Eddie Cantor (1892-1964) was a comedian, singer, songwriter and actor. “Banjo Eyes,” as he was sometimes called, was also the author of two little books on the Great Depression. “People used to rob banks,” he writes in Yoo-Hoo Prosperity. “Now we’re lucky when it isn’t vice versa.” Cantor jokes about many troubles in the Great Depression, but one recurring theme is the relative lack of food.

A millionaire is “one who eats three square meals a day.” Things were so bad that “the pigeons are now feeding the people.” They were funny lines…sort of. For many of the people living during those times, Cantor’s jokes were not so far from the truth.

We have it comparatively easy in this, the crisis of 2008. We may have to make do with fewer Swatch watches and Coach handbags. We may have to pass on the latest iPod and make do with last year’s winter coat. These hardships are not important, except for people selling those goods. But the credit crisis is also affecting the world’s ability to produce one thing important to everyone: food.

It’s harder for farmers to get credit for next season’s crop, especially farmers overseas. They need fertilizer, seed, fuel and more. And most farmers need to borrow money to obtain these essential items. No credit; no crops.

Therefore, the global credit squeeze might reduce plantings of key grains, even as world inventories of these grains hover near historic lows. In Russia, for example, cash-starved banks have cut off funding for the industry. The head of the Russian Grain Union says, “Many farmers probably won’t be able to borrow money for the spring sowing.” This is important because Russia is no lightweight in the grain division. It produces 9% of the world’s wheat, for instance. No surprise that the United Nations considers Russia a critical component of the global food supply.

Ironically, Russia just had its best harvest ever. And still, global grain inventories remain low. Bloomberg reports that global inventories of corn, wheat and soybeans are the second lowest they’ve ever been since 1974.

A number of countries already fear what might happen next year. The Washington Post Foreign Service in Shanghai reports that China adopted a number of measures to protect itself from the worsening food crisis: “Among the most extreme measures [China] took was to impose new export taxes to keep critical supplies such as grains and fertilizers from leaving the country.”

These taxes are extremely high, on the order of 150%-185%. China worries that richer countries may outbid its own farmers for supplies and weaken China’s own food supply. One Chinese fertilizer company, which produces 150,000 tons per year, already said that the new taxes mean exporting is no longer profitable. China was the biggest exporter of certain types of fertilizer. No longer. That’s a lot of supply off the market.

Fertilizers are absolutely critical in maintaining (and improving) crop yields. Without them, we’d produce far less per acre. As a result, in parts of Africa where people depend on Chinese fertilizers, the food supply problem is now more acute. China’s export taxes and bans follow those of other grain producers, including the Ukraine, India, Pakistan and Argentina.

Amazingly, despite these various maneuvers around the world to prevent grain exports, the prices for wheat, corn and soybeans are all half of their mid-summer highs. It seems the market believes a global recession will dampen demand. Maybe so, or maybe the market doesn’t know anything. The severe commodity selloff during the last few weeks might be saying a lot more about the desperation of hedge fund managers to raise cash than about the prospect that grain demand will fall – in which case, we could see another surge in prices next year.

Demand for grains is still very strong. In China, each wage-earner devotes about 40 cents of every dollar earned to buying food. In India, that number is a staggering 70 cents out of every dollar earned. In other words, the food budget in these countries is hardly a discretionary item. It will remain constant, or even rise, no matter what the global economy does.

Meanwhile, the people in these countries who have a couple of extra rupees to toss around are upping their consumption of meats, which increases the per capita demand for grains. As PotashCorp chief William Doyle recently pointed out: “The average daily protein intake in China has increased by 40% over a 20-year period, with the greatest percentage of that increase coming from meat consumption.” You can see it in the size of the people themselves: The average 6-year-old Chinese boy is 12 pounds heavier and 2 inches taller than 30 years ago. These people aren’t going back to the ways thing were. This is a long-term story, and these trends should continue.

Yet even if demand growth for grains slows, it’s not likely that those low global grain inventories will improve. Even if grain demand fell to 2% per year, we’d still need record production to keep grain inventories from falling further.

