Saturday, January 19, 2008

Precarious Economic Conditions & Gold

The Dow Industrials and S&P 500 have dropped ~ 14% since the October 07 top. The S&P has started this year worse than ever, and the drastic plunge over the past three days is the sharpest since 2002.

We’re now six months into the greatest credit crunch of the modern era. Defaults on mortgages, have skyrocketed as individuals find it more advantageous to mail the house keys back to the lender rather than make sharply higher reset payments they can’t afford.

It’s not just the borrowers who are suffering. It’s also the banks, pension funds, life insurance companies and individual investors who bought toxic mortgages, repackaged as complex securities from Wall Street investment banks.

But the roller coaster ride of bank and financial system losses has merely just begun:

Ambac Financial Group, the nation's second largest insurer of bonds, lost its precious AAA rating from Fitch Ratings on Friday over concerns that the company no longer had enough capital to guarantee billions of dollars in debt now imperiled by the subprime mortgage crisis.

The move to downgrade Ambac to a rating of AA could further roil financial markets, increasing pressure on Wall Street banks that hold this bad debt and making it even more costly for local governments to raise money for public projects.

This could spark a substantial sell-off by institutional investors such as pension funds that can only invest in top-rate securities, causing their value to drop. That in turn would prompt even more selling. As the securities become less valuable, Wall Street firms could be forced to write down billions of dollars on their balance sheets, restating how much their holdings of these securities are worth. The banks, which have already suffered staggering losses, have relied heavily on bond insurance to reduce their exposure to subprime mortgage debt and other complicated securities linked to these loans.

"Everyone thinks they're looking at the cliff over Armageddon," said Ed Rombach, senior derivatives analyst at Thomson Financial. "If you think the write-downs have been bad so far, the next write-downs could be twice as big."

Insurance company MBIA Inc. (MBI) Friday said it found the move by Mood's Investors Service to review the company's ratings for a potential downgrade, surprising. Moody's initiated a review of the Aaa financial strength ratings of MBIA Insurance Corp. and its affiliates as well as the Aa2 ranting of MBIA's latest Surplus Notes.

The rating agency also contemplates a downward revision of the Aa3 ratings of the Junior obligations of MBIA Insurance and the senior debt of MBIA Inc. MBIA stock is currently trading nearly 23% below the previous close.

End of the Line for Monolines

Just a few days ago Merrill Lynch stunned Wall Street by reporting a net quarterly loss of nearly $10 Billion. It was the worst quarter in company history. This much was well reported.

What didn't get nearly the attention was the largest reason for Merrill's loss. This involves a little known company called ACA Capital and a financial model on the verge of collapse.

Financial institutions that trade in mortgage-backed securities very often buy insurance, in the same way you buy insurance for your car, to protect themselves in the event of a default by the mortgage borrowers.

The problem is that a tidal wave of mortgage defaults are sweeping the nation, creating so many losses that small bond insurers like ACA are getting swamped. As it stands, ACA is expected to go under any day now.

Of course this means that when the bond insurer goes bankrupt all the bonds that it had insured are no longer protected, hence they are riskier. In the world of bonds, price and risk are directly and inversely proportional. Merrill's bonds go down in value the closer ACA gets to bankruptcy. Thus the huge losses.

These downgrades mean a lot more losses are in the works for financial institutions. If all the bond insurers were to be downgraded, that would mean $200 Billion in losses for whoever holds debt that is insured by the monolines. If the monolines all go bankrupt then the losses would be much more.

To put that into perspective, total losses from the entire subprime credit cruch since August that have rocked the financial world and garnered headlines so far have only amounted to a little over $100 Billion.

That's right. The damage from the credit crunch that has worried so many people could triple in the coming weeks.And for these struggling bond insurers, bad news can lead to more bad news. An entire financial model is on the verge of collapsing.

Created by Ronald Reagan back in 1988 through executive order 12631, the Working Group on Financial Markets, also known as the Plunge Protection Team (PPT) was created to respond to events in the financial markets surrounding October 19, 1987 ('Black Monday').

