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The United States Is Insolvent

Wednesday, March 14, 2007, 11:00 PM
Thursday, March 15, 2007

Prepare to be shocked.

The US is insolvent. There is simply no way for our national bills to be paid under current levels of taxation and promised benefits. Our combined federal deficits now total more than 400% of GDP.

That is the conclusion of a recent Treasury/OMB report entitled Financial Report of the United States Government that was quietly slipped out on a Friday (12/15/06), deep in the holiday season, with little fanfare.

Sometimes I wonder why the Treasury Department doesn't just pay somebody to come in at 4:30 am on Christmas morning to release the report. Additionally, I've yet to read a single account of this report in any of the major news media outlets, but that is another matter.

But, hey, I understand. A report this bad requires all the muffling it can get.

In his accompanying statement to the report, David Walker, Comptroller of the US, warmed up his audience by stating that the GAO had found so many significant material deficiencies in the government's accounting systems that the GAO was "unable to express an opinion" on the financial statements. Ha ha! He really knows how to play an audience!

In accounting parlance, that's the same as telling your spouse, "Our checkbook is such an out-of-control mess, I can't tell if we're broke or rich!" The next time you have an unexplained rash of checking withdrawals from that fishing trip with your buddies, just tell her that you are "unable to express an opinion" and see how that flies. Let us know how it goes!

Then Walker went on to deliver the really bad news:

Despite improvement in both the fiscal year 2006 reported net operating cost and the cash-based budget deficit, the U.S. government's total reported liabilities, net social insurance commitments, and other fiscal exposures continue to grow and now total approximately $50 trillion, representing approximately four times the Nation's total output (GDP) in fiscal year 2006, up from about $20 trillion, or two times GDP in fiscal year 2000.

As this long-term fiscal imbalance continues to grow, the retirement of the "baby boom" generation is closer to becoming a reality with the first wave of boomers eligible for early retirement under Social Security in 2008.

Given these and other factors, it seems clear that the nation's current fiscal path is unsustainable and that tough choices by the President and the Congress are necessary in order to address the nation's large and growing long-term fiscal imbalance.

Wow! I know David Walker has been vocal lately about his concern over our economic future, but it seems almost impossible to ignore the implications of his statements above. From $20 trillion in fiscal exposures in 2000 to over $50 trillion in only six years? What shall we do for an encore, shoot for $100 trillion?

And how about the fact that boomers begin retiring in 2008...that always seemed to be waaaay out in the future. However, beginning January 1st we can start referring to 2008 as 'next year' instead of 'some point in the future too distant to get concerned about now.' Our economic problems need to be classified as growing, imminent, and unsustainable.

And let me clarify something. The $53 trillion shortfall is expressed as a 'net present value.' That means that in order to make the shortfall disappear, we would have to have that amount of cash in the bank - today - earning interest (the GAO uses 5.7% & 5.8% as the assumed long-term rate of return). I'll say it again - $53 trillion, in the bank, today. Heck, I don't even know how much a trillion is, let alone fifty-three of 'em.

And next year we'd have to put even more into this mythical interest-bearing account, simply because we didn't collect any interest on money we didn't put in the bank account this year. For the record, 5.7% on $53 trillion is a bit more than $3 trillion dollars, so you can see how the math is working against us here. This means the deficit will swell by at least another $3 trillion, plus whatever other shortfalls the government can rack up in the meantime. So call it another $4 trillion as an early guess for next year.

Given how studiously our nation is avoiding this topic, both in the major media outlets and during our last election cycle, I sometimes feel as if I live in a small mountain town that has decided to ignore an avalanche, which has already let loose above, in favor of holding the annual kindergarten ski sale.

The Treasury Department soft-pedaled the whole unsustainable gigantic deficit thingy in last year's report, but they have taken a quite different approach this year. From page 10 of the report:

The net social insurance responsibilities scheduled benefits in excess of estimated revenues) indicate that those programs are on an unsustainable fiscal path and difficult choices will be necessary in order to address their large and growing long-term fiscal imbalance.

Delay is costly and choices will be more difficult as the retirement of the 'baby boom' gets closer to becoming a reality with the first wave of boomers eligible for retirement under Social Security in 2008.

I don't know how that could be any clearer. The US Treasury Department has issued a public report warning that we are on an unsustainable path, and that we face difficult choices that will only become more costly the longer we delay.

Perhaps the reason US bonds and the dollar have held up so well is that we are far from alone in our predicament. In a recent article detailing why the UK Pound Sterling may fall, we read this horrifying evidence:

Officially, [UK] public sector net debt stands at £486.7bn. That's equal to US$953.9bn and represents a little under 38% of annual GDP. Add the state's "off balance sheet" debt, however - including its pension promises to state-paid employees - and the total shoots nearly three times higher. Research by the Centre for Policy Studies in London says it would put UK government deficits at a staggering 103% of GDP.

If we perform the same calculations for the US, however, we find that the official debt stands at $8.507 trillion or 65% of (nominal) GDP, but when we add in our "off balance sheet" items, the national debt stands at $53 trillion or 403% of GDP.

Now that's horrifying. Staggering. Whatever you wish to call it. More than four hundred percent of GDP(!). And that's just at the federal level. We could easily make this story a bit more ominous by including state, municipal, and corporate shortfalls. But let's not do that.

Here's what the federal shortfall means in the simplest terms:

There is no way to 'grow out of this problem.'

What really jumps out is that the US financial position has deteriorated by over $22 trillion in only 4 years and $4.5 trillion in the last 12 months (see table below, from page 10 of the report).

The problem did not 'get better' as a result of the excellent economic growth over the past 3 years, but, rather, got worse, and is apparently accelerating to the downside. Any economic weakness will only exacerbate the problem. You should be aware that the budgetary assumptions of the US government are for greater than 5% nominal GDP growth through at least 2011. In other words, because no economic weakness is included in the deficit projections below, $53 trillion could be on the low side. Further, none of the long-term costs associated with the Iraq and Afghanistan wars are factored in any of the numbers presented (thought to be upwards of $2 trillion more).

The future will be defined by lowered standards of living.

As Lawrence Kotlikoff pointed out in his paper titled "Is the US Bankrupt?" posted to the St. Louis Federal Reserve website, the insolvency of the US will minimally require some combination of lowered entitlement payouts and higher taxes. Both of those represent less money in the taxpayer's pockets, and the last time I checked, less money meant a lower standard of living.

Every government facing this position has opted to "print its way out of trouble."

That's a historical fac,tand our country shows no indications, unfortunately, of possessing the unique brand of political courage required to take a different route. In the simplest terms, this means you and I will face a future of uncomfortably high inflation, possibly hyperinflation, if the US dollar loses its reserve currency status somewhere along the way.

Of course, it is impossible to print our way out of this particular pickle, because printing money is inflationary and is therefore a 'hidden tax' on everyone. What is the difference between having half of your money directly taken (taxed) by the government and having half of its value disappear due to inflation?

Nothing.

Except that raising taxes is political suicide, while the overprinting of money as the cause of inflation is, conveniently, never discussed by the US financial mainstream press (for some reason) and therefore goes undetected by a majority of people as a deliberate matter of policy. Ergo, we will get all manner of government monetary and fiscal excess, but carefully disguised as bailouts and deficit spending.

Unfortunately, all that printing can ever realistically accomplish is the preservation of a few DC jobs and the decimation of the middle and lower classes.

In summary, I am wondering how long we can pretend this problem does not exist? How long can we continue to buy stocks, flip houses, forget to save, pile up debt, import Chinese made goods, and export debt? Are these useful activities to perform while there's an economic avalanche bearing down upon us?

Unfortunately, I only know that hoping a significant and mounting problem will go away is not a winning strategy.

I know that we, as a nation, owe it to ourselves to have the hard conversation about our financial future sooner rather than later. And I suspect that conversation will have to begin right here, between you and me, because I cannot detect even the faintest glimmer that our current crop of leaders can distinguish between urgent and expedient.

What we need is a good, old-fashioned grassroots campaign.

In the meantime, I simply do not know of any way to fully protect oneself against the economic ravages resulting from poorly managed monetary and fiscal institutions. For what it's worth, I am heavily invested in gold and silver and will remain that way until the aforementioned institutions choose to confront "what is" rather than "what's expedient." This could be a very long-term investment.

Are you shocked?

Insider

The Game Is Afoot

Tuesday, August 7, 2007, 11:00 PM
Wednesday, August 8, 2007

First, a warning about the dollar. As you know, I've been keeping a close eye on the US dollar and have been very concerned over the years that the dollar would someday steeply decline against foreign currencies. In fact, the dollar has been steadily eroding in value for since 2002, and it is now poised at a critical spot where there are really only two choices: a sustained rally or a serious drop.

The dollar chart below shows the monthly 'value' of the dollar as measured against a basket of foreign currencies. The red line shows that the dollar is now perched at a level last seen in 2005 and (off the chart) in 1992.
Foreign Currencies

USD Monthly

Foreign Currencies
If the dollar breaks through this level of ~ 80 on this chart, then it's anybody's guess as to how much farther it would fall after that.

In truth, the dollar should be a lot lower than even this dismal level right now, but foreign central banks, notably Japan and China, have been working very hard to keep the dollar propped up over the past few years. If this foreign propping should ever end, we'd immediately experience two things, a rapidly falling dollar (leading to rapidly rising import prices, notably for crude oil) and sharply higher interest rates (because the Chinese hold their dollars in US bonds, which, when sold, cause interest rates to rise).

Higher oil and steeper interest rates? Crikey!

That's a certain recipe for unpleasantness in the US economy. So it is of critical importance that dollar support be maintained. However, China is now making threatening noises in this regard, warning the US that our insistence on a higher Chinese yuan is unwelcome:

The Chinese government has begun a concerted campaign of economic threats against the United States, hinting that it may liquidate its vast holding of US treasuries if Washington imposes trade sanctions to force a yuan revaluation.

Two officials at leading Communist Party bodies have given interviews in recent days warning - for the first time - that Beijing may use its $1.33 trillion (£658bn) of foreign reserves as a political weapon to counter pressure from the US Congress.

There may be a lot of compelling reasons why China would not want to follow up on this threat, but it's worth your time to consider what you'd do if it did. While there's no "one size fits all" solution, a few basic steps to consider would be:

  • Get out of debt, especially variable rate debt such as credit cards and any adjustable rate loans.
  • Get some exposure to assets that tend to vary inversely with the dollar. Gold, silver, oil, natural gas, and foreign currencies are my favorites.
  • Build up some cash reserves (savings) to get you through a potentially severe recession that could be brought about by high(er) interest rates.
  • Be prepared for a serious decline in equity and bond values.

On that last point (#4), there are some other reasons to be concerned right now. It turns out that the US credit markets, principally for mortgage debt, are undergoing some pretty dramatic convulsions, and while I can't say for sure how bad it will all be, I can tell you that fear has finally returned to our capital markets after a particularly long absence.

However, should the dollar start to break down in a serious way, I don't know what else to counsel besides "Stay alert!" It is entirely unknowable to me how our highly leveraged house-of-cards economy would actually behave in a dollar crisis, but I think it's prudent to question whether all of our financial institutions would remain solvent.

As you know, I've always been deeply suspicious of the modern financial alchemy that has allowed Wall Street to skim record profits off of dodgy pools of repackaged mortgage loans while simultaneously claiming to have reduced the risk of those instruments. Huh? How does one start with a pool of bad credit risk loans (many of them fraudulent 'liar loans'), strip out a whole bunch of money, and end up with a safer product? I don't believe it's any more complicated than that, and I've been saying so for several years.

And, in truth, this is now pretty much obvious to everyone in the financial industry as well. Paul Muolo, executive editor and associate publisher of National Mortgage News, had this to say:

"I'll put it bluntly: if you operate a non-depository mortgage firm (lender or servicer) and don't have a deep-pocketed parent or hedge fund as a sugar daddy you're likely to be out of business by year-end, probably sooner.

In the 20-plus years that I've been covering residential finance I haven't seen a financial meltdown this swift since the S&L crisis of the mid-to-late 1980s. One subprime executive who closed his shop a few months ago told me, "This is a liquidity crunch the likes I have never seen."

So industry insiders are publicly saying that this is the worst financial crisis to hit since the S&L crisis. Of course, that is the perfect analogy, because the S&L crisis was precipitated by the easing of lending standards that morphed into the usual mélange of bad investments and outright fraud. Same as our current crisis.

Because of this similarity, what should you, the beleaguered taxpayer, be on the lookout for? A bailout, of course.

Looks like we won't have to wait very long for the government officials to begin to look for ways to "help people keep their houses," which is DC code-speak for "help my uber-rich banking buddies avoid paying for their mistakes."

Here's an email from the CEO of IndyMac, the second largest independent mortgage lender, that came out last week:

Unfortunately, the private secondary markets (excluding the GSEs and Ginnie Mae) continue to remain very panicked and illiquid. By way of example, it is currently difficult, at present, to trade even the AAA bond on any private MBS transaction.

In addition, to give you an idea as to how unprecedented this market has become...I received a call from U.S. Senator Dodd this morning who seeking an understanding of "what is really going on and how can I and Congress help?"