For all these reasons, I think the future is still bright for agriculture and all that it entails. I think the fertilizer companies look cheap again. In my monthly newsletter, Capital & Crisis, my subscribers owned Agrium (NYSE: AGU) for nearly three years, and it more than tripled our money. The stock is now a good one-third below what we bought it for initially.

PotashCorp (NYSE: POT) and Mosaic (NYSE: MOS) are other names I’m looking at hard right now – both have been crushed in this troubled market.

Beyond that, irrigation companies have come way down, even after posting outstanding results. Lindsay (NYSE: LNN) and Valmont (NYSE: VMI) are two irrigation equipment makers, for example, both coming off great quarterly results.

In 1931, Eddie Cantor wrote that the biggest thing in years was bread. “Why, they’re giving it away free! Whenever four men get together at a street corner, it used to be a merger,” he writes. “Now it’s a bread line!” It’s funny now. Next year, it might not be, at least to some.

Regards,
Chris Mayer

December 03, 2008

Crash in Food Supply was originally featured on Whiskey and Gunpowder

I have been thinking a lot about the market and the beating we’re taking. It is the worst year I have ever had. Personally and professionally, this year will be — barring some fantastic rally — the worst year I’ve ever experienced. Far worse than the 2000-2002 meltdown, which I largely avoided. I actually made money during that stretch.

But this is wholly different. This is a crisis cutting deep into the very foundations of our financial markets. There has really been no place to hide in the stock market — just about everything has come down, and come down a lot, in hardly any time at all.

A few thoughts on what we’re seeing happening in this credit crisis. As I said, this is severe. This is the real deal. And I think it is possible good companies could go down as the credit markets lock up.

Just today, the Financial Times reports: “A virtual funding freeze…has affected even top-rated companies such as General Electric…and AT&T.” It’s a dangerous time. The fear out there is extreme. That explains why the yield on one-month Treasury bills fell to zero at one point during the recent panic. Investors just wanted safety. They didn’t care about yield. They wanted a place to put their money where they can be sure they will get it back.

Hence, the rush to Treasury securities. On the last day of the quarter, the 10-year note hit 3.83%. If you bought the 30-year T-bond a year ago — which most people thought was a dumb bet — you would have netted a 16% return one year later, as rates fell and your bond price rose. Not bad, huh?

This rush for safety is also rallying the U.S. dollar. Despite all its flaws and all that it’s been through, when people are scared, they want the old greenback. Cash. Commodities, meanwhile, have sold off something fierce.

It’s important to remember, though, that these things happen in markets from time to time. It can be difficult to know what to do when we’re in these times. On the train out here from Paris, I read a little commentary from John Templeton, the great investor who died earlier this year. Templeton lived to the ripe old age of 95. He was a man who’d seen a lot of water go under the bridge, so to speak.

So it’s appropriate, I think, to pull some wisdom from his comments. Some of them are particularly good for times like these. Here is one snippet:

“We have never been able to predict business cycles and we have never been able to predict stock market cycles…and we have never found any person whose predictions on this are right more than 60% of the time. But we say to our clients, ‘Don’t worry about it. Prepare yourself. You know there’s going to be a bear market. And you know there’s going to be a business recession. You just don’t know when.’”

Wise words, these. And keep in mind this is one of the greatest investors of all time. He goes on to say that you prepare for these periods by staying out of debt and keeping your own personal financial house in order. He also says: “You prepare yourself psychologically so you don’t get so frightened at the wrong time that you sell out foolishly. So if you are fully prepared and know you are going to live through bear markets and recessions, you can regard them not only without worry, but also as opportunities…”

Great stuff. By the way, the above comments are from the latest issue of Outstanding Investor Digest, a newsletter I’ve subscribed to for years. It comes out infrequently and has no stock picks. It just collects and publishes insights from some of most successful money managers around. I’d recommend it, if you enjoy that sort of thing.

For now, I’m trying to think like Templeton and see the market as one of opportunities.

Sincerely,
Chris Mayer
October 7, 2008

Wisdom During the Sell-Off was originally featured on Whiskey and Gunpowder

Since then, banks and brokerage stocks were punished. Energy and material stocks have soared-thanks to the Fed’s inflation campaign. Fed officials have taken their ability to devalue the U.S. dollar to new heights. What collateral backs today’s dollar? Mostly mortgage securities that nobody wants — as if Treasury bond collateral weren’t bad enough.

