Servias Ministries Blog

I posted a writing on December 23rd, 2007 on "Fraud and Deception…" http://www.servias.org/?p=28.  We are starting to see the sharks circling their prey in the derivative insurance arena of collateralized debt obligations (CDO’s) contracts :

Johnson & Perkinson Announces Commencement of Class Action Litigation Naming Ambac Financial Group, Inc.
Monday March 3, 4:32 pm ET

SOUTH BURLINGTON, Vt., March 3, 2008 (PRIME NEWSWIRE) — Johnson & Perkinson hereby announces the commencement of a class action lawsuit naming Ambac Financial Group, Inc. (“Ambac” or “the Company”). Individuals, families, trusts or other entities that purchased Ambac securities between October 19, 2005 and November 26, 2007, inclusive, have the opportunity to participate as Lead Plaintiffs in the currently pending litigation. To do so, you must apply to serve in that capacity by March 17, 2008.

Johnson & Perkinson, a litigation boutique law firm based in South Burlington, Vermont, has extensive experience prosecuting investor class actions and actions involving financial fraud. Attorneys Johnson and Perkinson are both former employees of the Securities and Exchange Commission. Dedicated to maximizing shareholder return, members of Johnson & Perkinson have prosecuted complex class actions alleging securities or consumer fraud/deception on behalf of investors/consumers against numerous public companies since 1985, resulting in the recovery of many hundreds of millions of dollars, and have been singled out for excellence by various courts. The firm is litigating, or has recently resolved litigation, as Lead or Co-Lead Counsel in securities class actions against Xerox, Priceline, Wireless Facilities, i2 and Xchange, and serves on the Executive Committee in the Global Crossing case.  http://biz.yahoo.com/pz/080303/137505.html

This is just the beginning.  On the mortgage-backed securities front,  litigation is moving forth:

Swap Skirmish: Risks Hidden, Says Hedge Fund

By Susan Pulliam, Serena Ng and Tom McGinty

Word Count: 1,212  |  Companies Featured in This Article: Citigroup, Wachovia, MBIA, Ambac Financial Group, Bear Stearns, Morgan Stanley, Goldman Sachs Group, Lehman Brothers Holdings

As financial markets boomed in recent years, some Wall Street players began selling insurance against things going wrong, in what looked like prudence.

It wasn’t.

In separate lawsuits filed in a New York federal court, a $58-million-asset hedge fund alleges that Citigroup Inc. and Wachovia Corp., respectively, improperly required the fund to pay out more money from insurance derivatives contracts known as "credit default swaps" amid a steep decline in the value of mortgage-backed bonds. More… http://online.wsj.com/article/SB120459196434709061.html

Most of us don’t understand the complexities of these financial instruments.  The one thing we do understand- losing money.  We can be assured that this is just the tip of the iceberg.  The legal system will be extremely busy with the fallout of the greed-induced investing in these complex financial instruments.  Do you remember in March of 2003 when Warren Buffett called the derivatives "financial weapons of mass destruction"?  See http://news.bbc.co.uk/2/hi/business/2817995.stm

I hope you have implemented your "personal defense plan".

A recent article in Harper’s Magazine suggested that the next bubble would be "alternative energy" also known as "going green".  I would suggest that there has been a mother of all bubbles forming.  This bubble has a different set of rules.  This is the commodity bubble.  Commodities differ from other bubbles in that we all need commodities.  We must eat, travel, and replace failing infrastructure.  Commodities are generally consumed.  The beloved farmers are having their day in the spotlight.  This segment of the workforce must love the job.  Dealing with drought, insects, floods, etc. the farmer has many variables to deal with.  Their product has been in a "bear" (down/sideways) market for years.  Their time has come.  With the burgeoning economies of China and India, the worldwide demand for commodities is strong.  Five years ago I warned that China was an 800 lb. gorilla that would have a tremendous global impact.  Once China began to develop its resources (people) we would see a brave new world.  When I was a child, the cheaper toys were made in Japan.  At that time there was a stigma attached to foreign made goods.  That time is past.  Most products on the shelves are made in China, Vietnam, India, Mexico, etc.  We are importing about $500 Billion per year of energy products.  This transfer of wealth will surely cause a decline in the U.S.

