Effor.com

Interesting daily update from The Daily Reckoning.com.au today.  The Mogambo Guru said (in part!):

I know what will happen in a crisis, because I know what the crisis is, which is that derivative holders will not be getting the money they were supposed to be getting, because the guys who owe them the money are already bankrupt, because they didn’t get the money they were supposed to get from guys who were bankrupt because the guys who owed them money were bankrupt, and they are all bankrupt because they put up a lousy $3 of their own money, and borrowed another $97 to buy an asset worth $100, and now that asset is worth only $90!

That’s what basically happens when someone defaults on a loan.  It’s a whole chain of people going bankrupt - or at the least taking huge write-downs - because a sub-prime borrower can’t make his payments.  The elephant in the room is the amount of money involved.  According to Wikipedia, it’s over $500 TRILLION!

To put that $500 trillion number into perspective, the total GWP (Gross World Product) of the entire world is estimated to be about $65 trillion.  The total market value of all the publicly traded shares in the world is about $44 trillion.  (These numbers are from The CIA World Factbook.)  And according to Wikipedia, the total value of all the property in the developed countries in world is about $62 trillion.

In other words, the money in derivatives total about three times the total of all the above values - combined.  That’s what happens when you leverage real property multiple times.  And when the property that the whole house of cards is built on drops in value by just a little bit, guess what happens to the chain. 

Does a derivative crash make any sound?  We’re getting ready to find out….

gk

I wonder how Doug Kass is feeling about this advice he gave on Jan 14th?

http://www.thestreet.com/s/kass-katch-buy-the-financials-yes-buy/newsanalysis/investing/10398482.html

Yup, you read that right - he said to “Buy the Financials. Yes, Buy”.  Since Mr. Kass published his story on the 14th, the Financial Sector Index (XLF) is down more than 8% - and it was down 10% at one time Friday.  I may be wrong (I often am!) but I don’t think buying on the 14th would have been a good idea….

I think it’s waaay to soon to be looking at this sector.  Personally, I think we’ll see a couple of big bank failures before the financial house of cards has collapsed fully.  No, I don’t know who it will be, but I do know that you don’t make money in the long run by borrowing money (especially at today’s higher rates) to pay down debt.  Eventually you run out of willing lenders (can you say credit crunch?) and you have to face the music.

Banks and other lenders have been putting off the inevitable for quite awhile, and they may be able to postpone it a bit longer, but borrowing from Peter to pay Paul still works the same way it did 100 years ago.  It doesn’t.  Infusions of capital from the Middle East, reductions in the Fed Funds Rate, and issuing corporate bonds simply makes the eventual crash worse.

In my humble opinion, we’re heading into a very rough period for almost all asset classes, but “soft” things like made up financial assets and corporate profits (measured in the dollar) will fare much worse than “hard” assets, such as commodities.  Another 20% to 30% decline from here is not out of the question, so sell some stocks and put the proceeds into simple money market funds or commodities.  In other words, it’s time to keep your powder dry (conserve your capital) so you can afford to pick up some bargains when this train wreck is over.

gk