There’s nothing free to do on airplanes anymore.

Even the peanuts and the soda come at a price. The ticket is more expensive, the flights are less frequent. Somehow, flying has become even less fun. For the more experienced travelers, whose miles are being voided as they spend the majority of their days sitting idly on a tarmac, this probably doesn’t seem possible. It is.

But wait — there is good news. There is still one ounce of fun that hasn’t been drained from your flight. It’s still free, and even a slowing economy can’t ground it. You know it’s there. It’s been right in front of you the entire time. Just reach into the seat pocket and pull it out. Right behind the racially and gender-ambiguous cartoon safety instructions and right in front of the People magazine the previous passenger left behind.

It’s the SkyMall catalog, and it’s all yours for the rest of the flight.

196 pages filled with the latest in gadgets and gizmos. The products you assumed did not exist, but now can’t resist. Your tickets to a quasi-futuristic world await. A world where digital cameras come on key chains. Where movies are projected inside your sunglasses. Where watches wind themselves — in cherry oak cases with silent motors.

And everything has a sensor. There’s no need to ever use your hands again. This is the life you’ve imagined for yourself, and SkyMall will help you get there. While you’re crammed into your ergonomically incorrect seat, wishing you were anywhere else, SkyMall opens the door to an easier, luxurious, and better life.

In case you haven’t been on a domestic U.S. flight in the past two decades, SkyMall is a catalog that sells “innovative merchandise” manufactured by a consortium of producers. SkyMall prints 20 million catalogs per year that are annually seen by more than 620 million travelers. The products in the catalogs range from inventively practical to laughably unnecessary.

Back on the ground, the economy is still in a slump. As you furiously rip through your catalog, most Americans are going through a period of conservation and saving. Gas is expensive, food is expensive, and more and more people are unemployed. That’s no secret. We see the headlines every day.

So why are people still buying frivolous items? Many retail chains around the country are closing stores and cutting back staff, and some are even filing for bankruptcy. Yet somehow, SkyMall has gone through one of its most profitable years. Estimates put SkyMall’s 2007 revenue at over $100 million.

Maybe things aren’t as bad as they seem. Over the past month, gas prices have begun to come back to Earth. Demand is down, and consumer confidence is actually nudging its way up. Sure, gas is still expensive, but maybe consumers are just accepting that. Maybe they can afford $4 gas. If they can’t, how can they afford to buy snow cone makers from SkyMall?

Airlines are in trouble. Fuel prices have destroyed profits, and tickets are more expensive than ever. On the ground, shipping rates have risen because of the high fuel costs. Yet SkyMall, a company whose target market consists almost entirely of airline passengers, and whose products are available only through delivery, is flourishing. Maybe consumers have more money to spend than we think.

Sure, a lot of people are cutting back on little expenses here and there. Starbucks has been forced to close a number of its stores because people are learning to live without $4 lattes. But can they live without the Dough-Nu-Matic home doughnut maker ($129.99)? Or what about the Double Chocolate Fountain ($119.99)? You never know when a spontaneous wedding reception might erupt.

So what should we believe? Should we look at the consumer confidence index and infer that the economy is at an all-time low? Maybe we should look at SkyMall’s sales, which tell us that consumers still have plenty of disposable income to blow on unnecessary impulse items. After all, what do consumers know, anyway?

Most consumers are not economists, and the majority have absolutely no clue what is going to happen. So why do we care what they think? Instead of assessing how consumers feel about the economy, we should be looking at how they contribute to it. They’re still spending their money, no matter what the headlines say.

Historically speaking, consumers polled for confidence indexes are mostly misguided. In 1992, confidence numbers were about as low as they are now. But that was after we had pulled ourselves out of a recession and poised to enter a sustained period of growth. Consumers might not have seemed too confident when asked their opinions, but their feelings and emotions had little effect on the actual economy.

Speeding through the air at 500 miles per hour, the average consumer may not feel very confident about the economy. They may perceive the current situation to be as shaky as the ride, but SkyMall sales show that they do have pretty high self-confidence. They’re confident they can afford impulse purchases on an already expensive flight. Confident that $89.99 isn’t too much for a pen that can hold 1,000 MP3 songs.

And SkyMall’s consumers also show a life-affirming confidence in airlines themselves. SkyMall’s sales may come from impulse purchases, but customers have to put up with some delayed gratification, waiting to receive their orders. They may think that the economy is in a free fall, but they have faith they’ll touch down safely and be able to enjoy their new purchases in the future.

Now, that’s confidence.

Regards,
Jamie Ellis
August 15, 2008

Consumer Confidence was originally featured on Whiskey and Gunpowder

Over the past year, I have spoken with numerous business and financial reporters in the U.S. and Canada. These reporters range from employees of small-town newspapers to my much larger hometown chronicle, the Pittsburgh Post-Gazette. I have spoken with representatives of industry trade publications like Oil & Gas Journal, as well as reporters from the Vancouver Sun, Canada’s The Globe & Mail, the Los Angeles Times, the Associated Press and the Dow Jones Newswires. In addition to the print media, I have also been interviewed on many different radio programs.

