Issue # 43 - February, 2008

Misunderstanding the ECB

Misunderstanding the ECB is a common mistake. It can also be a dangerous one for those who believe the central bank will follow the Fed’s lead in cutting rates merely because the European economy shows some weaknesses in output and employment.

The ECB’s primary official mandate is to control price-inflation. The foundational thinkers behind its concept wanted to create a new currency with a large economic base that would serve as a counter weight to the Fed’s slavish rate cutting whenever the air carries a whiff of recession.

The fact that the ECB continues to attempt at least in theory to maintain a 15% gold ratio to its total foreign exchange reserves, however tenuous it may be in practice, tells an additional part of the story. So does its policy of quarterly revaluing the entire euro systems central bank gold reserves at market value on its books, rather than maintaining an artificial and rigid “official gold price” in euro terms as the US dollar does.

In essence, it is rather clear that the ECB’s policy framework is designed to at least approach some of the restraining influence once exerted by the classical gold standard. European central bankers - at least those at the ECB, are selected to carry this idea on at least n principle, and at least to some degree.

Naturally, none of them are actual free-marketeers as most gold buffs at least believe themselves to be. They are still socialist-style central planners who want to have a huge say in what goes on in the markets. They are only a bit more pragmatic. They would like to outlast the US Fed, and they would like to outlast the US dollar as well.

With the foregoing in mind, it becomes rather clear that the ECB’s policy stance is inclined not to follow the US Fed when it comes to rate cutting in an economic environment that points to rising inflationary pressures. Price stability is thought of as an essential ingredient to sustainable economic growth. The focus is not “growth at all costs.” The euro was created with the firm conviction behind it that US monetary policy must and will lead to a serious collapse that may threaten the entire world economy. The reason: over-issuance causes massive “currency exports” that lead to the kind of horrendous trade imbalances the US trade position has exhibited over the past few decades, especially since 1971.

There is also no doubt that the euro was intended to serve as a reserve currency lifeboat for the world. If the dollar was to fail due to its own debt overload, the euro would be available to take up the slack to at least some extent.

That’s where we are today.

The ECB’s Trichet may not exactly be a Wim Duisenberg (its former chief), and its chief economist Juergen Stark may not quite be up to the inflation-hawkishness of his predecessor, Ottmar Issing, but the language emanating from both of them is certainly in line with the bank’s policy objective. Here is a sample of Stark’s thinking on the position of the US economy:

”Stark declined to comment on US President George W. Bush's economic stimulus programme but noted that the financial market turbulence had started in the United States, which he said had experienced "exaggerations" in some markets. This means that a correction of the "excesses of the past" was needed and that "what is important is regardless of how one reacts politically, one should avoid creating the basis for new exaggerations in the markets in the future."

Can you imagine a US Fed chief stating that “a correction of the excesses of the past” is needed? I have lived here since 1981, and if either Paul Volcker, Alan Greenspan, or Ben Bernanke ever said anything of the sort while in office, I am certainly not aware of it.

The point of all this is that the dollar will continue to go down against the euro because the ECB will either hold its repo rate, if the effects of the subslime crisis increase in European markets, or hike if the effects are limited and prices keep rising at or near 3 %.

How unhurried the ECB is in following the Fed is clear from the following chart.

The chart does not show the ECB’s main policy rate as the charting service does not provide the data. The overnight money market rate is sufficiently close, however, and provides a good reference point.

The news of the day (today, January 31, 2007) is that Juergen Stark, the ECB’s chief economist and successor in office of the infamous Ottmar Issing (infamous for being a super hawk on inflation and not acceding to corporations or governments’ pleas for easier credit to support the business cycle), indicated that the EU economies are doing well enough to support a potential rate hike in March if inflation continues to rise. EU-wide price-inflation was just reported to be 3.2 percent - the highest ever since formation of the EU, and a full 1.2 percent above the ECB’s policy target.

