Sunday, August 17, 2008

In our debt-based economy, new credit is the source of new money. Without ever more money (meaning credit) to fuel ever more spending, our economy will contract. Which is why I keep a close eye on credit. The stories below tell a very different tale from the recent stock market action.

In this type of economy, nothing is more important than the continuation of ever more borrowing in ever larger amounts. If this falters for any reason, extreme financial instability would be the expected outcome, especially given the extreme degree of leverage in the financial system, which we would experience as collapsing financial institutions and rising levels of default. The three main sources of demand for new borrowing are consumers, businesses, and the government. I will examine each below, along with some other evidence to make the case that our financial crisis is not over; in fact, it has hardly begun. This means that the recent perplexing actions in the dollar and the stock market very likely represent one of the largest head-fakes of all time.

We are all familiar with the fact that US residential real estate activity is basically down 33% from its all-time peak. This represents roughly 2 million homes that will not be sold this year, compared to 2005. Among other things, this includes 2 million fewer mortgages, sales commissions, inspections, title searches, and municipal transfer fees paid. The ripple effect extends to everything from granite countertop sales, to lumber prices, to furniture. Assuming that the average house sale resulted in a net increase of borrowing of $100,000 (= the size of a new loan on a newly purchased house when compared to the old one), that results in a direct borrowing hit of 2,000,000 times $100,000, or $200 billion. Add in the ripple effects, and we are talking another few hundred billion in lost activity.

Further, Mortgage Equity Withdrawal, the practice of “extracting wealth” from a house, peaked at $682 billion in 2006, and will be lucky to break $200 billion this year, which will represent a loss of nearly $500 billion/yr from the peak and some $275 billion from last year. Taken together, residential real estate is already off some $500 billion in consumer borrowing from last year. The question lurks: What will fill in that gap? Business borrowing? Even higher levels of government borrowing?

And here’s the mystery: For “money” to show up in the banking system, borrowing has to happen somewhere. Our indirect evidence that something is amiss rests in this chart of MZM, or Money of Zero Maturity, which is the next best descriptor of total money that we have left since the Fed stopped publishing M3 over a year ago. As you can see in the first chart below, MZM has been growing quite smartly throughout 2008, and you really have to squint at the very end of the chart to detect a slight abatement in the growth. There’s a little wiggle right at the end of the line.

If this is not clear enough, then we can switch to the second chart, which shows the change in the money supply from a year ago. That is, if the chart reads “$1,000 billion” (which = $1 trillion), it means that over the past 12 months, $1 trillion of new money was somehow created in the banking system.

This second chart of MZM shows a couple of interesting points. Note that in 1989, MZM went briefly negative, and we then entered a pretty nasty “double dip” recessionary period. Alan Greenspan got chewed out by Bush-the-First for “costing him the election,” because Greenspan failed to act quickly enough to remedy that situation. When money supply declines, it means credit is not expanding, and this quickly leads to economic pain and dislocation in our must-always-be-expanding system.

The second time that Alan was faced with MZM heading into negative territory was in 1995 (marked on the graph), and this time he was ready. Unfortunately, he did something really exceptional to “goose” the creation of new money/credit – he effectively eliminated bank reserves.

In theory a bank is limited in the amount of credit it can create by the so-called “fractional reserve” ratio, which is usually related to be 10%. But since MZM stands at 8,700 billion dollars and bank reserves currently stand at only $43 billion dollars we can easily determine that bank reserves are, in reality, only 0.5% of liabilities, not 10.0%. This means that instead of creating $900,000 out of every $100,000 held in reserve, banks have created something closer to $20,000,000.

While this is all very interesting, the really important questions are, “How exactly has money grown by more than a trillion dollars over the past year?” and “Who exactly has been borrowing all that new money into existence?”

Here’s where the story gets difficult, because we cannot easily identify these sources of borrowing in the news. For instance, one factor normally required for money/credit to continue expanding at a fast pace is that bank lending must remain easy and loose. As this next article makes clear, over this past year, banks have been making it harder, not easier, for borrowers.

Credit squeeze getting worse, banks say (emphasis mine)

Aug 11 – MarketWatch

Despite all the aggressive moves by the Fed in the past year to ease the flow of credit to the economy, a record percentage of banks were making it more difficult for borrowers in the three months ending in July, the Fed said in its quarterly senior loan officer survey of 52 major banks.

A majority of banks tightened their rules for granting loans to businesses and consumers. The survey shows little appetite at banks to lend for home mortgages, credit cards, home equity loans, commercial real estate loans, or commercial and industrial loans.

No bank in the survey eased credit terms for any type of loan in the past three months, and only one bank said it anticipated easing standards for consumers in the next 12 months.

C&I loans: 58% of banks tightened standards for commercial and industrial loans to large and medium firms, while 65% tightened for small firms.

Commercial real estate: 81% tightened standards, while 50% said demand was weakening.

Residential mortgages: A record 74% of banks said they tightened standards for prime mortgages, while 53% said they saw reduced demand. For subprime mortgages, 86% tightened standards, with the number of banks who offer such loans declining to 14% of banks from about 30% two years ago. For nontraditional mortgages, 84% tightened standards while 63% reported reduced demand.

Consumer credit: A record 36% of banks reported less willingness to extend consumer installment loans; only 2% were more willing. Eighty percent tightened standards on home-equity lines of credit. For credit cards, 67% tightened standards, mostly by refusing new loans to consumers without good credit.

Read this sentence again because it is truly unprecedented: “No bank in the survey eased credit terms for any type of loan in the past three months.”

NO BANK. As in ‘none.’ Zero. For any type of loan. This survey makes it clear that banks have tightened right across the board, in every segment of lending, often by RECORD AMOUNTS.

Now, it gets really tricky to understand how the money supply is reported to be close to a trillion dollars just this year while bank lending has dropped off by record amounts.

Here’s another example of a former source of lending that has experience a quite dramatic drop-off in volume over the first half of the year:

Office Building Deals Drop Off

Aug 11 – Washington Post

In the District [of Columbia], $1.4 billion worth of office space traded hands in the first six months of the year, a 61 percent drop from the $3.6 billion sold by mid-2007, according to Real Capital Analytics of New York. The drop-off was even more pronounced in Northern Virginia, where building sales plummeted 87 percent, to $914 million from $6.8 billion a year ago.

“The commercial real estate game doesn’t work without debt, and it is very hard to come by these days on attractive terms,” said Dan Fasulo, research director for Real Capital.

Other cities have faired similarly. Manhattan, the nation’s biggest office market, saw a 59 percent drop, to $6.4 billion from $15.5 billion. Deal volume fell 60 percent in Los Angeles, to $1.84 billion from $4.65 billion. Chicago had a 23 percent drop, to $1.7 billion from $2.2 billion.

In major cities on both coasts and in the Midwest, office space deals fell anywhere from 23% to 87%. The deals fell through because debt could not be arranged and the game doesn’t work without debt. No debt = no money. No money = bad economy.

So where is all the money coming from?

Is it coming from overseas borrowing? Nope, not if this next article is accurate.

The Credit Crisis Spreads to Europe

Aug 11 – Time

For banks across Europe, as for their U.S. counterparts, 2008 is proving painfully difficult. Globally, banks could write down as much as $450 billion more over the next three to four years, according to research from Deutsche Bank. Lenders, it says, are short of funds equivalent to 4% of their balance sheets, with those in Ireland, Spain and Britain finding fund-raising particularly tricky.

Even the banks are having a hard time raising money for their own balance sheets, which means they are certainly not lending it out to businesses and consumers.

Here’s one possible explanation for the continued increase in corporate borrowing: This link goes to a radio interview between a Bloomberg host and Mr. Goldman, who is a lively and clear orator. I really like the way Mr. Goldman makes clear that the so-called “credit crisis” is no such thing…yet. The credit crisis has not yet arrived, because major banks are contractually obligated to provide lines of credit to companies that are busy drawing those lines down. The credit crisis erupts when those loans are due to be renewed. He claims that banks do not have the balance sheets they need to extend that credit, and, therefore, the worst effects remain in front of us.  

The bottom line:   I do not have a great explanation for the mechanism that is creating the large reported increases in the money stock. At this point, my strong inclination is to go with the media reports of the actual situations out in the real world. They may be anecdotal, but they seem more accurate than the opaque reporting of the Federal Reserve or government.

Tuesday, August 12, 2008

Vineyard and Downey stocks take a tumble and management announces that customer withdrawals are sinking the ship. Looks like customers are finding out the truth even without much assistance from the media.

Tuesday, August 5, 2008

World commodity markets have entered a sudden free-fall. This information is important enough that I want both subscribers and registered members of the site to be aware of it. Please feel free to distribute this report.

My strong advice is to hold off on pre-purchasing your winter heating oil and not lock in any contracts for natural gas. Ditto for pre-purchases of food, all metals, and gasoline/diesel.

If you were thinking of buying into gold or silver, better prices would seem to lie in the future, although the charts are a little less clear here.

This is all consistent with my advice from the last Martenson Report for subscribers (sent 8/2/08), where I said:

“I have my concerns about commodity prices over the remaining portion of 2008, and even more so for 2009. The reason is that extra supply from mines and newly planted acreage should be coming online right as the recession (depression?) is hitting full force in 2009.”

Here are the charts of the commodity damage:

Below is a chart of heating oil, the price of which is falling rapidly. After the price (the blue line) broke through the 50-day moving average (red line), the price declines have been relentless. Because of this, I am personally waiting to lock in my winter oil. I will keep a close eye on the price of heating oil and alert you if or when I think it is ready to climb back up.

 

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Natural gas. Wow. Just wow. This price decline is staggering enough that I suspect there was some heavily leveraged hedge fund on the wrong side of this trade that has now blown up. Somebody is losing a lot of money and somebody is gaining a lot of money. If it turns out that Goldman Sachs was, again, on the right side of a destroyed hedge fund, I will be ready to call “foul.” At any rate, based on this chart you should not lock into any long-term natural gas prices right now, because what you will be sold is natural gas that was bought by your provider a few months ago.

 

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And here’s crude oil. This chart also speaks of severe weakness that could see oil return to $100/barrel in pretty short order. At that point I’ll want to re-evaluate where it might head next. For now, expect cheaper energy prices in the near future.

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And here’s the chart for gold. It’s much less clear what’s going on here, although there is certainly price weakness. Should that weakness continue, my next downside target is $850, where I see strong support. If it gets there, I would be a modest buyer of gold while I evaluated its next probable moves.

