Welcome to the Room - July 25, 2008

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July 18, 2008

Dear Investor,

Not so very long ago, I published here a photo of an honest-to-goodness bank run in England, as depositors tapped politely at the door of Northern Rock Bank in the hopes of receiving their money back.

As you know, the British government charitably stepped forward and, dipping into taxpayers’ pockets, made depositors whole.

Here is another photo of a bank run, this time in the U.S. from earlier this week, as depositors sit comfortably under an awning on chairs thoughtfully provided by the management of IndyMac.





Now, you have to ask yourself a question or two.

Are these two bank failures members of the species of “black swans” you hear so much of these days? You know, outliers that come from nowhere and are expected by no one until they splash down next to you… and bite your face?

Or are they the first wave in an evolutionary process that will soon darken the skies with flocks of the breed?

The answer to this question is of no small importance.

You see, while the great unwashed of investor-world – those that get their investment ideas from watching Jim Cramer’s Mad Money -- can handle a couple of bank failures, even a modest-sized number of same will, almost more than anything else, trigger real panic.

And in times of panic, people run for cover… increasing savings and holding off on discretionary spending… just the sort of thing that can turn a faltering economy into one for the history books.

It is worth noting that, while everyone tends to focus on the stock market crash of Black Monday, 1929, the worst of the bank failures didn’t occur until late in 1930 through 1933, with the Roosevelts’ euphemistically labeled “bank holiday” coming only on March 5, 1933.

With the rally in the U.S. stock markets this week, the financial talkies were abuzz with much speculation that the worst might now be over… and that the skies were bright blue and clear of anything other than swans of the white variety, handsomely offset by a puffy cloud here and there.

It’s a classic bear market trap.

The problems facing the banks are still miles away from being resolved… with the $5.3 trillion commercial real estate market now hanging by its fingertips over the same abyss that residential real estate has already tumbled into, the Fed clinging on its back like a powerless version of Gandalf.

Then there is the darkening picture on credit card delinquencies, which you can see in the graph below.





It is thus clearly in the interest of the banks, desperate as they now are to replace their evaporated capital, that investors not look too closely lest they discover the degenerated conditions and bleak prospects of many of the institutions.

And so this week the banks were pulling out all stops with “news” that could be spun into tidy sound bites such as these…

Citigroup Gains After Posting Smaller-Than-Estimated Loss of $2.5 Billion Citigroup Inc. rose in New York trading after reporting a smaller-than-estimated loss on fewer mortgage-bond writedowns, lower borrowing costs and job cuts.

Citigroup, the biggest U.S. bank by assets, said its second-quarter net loss was $2.5 billion, or 54 cents a share, because of $12 billion in writedowns and increased bad-loan reserves. Analysts estimated the New York-based bank's loss at $3.67 billion. The shares rose as much as 14 percent.

And this…

JPMorgan posted earnings of 54 cents, vs. $1.20 a year ago, and revenue fell 2.7%. However, Wall Street was expecting earnings about 10 cents per share lower. The bank took a $540 million hit related to its acquisition of Bear Stearns.

The JPMorgan report isn't the only evidence that some financial firms are avoiding the full impact of the financial crisis. Also Thursday, PNC Financial Services (PNC), the largest bank in Pennsylvania, said its second-quarter profits rose 19%. Earnings of $1.45 per share beat analysts estimates by 29 cents. On Wednesday, Wells Fargo (WFC) sparked a stock market rally when it raised its dividend and its second-quarter profits impressed investors.

Just as I was preparing to let out a long bottled-up Hip! Hip! and all that, a couple of items came across my desk. The first was an article out of Bloomberg…

July 14 (Bloomberg) -- At an investor presentation in May, Citigroup Inc. Chief Executive Officer Vikram Pandit said shrinking the bank's $2.2 trillion balance sheet, the biggest in the U.S., was a cornerstone of his turnaround plan.

Nowhere mentioned in the accompanying 66-page handout were the additional $1.1 trillion of assets that New York-based Citigroup keeps off its books: trusts to sell mortgage-backed securities, financing vehicles to issue short-term debt and collateralized debt obligations, or CDOs, to repackage bonds.

Hey, what’s $1.1 trillion between friends.

Then Steve H., a regular correspondent and fellow skeptic dropped me an email with the following off of www.minyanville.com.

Two Plus Two Equals Four

Financial companies are desperate for capital, but their stock prices are so low that any issuance would be dilution death for the companies. The government is desperately trying to keep the financial system together. Add that up and you get the possibility of a great manipulation.

How would the government engineer a rally in financial stocks so that these companies can sell stock to raise capital at a reasonable or at least palatable dilution level?