Part of a recent interview with an Orlando, Florida radio station focused on the immense losses announced by Merrill Lynch and Citigroup, and the departures of the top managers of both firms. Merrill wrote down over $8 billion of bad financial paper, leading to a quarterly loss of nearly $3 billion. And Citigroup has massive losses that may be in the vicinity of $13 billion or more. These are mind-boggling numbers, yet my view is that we are just seeing the tip of a few icebergs.

It seems that over the past few years, much of the financial industry loaded up on bad debt instruments. I will not even dignify this rotten paper by calling it some sort of “investment,” because there was and is essentially nothing to back it up. There are entire portfolios filled with subprime loans, initiated via “no documentation” loans against over-appraised buildings on the far side of the railroad tracks. In other words, these are worthless loans that will never see a dime of repayment. In many cases, these loans are evidence of economic crimes.

When the banks and investment houses acquired these bad books of business, the risk models that they used were pure guesswork. In the real world, engineering has made complicated structures like bridges and skyscrapers safer over time. But the so-called modern “financial engineering” has done nothing of the sort in the economic world. It all goes to show that just because the human mind can come up with an idea, it does not mean that people should act on it, let alone back it with their funds.

At this point, it is all but impossible to value much of what the financial houses have on their books. So the write-downs are just beginning. I believe that there are greater losses lurking in the shadows for both Merrill and Citigroup, and for many other banks and investment houses around the world. Several well-known banks in Germany, for example, are on the brink of disastrous write-downs. It is just a matter of time before these losses become public.

While on the air in Orlando, the interviewer and I cracked a few jokes about how Merrill Lynch’s Stan O’Neal is receiving a $160 million severance package for departing in the wake of his troubled tenure. This huge sum is surely far more than he deserves. After all, Mr. O’Neal took some big paydays over the past few years when things looked good at Merrill and he was firing 26,000 people to juice up the bottom line. So why does he get the big bucks again, on the way out the door, now that his ship has hit the rocks? Good question.

Then the interviewer asked what I anticipate for the U.S. economy and how the individual investor should protect himself from the coming turmoil. My reply was that I believe that the U.S. dollar is in a long state of decline. This is going to be an ongoing tragedy because so many people in the U.S. and around the world will be caught in the riptide as the value of the dollar washes away.

Do you remember when you would walk into a store and the owner might have the first dollar he ever earned in a frame, hanging on the wall behind the counter? People were proud of their money and trusted it as a long-term store of value. Not any more. Yet most people in the U.S. know only the dollar and understand only the dollar and their savings and investments are almost entirely in the dollar. So what happens when the value of the dollar just disintegrates? It is painful to think of the hardship that is coming down the road.

No one really knows how the decline of the dollar will play out. There is no modern precedent for what is about to occur as the world’s reserve currency evaporates in value.

Literally billions of people rely upon the U.S. dollar as the economic rock that holds up the foundations of the world economy. Yet that rock is turning into loose sand. How does one save, let alone invest, in a world where the value of the dollar is in irreversible decline? A declining dollar is the same as the destruction of capital.

My advice is to load up on gold and other precious metals and mining shares in companies that control real ore in the ground. While you are at it, also go for the companies that own or control real energy reserves, such as oil and gas, coal, uranium and renewable energy systems.

As if on cue, last month, the British newspaper The Independent launched a story with these words:

“A new phase in the credit crunch, one of ‘$1 trillion losses,’ seems to be dawning. The crisis at Citigroup and renewed doubts about some of the world’s leading banks disquieted stock markets on both sides of the Atlantic recently, with the fractious mood set to continue.”

So there are a trillion dollars of losses yet to be booked…and a company the size of Citigroup does not have the capital to manage itself as an ongoing entity…and the prices for gold and oil are skyrocketing as the value of the dollar declines.

My advice is to protect yourselves, dear readers. There are wolves at the door.

Until we meet again,
Byron W. King

December 11, 2007

More Dollar Doom was originally featured on Whiskey and Gunpowder

According to Robert Sheehan, the managing partner of the law firm of Skadden, Arps, Slate, Meagher & Flom, there is a tsunami coming in the bankruptcy arena. Mr. Sheehan made his comment before the recent stock market gyrations of the past couple of weeks, but he was merely looking ahead to what he apparently views, in his legal opinion, as the inevitable outcome of what has been going on in the U.S. economy these past several years.

The New York Times article to which I am referring profiled an attorney named Richard Levin, who practices primarily in the field of bankruptcy law. Among his other accomplishments, Mr. Levin served from 1975-1978 as counsel to the U.S. House Judiciary Committee, where he helped to draft much of the present U.S. Bankruptcy Code. Mr. Levin has had a distinguished career in the bankruptcy field and was recently hired away from his previous law firm, Skadden Arps, where he had been a partner for a decade, to join the old-line New York firm of Cravath, Swaine & Moore. This is symbolic, if not significant, for reasons we will discuss below.

