A Time for Reflection

HOW DO YOU CURE A HANGOVER?

The FED is still playing the same old game that brought about the current crisis, only it’s giving it new labels and anachronisms in their attempt to fool the public by pushing out more money and credit in the hopes of avoiding a major collapse of the financial markets. What all these strategies have in common; is an unwillingness to come to terms with the reality, that papering over the problem with “out of thin air” money might seem to work in the short run, but in actually it only pushes the problem into the future and will end up making it worse.

In response to the troubles with Bear Stearns, the FED offered primary dealers up to $200 billion in Treasury securities for 28 days in exchange for AAA rated mortgage backed securities (who is kidding whom) as collateral. Then, as Bear Stearns's cash holdings dropped from $17 billion on March 11 to $2 billion on March 14, the Fed decided to provide direct loans to investment banks (for the first time since the Great Depression) due to the serious risk to the large $4.5 trillion Repo market. Should confidence in that market be undermined, it could completely destabilize the financial markets. In the end, Fed officials forced the selling of the Bear Stearns to JP Morgan for $2 a share, $28 less than two days earlier and some $170 down from its high less than a year ago. Most commentators are praising the so called innovative methods being used by Bernanke, considered an expert on the causes of the Great Depression and the ultimate expert on how to counter the current economic crisis. But the truth of the matter is that Bernanke, is a Keynesian economist and believes that by means of aggressive monetary policy, the credit markets can be normalized. All that is really fancy talk to justify doing more of the same that got us into the trouble in the first place. In short, Bernanke like FDR and his advisors before him, believes that his so-called "innovative" (already tried and failed) policy of fixing the symptoms can cure the disease. What is the source of the disease and why are investment banks so heavily infected by it? The root of the problem is the Fed's very loose interest rate policy and strong credit creation from January 2001 to June 2004, when the Federal Funds Rate was lowered from 6.5% to 1% giving rise to massive speculation in, ultra high risk, low return projects, which always end up as BUBBLES, whose activities are never self-funding and must come at the expense of other self-funded productive activities. This means that less real savings is left for real wealth creation. (Monetary pumping gives rise to misallocation of resources, which manifests itself in increases in nonproductive activities, such as overbuilding (Negative interest rates mean that you are being paid to speculate). Money created out of thin air, is not felt instantaneously across all market sectors. The effect moves from individual to individual and from one market to another market, generating bubble activities along the way. As with any other business, investment banks are trying to "make money" giving rise to the creation of innovative, highly leveraged products like CDO’s and other mortgage-backed securities (MBS); securing as big a slice as possible out of the pool of newly created money. As long as the Fed kept pushing money into the system the various activities that sprang up on the back of their loose stance appeared to be for real, but only as long as money stays plentiful and interest rates stay low, leveraged investments in high-yielding CDO's and MBS's, that are made to masquerade as AAA grade investments become very attractive because the brokers can create almost as many as the over leveraged speculators want. However, once the central bank tightens its monetary stance, all of the various bubble activities are undermined. The damage from the loose monetary policies, cannot be undone by trying to fix only its symptoms. The various activities, such as home speculators and highly leveraged buyouts by Pvt. Equity and Hedge Funds, have weakened the structure of the economy: This fact cannot be undone by another dose of easy money and If anything, will only worsen the problem.

THE REAL PROBLEM

The problem stems from the general lack of understanding that there is a fundamental difference between Real Money (Capital) that can only come from savings and Fiat Money that is created out of thin air by the FED: Fiat Money that does not come from the non consumption (savings) of real goods and services must increase prices since there is now more money chasing the same amount of goods. As Interest Rates are artificially driven lower, savings drop. Who in their right mind will forego consumption in return for an interest rate that is lower than inflation and on which, they have to pay income tax. The proof is that the US has had for the first time in its history, a negative savings rate for more than 15 years. How can we ever expect to have a balance in trade when every major country that we trade with has a savings rate of between15% and 40% while ours is minus 1%? “You cannot change other people, you can only change yourself.”

As the flow of credit and savings diminishes, it starts to undermine the existence of these false paper shuffling activities and their solvency becomes questionable. A fall in the flow of money in turn puts downward pressure on the prices of the goods (Homes and Buyouts) of these activities; which have a tendency to fall sharply early on before the economic bust becomes obvious. This in turn reduces the flow of investors' money to these activities. As a result, the prices of their stocks also fall early and sharply (Home Builders Banks, Brokers etc.),.With the value of their assets falling, misdirected investments can then no longer secure funding. In contrast, wealth-generating activities that do not need an expansion of money for their existence actually start to gain strength. A fall in the prices of their goods is likely to be less severe than that of the goods of bubble activities, as their lower prices increases sales. An example is flat screen TVs. In fact, their prices may not fall at all. Remember that wealth generators are engaged in the production of goods and services that are on the highest priority list of consumers. In contrast, bubble investments are engaged in the over production of goods and services that are now on the low priority list of consumers (new homes).

