Failed States: Mexico & California

WHAT UP WITH THE MEXICAN PESO ??

At the same time the US Federal Reserve relaxed its rules, expanded it Lending Facilities, and rescued big US bank balance sheets with massive swaps of USTreasury Bonds for impaired private mortgage bonds, the Mexican Peso rose. See the March timeframe. It rose above the 93.5 critical resistance. The target on the rectangular range swing is roughly 4 points, a rise to reach 97.5, which has occurred. With deep trouble south of the border in economic fundamentals, one would expect the MexPeso to falter. Three theories will be offered, each very likely, somewhat laced together.

First theory, the Mexican central bank just announced an official interest rate hike to 7.75% on their official lending rate. This makes for a 5.75% higher rate than offered by the USTreasury short-term yield. Forex traders have seized on the differential, to lift the MexPeso. They have been anticipating the hike for a few months. Technical traders make up a bigger portion of FX traders these days, focused intently on the charts and breakouts, now fixated on interest rate differentials, ignoring the fundamentals of a nation. Mexican politicians and analysts warn that high borrowing costs put their economy at risk of further slowdown. Already, their consumer prices are up 4.95% in June versus a year ago. Food prices are up on par with those of the US. The corn price is key in Mexico, which supplies tortillas as a staple for the broad population. The tortilla price has tripled in the last year or more, in part a consequence of the US ethanol initiatives.

Second theory, money is moving back to Mexico from troubled banks the United States. As it does, the impact is direct on the bilateral exchange rate for the MexPeso in US$ terms. Not only do the wealthy individuals and corporate officials intend to pursue a higher offered rate in banks, but they wish to avoid severe distress among US banks. If the banks in the Untied States fail and enter into bankruptcy, depositors would be forced to wait to retrieve their money. Large deposits are unprotected at all. So money might be fleeing the US banks. Furthermore, Mexican drug cartel money might be coming back home, fearful of being stuck in the US, fearful of being scrutinized during discovery in a bank failure, fearful of exposing the players and relationships with higher level USGovt officials. Now we hear that JPMorgan is pursuing Wachovia for another acquisition. They have gobbled up a dozen major banks in the last 10 to 15 years. Wachovia is in trouble of insolvency and possible bankruptcy. Consolidation ensues, perhaps to obstruct credit derivative accidents and eruptions.

Third theory, an implosion is occurring in Mexico. A failed Mexican state requires protective measures that are very difficult to fully assess. Chaos reigns. Debts fail. Contracts face renege. Federal deficits rise. Labor strife spreads. Corrupt grabs by the powerful are enacted. Poverty widens. A bunker mentality prevails. Money returns home. This is the opposite of the orderly Japanese Repatriation every March. This is disorder gaining momentum.

MEXICO ON VERGE OF FAILED STATE

The situation in Mexico continues to deteriorate. As their nation falls further into outright chaos, three key questions arise. 1) What happens to the reliable supply of crude oil to the United States, even as Cantarell sees further decline in oil output? 2) What happens to the plans for implementation of the North American Alliance, the economic merger of the US, Canada, and Mexico? 3) What happens to foreign mining rights to Mexican properties, under possible threat of confiscation or hiked royalty demands? These are central questions. The underlying problems are too many to cite. The wealth of the nation is too concentrated with the oligarchs, where a small group controls up to 40% of the national wealth. See Carlos Slim, the multi-billionaire, now ranked #1 by Forbes Magazine among global wealthiest, the first time a Latino has registered that distinction.

As a group the Mexican oligarchs exert great control over the politicians, using the system to sustain power and wealth. Also, the PEMEX oil revenue is on the decline, a factor which forces change from huge strain to national finances. A shrinking pie always causes chaos. Their national oil industry is grossly mismanaged, suffers from inadequate investment, is seen predominantly as a government revenue source (cash cow), and is subject to intense control by labor unions. Lastly, PEMEX is forbidden to enter contracts with any foreign business entity as partner, consultant, or exploration agent. Mismanagement accusations by me are kind and soft lobs.

