Effor.com

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

It was interesting watching the stock market go into a steep sell-off today after the Fed meeting minutes were released.  For some reason, most people are still underestimating the severity of the problems in the economy, and they’re stunned when they see something that doesn’t fit into the Goldilocks scenario they’re anticipating.

Here’s how CNN phrased the dilemma facing the Fed: The Fed lowered its economic growth forecast for the year. At the same time, it raised its projections for inflation and unemployment. The combination of slowing growth and rising prices [emphasis mine] created a difficult situation that made the Fed’s latest decision to cut rates on April 30 a “close call.”

Webster defines “stagflation” as persistent inflation combined with stagnant consumer demand and relatively high unemployment

Notice the similarity between the two preceding paragraphs?  Everyone remembers the stagflation we had in the Carter years.  Carter was a disaster for this country, and it took Reagan to turn things around, but Carter was an economic genius compared to Bush!

At least Carter took steps in the right direction by deregulating the oil and natural gas industries - Bush ain’t done squat except to print more money to try to inflate his way out of the mess he caused by creating cheap credit after 9/11.  

The problem wasn’t so much the easy money policy, it was that they kept the easy money policy in place for far too long.  This created the housing bubble, which led to our current credit crunch as all the mortgage backed security instruments lose value as home owners can’t make payments on houses that are worth less than the mortgage balance.

The “close call” CNN refers to is that the Fed is stuck now.  They want to lower rates to stimulate the economy, but that will just exacerbate the inflation problem which is caused by too many dollars in circulation.   That’s what happens when the Fed tries to manipulate the economy instead of following their mandate to ensure a stable monetary system.

From the website of the Federal Reserve: The Federal Reserve System is the central bank of the United States. It was founded by Congress in 1913 to provide the nation with a safer, more flexible, and more stable monetary and financial system.

The Fed has become too political to do its’ job - which is to provide for a stable currency.  The same easy money policy (which leads to inflation) has caused the value of the dollar to drop by about 50% since Bush took office.  Like it or not, a dollar today will only purchase about half of the “stuff” that it would 7 years ago.  Thanks GW…  NOT!

When you see the price of commodities such as oil, wheat, soybeans, corn, etc. (the “stuff” we use) double and you wonder why, that’s why.  Global demand plays a part, but the major reason is that we are paying for the “stuff” in a global marketplace with inflated dollars that people don’t want.

That concludes your economics lesson for today.  Any questions?

gk

According to a story on CNN today, the “U.S. Treasury Department is violating the law by failing to design and issue currency that is readily distinguishable to blind and visually impaired people.”

I don’t know about you, but I’ve bought newspapers and junk food from blind people and we’ve never had any problems.  Think of the expense of redesigning all ATM’s and vending machines to accept redesigned paper money incorporating “Suggested solutions include making bills different sizes, including raised markings or using foil printing which is a method of hot stamping that is tactically discernable.”

May I humbly suggest that these judges get a life?  Let’s face it, with the government printing money like mad, which will soon cause inflation to take off, all our paper money is going to be worth about the same in a few years anyway….  Zero.

I don’t really care if they redo the greenback or not - I posted this simply to get in the part about the government and inflation causing paper money to be worthless in a few years. 

But it does seem like a giant waste of time and money to me.  Here’s an idea, for less total cost, the government could hire a sighted person to follow each blind person around all day and make sure they aren’t getting ripped off!  (That’s sarcasm for those of you about to bombard me with email and comments.) 

gk

I read a good article today in the NY Times.  Here’s the opening paragraph:

If the United States were any other country, these would surely be days of panic and austerity in Washington. With debts spiraling higher, a trade deficit exceeding $700 billion a year, and its currency plunging for years, the government would be forced to cut spending and jack up interest rates in a frantic bid to attract investment.

Very true, unfortunately the day when we’ll be forced to do just that is coming.  It might be later this year, or it may be 10 or more years away, but no one that I’m aware of has repealed the law of supply and demand.