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The next two charts of corn and wheat speak to enormous cash-flow difficulties for farmers. Since farm debt and land prices are in all-time record territory, lots of farms are going to go broke on these declines. But the outfits most affected by such wild price gyrations will be the grain elevators, who have to use grain futures to hedge their operations. These price declines will translate into huge swings in the margin positions of their futures accounts, and quite a few are going to find their profits entirely eaten up by interest payments on bank loans to cover their margin calls. Many will go bankrupt as a result. Given that the bankrupt grain elevators will get bought out by well-positioned financial and private equity firms, we are witnessing one of the largest transfers ever seen of physical wealth due to a paper crisis.

 

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I am still not quite sure what has happened to commodities, though I suspect that a major hedge fund or two has “blown up.” But it’s going to take awhile for this dust to settle. I speculate that world governments started pushing on these markets to help bring commodity prices down in order to allow them more political room to re-liquefy a stricken world banking system. I worry that the governments have actually triggered a destabilizing price crash that will bring its own issues of insolvency to farmers, grain elevators, energy companies, and pension and hedge funds. I fear that the law of unintended consequences will strike, and that ham-fisted government attempts to create the appearance of stability in the larger markets (by interfering with the commodity markets) will actually create the very thing they fear – a series of cascading cross-defaults within the financial system. We shall see.

What do I mean when I say “governments interfere with the markets?” One form of interference is words. Recently the European Central Bank, in concert with the G7 ministers, has made public statements about the dollar being too weak. Bingo! Next thing you know, the dollar turns around and starts going the other way. Since commodities are priced in dollars, the effect of this is to put downward pressure on the commodities. In the US, Congress held meetings and proposed new rules to reign in the impact of speculators on oil prices. There is nothing quite like the threat of government-enforced rule revisions to change the way people think about and act within targeted markets. I have no specific evidence that the government has been directly selling into the commodity markets, but this would not surprise me in the least, especially if done via a proxy, such as a well-connected Wall Street firm or two.

Which is why, if it turns out that Goldman Sachs is, once again, on the right side of this commodity rout (and we’ll know this by their trading profits), I will be more than suspicious – I will be pretty certain that they had implicit or even explicit Federal backing.

I am not against cheaper heating oil. But I am dead set against official interventions in markets because I don’t trust central planning, especially if done by the current crop of “leaders” in DC, who seem to have neither a sense of the risks and challenges we face nor any plan for the future. Worse, such “band-aid” approaches only serve to mask the underlying issues and can even exacerbate them by creating the illusion that everything is returning to ‘normal,’ thereby nurturing a prompt return to the same imbalances that are the source of our current ills. What we need is to wring out the excess borrowing, lending, and spending that marks the past 25 years and eliminate government-dictated pricing designed to hide the impacts of additional monetary and fiscal excess.

Wednesday, June 18, 2008

Executive Summary

• Relatively benign stock market index performance is masking severe financial weakness
• Judging by their stock charts, several good-sized banks might file for bankruptcy soon
• Financial market liquidity supplied by the Fed is at odds with their words that "credit market conditions are improving"
• The assets of the banks under duress are many, many multiples of total FDIC assets

"Pay no attention to the man behind the curtain!" barks the booming voice.

Unfortunately for the dumpy, balding ‘wizard,’ the curtain has already been removed and he’s been spotted.

The first two weeks of June (2008) have been all about knowing where to look. Let’s peel back the curtain.

Let me begin with a personal story. One of my main trading accounts was with a company called Lind-Waldock, a very reputable, stable, old company that got bought out by fast-flying Refco. All seemed well for the first few months, I had the same broker at the other end of the phone and I noticed no difference in my trading experience. But I was wary of Refco, so I kept a live stock chart up on my computer monitor, which I kept a close eye on. One day, the stock price of Refco took a stomach-wrenching dive, losing nearly 20% in a single hour. I immediately called my broker and shifted my funds out of that company that very day. I even got a call from the head of the division asking me to remain, insisting that all was well, and explaining that the stock was falling on the basis of unsubstantiated and certainly untrue rumors. It turns out that the rumors were true; Refco was involved in some shenanigans and had clumsily tried to hide billions in losses by stuffing them in an off-shore subsidiary. Refco was actually insolvent and ultimately went bankrupt. And it was also true that my money would have been safe even had I not moved it, but my position on these matters is to bring the money home and ask the detailed questions later.

Below you will see many examples of stock price performance that would cause me personally to remove my money to a safer location and save the questions for later.

After the dangerous downdraft in the dollar and the stock market seen on Friday the 6^th of June, the Federal Reserve and their brethren in Europe, the ECB, were all over the airwaves beginning Sunday the 8^th in an attempt to prevent the markets from selling off any further. Judging by the headline stock index performance, they did pretty well, as the indexes closed more or less unchanged for the week. However, if we peek behind the curtains, we see something very different.

I want to focus on the issue of banks and bank solvency. Actually, I want to broaden this definition to include what are termed "financial institutions," which include mortgage brokers and commercial lending institutions. Why? Because we are now a financial economy. Measured in dollars, our economy has much more activity in the business of moving money around than it does in the manufacturing real goods.

It used to be said that "as goes GM, so goes the US," meaning that the economic health of the country could be measured by the activity of its (formerly) largest manufacturer. Now it might be said that "as goes JP Morgan, so goes the country."

Here are the warning signs that major and probably systemic financial distress remains threaded throughout our economy like termite tunnels in a load-bearing beam.

The Fed’s words and actions are not aligned

Bernanke recently said that the risk the economy has entered a substantial downturn "appears to have diminished over the past month or so," while Alan Greenspan said that financial markets have shown a "pronounced turnaround" since March. Which leads us to the recent inflation-fighting words of Bernanke, who said that the Fed would "strongly resist" expectations that inflation will accelerate, hinting at the possibility that interest rates will be raised. Of course, all of these are simply words. What are the actions?

Since you and I know that inflation is caused by too much money lent too cheaply, we’ll spend less time listening to words and more time looking at the monetary data. In other words, let’s pay attention to what they are doing, not what they are saying.

Through a combination of Federal Reserve and Treasury actions, the total amount of liquidity that has been injected into the banking system has advanced over $40 billion in the last 10 days, smashing to a new all-time record of more than $307 billion dollars. If the worst was behind us and inflation was a real concern, this would not have happened. The actions here tell us that the fear of whatever is ailing the banking system vastly outweighs any concerns about inflation.

Further, short-term interest rates are set at 2.0%, which is a full two percent below the rate of inflation. What do you get when you combine negative real interest rates with extremely loose monetary policy? Inflation.

And finally, here’s a chart of the money supply of this nation. If this was a roller coaster ride, you’d be pressed back in your seat staring at the sky – not unlike oil, grains, and other basic commodities.

So there you have it: On the one side, record amounts of liquidity, deeply negative real interest rates, and a near-vertical rise in monetary aggregates. And on the other side, words.

Bank and financial stocks under attack

When I want to know how a company is doing, I turn to a chart of its stock price. Long before the headlines are written of a company’s undoing, the stock price has already told the tale. The story currently being told by the stock price of several mid-sized banks, mortgage companies, and bond insurers is nothing short of a disaster in the making.

You need to be paying attention to these next few charts. Remember, Bernanke and Greenspan want you to think that the worst is behind us and that things turned around in March.

First up is Bank of America (BAC): $130 billion in market capitalization, a giant bank, and the highest bidder for Countrywide Financial Corp (CFC). BAC has lost 42% of its value over the past 8 months and is 10% lower than it was even at its lowest in March. This is an ugly chart and says that BAC is in some pretty serious trouble. Based on this one chart alone, we can say "no, it’s not over yet."

Now, maybe the market is frowning upon the fact that BAC seems intent, for some reason, on going ahead with their purchase of Countrywide (CFC), which, to this observer, ranks as one of the least fiscally-sound moves of all time. I mean, CFC is saddled with an enormous portfolio of non-performing subprime, no-doc, and option ARM mortgages, not to mention more than 15,000 repossessed properties.

If this is true, then the market should be rewarding the CFC share price while punishing the BAC share price. Let’s see if that’s true…

Nope, it’s not true. That, my friends, is as ugly as it gets, and is the chart of a soon-to-be-bankrupt company. So we can pretty much conclude that BAC and CFC are being hammered on the basis of their business models and not as a result of their unholy alliance.

So, what sort of issues could the stock price be telegraphing about BAC? Let’s consider that BAC has a grand total of ~$150 billion in equity, but over $700 billion in level 2 assets (i.e. "modeled value") and an astounding $32,000 billion in derivatives on the books.

In fact, let me print the list of banks with significant derivative exposure, because I’ll be referring to several of these banks here:

There’s BAC, sitting at #3 on the list with an enormous derivative exposure, and their stock price is sinking like a stone. If Bernanke, et al., are not connecting these dots, then I am extremely worried, because it means they do not know trouble when they see it. But these are really smart folks, so we can fully assume that they are even more aware of this than anybody, leaving us to scratch our heads and wonder why their words do not even remotely match the situation. "Behind us?" Please, not a chance. This thing is just getting underway.

Tip: If you bank with a company whose share price is sinking like a stone, you should think carefully about the joys and sorrows of becoming part of a massive FDIC receivership process.

Speaking of bank stocks giving off some bad odors, consider these:

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Citigroup: $107B market cap, 62% loss within the past year, #2 on the derivative list.

Description: Citigroup Inc. (Citigroup)is a diversified global financial services holding company whose businesses provide a range of financial services to consumer and corporate customers. The Company is a bank holding company. As of March 31, 2008, Citigroup was organized into four major segments: Consumer Banking, Global Cards, Institutional Clients Group (ICG) and Global Wealth Management (GWM). The Company has more than 200 million customer accounts and does business in more than 100 countries.

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Wachovia: $36B market cap, 65% loss over the past 8 months, #4 on the derivative list.

Description: Wachovia Corporation (Wachovia) is a financial holding company and a bank holding company. It provides commercial and retail banking, and trust services through full-service banking offices in 23 states.

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Fifth Third Bank Corp: $6.8B market cap, 70% loss within the past year, #21 on the derivative list.

Description: Fifth Third Bancorp (the Bancorp) is a diversified financial services company. As of December 31, 2007, the Bancorp operated 18 affiliates with 1,227 full-service banking centers, including 102 Bank Mart locations open seven days a week inside select grocery stores and 2,211 Jeanie automated teller machines (ATMs) in Ohio, Kentucky, Indiana, Michigan, Illinois, Florida, Tennessee, West Virginia, Pennsylvania and Missouri

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Suntrust Bank: $14b market cap, 55% loss within the past year, #9 on the derivative list.

Description: SunTrust Bank (the Bank), the Company provides deposit, credit, and trust and investment services. Through its subsidiaries, SunTrust also provides mortgage banking, credit-related insurance, asset management, securities brokerage and capital market services. The Company operates in five business segments: Retail, Commercial, Corporate and Investment Banking (CIB), Wealth and Investment Management, and Mortgage. The Bank operates primarily in Florida, Georgia, Maryland, North Carolina, South Carolina, Tennessee, Virginia and the District of Columbia.

