk of borrowing so much money to buy those bonds.
And would the banks have taken the risk of lending so much money to those investors if the banks were not confident that they could find the money to make those loans? Banks and investors thought that they were taking no risk because home prices “could only go up.” Those four little words supported the whole house of cards.
As John Maynard Keynes observed more than 70 years ago, “Americans are apt to be unduly interested in what average opinion believes average opinion to be. The battle of wits to anticipate the basis of conventional valuation of a few months hence does not even require gulls amongst the public to feed the maws of the professional – it can be played by professionals among themselves.”
In reality, home prices could not only go up. If prices can only go up, all sellers are fools and only buyers are wise. A moment had to arrive when buyers would balk, sellers would bargain, and builders would flood the market with new houses. That moment arrived in the second quarter of 2006, as prices finally topped out. Prices have fallen every month since. As of June, home prices were down 5.2% from their peak – and the data for July and August are not yet available. There were risks after all.
The danger we may now face is the spreading belief that home prices “can only go down.” If such is the case, the fun has just begun.
Link here.IGNORE THE CREDIT GOBLINS
So many people are bearish, so many experts are wringing their hands over subprime lending, so great are the fears of a credit crunch, that you should be ... bullish! It is not just the media’s dirge about mortgage defaults that will supposedly ripple everywhere. Normally sounder-thinking Main and Wall Streeters are worrying themselves to death about the economy. It took just one lightning-quick month, beginning in mid-July, for the popular consensus to go from optimism to pessimism. A rapid switch like that never happens around market tops, only corrections. The bears are wrong.
In the September 17 column I detailed why we have no real credit crunch, scarcely even a hunch of a crunch. By the time Halloween is over, the credit crunch bogeyman will have disappeared along with the ghosts and skeletons.
The bigger picture, which has been apparent for three years, is that corporate earnings are very strong in comparison with stock prices and the aftertax cost of borrowed money. This phenomenon is fueling takeovers, leveraged buyouts and share buybacks. Bears do not see any good in this. They posit that corporate profit margins are abnormally high – therefore destined to revert to a lower level – and that the cost of borrowed capital will soar in the coming credit crunch.
Wait a minute. What credit crunch? Since June interest rates are down, not up. Not just short-term rates, not just government rates, but long-term corporate rates. Compare the earnings yield on stocks (the inverse of the P/E ratio) with the yield on 10-year corporate bonds rated BBB. That credit rating is at the lower end of what bond traders call “investment grade”. At the moment the 10-year BBB yield is 6.2%, or 3.7% aftertax if you assume a corporate federal-state income tax rate of 40%. Compare that cost of money with the earnings yield on the S&P 500. The index should earn $95 a unit this year, before nonrecurring items. That is 6.2% of the index’s price of 1531. In other words, corporations can earn more money on borrowed capital than the money costs them. Despite what you hear, recent buybacks and takeovers were not primarily funded by junk. By December buybacks and takeovers will both be back and stocks will be soaring.
Last month I said to make sure you owned Asia. The flight to quality made its faster-growing, albeit sketchier, companies too cheap. This month I am extending the buy recommendation to Latin America.
The demand is never-ending for good water in a growing but less developed nation. Companhia de Saneamento Basico (50, SBS), from a base in São Paolo, has become the largest water and sewage utility in South America and third largest in the world. Yet it still has huge growth potential and sells at only 10 times current earnings. Banco Santander (51, SAN) is Chile’s biggest and South America’s best-run bank. It dominates Chile’s financial services sector. It goes for 12 times 2007 earnings and less than 25 times the dividend you will get next year.
Link here.WHAT TO BUY WHEN FANTASY-LAND PRICING TAKES OVER THE MARKETS
It is back to Fantasy-land investment markets, right? With the Dow hitting new highs and the emerging markets heading to Mars, this might be a good time to talk about portfolio hedging. Amazing, but despite horrid earnings for UBS of Switzerland (UBS) and Citigroup (C), both stocks rallied last week. What is going on here?
Historically, the fourth quarter is the strongest 3-month period of the year to invest in common stocks. That includes strong returns even during the last secular bear market. Whether you like it or not, we are still in a bull market in late 2007. That means we have got even higher to go, barring some exceptional financial time-bomb still lurking out there.
Stocks have already discounted the worst of the subprime and mortgage-backed crisis. Markets look ahead and if the banking sector is rallying, it is because participants do not think the bad news will get any worse. After all, banks have set aside provisions to absorb this pesky subprime mess and the Fed has started cutting the monetary spigots to alleviate credit stress.
But despite powerful historical anecdotes pointing to higher markets ahead this quarter and lower interest rates, I am still hedged. I am never fully invested because I always like to be in a position to buy. That is something my stepfather taught me years ago. Believe me, it is NOT true that you must be fully invested to beat the markets. Instead, you need asset allocation or a mixture of stocks, bonds, currencies, commodities, cash, and alternative investments.
If, like me, you are not feeling too confident about pouring everything into stocks, you do have some options. Consider buying some Japanese yen, a reverse-index fund on the Russell 2000 Index and some commodities. And, of course, you should have some cash handy. Here is a 12-month chart of the Russell 2000 Index of small stocks. I like betting against this index now because it is highly cyclical. In a slowing economy, smaller companies are more vulnerable to a major decline than large-caps, a transition that has already occurred. A maximum 10% allocation to a reverse-index fund is sufficient. Combined with Japanese yen – highly negatively correlated to equities, cash and some commodities – you should be able to shield your portfolio.
Generally, hedge funds do not do a good job protecting assets in a protracted market decline. Hedge funds, however, have done a good job in bear markets, but only if the trend is long-lasting and managers can easily identify trends. Otherwise, the sector gets a big F in my books.
Link here (scroll down).FINANCIAL STRUCTURES
The credit expansion enabling machines defer the day of reckoning once more.
“There is no such thing as the ‘Bernanke Put’, former Federal Reserve Chairman Alan Greenspan claimed tonight. Speaking to a City audience here, Greenspan said there had been no ‘Greenspan Put’ while he had been at the Fed, and added ‘There is no Bernanke Put’ now. This was an ‘illusion’, he said. Greenspan also rejected suggestions made by some commentators that he would have behaved differently if he had been still been at the helm of the Fed. ‘This was not true,’ he said.” (Market News International, October 2)
Mr. Greenspan is delusional if he does not appreciate the market’s now unwavering faith in the “Bernanke Put”. Let us keep in mind a few facts related to the Fed’s September 18 50 basis point cut in the Fed Funds Rate. The Bernanke Fed chose an aggressive 50 basis point reduction even though the market was anticipating 25. This decision was made with the U.S. employment rate at 4.6%. Monthly Trade Deficits having settled stubbornly at around $60 billion. Nominal Q2 GDP growth has accelerated to 6.6% (3.8% real) annualized, the highest in five quarters. Crude was trading at about $80 and gold above $700, as the Goldman Sachs Commodities index broke out to record highs.
Obviously, Dr. Bernanke responded to marketplace tumult, clarifying unmistakably to all that market trading conditions had, in fact, become the deciding variable in determining monetary policy. One can look at this as a fateful and, perhaps, unavoidable facet of the dangerous interplay of contemporary finance and central banking. And it follows by less than a month Bernanke’s assurances to Senate Banking Committee Chairman Dodd that he would use “all of the tools at his disposal” to stabilize the markets. If there were, on the morning of September 18th, any uncertainties with respect to the veracity of the “Greenspan/Bernanke Put”, they had been fully laid to rest by early in the afternoon.
It is worth noting that the Dow Jones Industrials have surged 663 points (4.7%) to an all-time high since the Bernanke cut. The Broker/Dealers have rallied 7.9%. The NASDAQ 100 has surged 7.7%, increasing y-t-d gains to 22.4%. The speculative NASDAQ Telecommunications index has shot 8.5% higher and TheStreet.com Internet Index 7.4% higher. Effects upon emerging equities – an asset class experiencing acute inflationary biases (including rampant speculation) – have been even more spectacular. Brazil’s Bovespa has surged 12.5%, increasing 2007 gains to 40%. Russia’s RTS index is up 9.4% and India’s Sensex 12.8% since The Bernanke Accommodation.
As a macro credit and financial market analyst, recent developments have been nothing short of fascinating, as well as illuminating. My basic premise that the credit bubble has been pierced is, at this point, debatable. To be sure, the centerpiece of the analysis – first, that credit and economic bubbles will be sustained only by enormous credit expansion and, second, that this expansion will be inhibited by the impairment of “Wall Street finance” – remains very much unresolved.
I have written as recently as last week about the deleterious bubble effects – especially late in the credit cycle – to financial and economic structures. Impairment to the real economy generally transpires over extended periods. Financial structures are are similarly affected, although are much more susceptible to rapid and shifting market effects (especially during bouts of “euphoria”). Tremendous unappreciated damage has been inflicted over the past few years, only to have escalated greatly over the past few months. I will attempt to put a little meat on the “financial structures” analytical bone.