Despite the latest “reports,” current trends still have room to run. Just consider Fannie Mae and Freddie Mac. Those shareholders could be effectively wiped out by endless equity offerings as early as next year. The mountain of debt holders and bond insurance policyholders comes first.

Now, it’s possible that the federal government could issue hundreds of billions in new Treasuries to officially guarantee Fannie’s and Freddie’s liabilities. If no one lines up to buy these bonds, the Fed could monetize them. Such a scenario could herald a return to double-digit long-term interest rates and a collapse in confidence in paper money – demanding a new monetary system. We live in interesting times. Billionaire currency speculator George Soros thinks we’ve just entered the ugly side of a “super bubble.”

I wrote about George Soros’ investing framework in the August 2007 Strategic Investment. Here’s the excerpt on Soros:

The growth of securitization has truly altered the global economy…

One negative consequence is that financial markets are starting to shape the destiny of the real economy, not the other way around. Storied currency speculator George Soros was one of the first to speak publicly about the phenomenon of markets shaping economies. He calls it the theory of “reflexivity” and described it when testifying in front of Congress in 1994:

“The generally accepted theory is that financial markets tend toward equilibrium and, on the whole, discount the future correctly. I operate using a different theory, according to which financial markets cannot possibly discount the future correctly, because they do not merely discount the future; they help to shape it.”

Here’s reflexivity at work: As a company’s stock grows more coveted by wild-eyed speculators, its cost of capital gets lower and lower as its stock skyrockets; the higher its stock price, the more capital a company can raise in a secondary stock offering by issuing a set amount of shares. So its ability to reinvest capital and grow — its future — is shaped by the whims of speculators.

A second consequence of the securitization revolution: The further a lender is separated from a borrower, the more potential there is for fraud on the part of the borrower and underestimation of risk on the part of the lender.

Now, before you dismiss Soros as a Big Government “world improver,” keep in mind that he took the right side of every major financial crisis since World War II. The man clearly understands how markets can boom and bust, especially when greed and fear overwhelm rationality.

To see how Soros views the current crisis, I picked up his latest book, The New Paradigm for Financial Markets: The Credit Crisis of 2008 and What It Means. In the first half, Soros laments that reflexivity is not taken seriously in university economics departments. In the second half, he argues that the current crisis marks the end of a decades-long expansion of U.S. dollar-based credit. Soros dubs the period from the early 1980s-2007 a “super bubble.” He makes a convincing case:

Credit conditions have been relaxed to such an extent that I wonder how they could be relaxed any further. This is certainly true as far as the U.S. consumer is concerned. Credit terms for mortgages, auto loans, and credit cards have reached their maximum extension… It may also be true for commercial credit, particularly for leveraged buyouts and commercial real estate.

Only one thing is off the mark: Soros’ prescription for more government regulation.

Nowhere in his book will you find an explanation of how the global paper money system practically guaranteed the formation of his “super bubble.” This super bubble would not have been possible under an international gold standard. The international gold standard of the late 1800s fostered a time of incredible growth and wealth creation in a stable price environment. It wasn’t perfect.

It had periodic depressions. But it was far better than what we’re looking at: Government’s inflationary policy responses to problems created by its policy of perpetual bailouts.

Don’t forget that every paper currency in history eventually fell to its intrinsic value: zero. The dollar is no different, although it has taken longer than most others. For decades, foreign governments have aggressively bought dollars, propping up their value, hoping, thus, to insure long-term economic stability. Instead, this action is heavily responsible for the runaway inflation we’re seeing all over the world.

Soros seems to believe that the real economy cannot grow unless credit is growing. This ignores the fact that credit growth does not create economic growth. It merely assists growth. Over the long term, the economy grows as the capacity to produce goods and services grows. No credit necessary.

But we must invest in the environment we face, not the one that we wish were in place. The government response to the ugly side of Soros’ reflexivity will seriously impair confidence in paper money.

Look for gold, energy, and other natural resources to keep performing. Avoid financials, real estate, and consumer discretionary stocks.

