Gold

Gold.

Financial system implodes

When I started my blog in June of 2007, I suspected that this day would arrive. It has. This past week, the world's financial system, a tangled web of debt, and derivatives contracts, has crumbled. The central planners in the U.S., Hank Paulson, Ben Bernanke, Christopher Cox and George W. Bush, have deemed it necessary to arrest their long held ideals that capitalism and free markets, if left alone, will allocate capital and price assets with near perfection. However, they didn't like how free markets were pricing most assets. Accordingly, the world's beacon for democracy and free markets has summarily embraced socialism, or more precisely, statist capitalism. It's been a sad and humiliating week for the United States of America and its once proud and powerful capital markets. And still, even as the financial system has succumbed to forces of its own design there remains little resolve among the folks in charge of preventing such a colossal failure to come to grips with its real cause and its true culprits. Regulators vilify short sellers and rumor mongers for the demise of their once proud and powerful banking system. Nothing can be further from the truth. Even as Cox had initiated his first foray into "scape goat-ism" in July, not a single case of market manipulation, rumor mongering or naked shorting that involved any of the major U.S. investment banks has been brought forth. There have only been rumors and inuendos as it concerns the rumor mungering itself. Even through last Thursday, an abundance of shares in nearly every major bank and broker that had not yet filed for bankruptcy, remained easy to borrow and to short. As the arsonists flee the blaze, guys like David Einhorn of Greenlight Capital, who warned that Lehman Brothers (LEH) was broken, are being rounded-up in what has turned into a modern-day financial which hunt. Meanwhile, the arsons that torched these companies from the inside/out and who earned embarrassing sums in the process, are deemed sympathetic figures who have been done in by the evil, rumor mongering speculators. Again, Christopher Cox's vilification of short sellers and rumor mongers is akin to a pathetic drunk blaming everyone else for his own problems. Given the lack of resolve to go after the folks that ran these companies into ground is a telling sign. The U.S., its political system, its capital markets and its regulators persist in a woeful state of mass denial. And until there is a serious shakeout of these folks running the show, the United States is a scary place to invest. Misguided regulations, witch hunts and the inability to recognize the true causes of these sad events will indeed have steep and costly unintended consequences for years and perhaps decades to come.

Ummmm, gold might be a buy

In my blog of September 11th, 2007 (Gold Knows), I had opined: "It wasn't more than five minutes into Ben Bernake's speech in Germany today, as he again tried to explain away the Chernobyl-like global financial imbalances as a mere 'savings glut,' that gold began to levitate. Within minutes, gold had traded nearly $10/ounce higher. Savings glut? That sounds like a good thing. Gold knows what Gentle Ben doesn't."

The price of real money (gold bullion), had just breached the $700 price for the first time since the early 1980s. Since my post on that day, the U.S. Federal Reserve-- in conjunction with the U.S. Treasury and with the backing by Congress and the White House, have bailed-out Bear Stearns (BSC), that nations fifth largest investment bank (and its counterparties); and more recently, Fannie Mae (FNM) and Freddie Mac (FRE). Combined, the latter two entities have roughly $5-trillion of "agency" debt outstanding and either own or insure another approximately $6-trillion worth of mortgage debt. This debt is effectively now backed by the U.S. taxpayer. Furthermore, the Office of Management and Budget (OMB) says that the annual budget deficit will set a new record of roughly $450-billion for the fiscal year. While reality is actually much worse. As of today (Aug 19th, 2008), the total U.S. Federal debt has increased by over $620-billion, year-over-year, when many "off balance sheet" items are included. I beleive the real additional U.S. Federal deficit for all of 2009 will come perilously close to a $1-trillion!!! Add another roughly $45-trillion of existing private and local government debt along with untold trillions of unfunded entitlements promised to an aging and winded U.S. citizenry making the recent rally in the U.S. dollar somewhat unsustainable.

Much of the rest of the world has now been infected by the credit bug causing competing currencies to become marginally less attractive as foreign currency holders recalibrate their holdings. Again, there is no evidence that the dollar will retake its place as a reserve currency any time soon. Its just that the news here in London and throughout the rest of Europe and Asia is trying to be digested on the margin. Accordingly, gold's retreat back under $800/ounce for the first time since last November, appears to be a function of "forced" liquidations associated with an over-leveraged world even as the fundamental reasons for owning a form of money, gold, that is unable to be conjured-up from thin air, becomes marginally more attractive as testament to the recent surge in physical demand in recent days. The anomaly of "forced liquidations" is giving a world, soaked with fiat paper, its latest and perhaps last chance for some time to own gold under $800/ounce.

Last capitalists standing: "Evil short-sellers"

'It could be structured by cows and we would rate it,' said a Standard & Poor's analytical staffer in an inter-office e-mail exchange with another staffer concerning a newly assembled structured mortgage debt product. Another staffer's in-house e-mail chimes in with: '....Let's hope we are all wealthy and retired by the time this house of cards falters.;O).' All of this, according to a story in today's Wall Street Journal.

Its pretty darn clear folks, that there was a systematic breakdown of checks and balances througout the financial system at pretty much every juncture. And it was all caused by moral hazard due to the abdication of responsibility and total lack of proper risk controls all in the name of profit motives. Meanwhile, as this mess unfolds, those in charge of protecting the public good are chasing their own shadows; tracking down innocent scapegoats. The U.S. Securities and Exchange Commision and its Commissioner, Christopher Cox, in particular, have totally lost its moorings.