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Fannie Mae: $24B market cap, 65% loss within the past year. Derivative exposure unknown.

Description: Federal National Mortgage Association (Fannie Mae) is engaged in providing funds to mortgage lenders through its purchases of mortgage assets, and issuing and guaranteeing mortgage-related securities that facilitate the flow of additional funds into the mortgage market. The Company also makes other investments that increase the supply of affordable housing. It is a government-sponsored enterprise (GSE) chartered by the United States Congress and is aligned with national policies to support expanded access to housing and increased opportunities for homeownership. The Company is organized in three business segments: Single-Family Credit Guaranty, Housing and Community Development, and Capital Markets.

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General Electric: $287B market cap, 31% loss within the past year, derivative exposure unknown. Note: GE is hugely exposed to finance through its GE Capital division – some wags say that GE is a finance company that also makes stuff.

Description: General Electric Company (GE) is a diversified technology, media and financial services company. With products and services ranging from aircraft engines, power generation, water processing and security technology to medical imaging, business and consumer financing, media content and industrial products, it serves customers in more than 100 countries. GE operates in six segments: Infrastructure, Commercial Finance, GE Money, Healthcare, NBC Universal and Industrial.

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MBIA: $1.6B market cap, 91% loss within the past year, exposed to $137 billion in Credit Default Swaps.

Description: MBIA Inc. (MBIA) is engaged in providing financial guarantee insurance and other forms of credit protection, as well as investment management services to public finance and structured finance issuers, investors and capital market participants on a global basis.

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Each one of the above examples is signaling a severe financial crisis. These examples, of which I could pull many more, represent the largest financial company in the world (Fannie Mae), one of the largest banks in the world (BAC), two regional banks (Suntrust and Fifth Third), a national bank (Wachovia), the third largest company in the world (GE), a bond insurance company (MBIA), and a pure-play mortgage company (CFC). In short, we are seeing severe financial weakness across a diverse set of sectors, regions, and products, and I am at a complete loss as to how anyone could view these charts and make the claim that we are out of the woods.

Tip: If your bank is publicly traded, follow the stock closely. At any sign of weakness, get out and get safe.

Summary

Okay, why did I drag you through this tour of stock charts? Because I desperately want you to understand that this party is just getting started. The comforting words of the Federal Reserve are grossly mismatched to the price signals that these very large and very leveraged financial companies are giving off. The charts above are screaming that "something is broken." I don’t know exactly what it is, but my suspicion is that the derivative mess is at the heart of it.

My analysis suggests that the FDIC lacks sufficient funds to adequately insure all of the potential losses. Read my report on the FDIC if you need a refresher on the matter.

As go the financial companies, so goes America.

That’s what this fight is all about, and that is why the Fed is pouring liquidity on the markets even as inflation is screaming higher and ruining lives. The alternative, collapse of our banking system, is viewed as the far greater threat.

And rightly so.

Actions you can take

Tuesday, May 27, 2008

Executive Summary

• In this report, I lay out my near- and intermediate-term investment themes.
• My assessment is that the economic and financial risks are exceptionally high and possibly historically unique. This is no time for complacency. A defensive stance is both warranted and prudent. A 50% – 70% (real) decline in the main stock market indexes is a distinct possibility, and portfolios should be ‘crash-proofed.’
• Heeding the calls that “a bottom is in” and “the recession could already be over” could be hazardous to your wealth.
• The recession is just beginning and will be the worst in several generations.
• Residential housing data is still accelerating to the downside, while commercial real estate is just beginning its long date with tough times. There is no bottom in sight for either.
• Inflation for life’s necessities is up, and rising energy costs will likely keep certain items at persistently high – and rising – prices for a very long time.

Bottom line:  My assessment is that the financial and economic risks that currently exist are exceptional, historically unique, and possibly systemic in nature, and therefore call for non-status-quo responses. A defensive stance is both warranted and prudent. As for timing, my motto is, ‘I’d rather be a year early than a day late.’

Some Context

I am an educator and a communicator, and I focus on using the past to view the future. Some might consider me a futurist. I think of myself as a realist, and I try to let the data inform me about what’s going on. Of course, the extent to which the data is flawed represents the risk of being wrong.

My goal is not to simply inform, but to inform in a way that leads to you take actions. I want you to protect what you’ve got and prepare for a future that will, in all likelihood, be very different from the present. So different, in fact, that I think you should begin making changes to your lifestyle as soon as possible. In my own life I have found that the mental, physical, and financial actions I am advocating take a considerable amount of time to implement.

Broadly speaking, they are:

• Adapting to a general decline in Western standards of living. The servicing of past debts, coupled with relentless fuel price increases and a recession, speak to a massive shift in our buying and consuming habits. We’ll all have to find ways to be happy with less stuff. This is actually a good thing.

• Moving from a culture of “I” to “we.” The strength and depth of your community connections are going to increase in importance as time goes on. Needless to say, these connections cannot be manufactured overnight. They take energy and thoughtfulness, while trust requires time.

• Giving up the belief (or the certainty?) that the future will be like today, only bigger, and filled with more opportunities for the next generation(s). Maybe it will, and maybe it won’t. I personally found this belief the hardest to let go of because it comes with a sense of loss. I finally progressed past this blockage when I began to believe that the future will simply consist of new and different opportunities than today. But that took work. And time.

• Relying more greatly upon ‘self.’ I use this term broadly to include my entire region. While it may be true that oil and food will continue to flow to New England in sufficient and desired (required?) quantities, what if they don’t?

A Disclaimer and Some Good News

One thing that I cannot and will not do is give specific investment advice to individuals. For legal reasons, I cannot name companies or individual mutual funds, or anything else specific, except in the context of my role as an educator on these matters.

Which is fine by me, because I don’t want to be in the business of analyzing and recommending specific companies, bond offerings, or mutual funds.

To do this credibly and responsibly, I’d have to begin the immense process of sifting through all 20,000+ individual stocks and funds…and I simply don’t have the resources or time. Luckily, there are a lot of qualified people who do this professionally.

Rather, my work involves laying out themes against which specific investment opportunities and strategies can be assessed. I will lay out these themes, and even tell you what I’ve done in response, but it’s up to you to mesh them with your particular situation.

And now for the good news. For anybody who is interested, I (finally!) have a short list of investment advisors who have seen the Crash Course, largely agree with its premises, and are willing to work with people to manage their holdings accordingly. Imagine what it would be like to talk with an advisor who sees the same financial risks that you do, takes them seriously, and has already formulated a response to each of them.

I have no financial relationship with any of these advisors, will never take anything in return from them, and will not recommend one over another. You may request that I provide you with their names and phone numbers (never the other way around), but it will be up to you to make contact and assess the fit. However, I am thrilled to finally have a pool of financial advisors to whom I can refer people. What I get out of this is the satisfaction of knowing that I could help fulfill a very important need. Simply email me and I will forward their contact information to you.

My Themes

So, what does the future hold? Here I will admit that I cannot find any clear historical precedents against which to contrast our current state of affairs. The combination of a national lack of savings, record levels of debt, a failure to invest (in capital and infrastructure), an aging population, Peak Oil, and insolvent entitlement and pension programs has never before been encountered by humans. Worse, Alan Greenspan suckered, er, influenced the rest of the world to go along with the largest credit bubble in all of history, and so there are fewer ways to diversify internationally than might otherwise have been true.

Because the past can only provide clues, I’ve been analyzing and investing according to ‘themes’ that rely on equal parts of data, logic, and my faith that people will tend to behave as they have in the past.  And let me repeat that you can count on me to change my view when the data supports a shift.  Within the context of these themes, there will always be individual winners and losers. Threats and opportunities always exist side by side.  Our task is to choose wisely. My major themes for the next few years are:

Theme #1: Recession, or possibly a depression, due to the bursting of the largest credit bubble in history

My concern level is “high” and stretches from right now until late 2009 to 2010. Nobody alive has ever lived through the bursting of a global credit bubble, and history offers only clues and hints as to how this all might unfold. Your guesses are as good (or as bad) as mine. The recession/depression is going to be fueled by:

• The return of household savings. If households returned to saving even just 5% compared to the current 0%, then the impact to the economy would be the loss of 3.5% of GDP. If this happened, all by itself it would contribute to one of the worst economic periods in modern times.

• Job losses. As the credit bubble bursts, credit will become harder and harder to obtain, businesses will fold, and job losses will mount. Some regions, like Detroit (cars) and Orlando (tourism) will be especially hard hit. Certain job sectors will be particularly vulnerable, especially those related to discretionary or lavish spending.

STRATEGY:  Remain alert. Cut spending, reduce debt, and build savings. Be prepared to revisit portfolio assumptions and tactics on a more frequent (Quarterly? Monthly? Weekly?) basis.

WINNERS:  If a deflationary recession/depression, cash and high-grade bonds. If an inflationary recession/depression, energy, commodities, and consumer staples. In either case, only a very select group of stocks will perform well. The rest will suffer big losses.

LOSERS:  Stock index funds, low yielding stocks, and non-investment grade bonds. Everybody who failed to take this prospect seriously and plan properly.

Theme #2: Inflation is here and rising

(This is a near-term concern). I will remain concerned about inflation until I see my fiscal and monetary authorities begin to behave rationally.  At present, the only concern I see on their parts is to ‘reflate’ the banking system at any and all costs.  One of those costs is inflation.  My full list of inflation concerns is as follows:

• Dollar weakness. Even if the rest of the world experiences no inflation, if our dollar falls, we will still see rising prices for oil and all of the other essential products we import.

• Supply and demand mismatch (for oil and grains especially).  If there is a long-term imbalance created by the fact that the earth can no longer provide a surplus of the things that humans want/need, then prices for the desired items will consume an ever-greater share of our respective budgets.

• Structural inflation (e.g., higher oil prices make steel more expensive, leading to higher drilling costs, leading to higher oil prices….etc).  Once a structural inflation spiral gets started, it is a very difficult thing to stop. Such is currently the case for food and fuel.

• Monetary inflation (growth in MZM & M3 are at historical highs).  And it’s not just the US.  Inflation is spiking all over the world in lockstep with exploding money supply figures. One of the hallmarks of the Great Depression was a nasty series of competitive devaluations by various countries, as they attempted to preserve their manufacturing jobs by making their products appear cheaper than others.  This is a very ordinary and predictable response, as it represents both the appearance of ‘doing something’ and the path of least resistance.  That makes it practically irresistible to even an above-average politician.

• Likely actions by fiscal and monetary authorities.  Spending and easing, respectively, are heavily weighted towards inflation.

