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 Outlook for 2008"Let me end my talk by abusing slightly my status as an official representative of the Federal Reserve. I would like to say to Milton and Anna: Regarding the Great Depression. You're right, we did it. We're very sorry. But thanks to you, we won't do it again." --Ben Bernanke at Milton Friedman's 90th birthday party November 8, 2002 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 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 08: 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 a quote by Mr. Bernanke: "Let me end my talk by abusing slightly my status as an official representative of the Federal Reserve. I would like to say to Milton and Anna: Regarding the Great Depression. You're right, we did it. We're very sorry. But thanks to you, we won't do it again." 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. Common CentsPerhaps the sentiments contained in the following pages, are not YET sufficiently fashionable to procure them general favour; a long habit of not thinking a thing WRONG, gives it a superficial appearance of being RIGHT, and raises at first a formidable outcry in defense of custom. But the tumult soon subsides. Time makes more converts than reason. As a long and violent abuse of power, is generally the Means of calling the right of it in question (and in Matters too which might never have been thought of, had not the Sufferers been aggravated into the inquiry) and as the King of England hath undertaken in his OWN RIGHT, to support the Parliament in what he calls THEIRS, and as the good people of this country are grievously oppressed by the combination, they have an undoubted privilege to inquire into the pretensions of both, and equally to reject the usurpation of either... --Thomas Paine, from the Introduction to the third Edition of Common Sense Philadelphia, February 14, 1776 The recent surge in metals prices has caused some strange problems, particularly in the U.S. All across the nation emboldened thieves are stealing copper---from utility boxes that run traffic signals, rail road tracks, construction sights, power lines, turbines, communication infrastructure, and everywhere else they can find it. Many attempts at copper thievery have resulted in serious injury and even death for not-so-bright criminals who got more than they bargained for while trying to remove wiring from super charged utilities. But copper isn't the only metal that is super charged (pun intended) and thievery isn't just limited to the displaced citizenry---plunder of the legal variety is quickly becoming common place. With increased prices in copper many speculators have crunched numbers to take advantage of the U.S. Mint---193 pennies is equal to one pound, so that should mean that one could purchase one pound of copper for US$1.93, right? Wrong, copper content in pennies minted after 1982 is less than 2% (pennies are mostly zinc). So all I have to do is find pennies that were minted pre 1982, right? Right, sort of...to make US$10,000 profit melting pennies (at a Copper price of $3.50 per pound) you would have to find somewhere in the neighborhood of 1 million pennies minted prior to 1982 then you would have to ship a couple of metric tons of coins---hardly worth all that sorting and counting especially when you consider that the average life of a coin is about 20 years. Nickels, on the other hand, are a completely different story. A Nickel weighs 5 grams and is composed of 75% copper and 25% nickel. Within 364 Nickels, there is 1 lb. nickel, and 3 lbs. copper---91 Nickels is about equal to 1 lb. 364 Nickels can be purchased at your local bank for US$18.20. In the past year, Nickel has gone from just under US$7.0 a pound to touching just over US$22.0 a pound. Copper has also soared from less than US$1.0 a pound in 2002 to almost US$4.0 a pound in May of last year. At the current spot prices of these metals (Copper: $3.06, Nickel: $20.53) the actual worth of 1 nickel is about 8 cents (about 62.5% more than face value). So why aren't arbitragers the world over buying nickels and melting them down? Simple. It's illegal. On December 14, 2006, the United States Mint implemented regulations to limit the exportation, melting, or 'treatment' of one-cent and five-cent coins. "We are taking this action because the Nation needs its coinage," said Director Ed Moy "we don't want our coins melted down so a few individuals can take advantage of the American taxpayer ('taking advantage of the U.S. taxpayer' being the sole right of the U.S. government)." And what is the penalty for a person who violates this regulation? Up to five years in prison, a fine of up to $10,000, or both. You may be interested to note that the Dec. 2006 regulation is patterned after similar rules which were put into effect between 1967 and 1969 when silver coins were hoarded because of their higher intrinsic value. Additionally, between 1974 and 1978 laws were put into place to prevent the melting of one-cent coins. You may also recall that it was the monetary policy of this era that led to what we now call 'stagflation' when rising inflation coupled with economic recession led to outrageous lending conditions and the fanatic rise of commodities and gold prices from 1979-1981. What you may not know is that similar controls were issued to the Roman citizenry prior to the de-escalation of Rome and its subsequent fall in the fifth century after three centuries of currency debasement, heavy taxes, and 'swords and butter' spending left the Roman Empire completely bankrupt and vulnerable to the Germanic hordes. The ultimate problem with these sorts of laws lies in the outrageous presumption of governments and central banks that they 'know what is best' for everyone else. The presumption borders on tyranny when it crosses over to 'doing what is best' despite the wishes of those whose hard earned resources are at stake. There is more worthless paper floating around the world than ever before---fiat currency, "trust" currency, is nothing more than an empty promise whispered into a hurricane. In ancient Rome, government coin-clipping (one of the earliest types of inflation) caused citizens to hoard their coinage in a desperate attempt to grab hold of value in a world of empty government promises. Even when faced