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Outlook for 2008Miguel Villahermosa -Ben Bernanke
at Milton Friedman's 90th birthday party The Credit Crisis: It ain't over 'til the fat lady sings, and she hasn't even warmed up Massive levels of debt underlying the world economic system are about to crumble in an avalanche of fake money and central bank megalomania. The effects will be profound to be sure, and it isn't the fault of deadbeat American homebuyers or greedy mortgage brokers who cut corners to make sure the slobs [ouch] got into houses they couldn't afford. It is the fault of back-room financial bones men who found ways to securitize bad debt, banks which creatively shifted risk off of balance sheets into the hands of foreign investors, and pension/hedge fund managers who gobbled up those high yield debt instruments. Most of all it is the fault of regulators who stood by and watched it all go down, or worse, helped fuel the fire. U.S. sub-prime loans seem insignificantly small when put in the context of the massive, world-wide debt markets, but closer inspection reveals that they represent a much more explosive contingent than most know or are willing to admit. The reality is that the starry-eyed would-be American owner is just a pawn in a much larger liquidity game which is played between banks, hedge funds, and credit agencies. How the Mortgage Banking Crisis Developed Once upon a time, banks used to service their own loans, and thus they were far more scrupulous about who they loaned their money to. Banks would only accept a certain amount of risk because in the end, they were playing with their own money. If a loan defaulted, the bank ate the loss, and banks do not make money on foreclosures. When the dotcoms busted and all that money went to heaven, the fed stepped in and lowered interest rates to bolster the economy and prevent recession. The lowered interest rates subsequently sent homebuyers into a frenzy and spurred a real estate boom. The enthusiasm trickled up and banks got creative with their financing. This happened for two reasons; One, property values were skyrocketing so banks viewed the loans as less risky. Two, banks had come up with an ingenious way to shift risk off their balance sheets by packaging their mortgages into CDOs (collateralized debt obligations). By selling sub-prime CDOs to investors, banks were able to free up capital (because the CDOs were highly leveraged) which they then turned around and used to originate more loans. Credit agencies greased the wheels by predicting that CDOs would rarely default even though these agencies had very little experience with CDOs. Thus, these CDOs could be purchased as prime paper despite the fact that they are composed of sub-prime loans. "How do you create AAA paper from sub-prime loans?" you might ask. Here's how:
What separates the higher grade paper from the lower is who takes the losses first if there are defaults on the underlying mortgages. The first 8% of the losses are absorbed by the lowest trench (BBB-). The AAA trench doesn't experience any loss until over 24%. In this way, AAA grade paper is created from sub-prime mortgages. The AAA paper pays somewhere in the neighborhood of 5.5%. The BBB- paper pays somewhere in the neighborhood of 30%. Incidentally, a 30% return on the BBB- paper suggests an 80-90% loss within the trench. So far losses have been in the 12-15% range. One of the interesting modern phenomena of modern banking is how they are able to put a leveraged condition on almost every type of debt, and sell themselves on the idea that the greater the leverage the less the risk. Equally interesting is how quickly an idea of this type, which goes against all common sense, can be so vehemently embraced as 'smart thinking' by those in the investment community. It is a sheep mentality of an indescribable dimension. On the receiving end, investors were buying the CDOs using borrowed money which was readily available at low interest rates in the U.S. and Japan, and then turning around and using the CDOs as collateral for more borrowing. To make matters worse, the debt obligations rose in value throughout the real estate boom which allowed even more borrowing, and encouraged bankers to pull equity from hard assets in order to create and sell more CDOs. In this way U.S. sub-prime loans, which on the surface appear to be a small part of the global debt machine, are actually a very significant and important portion of the market. More significant is the fact that this problem is not limited to sub-prime loans, or just the mortgage sector (over 40 major mortgage companies went bust in 06'). The credit crunch was simply rolled over into other areas. American Express recently announced that they absorbed $275 million (for Q4) in uncollectible customer defaults and a subsequent drop in earnings. Those write offs rose from 3.7% in the Q3 to 4.3% in Q4. In the same statement American Express said they expected that number to go up to as high as 5.3 percent next year. Capital One Financial Corp., the largest U.S. card issuer expects unpaid loans to rise to $5.9 billion compared to an earlier forecast of $4.9 billion. Last month, a top analyst from Merrill Lynch & Co. (market cap 51 B - what is the shareholder's equity) recommended that investors sell American Express, Capital One, and Discover Financial amidst widespread predictions that consumer spending would fall off in 2008. Funny thing, Merrill lynch itself is expected to suffer $15 billion in losses (nearly double the initial estimates) and is currently in discussions to receive as much as $4 billion in foreign investment capital from Middle Eastern government investment funds. Sub prime issues have sent Citigroup Inc. in search of as much as $10 billion from foreign funds, and Citigroup's board cut its dividend in half to save money. The real kicker... Moody's credit rating agency announced Jan. 11, 2008 that the US is at risk of losing its triple-A credit rating within a decade unless it takes "radical action" to curb spending, and yet despite the overwhelming evidence to the contrary, there are still