This announcement initiated sell programs in almost every financial market. There are many reasons for this reaction, one of which was the recognition that the Federal Reserve is 0-for-whatever-it-has tried. All the Fed’s initiatives have failed, and now, all that Bernanke can think to do is drive down yields that are already below 2.00%!

The Fed’s efforts to revive the economy are failing because of the four topics that never enter the mind of Federal Reserve Chairman Ben S. Bernanke: money, credit, leverage, and capital.

The productivity of capital is an important consideration, one which most people understand, in their own words. A bank does not lend money to a business that cannot earn its way to paying back the loan. A potential borrower understands the banker’s hurdle. Similarly, an investor buys shares of common stock in a company that will produce the most from the least. The higher the profits produced per share, the more the shares should be worth.

In other words, most folks understand the classic connection between risk and reward. And most folks also understand that merely borrowing more money, without putting that money to productive use, will never solve anything.

Ben & friends do not think this way. They believe that funneling more credit into the economy is a surefire means of “kickstarting growth.” But the facts say otherwise.

During the quantitative easing programs, the Fed’s credit-from-the-heavens produced zero growth.

During the 1980s, the change (rise) in non-financial domestic debt divided by the change (rise) in nominal Gross Domestic Product was 2.2. That is, for every $2.20 borrowed, the United States produced $1.00 of additional goods and services (nominal). In the 1990s, debt was less efficient. The US borrowed $2.70 for every $1.00 of growth. More recently, between 2001 and 2008, this ratio soared all the way to $4.20 for every $1.00 of growth.

In other words, every incremental unit of credit has been less and less productive. But that’s the only tool Bernanke has in his toolbox, so he just keeps using it. Since the Fed rolled out its various quantitative initiatives in early 2009, the ratio of debt-to-production has been 3.7:1 (through June, 2011). But, the increase in transfer payments (1-in-7 Americans now receive food stamps, Cash for Clunkers, shovel-ready bank bailouts) exceeds the rise in nominal GDP by a wide margin. Thus, as a measure of financial efficiency, the ratio is now meaningless.

The additional debt being manufactured is not producing any additional goods and services. The more Bernanke applies his senior thesis to the real economy, the less the economy is able to pay down old debt, much less manufacture additional goods and services to pay down the new debt.

The Fed has pegged short-term interest rates at zero; Operation Twist is an attempt to drive long-term rates to zero (or, close to it); the rise of incomes in the United States since 2008 has been zero; “real” GDP growth since QE1 has been less than zero; the FOMC is an absolute zero.

Physical elements tend to behave very strangely as they approach absolute zero (-273 Celsius).

Economic elements, as it turns out, are not so different. The move toward “absolute zero” along the yield curve is producing some very strange behavior — in both the financial markets and the economy at large.

The Authorities have lost control of the markets they have been manipulating. Desperate tactics, with untold unintended consequences, such as the Swiss National Bank doubling its monetary base last month, ensure more fanatical outbursts from the Fed, the ECB, and the Bank of Japan.

In this setting, gold fell more than $150 last week. Strange, isn’t it? Other than remote islands, gold is the best bargain around.

Regards,

Frederick J. Sheehan,
for The Daily Reckoning

An Absolute Zero originally appeared in the Daily Reckoning. The Daily Reckoning, published by Agora Financial provides over 400,000 global readers economic news, market analysis, and contrarian investment ideas.

Osiris Investment Partners L.P. in Boston, under the authorship of Principal and Managing Member Paul Stuka, wrote to clients on August 18, 2011. The XAU Gold Index was down 6% for the year-to-date, and the GDXJ Gold Stocks Index of smaller gold miners had fallen 10%. On that same mid-August date, gold — the real stuff that hardly anyone owns but of which everyone within the media’s range is expected to express an opinion — had risen 26% in 2011.

The gap between gold and the diggers will close — when is hard to say. In which direction we will discover. The view here is that the stewardship of paper currencies, the medium in which gold, silver, and oil (crude, canola, and palm) are priced, has never been in worse hands. This is saying less than might be thought since it was not until 1971 that official money went untethered from impartial restraint (usually, gold). Alas, the world is slow to grasp the fact that central banks are peopled by political hacks (as Senator Harry Reid called then-Federal Reserve Chairman Alan Greenspan in 2005, but equally true of today’s empty suits). So now is the time to make money. Real money.

Money is to be made by holding “anti-dollars” like gold. Federal Reserve Chairman, Ben S. Bernanke, remains one of the anti-dollar’s very best friends, since he continuously reiterates his intentions to debase the dollar for the public good. Last week, Bernanke remarked that the United States is blessed with lower inflation than other countries and “Low inflation means that the buying power of the dollar, in terms of domestic goods and services, remains stable over time.”

It does not take a trial lawyer to see the inconsequentiality, inconsistency, or mendacity in that labored claim. Ben may be fishing turtles from the local creek, painting his barbarous equations on their backs, and selling them at the local five-and-dime (which would still be overvaluing his scholarship by at least a nickel), but shoppers at local farmer’s markets are paying the price for purchasing with dollars.

Osiris Investment Partners went on to write: “[S]ince the early 1980s, when the XAU Index was first constructed, until the fall of 2008, this ratio remained in a range of .16 to .38, even during the depths of the gold bear market. [That is the ratio of the XAU Gold Stock Index divided by the price of an ounce of gold in US dollars]. During the financial crisis of 2008, this ratio dropped briefly to .09. Since that time, it has traded up to .16, but it has never exceeded the former floor.

As I write today the ratio is .114. In other words, the gold shares are currently the cheapest that they have ever been, excluding a one-month period in the fall of 2008. On a fundamental basis, gold stocks have historically traded at 10 times or more annual cash flow. We are presently seeing many companies priced at one to three times potential forward cash flow, if they can execute their plan. Clearly, not all of them will realize the potential. However, many will.”

