More Inflation Expectations

I’ve been writing about the subject of inflation for years, but it only seems like mainstream media is focusing on the topic as the Dow looks to retake the 11,000 level. Since 2005, I’ve posted over 420 articles with a consistent investment thesis. I’ve continued to post my picks and invest steadily in the same fashion through the crash. In fact, the crash only made me hungrier to purchase additional shares of the same great companies I’ve invested in at lower prices. A flood of excess monetary supply and possible prolonged low interest rates have only bolstered my view that inflation/hyperinflation will be the inevitable outcome, as this has been the post outcome of every crash since the Great Depression.

Savers needed to prepare themselves for getting very hurt by inflation. Common sense dictates that the bigger the crash, the bigger the recovery. This is a part of human nature that we want to feel healthier and stronger as we recover after being sick.

I don’t buy into the idea that our children will have a lower standard of living than previous generations. In fact, our children will invent the necessary tools, policies and rules to improve their standard of living, just as we have. Remember how easy it was for our current generation to create paper instruments like swaps and derivatives to inflate wealth. Financial regulation is still under reformed and new instruments to create massively inflated wealth will be invented by the current generation. This is the drug of paper number growth. Seemingly positive growth is politically acceptable and is a feel good message to main street. It’s a vicious cycle and the only loser is the responsible saver.

To beat inflation, get into hard assets that will keep up with the rate of inflation. Currently money is flowing into the stock market, but I believe property is your best investment prospect as property prices have lagged the increase in stock prices. My top locations to invest are Las Vegas, Nevada and Miami, Florida. Condo and condo-hotel prices are still down over 60% from 2007 levels. You can buy a condo in the above markets for .25-.40 on the dollar that is less than 5 years old and has a chance to generate an after tax income yield of 3-7%. Like a dividend paying stock, you benefit from an increase in the asset price and may have a predictable income with the right tenant. For condo-hotel units you don’t have to worry about tenants, maintenance or management.

Taken from this article: Pray For Inflation — It’s Our Only Hope

Everyone thinks the Fed’s job is to fight inflation, but right now the Fed is actually doing everything it can to cause inflation.

Why?

It part to help the economy get cranking again. Inflation provides an incentive for people to spend cash rather than saving it, because if they save it, the cash will lose value rapidly.

Inflation also helps solve another problem, though–our debt problem. The more inflation we have, the less our dollars will be worth. Because our debts are based on a specific number of dollars and not a specific value, the less our dollars are worth, the easier it will be for us to pay off our debts.

(Imagine owing someone 100 Zimbabwe dollars at a time when the currency is collapsing. If you wait a week, the value of the Zimbabwe dollar will have collapsed, and you’ll be able to pay off your 100 Zimbabwe-dollar debt with currency that is only worth half as much as it was the week before).

The Fed can’t admit that one reason it wants high inflation is to reduce the real burden of our debt, but you can bet that that’s one of its objectives. What’s more, says Nobel-winning economist Paul Krugman, inflation should be one of the Fed’s objectives. Because that’s how we’ve gotten out from under debt burdens in the past.

Further into the article:

So inflation is an important tool in getting us out of this mess. It’s painful and unfair–those who have been responsible and saved money will pay the price for those who borrowed money, racked up huge debts, and spent more than they could afford. But it’s what the Fed is (quietly) aiming for.

The Next Wave of Inflation is on the Way

Fortune Logo
This Fortune article, The next wave of inflation is on the way, is telling.

Taken from the article:

Inflation can be a positive or negative, depending on the level and duration of it in our economy. The main negative associated with inflation is a drop in purchasing power of money, and therefore, consumers. In extreme cases, consumers may actually start hoarding if they fear continued and aggressive price increases. The positive side of inflation is to decrease the real value of debt, or essentially provide debt relief.

Further into the article:

Back in the treasury market, 30-year treasuries have gone from yielding 3.73% to yielding 4.72% over the last year. That increase has happened for shorter-term treasuries — the short end of the yield curve — as well. And all these increases have happened despite the fact the Fed has maintained its target rate at 0 — 0.25%. Bond yields, in other words, are already accounting for inflation.

Finally, in the chart at the top of this page, we’ve plotted the Journal of Commerce Industrial Price Index over the last year. This index charts the price of key commodities that are used in industrial production. The chart is up and to the right, screaming inflation.

The U.S. has over $62 Trillion in long-term debt, according to David Walker, former U.S. Comptroller General and head of the Government Accountability Office. We are no where close to having enough income to pay-down our commitments. According to David, we would need a few decades of double-digit GDP growth just to pay for our long-term debt. It’s common sense to me, that without any new source of GDP growth, part of the solution to paying for our enormous debt will involve printing money and inflating our way out.

96% of Active Fund Managers Underperform the Market

Taken from the video:

Citing Forbes research, Town says 96% of active fund managers underperform the market over periods of 15 years or longer.