I also have talked to the Chairman of Fannie Mae this morning and have traded calls with the Chairman of Freddie Mac (Fannie Mae's Chairman telling me that they are "prepared to step up and help the industry").

The interesting part is to hear this kind of talk already before the crisis has even really begun. Over the next 12-145 months, more than $1.5 trillion of additional subprime mortgages will be resetting to higher rates, and that's when I expect the crisis to really get underway. Still, I have to wonder how many more US tax dollars are going to be wasted trying to help people keep houses they can't afford (which many lied to get into) and thereby bail out a mortgage and banking industry that would prefer not to have to give back any of the obscene profits they made off of this racket.

I mean, what, with bridges crumbling, a waste-water infrastructure that scores a D-minus, two tragically expensive wars, and a looming pension crisis of biblical proportions, it's not like we really can afford to bail out the rich, the greedy, and the stupid. I say, let them live with the consequences of their decisions. Call it tuition or something.

Besides, a bailout will not help at all. The main problem is that house prices rose too far away from median incomes and no amount of mortgage assistance is going to remedy that problem. Median house prices need to fall anywhere from 10% to 60%, depending on the market.

My prediction is that this will happen over the next 3-4 years, no matter what sort of government intervention schemes are hatched.

In the meantime, I'm going to sit tight, stay alert, and ponder my options.

Insider

The Unkindest Cut of All

Thursday, October 18, 2007, 11:00 PM
Friday, October 19, 2007

Executive Summary

  • It's not over; the trouble has only just begun
  • Look out - inflation is coming!
  • The Fed cuts rates, bails out big banks
  • Inflation set to rip
  • Oil
  • Oh, the dollar!
  • August TIC data and the dollar
  • Bank runs in the US and England, and a failure in Germany
  • Uh oh - derivatives

Last time I wrote that the game is afoot. Boy, is it ever. This past month, while the stock market bizarrely hovered near all-time highs (more on that later), the credit markets slipped into even deeper disarray (an understatement) and commodities became pricier (a severe understatement). As always, my primary goal here is to help you understand what's going on, and that it's all a matter of policy, not accident. Bad policy, perhaps, but policy nonetheless. My secondary goal is to connect the dots and provide you with a source of news aggregation you can trust.

To begin, let's review my most recent recommendations from my August 30th newsletter:

  • Get out of debt, especially variable rate debt such as credit cards and any adjustable rate loans. If I'm right about the dollar, vastly higher interest rates are on the way.
  • Get some exposure to assets that tend to vary inversely with the dollar. Gold, silver, oil, natural gas, and foreign currencies are my favorites.
  • Build up some cash reserves (savings) to get you through a potentially severe recession.
  • Be prepared for a serious decline in equity and bond values.

I stand by all of these and will try to make the case below that now is a time calling for additional fiscal prudence and caution.



Unfortunately, there's so much juicy stuff going on right now that I am forced to limit this missive to a few of the tastier bits.



For starters, one of the central economic/investing conundrums seems to have been settled. Since I started giving The End of Money talks in November of 2004, I have been on the fence as to whether deflation (brought on by loan destruction first centered on residential real estate, next on commercial real estate, and finally on corporate bond defaults) or inflation would dominate our economic future (never underestimate what a determined government with a printing press can do, says Bernanke). Okay, I admit that I was not literally fifty-fifty 'on the fence,' but more like seventy-thirty, tipped in favor of inflation. So that's central theme #1 of this article: Inflation now seems to have the upper hand.



Further, to those who've come to my seminars over the past three years, you know that I have been consistently harping on the dangers posed by a housing bubble, which bred with recklessly reduced lending standards to produce a toxic offspring of derivative products, which are now running about like feral children on a Halloween night. These past few weeks we've seen the first warning signs that the big banks are seriously exposed to these derivative bombs and already lobbying for a taxpayer bailout. So that's theme #2: A housing-decline-fueled derivative crisis is approaching.



So, let's get started with the rate cuts by the Fed.



On August 16th, when the stock market was taking a small tumble, the Fed overreacted and cut one of their two key interest rates by a half a point, or 0.50%. This cut was in the so-called "discount window" rate, but insiders call it the "penalty window," because only dead-beat banks that can't otherwise borrow from other banks use it. While this may seem like an innocuous move to you (I can see you shrugging and yawning), it was rightly read by insiders as a sign that the Fed was deeply worried about the credit markets in general (probably about a specific mortgage related bank in particular), and that it was going to continue Al Greenspan's policy of bailing out poorly-run banks. The second rate cut on September 18th (actually a pair to both the Fed funds and discount window rates) just confirmed this view and added more fuel to the fire.



Once we strip away all the gobbledy-gook, what does a 'bailout' mean? It means that the Fed is determined to supply whatever liquidity is necessary to prevent any market declines from taking hold. And what does this mean? It means inflation. Lots of it.



Don't believe me? Then take a look at this chart (below) of commodity prices, and take a nice close look at what happened there on August 16th (blue arrow) following the rate cut.



CCI Chart

Holy smokes! That's a 14% gain in commodity prices in only 2 months! Oil is making the headlines, but literally everything is exploding in price - corn, wheat, zinc, gold, you name it. At this same rate, we can expect a 119% increase in commodities over the next year.



Or, as a Bloomberg article put it, September saw the biggest monthly gain in commodity prices in 32 years, leading one investment advisor to sum it all up thus:



Quote:
"The Fed has signaled pretty clearly that they will answer the problem of a slowing economy with greater liquidity," said Chip Hanlon, who manages $1 billion at Delta Global Advisors Inc. in Huntington Beach, California. "We're in a bullish phase for commodities."




That's euphemistic trader-speak meaning, "Commodities are gonna rip! Everybody who lives on a fixed income is in real, deep trouble."



Speaking of which, the just-announced Social Security COLA adjustment for this year is a measly 2.3%, the smallest since 2003. (Hey! that's $24 a month, on average!) As you know, I am highly critical of government inflation reporting (I still can't decide, is it merely negligent, or is it overtly fraudulent?), but this 2.3% number just takes the cake. I guess I'm leaning towards fraud now, because there isn't a single sentient person alive who can argue that inflation over the past 12 months was 2.3%. Why does the government do this? So it can redirect money that would go towards Social Security beneficiaries to other endeavors.



Hopefully, nobody on a fixed income needs to heat their house with oil, because oil is up 29% in the past 2 months (see chart below - can you spot August 16th???). Ouch.



Crude Oil

Of course, everybody from the middle class on down already knows that inflation is much, much higher than what our government admits. Here's an AP article that came out this morning (10-19-07):

What used to last four days might last half that long now. Pay the gas bill, but skip breakfast. Eat less for lunch so the kids can have a healthy dinner.



"It even costs more to get the basics like soap and laundry detergent," said Michelle Grassia, who lives with her husband and three teenage children in the Bedford-Stuyvesant section of Brooklyn, New York.



Her husband's check from his job at a grocery store used to last four days. "Now, it lasts only two," she said.

A paycheck that used to last four days now only lasts two? Does that sound like "2.3%" to you? No, obviously not, and the economic disconnect has never been more profound between the distorted version of reality that is being peddled by Washington DC and our daily shopping reality. Heck, even Newsweek is saying "There's No Inflation (If you Ignore Facts)." The charade is pretty far gone by the time Newsweek is calling shenanigans on the government.



How sure am I that the Fed & US government have charted a course of dollar abandonment and reckless inflation? Very.



Take a look at this table showing the percentage gains in our money supply. Note that this is a table of something called "MZM" (Money of Zero Maturity), and it's the best remaining measure, ever since the Fed scrapped reporting of the much more inclusive M3 measure, the most complete indicator of how much money was being created out of thin air. However, MZM is not a terrible measure, and it's all we've officially got, so we'll use it even though it misses about 35% of the total amount of money created.



MZM

Holy exponential expansion, Batman! Twenty five point three percent??? You might have expected that all the credit market woes would have stalled money creation, but instead, the Fed and its crony banks have somehow engineered a remarkable expansion of our money supply that is running at a better than 25% annualized rate over the last four weeks. If that rate continues, the Rule of 70 tells us that the total money supply will double in about three years. Let's see here....if I compare that against economic growth...it means that there is 10 times more money being created than economic growth.



As you may remember from our seminar series, money created in surplus of economic growth leads to inflation. It always does, and it always will. If you are still uncertain, go back and take another look at the commodity chart above and re-read the anecdotes from the linked article.



Not to be outdone by the Fed, the US government, having burned through the last $800 billion debt expansion in record time, recently raised the debt ceiling by another by $850 billion (to $9.815 trillion, with a "t"). For those keeping score at home, US government debt has expanded by 50% in only ten years. All of this debt represents hot new money that can only lead to even more inflation.



At any rate, to make a long story endless, the Fed has tipped its hand and has set us all on a course that favors inflation, but risks hyperinflation and the possible destruction of the dollar as an accepted international monetary unit. They did this because they fear the alternative even more.



The recommendations I have been giving out for the past three years stand - every one of 'em. While it may seem like I really hit a few out of the park in my prognostications, all I did was observe that 3,800 paper currencies have been destroyed by virtually identical mechanisms. So I simply applied those histories to the situation in the US and predicted that our own leaders would suffer from the same weaknesses as other humans throughout history.



If you are not extremely rich, I sympathize, because these next few years are going to be difficult. You see, inflation is an unequal-opportunity destroyer. In the short term, inflation dramatically favors the already rich but is devastating to everyone else. In the long term, severe inflation is bad for everyone, because it erodes the entire social and economic framework of a country. However, "short-term-itis" rules the roost down in the halls of power, so I do not expect to see a sudden outbreak of fiscal or monetary sanity anytime soon. For those in power, the path of least resistance is one that attempts to preserve the status quo and provides maximum short-term benefits to those already in power. So, best get ready for some rip-roaring inflation.

Dollar Daze

The dollar is hitting 30-year lows against the currencies of our trading partners. Why has the dollar been so weak lately? Besides the fact that we're printing massive, reckless quantities of them, you mean? Well, the actual mechanism by which the dollar rises or falls is really simple. It all depends on how many dollars are being bought vs. being sold, across, and outside of, our borders. One important report, the Treasury International Capital Flows report, which measures net foreign purchases of US paper assets, had a positively dreadful showing in August, indicating a net decline of $163 billion in US capital flows. This meant that foreigners sold a whopping $163 billion of US assets in a single month! And when foreigners sell US assets that are denominated in dollars, they then need to sell those US dollars for their native currency so they can bring their cash home. In short, a sell-off of US assets by foreigners typically means a decline in the dollar.



Which foreigners? Of particular note, Japan and China both cut their holdings of US Treasuries at the fastest pace in the last five years. Whoops.



At any rate, this report tells us that foreigners are not tip-toeing away from our markets, they are stampeding. Oh, to be a fly on the wall at the Fed, to know what's really going on behind the scenes. Of course, August could have been anomalous, so we'll be keeping a very close eye on the September figures due to be released November 16th. If that is also bad...look out below. And be sure to be holding some of your assets in foreign currencies, gold, and/or oil to protect against further dollar declines.

Bank Runs

You've probably heard about the bank runs that happened in the US and the UK. What? You didn't? This means you don't receive any foreign newspapers, because this was huge news and has been on the front page of the Financial Times (UK) for the past several weeks. For some reason, this news was minimized over here in the US.



Here's a breakdown of the past month: First, there was a run on Countrywide Bank in Los Angeles. Then, a major run on Northern Rock in the UK, complete with large queues of people desperately waiting to retrieve their money from the bank. Next, a major German bank completely failed and had to be taken over. Then the FDIC seized and shut down Netbank in the US.



What was the common element for all these banks? They were all in trouble because of excessive exposure to mortgage defaults.



I raise the issue of bank runs because I see a very strong possibility of the emerging mortgage derivative disaster crippling quite a few US banks - possibly more than can be serviced by a completely inadequate FDIC reserve of ~$50 billion. It is my suggestion that you spend a bit of time to be sure your bank is highly rated and somewhat insulated from this whole mess. You can start by following this link to thestreet.com, selecting the Banks & Thrifts tab, entering your bank(s), and then checking out how it/they stand. I personally would not have anything to do with a bank with less than a "B" rating. A surprising number of banks are rated B- or lower. And, of course, do not keep more than $100,000 in any one bank account, ever.



If you have the time, this is an excellent article by Jon Markham at MSN that details just how large and exceptional the risks are to the entire financial system. After reading this, I became even more convinced of the possibility of a major financial catastrophe that may completely shutter whole portions of our banking and insurance industries. To be clear, I am not saying it is going to happen, I am saying the risk is there and has been growing larger, not smaller, over the past several months. Like a prudent person who carries fire insurance on their physical dwelling, you need to consider taking out insurance on your financial dwelling. The recommendations above would be a good set of first steps.




Oh, woe is me. I planned to keep this short, and I failed. Worse, I didn't even get to the most recent housing data, which is both breathtaking and important. And there is more in the news in support of the notion that Peak Oil is already upon us. I will reserve both of these topics for special reports that will be coming out shortly.

