W.I.L. Finance Digest for Week of February 18, 2008

DRIP, DRIP, DRIP: THEN THE DAM COLLAPSES

History and Bible scholar and veteran financial analyst Gary North has been warning in sometimes apocalyptic tones about the ultimate collapse of the U.S.'s and world's debt-based financial system for decades. He famously predicted an infrastructure collapse from the Y2K transition. He proved to be utterly wrong there, in probably large part because so many people believed him (and others who made similar warnings) and took steps to avert catastrophe. It was a great, unsung success of the unfettered market in action.

It looks as if his financial sphere forecasts will not similarly prove to have been in error. The problems are not necessarily easy to identify, and are no purely technical with a well-defined deadline. To the extent credit markets are controlled by any identifiable agencies, they are large government beaurocracies serving multiple conflicting interests. In any case, North is predicting a major bear market in stocks.

Bear markets are abstract in the contemplation but visceral once they arrive. "Depend upon it, sir, when a man knows he is to be hanged in a fortnight, it concentrates his mind wonderfully," wrote Samuel Johnson long ago. North attempts to give a preview of coming attractions sufficiently vivid to concentrate the mind before the bear arrives in force.

So do stock markets. Day after day, there is bad news from the banking sector in Europe and America. There is bad news from the housing markets all over the world. There is bad news from the Institute for Supply Management, which reports on the state of suppliers. The service sector in January fell to 41.9%, with 50% as the borderline between contraction and expansion. In December, it was 54.4%. This is a very sharp decline.

The drip, drip, drip of bad news has a cumulative effect. It undermines investors' confidence in the economy. This calls the stock market into question.

Panic Selling

Panic selling does not hit a market without warning, smashing it into a meltdown that lasts for years. It hits after years of nagging doubts, followed by months of bad news in relentless sound bites, and then one unpredictable event that triggers a massive one-day sell-off, which is followed by more days of sell-offs.

Woe unto the investor who is caught fully invested in that initial sell-off. He will look in horror, paralyzed, denying the obvious. The market keeps going down, day after day. Tout TV commentators (age 30) interview fund managers, who deny that it is a meltdown, recommend "buying sector stocks," and say, "Buy on the dips." Dips? The market is collapsing. Then the poor soul who bought and held finally calls his broker or sends a message to his retirement fund: "Sell!"

Too late. Once smashed, a market can take years to recover. Gold and silver did not recover for 21 years, 1980–2001.

We have seen this kind of sell-off more recently. It began on March 24, 2000. On that day, the NASDAQ peaked, intra-day, at 5132.52. It closed at 5048. This marked the end of the dot-com bubble. You need to see a graph of that collapse, just to remind yourself of just how bad it can be next time. It bottomed on October 9, 2002 at 1114.

On January 2, 2002, it closed at 2059. That was down 60% from the peak. The chart of that decline looked bad. But was good news not straight ahead? Had the bad news not been discounted? No. The NASDAQ fell another 46% over the next ten months. Look at the chart. Today, it is in the range of 2300.

The consumer price index has risen by over 20%, 2000 to 2008 (bls.gov). It rose by 15%, 2002–2008. So, discounting for price inflation, the NASDAQ is lower today than it was in early January, 2002. Plus, the person who bought and held in 2002 suffered a 46% loss of capital in 2002. Had he sold in January and repurchased in October in a tax-deferred IRA or other retirement fund, he would have avoided this loss.

I know people who told me in January 2000, that the NASDAQ's price/earnings ratio of 206 was reasonable. I thought it was not, and I warned my readers to sell in February and March. No one on Tout TV ever mentions this. No one says, "This can easily happen again." No one says, "The NASDAQ has been in a bear market ever since March 24, 2000. The recovery after October 2002 is a bear market rally. That rally is fading."

Volatility

Day after day, the Dow is up or down 100 points or more, sometimes 200, sometimes more. Why? If the best forecasting minds on earth agree on the value of shares, should the Dow not rise or fall by under 50 points? Should there not be a trend, one way or the other?

We are seeing massive moves in and out of shares. The experts are not only not agreed, they are not agreed in a fundamental way. These are not random moves, in the sense of movements in response to unknown changes in perception at the margin. These are clashes between fundamental views of the future of this stock market and the international economy. Yes, these views are at the margin. All economic change is at the margin. But these are much larger moves than normal. The investors at the margin are much more aggressive, and they do not agree on what is coming.

The investor with money in his pension fund looks at these swings, and he has to wonder: "What is going on? Why is the stock market so volatile? Why are downward moves so big? Why does the market rebound briefly, then fall again?"

He sees volatility, and he senses confusion at the top. The big boys who allocate enormous pools of money just cannot get their act together. Yes, there are always bulls and bears, but the bears rarely are in a position to swing the market this widely. When they are in this position, this indicates that the stock market is at a crossroads.

Volatility is great for about 3% of commodity futures speculators. These are the people who make money. But volatility is not good for stock market investors. It points to major changes in both the economy and the market. Most stock investors do not want volatility. They want steady capital gains, year after year. They have not gotten this since March, 2000. What they have gotten is a nearly flat Dow Jones and S&P 500, and a much lower NASDAQ, accompanied by steady price inflation. They are getting poor slowly. They have not yet lost hope in the stock brokers' mantra, "The U.S. stock market has risen by 7% per annum." Not in 1966–1982. Not since 2000.

The victims who invest in a broad index of stocks have lost money for eight years. They refuse to change. They refuse to call their fund managers and say: "Sell my stocks and move the money into a money market fund." Yet they watch what is happening, and they get nervous. They refuse to sell. The smart ones who have automatic investing each paycheck have most of this money go into stocks. But they do not like what they hear about subprime loans. They do not like what they see in the stock market charts.

We are now entering the doubt stage. It has taken eight years of negative returns in stocks. These years can never be recovered. Meanwhile, gold went from under $300 to over $900.

The stock market touts who never told you to buy gold now tell you it is too risky. The Wall Street Journal ran a story, "How to Survive The New Gold Rush" on January 29. What was the advice? Do not buy gold. Why not? (1) Gold can be "extremely volatile." (2) Gold "hasn't always kept up with inflation." (3) Better to invest in a commodities funds, "advisers say." What advisors? The blind boneheads who did not put gold in their portfolios or recommend gold, from $257 to $900. Instead, they said "buy an index fund of U.S. stocks." And what did that do for investors after March, 2000? Nothing, at best. Capital losses at worst (NASDAQ). In short, these unnamed advisors are losers until proven innocent. Losers deeply resent winners. They deeply resent gold because gold's rising price announces: "The policies of the Federal Reserve System, the U.S. Treasury, and Wall Street have produced losses for eight years."

The Psychology of Fear

Some of my subscribers have read my warnings about real estate, Federal spending, and the tight-money policies of Bernanke's Fed for two years. Others have refused to read my reports. A few people have taken me seriously and have reallocated their portfolios. They got out of stocks and into other asset classes, such as gold. But most readers have just sat there. They have nodded in agreement, but they have not picked up the phone to call their broker or pension fund manager to tell them to sell their shares.

The average investor does not read information sources like mine. They prefer to rely on the mainstream financial press, which is advertising-supported. They prefer to read articles that are favorable to stocks, which is what mainstream financial press advertisers are paying editorial departments to publish.

But doubts are growing. Day after day, the news from the banks, from the American auto industry, and from the housing sector is depressing. The drip-drip-drip factor is eroding the foundation of confidence that is necessary to sustain rising stock markets.

We are seeing the undermining of the foundation of the bulls: investor optimism. There is no way that the news coming out of the financial sector can be interpreted as optimistic. The good news relates to specific companies. The bad news applies to entire sectors of the economy, and two of the biggest, housing and autos, are in trouble. General Motors lost $39 billion in 2007. How does any company lose that much money and still stay in business? Yet the recession has not hit yet. ...

Conclusion

The volatility of stocks point to economic conditions that are not understood. The economic fools in high places who approved the subprime loans that are now going bad did not see what was coming until July 2007. These fools committed their firms and their clients to debt packages that were toxic. They did not understand their credit portfolios any more than the subprime borrowers understood the adjustable rate loan contracts that they signed.