The Ultimate Go-to Firm

In a profile published on July 25, 2007, the authoritative Dow Jones’ Daily Bankruptcy Review described Cravath as “the ultimate go-to firm,” and further noted that Cravath “has perhaps the most demanding hiring standards” of any New York law firm. So it says something loud and clear that Cravath is hiring the guy who literally “wrote the book” for modern bankruptcy practice in the U.S., to include drafting the 1978 amendments to the U.S. Bankruptcy Code. Combine this with the fact that Cravath previously had no significant bankruptcy practice in recent decades (actually, Cravath reorganized Westinghouse after the Panic of 1907 and assisted with many railway reorganizations over the past century), although many of its fine attorneys have appeared often in the bankruptcy courts of many federal and foreign venues and jurisdictions. But it is fair to say that Cravath was not known lately as a “bankruptcy firm” in any respect. Rather, Cravath focused much of its large-caliber legal effort on what is called “transactional” work, such as putting together large merger and acquisition deals, or dealing with matters before the U.S. Securities and Exchange Commission (SEC) and similar foreign entities. The blue chip client list of the white-shoe Cravath law firm includes such powerhouse organizations as IBM, Xerox, Merck, Novartis, the board of directors of TXU, Credit Suisse and the Carlyle Group.

A Continental Shift

The New York Times article noted that “Cravath’s move, in the words of one bankruptcy lawyer in New York, was ‘a continental shift,’ a recognition by an old-line firm, however belatedly, that bankruptcy had moved beyond the days when it was the purview of collection lawyers chasing debtors to the courthouse.” Having practiced a good deal of bankruptcy law in my misspent youth, I take exception to that last characterization. Bankruptcy law is far more complex than just “chasing debtors to the courthouse.” Still, the point is that within the past decade, many law firms like Cravath did not offer bankruptcy services to their clients. (There are lots of client-conflict issues, among other reasons.) Top-line firms likely would have referred the bankruptcy work out to other firms.

But things change. Bankruptcy has become a serious, and certainly respectable, form of law practice now, and can be a large moneymaking part of a major law firm. For large-scope bankruptcy cases, billing rates at some law firms are in the realm of $750 (and more) per hour of attorney time.  In fact, a few lawyers recently cracked the psychologically important mark of charging over $1,000 per hour.  Yes, that is quite pricey. And the bankruptcy judges seem to approve the fees, too. So let’s put 2 and 2 together. Large mainline, white-shoe law firms are building up their bankruptcy practices because they expect a lot of that kind of “debtor-chasing” business to come through the doors in the near future and pay out big fees. And what else does the future hold?

Loaded up with Debt

First, let’s catch up to the present. During the past few years, there has been a major change in corporate reorganizations. Prompted by the availability of easy — if not cheap — credit, many companies have loaded themselves up with debt. The debt was used for everything from making acquisitions and alliances to paying bonuses to managers to buying back stock options and outstanding shares. (On rare occasions, U.S. firms even use the borrowed money to build a new plant or factory, or to buy new equipment. Really, it has been known to happen.) At many business schools, they refer to this process of financial decapitalization as “the discipline of debt.” (And no, we won’t go there just now.)

Much of this new debt was then repackaged by the loan underwriters into other forms of financial instruments and flipped, sold and resold down the line to a myriad of buyers who may or may not have understood the nature of the risks they were assuming. There are few ironclad guarantees in this world, but I can almost surely guarantee you that when the loans go bad and the time comes to litigate over who is not getting repaid, the jilted creditors will deny up and down at depositions that they understood the nature of the risks. The creditors will claim, with straight faces, that they were lied to, misled, defrauded. Don’t believe me? Want to bet?

Enter the God of Insolvency

As with many things in life, it is nice when all goes well. But then again, things do not always go well. So when the god of insolvency enters upon the stage and drops his thunderbolts upon these deeply indebted firms and they “breach a material covenant,” as the saying goes, they often wind up attempting a financial workout or visiting the clerk’s office of a U.S. bankruptcy court to file their petition and the utterly critical first day motions. And just so you know, filing for bankruptcy is not something that you do when you have “no money.” It actually requires quite a bit of money for a business corporation to operate successfully in bankruptcy. Thus, strange as it seems, it helps to file for bankruptcy with money in the bank and receivables coming in (called “cash collateral”), or at least some sort of backup lender who is bold enough and willing to fund your operations after the bankruptcy petition is filed.

Welcome to the Future

So welcome to the future, where the smartest of the smart law firm money is betting that many more business firms will be visiting the bankruptcy courts of the land. This is why the big law firms are beefing up their bankruptcy rosters. This is part of the takeaway point for this week’s update. But how do these law firms think that they will get paid?

In many ways, hedge funds and private equity firms have turned the corporate bankruptcy process into another form of return-driven market. Among other things, these cash-rich entities have come to view the bankruptcy process as a marketplace for assets they can purchase at distressed prices, although many of the higher-quality assets have tended to command premium prices in bankruptcy sales of recent vintage. For this reason alone (and there are others), the presence of hedge funds and private equity firms has significantly transformed the process of bankruptcy. They have brought new money to the table, and deep pockets.

