The best performing hedge fund this year?

So basically, for the past several years, Porsche has been making hundreds of millions, if not billions in profits thanks to its derivatives on Volkswagen.

The conclusion is that Porsche might be making more profits by trading and take prop-positions on the markets than by building and selling cars. That would make Porsche one of the top performing hedge funds this year! Plus, because they have a foot in the industry, they have access to industry information that banks and other hedge funds lack.

Plus, according to the quote below, Porsche is also behaving as a broker/dealer/market maker for VW shares.

I think it's fun, but the hedge-funds and banks which are loosing billions if not their shirts on this might not enjoy the joke as much as I do.

BBC News writes:

It meant that because Porsche had not declared the proportion of VW shares it controlled, traders may have been indirectly and inadvertently borrowing shares from Porsche, selling them to Porsche, buying them back from Porsche and then returning them to Porsche.

The incompetent and shameless liar Art Laffer

When you think that incompetent and shameless liars like this foolish Art Laffer are the people who advise our governments, it's easy to understand why we are digging and digging while stuck in the whole.

Just see for yourself.

1. Art Laffer vs Peter Schiff in 2006
2. Art Laffer in 2008 about his debate with Peter Schiff
   

Voice of Wisdom: Jeremy Grantham

I have been reading Jeremy Grantham's letters for quite some time, and I share almost all his opinions. I found in his last letter many ideas and opinions that I have been having for some time now, but which I never had the time to write down. So I am really happy that he did! Here are some quotes that are more related to our world than to markets:

[...]
1. We had an extended period of excess increase in money supply, loan growth, leverage, and below normal interest rates.
2. This combined with a remarkably lucky global economic environment that we described as “near perfect” to produce a bubble in asset classes, as such a combination has done without exception according to our research. Since all these factors were global, the combination produced what we have called “the fi rst truly global bubble” in all assets everywhere with only a few modest exceptions.
3. While these asset bubbles were infl ating, facilitated by easy money, the authorities – the Fed, the SEC, the Treasury, and Congress – rather than tightening existing regulations, partially ismantled them.
[...]
4. The combination of favorable conditions and irrationally exuberant encouragement from the
authorities produced an even more poisonous bubble – that in risk-taking itself. Everybody, and I mean everybody, got the point that risk-taking was asymmetrical and reached to take more risk. The asymmetry here was that if things worked out badly they would help you out (this sounds very familiar!), but if all went well you were on your own, poor thing. Ah, the joys of pure capitalism!
[...]

We have had a bloated financial industry feeding off the real world and a breach of the social contract with the increasing maldistribution of income (encouraged by tax changes!) in favor of the very rich at the expense of ordinary people. We also had unnecessary fl aunting of this new great wealth. To cap it off, we had blinkered, narrow-minded leadership by the government and financial corporations. Well, much of this is ending. Some undesirable elements will disappear for a long time and some will just be moderated, but it is truly the end of an era and a rather disgusting one in my opinion[...]

We have collectively had a touching faith that capitalism – just because it’s the only effective driving force behind economic growth – is basically fl awless, and any controls are bound to be counter-productive. Pure Ayn Rand capitalism obviously cannot deal with social issues of the tragedy of the commons variety, such as climate change. It cannot turn corruptible and greedy types into the reasonable and honest types that our readers represent. It cannot begin to address social justice. [...]

Still at the meta level, I would like to bring up the hope that as a result of our current misfortunes we will re-examine how we pick our leaders. It would seem for starters that a lack of prejudicial bias would be helpful. If you’re looking for an open mind, why would you pick Robert Rubin or Hank Paulson for a job at Treasury that might, just might, involve decisions on the life and death of their beloved Goldman Sachs? And in the case of Paulson, why pick one of the fi ve leaders of fi nancial fi rms who lobbied hard at the SEC against increased reserves for investment banks? Why would you pick an Ayn Rand extremist like Alan Greenspan to be the Fed Boss when he openly deplored increased regulation in almost any form and thought untrammeled capitalism was the bee’s knees? Wouldn’t an open mind be better? Or Ben B, whose refl ex is so
clearly to believe in market effi ciency? He believes it so profoundly that he prejudged important data such as the very dangerous housing bubble of the last few years. He seemed to believe that since no such extreme ineffi ciency should exist, then it did not exist.[...]

And as for Alan! He had a proven record. It was proven for years that he was a very mediocre, lightweight commercial economist. He sat on a few politically connected committees, met the right people a lot, and, hey presto, had the second most important job in the land. Lower down on the pecking order, I think we have learned not to value CEOs so highly. We have seen their limitations when under novel stresses, and we have examined how their reward system was out of kilter with the ordinariness of their talents. The boss of Lehman did an honorable and long service in my opinion, and I have no doubt he tried hard. But frankly, Lehman even in its heyday was a B player and, in its last few months, a D player. It is probably unfair to weigh too heavily his lack of skill down the home stretch and the pain he infl icted on many by holding out too long. He was obviously very unlucky to be picked out as a sacrifi cial lamb. But even before the unraveling, did he really deserve to have accumulated a $650 million holding in Lehman – all wealth that would otherwise have accrued to stockholders – in addition to immense annual rewards for basically doing an average job?[...]

The research science world is no doubt sighing with relief at their silver lining: the prospect of once again recruiting some of the best PhDs who had been lining up to work for Goldman or a hedge fund (and even, I must admit, a few for GMO). There they designed the cleverly epackaged mortgage paper so admired by Greenspan, or developed quant equity models and “stat arb.” Now they will have to waste their time once again designing nuclear facilities and second generation biomass projects. Oh well. [...]

The fl ood of money also allowed for over-funding of fi rst-rate hedge funds and the start-up of
thousands of second-rate funds. Real investment talent has always been scarce, and does not jump out of the ground just because there’s a massive demand. Nuclear physicists do not immediately become investment talents even with IQs of 150. The hedge fund industry is just an extension of our larger zero sum game. It adds collectively no value, it just reshuffl es the existing pool of wealth minus the higher fees. Last year, in its prime, it offered mainly in place of real value added, or alpha, a simulated alpha that was dependent on rising asset prices, falling interest rates, or easy credit. All three in many cases.

The Biggest Short-Squeeze in History

Bloomberg (and many others - it's impossible not to report this story) reports about the short squeeze on the Volkswagen stocks.

Basically, the stock was up about 100% after a couple of hours of trading today, which makes an increase of about 500% in 24 hours. The price of the stock rocketed from about 200€ to about 1000€ giving the company a market cap of about 320 billion euros, that is more than double the market cap of Microsoft and triple the one of General Electric (one could argue that GE is on the brink of bankruptcy anyway...). Today, Volkswagen is the biggest company on the planet in terms of market cap. Of course, this is totally artificial.

This in turn makes the German DAX 30 fly at +10%.

This short squeeze occured as Porsche announced it has increased its stake in the company to 74%, and Germany's Lower Saxony holds about 20% of the stocks, which reduces the floating shares to about 6%.

One could argue that the regulators and authorities have failed, since a company with a floating stake of 6% only shouldn't be public anymore and hence, they should have removed Volkswagen from listing (probably by forcing Porsche or Saxony to buy the remaining shares).

In the meantime, losses to hedge-funds and other arbitragers are probably north of hundreds of millions and the whole thing creates a major distortions in European indices since these same investors/speculators need to dump other shares and take losses to raise funds and close their shorts.

Gold update - 20081026

This article from a Bloomberg journalist (apparently) shows the extend of the incompetence and lack of understanding of the financial journalists and investors:

Gold fell in New York, heading for the biggest weekly loss since 1983, as a strengthening dollar reduced demand for the metal as an alternative investment. Silver also declined.