The Coming Ratings Disaster - Collusion at the Highest Levels

In the last Monitor update from 1-21-08 we briefly discussed the bond insurers’ crisis involving MBIA and Ambac. That crisis, as bad as it is and as severe of an effect it had on the Fed by prompting it to make its 75 bp emergency rate cut, is dwarfed by the possibility of a virtually complete breakdown of the top-tier international ratings companies like Moody’s, Standard & Poor, and Fitch.

Picture this in your mind:

You are a private banker, in the business of making loans to consumers. Loans of all kinds, whether for cars, small businesses, homes, you name it.

In the process of pursuing your trade, you rely on the credit ratings issued by the country’s top three consumer credit reporting agencies. After years and years of making loans ot consumers based on these credit ratings, you suddenly find out that the reporting agencies took money from consumers for making their credit ratings look better than they really ought to be. Then, suddenly, after years of few discernible problems, massive defaults start rolling in - and you go broke.

Now, translate that scenario to a global, all-encompassing scale, and you have a pretty good idea of what the world’s three top ratings companies of investment products have been doing for years and years.

The very foundation for the entire world’s investment decisions has just been taken away.

If you are a fund manager who has invested in municipal bonds that were rated AAA by Moody’s or Standard & Poor’s, or Fitch’s, you are now sh– out of luck. You can’t tell how safe those bonds are, anymore. The reality is that they could be downgraded at any time. That is now true for every single investor who has relied on one of these rating firms - and that’s a lot of people, institutions, fund managers, banks, insurance companies, governments, etc., throughout the developed world.

Having seen the writing on the wall, in order to deflect from all of this, Moody’s has recently issued a “warning” that it may downgrade the US’ international credit rating - just to show that it is willing, ready and able to comply with its job description: to serve as a reliable source of information on institutional debtor’s creditworthiness.

In the January 21st Weekly Update we dealt very briefly with the issue of the three top US bond insurers that were recently downgraded by Moody’s and others. Those bond insurers just had their credit ratings downgraded because they are strapped for cash dues to exposure to the subslime crisis, which effectively put them out of business.Between only the three of them, trillions of dollars worth of municipal bonds and other debt obligations are insured. Ambac alone has lost about $20 billion from its cash reserves as a result of defaults by bond issuers it insured. It was to a large degree the disarray caused by these downgrades that caused the Fed to make its 75 bp emergency rate cut on January 22nd.

The real threat to the world’s debt-based financial system, however, does not emanate from these downgrades, nor does it arise from the defaults of the bond issuers insured by these companies or the future inability of bond issuers to get reliable credit ratings that really count. The real threat comes from the fact that virtually every single past investment decision by those who relied on these ratings companies has now become highly questionable, to say the least.

These ratings companies in effect work like state government transportation departments that erect road signs alerting drivers to approaching hazards. Imagine driving your car down the road at night and passing a sing that says “DANGER! Sink hole in 1500 yards” The very next moment you fell weightless for a split second as your call falls into the very sinkhole the sign warned of - except that it was located only fifty yards or so behind the sign.

That is the situation every investor, institutional and otherwise, is in at this very time. They may not be falling into sink holes, yet - but they must slow down to a crawl in order to make sure they don’t get surprised.

And that’s where the analogy we have used above breaks down. In the world of debt-investing, these ratings companies used to constitute the only available means of determining the level of risk of any particular debt instrument issued by governments, their subdivisions, banks, or other corporations. And, let me tell you: the debt markets (bond markets) are far, far larger than the equities markets of the world. The “reality” they thought they were living and operating in turned out to be quite different from the actual reality of their lives.

To really get a fair representation of what is happening in the financial world as a result of this ratings agencies debacle, you need to think back to the “Matrix” movie trilogy. Imagine every debt-investor in the world as one of those humans slumbering in pods while literally living out their lives in the illusory world of the matrix.