STRATEGY:   Buy your essential items early and often.  Stock up your pantry and find ways to store more items in and around your house.  Don’t hold cash or cash equivalents, and avoid long-dated bonds, especially those offering negative real returns (i.e., a yield below the rate of inflation).  Be prepared to move out of paper assets altogether and into tangible wealth. Productive land might be one avenue to explore.

WINNERS:  Commodities, and stocks with a positive inflation sensitivity and/or strong pricing power (like energy and consumer staples companies).

LOSERS:  Bonds paying a negative real rate; companies with low pricing power.  Remember, it’s your real return that matters, not your nominal return.  The Zimbabwe stock market is up tens of thousands of percent this year.  Unfortunately, their inflation is up hundreds of thousands of percent.  Stocks that don’t keep pace with inflation are another way to lose.

Theme #3: Potential banking system insolvency

(This is also a near-term concern).  Yes, the Fed was able to patch things up for a while.  No, the danger has not passed.  Financial stocks are still getting killed in the market, and I am keeping an especially close eye on Lehman Brothers (LEH), as their stock took a particular beating at the end of last week (May 21 – 23, 2008).  It won’t take too many more major financial companies going bust due to derivative-based wipeouts before the whole system goes into shock.  Beyond that, here’s the basic data that gives me the most concern:

• Financial companies are holding $5 trillion (with a “t”) in level 3 assets, which utterly dwarfs the Federal Reserve balance sheet (what remains of it) and possibly even dwarfs the borrowing ability of the US government.  Level 3 assets are an accounting gimmick that allow executives to place whatever value they deem appropriate on ‘hard to value’ items, like bundles of subprime mortgages that really aren’t worth all that much.  Needless to say, there’s some incentive to, shall we say, be generous with the estimates of value.

• Certain derivative products, specifically credit default swaps and collateralized debt obligations, total in the tens of trillions of dollars, and their markets are in disarray.  Counterparty risk is unknown and possibly unknowable.  The risk here is unacceptable.  If these markets spin out of control into a series of cascading cross-defaults, my main question will be, “What will happen to our financial system?” which leads to, “What will happen to financial investments?”

• Total bank capital stands at $1.1 trillion, but the potential total losses across all residential and commercial real estate are much higher than that.  While a massive public bailout is probably in the cards, that will take time, and even I am shocked at how fast the housing market is deteriorating across several extremely large markets (notably all of CA, FL, Las Vegas, Phoenix, and Denver).  Again, the pace of the collapse is what defines the risk here, while the magnitude is without historical precedent.

STRATEGY:  Don’t have all your eggs in one basket – use several highly-rated banks. Remain liquid and alert; be prepared to access and move your funds away from troubled institutions as a tactic to avoid becoming enmeshed in a receivership process.

WINNERS:  People with their dollars held by strong banks, and those who don’t have all their wealth tied up in the banking system and are holding cash, gold, silver, and other sources of liquid, non-dollar-denominated wealth completely outside of the financial system. Having strong, dependable community networks to help manage the transition period.

LOSERS:  Everybody who is late to recognize that bank failures have begun and/or has their money tied up in an insolvent bank.  If a generalized bank system failure does occur, we all lose, to some degree.

Theme #4: Peak Oil

This theme offers both tremendous risk and enormous opportunity.  This used to be a medium-term concern of mine (2-10 years out), but has recently become a near-term concern.  I happen to believe it is here right now, and the only thing that could mask it for a bit longer would be a global depression.  A recession probably wouldn’t do it, though, because through all of history the largest ever yr/yr drop in global oil demand was a mere 0.4%, and that was after a particularly nasty recession back in the 1970’s…meaning it will take more than a garden-variety recession to produce the required 2%-3% drop in demand to mask declining oil production.

STRATEGY:  Begin to whittle down your dependence on energy as a means of reducing the energy portion of your daily budget.

WINNERS:  Energy investments of all sorts, ranging from traditional to alternative and from producers to servicers.  Those with the lowest proportion of spending on energy and access to alternative modes of heating, cooling, and transportation.  My prediction here is that once Peak Oil is generally recognized, solar systems will suddenly develop multi-year waiting periods.

LOSERS:  An enormously wide range of companies that are built around cheap energy. Certain SUV-dependent auto manufacturers come to mind. 

Theme #5: Boomer retirement

The retirement of the baby boomers will result in drawdowns that will exceed Gen-X buy-ups.  To whom are the boomers going to sell all of their assets?  Or, what happens when Cal-Pers (et al.) becomes a net seller rather than a net buyer?  (This is a long-term concern…as in, 10 years out).  Unfortunately, this retirement boom will create demands upon financial investments, concurrent with vast national needs to re-tool our energy, sewage, water, electrical, and transportation systems.  Here I am expecting a toxic combination of both falling asset prices (in real terms) and rising tax bills, as our politicians attempt to simultaneously fix everything they’ve been ignoring for the past two decades.

STRATEGY: Begin reducing total exposure to everything in which boomers are overinvested. This includes stocks, bonds, and McMansions. Avoid living in places or houses that require too much reliance on energy or have especially weak or overextended governments. Vallejo, CA (now bankrupt) is an example…tax bills there are remaining constant, even as services crumble and disappear.

WINNERS: Sectors that service retiring boomers.

LOSERS: High p/e ‘growth’ stocks, low dividend stocks, and other investments whose gains largely depend on persistent and sustained buying pressure. Second homes located in less than prime areas, especially those far from urban areas and therefore requiring large amounts of gasoline to access. 

The Path

While it is possible, I do not anticipate a one-way slide to the bottom, wherever and whenever that may be. I lean towards the ‘stair-step’ model, where a series of sequential shocks and relatively placid periods mark the path to the future.  The three possible scenarios around which I  form my thinking (and actions) are:

1. No change.  The future looks just like today, only bigger, and no major upheavals, shocks, or recessions happen.  The Fed and Congress are successful in fighting off the deleterious effects of the bursting of the housing bubble, and everybody carries on without any major changes or adjustments.  This is not a very likely outcome.  Probability:  1%.
2. A series of short, sharp shocks.  Moments of relative calm and seeming recovery are punctuated by rapid and unsettling market plunges and marked changes in social perspective.  Think of the food scarcity and riots, and you know what this looks like.  One day there is low awareness about food scarcity, and the next day shortages and prices spikes are making the news.  Soon enough, relative calm returns, prices fall, and order is restored, but prices somehow do not recover to their previous levels, leaving people primed and alert for the next leg of the process.  I see this as the most likely path forward.  Probability:  80%.
3. A sudden major collapse.  Under this scenario, some sort of a tipping point causes a light-speed reaction in the global economic system that requires shutting down cross-border capital flows.  Banks would no longer be able to clear transfers and accounts, which would wreak all sorts of havoc upon our just-in-time society.  Food and fuel distribution would be the most immediate concerns.  There’s enough of a chance of this scenario occurring, and the impacts are potentially so severe, that you should take actions to minimize the impacts to yourself and loved ones.  Probability:  ~20%.

Which of these three scenarios will actually unfold is, of course, unknown.  This is why I maintain an alert stance, and why I am constantly sifting the news and posting my thoughts in my blog.  Should a serious event warrant, I will send enrolled members an alert outlining the data and actions you should consider.  I have not yet sent out a single alert because no single event has crossed my threshold. If (or when) you receive one from me, it will be about something I take very seriously.

Of course, nobody can make all the changes that are required at once, or even over the next year.  Rather, there is a list of things that each of us, depending on our circumstances, should consider doing over the next few years.  I break them down into three tiers of actions.  Tier I actions are ones that you should do immediately.  Tier II are ones that you would do only after finishing the Tier I actions.  Tier III are longer-term actions that come after the first two are done, or can be worked in parallel, if time, money, and energy permit.

Let me close with this:  My sincerest hope is that you begin the process of adapting your lifestyle, right now, to the new future that awaits.  If you are waiting for the signs to become any clearer than this, you are waiting too long.

What are you waiting for?

Wednesday, April 9, 2008

Your bank account may not be as safe as you think (or hope). Taking a deeper look at the legal details and the financial depth of the FDIC reveals several troubling details that call into question how the FDIC would fare during a true banking crisis.

The US is coming out of a period of unusually low banking stress and failures. Since it is typical human behavior to let one’s guard down during tranquil periods, we might legitimately ask if this has happened with respect to the FDIC.

Before we address that, we need to understand bit more about the FDIC.

Tuesday, April 8, 2008

Are the current levels of debt in the US placing an immoral burden on succeeding generations? Here I make the argument that they are. (Note: This is an updated version of an article I wrote in 2006.)

Here’s what we know about debt.  

Debt comes in two forms. The first is called, in banker parlance, ‘self-liquidating debt,’ and represents borrowing that will boost economic activity and therefore will stand an excellent chance of ‘paying itself back.’ The simplest example would be a case where you could borrow money at 5% but loan it out, risk free, at 7%. Here the loan will clearly ‘pay for itself.’ More typically, self-liquidating debt has a productive asset tied to it, such as a utility company, an apartment building, or a factory which generates the income to pay off the debt.

The other type is ‘non self-liquidating debt,’ which, as you have already guessed, does not ‘pay for itself’ and is used for consumption, not investment. An example would be borrowing $40,000 to buy a car that does not help you earn any more money at work. Or the construction of a shiny new town hall. Or a war of choice in the Middle East. All of these represent debt taken on today in order to purchase and consume something today, but the purchases do not then lead to new economic earnings. The money is spent, but the debt remains.

Since 2001, our national level of debt has very nearly doubled. If we take a strict view and exclude debt taken on for the purpose of speculating, say, in the housing market, almost all of this mountain of new debt has been of the non-self-liquidating variety.

And here’s the one thing we need to remember about this kind of debt: It represents future consumption taken today. Sometimes people find this statement confusing, so let me flesh this out a bit. In the case of the auto purchase given above, $40k was borrowed and the car was purchased. But later on the loan has to be paid back, with interest, and every one of those future payments are made with cash that is not then available to spend on something else. Cash that you can’t spend in the future represents consumption that you must forgo in the future. In other words, a preference for a car today acquired via debt is really just another way of saying that having the car NOW has a higher ‘value’ than having a car’s worth of purchasing power in the FUTURE. So debt is really future consumption taken today.

And, finally, remember that there are only 2 ways to make a debt go away:

1) Pay it back

2) Default on it

Unless you are the federal government in which case you can always go for the third option:

3) Print money to pay the debt.

The federal government always favors this last option because so very few people correctly perceive the (inevitable) resulting inflation for what it really is, a hidden tax that erodes the value of all existing money, whereas everybody understands that raising taxes directly takes their money away. Inflation is everywhere and always a monetary phenomenon. Excess printing by governments always leads to inflation. Recently, many of our financial observers have been confused by the fact that the explosion in debt/credit, and therefore money, has resulted in asset, not commodity, inflation, but it is inflation nonetheless.

