Here is What is Wrong with our Economy

Rep. John Culberson came on Fast Money today and showed us why we are in an economic disaster. Watch and listen to this guy. He doesn't understand what he is saying and shows he is incapable of even listening to the experts on the show. We have no chance if this is who we have running our country.

http://www.cnbc.com/id/15840232?video=872233203&play=1

The Deal is Done

Monday morning, Sept 29, and the Deal is Done. We are going to get our $700B "bailout" of the American, if not world, financial system. But is this too little, too late to save the economy. This is what we have yet to find out.

There is no doubt in my mind, that if a deal hadn't been done by last night, we would have had an immediate devastation of the world stock markets. The backstop of the financial system will just allow the air to be let out of the balloon more gradually and less catastrophically. But the market is headed lower, maybe much lower, as the full effect of financial deleveraging and consumer angst is felt.

Another theme is developing: we will have many fewer banks in the next year, than we have had in the recent past. There is a deliberate effort by the Treasury and FDIC to consolidate banking assets to a few strong, or less weak, banks so that the crisis can be better managed. The "chosen ones" are apparently: USBank, Wells Fargo, JP Morgan, CITI and Bank of America. Goldman Sachs can also be added to the list as the only major investment banker left standing. I am somewhat vindicated in that I have long said (since last August) that I thought BAC and C would be considered "too big to fail" and would be protected by the Feds. I have to admit, though, that I have lost some money on this bet as even when I am right about their solvency, I have been wrong about the stock price.

All other banks are at risk. We know this because of the pattern that is developing. The FDIC just can't afford any more IndyMacs, which went bust in an uncontrolled way, leaving FDIC on the hook for $14B (or so) of insured deposits. FDIC only has around $45B of assets, so it can't afford to have all the banks go bust without some pre-emptive efforts. In the past week, it has overseen the dissolution of WaMu (assets only assumed by JP Morgan) and now, today, Wachovia (assets and liabilities assumed by Citi). Both banks were heavily exposed to the residential mortgage market.

On the investment banking side, Bear Stearns and Lehman have already been taken out with the help of Federal agencies. Morgan Stanley took itself out by selling itself off to Mitsubishi Bank.

What is next? The wave of banking failures is spreading around the world. Fortis and another less well know British bank were also dissolved over the weekend with assets transferred by European banking authorities. There is plenty of toxic exposure in China and other major Asian economies. The total effect of all this banking damage will be very negative for the world economy for many quarters to come. The markets must take a hit to reflect this reality.

Advice: it is too late to run for the exits, IMO. But, a little short side protection on existing positions is called for. I will buy SDS, the inverse and doubled short on the S&P500 index, in the next couple days. There may be an additional benefit of this action as I think when the Short Sale prohibition on many Financials comes off next week, that short positions may pop as a result of pent up demand into such a weak market.

A Look Back to Help Find the Way Forward

I have spent some time during recent days in remorse. "How did I not see all of this coming and get into cash?", I ask myself. But I am being unfair to myself, because I did see all of this coming, but could not bring myself to believe that it would actually happen or pull the trigger to sell out and get 100% into cash.

I looked to see what I was saying in January 2004, and low and behold, I thought all of this was a possibility, though in early 2004 I did not yet fully appreciate how much the real estate bubble would affect the future. By the end of 2005, I understood that was the true danger. But if our financial system was not so inherently weak prior to that bubble, it would not have brought the system down. Looking back on this advice, it sounds as relevant today, as it did almost five years ago.

Here is what I said in my annual letter, January 2004:

REAL ASSETS

This category was not mentioned in previous reports, but is an area of great interest. The base materials (natural resources) markets have outperformed many equities and all bonds in 2003. Gold, like oil and other natural resources, has reversed a 25 year downtrend. This is very significant. It was only two years ago that many central banks decided to liquidate gold reserves, pressuring prices with the anticipation of increased supplies. Now, gold has gone from $250, to well over $400/oz. in 18 months. What does this mean? Is it a portent of things to come? Gold has been the “Anti-dollar” since 1971, when the USA (and by extension, any central bank with currency linked to the dollar) went off the gold standard and onto a paper based standard (the USD). Gold prices went from $35 in 1971 and eventually to $850 in 1980, during the height of inflation. Then as now, gold strengthens when the dollar (and other paper currency) weakens, as gold is the alternate form of world financial exchange.

Gold and other commodity prices are considered by many economists to be predictors of future inflation. Inflation is created by excess debt leading to declining currency valuation. If government and consumer debt and money supply is again in excess, then inflation and declining purchase power of the USD is on the way (Boy, sure got this one right!!). The deficit spending of the past 3 years rivals the late 60s, during Johnson’s “Guns and Butter” program, as a percent of GNP. But the story is really worse this time. Unlike the 60s, when the USA was still the world’s creditor nation coming out of World War 2, with positive balance of trade, now, the USA has severely negative balance of trade. Continued build up of national and personal debt is doubly troublesome. Unlike the 1970s, now have nothing to offset our debt, except more paper.

Potential “Doomsday” scenarios come out of this ominous situation. At best, as hoped for by me, the large national debt will result in a price inflation, a stagnant economy, flat stock market, and declining bond prices in concert with increasing interest rates. See the 1970s for an example. I believe this is what the Fed is now trying to engineer: dollar devaluation and price inflation. The dollar devaluation makes exports more attractive and imports less attractive, helping our trade balance. Price inflation reduces the impact of long-term debt for both government and consumer at the expense of the creditors: mortgage holders in the case of consumer debt and foreigners in the case of government Treasury bonds.

In the worst case scenario, the dollar’s value will disintegrate taking the USA and many other dollar-denominated economies with, leading to a global financial crisis and depression that could last for 10 or more years. From this depression will emerge a new global financial power, China, which would de-link its currency from the USD, and make the China Yuan as the new global currency standard. As the new creditor power, replacing the USA role from the 50s and 60s, China will dictate world policy.

The end result of these concerns is the need to own either commodities in the form of mining, energy or other natural resource companies, and rare metals: gold, silver, platinum, etc, in certificate or in fact.

Energy stocks are another commodity that would do well in an international financial crisis. Asia (China) continues to increase consumption of energy products, like oil and coal. Supply is limited and requires years of effort to expand. Commodities will also do well during a period of global inflation, or deflation, as during the 30s. Raw material values may not increase in absolute terms during periods of deflation, but they do not decrease much, either. So, if currencies increase in value, as they do during a period of deflation, then commodities appreciate in relative terms.

Hold on for a Ride Up

Looking at the market before the open this morning, of course I wish I had a lot more Financial stocks than I do. The UYG and XLF will explode higher this morning. I had been short financials by selling the puts of SKF, a short fund. But I closed out my position yesterday because I hoped the actions that took place would happen. I closed it with SKF running very high on fear at $140. Today, SKF may open below $90. Boy, that was close. That would have been expenisve if I had not gotten out yesterday.

Meanwhile, the very large Goldman Sachs position I hold is looking a lot better. It was trading as low as $85 midday yesterday. I own it at $172 (actually, the options, but the loss would be the same). Today, it looks like it will open above $140 and could go to $160 during the day, getting me back close to even.

So, though I won't have a chance to get back into my long UYG position (the opposite of SKF), because it is soaring in the pre-market, I am happy for what I have. Hopefully you will also have a very nice market day with the action in front of us.

Be glad you are not a professional short seller with big short positions in Financials (hedge funds, Al Queda?) They will be wiped out if naked (not covered by equal long positions)

Short selling in crosshairs of world market regulators (recapped)

It didn't take long for the government and large financial institutions to respond as I thought they might, to the biggest financial crisis of our lifetime (at least for those of us under 75). There were a lot of actions taken today from the list I posted yesterday, which itself was culled from a number of sources and common sense. I thought this article on short selling was important enough to recap given the current market situation. It sheds a lot of light on the problems of weakened companies that are targeted and attacked by groups of short sellers, punished in spite of strong financials.

Late breaking news, today, has the Congress, Treasury and Fed working together on a plan to implement a modern day RTC, another of the actions I thought were necessary, and likely in the works. I will post more on this once the details are known.


SAN FRANCISCO (MarketWatch) -- Gathering anger over short selling of vulnerable financial stocks exploded into the open Thursday as top market regulators and industry giants took steps to limit the practice and begin investigation into possible abuses. Britain's stock market regulator on Thursday banned short selling in financial companies and said it might extend the ban to other sectors.

The move followed the Securities and Exchange Commission's curbs on the practice that went into effect Thursday morning. Read full story.In other steps aimed squarely at the bearish practice, the country's largest pension fund, the California Public Employees' Retirement System, said it was taking steps to limit the practice on three financial stocks and the New York attorney general called for a wide-ranging investigation of the short selling of some prominent financial companies, including Goldman Sachs (GS) and Morgan Stanley (MS).

