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Stop me if you’ve heard this one before….  The dollar and financial stocks fall, while gold and oil rise.  Damn, you already heard that one somewhere else? 

It’s a familiar refrain that seems to keep repeating, just like an obnoxious Barry Manilow song or that annoying dog commercial that goes “there might be bugs on some of you mugs but there ain’t no bugs on me”.  (Ha - now you’ve got it stuck in your head too!)

The reason that oil and gold continue to trend higher while the dollar and financial stocks continue to trend lower is one and the same - the Federal Reserve. 

The Fed continues to flood the system with cheap and/or free money.  It’s simple supply and demand.  There are more and more dollars but there hasn’t been a corresponding increase in the demand for those dollars.  So the amount of stuff a dollar will purchase continues to fall.

It’s called inflation, and it’s always CAUSED by the same thing - too much money chasing too few goods.  The classic way to explain inflation is that inflation “is always and everywhere a monetary phenomenon” (Milton Friedman) but it’s saying the same thing.

Even though this is nothing new, I’ve found that damn few people actually understand it.  And the more involved they are in the stock market, the less likely they are to understand it.  They blame inflation on rising wages, or rising oil prices, or the rising cost of (insert commodity here). 

They don’t understand that rising prices are CAUSED by too much money.  When the Fed injects billions of dollars into the money supply (without a real demand for the money) prices HAVE to go up. 

Pretend I have a blog that lots of people read (we’re pretending!) and visit everyday.  Now I take the blog posts that I write and post them on 7 other sites as well.  Assuming more people don’t want to read what I have to say, the number of people visiting each site would go down - even though the total number may stay the same.

Ok, maybe that isn’t the best analogy…. Try this one.  8 people are standing around a barrel of oil.  They all need that barrel of oil, and they’ve all got about $5 to use to purchase it.  Guess what the price of that barrel of oil will be?  Yup, about $5.

Now imagine that Uncle Sam gives (or lets them borrow cheaply) each one of them another $5.  There’s still only one barrel of oil, and all of them still need it.  How much will that barrel cost now?

Does that help?  That’s what the Fed is doing with dollars.  Helicopter Ben is doing everything he can to keep the over-leveraged financial institutions afloat, but he’s simply buying time.  Borrowing money to pay off debt never works - it simply delays the inevitable.

As the dollar loses value (because there are more of them in circulation) the amount of “stuff” each dollar can buy MUST go down.  So things like oil and gold go up BECAUSE the dollar is worth less. 

This sometimes isn’t obvious because with commodities like oil and gold (and corn and soybeans and wheat and rice and pork bellies) demand can also fluctuate and cause price movements, but the underlying cause is the same.  Too many dollars in the system.

Anyhoo, the major financial institutions all owe waaay more than they own.  And they’re finding out that as the value of their assets (and the payments they receive from those assets) fall, they suddenly can’t make the payments on their debt anymore.  But then the Fed comes riding in and lets them borrow more money (using the same assets which are falling in value as collateral) and suddenly everything is supposed to be ok…. Brilliant! (Not!)

There was a report by Reuters today saying “Federal Reserve Chairman Ben Bernanke told Freddie Mac chief Richard Syron that his company and Fannie Mae could take advantage of the emergency discount window, according to a source familiar with the conversation.” 

Since it’s pretty obvious to everyone that Fannie Mae and Freddie Mac are insolvent and going under unless someone steps in, this report was a catalyst for a huge rebound in the market today.  Investors were grasping at straws looking for something, anything to save the sinking financial ship.  They grabbed onto this report and stocks reversed course over 200 points and were even briefly into positive territory today.

Then they realized that even if the report was true, it didn’t change a damn thing.  So the market sold off again into the close. After the markets closed, the Fed denied the story - but I won’t be surprised if the Fed takes action over the weekend like they did with Bear Stearns. 

They know the companies are technically bankrupt, and they’ve got to act at some point.  I don’t know what they’ll do, but they won’t stand by while the ship sinks.  They’ll continue to bail water, only to eventually figure out that the water is coming in much faster than they can bail it out.  The ship will still sink, but they can drag out this soap opera for months. 

In my opinion, they should let it sink now so we can start building the new ship.

gk

I was responding to some comments to a post I made to www.seekingalpha.com a few minutes ago, when I said something that I think needs to be explained further.  I mentioned “leverage” and since that’s been in the news (especially regarding financial stocks) quite a lot over the past few months, I decided to expound on it a bit.

In the comment I referenced above, I said “Let’s say you have $1 million equity in your house, and you take it out in a HELOC. You take that $1 million and put 10% down on 10 other $1 million properties - and you depend on the renters to make your payments.“

That’s leverage.  I just took $1 million in assets (my home equity) and used it to gain control on $10 million in assets.  I used the words “gain control” rather than saying “to buy” because I don’t actually own them - the bank I borrowed the other $9 million from actually owns those properties.

