 March, 2009 Obamanomics Explored: “You never want a serious crisis to go to waste.” Americans are waiting, at the edge of their seats, for the magic of Obamanomics to make itself felt. They listen to the new president, a salaried optimist if there ever was one, talk resolutely of “responsibility” and promise to wrap up the current downturn by mid-summer. And that is their mistake. Listening to Obama. You can’t understand Obama if you listen to him. He uses his shimmering rhetoric to deflect attention from what he is actually saying. Don’t let yourself be fooled. You need to sneak up on Obama to understand his “new social compact economics.” He will not give you a straightforward statement of his economic policy. Besides, if you saw his policy propositions unadorned by rhetorical razzle-dazzle, they would remind you of the kind of silliness you used to hear late at night in your college dorm from left-wing English majors ranting about the evils of capitalism. When you get down to it, Obama offered three hidden causes of our economic slump: carbon-based energy dependence, insufficient health care and a deficiency of higher education among Americans. Obama’s Big Lies In This Issue:
If you believe Obama, the subprime crisis might never have happened if Wall Street tycoons had been able to drive electric-powered Hummers. Without actually providing any logical link between carbon emissions and risky banking, Obama presented one part of his grand solution to what ails America: a cap-and-trade carbon tax. Loading hundreds of billions in carbon emission fees on the economy is a policy that has been shunned by both Democratic and Republican administrations in the past because its high costs threaten to reduce incomes and destroy jobs. Now, under the guise of facilitating economic recovery, Obama introduces new taxes on energy, increased costs of government, new regulations for businesses and reduced energy-producing options for utilities — a policy Christopher Booker has dubbed “the most costly and economically damaging package of measures ever imposed on mankind.” Stay tuned for any evidence, however fanciful, that carbon emissions weaken the banking system — much less do anything sufficiently worthwhile to justify the fall in living standards implied by a cap-and-trade carbon tax. The only possible logical nexus I can see between imposing a carbon tax and remedying the causes of the credit collapse is that a stiff carbon tax would make Americans too poor to even think of buying big houses in remote suburbs. You can’t have a consumer economy without consumers. The New Energy Arithmetic Another of Obama’s solutions to the supposed contribution of carbon emissions to the subprime mortgage crisis, and the consequent undermining of the global banking system, is this: “We will double this nation’s supply of renewable energy in the next three years.” Although Obama’s statement, along with his promise to install “a cap on carbon pollution,” drew wild applause from Congress folk, it is a grossly unrealistic basis for mitigating American dependence on hydrocarbons, much less removing toxic assets from banks. According to the U.S. Energy Information Administration, total wind and solar energy output in 2008 accounted for about 1.1% of total electricity in the U.S. The 45,493,000 megawatt hours of electricity produced by solar and wind equate to 27.7 million barrels of oil over a year. This means the daily oil equivalent of renewables is 76,000 barrels of oil a day.S That roughly matches the daily production of one coal mine. For further perspective, the most recent daily primary energy use in the U.S. was 47.4 million barrels of oil. By doubling 1/600th of our daily energy use, it becomes 1/300th. Still a tiny fraction. Think of it this way. If Somali pirates intercepted one supertanker of oil on the way to the U.S., it would have 13 times more impact on U.S. daily energy supplies than Obama’s plan to double renewable within three years. But wait. There is more. “Universalizing” Health Care According to Obama, another cause of the crisis that includes a collapse of housing prices and insolvency of the banking system is the lack of universal health care and a thorough-going data base of computerized medical records. Does this mean mortgage brokers dished out subprime loans because of undiagnosed diseases? Is there evidence, however fatuous, that investment bankers who securitized subprime and Alt-A loans miscalculated because of anxieties over medical care or health insurance? I suppose a case could be made that some subprime loans were given to people without health insurance who subsequently defaulted on their mortgage payments when their kidneys failed or they ate themselves into diabetic comas. But to my knowledge, no such case has been made. And there is good reason to doubt that computerizing health records — a project to which Obama has committed $20 billion in his stimulus package — will improve health at all. As Professor Stephen Soumerai of Harvard Medical School points out, “evidence suggests that adoption of some computerized systems has not helped but harmed patients. After the Children’s Hospital of Pittsburgh added automated prescribing recommendations to a commercial electronic records system, the institution documented a more than three-fold increase in the death rate among child patients.” Dishing Out College Diplomas According to Obama, the third major contributing factor informing the credit bubble was not the easy money policy of the Federal Reserve. Nor was it the unwise efforts by politicians to nudge banks and mortgage lenders to make loans to people with bad credit. No. The problem was more insidious. Apparently, we are paying for the past sins of not conferring a sufficient number of subprime college diplomas. Obama would have us believe that there is a big deficiency in American college graduates, despite the record 26% of women and 29% of American men who now hold a college degree. True, the U.S. lags far behind Canada, where 53% hold college degrees. But the U.S. is well ahead of Switzerland and most other countries. Promoting superfluous higher education leads to “credential inflation.” This requires jobseekers to waste years in college to hold jobs that an enterprising high school graduate could perform. As Professors James Engel and Anthony Dangerfield write in their book Saving Higher Education in the Age of Money: “The United States has become the most rigidly credentialized society in the world. A B.A. is required for jobs that by no stretch of imagination need two years of full-time training, let alone four.” But perhaps that’s not the point. Presumably, you are to believe that if every single American had had a college education, more of us would have been smarter about the financing options we choose for houses we could not afford. And consequently Citibank, and the rest of the U.S. megabanks that are now “too big to bail,” would not be insolvent. In any event, Obama intends to shower college educations on everyone — even people with bad grades. Allegedly, the new flood of college graduates will somehow precipitate a reservoir of liquidity that will forestall future credit crises. It sounds to me as though Obama’s college initiative will be a colossal waste of money. That’s because it will divert people from the workforce by requiring years of training for doing jobs that don’t require college degrees in the first place. Like most of his agenda, Obama’s plan for credential inflation has no bearing on rectifying causes of the credit bubble or spurring recovery. It is inspired by the theories of egalitarians, who hold that the underlying cause of income inequality is educational disparity. Hence, Obama’s plan to generate a lot of subprime college diplomas. Let’s Pretend Obama’s “let’s pretend” causes and cures for the credit crisis are compounded by a whole spectrum of other dubious and contradictory policies. These include the $787 billion ’stimulus’ package — a bill distinguished mostly by the fact that it funds lots of long-frustrated bits of the Democrats’ spending agenda. Democrat lobbyists and interest groups have been pining for the program outlays enacted under the guise of ’stimulus’ for decades. Yet there is still a long ramp-up time before the money can be dispersed. Only $21 billion, or 2.6%, of the total stimulus package consists of government purchases to be made this year. Much of this will be spent on propositions that do not promise to be very stimulating. According to Harvard Professor Martin Feldstein, a former chairman of Ronald Reagan’s Council of Economic Advisors, the “U.S. economy faces a $750 billion shortfall of demand” because of the multi-trillion collapse in household wealth. But Feldstein calculates that Obama’s stimulus program will offset only about 40% of the lost demand in 2009 and 2010. My conclusion is that the ’stimulus’ package will fail, the depression will gather momentum as the economy falls into a deeper trough and the downturn will last throughout Obama’s term of office. Obama’s “Super Tax”  Obama Plans a Super Tax on the “Rich” Obama introduced his new budget under the title of a “New Era of Responsibility.” It projects a deficit of more than 12% of GDP. Yet in introducing this breathtaking experiment in spending money out of an empty pocket, Obama promised to cut the deficit in half within four years. How? By raising taxes. Obama spoke of the need for sacrifices from all. Yet his version of sacrifices for all comes down to a promise of tax cuts for 95% of Americans. According to Obama’s plan, his vast spending agenda will be paid for by a “super tax” on Americans earning more than $250,000. He must be counting on the Fed’s policy of printing trillions of new dollars to lift a great many earners into the stratosphere. Otherwise, he will face a critical shortage of persons earning more than $250,000 a year.