My advice is to pick an Index fund, like the Vanguard 500 Index Investor (VFINX), if you don’t feel comfortable actively managing your stock portfolio.

Savers and Retirees Beware

Recently I’ve met a number of older friends who’ve saved enough money to consider retiring. These friends have asked me, financially, what could jeopardize a comfortable retirement and how they should prepare for these potential problems. Here’s what I see as the major threats to a comfortable retirement:

1) Deflation, Stagflation and Inflation:

For those in the workforce, deflation and stagflation feels like trying to walk through mud on a rainy day. Things are painful and a recovery is slow and drawn out. For retired folk, this isn’t so bad. Prosperity led by inflation is actually the enemy of a retiree. Most retirees face a situation of managing a fixed income and fixed amount of assets. Deflation makes items more affordable and allows you to use your savings more effectively. Stagflation allows you to maintain your level of living and you can stretch your savings out without any significant need for new income.

Inflation is the greatest threat to a comfortable retirement. Currently the government deficit is out of control. At the time of this post, national government debt stood at $12,390,129,946,402, while GDP stood at $14,285,707,057,143. Our debt to GDP ratio stood at approximately 86.7%. There are three ways to handle such enormous debt.

- We can write off the debt
- We can generate income and pay down the debt
- We can inflate our way out of the debt

Writing off a portion of the national debt isn’t an option as it would guarantee a loss of our AAA rating and there would be a sudden loss of confidence in Treasuries. Generating income to pay down our debts is our best choice, but without any short-term growth driver it would be hard to pay down such enormous debt. Economic recovery in the U.S. has traditionally been led by the automotive industry, the housing industry or an emerging industry like the tech boom of the previous decade. With the automotive industry in decline, the housing industry struggling and without any innovative industry around the corner, I don’t see an easy way for the US to generate enough income to pay down our debts. Without any driver of income growth, the easiest way to get out of a heavy debt burden is to slowly inflate our way out.

In order to quickly emerge from the recession and spur business growth, the Fed is printing money at an alarming rate while keeping interest rates at basically 0. The longer the formula of growing money supply + low interest rate exists, the likelier we are to experience rapid inflation. I saved this picture from the Wall Street Journal that illustrates the effect of an easy money policy on the stock market. With capital inexpensively available to invest, the stock market aggressively rallied following previous major crashes and gave an early warning of the inflating bubbles to come. The products of inflation and the intended effects of an easy money policy will make the value of our debts appear smaller in the long-term. If 12 trillion felt more like 120 billion, it would certainly make the debt manageable.

A relevant example of inflating our way out of debt would be the Savings and Loan crisis. Between 1986 and 1995, 1000 financial institutions failed and the U.S. taxpayer was on the hook for $153 billion. The initial estimate to clean up the S&L crises was $30-$50 billion, a number that shocked many taxpayers at the time. Economists had predicted many decades to clean up the mess and get the economy back on track. What happened instead was the Greenspan policy of stoking inflation by flooding the economy with new money and dropping interest rates to as low as 1%. By the late 90′s, the tech boom was around the corner and economists quickly revised their opinions on how fast we would be able to pay down our debt. After the tech crash and 9/11, we had a return to easy money and a recovery led by housing. By the last decade, $153 billion in government debt no longer seemed like a difficult to comprehend number. Bernanke is clearly following Greenspan’s monetary policies by simultaneously increasing the money supply while keeping interest rates low. If we follow the pattern of previous recoveries, $12 trillion in a decade or so will no longer feel like an unacceptable number. We will be far along the path of an easy money + “insert industry” led recovery. A new generation of .com’s, biotech’s or green technology may be the future excuse to spend.

We can already see the early stages of recovery as financial executive pay packages have returned to record setting levels. Many financial executives are receiving bonus compensation in the form of stock and options. Compensation heavily slanted toward stock and options will only further incentivize financial executives to create business with the easy money under management. This should add further inflationary concern for retirees. Without any hidden or new problems in our financial institutions, frozen credit markets are only a short-term problem as financial institutions build up reserves and capital ratios. At the moment few asset classes and business proposals currently pass the tests of risk management and the loan approval departments of banks and venture funds. Just think back to a decade ago on how little information you needed to get an investment for a .com or a few years ago for a loan on a property. Once a hot industry is found money will eventually be freed for investment and it’s off to a spending race once this happens. For a retiree, this poses a danger as the effectiveness of their savings will appear to get smaller each year. The only way to combat inflation is for retirees to have strategies in place to grow their savings at a level equal to or faster than the real rate of inflation. For some, this may or may not be a challenge as many older retirees are only interested in maintaining their standard of living and a large enough nest egg will allow them to do so.

