09/01/08

A bank is a place where they lend you an umbrella in fair weather and ask for it back when it rains. — Robert Frost

If you stay outside as the clouds gather and the skies darken, you deserve to get wet when the rain starts. If you made the choice to bet on lasting sunshine, who could blame you? But when the clouds roll in, no one owes you an umbrella. It appears, however, that the banks and institutions that bet on the sunshine of the housing market and credit derivatives are now counting on a large Federal Umbrella to shelter them in the present financial storm. The question is: just how wet will taxpayers get as the Federal Reserve and US Treasury build a shelter out of easy money.

Perhaps of greatest concern is the future of Freddie Mac and Fannie Mae. Treasury Secretary Henry Paulson has championed the promise of government support for the mortgage giants, but many disagree as to what it all means. The Congressional Budget Office recently put an estimated price tag of $25 Billion on a full bail-out, but this appears extremely conservative at best. Researchers at the Ludwig von Mises Institute, an independent economic think-tank, suggest that the cost to taxpayers could easily reach $1.3 Trillion and could potentially double that. Freddie and Fannie have purchased or guaranteed $700 Billion of Alt-A and subprime mortgages. Based on present default rates, combined with a reduction in value of 10-30% in the underlying collateral (the homes), the Mises Institute has calculated a loss of $210 Billion in the subprime market alone. Combine this information with the fact that the general housing market will likely lose a third of its value before reaching bottom, and the potential losses reach $1 Trillion.

And that’s just the Freddie and Fannie portion of the problem. From there, the world’s largest investment banks have felt the pinch from their exposure to credit derivatives and lesser banks have suffered from the fear driven credit crunch. Lastly, the average consumer is beginning to feel the effects of the economic slowdown paired with the recent run-up of commodity prices; the same taxpayer that will be asked to foot the bill for the “paper umbrella”.

Meanwhile, the Federal Reserve money making machine continues to flood the market with easy money and denying the “Economy 101” fact that an increase in money supply leads to inflation. Because it hasn’t showed its face yet, it must not exist. The second basic rule of economics is that it is easier to avoid inflation before it starts than to control it once it starts. The basic definition of inflation is, of course, a lowering in the value of a Dollar. This, we might point out, has historically led to higher commodity prices as well as increased interest in Gold as a hedge. As a result, we believe strongly in these markets.

In terms of the market as a whole, it isn’t over just yet. Credit market losses are still mounting and the housing market, we believe, will deflate thirty percent before seeing daylight. Moving forward, it remains to be seen if the Federal Reserve will be able to keep inflation under control while simultaneously propping up Wall Street. For now, it seems like Fed policy is ignoring the inflationary winds that are blowing. Perhaps Mr. Bernanke missed that class.

08/01/08

An economist is an expert who will know tomorrow why the things he predicted yesterday didn't happen today.
Author: Laurence J. Peter

If the world’s largest economy falls in the woods and no one is listening, does it still make a sound? How, exactly, does one call a bottom until you have actually felt the impact? Many analysts, pundits and would be guru’s have tried to successfully predict a turnaround while investors are still flapping their proverbial arms on the way down. The fact is that any optimism for a sustained market rally is purely wishful thinking until the economic wounds are given time to heal from the inside. Stimulus Packages? Fed Auction Windows? Bailouts? All Band-Aids. Certainly, it is instinctual to apply immediate pressure to the wounds to prevent imminent bleeding, and this is not wrong. We do not suggest that the work of Bernanke, Paulson, et al was without merit. However, to deny the realities that we are faced is irresponsible at best.

While some believe we have merely witnessed a speculative bubble in commodities, we disagree. Simple supply and demand issues will continue to drive oil, coal, gold and other commodities. With half the world’s populous in China and India awakening to a new found hunger for growth and technology, demand will certainly continue to grow beyond sustainable supply. Also, the present U.S. administration’s policies and actions have led, and will continue to lead, to further instability in key regions, throughout the world. This, alone, could lead energy prices even higher.

In addition, current Federal Reserve policy has clearly indicated a bias toward protecting Wall Street before the Dollar. We expect any policy shifts toward curbing inflation will come too little-too late. As such, Gold will continue to attract investors as a flight to safety.

Unless Congress passes an energy independence mandate tomorrow or the Middle East wakes up in the morning to a new dawn of peaceful harmony, the smart money will remain in Gold and Energy.

6/20/08

It seems quite likely that over the next 12 to 18 months oil will reach the $180-210 per barrel. It is our view that demand will stay strong even as supply remains inelastic.

Last week’s price action is chiefly attributable to three factors:

• Further declines in U.S. oil inventories
• The announcement of a decline in Russian production in May
• Mexican sources indicating a strong decline in oil production over the rest of 2008

Spare capacity in all areas is limited. It is getting more and more difficult for countries to boost supply. The lower 48 States are mature. Mexico and the North Sea fields are declining. Although Angola and Brazil are growing if we net out these thoughts, non-OPEC supply seems unlikely to increase by much.

Demand has been growing. The places which have large quantities of recoverable oil, Saudi Arabia, Iran, Iraq, Venezuela, and Russia don’t appear to be growing their supply. High prices, of course, are a disincentive to opening up national industry or spending money on internal growth. These countries don’t need incremental revenue: they get revenue through price not volume (see Venezuela).

The sources of demand are not the expected. Indeed the Middle East is a big demand driver roughly equal to China. Latin American demand is also rising.