This person apparently has it all wrong. The demand for gold has never been higher! It's just that the Great Unwind is pushing the $ up and everything else down. Nobody want to hold USD, it's just that it's the medium for transfer to meet redemptions and margin calls... Check my previous Gold update for more details and also the following quote from BullionVault (Frank Holmes – CEO and chief investment officer at US Global Investors, and co-author of the new Goldwatcher: Demystifying Gold Investing (John Wiley & Sons):

Frank Holmes: If you make a 2% mistake in the $500 trillion derivative market, that's $10 trillion. What's $10 trillion? Well, the world's total GDP is $50 trillion, and the total amount of US dollars in circulation is roughly $15 trillion. That 2% mistake wipes out 20% of the world's GDP.
[...]
Frank Holmes: Asian economic activity has a big influence on the purchase of gold. At the London Gold Bullion Traders Conference in Kyoto, I was amazed to find the magnitude of the shortage of gold and silver coins. In Germany, they are lining up to buy Gold.
TGR: Do they have supplies?
Frank Holmes: No, but they do have gold in kilo bars. Everything is sold as soon as they get it.
TGR: I tried to buy some Swiss 20 Francs today and couldn't find any.
Frank Holmes: People are paying a large premium for small coins, and the purchase of safety deposit boxes is on the rise. People have been actually stuffing dollars in them, along with gold. It's not really a 1980-style mainstream panic, however. People are continuing to buy. The growth of Gold ETFs attests to that.
[...]
Frank Holmes: Over the next two years gold will be well over $1,000, maybe running up to $2,000. The number-one Asian analyst, Chris Wood, is advocating a 30% gold exposure to institutions. Now, this is the number-one brokerage firm in Asia and their research is excellent.
TGR: What's the name of the firm?
Frank Holmes: CLSA-Asia Pacific Markets. It recommends a portfolio allocation of 30% gold – fifteen per cent gold bullion and 15% unhedged gold stocks. When an analyst of Wood's stature advises putting 30% of your portfolio into gold, you have to take note. We tell our clients to put a maximum of 5% into bullion and no more than 5% toward gold equities.
TGR: Doug Casey's latest missive rounded it up to 30% too.
Frank Holmes: The significance here is that the institutional side is getting on board with gold. That's a big deal.

Losing My Integrity - Warren Buffet's Next Book?

Losing my Virginity is Richard Branson's (auto?)biography... for those who didn't understand where the title of this post was coming from.

I have been seriously questioning (and asking myself) the reasoning of Warren Buffett for the past several weeks as I believe that he is making less and less sense. I have respected Warren Buffett and as many, consider him as being the voice of wisdom and have read everything I can about him and watched all his interviews. But he simply doesn't make sense anymore. What has happened? I still don't know. I questioned his statements and thought that I had found the light from London Banker, with whom I exchanged a couple of messages.

So what's going on?

• First, Warren Buffet publicly states that the Paulson (non-)Plan is a great one and is necessary, while ALL the people (investors/economists) who foresaw the crisis coming think this is madness, and a strategic error. Warren Buffet is no idiot, so why does he backs this? Of course, it does help his own purpose, but... would he put his personal gain above the US one? He said in 2003 that "Derivatives are financial weapons of mass destruction " but he then wrote PUTs for a notional value in billions of USD on the market. So he is probably now in deep trouble and is wishing for the market to rally up?
• He invests $5 billion in Goldman Sachs on the 24th of September while the smart money knows that GS is not going to survive in its current state. He manages to get preferred shares yielding 10% and warrants for more equity. These shares are not available to the general public or common investors. But he nonetheless knows that his actions will lead a "sucker's rally" on the market by sending the wrong signal. I am sure he is clever enough to have obtained protection for his money by the Fed or the Treasury on top of that, meaning that the US Citizens will pay in case something goes wrong. Finally, sending wrong signals to the market is the best way to lead to a crash further down the road (the crash already occurred, just a couple of weeks further down the road!).
• He does it again with General Electric: $3 billion on the 1st of October. Again, the smart money knows that GE is in deep deep trouble... but he uses his reputation to send the wrong signal to the lemmings.
• Finally, on the 18th of October, he tells the American people that it is the time to buy American stocks and sends the lemmings against the wall at full speed. He does this while perfectly knowing that the market is still (very) expensive, that the earnings forecast are way too optimist and the deleveraging that is currently going on will be pushing the stocks down a lot further. Indeed, the stock market is already down 6-10% just the week following his statement!

So what is going on here? Has Warren Buffet lost his integrity? Does he have his arms twisted by someone? Should you have more information/opinion/ideas, please email me or comment on this post.

Gold update - 20081022

I have been quite busy for the past few days, and so many things are happening that it's hard to pick just one or two items and post about them... I now have had the time to pick of news pieces that nobody seems to have dealt with. The first one is the price of gold. Why is it declining?

So first of all, I already mentioned just a few days ago in Gold vs Gold (paper vs physical) pt3 that on the short term, the Great Unwind might affect negatively the price of Gold. So this could be the first place to look for an explanation.

Going further down this route, it appears that the US investors are liquidating everything they can, and most likely liquidating their foreign assets. In the light of this, we understand why the USD is rising so much and so quickly defying gravity and the fundamentals. If you also remember that Gold, is also a currency, under the ticker XAU, you will understand that the rise of the USD against every other currency means that the price of gold in dollar terms is falling. This is further confirmed by the fact that Gold didn't really move against the Euro or the Pound.

Fx charts below (can you detect similarities?):

Lahde's goodbye letter

Here is the full text of Andrew Lahde, the hedge fund manager whose one-year-old fund was up in the 800% and made a killing and decide to tell his truth to his clients and shut down his fund. It tells a lot about what the financial industry has become and how the US are managed:

Today I write not to gloat. Given the pain that nearly everyone is experiencing, that would be entirely inappropriate. Nor am I writing to make further predictions, as most of my forecasts in previous letters have unfolded or are in the process of unfolding. Instead, I am writing to say goodbye.

Recently, on the front page of Section C of the Wall Street Journal, a hedge fund manager who was also closing up shop (a $300 million fund), was quoted as saying, "What I have learned about the hedge fund business is that I hate it." I could not agree more with that statement. I was in this game for the money. The low hanging fruit, i.e. idiots whose parents paid for prep school, Yale, and then the Harvard MBA, was there for the taking. These people who were (often) truly not worthy of the education they received (or supposedly received) rose to the top of companies such as AIG, Bear Stearns and Lehman Brothers and all levels of our government. All of this behavior supporting the Aristocracy, only ended up making it easier for me to find people stupid enough to take the other side of my trades. God bless America.

There are far too many people for me to sincerely thank for my success. However, I do not want to sound like a Hollywood actor accepting an award. The money was reward enough. Furthermore, the endless list those deserving thanks know who they are.

I will no longer manage money for other people or institutions. I have enough of my own wealth to manage. Some people, who think they have arrived at a reasonable estimate of my net worth, might be surprised that I would call it quits with such a small war chest. That is fine; I am content with my rewards. Moreover, I will let others try to amass nine, ten or eleven figure net worths. Meanwhile, their lives suck. Appointments back to back, booked solid for the next three months, they look forward to their two week vacation in January during which they will likely be glued to their Blackberries or other such devices. What is the point? They will all be forgotten in fifty years anyway. Steve Balmer, Steven Cohen, and Larry Ellison will all be forgotten. I do not understand the legacy thing. Nearly everyone will be forgotten. Give up on leaving your mark. Throw the Blackberry away and enjoy life.

So this is it. With all due respect, I am dropping out. Please do not expect any type of reply to emails or voicemails within normal time frames or at all. Andy Springer and his company will be handling the dissolution of the fund. And don't worry about my employees, they were always employed by Mr. Springer's company and only one (who has been well-rewarded) will lose his job.