2) Institutional Failures

By far, the largest threat to a retiree is losing their savings or pension. During the S&L crises, 1000 financial institutions failed and many that failed held the savings of retirees. The enormous number of failures meant that retirees with more than $100k in a single account lost a part of their savings. If a retiree had $500k as a cash portion to retire, I would hope they had separated it into 8-10 deposits with different institutions. It’s a hassle to wait for the FDIC to sort out your saving deposits if an institution fails. By separating your savings between multiple institutions, you gain the safety of having available funds in the event one or more of the institutions fail. With the rapid rate of bank and fund closures, it makes sense to go through the hassle of managing multiple accounts to gain peace of mind. To date 182 banks have failed in the US since January of 2008 according to the FDIC website. Though I don’t have a total tally, in plain sight, a large number of pension funds, mutual funds, hedge funds and non-bank financial institutions have also failed since the beginning of 2008.

3) Asset Diversification

Everyone has their own judgment on what percentage to divide savings into different assets, so I’ll save my opinion of what percentage to divide for a different post. Retirees should have assets in few major categories to be considered truly diversified against #1 and #2 above.

- Self-Owned/Income Producing Property

Owning your own home free and clear to live in provides both safety for a part of your nest egg and can provide peace of mind. Income producing property can be a hassle from a management perspective and from a choice perspective as a retiree may choose a poorly performing investment property. Chosen correctly, high yielding investment property is a great way to keep up with inflation and provide a steady stream of income for retirees to spend.

- Paper Assets

The bulk of most retirees savings are likely to be held in paper assets. For cash, potential retirees should consider holding one or more alternative and higher yielding currencies to the USD. I’ve recommended holding AUD as it fell as low as .65. I continue to recommend AUD, CAD, and WON.

As potential retirees witnessed the fall of their pension funds and investment products with Fannie Mae, Freddie Mac, Lehman Brothers, Meryll Lynch, GM, AIG etc. many have realized the need to diversify any paper assets into a variety of categories. Paper diversification should mean holding a mix of cash, bonds, equities, funds, notes etc., preferably in more than one currency and held at more than one financial institution.

Retirees should have a look at the Wall Street News Network website as it provides a valuable resource of tax-free dividend stocks to supplement any rental or interest income.

A few of them that look interesting include (PMX, 7.8% yield), (PMF, 7.4% yield), (NMZ, 8.4% yield), (VMO, 7.4% yield), (BFK, 7% yield), (BBK, 7.1% yield), (BKN, 7.2% yield)

All of the funds above are mainly focused on investing in municipal bonds and pay dividends on a monthly basis.

- Physical and Paper Commodities

Commodities do a great job of holding up against inflation in the long-term. A mix of precious metals, agriculture and energy commodities will help maintain the value of your retirement portfolio. Exposure for some commodities like gold, silver, platinum etc. can come in the form of physical delivery that you can store and resell. Most investors exposure to commodities will come in the form of ETF holdings, fund holdings or shares in listed companies of the commodity sector chosen. Some of the commodity funds and listed companies offer high yield returns for investors.

All of the advice in this post can help maintain a retirees nest egg and provide a comfortable stream of income to protect against many unforeseen economic developments.

*Disclaimer: The author does not hold a position in any of the stocks mentioned above.

Essential Reading

Here is an article not to be missed by Raw Greed readers:

The End by Michael Lewis

Taken from the article:

That’s when Eisman finally got it. Here he’d been making these side bets with Goldman Sachs and Deutsche Bank on the fate of the BBB tranche without fully understanding why those firms were so eager to make the bets. Now he saw. There weren’t enough Americans with shitty credit taking out loans to satisfy investors’ appetite for the end product. The firms used Eisman’s bet to synthesize more of them. Here, then, was the difference between fantasy finance and fantasy football: When a fantasy player drafts Peyton Manning, he doesn’t create a second Peyton Manning to inflate the league’s stats. But when Eisman bought a credit-default swap, he enabled Deutsche Bank to create another bond identical in every respect but one to the original. The only difference was that there was no actual homebuyer or borrower. The only assets backing the bonds were the side bets Eisman and others made with firms like Goldman Sachs. Eisman, in effect, was paying to Goldman the interest on a subprime mortgage. In fact, there was no mortgage at all. “They weren’t satisfied getting lots of unqualified borrowers to borrow money to buy a house they couldn’t afford,” Eisman says. “They were creating them out of whole cloth. One hundred times over! That’s why the losses are so much greater than the loans. But that’s when I realized they needed us to keep the machine running. I was like, This is allowed?”

A Primer on Master Limited Partnerships

I first heard of Master Limited Partnerships a few years ago when a few fund managers spoke about the little known entities on a CNBC segment. MLPs are so obscure to the investment public that these fund managers were barely in their upper 20s.

Fast forward a few years and not much has changed in the benefit of MLPs or their level of awareness among the public. MLPs are often also referred to as publicly traded partnerships. The major benefit of MLPs comes from taxation, as income generated by the MLP is tax free. Since MLPs have no corporate income tax, MLPs typically pay very high quarterly dividends. A person who purchases shares in an MLP becomes a unit holder or one of the limited partners. As a limited partner you’re entitled to a portion of the assets held by the MLP, that in-turn also entitles you the income distribution made by the MLP.