Governments and central banks are now bailing out the dim-witted bankers to the tune of billions of low-interest loans and direct funding. Governments are also offering band aids -- or proposals for band aids -- to postpone the debtors' day of reckoning. But politicians know whose bread must be buttered: the multinational bankers' bread. They will be bailed out. The home owners, busted, will return from whence they came: the land of the renters.

No one really cares. They do not care that large banks are too big to fail. They do not care that small home owners are too small to be worth saving. As long as the government intervenes to keep the debt structure alive, voters do not care whose money gets used to do the bailing.

We are addicted to debt. But as the addiction grows, it becomes too big not to fail. It will fail. The question is: In what way? Outright default or mass inflation? I predict mass inflation. But not yet. Not this year. The downward pressure of the contracting housing sector and autos will keep downward pressure on prices.

The drip, drip, drip of bad economic news will eventually break the average mutual fund investor's will to resist this downward pressure. "Sell!"

"To whom? At what price?"

AMERICA’S ECONOMY RISKS THE MOTHER OF ALL MELTDOWNS

Martin Wolf, of the Financial Times, lays out a more detailed version of the meltdown scenario expounded by Nouriel Roubini than was summarized last week. It is the standard formula for a credit deflation with particulars added for the current situation. That writers for the mainstream financial press, academics at prestigious institutions, and Ben Barnanke and colleagues all recognize the danger may not be sufficient to fend off the envisioned scenario -- especially if the attempted cure makes things worse.

"I would tell audiences that we were facing not a bubble but a froth -- lots of small, local bubbles that never grew to a scale that could threaten the health of the overall economy." ~~ Alan Greenspan, The Age of Turbulence.

That used to be Mr. Greenspan's view of the U.S. housing bubble. He was wrong, alas. So how bad might this downturn get? To answer this question we should ask a true bear. My favorite one is Nouriel Roubini of New York University's Stern School of Business, founder of RGE monitor.

Recently, Professor Roubini's scenarios have been dire enough to make the flesh creep. But his thinking deserves to be taken seriously. He first predicted a U.S. recession in July 2006. At that time, his view was extremely controversial. It is so no longer. Now he states that there is "a rising probability of a 'catastrophic' financial and economic outcome." The characteristics of this scenario are, he argues: "A vicious circle where a deep recession makes the financial losses more severe and where, in turn, large and growing financial losses and a financial meltdown make the recession even more severe." ...

Here are [Roubini's] 12 -- yes, 12 -- steps to financial disaster.

(1) The worst housing recession in U.S. history. House prices will, he says, fall by 20 to 30% from their peak, which would wipe out between $4 trillion and $6 trillion in household wealth. 10 million households will end up with negative equity and so with a huge incentive to put the house keys in the post and depart for greener fields. Many more home-builders will be bankrupted.

(2) Further losses, beyond the $250-$300 billion now estimated, for subprime mortgages. About 60% of all mortgage origination between 2005 and 2007 had "reckless or toxic features", argues Prof Roubini. Goldman Sachs estimates mortgage losses at $400 billion. But if home prices fell by more than 20%, losses would be bigger. That would further impair the banks' ability to offer credit.

(3) Big losses on unsecured consumer debt: credit cards, auto loans, student loans and so forth. The "credit crunch" would then spread from mortgages to a wide range of consumer credit.

(4) The downgrading of the monoline insurers, which do not deserve the AAA rating on which their business depends. A further $150 billion writedown of asset-backed securities would then ensue.

(5) The meltdown of the commercial property market.

(6) Bankruptcy of a large regional or national bank.

(7) Big losses on reckless leveraged buy-outs. Hundreds of billions of dollars of such loans are now stuck on the balance sheets of financial institutions.

(8) A wave of corporate defaults. On average, U.S. companies are in decent shape, but a "fat tail" of companies has low profitability and heavy debt. Such defaults would spread losses in "credit default swaps", which insure such debt. The losses could be $250 billion. Some insurers might go bankrupt.

(9) A meltdown in the "shadow financial system". Dealing with the distress of hedge funds, special investment vehicles and so forth will be made more difficult by the fact that they have no direct access to lending from central banks.

(10) A further collapse in stock prices. Failures of hedge funds, margin calls and shorting could lead to cascading falls in prices.

(11) A drying-up of liquidity in a range of financial markets, including interbank and money markets. Behind this would be a jump in concerns about solvency.

(12) "A vicious circle of losses, capital reduction, credit contraction, forced liquidation and fire sales of assets at below fundamental prices".

These, then, are 12 steps to meltdown. In all, argues Prof Roubini: "Total losses in the financial system will add up to more than $1,000 billion and the economic recession will become deeper more protracted and severe." This, he suggests, is the "nightmare scenario" keeping Ben Bernanke and colleagues at the U.S. Federal Reserve awake. It explains why, having failed to appreciate the dangers for so long, the Fed has lowered rates by 200 basis points this year. This is insurance against a financial meltdown.

Is this kind of scenario at least plausible? It is. Furthermore, we can be confident that it would, if it came to pass, end all stories about "decoupling". If it lasts six quarters, as Prof Roubini warns, offsetting policy action in the rest of the world would be too little, too late.

Can the Fed head this danger off? In a subsequent piece, Prof Roubini gives eight reasons why it cannot. (He really loves lists!) These are, in brief: U.S. monetary easing is constrained by risks to the dollar and inflation; aggressive easing deals only with illiquidity, not insolvency; the monoline insurers will lose their credit ratings, with dire consequences; overall losses will be too large for sovereign wealth funds to deal with; public intervention is too small to stabilize housing losses; the Fed cannot address the problems of the shadow financial system; regulators cannot find a good middle way between transparency over losses and regulatory forbearance, both of which are needed; and, finally, the transactions-oriented financial system is itself in deep crisis.

The risks are indeed high and the ability of the authorities to deal with them more limited than most people hope. This is not to suggest that there are no ways out. Unfortunately, they are poisonous ones. In the last resort, governments resolve financial crises. This is an iron law. Rescues can occur via overt government assumption of bad debt, inflation, or both. Japan chose the first, much to the distaste of its ministry of finance. But Japan is a creditor country whose savers have complete confidence in the solvency of their government. The U.S., however, is a debtor. It must keep the trust of foreigners. Should it fail to do so, the inflationary solution becomes probable. This is quite enough to explain why gold costs $920 an ounce.

The connection between the bursting of the housing bubble and the fragility of the financial system has created huge dangers, for the U.S. and the rest of the world. The U.S. public sector is now coming to the rescue, led by the Fed. In the end, they will succeed. But the journey is likely to be wretchedly uncomfortable.

BERNANKE’S STATE OF THE ECONOMY SPEECH: “YOU ARE ALL DEAD DUCKS”

Last week Federal Reserve Chairman Ben Bernanke testified spoke to the Senate Banking Committee. Accustomed to Greenspanian obfuscation and doublespeak, they instead were treated to a straightforward presentation of just have grave the current situation is. Mike Whitney has now done us the favor of condensing the presentation further.

Even veteran Fed-watchers were caught off-guard by Chairman Bernanke's performance before the Senate Banking Committee on Thursday. Bernanke was expected to make routine comments on the state of the economy but, instead, delivered a 45-minute sermon detailing the afflictions of the foundering financial system. The Senate chamber was stone-silent throughout. The gravity of the situation is finally beginning to sink in.

For the most part, the pedantic Bernanke looked uneasy; alternately biting his lower lip or staring ahead blankly like a man who just watched his poodle get run over by a Mack truck. As it turns out, Bernanke has plenty to worry about, too. Consumer confidence has dropped to levels not seen since the 1970s recession, real estate has gone off a cliff, credit-brushfires are breaking out everywhere, and the stock market continues to gyrate erratically. No wonder the Fed-chief looked more like a deck-hand on the Lusitania than the monetary-czar of the most powerful country on earth.

Bernanke's prepared remarks were delivered with the solemnity of a priest performing Vespers. But he was clear, unlike his predecessor, Greenspan, who loved speaking in hieroglyphics. Bernanke:

"As you know, financial markets in the United States and in a number of other industrialized countries have been under considerable strain since late last summer. Heightened investor concerns about the credit quality of mortgages, especially subprime mortgages with adjustable interest rates, triggered the financial turmoil. However, other factors, including a broader retrenchment in the willingness of investors to bear risk, difficulties in valuing complex or illiquid financial products, uncertainties about the exposures of major financial institutions to credit losses, and concerns about the weaker outlook for the economy, have also roiled the financial markets in recent months."