So what does any of this have to do with the title? What does any of this have to do with morality?

Well, if we rotate the topic slightly, we can observe that there are two other ways to view debt. On the one hand, there’s debt taken on with the intent of paying it back, and then there’s debt taken on with the intent that it will not be paid back.

To pass judgment on these two approaches, the former is moral, the latter is immoral (and usually illegal). To really understand this judgment we’ll need to take look at this in greater detail.

Certainly we can all agree that taking out a loan with the intent of never paying it back runs afoul of a variety of civil and criminal laws. But what about a situation where one generation borrows with the intent that a future generation will be the one paying off the loan? Further, what if the loans were of the non self-liquidating (consumptive) variety and zero benefit would accrue to the future generation? How would we term such borrowing?

Well, the 6,000-pound elephant in the room is that this is exactly how the US has been operating for the past 20 years or so. This is not to point a finger of blame, or to create victims and victimizers. We have all been equal, eager, and willing participants in this game. We have been robbing Peter to pay Paul. Unfortunately, Peter has not yet even been born, which means that Peter never got a chance to voice his opinion on the matter.

At any rate, we can observe the phenomenon of generational theft in the negative $65 trillion net worth of the US at the federal level, the $9.4 trillion in direct federal debt (4/2008), and the negative $1 trillion in unfunded pension obligations at the state level. Each of these represents borrowed promises that the current generation has opted to lay upon future generations. In every case it has also meant that current and past generations have been able to enjoy both high consumption and low taxes.

Need more proof? Observe the record-breaking 97% pass rate of state bond issuances in the November 2006 elections. This Bloomberg article explains, and is worth your time to read:

 

Welcome to the Golden Age of Public Finance — Nov. 8 (Bloomberg)

That’s the message voters sent to the municipal market yesterday, as they approved the majority of the record $78.6 billion in bonds placed on the ballot this year.

Of the $56.5 billion in bond issues totaling $200 million or more being considered nationwide, Bloomberg News this morning calculated that 97 percent had passed. The majority appear to be for education, the remainder, money to be used for infrastructure construction and maintenance.

The election of 2006 marks a watershed for the municipal market. Never before have voters had to consider so many bond issues. Never before had they approved so many.

What’s going on here? The easiest answer would be to blame California, where voters were asked to approve that outlandish package of $43 billion for transportation, water, and school construction, and did.

That’s the easy answer. It would be harder to prove, but it wouldn’t be overstating the case to attribute the big election to generational change.

Stay with me here. The people who approved these bond issues, most of them, I’d bet, grew up in the 1970s.

What does that have to do with it? These are people who are used to having nice things. By comparison, those who grew up in the Great Depression and the 1940s were used to making do. They were suspicious of government, and of debt.

When they entered their 30s and 40s, it was the 1970s. The approval ratio for the 1970s, the entire decade, was 49 percent. There were years when this frugal generation approved 9.5 percent (1975), 18 percent (1971) and 33 percent (1973) of the bonds put before them for consideration.

Those who grew up in the 1950s and 1960s, certainly a happier group, approved marginally more borrowing 30 years later, when they started raising their families. The average approval ratio during the 1990s was 69 percent.

Now we’re talking about people who were born in the 1970s. These are the people who enjoyed air-conditioned schools and comfortable college dorms and coffee that tastes good, and they want the same things for their children, as well as things like smooth roads that aren’t too crowded, and new sidewalks, and nice parks, and roomy stadiums. They grew up cosseted, and squeamish about things that are less than just so.

These are the people who have moved to the suburbs and the exurbs and they see no reason why they shouldn’t borrow millions and billions of dollars for things that are going to have a useful life of, oh, when it comes to bridges and highways and sewers and the like, of 50 years to forever. The approval ratio for bonds put up for the vote in the 2000s is 80 percent, according to the Bond Buyer.

So welcome to the Golden Age of Public Finance. Now that this bunch has seen how easy it is to get a whole barge load of bonds passed, look for election ballots to swell to even more unseemly sizes in the years ahead.

I think the author, above, has made a very good set of observations. Namely that the current generation has lost all compunction about borrowing long-term to finance near-term consumption.
And this has come about because Greenspan’s “easy money 4-ever policy” of 1995 through 2005 has lulled us all into thinking that easy, cheap borrowing is a permanent condition. It is not. The piper always must be paid.

But, more importantly, I have serious moral reservations about one generation saddling the next with its debts. How can this be right? At the federal level we’ve decided, as a nation, to make all sorts of promises that cannot possibly ever be kept at current levels of taxation. So either future senior citizens are going to be sorely disappointed by meager entitlement payments, or future taxpayers (my kids) are going to have to shoulder crushing employment tax burdens.

For the senior citizens, this is patently unfair, since they paid more than their fair share into these retirement programs all their working lives. Should it be their fault that our leaders decided to use those ‘excess funds’ for current spending on hapless wars, bridges to nowhere, and other exotic examples of pork barrel spending of every conceivable stripe?

On the other hand, should it be the responsibility of subsequent generations to shoulder the burden of paying for all that past consumption and for our collective decision to ‘fund’ past societal excess with future promises to pay?

In this skirmish, I must side with the future generations. I think it is incumbent on each generation to figure out how to pay for whatever levels of consumptive spending it deems fit.

I think that racking up huge debts with the intent of pushing their repayments off to future generations is morally equivalent to loan fraud. It would not surprise me in the least if future generations decide that they have no legal or moral obligations to make good on that debt.

In the meantime, we each must ask of ourselves where we stand on this issue, how we’ve benefited, and whether we have any sort of an obligation to correct the situation.

And it is up to my children to decide if they want to make good on my generation’s debts. After all, they will someday have a say in the matter. Let’s hope they are feeling generous.

 

Wednesday, March 26, 2008

Be careful what you believe.

A television ad for Morgan Stanley’s brokerage service flickers across the screen, showing a retired couple walking across a beach with a dog and their grandchildren.  Smiles and ease and comfort drip off the screen.  It is a happy, shiny future that they are selling.  Separately, a letter goes out from Morgan Stanley to their private clients warning of a “50% chance of a systemic crisis."  Which do you believe? 

Executive Summary

• Keeping a wide-angle view on this developing crisis is the only way to avoid being whipsawed, and the stakes have never been higher (at least in our lifetime).
• The US financial markets, and probably the world’s, peered over an abyss on the night of Sunday March 16, 2008, but were rescued by very unusual and concerted official actions.
• On the “happy, shiny” side of the equation, we have the fact that stocks mysteriously went up immediately on the open after the announcement of the collapse of Bear Stearns, and have continued up since.
• On the “Cold, Hard Facts” side of the ledger, indicating that a particularly nasty recession is already underway, here is the recent data:

• Housing data was similarly unambiguous.  Sales were down, mortgage rates were up, foreclosures up, construction down, and prices slid at a rate “not seen since the Great Depression.”
• Unemployment claims ratcheted higher.
• Consumer confidence hit a 35-year low.
• Global trade has decelerated to a standstill.
• Retail sales are in the cellar, plunging by more than expected, and auto sales are fading fast.
• The Empire state index clocked in at a record low.
• T-Bills gave a very strong recession reading, by briefly trading at 0.21%.
• Tax receipts for the federal government are down by 12% over the past year.

• You can choose to believe that the worst is behind us (stocks), or you can choose to believe the facts (everything else). But be sure to choose carefully, because the penalty for being wrong here will be particularly steep.  
• Simple preparations will go a long way toward mitigating the effects of a possible systemic financial crisis.

On Sunday, March 16th, deep in the night, the US financial system, and, by extension, the world financial system, peered over the edge of an abyss.  If the Bear Stearns rescue (by the Fed & JPM together) had not happened, it is my firm conclusion that a systemic banking crisis would have ensued.  While some commentators are now saying that “the bottom is in,” with one even going so far as saying the Dow 20,000 is now a lock, I would implore you to be careful in choosing your beliefs

Here’s why.  In my economic seminars, we spend about as much time on the economic context and data that define our current reality as we do examining beliefs and asking ourselves whether the ones we hold might be of the enhancing or limiting variety.  This is important because what we believe shapes what we see, and what we see determines our actions – and therefore our future.  Holding the wrong beliefs at critical turning points can be extremely harmful.

In the book The Mind of Wall Street by Eugene Levy, a wonderful example of both a limiting and an enhancing belief are simultaneously on display when he recounts his experience during the take-over of a struggling railroad back in the 1970’s.  He made a bundle on the deal.  Here he describes the situation:

Management executives looked to the past in their assessment of the railroad.  They saw its wretched history of bankruptcy and losses, the thousands of miles of useless track, and the years of failed attempts at regulatory reform; from this they could only conclude that Milwaukee Road was a failed railroad that could never be profitable.  We looked at the same railroad and instead saw vast assets in real estate and machinery that could be sold.

The railroad executive team held limiting beliefs about their company that prevented them from seeing the value of what they held.  Because of this, they saw the wrong things and took the wrong actions, losing a ton of money as a result.  Meanwhile, Mr. Levy had an enhancing belief that allowed him to see things about the railroad that led him to a fortune.

I want to share a believe of mine with you:  I believe the stock market is being propped up by the Fed and/or US government (PPT), who are desperately afraid of allowing the stock market to signal the true state of affairs. In some ways I can understand this; I think that the authorities who are stabilizing the markets right now are quite justifiably worried about what would happen if the stock market was “allowed” to send a correct signal to a wider audience.  Because I believe that the stock market is being propped, I do not trust that it is telegraphing useful or meaningful price signals, and so I will take very different actions than someone who holds the opposite view.  I might be wrong, or the person holding the opposite view might be wrong, but one of us is making a colossal mistake.

And here’s a second belief:  The market is bigger than the authorities, and they will ultimately fail in their attempts to prop the stock market, because they are merely masking symptoms, not treating causes. If it were possible for an elevated stock market alone to cure what ails our economy, I might think differently.  But those efforts are surely misdirected.

The consumer-retrenchment genie is already out of the bottle, and intervention will only serve to exacerbate what is already a terrifying gap between the ‘official story’ (as told by the stock market), the daily lives of ordinary people, and the cold, hard facts.

Even as a possibly illegal and certainly ill-advised rescue of Bear Stearns is being revised and revisited, and the stock market keeps climbing or at least holding steady, we find that the current spate of fundamental economic news is especially worrisome, if not downright scary.  The question before you, then, is, which will you believe?  A happy, shiny stock market, or the cold, hard facts?