Sometimes a portion of the income distribution made by the MLP is classified as a return of capital to the original investors in the MLP. This classification of income may reduce your cost per share when you buy and sell shares in an MLP. Due to the unique structure of MLPs, shareholders are mailed a Schedule K-1 at the end of the year that details taxable and non-taxable income, gain, loss, deduction, and credits. Some MLPs now offer double-digit, after-tax, seemingly stable returns. MLPs are mainly available in commodities, energy and real estate.

I’m curious if my readers have found any MLPs tied to precious metals mining or mining royalty assets.

Here’s another article, Master Limited Partnerships: A New Way to Shop for Bargains, that discusses some more recent opportunities in MLPs.

Taken from the article:

Most investors have never heard of, or purchased, shares of a master limited partnership (MLP). But, with many yielding more than 10% and prices at historically low levels, these bargains are getting hard to ignore.

Few investors know that master limited partnerships are publicly traded asset pools. They have the tax benefits of a partnership plus the liquidity of a publicly traded stock.

Because they invest in many different types of assets, most master limited partnerships have significant debts on the balance sheet and have suffered from the credit crisis. But not all debt is bad debt. And their crisis could be your opportunity.

Profit From Master Limited Partnerships In the Energy Sector

I prefer master limited partnerships in the energy sector because their business is easy to understand. The ones that interest me own the pipes that move oil and natural gas from production to marketplace. Some of these companies also process natural gas, and they may even own an oil or gas field directly.

These companies are like utilities for energy production. Without their infrastructure, oil and gas couldn’t move to the consumers who need it. They play an integral part in the supply chain, and this makes their income stream steady and predictable.

The market has unfairly beaten up the prices of these partnerships. And the bankruptcy at Lehman Brothers only made things worse. They were dumping assets even before they went under. As a lender and advisor in this sector, Lehman was a major player in master limited partnerships.

One of my favorite master limited partnerships is Boardwalk Pipeline Partners (NYSE: BWP) – a firm that handles the storage and transportation of natural gas. Its largest shareholder, Loews Corp. (NYSE: L) heavily influenced BWP by assembling the core company assets, and taking the partnership public. It still owns 52% of the shares.

Loews Corp is controlled by the prominent Tisch family – known for their financial discipline. Boardwalk is no exception. It generates consistent cash flows and has limited debt. It has a ratio of long-term debt to capital of only 38%. Yet at a current share price of $16.30, it yields 11.5%.

Boardwalk’s shares have fallen 48% over the past 12 months. But even if energy prices stay depressed, it should rebound when the market sell-off subsides.

The Master Limited Partnership of NYSE: KMP

Another master limited partnership that I like is Kinder Morgan Energy Partners (NYSE: KMP). KMP is the largest independent owner and operator of petroleum-products pipeline in the United States, transporting more than two million barrels a day of gasoline, jet fuel, diesel fuel and natural gas liquids through over 8,300 miles of pipelines.

It is a major transporter of natural gas in Texas, the Rocky Mountains and the Midwest. The natural gas pipelines business segment consists of approximately 14,700 miles of pipelines with transportation capacity of about seven billion cubic feet per day, and working gas storage capacity of about 35 billion cubic feet. They also own or operate additional natural gas gathering, treating and processing facilities.

CEO David Kinder said in the dividend announcement, “While no company is 100% immune to external conditions, KMP continues to demonstrate that our diversified portfolio of stable assets is capable of generating consistently strong cash flow, even in extremely difficult market conditions.”

Having been formed in 1992, Kinder Morgan has now raised dividends for 12 years in a row – an exceptional record for a company that young. In fact, this pipeline giant just announced it was raising its payout again – increasing cash distributions per partnership unit from 99 cents to $1.02. With today’s price of $48.45, this puts its yield at 8.4%.

Master Limited Partnership Investing With An ETF

Another option for master limited partnerships is an exchange traded fund (ETF) that specializes in investing in the energy sector. The master limited partnership & Strategic Equity Fund (NYSE: MTP) holds a basket of energy master limited partnerships, and it’s currently yielding nearly 14%.

Many of these partnerships look incredibly inexpensive and they’re generating steady income. The income they offer will pay you until the share prices recover – perfect for investors looking for an alternative to stocks in this volatile market.

Owning these makes you a limited partner, which allows you to claim a share of the master limited partnership’s depreciation on your tax returns. In addition, they avoid the corporate income tax, on both state and federal levels. You still would owe tax payments (just like your other investments), but you suffer no double taxation.

This is why master limited partnerships are not appropriate for tax-deferred accounts – such as an IRA – because you would lose the ability to deduct this depreciation.

If crude oil and gas prices fail to stabilize, then sentiment against these master limited partnerships could stay negative. And that could mean even better bargain shopping down the road…

Alternative Currencies, A Look at the Australian Dollar

With the mounting debt faced by the U.S. government, it makes sense to exchange a part of your USD portfolio into a basket of alternative currencies. Long-term the devaluation of the dollar is almost inevitable. For a refresher, please watch this video by Congressman Ron Paul that succinctly covers the subject of a future falling USD.