Here is the crucial difference between the “Matrix” scenario of the movie and the situation of bond investors: The human batteries in the movie were lying securely in their pods while dreaming their lives away, responding to stimuli that had no connection ot the physical reality of the pods they existed in. Whatever they saw and felt in their dream world had no physical effects on their actual bodies.

Now picture in your mind the danger these humans would encounter on a daily, even minute to minute and second-to-second basis if they were walking or running around in one reality - the physical reality around them - while seeing, feeling, smelling and hearing the stimuli piped into their consciousness by the masters of the matrix. At any moment, they could be in danger of running into objects that exist in the real world, but that their program does not allow them to see.

What is happening - and what has been happening - in the financial world is very much akin to that scenario. Individual and institutional investors are actually operating (i.e., investing) in the world’s financial structure at varying “speeds” (i.e., at varying levels of risk) while responding to investment information supplied by these ratings agencies. Now, that information turns out to be totally unreliable - and there is almost no substitute available!

There is simply no way the financial world can function if every investor in debt-instruments has to research and determine the financial viablity of an instrument he is about to invest in by himself. Investors simply do not have the resources nor the time to undertake that kind of research before making their decisions. The financial world operates at lightning speed. Investment decisions by companies, funds, and governmental entities must be made very quickly in order to operate in this environment.

Here is an experiment for you. Wherever you are, just stand up, close your eyes, think of where you want to go and take of running as fast as you can without opening your eyes until you get there.

Of course, if you have any sense at al you say: “Forget it!” and stay in your chair. It is just too insanely dangerous to even consider doing anything like this.

That is exactly the situation te world’s debt-investors are in at this point in time. They are flying at night at high speeds and their navigation system has just turned out to be completely unreliable!

How nice it is to now that the value of gold is never determined by anyone’s promise or ability to pay. Gold is the very definition of payment itself. If you own gold, you have already made it to the finish line and you are standing on the podium with a medal hanging around your neck. A medal that says: “Smart investor.”

Meanwhile, the other competitors are still out on the track, running their race, hoping and praying that nobody moves the finish line on them.

The problem for modern civilization itself is that - to the extent investors begin to realize this in larger numbers and start behaving accordingly - local government development projects are going to find it immeasurable more difficult to raise capital for new developments, upgrades, or even simple maintenance of their infrastructure.

That means that, in order to entice future investors, they must offer far higher returns - and that raises their borrowing costs. Interest rates will have to go up.

The same thing is true on the international scale.

The US government, for example, will not be able to get investors to buy US treasury notes and bonds (which are the very definition of debt instruments) at their currently high prices anymore. The reason is that when investors begin to realize the full risk of placing their money into these types of instruments, they will demand far higher returns - and that lowers their prices. Bond prices and returns are inversely related, as you know.

Moody’s has already warned it intends to lower the US government’s international credit rating from “AAA” to “AA”. I am sure they have good reason to say that. I am also personally quite sure that the US credit rating needs to be far lower than “AA” due to all the structural problems we so often discuss here at the Monitor.

Hello, 1980!

I cannot predict this with any degree of confidence, but it is very possible that long term interest rates will rise to levels above 20, maybe even 30 percent as a result of this. Back in the years leading up to 1980, it was at least possible to coax money out of the vast majority of investors by raising rates to narly 20 percent - because they still had money. People had savings, back then.

Today, nobody has savings. People’s remaining wealth (to the extent it is not encumbered by debt already) is tied up in stock funds, which are very shaky and liable to collapse if too many people want to sell them in order to buy bonds.

In the process of long term rates rising that high, bond prices will have to collapse. For that to happen, institutional investors will have to do plenty of selling of bonds. The only way for government to avoid having to pay exorbitant interest for future loans from the public (“public” here includes foreign governments, a/k/a China!), is to start buying its own debt (treasuries) so as to put a floor under their price. Since tax revenues are tapped out, however, the government will have to borrow that money into existence from the Fed.