The concerted reaction followed two days of sharp declines in global stock markets, triggered by mounting fears that the credit crunch would spin out of control and deepen the financial crisis. As stock declines have deepened, the role of short sellers has come under fire. "The moves should help restrain the abusive short-selling practices lately rampant in the stock market," said analyst Thomas Brown of Bankstocks.com. "Short sellers can no longer deceive their brokers about their intention or ability to deliver shares. "The SEC on Thursday put a ban on so-called "naked" short selling, while Calpers said it won't allow lending of shares of Goldman Sachs, Morgan Stanley, and Wachovia (WB).

The California State Teachers' Retirement System made a similar move and it called on 60 other funds to follow suit. "We don't want to inadvertently contribute to the instability of these companies or the market," Clark McKinley, a Calpers spokesman, told The Wall Street Journal. Calpers has one of the largest securities lending programs in the country, at $38 billion.

Much of the concern in the U.S. focuses on naked short selling. Naked shorting can allow market manipulators to force prices down much lower than would be possible in a legitimate short sale. In an abusive naked short sale, according to the SEC, the seller doesn't borrow a stock, as would happen in an ordinary short sale. The seller also fails to deliver the stock to the buyer.

Bill Stone, chief investment strategist at PNC Wealth Management, supported the SEC ban on naked shorting. "They don't let me go out and buy stocks without paying for them, so they shouldn't be able to do that selling them. Fair is fair," said Stone. Brown and others want the SEC to take its authority even further. They argue the SEC should re-impose the so-called "uptick rule" that prevented traders from selling short unless there was a higher bid price in the stock. "They shouldn't outlaw shorting but putting more controls on it is necessary," said John Langston, analyst at Hodges Capital Management. The SEC repealed that the uptick rule in July 2007.

They also want the SEC to dig into the option and credit default swaps strategies used by short sellers. Short selling itself isn't illegal. Some investors contend short sellers are a reality check for the market, in some cases, shining light on possible accounting shenanigans at corporations. "Short selling provides market liquidity and keeps management honest," said money-manager Russell Glass at RDG Capital.

In a regular short sale, the seller borrows a stock and sells it, with the understanding that the loan has to be repaid by buying the stock. New York Attorney General Andrew Cuomo plans to investigate rumor mongering and illegal conduct. "The markets need to be stabilized," Cuomo said. "One way is to root out short sellers who spread false information."

In further moves that should rattle short sellers, the SEC is expanding its push into the trading records of hedge funds, which are less-regulated than mutual funds. The agency said it is sending subpoenas to at least 50 big hedge funds, seeking trading records and communications about trading in specific companies.

The SEC is considering a rule that would force hedge fund managers with more than $100 million invested in stocks to report their daily short positions. This is drawing the ire of famous short-seller Jim Chanos, who helped expose the accounting gimmicks at Enron. "For investment managers such a requirement is akin to the government suddenly requiring Coca-Cola to disclose their secret formula for free to all their competitors," Chanos said.

SEC Chairman Christopher Cox has been under scrutiny for his handling of the financial crisis sending shockwaves through the market. On Thursday, Republican Presidential candidate John McCain said SEC Chairman Christopher Cox should be fired. McCain said Cox "serves at the appointment of the president and, in my view, has betrayed the public's trust. If I were President today, I would fire him."

Is this Market Wreck an Attack by Al Queda?

This is just my speculation, but I wonder if this chaos is being initiated by Islamic extremists. There is enough money from oil sales in the hands of Iran or other anti-American oil nations to precipitate this crash.

Think about it: the entire goal of hitting the WTC on 9/11 was to collapse the Western world's financial system. Knocking down buildings didn't work, so I am sure Al Queda and other extremists went to work on a new plan to do the same.

There was evidence of short selling by Islamists against the American market on the days leading up to 9/11. They know how to use that tool. To make the case more compelling was the attack on the US Embassy in Yemen yesterday. Al Queda likes to conduct attacks on multiple fronts to undermine confidence in the Western economic system.

Today, I just heard that there is a short selling campaign against State Street Bank, which is a major clearing house for Wall Street, based in Boston.
If this is the case, it can be stopped by a concerted effort of the Central Banks and regulators. The terrorists know that we are very reluctant in a free economy to employ controls. They are counting on us allowing our free markets to solve the problem. But they are manipulating short selling against major banks, one at a time, first the weak, and then the strong. We should be suspending all short sales, period, against money center banks and major financial institutions. That will freeze the market, but at least it will get rid of the speculation.

Then, there should be an intense effort to trace every significant short sale against banks on record to trace back the transaction to its source. If those sources are foreign, the accounts that transacted the business should be frozen. If we find it is terrorists, we should do everything possible to eliminate those people. If the transactions are domestic, the FBI should be sent to question the transactors to find out their intentions. If the intentions are found to be manipulative rather than speculation, the transactors should be prosecuted on federal racketeering charges.

This is what I hope is happening today behind the scenes.

Back to Reality

I was at my annual boys golf tournament the past 3 days. We call it "Party At The Pines" at a resort in northern Minnesota. This is the 14th year we have gone north with 16 or 20 guys and played non-stop golf for 3 days. It is a great way to get away from it all. You can't think stocks or trouble at work, when you are focused on hitting that little white ball about 400 times over those 3 days.

Now that I have missed all the stock market fun this week, I have a little chance to consider what has happened and where we go from here. One thing is for sure, the market has left its moorings. It has entered the irrational phase when anything can happen. The one thing I know from all the reading I have done, is that at times like this, it is best to just stand still and do nothing.

I am not a disinterested bystander, by the way. I thought I was fairly well protected from this eruption (which I suggested was a possibility as early as 2005, based on the housing bubble bursting), but I have been more or less fully invested since I believe it is impossible to pick a bottom. And honestly, this market situation is at the extreme end of what I thought was possible. There has always been a doomsday scenario suggested by some analysts, that would be triggered by this type of loss of confidence in the financial system. But I never really thought it would go as far as it has.

You know that I have been buying high dividend stocks and funds and reinvesting the large dividends in the same stocks to average down my cost if the price goes lower. I am very diverse in my holdings so that the risk is spread. But still I am getting hurt badly in this market because even the babies are now getting thrown out. Even cash is no longer safe, as some big money market funds are now "breaking the buck" and unable to return $1 of principal.

But this has all the look of capitulation. VIX peaked at near 40 today, which is its highest level since the 2000-03. Generally any spike over 30 signals fear in the market and a buying opportunity, though note how long high market volatility went on in the Tech Bust:



What needs to happen to change the direction of the market? There are a few basic actions to look for. The basic need is to break the vicious feedback loop in which the market is now engaged. The actions need to come from the government as they are regulatory in nature and in most instances, the government initiated the rules or regulations that have precipitated this crisis.

1. Suspend the "Mark-to-Market" rule: It came out of Sarbanes-Oxley legislation and was implented by the accounting board, FASB. Mark to Market is the primary culprit for circular market action, since the action of marking down assets weakens the capital structure of a bank and causes it to decline in value. As assets decline in value based on the weakness in the institutions backing the financial assets, the market price declines requiring another round of markdowns. This has gone on until some banks have broken their statutory capital requirement level and become insolvent in the process. This must stop to repair the market, so look for a loosening here and the option of "Marking to Model"

2. Clamp down on short selling: Although I have been doing some short selling to provide protection, and believe in it from a free market perspective, but it can really exacerbate the snowball effect of a downward spiraling market. Because financial institutions use the equity on their balance sheet as capital against their book of bank financing, they are exposed to damage by short selling more than other businesses which don't leverage their equity to do business. The "uptick" rule should be reinstated and I see that there are further restrictions on Market Makers put into effect by the SEC today so that shorts have to have claim to the physical stock in order to short it (that is, no naked shorts).

3. Continue infusing liquidity into the market: The Feds need to continue flooding the market with capital so that the financial engine does not seize up. Money is like a lubricant to financial institutions and business in general. If it ever stops flowing, then business freezes. The Feds have many ways to put money back into the financial markets.

4. Back more institutions with capital as needed: AIG and Fannie/Freddie were both bailed out with large US government loans. But these are not necessarily bailouts that will cost the taxpayer over the long term. This is the modern equivalent of the Resolution Trust Corp (RTC). The Feds are giving capital loans at a high percent interest ($85B at 12% in the case of AIG). This paper can later be sold on the open market at a big profit once the market panic passes and the company's balance sheet is repaired, just as any bond can be sold.

Goldman Sachs (GS) and Morgan Stanley now look like the two that need the most help, though they were thought to be top of the heap a few weeks ago. GS just beat expectations with its earnings report on Tuesday. Apparently their CDSs (credit default swaps which are like loan insurance) sold to other banks to hedge risk in loan portfolios, are jumping in cost. The Fed can help them here by buying the CDSs onto the Fed's balance sheet and later reselling to the market at a profit, to the taxpayer's benefit.