The ECRI and NBER say “recession is here” 

To begin with, the highly-respected Economic Cycle Research Institute (ECRI) recently said, “Now the verdict is finally in.  We have unambiguously turned onto the recession track.”   In case that wasn’t strong enough, Lakshman Achuthan, managing director at ECRI said, "[Our indicator] is exhibiting a pronounced, pervasive and persistent decline that is unambiguously recessionary," while Martin Feldstein, who heads the equally-regarded National Bureau of Economic Research, said that contraction is already under way and that it’s likely to be severe, stating, "The risks are that it could get very bad."  The ECRI leading indicator incorporates a broad array of economic signals and has a very good track record of spotting recessions.  The stock market used to do this, but seemed to lose that ability around the time of the Fed rescue of August 2007.

Now, during your average, ordinary, garden-variety recession, which this one most certainly will not be, the average decline in the stock market is 28%.  Compared to a year ago, before all this financial uncertainty was widely recognized, the S&P 500 is only down -6.6%.  So, for whatever reason, the stock market is now deeply at odds with the ECRI, the NBER, and virtually every piece of economic data.  Somebody has it very wrong.

Housing data is "the worst since the Great Depression"

This housing bubble is bursting, and with alarming speed.  It’s hard to keep up with the data, it’s coming so fast.  Sales and housing starts have been cut in half since the peak (link supplied the quote below), and it’s important to remember that “sales” include transactions in which a bank takes possession during foreclosure, so the sales numbers are misleadingly high.  Notably, foreclosures for February 2008 were reported to be running 60% higher than last February, so we might expect bank repossessions to be a significant component of the recently reported existing home sales number.

CHICAGO (MarketWatch) — Housing is in its "deepest, most rapid downswing since the Great Depression," the chief economist for the National Association of Home Builders said Tuesday, and the downward momentum on housing prices appears to be accelerating.

The NAHB’s latest forecast calls for new-home sales to drop 22% this year, bringing sales 55% under the peak reached in late 2005. Housing starts are predicted to tumble 31% in 2008, putting starts 60% off their high of three years ago.

"More and more of the country is now involved in the contraction, where six months ago it was not as widespread," said David Seiders, the NAHB’s chief economist, on a conference call with reporters. "Housing is in a major contraction mode and will be another major, heavy weight on the economy in the first quarter."

Even worse, house prices have plunged by 10.7% over the past year, according to the highly-respected Case-Shiller index, although the US government (via the OFHEO) comes to a substantially different conclusion and reports a mere 3% decline.  As always, the US government has settled on a particular methodology that manages to paint a happier, shinier picture than does a private firm whose livelihood depends on delivering useful information.  Unsurprisingly, it’s the happier, shinier number that the Fed uses when calculating how much people’s homes are worth vs. how much they owe on them. But even with this deployment, a new benchmark has been set:

NEW YORK (AP) — Americans’ percentage of equity in their homes has fallen below 50 percent for the first time on record since 1945, the Federal Reserve said Thursday.

Homeowners’ percentage of equity slipped to a revised lower 49.6% in the second quarter of 2007, the central bank reported in its quarterly U.S. Flow of Funds Accounts, and declined further to 47.9% in the fourth quarter – the third straight quarter it was under 50%. That marks the first time homeowners’ debt on their houses exceeds their equity since the Fed started tracking the data in 1945.

The Federal Reserve is in a box

That last bit of data, above, is what has the Fed running around with its hair on fire.  Sure, we can all take comfort in the “bold, decisive action” that Bernanke took to preserve confidence in the system by pouring hundreds of billions of dollars into the banking system, but that leaves out a very important observation.  Namely, that the crisis is not based on the fact that banks have run out of liquidity; that’s a symptom.   The cause of this crisis is rooted in the fact that an entirely too-large proportion of the people who took out trillions of dollars in loans lack the means or the motive to ever pay those loans back.  It is now estimated that more than 1 in 10 homes is now ‘underwater’, meaning that more is owed on the mortgage than the house is currently worth.  Currently that’s 8,800,000 homes, a number that we can reasonably expect to grow as this negative housing-price dynamic plays itself out.

So the nature of this particular crisis, like literally every single other credit-bubble fueled crisis in history, is not going to be resolved until the bad debt is wiped out or the losses are socialized.  By this I mean that the Federal Reserve would have to print enough money (out of thin air) to buy all the bad debt, as in $1 to $2 trillion dollars worth of it.  If this happened, the Fed would become the largest property holder in America, its balance sheet would be ruined, and it is highly unlikely that the dollar would survive the attempt.  Therefore, like every other credit bubble that has burst in the past, massive amounts of bad debts will simply have to be wiped away.  And the sooner that happens, the sooner we can pick ourselves up and carry on.

But is this really possible?  Can all that debt simply be defaulted upon?

Probably not.  And the primary reason is that, like everybody else, the Fed has no idea what would happen if the $615 trillion derivative tower, with all of its unknowably complicated interlocking pieces, was suddenly exposed to a rash of defaults.  The fear that this would be an extinction-level event for the banking system, meaning the complete and permanent abandonment of fractional reserve banking as a concept (or for one or two forgetful generations, whichever comes first).

I have no particular insights into the complexity of the derivative system, but I can tell you that I have spent a great deal of time trying to understand the magnitude and location of the risks, without much success.  So I draw my conclusions from two anecdotes.  The first concerns Warren Buffet’s experience in the years after he bought General Re, a fairly ordinary re-insurance company.  The company got in some trouble and the decision was made to absorb its operations and shut it down.  But after several years (and much concerted effort), Berkshire Hathaway found itself stuck with 14,384 outstanding derivative contracts and 672 outstanding counterparties of indeterminate risk and unknowable value, leading Buffet to comment that derivatives are “financial weapons of mass destruction.”   It is important to note that the difficulties Warren Buffet’s organization experienced in assessing the risk and value of a single company’s derivative portfolio was during a period of stable market conditions.

The second anecdote concerns another company with a large derivative portfolio, Fannie Mae, which found itself in an accounting scandal and was forced by the government to restate its earnings for the years 2001 to 2004.  In December of 2006, after two full years of effort by an army of 1,500 expert accountants and $1 billion dollars expended, Fannie Mae was finally able to produce an earnings statement for 2004.  The reason for the excessive cost and time?  Derivatives.  There were simply so many and they were so complex that it took 3,000 person-years of effort to determine the earnings for one single year for one company.  Again, this was during stable market conditions, without the burden of counterparty defaults and the time pressures that fast-moving market conditions can impose.

Fast forward to today.  If it takes thousands of person-years of effort to calculate the impact of derivatives on a single company, what would happen during turbulent times, especially if defaults are cascading and multiplying throughout the system and tens of thousands of companies dotting the globe are involved?  Pandemonium and a major system-threatening crisis, that’s what.

So now you know why I view the Fed’s actions not as “bold and decisive,” but rather as “necessary and forced.”  They will need to go further and begin buying mortgage debt directly, as has already been publicly suggested.  In my opinion, the Federal Reserve (let alone the Bush administration) is institutionally ill-equipped to deal with this particular crisis.  The Fed relies on government data on inflation, house prices, etc., and therefore has a faulty instrument panel.  It is as if they are flying a plane with a stuck fuel gauge and an altimeter that is off by 5,000 feet.  At night, in mountainous terrain.  But, more importantly, the Fed is a sclerotic institution whose reliance on past example (the Great Depression and Japan come to mind) is poorly suited to a modern world that spent the past ten years creating financial products light-years distant from prior experience, while the Fed snoozed along basking in the false glory that came with financial stability and recklessly low but popular interest rates.

The worst is yet to come

Someday, this financial crisis will all be yesterday’s news, but already a lot of ink is being spilled to try and convince you that the worst is already behind us.  Don’t fall for it.  Even a cursory tour of the data will convince you that the bursting of this credit bubble is just getting started and that a particularly nasty recession has just begun.  Nothing the Fed has done, or even can do, will change the fact that trillions of dollars of losses lurk within the system.  And those losses will either have to be written off or they will have to be monetized (i.e., bought by the Fed for money printed out of thin air).  Writing them off would mean the possible destruction of the banking system (and massive political upheavals).  There is a slight chance, a hope, a faith, that we can somehow print our way out of this mess by monetizing the bad debts.  However, that is a knife-edge possibility with failure on one side and the utter destruction of our currency on the other.  While the destruction of our past mistaken pile of debt would be bad for those who took leave of their senses and participated in the credit bubble, placing your faith on our authorities to ‘fix this’ could be financially ruinous.  It is well past time to protect yourself and your financial assets.  While I personally hope for a favorable outcome, I am preparing for the most likely outcome – a currency and/or systemic banking crisis.

Okay, so what should you do?  

My role as a financial commentator and futurist is to help you understand that money systems come and money systems go, and that the US dollar-based system has been, and is being, seriously mismanaged to the point where it is at risk of imploding.  This could happen either in a deflationary impulse that could ruin the entire banking system (unlikely, in my view), or in a (hyper)inflationary collapse of the currency (most likely).  Either way, the effect will be to impoverish the many.  Please don’t be among them.

As I said, I see a risk that this could happen, not a certainty, but because the cost of a systemic banking crisis would be so catastrophic, I think we should each undertake certain preparations.  The analogy I like to use is fire insurance.  We all carry it on our primary residences, not because the likelihood of a fire is high, but because the cost of one is so catastrophic.

It is my belief that by taking a few simple steps, each of us can make significant strides toward enhancing our future prospects.  I sincerely wish everybody would do so.

Let’s review a scenario and some actions that could mitigate the impact(s).

Systemic banking crisis:  50% probability over the next year

Everyone should be prepared for the possibility of a severe systemic banking crisis. You may see a higher or lower percentage probability than I do, but you’d certainly better have something higher than 0% in mind.

What this would look like is some sort of a serious warning, possibly the surprise bankruptcy of Citibank or a blow-up at a massive hedge fund.  Within 24-48 hours, the stock market would be in pretty bad shape, the dollar would be spiraling downward, and interest rates would be shooting up, as foreigners dump Treasury bonds in a frantic bid to repatriate their money while some value still remains. To stabilize the situation, the President would come on TeeVee to declare a banking holiday and state that the banking system is in a crisis and that some time will be needed to “calm things down and work out some solutions.”  During this time, banks would be closed, and it is highly likely that credit and debit cards would not work, since the interbank clearing system would be a mess.  Rules against hoarding would immediately be put in place, and talk of rationing of certain staple goods, such as gasoline, would begin.