It’s an important distinction, because what happens to my $10 million in assets if just one renter falls behind on their payments?  Suddenly I can’t make my mortgage payments.  It’s only 10% less income, but it causes me to suddenly have to sell the whole $10 million in leveraged assets - because I can’t make the payments.

That’s what happened to Bear Stearns.  They had some assets which they leveraged (borrowed against) in order to buy (with other peoples money) other assets.  When one small part of the initial asset didn’t make their payment, the whole house of cards fell.

In my example, I used a leverage ratio of 10 to 1.  Bear Stearns was leveraged over 30 to 1.  I’ve sen some arguments from pundits (including Ben Stein) where they say the markets have over reacted; that a 10 percent jump in the rate of defaults doesn’t warrant a 20 or 30 percent drop in the stock price of financial companies. 

They’re wrong.  And they’re wrong for the reason above.  When you’re that highly leveraged; when you have 20 (or more) dollars of debt for every dollar of assets; you are hosed when just one percent of the underlying assets doesn’t pay up.

Suddenly you can’t make your payments on all the debt you’ve borrowed.  And since you really didn’t make much of a down payment anyway, you have no equity in the investment.  If you had some equity, you’d have a little breathing room.

But you don’t.  You need every dollar that you’ve counted on to make those payments - because you’ve leveraged your equity. 

And what happens when the value of thoseleveraged assets turns out to be too high?  You’re fucked.  Not only are you highly leveraged, but the base value of thoseassets has dropped, so now you are more leveraged than you were just a monthago.  And so you’re even more vulnerable when there’s a small rise in loan defaults and bankruptcies.

It’s a wild, wild world right now.  I can’t think of a single bank or REIT that I’d touch with a 10 foot pole.  Go ahead and Google the news results for the 3rd quarter of last year.  Check out all the stories that claimed that the 4th quarter was the “kitchen sink” quarter.  Be sure to read how damn near everyone thought that the banks and investment houses have finally fessed up and come clean.

Now watch the headlines during the week ahead.  Let’s se how many additional write-downs there are.  A lot of people have written me saying that I’m overestimating the impact of the sub prime stuff.  Many have told me that all of those losses for the upcoming rate adjustments (for the Option ARM’s and ARM’s written in 2005 through 2007) have been accounted for, and that there’s no where to go but up.

They may be right, but I don’t think so.  I don’t think people truly understand the impact of leverage.  I don’t think they truly understand that just a 3 or 4 percent drop in the base asset (mortgages) can cause a company to disappear.  

I’m not putting my money back into the market until I’m sure that risk has been priced in.  Given the (in my view) extremely optimistic earnings forecasts for 2008 and 2009, that risk is being ignored right now.  I may be wrong (I often am!) but I think I’ll be getting 2 or 3 percent in my money market funds while the optimists are losing 10 to 20 percent (or more) trying to bottom fish the market.

Any questions?

gk

I just posted about Bear Stearns and rumors, and the very next news article I saw was about Lehman.  It’s from Reuters, and the headline is “SEC probing if short sellers hitting Lehman: source

In part, the article says:

Shares of Lehman have fallen more than 40 percent since the beginning of February, far more than the broader index, amid market rumors the company was wobbly.

Lehman has said on multiple occasions that it has enough money to fund itself, it has ample access to financing, and that customers are standing by it.

Now where have I heard that before?

gk

I just read a report from Marketwatch via FoxNews that kinda ticked me off.  The report says that Market self-regulatory organizations late Monday warned traders against circulating any “sensational rumors that might reasonably be expected to affect market conditions” as well as trading on material, non-public information.

Sounds good, except the article goes on to say Although the organizations did not mention any specific companies, Bear Stearns Cos. executives had complained unfounded rumors of liquidity problems triggered actual flights of capital, leading to the firm’s near collapse.

Let me get this straight - they’re saying that “unfounded rumors of liquidity problems” were the problem with Bear Stearns?  Get real people - they might have been rumors, but they were NOT unfounded! 

Bear Stearns DID have a liquidity problem, they were leveraged 37 to 1 in illiquid investments, so they couldn’t pay up when people wanted their money.  And yet they had the gall (what is gall anyway?) to say they had plenty of liquidity ($18 billion if my memory serves) just 2 days before going under.

If you tell the truth you wont have “unfounded rumors” circulating about your company.

gk

It was quite a day today in the financial media.  I’ve read stories tonight about why it’s great for everyone that the Fed bailed out Bear Stearns, I’ve read stories about why it’s bad that the taxpayers are bailing out Bear Stearns, and I’ve read stories where I don’t think the author had a clue what he was talking about.