I have discussed extensively the “Moneyness of Credit” issue, and how the markets’ perception of safety and liquidity has a profound impact on the capacity to expand credit instruments. Importantly, marketplace perceptions of “moneyness” with respect to certain categories of debt can over a period of time have a tremendous influence on the development of institutions. These institutions, then, will tend to exert major influence on the development of market behavior, marketplace structures and, certainly, financial innovation. I have referred to the GSE’s as the “Anti-Ponzi” – a highly atypical financial structure with an extraordinary capacity to expand liabilities especially in the midst of financial crisis – in the process sustaining credit and liquidity creation. I have also noted Fannie and Freddie balance sheet constraints as an important variable with respect to crisis-mitigating liquidity creation.
Well, this perverse financial structure perseveres, in yet another example of contemporary financial institutions’ capacity to adapt in order to fill a liquidity void. The Federal Home Loan Banks (FHLB) expanded assets about $170 billion during the 2-month period August through September. This was for them an unprecedented market intervention. For perspective, the FHLB expanded about $19 billion during 2006 and $73 billion in 2005. Even during tumultuous 1998, the FHLB limited asset growth to about $90 billion. To my surprise, total GSE Q3 credit expansion will most likely approach $250 billion. For the entire year 1998, Fannie, Freddie and the FHLB combined for $300 billion of growth – at that time a record.
There is another financial structure that has evolved over the years into a powerful force of market stabilization. Over the past 10 weeks, money market fund assets have surged $308 billion. This pool of (of mostly Wall Street controlled) finance has expanded $510 billion y-t-d, or 27.8% annualized, to almost $2.891 trillion. Despite asset-backed commercial paper and special-purpose vehicle finance residing at the crisis’s epicenter, confidence that “money” funds will not “break the buck” has remained unshaken. “Moneyness” has been sustained, and Wall Street has retained great latitude in deploying readily available and now cheaper funds.
So far, the banking system also enjoys great latitude. With its liabilities (deposits, “Fed funds”, repos, and various market debt) retaining “moneyness” attributes, bank assets have expanded an astounding $425 billion over the past 10 weeks, or 21.9% annualized (bank credit has inflated $280 billion, or 16.8% annualized).
The combined expansion of “money”-like GSE, money market funds and bank obligations has been instrumental in sustaining credit creation and marketplace liquidity. Importantly, this massive liquidity backstop stemmed what was poised to be a devastating liquidation/de-leveraging throughout the leveraged speculating community. There is today, in contemporary credit systems, a precariously fine line between credit meltdown and liquidity melt-up.
The hedge fund and broker/dealer communities – along with the gigantic derivatives markets they command – have also evolved into powerful (distorting and destabilizing) financial structures. These highly geared vehicles enjoy windfall profits as long as credit bubble excess is sustained, which implies a robust inflationary/expansionary bias. They have ripened into the ultimate Ponzi Finance Units, at acute risk of a Northern Rock-style run on their assets – and/or run away from their liabilities.
Barely dodging a devastating run of withdrawals, renewed bubble dynamics have the banks scheming to extend further credit to the leveraged speculating community in the process of offloading bloated leveraged loan positions. These are just the types of financial shenanigans that should not be allowed to fester. Recall how a few billion of savings and loan losses were nurtured into a multi-hundred billion debacle, and one can hopefully appreciate how we are today gambling with the future solvency of the entire credit system.
The combined growth of Fannie and Freddie’s “books of business” will approach $500 billion this year (nearing $5.0 trillion). The (also thinly capitalized) FHLB is on track for unprecedented expansion (assets surpassing $1.2 trillion). The money fund complex is in the midst of unparalleled growth (approaching $3 trillion). These key interrelated financial structures are at once sustaining marketplace liquidity, while laying the groundwork for a much more perilous financial crisis. They are all ballooning exposures today at double-digit rates specifically because the market risk environment has deteriorated markedly while their liabilities (and GSE-guaranteed mortgage-backed securities) retain coveted “moneyness”.
But this does not alter the reality that this is an especially inopportune time to aggressively expand risk intermediation responsibilities. Indeed, the transformation of today’s highly risky credits into trillions of perceived safe and liquid debt instruments is but a seductively parlous expedient. I will further add that these financial structures comprise the greatest distortion of risk in the history of finance. Fannie and Freddie are adding significantly to their already massive exposure just as losses begin to mount – and mount mightily they will. The FHLB is aggressively lending as the risk profile of their borrowers deteriorates rapidly. And the money funds, well, I will just posit that the risk of eventually “breaking the buck” is rising right along with their growth in assets. In short, the money funds’ and GSE’s aggressive risk intermediation and market stabilizer roles imperil future “moneyness” – with enormous systemic ramifications.
I will remain dangling out on the analytical limb and opine that today’s commanding financial structures virtually ensure a future meltdown. I write this not as some nut-ball but as a diligent analyst that is witnessing a system absolutely incapable of moderating excesses or self-correcting imbalances. Excess begets only and everywhere greater excess.
There is today an incredibly speculative financial sector hell bent on sustaining credit and asset bubbles – and perfectly content to adulterate our functional system of “money” in the process. The Federal Reserve is perceived to condone the whole affair and is openly willing to employ all measures to avoid bursting bubbles. And in a contemporary world of acutely fragile finance structures, this ensures that bust avoidance translates briskly to bubble perpetuation and speculator delight.
And there are, let there be no doubt, prominent financial structures – from the gargantuan GSEs and the securitization marketplace, to the ultra-powerful Wall Street investment bankers and money fund complex, to a “banking” community willing to partner with the leveraged speculating community, to the opaque “repo” and “Fed funds” markets, to the ballooning markets in credit and market risk derivatives, and to the bulging global central banks and sovereign wealth funds – are virtually all working to profit from the perpetuation of bubble excess. And there is surely nothing like record global equities prices to embolden. Meanwhile, back in reality, the stage is being set for one or both of the following: an eventual run on today’s perceived “money-like” debt instruments and a run on our currency.
Link here (scroll down).WHEN THE MUSIC STOPS
Take advantage of the wise guys’ ignorance while you still can.
“When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing.” ~~ Charles Prince, CEO, Citigroup
That retroactively juicy statement appeared in an interview in London’s Financial Times on July 9. It was immediately picked up and posted all over the Web. There were many skeptics, but mostly in the hard-money crowd. Then came August’s collapse of the secondary market for subprime mortgages. In that market, the music ended abruptly.
Just before the New York Stock Exchange closed on Friday, September 28, Mr. Prince announced that Citigroup’s expected earnings will be down in the third quarter by 60%. But not to worry, he assured the media: “[W]e expect to return to a normal earnings environment in the fourth quarter.” ... “But,” the FT reported, “in an audio message on Citi’s website on Wednesday, Mr Prince said: ‘We are one of the largest providers of leveraged financing to clients around the world. When the leveraged loan market severely dislocated this summer, it had a significant impact on us, resulting in large write-downs.’”
Mr. Prince was a confident man in late July. Very confident. He was quoted in an August 2 article in the International Herald Tribune: “We see a lot of people on the Street who are scared. We are not scared. Our team has been through this before.” Scared? Not Mr. Prince. Then, over the next month, Citigroup lost $1.4 billion. The decline “was driven primarily by weak performance in fixed-income credit-market activities, write-downs in leveraged loan commitments, and increases in consumer-credit costs,” reported Prince.
Frankly, he should have been scared back in July 2006, when he could have unloaded this junk at face value. There is a lesson here: when you can unload future junk at face value, do so.
Citigroup is not alone. A comparably pessimistic report came from UBS, the giant Swiss bank. Its loss in the Q3 is expected to be in the range of $600 million. In May, UBS closed its hedge fund unit, Dillon Read Capital Management, after it suffered losses from trading in the U.S. subprime mortgage market.
The reality is that the best and the brightest in the financial world entered into high-risk ventures and then got caught by market realities. They did not see it coming.
The reaction of central bankers was swift. The Federal Reserve cut the federal funds rate and the discount window rate by half a percentage point on September 18. The European central bank pumped in close to $500 million worth of euros in mid-August. It had been contemplating hiking rates above the prevailing 4%. It reversed course and held rates steady.
The investment world assumes that central banks can, and will, always paper over any liquidity crisis in the financial markets. But what if the problem is not liquidity in general but insolvency in a capital market? It is not that there is not sufficient fiat money in general. The problem is that in a highly leveraged market there are no buyers at yesterday’s prices, when yesterday’s prices were the basis of the existence of a flow of new funds into this market.
When investors see that a gigantic market that was presumed by all to be liquid – easy sales without a discount – the money flows in. But then, one day, there are no more easy sales. Liquidity dries up in a specific market. Money in general is not the solution. Money injected into this specific market is required – and not just today, but next month and next year. These are decades-long mortgage contracts. Until August investors thought liquidity was assured. Now they are gun-shy. They saw what was widely believed to be a liquid market turn overnight into an illiquid loss-producer that sank the confident forecasts of huge banks like Citigroup and UBS – the best and the brightest.
