Capitalists of the world unite.. you have nothing (else) to lose

http://pensionpulse.blogspot.com/2008/09/capitalists-of-world-unite.html

ZIRP....

http://www.telegraph.co.uk/money/main.jhtml?xml=/money/2008/09/18/ccambrose118.xml

Read the headline (and tagline) a couple of times. For the US Treasury Bill to go to Zero that basically means that the demand for US Govt Debt is so high that the US does not have to pay any interest to the investor.

Now look at it this way for the investor to refuse interest it basically means he does not care about Return "on" Investment, in fact the only thing he is concerned about now is Return "of" Investment. So if he thinks that the only safe place that guarantees return of principal is US Govt Debt - then this implies that all other categories of debt is unsafe. This includes the debt of other countries and the debt of large corporations. At the extreme even a company like Shell will thus not be able to finance it's debt.

So what happens when Shell can't re-finance its debt? It has a liquidity crisis. OK so it generates liquidity by liquidating its illiquid assets i.e. property, oil rigs, plant and machinery, exploration rights etc. Now think of it on a global scale what if other corporations also face the same crisis - and all of them at the same time must sell their illiquid assets. There will be a buyer's strike. A global asset deflation of the scale that we have never witnessed before.

Corporations that have the most illiquid balance sheets and have the most amount of leverage will be the first to collapse as things turn bad the deflationary fire will reach up to the more stable, better capitalized corporation.

Some questions....

Why is gold "more" protected than other investments, like real estate?

The answer to this is a little complicated and long-winded, you may have to read this a couple of times to "get it". But first we need to go through some basic definitions. Some of these definitions may seem counter-intuitive and contrary to what is generally accepted but as you will see these are the true definitions of these terms.

Inflation: When we think of inflation we think of an increase in the price of good of services. That's not really true, the rise in the general price level of goods and services (most commonly measured through a Consumer Price Index - CPI) is an after-effect of inflation. Inflation is really an increase in the supply of money and credit. Because there is an increase in the supply of money (and credit) there is too much money chasing (relatively) fewer goods, thus the prices of goods as measured by money (the supply of which has increased) rises.

Deflation: The exact inverse of inflation is deflation; when the supply of money and credit contracts then that is called deflation. Because there is a decrease in the supply of money (and credit) there is less money chasing (relatively) more goods, thus the prices of goods as measured by money (the supply of which has decreased) falls.

An important thing to realize is that an increase in the prices of goods and services is the result of past inflations. Consequently when there is deflation it will result in future decreases in the prices of goods and services.

During periods of rising prices and (especially during severe or "hyper"- increases) you do not want to hold cash or cash equivalents. This is because with time can buy less and less of the goods and services you need. Consequently the value of money as measured by the amount of goods and services that can be purchased per unit of said money keeps decreasing. So what do you hold instead? You want to hold assets that can preserve or store value in the face of a general rise in prices. Real Estate, commodities such as Metals, Coal, Crude and Precious Metals i.e. Gold, Silver are such assets - these assets are also called "hard" assets. In fact in extreme increases of prices you want to hold as much debt as possible and use the debt to finance the purchase of these "hard" assets. This is because the rate of interest that you pay on your debt will almost always lag the increase in the value of the asset. Think of it this way: there are two graphs both rising, but the slope of the interest rate is less than the slope of the price increase. As a result Property - which you can easily finance - is a very good asset class to invest during periods of increasing price levels.

So if deflation is the exact inverse of inflation - then during periods of decreases in price levels you want to invest in assets that have the opposite characteristics of "hard" assets and you want to stay away from debt. In fact the only asset class that does well during decreases in price levels is money.

Gold is a very funny asset and has some important characteristics that make it special and different from everything else (including other precious metals such as Ag, Pt etc.)

1. All the Gold ever mined in human history approximately 150,000 - 160,000 tons is still with us.

2. The supply of Gold is very stable and is around 2% of the total Gold supply. It takes around 9-10 years for a new Gold mine to come online and then a further 5-7 years for production to hit the market. Thus from exploration to sale Gold takes about 14-17 years. By which time current Gold mines will be in decline. Thus this supply is not very likely to change over time. In fact in recorded human history there has been only one time in which the supply of Gold has increased dramatically, that's when Spain took the Gold of the Mayas and Aztecs in the 1600s and flooded Europe with it. Thus if Gold were to be used as money it would be relatively free from increases in supply i.e. Inflation.

3. Gold has very little industrial usage - its major use is as jewelery. As you are probably aware in India people often buy and gift jewelry not just for consumption but also as security and to use as money when in need. In fact this is true the world over.

4. Gold is almost indestructible (If I remember right you need Aqua Regia to dissolve Gold), relatively portable.

Because of these reasons Gold has and will continue to be regarded as money. In fact in the Foreign Exchange markets Gold trades like any other currency.

So in a deflationary scenario Gold should do well. I expect the world's industrial economies to fall into a deflationary depression thus the only asset class that will do well is money and it's equivalent - Gold falls in that category.

Why do you say that this worldwide depression is impossible to reverse? Haven't we faced crises of more severe magnitude before, and, come out of it before? Why is this depression more severe than (say) the Great Depression of 1929, starting with the crash of US stock market on the infamous "Black Tuesday"?