I recommend basing your alternative currency investments on your perception of the home countries political stability and future economic potential.

In the above two regards, The Australian Dollar is one of the possible hedges for safely protecting your cash holdings. Australia is a politically stable country with a GDP per capita higher than the UK, Germany and France. Australia is rich in many commodities.

Taken from the Australian Government Mines Atlas on Iron:

In 2007 Australia had about 13% of world EDR of iron ore and was ranked fourth after Ukraine (19%), Russia (16%) and China (14%). In terms of contained iron, Australia has about 15% of the world’s EDR and is ranked second behind Russia (19%). Australia produces around 16% of the world’s iron ore and is ranked third behind China (32%) and Brazil (19%).

Taken from the Australian Government Mines Atlas on Gold:

The USGS estimate of world gold reserves of 42,000 t was similar to 2006 According to the USGS, South Africa still has the world’s largest reserve of gold at 6000 t (14.3%), similar to 2006. According to the USGS Australia has the second largest reserve with approximately 12% of the world’s holdings.

Taken from the Australian Government Mines Atlas on Uranium:

Australia has the world’s largest resources of uranium in RAR recoverable at less than us $80/kg U (equates to EDR), with 34% of world resources in this category at December 2007. Other countries with large resources include Kazakhstan with 12%, Canada 11%, South Africa 7% and the Russian Federation 6%.

Olympic Dam is the world’s largest uranium deposit. Based on ore reserves and mineral resources reported by BHP Billiton as at June 2007, Geoscience Australia estimated that the deposit contains 26% of the world’s total resources in RAR recoverable at less than US$80/kg U.

Taken from this page on Australian Natural Resources:

Natural gas fields are liberally distributed throughout the country and now supply most of Australia’s domestic needs. There are commercial gas fields in every state and pipelines connecting those fields to major cities. Within three years, Australian natural gas production leapt almost 14-fold from 8.6 billion cu ft (258 million cu m) in 1969, the first year of production, to 110 billion cu ft (3.3 billion cu m) in 1972. All in all, Australia has trillions of tons of estimated natural gas reserves trapped in sedimentary strata distributed around the continent.

Particularly with commodities prices crashing, Australia is faced with concerns of exasperated negative GDP growth that is fueling the fall in the AUD. With the benefit of large reserves in many commodities, Australia enjoys a small level of self-sustainability not found in many well developed countries. In a world faced by pandemic uncertainties, wars and political instability, the AUD should be a consideration when focused on preservation of capital. If you believe we will eventually emerge from a recession and return to a commodity bull market, Australia’s rich reserves is a future story to focus on for possible currency appreciation.

The AUDUSD chart shows that the AUD has fallen from near parity with the USD at .95 to .67. I would build a position in the AUD at under .65. In the past decade the AUD has traded above .65 for nearly 7 out of the last 10 years. The fall of the AUD has been brutual and is an outlier compared with the performance of other major currencies.

If your long-term view is that the USD will fall, now would be a good time to build an alternative currency portfolio. The AUD has the benefit of high interest rates, with one year deposit rates still hovering in the 3.5-5% range. For multi-year strategies you may want to look at buying Australian Government Bonds. A quick look at Bloomberg.com for Australian Government Bond Rates shows that a 5-year government bond is currently yielding 3.3%.

Compare the above chart to what Bloomberg.com shows for US Government Bond Rates and we see that a 5-year US treasury bond is yielding 1.48%.

Analysts Flip Flop On Oil Again

I caught the following quote from this Yahoo Article on yesterdays fall in crude oil prices:

“I don’t think there’s anything they [OPEC] can say at this point,” said analyst Stephen Schork, who doesn’t expect a sustained rally in oil prices during the first half of this year.

“They didn’t have control of oil prices when it was on the way up,” he said. “They don’t have control of it when it’s on the way down.”

While I’m not familiar with Stephen Schork’s historical view on crude oil, a vast majority of analysts have rapidly switched their views on oil to echo the sentiment of the quote above. I remember less than a year ago how analysts cited fundamental demand being the driving force behind crude oil prices and how OPEC would never let the price of oil fall below $80. Analysts cited demand from emerging economies, mainly China and India, as the driving force behind existing physical demand. With prices having collapsed over 70% in slightly over half a year, did more than 70% of the people in China or India stop driving cars? For that matter, will 70% of the people in the world stop driving cars, stop taking airplanes and stop using heating oil? Automobiles, Heating, Airlines etc. will still continue to function and be required since they are a part of our global infrastructure and life needs. Physical demand will be curbed due to a global recession, but some basic demand will always be present. Global crude oil usage definitely hasn’t fallen by 70%+ and isn’t expected to fall by such a wide margin from current use. Roughly five years ago, analysts began harping crude oil prices and they quickly forgot that crude oil traded in the $20 range and below for a solid decade before that.