Of the cash flow, Erste Group, (Erste Bank, Vienna: “In Gold We Trust;” July, 2011; Ronald-Peter Stoferle), estimates the “aggregate free cash flow of the 16 companies in the Gold Bugs Index will amount to [$8.5 billion] this year and will increase to [$14 billion] by 2013.” Erste Group continues: “The companies in the Gold Bugs Index currently command an estimated 2011 [price-to-earnings ratio of] 14x, which is expected to fall to 12x in 2012. This is extremely low in terms of its own history (average PE 2000-2010: 33x) and in relation to many other sectors.” (The Gold Bugs Index consists of 16 mining companies that do not hedge their gold production. This is not necessarily true of the miners in the XAU Index.)

Potential investors seek the potential catalyst. What might that be?

First, the correlation among sectors in the S&P 500 has never been greater. ETFs and high-frequency trading rule the waves. Machines trade stocks in bulk, with little distinction among industries and companies. Such periods of over-zealous gimmickry and of intimidated investors are often good times to buy stocks that will later assert their superior characteristics.

Second, gold- and silver-mining shares are “under-owned” in relation to one-stop-shopping ETFs. The miners know this. Shareholders have enlightened management: they need to pay out dividends to distinguish themselves as real companies. Recently, Newmont Mining stated it will increase its dividend by twenty cents per share for every $100 rise in the price of gold. Gold Resource Corporation has set a target of paying out one-third of its cash flow in dividends to shareholders.

Third, the argument of whether the world is inflating or deflating is tangential to the price of gold. Better expressing the “price of gold”: how many units of paper currency (such as the dollar) does it cost to buy an ounce of gold? (We are returning, now, to the reference metal). Gold has performed better in deflations than inflations, but the cause and effect that this relationship addresses (“gold is an inflation hedge”) may be misleading. Monetary, military, and political chaos have more often corresponded with deflationary than inflationary times. The real story is that gold is money, but only speaks up when the credibility of states and their currencies deteriorate.

Fourth, the proportion of people who own gold and silver is small. (Particularly so in the United States, but that is not the point, here.) This is the greatest flaw of the “gold in a bubble” chorus. There has been no panic into gold, or, more likely for the Average Joe, into gold shares. At some point, the mere sight of Bernanke may be worth a quick $500-an-ounce trading profit. But that’s not happening yet.

Regards,

Frederick J. Sheehan,
for The Daily Reckoning

Buy Anti-Dollars! originally appeared in the Daily Reckoning. The Daily Reckoning, published by Agora Financial provides over 400,000 global readers economic news, market analysis, and contrarian investment ideas.

He told investors the “Obama administration is the greatest wet blanket to business and progress and job creation in my lifetime. And I could prove it…I could spend the next three hours giving you examples of all of us in this marketplace that are frightened to death about all the new regulations,[as] our healthcare costs escalate, regulations coming from left and right, [with a] President that…keeps using that word ‘redistribution.’”

Wynn’s pitch was not partisan: “I am a Democrat businessman….I support Harry Reid…[but] I am telling you that the business community in this country is frightened to death of the weird political philosophy of the President of the United States. Until he is gone, everybody is going to be sitting on [his] thumbs.

“[I]t is Obama that is responsible for this fear in America,” Wynn insisted. “The guy keeps making speeches about redistribution and [the need] to do something to businesses that don’t invest, that are holding too much money. You know, we haven’t heard that kind of talk except from pure socialists. Everybody is afraid of the government and there is no need soft-pedaling it. It is the truth. It is the truth.”

The [Chinese] State Administration of Foreign Exchange stated on July 20, 2011: “We hope the U.S. government will earnestly adopt responsible policies to strengthen international market confidence, and to respect and protect the interests of investors.”

Steve Wynn might have written the same words.

It is a strange time in financial history when a Democrat CEO heaps disgust on a U.S. President from the same political party. It is an even stranger time when Communists feel the need to remind Capitalists to “protect the interests of investors.”

Regards,

Fred Sheehan,
for The Daily Reckoning

What a Business originally appeared in the Daily Reckoning. The Daily Reckoning, published by Agora Financial provides over 400,000 global readers economic news, market analysis, and contrarian investment ideas.

Despite the band-aids, the trend towards insolvency continues. Central Falls has reached a dead end.

Quoting The New York Times (July 11, 2011): “The impoverished city, operating under a receiver for a year, has promised $80 million worth of retirement benefits to 214 police officers and firefighters, far more than it can afford. Those workers’ pension fund will probably run out of money in October…”

The retirees face a bleak future: “Central Falls, like many American cities, has not placed its police and firefighters in Social Security. Many have no other benefits to fall back on.”

The inability to meet payments, as is true across the western world, was evident decades ago. The parties refused to think through the consequences of their actions: “The city, just north of Providence, is small and poor, but over the years it has promised police officers and firefighters retirement benefits like those offered in big, rich states like California and New York. These uniformed workers can retire after just 20 years of service, receive free health care in retirement, and qualify for full disability pensions when only partly disabled.”

The previous paragraph reflects poorly on the grand wizards of Central Falls. The Times noted: “Central Falls…filled mostly with immigrant families, struggles on a median household income of less than $33,520 a year… The typical single-family house…is worth about $130,000.”

Although this was a news story, the Times reporters, Mary Williams Walsh and Abby Goodnough, could not restrain their fury: “It is hard to see how anyone thought such an impoverished tax base could come up with an additional $80 million for retirement benefits. If the city were contributing the recommended amount to the plan each year, it would take 57 percent of local property tax revenue.”

That is hindsight. We are used to expedients: delayed pension contributions; 8% projected investment returns; economic recoveries around the corner; market recoveries around the corner; real-estate appreciation (higher tax receipts); higher tax rates; bank loans; bond issues; state bailouts; federal bailouts.

These avenues are closed. The state of Rhode Island “has an investment-grade credit rating, but it is in no position to bail out a string of teetering cities, or take over their shaky local pension funds the way the federal government does when some companies go bankrupt.” The Pension Benefit Guaranty Corporation is the backstop to private pension plans. None exists for public plans. (Could there be a Christmas Eve Special – see emergency decrees on December 24, 2009, when no one was looking – that sweeps all public pension benefits into Uncle Sugar’s side pocket? No doubt.)