Violence has spread widely across Mexico. Murders and attempts of police officials are increasing, especially in the northern state of Nuevo Leon. Cease fires between warring drug lord groups are being violated, such as between the Gulf and Sinaloa cartels. Kidnap rings are in operation, with successful tactics. High value targets to date in the Baja and Tijuana have only involved Mexican citizens. A splinter group from the Peoples Revolutionary Army has attacked oil pipeline explosions in the past. That represented a change in tactics, shifting from online anti-government manifestos to actual bomb attacks. They have successfully hit multiple energy targets. Numerous incidents were reported in past months of dead bodies found along roads and in fields, arms tied behind the back, shot in the head. Police have in several cases found stolen police and army uniforms. Even US journalists have been threatened.

A failed nation state is the likely outcome south of the US border. Energy network attacks, growing poverty and inequality, inadequate government services, growing power of organized crime, corruption & desertion of police forces, assassination of judges and officials without consequences, and growing farmer bankruptcy are contributing to a failed system in Mexico. The current farm product price changes have resulted in tremendous additional disruption, losses, and disruption to Mexican agriculture businesses. Needs of people, upheld laws, tax structures, allegiance to authority, and sense of urgency all seem to be in breakdown mode, and have been for several months. Remarkably, the US press networks refuse to cover the stories that form long links in an ugly chain. The division between rich and poor is stark, and growing worse. Furthermore, the system is geared to aggravate that division. The failed state of Mexico will be evident from the top down, from the financial deterioration of its federal government, from the decline in their squandered energy business. Gigantic federal deficits will be the next major story coming from Mexico, along with energy strangulation by labor unions and drug lords who will continue to hold oil pipelines hostage. One must wonder if, amidst growing chaos, whether an external attack might occur of suspicious origin. Many believe autumn in 2001 saw such an event in New York City. When half the US population harbors suspicion, the doubt no longer qualifies as quackery. Mexico could ‘benefit’ from conjured disinformation to keep the nation together. The leaders and oligarchs manage to exploit the situation further for personal gain, in both nations.

UGLY DETAILS ON MEXICAN OIL INDUSTRY

The supply of crude oil to the United States is huge from Mexico, behind only Saudi Arabia (#2) and Canada (#1). As the oil supply production falters further in Mexico, a struggle will ensue as to whether the US receives less oil, or the Mexican customers receive less oil. This has been my concern for months, expressed regularly in the Hat Trick Letter. Now Mexico has finally announced a notable cutback in oil supply to the Untied States of almost 150 thousand barrels per day, another news story totally ignored by the US press networks. One would think that the obvious answer is for domestic customers to receive their own Mexican supply. If they decide to cut back on US oil exports, then the Mexican trade gap will be subjected to enormous deficits. Their Peso will drop in value badly, leading to widespread systemic price inflation EVEN WORSE THAN NOW. If however, they decide to deny domestic customers and satisfy US oil demand, then the Mexican economy will suffer shortages of gasoline and petrochemical products (like lubricants, synthetic fibers, fertilizer). Gasoline prices will skyrocket in highly visible fashion, leading to possible riots. This is a ‘lose-lose’ decision. So far, it seems cutbacks to US shipments and retention of domestic supply is the direction that Mexican authorities have chosen.

The Mexican energy picture has been deteriorating for some time, with an impact on their national finances soon to be felt. The elephant oil field Cantarell had been on an established 15% annual decline in year 2006 and year 2007, offset by expansion elsewhere in smaller volume from other Mexican projects. Now the Cantarell decline rate is 30% annually. However, according to the Mexico City business journal El Financiero, the broader national energy product output has been in major decline for a full year. Last June 2007, gasoline production fell in output by 56.4% at PEMEX refineries, versus the previous June output. Clearly, it follows the trend down in oil production, with less oil from which to derive products. The Mexican economy consumes 800 to 840 thousand barrels of gasoline per day, with any shortfall made up by imports. The shocking data point here is that their gasoline imports rose by 92.1% in June of 2007, versus the previous year, and continue to rise. The trend has continued, as Mexico is witnessing a gradual reduction of its trade surplus dominated by oil shipments.