The Federal Reserve is in a "no win" situation. Inflation is on the rise.  It is becoming serious.  Restaurant prices are up substantially, some by 10-15% in the last twelve months.  Expect to see price increases across the board- food, energy, utilities, vehicles, the list goes on.  Back in the late 70’s, early 80’s when inflation was moving to a hyper-inflationary status, Paul Volcker (Fed Chairman 1979-1987) increased core interest rates to 13.5% in 1981.  For people who had money to invest, those were the good ol’ days.  Banks were paying 14-16% on C.D.’S.  Companies were borrowing at similar rates.  Volcker knew that he had to contract the economy and purge the financial wastes that had accumulated.  This was a painful time for the U.S. economy.  Unemployment was at its highest level since the Great Depression.  Volcker was under political attack.  He held his position and rates subsided to 3% range in 1983.  The purging was completed.  This set the stage for the longest sustained economic expansion in the country’s history.  Ben Bernanke has a different set of circumstances to work with.  The debt to equity ratio of the private sector is much higher today.  The cost of housing in recent years has placed the consumer at risk.  Credit card debt in the 1970’s was insignificant compared to today’s levels.  The price of commodities was not being affected by China and India.  Now, the consumer is tapped out.  The real estate bubble has burst and housing prices are declining.  Consumers’ balance sheets are getting weaker.  Contraction of spending is ahead for most consumers.  At the same time, the financial crisis is in its early stages.  The Fed needs to cut rates to keep the banking system liquid.  Lower rates improve the profits of banks.  Higher rates reduce their profit margins.  The banks need profits to offset their investment and lending losses.  Can the banks recover before their losses must be booked?  That is the $64 Trillion question.  On the other hand, the primary inflation fighting tool of the Fed is "interest rate increases".  You have two opposing forces requiring opposite rate action.  What will Ben Bernanke do?  He wrote his Doctoral Thesis on the Great Depression and concluded that the depression could been avoided had the Fed pumped more money into the system.  This will reduce interest rates and at the same time increase inflation.  Remember, true inflation is defined by the increase in money supply.  Price inflation is the result of this increase in money.   There is more money chasing goods and services.  The Fed is also under pressure to keep the economy stable during the election cycle.  Rest assured that they will do everything possible to keep the stock market at its current levels through November.

Hyperinflation is ahead!  The Fed does not have the "guts" to raise rates and fight inflation.  Their mandate is to protect the financial institutions, not you or me.  At the same time the economy is in recession.  As inflation increases the consumer will continue to respond with reduced spending.  This will be observed as a downward spiral.  Consumer confidence (or perception) will determine the velocity of this downward spiral.  Global demand for commodities will provide a strong price base for commodities.  As the Fed injects more dollars into the system, the value of the dollar will decline relative to other currencies.  Any dollar denominated investments will decline in "global" value.  Since energy has been bought and sold in U.S. Dollars, international owners of this resource are losing money.  There will be continued pressure to move away from the dollar in pricing oil.  With less demand for dollars, inflation in terms of dollars will increase.  Ugly!!!

To summarize:

1. You have a housing bubble that has burst.

2. The Banking System has severe structural problems yet to be fully revealed.

3. The commodities are in a historic bull market which will affect the price of everything we buy.

4. The Fed cannot control inflation.

5. We are probably at "Peak" oil, thus a declining supply in a world of increasing demand.

6. The consumer has reduced ability to spend.

The true global currencies are gold, silver, oil, gas, water, grains, and other base commodities.  Your assets should include some of these or you will see your wealth evaporate.  Those who prepare for this perfect storm will be a blessing to those who failed to see the storm clouds forming.  Cleansing/purging cycles as mentioned in Scripture are necessary.  This may be the ultimate purge!

The International Energy Agency is projecting global oil demand at 116 million barrels per day by 2030.  Currently the global demand is approximately 88 million barrels per day.  China and India will continue to increase their demand for oil.  India is now manufacturing at $2,500 car.  As its exports grow, oil consumption will grow.  China is expected to overtake the U.S. in light duty vehicle sales by 2016-2017.  This alone will add about 10 million barrels of new oil demand by 2030.

Population:

With over 2.3 billion people and growing, China and India’s income growth will fuel auto sales, infrastructure spending, and commodity prices.  Sand, cement, copper, and other commodities are at record prices due to the infrastructure needs of these countries.  China is building new roads, gasoline stations, pipelines, and other infrastructure to support this increase in transportation requirements.

Peak Oil:

The U.S. 48 states experienced "peak oil" in 1970.  Overall production has been in decline ever since.  The North Slope of Alaska experienced peak oil in 1989.  Mexico’s Cantarell field (the 2nd largest field in the world) experienced peak oil in 2005 and has declined by 41% since.  OPEC countries have reported the same reserves for decades which is clearly not true.  Therefore we must assume that their fields are in decline as well.  The largest oil discovery in the world has been in production for over 60 years (Ghawar field in Saudi Arabia was discovered in 1948).  Considering the current decline curve of existing production, we will need to find over 60 million barrels of new oil by 2030. I do not expect this to happen. 17% of global crude supply comes from 10 super-giant oil fields.  The following table provides this breakdown:

In reviewing this chart, you can see that we would have to discover an equivalent of 14 new giant oil fields the size of Ghawar to meet the expected future demand.  There is no silver bullet of technology that will make up this difference in expected demand vs. supply.

Ownership of Reserves:

Who owns the oil in the ground?  The following chart shows that National Oil Companies (NOC) own most of the production:

U.S. Oil companies account for less than 20% of world production.  These companies do not have the ability to set prices.  OPEC is the major supplier of world oil and has pricing power.  Taxing U.S. oil companies for high prices produces no impact on pricing.  Oil companies are currently buying reserves by buying back their own stock in a repurchase program.  If there was a major probability in discovering huge reserves, they would be directing cash to those projects instead.