Yes, of course. The banks are ailing from their subprime investments while Europe is sinking fast from $500 billion in unsellable asset-backed garbage. The whole system is clogged with crappy paper and deteriorating collateral. Now there are problems popping up in auction rate sales and the normally-safe municipal bonds. The whole financial Tower of Babel is cracking at the foundation. Bernanke continues:

"Money center banks and other large financial institutions have come under significant pressure to take onto their own balance sheets the assets of some of the off-balance-sheet investment vehicles that they had sponsored. Bank balance sheets have swollen further as a consequence of the sharp reduction in investor willingness to buy securitized credits, which has forced banks to retain a substantially higher share of previously committed and new loans in their own portfolios. Banks have also reported large losses, reflecting marked declines in the market prices of mortgages and other assets that they hold. Recently, deterioration in the financial condition of some bond insurers has led some commercial and investment banks to take further markdowns and has added to strains in the financial markets."

Bernanke sounds more like an Old Testament prophet reading passages from the Book of Revelations than a central banker. But what he says is true; even without the hair-shirt. The humongous losses at the investment banks have forced them to go trolling for capital in Asia and the Middle East just to stay afloat. And, when they succeed, they are forced to pay excessively high rates of interest. The true cost of capital is skyrocketing. That is why the banks are protecting their liquidity and cutting back on new loans. Most of the banks have also tightened lending standards which is slowing down the issuance of credit and threatens to push the economy into a deep recession. When banks cramp-up, the overall economy shrinks. It is just that simple: no credit, no growth. Credit is the lubricant that keeps the capitalist locomotive chugging-along. When it dwindles, the system screeches to a halt. ...

The banks are battered by their massive subprime liabilities. Housing is in the tank. Manufacturing is down. Food and energy are up. Unemployment is rising. And consumer spending has shriveled to the size of an acorn. All that is missing is a trumpet blast and the arrival of the Four Horseman. How is it that Bernanke's economic post-mortem never made its way into the major media? Is there some reason the real state of the economy is being concealed from "we the people"? Bernanke continues:

On the inflation front, a key development over the past year has been the steep run-up in the price of oil. Last year, food prices also increased exceptionally rapidly by recent standards, and the foreign exchange value of the dollar weakened.... (If) inflation expectations to become unmoored or for the Fed's inflation-fighting credibility to be eroded could greatly complicate the task of sustaining price stability and reduce the central bank's policy flexibility to counter shortfalls in growth in the future.

Right. So, if the Fed's rate-cutting strategy does not work and the economic troubles persist (and prices continue to go through the roof) then we are S.O.L. (sh** out of luck) because the Fed has no more arrows in its quiver. It is rate cuts or death. Great. So, we can expect Bernanke to hack away at rates until they are down to 1% or lower (duplicating the downturn in Japan) hoping that the economy shows some sign of life before it takes two full wheelbarrows of greenbacks to buy a quart of milk and a few seed-potatoes. Sounds like a plan!

We do not blame Bernanke. He has been remarkably straightforward from the very beginning and deserves credit. He is simply left with the thankless task of mopping up the ocean of red ink left behind by Greenspan. It is not his fault. He should be applauded for dispelling the decades-long illusion that a nation can borrow its way to prosperity or that chronic indebtedness is the same as real wealth. It is not; and the bill has finally come due.

Of course, now that the low-interest speculative orgy is over, there is bound to be a painful unwind of hyper-inflated assets, falling home prices, tumbling stock markets, increased unemployment, and a generalized credit-contraction throughout the real economy. Ouch. Who said it was going to be easy? Bernanke's summation:

At present, my baseline outlook involves a period of sluggish growth, followed by a somewhat stronger pace of growth starting later this year as the effects of monetary and fiscal stimulus begin to be felt. ... It is important to recognize that downside risks to growth remain, including the possibilities that the housing market or the labor market may deteriorate to an extent beyond that currently anticipated, or that credit conditions may tighten substantially further.

(Editor's translation) "Discount everything I have said here today if the economy blows up -- as I fully-expect it will -- from decades of regulatory neglect and the myriad multi-trillion dollar Ponzi-schemes which have put the entire financial system at risk of a major heart attack."

Bernanke's candor is admirable, but it is little relief for the people who will have to soldier-on through the hard times ahead. Perhaps, next time he could spare us all the lengthy oratory and just forward a brief cablegram to Congress saying something like this:

"We are deeply sorry, but we have totally fu**ed up your economy with our monetary hanky-panky. You are all in very deep Doo-doo. Prepare for the worst."

Our sincerest regrets,
The Fed

When Bernanke succeeded Greenspan, the assumption was that his job was to continue in the vein of his predecessor, "The Maestro", and hopefully inherit Greenspan's legacy in time. Things have not worked out that way. It turns out that Greenspan was a maestro at buffing up the facade of a system whose foundations were (a) rotting, and (b) going unrepaired, and then exiting, stage right, before the whole edifice collapsed. In retrospect, Greenspan probably wishes he had left a year or two earlier. His timing looks a little too propitious now.

SCRAP HEAP FOR FINANCIAL MODELS

Martin Hutchinson's "Bear's Lair" column on the PrudentBear.com website consistently rewards a reading. In his latest he avers that the current "credit crunch was not due simply to bull market over-optimism, but resulted very largely from the failures of a number of the financial models that have been a staple of the last generation."

This may be splitting hairs, but the semanticist in us would add that the everyone's willingness to buy into what obviously might have been total nonsense was a bull market phenomenon in itself. It was the equivalent of "news" that any market seizes on to go the direction it was going to go anyway. It was like a squadron's worth of pilots jumping into their planes and taking off without any of them doing a pre-flight check. That requires herd optimism of a most reckless nature. No matter, Hutchinson enumerates the models in useful detail. Subprime mortgages, asset-backed commercial paper, credit insurance, credit default swaps -- "the full catastophe", as Anthony Quinn in Zorba the Greek once expressed it -- get worked over.

As the crunch spreads its malign tentacles ever wider into every corner of global economic life, the dust of collapse after collapse is not even beginning to clear. However there are now coming to be things one can usefully say about those models, and about the assumptions on which they were based.

From what appeared to be a modest glitch in the mortgage market, the damage to the world of financial modeling is ever-extending, and has now come to be surprisingly widespread, involving huge swathes of modern financial theory:

• Subprime mortgages turned out to be correlated with each other, so that securities apparently rated AAA were in reality dangerously concentrated in a particular sector of the market that could and did collapse.
• That also blew out the theory surrounding monoline insurance, that a well capitalized insurance vehicle could insure debt representing a large multiple of its capital base, without its bond rating or profitability coming into question.
• Then there was asset-backed commercial paper, under which commercial paper of short term maturity was issued by a shell company against the backing of financial assets of a long term maturity, and through this means removed from a bank's balance sheet -- it turned out that in a financial crisis the funding for these vehicles dried up.
• Finally, credit default swaps are showing signs of strain, and may have turned out to have concentrated risk in unsuitable hands rather than spreading it as had been promised for them. In particular the counterparty problem in the CDS market becomes acute when defaults rise to a substantial level and declared debt ratings turn out to be unreliable.

As well as the instruments themselves, their risk management turns out to have been flawed. "Value at Risk", the paradigm of risk management systems, recognized by the Basel II system of bank regulation and incorporated into it, has proved to be almost entirely useless -- like rain-proofing that works well in a light shower, but falls apart completely in a heavy storm. The central assumption of VAR, that if you have measured and capped the moderate risks, then extreme risks will also fall into line at only a modest multiple of the moderate ones, has been proved wrong. In reality, if a particularly risk class goes wrong, it is capable of destroying an arbitrarily large amount of value.

The hapless David Viniar, CFO of no less an institution than Goldman Sachs, who announced last August that he was "seeing things that were 25 standard deviation events, several days in a row" had in reality announced to the market that Goldman Sachs's risk management systems were [useless]. 25 standard deviation events should happen once every 100,000 years; if you think you are seeing them several days in a row, you are merely proving that in reality you have no idea of the characteristics of the risks you are supposedly managing.