The article mentions this, saying on page 2: Yes, foreigners have been lending alarming amounts of money to Americans, who have spent extravagantly in excess of their means, economists say. One day, balance will be restored in line with the basic laws of economics — perhaps chaotically, and probably via a substantial fall in the dollar’s value.  (emphasis mine)

If you want to know why the dollar is eventually doomed, read this:  When Americans head to the mall, backed by foreign largesse, they drive there burning gasoline made from oil pumped abroad, notably the Middle East. They drive home carrying electronics and clothing churned out in Chinese and Japanese factories. Making these goods absorbs commodities — energy from Australia and Africa; cotton from Texas and California; iron ore from Brazil and India.

That explains a lot to those unfamiliar with international finance - it even touches (in part) on why commodity prices have risen so drastically in the past few years.

Regardless of when it happens, we will eventually be forced to raise interest rates and borrow less from overseas.  Even if we eventually do that, inflation will still be rampant - it’s the only way the government can pay its’ debts. 

Inflation makes old debt cheaper to pay off, because you’re paying it off with inflated dollars.  Neat scheme (everyone from the Pharaoh’s to the Romans, to us has tried it) but it always fails.  No nation has ever inflated it’s way to prosperity.  And all paper money eventually returns to its’ intrinsic value - zero.

gk

Wow, lots of stories today about the “shocking” earnings miss (and lowered forecast) by GE.  MarketWatch said “GE’s warning pokes hole in recent sentiment that credit crunch has passed” and “The rebound had been fueled by renewed sentiment on Wall Street that the worst of the credit crisis — including the threat of spiraling financial bankruptcies — was past.”

A story on CNN said “My guess is that earnings forecasts for 2008 are still pretty high relative to the economic reality,” Davidson said.

I have one word for Mr. Davidson - Duh!

As I posted just yesterday, I don’t think we’re anywhere close to a bottom yet, and the earnings estimates for 2008 and 2009 are way too high.  Eventually, stock prices adjust to reflect earnings, and sometimes the adjustment process is long and painful - as we all learned in 2000 through 2003.

All the stories about Goldman Sachs’ and Lehman CEO’s saying that they can see the light at the end of the tunnel - while simultaneously upping their own writedowns - are crap.  If the CEO’s are so good at predicting the future, why couldn’t they tell us what losses their own companies were going to have?

Speaking of Goldman, I think the glitter is coming off.  This past week they announced that the amount of “Level 3 assets” increased from $69 billion to $96 billion during the first quarter.  If you haven’t been keeping score, “level 3″ assets are those for which there’s basically no market, no one wants them, so Goldman is stuck with them. 

Kinda like having a house that’s “worth” $1 million, but no one will buy it, so you’re stuck with the mortgage payments - but you can say you have a $1 million house.  At least until you have to sell it because you can’t make the payments any longer - then it suddenly becomes a $500k house - and you just lost $500k.

It also means that the value of those assets is a 100% guess.  In effect, Goldman is saying “we think we might have $96 billion in assets, but we really don’t know what they’d be worth if we tried to sell them.  They might be worth $96 billion (but we’re almost certain that that’s not right) but they might be worth 3 cents on the dollar.  We don’t have a clue, so we pulled that $96 billion number out of our butt.”

Level 3 assets are, by definition, “hard to value”.  In fact, they are impossible to value, because no one will buy them.  So companies use a “mark to model” method to come up with a number.  And since “mark to model” varies depending on the model used, we’re back where we started - no one has any idea what these assets are worth.

You may be asking why it’s a bad thing that the value of the assets rose so much in one quarter, and that’s a good question.  Wouldn’t it be a good thing if my $1 million house went up to $1.5 million in one quarter?   The answer to why it’s bad is that it’s a made up number.  I know that this is probably getting old but you need to understand it - NO ONE WILL BUY IT AT ANY PRICE RIGHT NOW!

Your next question is probably something like “why would they make up a higher number for these assets if that’s viewed as a negative?  Another good question, but the answer is easy.  You see, if you claim that your assets are worth more, you can use them as collateral so you can borrow more money.

Kinda neat isn’t it?  Goldman increased its’ ability to borrow by $27 billion in just one quarter.  But who would take these level 3 assets as collateral you ask?  You’re on your “A” game tonight dear reader - another good question.