The state of Rhode Island may follow its mendicant municipality’s plight: “Rhode Island must…stabilize its own pension fund, which continues to require more and more cash each year, despite four overhauls since 2005 that were supposed to get the cost under control. The Securities and Exchange Commission is investigating. If the state turns out to have understated its commitments, it could deliver a new jolt to bond markets still nervous after two traumatic years.”

Rhode Island is reluctant to seek federal aid for itself (a possible source of funds for Central Falls): “State lawmakers are trying to contain the damage, mindful that it would be a bad time for any state to seek help in Washington.” As a practical matter, one in four of the cities and towns in Rhode Island are in “some degree of distress.” A well-funded state would not know where to start.

A bright side to Central Falls’ requiem is that it must make decisions today that most others will avoid as long as possible.

An example of the latter is Cambridge Hospital in Cambridge, Massachusetts. The Boston Globe (July 11, 2011) reported: “A state Superior Court judge has ruled that the owner of Cambridge Hospital can’t move forward with its plan to cut retiree health benefits for 289 nurses, a decision being hailed as a victory by the Massachusetts Nurses Association.”

The judge is delirious. He would fit right in with the empty suits at the European Central Bank. Living in a world of make-believe, he (and they) interpret laws and freeze reality as if it were 1953. (Under Massachusetts law, courts are to interpret pension benefits within “reasonable expectations” of the beneficiary.)

Cutting to the chase, the owner of the hospital is down to its last buck. “An accounting change… would increase the hospital system’s costs by about $30 million over the next three years. The proposed cut [40% of the current benefit] prompted the union to reject a ‘last and final’ contract offer last summer.”

As with Central Falls, the avenues to acquire cash are shut (extrapolating from the article). The judge decided to ignore the facts and make matters worse for the nurses. Matters will be worse because Central Falls may be one of the first municipalities to go belly-up, but it won’t be the last. And as the old adage goes, if you’re going to go bankrupt, it’s better to be the first. The first to go bankrupt is also the first to sell off assets, cut spending and begin restoring solvency and economic viability.

Municipalities like Central Falls will have to sell or lease highways, parking garages, bridges, sewer systems, water systems, utilities, and many other services traditionally provided by states, counties and towns: from garbage to schools.

Central Falls may be fortunate in selling before prices plunge. A great buyer’s market is in the making.

Regards,

Frederick Sheehan,
for The Daily Reckoning

Bankruptcy: From Greece to Rhode Island originally appeared in the Daily Reckoning. The Daily Reckoning, published by Agora Financial provides over 400,000 global readers economic news, market analysis, and contrarian investment ideas.

Lewitt is demonstrably correct. Since 2007, global bureaucrats have broken any law that has hindered their attempts to ward off our inevitable reckoning. Attempts to prevent a euro eruption have become preposterous. The European Central Bank (ECB) is clearly in extremis.

A week does not go by without the ECB reducing its standards of collateral. The cost is not only its credibility as a central bank, but in the composition of its deteriorating balance sheet.

To make matters worse, Greece is the smallest economy among the impoverished PIIGS: Portugal, Ireland, Italy, Greece, and Spain. Since others will probably follow Greece, the current impasse is all the more discouraging. The Greek government cannot meet its July interest payment obligations to banks, central and commercial. It can no longer borrow from banks or in the bond markets. (This is also true for Ireland and Portugal, and possibly others.)

The Greek government has bills and salaries to pay. The ECB is doing its all to avoid default. This presents a dilemma: the further it goes in preventing (in fact: forestalling) a default by the Greek government, the more it compromises its legitimacy by breaking its own rules and ruining its balance sheet. A credit-sensitive bystander would say the ECB’s legitimacy and balance sheet are cases of the emperor wearing no clothes but conventional opinion being afraid to state the obvious.

Remembering that the euro is an experiment – a currency that is only 13-year-old and not issued by a sovereign government – the European Central Bank should, above all, adhere to the highest standards of integrity.

Let’s go back a year. After a meeting at the European Central Bank on May 6, 2010, the ECB confirmed its commitment to never buy sovereign (government) and corporate debt. On May 10, 2010, The ECB announced an unlimited program of buying sovereign (government) and corporate debt. On the same day (May 10), the ECB and IMF announced a $957 billion “shock-and-awe” loan program to calm markets. Said one European Union official: “We shall defend the euro whatever it takes.” The double-talk from European Union and ECB officials still pours forth. As St. Augustine or Bernie Madoff said: “Once you go down that road, you can’t stop.” And it is a frightening road for all the folks who calculate their wealth in euros.

“As the citizens of the economically strong countries (and citizens with wealth to lose across the entire Eurozone) reflected on their personal financial conditions,” writes Donald Coxe (Coxe Advisors LLP) in his May 26, 2011 edition of Basic Points, “they recognized a new fundamental risk: Their pay-checks, pensions, life insurance, bank deposits, bond investments, and cash were euro-denominated.”

The ECB’s balance sheet stands behind the euro. To generalize, as long as this balance sheet commands widespread trust, the euro will maintain its strength. But this balance sheet is not very trustworthy.

On the left side of the ledger, the ECB holds €1.9 trillion (about $2.6 trillion) of assets. On December 31, 2010, it posted €82 billion in capital and reserves. The leverage ratio is 23:1. If the value of ECB assets falls by 4.3%, it will be insolvent.

What do those assets consist of? The ECB holds €480 billion of asset-backed securities (ABS) and €360 billion of “non-marketable financial instruments.” That comes to 44% of total assets. These asset-backed securities are not the old reliables. No, these are vintage 2010 securitizations, in which year the ECB permitted European commercial banks to bundle their bad mortgages and mortgage securities, sell them at par value to the ECB.

As for “non-marketable financial instruments,” these presumably include the Portuguese government bonds issued in 1943 and due for repayment in the year 9999. The bankers in Lisbon surely broke out a vintage port when they unloaded the 1943’s that settle 8,000 years from now.