The Current PPT group is made up of:

Treasury Secretary Paulson (Chairman of the PPT)

Ben Bernanke (Chairman of the Board, Federal Reserve System)

Christopher Cox (Chairman of the Securities and Exchange Commission)
Walter Lukken (Chairman of the Commodity Futures Trading Commission)

These four PPT Kingpins, with inputs/suggestions from their numerous advisors, are currently operating in panic mode and are attempting to gin up new ways to thrust new money into the falling markets and US economy. The present situation has become so precarious they are now routinely advising President Bush and were actually the “brains” behind recent calls for tax rebates -- meant to pump up consumer spending. In the meantime (tax rebates will take time), they are using government funds to pump money into the futures markets--in an attempt to "fry" the shorts and make the impression that big money is buying up the falling market. The hope is: if other traders see this, they will start following the big money higher (probably futile).

President Bush acts on PPT Advice:

President Bush yesterday grabbed the headlines with his "economic stimulus" proposal -- it may be a "tax break," or a "rebate check" of $800 to $1600, and/or allow businesses to deduct half the cost of new equipment purchases. The stimulus will be "direct and rapid," "provide a shot in the arm," "lift our economy," and "help the economy create 500,000 more jobs 'more or less' than it otherwise would." (Article Below)

President Bush proposed a series of short-term tax cuts Friday that he said would provide a boost for the struggling U.S. economy.
Speaking at the White House, the president did not give details of his plan but said it would include tax breaks for businesses and individuals worth at least 1 percent of the nation's gross domestic product, or roughly $140 billion to $150 billion.

"By passing an effective growth package quickly we can provide a shot in the arm to keep a fundamentally strong economy healthy," said the president.

He said that his advisers believe the economy can keep growing, but that the risk of a downturn has convinced him to back a stimulus package.

"There are also times when swift and temporary actions can help ensure that inevitable market adjustments do not undermine the health of the broader economy," Bush said. "This is such a moment."

Federal Open Market Committee Rate Decision Due on 30 January 08

What should we expect? I think, due to recent market weakness, a 50bp cut is an absolute certainty while a 75bp cut is looking more probable by the day. My thoughts are: if we don’t see some market improvements soon, we may well see an emergency rate cut before the 30th, followed by another on Jan 30 – a total cut of 75bp or better.

So, what does all this mean for gold

Gold bounced from a one-week low on Friday after this week's climb to a record above $900 an ounce, but the market could consolidate before charging higher, fund managers and analysts said.

All eyes were on a U.S. Federal Reserve meeting on interest rates Jan. 29-30 after Chairman Ben Bernanke told a congressional committee more rate cuts might be required as the economic outlook worsened.

"Gold is consolidating after touching recent highs," said Christoph Eibl, head of trading at Tiberius Asset Management, noting that there had been some investor selling of gold held in exchange-traded funds (ETFs).

"ETF investors ... are holders rather than traders, therefore the recent drop has some strength," he said.

Gold's drop from the record high was partly driven by selling from investors and funds to cover margin calls from losses in stock markets amid fears of a recession in the United States.

Gold's investment appeal was intact owing to flight-to-quality demand on the back of turmoil in financial markets as a result of a mortgage-related crisis and worries about higher inflation.

"External factors such as higher inflation expectations, broader economic concerns, geopolitical tensions and Fed rate easing are likely to drive prices higher," Barclays Capital said in a report.

The World Melts for Gold

Gold-bug fever is spreading.

From China to the Middle East, new ways to invest in gold are rapidly popping up in developing countries. It's transforming the market for one of mankind's most venerable ways to sock away wealth.

The door is opening to a new class of investors who previously wouldn't have had access to gold futures and other tools. Their rush to invest has helped fuel soaring prices -- gold crossed $900 an ounce for a time in the past week, and there are some calls for $1,000 -- while adding volatile new dynamics to the market.