The answer is that there’s only one place to go to borrow against these assets that no one will buy - the Fed.  You and me (via the government) are loaning Goldman billions of dollars by allowing them to give (I’m going to make up some numbers here - let’s call them “level 3″ numbers) the Fed $10 billion in level 3 assets.  In exchange, the Fed give Goldman $10 billion in Treasuries.

So you and I are now on the hook for $10 billion of basically worthless assets, while Goldman now has $10 billion of nice safe Treasuries.  Nice trick ain’t it?  That’s the Federal Reserve’s new Term Securities Lending Facility (TSLF) in a nutshell.

That’s one of the ways that the Fed is propping up the banks and brokerage houses right now - short of an indirect buyout like they did with Bear Stearns anyway.  But sooner or later, the losses from these made up level 3 assets need to be accounted for. 

The only question remaining is who will pay for the losses - the banks who made the risky loans, the investment houses that took the risky loans and leveraged them, or the taxpayer.  My best level 3 guess is that we’ll see a combination of the above, but taxpayers will eat a significant chunk of the losses.

As a result, the Fed will have to print more money to pay the bills, so the dollar will continue to fall, and the stock market will drop in inflation adjusted terms - and quite probably in real terms as well.  Within the next 12 months, Dow 9,000 is much more likely than Dow 15,000 in my opinion.

gk

Despite the news about Bear Stearns, this may be the news that is the most significant in the long run.  The EEC economy is now larger than the US economy. 

According to the story “Taking the gross domestic product of both economies in 2007, the combined GDP of the 15 countries which use the euro overtook that of the United States when the European currency surged to a record high of more than $1.56 per euro.”

It’s not that Europe is growing faster than the US, it’s that our government is inflating the dollar faster than the Europeans are inflating the Euro.  And with all the billions the Fed has created out of thin air in the past few months, I don’t see that trend reversing anytime soon.

gk

This is something I’ve said would happen eventually.  Well, I haven’t said it here, but I’ve said it on a family email list where we discuss lots of weird subjects.  :-)  From todays’ Daily Reckoning Australia newsletter: “Treasuries tumbled after the government’s $9 billion auction of 30-year bonds at the lowest yields ever chased away investors,” reports Sandra Hernandez at Bloomberg. You reap what you sow, Chairman Bernanke. Prepare to reap the whirlwind.

It looks like we’ve reached the point where the Fed is stuck between a rock and a hard place.  They are being forced to lower rates to fight off a recession (which is probably already here) but no one wants our money at these ridiculously low rates.  The dollar isn’t worth much these days, but (although some are calling for the dollar to rebound) I don’t think we’ll see a meaningful correction in exchange rates as long as the fundamental factors which drove it down don’t change.

By fundamental factors, I mean stuff like Americans spending more than they make - personally, in business, and in government - which forces us (collectively) to borrow money from foreigners to keep things running.  What happens when foreigners no longer want to invest in the dollar (via US Treasuries)?  Rates have to rise to entice them to invest.  Although this is the first evidence I’ve seen of it, I think this will become more widespread.  Rates will rise while we go through a recession - or worse.

Play it through to see the end game….  The cost of borrowing goes up so businesses and individuals have to pay more to borrow the same amount.  Mortages cost more, auto loans cost more, credit card rates cost more - and perhaps most importantly - the government has to pay more to pay interest on our huge (thank you Mr Bush!) national debt.   All while the economy is slowing down.  That drives up unemployment, the dollar keeps falling (because we’re still spending more than we earn) and inflation starts to skyrocket. 

Does anyone remember 1979 and 1980?  I think we’re in for a repeat of that at the minimum - and we could potentially be looking at the 1930’s again.  I recommend paying off your debts, piling up cash, and keeping your powder dry.  Picking up some gold or silver on price dips like we’ve seen the past few days wouldn’t hurt either.  That’s good advice at anytime, but especially now with Bernanke dropping cash from helicopters….

That’s right, Bernanke has said he’d do anything to prevent deflation.  Here’s his speech from November 21st, 2002.

In the same speech he said “If the Treasury issued debt to purchase private assets and the Fed then purchased an equal amount of Treasury debt with newly created money, the whole operation would be the economic equivalent of direct open-market operations in private assets.”