Insider

Housing - Simple As That

Monday, December 17, 2007, 12:00 AM
Monday, December 17, 2007

Executive Summary

  • A series of government bailouts attack the symptoms, utterly failing to address the root cause.
  • The bailouts were for the big banks, not you.
  • House prices need to decline in price by 30% to 50%, and they will.
  • Trillions of dollars of losses lurk in ultra-safe pension bond funds and small Norwegian towns, as well as in some unlikely places.
  • Current crisis is one of solvency, not liquidity.

Q: "Has the housing market bottomed, is it soon to bottom, or is it in the process of bottoming?"

A:  No, nope, and no.

There is no means of avoiding the final collapse of a boom brought about by credit (debt) expansion. The alternative is only whether the crisis should come sooner as the result of a voluntary abandonment of further credit (debt) expansion, or later as a final and total catastrophe of the currency system involved.

~ Ludwig Von Mises

In order to get at the question of 'Just how bad is the current housing crisis?' we need to understand the dimensions of the problem. It is a complicated mess if one considers all the scenery in detail, but it's startlingly simple when viewed from a distance.

scenery

The threat to our banking system is described by the extent of the mortgage losses, and those will depend on how far (and how fast) house prices fall, together with the impact of outright fraud. Below we shall explore the (very) simple reasons that explain why house prices must fall by 30% to 50%. Each one can be lumped into a category of fraud, reducing demand, or boosting supply.

  • House prices rose far above income gains. Too far. They became unaffordable, and now they are in the process of correcting back to affordable levels. What goes up must come down. Simple as that.
  • Mortgage lending standards are tightening up, leading to fewer people qualifying for loans. Fewer qualified buyers means demand will drop and prices will fall. Simple as that.
  • From 2000 to 2007, regulatory oversight of lending practices was so lax that there was effectively none. This means that lots of fraud was committed (a fantastic summary of types of real estate fraud can be found here), and an even larger pile of bad loans were made to people who will never be able to pay them back. That money is gone, gone, gone, and somebody is going to have to eat those losses. Simple as that.
  • More than one out of every four homes sold in 2005 and 2006 were sold to speculators, and now house prices are at or below 2005 levels. This means that the speculators' investments are wiped out (and then some, considering transaction costs). Speculator demand is gone, and will not return for many years. Less demand equals lower prices. Simple as that.
  • Developers overbuilt the national housing stock by a very large amount, in part to meet the false speculator demand; I calculate somewhere in the vicinity of two to three million excess units. We have too much housing stock, and it will be a minimum of three years before population gains naturally work it off. All things housing-related will be in recession until that oversupply is worked off. Simple as that.
  • Even though the subprime foreclosure crisis is much closer to the beginning than the end, already hundreds of billions of dollars of losses have been recorded by small towns in Norway, in state and municipal investment funds, and by institutional money market funds. While big banks have managed to stuff all these investment channels with dodgy mortgage paper, they themselves remain as exposed to real estate loans as they've ever been. Truly, there is no historical precedent to inform us to how bad this could get. I estimate somewhere between $1 trillion and $2 trillion in losses, which means that the entire capital of the entire US banking system could be wiped out. This is an issue of solvency, not liquidity, and therefore this is a major crisis that goes far beyond the official actions and statements to date. Simple as that.
  • In summary, real estate supply, demand, and price are severely out of whack and can only be fixed by a significant decline in prices, which means that a whole lot of individuals and financial institutions are in trouble as a consequence. It all adds up to one simple conclusion: Banks, pensions, hedge funds, and money market funds will all have to dispose of a whole lot of bad paper. Possibly up to $2 trillion dollars worth, if my calculations are correct, meaning that the potential exists for the entire capital of the US banking system to be wiped out.



Now you have all the information you need to understand why there really are no policy fixes to this mess (e.g. 'freezing interest rates'), only an inevitable date with lower house prices. If you care to continue, below I provide my supporting data for the above statements.



From a purely logical standpoint, house prices need to fall to match those at the start of the bubble in 2000. Why? Because otherwise we have to believe in The Free Lunch. For The Free Lunch to be true, it must be possible for a person to buy a house, do nothing except sit on a couch drinking beer for the next 5 years, and get rich in the process. Examining 70 past examples of asset bubbles, we find that The Free Lunch has never worked before. It's not going to work out this time, either.



To illustrate, I put together the chart below by combining data from two government sources, the Census Bureau for income and the OFHEO for housing price gains.



House Price To Income



What is immediately obvious is that house prices and income gains have historically tracked each other very, very closely through the entire data series until about 2000, where house prices pull significantly away from income gains. I have marked two historical housing bubbles (1979 and 1989) with arrows, noteworthy because they were well supported by income gains and therefore seem insignificant when viewed on this graph. But that in itself is noteworthy, because, as both homebuilders and house sellers during those periods can attest, it means that even a very slight departure between the blue and the red lines can be quite painful. It also means that we have no historical precedent for the territory in which we currently find ourselves.



So, onto the primary question: "What would be required to bring house prices and income gains back in line?"



The answer to that is either:

  • An income gain of 51%
  • A decline in house prices of 34%

Of the two, income gains or house price declines, which seems more likely? Before you answer that, you should know that the average income gain over the past 6 years has been 2.3% per year (not inflation-adjusted). At that rate it would take 21 years, or until 2028, to close the gap. In the meantime, house prices would have to remain frozen at today's prices. In a normal world, we would see a bit of both, with house prices falling and incomes rising to meet somewhere down the road.



However, I expect house prices to do most of the heavy lifting, and I am expecting a decline of even more than 34%, possibly as much as 50%, because of the correlated job losses that will result from the housing wipeout. An outsized proportion of the meager job gains recorded since the recession of 2001 were in some way linked to housing. The ripple effect of job losses will extend far beyond realtors and mortgage brokers, and into window manufacturing, lumber, plumbing fixtures, nail salons, BMW detailing services, and so forth.



My calculations are therefore in rough alignment with those at economy.com:

NEW YORK (Reuters) - Housing markets from Punta Gorda, Florida, to Stockton, California, will crash and suffer price drops of more than 30 percent before the housing crisis is over, a report from Moody's Economy.com said on Thursday.



On a national level, the housing market recession will continue through early 2009, said the report, co-authored by Mark Zandi, chief economist, and Celia Chen, director of housing economics.

At this particular moment in time, banks are about as heavily exposed to mortgages (as a total percent of assets) as they have ever been. Further, banks are holding an enormous quantity of commercial real estate loans, especially in the rah-rah areas such as Florida, the Southwest, and in California. The FDIC reported last year that more than 50% of all the banks in the southeast and west regions had exposure to commercial real estate loans that exceeded their total capital by 300% or more. Holy smokes!



Here's how it happens. As the housing bubble takes off, people get into a buying frenzy, while builders get into a building frenzy. Soon enough, the commercial builders get excited and say to themselves "Saaaaay, would you lookit all these houses going up? We better build a few more malls and condos out this way!" They then go to a local or regional bank, who agrees that there's no possible downside to building more shopping areas and condos, and so they loan huge amounts of money to these developers. When the inevitable bust comes, everybody acts surprised, and the banks go to the FDIC for a bailout. At least, that's how it usually works. This time, because the amount of excessive building was so over the top and the banks were so unfavorably leveraged, I fully expect the FDIC to be inadequate for the job, which means Congress will have to get involved.



To put it in the simplest of terms, the total amount of bank capital in the entire country is a little over $1.1 trillion, while more than $11 trillion in real estate loans exist, meaning that a 10% to 15% loss on those loans would translate into the complete bankruptcy of the US banking system. What this all means is that we have a crisis of solvency, not liquidity. Currently the Federal Reserve has teamed up with European central banks to provide vast new sources of liquidity (unlimited, really) to the banking system. That is, banks can trade in their piles of dodgy loans for cash for a specified period of time. This gives banks access to cash. However, as currently structured, they have to buy those dodgy loans back at par, at some point in the future. If those loans are bad (which they are), then this maneuver by the Fed simply won't work. Instead, we need wipe those bad loans out, which means we will lose a financial intuition or two (or thirty) along the way.



It is against this relatively simple backdrop of overly expensive, overbuilt housing that the government recently launched an awful, poorly conceived and named subprime bailout plan named the New Hope Alliance. "Hope?" Well, I suppose since 'hope' is what got us into this mess, it makes sense that the government might choose to use 'hope' to get us back out of it. "Hope" is not a sound strategy, which makes it a natural fit for the current housing crisis.



Since this new plan of Hope will not prevent house prices from falling, it is pretty much dead on arrival, at least as far as actually helping to solve the primary problem. The primary problem is how a lack of housing affordability will lead to a decline in prices, as brilliantly captured by this industry insider:

One final thought. How can any of this get repaired unless home values stabilize? And how will that happen? In Northern California, a household income of $90,000 per year could legitimately pay the minimum monthly payment on an Option ARM on a million home for the past several years. Most Option ARMs allowed zero to 5% down. Therefore, given the average income of the Bay Area, most families could buy that million dollar home. A home seller had a vast pool of available buyers.



Now, with all the exotic programs gone, a household income of $175,000 is needed to buy that same home, which is about 10% of the Bay Area households. And inventories are up 500%. So, in a nutshell, we have 90% fewer qualified buyers for five times the number of homes. To get housing moving again in Northern California, either all the exotic programs must come back, everyone must get a 100% raise, or home prices have to fall 50%. None, except the last, sound remotely possible.

Wow. A tenfold reduction in buyers and a fivefold increase in house supply. There is only one way for that to resolve, and that is through reduced prices.



As presented, the purpose of the program of Hope was to help prevent or delay foreclosures - as if they were the problem. Unfortunately, foreclosures are merely the symptom. The cause is the fact that people bought overpriced houses they couldn't afford, while hoping that rising house prices would provide a ready source of cashout mortgage money. House prices are no longer rising, they are falling. That is the root of the current crisis, and this most recent government fix does absolutely nothing about it. So we can score the plan a zero on that front. Where the New Hope Alliance really breaks down and becomes a solid negative, though, is in how it undermines confidence in the sanctity of US contract law.

Dec. 7 (Bloomberg) -- President George W. Bush's plan to freeze interest rates on some subprime mortgages may prove to be a cure that breeds another disease.



"If the government goes in and changes contracts it will definitely have a chilling effect on the securitization of mortgages," said Milton Ezrati, senior economist and market strategist at Lord Abbett & Co. in Jersey City, New Jersey, which oversees $120 billion in assets.



"When the government comes in and says you have contracted to have this arrangement and you can no longer have it, I think it opens the door for lawsuits."

What's being said here is that enforceable contracts are a vital component of the US financial industry. Heck, of the entire US way of life, since it is the trust foreigners place in our 'system' that gives them the confidence to loan us back the money we spent on their products. Without the trust that a given contract will be collectible, then those contracts either get written at a much higher price to compensate for the risk of not being paid, or they do not get written at all. So if part of the subprime crisis is reduced house prices resulting from reduced demand, would we expect a serious disturbance in mortgage contract enforceability to result in more or fewer mortgages written? Who will be able to afford significantly higher mortgage payments? Who will issue them? Who would buy them and hold them?



This is an important concept, because a huge prop to our economy over the past decade has been the flood of foreign funds that allowed us to enjoy low interest rates even as our trade deficit plumbed new depths. Part of the reason foreigners felt comfortable, if not confident, investing in the US, is that our contract laws and supporting legal infrastructure are exceptionally strong in protecting investors' claims. Foreign investors bought many packaged mortgage products from Wall Street banks at a price based on expected returns that included future rate adjustments. That's now at risk. This would be no different than your boss telling you that next year's 5% raise, which you are counting on and have in writing, is actually going to be 0% - but could you please loan him another few hundred bucks?



So what was the purpose of the New Hope deal? Simple. It's meant to bail out big banks and mortgage companies who simply do not wish to recognize the actual value of the mortgages they hold at current market prices. When houses enter foreclosure and then get sold, a price discovery event happens that 'hits the books' of the financial institution involved.



Here's the best explanation of the week, courtesy of the San Francisco Gate:

Now, just unveiled Thursday, comes the "freeze," the brainchild of Treasury Secretary Henry Paulson. It sounds good: For five years, mortgage lenders will freeze interest rates on a limited number of "teaser" subprime loans. Other homeowners facing foreclosure will be offered assistance from the Federal Housing Administration.



But unfortunately, the "freeze" is just another fraud - and like the other bailout proposals, it has nothing to do with U.S. house prices, with "working families," keeping people in their homes or any of that nonsense.



The sole goal of the freeze is to prevent owners of mortgage-backed securities, many of them foreigners, from suing U.S. banks and forcing them to buy back worthless mortgage securities at face value - right now almost 10 times their market worth.



The ticking time bomb in the U.S. banking system is not resetting subprime mortgage rates. The real problem is the contractual ability of investors in mortgage bonds to require banks to buy back the loans at face value if there was fraud in the origination process.



And, to be sure, fraud is everywhere. It's in the loan application documents, and it's in the appraisals. There are e-mails and memos floating around showing that many people in banks, investment banks and appraisal companies - all the way up to senior management - knew about it.

However, this was actually the third bailout/remedy by the government. There were already two past bailouts that were simply not well publicized, and those are the ones to which you should be paying attention, because they involve vast gobs of public money.