Modern financial theory rests on two fundamental axioms: that markets are efficient, in the sense that there are no profits to be made legally by superior analysis or better information, and that price movements are in some sense random, so that risks can be assessed using standard well-understood Gaussian distribution analysis. In reality, neither assumption is true: superior analysis [or a superior investing philosophy] can indeed allow you to earn superior returns, and markets can from time to time behave in a highly non-random manner, jumping in price far more than would be suggested by analysis of past price patterns.

Subprime mortgages and derivative paper.

Whether or not modern finance rested on false assumptions, an enormous amount of money has been made by betting that they were true. If the market is thought to price all risks automatically, then even the dopiest mortgage broker can originate subprime mortgages for even the least creditworthy borrowers. The fact that the borrowers are incapable of making payments on the mortgage will magically be priced into the mortgage by the securitization process, which will bundle the mortgage with other mortgages originated by a similarly lax process and sell the lot to an unsuspecting German Landesbank attracted by the high initial yield. Everybody will make fees on the deal, everybody will be happy, and the Landesbank and the homeowner will have nobody legally to blame when the homeowner is unable to make payments and the Landesbank finds a shortfall in its investment income. By making the market responsible, modern finance has removed the responsibility of all the market's participants.

Looked at in this way, the subprime mortgage is simply a scam, and the market a giant Ponzi scheme that could survive only as long as more people entered into subprime mortgage contracts, keeping house prices high and mortgage brokers active. Once interest rates began to rise, the demise of the market became inevitable, and it also became clear that the market was not simply entering a downturn but would disappear altogether. In 10 years' time, only Fannie Mae and Freddie Mac will be making subprime mortgages, and they will exist only because they have been bailed out by the taxpayer through the generosity of their friends in Congress, possibly several times.

It is fair to point out that many people, including Hutchinson and his PrudentBear.com colleagues, have been pointing out the Ponzi nature of the subprime market, and modern Wall Street finance as a whole, for years. But, as the description of the scheme above implies, the party was too much fun to think of pulling the punch bowl -- not only before the partygoers passed out, but before they incurred acute alchohol poisoning.

Asset-backed commercial paper (ABCP).

Asset-backed commercial paper (ABCP), too, is unlikely to recover from its drubbing in the market. Investors will no longer believe that commercial paper can automatically be renewed, whatever the illiquidity of the assets and regulators will no longer believe that setting up assets in a separate vehicle funded by the commercial paper market automatically allows those assets to be removed from a bank's leverage calculations.

Credit insurance via the monolines.

Monoline insurance is an interesting hybrid case. There is no question that insuring pools of real estate debt or other assets to bring them to a AAA rating is like the subprime mortgage business themselves and ABCP, an economic activity that should be lost to the mists of history. However, there is a rather more worthwhile business -- that originally undertaken by monoline insurers -- that provided credit assurance to small municipalities, who by their size were unable to tap the public markets effectively on their own. By assembling a substantial pool of funding requirements from a number of municipalities, and putting a single guarantee over the entire pool, a careful monoline insurer is not assuming any excessive credit risk, but simply allowing small borrowing needs to be aggregated efficiently into larger ones.

There is some risk that a real estate downturn such as we are witnessing could remove the funding base for a high proportion of the nation's municipalities, by dragging down property tax valuations, but generally that risk is concentrated in the larger, higher taxing jurisdictions for which monoline insurance is not particularly economic. Thus, though the monoline insurers may disappear because of their non-municipal business, it is likely that other monoline insurers will take their place, funded by the deep pockets of the likes of Warren Buffett, and that these new insurers will continue to have a stable if not very exciting business --the quintessence of a good insurance business, in short.

Credit default swaps.

Credit default swaps (CDS), on the other hand, would appear almost pure scam, with very little reason for their existence. Credit assessment is a difficult task, better undertaken by specialist entities such as banks with a deep knowledge of the borrower. That is why rating agencies were invented, to allow bond investors to purchase credit products without the need for detailed credit assessment. However, credit default swaps allow the banks that best know a credit to sub-underwrite it not among other banks who might be supposed to have sophistication in credit assessment, but among institutional investors who generally do not have such sophistication. Further, the amount of credit default swaps written need bear no relationship to the size of the credit itself. Thus the original lender may "go short" in the credit risk by writing CDS for more than the amount of the loan.

Needless to say, the opportunities for chicanery and malfeasance in such a business are legion, and made more manifold by bonus systems which reward bank officers and brokers for the business done in a particular year, without regard to the losses that business may produce in later years. Risk assessment in this business is a joke. The VAR models that fail in assessing the risk of a broad-based portfolio fail even more spectacularly in assessing a narrow-based portfolio of credit risks, in which correlations between different assets are not properly explored and for which the experience is at most a few years. In spite of their convenience to loan originating banks, it is thus likely that the market for credit default swaps will in future be very limited indeed.

When all these products are taken into account, it becomes obvious that the financial system of the future will look very different from that of the recent past. Shareholders will pay much more attention to the conflicts of interest between traders', brokers' and bank officers' bonus schemes and their own returns. Opportunities to make large amounts of money by pure salesmanship, without regard as to the quality of the underlying assets, will disappear. Risk management will become much more conservative, and will treat exotic and little-understood assets with the utmost suspicion. That in itself will greatly limit the market for profitable "financial engineering" creativity.

The percentage of finance's value added in the U.S. and world economy will shrink once again, close to the levels of the 1970s and 1980s, around half those of today, and remuneration for bankers, traders and salesmen will be correspondingly more restricted. Since new career opportunities on "Wall Street" will be few and far between, there will be an aging in place of existing staff, which will itself increase those institutions' conservatism, probably replacing it with gerontocracy.

Eventually, perhaps not before 2030, another financial revolution, immensely profitable to its participants, will begin. It is undoubtedly the case however that the new revolution will involve products and sales methodologies far different from those of recent decades.

Note that the discredited assets laid out bare are basically creatures that escaped their narrow niches in the 1990s and ballooned into full flower this decade. Like, e.g., the institutionally-beloved "Nifty 50" stocks of the early 1970s that you supposedly bought and never sold (until they declined by 80% and were cheap), these assets as a credible investment class will disappear to whence they came.

Whether the whole idea of an "efficient market" will be discredited is another matter. That would render obsolete half the finance literature, which is a much more serious loss than trillions of dollars. If the assumptions about Gaussian ("normal") distributions have to be relinquished, the mathematical tractability of financial models would be severely, if not mortally, wounded. One must guess that this one will go down hard as well.

THE BREAKDOWN OF WALL STREET ALCHEMY

In this missive from Doug Nolan, he provides another in a series of "news directly from the front" type reports on the breakdowns in credit markets behind the credit crunch. It complements the piece by Martin Hutchinson noted immediately above (they both publish on PrudentBear.com, so this is no mere coincidence). Hutchinson highlights the breakdown in the convenient theories that provided the rationalization for all the imprudence, while Nolan duly reports on the reverberations in finacial markets and, increasingly, the real economy.

This week provided further confirmation of ongoing momentous credit market developments. ... On numerous fronts, the markets and economy confront a highly problematic breakdown in "Wall Street Alchemy" -- the disintegration of key processes that had for some time transformed ever-increasing quantities of risky loans into perceived safe and liquid debt instruments that enjoyed insatiable demand in the marketplace.

In the case of the "auction-rate securities," it was a clever restyling of long-term and generally illiquid municipal debt (as well as student loans and other borrowings) into perceived liquid securities that could be easily sold at regularly recurring auctions (every one to a few weeks). With scores of flush corporate treasury departments and wealthy clients (managing huge credit bubble-induced cash flows) keen to earn extra (after-tax) yield on "cash equivalents," the Wall Street firms had been diligent in ensuring (making markets for clients, when necessary) a highly liquid and enticing marketplace.

Now, with the onset of risk revulsion and acute financial sector balance sheet pressures, investors are running for cover and Wall Street firms are shunning the use of their own capital to support this and other markets. Market liquidity has evaporated, confidence has been shattered, and we are witnessing yet another "run" on a previously popular risk market/asset class. The music has stopped for another game of musical chairs.