But in a world where you have debtors in possession of bankrupt corporations, and creditors getting stiffed up and down the line, and lawyers and related professionals charging large fees, and deep-pocketed buyers waiting at the fringes to buy assets or participate in recovery plans, you will have many new and previously unexplored legal issues. Professor Douglas Baird of the University of Chicago Law School recently noted that “We are about to go into a period of bankruptcy history where there are going to be lots and lots and lots of really unclear issues.”

Lots and Lots and Lots

Note that Chicago’s professor Baird said there will be “lots and lots and lots” of those “really unclear issues.” That sounds to me like a lot of unclear issues, and a lot of headaches for people who are standing too close to the coming bankruptcy tsunami. And that is why you, dear readers, as investors should stay away from indebted companies with poor cash flow. That is why we have companies in our Outstanding Investments portfolio like Goldcorp (GG: NYSE), with no debt. Or Valero (VLO: NYSE), with immense cash flow and a price-to-earnings ratio of 6.9. At Outstanding Investments, we like well-managed companies with real assets in hand, such as ore in the ground or oil and gas reserves, or companies that make real things in real plants and factories. And we like to see little or no debt, certainly in this economic environment.

Finally on this topic, I hope that none of you ever has to see the inside of a bankruptcy court. The big bankruptcies are raw and brutal, and proceed in a meat-grinding sort of way. It reminds me of the case of Jarndyce v. Jarndyce, if you have ever read Charles Dickens’ great book Bleak House. Don’t go there if you don’t have to. We congratulate Mr. Levin on the flattering report about him in The New York Times and wish him well at his new job with Cravath. But we would prefer to read about Mr. Levin’s exploits in the pages of the newspaper and not own shares in companies on whose behalf, or against whom, he is litigating in bankruptcy court.

Until we meet again…
Byron W. King

September 10, 2007

There Is a Tsunami Coming was originally featured on Whiskey and Gunpowder

The fact is when it comes to currency manipulators, you have to ask: Who isn’t one?

With that said, buckle your seat belt for Part II.

If this Fair Currency Act does become law, it won’t take effect until January 2008. Only in spring will the process even begin, with Hank Paulson’s “findings.” Then we have 180 days to wait for China to respond with correcting policies. But if it doesn’t (and why would it) we must enlist the IMF.

On IMF’s heels would follow formal proceedings with the World Trade Organization. The WTO’s legal approval of our trade penalties would not happen until late 2010.

Now hear this: The IMF’s role is essentially null. It hopes to “shame” any currency-manipulating nation into changing its practices. Shame? That’s right. Despite a recent review of IMF procedure for monitoring monetary policies, it neglected to adopt new methods of enforcing its rulings. In the IMF’s June press release, it only announced a tightening up of the definitions set down in haste during the Post-Bretton Woods fallout in 1973.

Not having any widely excepted economic theory on how to manage exchange rates is a big part of the problem. And in fact, the same Articles of Agreement the senators wish to invoke are written so broadly that they give immense leeway for how countries choose to handle exchange rates. The only mechanism the IMF has in its arsenal is the “supplemental consultation.” This is a special investigation of a country’s interest rate problems.

Moral Suasion: Pressure Without Force

The supplemental consultation has been invoked only two times in 29 years: Sweden in 1982 and South Korea in 1987. The result: not successful. The U.S. failed to get the IMF to agree that South Korea’s account surplus should be reduced by half, from $10 billion. And post-IMF consultation, that account surplus actually grew to $14 billion.

In today’s case, the IMF does want the yuan to move, but says the timing should be left to China. All in all, the only tactic the IMF has is “moral suasion.” A consultation with Investopedia offered a stunning definition replete with examples: “closed-door meetings with bank directors, increased severity of inspections, appeals to community spirit, or vague threats.” Those last two are my favorite. The “good example” they provided: When the Fed chairman speaks, stocks fly or fall. Wow, and do we ever cave in to that pratfall.

Too bad the IMF’s suasion won’t be so effective. Especially since our own stance on IMF intervention is confounded. We, against the majority of Europe, championed the idea that China (as well as India and Turkey) needed to have more power in the IMF…not less.

This struck me as counterintuitive until I read the rationale of one Treasury undersecretary, Timothy D. Adams:

“I would urge that by re-engineering the IMF and giving China a bigger role, China will have a greater sense of responsibility for the institution’s missions.”

Now, it strikes me as just plain stupid (however much an appeal to “community spirit” that it is). That’s like saying our founding role in the U.N., with all its attendant power, makes the United States more likely to feel its responsibility to all the members of the U.N. and to its unified cause and mission.

So shame and responsibility are to save the day? That’s like saying corporations should have “feelings” simply because they are legally classified as “persons.”

But the decision to give China more veto power doesn’t fall into our lap. It belongs to the likely successor to the current IMF managing director: Frenchman Dominique Strauss-Kahn.

So how’s the preliminary “shaming” going? Back in April, the People’s Bank of China rejected the IMF’s yuan advice — emphasizing the importance of stability within member countries. So I wouldn’t hold my breath for IMF action. And in fact, our legislative pressure hardly seems to bristle the Chinese media.

How China Reacted to the Fair Currency Threat

Frankly, Xinhua made it seem about as consequential as swatting a fly. Before the Senate legislation gained its finance and banking following, the general line was that Hank Paulson knows the real story. The legislation is foolish. Hank is on our side.