There is another contradiction in Obama’s plan to soak the rich. He not only wants to make a tiny fraction of America’s population pay the costs of the Democrats’ pent-up spending initiatives. He also wants to flatten their pre-tax income. In other words, he wants the rich to pay for his programs, while at the same time he wants to prohibit people from earning high incomes. For example, he plans to limit bonuses and compensation for bankers, insurers and auto executives who take bailout funds will contribute to a critical shortage of rich people. The weary president of AIG, Edward Liddy, says he has “grave concerns” about AIG’s ability to retain the talent it needs “if employees believe that their compensation is subject to continued and arbitrary adjustment by the U.S. Treasury.” Liddy is only talking about AIG. But Obama wants the Department of the Treasury, and specifically the IRS, to subject your take-home compensation to “continued and arbitrary adjustment.” Without revisiting the whole supply-side argument, there is credible evidence that lower rates on high earners make tax collections more progressive. In other words, if you want the rich to pay a higher proportion of the total bill, you lower marginal tax rates. This makes it easier for people to become rich and increases the supply of rich people. If you want to reduce the share of the tax burden paid by the rich, you raise marginal rates. This discourages effort and makes it more difficult to become rich. This reduces the supply of rich people, straining government budgets that depend on high receipts from high earners. Of course, Team Obama does not care whether lower marginal rates increase the progressiveness of tax collections, meaning that richer people pay more of the burden of government. They don’t like that lower rates increase the share of total income earned by the most productive Americans (and thus increase the inequality of after-tax income.) The Obamaites want to raise tax rates for high earners now. And they are pressing where they can to subject the compensation of high earners to “continued and arbitrary (downward) adjustment.” Flattening Income Distribution Obama pretends he is promoting an economic recovery plan. But there is substantial evidence, in the U.S. and 33 other countries, that correlates stock market returns, long-term GDP data and consumption. This shows a strong correlation between stock market crashes (defined as cumulative returns of -25% or less) and economic depressions. In light of this evidence, improving stock market returns should be a priority for reducing the likelihood of depression. But this runs contrary to Obama’s overriding preference that the income distribution be flattened. He has advised Americans to invest in the stock market. But his new budget reduces returns on long-term investments by hiking taxes on dividends and capital gains by 25% beginning on October 1. Obama promises to revive housing. But among his specific proposals is a plan to reduce the tax-deductibility of mortgage interest for high earners. He talks about “saving jobs” and fighting unemployment, all while advancing contentious proposals designed to force unionization on firms where proposals to unionize have been defeated by workers in secret ballots. The effect of installing more unions will be to raise wages and other employment costs and reduce employment. Obama promises to fight protectionism. But he has nominated a trade representative to “crack down” trade pacts and impose punitive retaliation on “unfair” trading partners. He promises a second-half recovery. But his policies are aimed at flattening the income distribution, not promoting recovery. The reality is the credit crisis has created a macroeconomic gap because of altered consumer behavior that may take years to sort out. A year ago, Americans were spending 104% of their income. By the beginning of this year, the savings rate had risen to 5%. This signals a shift in the propensity to spend equivalent to 9% of personal income. Therefore, consumer spending should be expected to fall steeply. Think of what would happen to spending if the population suddenly fell by 9%. It would not be pretty. This is what would you could expect even if total income were to remain constant in 2009 as compared to last year. But that won’t happen, given the surge in unemployment and the collapse of so many industries (auto, banking, housing and construction). Duping the Chinese? The most charitable gloss I can put on Obamanomics is that the new president is talking nonsense about “a New Era of Responsibility” in an attempt to hoax the Chinese. Beijing now owns more than $1 trillion of U.S. government debt, and it is prudently considering putting a stop to their purchases of U.S. Treasury obligations in the wake of a 25% drop in their trade surplus in recent months. As Luo Ping, deputy head of China’s Banking Regulatory Commission put it recently: “We hate you guys. Once you start issuing $1 trillion-$2 trillion […] we know the dollar is going to depreciate, so we hate you guys but there is nothing much we can do.” Presumably, Obama hopes Chinese officials have a much weaker grasp of English and understand less about printing money than Luo evidently does. Obama must be banking on misleading the Chinese into believing he has put forward a coherent recovery program, which will lead to a balanced budget. He has not. Obama’s Giant Patronage Program The most important thing is that you not be misled. Obamanomics is not a program for economic recovery. It is a brazen plan to convert the U.S. economy into a gigantic patronage program that redistributes wealth away from those earn it to Democratic constituency groups. The whole project is aimed at showering goodies on those who look to government for favors. Obama has apparently taken the view that “the wealthy” are a fixed club, rather than a dynamic group. He has gone so far as to claim that the top 400 earners in the U.S. have seen their assets increase by a high margin over everyone else since 1990. It’s as if the 400 earners were the same people over almost two decades. This is remote from the facts, as you can easily verify by following the Forbes rating of the 400 wealthiest Americans, a listing which changes annually. Many of those at the top of that list in 1990 are dead now. Hundreds who were billionaires last year no longer are. Quite apart from the obvious fact that many wealthy people have lost bundles of money in the Great Wipeout of 2008, fortunes are always waxing and waning. The Forbes 400 list has never remained constant from year to year. There are always new arrivals who take advantage of entrepreneurial openings to make it big. This has tended to happen in all economic climates, notwithstanding even the most oppressive tax policies. Besides, when you look around the globe, you see it is practically impossible for even the most despotic governments to eradicate enterprise. Even in the dark days of the late Soviet Union, some so-called “capitalist running dog” entrepreneurs found ways to make money despite the oppressive propaganda of the Communist Party, the ever-present threat of the KGB, the prospect of imprisonment in the Gulag… and even the risk of execution by firing squad. The utter failure of “drug wars” to stop trafficking in illegal narcotics also shows that governments cannot easily suppress the entrepreneurial impulse. Accounting for the Recent Rally Given the amazing ability of people to make adjustments in free markets — and even in unfree markets — it is perhaps not surprising that stocks have