This week [Feb. 11-15] saw heightened systemic stress stampede toward the epicenter of the U.S. credit system. It certainly did not help that insurance behemoth AIG Group reported an almost $5 billion writedown of its credit default swap portfolio or that international securities dealer behemoth UBS reported massive losses on its U.S. credit positions. Confidence was further shaken by huge losses reported by mortgage insurers, as well the twists and turns of the "monoline" bust turned apparent bailout. In the markets, various indices of investment grade credits widened sharply to record levels. The key "dollar swap" (interest-rate derivative hedging) market saw spreads widen sharply.

Agency spreads also widened significantly. Benchmark Fannie Mae MBS spreads widened a remarkable 20 bps against 10-year Treasuries, while agency debt spreads widened a noteworthy 12.5 basis points to 69.5 bps (high since November). The breakdown of Wall Street Alchemy is now pushing the credit market dislocation uncomfortably close to the core of our monetary system.

I will return to financial aspects of this crisis, but I definitely feel the economic ramifications of the unfolding credit crisis are receiving short shrift in the media. This week saw parts of the municipal debt market grind to a virtual halt and the corporate debt market take another significant blow. Investment grade debt issuance has now slowed markedly after beginning the year at near record pace. At this point, the junk, CDO, ABS, "private-label" MBS, muni, and even investment grade debt markets are all somewhere between impaired, dislocated and completely dysfunctional. There is no mystery behind the recent string of abysmal economic reports. ...

Falling national home prices are clearly wearing on confidence. This week, Dataquick reported that home sales throughout much of California have collapsed to more than 20-year lows, while home price declines accelerate. This is a huge unfolding issue/debacle for the MBS, agency, mortgage insurance, CDO, and credit derivatives markets, not to mention the U.S. banking system and real economy. Countrywide Financial reported delinquencies on its $1.5 trillion mortgage servicing portfolio had jumped to 7.47%, up from the year ago 4.32%. The New York "Empire" Manufacturing index sank to the lowest levels since April 2003.

The economy is now faltering badly and there is every reason to expect the downturn to gather pace -- negative real interest rates compliments of the Fed and stimulus package compliments of the federal government notwithstanding. ... Importantly, total (financial and non-financial) corporate debt expanded at an 11.1% rate during the first three quarters of 2007, followed by 9.3% growth in state and local government borrowings. And while residential mortgage debt was slowing meaningfully, commercial mortgage debt was expanding at an almost 13% rate.

Total (financial and non-financial) credit expanded a seasonally-adjusted and annualized record $5.0 trillion during Q3 2007 -- as nominal GDP expanded at a 6% pace. While many trumpeted the "resiliency" of the U.S. economy in the face of mortgage and housing woes -- more adept analysis would have focused on the massive credit creation that had come to be required to sustain the Bubble Economy. Importantly, the faltering subprime market initially instigated only greater excesses throughout commercial real estate, municipal finance, M&A finance, and corporate lending more generally. The credit bubble was sustained at the great cost of heightened instability and weakened structures -- especially throughout leveraged lending, state and local finance, and investment-grade corporate borrowings. Keep in mind that through the third quarter CDO issuance was actually running ahead of 2006's record pace. Until the fourth quarter, record credit growth continued to fuel the finance-driven economy. This is all now coming home to roost.

Today, with bursting bubbles in corporate and municipal finance joining the mortgage bust, the U.S. bubble economy has quickly fallen desperately short of sufficient credit and liquidity. And the greater the credit market dislocation and broad-based tightness of credit, the bleaker become economic prospects and the more intense the revulsion to Wall Street's credit instruments. The days of free-flowing cheap finance for home buyers, state and local governments, LBO firms, commercial real estate speculators, college students, risky auto buyers, and high-risk credit card holders are over -- and they will not be returning for some time to come.

When I have previously underestimated the "resiliency" of the U.S. credit bubble and economy, it was in each instance a failure to appreciate the capability of Wall Street finance to expand to ever greater degrees of Bubble excess. Today, with "contemporary finance" mired in a historic collapse, I am confident that the credit system is today only in a position to surprise on the downside. It is this framework that shapes my view of a rapidly escalating credit crisis feeding an arduous economic adjustment period.

As was the case for many of us who watched -- with surprise, disbelief, and then horror -- the credit bubble of this decade unfold, Nolan underestimated just how far a bubble could inflate. He is hardly the first to prematurely predict a top to a mania.

And while it could undoubtedly prod a highly speculative stock market, there is no resolution to the "monoline" dilemma that would meaningfully influence the trajectory of the unfolding credit and economic bust. As we have been saying for awhile now, confidence in Wall Street finance has been irreparably shattered. Trust has been broken in "AAA" ratings, "mark-to-model," CDO structures, myriad risk models, credit insurance, counter-party risk, and various instruments and vehicles for intermediating risk in the markets. Moreover, old fashioned lending will not come close to sufficing the demands of a highly imbalanced bubble economy, especially with bankers nervous and retrenching. Again, we are witnessing nothing less than the breakdown of Wall Street Alchemy -- one that took a turn for the worst this week.

In a disconcerting development, recent market developments seem to confirm that the leveraged speculating community and the GSEs are poised as the next shoes to drop -- the next dominoes in an escalating contagion. Along with the "monolines" and mortgage insurers, the "credit default swap market" and GSE mortgage risk intermediation were at the epicenter of the most egregious systemic risk distortions and accumulations. They are now quickly moving to the forefront of current acute fragilities. Simplifying highly complex circumstances, the various risk models that empowered the greatest leveraging of risk in the history of finance no longer function as expected -- or as required to maintain highly leveraged exposures to a multitude of escalating risks. And it was all just only a matter of time. The overriding flaw was to ignore that a runaway bubble in market-based finance ensured that various market and credit risks all coalesced into one massive, unmanageable, highly correlated, unhedgable, undiversifiable association of interrelated systemic risks.

GERMAN STATE-OWNED BANKS ON VERGE OF COLLAPSE

Worst financial crisis since 1931?

It has been obvious to many for a long time that investing in U.S. subprime loans was a fool's game. You got an extra percentage point or two in yield in exchange for risking a hefty chunk -- possibly all -- of your capital. Who bought the paper backed by this crap? The answer will end up, we are sure, that it was almost all bought by those speculating with other people's money. A healthy portion of the world's financial assets are managed by agents rather than directly by principals, so this is not exactly a long shot bet. But it nevertheless does distinguish the mortgage credit bubble from, e.g., the dot-com bubble where day traders were speculating on their own dime.

The "principal-agent problem", as studied by economists, asks how a game can be set up, with what rules, so that the agent is induced to act in behalf of the principal's best interests. Consider a mutual fund operator who collects a fee of 1% of assets under management. His/her main priority will be to not do anything that would cause fund investors to pull their assets. The possible loss in fee income from losing the assets dominates the gain in fee income obtained from a few extra percentage points of returns. Knowing that as long as performance is not terrible that fund investors will tend to stay put, fund managers will try to perform acceptably versus their closest competitors, or versus an index that is warranted to embody the manager's professed investment style. This is, in essence, a recipe for mediocrity. Fund investors can expect to break even, opportunity cost-wise, minus fees and commissions.

Consider, on the other hand, a hedge fund manager who collects a fee of 2% of assets under management plus 20% of realized capital gains, but who suffers no fee decrement for capital losses. Add to this that the manager can close the hedge fund at any time, such as when cummulative losses get large enough so that the chance of getting back into positive -- 20% fee cut -- territory is unlikely. Clearly the incentive here is to take big risks that might result in a big payday of 20% of the gain realized. If the bet does not pan out then, oh well, tomorrow is another day. This is why Warren Buffett called hedge funds compensation schemes for managers, as opposed to an investment asset class.

What about a loan or investment officer working at a bank? It depends a lot on the culture of the particular bank. If the bank's management has been through a few cycles they may have learned their lesson. Many bank managements act as if they are unaware there are such lessons to be had. If the bank's culture encourages a mindset like that of venture capital or private equity partnership managers, the funds under a loan officer's purview will start to burn a hole in his or her pocket after a while. They are paid to loan the money out, not sit on their hands. And if you have to reach down the quality spectrum of would-be borrowers to get the business, well, that is because your fellow loan officers are forcing your hand. Somewhat similar to the mutual fund managers above, the incentive is to follow the herd -- even off a cliff.