But one of the best of the bunch has to be an article at Minyanville.com about why the housing market is nowhere near a bottom yet.  On page 2 of the article John Mauldin has a good synopsis of the current situation.  He states:

• 8.8 million homeowners will have mortgage balances equal to or greater than the value of their homes by the end of March.
• 30% of subprime loans written in 2005 and 2006 are already underwater.
• Nearly 3 million homeowners were behind on their mortgages at the end of 2007, with 1 million at risk of imminent foreclosure.
• As of the end of last year, 5.82% (!) of all mortgages were delinquent, the highest level in 23 years.
• 0.83% were in the process of foreclosure, also an all-time high.
• When you look at just subprime mortgages, you find that 20% are delinquent (the number is rising rapidly), and almost 6% were in foreclosure.
• Finally, the average American’s percentage of equity has fallen below 50% for the first time since 1945.

That pretty much sums up the current state of the market, but he goes on to explain why it’s going to get worse.  I’ve said much of this before, but he says it better:

Mortgage lending standards became progressively worse starting in 2000, but really went off a cliff beginning in early 2005. The worst loans are those with two-year teaser rates. As the subsequent pages show, they are defaulting at unprecedented rates, especially once the interest rates reset. Such loans made in Q1 2005 started to default in high numbers in Q1 2007, which not surprisingly was the beginning of the current crisis.”

 It’s an excellent article and I encourage you to check it out if you like knowing what’s probably going to happen over the next few years.

gk

Just had to pass this on.  Excellent write up of the financial issues facing Wall Street and (though I disagree with some of it) Allan Sloan does a good job of breaking down a complex subject.  Highly readable and highly recommended.

gk

Reading this story on FoxNewsreminded me to post my thoughts on the growing cries for more government regulation of the mortgage and brokerage industries.  Basically, I think we need to stop the Fed interventions and roll back the regulations we have now.

That comes with a caveat though - no regulation and no intervention also implies no bailouts.  That means that Bear Stearns would have shut their doors last week. That means that Citi and JP Morgan wouldn’t be able to dip their hands into the Fed’s cookie jar to stay afloat.  That means that more home owners would be in foreclosure.  But I happen to think that those are all good things.

The trillions of dollars of CDO’s, CDS’s, and derivatives that are based on bad mortgages (and that are being propped up by the Fed’s intervention) need to reflect the losses they’re actually sustaining at some point.  You can’t carry a bad mortgage on the books as an asset at full face value forever, and the longer they delay writing off the losses, the longer it will take to sort through this mess.

Get it out there, get it over with, and move on. 

gk

From the 400 point rally today in the stock market, you’d think that the bulls are running rampant in Pamplona.  And you may be right, however….

Stocks are still down over 10% for the year.  The highly leveraged banks and Wall Street firms are still highly leveraged.  Massive amounts of mortgage backed securities - and their higher default rates coming this year and next - are looming.  When a CDO takes a 10% loss because the home owners can’t make the payments, that translates to a 300% loss on a 30 to 1 leveraged portfolio such as Bear Stearns and Lehman Brothers.  (Citigroup is also highly leveraged.)  The $2/share Fed ”take it or leave it” financed JPM buyout of Bear Stearns still needs to be approved by shareholders.  Hmmm…. How would you vote if you owned BSC?

As I’ve written before, this unwinding of the leverage in the financial markets will take quite awhile.  The longer the Fed props up failing companies, the longer it will take to hit bottom.   JP Morgan is getting a deal only because the Fed is guaranteeing $30 billion of BSC’s “assets.”  They’re not really worth $30 billion, but the Fed took that much risk away from JP Morgan.   That’s $30 billion that US taxpayers will end up spending to finance this bailout - because the underlying securities are “riskier assets.”

 A couple of weeks ago, I thought we were headed for a repeat of the Carter years and stagflation, but it’s beginning to look more and more like we’re repeating Japan’s mistakes of the 1990’s.  Low interest rates, keeping bad debt on the books (instead of recognizing the loss and getting it over with) propping up banks with fake assets on their books, etc. 

Japan still hasn’t fully recovered from the 1990’s.  I sincerely hope that we don’t continue making the same mistakes, but today’s 3/4% drop in both the discount and Fed funds rates isn’t helping.  That only serves to drive up long term inflation, and that (rather than deflation that I’m reading about) is my long term worry.

As regular readers know, I don’t try to predict short term market swings, I simply try to stay on the right side of the market during long term trends.  I don’t know if today’s action signals a turnaround or not; my gut says no - because of the reasons listed above - but my gut doesn’t make the market move.