Another peculiar “non-marketable financial instrument” is called the “own-use” bond, sold by Irish banks to the ECB. These are bonds that Irish banks issue to themselves and then sell to the ECB in return for euros. This arrangement may be difficult to grasp at first since it is both new and bizarre. An example: Allied Irish Bank (AIB) issued a €2.87 billion “own use” bond on April 26, 2011. By issuing this bond, AIB owes itself €2.87. The €2.87 was used as collateral for cash – euros – wired from the ECB. The Irish government provides the collateral by guaranteeing these bonds.

But the Irish government has no money and it cannot print euros. Only the ECB can authorize money-printing. In what must be quite an understatement, the Irish Independent observed: “‘Own-use’ bonds are popular with banks because they can continue to access funding at the ECB’s one percent interest rate even when they have run out of the high-quality collateral typically demanded in Frankfurt.”

For its part, the ECB insists all of these loans are properly collateralized. One understatement follows another: “This makes some eurozone states uncomfortable, since any losses on the money advanced by the ECB would have to be funded by all 17 states.” This remark refers to the ECB relationship with the central banks of the countries feeding at the euro banquet. The national central banks must pony up for any losses incurred by the ECB.

The other 56% of the assets on the balance sheet (there may be some double-counting here) includes loans of €106 billion to the Irish central bank. On its December 31, 2010 balance sheet, the Irish central bank showed €70 billion in an “Emergency Liquidity Assistance” account, funds forwarded from the ECB.

At the end of 2010, the ECB also held outstanding loans of €92 billion to the Portuguese and Spanish central banks (€48 billion and €44 billion, respectively). More collateral (the Colossus of Rhodes?) stood behind the €90 billion in Greek assets held by the ECB.

The list of unconscionable deceits by the euro authorities is long, but that may be enough to indicate the euro is heading south. That is before looking at the European banking system, which has already suffered from bank runs. Depositors have withdrawn money and caution builds in the interbank lending market (one reason US Treasury yields remain so low.)

Here, specific and vulnerable bank exposures will be ignored and attention directed to one term: credit-default swaps. Nobody knows who owes whom what. This is 2008, again. Since then, United States politicians passed a financial reform bill that is taller than the Washington Monument, but credit-default swaps remain unregulated, uncollateralized, unmonitored, and requiring no capital. They may be bought, sold, and traded by, between, and among banks, insurance companies, pension funds, endowments, and hedge funds.

Credit-default swaps are the reason various parties want the negotiation of Greek debt to avoid a “credit event.” If a credit event is triggered, the insurer pays the owner of the CDS. Leaving European banks aside, US banks have written $34.1 billion of credit-default insurance on Greece, $54 billion on Ireland, and $41.2 billion Portugal sovereign debt.

Europe has an additional problem, not of prominence in 2008. Once triggered, the vintage 2011 CDS need to be settled in euros, not dollars, as was generally true when Lehman and AIG were on the front page. Federal Reserve Chairman Ben S. Bernanke has magnanimously announced the Fed has opened unlimited swap lines should Europe need them. (On our behalf: there is no recourse by the Fed if another central bank fails to pay us back. Thank you, Marshall Auerbach, for explaining this and other peculiarities.) However, Simple Ben cannot advance euros. Only the ECB can do that (through the national central banks).

To sum up, if an agreement cannot be reached to resuscitate Greece, the ECB will print billions of euros so that banks can settle CDS claims. To prevent this hypothetical Greek failure – really, to avoid a CDS credit event – the ECB may need to buy up the Greek debt. (Unintended consequences for doing so may spring to mind. The list is longer than that of scorned securities currently accepted by the ECB.) In either case, the world will be plastered with a new batch of euros. Ben Bernanke will not let the opportunity of international panic pass without matching new euros with new dollars.

This is why gold and silver were invented.

Regards,

Frederick J. Sheehan,
for The Daily Reckoning

The Euro and You originally appeared in the Daily Reckoning. The Daily Reckoning, published by Agora Financial provides over 400,000 global readers economic news, market analysis, and contrarian investment ideas.

Today, the Bureau of Labor Statistics (BLS) has a four-year-old mind. On the morning of June 3, 2011, it released its monthly Employment Situation Report. The very first words were: “Non-farm employment changed little (+54,000) in May…” Nowhere in the 38-page report does the BLS state that the addition of 54,000 jobs was actually a loss of 152,000 jobs.

The BLS invented 206,000 jobs. The Bureau has constructed an equation called the “Net Birth/Death Model.” Its purpose is to count “Business births.” That is, new jobs in new businesses net the number of lost jobs in “Business deaths”: companies that went out of business.

This figure plays a large role in how Americans are told to think about the economy. CNBC did not look beyond the first sentence that morning when it announced The Number: +54,000. It did not mention the 206,000 net birth-death jobs. The Wall Street talking heads who were then interviewed were also ignorant. Last month, on May 6, 2011, the BLS April Employment Situation Report opened: “Non-farm payroll employment rose by 244,000 in April…” The +175,000 net birth/death jobs were not mentioned by Bubble TV and maybe not by any other major media outlet.

There are those who say the net birth/death (NBD) figure is a sophisticated calculation. No doubt it is; but is it accurate? If it is, why does the BLS never mention that NBD jobs were added when it manufactured The Number? Why does it so diligently hide it?

The initiative for the NBD calculation addressed a real problem. The BLS is not equipped to include “business births” in its monthly Employment Situation Report. It makes sense to adjust The Number, but the BLS, like most of Washington, is detached from the economy.

In June 2011, it is ridiculous to conclude the US economy is adding more jobs than it is losing. On June 2, 2011, the National Federation of Independent Business (NFIB), a trade group of smaller businesses, released its latest survey results. (I have found the direction of the trend in the monthly NFIB survey offers a good indication of the direction of the economy.)

Some of the highlights from the June 2, 2011, NFIB release:

“Chief economist for the National Federation of Independent Business (NFIB) William C. Dunkelberg, issued the following statement on May job numbers, based on NFIB’s monthly economic survey: “After solid job gains early in the year, progress has slowed to a trickle. The two NFIB indicators – job openings and hiring plans – that predict the unemployment rate both fell, suggesting that the rate itself will rise. “Meaningful job creation on Main Street has collapsed.” With one in four owners still reporting ‘weak sales’ as their  No. 1 business problem, there is little need to add employees, especially with the uncertainty about future labor costs arising from new regulation and legislation.”