Just how far down this quality spectrum bankers have been willing to go is evidenced in how much U.S. subprime mortage-backed paper has shown up on bank balance sheets in the last year. Oddly, among the biggest victims have been state-owned German banks. One might expect German banks to be conservatively run based on how the Bundesbank used to run (pre-euro) German montary policy. But no. Instead we see a bad combination of managers investing (so to speak) other people's money while being unaccountable for even having to explain their actions. Of course, this is government in a nutshell -- with a little leverage to speed up the cause-and-effect chain reaction added for good measure.

The German government has had to bail out state-owned banks with taxpayers' money after their managements recklessly gambled away billions on subprime investments. But if a state-owned bank were to go under, the consequences could be disastrous for the whole economy.

Ingrid Matthaus-Maier, a member of the center-left Social Democratic Party (SPD) and the CEO of the state-owned KfW banking group, is undoubtedly in one of Germany's highest earnings brackets. ... That is nice for Matthaus-Maier. A lawyer by profession who was a financial expert for the SPD for many years, she would not have been able to get on the board of a private bank in 1999, the year she joined the board of KfW -- she lacked the banking experience required by law. But KfW is not subject to the same regulations as other banks, which explains why Matthaus-Maier does not owe government auditors an explanation -- not even now, in the wake of recent public accusations that she botched the IKB crisis.

As the head of KfW, Matthäus-Maier is a major shareholder in IKB, the Dusseldorf-based bank that is on the brink of bankruptcy and is only being kept afloat by a series of government bailouts running into the billions. Last week was marked by one crisis meeting after the next, but the headstrong government banker had more than the future of IKB on her mind. Indeed, she seemed more concerned about her employment contract and whether it would be extended. ...

Two days later, it was announced that former IKB CEO Stefan Ortseifen could look forward to a princely retirement pension of €31,500 a month -- effectively a token of appreciation for his failures. Ortseifen, after investing billions in the high-risk U.S. subprime mortgage sector, insisted that the "uncertainties in the American mortgage market" would have "practically no effect" on IKB's investments. A few days later, IKB was on the verge of bankruptcy, with its supposed wonderful U.S. investments worth little more than the paper it was printed on.

German banks are not the only ones being hard hit by the subprime crisis. In the UK, the government earlier this week announced plans to temporarily nationalize the troubled bank Northern Rock until market conditions improved. The bank ran into difficulties last year as a result of the global credit crunch and was forced to ask the Bank of England for a bail-out. ...

Ortseifen and Matthaus-Maier are perfect examples of the fatal mix of amateurism, greed and political protection that is symptomatic for many of Germany's state-owned, partially state-owned and public sector banks. It is an environment that can only thrive in the shadow of the state -- and that has drained more than €20 billion from the public treasury within the last decade.

Until now, the government has always been there to pick up the tab in the end. Fully aware of this safety net, the executives at state-owned banks gambled with their employers' assets as if there was no tomorrow. Munich-based BayernLB did it with stocks in Singapore, Bankgesellschaft Berlin with real estate investments, and WestLB with holdings in British companies.

Anyone who is not responsible for bearing the consequences of the risks he or she takes can easily turn into a gambler. And the bets kept increasing in recent years, getting more and more public-sector banks into financial hot water. Now the banks find themselves lacking the assets they need to weather the turmoil of an international financial crisis. ...

The situation for Germany's public banks has become so dramatic that it threatens to topple what has been one of the key pillars of the country's banking system. The state-owned banks are supposed to bail each other out when necessary, but the problem is that many are in trouble themselves and hardly in a position to help their peers. And things could get even worse.

If an industry giant like WestLB were forced to its knees -- which almost happened two weeks ago -- at least two other state-owned banks and a dozen savings and loan associations would crumple along with it. The member banks of the German Savings Banks Finance Group (Sparkassen-Finanzgruppe) are closely interlinked, and they are required to vouch for each other -- as long as they are in a position to do so, that is. The failure of a major state-owned bank like WestLB would also inevitably affect corporate customers, even forcing some into bankruptcy.

It is a nightmare scenario that the government financial supervisory authority now believes is increasingly likely. Germany's public-sector banks speculated far more heavily than private banks in American subprime mortgage securities. Now these banks' beleaguered executives are calling on the government to bail them out from a disaster of their own making.

It is a paradoxical situation, because the government, responding to pressure from Brussels, was required to withdraw its guarantee of protection for state-owned banks as of July 2005. Since then, it has only been liable for risks incurred before that date. The consequences of the change were devastating for the public-sector banks, which suddenly found their business model pulled out from under their feet. In the days of government backing, they were able to borrow money at lower rates, which in turn allowed them to offer loans at lower rates than their private competitors. But that advantage ended in 2005.

Hard up for funds, many of the public-sector banks began speculating with high-risk securities. According to a former bank executive, many "literally stocked up on these investments" shortly before the cut-off date. Others even continued to do so after the cut-off date. Lacking a functioning business model, they turned to what was essentially gambling -- and lost.

The hard-hit German banks are now trying desperately to save their skins. The situation is most dramatic at Düsseldorf-based IKB, the first German bank that was almost driven into bankruptcy by the U.S. real estate crisis. Last week, once again, IKB's equity capital vanished into thin air. ... KfW, IKB's biggest shareholder, was no longer able to bail out the Düsseldorf bank without jeopardizing its official mission, namely supporting small and mid-sized businesses.

In the end, the federal government and private banks came up with the funds for the bailout. For Finance Minister Peer Steinbrück, it was critical that IKB not be allowed to go under. The bankruptcy of a bank with such a high credit rating would trigger an unprecedented loss of confidence in the German financial market. ... "The issue here is ultimately about choosing the lesser evil, and about what is less damaging to the economy," Steinbrück explained ...

Coverage on the U.K. version of government bank bailouts, albeit not government-owned banks, may be found here.

BEAR MARKET OPPORTUNITIES

Make a shopping list.

Bear markets are a good time to wait for stocks on your buy list to fall to prices that constitute values. Some will actually get there. Chris Mayer of Whiskey & Gunpowder even has a couple of ideas that look reasonable now.

Adversity breeds opportunity. That is how financial markets work. I am not sure if the global stock markets have suffered enough adversity lately to create really great opportunities, but I am keeping a close eye on the situation. And I would advise you to do the same. It is time to make a shopping list.

Back in 1986-1987, Bank of America wrote off $1.5 billion in bad loans, wiping out its reported earnings. Analysts asked Sam Armacost, the bank's president, where the problem areas were. Sam's classic response: "Have you got a globe?"

That is how it feels with today's mortgage bubble finally popping. Problems seem to crop up everywhere, with a long list of financial firms taking a beating from subprime losses. It is so bad out there that central banks around the world have been pumping tens of billions of dollars into the short-term credit markets.

Okay, so we know it is bad "out there" ... But are financial conditions so bad that there is not one single stock to buy? In the stock market carnage of 2000, for example, you could have picked up any number of oil and gas companies on the cheap. You could have bought REITs (real estate investment trusts), homebuilders and gold. These are just some examples. You did not even have to be particularly smart about which ones you bought. You just had to have the guts to put the money down and the patience to hang on.

Sometimes it is best not to try to predict where the market is going to go. My favorite investor of all-time is Marty Whitman, who runs the Third Avenue Fund. I looked back and read what Whitman wrote to his shareholders back in 2000. In April 2000, near the peak of the bubble, Whitman told his shareholders that the overall market was not important. He criticized Tiger Robertson, a successful fund manager, for closing his fund. Tiger wrote to his shareholders: "There is no point in subjecting our investors to risk in a market, which I frankly do not understand."

Whitman responded: "If understanding a market means, as it obviously means for Robertson, understanding fluctuations in securities prices, then I can safely state that I have been in the investment business for almost 50 years and I still do not understand markets -- never did, never will. Understanding the market belongs to the realm of abnormal psychology." Instead, Whitman advises focusing on understanding companies and specific investment opportunities. The rest would take care of itself over time. And even though the overall market appeared to be in nosebleed territory, Whitman wrote that many common stocks were "dirt cheap."

So where are those pockets of opportunity today? While the market trades at 18 times earnings, you can pick up Loews Corp. (LTR) today for only 11 times earnings -- less than 10 times the estimate for 2008. This is a company loaded with cash. It trades at a discount to NAV. Plus, you get the Tisch family, which has a great track record of creating wealth for shareholders. Over the last 25 years, the average annual return on Loews stock is 17%, versus only 11% for the S&P 500. So you tell me, does this stock really deserve to trade at only 60% of the market multiple?