The engine of economic growth, contrary to popular thinking, is not money but real savings. If the pool of real savings is declining or stagnating, then the economy will follow suit. Economics 101 says: If you want to increase the supply of anything, increase the price (if you want more savings, raise interest rates). However, if the Fed resumes its policies of lower interest rates, which entails the creation of massive amounts of “out of thin air money, galloping Inflation must be the end result. If the pool of real savings is falling or negative like it is now, bubble activities dominate the scene raising the likelihood that the commercial banks' expansion of credit must eventually come to a halt. As is now happening. Bernanke's policies will only do further damage to the stock of savings and sound capital investment and plunge the economy into a severe and prolonged crisis.

WILL WE EVER LEARN?

We are always confusing cause and effect. In so doing, we never uncover the real culprits and therefore the stage is always set for a repeat of the exact same crisis some 15 to 20 years hence. CONGRESS is already holding hearings in an attempt to place blame and divert attention away from the real culprits, Congress itself. Both during the S&L debacle as well as today, it was Congress, the President and the FED that basically coerced the mortgage lenders to make those ridiculous Zero Down, abnormally low “Teaser” interest rates (Liar Loans) all in the name of fairness in achieving the American Dream – attempting to buy votes). To compound the error, we had Dr. Greenspan encouraging everyone to use ARM's when 5%, 30year mortgages were readily available. The S&L problem was exacerbated by Congress when, in the name of fairness, they eliminated the Usury Laws as well as the S&L’s interest rates advantage over banks, in conjunction with creating massive inflation. They are doing the same thing today. This leaves two questions, “Will we be able to avert a Depression this time? But more importantly, “Who is going to investigate Congress?”

The recent interventions by the Federal ResERVE: – $100 billion in “Term Lending” financing and another $200 billion “Securities Lending Facility” - are in fact, large interventions. But investors should fully understand that these only address short-term liquidity problems, not solvency problems. In other words, they make it easier for various financial institutions to carry on their day-to-day transactions for a while. But they do not lower the probability of continued major losses on defaulting mortgages. Even if the mortgage securities used as collateral go into default while they are in the hands of the Fed, the primary dealer still has to repurchase them from the Fed after 28 days at the original price plus interest. The Fed does not take on the risk of default of the collateral since it will get paid back: BUT only as long as the member bank makes good. The real risk that the Fed takes on is the possibility that the primary dealer itself – a major U.S. bank – will go bankrupt during the 28-day period.

CREDIT DEFAULT SWAPS (CDS): The market hasn't even considered the potential losses in CDS. The single largest trader in this market is ironically, J.P. Morgan.

TREASURY bonds: We continue to observe a periodic flight-to-safety at all maturities, but this should be viewed as fear pressure, not investment merit, since the prevailing yields-to-maturity are by definition not at a level that provides positive (after tax & inflation) long-term total returns.

The feel good rally following the latest Fed rate cut might be believable if anything had changed, but alas, nothing has! On Wednesday, Fannie Mae and Freddie Mac had their capital reserve requirements lowered from 30% to 20%, permitting them to take on greater amounts of mortgages. They have been in trouble for awhile now. Did that some how make them stronger? We have to assume that the Fed figured out the clock was ticking and the 28 days would pass and the ugly problem of nobody wanting the underwater mortgages would resurrect itself. So lets get the GSE’s to step up, and take the illiquid securities off the Fed’s Balance Sheet. That should strengthen them alright. That and the new proposals to change the accounting rules– instead of marking mortgages to market, how about holding some part of them for investment purposes? Since these could be re-classified as long term investments to be held to maturity, they could be valued at full principle value thus Fiat money, manufacturing new capital out of thin air. Incredible what a rule change can do?