I have no interest in any deals in which anyone would like me to participate. I truly do not have a strong opinion about any market right now, other than to say that things will continue to get worse for some time, probably years. I am content sitting on the sidelines and waiting. After all, sitting and waiting is how we made money from the subprime debacle. I now have time to repair my health, which was destroyed by the stress I layered onto myself over the past two years, as well as my entire life -- where I had to compete for spaces in universities and graduate schools, jobs and assets under management -- with those who had all the advantages (rich parents) that I did not. May meritocracy be part of a new form of government, which needs to be established.

On the issue of the U.S. Government, I would like to make a modest proposal. First, I point out the obvious flaws, whereby legislation was repeatedly brought forth to Congress over the past eight years, which would have reigned in the predatory lending practices of now mostly defunct institutions. These institutions regularly filled the coffers of both parties in return for voting down all of this legislation designed to protect the common citizen. This is an outrage, yet no one seems to know or care about it. Since Thomas Jefferson and Adam Smith passed, I would argue that there has been a dearth of worthy philosophers in this country, at least ones focused on improving government. Capitalism worked for two hundred years, but times change, and systems become corrupt. George Soros, a man of staggering wealth, has stated that he would like to be remembered as a philosopher. My suggestion is that this great man start and sponsor a forum for great minds to come together to create a new system of government that truly represents the common man's interest, while at the same time creating rewards great enough to attract the best and brightest minds to serve in government roles without having to rely on corruption to further their interests or lifestyles. This forum could be similar to the one used to create the operating system, Linux, which competes with Microsoft's near monopoly. I believe there is an answer, but for now the system is clearly broken.

Lastly, while I still have an audience, I would like to bring attention to an alternative food and energy source. You won't see it included in BP's, "Feel good. We are working on sustainable solutions," television commercials, nor is it mentioned in ADM's similar commercials. But hemp has been used for at least 5,000 years for cloth and food, as well as just about everything that is produced from petroleum products. Hemp is not marijuana and vice versa. Hemp is the male plant and it grows like a weed, hence the slang term. The original American flag was made of hemp fiber and our Constitution was printed on paper made of hemp. It was used as recently as World War II by the U.S. Government, and then promptly made illegal after the war was won. At a time when rhetoric is flying about becoming more self-sufficient in terms of energy, why is it illegal to grow this plant in this country? Ah, the female. The evil female plant -- marijuana. It gets you high, it makes you laugh, it does not produce a hangover. Unlike alcohol, it does not result in bar fights or wife beating. So, why is this innocuous plant illegal? Is it a gateway drug? No, that would be alcohol, which is so heavily advertised in this country. My only conclusion as to why it is illegal, is that Corporate America, which owns Congress, would rather sell you Paxil, Zoloft, Xanax and other additive drugs, than allow you to grow a plant in your home without some of the profits going into their coffers. This policy is ludicrous. It has surely contributed to our dependency on foreign energy sources. Our policies have other countries literally laughing at our stupidity, most notably Canada, as well as several European nations (both Eastern and Western). You would not know this by paying attention to U.S. media sources though, as they tend not to elaborate on who is laughing at the United States this week. Please people, let's stop the rhetoric and start thinking about how we can truly become self-sufficient.

With that I say good-bye and good luck.

All the best,

Andrew Lahde

S&p 500 and DJ indices update

Two weeks ago, I made the following statements in my post: Are we done yet? No Expect a lot more decline:

• The equity markets are still very expensive in historical terms and will decline sharply
• The VIX and VXO volatiliy indices will beat their previous historical records

It appears that I was very lucky on my timing, since both happened exactly when I predicted them. The equity markets declined by about 15% in dollar terms and the volatility indices beat their previous records by as much a 50%-70%.

I would like to provide the following updates, and draw the following conclusions from what happened today:

• The DJ INDU and Russell 2000 still have negative earnings and hence no PER
• The S&P 500 had a big decline in the PER (probably thanks to the rebalancing of the indice, removing several big loosers in the past few weeks, including Fannie, Freddie, Lehman, WaMu, etc.). But, the PER is still at about 20, which is very high historically. Should the S&P PER decline to it's historical mean, it would mean a drop of another 25% to 33% of the value OR an increase of about 25-33% of the corporate profits (or somewhere between the two). What are the odds of a huge increase in corporate profits? Who would bet on major declines in corporate profits in the coming months/quarters? In which case, as during major recessions, should the PER drops to about 7, this would mean another 60-70% decline, provided that corporate profits do not decline! Given the current inflation figures and all the bullishness in the market, I expect the market to rebound at some point, but on the long term, we could see a major decline... (See Fig.1)
• Regarding the market decline, if you look at the DJ and S&P 500 in EUR or Gold terms, you will see that since the USD rallied massively in the past several weeks meaning that the US indices have actually made only a small decline. (Un)fortunately, this is bearish for them, since during the past few years, many companies massively benefited from international sales and the devaluation of the USD. Comparing the INDU30 to the CAC40, the difference is a massive 13%. So it is very likely that the German and French markets would beat the INDU on the mid-term and that a long CAC/DAX short DJ would be a nice strategy - specially since I am very bearish US, given the mess over there...
  

Fig. 1: Historical PER on the S&P 500 (click for bigger image)

Fig. 2: S&P 500 in Gold, EUR, USD and compared to French CAC 40 (click for bigger image)

Fig. 3: DJ INDU in Gold, EUR, USD and compared to French CAC 40 (click for bigger image)

UBS saved by their central bank

UBS is on the verge of collapsing, and they have received special authorization from the SNB to move $60 billion of illiquid assets to a seperate entity and raise CHF 6 billion, among other many things (it is definitely worth reading the full statement):

Up to USD 60 billion in assets to be transferred to new entity, fully owned and controlled by SNB

Based on an agreement with the SNB, UBS will transfer up to USD 60 billion of assets to a newly created fund entity. UBS will capitalize the fund with equity of up to USD 6 billion.

The SNB will finance the fund with a loan of up to USD 54 billion, secured on the assets of the fund. At the time it grants the loan, the SNB will take over control and ownership of the entity by purchasing the equity for a nominal price of USD 1. The loan will be non-recourse to UBS, assuming no change of control of UBS and will be priced at LIBOR plus 250 basis points. It will mature in eight years, but the maturity may be extended to 10 or 12 years.

The USD 6 billion equity will absorb any potential realized losses up to this amount.

Credit Suisse is also raisong CHF 10 billion (no link to provide at this time).

Looks like it is not just the US and UK banking system that are safe and sound, the Swiss one is also in the same category.

I read everywhere that the markets are panicking. But they tend to ignore or downplay the causes, the same way the main stream media fails to report the real causes of this crisis and behaves as if it was a major surprise that was totally unpredictable (forgetting that many people had predicted it, but were all laughed at...). Always remember this quote from John Mills:

“Panics do not destroy capital — they merely reveal the extent to which it has been destroyed by its betrayal into hopelessly unproductive works.” (John Mills - Credit Cycles and the Origin of Commercial Panics)

Gold vs Gold (Paper vs Physical) pt3

This is my 3rd post about Gold vs Gold (you can find the 2nd one here and the 1st one here).
What has changed since the last post? We had a major interest rate decrease by western central banks, which should be very bullish for gold, but gold still failed to rally. The reasons might be that on the short term, the Great Unwind is preventing Gold to take off. But once we are done with the short term liquidation of gold, I think we will have a very long bull run on the physical.

So, here's the update:

• Kitco removed all gold products from its listing, even the 1kg one, and the only product left on the store is the 400 oz bar, priced at about $336,000. (They also list Canadian Olympic Edition of the Maple Leaf but this one is only for Canadian Residents) and has only 1000 oz silver bars listed on top of that 400 oz gold bar.
  
• Other bullion merchants are also out or low on stocks (example in London: "UPDATE 15/10: Coins are still unavailable, bars can however be ordered. There are delays of approx 2 weeks to all Platinum, Palladium & Silver bar orders due to backlog.")
• But the two most important news the following.
  