It might go something like this. Since financial stocks are in such trouble, they have heavy short interest; this is natural and well known and can be used to their advantage. A clever “berry” might think to introduce confusing rules that raise the cost of borrowing short stock and temporarily confuse shorts into covering and not shorting more. And this is precisely what the SEC did.

It seems innocuous to most folks, but it put stock loan desks and dealers in complete disarray. New short sellers could find no stock to borrow and many existing short sellers were forced to cover as the technical rules forced allocation of loans at much higher costs.

For example, the rebate rate on Fannie Mae (FNM) the day before the SEC announcement was 1%; the day after it was -5%. Many who were short the stock were forced to cover, thus driving the stock price up.

But this alone would only drive stock prices up so much. The clever berry needs a catalyst, one that would force panic buying into now truncated supply.

It just so happened that the new SEC rules came conveniently the day before many of these financial companies were to report earnings. If just somehow these earnings were really good, the match would be lit on the kindling.
So far banks have miraculously come through on their end of things. Wells Fargo (WFC) and JPMorgan (JPM) reported better-than-expected beaten-down earnings. Things must be getting better just as the companies need capital.

What a coincidence.

But if you look at how the banks “beat” their earnings, the coincidence becomes clear. WFC took the unprecedented step of extending charge-off acknowledgment from 120 days to 160 days. This allowed the bank to move less capital to loan loss reserves and report better-than-expected horrible earnings. And JPM was even more aggressive. It actually lowered its loan loss reserves quarter to quarter.

The list of financial companies where shorting regulations are being enforced/enhanced is precisely the banks and dealers (and FNM/Freddie Mac (FRE)) that have access to the Fed's balance sheet (dealers through the PDCF and FNM/FRE through the recently allowed access to the discount window). So we can speculate on the nature of the ''coincidence'': Perhaps the Fed is getting worried about the value of all that collateral these dealers have posted to the Fed balance sheet and must boost the capital of these companies to protect that value.

And now on cue FRE, a $5 billion market capitalization company wants/needs to issue $10 billion in new stock? Doesn’t that sound a little crazy? Well, get ready for others to do the same because the banking system needs capital desperately and the government is there to help.

But help at the expense of whom?

And the Minyanville contributors are not the only ones noticing what’s going on… just today The Economist published the following commentary that (accurately) paints the SEC in a less-than-favorable light.

America’s SEC fights dirty

BEAR markets often involve bare-knuckle fights, but it is still a shock when the referee starts punching below the belt. The Securities and Exchange Commission (SEC) has intervened in the epic struggle between financial companies and the hedge funds that are short-selling their shares.

Desperate to prevent more collapses, the main stock market regulator has slapped a ban for up to one month on “naked shorting” of the shares of 17 investment banks, and of Fannie Mae and Freddie Mac, the two mortgage giants. Some argue that such trades, in which investors sell shares they do not yet possess, make it easier to manipulate prices. The SEC has also reportedly issued over 50 subpoenas to banks and hedge funds as part of its investigation into possibly abusive trading of shares of Bear Stearns and Lehman Brothers.

The SEC’s moves deserve scrutiny. Investment banks must have a dizzying influence over the regulator to win special protection from short-selling, particularly as they act as prime brokers for almost all short-sellers. There is as yet no evidence that market abuse has driven down financial firms’ share prices—and plenty that their trashed balance-sheets and credibility have. London’s financial-services regulator has as yet failed to provide evidence to justify its decision to tighten the disclosure rules on short-selling of some bank shares.

The SEC’s initiatives are asymmetric. It has not investigated whether bullish investors and executives talked bank share prices up in the good times. Application is also inconsistent. The S&P 500 companies with the biggest rises in short positions relative to their free floats in recent weeks include Sears, a retailer, and General Motors, a carmaker. Like the Treasury and the Federal Reserve, the SEC is improvising in order to try to protect banks. But when the dust settles, the incoherence of taking a wild swing may become clear for all to see.

In past musings, I have wondered aloud what measures the government will use in its attempt to maintain the status quo… or at least the status quo that used to be the status quo until the new status quo grabbed the global economy by the neck last year.

At this point we are, in my opinion, still in the early rounds of the crisis, and the reaction of the “authorities” to the crisis. And the low blows to investors foolish enough to remain in the same ring as the regulators and their cronies are just beginning.

As one frantic, clumsy or heavy-handed regulatory attempt to patch things up fails, things will grow steadily worse, leading, I continue to be convinced, to an announcement by the newly sworn-in President Obama of a new deal whose net result will be to knock the excesses out of the economy with an “ambitious” new body of legislation.