The democratization of gold speculation outside traditional Western financial centers has the potential to magnify the already strong appeal of gold as a hedge against global recession, inflation or just general uncertainty.

The appeal of gold as an alternative investment is increasing in China as its price hits new highs and is forecast to keep rising in the mid to long term.

Stimulated by expectations of U.S. interest rate cuts and soaring global oil prices, gold reached an all-time high earlier this month. Citibank estimated its price is expected to hit 1,000 U.S. dollars an ounce this year.

The strong upward trend has attracted individual Chinese investors such as Yao Yun. The chief financial officer of a Shanghai-based foreign company bought 50,000 yuan (6,849 U.S. dollars) in gold bars and the price has risen by 12 yuan per gram in just half a month.

"I believe the price will keep rising," he said. "The stock market is too volatile, and the real estate sector is subjected to macro-control. Investing in gold is a good choice at this time."

In Caishikou Department Store, a popular physical gold dealer in Beijing, more than 100 people lined up to purchase bullion for the Lunar Year of the Mouse on Nov. 22, the first trading day of the products. More than 200 kilograms of the gold bars were sold within 1.5 hours. Moreover, the total subscription amounted to two tons.

Li Xiang, a manager of the department store, said sales of gold products surged more than 50 percent to 2.38 billion yuan in 2007.

China Gold Association statistics revealed that gold investors nationwide have exceeded 1 million. The number doesn't include speculators of gold futures, which made a strong debut in Shanghaion Jan. 9.

On that day, China gold futures contracts surged to the daily 10 percent limit minutes after trading started at 9 a.m. on the Shanghai Futures Exchange (SFE). More than 6,000 clients traded on the market.

Experts believe the China gold futures market will grow into a leading global market as it was launched at a time when international gold prices have repeatedly been hitting new highs. Global prices jumped more than 30 percent throughout last year, representing the biggest increase since 1979.

Russia’s gold and forex reserves reach all-time high

Russia’s gold and foreign currency reserves have increased by $11.5 billion (2.5 percent) over the past three weeks, to $477.7 billion. This is the highest level since records began.

Bottom Line w/regard to Gold:
Expect to possibly see some more short-term consolidation, but with future (significant) rate cuts in store and growing worldwide demand increasing, the long-term trend will be up, up, up.

Summary of this article:

Major problems are on the horizon, markets are reeling and the mainstream is finally catching on to what we've been predicting for quite some time. The Plunge Protection Team however is working overtime and with an oversold equities market, I expect to see a short-term bounce, but it will fail to ultimately recover or impress.

Additionally, the Fed is certain to cut rates big-time in the coming weeks, and Congress will approve some sort of stimulus plan next week (probably too little too late), but once the Monoline downgrades (w/more to come) start the chain reaction of downgrade/markdown dominoes, we will begin to hear the fat lady sing.

As an aside, these new rate cuts and stimulus plans will most certainly cause the dollar to plummet to new all-time lows, and consumer inflation (already running at > 12%--see blue line on chart below) will soar, causing gold to take off on another tremendous up-leg.

I took the liberty of borrowing this Gold spot price chart below from Axstone.




Unknown said...

Randy, for a telecomm guy you sure have read a ton about finance, mortgages, etc. For the last two years I have spent most of my spare time reading about the American housing situation and I'm afraid it is about to be revealed to all. I saw on that half of houses for sale in California are foreclosures! In Canada, I doubt that 1% would be foreclosures.

God bless

Randy said...


I'll take that as a complement. Thanks much!

Yes, I spend much of my free time and actually enjoy following the markets/overall economy.

To be honest, I'm really surprised it took this long for people/markets to wake up to the many negative issues in play--though there are still many with their heads burried in the sand.

Anyway, I would have to agree with you in that "it is about to be revealed to all". I just hope the ensuing downturn is not as severe as I envision it to be.

God Bless you also -- and thanks for your readership. I remember you as one of my very first visitors back in late 2005/early 06


Anonymous said...