Even though they have so far avoided attack by the short sellers, USB and Wells Fargo are not out of the woods. In this market, the shorts can ruin any bank.

5. Coordinate Central Banks globally to take a similar approach with their own national banking companies. There is so much linkage in the financial system this is not an exclusively American problem, though it may have started here. The Central Bankers should be talking to each other (I am sure they are) to coordinate actions for the maximum positive effect. The Euro can be used to prop up European banks and the Chinese and Japanese central banks are flush and should do the same for their home banks.

6. The Central Bank should not worry about inflation right now. Everything happening right now (not 6 months ago) is Deflationary, not Inflationary. Financial contraction, in terms of deleveraging of financial institutions and dropping real estate prices, is inherently deflationary. The Fed can pump as much money into the banking system as it wants without adverse effects today. Once there is recovery, the Fed then would need to take money back out of the financial system by calling its loans, or selling them off.

7. Shut down the ratings agencies: Moody's, S&P, and other ratings agencies are doing more harm than good. They were big contributors in blowing up the real estate bubble by rating sub-prime securities as AAA, thereby attracting cheap money from abroad into our housing market. And now they are over-reacting the other direction and are dropping ratings on good companies because their stock price is declining and it is decreasing capital ratio coverage (see points 3 and 4). The function of agencies is to provide constructive guidance to investors based on their research departments. But the agencies have not lived up to that promise for more than a decade. They missed the Tech Bust as well.


8. Finally, remember that when the market does get over its panic, the rebound will be substantial. It may not bounce back to 14,000 Dow anytime soon, but it could bounce back to 12,500. The Financials that are left standing can double or triple over a 6-12 month period as they regain the irrational / non-fundamental losses. So, financial index UYG, as one suggestion, will do very well at some point.

I hope Bernanke and Paulsen work quickly on the above, plus anything else they can think of that I have not. They need to do so to keep us from crashing into a Depression. I think we have the right people at the top to avoid a real crash with Bernanke an expert on deflations and Paulsen an expert on investment banking finance. Watch for any or all the above and when you see action taken, it should solve the problem.

Until I see what comes from the Fed, I am sitting on my hands trying to avoid doing any more damage to my accounts by selling low, but also not sure if we are at the bottom, so not willing to buy, other than through the methodical reinvestment of dividends that I have set up.

Watch VIX Today

I think VIX will cross 30 today and on a bit of panic will set a new market low. This low will be in the same range as the market low on July 15 at around SP500 (1180-1200) and will set up a reasonable period of market recovery. This is a continuation of the bottoming process that started back in March, with the Bear Stearns takeover by JPM. Because of the severity of the financial crisis, and its continuing ripple effects around the world, this bottoming can take a long time.

If we remember back to the 2000-2003 market decline at the end of the Tech boom, there was ripple after ripple that unwound separate excesses, from the Teleom sector, to the Internet sector, to the Large Cap growth sector, to Enron and Tyco. One after the other of these segments came apart until all the previous excess was exhausted.

This is what we are seeing again. It started with the riskiest of the mortgage companies (those specializing in sub-prime) and has continued through home builders, banks, insurance companies and then spread overseas causing export declines in Asian and European economies, leading them to recession and market declines (check out China, FXI, which has declined by 70% from its peak last year). Now, the energy, metals and commodities sectors, which were overheated, are getting taken down because of the reversal of the Yen and Euro carry trades against the US dollar (with the strengthening dollar). The Hedgies are dumping their commodity positions and some of those hedge funds will crash.

But, we are getting closer to the end of the chaos. It is hard to think about any other sectors that were run way up that have not already come down. So, the bottom will likely hold (1200) and we will rebound once again. Eventually, I am saying after the election uncertainty is eased in November), the market will rebound and continue working its way higher. The Fed is now in a position to drop interest rates (with spreads stabilizing with the GSE rescue) and the Euro in trouble with recession in Europe. That should signal the turnaround. Expect the Fed to drop by at least 0.25% by year end.

Is Fannie / Freddie Takeover the Last Shoe?

On Friday, at the market close, and less than 6 hours after the Financial stocks tanked on the bad employment data from August, Treasury Chairman Hank Paulsen let leak that the Feds would be taking over Fannie and Freddie on Sunday.

My reaction was: DARN! or something close to that. I had been waiting for this to happen and knew it would create a trading opportunity on the financial indexes that I have been trading. But unlike the Bear Stearns bailout in March, where the rumor was on the net a couple days before the event, this one was very well guarded. Some people must have known as after the financials tanked Friday, they worked their way higher all day from about 10am on. Then, at the close, when the press release about the meeting on Sunday was announced, the UYG popped by 10% and I knew my goose was cooked, at least for a few days.

I would have loved to have been on the right side of this trade, but the financials had not dropped enough for me to cover my short position (SKF) and take a new long position (UYG). I was close, but about 5% away from pulling the trigger. And, as I have a day job, I did not have a chance to watch the financials move higher all day long into the close and the Fed press release. Had I been a full time trader, I would have looked into that counter trend movement (against the backdrop of the bad employment data in the morning) and might have found enough information to get me to switch direction.

But all is not lost! This is NOT the proverbial "other shoe dropping" signaling a change in direction for the financials, the stock market and the economy. In fact, I was stunned that the market reaction was so dramatic this morning. The fact that the Fed would have to intervene in Fannie and Freddie has been known for many weeks, really since the July 15 bottom when Paulson asked for and received authority to make this move. Most market followers expected this move sooner than this, so there should have been no "surprise factor" here.

In fact, the deal went down just about as expected. Fannie and Freddie common share is basically wiped out. This was necessary to eliminate concern of "moral hazard" where investors get taken off the hook by taxpayers. But Paulsen did not stop at common shares, he also took out the preferred shareholders. He did not actually bankrupt the company, but by giving warrants to the US government / taxpayers that give 80% of the equity to the government, with no dividends until Fannie and Freddie get profitable, for practical purposes, the stock is worth very near zero.

Worse for the financial market, many banks hold Fannie and Freddie preferreds as part of their capital structure. This was an arrangement with the bank regulators where FNM and FRE stock was considered as safe as cash, so avaiable as collateral for capital. But, it was not so safe and has now been written down to nothing. In fact, the preferred was not convertible to common, so its only value is for the dividend, which has now been eliminated for the forseeable future.

This is a material surprise. And it has a materially negative impact on many banks. That information will get back into the stock price in the next few days. I still think the Financials will continue to go down, with bounces along the way. I would use this opportunity to get short on Financials, which I am doing by selling more puts on SKF.

What $300 a Barrel Oil Means for us

Even though energy prices are down for the time being, and perhaps going lower, I have maintained that they will eventually go much higher. I say this because the marginal cost of extracting oil keeps increasing, and cost becomes the floor for price. So, as long as energy demand continues to increase through growth in Asia and other developing markets, the price of oil must continue to increase to encourage additional supplies.

The only thing that will stop the increase in petro energy is the growth of cheaper alternative energy sources, especially that can be used in transportation. With the advent of fuel cell or other electric powered vehicles, substitution of energy sources will eventually reduce demand. But the alteratives are many years away from practical and widespread use. So, for the next 10-20 years, petro energy will continue to be our most important source of energy. Here is an article from this week's Barrons. Read on:


What $300-a-Barrel Oil Will Mean for You
Charles Maxwell, Senior Energy Analyst, Weeden & Co.
By LAWRENCE C. STRAUSS

AN INTERVIEW WITH CHARLES MAXWELL: He correctly predicted the recent price spike -- and he sees an eventual move to around $300 a barrel.

CHARLES MAXWELL, WHO BEGAN HIS CAREER in the energy business in 1957 working for Mobil Oil, is no stranger to Barron's readers. In an article he penned nearly four years ago, Maxwell predicted that oil prices would move sharply higher by 2010, and then higher still. Maxwell, 76, got the timing and trend right, though his top price of $60 a barrel by 2010 proved far too low. "Oil is unique in that when it begins to disappear, there really aren't any good substitutes, which there are for so many other commodities," Maxwell says. "It's that lack of substitutes that forces the pricing mechanism to balance supply and demand." "Only price will slow the use of oil; the rising price tells us we don't have enough. So, we are now beginning a bitter, bitter competition for fuels that will see the price rise to ridiculous levels."

Maxwell has worked since 1999 as senior energy analyst at Weeden & Co., an institutional brokerage firm in Greenwich, Conn., having started as an energy securities analyst in 1968. Oil prices came down last week, trading at around $108 a barrel, but he predicts an eventual sharp move upward -- to around $300 a barrel -- owing to a lack of available supply. Barron's caught up with Maxwell recently for his latest assessment.

Barron's: What's your prediction for the price of oil over the long term?