The Impact of Two Decades of Low Prices:

The last 20 years’ prices drastically reduced infrastructure investment and replacement.  The pipeline infrastructure is made of steel and is rusting.  This will force notable investment in infrastructure thus supporting high commodity prices.  In the U.S. alone, oil and gas employment was reduced by 50%.  The drilling rig count plummeted and rigs sat rusting away in fields.  A small drilling rig costs in excess of $500 thousand to build.  Oil field experience is at a multi-decade low.  50% of Exxon’s employees will be at retirement age in 5 years.  Low prices caused a "brain drain".  The IEA projects energy infrastructure cost to exceed $5 trillion for growth alone.

Alternative Energy- Ethanol

Ethanol is a poor substitute for oil.  It is corrosive to the existing pipeline infrastructure.  Its energy output versus energy required to refine it is low compared to oil.  Ethanol requires a feedstock and fresh water.  Both ingredients are in limited supply and are expected to be in shortage as well.  The current primary feedstock is corn.  Its price is at an all time high.  Although we all support the farmers in their effort to generate a profit, ethanol will lose its support as the impact of production is understood by the politicians.  Ethanol contains 84,100 BTUs per gallon and the replacement energy value for the other co-products is 27,579 BTUs. Thus, the total energy output is 111,679 BTUs and the net energy gain is 30,589 BTUs for an energy output-input ratio of 1.38:1. Oil ratio is much higher (8:1 to 23:1 depending on the logistics).

Alternative Energy- Wind

Wind is totally dependent upon geography and weather.  Although it will supplement the power grid in some states, the economics do not support a major infrastructure investment to solve the energy demands of the upcoming crisis.  Individuals living in windy areas might consider the use of wind to generate electricity.  Major population areas will not benefit from this technology anytime soon.

Alternative Energy- Solar

Existing technologies will not support the growth of the electrical requirements of the U.S.  Although a reasonable personal alternative for supplemental power, the solar solution will not be effective as a national solution.

Alternative Energy- Nuclear

Although 3 Mile Island reactor incident never caused a death, Americans have been afraid of nuclear power since.  France generates over 70% of its power from nuclear power plants.  Red tape and civil litigation contribute to 10 year construction cycles of new power plants.  If the U.S. power companies were to start plans immediately for new nuclear plants, it would take 10 years to become operational.

Alternative Energy- Electric

There are approximately 170,000 service stations in the U.S.  Building electric cars will necessitate a substantial infrastructure cost to ramp up service stations to handle increased recharging needs.  This will take time.  Early buyers of electric cars will be restricted in their driving range.  Another issue is that our electrical grid is growing and outpacing power plant construction.  Any additional burden on the grid will move it to a crisis sooner than later.  The U.S. commercial infrastructure is heavily dependent on oil for energy and thus the impact of electric cars would be minor for 15-20 years.  The U.S. has a 17 year inventory turnover rate of vehicles.  It would take at least 8 1/2 years to replace half of the country’s fleet if electric cars were available and could meet the transportation requirements of the population.

Alternative Energy- Coal

Coal is an abundant resource in the U.S.  However, the "green" direction of the U.S. will prevent new coal plants from being built.  New coal plant construction has been denied in several states.  Instead, natural gas plants are being considered as an alternative.  These plants will generate electricity at a higher cost versus coal.  Green is in, coal is out!

A comparison to oil:

To obtain in one year the amount of energy contained in one cubic mile of oil, each year for 50 years we would need to have produced the numbers of dams, nuclear power plants, coal plants, windmills, or solar panels shown below:

Summary

The energy crisis is here.  There is no alternative that could be developed in time to avert this crisis.  Wars have been fought over resources throughout history.  Unless we have a Divinely appointed intervention, energy prices will skyrocket and will support a global depression.  The response to the Great Depression of the 1930’s was a World War.  The NOC’S have no incentive to sell their inventory at lower prices.  In fact, their incentive is to slow production and receive a higher price for their product.  U.S. oil companies will enjoy the profits but have no ability to determine price.  Investing in well run energy companies will be the best defense against rising prices at the gas pump.  "You might as well buy the product from yourself."

The basic economic cycle is divided into four parts: boom, recession, depression, and recovery.  There is no absolute, firm definition in today’s environment of exactly what quantifies each aspect of the business cycle.  Economists continually increase the complexity of their trade by adding new formulas and statistics in an attempt to describe which part of the cycle we are in.  Complexity steers us in the direction of chaos.  Simplicity moves us to "order".

Tampering with the business cycle has disastrous consequences.  The natural business cycle allows for orderly expansion and contraction.  Contraction is designed to be a "cleansing cycle."  Entrepreneurs will eliminate waste created from bad business decisions during this period.  This is a time of reflection.  Do we really need this expense?  Did this sales program produce additional profit?  The list goes on.  However if the cycle is tampered with by delaying this cleansing cycle, the result will be a longer, deeper cleansing cycle.  A sustained boom will result in a sustained bust.