The Bureau of Labor Statistics pushes the Old Maid above the other cards in its hand each month. It takes five seconds to type “net birth death” into the BLS website’s search engine and read this month’s NBD number. Yet, it is not mentioned by the media or by Wall Street talking heads. The Bureau of Labor Statistics has every reason to look at America and proclaim: “Ha, Ha, you have the Old Maid!”

Regards,

Frederick J. Sheehan,
for The Daily Reckoning

Playing Old Maid originally appeared in the Daily Reckoning. The Daily Reckoning, published by Agora Financial provides over 400,000 global readers economic news, market analysis, and contrarian investment ideas.

The authorities are doing all they can to prevent the necessary deleveraging. That is the context in which Michael A.J. Farrell, CEO of Annaly Capital Management (NYSE:NLY), spoke to investors during his company’s first quarter 2011 conference call:

“[T]he change that is happening in the financial markets is a chaotic mess. I believe the simultaneous execution of radical monetary policy, fiscal policy, and financial regulatory reform is introducing rather than reducing systemic risk in the global financial system by ignoring the simplest lesson of the scientific method. Rather than change one variable in a complex system and test the outcome, regulators and policymakers are changing virtually all of them at the same time: QRM [quantitative risk management], risk retention, the Volcker Rule, Basel III capital rules, derivatives clearing and related margin requirements. GSE reform. FAS 166 and 167. Zero-bound fed funds policy and QE2. Deficit financing, structural budgetary imbalances, and debt limit debate.”

Where will this end? Michael Lewitt, proprietor of Harch Capital Management in Boca Raton, Florida, discussed the consequences of our leaders’ catastrophic policies in the May issue of his monthly letter, The Credit Strategist:

“Rather than confronting sources of volatility, policymakers have sought to smooth out volatility at all costs. Unfortunately, these costs are proving to be very high and will ultimately prove prohibitive. Pressures build inside complex systems until they can no longer be suppressed. When these pressures can no longer be contained, they tend to erupt with far greater violence than had they been allowed to adjust earlier.

Lewitt continued. Federal Reserve Chairman Greenspan and Bernanke “convinced investors the Fed would bail them out if the economy or markets got into serious trouble. As a result, investors engaged in increasingly reckless behavior…” The result: “Rather than saving the markets, Mr. Greenspan’s philosophy and approach guaranteed their failure.” One of the consequences is “the build-up of unsustainable debt levels.”

We are overleveraged, undercollateralized, and accentuating these unsustainable imbalances. Lewitt notes, “the Federal Reserve has accounted for 101 percent of the net Treasury bond issuance during the first four months of 2011.” He goes on: “The US government has been the largest purchaser of Treasuries, promulgating a Ponzi scheme of unprecedented scale.”

The US Treasury issues debt and QE2 buys it. Lewitt notes that 10-year Treasury yields have fallen from 3.59% on April, 11 2011, to 3.15% on May 6, 2011.

Since the Fed is the sole net buyer, the 10-year-yield is not a real interest rate. This is also true of the zero-percent short-term yield, one of the trial balloons listed by Michael Farrell. Interest rates are integral to the pricing of assets. A country without an interest rate has a stock market with a price, but not a value.

The future-focused investor should estimate the value of stocks, commodities, and bonds as if interest rates were 5% higher. That day will come to pass: when assets seek the price of their true collateral. This is not widely appreciated. For instance, the recent dive in silver prices has been acclaimed as a bubble that popped. That might be true, if paper contracts were worth the value they purport to represent. There is not enough silver in the world to meet derivative claims – of ETFs, forward contracts, and so on. When this misrepresentation is widely recognized, physical silver will attract panic buying.

Silver is a fairly small market, so this may go unnoticed. That will be a shame for the majority since everyone holds a paper claim that is not worth the money it is written on. Dollar bills, still flowing forth from the Federal Reserve (more exactly: from the US Treasury’s Bureau of Printing and Engraving), are losing value every minute. Treasury securities are undercollateralized: the Treasury spends $3 for every $2 it receives in tax payments.

What to do? One idea comes by way of footnote #8 in this month’s The Credit Strategist: “Readers interested in owning the Chinese currency can walk into the Bank of China in New York or Los Angeles and open a remnimbi-denominated account. While these accounts originally had limits on size, The Credit Strategist understands that these limits have now been lifted and meaningful amounts of money can be invested. These accounts are insured up to $250,000 by the FDIC (there must be some irony in that.)”

Regards,

Frederick J. Sheehan,
for The Daily Reckoning

In an Undercollateralized World originally appeared in the Daily Reckoning. The Daily Reckoning, published by Agora Financial provides over 400,000 global readers economic news, market analysis, and contrarian investment ideas.

The last time the US dollar exceeded 120 on the dollar index (DXY) was in January 2002. Today it’s trading at 74.04, a 38% decline. Since January, 2002, gold has risen from $282 to $1,509 an ounce. Silver has risen from $4.30 to $47.36 an ounce. A barrel of crude oil (WTI) has risen from $20 to $112. A rising oil price increases the costs and prices of wheat, corn, gold, silver, shipping, and Internet searches.

Some other relationships:

Federal Reserve Chairman, Ben Bernanke, knows that his stock-market support operations are coming to an end, or a pause – time will tell. Propping up the stock market was an explicit objective of QE2. Quantitative Easing 2 (QE2), a process by which the New York Federal Reserve is buying $600 billion of US Treasury securities, is due to end in June. Classified as Permanent Open Market Operations (POMOs), the New York Fed dispatches about $6.5 to $8.5 billion into the banking system every day, as payment for 5- to 7-year Treasury notes. Chairman Bernanke wants the POMOs to continue, forever.