The first was this eye-popping advance by the Federal Home Loan Bank system (FHLB) to the overall mortgage market in October:

NEW YORK (Fortune) -- As the credit crunch hit hard in the third quarter, most banks were forced to cut back their lending. But one group of banks increased lending by an incredible $182 billion. Who were these deep-pocketed lenders -- and are they capable of handling such a large rise in loans, especially at a time when credit markets are unsettled and mortgage defaults on the rise?



The lenders in question were the 12 Federal Home Loan Banks, set up under a government charter during the Great Depression to provide support to the housing market by advancing funds to over 8000 member banks that make mortgages. In the third quarter, loans to member banks, also called 'advances,' totaled $822 billion, a 28% leap from $640 billion at the end of June.

This is a staggering amount of mortgage-buying activity. Where did this $182 billion come from? Did the FHLB just happen to have nearly $200 billion lying around? If not, how was it that the FHLB was able to find buyers for mortgage paper at a time when the mortgage markets were more or less frozen? What sorts of mortgages were purchased? Were they high grade or the subbiest of the subprime? In point of fact, it is a bailout, plain and simple. It is an egregious use of public monies that was not voted on, but is guaranteed, by the public. But the FHLB fiduciary stewards did not stop there. They went further, by advancing a stunning $51 billion to Countrywide Financial Corp, recently voted as most likely to fail by its classmates. How bad does this move smell? Bad enough for a US Senator to notice.

In a letter to the regulator of the Federal Home Loan Bank system, Sen. Charles Schumer said Countrywide, the largest U.S. mortgage lender, may be abusing the program.



At the end of September, Countrywide had borrowed $51.1 billion from the Federal Home Loan Bank system -- a government-sponsored program.



"Countrywide is treating the Federal Home Loan Bank system like its personal ATM," Schumer, a New York Democrat who heads the housing panel of the Senate Banking Committee, said in the letter. "At a time when Countrywide's mortgage portfolio is deteriorating drastically, FHLB's exposure to Countrywide poses an unreasonable risk."

So what we have here is a case where the fiscal and monetary authorities are desperately shoving enormous amounts of money (and new policy) into a very stressed and ultimately unsavable situation. On a personal level, this bothers me a great deal. Partly because I have been prudent and saved and rented while waiting for the silliness to end, yet the very first response of my government is to punish me and reward the imprudent. But mainly because big bailouts doubly punish us all; first, by the inevitable inflation that results, and second, because our future options will be diminished by debt.



What needs to happen is very clear. The bad debts need to be wiped out. The mal-investments need to be written off.



So now that we know this thing is going to implode, the only relevant part left is to ask the questions, 'How am I exposed, and how can I avoid having the bag passed to me?'



Here I will revert to my past recommendations:

  • Get out of debt.
  • Be very careful about where you keep your money. Already several high profile money market funds have suffered losses and closed down, returning less than the deposit amount to their clients. Expect this to get worse.
  • The dollar is in a precarious situation, especially if the Fed begins buying up bad debt for paper money in a big way. Gold. Silver. Top off your oil tank at home.
  • Be aware that pensions, municipal investment accounts, and even your bank are all highly likely to be exposed to the leveraged losses that are now upon us. If you are exposed here, figure out how not to be.
  • If you are a citizen of a country whose central bank insists on bailing out the monied elite (big banks) with your current and/or future tax dollars, use every possible avenue available to legally apply pressure upon your political representatives to prevent this from happening.

Now, go back to the top and re-read the quote by Ludwig Von Mises. It neatly describes everything you need to know. The preceding 20 paragraphs were my way of illustrating that there will be no voluntary abandonment of credit expansion. In fact, the data shows that our fiscal and monetary authorities are fighting that possible outcome tooth and nail. That leaves the dollar exposed to the risk of losing its reserve currency status as it heads towards international pariah status. Not that there's anything wrong with that...unless you think we might, someday, need to import oil, or something made out of plastic, or electronics, or underwear, or ...

Insider

The End of Money

Monday, March 10, 2008, 3:17 PM
Monday, March 10, 2008

The greatest shortcoming of the human race is our inability to understand the exponential function.

~ Dr. Albert Bartlett

While it was operating well, our monetary system was a great system, one that fostered incredible technological innovation and advances in standards of living. But every system has its pros and its cons, and our monetary system has a doozy of a flaw.

It is run by humans.

Oh, wait, that's a valid complaint, but not the one I was looking for.  Here it is:

Our monetary system must continually expand, forever.

What's going on here? Could it be that the US economy is so robust that it requires monetary and credit growth to double every 6 to 7 years? Are US households expecting a huge surge in wages, to be able to pay off all that debt? Are wealthy people really that much more productive than the rest of us? If not, then what's going on?

The key to understanding this situation was snuck in a few paragraphs ago: Every single dollar in circulation is loaned into existence by a bank, with interest.

That little statement contains the entire mystery. If all money in circulation is loaned into existence, it means that if every loan were paid back, all our money would disappear. As improbable as that may sound to you, it is precisely correct, although some of you are going to consider this proof that I could have saved a lot in tuition costs if I had simply drunk all that beer at home. But with a little investigation, you would readily discover that literally every single dollar in every single bank account can be traced back to a bank loan somewhere. For one person to have money in a bank account requires someone else to owe a similar-sized debt to a bank somewhere else.

But if all money is loaned into existence with interest, how does the interest get paid? Where does the money for that come from?

If you guessed "from additional loans," you are a winner! Said another way: For interest to be paid, the money supply must expand. Which means that next year there's going to be more money in circulation, requiring a larger set of loans to pay off a larger set of interest charges, and so on, etc., etc., etc. With every passing year, the money supply must expand by an amount at least equal to the interest charges due on all the past money that was borrowed (into existence), or else severe stress will show up within our banking system. In other words, our monetary system is a textbook example of a compounding, or exponential, function.

Yeast in a vat of sugar water, lemming populations, and algal blooms are natural examples of exponential functions. Plotted on graph paper, they start out slowly, begin to rise more quickly, and then, suddenly, the line on the paper goes almost straight up, threatening to shoot off the paper and ruin your new desk surface. Fortunately, before this happens, the line always reverses somewhat violently back to the downside. Unfortunately, this means that our monetary system has no natural analog upon which we can model a happy ending.

When comparing the two graphs above, you are probably immediately struck by the fact that one refers to a nearly mythical creation especially revered at Christmas time, while the other is a graph of reindeer populations. You may have also noticed that our money supply looks suspiciously like any other exponential graph, except it hasn't yet transitioned into the sharply falling stage.

To get the best possible understanding of the issues involved in exponential growth while spending only 10 minutes doing so, please read this supremely excellent transcript of a speech given by Dr. Albert Bartlett. If, like me, your lips move when you read, it may take 15 minutes, but I'd still recommend it. In this snippet he explains all:

Bacteria grow by doubling. One bacterium divides to become two, the two divide to become 4, become 8, 16 and so on. Suppose we had bacteria that doubled in number this way every minute. Suppose we put one of these bacterium into an empty bottle at eleven in the morning, and then observe that the bottle is full at twelve noon. There's our case of just ordinary steady growth, it has a doubling time of one minute, and it's in the finite environment of one bottle.

I want to ask you three questions:

First, at which time was the bottle half full? Well, would you believe 11:59, one minute before 12, because they double in number every minute?

Second, if you were an average bacterium in that bottle at what time would you first realize that you were running out of space? Well let's just look at the last minute in the bottle. At 12 noon its full, one minute before its half full, 2 minutes before its 1/4 full, then 1/8th, then a 1/16th.

And inally, at 5 minutes before 12 when the bottle is only 3% full and is 97% open space just yearning for development, how many of you would realize there's a problem?

And that's it in a nutshell, right there. Exponential functions are sneaky buggers. One minute everything seems fine; the next minute your flask is full and there's nowhere left to grow.

So, who cares, right? Perhaps you're thinking that it's possible, just this one time in the entire known universe of experience, for something to expand infinitely forever. But what happens if that's not the case? What happens if a monetary system that must expand, can't? Then what? How might that end come about? And when? For an excellent description of this process, read this article by Steven Lachance (emphasis mine):


A debt-based monetary system has a lifespan-limiting Achilles heel: as debt is created through loan origination, an obligation above and beyond this sum is also created in the form of interest. As a result, there can never be enough money to repay principal and pay interest unless debt is continually expanded. Debt-based monetary systems do not work in reverse, nor can they stand still without a liquidity buffer in the form of savings or a current account surplus.

When interest charges exceed debt growth, debtors at the margin are unable to service their debt. They must begin liquidating.

Mr. Lachance reveals the mathematical limit as being the moment that new debt creation falls short of existing interest charges. When that day comes, a wave of defaults will sweep through the system. Which is why our fiscal and monetary authorities are doing everything they can to keep money/debt creation robust.

But it's a losing game, and they are only buying time. How do I know? Because nothing can expand infinitely forever. The evidence clearly points to exponentially rising levels of money and credit creation. As the bacterium example shows, once an exponential function gets rolling along, its self-reinforcing nature quickly takes over, requiring larger and larger aggregate amounts, even as the percentage remains seemingly tame.

Similarly, our supremely wealthy suffer only from an inability to spend what they 'earn' on their capital (interest & dividend income), which means their principal is compounding. But, because each dollar is loaned into existence, it means that when Bill Gates 'earns' $2 billion on his holdings, a whole lot of people somewhere else had to borrow that $2 billion. Taken to its logical extreme, and without enforced redistribution, this system would ultimately conclude with one person owning all of the world's wealth. Game over, time for a Jubilee, hit the reset button, and start again.

When we started our monetary system, nobody ever thought that we would fill up our empty bacterium bottle. Nobody really thought through what it would mean to society once wealthy people earned more in interest & dividends than they could possibly spend. Nobody considered whether it was wise to place 100% of our economic chips into a monolithic banking system that requires perpetual, endless growth in order to merely function.

So, we must ask ourselves: Does it seem possible that our money supply can continue to double every 6 years forever? How about another 100 years? How about another six? What will it feel like when we are adding another $1 trillion every month, week, day, and then, finally, every hour?

Just remember, money is supposed to be a store of value; or, said another way, a store of human effort. Currently it seems to be failing at meeting that characteristic and therefore is failing at being money.

Who ever thought that oil production would hit a limit? Who knew that every acre of arable land, and then some, would someday be put into production? How could we possibly fish the seas empty?

We have parabolic money on a spherical planet. The former demands perpetual growth while the latter has definitive boundaries. Which will win?

What will happen when a system that must grow, can't? How will an economic paradigm, so steeped in the necessity of growth that economists unflinchingly use the term 'negative growth,' suddenly evolve into an entirely new system? If compound interest based monetary systems have a fatal math problem, what will banks do if they can't charge interest? And what shall we replace them with?

Since I've never read a single word on the subject, I suspect there's even less interest in exploring this subject by our leaders than there is in being honest about our collective $53 trillion federal shortfall.

I am convinced that our monetary system's encounter with natural and/or mathematical limits will be anything but smooth (possibly fatal), and I have placed my bets accordingly. It seems that our money system is thoroughly incompatible with natural laws and limits, and therefore is destined to fail.

Now you know why I have entitled my initial economic seminar series "The End of Money." [Although I later renamed it The Crash Course.]

But the end of something is always the beginning of something else. Where's our modern day Adam Smith? We need a new economic model.

The greatest shortcoming of the human race is our inability to understand the exponential function. ~ Dr. Albert Bartlett

Insider

Uh Oh.

Saturday, March 15, 2008, 4:40 PM
Monday, December 10, 2007 (reprinted Saturday, March 15, 2008)

Executive Summary

  • The credit bubble collapse is just getting started.
  • Odds of a major systemic financial crisis now higher than ever.
  • Dollar collapse is underway.
  • Your opportunities to protect your assets are dwindling fast.

(Originally printed on 12-10-2007. Uncannily good predictions and recommendations, all of which I still stand by.)

The Great Credit Bubble, for which you can thank Alan Greenspan, is now in the process of bursting. While the US media implacably attempts to assure everyone that it is well contained or almost over, nothing could be further from the truth. As one financial commentator recently put it, "the good news is that the subprime crisis has been contained...to the planet earth."

The odds of a major systemic financial collapse are now higher than ever.

If you’ve seen the Crash Course (formerly the End of Money seminar), you know I’ve been concerned for a number of years about the toxic witch's brew of poor-quality loans and unfathomably risky derivatives that are poisoning our financial body. Part of my concern stems from the fact that no matter how hard I try, I cannot understand how the derivatives markets work.

I’ve been unable to discover the most basic answers to the most basic questions, such as “how much capital is actually backing these things?” and “who’s holding the bag?” Wall Street and its ever-compliant financial propaganda services organizations (CNBC, WSJ, et al.) have maintained all along that these new products have completely eliminated risk by spreading it so thin that it has literally disappeared. I do not believe in financial alchemy, and I do not believe this version of ‘reality,’ because it makes no sense at all. Just as it made no sense to finance 19 houses to a part-time hairdresser in Las Vegas with subprime, negative amortization loans (true story), it makes no sense that this level of malinvestment could simply 'disappear'.