Maxwell: I see it heading on an upward slope. Around that long-term line, there will be a lot of ups and downs. I thought the peak on this cycle might be somewhere around $100 a barrel, but it turned out to be a lot higher, more than $145 in early July. But like a child's blocks piled one upon another, you finally reach a point where at $145 they were beginning to sway. It had gone far beyond the fundamentals. So the questions are: 'What are the fundamentals and what should the price be?' The answers depend on where you are sitting and what you own.

Barron's: What's your view?

Maxwell: I would put the price of oil today at somewhere between $75 and $115. That implies quite a fast rise, given that we were averaging about $32 a barrel for West Texas Intermediate in 2003. However, it is perception that really is changing, not the true value of oil throughout the system. The perception change involves whether we are going to move into an era where oil supplies will be generous and easy to find and, therefore, relatively cheap -- or whether those supplies are going to be closed off for both political and geological reasons.

Barrons: Which scenario do you see?

Maxwell: We are not going to have enough oil, and we are going to have to start a huge switch in which we make do with a number of other fuels that are not so easy to convert to our immediate energy needs, mainly for transportation.
It sounds like this comes down to not having enough supply to meet demand.
We will have enough coal supply to meet demand, but the real question there is, 'Can we afford to substitute a great deal of coal given the emission problems?' The carbon footprint of coal is very high. We will be forced to use some more coal, but until we develop clean-burning coal technologies and underground gas fields to store carbon dioxide, we are going to be under very tight restrictions on its incremental use. That doesn't seem to be such a bad thing until you look at, say, nuclear power, which would be another big alternative, and you realize that it's being used effectively by the French, the Japanese and the Germans. But for various reasons, nuclear power has become a political football in the United States. If we committed to nuclear power today, we wouldn't have it up and running for another 10 years or longer.

Barron's: Does the tight oil supply, coupled with a lack of enough viable alternatives, make the U.S. vulnerable in terms of having enough energy supply?

Maxwell: It does, probably between about 2010 and 2025, thanks to a lack of sufficient power to drive our economy on an upward course. We haven't yet seen declining energy supply at a time of growing GDP. So for the moment, we will need more power to drive the world economy higher.

Barron's: What's been constraining the supply of global energy, oil in particular?

Maxwell: There are several factors, one being resource nationalism. The Russians are the classic example. They are not against us, but they simply want to develop their own supplies in their own way, on their own timetable, with their own money and with their own methods. Another example is Iraq. I said once to a junior minister of that country that Iraq would be producing 9 million barrels a day with the full development of reserves that most of us think are here, as against the 2½ million barrels a day they were producing at the time. And he said to me, 'Could we do that? Yes. Would we do that? No.' He said, 'I predict you will never see more than 6 million barrels a day coming from Iraq, ever' [to preserve the supply].

Another constraint is political instability in various places, including Nigeria. There's also refining, which is probably one of the easier constraints to solve. The world is using a great deal more lighter crudes, and we are actually producing more of the heavier crudes. We have to continue to change the refining system to handle the heavier crudes in order to give us the lighter products.

Barron's: What other constraints exist?

Maxwell: Many countries, for political reasons, don't want to allow oil companies to come in and do business. They don't like us, the U.S. in particular. Venezuela is an example where they do allow you to come in, but under terms that are so harsh that companies don't. The remaining constraint relates to geology, although it's not the primary issue today. It is the geopolitical and the instability issues that are stopping the biggest part of the development.

Barron's: How would you sum up the geological issue?

Maxwell: The easy places to find the oil have been, in most cases, tested, proven and produced. This occurred in the continental U.S. in the 1920s and 1930s and, on a worldwide basis, in the 1960s and 1970s. Now we are looking for oil in places like the Arctic of Russia or the Arctic of Alaska, where costs are much higher. It is not only more difficult to operate in those places, but it is a long way to transport the oil. There may be a great deal of oil under Antarctica, but, because it is a land mass, unlike the North Pole, which is water, we can't see through the ice sheets that cover Antarctica. So we don't know where to drill there.

There's also the issue of existing fields that are diminishing. The classic example is that in 1985, the North Sea produced 2½ million barrels a day from nine fields, compared with about 1.7 million barrels today from nearly 100 fields. We are running desperately on a treadmill on which it is very difficult to stay up, because they are not finding as many new fields as old fields are being depleted.

Barron's: At some point, doesn't it come down to lowering consumption or tapping alternative sources of energy?

Maxwell: Right, and we will probably do both. Ten years ago, 40% of the world's energy was in oil, versus 39% in 2006. It should reach 38% in the next five years -- and 37% three years after that. So oil is slowing, and I expect it will stop its growth around 2015, at which point the supply begins a slow retreat.

Barron's: Then what?

Maxwell: We will either have to reduce our economic growth around the world, which has all kinds of political and social repercussions attached to it, or we will have to find a substitute for oil. But it turns out that oil is a remarkable type of energy, as it doesn't spoil when you keep it overnight in a warm dish. It transports easily. It stores easily. It is very fluid. You can pump it across long distances. Oil has been the basis on which we have made a remarkable economic expansion, and now we may be tested by something a lot more serious, which is a coming shortage of oil and a need to start using other forms of fuels, which are not naturally the ones that we have developed.

Barron's: Where does natural gas fit in?

Maxwell: Its supply should last another 40 or 50 years before it runs into the same problems of peaking that we have in oil. Natural gas has a very low carbon footprint, meaning it's a cleaner type of energy, and it has wonderful petrochemical adaptability. But it doesn't help at the moment to solve our principal problem, namely oil supply, particularly for transportation uses.

Barron's: The dependence of the U.S. on foreign oil has grown significantly. Where do you see that going?

Maxwell: Dr. M. King Hubbert, the great geophysicist for Shell who gave his name to the Hubbert's Peak, said that we would reach the limit of domestic production of oil in the continental United States in the early 1970s. That, he said, would touch off a major change in the way we lived, the way we drove, where we lived, and so forth. But when we actually got there -- and he was correct that it was the peak of American oil in November 1970 -- the transformation to the use of foreign imported oil was almost seamless. There was no great change in people's habits. He thought the American public would never be stupid enough to fall for the concept of foreigners continuing to give us all the oil that we wanted.

Barron's: Could you elaborate on why you see the price of oil going much higher?

Maxwell: The price is eventually the only thing that will slow down the use of oil; the rising price tells us that we don't have enough of it. So, we are now beginning a bitter, bitter competition for fuels that will see the price continue to rise to these ridiculous levels.

Barron's: How high do you think the price of oil will go from here?

Maxwell: We will see $300 a barrel -- or roughly $250 in today's dollars -- because oil supply will be so short. If you want that oil, that's what you will have to pay for it. That will be in 2015, after the peak of oil [supply]. But even earlier, around 2010, more than 50% of the non-OPEC world will have peaked in its production of oil so the dependence on OPEC will become extreme. That will give OPEC a chance, I'm afraid, to lift prices rather more quickly on us than they are doing today.

Barron's: What concerns you the most about such high oil prices, assuming that turns out to be the case?

Maxwell: One thing is that people are going to be asked to change much faster than they are willing to.

Barron's: What's on the horizon over the next two years?

Maxwell: Supply and demand will be equal temporarily. There are three or four Saudi oil fields coming on stream, but there won't be any more low-sulfur crude fields coming on after the end of 2010. There's also the recession, which takes away some demand, but oil prices will remain high.

Barron's: Where do you see energy investment opportunities right now?

Maxwell: The tar sands, particularly those in western Canada, will be one area where the oil industry will continue. That includes companies like Suncor Energy (ticker: SU) and EnCana (ECA), both of which are on my buy list. They are integrated energy companies with big exposure to natural gas. EnCana has a deep asset base, huge North American land holdings and a disciplined management team. My target price, which is for the next 18 months to two years, is $112, compared with around $67 recently. My price target for Suncor is $90 (versus about $50 last week) but it might take three or four years to get to that level.

Barron's: Any other investment themes?

Maxwell: I see other types of opportunities developing in energy, although not in the traditional areas. It is going to be a lot easier in the next 10 years to reduce demand than it is going to be finding new supplies to substitute for oil. That's a very big principle. It will require increasing amounts of energy, particularly electricity, to run the new world.

Barron's: Can you be more specific on companies?

Maxwell: There are going to be so many new companies and so many new technologies that it boggles my mind at the thought of identifying all of them. There are going to be a lot of new industries coming in and wonderful opportunities in the stock market. But the old names in energy that I've covered for years won't be what they were. Most of the oil companies will be swallowed up by the larger ones. Then the larger ones will be broken up into trusts or new corporations. I don't think the oil industry can go on as it is now.

Barron's: What kind of world can we expect to live in with all of these changes?