Then, on Aug. 8, Mr. Ambrose-Evans-Pritchard screamed the headline, “China Threatens ‘Nuclear Option’ of Dollar Sales” from his privileged U.K. Telegraph view. The source was “state media.” But none of the phrasings of the officials he cited ran quite that way. The finance chief at the Development Research Center, Xia Bin, called the foreign reserves a “bargaining chip.” And that, folks, is simply moral suasion right back at you.

Supposed “NUCLEAR OPTION” Would Be Sinocidal

Call me a fool, but I believe the People’s Bank of China officials were speaking the truth when they resoundingly denied a huge treasury sell-off in response to Mr. Pritchard’s outcry.

After all, it’s really NOT in China’s interest. And since China has yet to return to true “empire” status, it doesn’t have the swollen balls to make a point outside of fiscal interest…

When you’ve got $1.33 trillion in greenbacks, you’re not going to sell them off en masse. It would be “Sinocidal.” China could only dump a tiny fraction of the reserves on the market, or else its remaining reserves would take a huge hit in value. Secondly, the yuan is not yet unpegged from the dollar, which is why buying Treasury reserves works so well for China in the first place. This limits the yuan from rising — by propping up the dollar.

Truth is China doesn’t have to do much of anything. Aren’t we already imploding?

Don’t Place the Entire Trade Deficit on the Yuan’s Doorstep

My personal favorite post-Senate approval remark comes from the chief economist of Hong Kong’s BNP Paribas Peregrine Securities. It didn’t get much press:

“They have stuck to their anti-China stance simply to win over voters.”

With this, the Asian chief economist shrugged. His conclusion: This nation of deficits will suffer from its own detrimental behavior, no matter what happens with China.

What “We the People” don’t fritter away on higher-cost consumer goods from China we’ll lose snapping goods up from lower-cost nations. And besides, China’s labor costs are so low that there will be no shot in the arm for American manufacturing. It’ll go to China’s increasingly competitive neighbors!

So what really is all this China business but a waving of a red flag in front of a bull? (That is, a flagging bull coming to the edge of easy-money pastures.) How else to divert Americans from the clear and present dangers in the economy? For example, the recent $120 billion liquidity injection from our fearless central bankers? Instead, we ask for a good old “enemy.”

Because surely the recent “consumer confidence” numbers for August at their “highest in five months” aren’t enough to keep us buoyant. Nor do we see in them the chastisement I think we deserve.

Exercise Your Way to a Healthy Economy

Hmm…our less than 1% savings rate compared with China’s personal savings at 40% of an individual’s income. Believe it or not, we have some liberty to “vote” with our dollars.

Hillary Clinton recently got her panties in a bunch over this yuan game, preaching the prevention of America’s being “held hostage to economic decisions being made in Beijing, Shanghai, or Tokyo.” What you’re not allowed to say on the campaign trail is the truth: “You are held hostage by your own purchase of gewgaws, SUVs, and houses you couldn’t pay for…”

Sure, you can say, “We were tricked into thinking they [the houses, at least] would appreciate so much.” But you, dear reader, surely needn’t be pointing that finger.

And if we all acted like Sara Bongiorni, the business writer who penned A Year Without “Made in China”: One Family’s True Life Adventure in the Global Economy, at least we could have a high horse to ride into the China Currency War on.

Bet you could do it. One of Ms. Bongiorni’s big complaints was not having a coffee maker once the old one broke. Try boiling water in a saucepan on the stove. Add grounds. Strain if desired. Or better yet, forget the coffee. Take a shot of good ol’ American bourbon whiskey — we’re gonna need it in the coming months.

I agree with the Hong Kong economist. Don’t let the congressmen yank our chains. To take the words straight from the China Currency Coalition’s press release on the Fair Currency Act of 2007:

“American manufacturing workers, their industries, and their communities are counting on Congress to act.”

But as I hope we’ve uncovered above, this is an act promising no action. Let’s not forget that Bush is keen to veto it anyway. This would be one of the better moves in the twilight of his presidency.

To paraphrase the character Vizzini, from my generation’s cult classic film The Princess Bride: The most famous classic blunder is never get involved in a land war in Asia…And (I add) only slightly less well known, never get involved in a currency war where you have no weapons — just IOUs.

Here’s how that battle unfolds. Send out a spokesman, say, Treasury Deputy Assistant Secretary Mark Sobel. This ersatz “rear admiral” tells Congress:

“While China’s currency policy is critical to the United States and to China, currency movement alone will not significantly reduce China’s trade surplus nor eliminate the distortions in the Chinese economy. China’s trade surpluses are rooted in the structure of the Chinese economy and are not solely the result of currency policy. China needs to restructure its economy so that household consumption, rather than exports and excess investment, powers growth…Vibrant domestic consumption is key to the welfare of the Chinese population and is the only way that China can grow without generating huge trade surpluses.”

In fact, that’s exactly what Sobel said in May 2007, in his testimony on how currency manipulation affects U.S. workers. Hmmm…that’s all he’s got?