Those in control of the creation of money seem to be on a continual quest for the "Holy Grail"- a formula that will eliminate the business cycle and only produce sustained growth.  They study Economics and write theses to introduce their perspective of economic prosperity.  In the last 100 years, the Great Depression became a popular case study.  How can we eliminate another great depression.  Economists agree that a depression contains negative growth of the "Gross Domestic Product", high unemployment (10-20%+), and a lower standard of living for most of the population.  Those in control of the money supply have experimented with our livelihoods.  Interest rates were consistently higher in the 1970’s to fight inflation.  For years passbook savings accounts were paid 5% interest.  That rate rarely changed.  Mortgage rates varied from 7 to 10%.  The standard down payment on a conventional loan was 20%.  FHA loans required less but not the 0% allowed in recent years.  Fixed interest rates were the standard.  The gold standard was dismantled in the 70’s.  When inflation started rising in the early 80’s, Paul Volcker as Fed Chairman raised interest rates to arrest the boom cycle and force a recession and thus cleanse the waste out of the system.  During that time I was a Chief Financial Officer.  Our plans for expansion would take into account the cost of money and the expected return on investment (ROI).  If the ROI was not substantial we would axe the plan.  Only the plans with the greatest potential were implemented.  The high rates slowed our growth.  Those same rates minimized our mistakes by requiring greater scrutiny of each project before implementation.

Our current central banks around the globe are postponing the cleansing cycle.  By providing "easy and cheap" money, they have promoted poor economic decisions throughout the entire global population.  The average family has created substantial liabilities including excessive mortgages, credit card debt, and consumer loans.  At the same time creditors have successfully eliminated the bankruptcy alternative that eliminates the consumers’ mistakes (a jubilee).  Once again, we’ve been bamboozled!  At the same time, this easy money policy has fueled inflation.  Those that did not fall into the borrowing trap are having their savings eaten away by excessive inflation.

In college, we did not have an economics lab class.  A school laboratory was a place where you could experiment with the principles you learned during the lecture class.  Physics principles were validated in the lab class.  How do you validate economic principles?  In the biggest lab of all-the globe.  What happens when all of the economists are taught by a prevailing theory?  The result is a "cluster of errors".  Those in charge continue to operate under assumptions that may be invalid.  The gold standard was eliminated since it seemed to restrict growth.  Who decided that growth was being restricted?  Those in power motivated by greed.  Biblically, the gold standard has been used for thousands of years.  There was a reason for this.  It created a reasonable business cycle without the volatile changes.  The Lord God Almighty created the business cycle.  Man has decided to tamper with it.  The current "cluster of errors" will produce a well-defined view of economic depression in our economics lab.  After it is all said and done, we will have a close and personal view of the negative economic impact created by financial derivatives, selective regulation, investment bankers’ greed, and poor lending/borrowing practices.

I was recently asked what to do with funds contributed to a retirement plan.  This is difficult to say since I do not have the balance sheet/income statement of the individual.  However I can provide a plan that I believe will help a family weather the uncertain future economic reality.  Nobody but the Lord God Almighty can be certain of what we will face over the next five years.  We can only use the knowledge, wisdom, skill, and understanding (Daniel 1:17) to direct our loved ones and friends to what we believe is best in preparation.  Some of us are called to the financial arena, others are not.  They must rely on and trust the brethren who are called to look out for the best interest of the Body of Christ.  Every joint is to supply the others: Ephesians 4:15 but, speaking the truth in love, may grow up in all things into Him who is the head–Christ– 16 from whom the whole body, joined and knit together by what every joint supplies, according to the effective working by which every part does its share, causes growth of the body for the edifying of itself in love.

For the body of Christ to grow, people must give.  I am giving the following advice in order to help you defend yourself against expected economic downturns based on the global direction of the current system.  I understand the many people do not have enough assets to take advantage of the following steps.  Do what you can.  Most of us can afford to buy an ounce of silver weekly.  It’s a start.  Go to the local coin shop and start an accumulation plan.  Don’t worry about the daily price.

1. Buy gold and silver (the metals) as insurance.  I would buy one ounce coins.  I have no interest in rare coins because their value is perception based.  Consider having 5-10% of your cash in these two metals.  I expect gold to exceed $1,600 per ounce and silver to exceed $100 per ounce over the next 5 years (in U.S. Dollars).

2. Maintain 6-12 months’ supply of expenses in cash on hand or in the bank.  If you personally lose a job, you want to be able to meet monthly obligations while looking for employment.

3. Check your bank’s exposure to derivatives and profitability at: http://www2.fdic.gov/ubpr/UbprReport/SearchEngine/Default.asp  Look on Page 5 of the report for the derivatives’ exposure. Page 2 provides a 5 year comparison of net income.  If they are losing money you might want to find a new bank.

4. Spread CD’S over multiple banks if you have more than the insured limit.  CD rates are expected to decline over the next 12-24 months.  The Federal Reserve has historically supported the banking system’s profitability at the expense of savers.  This is done by lowering savings rates while the loan rates are lowered at a slower pace.  You ultimately pay for their investment mistakes.