I do agree with analysts, that there was a necessary premium attached to crude oil prices over fears of political instability and war negatively impacting the supply side of the equation. Those fears are still in the market today. With that premium in place, a smooth and steady rise in crude prices, in lock-step with real physical supply and demand, should have been what we experienced from oil’s initial rise. Financial instruments instead mucked with real market supply and demand.

This all goes to show that speculation above fundamental demand was the driving force behind rising oil prices. All manner of speculation led to structured products that were tied to spot prices and futures contracts. These notes and products almost never entailed some form of physical delivery and often included some form of principal protection so losses were converted into dollar terms. Bankers created products tied to future production by private firms and made bets on spot prices that had nothing to do with taking some form of delivery in a certificate form or storing barrels of oil. The lax regulation among these products is similar to the lax regulation with short-selling. Most shorts don’t have physical shares to deliver when they are required to cover positions and short volumes can exceed the actual number of physical shares available. Fundamental physical demand may not have done so much to drive up prices as some analysts considered. Previously available liquidity and interest in structured products has nearly evaporated causing the current collapse in prices. In many ways the fall in crude oil is the result of forced deleveraging since many people are selling anything they can, including derivative notes and futures contracts, in order to raise cash.

What the Yahoo article quote above also accurately illustrates is that trusted analysts have no better idea apart from you or I what the price of oil will be tomorrow. The price collapse in crude has put tremendous pressure on giant oil trusts like PWE, Penn West Energy, one my previous picks for its enormous dividend payment. Production costs haven’t fallen in-line with the fall in physical prices and until they do I expect that there will be additional operation suspensions and downward pressure on energy related shares.

Once oil prices stabilize in a illiquid market, we will see true market supply and demand without the influence of the highly leveraged credit, structured products and derivatives industry.

Holding Up FASB Rule 157

The SEC is in talks again about possible adjustments to the Mark to Market accounting standards that are held up by FASB (Financial Accounting Standards Board) Rule 157. Any suspension of FASB 157 would have dramatic implications on our economic recovery. Book value for many publicly traded companies would once again shoot through the roof. This would create a false sense of security and credit quality. What companies like Blackstone (BX), AIG (AIG) and even General Electric (GE) are looking for is a source of affordable credit so they can slowly spread out the eventual further writedowns they will likely need to take. Although a tremendous amount of new liquidity has been injected into banking markets, lenders are increasingly fearful of servicing new loans and have set very tight internal qualification standards. Relaxing or suspending FASB 157 would allow firms to gain easier access to bank funds. Executives, commercial loan officers and credit origination teams would be able to go back to the Board of Directors of their banks and say “the borrower legally met our internal qualifications”. People want to do business, but in this fragile credit market, many need a scapegoat before being willing to take the risk of a borrower defaulting.

Taken from this Marketwatch article, Mark-to-market manipulation:

A movement spurred by bankers including Aubrey Patterson, chief executive of Bancorpsouth Inc. (BXS) , and Wall Street power brokers including Blackstone Group (BX) Chief Stephen Schwarzman are arguing for at least a temporary suspension of Financial Accounting Standards Rule 157.

Patterson and other supporters argued for the rule’s suspension in a Securities and Exchange Commission roundtable Oct. 29. Other critics of FAS 157 included Damon Silvers, AFL-CIO general counsel, and Bradley Hunkler, an insurance executive from Western & Southern Life.
Simply put, these guys want the government to stop requiring mark-to-market accounting so the financial industry can put blinders on to the deep trouble that lies on its balance sheets. Not surprisingly, the proponents of a suspension would also apparently benefit from it.
For guys like Patterson, it would mean his bank wouldn’t have to take big charges each quarter to build reserves. Bancorpsouth increased its reserves by 50% to $16.3 million to gird against loan losses at the end of the third quarter.

For Schwarzman, suspension of the accounting rules might allow banks to start lending willy-nilly again — and that would mean a return of the cheap financing that fueled the private-equity buyout boom between 2005 and 2007. Private equity now must re-fund many of those deals with new loans or debt extended at much higher interest rates.

To learn more about FASB Rule 157 visit: FASB, Summary of Statement 157

New Accounting Practices Will Boost Bank Equity Values

Incase you missed it, the SEC has announced new accounting rules that will help companies value illiquid assets.

Taken from this article, Rethink of rules on value boosts banks

The Securities and Exchange Commission said on Tuesday that managers could use their own judgment when valuing securities in illiquid markets, which means they can use measurements other than actual market prices.

I believe this is utter hogwash. Bank managers should never be allowed to use a measurement other than Mark to Market to value an illiquid asset. This kind of accounting applied to a typical wholesaler would create a huge mis-valued inventory. Lets say I owned a company that sold sportswear, if there was suddenly no market for my particular brand of sportswear, the new accounting rules would allow me to book a subjective value for the inventory assets instead of basing them on true closeout prices.