many who refuse to see this crisis for what it truly is - the first rumblings of an epic bear market, they say "everything is going to be ok." I'm sure the captain of the Titanic said the same. What will happen? Investing in "the Real" Perhaps the best way to capitalize on the coming liquidity crisis is to invest in hard or "real" assets. What is a "real" asset? Anything you can touch, see, or eat - in other words, commodities. It is also our feeling that the current sub-prime crisis will create a rarely seen real-estate buy opportunity in the coming years for those with quick cash. The inherent problem with the Fed and its monetary policy is that it approaches the market with an extremely shortsighted view. In other words, a slowing economy trumps inflation. That's why we have seen the recent (and successive) drops in interest rate. Mr. Bernanke has even gone so far as to preclude upcoming activity with comments suggesting what kind of action the central bank would take - a bizarre move, in our opinion, that only solidifies our suspicions that the Fed is on the edge of panic. The ultimate problem with the lowering of the interest rate at this time is that while it may be a shot in the arm for the US housing market, it is a kick in the groin for the US dollar (which limped through last year anyway). The US government has grown fat and sloppy with its spending, and the undisciplined policies of the Federal Reserve Board are only making things worse in the long run. Things likely to happen in 2008: Soon we will start hearing about a "renewed" housing market. Already real estate agent's phones are ringing off the hook. Why? Two reasons. One; the average American Joe doesn't really believe that the boom is over. Not only that, he would be incensed and offended if you told him that all that equity stored up in his house doesn't really mean anything in terms of real (adjusted for inflation) dollar gains. Two; although the market wasn't allowed to hit rock bottom, it still slid substantially in terms of home inventory prices. In other words, the price of many homes dropped when sellers/builders couldn't immediately off-load their houses. Low prices + cheap capital = increased home-buying activity. I'm sure that all of my friends and colleagues in the US who have been so devout in their worship of the real estate markets will be thrilled. What they will almost certainly miss is that while their properties may be increasing in terms of US dollars (for a time), they will actually be dropping in terms of other hard assets like gold, sugar, or common sense - things that seem to be in short supply of late. To revisit the quote by Mr. Bernanke:
We are of the opinion that Mr. Bernanke sees the US economy at a crossroads (it is) similar to that which eventually led to the great depression - The depression or the "Great Slump" as it was known in the U.K. has been a favorite topic of Mr. Bernanke throughout his career. We might even go as far as to say that Bernanke welcomes this challenge as a test of his metal. After all, our esteemed chairman doesn't hail from the board rooms of some wildly successful company, but rather from the world of Ivy league Academia. He will approach this problem, not as a businessman, but as an academic. In this regard, the Feds policy is all too predictable. There are three dominant schools of thought as it relates to the Great Depression, but we shall only briefly concern ourselves with two. Monetarists, including Milton Friedman and Ben Bernanke, argue that the Great Depression was caused by monetary contraction and that it could have been largely prevented if the Fed would have provided emergency lending and/or liquidity in the form of open market bond purchasing, or outright bailout of major banks, such as the official-sounding private Bank of the United States in December, 1931. The Austrian School of economics, including Hayek and Von Mises (who both predicted the Great Depression), viewed the key cause of the Slump as being the expansion of the money supply in the 1920s that lead to an unsustainable credit driven boom. Sound familiar? Ben Bernanke, who most certainly sees the parallels between the present and the 1920s, will almost surely continue to politicize expansion of the money supply. The Central Bank will lower interest rates until the economy responds. As a result of this "easy money" policy, the dollar will continue to lose value, and gold, which has been performing spectacularly, will continue to do so. Other commodities, sparked by tremendous growth of the middle class in China and India, will do the same. The Bottom Line The Fed continues to play the average American for a fool, and rightly so. Undoubtedly, the recent interest rate drops will have at least some of the desired effects - the US economy will pick up in Q1 thanks to increased consumer confidence - the phrase "dead cat bounce" comes to mind... all of those forecasts predicting a rise in defaults may even prove to be over-baked. But the fact of the matter remains - at the end of the day (the end of Q1 beginning of Q2), the dollar (along with all other fiat currency) is worth even less than the paper it is printed on. Invest long term in what you can see - the things that you use and value every day and the ingredients that make those things. Invest using your common sense. Everything else is just an illusion. Miguel Villahermosa Miguel Villahermosa has served in a number of capacities for various companies. He graduated with a BA from Pepperdine University (Malibu, CA) and went on to do Master's work at the University of Washington. Miguel was assistant editor and contributor for Larry Abraham's "Insider Report" a long-standing and very well-respected publication with an international following and more than 30 years in print, and also enjoys consultancy positions with various companies and organizations in Central America where he lived and worked. Miguel is a student of history and greatly enjoys both the study and performance of opera. He has been seen performing both at home in Seattle, Wa., and in numerous venues across the globe. 321gold Ltd |