rallied lately in spite of Obama’s policies. The market was very oversold, with good reason, as traders focused on Obama’s budget proposals, especially his higher taxes on investment income and Geithner’s incoherent bank rescue package. (The Dow jumped 500 points when a more persuasive version of the bank bailout, Part III, was announced.) Basically, the Treasury secretary told the markets, as Paul Krugman says, that “there are no bad assets, only misunderstood assets. And if we get investors to understand that toxic waste is really, truly worth much more than anyone is willing to pay for it, all our problems will be solved.” Now, in addition to the Treasury giving hedge funds billions of dollars to buy toxic (or as Geithner wants us to call them now: “legacy”) assets from banks, there are hints that mark-to-market accounting will be suspended — another gimmick to disguise the insolvency of the banking system. This recipe for “cooking the books” with official sanction entails its own problems and complications, as I explore later in this issue. But papering over the problem and disguising the true state of bank balance sheets will probably be seen as “bullish.” We Are Still in a Deepening Depression Despite Obama’s misleading and illogical cures for the credit crisis, such as national health insurance, imposing a carbon tax and passing out subprime college diplomas, the stock market was oversold and looking for a bounce when the recent rally began. For one, credit spreads and the yield curve had taken a more positive configuration. For another, the market had hammered financial stocks so much that they were priced for oblivion. Values were down across the board. Only days ago, we had the strange spectacle of seeing Citigroup selling at a price that was less than an ATM fee. General Electric was selling for less than the price of a light bulb. And General Motors was quoted for less than a gallon of gas. There was obviously room for a bounce. But don’t let the bounce deceive you. We are still in a bear market. And we are still in a deepening depression. Even if the market is temporarily bottoming, there is a high risk of further downward movement. There is utterly no visibility on earnings for most companies now. And unlike most previous bear markets in living memory, there is no “easing cycle” for the market to look forward to. A Treacherous Market Environment Remember, we had not seen even a marginally convincing rally after the Great Wipeout of 2008 until now. Renain cautious. An inherent feature of capital markets during depressions is their ability to mislead. Most investors do not appreciate the demonic efficiency of market crashes in eradicating wealth in the wake of credit bubbles. Consider the track record of the stock market after 1929. Many people recall that the Dow declined 89% from its peak in September 1929 to its trough in July 1932. This implies that it would have been easy to stay short and make a tremendous fortune while the market tanked. Wrong. What is less appreciated is that the market found a way of wiping out bears as well as bulls. The bears were busted by seven bear-killing rallies of 15% or more. The bulls were creamed by eight declines of 25% or more. Bulls, value investors, momentum traders - even the horoscope traders - if there were any, were wiped out. It did not matter what investment criteria impatient bulls applied, they were wiped out by premature calls of the bottom. Any conventional investment plan was a failure. That is why Crisis Strategy Alert is a necessary addition to your investment arsenal. It is your chance to take advantage of the years that I have spent studying past depressions. And experience shows you must play this and any rebound cautiously, which we were well positioned to do with our MITTS positions. These are in profit, despite the overall market being down considerably since we bought in on January 7. Descending into Bankruptcy Finally, don’t expect Obamanomics to improve the real economy; if the economy does improves, it will be in spite of Obama’s budget and his ’stimulus’ programs. As suggested Rahm Emmanuel, the White House has seized on the worst financial crisis since 1929 as an opportunity to push through long-stymied elements of the Democratic Party’s spending agenda. They think they are being clever. And perhaps they will get away with it. But they run a risk that Americans may just become fed-up with their spasm of interventions if these are not seen to have worked in by the time of the next election. As Lord Rees-Mogg and I wrote in The Great Reckoning: Protecting Yourself in the Coming Depression:
The Obama administration has postponed recovery and squandered a lot of treasure and political capital. His program will test whether “government can successfully contain depression by aggressively refunding bad debt and deploying public credit when private demand is slack. The crux of the issue is whether running down the balance sheet buys recuperative time or merely postpones the inevitable.” The multi-trillion-dollar loses due to malinvestments in the credit bubble are real. The shortfall of three-quarters of a trillion dollars in consumer demand will continue to be felt in a deep and prolonged unwinding. This can only be disguised until the good credit of governments is depleted. With Obama at the helm, I expect that to happen sooner rather than later. In particular, watch the upcoming G20 summit in London on April 2 for evidence that European countries are not prepared to join Obama in running down their balance sheets to finance bailouts and “recovery plans.” Former Czech prime minister Mirek Topolanek has laid the ground work by telling the European Parliament that Obama’s spending plans were “the road to hell” that Europe must avoid. This will put more burden on the U.S. to bailout the weak players, including the countries of eastern Europe and the more heavily exposed western European countries, including Ireland, Greece, Austria, Italy and Spain. We are only beginning to experience the market and social consequences as the world descends into bankruptcy. James Dale Davidson The Floyd Bostwick Odlum Memorial Strategies inspired by Floyd Bostwick Odlum (1892-1976), possibly the only man in the United States who made a great fortune out of the Great Depression. Odlum’s key insight was that credit liquidations dramatically misprice assets. We aim to follow this insight in Crisis Strategy Alert. You see, you can be a victim of this mispricing. Or you can watch carefully, move boldly at the right moment and seize these mispricing opportunities to build wealth rather than lose it. Odlum turned an initial $39,000 into $100,000,000. Suspending Mark-to-Market Won’t Save Banks: A recent estimate by Bloomberg puts the total the U.S. government has spent, lent or committed to ‘fix’ the current economic crisis at about $9.7 trillion. And this shocking figure was superceded when the Federal Reserve announced it was printing yet another trillion dollars or more to buy T-Bonds. Yet despite this impressive effort at dollar devaluation, the greenback has gained value in the wake of the Great Wipeout of 2008. Part of the explanation, as I have said before, is that debt denominated in dollars is the equivalent of a “short” position in the dollar. The world is massively short of dollars. The stronger the deflationary impulse, the stronger the dollar becomes. However, I expect we are soon to see another major contractionary development, as eastern Europe goes through the wringer and a number of western European countries, led by Ireland, Greece