The End of Gold Carry Trade

Lease rates on Gold are raising a lot as showed on these two charts, while interest rates on currencies are falling. They have raised from about 0.25% to almost 2.5% in a matter of weeks. Why is this important? Because the lease rate jumping while the interest rates falling will break the back of the "gold lease carry trade" and is hence a very bullish signal for Gold.

short term lease rates:

long term lease rates:

The Vaults are Full

Bloomberg just posted the following story, which doesn't need further explanations (emphasis mine):

Zurich Bank's Vault `Full to the Top' With Gold on Fund Demand By Rachel Graham
Oct. 15 (Bloomberg) -- Zuercher Kantonalbank, the Swiss lender that manages about $107 billion, said its gold vault is full after a surge in demand from investors seeking a haven during the credit crunch.
Assets in the Zurich-based bank's ZKB Gold ETF, backed by about 2.66 million ounces of the metal, have risen to a record for seven consecutive weeks. That amount of gold is worth about $2.25 billion at today's prices and equal to about 12 days of global production.
``Demand is so strong,'' Susanne Toren, a metals analyst at the bank, said by telephone from Zurich today. ``Our vaults are full right up to the top.''
Investors are buying gold coins and bars, and exchange- traded funds backed by physical metal, after banks including Lehman Brothers Holdings Inc. collapsed. Assets in SPDR Gold Trust, the largest ETF backed by bullion, advanced to a record 770.64 tons (24.78 million ounces) on Oct. 10.
Rand Refinery Ltd., the world's largest gold refinery, in August said it ran out of South African Krugerrands. The Perth Mint, producer of 10 percent of the world's bullion, doubled output in the past six months.
Zuercher Kantonalbank, which is privately owned, also manages funds for silver, platinum and palladium. Sibylle Umiker, a spokeswoman for the bank in Zurich, confirmed the vaults are full and the company is looking for more space in Switzerland.

And yet, gold is down to $835 an ounce as I write this. This might be a tremendous buying opportunity. Actually, the paper gold (futures contracts) might be highly undervalued and if I had the possibility to take physical delivery, I would probably load some on my portfolio.

The Great Unwind and Fair Value of the Market

The two questions that I see asked and answered everywhere in the financial news are:

1. When will we hit the bottom?
2. What is the fair value of the market?
   

I would like to provide my point of view and my (very short) answers to these questions. I keep it short due to the lack of time.

When will we hit the bottom?

In any bear market, the market is hit when all the greed has disappeared and has been replaced by fear. But note that while this is a needed to hit the bottom, it doesn’t necessarily mean that you have actually hit it yet. Let me rephrase: to hit the bottom you need to have replaced all greed by fear. But the reciprocal sentence is not true: you cannot say: you have replaced all greed by fear so you have hit the bottom. Or you might want to have a local short term bottom, but it’s not going to be the real, long term bottom.

Why is that? Because first it might take a while to recover, and second, the bottom will be hit only when everybody will believe that there is no bottom and that all the prices will go forever down.

Have we reached that point yet? Of course not. When the stock market is able to make a huge reversal from -10% to +2% and then rally 11% on the following day, can you really believe that all hope has disappeared? And when everybody is afraid of missing the rebound? When many still believe that the economy is not in recession, that inflation is contained, and that we will be out of the woods in early 2009, have we really reached the bottom?

This holds true for stock markets but also for the real estate market. We have not bottomed yet, and it’s still going to require a lot of losses from bottom fisher to reach it. As long as you will have bottom fishers and people calling the bottom, it’s not going to be the bottom. The bottom will be reached when speculators will have given up on the market, believing that it will never stop sliding further and further down and will never recover. This leads me to the next question:

What is the fair value of the market?

My answer would be: who cares about the fair value? The market is currently driven more by sentiment and even more by the Great Unwind than rationality and fair valuation. To be totally honest, I believe that if it was driven by rationality and fair value, it would be a lot lower than it currently is.

Now think about what is happening: deleveraging and unwinding. During the past few years of cheap money (far below the real value you would have get without the “price-fixing” of central banks). When you see banks and hedge funds and other investment management companies having a leverage of 2, 3, 15, 20, 40, you can easily understand that once they start to liquidate position, it will hurt badly. Moreover, with the Yen carry trade you add insult to the injury. Also note that the saving rate has been close to zero in many European countries and even hit negative values in the US. So it’s more than likely than the markets were not pushed higher by consumer/individual investors.

I cannot really quantify the amount of $ and € and £ etc. that will need to be extracted from the markets to pay back the credit lines with the brokers and the redemptions that will flow from now on that many investors are panicking, but one thing is for sure: forced liquidation will drive prices a lot lower and very likely to level far lower than fair value.

R.I.P EUR

I already mentioned this a few month ago on my August post, Trichet has abandoned the ship of monetary stability and has given up on this duty as the safe keeper of the Euro.

For the past week or so, Trichet and the various governments of the Eurozone have decided to plot the murder of the Euro, and to celebrate that with hyperinflation in order to revive the stock markets from its due correction.

Here's a small non-exaustive list of what they have done (or not done) in order to kill the Euro:

• Trichet didn't raise interest rates while inflation was already 150% above his targets.
• Trichet droped interest rates to avoid a collapse of the USD, and hence decided to sacrifice the Euro to save USD. I didn't know that the ECB's job was also to prevent the collapse of the USD.
• EU Nations Commit 1.3 Trillion Euros to Bank Bailouts, that is more than 250% of the bailout package of the US, which was already outrageously enormous.
• Fed Lets Europe Central Banks Offer Unlimited Dollars, Removes Swap Limits."The European Central Bank, the Bank of England and the Swiss National Bank will offer European banks unlimited dollar funds with maturities of seven, 28 and 84 days at fixed interest rates". I am trying to make sense of this.

I used to be a €-bullish, then I turned a €-sceptic in August, and now, well, I am preparing the Funeral of the €, which will probably pass away at the same time as its older relatives: the £ and the $.

The biggest (bear) rally in seven decades, seen through reality lenses

Oct. 13 (Bloomberg) -- U.S. stocks staged the biggest rally in seven decades on a government plan to buy stakes in banks and a Federal Reserve-led push to flood the global financial system with dollars.

The Standard & Poor's 500 Index rebounded from its worst week in 75 years with an 11.6 percent advance, its steepest since 1939, and the Dow Jones Industrial Average climbed more than 936 points. Morgan Stanley soared 87 percent after sealing a $9 billion investment from Japan's Mitsubishi UFJ Financial Group Inc. Alcoa Inc., General Motors Corp. and Chevron Corp. climbed more than 20 percent each as all 10 industries in the S&P 500 added more than 7 percent.

Let's try to contrast a little bit this news with a bit of reality:

• The Fed and the US government flood the world with valueless USD and the result is a drop of 3% of the price of Gold.
• A mega-market rally where even bankrupt companies like GM rise +36%. At the end of the day, what matters for GM is to sell cars, right? But to whom? Are the American citizen any more solvent than they were yesterday? It seems like all of the sudden, investors forgot about the real estate crash, foreclosures, tent cities, and woke up in Wonderland.
• Morgan Stanley, see below.

Morgan Stanley

Morgan Stanley's 12 month Ending 2007-11-30 income available to common shareholders was 2,495 million USD.

No UFJ-Mistubishi takes 21% of the shares (by diluting the current shareholders) and has a 10% guaranteed yield with their preferred shares for $9 billion USD. This makes a yearly income of 900 million USD that won't be available to the current shareholders.

This is 36% of their income, provided that it remains at the 2007 levels, which is more than unlikely. This is about 15% of the 2006 6,316 all-time-record of the Morgan Stanley.

On the news, Morgan Stanley's stock rose +87% and has now a market cap of $19 billion.