This was not supposed to happen. ... Not yet, anyway. Prince saw in general what was coming, just not when: “The depth of the pools of liquidity is so much larger than it used to be that a disruptive event now needs to be much more disruptive than it used to be,” he said. “At some point, the disruptive event will be so significant that instead of liquidity filling in, the liquidity will go the other way. I don’t think we’re at that point.”
We may not be at that point, but it is surely coming. When it does, the smart guys who run the pools of capital will be seen as wise guys looking for escape hatches.
When liquidity moves out of a market, the problem is then insolvency, not liquidity. Liquidity is the product of confidence. A market is liquid because investors think it is priced rationally by the best and the brightest, and therefore other investors stand ready to buy a capital asset when the seller is ready to sell. But then, without warning, other investors learn that this market had been way overpriced, and so they move to the sidelines. Liquidity is restored at (say) 50% of the previous price.
Mr. Prince may be able to retain the confidence of his board of directors. He may even be making similarly optimistic statements a year from now, although I doubt it. But the fact is, he went public with his happy-face statements in July, and the market tossed a cream pie in his happy face in August. The market can change its mind overnight. There are no loss-avoiding exit strategies for such events. There are only write-downs.
The wise guys’ solution was an announcement by the Fed that, (1) it would lower short-term interest rates, and (2) it would accept subprime mortgages as collateral for loans. This is always their solution. They have no other solution except the expansion of fiat money, coupled with optimistic press releases.
The smart guys believe these press releases. It is astounding, but they do. They believe that the stock market is the tail of the Federal Reserve System. The Fed wags the tail upward or downward in terms of its press releases. For a time, the stock market does act as though it is that tail. But reality is more than perception. Reality is the profitability of prior allocations of capital. If consumers do not ratify the Fed’s press releases, the exit from specific markets begins.
It would be a lovely world if the FOMC were to stick to its policy of minimal money expansion, and the prices of goods and services would continue to rise at ever-lower rates. The employment figure would stay low, and the number of people looking for work and finding it would increase. The $800 billion trade deficit would disappear. It would also be wonderful if China’s central bank would cease inflating at 18% per annum, and the Chinese government would repeal the price controls on electricity and other government-supplied goods that it imposed last month. But this combination of pleasant events is unlikely to the point of absurdity.
The world of the smart guys of the world – the fund managers, multinational bank boards, and economic forecasters – is one in which years of FOMC inflation, declining thrift, increasing trade deficits, and the demise of subprime mortgages means nothing significant. The dependence of the U.S. government on Chinese central bank purchases of its debt does not raise red flags to these people. They really do believe that the possibility of FOMC intervention into one narrow financial market – the overnight bank loan market – is sufficient to keep the American economy recession-free and inflation-free at the same time.
For as long as America’s investors believe this, they will not prepare an exit strategy, just as U.S. Treasury officials have not prepared an exit strategy for the time that China ceases to buy T-bills, let alone starts selling them. Of course, if China were to sell dollars, the yuan would appreciate even more. The smart guys assume that China, an exporting nation, will not sell dollars, ever. They forget about such things as politicians’ pride, their desire to put Americans in their place, and the universal desire of investors to get out of a bad investment while there is still time.
Today, Americans who are in bad investments have time to get out. The smart guys and the smart money continue to believe the old phrase, “I’m from the Federal Reserve, and I’m here to help you.” They continue to believe that legalized counterfeiting is still productive. They still believe that timely intervention by the FOMC will keep recession at bay.
Their faith is based on a premise that bad money produces rational prices. This leads to a conclusion that there will be no need to reprice and reallocate capital when the original fiat money conditions no longer exist.
I say, take advantage of the smart guys’ ignorance while you still can.
Link here.THE SUBPRIME MESS HAS HURT ALL FINANCIAL STOCKS, INDISCRIMINATELY. TRY DISCRIMINATING
John Maloney knows about financial companies. He runs one, M&R Capital Management, which manages $600 million in assets for institutions and rich folks. His value-oriented firm spots great buys in financials, beaten down by the subprime mortgage crisis, both in the U.S. and abroad (see table). Although the Federal Reserve’s rate cut has helped financials, suspicions about them linger.
At 54, with a long history as a banker and money manager, he is picky about what he wants in the financial realm. One client asked him about Bear Stearns, which had sponsored two hedge funds sunk by a deadweight load of subprime loans. Partly as a result, Bear saw earnings dive 61% in the third quarter. But Bear is not about to go bust, so it sounds like a value play candidate. Maloney, though, feels Credit Suisse is a better bet and is cheap with a trailing P/E ratio of just 9, comparable with Bear’s. While neither firm has significant exposure to subprime loans (the hedge funds were off Bear’s books), the bigger Swiss bank is less risk-laden. Besides, Credit Suisse has a stronger asset management operation, which accounts for 40% of its profits. This is a steady, fee business.
Another financial Maloney likes is American International Group (AIG), the insurer and financial services outfit. A blowout earnings report for the most recent quarter, announced in August, has helped the stock lately, yet its 11 P/E means it remains a bargain. Maloney’s worst nightmare scenario for AIG – meltdowns in its real estate investments and lending – would shave just 13 cents off its expected 2007 earnings of $7 per share.
The July merger of Bank of New York (BK) and Mellon Financial created a powerhouse in asset management and custody services for institutions. The new entity has a substantial global presence now, and international could generate 50% of its revenue in five years or so, up from 25% now. Subprime dealings are minimal, and so is its exposure to conduits, which are affiliated investment vehicles funded by commercial paper. According to Maloney, a 2% default on conduits for the new Bank of New York Mellon would slice a mere 4 cents from its projected 2007 earnings per share of $2.57, while rival State Street would lose 89 cents on its $3.93.
Maloney also is a fan of Shinhan Financial (SHG), South Korea’s 2nd-largest bank (behind Kookmin) but its most profitable lender. Shinhan has the most corporate business and also just took over the nation’s largest credit-card issuer.
Link here.ARE THERE TOO MANY DOLLAR BEARS?
As a contrarian, it is my nature to worry when too many people start agreeing with me. Currently, many of my most vocal critics, who had previously ridiculed my warnings about the dollar, now concede that it will continue to decline. With so many people now on the bandwagon, some currency watchers have asserted that sentiment now has nowhere to go but up, and that the stage is set for a dollar rally. Although I am unnerved by the company, I take solace in the fact that the conclusions that many of these nouveau-dollar bears draw are completely off the mark.
The group is united by two basic assumptions. First is that the dollar’s decline will be orderly, and second is that the decline will actually be positive for both the U.S. economy and the stock market. Therefore, other ways to confound the consensus would be for the dollar’s decline to be disorderly or for it to be negative for both the U.S. economy and the stock market.
For the dollar to register a significant short-term bottom based on negative sentiment, I feel there would have to be a much greater sense of panic associated with its weakness. Such is clearly not the case. The overwhelming consensus is that a weak dollar is good for America. Ironically there is more worry in Europe over the strong euro than there is in America over the weak dollar. My prediction is that before we get any significant dollar bounce this complacency will need to be replaced by outright fear, and that the dollar needs to fall more sharply as investors actually act on those fears by dumping dollars.
Of course should such a run on the dollar commence, it will not be the orderly decline everyone seems to expect. However, I am still not sure why so many feel a declining dollar is not a problem so long as it does so in an orderly manner. If you are headed to the poor house what difference does it make how you get there? You are just as broke when you arrive!
In addition to being wrong about how quickly the dollar will decline and how it will impact the economy, most dollar bears are also wrong when it comes to their explanations as to why the dollar is falling in the first place. Whenever benign inflation statistics are released, ensuing dollar weakness is always explained as resulting from increased expectation that the Fed will cut rates. Lower interest rates are seen as dollar bearish as they reduce the returns on holding dollars, making dollars less attractive relative to other currencies.
In actuality, officially benign inflation statistics give the Fed further cover to create even more inflation. So the dollar is not weak because inflation is under control as the consensus believes, but because the opposite is true. Inflation is completely out of control and the Fed, hiding behind phony government numbers that purport otherwise, has the green light to add additional fuel to inflation’s fire. It is the ultimate irony that the lower the official preferred measures of inflation are the worse inflation actually gets.
For a more in depth analysis of the tenuous position of the Americana economy and U.S. dollar denominated investments, read my new book Crash Proof: How to Profit from the Coming Economic Collapse.
Link here.HOW CENTRAL BANKERS CONTROL THE GOLD PRICE
The gold market analyst I met one warm summer’s evening in Soho, London, earlier this year took himself very seriously. A report from Chevreux – a division of Credit Agricole – on the other hand, made him wince. The report “Remonetization of Gold” by Paul Mylchreest put the reputation of France’s largest bank right on the line – the very same line spun by the Gold Anti-Trust Action Committee (GATA) since 1999:
“Central banks have 10-15,000 tonnes of gold less than their officially reported reserves of 31,000,” the Chevreux report announced. “This gold has been lent to bullion banks and their counterparties and has already been sold for jewelry, etc. Nongold producers account for most [of the borrowing] and may be unable to cover shorts without causing a spike in the gold price.”