I'm not saying this is the end of mankind as we know it. We will get through this, it just so happens that we will fall into a deflationary depression and then with time (5 years, 10 years who knows how long...) we will come out of it. It will be more severe than 1929 (which by the way was exactly the same thing) simply because the magnitude of the deflation is much larger. If you think of it as a wave, the amplitude of the wave is greater by several degrees of magnitude consequently the effects of the wave will be that much more severe.

You say that "cash and cash equivalents" are the best bets to invest in - in that case, why is US dollar is better mode of saving than, say, Euro or Yen? Isn't this meltdown expected to affect all industrial markets?

The Dollar is the best of a worse lot. The Euro has political issues. No currency without the backing of a stable nation state survives for very long. The European Monetary Union is a grand experiment that will unfortunately fail if it is not accompanied by a political union. Japan's economy is in terminal decline because of demographic issues unless they start allowing massive immigration their economy will slowly reduce to insignificance.

AIG bailout doesn't change a thing

I think they should just merge with LIC.. :-)

Seriously its a $85B loan at 850 bps over Libor - which is around 2.9%? - so that's 11.4%. The Interest expense alone is $2.4B per quarter. The last 3 quarters their loss was $14B the only quarter they made money - they made about $3B. But lets say by some miracle they manage to make the interest payment.

Their B/S equity is 78B - so not only are they wiping that out they are effectively making the firm insolvent. I just don't see how this preserves the firm's credit rating, which was the original intent no? Admittedly the equity is book value but in this situation I don't expect a buyer to pay a whole lot more than book.

Which brings me back to my original point.. This doesn't change anything but it does give AIG's counterparties time to unwind their position, and maybe that's all that the Fed wants at this point. But you have to wonder that if it takes $85B (there's no way in hell that the loan is going to be repaid fully) to buy time, what sort of dis-orderly liquidation were we looking at?

Mutually Assured Destruction

We are faced with the total and complete annihilation of modern capitalism as we know it. With Lehman bankrupt and hence it's debt gone to junk status, AIG facing ratings downgrades and WaMu down to junk, here's whats going to happen as the dominoes fall one by one:

1. Lets say that I am financial institution. My balance sheet is probably a couple of hundred billion dollars, but the equity position (i.e. assets less liabilities) is quite possibly in the tens of billions of dollars i.e. at the minimum a 10 to 1 leverage. Lets assume that I have been conservative with my investments and most of my Assets are AAA (the highest investment grade) rated. So I don't have to carry that much Cash because the value of these investments should cover my liabilities.

2. Therefore as and when these investments receive a ratings downgrade I must increase the level of cash that I carry, so that I can cover the loss in value of the erstwhile AAA investments. If I can't raise cash then my own ratings get downgraded.

3. That in itself is not so bad except....everything and everyone else (i.e. other financial institutions) is leveraged and at equilibrium. So if I can't raise cash not only do I get downgraded but anyone else holding investments issued by me is affected and they have to raise capital to cover the loss in values of paper that I have issued or contend with having their rating lowered.

4. Well that's still not fatal in itself .... except much of the investments that I have made and others have made based on paper I have issued are made up of derivatives which are not regulated and are of indeterminate value. Or to be precise whose value can be determined only by a bunch of PhD(s) and a gaggle of lawyers.

5. Now all these investments are interconnected and held by State funds, mutual funds, world funds , sovereign funds and god knows what else then the entire world's markets melt down together because no one knows what the true values of any investment are and therefore no one can be trusted to make good on any liability.

Default thus turns to liquidation... KABOOM!

For the record I am short the US Financial Sector, Short Crude and Natgas, Short Small Cap and Short Basic Materials.

Senators Ask Fannie, Freddie to Freeze Foreclosures

Bloomberg says:

U.S. Senate Banking Committee members urged Fannie Mae and Freddie Mac, the mortgage companies placed under federal control this week, to freeze foreclosures on loans in their portfolios for at least 90 days.

There's another quote:

"This action would provide immediate relief to many homeowners'' and let the companies "turn these non-performing loans into performing assets to minimize losses,'' Senators Charles Schumer, Robert Menendez and other panel Democrats said today in a letter to the companies and the Federal Housing Finance Agency, which is overseeing them under the government conservatorship.

Umm.. No. If not collecting the EMI on a loan makes the loan into a "performing asset and minimizes losses" we would have to rewrite the history of banking, in fact while we're at it why don't you change the definition of all loans and just start calling it gifts - because thats what these supreme intellects propose.

I guess politicians all over the world are the same, and here was I thinking that only our Desi politicians had a monopoly on economic illiteracy.

Never Forget...

Here's to you Jeremy, this last pepperoni slice is for you.

So much for Gustav

Well so much for Gustav - turned out to be quite literally a tempest in a teacup. Looks like my bet on NATGAS turned out wrong and NATGAS, Crude and Gold all collapsed through early trading on Tuesday AM. Crude is at $110, NATGAS at $7.50 and Gold at $819.
I am currently down about 7% from my position and am seriously considering throwing in the towel. It looks demand destruction is going to trump all other themes. I full expect Crude to go down to $75.