and Austria, stumble into a deeper stage of crisis. This should pressure European currencies and result in dollar buying. Typically, the correction after any credit bubble bursts results in the senior currency being chronically strong relative to other currencies and other assets until the excess burden of debt is liquidated. For example, when stocks were at their high in October 2007, the U.S. Dollar Index was all the way down to 75. On March 3, before the current bear-market rally in the stock market got underway, the dollar index climbed as high as 88.9. As I write, it has sold off to 86.79 as the Dow and other broad stock indexes rebound. I point to dollar strength as an example of a paradox, another quirk of crisis investing. The Treasury and the Federal Reserve are ostensibly charged with preserving the dollar’s value. But nothing could be worse from their perspective than seeing the dollar strengthen. In fact, all their ambitions depend upon dollar depreciation. The Story of Darrell Dochow  Office of Thrift Regulator Darrell Dochow This may account for the strikingly chilly treatment dished out to Darrell Dochow, a senior federal banking regulator who stole a step on the authorities by allegedly approving a plan by IndyMac Federal Bank to exaggerate its financial health in a federal filing last May. This allowed IndyMac to avoid regulatory restrictions only two months before it collapsed. According to a federal inquiry, Dochow let IndyMac falsify a statement of its capital. Who says that civil servants are not inventive in doing their jobs? Mr. Dochow was singularly inventive with what will soon be the official remedy for what ails the banks: allowing them to “cook their books” by suspending mark-to-market accounting. Even before the Financial Accounting Standards Board (FASB) and the Department of the Treasury came to the conclusion that the banks were being killed by too much transparency in their accounting, Dochow had already concluded that zombie banks should not be obliged to tell the truth about their solvency. The regulatory agency for which Dochow worked, the Office of Thrift Supervision, allowed similar legerdemain by other banks, according to a letter sent last December to Congress by the Department of the Treasury’s inspector general, Eric Thorson. Thorson did not provide details about the other incidents. Perhaps he should collect these tricks in a binder and walk them over for close study by Treasury Secretary Timothy Geithner. The Treasury secretary has been looking for creative ways that banks and other financial institutions can cook their books. He is still scratching his head, but Dochow wasted no time improvising a cost-efficient way of making a big bank appear solvent when it isn’t: lie about it. From Mark-to-Market to “Little White Lies” The FASB, under prodding from Congress, is about to announce the terms under which banks, insurers and other investment companies will substitute “little white lies” for capital. Of course, mind-numbing technicalities will obscure whatever new rules replace mark-to-market accounting. See, rather than explicitly dropping mark-to-market, the FASB’s plan is to introduce weasel provisions such as this one:
In other words, if you’re holding an asset on your books for which bids have dried up, and you don’t like the value an asset commands in the market, make up a higher one. For Washington, there’s a great efficiency in suspending mark-to-market accounting. Talk is cheap. But actually buying up banks’ toxic assets takes billions and even trillions of dollars the government doesn’t possess. If banks can simply give new valuations to their toxic assets, there may be no need for the government to step in and buy these assets. The U.S. banking system is effectively insolvent. And as I explained last month, the reason Geithner cannot afford to actually buy the toxic assets is not only because they are expensive. Another issue would be that writedowns associated with recognizing the real market prices would absorb all the capital of the banking system, plus trillions of dollars more. For example, BBB subprime mortgage securities that were priced at 100 at the top in 2007 were recently going for 2.38. When market prices are this grim, it doesn’t take much imagination to see why banks would rather substitute some new accounting rule for mark-to-market. The alternative that comes immediately to mind is “wishful thinking.” This is what banks will effectively use if the FASB does what it is told by Congress and suspends “mark-to-market” rules. They will substitute their own forecasts for the market’s judgments. They will estimate BBB subprime securities to be worth 30 times their market price. And based on these new metrics, Citigroup would be as solvent as IndyMac appeared to be after Dochow applied a little lipstick to the ugly face of its capital account. Blessing a Fiction The finding that banking regulators on several occasions “blessed a fiction,” in the words of one congressional staffer, raises some serious questions. Was this an example of “regulatory capture” (when officials become too cozy with the companies they regulate)? Or were Dochow and his colleagues regulatory visionaries who anticipated the tortured path that bailing out the banking system would take and simply decided to leap directly there without passing “Go.” In any event, it is now clear that the “Dochow Solution” will be Washington’s answer to the banking crisis. That’s because cooking the books is much cheaper than actually recapitalizing the banks. This is a crucial advantage where the Obama administration is concerned. I continue to doubt that the political mood will allow Obama to escalate the bailout with additional boatloads of appropriated funds. Obama asked for another $750 billion for banking bailouts in his new budget. But judging by all the fulminating over the AIG bonus payments, he’ll be lucky to persuade Congress to appropriate another $750 for bank bailouts. And the market appears to expect that the suspending of “mark-to-market” will be an unalloyed lift for the financial sector. Perhaps it will be… for a time. For one, it means the depreciation of securitized commercial and household mortgages will no longer swamp operating profits. It also introduces the prospect that operating profits will eventually be augmented by “write-ups.” These will no doubt come about as banks dream up new analytic approaches to valuation that can conjure up the “capital appreciation” they so desperately want to include in their results. But the problem with cooking the books as a solution to insolvency was illustrated by the collapse of IndyMac after Darrell Dochow exaggerated its financial health last year. The bank went bust. The Problem with Analytical Evaluations The essence of the Floyd Bostwick Odlum approach to profiting during economic crises is the recognition that assets are often mispriced under duress. So they are. But the trouble with analytical forecasts, as compared to market valuations for determining capital values, is that sometimes grim prices accurately anticipate the future. Also, the Great Wipeout of 2008 is evidence that analytical valuations are often wrong. For example, the AAA status the ratings agencies gave some securitized subprime mortgages was allegedly based upon strong analytics. Last March, Moody’s and S&P’s still rated as AAA one bond Deutsche Bank sold in May 2006, despite 43% of the underlying mortgages being delinquent at the time. Make no mistake: these analytical valuations had follow-on effects that contributed mightily to the Great