So basically, common shareholders just rewarded UFJ-Mistubishi with an instant gratification of +87% for diluting them, and they are now happy to hold these shares which are unlikely to perform well, and which are far more risky than they used to be because after bond holders, it's UFJ-M which will be served next.

The contrast is surprising when you notice that UFJ-M required to have:

• preferred shares
• 10% yield
• priced at 10$ each
  

And then that the market thinks that this is a fantastic deal:

• common shares
• very likely to get a 0% yield for the foreseeable future
• priced at 18$ each
  

My opinion is that Morgan Stanley is a nice short-sell. But I will hold for now, as I am sure that short selling will be banned again in a matter of days...

Other points of interest today:

- The (official) US dept, which hit $10 trillion on the 30th of September 2008 was at $10.266 trillion on the 9th of October 2008, that is a 2.66% increase in 10 calendar days. Annualize that and you will see how close we are from hyper-inflation.

- Mish - shares my opinion Big Robery Plan sorry, I ment, the the Rescue Plan:

To stimulate lending, the bailout plan will attempt to recapitalize banks. The method of recapitalization is best described as robbing Taxpayer Pete to pay Wall Street Paul. In essence, money is taken from the poor (via taxes, printing, and weakening of the dollar) and given to the wealthy so the wealthy supposedly will have enough money to lend back (at interest) to those who have just been robbed.

All this talk about Strategy, Implementation, Recruitment, Procurement, operations, compliance, and other details masks the essence of the plan.

After 20 years of decadence, pay-back time!

Bloomberg says "U.S. Stock Futures Gain as Fed Says All Options Open for Market":

Oct. 13 (Bloomberg) -- U.S. equity futures gained after the worst week for stocks in 75 years, boosted by the Federal Reserve's pledge to ``consider every option'' to restore investor confidence and a government plan to buy stakes in banks.

Well, the balance sheet of the Fed has almost doubled the last 3 weeks only up to about 1.6 trillion USD (trillions do not scare anyone anymore, we use the words many times a day...) and what has been the result? Do we have any more confidence? Of course not, and that's the reason why they are showering the markets with "liquidity" measures which are obviously useless, since there is no liquidity shortage, but hidden losses on the balance sheets and several skeletons in every closet you open.

All the options have been tested to restore confidence except the single, very simple, zero-dollar one: forcing US financial institutions to show their books and force transparency on the markets. Why? (WHY?).

At the same time, you can see on these charts from the Fed itself that the Financial System is insolvent, and also remember that they are lagging, so things are probably far worse than what these charts show. I have been showing them every month now, but the singularity and the exponential rise that they show month after month scare me to the guts.

The Fed has also started the stagflation of the US economy at best (which is very likely to be exported worldwide because of the various currency pegs and puppy behavior of the European policy makers) and maybe hyperinflation if we are unlucky enough. The silverlining is that at least if we end up with hyperinflation, we will get rid of the Fed and maybe start over with a sound currency. I will write a post about sound currency very soon.

"Our financial system is safe and sound"

(click for bigger images)

inflation unleashed (look at the major jump at the current month!):

Gold vs Gold (Paper vs Physical) pt2 [UPDATE]

One month after my first post, I would like to provide an update and share quite interesting information I found out today.

First of all, the official Kitco webstore shows that stocks are actually decreasing and they basically have nothing left to sell:

• Gold Eagle 1 oz
• Gold Maple 1 oz
• Special Gold Maple 5 X 9 pure 1 oz
• Gold Buffalo 1 oz
• Gold Krugerrand 1 oz
• Gold Bar 10 oz
• Gold Bar 1 oz
• Kitco Gold Bar 1 oz
• Kitco ChipGold 10 g
• Kitco ChipGold 20 g
• Gold Philharmonic 1 oz
• Silver Philharmonic 1 oz
• Silver Eagle 1 oz
• Silver Maple 1 oz
• Silver Bar 100 oz
• Platinum Eagle 1 oz
• Palladium Maple 1 oz
• Silver Maple Olympic Coin 1 oz.

They really do not have anything left. I actually called them, and they told me over the phone that they have 1,000 oz silver bars (that is about 31 kg, who can move this around except custodians?) and they have 1 kg gold bars - but after checking, they only had 2 and they weren't even sure that these two weren't already sold!

So I called some other bullion stores which I have been touch previously and here's what I have heard:

1. From the first one: they said that the Mint was not taking any more order for at least until January 2009. They have such a huge back order that they simply won't take any more orders. This looks like Kitco which is struggling with its shipments and is no longer able to take any order due to lack of any stock! They weren't able to provide any estimate of when they would receive new stocks and be able to take new orders.
   
2. The second one: they told me that they are receiving an unprecedented amount of calls per day for the past few days (more than 1,000 calls, where they usually receive far less) and orders by email. They have ran out of gold coins and cannot take any more orders. They said they were able to sell their coins with an massive premium. So they only have gold bars in stock now, and with the number of orders they have received, there is a 24-48-hour-delay just to get the order processed. They will have to come and work week-ends to get the orders processed and that's the first time it ever happened to them!
3. Finally, I called a sales person from a company which business is to install vaults for both corporate clients and consumers. He told me that within the past few weeks, the number of orders has doubled (+100%!) and that their competitors have been having the same magnitude of growth. He concluded that the banking crisis was very beneficial for their business!

At the same time, today, gold paper on the futures market was falling 4% to less $850 per oz. The number of contracts exchanged was above 200,000 which is many times the yearly production of gold from all the gold mines on Planet Earth.

Another point of interest: the Icelandic Krona is collapsing, the Australian dollar lost 20% (!!!!) against the USD this week, same for the Kiwi Dollar from New-Zealand (20%!!! in 5 days!!). These kind of moves not only are big enough to wipe out many hedge funds and banks which models do not include these kind of 6-sigma events, but moreover, they are highly inflationary in the affected countries and are just a warning of what could (will?) happen in the US, UK or Europe.

Draw your own conclusion.

Update: Bill Flickenstein is writing valuable information and also confirming my opinion on his Chronicle:

I've also heard rumblings about some large holders of gold futures deciding to take delivery, since they're having trouble buying physical gold in sufficient size.
If that's the case, it could cause a mad scramble at the ComEx, the commodities exchange, because there's not enough gold to meet the open interest. It looks like physical gold, as opposed to paper gold, is rapidly becoming the flavor of the day -- meaning that a huge price move may lie just in front of us. And, if that thesis is correct, when more folks start understanding it, there might not be enough gold around to satisfy demand at anywhere near current prices

Central Banks Market Tinkering & The Unintendended Consequence - pt 2

Another unintended and costly consequence of the Fed tinkering the rates and changing the rules overnight and panicking has been spotted by Mish:

Why Banks Aren't Lending

• Banks are insolvent.
• Banks do not trust each other.
• There can be no trust with suspended mark to market accounting. No one believes what assets on balance sheets are really worth and there is no way to find out.
• By suspending mark to market accounting the SEC heightened mistrust.
• As part of the TARP passed by Congress, the Fed is paying interest on reserves.
  

Bernanke wanted ability to pay interest on reserves to put in a floor on interest rates. I am quite certain he believed he could hold rates at 2 with this provision. It did not work that way did it? The Fed Fund rates is now at 1.50 and interest rates futures suggest it is headed to 1.00 by March.

But an easily seen (yet still unseen by the Fed) ramification of paying interest on reserves is the fact that banks can collect interest by leaving money on deposit at the Fed rather than lending it out [emphasis mine].

Why should banks risk lending money to consumers or bank when instead they can deposit money at the Fed and collect interest? Thus, paying interest on reserves not only failed to put in a floor on rates, it also gave banks one huge reason not to lend.

This cancerous activity is now starting to get extremely counterproductive.

