Fried in the Financial Sun

If you were asked to tell a story about yourself, you’d probably omit some less-than-flattering facts in order to make yourself look better, right? Well, as the Mighty Mogambo points out, this might be a problem for someone who already has a penchant for lying.

There is a new report from the Comptroller of the Currency titled "OCC’s Quarterly Report on Bank Trading and Derivative Activities, Fourth Quarter 2007", which shows that total bank holdings of derivatives is estimated to be "only" $164.2 trillion, whereas I seem to remember that the global glut of derivatives is upward of $700 trillion, which are both numbers so big that I cannot even begin to comprehend the enormity of them.

The report shows that the notional value of derivatives held by U.S. commercial banks has suddenly plunged by a whopping $8 trillion, which is (unbelievably) still only 5% of the total, and which merely takes the total down to the aforementioned-yet-still-staggering $164.2 trillion.

When I realized that $8 trillion is more than half of America’s GDP, that is when I realized that "Houston, we seem to have a problem, as we are on fire, and we are tumbling out of control into the sun where we will soon be fried to a cinder."

And let’s not forget that even this baleful news is the best that the banks can come up with, as the whole report is based on banks volunteering to tell stories about themselves, which is unbelievably the same as with, according to an article in the Financial Times, Libor rates, which are the agreed-upon interest rates that London bankers agree to charge on short term loans to each other.

The upshot of asking lying, greedy bankers (the villains of history) to tell the truth and let everyone know what disreputable, untrustworthy scum they are has now proved to be an unreliable system of self-regulation, and thus the Libor rate may be understated because the rate is based on self-reports of people who are bankers, which means that they are lying scumbags who falsely report that their short-term borrowing costs are lower than they are, because they know it looks bad that they are getting charged a high interest rate, which proves that the people who are loaning the money to them know what kind of lying, scumbag bankers (as redundant as that is) they are.

But it is these self-reports, like the American O.C.C reports, that are the backbone of the Libor rate, which affects lots and lots and lots of other rates.

By how much is the Libor lending rate understated? Maybe as much as 0.3%, which doesn’t sound like that much, but when you are talking about trillions and trillions of pounds and euros of debt, it adds up to a lot of money! Now you see why they are so interested in lying!

And the last thing we need is higher interest rates, as reports that "U.S. corporate bankruptcies are accelerating as the economic slowdown compounds the end of easy credit", which is being made manifest by noting that a Merrill Lynch index showed that "The amount of distressed corporate bonds jumped to $206 billion April 11 from $4.4 billion in March 2007." Wow! What’s that, an increase of 5,000% or something?

And another scary Bloomberg item was that loans are becoming harder to get, regardless of the interest rates, and "Banks worldwide are demanding 60% more in collateral from investors such as hedge funds to cut the risk of derivative trades going bad, the International Swaps and Derivatives Association said."

And another horror is that the stock market went up, which is Pretty Freaking Strange (PFS) since Barron’s reports that the earnings of the Dow Jones Industrials went down, dropping to $225.53 from $234.49. This has produced the unbelievable price-to-earnings ratio of 57! Earnings are going down, but the stocks are going up! To a P/E of 57! Un-freaking-believable!

And not only that, but DJ Transportation index saw its earning drop, too, to $218.60 from $230.91, taking this index’s P/E to 23!

And while the venerable S&P500 has not yet shown any more deterioration in its earnings, the fact that the market went up made the P/E of this index go to a lofty 21! All of this in the face of deteriorating conditions and economic collapse! This is beyond incredible!

How can you NOT run to gold in such crazy times? Ponder this question well, as a lot depends on your answering it correctly, much like when the minister asked you, "Do you take this woman to be your lawfully wedded wife?", and you know how well that turned out. So, like I said, ponder it well!

Until next week,

The Mogambo Guru
for The Daily Reckoning
April 28, 2008

The Mogambo Sez: The nice thing about owning exclusively gold, silver and oil is that you make a lot of money when inflation is roaring like this, and you are sure to make a lot more in the future, too, which is even nicer!

There is a valuable lesson in there for you if you will look for it and then act on it. If not, then you are not as smart as you look! Hahaha!

Richard Daughty is general partner and COO for Smith Consultant Group, serving the financial and medical communities, and the editor of The Mogambo Guru economic newsletter – an avocational exercise to heap disrespect on those who desperately deserve it.

The Mogambo Guru is quoted frequently in Barron’s, The Daily Reckoning and other fine publications.

We spent Saturday looking at a certain part of the male anatomy. Big ones. Little ones. We had never seen so many.

Our guide at Pompeii told us that the masculine protuberances in front of us were seen as "a symbol of fertility, abundance and good luck," said Carla, "So, as you can see, it is everywhere here. Even sticking out of the walls."

There was one poking out over a doorway. Another was carved into the stone of the roadway itself, pointing the way to a brothel. Others were on the walls, some of mythic size. One man had his pride and joy on the scales. Others used them in more traditional ways…

But today is Monday, a working day. So, we set to work and leave our discussion of 2000-year-old dongs for later.

First, we look at how last week ended.