That things will roll out this way is due to the quaint tradition in our modern democracy that the new resident of the White House will do “whatever it takes,” no matter what the effect on the economy, to try and eliminate any long-term negative consequences of the mess left by the prior president. The trick is to “git ‘er dun” early in the new presidency, while the memory of the previous administration’s role in creating the mess is still fresh in the public mind.

The problem is that getting her done this time around would require an approach that is literally foreign to either of the leading aspirants of the highest office of the land… not to mention 99% of officialdom, elected and otherwise.

Of course, I arrogantly assume that I know the solution… to let the failed banks fail, to end the fiat monetary system, to cut the size of government in half… for starters… etc. An anarchist/libertarian utopian dream, to be sure. But before writing it off, take a close look around and then tell me how well you think the current Frankenstein model that is just one tick away from communism is working out?

Because I am, once again, massively time-stressed, I will have to leave it there… but as it is a given that Obama will approach his new deal using more traditional – which is to say “statist” – methods, I would love to hear your best bets on what sorts of “tough love” measures the newly elected president will take in an attempt to right the listing economy. Correctly anticipating his moves could lead to a serious money-making opportunity for properly positioned investors.

Drop me your thoughts at david@caseyresearch.com and I’ll run the more cogent thoughts in an upcoming edition.

Speaking of Intervention

I have been rather pleased to read various commentaries in some fairly mainstream outlets pushing back against the notion that it is the evil speculators who are entirely responsible for driving oil prices higher… and that they must be punished through changes in the regulatory regimes that will serve to separate them from their daily bread.
This notion is, of course, not new… as the Commodities Futures Trading Commission (CFTC) is a busybody of long and well-deserved reputation.

But this week, CNN and the Wall Street Journal have brought to light the story of onions… the only commodity where trading in futures contracts are verboten.

The following excerpt is from CNN…

And yet even with no traders to blame, the volatility in onion prices makes the swings in oil and corn look tame, reinforcing academics' belief that futures trading diminishes extreme price swings. Since 2006, oil prices have risen 100%, and corn is up 300%. But onion prices soared 400% between October 2006 and April 2007, when weather reduced crops, according to the U.S. Department of Agriculture, only to crash 96% by March 2008 on overproduction and then rebound 300% by this past April.

Full article here

And this from the Wall Street Journal…

Congress is back in session and oil prices are still through the roof, so pointless or destructive energy legislation is all but guaranteed. Most likely is stiffer regulation of the futures market, since Democrats and even many Republicans have so much invested in blaming "speculators" for $4 gas.

Congress always needs a political villain, but few are more undeserving. Futures trading merely allows market participants to determine the best estimate – based on available information like supply and demand and the rate of inflation – of what the real price of oil will be on the delivery date of the contracts. Such a basic price discovery mechanism lets major energy consumers hedge against volatility. Still, "speculators" always end up tied to the whipping post when people get upset about price swings.

Full article here

At the risk of coming across optimistic in these bearish times, I have been detecting a quite interesting and even positive trend of late, a trend reflected in those two articles.

Namely, whereas people used to believe the government, and the media would parrot the party line… new legions of skeptics armed with well-read blogs are willing, eager even, to call a spade a spade and support their contentions with hard facts and data. Upon being confronted with hard facts, researchers for the mainstream media, who regularly troll and even participate in this new world, are then forced to report back to headquarters with a more accurate slant.

It is not so much about the much-touted and long-awaited democratization of media, as it is about a rising new meritocracy whereby the many voices yearning to be heard, on recognizing one of the many that actually knows of what they speak, will republish the voice and send it out to everyone they know. Next thing you know, the truth will out.

I must confess, after years of listening to drivel in public media -- and the long tails of that drivel in private conversations -- I have written off most of humanity.

But should this new trend actually turn into a paradigm shift that provides some larger percentage of the population access to the facts so necessary to informed opinion, there might be hope after all.

On that general theme, Doug Hornig of our Daily Resource PLUS service sent along the following email message this morning. The Chuck Butler he refers to is my former comrade in arms at EverBank.com (if you haven’t checked out their FDIC-insured World Currency CDs and deposit accounts, click here.)

Did you all see this from Chuck Butler's column yesterday? He was quoting some words from Jim Bunning, the old Phillies pitcher whose Senate career has so far been totally undistinguished, as far as I can recall, but who now appears to have seen the light. This was his very public dressing down of Big Ben, during the Chair's appearance before Congress. Dr. Paul, you got a pal on the other side of the Hill. . .


