Sunday, May 25, 2008

Watch Out Below!

Very good Forbes article confirming much of what I've been saying: "We ain't anywhere near done yet."

Watch Out Below

Oil prices continue to surge to new records. Gold prices climb. Stocks retreat in the U.S., Europe and Asia. The dollar goes south. Housing prices continue to fall. Consumer confidence erodes. The banking crisis has not hit bottom. Fed action is not enough. Congressional intervention is necessary.

So says Thomas J. Barrack Jr., chairman and chief executive officer of Colony Capital, a California-based hedge fund, in his April letter to Colony partners.

It may come as a shock--but Croesus believes we are only a third of the way through the credit crisis, and investors should get ready to experience more pain. As Barrack put it to Croesus quite directly this week: "The denial is beyond belief--at every level."

No one wants to deal with the losses on Alt A mortgages, which are greater than subprime. Or the prime mortgages which in total dollar terms represent twice as many dollars as subprime. What about the regional banks wasted by lousy real estate loans? Then there's the unwillingness of European banks to lend to each other, or the vast amount of assets running from troubled institutions like UBS, not to mention the Swiss investors demanding delivery of gold bullion rather than gold certificates. Still, the recession deniers are everywhere.

Croesus has some advice for everyone. Buy yourself two recently published books that will explain how we got to this fragile place and what public policy steps have to be taken to make sure the financial system doesn't still implode--on a step-by-step basis.

Charles Morris' The Trillion Dollar Meltdown, Easy Money, High Rollers, and the Great Credit Crash explains in clear narrative style how the credit bubble developed and had to burst. We owe a debt to Morris for underscoring how the power of vastly deregulated financial markets--and the development of mortgage-backed securities markets was eventually going to lead to the "great unwinding" that is only partly over. For all of you who have been bewildered by reading about CMOs, CDOs, CLOs and the other toxic waste of 21st century finance, here's your handbook to comprehend the fallout.

Morris makes sense of the process by which the stock market crash of 1987 and the failure of hedge fund Long Term Capital, cured by the easy money policies of Alan Greenspan, led eventually to excess leverage and massive losses in the financial system. Listen up. Morris' prickly definition of the so-called "Greenspan put" explains the mystique that kept the markets from massively tumbling--"No matter what goes wrong, the Fed will rescue you by creating enough cheap money to buy you out of your troubles."

Morris calls all this folderol "the last gaspings of the raw-market Chicago school brand of financial capitalism that moved into the vacuum created by the 1970s collapse of the Keynesian liberal paradigm."

And fabled investor/speculator George Soros has neatly carried this theme forward in his brilliant analysis of the crisis, which he warns everyone and everywhere is deepening into a more serious matter. Soros' The New Paradigm for Financial Markets, The Credit Crisis of 2008 and What It Means is a clever explanation of why "financial markets are always wrong."

Soros made his fortune by understanding how to take advantage of how markets overshoot on the upside and then on the downside. He goes short when we're in bubble mode, bidding shares or commodities to unrealistic prices. And he buys when prices are unrealistically low. Investors, Soros proves, "base their decisions on incomplete, biased and misconceived interpretations of reality, not on knowledge."

Under the new paradigm, investors will have to base their decisions on less leverage. In fact, Soros, like others, is calling for the regulation of limits on the use of leverage by investment banks and hedge funds. Come the revolution, Croesus thinks this will only happen on a voluntary basis. But Soros is adamant that "credit creation has to be a regulated business. The financial industry was allowed to get far too profitable and far too big." Avoiding asset bubbles should be a priority, Soros suggests.

Croesus scoffs at this nonsense as Wall Street's political power and influence in Washington is too strong. Even if Obama gets in the White House, his hedge fund buddies will tell him the score. Don't mess with Wall Street.

Be clear, though. The asset bubble that is still bursting will be severe enough to cause a serious recession, Soros believes. He is negative about the economy and the stock market. He has more vision and understanding than your run of the mill Wall Street expert who thinks every capital raising is the turning point for the market to improve.

You may find Soros' public policy solutions to be anathema. But you can learn one invaluable investment lesson from this book. He proves that "reflexivity" is an intellectual insight that can be a framework for successful investing. All you have to know is when prices get too high (out of whack with reality) or when they get too low (out of whack with reality). Reflevity signaled Soros when to sell the conglomerates in the late 60s, when to sell the REITs in the 1980s--because they got up to crazy unrealistic levels. Soros knows how to take advantage of the crowd's wishful thinking. And let him be a philosophe about it. Why not.

This super bubble took 25 years to develop, Soros writes. It can't be over in one year. Expect home prices to drop another 20%. Expect credit contraction to continue. Expect new bubbles to develop like in the commodity area. Soros wants to bet gold, oil and other commodities will fall in price. It's just that his "reflexivity" button hasn't lit up.


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