Maxwell: It will be a little simpler. Your friends are going to be a little closer to you than they were before. Your vacations are going to be a little closer to home. You are going to have lower temperatures in the house. We will drive smaller cars with less horsepower, but they will get 60 to 80 miles to the gallon, enabling us to stretch gasoline supplies a lot further. There are going to be thousands of new adjustments leading to new investment opportunities. But the adjustment to that rising oil price, which could take as long as 20 years, will be a very harsh social experience -- not only for our society, but for every society.

Thanks very much, Charley.

Staying alive in this topsy-turvy market

It has been a week since I last posted, and what a week it has been. We witnessed Hurricane Gustav and its less than disatrous landfall, the postponement and then spectacular conclusion of the Republican convention where we were not disappointed by Gov. Palin (really, better than hoped for) and Sen. McCain. And we saw another week of violent whipsawing in the stock market.

What to do?

I have been successful playing the whipsaw. I don't see any other way to go, other than to hunker down in cash and take a long nap. In my trading account (my retirement accounts are full of conservative high dividend, buy-and-hold stocks and funds) I continue to play the trading range of the Financial index. UYG and SKF are the two bookends of the trade, SKF being short and UYG being long. They are both based on the XLF S&P index for Financials, but levered by 2X. The XLF range is oscillating between 20 and 23 since mid-July with a round trip every 10 days (which is very volatile).

In the latest cycle, I closed out my UYG Sept 25 sold puts contracts on Wednesday for around $3 (with the XLF around 22.00). Then I sold puts on the SKF October 125 for $20. On Thursday, at the open, the XLF moved to 22.50 and I could have sold more SKF puts at $23, but I held on as I was in the red. By Thursday close, the XLF had dropped 6% and was at 21.50. My SKF puts were in the black.

Today, on Friday, the XLF continues to drop and is now close to $20. The SKF which was at $110 on Thursday at the open, is now at $123. UYG has gone from $23.50 to $20 as of now. As mentioned, $19 or just a little less, is the low end of its 7 week range. I have a "buy to close" order on the SKF puts at $10.50 and a "sell to open" order on another round of UYG sold puts (Sept 25) for $7 (which will execute when UYG gets close to 19). I expect to close out the SKF today or Monday, depending on how quickly the market drops, and then get back in for the ride back up on the UYGs next week. I will continue playing this cycle until I can't.

Another trade on the horizon is selling more PWE canroy puts short. PWE is approaching its 24 month weekly low of $25. (it did hit 23.50 for one day on Jan. 24). It has corrected back to the level it was at when Nat Gas was $5.50 and oil was $70. But they are not at those low levels. PWE gets sold down hard by speculators even though it is not a speculative stock with its 15% dividend. It will always bounce back based on solid cash flow for the forseeable future.

The PWE Dec 30 put is at $5 as of today. I have orders in to sell puts at $5.50 and $6, giving me prices of $24.50 and $24 on the underlying stock if assigned. I will take that price on PWE any and every day.

Palin is Great Choice for VP

I went to CNN’s website to find out what the Left was saying about Gov. Sara Palin's selection to run as VP with John McCain. Predictably, most of the Lefties are crowing that McCain made a huge error. They are saying that Gov. Palin is a lightweight, nominated for her looks and because she is a woman, that she won’t pull any moderate women voters because of course, they all vote as one for Pro-Choice, which is always a woman’s number one election issue.

As a centrist who was looking for a reasonable option in this election, I am elated that the Lefties are so over-confident and are displaying so much hubris and arrogance. There are plenty of women in the middle, who like me, just want a good moderate Presidential / VP option. How many women want a smaller government and a society where the private sector solves social problems and doesn’t want government to control their lives?

I am sure there are many centrist women both Republican and Democrat, who were a large part of Hilary Clinton’s constituency. With Hilary as the Dems Presidential candidate, those votes were a lock and would have made McCain's task almost impossible. The same moderate women who would have voted for Hilary will find Gov. Palin very attractive as a VP candidate. And in the process of examining this ticket, they will find that Sen. McCain is not the caricature of a Bush-clone that the Dems want to make him. With the illumination of Gov. Palin, they will see McCain as the courageous, passionate, ethical, maverick that he is.

Gov. Palin was put on the ticket, not because she was a woman, but because she is a kindred spirit and represents the American ethos better than any other VP candidate. This will be a great election season and I look forward to debating my Dem friends as they come to realize what a brilliant move by McCain, this really was today.

Could the Commodity Boom be Nearing an End?

I found a provactive post on the Barrons Online site this week. It was authored by Randall Forsyth, one of Barrons' editors. The idea proposed is that commodities will decline as a result of a backlash or reaction against recent trade deficits in the USA. I accept this argument over the intermediate term. I still think Commodities are in a long term bull market, but it won't surprise me if they take a couple years off while the world economy adjusts to their higher prices.

A strong argument can be made that American trade deficits will continue shrinking due both to a weakening global economy, already under way, and a domestic political reaction reinforced by election pledges of the two Presidential candidates. Specifically, protectionist actions as pledged by Obama, an increase in taxes on the wealthy and corporate windfall taxes against several multi-national companies will all accelerate a shrinking of the American trade deficit. At the same time, to counter inflation imported from America, foreign treasuries will dump their dollars and tighten their own lending standards to reduce liquidity. The net effect is to create a dollar deflation, rather than inflation. It will also raise our own Treasury interest rates as there will be less foreign demand for dollars. This reduces economic stimulus domestically.

As trade deficits decline and move toward a surplus, the dollar naturally strengthens. A stronger dollar is inherently bad for commodities priced in dollars. But what would be bad for commodities would ultimately be good for domestic financial based industries like Banking and Technology. We may be at a crossroads, so consider this possibility while planning your investment strategy for the next six to 24 months.

THURSDAY, AUGUST 21, 2008
UP AND DOWN WALL STREET DAILY

Is the Global Liquidity Tide Turning?
By RANDALL W. FORSYTH

MY INVITATION TO HOB-NOB with the world's monetary muckety-mucks in Jackson Hole this weekend got lost in the mail, yet again. Amidst the Grand Tetons of Wyoming, the Federal Reserve hosts its end-of-summer junket for the movers and shakers and hangers-on to discuss the key monetary matters of the day.

Too bad they are little more than corks tossed on violent seas of global forces totally beyond their control.

The inflationary surge now hitting the U.S. is being felt in spades overseas. Countries that have linked their currencies to the dollar, either explicitly or de facto, are feeling the price effects of the greenback's slide in the past seven years. But as the credit crisis pushes the U.S. economy into recession, the process that pushed prices up abroad could go into rewind.

In a world that's become so interconnected, it seems almost superfluous that what happens in America doesn't stay in America. But it goes beyond the old saw that when the U.S. sneezes, the rest of the world catches cold. The U.S. economy, while the largest in the world, no longer is as dominant. So, the process takes some explanation, so bear with me.

To varying extents, countries in Asia and elsewhere in the world for the past decade or so have tried to keep their currencies' exchange rates relatively stable with the dollar. The U.S., after all, was their best export customer and they all wanted to keep it that way. The key example has been China, which had held the renminbi's exchange rate versus the dollar in a tight band.

With China's burgeoning trade surplus with the U.S., Chinese exporters would accumulate a surfeit of greenbacks. Under freely floating exchange rates, the dollar would decline and the renminbi would rise.

To prevent that, China's central bank would buy up the surplus dollars to keep its currency within a tight band. In the process, the central bank sells renminbi, thereby increasing their supply. The process is the same as Money and Banking 101 textbooks, where the Fed buys Treasury bills, increasing banks' reserves and thereby the money supply.

Other Asian countries, not wanting to lose export competitiveness to China, similarly buy dollars to keep their currencies capped. In the process, they also expand their domestic money supplies.

Of course, these central banks don't keep greenbacks in their vaults but invest the dollars in interest-bearing assets, such as Treasury securities, agency securities such as those from Fannie Mae and Freddie Mac, and U.S. mortgage-backed securities. Private institutions such as banks and insurance companies got funkier and bought higher-yielding mortgage paper rated triple-A but backed by subprime loans.

Economists dubbed this ad-hoc arrangement as Bretton Woods II after the quasi-fixed exchange-rate system lasting from the end of World War II until the early 1970s. Under Bretton Woods I, currencies would be exchanged for dollars at a fixed rate. The dollar, in turn, would be redeemable in gold at $35 an ounce to foreign monetary authorities (U.S. citizens couldn't turn in their greenbacks for gold.)

When the U.S. external deficit grew and foreign central banks found themselves with more dollars than they wanted, they sought to exchange them for gold. On Aug. 15, 1971, President Nixon ended that pledge to redeem dollars for gold, and a year and a half later, the present system of floating exchange rates came into being.

Under Bretton Woods II, foreigners would hold dollars out of their self interest, not because of any U.S. pledge behind its currency. Be that as it may, for years it has been a wonderful system rivaling perpetual motion. The more Americans spent in excess of their income, the more the rest of the world lent to them. That resulted in the famous "conundrum" described by former Fed Chairman Alan Greenspan—that longer-term interest rates remained relatively low even as the U.S. central bank hiked short-term rates.