In other words, “Covert selling (via central bank lending) has artificially depressed the gold price for a decade [and a] strongly rising gold price could have severe consequences for U.S. monetary policy and the U.S. dollar.”
The conclusion? “Start hoarding,” said Mylchreest. A smart call. Because in finance, being right – even if for the wrong reasons – still pays off. The Credit Agricole report was published in January last year. Come May 2006, the gold price leapt to a 26-year high. It has since gone on to break those levels again, rising to its highest price since the all-time peaks seen at the start of 1980.
As for the world’s central banks, they seem to have done a pretty bad job of “covert selling” since the start of this decade. The gold price has now doubled for U.S. investors and savers, and it is pretty much doubled for British and European gold owners, too. Japanese gold prices have more than tripled. Why? Whatever the reality of active, covert manipulation, the world’s central banks do, indeed, control the gold price, as former Federal Reserve governor Wayne Angell put it in 1993:
“The price of gold is pretty well determined by us ... But the major impact on the price of gold is the opportunity cost of holding the U.S. dollar. ... We can hold the price of gold very easily; all we have to do is to cause the opportunity cost in terms of interest rates and U.S. Treasury bills to make it unprofitable to own gold.”
By cutting interest rates below the rate of inflation between 2003-2005, the Greenspan Fed guaranteed a bull market in gold. Cutting rates again now in late 2007, even as oil and global crop prices move to new record highs, the Bernanke Fed seems bent on pushing gold prices higher, too.
A new report from Citigroup – the U.S.’s largest bank – agrees with Credit Agricole’s conclusions. “Central banks have been forced to choose between global recession or sacrificing control of gold,” say John Hill and Graham Wark at Citi. More than that, the flood of central bank gold sales earlier in 2007 was, “clearly timed to cap the gold price,” they say. But little good it did the central bankers’ aim of capping gold if so.
Why suppress gold? If gold goes higher, or so the thinking runs, the world’s confidence in the confidence trick of paper money backed by government promises alone might just collapse. That was the threat in the late 1970s. That might come to be seen as a possible threat again today.
Allegations that the world’s major central banks actively work together to suppress the price of gold were given credence in only 2004 when Paul Volcker – chairman of the U.S. Federal Reserve at gold’s all-time top – wrote in his memoirs that “letting gold go to $850 per ounce was a mistake” during the last great bull market in gold bullion. At one of the policy meetings led by Volcker in late 1979, his Federal Reserve committee noted the threat of “speculative activity” in the gold market. It was spilling over into other commodity prices. One official at the U.S. Treasury called the gold rush “a symptom of growing concern about worldwide inflation.”
Besides waving a gun at anxious gold owners, there seemed only one other route to stopping speculators profiting from – or, rather, defending themselves against – the demise of the dollar. Fix it up with higher interest rates. The Volcker Fed took U.S. interest rates to 19%, putting the real cost of dollars above 9% after adjusting for inflation. The gold price sank almost in half inside 12 months.
Because just like Wayne Angell says, the price of gold really is determined by central bankers. They hold it very easily, simply by causing the opportunity cost in terms of interest rates and U.S. Treasury bills to make it unprofitable to own gold. To do that, however, they have to raise interest rates dramatically above inflation. If you do not trust the Bernanke Fed to do that – not the least after it cut 0.5% off the returns paid to dollar savings in mid-September – then you want to consider buying gold today.
Link here.THE BULLION PUZZLE
John Hathaway and I go back a long way. I believe that I was the first journalist to misspell the name of his gold fund. It is “Tocqueville”, with a “c”. That was in 1998, and the fund – which invests in mining stocks and bullion – was shiny new. Gold was then a footnote to an afterthought in the levitating stock market. Then, as now, the ancient monetary metal yielded nothing. It just sat there looking good, like some people you may know.
Two years later I interviewed Hathaway for this column. He was confident about the future but discouraged about the present. “It’s a bad business, magnified by the lousy pricing environment,” he said of the industry on which he was bullish. For all his trouble, the Tocqueville Gold Fund (TGLDX) had accumulated just $20 million in assets. The price of the metal he loved was $275 a troy ounce.
Then, just as he predicted, the gold price zigged when the stock market zagged. By November 2003 gold changed hands at $398, and the Tocqueville fund had accumulated $500 million in assets. Last April, with gold at $677, assets passed $1 billion. Yet, curiously, Hathaway is grinding his teeth. It was frustrating to watch gold loitering below its post-1980 high price of $725, which it set in May 2006. And it was frustrating to watch the Tocqueville Gold Fund trail a tomato can of a benchmark like the Philadelphia Gold & Silver Index (XAU). In the year to date Tocqueville has a total return (price appreciation plus dividends) of 6.2%, the XAU 16.6%. However, since its inception in July 1998 the Tocqueville fund has produced an average annual return of 22.3%, versus 9.2% for the XAU.
Another source of Hathaway’s irritation is unrelated to the frustrations of 2007. It is the chronic mismanagement of gold-mining companies. They drive him crazy, he says. Never mind maximizing return on the stockholders’ equity. The miners are forever issuing stock in the cause of producing more ounces of metal.
So as a long-term bull on gold (see my June 18 column), why not just invest in StreetTracks Gold Trust (GLD), the gold ETF, rather than mining companies? Hathaway says that investing in GLD, which tracks gold prices, not mining company stocks, might have made sense a couple of years ago. But today, so miserable are mining company returns on equity, so marginal are the overall economics of the business, he says, that a change in the price of gold should translate into a much larger change in the profits of a miner. “Let’s just hope that the industry does a better job in managing their prosperity than they did before,” he says.
Just before Labor Day Hathaway composed a sermon to his shareholder choir on the case for a much higher gold price. The general breakdown in lending and borrowing is very serious business, Hathaway led off, and exactly the circumstance that ought to favor gold in its original monetary capacity. If the Nasdaq disaster was good for gold, the credit crisis should be even better. The drop in tech stocks was a circumscribed problem. The seizing up of the mortgage market is a universal problem. “The extent of the damage in 2000 was readily apparent,” Hathaway noted. It won’t be so quick and easy to repair the damage done to complex credit, off-balance-sheet structures, the Fed’s big rate cut notwithstanding.
“The page has been turned for gold,” Hathaway’s sermon continued. “In the previous chapter, the metal was just another hard asset and a laggard at that. It was outperformed by base metals, energy and all manner of tangible assets. It was an also-ran and an afterthought in the commodities derby driven by the expectation of unstoppable growth in the emerging sectors of the global economy. In the current chapter I expect gold to outdistance its tangible brethren as its unique monetary traits become more widely understood. Unlike dollars, euros or yen, it cannot be printed. In comparison with those suspect contenders for safety-seeking capital, it is scarce and difficult to produce.”
Just how hard gold is to find and to produce is seen in the meager results of the companies in the Tocqueville portfolio. But a much higher gold price would cure many things, including – suddenly and dramatically – the miners’ lackluster profits.
Link here.THE ABUNDANT VALUE OF SCARCITY
Buying scarcity is usually a good idea. Beachfront properties, mint condition coins and limited production automobiles all testify to the enduring value of scarcity. But sometimes scarcity is temporary, especially in the commodity markets. For months or years at a time, demand will swamp supplies of a given energy product or metal or grain. Eventually, however, production catches up with demand and scarcity yields to excess.
As investors, we should always be on the lookout for scarcity, whether that scarcity be enduring or temporary. Scarcity creates opportunity, as my anecdote below illustrates.
I just returned from a weekend of camping in Pennsylvania. There was a pile of newspapers waiting for me. Lots of stuff in the mail too – newsletters, research, magazines and more. The e-mail box was even more loaded. Amazing what happens when you are gone even for only a few days.
After quickly digesting the pile of newsprint in front of me, I wrote up a quick comment for my readers. Usually, I will pick out what I think is the most compelling story of the day – one that also ties in with what I am doing in my investment letters. There is always something going on somewhere that makes me sit up and go, “hmmmm.” Many times I do not even know where a story might lead. Investment ideas do not usually leap off the page and grab me around the neck. More often, I just clip out bits and pieces of things of interest and file them away in my office. After awhile, certain threads and themes emerge. Sometimes an actionable investment idea comes out of all of this.
Today’s piece is about China’s massive plan to build many more nuclear power plants. China’s nuclear ambitions stagger the mind: $50 billion and 32 plants by 2020. The rumored number of 300 more by the middle of the century is even more mind-blowing. Something of a nuclear renaissance has been in the works for some time now. Perhaps the best testament to that fact is the price of uranium. In 2004, the price of a pound of processed uranium ore was only $14.40. Today, it is more like $120. You might think the soaring uranium price would put a brake on new plants. But that is obviously not the case.