SOLVENCY: The problem here is that the Fed has been addressing only the liquidity issues not the solvency issues. They are not yet recognizing that there has been an enormous amount of Equity lost. There’s a disturbing pattern here. First they let those who completely failed in their regulatory oversight attempt to fix the problem for themselves and what we get is unjustified rate cuts, in conjunction with usury and gouging of the public. Secondly, they permit special rules for banks so they can move risk off their balance sheet, (the guys at ENRON went to jail for doing the exact same thing) while banks are offered public money at lower and lower rates to boost their profits. Thirdly, the Government fails to disclose what the losses at Ginnie & Freddie and the like are ballooning too in the hopes they’ll get bailed out in time. It’s obvious that the regulators are violating the first rule of prudent trading–cut your losses, don’t ever think that time will heal a bad situation or trade. It’s also obvious that Regulation SB requiring full and timely disclosure of material events doesn’t apply to the Government sector–most notably Ginnie and Freddie. We have a crisis and we have irresponsible actions by irresponsible people. The Government writes the rules, but enjoys immunity from their breach – and then cleverly changes them if it suits their purpose all of which is explained as being in the public good.

This serious financial crisis requires going back to sound lending standards, not desperate actions to hide, disguise, and ignore the problem caused by the gross inflation of housing values and excess leverage. The bottom line is that the Government (Taxpayers) is getting its pocket picked by a factor that will likely prove to be considerably more than two trillion dollars: Its time for a strategy that recognizes the inevitable losses and seeks to minimize the cost to the public. The time for this action is NOW. The longer we ignore the real problem, the larger the losses will be. Continuing reactionary, piecemeal policy actions will only prolong the inevitable. By election time, the Fed will be out of bullets having used up all their monetary tools at a time when they need them most. It’s foolish policy to think that time and interest rate cuts will heal a falling but still inflated value problem, particularly in a recessionary economy. Changing the rules to perpetuate the charade that an extraordinary amount of US homes are not worth their principle value and will not be for years to come is tantamount to fraud.

RANDOM THOUGHTS

What you are witnessing is a general lack of confidence winding and expanding its way through all markets; the precursor to a real secular BEAR MARKET. Sell short or buy puts into any one to three week (500–900 pt) rallies. Even though the commodities are flying, their related stocks are not because there are two different sets of players: Commodity Traders and Hedge Funds are used to going either way and are trend followers. Stock Market Investors, on the other hand, really only play one way and that is up. In a Bear Market they lose all confidence. It looks like that is what is beginning to happen NOW.

But the most bizarre idea was introduced on the pages of the Wall Street Journal when veteran opinion page writer Holman Jenkins Jr. recommended that the government buy and “bulldoze” foreclosed homes in order to prop up the values of those that remain standing. There is no question that we built far too many homes during the housing bubble. However, destroying them now will merely compound our losses. The one benefit we have from excess construction is an ample supply of what will soon be highly affordable homes. At the moment, foreclosed houses are only unwanted because their prices are still too high and not affordable to the average American family. Once prices drop sufficiently, there will be plenty of demand. However, destroying existing homes reduces their value to zero (actually less due to demolition costs) and only exacerbates the losses to both creditors and taxpayers. Mr. Jenkins’ thinking is formed by the same perverse logic that led the Roosevelt Administration to destroy farm animals and crops during the 1930’s in order to prop up food prices. He confused cause and effect. Since Depression meant lower prices, he assumed that if prices could be maintained, Depression could be averted.

What kind of timing are we looking at?

This crisis situation will probably come to a head between now and May. The credit fiasco that’s currently going on can best be compared to a BLACK HOLE that sucks in everything that it touches. Not only have we got the Japanese year-end on March 31, but we also have a lot of quarter-ends and year-ends coming up and due to be reporting between now and the end of April. In theory, you have to mark to market, but how do you do that when there is no market? You mark to the model. Well, the models have proven to be broken and even if they were not, nobody trusts them anymore

I have mentioned in a few of my past letters that it’s going to be a field day for lawyers. We are already seeing a couple of lawsuits against a few boards of directors and even against the audit committee members of Citigroup — just one or two of those suits being filed is going to get everybody’s attention, so the write-offs are going to start getting pretty serious. I wouldn’t sit on the board of an Investment bank right now for all the tea in China. And we ain’t seen nothing yet, as the lawyers have not yet figured out who and what to sue about; rest assured they will. When there is Blood in the water, the sharks always gather and since the money involved is so huge, it will become a feeding frenzy.

HOW LONG CAN ALL THIS GO ON?

We are now basically in a Denial Rally (bounce) phase Wave 2 or a Wave B of what I would call a crash or at best a pre-crash mode. There is a credit debacle going on and the irony of it all is that it’s dragging the economy down, while they are still debating whether we’re in recession or heading into recession and whether Bernanke can cut rates low enough to stop the recession in its tracks. If you look at the growth of credit and the growth of GDP in the US, the real danger is that it now takes about $5.50 of new credit to add $1 to GDP. That’s about three times what it was 20 years ago. If the credit markets are basically frozen, where is the new credit coming from to fund any new growth in GDP?