Before any of this happens, here are the things you should consider doing:

Tier I actions:

• Have 3 months of living expenses at home, in cash.  The idea here is to be able to buy things even if checks and debit and credit cards are temporarily inoperative.  What you risk here is losing the miniscule interest that your checking account is currently paying.
• Have 1.5 months of living expenses at home in gold &/or silver. This protects against the impacts of a potential dollar crisis.  The more, the merrier, but 1.5 months is the bare minimum.
• Make sure your bank accounts are with the safest possible banks.  Use a rating service such as Veribanc (the Blue Ribbon Report is good).  Better yet, spread your accounts across several highly-rated banks.  The idea here is that these banks will have the best chance of surviving and reopening first after a crisis.  Stay away from big banks – they have the greatest exposure to the unknowable derivative risks.
• Do a little extra buying every time you shop, until you have at least 3 months worth of food on hand.  While the likelihood of a total shutdown of the food system is remote, not having to worry about this possibility if/when a crisis hits will free up an important part of your brain for other tasks.  This means buying extra cans, jars, and packages of food (pasta, etc) that generally will keep for ~1 to 2 years.  Buy only the foods you like to eat.  Rotate the new food behind the older food.
• Have any medicines you can’t live without?  Begin accumulating and storing them, if this is an option.  Again, this is so that you have one less thing to worry about later on.

Tier II actions – only undertake these after Tier I actions are complete:

• Increase your gold exposure until you have 10% (minimum) to 50% of your nest-egg socked away.  Read the Buying Gold and Silver guide in the Take Action section at PeakProsperity.com for types and tips on how to go about this.
• Perform a self-assessment to identify your strengths and weaknesses, and the opportunities and threats that you could imagine arising during a systemic crisis. 
• Address any critical weaknesses or threats that arise in the exercise above.
• Develop “buy-lists” that you can follow in the early phases of a crisis. Having a plan for obtaining last minute items will not take you much time to develop now, but will be a godsend if anything comes to pass.
• Have a plan for what you’ll do.
  • Who will you trust for news?
  • What will you do first?
  • If you and your immediate family are separated by a significant distance, will you all know where to meet and who is responsible for what?
  • Could you anticipate other family members, or even friends, moving in with you (or you with them) as a possible outcome? I f so, does this change any of your other preparations?
  • Thinking these through is just good, common sense, and it is something that all mature businesses do as a matter of course.  They call it continuity and/or disaster planning. If my local co-op bank can do it, so can you.
• Know who your support network is.  Begin cultivating local networks of people who can help you share the load and provide support.

Tier III – only after you’re done with I and II:

• Prepare your home.
  • Water storage. What if the power went out during the crisis?
  • Make your home more self-sufficient with respect to heating and cooling
  • Store more food (for family and neighbors…be a hero!)
• Think about your job.  Will it be more secure/needed in the event of a financial crisis, or insecure?  Build up your cash and gold/silver reserves.  Eliminate debts, especially floating rate and secured debts.
• What skills would be especially handy during a crisis?  Do you have them?  Is there anything you ever wanted to learn that falls under this category?

Conclusion

A bit of foresight and preparation will go a long way to mitigate the personal effects of a systemic financial crisis.  What we believe shapes what we see, and what we see determines our actions – and therefore our future.  We may not be able to change the game that the Federal Reserve is playing, but we can certainly take steps to prepare ourselves for the impact. 

Monday, December 10, 2007 (reprinted Saturday, March 15, 2008)

Executive Summary

• The credit bubble collapse is just getting started.
• Odds of a major systemic financial crisis now higher than ever.
• Dollar collapse is underway.
• Your opportunities to protect your assets are dwindling fast.

(Originally printed on 12-10-2007. Uncannily good predictions and recommendations, all of which I still stand by.)

The Great Credit Bubble, for which you can thank Alan Greenspan, is now in the process of bursting. While the US media implacably attempts to assure everyone that it is well contained or almost over, nothing could be further from the truth. As one financial commentator recently put it, "the good news is that the subprime crisis has been contained…to the planet earth."

The odds of a major systemic financial collapse are now higher than ever.

If you’ve seen the Crash Course (formerly the End of Money seminar), you know I’ve been concerned for a number of years about the toxic witch’s brew of poor-quality loans and unfathomably risky derivatives that are poisoning our financial body. Part of my concern stems from the fact that no matter how hard I try, I cannot understand how the derivatives markets work.

I’ve been unable to discover the most basic answers to the most basic questions, such as “how much capital is actually backing these things?” and “who’s holding the bag?” Wall Street and its ever-compliant financial propaganda services organizations (CNBC, WSJ, et al.) have maintained all along that these new products have completely eliminated risk by spreading it so thin that it has literally disappeared. I do not believe in financial alchemy, and I do not believe this version of ‘reality,’ because it makes no sense at all. Just as it made no sense to finance 19 houses to a part-time hairdresser in Las Vegas with subprime, negative amortization loans (true story), it makes no sense that this level of malinvestment could simply ‘disappear’.

The rest of my concern centers on the fact that 3,800 paper currencies in the past have all gone to money heaven due to the exact same formula of mismanagement that our fiscal and monetary authorities are applying to the US dollar. A few key warning signs would be, (1) bailing out the poor decisions of big banks by flooding the markets with hundreds of billions of dollars of public money/credit, and (2) conducting a pair of very expensive wars “off budget,” while (3) expanding your total monetary base at an astounding, banana-republic double digit percentage rate (as we discussed last time).

I won’t be disappointed if you tend to believe proclamations from the titans of Wall Street more than you would from some random guy named Chris. However, before you place too much faith on the possibility that those guys on Wall Street “must know what they are doing,” I would ask you to consider these facts:

Exhibit A:

Out of all the toxic subprime mortgages ever issued, the subprime loans with highest rates of default were made in the first 6 months of 2007 .

While you and I and everybody else had figured out that the subprime jig was up in 2005 or 2006, the Wall Street machinery couldn’t figure out how to stop what it was doing even as late as July of 2007. Titans or nitwits? You be the judge.

Exhibit B:

Rather than admit they made a bunch of really stupid loans, Wall Street banks first went straight to the US Treasury to mediate a bailout, and, when that proved to be too slow a course of action, simply hid the extent of their losses by massively abusing an obscure accounting gimmick .

Nov. 7 (Bloomberg) Banks may be forced to write down as much as $64 billion on collateralized debt obligations of securities backed by subprime assets, from about $15 billion so far, Citigroup analysts led by Matt King in London wrote in a report e-mailed today. The data exclude Citigroup’s own projected writedowns.

Under FASB terminology, Level 1 means mark-to-market, where an asset’s worth is based on a real price. Level 2 is mark-to-model, an estimate based on observable inputs which is used when no quoted prices are available. Level 3 values are based on “unobservable” inputs reflecting companies’ “own assumptions” about the way assets would be priced.

In other words, these so-called “Level 3” assets are balance-sheet entries that company management value at whatever they say they’re worth. This is like your drunk uncle claiming to be a millionaire because he said he found a lottery ticket in the gutter on the way home last night, but he won’t let anybody see it. The value of these so-called assets is entirely in the eye of the beholder, or bank management in this case, who has decided that they are ‘worth’ every penny that they paid for them and that’s how much they are going to continue insisting they are worth, thank you very much.

Exhibit C:

As the subprime derivative debacle was unfolding, what do you suppose was the response of Wall Street? If you guessed “doubling down,” you are a winner!

Nov. 22 (Bloomberg) — The market for derivatives grew at the fastest pace in at least nine years to $516 trillion in the first half of 2007, the Bank for International Settlements said.

Credit-default swaps, contracts designed to protect investors against default and used to speculate on credit quality, led the increase, expanding 49 percent to cover a notional $43 trillion of debt in the six months ended June 30, the BIS said in a report published late yesterday.

Wow. Wowowowowow. This is shocking. First, because of how hard it is to set new records for the “fastest pace” at the same time that you are setting records for the total amount. This would be like a weightlifter setting a new world record by adding 700 pounds to the old record. Second, because the specific types of derivatives that expanded the fastest were those designed to speculate on credit quality – the very area that is most at risk right now. So we now know that even as the credit debacle was so completely obvious that people returning from year-long wilderness solos knew something was wrong, Wall Street and Hedge Funds were busy accelerating the pace at which they continued to pursue these broken bets on shaky mortgages. Rather than sound fiscal prudence, this appears to be a last desperate grab for what few chips remained on the table.

It is possible that each individual transaction made a lot of sense to the hedge fund managers, but to outsiders like us they look foolish collectively. Why? Because when everybody is hedged, nobody is. Hedging is a zero-sum game. For somebody to win, somebody has to lose. So while all these smarty-pants were busy ‘hedging their risk away,’ nobody seems to have taken stock of the fact that the assets they were hedging were themselves seriously impaired and were going to result in massive losses for somebody. In short, it is impossible to hedge a failed system.

So, there are three perfectly good reasons to suspect that the captains of Wall Street are rather mortal after all and possibly even less competent than the average soul. I could give you forty more, but in the interest of time, I won’t, except to offer the best explanation I’ve ever read on how the derivative market works (PDF) and the human mechanisms at play that allowed all this to get so out of hand. This article will be well worth your time.

Systemic Banking Crisis?

If you own a house, odds are you carry fire insurance. Not because the chance of a house fire is particularly large, but because the cost of a house fire is catastrophic. You carry fire insurance because you have rightly calculated that (small chance) x (a big cost) = unacceptable risk. So you offset that risk with insurance.

Now I want you to seriously consider what the cost to you would be if there were the equivalent of a house fire in the banking system. I’m talking about a major system ‘freeze’ where banks close, huge losses spread throughout the system, electronic interbank transfers become impossible (ATMs, credit cards, electronic funds transfers, wires, and all the rest simply stop), and many banks and brokerages simultaneously go out of business. I’d imagine the impact to you would be quite large. So the next question is, what can/should mature, responsible adults do to insure themselves against such an outcome? How much time, energy and money should one dedicate to insuring one’s financial house?

When I started giving The End of Money seminar three years ago, I had put the possibility of this sort of event at about 15% to 20% over the next 5-10 years. It turns out that I was a raging optimist compared to some financial professionals such as this guy:

Nov. 13 (Bloomberg) — There’s a greater than 50 percent probability that the financial system "will come to a grinding halt" because of losses from mortgages, Gregory Peters, head of credit strategy at Morgan Stanley, said.

This is serious business especially now that the head of credit strategy at a major Wall Street bank is openly writing about it to their main clients. In fact, there are now many respected economists and financial professionals who are calling for a generalized systemic financial meltdown or a severe stock market decline. Even if you have no assets in the larger speculative financial markets (stocks and bonds), or have already taken steps to protect them by getting them out, you are still at risk if your assets are sitting in a risky bank. The possibility of massive bank failures is now a stark reality and it is my opinion that several are already insolvent, just not publicly (yet).