A few Federal Reserve Bank presidents have recently stated their reservations, in public. They warn that it is time to stop POMO-ing, QE-ing, or otherwise bankrupting America. (“Bankrupting” was not their description.) But Christina Romer, former chairperson of the “Council of Economic Advisors,” is “all in.” During a recent interview on Yahoo’s Daily Ticker, Romer gushed, “I think the evidence is that QE2 was very effective and certainly QE1 was very effective. I don’t understand why we’d be dialing back that tool.”

Central to her argument is that a lower dollar helps Americans. Since she worked so hard to emphasize this view on the Daily Ticker, we can be sure that: (1) Ben Bernanke is doing all that he can to lower the value of the dollar against other currencies, (2) jobs, wages, working hours, and production industries will continue to shrivel, and (3) tried-and-true asset relationships of the past decade (i.e. gold up, dollar down) will accelerate.

The Bureau of Labor Statistics (BLS) calculated the civilian population available to work was 216 million in January 2002. It was 239 million in December 2010, an increase of 23 million. Within this group, the BLS calculated 132 million were working in January 2002. In December 2010: 138 million, an increase of 6 million. Thus, the percentage of those with jobs among those who can work has dropped significantly. Those who do have jobs are worse off, in general, than they were in 2002.

The BLS calculated the weekly earnings of the average worker at $341 in January 2002. In December 2010, it was $342. This calculation is adjusted for inflation – but given the corruption of government inflation numbers, the latter figure ($342) should be reduced by at least 20%.

However, despite the overwhelming evidence that QE I and II have been dismal failures, Romer continues to applaud them as successes, just like Chairman Bernanke. The striking similarity between Romer’s perspective and Bernanke’s seems odd…until you examine their resumes.

We have, first, Christiana Romer, Class of 1957, Garff B. Wilson Professor of Economics at the University of California, Berkeley, former Chair of the President’s Council of Economic Advisers, former economics professor at Princeton University, current co-director of the Program in Monetary Economics at the National Bureau of Economic Research (NBER),former member of the NBER’s Business Cycle Dating Committee, a John Simon Guggenheim Memorial Foundation Fellowship recipient, who received her Ph.D in economics from the Massachusetts Institute of Technology in 1985.

We have, second, Ben S. Bernanke, current chairman of the Federal Reserve Board, former Howard Harrison and Gabrielle Snyder Beck Professor of Economics and Public Affairs at Princeton University, former chair of the President’s Council of Economics Advisers, former Director of the Program in Monetary Economics at the National Bureau of Economic Research (NBER), former member of the NBER’s Business Cycle Dating Committee, a John Simon Guggenheim Memorial Foundation Fellowship recipient, who received his Ph.D in economics from the Massachusetts Institute of Technology in 1979.

Perhaps there’s a bit too much “in-breeding” in the gene pool of professional economists. Now some “highlights” from the Romer interview:

The Daily Ticker’s, Aaron Task: A lot of people say the Fed’s been very successful helping financial markets and helping people at the upper end of the income scale. There hasn’t been a translation into wage growth for the average worker or substantial hiring, so [how] would the Fed be doing more to help [if it continued to QE]?

ROMER: Noooooooo! If you look in fact at what quantitative easing does, it tends to lower the price of the dollar, both of those things that are good for ordinary families and lower long-term interest rates means firms can do investment. It means it’s easier for consumers to afford borrowing, so that tends to encourage spending and when people spend that puts the people back to work. A lower price of the dollar helps to make goods more competitive in foreign markets. If we’re exporting more, we need more workers to produce it.

TASK: Isn’t it true that long-term rates have risen since the Fed announced QE2 in August? And also, a lot of people think a “weaker dollar” means the dollar doesn’t go as far, when I go to the grocery store and when I put gas in my tank, or things of that nature. So, I think a lot of people think the weaker dollar is hurting them, not helping them

ROMER: So, you need to be very careful. It’s hard to evaluate what QE has done to long-term interest rates, because there were a lot of announcement effects. What I can tell you is that the academic studies that have looked at this absolutely say that QE does what we thought it was going to do.

And, of course, on the price of the dollar we’re not talking about what’s happening to your purchasing power here; we’re talking about what the price of the dollar is in the foreign exchange markets. I think that everyone agrees that a lower price of the dollar tends to make us export more, which ultimately causes unemployment to come down… There’s no evidence that what’s holding back business spending or consumer economy is government activism.

[Editor’s note: In 2010, David Farr, President, Chairman and CEO of Emerson Electric Corporation, in Chicago, told investors: “Why would any CEO invest one penny in the US? There is not one reason based on the new rules of the game.”]

Many brand-name professors and economists from the Romer/Bernanke gene pool also continue to cheer the “successes” of quantitative easing. Average Americans, not so much…

“Comments” by Yahoo! viewers responding to the Romer interview, featured widespread contempt for QE, and therefore for Romer’s perspective.

Comment #1 was from “Ross,” who asked, “Is this chick retarded or what?” Of viewers who expressed an opinion about Ross’ analysis, 227 liked his comment; 16 disliked it.

Comment #2 was from “Brian,” who queried: “Who knew it was so easy? Someone should go tell those poor nations in Africa that we’ve learned the secret: just produce more of your currency.” (Score: 182 to 11.)

Comment #3 was from “Kimmie Taylor” who observed: “QE1 has failed on jobs. QE2 has failed on jobs. The only success with these QEs are increased bank profits.” (253-18)

Comment #4 was from “Jack,” who stated one obvious problem and a fair conclusion: “The woman has never held a real job and knows nothing about the real world. She is a complete failure.”

There was not a single Romer defender as far as the eye could see. (The eye saw the first 20 reviews.)

We will finish with “PhilippeB” (#6), a fast learner: “No idea who she is, but it is now official: Christina Romer is a certified idiot.” (62-3)

What to do about it? Please refer to the very top: “Some relationships.”

Regards,

Frederick J. Sheehan,
for The Daily Reckoning

Go Long Material, Go Short Certified Idiots originally appeared in the Daily Reckoning. The Daily Reckoning, published by Agora Financial provides over 400,000 global readers economic news, market analysis, and contrarian investment ideas.