The new rules will benefit most of the large banks such as JP Morgan (JPM) and Goldman Sachs (GS). I’m not sure if the SEC’s decision is wise, since it will just mask the problem of investor confidence and an on-the-brink failure of the OTC derivatives market. I believe the new rules will also give leeway to possible accounting manipulation. For investors, the rules further obscure our ability to determine the value of a companies equity.

Mark to Market is an important principal behind our financial ecosystem. To read more about Mark to Market, I suggest this article, Financial Crisis: Mark to Market Accounting Demystified.

Taken from the article:

[Mark to Market]…was primarily intended to prevent shady accounting practices that hide underlying liabilities. The Accounting Standards bodies were concerned that companies were keeping “bad” assets on their books instead of “writing them down” to their real value (assigning a new, lower value to the asset). Mark to Market gives investors a much better “picture” of the health of the company if their assets are correctly priced (i.e. market price).

Congressman Ron Paul, A US Dollar Crises

Raw Greed readers should pay special attention to the Fox Interview below where Texas Congressman Ron Paul speaks about a US Dollar crises.

Here are some notable quotes taken from the interview:

“What we are doing here is guaranteeing the devaluation of the dollar.”
“This country is bankrupt and we wont admit it.”
“Eventually the dollar will go bust.”
“We are on the verge of destroying our dollar.”

If our global lenders lose faith in the US Dollar, the devaluation of the currency is nearly inevitable. I believe a collapse of the dollar is unlikely, however some degree of hyperinflation has been guaranteed by the Fed’s monetary policies. Lowering the Fed funds rate and printing money at a voracious pace will ease access to credit and has been the formula for recovery since the Greenspan era of the Fed.

The Collapse Of The Great British Pound

The speed at which the Great British Pound is falling against the US Dollar is staggering.

Historically, the GBP has fallen under 1.4 twice in the past 16 years. Current levels are a stark contrast to the levels set at the end of 2007, when the GBP traded a bit higher than 2.1. In less than a year the GBP has fallen roughly 23%. I believe there is a possibility that we may revisit the sub 1.4 levels.

This is an extreme oddity, considering that the Fed Funds Rate stands at 1.5% and there is a possibility that the Fed may cut rates to 1%.

Taken from this Reuters Article, US RATE FUTURES-Bets tilt further toward 50 bps Fed cut:

WASHINGTON, Oct 21 (Reuters) – U.S. short-term interest rate futures on Tuesday tilted further toward an aggressive rate cut at next week’s Fed policy meeting, picking up on prospects for an protracted slowdown in the U.S. economy.

For the first time, futures suggest more than a 60-percent chance for the Fed to lower rates by one-half percentage point at the Oct. 28-29 meeting, backing up a similar-sized emergency cut on Oct. 8.

Normally falling interest rates would cause the base currency to fall in value against higher yielding currencies. In the past year when the Fed started dropping interest rates the USD fell against higher yielding currencies such as the New Zealand Kiwi, the Australian Dollar and the Great British Pound.

There is a market expectation that governments around the world, and especially in those with a high yielding currency, will drop rates aggressively similar to the USD.

The USD strength is non-indicative of a Fed Funds Rate of 1.5% and possibly lower. The Fed is now creating and pumping cheap money into the financial system at a breakneck pace. The debt racked up by the credit crises is close to getting out of control and we still haven’t faced the full brunt of a possible OTC derivative collapse. To compound the problem of the influx of new money, the Fed has announced the possibility of a second stimulus package.

Taken from this Forex Article: Mid-Day Report: Dollar Strengthens on Talk of Second Stimulus Package

Dollar strengthens in early US session after Fed Chairman Bernanke said that additional fiscal stimulus package should be considered to help improve “access to credits” by consumers, homebuyers, businesses and other borrowers given the “extraordinarily uncertain” economic outlook. In his testimony to House Budget Committee, Bernanke said that such actions might be “particularly effective” at promoting “economic growth and job creation.” Dollar index soars to as high as 82.92.

The USD Index has broken the 85 level and may well be on its way back to the 90 level. If the USD does break 90, we should see the GBP fall under 150 and possibly 140 if GBP rates are slashed aggressively in the near-term.

A Note of Appreciation

Raw Greed readers may have noticed that a few of the graphical and plug-in glitches with the blog have been fixed. The changes were handled by Vladimir Prelovac, a WordPress Services provider. I highly recommend Vladimir if you have any WordPress development needs.