Wipeout of 2008 and its aftermath. When formerly AAA mortgage bonds went into default, the consequences cascaded down the ratings chain. This undermined the values of all lower-rated securitized mortgages. It also creamed the values of supposedly high-grade collateralized debt obligations. So, securities that were bid at par (100) before home prices began to sag were at 80 a year ago. And they have continued on their merry way toward oblivion. (They were bid more recently at 33.8.) In short, much of the damage to the valuations of what have become known as “toxic” assets – and now “legacy” assets in the new parlance of the Treasury – arose from the decay of the underlying economics of the assets in interaction with valuation metrics based on analytical rather than strictly market-based pricing. Simply put, values notched down not because of merciless selling by hedge funds, but because the performance of the securities breached the indentures established by their underwriters when they were issued. As delinquencies and foreclosures rose, loses exceeded the “safety margin” available to absorb them. Consequently, credit rating agencies such as S&P’s, Moody’s and Fitch eventually, though reluctantly, downgraded the securities in keeping with well-established bond-rating criteria. The notion that toxic assets held by banks and companies such as AIG were marked down by 70% or even 97% because bids were weak due to illiquidity simply isn’t true. Instead, they were marked down because the securities failed to perform as advertised when they were issued. More broadly, they were marked down in keeping with the decay in value of the real estate that collateralized the mortgage loans. Delaying the Ultimate Recovery The trouble with suspending or even significantly relaxing mark-to-market accounting rules is that it does nothing to suspend the erosion of the underlying collateral of the many tens of thousands of subprime bonds. And as long as the collateral keeps eroding, the value of the income streams seems destined to fall as growing percentages of homeowners and commercial real estate holders fall behind on their mortgages. This also radiates out to additional loses on collateralized debt obligations and those tricky little instruments known as credit-default swaps. And bear in mind that just because banks in the U.S. drop mark-to-market accounting doesn’t mean that banks everywhere will play “let’s pretend” with the eroded value of their assets. Securitized mortgage bonds were sold all around the world; and many credit-default swaps insured the value of these securities rather than their income flow. This means if certain issues plunge in value anywhere in the world, holders would arguably be able to exercise swap contracts and exchange their securitized bonds for cash. Thus, even easing mark-to-market accounting standards will not necessarily stop the deleveraging unleashed when the housing bubble began to burst a few years ago. In fact, I expect it to continue. The gambit of cooking the books will only postpone a solution to the problem of banking insolvency. In doing so, it will delay the ultimate recovery. I also fully expect the Federal Reserve and other central banks to follow the lead of Zimbabwe and print money by the bushel to try to patch up holes in the balance sheets of banks large and small. Gold - A Better Investment Central Banking Publications recently released an important survey that was subsequently published in the New York Times. It showed that a majority of central bankers — who control 42% of the world’s reserve assets — said they expect reserves “to fall as the crisis unfolds before recovering to only ‘marginally’ above current levels over the next four years.” This more or less confirmed our belief at Crisis Strategy Alert that the recovery will not happen any time soon. The same survey also revealed that central bankers had experienced illiquidity in government bond markets. As a consequence, 57% said that “gold was a better investment.” And over two-thirds central bankers surveyed said that every investment class other than gold was a less attractive investment than a year ago. This marks a dramatic change in the attitude of central bankers towards gold. Over the past half century central bankers have tended to be sellers of gold because they felt the need to manage reserves to earn a yield on their assets. Today, however, central bankers are well aware of the many trillions of dollars the U.S., Britain and other countries have spent and plan to spend out of an empty pocket to bailout zombie banks and stimulate flagging economies. And this taken together with interest rates at or near zero, dramatically increases the attraction of investing in gold. This is in keeping with the historic pattern that sees gold reach a cyclical low in its real price at the peak of the credit boom and then move to a peak in its real price in the trough of the downturn. I have little doubt that gold will be the asset category of choice before the current crisis reaches a resolution. In keeping with this, I have another strong investment pick this month that reflects this analysis. Profiting from Mr. T’s “Virtual” Gold Mine  Laurence Tureaud, aka Mr. T You remember Mr. T, the famous social philosopher from the 1980s TV show “The A-Team.” Born Laurence Tureaud, Mr. T had a colorful career as a bouncer and bodyguard to the stars before he became a star himself. Among his clients were well-known personalities including three heavyweight boxing champions, Muhammad Ali, Leon Spinks and Joe Frazier. (A bald-headed Mr. T can be seen on film escorting Frazier to the ring in his rematch against George Foreman in 1976.) In 1980, Sylvester Stallone picked Mr. T. to play Clubber Lang, the boxer facing Rocky Balboa, in Rocky III. And it was in this film that Mr. T first uttered what became his catchphrase – “I pity the fool.” (He was also fond of saying “Mr. T ain’t got no time for the jibba-jabba.”) In total, Mr. T has appeared in 30 films and TV series. He was also a professional wrestler and was Hulk Hogan’s tag-team partner at the first WrestleMania. Mr. T also had something of a career in music. He released an album called “Mr. T’s Commandments” and both a film and an album called “Be Somebody… or Be Somebody’s Fool.” In 2002, Mr. T appeared in the video for “Pass the Courvoisier” by Busta Rhymes, which featured P Diddy and Pharell Williams. In short, Mr. T has been a celebrity of some note over the past three decades. This brings me to his gold mine and an interesting opportunity to profit. As you no doubt recall, Mr. T has a visual signature. He wears thick gold chains, rings and bracelets – a collection so extensive it takes him about an hour to put it on. In mid-eighties prices, his gold jewelry was worth about $300,000. To put that in perspective, the average closing price of gold in 1985 was $317.22. Today, the shiny metal costs $936.49 per ounce. The same hoard of gold jewelry that Mr. T wore back in the day would be worth about $900,000 now. He was obviously a man ahead of his time. Now, he is back with an idea that seems remarkably well suited to these times. When big banks borrow billions from taxpayers to stay afloat, financiers get bonuses for bankrupting world finance and pink slips float on a tidal wave of red ink, Mr. T is ready. He is the new public face of Money4Gold Holdings, Inc. (OTCBB:MFGD), the first public company to specialize in the large-scale recycling of gold, silver and platinum. Money4Gold started in the U.S. last summer, quickly expanded to Canada and is now also active in