Regards,
Dan Amoss
August 5, 2008

P.S.: While the Fed works to try and stave off massive inflation for the current time period, history shows us that all fiat currencies are bound to fail. When this happens, it will be extremely difficult for our financial system to recover. This is a very serious and increasingly looming threat to our economic way of life. But that’s not even the biggest problem we’re currently facing.

Financial Market Speculation was originally featured on Whiskey and Gunpowder

But Hofmann’s hallucinations seem little worse than most acid-induced visions. Or so people tell us…

“Beginning dizziness,” he wrote in his lab journal for 19 April 1943. Looking to find a stimulant for the circulatory and respiratory systems, he’d just concocted — and taken — a big dose of lysergic acid diethylamide-25.

“Feeling of anxiety,” he noted, before adding in due course “Difficulty in concentration. Visual disturbances. Desire to laugh.”

Finally, Hofmann scrawled the words “most severe crisis” and fled the lab on his bicycle. It seemed to stay stationary even as it wheeled him back home, where his neighbor — who brought him a nice glass of milk to calm him down — appeared as a witch in a colored mask.

He felt possessed by demons. The furniture in his bedroom began to menace him. All pretty run of the mill stuff if you dabble with psychotropics, in short.

But such “fantastic images” don’t always ease into the sensations of “good fortune and gratitude” Hofmann got to enjoy later that day. Hallucinations can still cause the “most severe crisis” — even without some fool laying Witches Hat by the Incredible String Band on the turntable.

“Inflation will return to the two percent target,” claimed Mervyn King, head of the Bank of England, and one half of the financial furry freak brothers running Anglo-American monetary policy.

“Growth will eventually recover to a sustainable rate.”

Just a central banker’s wide-eyed hallucination? Maybe not. Like Albert Hofmann’s wobbly bike-ride six decades ago, the credit cycle will get us home in good time, ready to turn once again from boom to bubble to bust. But like any powerful psychedelic, the trip gobbled down by Western investors could last much longer than anyone dares hope right now.

And just what was the Governor smoking when he claimed, “In these [current] circumstances, the household saving rate is likely to rise…”?

The Bank of England has been cutting U.K. interest rates since December. Its latest Inflation Report says it will continue to cut interest rates “in line with [bond] market expectations,” too.

And U.K. households have grown their savings only once when interest rates fell in the last four-and-half decades. That brief period lasted for two years at the start of the 1990s.

Both before and since — and most markedly during the previous post-war recessions (of 1974 and 1981) — people have tweaked their savings almost precisely in line with changes to the rate of interest, as set by the Bank of England itself.

King’s starry-eyed vision, however, “is part of a rebalancing of the U.K. economy, away from spending and importing, toward saving and exporting,” he told reporters last week.

The sky’s turned all purple in Washington too if U.S. policy-makers think the credit crunch will somehow boost household savings there.

Put another way, “who had heard of collateralized debt obligations just 10 years ago?” as Niall Ferguson, history professor at Harvard, asked in a speech opening New York’s new Museum of Finance back in January this year.

“Collateralized loan obligations? Credit derivatives? These forms of financial instrument are of very recent origin. So are the hedge funds; so are the private equity partnerships; so are the sovereign wealth funds; and so are those wonderfully named entities, the conduits…”

Ferguson then flashed up a series of charts “to illustrate the speed with which these phenomena have proliferated.” First, mortgage-backed securities. Starting in 1980 – “when scarcely any such thing existed” — they total $3.5 trillion-worth today. Then he cited “the whole range” of other newly born asset-backed instruments — automobile loans, equipment loans, student loans, credit card-backed debt derivatives…

“Over the counter derivatives outstanding?” the professor asked. “Well, if you’d asked someone to name that figure in 1987 it would have been a very small number indeed.”

Ferguson’s theme bears repeating; he likens the huge growth in complex financial products to an evolutionary spurt, “an explosion of life forms [amid an] unusually benign climate.”

Whereas I see it more as a chemistry experiment gone horribly wrong. The hare-brained PhDs mixing up the medicine are too spaced out to even guess at what’s now sitting in the Petri dish. And the financial monsters it has spawned aren’t merely in the scientists’ minds.