Central Banks Market Tinkering & The Unintendended Consequences

Bloomberg reported that the major central banks decided to lower rates all together by 0.5% in order to help the credit markets:

Oct. 8 (Bloomberg) -- The Federal Reserve, European Central Bank and four other central banks lowered interest rates in an unprecedented coordinated effort to ease the economic effects of the worst financial crisis since the Great Depression.

The Fed, ECB, Bank of England, Bank of Canada and Sweden's Riksbank each cut their benchmark rates by half a percentage point.

Is this going to help the markets recover? No.
Is this a good thing for the economy? No.
Is this a good news for your savings and your currency? No.

Why isn't it going to help the markets?

Well, to understand this, you need to read again the quote above. Who is missing there? We have the US, EuroZone, Sweden and Canada. One major bank is missing, and it is Japan. Japan's rate is already at 0.5%, so they won't decrease it to 0.0% (hopefully!!). But what happened with a "surprise" rate cut (which I had forcasted this week-end) is that it created a massive short-squeeze on the Yen, with the hundred of billions of USD and EUR invested by borrowers of JPY. This led the Yen to rise 10% against the USD in a couple of minutes only! The USD crashed from about 106-107 Yen to 99!

The unintended consequence of market tinkering is that the yen-carry-trade will have to unfold and lead to a massive delveraging that is going to cost a lot to many players and investors and further sunk the markets.

Why isn't it a good thing for the economy?

Because the economy is already chocking due to too much credit and the unability of the market players and consumers to pay back. This is not going to help people borrow more. This is not going to help the banks neither, since the effective Fed Funds rates was already 0.0% as I mentioned yesterday.

People who couldn't pay back their mortgages won't be able to do so thanks to a 0.5% decrease rate.

Why isn't it a good thing for your currency?

Inflation will be unleashed (if it wasn't already). Gold is up 40$ an ounce.



PS: side note - comments are more than welcome on all my posts and also, please help people discover my blog by sending them the post you find interesting.

Fed Funds effective rate are at... 0%

David Altig from the Federal Reserve of Atlanta publishes a very interesting post about “Why is the Fed Paying Interest on Excess Reserves?”
It is worth reading the post. I just paste here the chart of the Effective Fed Funds rate he publishes.
Bernanke is soon going to pay people to borrow! One step closer to the demise of the USD.

What Bill Gross wants, Bill Gross gets

Yesterday (I mentioned it here):

(Reuters) - Bill Gross, head of the world's largest bond fund, on Monday urged the U.S. Federal Reserve to take more dramatic steps to jump-start paralyzed credit markets, including direct purchases of commercial paper.

[...] Gross, chief investment officer at Pacific Investment Management Co, wrote in his October letter to investors released Monday afternoon.

Today:

Oct. 7 (Bloomberg) -- The Federal Reserve Board, invoking emergency powers, will create a special fund to backstop the U.S. commercial paper market in an effort to support the financing needs of corporations.

One of the axioms of the Fed is the following:Take from the people to give to Bill Gross.

Fed's stealth cut of interest rates

I mentioned it at several occasions previously (here for example): the Fed is going to cut rates to 1% and is shooting it's very last bullets and it is now confirmed by Bloomberg: Fed Sets Floor Below Rate Target, Engineering `Stealth' Cut

The Fed may now pay interest on bank reserves while it floods financial markets with liquidity, pushing down the overnight lending rate by about 0.75 percentage point to 1.25 percent.

``Absolutely, it's a stealth easing,'' said John Ryding, founder and chief economist of RDQ Economics LLC in New York and a former Fed researcher.

The announcement, and a Fed decision to double the auction of cash to banks to as much as $900 billion, failed to avert a 3.9 percent decline yesterday in the Standard & Poor's 500 Index.

The next step? Comrade Gross is asking the Fed to start buying commercial papers and unsecured papers. Soon the Fed will own all the US dept securities, and is likely to also buy those abroad, since Paulson has to bail out China. Bernanke must be happy, this will bring a lot of profits for the Fed while it doesn't cost anything to print electronic money!

BofA Merrill Lynch - The creature of Bernankenstein

I have already mentioned that I didn't understand why Ken Lewis decided to buy Merrill Lynch before it went bust and was willing to pay a 70% premium in order to get it. And of course, I am not the only one wondering why on earth he would do that. Also remember that, on the 15th of September 2008

When asked why he didn't wait until Monday to get Merrill at a lower price, Bank of America CEO Ken Lewis stated "the strategic opportunity was so compelling it couldn't wait."

Well, today after market, BofA reported its quarterly results were worse than expected. Profits fell 80% and BofA will cut its dividend by 50%. Also, the very well capitalized bank (remember, the US Banking system is safe and sound and well capitalized that's the reason why Paulson will buy back for 700 billion of toxic waste and that the Fed is injecting trillions of USD in the system) said that they will dilute their shareholders in order to raise 10 billion USD. That's about a 7% dillution at the current stock price. Expect a lot lower price for the new shares and hence a bigger dilution. According to the press release:

``These are the most difficult times for financial institutions that I have experienced in my 39 years in banking,'' Chief Executive Officer Kenneth Lewis said in the statement. ``It is prudent to raise capital to very substantial levels in this uncertain environment.'' (only 3 weeks after the biggest strategic opportunity Ken Lewis ever saw, that is, even better than the CountryWide deal)

So when these are the most difficult times in 39 years, why would you go and pay a 70% premium to buy a collapsing company? More and more, Ken Lewis doesn't make any sense, unless there's something going on that we don't know about, most likely involving Paulson and Bernanke.

Speaking of CountryWide, they (BofA) will pay $8.4 billion to settle the fraud case.

Now, here's a very interesting quote in found in the Gold Wars and dates back from 2000:

"Of particular note are the strange sequence of events leading to the merger of Chase Manhattan and J.P.Morgan & Co. [...] On Thursday, September the 7th, JPM's CFO and guiding light of the bank's derivatives strategy, Peter Hancock, suddenly resigned 'to pursue entrepreneurial interests'. On Monday, September 11th, the Chairman of CMB and JPM met for five minutes to agree to a merger. Five minutes??? Was someone present at this meeting holding a shotgun? There is a certain urgency about this whole affair, which leads me to wonder whether the Fed arranged this union. When something has to be done in such haste, there must be a problem. [...] The Fed might want to get the huge derivatives positions of thes two banks lodged together under one roof in the event that a rescue operation become necessary. Both from a practical and a political standpoint, it would be easier to achieve and justify a bail-out of one Wall Street 'fat cat' rather than two". (US Stockbroker Joseph J. Cacciotti of Ingalls & Snyder)

Hum... Sound familiar? It looks like BofA+Merrill is the twin sister of JPMChase, created in the same conditions and with the same original goal.

US Markets avoid crash (for now)

Today was another very long and painful day, full of surprises (bad ones only) and without a single good news:

• The Fed said they will inject $900,000,000,000 (billion) in the banks which confirms to those who needed a confirmation that the $700 billion USD of the Paulson Plan are meaningless.
• Major European banks collapsed during the week-end, among which Fortis (part of the Bel 20) and Hypo (which is part of the Dax 30) and many others are on the brink of collapse like Dexia (part of the Bel 20 as well) or the French bank Natixis.
• Iceland's currency fell about 15-20% against the USD and the EUR as it is more and more likely that the country will default
• The Japenese Yen started rallying, which could mean the end of the Yen Carry Trade with all the deleveraging that it will bring. The Yen raised as much as 10% against the Australian Dollar.
• The USD is rallying against many major currencies (not very rational, and certainly not good for US companies profits).
  
• The VIX hit a new all time high, hitting 58!

All in all, this nightmare scenario brought apocalypse on the US markets which were down as much as 7-8% before one of the biggest reversal in my short trading experience: a 5% rally in the last hour.

