Q4 ’07:   A Time for Caution

Wall Street loves to tell the world that there’s no free lunch. Except, of course, when lunch consists of Wall Street bankers feasting on OPM.

If you want to understand the underlying issues driving the current market turmoil, I recommend the following two articles, both published on January 23rd:

The Worst Market Crisis in 60 Years” in the Financial Times by George Soros.
The Dollar and the Market Mess” in the Wall Street Journal by Bill Wilby.

The financial world is transfixed by the ongoing fallout from the sub-prime meltdown. Of course it is not really the sub-prime mortgages that are causing the big problems. Sub-prime mortgages comprise only 10-12% of all mortgages and the vast majority of them are performing just fine, thank you. Worst case sub-prime losses, somewhere in the neighborhood of $250 billion, would still only amount to a fairly minor hit to the economy.

What the sub-prime debacle has done is unmask the gigantic pyramid scheme that Wall Street bankers and their big hedge fund pals have been running.

The story begins with the financial innovation known as “structured finance.” In a structured deal, assets such as mortgages, credit card debt, corporate debt – any assets with cash flow associated – are pooled into stand-alone investment companies. Credit agencies such as Fitch, S&P and Moody’s analyze the cash flow and default characteristics of those asset pools and create a laddered structure of bonds with the bulk of the bonds being transformed by financial alchemy into AAA and the balance laddered down from AA, A, BBB, BB, B, and finally the unrated or “equity” portion. Income from the assets flows into the laddered structure from the top and is distributed in a preferred sequence from AAA downward to unrated, while losses from defaults flow into the structure from the bottom with the unrated taking all losses until it is wiped out and the single B then taking all losses until it is wiped out, etc.

Structured finance is a truly brilliant and benefic innovation unto itself. It creates a series of investment opportunities for those with varying risk appetites, and enables liquidity to flow to otherwise neglected segments of the economy. As long as everyone in the system behaves with integrity, structured finance is a boon to the economy. But as one might suspect, this is where the plot thickens.

A big problem with structured finance is that for the uninitiated, the arcane models with endlessly creative features and the related array of derivatives used for “balancing” risk seem hopelessly complex. As a result, few people really understand it in detail, even most otherwise sophisticated investors. I’m told that even new Fed Chairman Ben Bernanke needed a refresher course in structured finance when faced with the sub-prime meltdown.

The arcane nature of structured finance along with a lack of any regulatory oversight created an environment ripe for abuse. Structured Investment Vehicles (“SIV’s”) and “credit default swaps” became all the rage. The SIV’s allowed the banks to hide their liabilities to the structured deals by placing them “off book,” and the credit default swaps allowed everyone to pretend that they had “balanced” their liabilities.

In recent years investment banks and big hedge funds have generated a blizzard of credit default swaps. CDS contracts today total over $45 trillion, which, to give some perspective, amounts to over three times US Gross National Product and is more money than is on deposit in all the banks in the world. Total outstanding derivatives are over 10 times that amount. These are what Warren Buffett has been calling “economic weapons of mass destruction.” Every swap contract has an issuer and a buyer, each dependent on the other to fulfill their obligations. And of course each side can offset their obligations to others. All of this operates on an honor system with no regulatory oversight, no central exchange or clearing house and no reserve requirements.

The SIV’s and related derivatives amount to what Bill Gross calls a Shadow Banking System. Everyone in the system is exposed to massive counterparty risk. Worse, since there is no transparency in the system, no-one knows how badly exposed anyone else is. Hence, now that the bubble has popped, a reluctance to lend, and the resulting credit contraction.

The big investment banks and big hedge funds (this was an exclusive club) were literally creating money…trillions of dollars…issuing, trading, packaging, swapping and repackaging asset backed deals and derivatives. The result was a global tsunami of liquidity that caused a global run-up in asset prices, which is beginning to deflate. Our central banks are now trying to monetize this bubble without destroying our paper currencies and crashing the markets. Read “The Global Money Machine” by David Roche in the December 14th Wall Street Journal, an excellent review of the rise and incomplete fall of the global credit bubble.

The most remarkable thing about this whole fiasco is the huge bonuses being paid to the executives who are responsible for it. Citicorp is an excellent example.