That would be the very definition of “monetizing the debt.”

As the “older” generation of Monitor subscribers (those who have been with us for a number of years) already knows, I suspect that has been happening to some degree for years, now. It is not anything new in this gangster world of government and banking shysters. But it will now have to happen at an ever-increasing rate - and that is the very definition of hyper-inflation.

How close are we to that scenario?

The treasury long bond has been rising for over seventeen years now, an almost two-decade, secular bull market for the long bond.

Back in October 2001, the Treasury Department killed the long bond to restrict supply and therefore drive up its price, keeping long term interest rates at a minimum. It did not revive the bond until May of 2005. AT that time, the long bond put in its second top of the multi-decade triple top formation shown below.

It appears that the bond is now putting in its third top. If it falls back down below the blue uptrend line, the 20-30 percent long term yield scenario becomes very likely. The consequences that would entail for the US economy and the US consumer would be catastrophic.

Naturally, the Fed will think that it has to "do something". The only "something" it is equipped to do, however, is to buy long term bonds. Trying to overcome the effects of a multi-decade secular bond market triple top with Fed buying will entail monetary inflation on a scale so massive that it boggles the imagination. Hyperinflation would be the inevitable result.

The only place for money to go in that scenario will be precious metals and their related investments. It will be huge, but very, very uncomfortable - and absolutely necessary to restore any kind of sanity to the markets.

We will have to watch and see what happens.

Goldman Sachs - An Insider Among Insiders

Gold advocates remember Goldman Sachs primarily for its role in masterminding the elaborate and probably illegal gold suppression scheme of the 1990s, but that was not the only “contribution” to the financial elites’ arsenal of free-market subversions and other shenanigans. In the best tradition of modern world financiers, it has a well-earned reputation for playing both sides of any issue. Deal, or controversy. That way, as may be obvious, it cannot lose.

The history of GS reads like a "Who's Who" of debt-banking and financial manipulation. Marcus Goldman, the firm's founder and original namesake was a German Jew who immigrated to the US in the mid 1800s. He began his career as a peddler with a horse-drawn carriage and a shopkeeper.

Twenty years after his arrival, he set up a new business called Marcus Goldman & Co., brokering IOUs. From his first year of operation, he was able to transact as much as $5 million worth of business, which soon grew to $30 million a year.

For the first fifty years, every major position in GS was held by "family" – a circle of supporters nurtured through a tightly woven web of intermarriages with other influential Jewish financiers. The “Sachs” portion of its modern firm name was supplied by the man who married his daughter, Samuel Sachs. In 1896, the company was invited to join the New York Stock Exchange.

Through its history, Goldman has singlehandedly pioneered the use of virtually every major financial technique known and practiced today. Here is a bullet-point list of the more important ones:

• Commercial paper, late 1800s;

• Initial Public Offerings (IPOs), early 1900s. (Famous IPO Clients: Microsoft, Bank of China, Ford Motor Co., Sears Roebuck, et al.)

• Early use of Ponzi-scheme principles in starting Goldman Sachs Trading Corp., which collapsed in 1929 and cost GS its reputation for decades to come;

• Early innovator in Risk Arbitrage, 1950s;

• Pioneered "block trading" technique which allows for sales of large holdings of stocks or bonds without degrading the selling price by using an investment bank (like Goldman) as an intermediary;

• Caused origination of credit ratings companies when a company for which GS issued $80 million in commercial paper went bankrupt;

• Pioneered "White Knight" strategy to defend a target company from a hostile takeover by bidding higher than the "black knight" bidder. 1974;

GS has a reputation for pushing the boundaries of legality in making its buck. As shown in the list above, one of its low points was when a Ponzi-like scheme perpetrated by its trading unit in the late 1920s blew up after the 1928 stock market crash. Several of its mid to high-level executives have been indicted on criminal charges.