"Thank you, Mr. Chairman. I know we have a lot of ground to cover today, but I want to say a few things on the topic of this hearing and of the next.

"First, on monetary policy, I am deeply concerned about what the Fed has done in the last year and in the last decade. Chairman Greenspan’s easy money the late nineties and then following the tech bust inflated the housing bubble and created the mess we are in today. Chairman Bernanke’s easy money in the last year has undermined the dollar and sent oil to new record highs every few days, and almost doubling since the rate cuts started. Inflation is here and it is hurting average Americans.

"Second, the Fed is asking for more power. But the Fed has proven they cannot be trusted with the power they have. They get it wrong, do not use it, or stretch it further than it was ever supposed to go. As I said a moment ago, their monetary policy is a leading cause of the mess we are in. As regulators, it took them until yesterday to use power we gave them in 1994 to regulate all mortgage lenders. And they stretched their authority to buy 29 billion dollars of Bear Stearns assets so JPMorgan could buy Bear at a steep discount.

"Now the Fed wants to be the systemic risk regulator. But the Fed is the systemic risk. Giving the Fed more power is like giving the neighborhood kid who broke your window playing baseball in the street a bigger bat and thinking that will fix the problem. I am not going to go along with that and will use all my powers as a senator to stop any new powers going to the Fed. Instead, we should give them less to do, so they can do it right, either by taking away their monetary policy responsibility or by requiring them to focus only on inflation."

To which I say, Hip! Hip! Hooray!

Making Leverage Pay

Earlier this week, we announced our first ever Investors’ Intensive… a comprehensive “boot camp” dedicated to providing subscribers with the specific knowledge needed to use options and futures to maximize profits from the powerful investment trends now sweeping the globe.

Paradoxically, you can also use these instruments to greatly reduce your overall portfolio risk. In Chicago, you’ll learn how… but I’ll also provide a useful example in a second.

First, however, I want to let you know that the limited seating available for this hands-on session is already over half-sold out, with the balance of the seats going quickly.

• If you are even a little bit interested in attending, and you should be, you need to make your decision right away.

For your convenience, here’s a link to the information site and secure registration form.

1,888% or 33%... a Real-Life Illustration

The following example of the reason why options and futures belong in your portfolio mix is from a trade actually recommended by one of the Chicago faculty members.

(I apologize in advance if this seems a bit complex… after Chicago, you’ll fully understand the ins and outs of options and futures trading.)

At the time of the initial recommendation, in March 2007, crude oil was trading for $63.80. If you had acted on the recommendation, you would have bought a December 2008 “call” option (meaning you had the option but not the obligation to buy the underlying commodity at a specific price… the “strike price”) with a strike price of $77.50.

An option controlling 1,000 barrels of oil back then was $3.50, for a total cost of $3,500 (1000 x $3.50). So, the trade was simply this: being bullish on oil back in March of 2007, you could have bought an option with a far-off expiration date -- December 2008 -- just the sort of buy-and-hold play we here at Casey Research are fond of.

Now, jump forward to yesterday with the price of oil at $146.68.

Because oil moved well over the strike price, each option you bought back in March of 2007 for $3,500 would now be trading for $69,600! Thus, after returning your original $3,500, you could have pocketed a profit of $66,100… for a total return before commissions of 1,888%!

Importantly, to earn your $66,100, you would have risked only $3,500. A very acceptable risk/reward ratio by any measure.

Of course, the oil market did very well over the period, but we are seeing similarly big moves shaping up in a number of markets. Apply a little leverage and, well… you get the idea.

• For the record, if you had made the same trade using futures, you would have risked $6,380 for an $82,800 return (in Chicago, you’ll learn when futures are a better play than options and vice versa).



• Or, back in March of 2007, you could have bought an oil ETF such as the 434 OIH. But this is the really important point: without the use of leverage, in order to control the value, you would have had to invest $63,800… not the $3,500 you paid for your option.
  
  As a result, with an ETF you would have earned a net profit on your investment of $21,620. That’s a 33% gain. Not bad at all. But, as you can clearly see, an order of magnitude less than the 1,888% earned by the options investors or the 1,197% return earned by the futures traders.

We live in exciting times, times that are marked by extreme volatility… the ideal market environment for making big profits from options and futures trading.

And that’s why we have pulled out all the stops to get this new Investors’ Intensive organized… and why you should make every attempt to attend.

The two days at the luxurious Fairmont Hotel in Chicago, August 14 & 15, should pay for themselves many, many times over… and then keep paying for the rest of your investment career.

Here again is the link to the information site with a tentative schedule and registration form.

Hope to see you there.

Inflation/Deflation?