The rest of my concern centers on the fact that 3,800 paper currencies in the past have all gone to money heaven due to the exact same formula of mismanagement that our fiscal and monetary authorities are applying to the US dollar. A few key warning signs would be, (1) bailing out the poor decisions of big banks by flooding the markets with hundreds of billions of dollars of public money/credit, and (2) conducting a pair of very expensive wars “off budget,” while (3) expanding your total monetary base at an astounding, banana-republic double digit percentage rate (as we discussed last time).

I won't be disappointed if you tend to believe proclamations from the titans of Wall Street more than you would from some random guy named Chris. However, before you place too much faith on the possibility that those guys on Wall Street “must know what they are doing,” I would ask you to consider these facts:

Exhibit A:

Out of all the toxic subprime mortgages ever issued, the subprime loans with highest rates of default were made in the first 6 months of 2007 .



While you and I and everybody else had figured out that the subprime jig was up in 2005 or 2006, the Wall Street machinery couldn’t figure out how to stop what it was doing even as late as July of 2007. Titans or nitwits? You be the judge.

Exhibit B:

Rather than admit they made a bunch of really stupid loans, Wall Street banks first went straight to the US Treasury to mediate a bailout, and, when that proved to be too slow a course of action, simply hid the extent of their losses by massively abusing an obscure accounting gimmick .

Nov. 7 (Bloomberg) Banks may be forced to write down as much as $64 billion on collateralized debt obligations of securities backed by subprime assets, from about $15 billion so far, Citigroup analysts led by Matt King in London wrote in a report e-mailed today. The data exclude Citigroup's own projected writedowns.

Under FASB terminology, Level 1 means mark-to-market, where an asset's worth is based on a real price. Level 2 is mark-to-model, an estimate based on observable inputs which is used when no quoted prices are available. Level 3 values are based on ``unobservable'' inputs reflecting companies' ``own assumptions'' about the way assets would be priced.

In other words, these so-called “Level 3” assets are balance-sheet entries that company management value at whatever they say they’re worth. This is like your drunk uncle claiming to be a millionaire because he said he found a lottery ticket in the gutter on the way home last night, but he won’t let anybody see it. The value of these so-called assets is entirely in the eye of the beholder, or bank management in this case, who has decided that they are ‘worth’ every penny that they paid for them and that’s how much they are going to continue insisting they are worth, thank you very much.

Exhibit C:

As the subprime derivative debacle was unfolding, what do you suppose was the response of Wall Street? If you guessed “doubling down,” you are a winner!

Nov. 22 (Bloomberg) -- The market for derivatives grew at the fastest pace in at least nine years to $516 trillion in the first half of 2007, the Bank for International Settlements said.

Credit-default swaps, contracts designed to protect investors against default and used to speculate on credit quality, led the increase, expanding 49 percent to cover a notional $43 trillion of debt in the six months ended June 30, the BIS said in a report published late yesterday.

Wow. Wowowowowow. This is shocking. First, because of how hard it is to set new records for the “fastest pace” at the same time that you are setting records for the total amount. This would be like a weightlifter setting a new world record by adding 700 pounds to the old record. Second, because the specific types of derivatives that expanded the fastest were those designed to speculate on credit quality – the very area that is most at risk right now. So we now know that even as the credit debacle was so completely obvious that people returning from year-long wilderness solos knew something was wrong, Wall Street and Hedge Funds were busy accelerating the pace at which they continued to pursue these broken bets on shaky mortgages. Rather than sound fiscal prudence, this appears to be a last desperate grab for what few chips remained on the table.

It is possible that each individual transaction made a lot of sense to the hedge fund managers, but to outsiders like us they look foolish collectively. Why? Because when everybody is hedged, nobody is. Hedging is a zero-sum game. For somebody to win, somebody has to lose. So while all these smarty-pants were busy ‘hedging their risk away,’ nobody seems to have taken stock of the fact that the assets they were hedging were themselves seriously impaired and were going to result in massive losses for somebody. In short, it is impossible to hedge a failed system.

So, there are three perfectly good reasons to suspect that the captains of Wall Street are rather mortal after all and possibly even less competent than the average soul. I could give you forty more, but in the interest of time, I won’t, except to offer the best explanation I’ve ever read on how the derivative market works (PDF) and the human mechanisms at play that allowed all this to get so out of hand. This article will be well worth your time.

Systemic Banking Crisis?

If you own a house, odds are you carry fire insurance. Not because the chance of a house fire is particularly large, but because the cost of a house fire is catastrophic. You carry fire insurance because you have rightly calculated that (small chance) x (a big cost) = unacceptable risk. So you offset that risk with insurance.

Now I want you to seriously consider what the cost to you would be if there were the equivalent of a house fire in the banking system. I’m talking about a major system ‘freeze’ where banks close, huge losses spread throughout the system, electronic interbank transfers become impossible (ATMs, credit cards, electronic funds transfers, wires, and all the rest simply stop), and many banks and brokerages simultaneously go out of business. I’d imagine the impact to you would be quite large. So the next question is, what can/should mature, responsible adults do to insure themselves against such an outcome? How much time, energy and money should one dedicate to insuring one’s financial house?

When I started giving The End of Money seminar three years ago, I had put the possibility of this sort of event at about 15% to 20% over the next 5-10 years. It turns out that I was a raging optimist compared to some financial professionals such as this guy:

Nov. 13 (Bloomberg) -- There's a greater than 50 percent probability that the financial system "will come to a grinding halt" because of losses from mortgages, Gregory Peters, head of credit strategy at Morgan Stanley, said.

This is serious business especially now that the head of credit strategy at a major Wall Street bank is openly writing about it to their main clients. In fact, there are now many respected economists and financial professionals who are calling for a generalized systemic financial meltdown or a severe stock market decline. Even if you have no assets in the larger speculative financial markets (stocks and bonds), or have already taken steps to protect them by getting them out, you are still at risk if your assets are sitting in a risky bank. The possibility of massive bank failures is now a stark reality and it is my opinion that several are already insolvent, just not publicly (yet).

These sorts of crises always start at the edges and work in. First it was the shakier mortgage broker ‘bucket shops’ that began going under in late 2006. Then larger and seemingly firmer mortgage outfits began going under. Now more than 190 mortgage brokers, including most of the ‘top ten’, have gone bankrupt. And today not only is the very largest of them all (Countrywide Financial Corp) rumored to be a strong candidate for bankruptcy, the unthinkable seems to be unfolding before our very eyes. Both Fannie Mae and Freddie Mac, collectively holding several trillions of dollars worth of US mortgages and an even larger portfolio of associated interest rate derivatives, appear to be in some serious trouble . If either, or both, of these companies goes bust, it is highly unlikely (to me) that both the US banking system and the dollar could survive the event.

I am now putting out my strongest warning ever.

If you do not already own gold and/or silver, your time is running out. My best guess would be that once the world’s paper markets implode, the price of gold and silver will skyrocket to unimaginable and unreachable heights, if you can even locate any to buy. Get some.

By the time it is completely obvious that this is the right thing to do, you will find it difficult either due to price, availability, or both. Luckily, the world’s central banks are still capping the price of gold and silver, offering you a wonderful subsidy, which is really quite nice of them. Why do I advocate gold and silver? Simple. Because they are among the very few money-like assets that you can own (hold) that are not simultaneously somebody else’s liability. Consider that a bond (your asset) is the liability of a corporation or government. Even your checking account is your bank's liability. A house owned free and clear would certainly qualify as a valuable asset, but a house is not very “money like.” When you go through the list (stocks, bonds, annuities, money-market accounts, etc), there is virtually no paper asset that you can identify that is not somebody else’s liability. Even a cash dollar is the liability of the Federal Reserve. But when you own physical precious metals (not mining shares or other paper claims), that’s the long and the short of it. It’s yours. Period.

Next, in order to protect from the possibility of a general banking ‘holiday’ (freeze), every family should have somewhere between one and six months worth of living expenses on hand in the form of cold, hard cash. You know, the bits of paper that work even if the ATMs and credit card readers do not. To be clear, I am not talking about cash in your checking account, I am talking about cash out of the bank and in your hands. Katrina, a natural storm, taught this lesson and we now need to apply that learning to the potential arrival of an economic storm.

Unfortunately, not very many people will be able to do this because the total cash available is a very small percentage of total deposits (~5%). Your bank will look at you funny when you take cash out, mainly because they do not have very much on hand at any given moment. If you plan to cash out more than a few thousand dollars, I highly recommend that you give your bank advance warning and thereby avoid the awkward social moment that will result when they have to tell you that they don’t actually have that much on hand. One thing to remember is that if you take out $10,000.00 or more of cash your bank is required to report you to the federal government via a SAR (Suspicious Activity Report). So the banks appreciate amounts smaller than that as it cuts down on the paperwork.

I would maintain a cash balance until we see clear signs that the evolving credit crisis is getting better, not worse. Given the latest data, which all point to a serious erosion of the credit markets, this could be awhile.

All that’s really happening here is that the long-awaited credit bust is finally upon us. It is important to remember that historically, bubbles have always deflated over approximately the same amount of time as they took to inflate. This means we are looking at a potential end to this crisis somewhere in the range of 2012 to 2020, depending on where you mark the beginning. In the meantime, there will be plenty of false dawns and countertrend rallies that will siphon even more wealth from the unwary.

Don’t be among them.

Insider

The Federal Reserve Plays a Dangerous Game

Wednesday, March 26, 2008, 8:00 AM
Wednesday, March 26, 2008

Be careful what you believe.

A television ad for Morgan Stanley’s brokerage service flickers across the screen, showing a retired couple walking across a beach with a dog and their grandchildren.  Smiles and ease and comfort drip off the screen.  It is a happy, shiny future that they are selling.  Separately, a letter goes out from Morgan Stanley to their private clients warning of a “50% chance of a systemic crisis."  Which do you believe? 

Executive Summary

  • Keeping a wide-angle view on this developing crisis is the only way to avoid being whipsawed, and the stakes have never been higher (at least in our lifetime).
  • The US financial markets, and probably the world’s, peered over an abyss on the night of Sunday March 16, 2008, but were rescued by very unusual and concerted official actions.
  • On the “happy, shiny” side of the equation, we have the fact that stocks mysteriously went up immediately on the open after the announcement of the collapse of Bear Stearns, and have continued up since.
  • On the “Cold, Hard Facts” side of the ledger, indicating that a particularly nasty recession is already underway, here is the recent data:
  • Housing data was similarly unambiguous.  Sales were down, mortgage rates were up, foreclosures up, construction down, and prices slid at a rate “not seen since the Great Depression.”
  • Unemployment claims ratcheted higher.
  • Consumer confidence hit a 35-year low.
  • Global trade has decelerated to a standstill.
  • Retail sales are in the cellar, plunging by more than expected, and auto sales are fading fast.
  • The Empire state index clocked in at a record low.
  • T-Bills gave a very strong recession reading, by briefly trading at 0.21%.
  • Tax receipts for the federal government are down by 12% over the past year.
  • You can choose to believe that the worst is behind us (stocks), or you can choose to believe the facts (everything else). But be sure to choose carefully, because the penalty for being wrong here will be particularly steep.  
  • Simple preparations will go a long way toward mitigating the effects of a possible systemic financial crisis.

On Sunday, March 16th, deep in the night, the US financial system, and, by extension, the world financial system, peered over the edge of an abyss.  If the Bear Stearns rescue (by the Fed & JPM together) had not happened, it is my firm conclusion that a systemic banking crisis would have ensued.  While some commentators are now saying that “the bottom is in,” with one even going so far as saying the Dow 20,000 is now a lock, I would implore you to be careful in choosing your beliefs

Here’s why.  In my economic seminars, we spend about as much time on the economic context and data that define our current reality as we do examining beliefs and asking ourselves whether the ones we hold might be of the enhancing or limiting variety.  This is important because what we believe shapes what we see, and what we see determines our actions - and therefore our future.  Holding the wrong beliefs at critical turning points can be extremely harmful.

In the book The Mind of Wall Street by Eugene Levy, a wonderful example of both a limiting and an enhancing belief are simultaneously on display when he recounts his experience during the take-over of a struggling railroad back in the 1970’s.  He made a bundle on the deal.  Here he describes the situation:

Management executives looked to the past in their assessment of the railroad.  They saw its wretched history of bankruptcy and losses, the thousands of miles of useless track, and the years of failed attempts at regulatory reform; from this they could only conclude that Milwaukee Road was a failed railroad that could never be profitable.  We looked at the same railroad and instead saw vast assets in real estate and machinery that could be sold.

The railroad executive team held limiting beliefs about their company that prevented them from seeing the value of what they held.  Because of this, they saw the wrong things and took the wrong actions, losing a ton of money as a result.  Meanwhile, Mr. Levy had an enhancing belief that allowed him to see things about the railroad that led him to a fortune.