Stocks rose a bit; the dollar fell; gold held steady – but at $889, well below $900.

These are the times that try our confidence. Stocks and gold are going in opposite directions – opposite, that is, to the direction we think they should be going. Stocks seem to want to go up. Gold has wanted to go down for a long time; now it is doing so.

But if our guess is right – ‘flation is inevitable in the financial system. And our guess is that this ‘flation will show itself in rising prices for gold, commodities, and emerging markets…but lower (relative) prices for stocks, property and financial assets, generally.

‘Flation is inevitable because there are billions…no, probably trillions…of dollars worth of financial mistakes in need of correction and a world full of financial authorities trying to prevent it.

"A lot of people made a lot of mistakes," says former Treasury Secretary, Former CEO of Goldman, and now chief of Citigroup’s executive committee, Robert Rubin. Rubin made one himself, says today’s International Herald Tribune, by failing to rein in Citigroup’s excessive risk taking over the last five years.

But just because a lot of people made a lot of mistakes, it doesn’t prevent the authorities from making more. They’ve bailed out banks in Britain…and Wall Street brokers in America. The Fed has cut rates 6 times already…and is ready to cut a 7th time this week – bringing the key Fed lending rate to about half the level of consumer price inflation.

The result: money and credit flood the system…but many investors still drown.

Ours is not a common view. Most analysts think the authorities will either succeed or fail. If they fail, everything goes down. If they succeed, everything goes up.

Of course, no one really knows. We’ve never been in this financial situation before…so it is almost all guesswork. All we can do is to try to strip it down to the essentials to see if we can make sense of it.

"Is finance’s economic role ebbing?" asks a Wall Street Journal headline.

Yes, is our answer. Wall Street made money by ‘financializing’ the economy. Businessmen, for example, ceased thinking about how to produce better products at better prices; instead, they became much more interested in mergers, acquisitions, stock options, asset shuffling, IPOs and buybacks. Some of these activities may have added value, but not many. But for Wall Street, these were the glory days. Billions in fees could be charged…and, as long as prices were rising, few people complained. But when prices began to go down, lenders looked at the collateral and discovered it wasn’t worth what they thought it was. The triple-A credits were marked down…banks teetered and had to beg for more capital…the government stepped in to protect the rich and, so they said, avoid a meltdown.

Wall Street also helped turn homeowners into speculators. Instead of buying houses to live in, people bought them – often with no money down – in the belief that they would go up in price. What is a no-money-down mortgage but an option to buy a house later? And now that house prices are going down, the mom-and-pop options are expiring worthless. Housing speculators are putting the keys in the letterbox, dumping cement down the toilet, and walking away.

"The bright new financial system," said Paul Volcker a couple of weeks ago, "has failed the test of the marketplace."

Volcker is right. Wall Street has peaked. The credit cycle has peaked along with it. When Addison and Short Fuse met with him to interview him for I.O.U.S.A. this past December, Volcker said, "Right now we are in a very difficult circumstance in a financial world with a lot of excesses and lending, and particularly in the infamous subprime mortgages.

"A lot of the excesses are coming home to roost, and it puts a lot of pressure on economic institutions, and the question is how much pressure it will put on the economy as a whole. We’ve got a very good run of economic activity and a lot of success in the financial world in the past 20 years, but now it reached a point, I think, of excess and maladjustments and tensions that have to be corrected. And it’s gonna be a little bit painful."

Instead, the current leaders of the Fed seem inclined to try to avoid pain at all cost. This week, they are expected to announce another quarter point rate cut. The smart money considers another 25-bps cut in the bag. The smart money is not wondering what the Fed will do…but what it will say. If it signals the end of the rate cuts – what more will investors have to look forward to?

But here at the mobile Daily Reckoning headquarters in Rome, we’re still trying to look at the essentials. And the essential condition is this: the boom in the financial industry and things that depend on it is over. Now it is time for painful but necessary adjustments. The only question is how those adjustments will be made – by inflation or deflation, or – our guess – both.

*** Before we return to our trip to Pompeii, news comes that Americans are hoarding food. The big discount stores are apparently rationing rice, for example.

"Sam’s Clubs, Costco limit bulk rice purchases," said an AP story last week.

Today, the New York Times talks of a "recession diet," in which shoppers try to switch to cheaper foods. And there is talk of a drought this year, further reducing the supply of available grains.

"We’ve reached the peak for grain production," says Resource Trader Alert’s Kevin Kerr.

"World farmland planted with grain has declined since 1980, mostly due to environmental factors such as soil erosion, waterlogging and salting of irrigated land, air pollution and water shortages."

"We are also running out of crop varieties and have ridden fertilizer as far as it will take us. Thus, world grain output has been holding flat at around 1.6 billion tons and may begin to fall."

The LA Times mentions consumers "coping with soaring prices." And the Boston Globe reports that drivers are trading in their gas-guzzling SUVs in favor of smaller cars. Maybe that is why Toyota is now the world’s leading automaker – selling more vehicles than General Motors.