Huh?  Basically Bernanke said that if the government (via the Treasury Dept) printed more money, then the same government (via the Federal Reserve) bought the same amount of treasury bonds, it’s the same thing as the private sector producing something.  To translate this into your personal life, Bernanke is saying that you’re better off if you take out a second mortgage, then use that money to pay yourself to cut the grass.  What the hell is he smoking?

Sorry for the side track rant, the main point of this post is to let people know that today the US Government tried to get anyone to loan them money at 4.41% but no one would give them money at that rate.  The rate on those bonds at the end of the day was 4.51%.  There’s a good story with all the details at Bloomberg.com.  Here’s part of it:

The auction yield on the new long bond was the lowest since regular sales of the security began in 1977, according to Steve Meyerhardt, an official in the Bureau of the Public Debt in Washington.

In today’s auction, indirect bidders, the class of investors that includes foreign central banks, bought 10.7 percent, the lowest on a new 30-year bond since the Treasury resumed sales of the maturity in February 2006 after an almost five-year hiatus. The 20 primary dealers bought 89 percent of the sale, the most since sales resumed.

“Most of it was a dealer auction which meant that customers themselves didn’t put their money where there mouths were,” said James Collins, an interest-rate strategist in Chicago at Citigroup Global Markets Inc., a primary dealer. “The market knows dealers are going to have to sell the issue at a steep discount.”

Regardless of what the Fed does with short term rates, real rates are going up as we become less credit worthy as a nation.  Who will we borrow from in order to keep spending more than we earn tomorrow?

gk

I have a “My Yahoo!” page setup with a couple of portfolio’s, one to view the funds I have available in my 401k.  The other has a few stocks that I own in various accounts, such as the kids college funds, a Roth IRA, and a small “play” account.  The second portfolio also has a few stocks that I’m interested in, plus the major indexes so I can tell at a glance what the market is doing whenever I’m interested.  So with one click on a favorites button, I can see what’s happening during the day.

With the Fed due to announce on Thursday, I was was curious to see how the markets would react, so I checked my custom Yahoo! page several times during the day.  It never fails, when the Fed does ANYTHING, the markets react big time - the only question is will they go up or down? 

All morning the market was down slightly, 30 to 40 points most of the day.  When the Fed announced at 2:15pm, there was an instant surge up, with the Dow up as much as 200 points very briefly.  Then the news hit about Financial Guaranty Insurance being downgraded from AAA to AA.  Stocks immediately took a nosedive, and ended the day right about where they’d been until the Fed announcement - down about 40 points.

In case anyone is wondering why a downgrade of a fairly insignificant bond insurer caused such a downturn, I’ll try to explain it as I understand it. 

Bond insurers do just what their name suggests - they insure corporate and municipal bonds.  It’s an important function which allows corporations and municipalities to sell their bonds at a lower rate than they might get based on their own rating.  For example, lets say that Memphis needs a new sewage treatment plant at a cost of $100 million.  They don’t have $100 million laying around, so they need to borrow it - but (lets assume) they already owe $200 million for other projects, and there is some doubt that they will have the money to repay the sewage bonds on time.

The city of Memphis might be able to sell their bonds at a 10% interest rate (all these numbers are 100% made up - they’re for example use only!) on their own, but if the bonds are insured by a AAA rated insurance agency, they may be able to sell them at a 6% rate - which saves the city a LOT of money on a 20 or 30 year bond.   Let’s assume that the insurer also insured other debt instruments, such as mortgages, derivatives, and CDO’s (Collateralized Debt Obligations), as most of them do in order to have a broader customer base. 

Now what happens when the bond insurer doesn’t have enough money to pay off the claims they’ve insured?  Those city of Memphis bonds were that were yielding 6% because they were insured by a AAA rated (investment grade) insurer, are suddenly being guaranteed to be repaid by a AA (”less than” investment grade) insurer.  The bond ratings are only as good as the insurer, so guess what happens?  Yup, the rate goes up to match the increased risk.

Note that this doesn’t affect bonds that have already been sold.  The people who have bought them will be repaid on time, and at the going rate when they were purchased.  The problem is that very few people actually hold onto bonds for the whole term - they sell them on the secondary market in order to free up their money for something else; buying a home, car, sending little Sally to college, or to move the money to something that they think will give a better return.