To be precise, the U.S. current account provided a river of dollar liquidity to the rest of the world. Some of it was offset—sterilized in monetary parlance—by foreign central banks by raising interest rates, increasing bank reserve requirements or selling bonds. For the most part, however, the process inflated the credit bubble.

Like its predecessor, Bretton Woods II became an engine of inflation. Buying up the excess dollars forced banks to expand their money supplies, sending inflation skyward. Some countries that had tied their currencies to the dollar, such as Kuwait, abandoned that peg to fight inflation and no longer import the effects of America's profligacy.

The debasement of the dollar was most evident in the price of gold, which climbed from around $300 an ounce at the turn of the century to a peak of $1,000 last spring. As with the breakdown of Bretton Woods I, this fall in the dollar is being manifested in a surge in oil and other commodities. Foreign economies, which are more dependent on tradeable goods, are feeling this upsurge in prices most acutely.

But is this engine of inflation, the credit bubble that resulted in the massive U.S. external deficit, about to go into reverse?

At this point, it is speculative to conclude that. But alert investors should consider that possibility.

Indeed, Barron's Roundtable member Marc Faber suggests this could happen in his latest missive to subscribers to his Gloom Boom & Doom Report.

A declining U.S. current account deficit could lead to a tightening of global liquidity as foreign central banks accumulate less dollar reserves, which are recycled into the global capital markets. The U.S. current account gap has shrunk from a peak over 6% of gross domestic product to under 5% as weakening consumer demand has cut imports while exports remain relatively robust as growth continues in emerging economies and the dollar is cheap.

As the growth of foreign monetary dollar reserves slows, the dollar is boosted and gold and commodities are hurt, Faber points out. Further, he writes:

"I have a friend who is an outstanding economist who thinks that the Asian current account surpluses will shrink in 2009 by about 50% from their peak in 2007. In this scenario, globally liquidity would become extremely tight and would have a devastating impact on asset markets including real estate, commodities, non-AAA bonds and equities. Such a decline in the Asian current account surpluses would cut the U.S. current account deficit by half and lead to a very strong U.S. dollar."

Let's recap. The credit crunch that has resulted in the U.S. recession (that's yet to be officially recognized) is being transmitted abroad by the reduction of the U.S. current account deficit and the quasi-fixed exchange-rate currency system.

Indeed, if Asian currencies begin to come under downward pressure, either in an international flight to quality or as a consequence of a declining trade surpluses, their central banks could use their cache of foreign exchange—mainly dollars—to stabilize their exchange rates. That would turn them into sellers of dollar assets or at least less vigorous buyers.

The inflationary tide in global liquidity could be turning as a result. The sharp break in gold suggests that could be happening, and that's being transmitted through the commodities markets. The dollar has stopped going down, and even has flattened out against the renminbi. The bear market in risk assets, such as stocks and particularly the Chinese market, also is symptomatic of a liquidity squeeze. As for the U.S. housing market, it is at the nexus, resulting in wealth losses for borrowers and a reduction in lenders' ability and willingness to extend credit.

That's something that the crowd in Jackson Hole can scarcely control. So they might as well enjoy themselves on their junket.

Endgame Nears For Fannie and Freddie - Barrons Article

I have attached the text from a great Barrons piece on the reorganization of Freddie and Fannie. This will be bitter medicine for owners of its stock, but necessary to salvage our home mortgage financial system and stop the housing price declines. If you own FNM or FRE, I would sell on Monday for sure:



MONDAY, AUGUST 18, 2008


The Endgame Nears For Fannie and Freddie
By JONATHAN R. LAING

The almost inevitable government recapitalization of Fannie Mae and Freddie Mac will likely wipe out investors—and management.

IT MAY BE CURTAINS SOON FOR THE MANAGEMENTS and shareholders of beleaguered housing giants Fannie Mae and Freddie Mac . It is growing increasingly likely that the Treasury will recapitalize Fannie and Freddie in the months ahead on the taxpayer's dime, availing itself of powers granted it under the new housing bill signed into law last month. Such a move almost certainly would wipe out existing holders of the agencies' common stock, with preferred shareholders and even holders of the two entities' $19 billion of subordinated debt also suffering losses. Barron's first raised the possibility of a government takeover of Fannie and Freddie in a March 10 cover story, "Is Fannie Mae Toast?"


Martin Kozlowski

Many of Fannie's and Freddie's credit losses come from risky mortgages that the agencies bought or guaranteed in recent years to boost their market share.
Heaven knows, the two government-sponsored enterprises, or GSEs, both need resuscitation. Soaring mortgage delinquencies and foreclosures have led the companies to gush red ink for the past four quarters, and their managements concede the outlook is even grimmer well into next year. Shares of Fannie Mae (ticker: FNM) and Freddie Mac (FRE) have lost around 90% of their value in the past year, with Fannie now trading at $7.91, and Freddie at $5.88.

Similarly, the balance sheets of both companies have been destroyed. On a fair-value basis, in which the value of assets and liabilities is marked to immediate-liquidation value, Freddie would have had a negative net worth of $5.6 billion as of June 30, while Fannie's equity eroded to $12.5 billion from a fair value of $36 billion at the end of last year. That $12.5 billion isn't much of a cushion for a $2.8 trillion book of owned or guaranteed mortgage assets.

What's more, the fair-value figures reported by the companies may overstate the value of their assets significantly. By some calculations each company is around $50 billion in the hole. But more on that later.

Bringing Fannie and Freddie to heel will be difficult for the Bush administration, despite the GSEs' (Government-Sponsored Enterprises') parlous financial condition. Consider their history. In the early 1980s Fannie was effectively insolvent, but the government allowed it to continue operating. Eventually long-term interest rates dropped, bolstering the value of the company's mortgages and bringing it back from the brink. Earlier in the current decade Fannie and Freddie successfully fought a full-scale attempt by the White House and some brave Republican legislators to clamp down on their operations, after they were caught perpetrating accounting frauds.

Note, too, that Fannie and Freddie have nonpareil lobbying operations and formidable political strength, owing to their hefty donations and penchant for hiring former political operatives. Besides, the agencies claim they've landed in their current predicament through no fault of their own. As Freddie Mac Chairman and CEO Richard Syron recently put it, the GSEs have been hit by a "100-year storm" in the housing market, accentuated by some higher-risk mortgages that they were forced to buy to meet government affordable-housing targets.

The latter contention is more than disingenuous. A substantial portion of Fannie's and Freddie's credit losses comes from $337 billion and $237 billion, respectively, of Alt-A mortgages that the agencies imprudently bought or guaranteed in recent years to boost their market share. These are mortgages for which little or no attempt was made to verify the borrowers' income or net worth. The principal balances were much higher than those of mortgages typically made to low-income borrowers. In short, Alt-A mortgages were a hallmark of real-estate speculation in the ex-urbs of Las Vegas or Los Angeles, not predatory lending to low-income folks in the inner cities.

In the current bailout the Bush administration is playing from strength. Not only have the GSEs' stocks been decimated, but trading in their debt -- whether the $1.6 trillion of corporate obligations or $3.6 trillion of mortgage-backed securities the two have guaranteed -- would have been in disarray had the recent housing bill not made explicit the U.S. government's backing of that debt. Even so, GSE debt spreads are starting to widen, relative to Treasury yields.

An insider in the Bush administration tells Barron's Fannie and Freddie are being jawboned by the Treasury Department and their new regulator, the Federal Housing Finance Agency (FHFA), to raise more equity. But government officials don't expect the agencies to succeed. For one thing, only a "capital raise" of $10 billion or more apiece would have any credibility. Yet, what common-stock investors would advance that kind of money to entities that have market capitalizations of $8.5 billion (Fannie) and $4 billion (Freddie), especially as the FHFA will use its new powers to boost dramatically the regulatory capital the GSEs must have in coming years?

Just as disconcerting for prospective shareholders, all but $300 million of the $7.2 billion in equity Fannie raised in the second quarter was lost in the very same quarter, according to its fair-value balance sheet. With credit losses surging at both agencies, $20 billion in new common equity wouldn't last long.

The cost of selling new preferred stock, meanwhile, would seem to be prohibitive for Fannie and Freddie. The dividend yields on their preferreds have soared to around 14%, in part because of a recent rating downgrade by Standard & Poor's. Yields that high would blight the future earnings prospects of both concerns.

Should the agencies fail to raise fresh capital, the administration is likely to mount its own recapitalization, with Treasury infusing taxpayer money into the enterprises, according to our source. The infusion would take the form of a preferred stock with such seniority, dividend preference and convertibility rights that Fannie's and Freddie's existing common shares effectively would be wiped out, and their preferred shares left bereft of dividends. Then again, the administration might show minimal kindness to preferred shareholders; local and regional bankers have been lobbying the Bushies not to wipe out the preferred since the bankers own a lot of that paper and rely on the bank preferred-stock market for much of their own equity capital.