5. Weight your stock portfolio to energy (oil & gas), gold, silver, & coppper stocks, and consistent dividend paying stocks.  Chevron, Petrohawk, Goldcorp, Yamana Gold, Silvercorp, GE, Southern Copper, Penn West Energy are all stocks for your review (see disclaimer).  There are other stocks but these have had some prior review.  I expect oil to trade over $150 per barrel.  I expect natural gas to exceed $10 per mcf.

6. Bonds may be good but I am concerned about the insurers going bankrupt thus having a negative impact on the bond market.

7. Eliminate any leverage you have been using in investing.  If necessary, sell stock to pay off the leveraged position.

8. Reduce/eliminate debt.  Its time to contract your liabilities.  If you use credit cards, pay off the balance each month.  If you are making credit card payments, quit using the cards.  If you can’t pay cash you probably don’t need it.  Debt consolidation only works if you have the discipline to refrain from creating more credit card debt.  Even though credit card usage is easy, start writing checks for purchases.  This reinforces your awareness of the impact purchases has on your cash position.  Credit card purchases seem to be "out of sight, out of mind" until that bill comes in.

9. Simplify.  Look at what is controlling you and your time.  Less is better.  A friend of mine had a large pickup because he used to pull horse trailers.  He doesn’t do that anymore.  Get rid of your "pickup".  It’s costing you money.  It is easier to obtain than to "maintain".  Calculate the 5 year cost of any asset that has an ongoing maintenance expense.

10. Eliminate on-going expenses if possible.  Review your budget.  If you don’t have a budget, create one.  Look at your last six months’ expenses to see if there is something unnecessary.  Don’t overlook the small expenses either.

These steps are intended to help direct your thinking, not eliminate your accountability in your financial affairs.  Each of us are called to be stewards.  If this website is helpful to you, share it with your friends.

Disclaimer:

The material on this website has no regard to the specific investment objectives, financial situation, or particular needs of any visitor. This site is published solely for informational purposes and is not to be construed as a solicitation or an offer to buy or sell any securities or related financial instruments.

References made to third parties are based on information obtained from sources believed to be reliable, but are not guaranteed as being accurate. Visitors should not regard it as a substitute for the exercise of their own judgment. Any opinions expressed in this site are subject to change without notice.  Servias Ministries, Inc. is not under any obligation to update or keep current the information contained herein.

Servias Ministries, Inc.’s officers, directors and associates may have an interest in the securities or derivatives of any entities referred to in this material and accepts no liability whatsoever for any loss or damage of any kind arising out of the use of all or any part of this material. Our comments are an expression of opinion. While we believe our statements to be true, they always depend on the reliability of our own credible sources. We recommend that you consult with a licensed, qualified professional before making any investment decisions.

The material on this website has no regard to the specific investment objectives, financial situation, or particular needs of any visitor. This site is published solely for informational purposes and is not to be construed as a solicitation or an offer to buy or sell any securities or related financial instruments.

References made to third parties are based on information obtained from sources believed to be reliable, but are not guaranteed as being accurate. Visitors should not regard it as a substitute for the exercise of their own judgment. Any opinions expressed in this site are subject to change without notice.  Servias Ministries, Inc. is not under any obligation to update or keep current the information contained herein.

Servias Ministries, Inc.’s officers, directors and associates may have an interest in the securities or derivatives of any entities referred to in this material and accepts no liability whatsoever for any loss or damage of any kind arising out of the use of all or any part of this material. Our comments are an expression of opinion. While we believe our statements to be true, they always depend on the reliability of our own credible sources. We recommend that you consult with a licensed, qualified professional before making any investment decisions.

The television show mentioned above takes place in New York City.  NYC is a vibrant, never sleeping city known as the financial center of the universe.  The waters around the city are shark-infested.  No, not those from the Animal Kingdom Phylum Class Order Family Genus Species, Animalia Chordata Chondrichthyes, this group is from the legalis attorneyicum class.  The lawyers are ready "to roll" in this derivative crisis.  New York City is suing Countrywide, Officers, and Underwriters. See http://www.reuters.com/article/businessNews/idUSN2536805820080125?feedType=RSS&feedName=businessNews

The executives of the company cashed out with bonuses of over $700 million.  As I wrote in a previous blog many pension funds can only invest in "investment grade" securities.  The ratings agencies define "investment grade" based on the data and information presented to them.  You can be sure that there will be a multitude of fingers pointing everywhere.  Individuals will "plead out" early in order to minimize the impact to their personal lives.  This lawsuit is just the tip of the iceberg.  There will be many more lawsuits to come.  The lawyers will be the winners.  Countrywide will lose, the pension fund will lose, Countrywide stockholders will lose,…

Greed produced this debacle.  Perception displaced reality among the lenders, underwriters, regulators, stockholders, Congress, and the Fed.  The rich and famous went for a joyride with our hard earned money.  In the end, the global taxpayer will pay for the ride.  If we run out of money, which is possible, there will be a calamity of Biblical proportions.  The people who have been running the monetary system are nearly out of tricks.  The courts will be busy for years to come.  The recent surprise rate cut was in response to the volatility of the the world markets.  The U.S. economy has been the economic juggernaut over the last sixty years.  Interest rate declines are inflationary and negative to the value of the U.S. Dollar.  Gold and silver will continue their climb to $1,600/$50 and beyond.  Inflation is the silent killer of the elderly’s savings.  The bigger the problem, the greater the cleansing.  Cleansing cycles are Biblical, whether is be 76 days, weeks, months, or years.  Cleansing removes the worthless and unproductive.  Pruning time is upon us.