I will discuss four topics:

First, some background to current problems;

Second, why it is not wise to make predictions about the amount and size of defaults;

Third, some areas where municipal solvency and bonds are most vulnerable;

Fourth, the opportunities.

Okay, so let’s begin…

#1 – The background for today’s municipal funding crisis. The story, in essence, is very simple: There is a link between real estate bubbles and municipal finance bubbles.

A.M. Hillhouse, author of a splendid study of municipal bonds – Municipal Bonds: A Century of Experience, 1836-1936, analyzed the US municipal bond market across that century. He concluded: “[T]he major portion of overbonding by municipalities arises out of real estate booms… There will be no justification for a city’s coming forward [in the future] with the excuse that…its revenue has dried up in times of falling property values… [T]he cause of the debt trouble [must be regarded] as an unwarranted failure of the city to adjust its borrowing program to certain known facts.”

I wrote a study, “The Coming Collapse of the Municipal Bond Market” in 2009. The title may or may not turn out to be accurate, but there was and is no doubt municipal extravagance had left us with a grave problem. This extravagance was born of a massive real estate boom. A nearly identical scenario unfolded during the 1920s.

In a March, 1933 lecture before the American Economic Association, Professor Herbert D. Simpson, explained the link between the booming real estate market of the 1920s and municipal spending excesses:

During this period of prosperity, real estate taxes were paid with little complaint… [U]nder these conditions, public expenditures expanded and taxes were increased without protest; and public officials exploited the real estate groups as systematically and thoroughly as the real estate groups had exploited the rest of the public. The result has been a structure of public expenditure which has been difficult to curtail, and a volume of indebtedness whose solvency is now jeopardized on a large scale…

Throughout this period, there was another form of real estate speculation, not commonly classified as such, but one that has had disastrous consequences. This is the real estate “speculation” carried on by municipal governments, in the sense of basing approximately 80 per cent of their revenues upon real estate and then proceeding to erect a structure of public expenditure and public debt whose security depended largely on a continuance on the rate of profits and appreciation that had characterized the period from 1922-29.

Inflated civic conceit hired construction crews to build houses, roads, sewers, schools, skyscrapers, and highways that crossed the country for the first time. When Treasury “Secretary Mellon endeavored to cut back federal spending, state and local governments stepped up spending at a rate that more than offset the Mellon program….”

The spending did not stop until the real estate taxes dried up. Sound familiar?

Simpson concluded:

The financial difficulties of local governments in consequence of both the inflation and deflation of real estate values demonstrates strikingly the unwisdom of a revenue system concentrated so heavily upon real estate…

But no one listened.

#2 – It’s not wise to make predictions about the amount and size of defaults because there are too many “don’t knows.”

• We don’t know if unions and municipalities will reach agreements over benefit reductions.

• If they do not reach an agreement, and the decision goes to a court, we don’t know how courts will rule. Union pension plans are legal contracts. Yet, pensions and benefits are unsustainable. How will judges rule? It is worth keeping in mind that most, if not all, states have legal recourse to amend pensions under certain conditions. In California – I quote: “an employee does not have the right to any fixed or definite retirement benefits but only to a substantial or reasonable pension.”

• We don’t know what the federal government – including the Federal Reserve – will do if states and cities go into default. Treasury Secretary Geithner may copy Hank Paulson’s bazooka maneuver with Congress. The Fed may, or may not, buy a trillion dollars worth of municipal bonds before the Senate Banking Committee puts Chairman Bernanke in the witness box.

• We don’t know what cities and towns that rely on a certain level of state aid to pay the bills will do. This, of course, is a don’t know only after we do know that a state has stopped or reduced local aid payments.

• We don’t know if states and municipalities will tell the feds to fund their own mandates. That is, regarding state and local costs that were either signed into law or regulations imposed at the federal level, but were not funded by the federal government. We are seeing some opening salvos, here, in Arizona, which is making cuts to Medicaid. I think cities and towns will test the waters, for example, in schools – where, instead of laying off teachers, they may drop federally mandated requirements.

• We don’t know, once this step is taken, the response of the federal government and the courts.

• We don’t know if states and municipalities will raise taxes if they are unable to meet municipal bond payments. Rating-agency and brokerage-firm literature publish statements such as the following:

“What makes general obligation bonds…unique is that they are backed by the full faith and credit of the issuing municipality. This means that the municipality commits its full resources to paying bondholders, including general taxation and the ability to raise more funds through credit.”

But this is only true on occasion. A good place to study the variety of decisions is with a paper written by Kevin A. Kordana, an Associate Professor of Law at the University of Virginia. [“Tax Increases in Municipal Bankruptcies,” Virginia Law Review, September 1997, Volume 83, Number 6.]

• Another don’t know is the level of ignorance in cities and towns, where it is too often the case that nobody understands the financial situation. An outsider who drops by city hall can be amazed at how little anyone knows.

• Finally, and most importantly, the decision – or indecision, as it may be – to break the cities’ or towns’ contractual obligation to pay its lenders includes a lack of will among the parties. Here, we will have to wait and see.

#3 – Some areas where municipal solvency and municipal bonds are most vulnerable:

Disagreements about public employee benefits and payments are in the headlines, so I will start there….

I used to work with investment committees of corporate, union, and municipal pension plans, to design pension policies. This included analyzing assets and liabilities. Understanding future, annual cash flows – outflows to retirees – was important for duration- and cash-matching of assets to payments. I said to the pension committee of a town in 1989: “There will come a point when you won’t be able to pay these benefits.”

This was not a surprise at all. They knew that. They had no say in negotiations between the different union groups in the town and the selectmen who approved the benefits. There had been an increase in future benefits through improvements to the benefit formula almost every year for several years. And, there was a boost to the formula almost every year during the next decade.

The proportion of retirees to current workers was small back then. Plus, discounting the much higher future payments 20 or 30 years out produced tiny numbers that, over time, have blossomed. Now, we have reached the point when the benefit payments are exploding as a percentage of costs for many municipalities.

A second problem is maintenance expenses for municipalities that went on a building spree. A rule of thumb is they are about 30% higher than the prior trend.