Take hedge funds, for example; Ferguson notes that in 1990, those financial life forms known as “hedge funds” numbered around 600 (also including funds of funds). Now they’ve reproduced and multiplied up toward 10,000.

“As a form, the hedge fund dates back to the 1940s. But this population explosion is of very recent origin.”

The raw numbers also hide a “regular, annual dying out”; there’s chronic survivorship bias in the data. In 2006, for example, 717 hedge funds were culled; the 2007 figure should be even larger. And here, believes Ferguson, we see survival of the fittest in action. If he’s wrong, perhaps it’s just the contingency of life itself, allowing the standard proportion of idiots to thrive and market their “top decile” performance to a new generation of unwitting investors.

“A lot of reporters ask me these days whether we’re in the midst of a commodity bubble,” said Dr. Benn Steil, senior fellow at the Council on Foreign Relations, at the Hard Assets Conference in New York in mid-May.

“In fact, I’m going to Washington to give a Senate testimony. [Because] my perspective is that the more interesting, and indeed more important, question to ask is whether we’re at the end of what I would call a ‘fiat currency bubble’.”

Like Professor Ferguson, Dr. Steil looks back “to the early 1980s” to find the origins of whatever it is we’re now watching mutate, if not die out.

Under Paul Volker at the Federal Reserve, “inflation, and at least equally importantly inflation expectations, were driven out of the system through a pretty ruthless policy of very tight money, high interest rates. Very tight money.”

What followed was “the golden age of the fiat Dollar” says Steil, reminding us that credit expansion was unshackled from gold in 1971, when Richard Nixon stopped redeeming the U.S. currency for bullion altogether. It took tight money — “very tight money” — to bring the resulting inflation of the 1970s under control.

The fiat money experiment then broke out of the lab with the “explosion” of financial life-forms witnessed from 1980 right up to last summer. Indeed, it all ran just fine until around 2002, when the cost of key raw materials — notably wheat and oil, as in Steil’s charts above — began to shoot higher in terms of Dollars and other government-backed currencies.

Measured against gold prices, however, they’ve barely budged. “That shouldn’t surprise people,” says Steil, “because as we go back to the era of the gold standard from about 1880 until the outbreak of the First World War in 1914, prices around the world in countries that were on the gold standard were also remarkably flat.

“The figure looked just like this. So gold is behaving as it has historically.”

In the hot, fetid climate of low interest rates and surging credit supplies, central bankers like Ben Bernanke and Mervyn King are hallucinating if they think they can control the monsters spawned by the fiat money experiment.

And tripped out on delusions of “minor god” status, these furry freaks really do believe they can talk Wall Street and the City back down from their current wave of “worst crisis ever.”

Regards,
Adrian Ash
BullionVault
May 27, 2008

Central Bank Mistakes was originally featured on Whiskey and Gunpowder

I believe the charts I have in this column contain some powerful insights. You will want to keep them handy when things get rocky. They come courtesy of Barry Bannister, an analyst at Stifel Nicolaus, who delivered an interesting talk in Baltimore recently.

I’ll focus on oil, though a similar story holds true throughout the commodity sector. I don’t put a lot of faith in macro predictions — as no one can predict the future. But you can study track records. You can look at history. History reveals some interesting clues about what the future may hold.

The quick take? It doesn’t look like the party is over just yet. But even if it is, past peaks in oil give us clues. When you dig a little deeper into those relationships, you find a great road map for making money.

If you look at the price of oil, you find something interesting. Since January 2001, you can explain the move in the price of oil largely as a function of increasing money supply. As the amount of money grows, the price of oil rises. In fact, almost 87% of the move in the price of oil can be explained by the increase in money supply, as this next chart shows:

Basically, $100 per barrel oil is what we would expect to see, given this relationship between the oil price and money supply. Given that we are still in the midst of a credit crisis of sorts, it seems unlikely the Fed will tighten money in any way at all. That leaves a clear path for the price of oil and commodities to continue to rally in nominal terms.