Citicorp’s Sandy Weil, widely hailed as a banking genius as he led the way in the massive pyramid scheme, was paid the largest bonus in Wall Street history, $850 million, when he retired in 2003. He handed off the pyramid scheme to his successor, Chuck Prince. The roof fell in on Prince, but he still got a firing bonus of $100 mil. Together Weil and Prince were paid almost $1 billion dollars, while Citicorp has so far written off $24 billion in losses from their clever deals, and shareholders have lost $150 billion. Over at Merrill Lynch, Stan O’Neil got a firing bonus of $159 million even as Merrill was writing down $12-15 billion in losses and shareholders were taking a $50 billion hit. Is it too strong to call this “board room looting”

Meanwhile, as you would expect, lawsuits are sprouting like weeds in a vacant lot. So far, the common defense is “we were clueless but not conniving.” If you believe that one, I’ve got some really good income producing property I’d like to talk to you about. It’s a bridge…steady traffic, perfect for a toll booth…


Most of the political news we are getting these days is either heavily slanted or the product of insipid “inside the beltway” horserace reporting, or both. CNN and Fox are especially egregious as they jockey for market share by spinning and hyping the news into “newsertainment” designed to capture one segment or another. You have to do some digging to get good in-depth information.

I have come across a few good pieces recently. There was an excellent and dispassionate review of the accomplishments and frustrations of the new Democrat majority in Congress in the December 12th Los Angeles Times by Richard Simon and Noam N. Levey entitled “Democrats savor power for a year but end it feeling unfulfilled.” The New Yorker (January 29th edition) published a very good piece contrasting Hillary and Obama entitled “The Choice.” Ari Berman has been doing some good in-depth reporting at The Nation. And of course, Frank Rich’s Sunday columns in the New York Times are always brilliant and insightful.

In my opinion the most interesting phenomenon in the political world right now is the rising tide supporting Barack Obama. He is talking unity and non-partisanship and getting a strong response from an electorate weary of the destructive partisan warfare. Young people in particular are going for him in a big way.

The Lieberman Factor: Republicans have been exulting in their success in obstructing almost all of the Democrat initiatives since the Dems took control of Congress. Pretty tacky if you ask me after all the huffing and puffing about “up or down votes” when they were in the majority. Rank and file Democrats are furious with the weak Democrat response to Republican obstructionism. It especially makes Harry Reid look like a pansy. But what most people are not cognizant of is the Lieberman Factor. Lieberman caucuses with the Democrats, and his presence among the Democrats is what gives them their one vote majority in the Senate. Why Lieberman continues to caucus with the Democrats is a mystery to me. But he does, and that is a huge consideration in all that happens in the Senate. If Lieberman decides to bolt to the Republicans, all the committee chairmanships will switch back to the Republicans. This is something that Democrats will avoid at all costs if possible. So Lieberman gets what Lieberman wants. If Lieberman wants capitulation to the President on war funding, FISA or any other specific measure, that’s what Harry Reid gives him. Reid has been taking a pounding from liberal bloggers who deride him as the chief Bush enabler. The reality is that Harry Reid despises Bush and would go to the mat with him in a heartbeat if he had the votes. But he doesn’t. So for one more year at least, Lieberman will call the shots in the Senate.


What a difference a few months can make. As recently as November the Bush folk were actively promoting another pre-emptive war, this time with Iran, which even they acknowledged would probably ignite all out regional war in the Mideast. But resistance began to rise from within the military, which has grown weary of being cannon fodder for the neo-con agenda. The Joint Chiefs let it be known that they think an attack on Iran would be lunacy, and at least five Generals and Admirals are reportedly prepared to resign rather than participate in what they would consider a reckless act. Such a mass revolt at the top level of the U.S. military would be unprecedented.

In November the CIA dropped a bomb on the neo-cons in the form of its Report on Iran, which stated that Iran shut down their nuclear weapons program in 2003. The neo-cons are up in arms (even more than usual) over the CIA report. They have convinced the President that the CIA report is baloney and that he needs to continue to beat the drum for confrontation against Iran, which he did loudly during his recent visit to the Middle East.