Four senior level GS employees were convicted of insider trading between 1986 and 2006. In 2005, the company advised both the New York Stock Exchange and Archipelago, a company operating an online trading platform, in merger talks. Goldman owned a 15 percent share in Archipelago at the time, and the NYSE was headed by a former Goldman executive.

Ex-Goldman CEO Henry Paulson - yes - the guy who’s now heading the US Treasury Department - advised the Bank of China on its record-breaking IPO in 2006. That is interesting for the mere fact that China, although a trading partner, isn’t exactly a friend of the US. It has several tens of nuclear-tipped missiles (which Bill Clinton helped it to build) pointed at our west coast cities, but that just goes under the rubric of “playing both sides of a conflict.” Nothing unusual for Goldman Sachs, and apparently not anything to worry about for an administration that claims to “fight terrorism” while doing everything it can to leave our borders unprotected from terrorist infiltration through South America/Mexico and Canada.

But Goldman’s biggest heist came with the ongoing subrlime mortgage crisis and following global credit crunch.

All indications are that GS has its fingers deep in both sides of the game again, this time to the tune of a more than eight billion dollar trading profit, a 70 percent increase over last year, as a result of betting against the very subslime mortgage-backed credit obligations it peddled to its customers since 2005 - under Henry Paulson’s leadership.

Now, Paulson in his newfound role as the Bush-appointed savior of the economy gets to pretend that he is working on undoing a crisis that was to a considerable extent of his former employer’s own making.

The crowning achievement of the firm came only last week, however, when it got the chance to really stick it to a former competitor who overshadowed its rising fortunes on Wall Street for over a century. JP Morgan & Co. and its offshoot, Morgan Stanley, were always the head honchos on Wall Street, but my oh my, have things changed. Partially as a result of Goldman’s unprecedented “luck” in “foreseeing” the subprime lending crisis, its competitor and erstwhile overlord, Morgan Stanley, just had its credit rating downgraded - by none other than its former underling, Goldman Sachs.

Looking for Some Quick Trading Profits?

If you are of the trading kind, you may be interested in locking in some quick profits on world base metal prices - courtesy of China’s catastrophic snow storms.

China is normally credited with driving up natural resource prices because of its burgeoning demand, but this time it is happening on the supply side, and is not a phenomenon of China’s own making - unless you believe China is in the weather-making business.

China just happens to be the world’s top producer of aluminum and zinc, and those are the metals that are predominantly produced in the southern provinces of Hunan and Guizhou. Transportation problems due to road blockages prevent coal shipments from reaching smelters.

Here is the article in “ChinaStakes.com that gives all the details. If you are of the trading kind, go to it.

From Gold to Scrap?

Gold absolutely needs to consolidate here at the $900 level. Regardless how ridiculous the notion is to a long term gold advocate, too many people think that gold is “expensive” at these levels. They are turning in their “scrap gold” as the press likes to call it for paper dollars. Just goes to show how early on we still are with regard to the gold bull’s second phase - the phase where investment demand takes over from those who buy it for jewelry and other purposes.

Gold’s physical offtake by Indians has decreased dramatically as we have discussed several times already. Indians are selling their gold to invest their fiat-rupee proceeds in the booming Indian stock market. Even Chinese are selling some of their gold - but fund managers have taken over the demand slack.

This, however, is extremely shaky in the near term. Fund managers are still new to the realization that gold represents value. They are buying it strictly as insurance at this point, seeking cover from all of the unknowns spewing forth from the “root of bitterness” - the subslime debacle.

At this point, all it takes is just a little bit of positive IUS economic news, and the dollar will bounce, “risk appetite” (think: a longing to eat rotten garbage) returns, and institutional investors will look for ways to leverage their returns and earn that drug of all investment drugs called “interest.”