Regardless, I don’t see any fundamental change in the long term trends of the dollar going down, commodities (especially gold, silver, corn, and oil) going up, and the broad market (especially financials) going lower.

My feeling is that the majority on the street think that the worst news is behind us; that most people are looking for a reason to buy.  They’ve discounted all the bad news and they’re ready for another bull market.  I don’t think they’ll get it just yet.

Too many firms have too much debt.  Too many firms are leveraged enough so that a small change in the base assets (mortgages in most cases) results in a huge change to their balance sheets.  One little piece of unexpected bad news will be enough to cause a dramatic sell off.  I’m talking about a sell off big enough to trigger a halt to trading. 

I think the coming upswing in the foreclosure rate (because of all the ARM’s taken out in 2005 through 2007) hasn’t been fully factored in to the stock prices of the companies that are using these mortgages as collateral on their loans. 

When people realize how little capital is propping up these companies, share prices will drop.  The dollar will drop, and commodities will rise.  Again, I have no clue what the market will be at in a week or a month.  I don’t know if commodities will be higher a month from now or not.  But I’m betting that 10 years from now, you’ll be glad you bought gold at $1000/oz, silver at $20/oz, oil at $105/barrel, etc. 

If we really are following the deflationary path Japan took in the 90’s, the Dow may well be at 7000 10 years from now.  As it stands, buy and hold investors are down from where they were 8 years ago….  How much longer do we need to prolong the agony? Take the losses now, write off the sub prime and alt-a loans, get it over with!

Of course that’s just my opinion, I could be wrong.  :-) 

gk

According to CNN, it appears that the deal bailing out Bear Stearns is costing JP Morgan a lot more than the $236.2 million that the $2 per share announcement would lead you to believe.   According to CNN:

The Fed also approved the financing arrangement announced Sunday in which JPMorgan Chase & Co. will acquire rival Bear Stearns Cos. The deal valued at $236.2 million, a stunning collapse for one of the world’s largest and most venerable investment banks. The Fed will provide special financing to JPMorgan Chase for the deal, JPMorgan Chase said. The central bank has agreed to fund up to $30 billion of Bear Stearns’ less liquid assets.

In other words, the Fed just printed another $30 billion in fresh money to loan to JP Morgan.  JP Morgan will use that money to buy up the Bear Stearns “assets” - and I use that term loosely - and give them to the Fed.  In other words, the US taxpayers are now on the hook for the defaults looming in Bear Stearns portfolio.

Hmmm….  How is JP Morgan going to make the payments on that $30 billion loan?  Think that has anything to do with the discount rate cut from 3.5% to 3.25%?  I wonder what interest rate that $30 billion loan carries…. 

Of course it doesn’t really matter, as when you always lose in the long run when you borrow money short term to pay back long term debt. 

Now the question is who’s next?  There’s a lot of chatter about Lehman, but there’s going to be bigger fish to fry soon.  JP Morgan may be safe for now, but I think we’re going to see some chinks in the venerable Goldman Sachs’ armor soon. 

I’m going to try to total up the amount of money the Fed has injected into the markets over the past 6 months or so;  regardless of the amount, it dwarfs the $160 billion stimulus package to taxpayers coming in a few months. 

If the hundreds of billions (it’s got to be over $500 billion) that the Fed has put into the economy hasn’t solved the crisis, do you really think another $160 billion is going to do it?

gk

Just two days ago on Wednesday, March 12th, Bear Stearns CEO Alan Schwartz said (I’m quoting from a Reuters story) “We don’t see any pressure on our liquidity, let alone a liquidity crisis.”

He also said “We have $17 billion or so excess cash on the balance sheet.”

Today he said “Our liquidity position in the last 24 hours had significantly deteriorated.  We took this important step to restore confidence in us in the marketplace, strengthen our liquidity and allow us to continue normal operations.”

Bullshit.  Rumours about Bear Stearns and their problems have been circulating for quite awhile.  I even mentioned it here on Monday in a post titled “Who is this guy Margin - and why does he keep calling?” 

To put it bluntly, Schwartz lied.  He knew he was lying when he said it.  He should be fired immediately and prosecuted for fraud.

The bailout of Bear Stearns by the Fed today is the tip of the iceberg.  This will get worse, and the Fed has now set a precedent of bailing out non-banks.  Here’s a quote from a CNN story today. 

“The crisis, however, is not isolated to Bear Stearns, said Christopher Whalen, managing director of Institutional Risk Analytics, who predicts that the liquidity crunch will only get worse. The heart of the problem is that no one knows how to value the assets these Wall Street firms are carrying so noone wants them.  A lot of firms are right behind Bear,” he said”

gk