I want to share a believe of mine with you:  I believe the stock market is being propped up by the Fed and/or US government (PPT), who are desperately afraid of allowing the stock market to signal the true state of affairs. In some ways I can understand this; I think that the authorities who are stabilizing the markets right now are quite justifiably worried about what would happen if the stock market was “allowed” to send a correct signal to a wider audience.  Because I believe that the stock market is being propped, I do not trust that it is telegraphing useful or meaningful price signals, and so I will take very different actions than someone who holds the opposite view.  I might be wrong, or the person holding the opposite view might be wrong, but one of us is making a colossal mistake.

And here’s a second belief:  The market is bigger than the authorities, and they will ultimately fail in their attempts to prop the stock market, because they are merely masking symptoms, not treating causes. If it were possible for an elevated stock market alone to cure what ails our economy, I might think differently.  But those efforts are surely misdirected.

The consumer-retrenchment genie is already out of the bottle, and intervention will only serve to exacerbate what is already a terrifying gap between the ‘official story’ (as told by the stock market), the daily lives of ordinary people, and the cold, hard facts.

Even as a possibly illegal and certainly ill-advised rescue of Bear Stearns is being revised and revisited, and the stock market keeps climbing or at least holding steady, we find that the current spate of fundamental economic news is especially worrisome, if not downright scary.  The question before you, then, is, which will you believe?  A happy, shiny stock market, or the cold, hard facts?

The ECRI and NBER say “recession is here” 

To begin with, the highly-respected Economic Cycle Research Institute (ECRI) recently said, “Now the verdict is finally in.  We have unambiguously turned onto the recession track.”   In case that wasn’t strong enough, Lakshman Achuthan, managing director at ECRI said, "[Our indicator] is exhibiting a pronounced, pervasive and persistent decline that is unambiguously recessionary," while Martin Feldstein, who heads the equally-regarded National Bureau of Economic Research, said that contraction is already under way and that it’s likely to be severe, stating, "The risks are that it could get very bad."  The ECRI leading indicator incorporates a broad array of economic signals and has a very good track record of spotting recessions.  The stock market used to do this, but seemed to lose that ability around the time of the Fed rescue of August 2007.

Now, during your average, ordinary, garden-variety recession, which this one most certainly will not be, the average decline in the stock market is 28%.  Compared to a year ago, before all this financial uncertainty was widely recognized, the S&P 500 is only down -6.6%.  So, for whatever reason, the stock market is now deeply at odds with the ECRI, the NBER, and virtually every piece of economic data.  Somebody has it very wrong.

Housing data is "the worst since the Great Depression"

This housing bubble is bursting, and with alarming speed.  It’s hard to keep up with the data, it’s coming so fast.  Sales and housing starts have been cut in half since the peak (link supplied the quote below), and it’s important to remember that “sales” include transactions in which a bank takes possession during foreclosure, so the sales numbers are misleadingly high.  Notably, foreclosures for February 2008 were reported to be running 60% higher than last February, so we might expect bank repossessions to be a significant component of the recently reported existing home sales number.

CHICAGO (MarketWatch) -- Housing is in its "deepest, most rapid downswing since the Great Depression," the chief economist for the National Association of Home Builders said Tuesday, and the downward momentum on housing prices appears to be accelerating.

The NAHB's latest forecast calls for new-home sales to drop 22% this year, bringing sales 55% under the peak reached in late 2005. Housing starts are predicted to tumble 31% in 2008, putting starts 60% off their high of three years ago.

"More and more of the country is now involved in the contraction, where six months ago it was not as widespread," said David Seiders, the NAHB's chief economist, on a conference call with reporters. "Housing is in a major contraction mode and will be another major, heavy weight on the economy in the first quarter."

Even worse, house prices have plunged by 10.7% over the past year, according to the highly-respected Case-Shiller index, although the US government (via the OFHEO) comes to a substantially different conclusion and reports a mere 3% decline.  As always, the US government has settled on a particular methodology that manages to paint a happier, shinier picture than does a private firm whose livelihood depends on delivering useful information.  Unsurprisingly, it’s the happier, shinier number that the Fed uses when calculating how much people’s homes are worth vs. how much they owe on them. But even with this deployment, a new benchmark has been set:

NEW YORK (AP) -- Americans' percentage of equity in their homes has fallen below 50 percent for the first time on record since 1945, the Federal Reserve said Thursday.

Homeowners' percentage of equity slipped to a revised lower 49.6% in the second quarter of 2007, the central bank reported in its quarterly U.S. Flow of Funds Accounts, and declined further to 47.9% in the fourth quarter - the third straight quarter it was under 50%. That marks the first time homeowners' debt on their houses exceeds their equity since the Fed started tracking the data in 1945.

The Federal Reserve is in a box

That last bit of data, above, is what has the Fed running around with its hair on fire.  Sure, we can all take comfort in the “bold, decisive action” that Bernanke took to preserve confidence in the system by pouring hundreds of billions of dollars into the banking system, but that leaves out a very important observation.  Namely, that the crisis is not based on the fact that banks have run out of liquidity; that’s a symptom.   The cause of this crisis is rooted in the fact that an entirely too-large proportion of the people who took out trillions of dollars in loans lack the means or the motive to ever pay those loans back.  It is now estimated that more than 1 in 10 homes is now ‘underwater’, meaning that more is owed on the mortgage than the house is currently worth.  Currently that’s 8,800,000 homes, a number that we can reasonably expect to grow as this negative housing-price dynamic plays itself out.

So the nature of this particular crisis, like literally every single other credit-bubble fueled crisis in history, is not going to be resolved until the bad debt is wiped out or the losses are socialized.  By this I mean that the Federal Reserve would have to print enough money (out of thin air) to buy all the bad debt, as in $1 to $2 trillion dollars worth of it.  If this happened, the Fed would become the largest property holder in America, its balance sheet would be ruined, and it is highly unlikely that the dollar would survive the attempt.  Therefore, like every other credit bubble that has burst in the past, massive amounts of bad debts will simply have to be wiped away.  And the sooner that happens, the sooner we can pick ourselves up and carry on.

But is this really possible?  Can all that debt simply be defaulted upon?

Probably not.  And the primary reason is that, like everybody else, the Fed has no idea what would happen if the $615 trillion derivative tower, with all of its unknowably complicated interlocking pieces, was suddenly exposed to a rash of defaults.  The fear that this would be an extinction-level event for the banking system, meaning the complete and permanent abandonment of fractional reserve banking as a concept (or for one or two forgetful generations, whichever comes first).

I have no particular insights into the complexity of the derivative system, but I can tell you that I have spent a great deal of time trying to understand the magnitude and location of the risks, without much success.  So I draw my conclusions from two anecdotes.  The first concerns Warren Buffet’s experience in the years after he bought General Re, a fairly ordinary re-insurance company.  The company got in some trouble and the decision was made to absorb its operations and shut it down.  But after several years (and much concerted effort), Berkshire Hathaway found itself stuck with 14,384 outstanding derivative contracts and 672 outstanding counterparties of indeterminate risk and unknowable value, leading Buffet to comment that derivatives are “financial weapons of mass destruction.”   It is important to note that the difficulties Warren Buffet’s organization experienced in assessing the risk and value of a single company’s derivative portfolio was during a period of stable market conditions.

The second anecdote concerns another company with a large derivative portfolio, Fannie Mae, which found itself in an accounting scandal and was forced by the government to restate its earnings for the years 2001 to 2004.  In December of 2006, after two full years of effort by an army of 1,500 expert accountants and $1 billion dollars expended, Fannie Mae was finally able to produce an earnings statement for 2004.  The reason for the excessive cost and time?  Derivatives.  There were simply so many and they were so complex that it took 3,000 person-years of effort to determine the earnings for one single year for one company.  Again, this was during stable market conditions, without the burden of counterparty defaults and the time pressures that fast-moving market conditions can impose.

Fast forward to today.  If it takes thousands of person-years of effort to calculate the impact of derivatives on a single company, what would happen during turbulent times, especially if defaults are cascading and multiplying throughout the system and tens of thousands of companies dotting the globe are involved?  Pandemonium and a major system-threatening crisis, that’s what.

So now you know why I view the Fed’s actions not as “bold and decisive,” but rather as “necessary and forced.”  They will need to go further and begin buying mortgage debt directly, as has already been publicly suggested.  In my opinion, the Federal Reserve (let alone the Bush administration) is institutionally ill-equipped to deal with this particular crisis.  The Fed relies on government data on inflation, house prices, etc., and therefore has a faulty instrument panel.  It is as if they are flying a plane with a stuck fuel gauge and an altimeter that is off by 5,000 feet.  At night, in mountainous terrain.  But, more importantly, the Fed is a sclerotic institution whose reliance on past example (the Great Depression and Japan come to mind) is poorly suited to a modern world that spent the past ten years creating financial products light-years distant from prior experience, while the Fed snoozed along basking in the false glory that came with financial stability and recklessly low but popular interest rates.

The worst is yet to come

Someday, this financial crisis will all be yesterday's news, but already a lot of ink is being spilled to try and convince you that the worst is already behind us.  Don’t fall for it.  Even a cursory tour of the data will convince you that the bursting of this credit bubble is just getting started and that a particularly nasty recession has just begun.  Nothing the Fed has done, or even can do, will change the fact that trillions of dollars of losses lurk within the system.  And those losses will either have to be written off or they will have to be monetized (i.e., bought by the Fed for money printed out of thin air).  Writing them off would mean the possible destruction of the banking system (and massive political upheavals).  There is a slight chance, a hope, a faith, that we can somehow print our way out of this mess by monetizing the bad debts.  However, that is a knife-edge possibility with failure on one side and the utter destruction of our currency on the other.  While the destruction of our past mistaken pile of debt would be bad for those who took leave of their senses and participated in the credit bubble, placing your faith on our authorities to ‘fix this’ could be financially ruinous.  It is well past time to protect yourself and your financial assets.  While I personally hope for a favorable outcome, I am preparing for the most likely outcome - a currency and/or systemic banking crisis.

Okay, so what should you do?  

My role as a financial commentator and futurist is to help you understand that money systems come and money systems go, and that the US dollar-based system has been, and is being, seriously mismanaged to the point where it is at risk of imploding.  This could happen either in a deflationary impulse that could ruin the entire banking system (unlikely, in my view), or in a (hyper)inflationary collapse of the currency (most likely).  Either way, the effect will be to impoverish the many.  Please don’t be among them.

As I said, I see a risk that this could happen, not a certainty, but because the cost of a systemic banking crisis would be so catastrophic, I think we should each undertake certain preparations.  The analogy I like to use is fire insurance.  We all carry it on our primary residences, not because the likelihood of a fire is high, but because the cost of one is so catastrophic.

It is my belief that by taking a few simple steps, each of us can make significant strides toward enhancing our future prospects.  I sincerely wish everybody would do so.

Let’s review a scenario and some actions that could mitigate the impact(s).

Systemic banking crisis:  50% probability over the next year

Everyone should be prepared for the possibility of a severe systemic banking crisis. You may see a higher or lower percentage probability than I do, but you’d certainly better have something higher than 0% in mind.

What this would look like is some sort of a serious warning, possibly the surprise bankruptcy of Citibank or a blow-up at a massive hedge fund.  Within 24-48 hours, the stock market would be in pretty bad shape, the dollar would be spiraling downward, and interest rates would be shooting up, as foreigners dump Treasury bonds in a frantic bid to repatriate their money while some value still remains. To stabilize the situation, the President would come on TeeVee to declare a banking holiday and state that the banking system is in a crisis and that some time will be needed to “calm things down and work out some solutions.”  During this time, banks would be closed, and it is highly likely that credit and debit cards would not work, since the interbank clearing system would be a mess.  Rules against hoarding would immediately be put in place, and talk of rationing of certain staple goods, such as gasoline, would begin.

Before any of this happens, here are the things you should consider doing:

Tier I actions:

  • Have 3 months of living expenses at home, in cash.  The idea here is to be able to buy things even if checks and debit and credit cards are temporarily inoperative.  What you risk here is losing the miniscule interest that your checking account is currently paying.
  • Have 1.5 months of living expenses at home in gold &/or silver. This protects against the impacts of a potential dollar crisis.  The more, the merrier, but 1.5 months is the bare minimum.
  • Make sure your bank accounts are with the safest possible banks.  Use a rating service such as Veribanc (the Blue Ribbon Report is good).  Better yet, spread your accounts across several highly-rated banks.  The idea here is that these banks will have the best chance of surviving and reopening first after a crisis.  Stay away from big banks – they have the greatest exposure to the unknowable derivative risks.
  • Do a little extra buying every time you shop, until you have at least 3 months worth of food on hand.  While the likelihood of a total shutdown of the food system is remote, not having to worry about this possibility if/when a crisis hits will free up an important part of your brain for other tasks.  This means buying extra cans, jars, and packages of food (pasta, etc) that generally will keep for ~1 to 2 years.  Buy only the foods you like to eat.  Rotate the new food behind the older food.
  • Have any medicines you can't live without?  Begin accumulating and storing them, if this is an option.  Again, this is so that you have one less thing to worry about later on.