Could Ben Bernanke, Fed Chief, be thinking, "Why didn’t I keep that job at the University?"

http://www.telegraph.co.uk/money/main.jhtml?xml=/money/2008/01/25/bcnswiss125.xml

When I was a Chief Financial Officer (CFO) our growth was dictated by a formula known as the "sustainable growth rate" formula.  Basically our growth was restricted by the amount of profit that was added to the retained earnings at the end of the year.  Retained earnings is a category of Owner’s Equity in the company.  Secondarily growth could be enhanced by improvement of asset turnover.  For instance, if you sold $50 million a year of inventory and kept $10 million of inventory in stock, your turnover rate is 5.  If you could reduce your inventory to $7 million and still maintain enough to satisfy customer demand, your turnover rate would exceed 7.  You would free up $3 million to help grow the business.  The sustainable growth rate formula took into account these factors in determining how fast we could expand the business.  Another factor was the debt to equity ratio.  If we had liabilities of $4 million and Owner’s Equity of $2 million, our ratio was 2.  Our bank watched these ratios as we did.  If we could increase our leverage thus expand our assets and liabilities by $4 million, then our debt to equity ratio would be 4.  Banks kept historical statistics by industry of acceptable financial ratios in order to compare the industry to our ratios.  This was the way they did business 25 years ago. It is not important for you to understand the financial terms, it is important to understand that the financial institutions have had plenty of tools to monitor their lending practices.

By relaxing credit analysis standards you accelerate expansion of the economy at an increasing rate of change- Accelerator Factor.  The sustainable growth rate formula restricted the rate of change of growth due to the consistent restriction of leverage.  What is leverage? It is the use of borrowed funds to complete an investment transaction. The higher the proportion of borrowed funds used to make the investment, the higher the leverage and the lower the proportion of equity funds.  We were restricted from growing our company too fast by over leveraging our assets.  Why is this a problem?  It is all about cash flow.  Cash pays interest expense.  Cash pays down the principal of you note to the bank.  Cash "makes" payroll.  Cash is the "oil" of the business to keep it running.  Too much investment in non-cash assets works against the ability to repay debt.

There are three types of borrowers.  The hedge borrower is one who can meet all his debt payments with cash. The second type is the speculative borrower who can meet interest payments but must constantly roll over his debt to be able to repay the original loan.  The third type of borrower is the "Ponzi" borrower; he can repay neither the interest nor the original loan. This borrower relies on the appreciation of the value of his assets to refinance their debt.  This type of borrower’s philosophy is a "greed" based philosophy.  This borrower hopes that the asset will continue to appreciate forever.  As long as his assets appreciates in excess of the original loan plus interest, he is in good shape.  This borrower wears rose colored glasses.  The sub-prime mortgage loans promoted this type of borrower.  The lending institutions virtually created Ponzi borrowers by appealing to the "greed" factor.  Why not buy a bigger house than you can afford?  The problem did not stop there.

Financial institutions allowed hedge funds to "leverage up" their assets by 20 to 30 fold in order to achieve unbelievable returns for their investors.  This avenue of lending raised the stakes of failure dramatically.  This accelerated the growth of financial instruments and funded excessive growth in various sectors of the economy.  The insatiable appetite of borrowers was welcomed by the lending institutions who threw out their "credit analysis" handbooks!  CEO’S of these institutions received large bonuses based on the yearend profit results of the institution.  Greed raised its ugly head again.  The underlying motivation of the Accelerator Factor is greed.  This motivation is the rocket fuel for the increasing rates of change in credit expansion through leverage.  However, this is a two edged sword.  The other edge is fear.

Once the market moves from greed to fear, the Accelerator Factor works in the opposite direction.  The Leverage Factor is reduced and the balance sheets shrink at an increasing rate of change.  Its like an accordion.  The Fed and other central banks are now trying to manage fear.  In the markets, fear tends to be a stronger emotion than greed, thus the ramifications of mismanaging fear on a global basis can have disastrous effects.  Since in the history of man there has not been a similar financial environment to compare, those in charge are forging new territory.  Are you ready to trust your financial future to them?

Federal Reserve Board Chairman Ben Bernanke pauses while discussing the near-term economic outlook during testimony before the House Budget Committee on Capitol Hill in Washington in this Thursday, Jan. 17, 2008 file photo. (AP Photo/Dennis Cook. File)

The underlying economic issues I’ve been writing about are gaining publicity.  The following article from The Economist explains the latest problems:

All fall down?