One of my camping buddies works for the Department of Energy. He oversees several research projects related to nuclear power. Over a campfire one evening, we chatted about the nuclear renaissance. When I mentioned the price of uranium, he said there was plenty of uranium. “We know where it is,” he said. “We can make the Australians very rich, like the Saudis with oil.” The Canadians produce quite a bit of it, as does Kazakhstan.
The problem is that there is not plenty of uranium right now. Uranium in the ground is not the same thing as uranium at the power plant. It takes time to build a new mine, especially when the world’s largest uranium producer, Australia, continues to impede the development of new mines. So uranium prices might continue climbing for several more years, especially because higher prices are unlikely to curb demand.
Even at $100 a pound, uranium is not a huge component of the cost of nuclear powered-energy. “Fuel accounts for only 26 percent of the production cost for nuclear-generated electricity,” the Nuclear Energy Institute (NEI) explains. “In contrast, fuel accounts for more than three-quarters of the cost of coal-, gas- or oil-generated electricity.” This pricing advantage is one reason why nuclear energy is relatively cheap. “U.S. nuclear power plants have the lowest production costs of any large-scale source of electricity, except hydroelectric,” the NEI continues. “In 2005, the production cost for nuclear-generated electricity was 1.72 cents per kilowatt-hour (kWh), compared with 2.21 cents per kWh for coal, 7.51 cents for natural gas and 8.09 cents for oil.”
So even if uranium prices double over the next few years, nuclear energy would remain an extremely competitive energy source. Eventually, of course, new uranium mines will come on line. And eventually, of course, the price of uranium might retreat. But the price might soar in the meantime. We should take note of China’s new surge into nuclear power. It would seem to bode well for the price of uranium and the profits of those who sell it.
I am not saying investors should run out and buy uranium-mining stocks. Those stocks have had a great run already. I would say it would be hard to find a “hidden gem” in that lot. But I would also say that the uranium bull market has probably not run its course. Uranium, however, is not the only scarce resource in the nuclear energy market at the moment. Skilled labor is also scarce.
I told my friend about what I had read about the lack of nuclear physicists and other qualified scientists in the field. Most are either very old or very young. There was a long time when the nuclear industry was dead and few wanted to go into the field. He agreed with me and pointed out that two of the most valuable employees in his department are both over 70 years old.
For about a year, I followed a company called Washington Group International (WNG: NYSE). The company had a niche in nuclear power and many qualified people on its payroll, not to mention an accumulation of institutional knowledge gained over the years. I came very close to recommending this company several times. In late May, I noticed that URS Corp. bought the company. So the stock is up more than 45% since I put it on my watch list about a year ago. I am sorry I missed that one. But this buyout speaks to the growing need for experts on nuclear issues&and also to the value of scarcity.
The shares of WNG were never cheap on the basis of their earnings. But URS bought out the company anyway, apparently because nuclear expertise is very scarce at the moment, and therefore, very valuable.
Somewhere, sometime on this big blue globe of ours, there are assets of a kind in short supply and high demand. Finding assets that are scarce and likely to get scarcer – and not paying too much for them – is probably not a bad investment formula.
Link here.DELTIC TIMBER AN INTERESTING ASSET PLAY
Financial panics have a way of unsettling the nerves. You seek refuge in things you can trust. Assets you can see and watch over. And sometimes those assets hold their own secrets, which are unveiled only after the passage of a century.
One C.H. Murphy Sr. found refuge in the pine forests of central and southern Arkansas after the Panic of 1907. Here in the deep-fried South, Murphy not only saved a fortune, he planted the seeds for another. Murphy bought up thousands of acres of timberland. Timberland is one of those old-world assets that never go out of style. Trees grow by nature’s grace. They hold their value by the grace of a marketplace that needs timber to make things.
If we fast-forward a century, we find that Murphy’s old timberland is now in the hands of Deltic Timber (DEL: NYSE). The Murphy family still owns 26% of this timber stock. Deltic is actually a spinoff of Murphy Oil, having achieved independence back in 1996. Deltic Timber is a fine investment on its own, but the reason I am excited about Deltic has little to do with trees. It has more about what lies beneath.
Deltic Timber Corp. is a natural resources company. Deltic owns 437,700 acres of timberland. (See this map, “Murphy’s Legacy”. The area highlighted indicates counties and parishes where Deltic owns timberland). It also runs sawmills in Ola and Waldo, and has real estate developments in Little Rock and Hot Springs.
Most of this timber is Southern pine. The company is patient in its cuts. It manages to a 35-year cycle, as opposed to the 20-year cycle for most timber companies. Family owners are patient stewards of shareholder capital because it is their own investment, too – always important, this is more so today because many people who run companies have little or no financial stake in the businesses they run. A recent study by Credit Suisse found that companies in which “founding families retain a stake of more than 10% of the company’s capital enjoyed a superior performance over their respective sectorial peers.” Since 1996, this superior performance amounts to 8% per year. In Deltic’s case, it has whooped its peers in paper and forestry, and it has trounced the popular indexes.
With the housing market falling like an old drunk down a flight of stairs, you might worry about buying a timber company. No doubt, housing woes do not help Deltic. Last quarter, lumber prices were 20% lower than the year before. Volumes are down, too. Deltic’s mills lost money last quarter. However, Deltic made a lot of money in its woodlands segment, in which it harvests timber. Pulpwood prices are up 56% from stronger demand from paper mills. The company also has upscale real estate development projects in Arkansas. Strength in these other divisions made up for the loss in the mills, such that Q1 2007 income rose 65%.
Anyhow, Deltic is not an earnings story. The P-E ratio is more than 50 times – not cheap by the usual standards. Deltic is an asset play. The sum-of-the-parts value of the company’s timberland assets, real estate projects and mills covers your investment, which limits your downside. The upside excitement is the potential for the mineral rights of Deltic’s land. I am talking about the potential for natural gas under its trees, and the potential value of its lands’ water rights.
Let us start with the natural gas. Deltic owns 55,000 surface acres within an area known as the Fayetteville Shale Play. Natural gas aficionados will recognize its equivalents, in particular Barnett Shale – which some speculate may be the largest onshore gas field in the U.S. Some call the Arkoma Basin Barnett’s cousin. That leaves Fayetteville in good company. Fayetteville is a large area – some 2,000 square miles. Southwestern is already producing copious amounts of gas here. The area has also attracted substantial investments from Royal Dutch Shell and Chesapeake Energy. The latter has already leased more than 1 million acres.
The potential for lease income from Deltic’s shale properties is the cream on top for shareholders. Deltic has already leased 15,000 acres to exploration companies. For this, it gets small lease payments. If these exploration companies start to produce gas, then Deltic gets a much more significant royalty stream. Deltic first disclosed this possibility in its 2005 10-K filing, published in March 2006. The market gave it rave reviews, sending the stock to new highs of $60 per share. But speculators are impatient. I listened to a Deltic conference call. In it, management said they were “anxiously awaiting the results of drilling.” When it came time for questions, there were none. Not a single analyst follows this stock. Good for us.
Details are scant as to how much gas Deltic’s properties could produce. It is easy to speculate, based on Southwestern’s experience. You could take Deltic’s acreage, assume so many drills and so much gas and back into rough royalty payments. I have fiddled with these numbers in many ways. Before I share my thinking on valuation, there is one other asset on Deltic’s property that is particularly interesting: water.
In its latest quarterly report, Deltic disclosed that it sold 680 acres to Central Arkansas Water for $8.2 million, or $12,000 per acre. Again, we must speculate as to how valuable Deltic’s water rights may be. Arkansas water rights are not as valuable as Nevada water rights, but they have value. That value ought to rise in the new water-constrained world we are only beginning to see and experience. Putting a value on Deltic means lots of estimates and guesswork. But when the guesswork gets me numbers comfortably above today’s stock price, even on the low end, I get excited.
Timberland at only $1,000 per acre – which is 20% less than what large tracts of forest have sold for lately – gives you $437 million right way, or about $36 per share. Add in the real estate developments, land and mills and you can tack on another $30 per share. That gets you to $66. Subtract the debt and you get about $60 per share in a conservative – and growing – net asset value. Now add the gas and water rights. Assuming the company produces gas only on the 15,000 acres it has leased gets you another $15 per share or so. Should it produce gas on all 55,000 acres, you get an astronomical figure of around $50 per share. And I have not yet guessed at the water.
You have a proven operator anyway, even if none of this pans out – Deltic Timber itself is a wealth-creating business. It has many of the things we look for – chiefly, lots of tangible assets supporting your investment and a strong financial condition. We have got strong insider ownership. Best of all, we have got a cheap backdoor play into a promising natural gas and water play.
Buy Deltic Timber at up to $60 per share [around the current price]. Deltic’s shares are not very liquid. Be patient. It will not double overnight. Deltic is not the “sexiest” timber stock out there. We are waiting for lightning to strike the pines, so to speak. Look for those drilling results sometime late this year.