In other words, bonds are traded almost like stocks, and almost as often.  When you have a bond fund in your 401k and you move money in or out of it, someone is buying and selling those bonds, be they government bonds as in the example above, or corporate bonds, or maybe even someones mortgage.  So, if I owned a $1000 city of Memphis sewer bond yielding 6% and I wanted to sell it to get my money out, no one in their right mind would settle for a 6% return because it’s no longer investment grade (AAA) rated.  They will demand a higher interest rate to compensate for the increased risk.

You need to realize that the interest rate doesn’t actually change, the price of the bond changes instead, which is effectively the same thing.  If the price I sell the $1000 bond at is $900 instead of $1000, the effective yield to the new owner (assuming it’s a 10 year bond) is 6.667% instead of 6%.  And it yields 7.454% if they hold it for the full 10 years to maturity.  At least that’s what the calculator at http://www.moneychimp.com/articles/finworks/fmbondytm.htm says.  Your mileage may vary. 

The thing to keep in mind is that as the bond is worth less on the secondary (reseller) market, the effective interest rate goes up.  The opposite is also true - if the price of the bond is worth more, the interest rate (yield) goes down.  That’s why Treasury bonds (which are backed by the US Government and your tax dollars) are considered a “safe haven” in times of turmoil.  More people want them because they are the safest investment you can make, so the price goes up.  Simple supply and demand.

Now back to the Memphis sewer bond.  If the insurance company is now rated lower, those sewer bonds are now riskier, so they drop in price.  No one wants to buy or trade them anymore.  The secondary market has dried up, and (since I can’t sell them and do something else with my money) we have a credit crunch.  I can’t invest that money in a new business, I can’t invest that money in the stock market, and the asset I paid $1000 for is only worth $900, so I can’t borrow as much using that bond as collateral.  My net worth has also decreased by the amount that the bond has dropped in value.

Extrapolate this out.  Instead of an individual owning  one or two bonds, imagine that I’m an institutional bank or investment company, such as Bear Stearns.  I have billions of dollars in bonds - both government and corporate - that I own as assets.  In order to get a better return for my shareholders, I’ve borrowed against those assets (just like you or I might take out a second mortgage using our home as an asset) and invested the borrowed money in the stock market, or other places where I think I can get a better return on my investment.  

Overnight my assets  have dropped in value by a good percentage just because the insurer of my AAA rated bonds was rated one notch lower.  What happens?  Since I’ve borrowed against the assets which have dropped in value, I suddenly owe more than what the assets are worth - just like if I’m “upside down” on my car loan or mortgage.  I can’t sell it for what I owe on it, so I’m stuck with something that’s worth a lot less than I owe. 

This is happening at most of the major banks and investment companies all at the same time - the credit crunch “crunches” even tighter.  No one will buy my assets for anything near what I owe on them, so I owe a lot more overall than what what I’m worth.   What can I do?  There are three ways to approach it:

1)  I can ‘fess up and admit that I owe a lot more than my assets are worth.  I produce a quarterly earnings report that shows how much my assets have fallen in price.  That’s what the major investment banks have been doing.  That’s essentially what happened when Merrill Lynch “wrote down” $7.9 billion in the 3rd quarter.  The same for when CitiGroup reported $18.1 billion in write offs.  And when UBS writes down $14 billion, and when (pick your bank writes down billions more).

2)  I can pretend everything is fine and do nothing.  I can say that everything is coming up roses in my report, and everyone believes me.  After all, there really isn’t a loss until you sell the asset for less than you paid for it.  But that’s a house of cards, just like if you or I were upside down on our car loan.  You have to keep making the payments long after you’ve paid what it’s actually worth.   But you can’t sell it and you can’t borrow against it.  Your money is locked up and unavailable to loan to anyone else.

3)  I do what most banks and investment company are doing - at least in my opinion.  I combine the previous two methods.  I write down some assets, but I don’t dare write down all of them that are affected - because that would make it clear that my prestigious company is nothing but a house of cards.  But eventually I will have to come clean and fess up, because the stuff I’ve invested the borrowed money in (mainly other peoples debt obligations) isn’t going to pay enough for me to keep making my payments on the original loan (bond) that I bought.