An equity injection by the government would be tantamount to a quasi-nationalization, without having to put the agencies' liabilities on the nation's balance sheet, and thus doubling the U.S. debt. Treasury would install new management and directors at both, curb the GSEs' sometimes reckless investment and guarantee operations, and liquidate in an orderly fashion the GSEs' troubled $1.6 billion in on-balance-sheet investments. Then the companies could be resold to the public without their explicit government debt guarantees, or folded into government agencies like Ginnie Mae or the FHA.

Should the Bush administration lose its nerve and kick the GSE bailout forward to the next administration, a similar scenario still might unfold. In a column last month in the Financial Times, Lawrence Summers, Treasury Secretary in the Clinton administration and an important economic adviser to Democratic presidential candidate Barack Obama, opined that in view of the sad financial condition of Fannie and Freddie, both should be thrown into government receivership to protect the U.S. taxpayer. Republican presidential contender John McCain, for his part, fulminated in a recent op-ed in the Tampa Bay Times that if a dime of taxpayer money is used to bail out the companies, "the managements and the boards should immediately be replaced, multimillion-dollar salaries should be cut, and bonuses and other compensation should be eliminated."

THE WHITE HOUSE BEGAN to worry about Fannie's and Freddie's solvency in February, when both agencies reported capital-shredding losses for the fourth quarter of 2007. Adding to the official concern was the deepening turmoil in the residential- mortgage market, and the need for the agencies to keep mortgage money flowing.

The White House dispatched Treasury's then-Undersecretary for Finance Bob Steel to cut a deal with both Fannie and Freddie. In return for the pair doing its best to raise $10 billion each in new equity, the administration would eliminate the cap on mortgage paper the agencies could put on their balance sheets, and lower the increased minimum regulatory capital requirements imposed on the GSEs after their previous accounting scandal.

According to our source, both agency managements seemed amenable to the March deal, though they demurred on raising new capital immediately. They thought, and Treasury agreed, that any share flotation would have to wait until May, when first-quarter earnings were scheduled to be announced, providing investors with material information. Come May, Fannie kept its side of the bargain by raising $7.2 billion in mostly common equity. But Bush officials were shocked when Freddie failed to follow suit on an announced $5.5 billion equity raise.

According to our source, Freddie's Syron offered a variety of excuses. He said neither he nor several senior board members wanted to dilute current shareholders since the stock had fallen from 67 in the summer of 2007 to around 25 in May. He also insisted Freddie could do nothing on the core capital front until it had completed its formal corporate registration with the SEC under the 1934 Act. That argument seemed fishy, since Freddie had raised $6 billion in preferred capital the previous November, and like Fannie has an exemption from registering stock issues with the SEC. A Freddie Mac spokesperson says the company was acting according to legal advice.

Freddie succeeded in exploiting the Prague Spring of regulatory forbearance. Monthly statements show it bought even more mortgages, gunning the growth in its retained, on-balance-sheet portfolio by 11% in the second quarter. By reducing its hedging costs, it also doubled its vulnerability to loss from interest-rate moves. It appears Freddie was hoping a Hail Mary Pass with the portfolio would somehow reduce its spiraling operating losses.

In retrospect, the agency meltdown seemed inevitable as the housing crisis deepened and credit losses mounted. On July 7 an analyst report claimed both agencies might have to raise substantially more capital because of a change in accounting regulations. Both stocks went into free fall, tumbling nearly 50% on the week.

The Bush administration feared the stock collapse would signal that the companies were heading for insolvency, and thus call into question the safety of their $5.2 trillion debt and guarantee obligations, despite the government's implicit guarantee of that paper. The impact of a failed GSE debt auction would be global and catastrophic, since foreigners, including many Asian central banks, owned $1.5 trillion in Fannie and Freddie paper.

After a frantic weekend meeting, Treasury Secretary Paulson announced on July 13 a rescue plan under which the Fed, and ultimately the Treasury, would backstop all Fannie and Freddie debt, and buy equity in the companies should that be necessary to bolster them. The omnibus housing bill passed and signed into law several weeks later codified all this in addition to establishing a new regulator for the GSEs with strong receivership powers.

In the weeks since, Freddie has continued to put off raising capital, even though it finally completed its registration as a corporation with the SEC. Syron said when second-quarter earnings were released Aug. 6 that the company was waiting for a more "propitious" time. One might argue it came in May, when the stock was 25, not 6.

BOTH GSES CONTINUE TO NOTE their so-called core or regulatory capital levels remain comfortably above the minimum required by federal regulation. This ignores what would happen, however, if their balance sheets were marked to fair value -- or if their fair-value estimates were hugely inflated, as indeed may be the case. Both balance sheets, for one, contain an entry called deferred tax assets that bulks up Fannie's fair-value net worth by $36 billion and Freddie's by $28 billion. These assets don't represent real cash but tax credits the agencies have built up over the years that can be used to offset future profits. But, since the tax assets can't be sold to a third party, or disappear in a receivership or sale of the company, they are disallowed in the capital computations of most financial institutions. Ironically, the worse a company does, the more capital cushion this asset creates.

The Bottom Line

A quasi-nationalization of Fannie Mae and Freddie Mac could involve the issuance of new preferred stock. The companies' assets may be worth negative $50 billion each.The companies also appear to have boosted their capital ratios by sharply curtailing their repurchase of soured mortgages out of the securitizations they've guaranteed. In the fourth quarter of last year, for instance, Freddie Mac took a loss of $736 million on loans repurchased. In this year's first quarter that figure dropped to $51 million -- a stunning decline in view of the continued deterioration of the housing and mortgage markets. Instead, the company made the interest payments to bring the mortgages current -- a much smaller outlay, but a tactic that only pushes an inevitable loss forward into future quarters. In Fannie's case, by postponing the buyback of bad loans the company avoided more than $1 billion in second-quarter charge-offs and a hit to its net worth.

Other numbers also give pause. Less generous marks to Freddie's $132 billion investment holdings in private-label subprime and Alt-A securities would lop another $20 billion off its net worth. And, more than likely, Fannie's credit reserves of $8.9 billion won't fully protect it from future losses on $36 billion of seriously delinquent mortgages on its $2.8 trillion book.

After accounting for deferred tax assets and generous asset marks, Fannie and Freddie each may have a negative $50 billion in asset value, and little prospect of digging themselves out of the hole. Whether Fannie and Freddie are liquidated or nationalized as a prelude to privatization, in their current form they won't be missed.

Updating Jim Rogers' World View

It has been a while since I have checked in on Jim Rogers and his world view. He is the most traveled and convincing speaker / investor in global markets, and has become decidely anti-American, even though he hales from Alabama. He recently moved his family to Singapore to get closer to the locus of future world growth, Asia, and more specifically China. He also is fleeing the American dollar, which he considers to be doomed.

Jim Rogers first gained fame as the partner of George Soros managing the Quantum Fund in the 1970s. He did very well for himself garnering a net worth over $100M by 1980. Now, almost 30 years later, he has grown that to over $1B, according to news reports. Since the late 1990s, Rogers has been an outspoken bull on commodities. His self-designed commodity index has returned almost 500% over that time. Here is a chart of the index performance over the past 3 years (since trading began in 2005):

The "sell signal" is clear at about 37.50 on this chart. The Sell occurred on around July 20, which was very close to other commodity downturns (some of which did begin back in June). But observing this Sell would save quite a bit of future losses until commodities strengthen.

But what sets Jim Rogers apart more than his wealth, is his unique contrarian perspective on the world and investments therein (though, maybe a little less contratrian today, then in 2000 during his world tour of investment locales, with wife Paige). (see "Adventure Capitalist").

I am leary about commodities over the next 6 months to a year, as the world economy temporarily slows and the US dollar strengthens relative to other weakening economies (mostly Euroland). I recently sold almost all my commodity stocks, except for one mutual fund (VGPMX) and my Canroy stocks.

But, I agree with Jim Rogers' long term thesis that the balance of world economic power will shift to Asia over the coming 20 years and will be marked by a long running shortage of materials while enduring increasing demand. I will invest accordingly and keep an eye on the dollar to signal my move back to commodities and energy.

I found a couple recent stories on Jim Rogers and will provide a link to them so you can read up and learn what Rogers is up to:

The first is "Rogers Sill Bullish on Commodities" August 15, 2008 at the "Living off Dividend website: http://livingoffdividends.com/2008/08/15/rogers-still-bullish-on-commodities/

The second story is from Bloomberg News which I have repeated below:

http://www.bloomberg.com/apps/news?pid=newsarchive&sid=aLr71mSZqOLI

Avoid Dollar `At All Costs,' Investor Rogers Says (Update2)
By Zhang Shidong

June 30 (Bloomberg) -- Jim Rogers, who in April 2006 correctly predicted oil would reach $100 a barrel and gold $1,000 an ounce, said investors should steer clear of the dollar as the U.S. economy slows and favor commodities this year.