How far are we really going to get by telling China to become like America? We, with our oh-so-well-oiled economic machine.

Since currency talk has “gone nuclear,” let’s call America’s weapon of spreading the gospel of household consumption “bioterrorism.” Because the urge to consume, nicknamed “keeping up with the Joneses (or Chens),” is surely the result of some overactive gene.

So let’s leave off with the revised headline “Bioterrorist U.S. Bids China CONSUME.”

Till Congress makes its next blunder,
Samantha Buker

August 24, 2007

Why the IMF Won’t Make Our Day was originally featured on Whiskey and Gunpowder

This month’s free issue of Contrary Investor, called “Deficit Attention Syndrome,” contains some interesting charts and commentary on still more indicators that are signaling recession. Let’s take a look at a few of the charts:

Nominal Retail Sales

U.S. Imports Annual Rate of Change

Trade Deficit Spread

Trade Deficit 12-Month Moving Average

The trade numbers, auto sales, retail trends, housing conditions, and slowing in corporate capital spending all point directly toward a recession as a very strong possibility, based on historical precedent. But this real world of the U.S. economy is colliding with the global financial markets of the moment — financial markets that are clearly being supported and elevated by acceleration in monetary accommodation as of late. Across the globe, the year-over-year rate of change in monetary aggregates in the major economies is running in the double digits.

Here in the U.S., we know that M3 was bound, tied, and thrown off the side of the ship into the deep blue abyss a year ago. But as a quasi-substitute, MZM (money of zero maturity) is relatively broad in and of itself as a measure of monetary levels and acceleration. As an example of what’s really happening in the land of stateside money/credit creation, the following table lists the annualized growth rates of MZM over the last one, two, three, six, and 12 months. Get the picture?

M3 Reconstructed

There is no need for a quasi-M3 substitute. Bart at NowAndFutures.com has reconstructed M3. The only component that is not available is eurodollars, and Bart estimates that based on historical correlations. Still, eurodollars are only about 3% of M3, so unless eurodollars have skyrocketed unbeknownst to anyone, whatever he is off on eurodollar estimates is not likely to be statistically significant. Bart calls his reconstructed numbers M3b. Here is the weekly chart as of April 28:

M3b

Is this a start of a pullback in M3? It will be interesting to watch going forward. A couple weeks do not a trend make, but the Fed is having a difficult time defending a 5.25% target (on the high side). There have been several reverse repos recently, so we need to watch and see if this pattern continues.

Excluding Everything, Things Are Fine

Caroline Baum is writing, “Housing? What Housing? I Don’t See Any Housing”:

“Excluding housing, the U.S. economy is doing just fine.

“That’s the latest rationalization of a select group of operators who think that the Bush administration’s 4.6 percentage point cut in the top marginal tax rate and 5 point reduction in the top capital gains rate can protect the economy from any and all ills.

“To say that ex-housing the economy is doing just fine is tantamount to claiming that ex-Iraq, Bush’s Middle East policy is a rousing success.

“How valid is the claim that outside of housing everything is hunky-dory? Let’s go to the videotape to see how housing-centric the U.S. economy’s weakness really is.

“The Commerce Department reported Friday that real gross domestic product rose 1.3% in the first quarter, the slowest pace in four years. The year-over-year growth rate slipped to 2.1%, also a four-year low…

“The first quarter’s sluggish growth wasn’t confined to housing, however. Exports declined, inventories were a small drag, and capital spending (investment in equipment and software) rebounded 1.9% — better than expected based on monthly data on shipments, but nothing to write home about after declines in the second and fourth quarters of last year.

“‘The initial weakness was in housing, but the weakness in capital spending is not a cross-infection from housing,’ says Ian Shepherdson, chief U.S. economist at High Frequency Economics in Valhalla, N.Y.
 
“One year ago, capital spending was growing at a 9% year-over-year rate, he points out. Now it’s zero.

“‘A year ago, people said capital spending was going to rescue us as housing slowed,’ he says. ‘Capital spending is down to zero (year on year). There’s been an unambiguous slowdown’…

“Companies that haul the stuff consumers buy — United Parcel Service, for example — are reporting weakness in their domestic operations. UPS, the world’s largest package-delivery company, said U.S. volume showed no change in the first quarter from a year ago.

“‘I don’t think much of UPS’s business is housing related,’ [Northern Trust's Paul] Kasriel says. ‘They don’t ship lumber, wallboard, and toilets’…
 
“Another quarter of growth with a 1% handle is apt to make Fed officials nervous for the simple reason that there is no mandate for a recession with inflation running at 2-something percent. When growth is that slow, all it takes is a big quarterly inventory decline to thrust a negative sign in front of GDP, which in turn leads to a diminution in confidence.

“While Fed Chairman Ben Bernanke’s reaction function is different than Alan Greenspan’s — he’s not a politician, looks uncomfortable at hearings, and keeps his answers short and to the point — he isn’t immune to what’s going on around him.

“Imagine how it would look if Congress were to ask him to explain why the Fed let the economy slip into recession with inflation so low. Would Bernanke be able to keep a straight face when he told them that GDP ex-housing was solid?