That’s basically what’s happening in the markets right now - but it’s actually 10 or 100 times worse than this.  That’s because banks and investment companies don’t do what I described above - they do it times 10 or 100.  No one really knows the real numbers, but it goes something like this:

I get a sub-prime home loan from a local bank at a ridiculously low teaser rate that resets in 2 or 3 years.  My local bank doesn’t want to wait that long to get their money back, so they sell my loan to someone else.  The company who purchases my loan (at a discount) also wants to use their money for other things, so they bundle my sub-prime loan with other (mostly prime, but a mixed bag) loans and bonds and sell it to someone else.  My sub-prime loan is a very small part of the overall loan, so you’ll probably get most of your money - if not all of it - back at this point.  Besides, this company paid an insurance premium on the whole thing (it’s actually broken up into “traunches” at this point, but that’s another subject) to be insured by an AAA rated bond insurer.

But the company who now “owns” your AAA rated sub-prime mortgage also wants to get higher returns than the discounted teaser rate (here’s where your super low ARM for the first 3 years hits everyone else) they are getting on paper, so they again bundle it with other loans and bonds, and sell it to someone else.  After all, it’s investment grade AAA rated (and because of the discounts in price every time it’s sold) lot’s of pension funds and other conservative investors will buy it for the nice interest rate they’ll receive.

And the returns will only get better as the teaser rates adjust!  That’s assuming that I can pay my mortgage after my rate resets anyway.  If I can’t, the whole house of cards falls down.  My loan is bundled with hundreds or thousands of others at this point, so if I default on the loan (that I can no longer pay because I was stupid and bought more house than I could afford) it affects the whole bundle.  The owner of that bundle has to take a write off for the amount of my loan - so that AAA rated insurer has to pay up for my non-payment.

But guess what?  How was that AAA rated insurer making money?  By investing their capital into AAA rated debt instruments - thats’ right, the insurers assets are in the same (or a derivative) of the same AAA rated securities that they’re insuring.  So they can’t pay up, because the sub-prime mortgages that they own as assets aren’t making their payments either.

The same debt has been resold over and over.  The same debt has been counted as an asset by 3 or 4 or 10 different companies - because it’s been leveraged multiple times.  An example of leverage is when I buy a stock or bond “on margin” from my broker.  In effect, I’m borrowing money from my broker based on nothing but my guarantee to repay them when the asset goes up in value.   But because my neighbors’ house has also gone down in value (because of the foreclosure on my sub prime loan) none of these leveraged assets are worth what they were. 

The biggest problem is that NO ONE KNOWS where these sub prime mortgages are today.  They’ve been bundled with other prime loans, sold as CDO’s, used as assets against leveraged loans, etc.  No one wants to purchase them so the price keeps falling.  And as the price of a bond (or any other debt instrument) falls, the interest rate goes up.

So regardless of what the Fed does with interest rates, real rates are going up right now.  And the value of all those “assets” held by banks and investment companies is going down.  I think it’ll take years for all of this bad debt (and the subsequent write downs) to work their way through the system.  I don’t know who, when, or where, but I think more than one major bank will fail.  Its’ assets will be bought by another bank and/or the government, but the end result will be the same.  We’re borrowing money to pay back borrowed money.  At some point this always fails.

Personally, I think we’re in for a repeat of the late 1970’s, with high interest rates, little to no growth, and higher inflation.  Because of all the leveraged debt, I think the true picture will only be clear years from now.  Some are saying that we’re entering a deflationary period.  It could be, but my money is betting that “you ain’t seen nothing yet” regarding write downs and losses.  When this house of cards comes down, no one will want the dollar, so it’ll inflate dramatically - especially if the Fed keeps lowering rates and effectively printing more money.  It’s simple supply and demand, and we’ve got way to much supply right now.