The public - including the TV financial channel pundit public - has not realized yet that the subslime mess is already at stage five. We are no longer talking just about people defaulting on mortgages they could not afford (Stage 1). We are no longer talking about just the commercial paper and therefore the credit market that has been affected by the mess (Stages 2 and 3). We are even past the realization that the top US bond insurers are likely going to have to forfeit their ill-deserved “AAA” credit ratings and all of the debt downgrades and higher borrowing costs for municipalities associated therewith (Stage 4). The real crisis is just beginning to light up the night sky with its first tentative rays fingering their way over the horizon.

Only those who went to free-market economics school, those who know how to distinguish value from garbage, and who know that money is created from nowhere resulting in monetary inflation and rising debt ceilings know which way the world turns and can therefore extrapolate that these early rays will soon result in a full-blown sunrise that will expose the elites’ debt-based monetary machinations to the blinding, unforgiving light of day.

If you have ever watched the movie “The Chronicles of Riddick” with Vin Diesel you know what I am talking about. It’s that kind of a sunrise. It burns everything in its path, everything that cannot hide behind the rocks in time.

Ratings, Shmatings

The Ratings Catastrophe we have discussed at the beginning of this issue is the real threat breathing down the financial establishment’s neck, and it constitutes Stage 5. With it, every assumption that was the foundation of every investment decision by every institutional investor in the entire world will be not only thrown into question, but it will show itself to be utterly unreliable.

In effect, the entire financial structure of the world will have to voluntarily downgrade itself - or lose all credibility, even among those who believe in the system.

Egan-Jones is a brand new ratings company that has received the SEC’s coveted NRSRO (“Nationally Recognized Statistical Ratings Organization”) designation. That now puts it on a par with its entrenched rivals, Moody’s, S&P, and Fitch.

Egan-Jones has shown itself to be light years ahead of the dinosaurs of the industry. It blew the whistle on Enron and Worldcom before anyone even thought these giants could fall if they tried to. What makes then stand out is that they operate under the older, saner income model. They get paid by investors who use them for their ratings services, not by the bond issuers they rate.

The latter creates an in my eyes unresolvable conflict of interest between bond issuer and ratings agency. If the issuer is big and its business is coveted, there is a huge temptation to act on the slow side when it comes to downgrading due to credit risk. There is even temptation to do shoddy research or to let the research fall by the wayside altogether. After all, if the issuer doesn’t like the rating you give him, it can go to one of the two or three competitors to get its ratings and bribe (er, I meant pay) them instead.

Egan Jones is the squeaky wheel of the industry. They are also its rising star. If the other companies don’t forswear their shoddy practices and follow their own old model of taking money from investors instead of issuers, they will falter and die.

Just to give you an idea, while Moody’s is debating if it should downgrade bond insurer Ambac from AAA to AA, Egan’s ratings for the company have been at the BB+ level for quite a while - essentially relegating it to junk status.

I have been unable to find out whether Egan-Jones is a publicly traded company. It looks like it is not. Too bad. I wouldn’t mind investing in them, at all. But there may be an even better way to gain from this ordeal. An astute trader should be thinking about shorting other companies that are on its B-list, but which currently still maintain AAA ratings with the other agencies.

Just a thought.

I’m not a trader, so I won’t do it, but an experienced trader might want to think about that for a while.

Anyway, gold will need to settle down a bit right here. Traditional physical demand is weak to negative, and investment demand is still unsure of itself and prone to bolting at even the hint of positive economic news.

The dollar jumped on positive IMS numbers last week, which was the primary cause for gold’s $20 drop on Friday. Al that was supported by GM’s astonishing 2.6% car sales gain over January last year and a handful of other positive earnings news.

The good news for gold stocks is that Friday’s drop did not result in an exaggerated drop in the gold stock indexes. Their response was rather muted, which makes me think that investors are beginning to realize the potential of gold and its producers’ shares. This is especially so since the Dow rose for four out of five trading days last week while treasuries lost only a tiny bit. It is still too early to tell, however.

See you next time.

Alex Wallenwein
(832) 452-9966 (cell)
(You can call me anytime during normal business hours if you have any questions).

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