A third potential problem is that many cities and towns are dependent on continual access to the bond market. If Treasury rates jump 3% or 4% in a failed auction, the light bill may not be paid.

A fourth means by which municipalities have telescoped the future into the present is by raising money through General Obligation bonds that is supposed to be used for a specific purpose but, the money is instead used to cover current expenses.

A fifth problem is the next step in the misuse of General Obligation proceeds. There are cities and towns that raise enough additional money in the bond market to cover the projected rise in next year’s operating expenses.

#4 – Are there any investment opportunities in the municipal bond sector?

Opportunities in municipal bonds will spring from ignorance. They already have. There may be a panic of indiscriminate selling when owners of munis understand a municipal bond is not simply “money good.” Such ignorance has produced great buying opportunities in the past.

For instance, in May 1933, all City of Miami bonds (with yields ranging from 4-3/4% to 5-1/2%, and maturities from 1935 to 1955) were quoted at $26. In the mid-1970s, the same combination of ignorance and fear created great buying opportunities for New York City bonds. All bonds traded for $25.

It will be awhile before buyers should pile in, but it’s no too early to begin paying close attention to the sector.

Regards,

Frederick J. Sheehan
for The Daily Reckoning

The Muni Minefield originally appeared in the Daily Reckoning. The Daily Reckoning, published by Agora Financial provides over 400,000 global readers economic news, market analysis, and contrarian investment ideas.

When inflation is rising, it is necessary to take matters into ones’ own hands, or, get crushed. Those who remain whole during inflationary periods act early.

What follows are summaries of recent quarterly earnings reports. Most of these companies have headquarters in the United States, although they buy and sell worldwide. The key take-away is that inflation is a major burden.

As such, the key question investors must ask themselves is, “How imminent and pervasive is the threat of resurgent inflation.” Bernanke says inflation is “very, very low.” Corporate America begs to differ.

Numerous quarterly reports from large multi-national companies indicate very clearly that inflationary pressures are building. Here’s a representative sample:

DuPont & Co. – Fourth quarter sales rose 15%; net profits fell 15%. “DuPont forecast raw-material and freight costs to be some 4% to 5% higher this year than last, moderating from the 6% rise seen in 2010. [Executives] were confident they would be able to pass these on to end users. Ethane, chlorine, solvents, and pigments were seen as the key areas of cost pressure.”

Procter & Gamble – Sales rose 2%; net profits fell 25.5%. “P&G, which sells everything from Tide detergent to Olay skin-care products, said its commodities bill will cost $1 billion for the fiscal year that ends in June, more than double what it had expected.”

Colgate-Palmolive – “Colgate’s profit fell [in the fourth quarter] 1%…squeezed by higher commodity costs and money paid to promote its products.”

3M Company – Fourth quarter sales rose 10%; net profit fell 0.7%. “Margins declined under rising material costs and weakening sales in the company’s health care and graphics businesses… 3M said it intends to recover higher material expenses through price increases, which include Scotch tape, Post-It notes, furnace filters, sand paper, automotive components, and thousands of other household and industrial items.”

Pepsico – [Pepsi-Cola, Frito-Lay, Quaker, Tropicana, Gatorade] – Full-year reported earnings per share increased 4%; fourth quarter earnings per share declined 6%. CEO Nooyi was pleased with the results, but acknowledged she is “mindful of three realities: (1) A weak consumer landscape given the poor macroeconomic picture, especially the high level of unemployment in key developed markets; (2) High levels of cost inflation for the coming year, driven by broad and pronounced commodity inflation; and, (3) A potentially difficult competitive pricing environment, particularly in beverages.” Hugh Johnson, Pepsi’s CFO, talked about cost inflation of 8% to 9.5%: “That type of inflation has a pretty strong impact.”

Goodyear – [tires, blimps] Net fourth quarter sales rose 14%; with a $177 million fourth quarter loss. “Raw material prices costs are likely to rise 25% to 30% in the first quarter of 2011 and rubber prices have risen 40% since October [2010].”

Whirlpool – [Maytag, Kitchen Aid] Fourth quarter sales fell 1%; profits fell 61%. It is “seeking to offset cost increases for such items as steel, copper and plastics…”

Electrolux – [refrigerators, washers] “Operating income in North America and Europe declined as the company was hit by higher costs for raw materials and lower sales prices.” “The costs for our most important raw materials continue to increase,” Electrolux CEO Mr. McLoughlin, said in a statement. “In addition to increased costs for steel, we also see considerable increases in resins (used in plastics) and base metals.”

In light of these firsthand accounts from the business world, Bernanke’s QE2 campaign is succeeding all too well. Inflation is on the upswing, just as he planned. But once this genie emerges from the bottle, there’s no telling what will happen next. Before long, the genie makes the rules; not the Federal Reserve Chairman. And often, the rules the genie makes are ones that punish the prudent and reward the reckless.

“Inflation is a means by which the strong can more effectively exploit the weak,” Federal Reserve Governor Henry C. Wallich, declared in a 1978 commencement address at Fordham University. “[Inflation] introduces an element of deceit into our economic dealings… [T]he increasing uncertainty in providing privately for the future pushes people who are seeking security toward the government.”

Wallich went on to tell the Fordham graduating class of 1978 that, during inflationary periods, contracts are no longer made to “be kept in terms of constant values.” By definition, one party to the contract understands this reality better than the other. The one who understands that tomorrow’s values will be much lower than today’s values is the one who benefits.

In other words, as inflationary pressures build, the forward-looking individual will want to prepare in advance. But that means the forward-looking individual will also want to ignore all the assurances from Washington and Wall Street that “everything is under control.” The latest testimony from the titans of global commerce demonstrates very clearly that Bernanke’s “very, very low” inflation has already become uncomfortably high.

Prepare accordingly…or you might get crushed.

Regards,

Frederick J. Sheehan
for The Daily Reckoning

“Inflation is Very, Very Low”…For Now originally appeared in the Daily Reckoning. The Daily Reckoning, published by Agora Financial provides over 400,000 global readers economic news, market analysis, and contrarian investment ideas.