In the upcoming edition of The Casey Report, our illustrious chairman and always engaging partner Doug is tackling the inflation/deflation debate head on. (By the by, when you subscribe before the end of July, you can still take advantage of our two-for-one offer and get the International Speculator free. Details here.)

Meanwhile, as part of his preparations for an interview with Fox News, our own Bud Conrad, the chief economist of this operation, sent over some brief notes on the topic that I thought you might like to see, given the less-than-rosy inflation numbers released earlier this week. Here’s Bud…

Today's 1.1% inflation calculates out to 14% a year, which is about what Americans have been experiencing, and already know without believing the words of our government that inflation is contained. The CPI numbers have not been properly calculated. This month’s 6.6% inflation for energy is, annualized, about 100% compounded. Yesterday's 1.8% Producer Price Index annualizes to 24%. The raw materials take 6 months or so to filter through the production pipeline, so there is more inflation on the way.

The root cause of the situation is the debasing of the dollar, primarily based on government deficits. While Congress put Bernanke and Paulson on the hot seat, as well they should, Congress has its fingerprints at the crime scene. The inflation should be seen as a hidden tax, not officially levied on people but spread around as the deficits work themselves into loss of purchasing power for everyone.

This big-picture view is what has made Casey Research focus on precious metals and energy. I predicted the price of corn to jump in my August 2006 article and it is up 3 times since then. Food is our next big situation. The deficit this year is projected at a record $500B and Congress and Bernanke and Paulson are talking another $300B bailout for mortgages and Fannie and Freddie… all part of our long-held negative view on financials.

Bud

Put Your Hands Up, You Are (Getting) Surrounded

I received the following this week from one of our many subscriber-correspondents… from Canada.

You may remember that I'm a real estate broker by profession... since Sept. 11/01 we have experienced many changes in our profession in Canada in response to the perceived threat of terrorism and its related activities such as money laundering.

Fintrac, the government body whose collective nose follows the money supposedly related to said activities, recently implemented a bunch of new rules that govern our profession.

Effective Jun. 23/08, we now have to complete a "Receipt of Funds Record" anytime we receive funds in any amount and in any form, whereas previously we only had to report if we took a cash deposit of $10K or more, which never occurs.

A previous rule required us to pick up the phone and sing like canaries to the boys in Ottawa if we "thought" or "felt" the transaction was "suspicious" (heavy objectivity there!).

As of Jun. 23/08, we now have to complete an "Individual Identification Information Record" on everyone who becomes a client and includes such things as name, address, date of birth, occupation, and we must see some form of ID such as a driver's license, birth certificate, provincial health insurance card (but these are only acceptable if from certain provinces), passport, record of landing, permanent resident card, old-age security card, certificate of Indian status or SIN card (although the numbers are not to be used)... and this list will differ in different provinces.

Now get this!... If a prospective client refuses to give us the required information, we are required by law to walk away from the situation, otherwise we are in violation of the "Proceeds of Crime (Money Laundering) and Terrorist Financing Act" and could have enormous fines imposed upon us!

Just thought you might like a glimpse into the lives of others in another country as their government tries to impose its will on a large segment of its citizenry. If I'm not mistaken, I think CREA (Canadian Real Estate Association) has 80,000-100,000 members. (And Realtors are not alone in this... others include, with varying degrees of responsibility, insurance agents/companies, stock brokers, accountants, financial entities, etc.)

Remember that TV show in the ‘70s called “The Prisoner” starring... I think it was Patrick McGoohan? I keep thinking of that big bubble emerging out of the water on its way to do its next dirty deed.

The noose tightens.

Miscellany

• Phyles… Bud Conrad attended a phyle meeting in Silicon Valley this week and came away very favorably impressed with the group and the caliber of the conversation.
  
  Another one of our long-term subscribers and periodic correspondents, Paul K. has volunteered to host a group in the Denver area. The first meeting is tentatively arranged for Friday, August 1st, from 7-9 pm.
  
  If you live in either of those areas and are interested in joining, drop us a note at phyle@caseyresearch.com and we’ll get you connected.

And that, dear readers, is it for today. Given the booming summer lightning storm approaching quickly, and the sure knowledge that having my computer fried before shipping today’s labors off would send me into deep despair, I rush to the close.

But yet, I can’t resist a quick look at the numbers… which show me that the DJIA is struggling to hold on to its paltry gains, up just 22 points… and gold, after looking like $1,000 might go down again this week, has pulled back somewhat, to $956 as the wind-driven rain begins to make its way through the screen and onto the keys of my computer.

And so, until next week, goodbye… gotta run!




David Galland
Managing Director
Casey Research, LLC.