The other thing to remember — and people forget this by worrying excessively about a U.S. recession — is that the story of oil is no longer a U.S.-centric story. You’ve surely heard about how the rapid growth in China and other emerging markets drives oil demand. Well, it’s good to keep that in mind. See the chart below:

China and India are only beginning to consume oil at any meaningful level. Right now, they are consuming oil at a rate the U.S. did in the early years of the 20th century. But look, we don’t need China to start guzzling oil like we do. Even if it moves half the distance between it and Hong Kong, that’s a lot of extra demand. The way I look at it is this: What’s more likely, China stays at 1910 oil usage or moves somewhere closer to, say, 1950s U.S. oil usage? I think the latter.

Even if oil has already peaked, that doesn’t mean oil is headed back to $40 per barrel or lower. In fact, if this oil boom follows history at all, we’re looking at years of oil prices right around $100 per barrel.

After studying the history of other recent oil booms, what you learn is that in no prior oil boom did the price of oil retreat rapidly toward where it was before the boom began. In each case, the price of oil stayed up for years after the peak. If you’ve got investments tied to the booming oil prices, that means you’ve got plenty of years to make more money.

So where do you go to make that money?

The one obvious place people will automatically look is to own oil and gas producers. That’s not a bad idea at all. But I’ve got another angle here. If you look at the capital and exploration spending of both Exxon and Chevron from 1928-2007, they show spending bottoms in 1948 and 1974. After each bottom, there was a long run of spending.

Spending peaked nine years after 1948. Spending peaked seven years after 1974. If 2005 proves to be the bottom on capital spending — and it seems so, since Exxon only recently announced it would increase its capital spending to $25-30 billion over the next few years, a 25% increase — we won’t see capital spending peak until 2012 at the earliest.

Now, why is this important? Think about what the oil companies spend money on. Where do they go shopping? They go shopping at the oil field services and equipment companies.

So that is where you want to be. Because even if oil has peaked, we’re still looking at years of strong spending by the oil companies. You want to have some exposure to the receiving end of all that spending. Such companies will mint cash. And they give you a little different payoff than owning a straight producer. As Bannister pointed out, it can sometimes be better to own the picks and shovels. You don’t actually own or produce the oil or gas, but your equipment is vital to those that do.

He used Newmont Mining, the big gold producer, as an example of a producer that has profoundly disappointed investors amid what may be the greatest gold bull market in history. Newmont’s costs rose so fast and so much that it never really enjoyed (at least not so far) the higher price in gold. But if you were in some mining equipment manufacturer, you got paid.

So the key takeaways here are these: The price of oil has room to run yet, in part because of the growth in money supply and in part because of pressing international demand. Secondly, even if we already saw oil peak, history says that prices won’t retreat by much over the next several years. And finally, the capital-spending boom by the big oil companies is just getting started, which is great news for investors in oil field services companies.

Regards,
Chris Mayer
May 20, 2008

Rising Oil Prices was originally featured on Whiskey and Gunpowder

As the quarter unfolded, it became clear that the world’s credit system was drifting aimlessly, like a ship sailing with no wind. A lot of business that should have gotten done just did not happen, for lack of funding. Funding went away because risk aversion kicked in with a vengeance, and for a very real reason.

The last 12 months or so have been a time of re-pricing risk — and this occurred on a global scale. But the re-pricing was not orderly. The U.S. dollar was steadily drifting downward in value, and prices for most things were readjusting just on this monetary basis alone. Add to this some severe industrial disruptions, from power shortages in South Africa to floods in Australia to economy-stopping winter weather in China.

Closer to home, the downward re-pricing of risk rapidly became a collapse as flaws in the U.S. rating agency process bobbed to the surface. With so much distressed commercial paper floating around, many people were paranoid about risk. It was like the old game of “hot potato,” except nobody could pass their potatoes onto the next guy down the line.

For example, in one major presentation, I heard General Electric CEO Jeff Immelt spend a large part of his discussion defending GE’s “triple-A credit rating.” Normally, Immelt would be up there slapping the pointer against the screen and bragging about all the great products that GE makes and sells. Instead, he was busy trying to “prove a negative,” that GE does not hold bad paper in its money operations. But Immelt believed he had to defend GE’s stock price by dispelling fears of a rating markdown.

And through it all, the resulting stock market gyrations were a reflection of investor confusion about the future. Are we at the end of something good? Are we at the beginning of something bad? Is this the beginning of the end? Or is it only the end of the beginning? Really, what comes next? Will credit markets liquefy? Or will they stay dried out? Can we do business? Or should we hold tight and sit on the cash?