with death under the price control reforms of Emperor Diocletian, citizens refused to part with their gold and silver because in the end, after being mystified and fooled by the inflationary antics of government, they realized that money is much more than a medium of exchange. It is an expression of freedom. Unlike the Romans, the citizenry of the world today has options. Even in the unlikely event of a complete U.S. monetary collapse there are avenues for the well informed investor, ways of protecting one's self from governments' veracious appetite. As for me, I say "give me the hard stuff" even as I count myself blessed that it is not a life or death choice. Perhaps I will even hoard my nickels. In any case, commodities represent the only 'real' money. Commodities = money. Even the Copper pilfering recalcitrant understands this concept though many in the world do not... Make sure to be insured in case the rest of the world discovers that a dollar is just a piece of fancy paper painted to look nice. Good Investing!! Patrick Abraham Growing Socialization, Growing Distrust"We're moving toward a socialist republic in Venezuela, and that requires a deep reform of our national constitution...We're heading toward socialism, and nothing and no one can prevent it...The nation should recover its ownership of strategic sectors, all of that which was privatized, let it be nationalized, all of those sectors in an area so important and strategic for all of us as is electricity...The eight-year transition phase is ending and we're entering a new era -- the Simon Bolivar national plan, Bolivarian socialism." --Hugo Chavez You may know that Hugo Chavez was elected to the Venezuelan Presidency in 1998, but what you may not know is that he has been active in Central American politics for more than two decades. Chavez, born in 1954 graduated from the Academy of Military Sciences in 1975. In 1982, just a few years later, he organized the Bolivarian Revolutionary Movement. The MBR-200 (the 200 was a reference to the 200th anniversary of Simon Bolivar's birth) was committed to overthrowing the political establishment which it considered to be corrupt. In 1992, Col. Chavez launched a coup against the Perez administration, and soldiers loyal to the MBR-200 tried to seize key installations, including the Miraflores presidential palace. When it was apparent that the coup had failed, Chavez was imprisoned. The following year, President Perez was impeached on corruption charges. Perez, who first took office in 1974, was responsible for nationalizing foreign-owned oil and steel companies during the oil boom of the 1970's---the nationalizations had the predictable effects on the economy. Chavez was released from prison in 1994. In 1998 Chavez was elected to the Presidency of Venezuela. He wasted little time implementing his socialist agenda. Beginning in early Dec. 2001, a strike was organized by business and labor leaders preceding an attempted coup in April 2002. Another strike was organized in Dec. 2002, bringing the economy, including the oil industry, to an almost complete standstill. In August of 2003, a petition with 3.2 million signatures was submitted demanding a Chavez recall. The petitions were rejected as invalid by the Chavez administration and all petitions were effectively delayed until June 2004. By that time, Chavez had managed to swell the ranks of his constituency by extravagant social program spending, and won the referendum with 58% of the vote. In the wake of Chavez's Dec. 2006 reelection, it is becoming more and more apparent that he will use his momentum to try and create a Castro style Venezuela. Cuba, one of Chavez' closest allies, nationalized major industries just following Castro's rise to power in 1959. Coca growing Evo Morales, of Bolivia, another Chavez ally, moved to nationalize certain sectors after taking office last year. Chavez' recent announcement that he will begin nationalizing key sectors comes as no surprise and the outcome is equally as predictable---the economy and the people will suffer. What is the moral of the story? Best case scenario---socialist policies lead to depressed economies, and in the worst case, they lead to fascist dictators who use the plight of the poor to propel themselves to totalitarian power. As Chavez continues to gain momentum and allies, it seems that lines are being drawn. A general hatred for American foreign policy has also served to amalgamate the leftist movement and still there is talk of a 'surge' in Iraqi troop deployment. Meanwhile, the newly elected Democrat House of Representatives has wasted no time wasting time. After Majority leader Steny Hoyer announced to the Washington Post that members of the House will be expected in the Capitol for votes five days a week in order to complete a flurry of legislation within 100 hours, he promptly cancelled the Monday session of what would have been the Dems first full week. What does it all mean? With socialism flaring up in the Western Hemispere, and the problems in Iraq that seem to have all but buried the Bush administration, it is clear that we are in for a geo-politically tumultuous 2007. Insane government spending and rampant monetary inflation are swirling into what will be one of the greatest economic storms since the 70's 'stagflation.' The Democrats are too anxious to placate their constituency to make any real moves to stop it. They will probably aggravate the situation with their own semi-socialist agenda. The Bush administration is preoccupied with civil war in Iraq. These situations will only get worse as the dollar languishes... Still, 2006 was a banner year for PanAmerica and its clients, and we have no doubt that 2007 will be even better. Do we know something that others don't? Maybe. Do we keep a level head when others don't? Most certainly. In any case, with global politics shaping up the way they are, it pays to have a cool head a steady hand, and a pocket full of gold, silver, copper, oil, and base metals. Winter may be over, but the cold winds of recession and inflation are blowing. Still, the coming storm will find us comfortable with opportunity and profit to warm our hearths. Happy New Year and Good Investing, Patrick Abraham President and CEO, PanAmerica Capital Group |
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