Sure, it is more exciting to believe that the biggest profits of your life are going to come from investing in some exciting company that has a stable of new lifesaving drugs. Or a firm that is pioneering some new electronic gizmo to keep us more in touch or better informed. But stocks with tangible assets. But “boring” asset-heavy stocks could triple your money time and time again.
Link here.FOUR RULES TO FOLLOW IN THE FACE OF MARKET MAYHEM
The successive market tumults of the past months have everybody wondering: Is there a single “safe” place in the investment landscape left in which to entrust my funds? When it comes to investments, we do not follow the maxim “where there’s a will, there’s a way” – especially when our Central Bankers are thinking that! Knowledge paves the way and keeps the successful investor from being rocked by all the gyrations. We have some essential criteria for just this turbulent situation.
There are few businesses in this world that are more “long haul” and “hard asset” than the oil and natural gas business. Over the life of any given hydrocarbon province, exploration may take many years, if not decades. Development proceeds in stages, with widely varying scales of risk, and again may last for decades. Extraction operations may last for many decades as well, with some oil or gas wells yielding product for a century or more. (For example, there is an old oil well just north of Pittsburgh – called the McClintock No. 1 – that has been in continuous operation since 1861.)
However, virtually all wells eventually deplete the reservoir to the point of no return. And then they must be “plugged and abandoned”. Plugging a well first requires that the down-hole equipment and casing is pulled out of the ground. Then, the hole is filled and sealed with concrete. And the many systems associated with oil and gas extraction, such as gathering pipelines, pumps, trunk pipelines and downstream refineries, also have time frames spanning multiple decades. It stands to reason that the more parts of the business your company can service, the better shot you will have at capturing more profits over the long haul. One good client can provide decades worth of business. Take 10 such clients from several nations, and you will see a multi-billion dollar empire of energy service.
These elements of the oil and gas business constitute highly complex industrial processes. To make it all work, oil and gas companies have to invest large amounts of money to build out and create capital. And the equipment and systems require constant servicing and maintenance, up through and including the process of P&A. According to some studies, over the entire life cycle of a typical oil field or larger hydrocarbon province from exploration to eventual P&A, about 70% of the funds that are spent go toward later-stage field development, long-term extraction and enhancements to development wells, plus eventual P&A and the winding up of operations. Only about 30% of the total life cycle cost is up front with the relatively high-visibility exploration and discovery, plus appraisal and early development. A stellar P&A player is a good bet to grab some high-margin profits.
The five factors that a perfect oil patch P&A play must have:
If you can say “yes” to these five factors, you will be weeding out a lot of the risk in any oil investment. Do not be afraid to dip your toes in the rich offerings of the energy service market, no matter what our markets have in store in the days ahead.
Link here.INFLATION HEDGES
In early August, a major storm swept across Wall Street credit markets, leaving hedge fund implosions and fear of undisclosed losses in its wake. On September 7, Countrywide Credit announced its intention to eliminate 10,000-12,000 jobs – a complete reversal of what the company had been saying just a month or two earlier. At that time, CEO Angelo Mozilo could hardly contain his enthusiasm about poaching top mortgage brokers from busted outfits like American Home Mortgage and New Century. Countrywide’s survivability is now being called into question.
At the very least, if Wall Street’s mortgage securitization machine remains stuck in neutral, Countrywide’s business plan will have to be completely overhauled. The ability to maintain operations depends on Wall Street funding that can dry up in an instant. This huge layoff is a crystal-clear signal from Countrywide that Wall Street’s credit “indigestion” is likely to continue for an uncomfortably long period of time.
Aside from emphasizing their reputations for stellar underwriting practices, several of the banks I have looked at recently are reminding a panicky stock market about the strength of their underwriting discipline.
Call me skeptical. Just as surveys indicate that most Americans consider themselves to be “above average” drivers, it seems that most banks believe they are “above average” mortgage underwriters. A handful of banks resisted the temptation to underwrite irresponsible mortgages, and they should be lauded for their integrity and foresight. But focusing on quality underwriting standards misses a key point about collateralized lending: Once collateral is fully overinflated by irresponsible lending, all collateral-based lenders suffer during the inevitable post-bubble fallout. During the bubble, you will recall that house value appraisals were based almost entirely on “comps”.
Should the mortgages written in the coming years reflect depressed housing values? Perhaps not, but they will anyway, because lenders will be fearful about lending against weak collateral. But there will eventually be another bubble as long as the current paper money system remains in place.
While central bankers will gradually intensify their inflation campaign, we cannot expect them to ride to the rescue immediately. They have pumped hundreds of billions of dollars into the system in recent weeks, without fully realizing or acknowledging the core problem: a crisis of confidence among banks. This crisis will not enter its final stages until it becomes reasonably clear who is holding the bag and they take their losses, even if it includes bankruptcy. Right now, the market is not hungry for liquidity – it is hungry for information.
Is what I am describing a prescription for “deflation”? I think it is not rational to expect that the supply of money and credit will be allowed to contract very long on its own without massive government intervention. Financial crises always prompt the general public to demand the “socialization” of both losses and risk. And the only way for the government to do that is to expand its debt, its paper money supply, and the charter of the Fed (to include the unconventional policy actions outlined by Ben Bernanke in his famous 2002 “helicopter” speech).
To protect yourself, I advise adding “inflation hedges” to your portfolio. These hedges include precious metals, energy, and natural resource stocks. Then, you should hedge these positions against a general market decline by holding short positions in vulnerable stocks and sectors.
Link here.ANTICIPATING THE PROFITS ON TOMORROW’S HYBRID CARS
Though hybrids have entered the public consciousness as a way to conserve fuel and reduce emissions, they have yet to break any records in performance or curb appeal. There is a reason for the sub-par performance. First, have a look at these stats:
Over 228,000 hybrid cars have been sold in the U.S. this year. But between 1 and 1.5 million total cars and trucks are sold in the U.S. each month. It is obvious that hybrids comprise a small slice of the automotive pie. Are hybrids going to revolutionize the auto industry? Yes, they eventually will. Is this “revolution” something you need to worry about right now. Should you fret over knowing your next car will be ugly, powerless and marginally eco-friendly? No, because chances are the next generation of hybrids will be significantly more attractive and gutsy than current models. Today, you have a chance to profit from the evolution of hybrids.
Within about eight years, 80% of all cars will employ hybrid technology (estimate provided by Booz Allen Hamilton). That “technology” will also change markedly between now and then. The advance that will put hybrids over the top does not involve a great deal of Isaac Asimov-like science or wild leaps in believability. It is actually kind of simple. The revolution will be centered on the car’s battery ...
Link here.RERUNS VS. REAL MANIAS
Last night my wife was watching an old I Love Lucy episode. I not only watched Lucy reruns as a kid in the 1960s, I watched those same reruns as my boys were growing up in the 1990s. Now it is 2007, and I am still watching a group of individuals who have not aged a day and are just as funny now as they were 40 years ago.
With the continuous upward movements of our markets these days, regardless of negative economic and financial developments, many have come to believe that nothing really changes with this story either. It is as if investors are thinking, “Oh, I have seen this market a dozen times. This is the one where the markets are in trouble and the Fed steps in and saves the day. It’s a rerun.” As much as I love to laugh and watch comedies, I understand the difference between a show and reality.
Those of us who have taken the time to change the channel and look for clues as to why the real world feels different from the movie land version of the markets are likely to realize that investors who refuse to differentiate between the two are about to be contestants on the, “Wheel of Misfortune” or “Who Wants to Lose a Million Here?”
Many investors fail to recognize that one asset has been destroyed in order to provide the firepower to drive another asset’s price higher. They have not noticed the trade-off between the market’s growth and the destruction of the U.S. dollar.
While this game has gone on since the start of the 21st century, we continue to see signs warning of the end of this period of worldwide credit expansion. Since July the world has watched a severe credit contraction take place. This is impacting real estate, business, and banking relationships around the world, but especially in Europe and the U.S.
Consider the following: In the months following Katrina, the commercial paper market continued to rise. After the equity markets sold off in May of 2006, the commercial paper market continued to rise. After the sharp sell off of the Shanghai and other world equity markets in February of 2007, the commercial paper market continued to rise. However, after equity markets around the world declined in late July and early August, the commercial paper disconnected. This short-term debt instrument, stuffed in money market funds across the country and used for short-term liquidity needs by hundreds of highly leveraged hedge funds, has declined more than $364 billion in 10 weeks.
Trying to combat this, central bankers are pulling out all the stops. The trouble is that very few investors are factoring in what happens when crowd sentiment moves from greed, or complacency, to fear. Right now, learning and thinking are more critical than ever. We must look to sources with solutions very different from our own in order to challenge our thinking. None of us have ever been through a period like the one that is in front of us, but if we are willing to look at unpleasant realities, we can all gain increasing levels of insight.