Is there anything we can do to avoid this impending disaster?

I’ve said for years that ultimately they will try to print their way out of it and effectively go into a hyperinflation mode. It would take a deflationary accident — essentially a crash in asset values — to precipitate that. I think that deflationary crash in real values is now underway. It’s obviously now going on in houses and the car recall industry can’t get enough drivers to repossess all the cars. People are forgetting that most of that automotive debt is also floating around in various collateralized debt obligations paper. We haven’t even heard about car payments being defaulted on yet. At the moment, we’re only talking about mortgages – but there are also credit card balances and car payment balances too. Basically, we have a generation that’s been living on debt and the debt machine is in the process of shutting down. If the government continues to print that will effectively be the attempted inflationary solution that inevitably leads to hyperinflation. It’s the crashing real estate prices that leads to inflate, inflate, inflate – oops, hyper. And that’s when they start throwing money at everything: Gold will go up into the $2,000 or $3,000 or $5,000 plus neighborhood - pick a number. At that stage an ounce of gold is an ounce of gold. The price of gold is just how many pieces of paper it takes you to throw at me to persuade me to give you some. BUT “Don’t salivate at the prospect. You’re not going to like how it gets there.” “What’s a dollar?” It’s a promise backed by a whole bunch of lying politicians.

VOLATILITY: We are getting into a period of substantially greater and greater volatility. As a stock market indicator, we used to get really excited whenever the upside/downside volume was at a 9:1 ratio. Invariably it happens on sell-offs because fear is a more urgent emotion than greed. So whenever you had a 9:1 day, that was really pretty meaningful. To put this in perspective, in the seven years from 1994 to 2001, we had a total of 15 of those 9:1 days: We’ve now had 32 of them in the last 12 months alone. It’s absolutely mind-boggling with everybody in, everybody out. Part of it is a function of virtually no transaction cost. Everybody is sitting there with a computer and pushing buttons. We’ve got a generation of traders who grew up playing computer games. They went to Harvard, and now they’re running hedge funds and they’re still playing computer games. It’s basically this period of extreme volatility that really worries me, and yet there’s still so much complacency, Don’t forget that they are immature and emotional and have never witnessed a Bear Market. Moody’s is going to cut the credit rating of a couple of the insurers. So Buffet comes out with a proposal that he’ll be the backstop insurer behind them. Nobody’s questioning the fact that he’s the major shareholder in Moody’s. So effectively, Moody’s threatens to cut the rate, Buffet’s standing there saying, “I’ll solve your problem for you, and if you don’t take my offer, I will call my pals at Moody’s.”

The Fed’s moves did get the cash flowing again but only temporarily. It only allows banks to kite checks for 28 days. The dollar, on the other hand, is trading to new lows, instead of bottoming and preparing for recovery. I heard from several European subscriber traders this morning and the view over there is that this does not fix our problem; it is a temporary stop gap measure at best. It may keep the heat off Citigroup and the like for a few days or weeks, but not a dime of that $200 billion will end up going to fund business or consumer loans to stimulate economic activity. As is always the case we are just bailing out the very individuals and institutions that created the mess in the first place!MEANWHILE: U.S. household wealth fell by $532.9 billion in Q4, its first drop in five years, led by a $176.4 billion drop in housing-related net worth. Mortgage borrowing slowed to 5% growth, its smallest gain in more than 10 years. "Consumers are being squeezed from several directions." The Fed's Mishkin pointed out that “Reduced household wealth, a weakening job market and soaring fuel prices, are likely to restrain spending growth in the period ahead."

WHAT DO WE AS INDIVIDUALS DO ABOUT ALL THIS?

First and foremost, we must realize that any 500 to 900 point emotional FED induced rally is a phony rally and should be used to sell out the last of our positions and initiate new shorts (for those who know how to do that). Whatever you do, do not get sucked into believing that the Bull Market has resumed.

COMMODITIES: Just a few quick thoughts about the drop in commodity prices we saw last week. First, it was about time. Gold and other commodities went too far, too fast in a largely speculative frenzy. A correction was overdue. Gold saw the largest one-day drop in 28 years, since the bubble days of the '80s. Gold may still have some room to fall before it bottoms out. But I am not worried about it and I seriously doubt that we have seen the highs for Gold, Silver and a host of other commodities (although I am no expert on commodities). As for Gold and Silver, we got that $100 pullback that I was looking for, so what more do you want. Has the ultimate pullback low been made? I don’t know and I don’t care. Only Drunks and liars can pick the exact bottom and besides I don’t drink.