New York Times columnist Paul Krugman recently told Fortune “Large parts of the financial system will have to be reinvented.” And there’s no argument from me on that one. But so much of the financial system is broken that the question is where to even start.

The Flipping Industry

It is apparent that much of the old way of doing business — particularly in the realm of lending money — was rotten to the core. In my view, it begins with the dollar itself. The dollar has been steadily deteriorating in value for decades, so inflationary expectations are part of the worldwide consciousness. That is, just because of the long-term decline in the value of the dollar, most people expect most things to go up in price most of the time.

So is it any wonder that people developed a “speculation expectation”? This fed into an entitlement mentality, as well, that tainted every rung of the credit ladder. A lot of people wanted to buy and flip, whether it was houses or stocks or commodities. So other people lent to people to enable buying and flipping. Flipping became a dominant, if not defining, element of the financial “industry,” of sorts.

The Money Was Just Too Good

But what an industry! For example, in the past five years, many people just plain lied through their teeth on everything from credit card applications to mortgage applications to the lending documents for multibillion-dollar takeovers. It was pure and brazen fraud in many instances, verging on burglary in plain sight. The next level up the food chain — the brokers and loan officers — often just looked the other way and rubber-stamped the papers. “Hey, not my problem.”

This kind of bad buck-passing went all the way to the top of some firms, many with familiar names. There in the ethereal reaches of the nice office buildings in Irvine, Calif., and Fort Lauderdale, Fla. — let alone Wall Street — the chief executives knew, or should have known, how risky the portfolios were becoming.

But these corporate worthies let it happen. The pressure to “make the numbers” was too much. The money was just too good. The bonuses were too sweet. And besides, there is always the old excuse that “Everybody does it this way.” Yet it was not for nothing that the ancients defined greed as a deadly sin. At each step of the ladder of financial deceit, people just let it slide. They should have known better, and maybe they did know better.

Now looking ahead, we have a hell of a rocky road before us. And can we as a society really “regulate” our way out of that situation? Or is there a systemic problem with deeper roots? Really, what do the Furies have in store for us?

Until we meet again…
Byron King
April 8, 2008

2008 First Quarter was originally featured on Whiskey and Gunpowder

The price of our favorite yellow metal, although it’s surely a telling commodity, isn’t the most compelling thing that I have been noticing over the past couple of weeks.

I am exposed to many different mediums of information. I read several economic journals. I keep myself aware to what the talking heads are saying on Bloomberg and CNBC. I also listen to what people are saying in order to keep a feel of what Joe Sixpack’s mentality is towards the markets.

These mediums all have one thing that has been very consistent, and very worrisome.  They are telling me that the markets are once again feeling invincible, and with that we have seen a reemergence of an appetite for risk.

It’s amazing how short some people’s memories really are. The mentality surrounding the markets today is eerily similar to what it was in July before the 10% correction in August. The rhetoric I have been hearing these past couple of weeks is also far too similar to that of 1929.

So how does something like this happen? How can so many irrational investors drive markets in the wrong direction? Is that the case, or is it that we’re in the midst of an equities bull market and I’m just missing out on all of the profits?

The Credit Market’s Effect on Equities

I’m sure you are aware of the recent record highs set by the DOW and S&P. I happen to be under the opinion that the credit market is driving equities. It is definitely the culprit of the August sell off. With that belief, I have to look forward to both housing and credit to decide on the direction of equities.

I don’t need a crystal ball to tell you that we have only seen the tip of the iceberg when it comes to turmoil in the credit markets.

This recent period of time has been a telling one for the investment bankers. Both Merrill Lynch and Zurich-based UBS, the largest U.S. brokerage house and largest European bank, respectively, posted losses for the third quarter. For UBS, this was their first quarterly loss in four and a half years. 

Bear Stearns reported its biggest earning decline in the last 10 years and Citigroup posted a 60% decline in earnings. Recently, Morgan Stanley reported that it would have an estimated third quarter loss of $.50 per share, after an initial estimate of having positive earnings of $1.25 per share.