While this rally is not really surprising given the level of the VIX and bearishness (I would have thought that the Dow would rebound on the 10,000 mark, but fell until 9,550!! before rallying to more than 10,000) it is unfortunately base only on sentiment without any sound foundamental original. While further rally is not excluded on this basis, BofA probably broke the back of the bottom fishers (again!) with very poor quarterly results (to be discussed in the next post).

Also, governments in all countries are willing to help, and we know than they are going to do the wrong thing at the wrong time and only make things worse by willing to buy votes.

Quarterly season will probably help make things clearer as to whether it's going to go further south or start recovering. Take your side, I have already chosen mine!

Are we done yet? No, expect a lot more decline

Many interesting things happened this week, which seems like it lasted for months. The two events that caught the most my interests are the rise of the USD in spite all the bad news against it and also the big surprise comes at the Market decline following the Senate vote on Friday which passed the bailout bill. Though it is kind of rational to have had this decline, I wasn't expected the market to behave in any rational way (see my previous post on the Bernanke+Paulson PUT).

So the several trillion USD question is: Are we there yet? Has the market correction been overdone and is it a good time to buy bargain stocks?

The short answer is: No, we're far from there!

The long answer follows.

1- The Market is at historically high level still. Even after this sharp correction, the S&P 500 has a PER of above 25. The Dow Jones IA and the Russell 2000 still have a negative EPS and hence no PER! See graph below. The profits declining sharply in the best case, and big losses on the normal cases, the markets are going to have a hard time maintaining the current levels.

2- The VIX hit all time high but this is irrelevant. As you can say on the graph below, the VIX hit an all time high this week and has been trading at historical high levels for the past week or two. Many consider this as a good opportunity to buy stocks on the cheap as it is considered that VIX levels of about 40-45 are signs of market bottoms (see chart below). Unfortunately, the VIX has been computed only since the early 90's which makes it irrelevant since we are currently in uncharted territory. There has been no crashes since the early 1990s, there has been the TechBubble bust but it's not comparable to what we are living today. That's the reason why I have kept my PUTs so far and with now regrets. I might change my stance in the next few days because:

The VXO might be more appropriate for these kind of comparisons. And if you take a look at the chart below you will see that it hit 60 during the 87 crash. So there's a lot more to go for the volatility as well, contrary to what I have read here and there. Of course this doesn't exclude a short term sucker-rally, since so many just have been bottom fishing for the past 12 months.

VIX (click for bigger image)

VXO (click for bigger image)

3 - The US Markets haven't really declined since mi-July, despite the disastrous news piling up and the big sucker rally in the USD is not going to help. As you can see on the chart below, the Dow Jones and S&P 500 are almost flat since mid-July in EUR terms.

Dow Jones Industrial in various currencies (click for bigger image)

S&P 500 in various currencies (click for bigger image)

What to expect next?

• I think the market starts to realize that the $700,000,000,000 bailout is not going to change anything and is going to be a big waste, a drop in the ocean of derivatives and other ABS and MBS... Bill Gross, the person who is going to make the most profit out of this and who is going to be totally bailed out even dares asking for $500,000,000,000 for the bailout! It's easy to see that the $700 billion won't be enough as the Fed increased his balance sheet by about $600 billion worth of illiquid toxic junk in just 2-3 weeks! This is a massive 55% increase!
  
• Stephan Karlsson explains that the dollar rally is due to central banks interventions. Which makes sense to me, since the bailout could have created a run in the USD and a collapse of both the US Dollar and of the Treasuries. So basically what this means, is the the Europeans and Asians will, willingly or more likely unwillingly, take part in this Bailout Bill, by buying overvalued (valueless!) USD in exchange for their own currency. The whole bailout bill was about buying assets at above market price right? So we can expect a drop in the USD once the interventions end.
  
• The massive intervention in the USD pushed the prices of commodities a lot lower and lead the path to a probable surprise rate cut at the Fed. This could be the very last bullet in Bernanke's arsenal, and I don't think he will keep rates that high for a lot longer. Why not a Fed Fund rates of 1% within the next few days? I think it's very likely.
• The SEC extended the ban on short selling for another couple of weeks. Another intervention that will not only decrease confidence in the markets, but also make any drop steeper since there will not short covering during big downward moves.
  

Paulson - the John Law of the 21st century?

Question: Will Paulson's (and his puppy dog Bernanke) reckless actions lead to a run on the US Dollar and Tresuries? And lead to a revolution in the US?

Question: Who is John Law?

Answer: From the HISTORY OF ECONOMIC THOUGHT:

Law's "Real Bills Doctrine" of money applied the "reflux principle" to the money supply. Money, Law argued, was credit and credit was determined by the "needs of trade". Consequently, the amount of money in existence is determined not by the imports of gold or trade balances (as the Mercantilists argued), but rather on the supply of credit in the economy. And money supply (in opposition to the Quantity Theory) is endogenous, determined by the "needs of trade".

Law's schemes were launched on the basis of this logic. Exiled in Europe because of a duel, Law ingratiated himself into the French court through patronage and friendship of the Regent, the Duke of Orleans. The state of French finances after Louis XIV's death in 1715 was so dismal that the Duke turned to Law for assistance. Law proposed the establishment of a state-chartered bank with the power to issue unbacked paper currency, the Banque Générale, which was established in 1716. Around the same time, Law also established the Mississippi Company, an enterprise designed to develop the then-French colony of Louisiana in North America.
Law's note-issuing bank was a spectacular success -- until it collapsed after a bank run in 1720, plunging France and Europe into a severe economic crisis, which had an important role in setting the stage for the later French Revolution.

Answer: From WikiPedia:

The wars waged by Louis XIV left the country completely wasted, both economically and financially. [...] It was in this context that the regent, Philippe d'Orléans, appointed John Law, as Controller General of Finances.
[...]
In May 1716 the Banque Générale Privée ("General Private Bank"), which developed the use of paper money was set up by Law. It was a private bank, but three quarters of the capital consisted of government bills and government accepted notes.
[...]
The Banque Royale was created by default as a result of Law attaining the majority of the government issued notes (debt). It effectively became the Central bank of France. In 1720 the bank and company were united and Law was appointed Controller General of Finances to attract capital. Law's pioneering note-issuing bank was extremely successful until it collapsed and caused an economic crisis in France and across Europe.
[...]
Law exaggerated the wealth of Louisiana with an effective marketing scheme, which led to wild speculation on the shares of the company in 1719. In February 1720 it was valued for a very high future cash flow at 10,000 livres. Shares rose from 500 livres in 1719 to as much as 15,000 livres in the first half of 1720, but by the summer of 1720, there was a sudden decline in confidence, leading to a 97 per cent decline in market capitalization by 1721. Predictably, the 'bubble' burst at the end of 1720, when opponents of the financier attempted en masse to convert their notes into specie. By the end of 1720 Philippe II dismissed Law, who then fled from France.
[...]
Law initially moved to Brussels in impoverished circumstances. He spent the next few years gambling in Rome, Copenhagen and Venice but never regained his former prosperity. Law realised he would never return to France when Phillipe II died suddenly in 1723 and was granted permission to return to London having received a pardon in 1719. He lived in London for four years and then moved to Venice where he contracted pneumonia and died a poor man in 1729.

Paulson+Bernanke PUT - The Sequel

On Monday, the market declined big time (about 8% on average on the US indices) on the news that the Congress didn't pass one of the most abject rescue plan ever created and that was a big victory for liberals and libertarians (which seem to be an endangered species now, while they constituted 95% of the US citizens just 12 months ago) and also for the 300,000,000 American citizens and the billion of other people who own valueless paper from the Fed (Federal Notes, aka US Dollars).

The Market didn't crash though, this was merely the pricing of the rejection of the bailout. As Paulson and Bernanke used to say just a couple of months ago, the markets are efficient and adapt automatically to any new piece of information.