Britain. And it enjoys efficiencies from close ties with Republic Metals Corp., one of the largest U.S. gold refiners. Normally, the market does not afford much value to metals recycling companies because the margins in mining have historically been so much higher than those in recycling. But metals recycling has heretofore been largely confined to recycling of scrap metals from wholesalers and junk dealers. “Mr. T’s Gold Mine,” Money4Gold, is different. Its cost of production compares favorably with all but a handful of operating gold mines. Although it pays consumers more than other gold recycling companies, which are all private businesses, it pays an average of only 25% of the gold spot price. If Money4Gold were extracting gold from rock, rather than from people’s dressers, it would be in the top tier of producers in terms of lowest production costs per ounce. This points to another strength of Money4Gold, namely that it has variable costs that tend to decline when there is a correction in the gold market. A mining company with a production cost of $400 per ounce would have its margins squeezed at $700 gold. Money4Gold’s “production cost” falls with the gold price. (MFGD’s buying prices have been holding at an average of 25% of the spot bullion price. So while it may be paying an average of $235 an ounce with gold at $936, its average payout per ounce would likely fall to $175 per ounce at $700 gold. No physical gold mine can so readily avoid margin compression with price fluctuations of the sort that can be expected going forward. Three other special circumstances permit the Money4Gold model to work. One is that gold, silver and platinum prices have risen sharply in recent years. Consequently, the intrinsic value of the precious metals content of old jewelry is much higher than most people realize. Because most people have only a weak grasp of value of old gold, there is less resistance to selling at a big discount to the smelter price. (Note that Money4Gold is getting a 95% acceptance rate on its offers for consumer gold. This signals that the prices the company offers have matched or exceeded customer expectations.) The second factor that makes the Money4Gold operating model attractive is that consumers are pinched for cash right now (and are likely to remain so for the foreseeable future.) That means people are more eager to dump assets to raise cash. For the same reason that desperate hedge funds were dumping stock at prices below book value, and even below earnings, consumers will continue to sell their scrap gold, silver and platinum for low prices. This puts Money4Gold on a similar footing to a low-cost mining company in terms of cost of production, pointing to another big advantage of this “virtual gold mine” over geological gold mines. You see, all geological mineral deposits are limited in scope. So any real ore body is soon exhausted or its ore values become so marginal that it becomes ever more costly to extract additional gold. But there is no geological limit on the production of a virtual gold mine. Its production is limited only by the economy. The more desperate economic circumstances become the more tempted people will be to part with their jewelry to raise cash. Conditions compatible with a doubling or trebling of the gold price imply a sharp decline in real income and dire pressures on consumers. Under these conditions, Money4Gold is well-positioned to expand profitable output from its virtual mine. Of course, it’s likely that as gold prices rise there will be greater competition in the precious metals recycling sector. But with Mr. T as its public face, Money4Gold will have first mover advantage and a secure position in the field. The company is growing rapidly. And I believe its margins will improve sharply as Mr. T’s new advertisements come on the air. Another factor that underscores the attractiveness of Money4Gold is that it is getting ever easier to find placements and purchase advertising to large TV audiences. During the boom years, TV ads were pricey. And it was rare to find an ad featuring any product or service aired during prime time that wasn’t offered by a leading corporation. Now, with formerly big advertisers such as Circuit City in liquidation, the auto companies teetering on the brink of bankruptcy and even local dealers barely clinging to life, Money4Gold will be able to reach millions with its message – a message presented by a cultural icon who knows gold, Mr. T. I expect these messages to be very successful, as have his previous endorsements. According to the Wall Street Journal, a record 12% of American homeowners were either behind on payments or in foreclosure at the end of 2008. These are people with whom Money4Gold’s message will resonate. Mr. T has already enjoyed a stellar career as a corporate spokesperson. He appeared in a number of long-running ads for MCI’s 1-800-COLLECT and in a popular commercial for the Oregon Lottery. More importantly, his recent TV spots for Snickers created a sensation in Britain, Ireland, Australia and New Zealand. Mr. T also proved highly effective as a corporate spokesperson for Hitachi. According to Steven Zivanic, senior director of corporate communications at Hitachi’s Data Systems, the “Mr. T: The T in IT” campaign “has not only helped the firm in its own area, but it has given data storage a broader audience.” I anticipate that Mr. T will be no less effective as a spokesperson for Money4Gold than he was as “The T in IT.” Action to Take: Buy Money4Gold (OTCBB:MFGD) but don’t pay more than $.60 a share. It is the first virtual gold mine to be traded in public markets and the new Mr. T campaign should help share prices soar.. James Dale Davidson Time to Invest in Oil’s Coming Rise Thanks to the global credit crunch, oil prices have fallen 68% since July of 2007. At the time of writing Nymex crude April futures are selling for $54.02 a barrel. Meanwhile, as credit dries up we’re seeing drops in oil consumption figures across the globe. The Energy Information Agency (EIA) predicts global oil demand for 2009 will fall by three million barrels a day – or nearly 4% year-over-year. At the current price levels (crude has been trading within a range of $35 and $50 a barrel since December of 2008) it’s becoming difficult for oil majors to make a profit on their more expensive finds. Some of these finds can cost upwards of $50 a barrel to produce. So to oil majors have recently begun shuttering more expensive operations to keep their margins intact. This has effectively laid the foundation for the next great oil shortage. Chinese Demand and Inflation Will Send Crude Soaring But demand won’t stay in the doldrums for long. A big reason for this is China. In 2008, China’s oil consumption increased 12% year-over-year. And even in the teeth of a global recession, Chinese oil company PetroChina Co. expects national oil consumption to rise 2.8% this year. Much of that growth can be attributed to China’s $586 billion stimulus spending program. At the very least, this will keep oil demand steady; at best, it will lead to an even greater increase in oil demand than PetroChina expects. There is another reason why we will see higher oil prices soon: inflation. The Chinese government is not alone in injecting huge amounts cash into the global economy to try to kick-start growth. And this is strongly bullish for oil prices. The best way to take advantage of higher oil prices is with Brazilian oil major Petroleo Brasileiro SA (Petrobras) (NYSE:PBR). The Fourth Largest Oil Company in the World Petrobras is Brazil’s largest oil company.