Jan 18th 2008 | NEW YORK
From Economist.com

Huge new problems in the capital markets?

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AMERICA’S big bond insurers, which have underwritten some $2.4 trillion of private and public-sector bonds, usually go about their business largely unnoticed. But now they are looking distinctly wobbly they have started to attract attention. If one or more of them were to topple over, there will be a huge knock-on effect on banks and other financial institutions that rely on their guarantees. This in turn will further worsen the credit crunch and cause an even bigger headache for policymakers already grappling with a sharp slowdown in the American economy.

The threat of such a financial domino effect looms large. Moody’s, a credit-rating agency, has signalled that it might downgrade the AAA-ratings of two of the biggest bond insurers, MBIA and Ambac, in the near future. On Friday January 18th, Ambac said that it had dropped a plan to raise $1 billion of new equity capital to preserve its rating—making futher downgrades even likelier. In response, Fitch, another rating firm, cut Ambac’s rating.

MBIA, which recently managed to raise $1 billion of new capital on top of another billion that it received from Warburg Pincus, a private-equity firm, will almost certainly need even more money if it is to preserve its AAA-rating. ACA Financial Guaranty Corporation, another insurer, is in even direr straits. In December its single-A credit rating was cut to junk status. The firm begged its trading partners to give it more time to sort out its problems. But by Friday it had still not come up with a rescue plan. The state insurance regulator of Maryland, where ACA is incorporated, has already assumed responsibility for some of its operations.

Bond insurers in effect “lend” their top-notch ratings to lower-quality debt, raising its value in the eyes of investors. Any cut in those ratings may make it impossible for the bond insurers to take on new business and would reduce the value of the securities they have already underwritten. Such cuts are now a distinct possibility because the insurers have underwritten billions of dollars of mortgage-backed securities, including those notorious collateralised-debt obligations (CDOs) that have now gone sour……

  http://www.economist.com/daily/news/displaystory.cfm?story_id=10553166 

In the Book of Daniel, The Lord gave Daniel, Hananiah, Mishael, and Azariah (Shadrach, Meshach, and Abednego) knowledge, skill, wisdom, and understanding.  The current economic problems stem from the fact that knowledge and skill were used to leverage investments against the market without wisdom and understanding.  Technical traders did not understand the fundamentals of investing and assumed that technical analysis was sufficient to beat the market returns.  The Derivative Instruments assumed theory to equal reality.  We are on the verge of a reality check!

I recently wrote about MBIA and Ambac.  As of this writing, the world markets are responding negatively concerning the subprime crisis.  Many markets lost over 5% in one day.  Volatility will continue to be the norm.  The world’s central banks are in uncharted territory.  If you are highly leveraged, reduce your leverage immediately.  Raise cash, cash is king!  If you own commodities, don’t get rid of them.  The central banks will flood the market with cash which in turn will be inflationary.  Hard assets will rise.  Food and energy costs will rise.  Brace yourself!

I sincerely believe… that banking establishments are more dangerous than standing armies, and that the principle of spending money to be paid by posterity under the name of funding is but swindling futurity on a large scale. — Thomas Jefferson

This is a lengthy and somewhat technical article.  It is not as important to understand the specific statistics as it is to get a perspective of the downward economic spiral that plagues the current economic system.  The numbers are large and history has shown that those in authority soon forget what previous generations learned.  The Great Depression was preceded by the Roaring 20’s.  The current environment has many parallel themes occurring.  The super-charged egos of those in charge believe that they can defy the compression aspect of economic cycles.  Compression is good.  Delayed compression can be life threatening.  We are currently at risk of an economic depression in the 2009-2010 time frame.  Read on…

The financial industry operates on leverage.  It loans other people’s money and collects interest income.  For instance, if you are paid 5% on your bank certificate of deposit (CD), the bank will use that money to loan out at a rate typically at least 2% higher.  The bank makes its money on the "spread" of 2%+.  Only the best customers receive the bank’s prime rate.  A standard savings account may receive 2-3% interest whereas the bank is loaning money at 7-12% interest.  The financial industry is inherently structured to make money.  The assumption of this model is that the lending and investment practices adhere to strict guidelines to insure minimal loan/investment losses.  Regulators closely monitor loan loss ratios.  They are also expected to closely review investment portfolio valuations.  This is currently where the problem lies.