Purchasing a car is a dream that everyone wants to realize. But not everyone can afford to buy a car at one go. Availing a loan is not a bad idea in such a situation. But what to do if a person is having a bad credit status? Bad creditors find it difficult to apply for any loan but due to the tight competition existing in the market, lenders are now ready to advance loan to such people. Car loans for people with bad credit is also one such loan.

Randy said...


Many auto loans are securitized much like home mortgages. I expect to see this come to an end sometime later this year.

Ushering In a New Economic Era
Simultaneous with the above issues and related in nature, we will also soon see unemployment numbers rise as credit continues to dry up (spilling over into commercial loans, auto/boat/motorcycle credit, credit cards, etc) and consumer spending and confidence falls—compounding the equities problems mentioned above.

Anonymous said...

Just an awesome summary.
I am a novice at this and have a couple questions. Well actually a lot of questions but I will just start with a couple!

There has been some discussion on the internet about the "true" nature of the money supply and whether there will be inflation or deflation or both in the next couple years.
M1 has actually gone down over the last couple years. (See Gary North article.) Do you know of any good correlations and the charts that show a correlation of a money supply and the price of gold?
[There seems to be a lot more psychology and what I call the “road runner” syndrome (if you do not look down when you run off the cliff, then you can just keep running without falling, or you “gotta believe”, if you believe the dollar is OK then everything will be OK, even if it is not; but the question is: How do you know when it is not?)]
My concern is that if the credit bubble has created a huge "non-central" bank rise in a money supply (read non-M1) that is actually tracking with the price of gold, then when it collapses we will have deflation and the price of gold will collapse. There is also the continuing problem of the rural Chinese moving to the cities underbidding their city counterparts who are already 1/5 to 1/10 the salaries of the US and Europe. These folks are underbidding us and lowering prices. I am also not sure what it means that the median salary of Great Britain just topped the median salary of the US.

It seems to me, a novice, so please be gentle, that a contrarian's contrarian would be in quite a muddle right now.
So practically, what happens to the price of gold right over the next year or two AND when do you sell some and put it back into the market? When Bernanke starts raising rates when Hillary is elected? I somehow do NOT see this happening.

Thank your again and God bless.

Randy said...

Appreciate your comments and questions.

Yes, I read the recent discussion w/regard to money supply and gold prices over at Ax's thread (page145).

Regarding the Inflation/deflation debate: Yes the fed is currently fighting deflation w/new inflation. I've discussed this in the past (pls read if you have time):
Inflation or Hyperinflation

Will Bernanke Cut Rates

Credit Crunch Update

Bottom Line w/regard to the inflation/deflation debate: as I've stated in other posts, if we are fortunate enough to evade a complete systemic banking failure (Which I think we will, but if not--then all bets are off), I feel the powers that be will find a way for us to muddle through until ~ 2010 (hyper-inflating and killing the dollar along the way), but fortunately (or unfortunately depending on how you feel) I don't think Ben “The Helicopter-Man” Bernanke can inflate forever and Kondratieff Winter/depression will arrive ~ 2010-2012.

Regarding the US Dollar: It's not going to collapse today, tomorrow or 2 years from now, but it will visit substantially new lows on a regular basis. Hyperinflation is our only way out of this mess:
American Wake Up Call

So, for the next year or two--I believe gold prices will be up, up, up.

When do you take some off the table?

We will see many ups and downs over the next few years (with the long-term trending up), but personally, I think as the dollar tanks and inflation rages people will seek security in precious metals and a bubble will eventually grow. When your dinner party guests, taxi cab driver and barber all begin to discuss w/you the benefits of gold ownership, it may be time to start cashing out.

Again, as a disclaimer: this is not investment advice--just my thoughts.

Regards and God Bless

Anonymous said...

Just what I needed to know.
I will read your other articles and come back again.
I really appreciate your blog on this topic and Ron Paul for getting me started on this.


I would take gold over the dollar anytime.


Great conditions alright.