Israel is also not happy about the U.S. retreat from confrontation with Iran. They are convinced that Iran is not only working full speed ahead on nuclear weapons technology, but also on warheads and delivery systems. Unchecked, Israel expects Iran to have nuclear weapons in three years. Who is right? It’s not possible for us ordinary folks to know, but if I had to bet my life on intel from the CIA or Mossad, I think I would have to put my chips on Mossad. Israel’s survival depends on Mossad’s accuracy.

Israel is in a difficult situation. Iran is arming, training and financing Hamas in Gaza and Hezbollah in Lebanon, as well as Syria. The Iranian President regularly announces the inevitable destruction of Israel. All of these parties have been preparing for war and Hamas is launching dozens of missiles daily into Israel. Under these conditions the prospect of a nuclear Iran is simply not tolerable to Israel and it is entirely possible, even likely, that they will decide they need to take care of Iran themselves if the U.S. can’t or won’t do it. Any cost is better than a nuclear Iran. They will be watching the U.S. election campaign carefully to decide whether they need to act while Bush is still in office, or whether the likely winner will be a reliable supporter down the road.


It becomes increasingly difficult to find solid opportunities. The global tsunami of liquidity created by the Shadow Banking System has run up the price of assets across the board. Real estate is done and overpriced everywhere, as are assets in general. Stocks may hold here and even rally for awhile, but they are rich just the same. Foreign investments, especially emerging markets have been great beneficiaries of the sagging dollar, but the dollar is already down almost 40% since 2001 and sentiment is in the sub-basement. It could go down more, and over the long run it most likely will. But in the intermediate term I think the dollar is more likely to surprise on the upside than on the downside. Forget about bonds. Everything that is being done and will be done to try to stabilize the markets and pump up the economy is inflationary. Sooner or later bonds will start discounting that inflation. All things considered, cash is looking like a pretty good opportunity.

Gold has had a great run, up 268% since 2001. Over the long run it will probably continue much higher, but at $900 it’s tough to pull the trigger on gold. Richard Russell is probably the guy to listen to on gold. In fact, I would say that if you don’t subscribe to Dow Theory Letters, you should. At $300 this newsletter is the best value in the business. Russell is one of our most successful long term investment advisors and his sage perspective is valuable, especially in uncertain times.

The Bottom Line

The sub-prime shock has unmasked the house of cards that Wall Street built, ushering in a bear market of as yet undetermined magnitude. The stock market has put in a rather ominous looking top and has sold off approximately 20% from the October highs. My point and figure chart projects the potential for a move down to 10,000 in the S&P 500. That’s another 20% for a potential total correction of 36%. That is not unreasonable. However, considering the extreme negative sentiment at the lows and the lack of follow through so far, I am starting to feel that the bottom may be in on this bear market, or close. Also, the Presidential Cycle has been a pretty reliable general guide of stock market behavior, and we are in a bullish phase of that cycle until March of next year. See Risk &Opportunity Q1’07 for more detail on the Presidential Cycle.

At present I see three possibilities for the stock market. (1) The market chops sideways for the next year before rolling over and heading down. (2) The market sells off now (possibly already complete) and then rallies into the election to make a new or possibly a secondary top before beginning the real bear market in ‘09. (3) An export boom ignited by the weak dollar and global injections of liquidity by governments and central banks takes stocks on another major move up. Which do I favor? Currently, based on sentiment and cycles I would favor option #2, but only time will clarify which scenario is unfolding.

As Richard Russell likes to day, the Fed’s mantra is “inflate or die.” The Fed has made it clear they are going to do everything in their power to put off or minimize any recession. After 40 years of fiscal mismanagement we are now trapped in a semi-permanent stimulus driven, “inflate or die” economy, and the Fed currently has its foot down hard on the stimulus pedal.

Eventually, central bank intervention will no longer have the desired effect of jumpstarting the economy. Globalization and serial bubbles have both eroded Fed power and the day will come when the Fed pulls all the levers at its disposal and nothing happens. That will be the day that the cumulative impact of many delayed recessions will have to be endured.

The big question is…has the day of reckoning come? I think we’re not there yet. The Fed still has considerable power to impact the marketplace and has made it clear that it is going to act aggressively to do so.

My read is that volatility will continue to be high. The bear may take another bite out of the market, but the market will come back strong into the election for a secondary or possibly a new high. After that…well, we can’t put off our debts forever.

All things considered, caution should be exercised in all matters financial. Cash may well be your best opportunity right now.