You probably first heard about it in 2007 when it made the largest offshore oil discovery in history: the Tupi oilfield. This offshore field holds an estimated eight billion barrels of oil equivalent. (This includes natural gas.) The find has boosted Brazil’s total oil and natural gas reserves by 62% to 14.4 billion barrels. And it makes Petrobras the fourth largest oil company in the world by reserves. The Tupi field, which commercially viable even if oil prices drop to under $40 a barrel, is critical to Petrobras. Better known oil majors such as ExxonMobil and Chevron have seen their total oil reserves decline recently. But Petrobras has seen exactly the opposite. This means makes Petrobras more promising than any of the other oil majors in the world today. Development of the Tupi field is on schedule. Brazilian president Lula da Silva says that on May 1 Petrobras will begin to pump about 15,000 barrels of oil a day from the Tupi field. And by 2010 Petrobras expects to have a floating production, storage and off-take vessel pumping 100,000 barrels of oil a day. Considering the Tupi field holds roughly eight billion barrels of oil equivalent, production should increase to over a million barrels of oil a day within the next few years. At 100,000 barrels of oil a day, Petrobras would turnover $80,000,000 a day assuming an oil price of $80 a barrel, which is not unreasonable. That’s $2.4 billion a month and $28.8 billion a year – from just one oilfield. If oil prices shoot back up to $140 within the next five years, Petrobras would make roughly $57.6 billion a year from this field alone. That’s more than one-third of this company’s market value (market cap) of $150 billion. Most companies take ten years or longer to produce enough sales to cover their market cap. So at today’s valuation, Petrobras is dirt cheap. Tupi Isn’t the Only Ace in the Hole The Tupi oilfield is a massive find. But early estimates point to nearby oilfields containing well over 100 billion barrels of oil. This form the Financial Times:
See, back in February, ExxonMobil found oil in a field bordering Tupi that is partly operated by Petrobras. And analysts estimate this field contains between 2.2 and 8 billion barrels of oil. The find is based around the Carioca oilfield. Last year, Brazil’s National Petroleum Agency said this field contained up to 33 billion barrels of oil. Petrobras won’t confirm the estimate. It says it would like to drill in the area more and get a good gauge of how much oil is there. Nobody knows yet how much oil these fields contain. But it’s clear that Brazil is well on its way to becoming the Saudi Arabia of offshore oil. To produce this oil, Petrobras will need to invest $174 billion from 2010 to 2013. This is where China enters the picture. International Agreement Cements Petrobras’s Future Production Figures In a testament to the strength of Petrobras, the company recently penned a $10 billion loan agreement with the China Development Bank. The deal isn’t fully cemented yet. And it won’t be until May. But the agreement follows the same format as an agreement China made with Russia earlier this year. In that deal, Russia agreed to supply China with up to 100,000 barrels of oil a day for the next 20 years in exchange for $25 billion. The Petrobras loan looks similar – except it’s in return for around 100,000 barrels a day over the next ten years. China is willing to do this because it needs a steady supply of crude oil to keep its rapid industrialization on track. If China’s industrialization stops, the country risks popular uprisings and riots. Two Million Barrels a Day and Growing Even without counting future production from the Tupi field, Petrobras produces upwards of two million barrels of crude oil a day. With crude oil at just $50 a barrel, that means yearly revenues of $36.5 billion. At $150 a barrel revenues jump to $109.5 billion – or more than two-thirds the market cap of this company. And with demand for crude oil set to rise from emerging economies such as China and India, higher oil prices are already in the bag. And that puts Petrobras in the sweet spot: It will be able to supply expensive oil in a tight market to countries desperately in need of it. Petrobras Is Trending for Gains
If you take a look at the chart above, you can see that since PBR bottomed in late November, shares have rallied well over 100%. A nice little trend line has also formed that connects the bottoms in late November, early December and early March. More importantly, PBR broke through $30 a share, which it has had a difficult time climbing above. This could signal further gains ahead. Part of this rally was due to news that China was loaning PBR billions to build capacity. Another reason was the simple fact that PBR shares fell too far considering their inherent value. Remember, this is the fourth largest oil company in the world (by reserves). There is no real reason for it to be trading at $15 per share. Although most companies have been shuttering production, PBR has steadily worked to expand production. And when the global depression finally abates, this company will sell more oil and make more profits. Within the next two years, as oil prices move higher, expect Petrobras to hit its recent highs of $70 a share – a 100% gain from today’s level. Action to take: Buy shares of Petroleo Brasileiro (NYSE:PBR) but don’t pay more than $38 a share. Charles Delvalle Stoking the Boiler: 5 Approaches to  Lord William Rees-Mogg In the 1980s – which are now twenty five years ago – James Davidson and I were already concerned about the resemblances between the developing boom in world stock markets and the conditions of the late 1920s, before the Great Depression. We were able to predict the 1987 crash and the recession of the early 1990s. Each time, the Federal Reserve responded by cutting interest rates and increasing the money supply. Under Alan Greenspan, the Fed fought every correction. Each time the market responded. Contrarians, who still thought that there was a crisis ahead, were regarded as eccentrics. If they were Wall Street analysts, they lost their jobs. Among economists, there was little interest in the trade cycle, or in most of the pioneering economic theory of the 1930s, which had been a response to the Great Depression. In so far as there was an economic debate, it concerned the difference between Maynard Keynes and Milton Friedman, between Keynesianism and monetarism. Friedman was still alive, while Keynes had died in 1946, and the debate concerned inflation rather than deflation. The common opinion was that monetarism was the answer to world inflation, but that Keynes had as much or more to offer as a cure for a world slump. The job of the central banks was to lean against the wind and to fight inflation by tight control of the money supply, and to fight deflation by cutting rates and easing monetary conditions. This is still the policy