No new gasoline refinery has been built in Mexico in over 20 years, not as bad as in the US, where no new refinery has been built in 35 years. The net financial impact is that Mexico earned $34.7 billion in FOREX reserves in 2006 from oil export, but of that, $10 billion was spent on gasoline import, or 29% of the gain. The trend continues to kill off their trade surplus, as they continue to import more gasoline and produce less crude oil. The great boon from oil discovery in the 1970 decade is coming to an end. Their oil exports in the first half of 2007 stood at 1.718 million bbl/day, 10% less than the first half of year 2006. The Mexican trade surplus from energy is vanishing. Analysts expect it to be gone by 2011. They do not enter disruption and a breakdown of order into the equation. It could be sooner. They do not seem to enter in growing gasoline import, which forces the timetable forward. The effect on their national politics will be severe, causing a failure of state, with a broad internal breakdown of order. Gold usually responds to such crises, even if in Mexico.

Then there is the North American Alliance, all surreptitiously planned by those in power. The greater plan seems intended (without debate, analysis, or vote) to share US financial might, broad technology expertise, pharmaceutical depth, augmented by military prowess WITH Canadian energy supply and mineral wealth and certain other expertise WITH Mexican cheap labor, energy supply and mineral wealth, and a bonus of new port facilities.

Faltering crude oil supply interrupts the Mexican contribution. A chaotic state down south in Mexican might conceivably disrupt the entire Alliance plan, perhaps only if it leaks over into a US problem. This could happen if millions of Mexicans jump the border into the US, or if their drug lords expand operations into California, Arizona, New Mexico, and Texas. IF MEXICO IS FORCED TO INFLATE WITH MASSIVE FEDERAL EMERGENCY FUNDS, OR FACES WIDESPREAD DEFAULTS AND BOND FAILURES, CONDITIONS MIGHT ARISE FOR BROAD MOVEMENT INTO GOLD AS REFUGE. The process is deteriorating, again without any reporting from the sleepy lapdog US press networks.

CALIFORNIA DISTRESS EPICENTER

A snapshot of home foreclosures exposes the continuing nightmare, nowhere near end, with California at the epicenter. On an annual basis, foreclosures ran at 112% above 1Q2008 versus Q1 of last year. The pace continues, as May national foreclosures rose by 48% versus a year ago. One might expect the pace to level off, but the increases continue. According to RealtyTrac, almost 650k properties were in some stage of foreclosure during the first quarter of 2008, an astounding ratio of 1 of every 194 households nationally. Nevada suffers a ratio of 1 in every 54 households in foreclosure. For California, the rate is 1 in every 78 households, and for Arizona 1 in every 95 households. This is a national tragedy. The rise in home foreclosures is truly frightening. A national catastrophe is unfolding. In California alone, lenders sent out 113,676 default notices in 1Q2008, up 39% from 4Q2008, and up 143% from 3Q2007. The number of California homes lost to foreclosure in 1Q2008 was 327% above that of Q1 a year ago!!!

In the month of April, foreclosure filings were reported on more than 243,000 properties, a 65% increase compared with April 2007, according to RealtyTrac. In San Bernardino California, a friend told me that 800 foreclosures per day are being filed in the area. By the way, towns dominated by military bases suffer foreclosure rates four times worse than the national rate. California has more than its share of military base towns. This does not sound like support of troops. California generally saw home prices fall by 32% in April, versus the same month in 2007. Sales in the Golden State actually increased by 2.5%, but with heavy price cuts. Again shockingly, one in every 204 US households is in some stage of the foreclosure process, by latest figures available.Bank owned properties are soaring in number. In January 2007 they totaled 231k homes, in January 2008 it was 493k homes, and in April 2008 it was 660k homes.