SIVs are investment companies that use short-term borrowings to buy a higher-yielding asset.  When I was in banking in the 1970’s, I discovered an opportunity- borrow at 7% for 36 months and invest in 30 year Treasury Bonds at 8%.  I would simply pocket the 1% profit.  I would use the Bond as collateral.  All is good.  However I had a couple of problems.  First, I did not have the capacity to borrow much.  1% on $10,000 would only yield $100 per year, hardly worth the effort.  I would need to be able to borrow $1,000,000 to create a notable return.  Since I knew that my balance sheet would not support that kind of loan, I dismissed the opportunity.  Things have changed in the financial industry.  Hedge funds raised large amounts of money and were able to leverage their investing by 20 to 30 times.  Additionally, they could justify their investments by buying "insurance" on the asset or its stated interest rate.  What a complex arrangement!  In simple terms, the risk was spread among multiple players.  The problem is that the investment was only as good as the weakest player.  If the security was devalued, there were problems.  If the insurer became weak, there were problems.  If the bank lost money and was required to reduce its lending and thus "call" the note, there were problems.  As you can see there are many things that could go wrong in these complex transactions that base "leverage" as the underlying fuel to high returns. If the SIV invested in subprime mortgage backed securities, all of the participants would be severely impacted if the valuation of the underlying asset (houses) substantially dropped.

The housing bubble is bursting in the developed countries.  Speculators were allowed to borrow money outside the normal, historical lending criteria.  The participating banks were not innocent in this fiasco.  The mortgage lenders (equivalent to bank loan officers) were also complicit in this fraudulent activity.  Technology has provided the lending institutions with plenty of "no brainer", "fill in the blank" loan/credit analysis tools to insure safe lending practices.  Credit reporting agencies provide an easy means to verify payment history.  Once again, corporate greed has raised its ugly head and will severely impact the global financial system.  There will be many to lose their home and any savings they have accumulated.  Those marginal families will be at risk of bankruptcy.

Another bubble of equal concern is the upcoming baby boomer retirement bubble in the U.S.  The unfunded liabilities on the U.S. Government’s Balance Sheet dwarfs any potential source of revenue.  How will the U.S. be able to survive this liability?  The Federal Reserve will cut down all the trees in the country to print money.  This will be hyperinflationary.  The elderly who saved their entire lives will suffer with reduced purchasing power of their savings.  Those who are marginally surviving will become welfare recipients.  The 2007 Medicare/Medicaid insurance trust fund report reveals an unfunded liability of $40.9 Trillion on Page 190 of their latest report.  See the following link: http://www.cms.hhs.gov/ReportsTrustFunds/downloads/tr2007.pdf.  In USA Today, the overall unfunded liability to the taxpayer was $59 Trillion. http://www.usatoday.com/news/washington/2007-05-28-federal-budget_N.htm

The third bubble is peak oil.  The globe is not out oil, it is just more difficult to extract with the current, available resources.  "Peak oil" suggests that production from new discoveries no longer exceeds the production decline in output of existing fields.  The largest discovered fields around the world are in decline.  No new fields of a similar size/output have been found in decades. The world’s largest field Ghawar in Saudi Arabia was discovered in 1948 and put on stream in 1951.  With all of the technology available, oil companies have not found a larger field in the last 70 years.

The Derivative Crisis is the fourth bubble.  There are many other derivatives not tied to the subprime mortgage crisis.  In 2003, Warren Buffett warned that derivative securities were a "mega-catastrophe" and "financial weapons of mass destruction" in the annual letter to shareholders of Berkshire Hathaway, published in the Fortune Magazine:

[T]hese instruments call for money to change hands at some future date, with the amount to be determined by one or more reference items, such as interest rates, stock prices, or currency values. If, for example, you are either long or short an S&P 500 futures contract, you are a party to a very simple derivatives transaction–with your gain or loss derived from movements in the index…

…Large amounts of risk, particularly credit risk, have become concentrated in the hands of relatively few derivatives dealers, who in addition trade extensively with one another. The troubles of one could quickly infect the others. On top of that, these dealers are owed huge amounts by nondealer counterparties. Some of these counterparties, as I’ve mentioned, are linked in ways that could cause them to contemporaneously run into a problem because of a single event (such as the implosion of the telecom industry or the precipitous decline in the value of merchant power projects). Linkage, when it suddenly surfaces, can trigger serious systemic problems.

This derivative industry has grown into the trillions of dollars.  The Bank of International Settlements (BIS) report:

Data from the BIS Statistical Report Q4 2006
• OTC Notional Amount of Derivatives is over $414 Trillion
• 70% of Notional are Interest Rate Contracts
• Credit Default Swaps are the fastest growing product
– Over $28 Trillion
– 65% Single Name Instruments
– 35% Multi – Name Instruments

As of June, 2007 the Derivatives total stood at $516 Trillion. see: http://www.bis.org/statistics/otcder/dt1920a.pdf

Why would I put all of this information in this writing?  The average person will never hear about all of these global risks in a summary similar to the above.  The average person would not comprehend the inherent risk to his or her future that these bubbles represent.

These four bubbles combine to represent a perfect storm.  Tax hikes or other changes to the current global economy can affect the outcome, the timing, and the severity of the expected compression.  What should one do to prepare?  Reduce your leverage and borrowings.  Protect your assets from the financial institutions that may fail.  Take possession of your stock certificates (if you are fortunate to own stock).  Keep cash on hand.  Invest in gold and/or silver (hard money).  Tangible assets will ride out the storm.  People need a place to live, food to eat, and energy for heating, cooling, and transportation.  Will the severe compression take place?  A good businessman hopes for the best but plans for the worst.