Tier II actions – only undertake these after Tier I actions are complete:

  • Increase your gold exposure until you have 10% (minimum) to 50% of your nest-egg socked away.  Read the Buying Gold and Silver guide in the Take Action section at PeakProsperity.com for types and tips on how to go about this.
  • Perform a self-assessment to identify your strengths and weaknesses, and the opportunities and threats that you could imagine arising during a systemic crisis. 
  • Address any critical weaknesses or threats that arise in the exercise above.
  • Develop “buy-lists” that you can follow in the early phases of a crisis. Having a plan for obtaining last minute items will not take you much time to develop now, but will be a godsend if anything comes to pass.
  • Have a plan for what you’ll do.
    • Who will you trust for news?
    • What will you do first?
    • If you and your immediate family are separated by a significant distance, will you all know where to meet and who is responsible for what?
    • Could you anticipate other family members, or even friends, moving in with you (or you with them) as a possible outcome? I f so, does this change any of your other preparations?
    • Thinking these through is just good, common sense, and it is something that all mature businesses do as a matter of course.  They call it continuity and/or disaster planning. If my local co-op bank can do it, so can you.
  • Know who your support network is.  Begin cultivating local networks of people who can help you share the load and provide support.

Tier III – only after you’re done with I and II:

  • Prepare your home.
    • Water storage. What if the power went out during the crisis?
    • Make your home more self-sufficient with respect to heating and cooling
    • Store more food (for family and neighbors…be a hero!)
  • Think about your job.  Will it be more secure/needed in the event of a financial crisis, or insecure?  Build up your cash and gold/silver reserves.  Eliminate debts, especially floating rate and secured debts.
  • What skills would be especially handy during a crisis?  Do you have them?  Is there anything you ever wanted to learn that falls under this category?

Conclusion

A bit of foresight and preparation will go a long way to mitigate the personal effects of a systemic financial crisis.  What we believe shapes what we see, and what we see determines our actions - and therefore our future.  We may not be able to change the game that the Federal Reserve is playing, but we can certainly take steps to prepare ourselves for the impact. 

Insider

An Immoral Level of Debt

Tuesday, April 8, 2008, 10:33 AM
Tuesday, April 8, 2008

Are the current levels of debt in the US placing an immoral burden on succeeding generations? Here I make the argument that they are. (Note: This is an updated version of an article I wrote in 2006.)

Here’s what we know about debt.  

Debt comes in two forms. The first is called, in banker parlance, ‘self-liquidating debt,’ and represents borrowing that will boost economic activity and therefore will stand an excellent chance of ‘paying itself back.’ The simplest example would be a case where you could borrow money at 5% but loan it out, risk free, at 7%. Here the loan will clearly 'pay for itself.' More typically, self-liquidating debt has a productive asset tied to it, such as a utility company, an apartment building, or a factory which generates the income to pay off the debt.

The other type is ‘non self-liquidating debt,’ which, as you have already guessed, does not ‘pay for itself’ and is used for consumption, not investment. An example would be borrowing $40,000 to buy a car that does not help you earn any more money at work. Or the construction of a shiny new town hall. Or a war of choice in the Middle East. All of these represent debt taken on today in order to purchase and consume something today, but the purchases do not then lead to new economic earnings. The money is spent, but the debt remains.

Since 2001, our national level of debt has very nearly doubled. If we take a strict view and exclude debt taken on for the purpose of speculating, say, in the housing market, almost all of this mountain of new debt has been of the non-self-liquidating variety.

And here’s the one thing we need to remember about this kind of debt: It represents future consumption taken today. Sometimes people find this statement confusing, so let me flesh this out a bit. In the case of the auto purchase given above, $40k was borrowed and the car was purchased. But later on the loan has to be paid back, with interest, and every one of those future payments are made with cash that is not then available to spend on something else. Cash that you can’t spend in the future represents consumption that you must forgo in the future. In other words, a preference for a car today acquired via debt is really just another way of saying that having the car NOW has a higher ‘value’ than having a car’s worth of purchasing power in the FUTURE. So debt is really future consumption taken today.

And, finally, remember that there are only 2 ways to make a debt go away:

1) Pay it back

2) Default on it

Unless you are the federal government in which case you can always go for the third option:

3) Print money
to pay the debt.

The federal government always favors this last option because so very few people correctly perceive the (inevitable) resulting inflation for what it really is, a hidden tax that erodes the value of all existing money, whereas everybody understands that raising taxes directly takes their money away. Inflation is everywhere and always a monetary phenomenon. Excess printing by governments always leads to inflation. Recently, many of our financial observers have been confused by the fact that the explosion in debt/credit, and therefore money, has resulted in asset, not commodity, inflation, but it is inflation nonetheless.

So what does any of this have to do with the title? What does any of this have to do with morality?

Well, if we rotate the topic slightly, we can observe that there are two other ways to view debt. On the one hand, there’s debt taken on with the intent of paying it back, and then there’s debt taken on with the intent that it will not be paid back.

To pass judgment on these two approaches, the former is moral, the latter is immoral (and usually illegal). To really understand this judgment we’ll need to take look at this in greater detail.

Certainly we can all agree that taking out a loan with the intent of never paying it back runs afoul of a variety of civil and criminal laws. But what about a situation where one generation borrows with the intent that a future generation will be the one paying off the loan? Further, what if the loans were of the non self-liquidating (consumptive) variety and zero benefit would accrue to the future generation? How would we term such borrowing?

Well, the 6,000-pound elephant in the room is that this is exactly how the US has been operating for the past 20 years or so. This is not to point a finger of blame, or to create victims and victimizers. We have all been equal, eager, and willing participants in this game. We have been robbing Peter to pay Paul. Unfortunately, Peter has not yet even been born, which means that Peter never got a chance to voice his opinion on the matter.

At any rate, we can observe the phenomenon of generational theft in the negative $65 trillion net worth of the US at the federal level, the $9.4 trillion in direct federal debt (4/2008), and the negative $1 trillion in unfunded pension obligations at the state level. Each of these represents borrowed promises that the current generation has opted to lay upon future generations. In every case it has also meant that current and past generations have been able to enjoy both high consumption and low taxes.

Need more proof? Observe the record-breaking 97% pass rate of state bond issuances in the November 2006 elections. This Bloomberg article explains, and is worth your time to read:

Welcome to the Golden Age of Public Finance — Nov. 8 (Bloomberg)

That’s the message voters sent to the municipal market yesterday, as they approved the majority of the record $78.6 billion in bonds placed on the ballot this year.

Of the $56.5 billion in bond issues totaling $200 million or more being considered nationwide, Bloomberg News this morning calculated that 97 percent had passed. The majority appear to be for education, the remainder, money to be used for infrastructure construction and maintenance.

The election of 2006 marks a watershed for the municipal market. Never before have voters had to consider so many bond issues. Never before had they approved so many.

What’s going on here? The easiest answer would be to blame California, where voters were asked to approve that outlandish package of $43 billion for transportation, water, and school construction, and did.

That’s the easy answer. It would be harder to prove, but it wouldn’t be overstating the case to attribute the big election to generational change.

Stay with me here. The people who approved these bond issues, most of them, I’d bet, grew up in the 1970s.

What does that have to do with it? These are people who are used to having nice things. By comparison, those who grew up in the Great Depression and the 1940s were used to making do. They were suspicious of government, and of debt.

When they entered their 30s and 40s, it was the 1970s. The approval ratio for the 1970s, the entire decade, was 49 percent. There were years when this frugal generation approved 9.5 percent (1975), 18 percent (1971) and 33 percent (1973) of the bonds put before them for consideration.

Those who grew up in the 1950s and 1960s, certainly a happier group, approved marginally more borrowing 30 years later, when they started raising their families. The average approval ratio during the 1990s was 69 percent.

Now we’re talking about people who were born in the 1970s. These are the people who enjoyed air-conditioned schools and comfortable college dorms and coffee that tastes good, and they want the same things for their children, as well as things like smooth roads that aren’t too crowded, and new sidewalks, and nice parks, and roomy stadiums. They grew up cosseted, and squeamish about things that are less than just so.

These are the people who have moved to the suburbs and the exurbs and they see no reason why they shouldn’t borrow millions and billions of dollars for things that are going to have a useful life of, oh, when it comes to bridges and highways and sewers and the like, of 50 years to forever. The approval ratio for bonds put up for the vote in the 2000s is 80 percent, according to the Bond Buyer.

So welcome to the Golden Age of Public Finance. Now that this bunch has seen how easy it is to get a whole barge load of bonds passed, look for election ballots to swell to even more unseemly sizes in the years ahead.

I think the author, above, has made a very good set of observations. Namely that the current generation has lost all compunction about borrowing long-term to finance near-term consumption.
And this has come about because Greenspan’s “easy money 4-ever policy” of 1995 through 2005 has lulled us all into thinking that easy, cheap borrowing is a permanent condition. It is not. The piper always must be paid.

But, more importantly, I have serious moral reservations about one generation saddling the next with its debts. How can this be right? At the federal level we’ve decided, as a nation, to make all sorts of promises that cannot possibly ever be kept at current levels of taxation. So either future senior citizens are going to be sorely disappointed by meager entitlement payments, or future taxpayers (my kids) are going to have to shoulder crushing employment tax burdens.

For the senior citizens, this is patently unfair, since they paid more than their fair share into these retirement programs all their working lives. Should it be their fault that our leaders decided to use those ‘excess funds’ for current spending on hapless wars, bridges to nowhere, and other exotic examples of pork barrel spending of every conceivable stripe?

On the other hand, should it be the responsibility of subsequent generations to shoulder the burden of paying for all that past consumption and for our collective decision to ‘fund’ past societal excess with future promises to pay?

In this skirmish, I must side with the future generations. I think it is incumbent on each generation to figure out how to pay for whatever levels of consumptive spending it deems fit.

I think that racking up huge debts with the intent of pushing their repayments off to future generations is morally equivalent to loan fraud. It would not surprise me in the least if future generations decide that they have no legal or moral obligations to make good on that debt.

In the meantime, we each must ask of ourselves where we stand on this issue, how we’ve benefited, and whether we have any sort of an obligation to correct the situation.

And it is up to my children to decide if they want to make good on my generation's debts. After all, they will someday have a say in the matter. Let's hope they are feeling generous.

Insider

How Safe Is My FDIC-Insured Bank Account?

Wednesday, April 9, 2008, 11:30 AM
Wednesday, April 9, 2008

Your bank account may not be as safe as you think (or hope). Taking a deeper look at the legal details and the financial depth of the FDIC reveals several troubling details that call into question how the FDIC would fare during a true banking crisis.

The US is coming out of a period of unusually low banking stress and failures. Since it is typical human behavior to let one’s guard down during tranquil periods, we might legitimately ask if this has happened with respect to the FDIC.

Before we address that, we need to understand bit more about the FDIC. » Read more

Insider

Charting a Course Through the Recession

Tuesday, May 27, 2008, 5:58 AM
Tuesday, May 27, 2008

Executive Summary

  • In this report, I lay out my near- and intermediate-term investment themes.
  • My assessment is that the economic and financial risks are exceptionally high and possibly historically unique. This is no time for complacency. A defensive stance is both warranted and prudent. A 50% - 70% (real) decline in the main stock market indexes is a distinct possibility, and portfolios should be ‘crash-proofed.'
  • Heeding the calls that “a bottom is in” and “the recession could already be over” could be hazardous to your wealth.
  • The recession is just beginning and will be the worst in several generations.
  • Residential housing data is still accelerating to the downside, while commercial real estate is just beginning its long date with tough times. There is no bottom in sight for either.
  • Inflation for life’s necessities is up, and rising energy costs will likely keep certain items at persistently high - and rising - prices for a very long time.

Bottom line:  My assessment is that the financial and economic risks that currently exist are exceptional, historically unique, and possibly systemic in nature, and therefore call for non-status-quo responses. A defensive stance is both warranted and prudent. As for timing, my motto is, ‘I’d rather be a year early than a day late.’

Some Context

I am an educator and a communicator, and I focus on using the past to view the future. Some might consider me a futurist. I think of myself as a realist, and I try to let the data inform me about what’s going on. Of course, the extent to which the data is flawed represents the risk of being wrong.

My goal is not to simply inform, but to inform in a way that leads to you take actions. I want you to protect what you’ve got and prepare for a future that will, in all likelihood, be very different from the present. So different, in fact, that I think you should begin making changes to your lifestyle as soon as possible. In my own life I have found that the mental, physical, and financial actions I am advocating take a considerable amount of time to implement.

Broadly speaking, they are:

  • Adapting to a general decline in Western standards of living. The servicing of past debts, coupled with relentless fuel price increases and a recession, speak to a massive shift in our buying and consuming habits. We’ll all have to find ways to be happy with less stuff. This is actually a good thing.
  • Moving from a culture of “I” to “we.” The strength and depth of your community connections are going to increase in importance as time goes on. Needless to say, these connections cannot be manufactured overnight. They take energy and thoughtfulness, while trust requires time.
  • Giving up the belief (or the certainty?) that the future will be like today, only bigger, and filled with more opportunities for the next generation(s). Maybe it will, and maybe it won’t. I personally found this belief the hardest to let go of because it comes with a sense of loss. I finally progressed past this blockage when I began to believe that the future will simply consist of new and different opportunities than today. But that took work. And time.
  • Relying more greatly upon ‘self.’ I use this term broadly to include my entire region. While it may be true that oil and food will continue to flow to New England in sufficient and desired (required?) quantities, what if they don’t?