Down in South America, the shares of Argentinean property developer, IRSA (IRS) [a memorable ticker symbol!], also seem very cheap. This owner/operator of commercial real estate sells for about 17 times earnings and 1.2 times book value. IRSA is also in good financial shape, with little debt and ample cash. But the real sex appeal of the stock is the fact that its real estate portfolio is worth much more than the current share price. Additionally, rental rates continue to increase as older leases expire. Therefore IRSA has many things I like: Tangible assets that sweat (or that throw off cash and increase in value over time), a strong financial condition and a cheap share price. What we have here is an asset story ... with a high-growth kicker.

Another real estate-focused company, Cohen & Steers (CNS), also looks like a great value at it current quote of $25.92 a share. The stock price has been nearly cut in half since hitting $41 a share last October. The good news is that the company's real estate has not gone away. It sits right where it did last October and earns the same rental income. The only thing that has changed is the share price.

Cohen & Steers is primarily a money manager of funds that invest in real estate. The company's tumbling share price reflects the widespread anxiety that the credit crunch will cause a global economic slowdown, which could reduce the company's cash flow. But I doubt Cohen & Steers will suffer a serious decline in earnings, if any at all. Besides, the company's debt-free balance sheet provides a great deal of protection against bad times. Additionally, the two principals own 60% of the stock. If it gets too cheap, they could buy back the other 40% and go private.

THE ONE METAL THAT SECRETLY CONTROLS THE ENTIRE ENERGY INDUSTRY

As the 1970s bull market in commodities was culminating, and people were looking for something/anything in the way of a theretofore neglected play in the arena, a brief but expensive -- for those who bought in -- captivation with "strategic metals" took off. The world was supposedly running out of everything, including those metals whose total yearly consumption was small but which played vital roles in industrial production. Suggestions were floated that the U.S. should create strategic stockpiles of the metals similar to the Strategic Petroleum Reserve, including -- incongruously, for those of us who remember finding it virtually everywhere in rocks as kids -- mica.

30 years later, a multitude of similar "demand is going up and supply is running out, and so prices will go through the roof" forecasts are being trotted out. Oil and uranium are prominent members of this not-so-exclusive club. How many of these scenarios will actually work out this time? Hard to tell. Left to its own devices, the free market consistently makes fools of "We are running out of X" forecasters. Sometimes it takes a few years of high prices to kick a search for substitutes into gear. Enough resource industry veterans remain who remember the collapse in prices that followed the 1970s boom that this process may take longer to play out than otherwise.

This analysis of the molybdenum market follows the standard outline. It sounds like a compelling case, but these analyses always sound compelling. It appears plausible that a spike in prices could happen a couple of years from now when demand exceeds capacity. After that it is anyone's guess.

The name of the game is molybdenum, or just "moly" for short -- but for your sake and mine, I looked up the pronunciation: muh-lib-duh-nuhm. This metal has several interesting characteristics that make its usage integral to several forms of energy creation.

Moly has the 6th highest melting point of any element. It is highly corrosive resistant and does not expand, contract, harden, or soften under extreme temperature changes. In fact, of all the commercially used metals, moly has the lowest heating expansion. For example, moly is used in making stainless steel; hence the corrosion resistance and life span of your shiny ratchet set.

Moly is added to steel and cast iron to make metal alloys and superalloys that are much greater in strength. It can be found in anything from airplanes and cars to construction beams and filaments. This metal has tons of application and ... is used in almost every aspect in the world of energy. ...

It can be found in almost every modern drill. It greatly increases the strength of the drill and can limit technical mishaps, reducing costs. In that sense, moly is needed in every aspect from drilling exploratory holes in an oil and natural gas field to drilling the production and injection wells that go into getting a geothermal power plant up and running.

You can also find moly in the coal field. If it is a longwall mining operation, it can be found in the shearers used to extract the coal and the conveyers used to transport it. In an open-pit, truck-and-shovel operation, moly is again used in both the extraction and transportation processes.

The corrosion resistance, combined with temperature insensitivity, makes moly very important in the production of oil and natural gas pipelines. ... Molybdenum is also used as a hydroproccessing catalyst in petroleum production. In English, moly is used to remove sulfur and nitrogen in making light, sweet crude. ... Canadian oil sands and the tar oil from Venezuela are examples of oil that contain high levels of external elements that need to be purged in order to create light, sweet crude oil.

Molybdenum can be found in every modern turbine used in a power plant. All power plants, except wind and water, directly use heat to turn a turbine. In the highly abusive environment of a turbine, strength, corrosion resistance, and heat insensitivity make moly the perfect industrial metal for power plant turbines. It greatly increases the life span, reducing the cost of the power plant. ...

Molybdenum's contributions to the world of nuclear energy are by far the most significant. Without molybdenum, the nuclear world would be set back at least 20 years. Newly developed high-performance stainless steel (HPSS) contains up to 7.5% moly. ... This alloy can more than triple the life of aging fleet condenser tubes. Fleet condensers, which are rather large, are used in the heat transfer process. Brass, copper, and nickel made up the alloys previously used in fleet condenser tubes. Although these alloys were efficient in conducting heat, their life span was only eight years. HPSS conductors were brought into play about 30 years ago. As of right now, the longest HPSS conductor has remained in service for over 26 years and is still going strong. ... Corrosion resistance leading to less buildup of undesirable substances increased the capacity of reactors by up to 20%.

The importance of molybdenum in nuclear energy is undeniable. But it is also used in harvesting every other form of energy. Moly is the only way you can play these markets all at once. Just because moly is vital to these markets does not necessarily mean that there is a bull market in this industrial metal. But, the supply-and-demand picture proves there will be ...

Supply for molybdenum faces a similar conundrum to that of oil. Although there is current mine production significant enough to meet demand, refiners, or roasters, are expected to run into a shortfall. Guesses on when this shortfall is estimated to come fall somewhere between 2009-2015, depending on demand. Yes, that is kind of a large range ...

A roaster is similar to a refinery in that it processes the moly into a fine powder, pellets, or any other form of refined moly used in the industrial world. Total world moly roaster capacity can currently put out at an annual rate of 320 million pounds. That 320 million pounds also barely meets global demand. There is not much more roasting capacity left. The problem is that there is no one actively permitting for the production of any new roasters here in the U.S., and roaster production looks grim on a global level as well.

The exact date is impossible to predict, but a roaster shortage is definitely on its way. The data above are based on one very important assumption. The assumption is that mines will also be able to increase their output. Western demand looks to increase by around 3% annually, while China and the CIS are looking at a demand increase of around 10% annually. Globally, demand is expected to increase at around 4.5% per annum. Unless moly mine production picks up at a rapid pace, shortfalls of the silvery metal are expected to arrive around 2009. Note that we are talking about mine production, and not roaster capacity anymore.

This increasing demand can be attributed to two main factors. Hydroprocessing catalysts are becoming essential in today's market for crude oil. The other contributing factor is the increase in nuclear reactors planned for production. There are 48 nuclear reactors to be built by 2013, and approximately 100 are to be built by 2020. ...

China currently produces around 20% of global production. If global supply is able to keep up with global demand, which I sincerely doubt, we are still looking at China beginning to hoard the 1/5 of global production that it currently produces. ...

The supply-and-demand picture presents us with a double-edged dagger: Roaster shortages are unable to keep up with growing demand or mine production is unable to keep up with growing demand. I see both of these scenarios as very likely, but only one is necessary to send the price of molybdenum to new highs. As one or both of these scenarios come to light, expect China to limit and eventually negate exports, only throwing gasoline on the already blazing fire.

There are not many molybdenum plays, but we did find one ... China Molybdenum Co. Ltd. (HK: 3993). Trading on the Hong Kong Exchange is both difficult and expensive. If you are serious about an investment like this, consult your broker. Until that one becomes more readily available, we will keep our eye out for others just like it.

THE SINGLE BEST WAY TO TAKE ADVANTAGE OF THE INCREDIBLE AGRICULTURE BOOM

Agricultural commodities have been in a massive bull market for several years now, with prices having decisively moved above their old late-1970s highs. Some of this is due to supremely ill-advised government encouragement of ethanol and other bio-fuels production, but it is undeniable that worldwide demand for grains in their tradition use as foodstuffs is a major factor.