Freelance credit analyst Jas Jain said of California, “Since the credit crisis began in August 2007, home prices (on a price per square foot basis) have been steadily dropping at a 20% to 40% annual rate, depending upon region. There could be some leveling off in prices for a few months before the second leg takes [housing] prices down more than 50% from their peaks in most areas by year-end. California has been in a recession since July 2007 based upon employment data, and should enter a depression in 2009. The housing bubble kept Silicon Valley out of the depression after the tech bubble burst, causing employment to fall by 20% in 2001 to 2003. That is a depression by any definition. This time there is nothing to save the California economy.” Wow! Ouch! Batten the hatches on the Left Coast !!!

The $4.8 state billion budget cut by Gov. Schwartzeneggar in educational funding this year has hit hard, cutting 20 thousand jobs among teachers and other school employees. Many wealthier communities in California have begun initiatives to solicit private funding to aid the schools, even a separate tax levy proposed in Alameda County outside San Francisco. Home values in California are already down by 29%, from March 2008 versus last year March. That translates from median value $582k last March to $414k this March, a median average drop of $168k per home. Conditions are worse with bigger losses in Monterey, Riverside, Sacramento, High Desert, and Santa Barbara. Rick Sharga of RealtyTrac said, “California still has not hit bottom. We have a lot of California homes that are in early stages of default that may not be salvageable, because either there is no market or financing available, or both.”

The national housing inventory problem grows worse, not better. Pollyanna analysts continue to miss the direction toward more bloated, as prices are threatened continually. The inventory for existing homes was high in March, at 9.9 months supply, and went to 11.2 months in April, a record covering 23 years. In California, the existing home inventory is at least two months greater supply than the national figure. On the existing home side, foreclosures relentlessly flood the market, aggravating supply, serving as the most significant factor weighing down housing price. In fact, fully 40% of all sales in California come from bank & lender foreclosures. And the condominium picture is worse, as pressure comes from rising condo fees. The median national housing price has fallen to $202.3k, down 8% from a year ago. Sales activity has fallen for eight of the last nine months. A key data point is seen in the West, where sales activity rose by 6.4% but where prices fell the largest amount. Prices fell in 43 states, with California and Nevada registering the biggest declines. An opportunity for price stability might come out West where prices came down hard to encourage buyers, but it is early to conclude stability. The foreclosure process still drives the process out West. My belief is that the foreclosure process generally will continue to pressure inventory for another year at least, and push prices down further. Lending institutions are dumping their inventory, lowering price, and achieving some sales. Just because price has fallen, and sales activity has risen, does not mean that price will stabilize. Lending institutions are not seeing any reduction in their inventory, the key point! They incur costs from insurance, property tax, and maintenance, plus legal fees. They bribe homeowners to leave quietly without damage to the property, as in sabotage. Banks even call the cost ‘Anger Escrow’ in their financial reporting. So time to hold properties on the books costs money, an inducement to cut price for distressed or auction sales.

The Standard & Poor Case Shiller composite index provides broad aggregate price data, but two months old. Its index of 20 metropolitan areas showed prices of existing homes fell 2.2% in March, accelerating to worse than a scary 20% annualized decline. The venerable serial bubble engineer Greenspan estimates that house prices will decline by another 10% from February levels, and perhaps 5% worse than that if the USEconomy remains weak. He expects a peak to trough total decline of 25%. Economist Paul Krugman uses a different reasonable measure, a ratio of home prices to rental rates, to arrive at a 25% overall home price decline in the overall correction. Goldman Sachs keeps its simple, stating home prices will fall 15% without a recession, and 30% with a recession. Yale Univeristy professor Robert Shiller expects a shocking 50% home price decline in the formerly hot property zones, like California, Las Vegas, south Florida, and parts of Arizona. My forecast is for a national housing price decline to the levels seen in 1990, plainly put, a double housing recession since no housing recession was permitted in 2000-2002.