“Heck, GDP excluding consumer spending, business investment, housing, and exports was robust in the Great Depression, too.

Things aren’t fine when you have to exclude everything to prove it. Then again, that’s the difference between the real world and a financial world gone crazy with leveraged buyouts, derivatives, and carry trades.

Regards,
Mish

May 4, 2007

Real World vs. Financial World was originally featured on Whiskey and Gunpowder

Sudbury Basin

The Sudbury Basin, or what is left of it, is about 37 miles long, 17 miles wide, and 9 miles deep. It formed about 1.85 billion years ago when a 6-mile-wide meteorite (some researchers believe that it was a comet) struck the Earth at a hyper-velocity. The impact penetrated the crust as far down as the mantle, and was of such scale of energy that large pieces of the Earth’s crust were in all likelihood blown back, and accelerated far into outer space. It must have been a true Star Trek moment.

The present size of the Sudbury Basin is just a small remnant of what is believed to have been the original crater of about 155-mile diameter. Subsequent geological processes in Precambrian time, as well as extensive erosion over the past billion years, have extensively deformed the crater into its present, smaller oval shape. And it is certainly one fascinating body of rock.

The original impact crater rapidly filled with magma from the Earth’s mantle, which, over time, crystallized into minerals containing nickel, copper, platinum, palladium, gold, and other metals. As a result of these mineral deposits, the Greater Sudbury area is one of the world’s most important mining districts. The rock formations of Sudbury hold within them some of the world’s largest deposits of nickel and copper ores. One of the major producers of nickel ore and associated nickel products is the International Nickel Co., or INCO, and its subsidiary the International Nickel Company of Canada Ltd.

Smacked Upside the Head by a Meteorite

Last week, the management of INCO, a worldwide metals producer, must have discovered what it was like to get smacked upside the head by a giant meteorite, when shareholders of Falconbridge, another mining company and a significant nickel producer in its own right, rejected an INCO takeover offer. Let’s back up to last year and review what happened.

On Oct. 11, 2005, INCO announced that its board of directors had agreed with the board of directors of Falconbridge Ltd. that INCO take over all of the outstanding common shares of Falconbridge, by way of a “friendly” takeover bid that included both cash and INCO shares. INCO’s assets total in excess of $12 billion. Falconbridge owns over $13 billion in assets. The combined INCO-Falconbridge organization would have been one of the world’s largest producers of both nickel and copper, and controlled one of the mining industry’s most attractive portfolios of low-cost, profitable new mining projects.

Falconbridge, a Canadian company founded in 1928, is one of the world’s leading producers of nickel, copper, zinc, and aluminum. In June 2005, a few months before the INCO offer was announced, Falconbridge had dramatically increased its size by merging with another venerable name in the mining business, Noranda. Thus a merger between INCO and Falconbridge would have created a colossus in the nickel and copper mining business.

In late 2005 and throughout 2006, the INCO offer for Falconbridge was held up by regulatory review in Canada, the U.S., and Euroland. And all the while, commodity prices for nickel, copper, zinc, cobalt, and many other products were moving upward at a rapid rate. In no small measure, this was because of industrial demand from China.

Xstrata Crashes the Party

In May 2006, another mining company named Xstrata PLC made an unsolicited offer to purchase for cash all of the outstanding common shares of Falconbridge. Xstrata is a major global diversified mining group, listed on the London and Swiss stock exchanges and with headquarters located in Zug, Switzerland. Xstrata produces six major types of industrial commodities. These are copper, coking coal, thermal coal, ferrochrome, vanadium, and zinc, with some additional production of gold, silver, and lead. Xstrata’s operations span five continents, namely Europe, Africa, Australia, South America, and North America (more specifically, Canada).

Initially, Xstrata offered C$52.50 in cash for each share of Falconbridge. Falconbridge management replied that it believed that the offer was not enough and did not reflect the full and fair value of Falconbridge shares, nor did Xstrata’s offer give shareholders the opportunity to participate in the growth that was anticipated as a result of the INCO-Falconbridge merger.

In mid-July 2006, Xstrata increased its cash offer for Falconbridge to C$62.50 per common share in cash. Under the terms of the offer, the Falconbridge shareholders would also receive a special cash dividend of C75 cents per common share declared by Falconbridge on July 16, 2006, representing total proceeds of C$63.25 per Falconbridge common share.

The bottom line for Falconbridge shareholders was that the INCO offer was “higher” in the sense that it added up to more in terms of cash per share, plus INCO shares, totaling about C$65.25 per share. But the Xstrata offer of C$63.25 was all in cash and offered a fast payout. For INCO to be successful in its takeover bid for Falconbridge, INCO had to obtain a majority of shares tendered by Friday, July 28, 2006. This did not happen, and thus, the deal fell through.

Money Listens, Money Talks

In the week or so before the July 28 deadline, INCO had only obtained about 20% of the Falconbridge shares to its side of the takeover proposal. But in the past year or so, a large number (estimated to be about 40%) of Falconbridge shares have been bought up by hedge funds. These hedge funds are pools of funds that are invested with a promise of generating a specific return, regardless of whatever else occurs in the financial markets.