Recently, Michael Panzer interviewed Satyajit Das, a gentleman with 30 years experience in developing and marketing derivatives who has written a 4,200-page reference work on these exotic instruments. Panzer asked Das about the recent credit crisis and where we are in the process of things getting “back to normal.” Das, who knows as much about global money flows as anyone in the world, suggested that we are “still in the middle of the national anthem before the game destined to go into extra innings.”
As almost everyone looks to the Federal Reserve and central bankers around the world to continue this giant liquidity bubble forever, we would do well to look at the sentiment readings from Rich Ishida.
Gold recently hit a bullish consensus reading of 90. The last time investors were this bullish on gold was May of 2006, when gold hit a bullish consensus of 92. Its price then fell from $730 to $542 in four weeks. In September of this year bullish consensus on the dollar hit 20, and bullish consensus on the Euro reached 93. Again, the last time these consensus readings were at similar levels was in May of 2006. With most people bearish on the U.S. dollar and bullish on the Euro, the U.S. dollar hit a bullish consensus of 35 and the Euro came in at 69. Over the next four weeks, the U.S. dollar climbed from 83.06 to 87.05, and the Euro declined from 129.74 to 124.81. We also notice that the NASDAQ hit a bullish level of 78, the highest level it has hit in the last 2 years.
If these sentiment levels back off from these extremes, this could be a tumultuous month. As to whether this is finally the top, I have seen some good arguments for another explosion higher after the next move down and good arguments for this being the top. All we know is that rapid increases in confidence or fear, as shown in these readings, usually mean that the markets are poised for rapid price changes in the near future. History shows that when everyone is on the same side of the trade, it may be time to rethink one’s strategy. As the markets continue to climb, the pressure to revert to the mean only gets stronger.
The recent volatility in the Hong Kong’s Hang Seng Index only demonstrates the speed in which trades are being executed. Were the investors, or traders who rode the Hang Seng up, on Monday, October 2nd, thinking, “the next two days the markets are going to fall over 2,000 points?” Is this type of enormous volatility in the largest market in China a sign of stability and millions of investors carefully evaluating risk, or are they saying, “Forget the cookie – just give the Chinese Fortune”? In an environment like that which the Hang Seng has experienced in 2007, I venture to guess that not much thinking is taking place.
We are dealing with polar extremes. Similar to other critical junctures, millions are extrapolating the paper gains of the past as proof that this is the show that will never end. We need to remember that “thinking positive,” while a necessity to keep our sanity at this time, will not make our mammoth financial issues disappear. We need to stop ourselves and question what the crowd is doing. We should look for solutions that are not popular and consider actually getting ahead of this credit contraction, which will most assuredly continue.
Link here.RECKLESS RESCUES
Just where is the line drawn on bailouts? Nowhere, it seems.
Sheila Bair, chairman of the FDIC urged mortgage servicers to force mortgage pools to reduce the long term interest rate at which subprime mortgages refix after the first few years, fixing the rate instead at the initial “teaser” rate. I trust no Bear’s Lair reader is remotely surprised at this development. It is typical of the soft-option-mania that has infested financial thought in the last decade.
Once upon a time, governments did not do rescues. The great Robert Banks Jenkinson, Lord Liverpool in a prime ministerial speech to the House of Lords during the 1825 speculative bubble, said: “I wish it however to be clearly understood, that those who now engage in Joint-Stock Companies, or other enterprises, enter on those speculations at their peril and risk. I think it my duty to declare, that I never will advise the introduction of any bill for their relief; on the contrary, if such a measure is proposed, I will oppose it, and I hope that Parliament will resist any measure of the kind.”
Even as late as 1929 in the U.S., the established policy was not to engage in rescues. Andrew Mellon, Secretary of the Treasury under Warren Harding, Calvin Coolidge and (unluckily for him) Herbert Hoover, said in December 1929, after the Wall Street Crash: “Liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate ... purge the rottenness out of the system.” No sign of any bailout nonsense there!
The first sustained attempt at bailout was Herbert Hoover’s Reconstruction Finance Corporation, for which lending began in 1931 and full operation began in June 1932. This was nothing short of a disaster, because it was combined with sharp tax increases and reductions of veterans’ and other benefits, thus shifting resources from the middle classes and the needy to the country’s least productive businesses. It resulted in a sharp further downturn in the U.S. economy, which had already been battered by the 1929 stock market crash, the Smoot-Hawley tariff, the Fed’s tightening of monetary policy after the Bank of the United States crash, and the internationally damaging Creditanstalt bankruptcy.
Had Hoover confined himself to modest relief payments to the truly needy, at a level the U.S. budget could have sustained without damaging tax increases, the Depression would have turned into recovery by the beginning of 1932, as it did in Britain, and Hoover might have had a reasonable shot at reelection. However, having by his bailout put politics egregiously ahead of economic common sense and abandoned 150 years of sound fiscal management, he deserved to lose.
Hoover’s RFC was typical of later bailout programs. By definition the entities that get in trouble first in a downturn are those whose economic justification is most doubtful. In the unsuccessful “lifeboat” bailout of the British banking system in 1973-74 the first bank to get into difficulties, London and County, proved eventually to have a portfolio of real estate loans that was almost entirely without value. It is likely that the same will prove true of Northern Rock, bailed out by the Bank of England a few weeks ago. Northern Rock, a fairly small and hitherto obscure building society, had expanded beyond all reason by taking wholesale funding and aggressively selling mortgage loans. As always when loans are sold rather than begged for, Northern Rock’s portfolio appears to have been of markedly lower quality than its competitors’. Hence by rescuing it, the Bank of England subsidized the worst lending practices and the most unsound funding, at the expense of the rest of the community who have restrained themselves by comparison.
Sheila Bair’s proposed rescue suffers from the same problems, especially as it is being proposed well before the U.S. housing market has hit bottom. Bailouts undertaken when the market is only halfway down are especially likely to reinforce failure. Under her proposed system, the most feckless borrowers would be most heavily subsidized. The subsidy would effectively be paid by holders of mortgage bonds, who would see the value of their assets decimated.
The mortgage bond market would presumably be severely affected by a Bair bailout, preventing new borrowers from getting mortgages (since the savings and loans, from which they would have borrowed when the home mortgage market was properly structured, have more or less disappeared.) This would reduce house prices still further. More important, it would greatly reduce liquidity in the housing market, adversely affecting the fortunes of existing homeowners, particularly those who for other reasons had to move. In turn, the subprime borrowers who had been given the lower-interest mortgages would find themselves trapped in their excessive homes, unable to move without defaulting on a mortgage that was now far larger than the value of their home. The bailout, in short, would only make things worse.
At some point, the housing market will hit bottom, and a bailout will become possible, as supply will once again match demand. The greatest need then will be an active mortgage lending industry that is prepared to lend against the reduced value of housing without too many restrictions on the borrower. From past experience that is unlikely to be available. Losses to holders of mortgage bonds and bankruptcies among mortgage banks will have decimated the industry, and those few institutions remaining in the business will have adopted a policy of extreme conservatism.
In 1980, for example, after a real estate downturn and rise in interest rates that decimated values and cash flow in the mortgage industry, I was informed that as a salaried employee of a major bank, I could qualify for a mortgage of only 1.5 times my income from that bank’s own mortgage arm. That was as foolish in the restrictive direction as the subprime mortgage bonanza was in the opposite direction, and it will be deeply damaging to the housing market and the U.S. economy if it allowed to recur. At present, with new home sales running at 795,000 units compared with an average bottom in the last four recessions of 382,000, the market is nowhere near bad enough for a bailout to be appropriate.
The bailout impulse will doubtless recur as the wheels drop off various other parts of the ramshackle world financial edifice:
Logically, there is nowhere for the bailout impulse to stop, no set of market participants so foolish or unsound that it cannot construct a rationale for aid from its customers, its business partners or the state. Normal capitalist transactions become impossible under such a system. It is a monstrous expansion of the pernicious principles that underwrite the trial bar. The world is sufficiently uncertain already, without the dangers of that uncertainty being increased by meddling governments. In a sound market, participants limit and manage their own risk, without seeking to pass it off to somebody else.
In 2020, when we have all paid the price for the forthcoming succession of ill thought-out bailouts, these principles will be obvious and universally respected. But the process of getting to that point is likely to be unpleasant and expensive, rewarding some thoroughly undeserving people in the process.
Link here.Poole Party: No housing lessons learned
William Poole, president of the Federal Reserve Bank of St. Louis, made a lengthy speech on Real Estate in the U.S. Economy. He correctly concluded that outlays for business structures will not continue to increase at double-digit rates. Commercial real estate is extremely overbuilt. Overcapacity is rampant. A consumer-led recession will highlight all the commercial malinvestments sooner or later.
Poole is also correct when he said that the Fed has no power to bail out bad investments (at least not forever). However, it was disingenuous of him to state it has no desire or willingness to try to do so. Recent Fed actions should be ample proof. The most galling thing about Poole’s speech is his attempt to blame the free market for problems entirely created by: (1) The Fed, (2) the SEC, and (3) political hacks.