A Disclaimer and Some Good News

One thing that I cannot and will not do is give specific investment advice to individuals. For legal reasons, I cannot name companies or individual mutual funds, or anything else specific, except in the context of my role as an educator on these matters.

Which is fine by me, because I don’t want to be in the business of analyzing and recommending specific companies, bond offerings, or mutual funds.

To do this credibly and responsibly, I’d have to begin the immense process of sifting through all 20,000+ individual stocks and funds…and I simply don’t have the resources or time. Luckily, there are a lot of qualified people who do this professionally.

Rather, my work involves laying out themes against which specific investment opportunities and strategies can be assessed. I will lay out these themes, and even tell you what I’ve done in response, but it’s up to you to mesh them with your particular situation.

And now for the good news. For anybody who is interested, I (finally!) have a short list of investment advisors who have seen the Crash Course, largely agree with its premises, and are willing to work with people to manage their holdings accordingly. Imagine what it would be like to talk with an advisor who sees the same financial risks that you do, takes them seriously, and has already formulated a response to each of them.

I have no financial relationship with any of these advisors, will never take anything in return from them, and will not recommend one over another. You may request that I provide you with their names and phone numbers (never the other way around), but it will be up to you to make contact and assess the fit. However, I am thrilled to finally have a pool of financial advisors to whom I can refer people. What I get out of this is the satisfaction of knowing that I could help fulfill a very important need. Simply email me and I will forward their contact information to you.

My Themes

So, what does the future hold? Here I will admit that I cannot find any clear historical precedents against which to contrast our current state of affairs. The combination of a national lack of savings, record levels of debt, a failure to invest (in capital and infrastructure), an aging population, Peak Oil, and insolvent entitlement and pension programs has never before been encountered by humans. Worse, Alan Greenspan suckered, er, influenced the rest of the world to go along with the largest credit bubble in all of history, and so there are fewer ways to diversify internationally than might otherwise have been true.

Because the past can only provide clues, I’ve been analyzing and investing according to ‘themes’ that rely on equal parts of data, logic, and my faith that people will tend to behave as they have in the past.  And let me repeat that you can count on me to change my view when the data supports a shift.  Within the context of these themes, there will always be individual winners and losers. Threats and opportunities always exist side by side.  Our task is to choose wisely. My major themes for the next few years are:

Theme #1: Recession, or possibly a depression, due to the bursting of the largest credit bubble in history

My concern level is “high” and stretches from right now until late 2009 to 2010. Nobody alive has ever lived through the bursting of a global credit bubble, and history offers only clues and hints as to how this all might unfold. Your guesses are as good (or as bad) as mine. The recession/depression is going to be fueled by:

  • The return of household savings. If households returned to saving even just 5% compared to the current 0%, then the impact to the economy would be the loss of 3.5% of GDP. If this happened, all by itself it would contribute to one of the worst economic periods in modern times.
  • Job losses. As the credit bubble bursts, credit will become harder and harder to obtain, businesses will fold, and job losses will mount. Some regions, like Detroit (cars) and Orlando (tourism) will be especially hard hit. Certain job sectors will be particularly vulnerable, especially those related to discretionary or lavish spending.

STRATEGY:  Remain alert. Cut spending, reduce debt, and build savings. Be prepared to revisit portfolio assumptions and tactics on a more frequent (Quarterly? Monthly? Weekly?) basis.

WINNERS:  If a deflationary recession/depression, cash and high-grade bonds. If an inflationary recession/depression, energy, commodities, and consumer staples. In either case, only a very select group of stocks will perform well. The rest will suffer big losses.

LOSERS:  Stock index funds, low yielding stocks, and non-investment grade bonds. Everybody who failed to take this prospect seriously and plan properly.

Theme #2: Inflation is here and rising

(This is a near-term concern). I will remain concerned about inflation until I see my fiscal and monetary authorities begin to behave rationally.  At present, the only concern I see on their parts is to ‘reflate’ the banking system at any and all costs.  One of those costs is inflation.  My full list of inflation concerns is as follows:

  • Dollar weakness. Even if the rest of the world experiences no inflation, if our dollar falls, we will still see rising prices for oil and all of the other essential products we import.
  • Supply and demand mismatch (for oil and grains especially).  If there is a long-term imbalance created by the fact that the earth can no longer provide a surplus of the things that humans want/need, then prices for the desired items will consume an ever-greater share of our respective budgets.
  • Structural inflation (e.g., higher oil prices make steel more expensive, leading to higher drilling costs, leading to higher oil prices….etc).  Once a structural inflation spiral gets started, it is a very difficult thing to stop. Such is currently the case for food and fuel.
  • Monetary inflation (growth in MZM & M3 are at historical highs).  And it’s not just the US.  Inflation is spiking all over the world in lockstep with exploding money supply figures. One of the hallmarks of the Great Depression was a nasty series of competitive devaluations by various countries, as they attempted to preserve their manufacturing jobs by making their products appear cheaper than others.  This is a very ordinary and predictable response, as it represents both the appearance of ‘doing something’ and the path of least resistance.  That makes it practically irresistible to even an above-average politician.
  • Likely actions by fiscal and monetary authorities.  Spending and easing, respectively, are heavily weighted towards inflation.

STRATEGY:   Buy your essential items early and often.  Stock up your pantry and find ways to store more items in and around your house.  Don’t hold cash or cash equivalents, and avoid long-dated bonds, especially those offering negative real returns (i.e., a yield below the rate of inflation).  Be prepared to move out of paper assets altogether and into tangible wealth. Productive land might be one avenue to explore.

WINNERS:  Commodities, and stocks with a positive inflation sensitivity and/or strong pricing power (like energy and consumer staples companies).

LOSERS:  Bonds paying a negative real rate; companies with low pricing power.  Remember, it’s your real return that matters, not your nominal return.  The Zimbabwe stock market is up tens of thousands of percent this year.  Unfortunately, their inflation is up hundreds of thousands of percent.  Stocks that don’t keep pace with inflation are another way to lose.

Theme #3: Potential banking system insolvency

(This is also a near-term concern).  Yes, the Fed was able to patch things up for a while.  No, the danger has not passed.  Financial stocks are still getting killed in the market, and I am keeping an especially close eye on Lehman Brothers (LEH), as their stock took a particular beating at the end of last week (May 21 – 23, 2008).  It won’t take too many more major financial companies going bust due to derivative-based wipeouts before the whole system goes into shock.  Beyond that, here’s the basic data that gives me the most concern:

  • Financial companies are holding $5 trillion (with a “t”) in level 3 assets, which utterly dwarfs the Federal Reserve balance sheet (what remains of it) and possibly even dwarfs the borrowing ability of the US government.  Level 3 assets are an accounting gimmick that allow executives to place whatever value they deem appropriate on ‘hard to value’ items, like bundles of subprime mortgages that really aren’t worth all that much.  Needless to say, there’s some incentive to, shall we say, be generous with the estimates of value.
  • Certain derivative products, specifically credit default swaps and collateralized debt obligations, total in the tens of trillions of dollars, and their markets are in disarray.  Counterparty risk is unknown and possibly unknowable.  The risk here is unacceptable.  If these markets spin out of control into a series of cascading cross-defaults, my main question will be, “What will happen to our financial system?” which leads to, “What will happen to financial investments?”
  • Total bank capital stands at $1.1 trillion, but the potential total losses across all residential and commercial real estate are much higher than that.  While a massive public bailout is probably in the cards, that will take time, and even I am shocked at how fast the housing market is deteriorating across several extremely large markets (notably all of CA, FL, Las Vegas, Phoenix, and Denver).  Again, the pace of the collapse is what defines the risk here, while the magnitude is without historical precedent.

STRATEGY:  Don’t have all your eggs in one basket – use several highly-rated banks. Remain liquid and alert; be prepared to access and move your funds away from troubled institutions as a tactic to avoid becoming enmeshed in a receivership process.

WINNERS:  People with their dollars held by strong banks, and those who don’t have all their wealth tied up in the banking system and are holding cash, gold, silver, and other sources of liquid, non-dollar-denominated wealth completely outside of the financial system. Having strong, dependable community networks to help manage the transition period.

LOSERS:  Everybody who is late to recognize that bank failures have begun and/or has their money tied up in an insolvent bank.  If a generalized bank system failure does occur, we all lose, to some degree.

Theme #4: Peak Oil

This theme offers both tremendous risk and enormous opportunity.  This used to be a medium-term concern of mine (2-10 years out), but has recently become a near-term concern.  I happen to believe it is here right now, and the only thing that could mask it for a bit longer would be a global depression.  A recession probably wouldn’t do it, though, because through all of history the largest ever yr/yr drop in global oil demand was a mere 0.4%, and that was after a particularly nasty recession back in the 1970’s…meaning it will take more than a garden-variety recession to produce the required 2%-3% drop in demand to mask declining oil production.

STRATEGY:  Begin to whittle down your dependence on energy as a means of reducing the energy portion of your daily budget.

WINNERS:  Energy investments of all sorts, ranging from traditional to alternative and from producers to servicers.  Those with the lowest proportion of spending on energy and access to alternative modes of heating, cooling, and transportation.  My prediction here is that once Peak Oil is generally recognized, solar systems will suddenly develop multi-year waiting periods.

LOSERS:  An enormously wide range of companies that are built around cheap energy. Certain SUV-dependent auto manufacturers come to mind. 

Theme #5: Boomer retirement

The retirement of the baby boomers will result in drawdowns that will exceed Gen-X buy-ups.  To whom are the boomers going to sell all of their assets?  Or, what happens when Cal-Pers (et al.) becomes a net seller rather than a net buyer?  (This is a long-term concern…as in, 10 years out).  Unfortunately, this retirement boom will create demands upon financial investments, concurrent with vast national needs to re-tool our energy, sewage, water, electrical, and transportation systems.  Here I am expecting a toxic combination of both falling asset prices (in real terms) and rising tax bills, as our politicians attempt to simultaneously fix everything they’ve been ignoring for the past two decades.

STRATEGY: Begin reducing total exposure to everything in which boomers are overinvested. This includes stocks, bonds, and McMansions. Avoid living in places or houses that require too much reliance on energy or have especially weak or overextended governments. Vallejo, CA (now bankrupt) is an example…tax bills there are remaining constant, even as services crumble and disappear.

WINNERS: Sectors that service retiring boomers.

LOSERS: High p/e ‘growth’ stocks, low dividend stocks, and other investments whose gains largely depend on persistent and sustained buying pressure. Second homes located in less than prime areas, especially those far from urban areas and therefore requiring large amounts of gasoline to access. 

The Path

While it is possible, I do not anticipate a one-way slide to the bottom, wherever and whenever that may be. I lean towards the ‘stair-step’ model, where a series of sequential shocks and relatively placid periods mark the path to the future.  The three possible scenarios around which I  form my thinking (and actions) are:

  1. No change.  The future looks just like today, only bigger, and no major upheavals, shocks, or recessions happen.  The Fed and Congress are successful in fighting off the deleterious effects of the bursting of the housing bubble, and everybody carries on without any major changes or adjustments.  This is not a very likely outcome.  Probability:  1%.
  2. A series of short, sharp shocks.  Moments of relative calm and seeming recovery are punctuated by rapid and unsettling market plunges and marked changes in social perspective.  Think of the food scarcity and riots, and you know what this looks like.  One day there is low awareness about food scarcity, and the next day shortages and prices spikes are making the news.  Soon enough, relative calm returns, prices fall, and order is restored, but prices somehow do not recover to their previous levels, leaving people primed and alert for the next leg of the process.  I see this as the most likely path forward.  Probability:  80%.
  3. A sudden major collapse.  Under this scenario, some sort of a tipping point causes a light-speed reaction in the global economic system that requires shutting down cross-border capital flows.  Banks would no longer be able to clear transfers and accounts, which would wreak all sorts of havoc upon our just-in-time society.  Food and fuel distribution would be the most immediate concerns.  There's enough of a chance of this scenario occurring, and the impacts are potentially so severe, that you should take actions to minimize the impacts to yourself and loved ones.  Probability:  ~20%.

Which of these three scenarios will actually unfold is, of course, unknown.  This is why I maintain an alert stance, and why I am constantly sifting the news and posting my thoughts in my blog.  Should a serious event warrant, I will send enrolled members an alert outlining the data and actions you should consider.  I have not yet sent out a single alert because no single event has crossed my threshold. If (or when) you receive one from me, it will be about something I take very seriously.

Of course, nobody can make all the changes that are required at once, or even over the next year.  Rather, there is a list of things that each of us, depending on our circumstances, should consider doing over the next few years.  I break them down into three tiers of actions.  Tier I actions are ones that you should do immediately.  Tier II are ones that you would do only after finishing the Tier I actions.  Tier III are longer-term actions that come after the first two are done, or can be worked in parallel, if time, money, and energy permit.

Let me close with this:  My sincerest hope is that you begin the process of adapting your lifestyle, right now, to the new future that awaits.  If you are waiting for the signs to become any clearer than this, you are waiting too long.

What are you waiting for?