consensus of pragmatic central bankers. The world failed to notice that there were very weak theoretical underpinnings for this pragmatic policy. Between the mid-nineteenth and mid-twentieth century, there had been a vigorous debate about the causes of the trade cycle, and of the crises which had upset the growth of the world economy. That debate had, however, never reached a conclusion. Among economists there was no consensus on what caused the crises or on what measures would help to stabilise another depression. The Cambridge professor Pigou had asked the question whether it would help to stabilise a crisis if individuals saved more, or if they saved less. The challenge of this question was not answered in the debate of the 1930s, and after 1945 the debate fizzled out. Between 1945 and 1972, there was some belief that we did not have to worry too much about depressions because Keynes had left the legacy of a kit that would allow governments to prevent them happening. But even that confidence had ebbed away after 1972, when the impotence of Keynesianism in the face of world inflation became apparent. Nevertheless, there was a dangerous complacency. People thought there would never be another slump. They always do think that in the later years of a long period of prosperity. In Strategic Investment and our books, Jim Davidson and I begged to disagree. The first signs of the present depression appeared in August 2007, when banks became reluctant to lend in the interbank market. Again, James and I had originally pointed to loss of confidence in the interbank market as a potential weakness of the global economy. In September 2008, the failure of Lehman Brothers turned this loss of confidence into a global panic. It is difficult to imagine how any Treasury secretary fighting to protect the U.S. banking system could have allowed Lehman to fail. It is enough to make one swear in German – dumkopf is the world that comes to mind. Yet the panic cannot simply be attributed to individual mistakes. What has happened in 2007-08 is a phenomenon that has often happened before. There is a cyclical regularity that seems to produce a serious depression about twice a century. The crisis of 2007-08 has a close resemblance to the Great Depression of 1929-33, which only reached full recovery in the United States in 1940. That was a ten-year depression; one cannot tell how long this one will be. When one reviews the literature, one finds that exceptionally gifted economists have disagreed about the causes of the Great Depression or of earlier depressions. If they cannot agree on the causes, one can hardly expect them to agree about the appropriate remedies. Although a division into five groups is not comprehensive, one can list major economists into five groups when considering the cause of crises – which is almost a separate subject in itself. Eugen Slutsky, a Russian economist who died in 1948, produced a theory of “Random causes as the source of cyclic processes”. He believed that a series of random events would build up into a wave pattern, and that the waves would be of various heights. As the Slutsky theory removes the need to identify any other causes, I put it above in the first and simplest category. However, as Slutsky’s theory is based on random events it does leads logically to only a random set of remedies. The largest group can be described as monetarist, though there are important differences between the various monetarist groups. Keynes himself explained the Great Depression in monetary terms. The other monetarists include Friedman, Hayek, Fisher and Hawtrey. All of these believe that panics arise because of imbalances in the banking system, which result in shortages of money and limitations on lending. The task of the Central Bank is to create a better balance in the money supply, so that ordinary lending is resumed and sound borrowers can borrow. The actual policies pursued in 2008 have been monetary policies in this sense, though they have not always been well applied. The Department of the Treasury operates on a monetarist theory. But it allowed Lehman to fail, which no rational monetarist, of any school, would have done. One of the virtues of the monetarist school is that it directs attraction to the monetary crisis, which always plays an important role in a depression. However, there are other possible causes. There is a distinguished school of economists that holds that crises emerge from what one might call real events – that is the ordinary development of economic growth. This view is shared by Marx, Wixksell and Schumpeter, who can be described as belonging to a German realist school. Marx obviously includes a socialist element in his explanation of crises. That is the third school. The fourth school can be called the classical economists. These include Ricardo, Pigou and Marshall. Perhaps unexpectedly, the classical school is strongly psychological. The classical economists attributed central importance to the need to maintain confidence, or restore it when lost. Of course, actions taken to improve the money supply are likely to have a favourable impact on the confidence of markets. In practical terms, the classic and monetarist schools may advocate similar policies, though the classic school will be more concerned with questions of long term equilibrium through balance budgets. There is also a purely cyclical school. This includes Juglar, the French economist who established the ten-year cycle; Kondratiev, the Russian who established the 54-year cycle; and Jevons who thought that the business cycle was governed by the cycle of sunspots – he was rather close to the issue of global warming. The important fact is that there are at least five different alleged causes, which are still arguable. If the central bankers and Treasury officials do not agree on the cause of the present crisis, they are not likely to agree on the remedy. One needs to keep theory in mind because it influences decision-making. However, we are beginning to see that there is a consensus developing on the policy that is needed. Economists and politicians are concentrating on the need to restore confidence. President Obama’s inaugural address repeated the theme of Franklin Roosevelt’s address in March 1933: “We have nothing to fear, but fear itself.” He also attacked the greed and irresponsibility of the bankers, who had behaved just as badly as they did in the early 1930s. The practical action of governments around the world is to increase the money supply until businesses will borrow and banks will lend. Everyone recognises that this makes a risk of excessive inflation of the money supply. But it is a risk governments feel they have no choice but to take. They are not trying to rebalance the world economy; they are desperate to relight the boiler. In the end they will succeed. Lord William Rees-Mogg
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