These sorts of crises always start at the edges and work in. First it was the shakier mortgage broker ‘bucket shops’ that began going under in late 2006. Then larger and seemingly firmer mortgage outfits began going under. Now more than 190 mortgage brokers, including most of the ‘top ten’, have gone bankrupt. And today not only is the very largest of them all (Countrywide Financial Corp) rumored to be a strong candidate for bankruptcy, the unthinkable seems to be unfolding before our very eyes. Both Fannie Mae and Freddie Mac, collectively holding several trillions of dollars worth of US mortgages and an even larger portfolio of associated interest rate derivatives, appear to be in some serious trouble . If either, or both, of these companies goes bust, it is highly unlikely (to me) that both the US banking system and the dollar could survive the event.

I am now putting out my strongest warning ever.

If you do not already own gold and/or silver, your time is running out. My best guess would be that once the world’s paper markets implode, the price of gold and silver will skyrocket to unimaginable and unreachable heights, if you can even locate any to buy. Get some.

By the time it is completely obvious that this is the right thing to do, you will find it difficult either due to price, availability, or both. Luckily, the world’s central banks are still capping the price of gold and silver, offering you a wonderful subsidy, which is really quite nice of them. Why do I advocate gold and silver? Simple. Because they are among the very few money-like assets that you can own (hold) that are not simultaneously somebody else’s liability. Consider that a bond (your asset) is the liability of a corporation or government. Even your checking account is your bank’s liability. A house owned free and clear would certainly qualify as a valuable asset, but a house is not very “money like.” When you go through the list (stocks, bonds, annuities, money-market accounts, etc), there is virtually no paper asset that you can identify that is not somebody else’s liability. Even a cash dollar is the liability of the Federal Reserve. But when you own physical precious metals (not mining shares or other paper claims), that’s the long and the short of it. It’s yours. Period.

Next, in order to protect from the possibility of a general banking ‘holiday’ (freeze), every family should have somewhere between one and six months worth of living expenses on hand in the form of cold, hard cash. You know, the bits of paper that work even if the ATMs and credit card readers do not. To be clear, I am not talking about cash in your checking account, I am talking about cash out of the bank and in your hands. Katrina, a natural storm, taught this lesson and we now need to apply that learning to the potential arrival of an economic storm.

Unfortunately, not very many people will be able to do this because the total cash available is a very small percentage of total deposits (~5%). Your bank will look at you funny when you take cash out, mainly because they do not have very much on hand at any given moment. If you plan to cash out more than a few thousand dollars, I highly recommend that you give your bank advance warning and thereby avoid the awkward social moment that will result when they have to tell you that they don’t actually have that much on hand. One thing to remember is that if you take out $10,000.00 or more of cash your bank is required to report you to the federal government via a SAR (Suspicious Activity Report). So the banks appreciate amounts smaller than that as it cuts down on the paperwork.

I would maintain a cash balance until we see clear signs that the evolving credit crisis is getting better, not worse. Given the latest data, which all point to a serious erosion of the credit markets, this could be awhile.

All that’s really happening here is that the long-awaited credit bust is finally upon us. It is important to remember that historically, bubbles have always deflated over approximately the same amount of time as they took to inflate. This means we are looking at a potential end to this crisis somewhere in the range of 2012 to 2020, depending on where you mark the beginning. In the meantime, there will be plenty of false dawns and countertrend rallies that will siphon even more wealth from the unwary.

Don’t be among them.

Monday, March 10, 2008

The greatest shortcoming of the human race is our inability to understand the exponential function.

~ Dr. Albert Bartlett

While it was operating well, our monetary system was a great system, one that fostered incredible technological innovation and advances in standards of living. But every system has its pros and its cons, and our monetary system has a doozy of a flaw.

It is run by humans.

Oh, wait, that’s a valid complaint, but not the one I was looking for.  Here it is:

Our monetary system must continually expand, forever.

What’s going on here? Could it be that the US economy is so robust that it requires monetary and credit growth to double every 6 to 7 years? Are US households expecting a huge surge in wages, to be able to pay off all that debt? Are wealthy people really that much more productive than the rest of us? If not, then what’s going on?

The key to understanding this situation was snuck in a few paragraphs ago: Every single dollar in circulation is loaned into existence by a bank, with interest.

That little statement contains the entire mystery. If all money in circulation is loaned into existence, it means that if every loan were paid back, all our money would disappear. As improbable as that may sound to you, it is precisely correct, although some of you are going to consider this proof that I could have saved a lot in tuition costs if I had simply drunk all that beer at home. But with a little investigation, you would readily discover that literally every single dollar in every single bank account can be traced back to a bank loan somewhere. For one person to have money in a bank account requires someone else to owe a similar-sized debt to a bank somewhere else.

But if all money is loaned into existence with interest, how does the interest get paid? Where does the money for that come from?

If you guessed "from additional loans," you are a winner! Said another way: For interest to be paid, the money supply must expand. Which means that next year there’s going to be more money in circulation, requiring a larger set of loans to pay off a larger set of interest charges, and so on, etc., etc., etc. With every passing year, the money supply must expand by an amount at least equal to the interest charges due on all the past money that was borrowed (into existence), or else severe stress will show up within our banking system. In other words, our monetary system is a textbook example of a compounding, or exponential, function.

Yeast in a vat of sugar water, lemming populations, and algal blooms are natural examples of exponential functions. Plotted on graph paper, they start out slowly, begin to rise more quickly, and then, suddenly, the line on the paper goes almost straight up, threatening to shoot off the paper and ruin your new desk surface. Fortunately, before this happens, the line always reverses somewhat violently back to the downside. Unfortunately, this means that our monetary system has no natural analog upon which we can model a happy ending.

When comparing the two graphs above, you are probably immediately struck by the fact that one refers to a nearly mythical creation especially revered at Christmas time, while the other is a graph of reindeer populations. You may have also noticed that our money supply looks suspiciously like any other exponential graph, except it hasn’t yet transitioned into the sharply falling stage.

To get the best possible understanding of the issues involved in exponential growth while spending only 10 minutes doing so, please read this supremely excellent transcript of a speech given by Dr. Albert Bartlett. If, like me, your lips move when you read, it may take 15 minutes, but I’d still recommend it. In this snippet he explains all:

Bacteria grow by doubling. One bacterium divides to become two, the two divide to become 4, become 8, 16 and so on. Suppose we had bacteria that doubled in number this way every minute. Suppose we put one of these bacterium into an empty bottle at eleven in the morning, and then observe that the bottle is full at twelve noon. There’s our case of just ordinary steady growth, it has a doubling time of one minute, and it’s in the finite environment of one bottle.

I want to ask you three questions:

First, at which time was the bottle half full? Well, would you believe 11:59, one minute before 12, because they double in number every minute?

Second, if you were an average bacterium in that bottle at what time would you first realize that you were running out of space? Well let’s just look at the last minute in the bottle. At 12 noon its full, one minute before its half full, 2 minutes before its 1/4 full, then 1/8th, then a 1/16th.

And inally, at 5 minutes before 12 when the bottle is only 3% full and is 97% open space just yearning for development, how many of you would realize there’s a problem?

And that’s it in a nutshell, right there. Exponential functions are sneaky buggers. One minute everything seems fine; the next minute your flask is full and there’s nowhere left to grow.

So, who cares, right? Perhaps you’re thinking that it’s possible, just this one time in the entire known universe of experience, for something to expand infinitely forever. But what happens if that’s not the case? What happens if a monetary system that must expand, can’t? Then what? How might that end come about? And when? For an excellent description of this process, read this article by Steven Lachance (emphasis mine):

A debt-based monetary system has a lifespan-limiting Achilles heel: as debt is created through loan origination, an obligation above and beyond this sum is also created in the form of interest. As a result, there can never be enough money to repay principal and pay interest unless debt is continually expanded. Debt-based monetary systems do not work in reverse, nor can they stand still without a liquidity buffer in the form of savings or a current account surplus.

When interest charges exceed debt growth, debtors at the margin are unable to service their debt. They must begin liquidating.

Mr. Lachance reveals the mathematical limit as being the moment that new debt creation falls short of existing interest charges. When that day comes, a wave of defaults will sweep through the system. Which is why our fiscal and monetary authorities are doing everything they can to keep money/debt creation robust.

But it’s a losing game, and they are only buying time. How do I know? Because nothing can expand infinitely forever. The evidence clearly points to exponentially rising levels of money and credit creation. As the bacterium example shows, once an exponential function gets rolling along, its self-reinforcing nature quickly takes over, requiring larger and larger aggregate amounts, even as the percentage remains seemingly tame.

Similarly, our supremely wealthy suffer only from an inability to spend what they ‘earn’ on their capital (interest & dividend income), which means their principal is compounding. But, because each dollar is loaned into existence, it means that when Bill Gates ‘earns’ $2 billion on his holdings, a whole lot of people somewhere else had to borrow that $2 billion. Taken to its logical extreme, and without enforced redistribution, this system would ultimately conclude with one person owning all of the world’s wealth. Game over, time for a Jubilee, hit the reset button, and start again.

When we started our monetary system, nobody ever thought that we would fill up our empty bacterium bottle. Nobody really thought through what it would mean to society once wealthy people earned more in interest & dividends than they could possibly spend. Nobody considered whether it was wise to place 100% of our economic chips into a monolithic banking system that requires perpetual, endless growth in order to merely function.

So, we must ask ourselves: Does it seem possible that our money supply can continue to double every 6 years forever? How about another 100 years? How about another six? What will it feel like when we are adding another $1 trillion every month, week, day, and then, finally, every hour?

Just remember, money is supposed to be a store of value; or, said another way, a store of human effort. Currently it seems to be failing at meeting that characteristic and therefore is failing at being money.

Who ever thought that oil production would hit a limit? Who knew that every acre of arable land, and then some, would someday be put into production? How could we possibly fish the seas empty?

We have parabolic money on a spherical planet. The former demands perpetual growth while the latter has definitive boundaries. Which will win?

What will happen when a system that must grow, can’t? How will an economic paradigm, so steeped in the necessity of growth that economists unflinchingly use the term ‘negative growth,’ suddenly evolve into an entirely new system? If compound interest based monetary systems have a fatal math problem, what will banks do if they can’t charge interest? And what shall we replace them with?

Since I’ve never read a single word on the subject, I suspect there’s even less interest in exploring this subject by our leaders than there is in being honest about our collective $53 trillion federal shortfall.

I am convinced that our monetary system’s encounter with natural and/or mathematical limits will be anything but smooth (possibly fatal), and I have placed my bets accordingly. It seems that our money system is thoroughly incompatible with natural laws and limits, and therefore is destined to fail.

Now you know why I have entitled my initial economic seminar series "The End of Money." [Although I later renamed it The Crash Course.]

But the end of something is always the beginning of something else. Where’s our modern day Adam Smith? We need a new economic model.

The greatest shortcoming of the human race is our inability to understand the exponential function. ~ Dr. Albert Bartlett