This post ended up being a stream of consciousness type of post.  I had one point in mind (the importance of bond insurers) when I started, but it morphed into the other types of debt that make up this house of cards.  It’s way longer, and much more rambling than I originally intended, but hopefully it will provide some insight.  As always, if you spot a factual error, please let me know so I can correct it.  My intent is to enlighten, not to obscure.

gk

I was aimlously surfing tonight when I found this:

In a credit-based economy, a fall in money supply leads to markedly less lending, with a further sharp fall in money supply (since debt is money), and a consequent sharp fall-off in demand for goods. Demand falls, and with the falling of demand, there is a fall in prices as a supply glut develops. This becomes a deflationary spiral when prices fall below the costs of financing production. Businesses, unable to make enough profit no matter how low they set prices, are then liquidated. Banks get assets which have fallen dramatically in value since the (mortgage) loan was made, and if they sell those assets, they further glut supply, which only exacerbates the situation. To slow or halt the deflationary spiral, banks will often withhold collecting on non-performing loans (as in Japan, most recently). This is often no more than a stop-gap measure, because they must then restrict credit, since they do not have money to lend, which further reduces demand, and so on.

Sound familar?  To me it sounds like what’s beginning to happen in the US right now.  The above text is from:

http://en.wikipedia.org/wiki/Deflation_(economics)

Yup, it’s about deflation.  I keep wavering about if we’re heading down the deflationary road, or if we’re setting up for a round of hyper-inflation.  Anyone care to enlighten me?

gk

Ok, I don’t understand how such bright and well educated people can be so stupid.  I’m referring to the Federal Reserve which released their meeting minutes today.   In case you didn’t notice, here’s what happened in the markets today:

Gold and oil hit record highs - http://www.foxbusiness.com/article/gold-prices-hit-28year-high_421594_1.html

The stock market swoons:  http://money.cnn.com/2008/01/02/markets/markets_0405/index.htm?cnn=yes

Here’s some background - basically all commodities have been going up for the past few years.   I’m not just talking about oil and gold - corn, wheat, soybeans, pork bellies (anyone ever bought a pork belly?) - basically anything material “real” thing has gone up at least 35% to 40% or more in the past 7 years.  And it’s not a coincidence that the stock market is about the same as it was 7 years ago, because the reason is the same.  Inflation.

The Fed’s dirty little secret is that they’ve been printing money like mad.  Everytime you see an article mention something like “The central bank, in conjunction with central banks in Canada and Europe, have already conducted two auctions of $20 billion apiece.” (from http://money.cnn.com/2008/01/02/news/economy/fed_minutes_analysis/index.htm) ask yourself where that $20 billion came from.  When you realize that the Fed “created” that money from absolutely nothing, you’ve understood the major issue. 

That $20 billion isn’t setting in a vault somewhere, it isn’t gold reserves that they sold and/or loaned out, it’s not even actually printed - it’s simply bookkeeping entries.  The Fed “made it up” and then loaned it out to banks - so the banks appear to have more money than they do.  It makes the books look better because - get this - the banks don’t even have to report to stockholders that they’ve borrowed the money!  That’s the key to the new “Term Auction Facility” that they’re lending the money through.

Unlike the usual overnight Fed Funds borrowing - which is required to be reported - there’s no reporting requirement for the TAF.  Since the Fed is sen as the lender of last resort, borrowing money to cover shortfalls from the Fed meant that that bank was struggling.  Now that they can do it secretly, the banks will do it even if it carries a higher interest rate, because they don’t need to disclose the fact.  And the Fed gets to “print” another $20 billion and put it into circulation.

They quit reporting on M3 a while back, but you can still find it at a site that compiles it from publicly available information.  Check it out at: http://www.nowandfutures.com/key_stats.html

Is it starting to make sense yet?  In a nutshell, it’s simple supply and demand.  We’re putting more dollars into circulation, but there’s nothing behind them - no tax revenues, no gold or silver deposits, not even the fake backing of government bonds.  What happens when you increase the supply of something but the demand doesn’t change?  That’s right, the price drops - but in this case the thing that’s dropping in price is the money itself, so real things (commodities) HAVE to go up.

Prediction:  Commodities will go up and down in 2008 (brilliant huh!) but they’ll go up a lot further than they go down.  You won’t regret putting 20% to 30% of your portfolio into some gold, oil, Euro, corn, etc, ETF’s a year from now.  And until the Fed stops printing money like madmen, the commodity boom will continue.

gk