Piling On The Debt

The U.S. is currently racking up a massive amount of new debt. Here is the current tally taken by Alex Patelis, an economist at Merrill Lynch:

Treasury buying mortgage-related assets: $700bn
Potential supplementary stimulus package favoured by Democrats: $100bn
Insuring money market funds: $50bn
Treasury fortifying the Fed’s balance sheet: $100bn
Expansion of temporary swap lines with central banks: $180bn
Loan to AIG: $85bn
Fed purchase of agency discount notes & ABCP: amount not specified
Fed loans through the Primary Dealer Credit Facility: $20bn through Sep 17
Fed’s discount window: $33bn balance
Treasury purchase of GSE MBS this month: $10bn
Potential cost of Fannie/Freddie bailout: $200-$300bn

The grand total of the above list is roughly $1.5 Trillion USD and I’m sure the U.S. isn’t done yet. If the government were to completely bailout Fannie Mae (FNM) and Freddie Mac (FRE), the resulting bill would amount to $5.2 Trillion or double our national debt. My guess is that the total cost of the government bailouts, if a $700 billion package to purchase mortgage backed assets is approved, will run close to $2 Trillion before the end of 2008.

In regards to the subsequent inflation from printing all this new money, Monty Guild of jsmineset.com says:

“INFLATION IS AHEAD OF US AND IT WILL BE A BIG PROBLEM

Not for the next few months, but in coming years, inflation will be a big problem…and we had all better prepare for it. You may be getting tired of hearing us beat this same old drum but if you prepare for the next problem before it arrives, you will be much more financially secure.

The only solution for the current crisis is to liquefy the global economic system and liquefy it to an extreme never before experienced. You think that the mortgage bubble was a big one? Wait until you see the next bubbles.

The U.S., Europe, Australia, Japan, Canada, and others will all join the parade to fiscal and monetary irresponsibility by inflating their money supplies and creating our next big investment opportunity.”

All this new money entering the system to “fix” previous problems will lead to new bubbles and massive inflation. This is a formula that has been repeated in nearly every modern economic crises. Low interest rates and a “fix” of printing new money has lead to bubbles in the past. Look at how we moved from a tech bubble collapse to the problems we face with the credit bubble. I’m not sure how we are fixing a problem by covering it up in the same manner.

Credit Default Swaps, The Show Isn’t Over

If you haven’t read my previous article, The Greatest Show on Earth, please do yourself a favor and give it a read.

In this post, I am going to expand on watching CDS (Credit Default Swaps) with banks. What CDS can tell you is how much money a person is willing to pay to insure the debt of a bank. The healthier a bank is, the lower the premium will be to insure its debt. If a banks financial situation sours, the higher the premium will be to insure its debt.

Monitoring CDS is essential to determining the health of our financial investments. With the rapid falling value of bank equities, it pays to look at CDS as an early indication of whether a bank may go out of business. CDS tied to banks are one of the most heavily traded form of derivatives.

In addition to reading traditional news media, waiting for earnings results, and for a bank to announce whether or not it has additional write-downs, you should watch CDS as it can give you a glimpse at trading activity between people who may have advanced daily knowledge of a banks operations. The CDS market is laxly regulated in comparison to common equities trading.

Let’s look the current CDS premiums for some of the worlds major banks.

Looking at the CDS premium for Lehman Brothers on 9/12 before it collapsed, we can see that figures grew well above the levels of HSBC (HBC) and JP Morgan Chase (JPM). The list above can be viewed as a most healthy to least healthy list of banks.

This also demonstrates that traditional media unfairly lumps “Banks” into one simple category. A well diversified bank like HSBC with strong retail banking, commercial banking and wealth management divisions is different from an investment bank that mainly derives its revenue from dealer-broker, trading desk, underwriting and structured finance offerings. When determining possible continued or new investment in bank equities and bank debt offerings, it pays to give CDS premiums a quick glance to see an immediate outlook on a banks health.

For further information about the CDS market, please read Credit Default Swaps: Evolving Financial Meltdown and Derivative Disaster Du Jour. In the article, the author Dr. Ellen Brown says, “CDS are private bets, and the Federal Reserve from the time of Alan Greenspan has insisted that regulators keep hands off.

The sacrosanct free market would supposedly regulate itself. The problem with that approach is that regulations are just rules. If there are no rules, the players can cheat; and cheat they have, with a gambler’s addiction. In December 2007, the Bank for International Settlements reported derivative trades tallying in at $681 trillion – ten times the gross domestic product of all the countries in the world combined. Somebody is obviously bluffing about the money being brought to the game, and that realization has made for some very jittery markets.

“Derivatives” are complex bank creations that are very hard to understand, but the basic idea is that you can insure an investment you want to go up by betting it will go down. The simplest form of derivative is a short sale: you can place a bet that some asset you own will go down, so that you are covered whichever way the asset moves.

Credit default swaps are the most widely traded form of credit derivative. They are bets between two parties on whether or not a company will default on its bonds. In a typical default swap, the “protection buyer” gets a large payoff if the company defaults within a certain period of time, while the “protection seller” collects periodic payments for assuming the risk of default.”

I believe we are facing a global derivatives problem of $1,140 trillion and upwards. To echo the sentiments of my previous article, monitoring the health of your investments, especially if they are related to financial services, is of paramount importance in times of crises. Based on the CDS list, I have a stronger feeling that Intel (INTC) will be around, instead of Washington Mutual (WM) in the future.