But this was just enough for the US government to be scared to death, and push for the bailout plan to be resurrected from the ashes, like the Phoenix. And the market got hysterical again on Tuesday, gaining 4 to 5% on average on the US indices. The Paulson+Bernanke PUT was back on track: all the bad news got discarded straight to the bin both Tuesday and Wednesday (today).

So what happened during the last two days? Here's a brief summary:

• Yesterday, President Bush signed a bill into law that gave U.S. automakers a $25 billion low interest loan. Yet another bail-out.
  
• Consumer spending is at best stable, more likely decreasing
• Auto sales are collapsing as the sales of Ford showed a decline of 35% YoY, 24% for Honda, 32% for Toyota 37% at Nissan.
  
• Unemployment is still rising
• The ISM Index is collapsing
• Crude Inventories are increasing (which might be confirming the declining consumer spending and slowing down of the economy)
  
• CNBC reported that the SEC staffers say the commission is heavily leaning toward extending the short-selling ban
• General Electric is in deep deep trouble and will be raising $15 billion USD through a $12 billion of common shares sales and $3 billion of preferred stock yielding 10% to Berkshire Hathaway. (Somehow, the market manages to consider this as good news!).
• The US National Dept reached above the $10 trillion dollars

After all this, it easy to see that the Market keep on repeating the same pattern over and over again for the past 12 months:

• Every time there is no news, the market rallies. No news is good news!
  
• 50% of the time, when there is real bad news, the market rallies. That's because we hit the bottom, of course.
  
• Every time there is pure speculation but no tangible news, the market rallies.

What does this mean? That the market is overly bullish still and that the day there will be a real readjustment of the risk and the fact that we are in a severe recession, we will have a real crash. Real like -20% or -30%.

You can still see contradictory and irrational behavior on the various assets such as:

• The USD rallying while the market rallies on the bailout package.
• Gold and Oil declining while the bailout package is considered as being passed.
• Bank and financial rallying while the bailout package is only a drop in the ocean of the bad dept.
• Bankrupt companies - Fannie, Freddie, AIG, Wachovia - rallying.

And have you noticed that:

• JPMorgan is only at 2-3% from a multi-year high?
• Citigroup is up +100% in two weeks or so?
• The Euro is falling against the USD because the European countries bailed out several banks with about 10 billion € while the US have spent about 100 times this amount in the past 2 weeks? (actually, this is not totally right as Ireland has gone crazy and created its own Paulson-flavoured bailout package as you can see on this Reuters news).

As predicted just a few months ago by several bright minds (like Jim Rogers or Peter Schiff), the US government has now totally nationalized the mortgage industry, a big slice of the insurance industry, the 3 major automobile companies (3 times $25 billion = $75 billion in loans for a total market cap of these companies of about $20 billion) and the financial industry is about to get nationalized as well. Soon will follow credit cards, then auto-loans and students loans, as they predicted?

If the bailout passes and then if the market rallies (this is likely, even though the bailout package is supposedly already priced in the markets), it is probably going to be one of the best shorting opportunity in the bear market. Provided that the SEC doesn't ban short selling on the remaining stocks or even worse: ban any selling at all. Wouldn't that be just great!

Decyphering the Paulson Plan

John Needham is explaining the Paulson Plan in his article on Financial Sense. Here are the most meaningful excerpts (emphasis mine):
[...]

Paulson believes that if he sprinkles enough fairy dust (taxpayers’ money) on the lame and the halt of Wall Street, they too can fly again. Bernanke has been reduced to irrelevance as the Fed has shot its ammo and he now wanders around looking like Hank’s lap dog. Just like the dying fairies, the Wall Street icons can only survive if the people believe. Aping the children at the famous play, the cast of Wall Street is now shouting “I believe in fairies” but the unanswered question as the sleight of hand continues virtually unquestioned in main street media and on Capitol Hill today is “Believe in what”?

As the party heads to Capitol hill today with the administration parroting Chicken Little’s cry “The sky is falling”, it has more than a whiff of panic to accompany it. The urgency I suspect is tied to the notion that Hank can stampede Congress into giving him the unlimited powers he seeks so that he can “work it out” as he goes. The “work it out” part relates to Bernanke and Paulson’s assertion that a failure to rapidly approve their $700 billion plan to remove “illiquid” assets from the banking system will imperil the global financial system and harm ordinary Americans.

That is pure spin. Paulson and Bernanke wouldn’t know an ordinary American if they fell over one. Neither have lifted a finger to help beleaguered citizens stuffed into predatory mortgages. Their concern is only the restoration of order in the US banking system and that means capital.

The problem

You see, these “illiquid” assets are not illiquid at all. They, like all impaired assets are sellable at a price, but the asset holders, mainly the shadow banking community of banks, investment banks, hedge funds, monoline insurers, structured investment vehicles (SIVs), conduits, money market funds and thrift institutions won’t take what the market is prepared to pay for these assets. Indeed based on NAB’s total write off of its US mortgage backed CDOs and Merrill’s write down of its mortgage paper we have a fair idea that the broad brush value of the lower tranches of these horrors is between 25% of face value and zero.

And that is only the first part of the problem. The second is that in the push to gear up the profits flowing from these mortgage backed securities, banks and others added leverage to make the model work at the required rates of return. That leverage is generally about 10 times for regulated banks, thirty times for investment banks and more for others. So, if they take a 10% hit on the face value of the security and they have, let’s say 12 times leverage (modest by today’s standards) they effectively take a 120% write down on the value of that asset. Do the sums at a 50%-75% write down and you can see why these guys are staring into the abyss.

In short, if the wider banking system is forced to hold these assets because they can’t accept the market price for them, and if they are finally forced to value them at true market value (and one suspects even the clueless auditors have an inkling by now of what their clients are facing), they will effectively be insolvent or so capital impaired that they will not be able to undertake their proper functions. Indeed many are insolvent now, but nobody is prepared to shout the obvious, that the Emperor has no clothes. With insolvency comes dangerous secrets. UK regulators are just discovering that Lehman’s UK pension fund is light about $200 million. Many major US pension funds were also light on the necessary. And as most like to stuff the pension funds with their own shares, the problem of failing companies and lower stock prices compounds the staff and punters’ risks dramatically.

Paulson’s real job is to restore Capital

Thus Paulson’s brief in making these institutions whole is not just to relieve them of the impaired assets as his public statements assert, but to do so in a manner that leaves the holders’ capital and balance sheets intact, and here is the great lie.

My father once told me in simpler days before CDO squared and other fiscal junk that there were only two ways to make a quid (dollar). Either you bought oranges for less than they were worth and sold them for what they were truly worth or you bought oranges for what they were worth and sold them for more than they were worth.

Paulson has found a third way. He is going to buy this toxic paper for many times what it is worth and sell it to the taxpayer for even more!

Unless he pays the banks somewhere near face value, less a haircut for these securities, the plan is useless. The real plan is to restore capital. And that is precisely what he and Bernanke are plotting. Talk of illiquid assets is just the smokescreen.

In the process he is asking for immunity from judicial review, a very good idea as otherwise he can plan on spending the rest of his natural days in various courtrooms explaining the unexplainable.

The boys are bailing out Wall Street and you are paying the bill for all those multi million dollar bonuses. You are also paying for the negligence or incompetence (it must be one or the other) of all those regulators who knew what was happening but acquiesced to keep the game going. When asked if he thought that executives of companies taking the handout should have some restrictions on their salaries and bonuses, Paulson replied that such action would be punitive. Clearly that is not on his agenda. No accountability and now no consequences.

So the game is to pass the parcel to an entity that can disguise the losses for many years and whose balance sheet is not really up for scrutiny-the US Treasury. Then the boys can get on with their wonderful lives without this undoubted inconvenience.

You might also want to read this post from Mish.