No housing lessons have been learned by any of the three. Poole said, “There is no new lesson here.” He was wrong. He does not even understand what the problem is. Instead of attempting to figure it out, we see legislation on top of legislation on top of legislation. The legislation onion grows more layers every year. Each layer of legislation masks (at best) or compounds (at worst) the problems of the previous layer. The only way to fix the problem is to scrap our tax laws in entirety, dissolve the Fed, stop promoting housing (and everything else, too), and get government out of our lives.
Link here.WALL STREET VS. THE MIDDLE CLASS
Anyone who thinks that the super-rich, the rich, and the wanna-be rich who comprise Wall Street are defenders of prosperity in the name of the middle class is terminally naïve. He or she is confusing Wall Street with the free market.
The free market is the great friend of all classes. Through the division of labor engendered by private ownership, the free market supplies ever-increasing quantities of goods and services for all classes, but especially the middle class. People in the lower classes can legitimately hope to enter the middle class. A few will become rich.
There is a price for this upward access to greater wealth – the possibility of a fall into poverty. This is a greater threat to the rich than to the middle class. The rich are at the far right edge of the bell-shaped curve. There are few of them. Their position is insecure, for good reason. The free market rewards those sellers who serve consumers efficiently, wasting few scarce resources. Consumers are a fickle bunch. They keep asking sellers, “What have you done for us lately?” There are always many competitors trying to get rich. They are ready to replace today’s rich people. Today’s rich people know this. They are therefore ready and willing to pull up the ladder that enabled them to replace yesterday’s rich.
The free market’s ladder of mobility, upward and downward, is based on these legal principles: open entry of new buyers and new sellers, the predictable enforcement of contracts, and the absence of government favoritism of any special-interest group.
These principles should also govern the monetary system. They have never done so perfectly, and ever since 1914, hardly at all. Because of the tremendous profitability of legalized counterfeiting, fractional reserve banking has always been based on two principles: (1) Keeping out new counterfeiters, who would debase the currency through price competition – mass paper money inflation – and thereby end the game of wealth-redistribution from depositors to bankers. (2) The creation of a central bank that protects existing commercial banks from bank runs by depositors.
The fractional reserve banking system is engaged in a war against depositors and also a war against people on fixed incomes, who are unable to hedge their assets against monetary depreciation. The depositors get their pittance, based on the money they deposited. The bankers then multiply these small deposits through fractional reserve banking and thereby enjoy income from many interest-paying borrowers.
The threat to bankers arises when depositors realize that a bank is insolvent – lent long and borrowed short – and start demanding their money back in currency. This is the nightmare scenario for bankers. They do not want depositors to catch on to the obvious, that their money is being used to create multiple loans, meaning multiple new income streams for banks. They do not want depositors to kill the goose that lays the fiat money eggs for bankers. How? By pulling out their money in currency and not redepositing this currency in another bank. Bankers know what happened to over 6,000 small, federally unprotected banks, 1929–32, and they never want to see it again.
Enter the Federal Reserve and the FDIC, semi-private, profit-seeking protectors of the little guy! And just how is the little guy protected? By the full faith and credit of the U.S. government. When you think “full faith and credit,” think of the scene in the first Superman movie. Lois Lane has just fallen from the top of the Daily Planet’s building. Superman flies upward just in time and grabs her. “Don’t worry, miss. I’ve got you.” To which she replies, “Who’s got you?” As in the case of the cosmic elephant, which is standing on the cosmic turtle, what is the turtle standing on? It is turtles all the way down.
With the Federal government and the FDIC, their full faith and credit stand on two factors: taxation and the Federal Reserve System. What holds up the Federal government when it can no longer collect enough taxes from the coalition of the unwilling to pay the bills? The Federal Reserve’s fiat money. It is digits all the way down.
If you follow the financial news media, you will notice how much attention is paid to the Federal Funds rate, which is the overnight bank rate. This is the rate that the Federal Open Market Committee can control directly. Whenever the FED is raising this rate, the media never warn the public that this policy could send the U.S. stock markets into a bear market phase. But when there is even the slightest possibility that the FOMC might lower the FedFunds rate, market commentators get all a twitter over the possibility of another upward move of stocks. This is what I call the asymmetric nature of the financial press: “upward rate move = no problem; downward rate move = boom ahead.” What is bad news for the stock market? Officially speaking, nothing.
Why is the financial press asymmetrical? First, the middle class reads the financial press and dreams of getting rich. Second, Wall Street and its large corporations advertise in the financial press, and therefore shape the content. Financial editors are careful to exercise self-censorship. Unlike the non-financial press, which flourishes on bad news – “If it bleeds, it leads” – the financial press is dependent on the flow of good news: “Buy your piece of the American dream,” not “buy your piece of the American nightmare.”
The Fed dominates discussion these days. Will it lower “rates”? Will it let “rates” sit? If the Fed lowers “rates” by waving its magic wand – sorry, scratch that – by debasing the dollar more rapidly than today, the broad middle class will receive a lower rate of interest in its bank savings accounts. This is great for banks, which can now borrow short at a lower rate, such as 3%, while lending money at 10% to 30% to other members of the middle class and the poor, who are addicted to credit card debt. The spread between borrowed funds and loaned funds widens. This is the dream of the financial sector.
Why do credit card rates not fall? Because consumers who use credit card debt are not sophisticated. They do not shop for better rates. Even when they do, they do not read the fine print of the new contract, which allows the card company to double or triple the introductory rate if the borrower falls behind on a payment, even a payment to a company in no way connected to the credit card. A free market society enforces contracts. It does not protect those people who refuse to read their contracts or cannot understand them. If you do not understand the fine print, do not sign the contract, e.g., the credit card application.
Lower rates produce an economic boom. Businessmen borrow from banks to take advantage of the expected boom. Banks make more money. But if long-term rates are not higher than short-term rates, banks do not make much money. Today, long rates are barely above short rates. Meanwhile, large banks are still losing big money in the subprime mortgage market. This has only just begun.
When you hear about the “good news” that the Fed is about to lower rates, it is not good news if you have money in a bank account or a money market fund. Wall Street does not care about the plight of the middle-class lender who deposits money at 3% in his bank, only to suffer 2% to 3% price inflation, after paying 20% or more to various governments on the interest received. The middle-class saver is the loser when Wall Street screams its way into the thinking of the FOMC. Jim Cramer threw a tantrum. The FOMC responded.
The dependence of Wall Street on a continuing stream of new fiat money is very high. If this flow of funds were to cease, Wall Street would go into withdrawal seizures. The various stock markets would plummet. This cannot be allowed, say Wall Street’s many spokesmen. This would “harm America.” So, the Fed is called on to continue the flow of counterfeit funds, multiplied through the fractional reserve process.
The losers are those people who trust the banking system and deposit their money. The other losers are those who are on fixed incomes or close to fixity. They pay higher prices for whatever they buy. The resulting boom on Wall Street comes out of their lifestyles.
When Wall Street and its media mouthpieces call for another cut in the FedFunds rate to “keep the American dream alive,” they mean the dream of corporate insiders whose stock option plans are being threatened by the readjustment in capital values posed by stable money. They do not mean the broad mass of Americans.
Only 56% of American households actually saved any money in 2004. They do not have large retirement funds. The median American, as of 2004, had a net worth of under $95,000. Of this value, well over 60% was the value of their residences. Retirement? Living on Social Security? Those in the 50 to 75 age range had a median net worth of $171,000. But most of this was the value of their homes. They will have to pay for space somewhere. In terms of liquid assets to invest and live off the earnings, they are in very bad shape.
Their debt pressures them monthly. They worry about meeting their monthly expenses. This gets their attention. If they were to lose their jobs for two months, they would be in trouble. Rising interest rates threaten them. So they are with Wall Street’s call for the Fed to lower rates. They are far more worried about losing their jobs than they are about price inflation under 3%. They do not understand that the means for lowering rates – monetary expansion – threatens to raise prices. These hats are all present hats. They take precedence over future hats. Retirement is way off in the distance. They will think about it mañana.
So, when the Wall Street wizards perceive a looming decline in their stock portfolios and call for the Fed to intervene and save the various stock markets, the wizards get support from the broad masses, who are actually threatened by the return of monetary expansion. The wizards have their futures tied to the stock market and bond market. The fact that price inflation is a threat to the average American’s way of life is of no concern to the wizards.
Conclusion: We see today a clash between the long-run interests of the middle class and the short-run interests of those who make their living in the financial markets. Because the process of economic cause and effect is not understood by the media, and because it is not understood by the average American, the wizards of Wall Street get away with their endless supplications to the Fed. The world apparently believes in magic. They believe that the FOMC committee merely has to issue a press release promising to lower the FedFunds rate and, wonder of wonders, the rate is lowered cost-free.
My sense of the Fed today is that it will not lower the FedFunds rate again at the end of October. In late August, I was sure the FOMC would lower the rate by half a point on September 18. It did. I do not think they are facing equal pressure from Wall Street today. For the sake of the U.S. dollar, let us hope I am correct.
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