Gasoline is at about $3.60 a gallon. Milk is even higher, at more than $4 a gallon. Consumers have no choice – they have to cut back. That, too, is one of the essential verities of today’s economy. Ours is a consumer economy in which consumers have less money to spend.

"In short, we’re facing a crunch in just about every natural resource you can name," Kevin tells us. "But for investors, the indicators for real asset investments are flashing green. My expectation is that we are at the beginning of a major bull market in commodities. That will mean an unending trend of higher prices for the things that keep the world running.

"So the cycle of ups and downs will continue. But now there is a floor – a level commodity prices simply cannot fall below. And the emerging economies – and the booming population – push that floor a little higher each day. It will just take awhile before the market is ready to admit it.

"Until that happens, we can play those ups and downs for tremendous opportunities. And while we’re not the only ones who’ve noticed, we do have one advantage over most investors…"

This ‘advantage’ Kevin is talking about is a bull market which most investors avoid…but those that take full advantage of it have been making money hand-over-fist. For a limited time, Kevin is offering DR readers a guest pass into this "Millionaires Market".

*** Everyone should spend some time amid the ruins. It cultivates a sense of humility. "Look on my power," the old stones of Pompeii seem to whisper, "and weep."

The city of Pompeii sits on the coast of Italy, near Naples, about two hours’ train ride south of Rome. It also sits beneath a volcano – Vesuvius. It was this latter detail that brought it to an abrupt end…in 79 AD…and earned the city a notable place in history. In late August, Mt. Vesuvius began to rumble. The people looked up at the mountain and noticed a strange cloud over the peak – it was orange, and the shape of a typical pine tree from the area. Some Pompeiians took to boats to get away. Others went by land. Then, nothing happened. Pliny the Younger says his uncle returned to town, confident that it was nothing to worry about, and took a nap. Others, came back to town to get valuables and other properties. Still others just seemed to go about their business.

Rumbles were nothing new to them. An earthquake and tidal wave had hit the city 17 years before. The city had already been rebuilt. Worse case, people figured they were in for another shaking up.

Instead, the mountain blew up. The explosion took the top off Vesuvius and sent it flying. A wave of burning gas and hot ash hit Pompeii. People were knocked over, burned and smothered. Wood was carbonized. Ceilings collapsed under the weight. The whole city was covered up with volcanic dust, ash, and lava; Pompeii was extinguished.

"You see," said Elizabeth, "you’re wrong. It’s not always better to do nothing. When the mountain began to smoke, these people would have been better off if they had panicked and ran."

The people she meant were the people we were looking at. They were not people at all, but plaster casts of what had been people – sometimes with their bones and teeth still intact. In the 19th century, when serious excavations of Pompeii began, the archeologists on the case learned to pour plaster into the cavities in the rock left by flesh and wood. As the ash covered people, it was shaped by their bodies; then it hardened. The bodies disappeared, leaving a hole which could be filled with plaster. We were looking at a young woman, obviously pregnant, lying on her stomach, just as she was found. We can see the folds of her dress. Her arms are up over her head, trying to protect herself from the cloud of hot gas. Dozens of these ‘bodies’ have been found…some in touching positions, such as a small family, where the father was trying to protect his wife, while she tried to protect the children.

"The city was founded in the 6th century BC, we believe," said Carla. "It was not a Roman city, but a Greek city. The whole Mediterranean rim is dotted with Greek cities…colonies of Greeks who were setting up trading stations or just trying to get away from the wars between the Greek city-states. This city didn’t become a fully Roman city until about the time of Caesar."

The city was built of stone and carefully laid out, with two major East-West axes, and many streets running North-South. The streets are in stolid stone, with wagon ruts showing that they had been used for centuries before the place was obliterated. The streets have curbs, sidewalks, and stepping stones to get across from one to another without having to walk in the street itself.

From what we can tell, Pompeii was a more agreeable place to live than most modern cities. It was compact, easy to get around, and beautiful. Looking down one street, we see Vesuvius. Looking down another, there is the blue sea. The houses were substantial…and very pretty, with extensive wall paintings, frescoes, interior gardens, and mezzanines. They had running water…fountains and drains.

Most impressive is the town square. It is a place of statues and columns…a place for elections and town meetings…with a market area…and a place for getting together to discuss the issues of the day. And it is all beautifully built and symmetrically designed. It seemed to have so much that modern cities lack – harmony, permanence…stability.

"It is a wonderful thing that Pompeii was covered up," Carla continued. "Because now we get to see a city exactly as it was 2000 years ago. "There were public baths, lunch counters with huge amphorae for wine, and whorehouses. The whorehouses are the most popular place for tourists now…because there are frescoes on the walls that show the various positions or services you could get. Remember, this was a port city, so many of the customers came from other cities. Often they didn’t speak the same language. So, they could just point at what they wanted."

"When they began excavating in the 19th century," Carla explained, "they were shocked by what they found. They put all those things into a special museum, where women weren’t allowed to go. But now, everyone is much more relaxed. The trend is to try to put everything back where it was…so you can see it as it was."

Until tomorrow,

Bill Bonner
The Daily Reckoning