The dollar has slipped 7.7 percent against the euro and 5.9 percent versus the yen in 2008 as the Federal Reserve cut interest rates to stave off a U.S. recession. Oil prices have doubled in the past 12 months, while gold is up 44 percent.

Avoid the dollar "at all costs", said Rogers, chairman of Rogers Holdings, in a speech in Shanghai today. "The best investments in 2008 are commodities and natural resources. Agricultural prices have much higher to go over the next decade. We have a shortage of everything, including seeds.''

Oil and metal prices in New York have surged as a slumping U.S. currency made them cheaper for non-dollar investors to buy as a hedge against inflation in a slowing global economy. The dollar has stabilized in recent weeks, with currency volatility falling by the most since 1999 this quarter.

The comments from Rogers, 65, come two days after he told investors at a conference in Nanjing not to "give up" on Chinese shares, which have made China the world's second worst performers this year. Rogers, who first started buying Chinese stocks in 1999, said he hadn't sold any of his holdings.

Commodity Bull

Investors failed to take heed today, as the benchmark CSI 300 Index extended an eight-month slump amid expectation government measures to slow inflation will hurt corporate profits. The gauge is down 53 percent from its Oct. 16, 2007 record and has dropped 23 percent in June. That would be the index's worst month since it was introduced in April 2005.

Rising food and fuel costs have helped to drive China's consumer prices to their highest in almost 12 years, prompting the central bank to lift interest rates six times last year and order banks to set aside a record amount in reserve to curb loan growth.

Speculation that the People's Bank of China would raise borrowing costs for the first time this year dragged the CSI 300 down by 5.5 percent on June 27.
Rogers, who now lives in Singapore, is best known for being a commodity bull since 1999, before the market started to rally in 2002. His Rogers International Commodity Index has more than quadrupled since it started in 1998.

The price of wheat, rice and soybeans reached records this year after adverse weather curbed global output and reduced stockpiles amid rising demand.

"Not High Enough"

Rogers is anticipating further gains in crude oil, which reached an all-time high of $142.99 a barrel on June 27. Futures were recently at $142.74.

"Crude oil prices are not high enough to stop people from consuming more energy,'' the investor said. "The bull market will not go to an end until supply and demand come to a balance.''

His comments today echo the themes in his latest book "A Bull in China: Investing Profitably in the World's Greatest Market,'' in which he tells investors to get out of the dollar, teach their children Chinese and buy commodities.

Rogers said last October he planned to shift all his assets out of the dollar, which fell to a three-week low against the yen on June 27. He predicted last month that the U.S. currency's decline would pause in the second quarter because it was overdone.

To contact the reporter on this story: Zhang Shidong in Shanghai at szhang5@bloomberg.net.

Playing the Rotations at the Bottom

Today I am sharing with you some of my recent experiences in "playing the rotations". While I don't have any evidence that the current market is typical of a deep market selloff, like we just experienced (I would need to research in detail 2002-03 and 1991-92 to make a proof), it is logical. At the bottom of a deep selloff, the typical pattern is a "smiley face". The price action decelerates from the selloff into a long "basing" pattern where there is much treading of water. Traders will just move between sectors to get some action during this sideways trend. The market will consolidate behind typical early stage leaders as the market moves up the right side of the smiley face, which might be 2009 or even 2010 given the depth of this selloff.

A good example of the "Smiley Face" basing pattern is the US Currency vs. other world currencies. There is an ETF with ticker of (UUP) that allows us to chart this pattern. Notice how the declining trend is broken by the right corner of the smile. The breakout above the declining trend line at around $22.70 on July 17 (same day as Financials bottomed) was the buy signal.

So, for those who want to stay active in the market, a shorter term trading mentality is required, for at least part of the portfolio. A close eye on individual sectors and their trends along with well defined buy limits and sell stops (at chart bottoms and tops) are a must.

Today I made a couple trades that reflect this concept. I have been playing the basing of the Financials sector, as expressed by XLF or its levered cousin, UYG on the long side from $20 on up. But when UYG gets to $23, I jump back into SKF, the inverse ETF fund for the Financial sector (goes up when financial stocks go down). This pattern has been very solid since late July and I have participated in each direction each time, using sold put options on the near month, making profits on both the up and downside. This trend could continue much longer. If the financials bottomed on July 17, it will take some time before they regain their earning power so that the stock prices can advance significantly. In between, the price will just gyrate in a fairly narrow zone, as it has for a month.

I have created a "Prophet Chart" on the UYG to illustrate this action and the potential buy and sell levels based on the short term trends (usually only a few days long each). It is easy to see the pattern than is now established between $20 and $23 on this chart. This sideways action can continue for some time, until fundamentals change significantly one way or the other.

Another chart that shows promise for the sideways action is the Tech index, XLK. There is a levered version of this sector as well, the ROM which will provide a lot of volatility in its near term options. Because the Tech sector was not as overpriced in 2007 and so was not as damaged by the selloff, it is possible, even likely, that the XLK will break out sooner rather than later. Tech is typically an early cycle sector. As soon as the economy looks to recover, the Techs will break out. See the flag pattern on the chart? This is the narrowing funnel trending the highs and the lows. If the price action breaks out of a "flag" pattern, it will have quite a bit of momentum. Watch to see if XLK breaks out to the high side, at around $25.

Finally, let's look at the Energy sector, XLE. Here is a sector that has had a large correction, but looking over a one year time frame, it can be shown that the correction may have just run its course, as it approachs the bottom from January this year. There is definite trading support for oil at $100 a barrel. So, unless we are entering a deep global recession that shuts down demand, the trading action shows that we are nearing the bottom of the materials / commodity selloff and are getting ready to bounce (and may have done so today). The price line today is just moving above the downward trend line of the recent highs. The best way to play this sector is to the upside, but with very tight stops to get out if the economy does change the fundamentals of the commodity boom, drying up demand.

See you soon.

Watching the Indexes for Direction

Jeff asked me yesterday to keep an eye on a few key charts for signals to buy or sell within that sector, or the sector itself. So, I will monitor the S&P 10 sectors plus a few other specialty sectors like Materials and Mining. I will post them here regularly, as there are changes to report.

We talked about Technology. After hearing the Cisco news yesterday, it seems like Tech might be taking a little turn for the better. Tech is a good sector to buy as a sector since there are a lot of casualties in that sector. The chart for the S&P Tech is XLK. It does show a recent breakout where the third green arrow was made two days ago, so now is a time to buy the sector, or good stocks within the sector. I hope this change in trend helps out Microsoft, which I have in a big way:




Another sector to monitor is the Energy sector. We recently looked at the OIH (yesterday it was in a report I sent out). Jeff was concerned about the prospects of equipment builder RIG, which has been declining steadily along with the entire sector. You can make the comparison yourself, but both charts are down about 25% from their high and are trending lower.

RIG is getting very cheap by all measures (P/E, P/CF, Book Value, PEG, etc). But what about the overall Energy Sector, XLE? It is in a downturn and should be watched for a break to the upside. But there is no rush. When a chart is in steep decline as this one is, it can continue quite a bit lower. Don't try to catch the falling knife, is the saying. A cheap Value guy like me, has been stabbed numerous times by not heeding this advice. The 12 month low in XLE is 10 points lower than where it is today (62.50). Don't fight the tape is another of the oldest sayings in investing. We should wait till we get three Green arrows, before we commit new money to Energy stocks.

Finally, we should continue to watch the Banking and Financials sector as it is the source of all our economic problems (Housing is a huge contributor to economic decline with Mortgages and Building Materials in the tank, plus high construction unemployment). When Financials turn higher for good, the economy will be on its way back. But the chart right now suggests that while it may have made a bottom on July 23 when the XLF spiked lower to $17.50, it may also take a long time to come back. It looks like a sideways phase has begun where the stock price will form a "base" in the chart. This phase could take months, so represents a trading opportunity as the line wiggles within its range between 20 and 23 (today, it is right in the middle of that range, so no action is called for).

Finally, I would like to congratulate Jeff for getting out of Walmart recently, after a nice gain. It is down big today, and the chart would not have got him out till today's drop. It had just recently started moving up to over $60 off a holding level around $57.50. Earlier the past 12 months it was as low as $42.50, so had been making higher highs for some time. This is typically very bullish. But, today's drop is below the MA, so it is likely it will cause a breakdown in the indicators and create a Sell signal, unless quickly reversed. Jeff got out in front of this and saved himself a few bucks. Sometimes instincts are better than charts.