In a sense, hedge funds are emblematic of what you might characterize as “tactical” investors who are chasing the highest yields possible over the shortest time frames. A tactical investor is simply pursuing a stock position in a particular situation, almost without regard for the underlying company itself. To the extent that a hedge fund has any investment strategy, it is a “strategy of tactics.” That is, hedge fund managers have little, if any, loyalty to a given company. The hedge fund managers own shares with the expectation of seeing a run-up in the stock price. Then they will move to liquidate the position for the best gain possible. The mandate of hedge funds is to make fast money in the stock market, not to focus on long-term issues of corporate governance.

The competing offers for Falconbridge by INCO and Xstrata illustrate the point with great clarity. INCO offered Falconbridge shareholders cash and stock totaling more than the Xstrata offer, and with the prospect of the resulting merger allowing the shareholders to participate in future growth of the company. Xstrata’s deal offered a slightly lower overall value (by about C$2), but it was all in cash, thus allowing the hedge fund managers to take the money and run. There was no real need for the hedge fund managers to consider the future prospects of the nickel market, or markets for other industrial metals, that a merged INCO-Falconbridge firm would produce in the future.

Compounding the problems for INCO, many of the hedge funds that own Falconbridge shares also own shares of INCO. The recent announcement by Phelps Dodge that it wants to take over INCO has already placed INCO into play on Wall Street. Teck Cominco also has announced a hostile bid for INCO. And now the hedge fund managers are anticipating that other mining firms might enter into the fray and drive up the price of INCO. Thus the “strategy of tactics” for the hedge funds is to take the Xstrata payday and hold onto their INCO shares in anticipation of another bidding war for the mining firm.

As if on cue, Grupo Mexico SA, one of the largest copper producers in the world and parent of Southern Copper Corp., has reportedly hired U.S. financial advisers to explore taking over Phelps Dodge, and, by implication, INCO. In addition, Companhia Vale do Rio Doce (CVRD) has expressed interest in acquiring INCO. And other firms, such as Rio Tinto, BHP Billiton, or even Russia’s Norilsk could decide to make a play for INCO, if not for Phelps Dodge.

Restructuring the Mining Industry

So the near-term future of the mining industry is probably going to be one of competing takeover offers and eventual consolidations on a massive scale. But whatever happens to INCO, and to the other companies in the heavy metals mining industry, it appears that hedge fund money is going to control the outcome.

In the world of hedge funds, the proverbial tail wags the dog. Hedge fund thinking is entirely short-term, such that any deal will have to be structured to offer cash, instead of commercial paper or other forms of stock. This means that acquiring companies have to issue debt and hope that future prices for their products will be sufficient to pay it down. Keep in mind that while the mining business is inherently a long-term effort (over and above the fact that Sudbury is a 1.85 billion-year-old ore deposit), long-term corporate governance is not high on the priority list for hedge fund managers.

Lots of people, including me, like to think that markets and market mechanisms work even in a massively regulated global industry such as what the mining industry has become. If hedge funds are driving the results of mergers and consolidations of the biggest players in the mining industry, then so be it. Whoever said that company managers should not have to justify their efforts frequently, as opposed to getting a free pass that might otherwise extend for years to construct that so-called “shareholder value”? The hedge fund managers will, in all likelihood, make their short-term plays, take their money off the table, and meet their numbers along the highway of industry consolidation. I do not doubt that they will feel darn good about themselves as they make their visits to the bank.

The free-market implication of all this is that in a world that works, a hedge fund-driven “strategy of tactics” ought to lead to the “right companies” with the “right managers” controlling the “right assets” and running them “right.” The corporate managers who control the big mining companies are just going to have to figure out how to run what are, at root, long-term businesses in an environment of short-term financial pressures and associated manipulations. So the people best at showing “results” will have to rise to the top, and preferably not of the same “results-oriented” ilk as those that ran Enron. It would be a terrible thing for mining assets to fall into incompetent hands, especially in that it takes 6-mile-wide meteorites slamming into the Earth every billion years or so to create some of the really good digs.

But what if things do not work out the way we hope? What if a “strategy of tactics” leads essentially nowhere, and to an end point of no real long-term strategy? What if the “wrong companies” with the “wrong managers” wind up controlling the big assets, and in the long-term, they screw things up because they have structured themselves into unworkable business forms burdened with unpayable debt? Does this wave of big-dig consolidation, being driven by short-term hedge fund thinking, amplify the risk that the mining industry will become a relatively small group of really massive, overleveraged, overly indebted, underinvested behemoths that run their businesses right into the ground? I suppose that is what bankruptcy courts are for, but I would hate to see it come to that.

It takes a long time to make an ore deposit (1.85 billion years at Sudbury). It takes a long time to open a mine, and it takes a long time to get good at running one. Considering all of the moving parts and other rotating machinery involved, you really do have to know what you are doing when you pull ore out of the ground. Then again, in a world of hedge funds and rising commodity prices, I suppose the world will get exactly what it deserves.

Until we meet again…
Byron W. King

August 1, 2006

Money, Mines and Nickel was originally featured on Whiskey and Gunpowder