Let’s not forget about the bank run that occurred at England based Northern Rock.  Citigroup is in the process of organizing a bailout, but this all comes after the Bank of England supplied all the liquidity needed and guaranteed all bank deposits.

How about the fire sale by Lennar Homes? They unloaded a huge amount of inventory as discounts of up to $100,000. The editors here at Agora Financial warned that more of these fire sales would occur. That is exactly what has happened.

As I write on this fall day in Minnesota, St. Joe Co., Florida’s largest private landowner, has announced that they will also have a fire sale of sorts. They plan to fire 75% of their employees and sell 190 homes and approximately 1,200 sites planned for development. They threw their dividend out the window and will report a 41% decline in sales. That hurts…and you can expect more of the same to keep on coming.

The culprit of all these credit losses was tens of billions of dollars in write downs of mortgage-backed securities and other fixed income assets. In short, the reason for the write downs were bad loans made to people who couldn’t pay for them, and increased foreclosures resulting in a glut of homes on the market. It’s easy to see how this carries a snowball effect. 

More Credit Concerns Could Be on the Way

If you ask both Wall Street and Main Street, they will tell you that we have put the worst of the credit concerns behind us. In fact, there’s no need to ask, just look at how the homebuilder and financial stocks have rallied up to 20%. This seems encouraging, but I couldn’t disagree more.

There are two very important statistics I have been watching. First and foremost, we must understand that there are still $300 billion dollars of interest rates reset by the end of 2009, with a large chunk of those coming in the next six months. The implications of this cannot be denied. Remember it was the marked-to-market mortgage-backed securities that made up the majority of losses for the investment banks I just mentioned.

Those mortgage-backed securities are just sliced up mortgages packaged into bonds, and given investment grade ratings by Moody’s. Whether or not these bonds pay out is directly dependent on whether or not these mortgages get paid for by the homeowner. That is the risk in these bonds, which has been grossly under priced. 

Pimco’s Bill Gross referred to theses subprime mortgage-backed securities as “toxic waste.” There are a lot more skeletons on these investment bankers’ balance sheets. I expect there to be many more “earnings reductions” and “unforeseen circumstances” that result in some large losses. Don’t look for one of the big investment brokerage houses to go bust, but I wouldn’t be surprised to see one of these guys get bought out.

The other worrisome statistic is the $12 billion increase in credit card debt and non-mortgage loans that American consumers hold. This brings the running total to $2.47 trillion dollars. The private sector debt as a share of private sector GDP is now an astounding 340%. This is a scary thought, but the trend is even scarier.

We have seen a frightening trend that shows how truly stretched out American consumers are. There has been an exponential increase in Americans paying their mortgages with their credit cards. Homeowners do this to prevent themselves from defaulting on their mortgage payments, but in the process build up an unnerving amount of high interest debt. Even with Halloween right around the corner, what could be more terrifying?

This is exactly what Alan Greenspan has taught Americans. Bill Bonner of the Daily Reckoning had this to say on the topic: “Thanks largely to ‘Easy’ Al Greenspan down at the Fed, they could always stretch one end of their budget — the spending end. ‘Just put it on the credit card, honey…we’ll extend the equity line if we need to.’ But now the equity line is snapping back and hitting them in the face.”

So Americans are using their credit cards to postpone the inevitable foreclosures a little big longer. The amount of loans to reset at a higher interest rate is going to increase dramatically, resulting in more homes on the market, more losses on mortgage-backed securities and more losses on bank sheets.

I almost pity the dumb money that has bid up the financials and homebuilders. In fact, I almost pity the dumb money that has been purchasing any of the industrials at or near this record high…almost.

The fact of the matter is that while dumb money is at a historical record in size, it is also at a historical record in stupidity. As a result of the shear quantity of money in the wrong hands, we have seen equities boosted while the smart money notices that transports have trailed behind. We have seen dumb money buy treasury notes in huge numbers while receiving nearly a -10% real return on investment.

So have I missed out on the run to DOW 15k? Maybe. But I do understand the fundamentals of this market. So while the dumb money may have been king for the past couple of weeks, it will soon be dethroned. Ignorance can only rule for so long.

Regards,
Nick Jones

October 17, 2007

The Dumb and the Restless was originally featured on Whiskey and Gunpowder