In year 2005, a very intriguing sequence of events occurred. California state contractors were not properly paid in cash and instantly redeemable checks issued by the state. The state was actually in severe arrears on payments and at risk of losing contractor work. So California issued state coupons, like IOU on pieces of paper. It is unclear to what extent state employees received such coupons. Of itself, this is not so important. What struck legal and political scholars was how the state coupons were used. THEY WERE REDEEMABLE AS CASH, AS IN LEGAL TENDER, AT SUPERMARKETS AND UTILITY FIRMS. The coupons were essentially cash in restricted usage. They were a bizarre form of money created by the State of California, inflation to be sure, but money printed illegally outside the realm of the federal USGovt. Only the USGovt has the privilege of inflating the money supply and destroying the currency! The problem resolved itself in the ensuing months. Fast forward to today. Gov Schwartzeneggar announced a 10% budget cut a few months ago, with additional budget cuts in progress. California is under great distress. Its economy is probably in a mild depression, much like Michigan and Ohio. The Governor recently announced the inability to float a state bond to cover ongoing expenses to run the state. So they resorted to floating some emergency measure bonds, using state lottery income as collateral. Gambling income is the only reliable income stream to the state, WOW! Watch for future attempts to print money via the back door, if desperation runs thick. Look for challenges to the federal privilege to print money. The implications could actually work toward strain in the union, as in USA. That is not my forecast, but one should expect strains to individual states to become acute. Some will want to print money. Imagine a California Dollar with a golden bear on it. Oh yes, the Governator declared a state of drought, which forced an emergency order of resource sharing for water, and some conservation measures. The state has enough problems, let alone drought. What is next, locusts? How about rising salinity levels in irrigated water?

If California is forced to inflate with state coupon devices, or receive massive federal emergency funds, or faces widespread defaults and bond failures, conditions might arise for broad movement into gold as refuge. Vallejo already declared bankruptcy at the town level. The process is degenerating.

THEY CANT KEEP GOLD DOWN

Despite the technical rebound of the USDollar since March, the gold correction refuses to go below 860. Another successful retest occurred in the last couple weeks. The stochastix cyclical index has begun to turn upward from oversold levels. The magic new level is 940 for gold to surpass. Fundamentals support the gold price. Mine output continues to struggle. My ongoing point of gold supply inelasticity bears repeating. Higher gold price has not resulted in higher gold mine output. Thus, the gold price should continue higher. The silver chart is nearly identical. The prevailing story driving the gold price correction in the last few weeks has been that the USFed will actually raise its official FedFunds rate before the end of the year. The Euro Central Bank has wrested leadership and bank power prestige from the hack Americans, who seem hellbent on the destructive cycle of inflation, bust, liquidity provision, corrupt with bond fraud, paper over, consolidate with raids. The bluffs by the EuroCB to hike rates are being taken seriously. But not here! The Europeans cannot hike rates when the southern bloc is awash with housing liquidation and price declines, and assured recession. The Europeans cannot hike rates when the German economy has suffered five consecutive down months in industrial production, and when ZEW economic expectation measures are heading down. The big German banks are due for more bond and credit market losses, just like the American banks, but on a smaller scale.

Neither the USFed nor the EuroCB will hike rates this year. Yet another massive marketing scheme (aka propaganda) has taken place. The gullibility of the US investment community has become laughable. They are always ready to swallow the next myth, chapter and verse. When the bond market and currency market realize no official rate hikes will come, the USDollar will head lower. Price inflation must be permitted, even in wages, an all important distinction. Gold will rise in US$ terms. Gold will rise in euro terms. Then lest one forget, the Summer Olympics in China are sure to produce some surprises. Such a grand political stage is not to be unexploited. Gold might like the hubbub. My preference is to watch the magnificent athletes more than to pay attention to sideline developments. However, with trade conflict on the rise between the US and China, and bank power being fought for, my ears will be trained for stress fractures. Gold will respond.

Congratulations to the Boston Celtics, NBA basketball champions! Boston rules in sports!

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Jim Willie CB is a statistical analyst in marketing research and retail forecasting. He holds a PhD in Statistics. His career has stretched over 25 years. He aspires to thrive in the financial editor world, unencumbered by the limitations of economic credentials. Visit his free website to find articles from topflight authors at www.GoldenJackass.com . For personal questions about subscriptions, contact him at [email protected]