How high the moon? Who knows. Here is a suggestion for speculating on the bull market without going long agricultural product futures market contracts.

It is impossible to deny the booming agricultural commodities market. It has simply been all over the news. Whether you are aware of this in a positive sense because of portfolio profits or in a negative sense from inflation at the grocery store is irrelevant.

The beautiful thing is that the biggest profits are still unrealized and the true potential is still unreleased. Before I discuss this fantastic company set to make big profits off of the boom, I would like to give you my perspective from the wheat pits on the trading floor of the Minneapolis Grain Exchange as to the scope of the agricultural boom thus far.

Minneapolis wheat for March delivery hit an intraday peak on Friday, February 15, of $19.80 before closing slightly below that number. At that peak, wheat traded with as high as a $4.25 gain on the week. Can anyone say $20 wheat? The March contract has traded limit up in every trading day except Friday. That includes the historic doubling of limits that started Monday. After multiple contracts traded limit for consecutive days, on Wednesday, limits were again increased by 50%, according to exchange rules, but they did not stop there. We again had multiple contracts trading limit on Wednesday and Thursday. This means that another 50% increase in exchange trade limits was in order. ... This past Friday, limits were 30 cents. On Monday, they were 60 cents, Wednesday was 90 cents and this Friday until the following Wednesday, the futures contracts for Minneapolis wheat will trade with a $1.35 limit.

In wheat futures, each cent equates to a $50 gain or loss per contract (1 futures contract = 5,000 bushels of wheat) depending on whether you are long or short. So let us say you had bought one futures contract for March wheat on this past Friday's close and sold it during the recent Friday's intraday peak. You would have made more than $21,000 ... on one contract. ...

Soybeans also closed at a record high this week, and corn has been, and will continue to be, an astounding investment. Agricultural commodities are hot ... really hot. However, not all the big money is going to be made in commodities. A lot of it will come from the equities market.

You need look no further than seed and fertilizer giants such as Potash, Monsanto and Agrium. Just look at a 6-month or 1-year chart of these companies. If that does not do it for you, then check out the most recent earnings of these particular companies and you will be quite impressed. ...

I have a penny stock that has the profit potential of the options market, but carries the potential risk of a large-cap stock. The name of this particular stock is Hanfeng Evergreen (HF: TSX; HFGVF: PINK SHEETS). This company is attractive for a couple of reasons. Not only is Hanfeng a manufacturer and distributor of fertilizer, but the majority of its sales are located in China. ... Not only do you have access to the massive profit potential of the agricultural markets, but you can also gain exposure to the Chinese markets. Recent financials showed a 144% increase in sales and a 248% increase in earnings over the last nine-month period. Another fantastic positive for this company is that the NPK slow-release fertilizer that HF uses was just named an industry standard, giving the company a leading product. These are all positives going forward.

THE BEST INVESTORS NEVER ATTEMPT TO BALANCE THEIR PORTFOLIOS

Here is more fuel for the diversify your investments vs. concentrate on your best ideas debate. Note that some might contend that what is being discussed here is "speculation" rather than "investing". In January we flagged a two-part series (see here and here) by Michael Rozeff, "On Sound Fundamental Principles of (Passive) Investment" and its followup, which drew exactly such a distinction.

Most investment advisors would advocate a "diversified portfolio." Warren Buffet says to "put all your eggs in one basket and watch that basket." We are inclined to trust the billionaire's judgment. A diversified portfolio delivers comfort. But a concentrated portfolio -- in the hands of a savvy investor -- can produce excellence.

The name Nick Train probably means nothing to you. He runs the Finsbury Growth & Income Trust, a mutual fund that has posted a total return of 144% over the past five years. How did Train deliver those fancy returns? By running a concentrated portfolio. Train holds only 23 stocks. Most funds invest in hundreds. Train seldom sells a stock. Most funds turn over their entire portfolio in a year's time.

Most great investors pursue a similar strategy. ... Warren Buffett probably needs no introduction. He may be the greatest investor who ever lived. If you study his portfolio over the years, a couple of interesting things stand out. The first is the fact that Buffett owns large amounts of relatively few stocks. On average, over the past 30 years, Buffett's top five holdings made up 76% of his total portfolio. Also, Buffett held onto his stocks for nearly four years, on average. That is a far cry from the annual flipping most investors do.

Now, what about that guy who did a shade better than Buffett? His name was Claude Shannon. He was a brilliant scientist whose work lies behind computers, the Internet and all digital media. Shannon was also a director for Henry Singleton at Teledyne. I wrote a bit about Singleton and Teledyne in my last letter to you.

Well, Shannon also invested his own money in the stock market. He did not start with much money when he first started investing in the 1950s. But what is amazing is the return he made over time. From the 1950s-1986, Shannon racked up an annual return of 28%. That is better than Warren Buffett's. How did he do it? ... Shannon's approach to investing could hardly be simpler. He was a simple buy-and-hold fundamentalist.

When researchers dug up his investment portfolio, like archeologists poking around for the Holy Grail, they found something that would have appalled any modern financial adviser. They found that his three largest positions made up 98% of his portfolio. Nearly 80% of his account was in a single stock, Teledyne. Shannon's original cost was only 88 cents, after adjusting for splits -- a mere penny stock. By 1986, a share of Teledyne was worth $300.

So much for diversification. "We have not," Shannon once explained, "at anytime in the past 30 years, attempted to balance our portfolio." Shannon, mind you, was 70 years old at the time and fully invested in stocks. Talk about going against the conventional wisdom! (An interesting book to read, if you like this sort of thing and want to learn more about Shannon's story, is William Poundstone's Fortune's Formula. Charlie Munger highly recommended it at a recent Berkshire shareholder meeting.)

Now, I know we are not junior "Warren Buffetts." And we are not junior Claude Shannons, either. So we should probably not recommend putting 98% of our money in our three favorite stocks. But I want to make the point that great investment returns often come out of portfolios made up of a few stocks held for a long time. And over time, these stocks come to dominate the portfolio.

Really, it gets to one of the key ingredients to successful investing. You should invest only when the odds tilt heavily in your favor. Since these opportunities are naturally rare, you ought to bet big when you find them. If you manage to avoid big losers, you will do well over time. There are a number of investors out there today who practice this credo. Mark Sellers at Sellers Capital is one of them. I saw him speak about this exact topic at a recent investment conference. In his presentation, he showed the following table. It lists some of the most successful long-term investors in the market today. It also shows what their largest holding is and how much it represents of their portfolio.

A cursory glance shows you how important their top holdings are. At the bottom of the chart is the Vanguard 500 Index, which represents the market. You can see that Exxon Mobil, the largest stock in the Index, makes up only 3.9% of the total. By contrast, all of the top positions of these investors make up a much bigger percentage of their portfolios.

I have taken this lesson to heart in my own investing. As of this writing, the largest position in my account makes up 31% of the total. It has always been a big position, and it has gone up a lot. I refuse to sell it -- so naturally, it has come to represent an ever bigger chunk of my portfolio. ... (Again, I am not recommending you do this.)

You have to have a lot of conviction about an idea to bet that big. But you do not have to go whole-hog to apply the basic lesson to some degree in your own investing. Instead of owning 50 or 100 stocks ... try to pare that list down to the best ideas. Instead of investing in mutual funds that own hundreds of stocks and turn them over every year, try to find those that own fewer stocks and hold them longer.

The Wall Street Journal recently ran a screen of these kinds of funds. I have pasted the table below for your convenience. It is not a bad list to start research of your own. All of these funds carry no loads, have 50 or fewer stocks and are run by managers that have been there for at least five years. Each of them also has, not surprisingly, a track record better than those of 75% of its peers.

A word of caution: Focus means that your portfolio becomes more volatile. For the great investors, this is no concern. They take on that price volatility in the short term if it means better returns over the long haul.

Take Nick Train, whom I mentioned above. His fund was actually down as of late 2007. So does that mean he gives up on these ideas? Of course not. "I don't really care that much about performance relative to the market over the next six months. I don't want to sound blase or [say] that it does not hurt, but the only thing we could do about it would be to dismantle a set of investment principles we have had in place for some time and that have done well by our investors."

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