Despite the mildly tough language in its statement, it should be clear to all that the Fed sees inflation as the only politically acceptable “solution” to the problems it created. The conclusion that a 75 point cut shows concern about inflation is half right. The Fed is concerned, but only to the extent that the markets stay focused on bogus CPI numbers and fail to notice severe price increases throughout the economy. The fact is that inflation will be with us for some time, and the knee jerk drop in Gold is yet another excellent buying opportunity. It is a testament to how low the bar has been set that the Fed can slash rates by 25% in the face of a collapsing dollar and soaring commodity prices and still be viewed as being hawkish on inflation.

GOLD & SILVER vs GOLD & SILVER STOCKS

If there is one question on the minds of every single investor or interested party in precious metals, it is “WHY are the stocks lagging Bullion by so much, when they usually lead?” As a matter of fact, this has never happened before, so why now? After some long and serious thought, the only thing the comes to mind is that this time around, we have a plethora of Precious Metals ETF’s and if that we’re not enough, we also have a whole lot of other commodity ETF’s sucking up billions of dollars that in the past would have gone to Gold and Silver stocks of all stripes. Why GLD alone has amassed over $20 Billion and that’s not counting, I do not know how many, billions of dollars that have found their way into the other ETF’s of similar vein around the world. But this situation can only last so long. In my opinion, the big Gold companies are poised to take off. The impetus should come from tremendously improving profit margins which, lo and behold, we have begun to see in the quarterly reports now being released. Just last week, Goldcorp announced that fourth-quarter profit had nearly quadrupled over the same quarter the year before. And then Kinross announced that it, too, had posted a record quarter with profits up almost three-fold over Q4/06. Meanwhile, Barrick reported that net profit for 2007 was 28% ahead of 2006. In addition, Barrick is feeling sufficiently flush (and optimistic) that it's buying out Rio Tinto's 40% interest in the Cortez Hills joint venture for $1.695 billion cash. Although Newmont announced a loss of $1.8 billion in 2007, most of it came from a one-time house cleaning -- $531 million to unwind 18.5 million ounces of forward Gold sales and a $1.6 billion non-cash charge to terminate operations related to merchant banking. Look past those elements, which are an overdue recognition of money that went down the drain years ago, and you find that Newmont's mining business is actually in a healthy position. Look at it from another angle, Newmont took these charges now because they could afford to do so and because they felt that the damage to their share price would be softened by the strong performance of their current operations. Now that they've cleaned up the books, they too are dressed up to join the profit party. And all that is under $700 gold and $16 Silver. Wait till you see what happens at $1,500 and $2,500 Gold.

As for the JUNIORS: $800 Plus Gold and $20 plus silver gives them internally generated cash flow to complete their projects but more importantly, complete their drill programs allowing them to prove up their reserves without diluting their shares. As the Bull Market in precious metal stocks proceeds, you can rest assured the Juniors will not only catch up, but greatly surpass the stock profits of both the Seniors and the Metals.

How to Profit

• Start buying the established producing companies: ABX, AEM, GG KGC to name a few.
• You can now move into the higher-quality Junior exploration stocks. History has proven that, absent an exciting discovery story, the big Gold stocks must get in gear before investor sentiment can then ignite the Juniors. History also shows that as profitable as the big Gold companies are, in a Bull Market, returns on the Juniors can blow those away. This upside, of course, comes with a greater degree of risk. But paradoxically, this risk has been largely mitigated by the majors' slow take-off. That's because anticipating that the Gold stocks would follow the metals higher - and history shows no example of them not doing so - investors have already poured record amounts of money into exploration programs. As a result, we now know which companies have the goods -- significant discoveries that Juniors have spent tens of millions to define and prove up with the clear intent of selling to the majors. The missing element, of course, has been that, until recently, the majors didn't have enough free cash to make those acquisitions. That is about to change.

Most of you don't know me and so will have to take my word for it. I am not the type of person to fall in love with any material things. And any time I feel such an urge coming on, I check all my assumptions twice and then check them again. That said, I will also say that I have never been more Bullish than I am now on the Gold and Silver mining sector as a whole, with an added nod to the well-run exploration companies.

GOOD LUCK AND GOD BLESS

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Aubie Baltin CFA, CTA, CFP, PhD.
2078 Bonisle Circle
Palm Beach Gardens FL. 33418
[email protected]
561-840-9767