As Cox goes rooting around everywhere exept where the crimes have occured, he concerns himself with evil short-selling speculators, many of whom have done a tremendous public service by voicing their concerns about the U.S. banking system's house of cards, the real perpetrators of the history's most obcesne credit bubble go mostly unpunished. Additionally, as Merrill Lynch (MER) announces this past week its plans for a massive new round of capital raising, after reporting earnings just weeks ago, the U.S. Congress and Senate are busily holding hearings in efforts to track down evil speculators in the oil futures market. Another dysfunctional effort by many of the folks more responsible for skyrocketing oil prices than anyone that has ever actually purchased a crude oil futures contract. All of this, as Merrill Lynch and its CEO, John Thain, quite possibly violated SEC disclosure laws by failing to report the disclosure of material events.

Specifically, Merrill Lynch (MER) said on Monday, unexpectedly, that it is selling more than $30 billion in mortgage assets, specifically “super-senior” tranches of CDOs, at 22-cents on the dollar to private equity firm, Lone Star Capital. Merrill is financing 75% of that purchase which equates to receiving just 5.5% of its original $30-billion notional value in cash. Imagine what non-super junior tranches of the same crap may be worth and what this may mean for many banks and brokers that were hoping to “mark-to-market” said crap at a rate that may go unnoticed by yours truly and my ilk (evil short sellers). In essence, given that Merrill is financing 75% of Lone Star’s purchase, it can almost be viewed as putting this asset out on consignment. Merrill also said it plans to raise about $8.5 billion in new common stock. This is also an onerous maneuver given that an earlier issuance of stock this year to Temasek Holdings, a Singapore state-owned investment company, had stipulated that compensation would be due in the event that Merrill went to market at a lower price. Temasek Holdings sunk $6.2 billion in Merrill stock at $48 a share earlier this year. Its closing price yesterday is $26.85—equates to a tidy 44% haircut. Merrill said at the time that if it sold stock at a lower price within 12 months, it would compensate the $48-a-share investors. According to Bloomberg, the compensation to Temasek will cost Merrill Lynch another $2.5 billion. However, Temasek has apparently agreed to “average down” and has agreed to dump the punitive sum back into Merrill’s latest offering. The incredible and surprising capital rasining effort coupled with a purging of $30-billion in notional value toxins not only smacks of desperation, given the heavy toll of the maneaver, but more incredible (and unlikely) is that Mr. Thain did not see this coming. Even on its conference call roughly two weeks prior, following its earanings announcement, Thain declared that he was in a "comfortable spot" in terms of capital. Furthermore, Thain said that "Our core franchise continues to perform well despite the extremely challenging market environment." Indeed, its performing so well, that two weeks later, Thain and his company resort to just about the most onerous form of capital raising effort conceivable. Of course, shares of Merrill Lynch rallied to as high as $34/share in the week following Thain's polyanish utterances. Were you romanced into making a purchase during that week, at prices as much as 50% higher than what Thain himself was able to purchase for himself on July 29th (500,000 shares at $22.50 each)? Well too bad, becasue the U.S. Securities and Exchange Commission couldn't give a rat's ass about anyone stupid enough to beleive John Thain.

Perhaps Mr. Cox might actually find some wrong-doers if he looked in the places where the misdeeds have actually occurred, i.e. the investment banks, instead of chasing after the folks that now appear to have gotten it right, "evil" short sellers. Isn't that the way capitalism is supposed to work? Reward dilligence, intelligence and ingenuity and punish greed, mismanagement, stupidity and the total abdication of responsibilty? Profiting at the expense of these firms’ misdoings and horrendous management of risk controls, Mr. Cox, is just all part of a system that you profess to admire so much.

The cloak is lifted

There is growing evidence that the greatest fraud foisted upon the world's unsuspecting (or just delusional) investors and the working class is now being exposed. The fabric that once made up the cloak that once hid the visage of this scurrilous perpetrator is slowly being dissolved. The fallacy that debt is wealth is only now being discovered by Wall Street, pols, regulators, business people, supply-side economists, the nouveau riche, the middle-class, the working class, and unfortunately, the desperate poor. I'm afraid that we are now entering the third stage of the credit crisis. Whatever you want to call it, this is the stage after first recognizing that there is a problem, but in denial as to its severity. We are now entering that stage where denial is going to give way to "fear and distrust". Fear that things are indeed worse than previously told and what we are experiencing is not your normal run of the mill economic contraction. Couple this with distrust of those people and institutions that covered-up the reasons for and severity of problems while also propping-up assets and those institutions most responsible for the economic pain now being felt (i.e. Bear Stearns and its ilk).

The situation appears bleak. Although a contrarian by nature, the logic against a painless resolution of the of situation is so incredibly impaired, as it concerns how entrapped the world's financial system appears to be in, that even with a 20% drop in the Dow Industrials since reaching its all-time high last October, the level of fear does not appear to be analogous with the severity of the situation. The U.S. federal Reserve is nearly out of bullets. With inflation now exerting its own stranglehold on world economies and the all-important U.S. consumer, the folks at the Fed are almost totally trapped. Even as the more serious issue remains to be the unwinding credit bubble, the Fed no longer possesses political cover to run an overtly loose monetary policy. Its printing presses will have to run exclusively veiled by empty promises to be alert to any further inflationary pressures. Temporary auction facilities and exerting its will on those in Washington as it continues to grab more power from from the SEC and the SROS will be its modus operandi. It will push for looser regulation within the shadow banking sector in hopes that the less regulated shadow banking system will give the Fed more room to maneuver and intervene.

But I don't see a way out. Ponder the depths of the problem. Not only has the Federal Reserve used up a substantial portion of its own balance sheet via its Temporary Auction Facilities, but those institutions it hoped to save continue to deteriorate. Perhaps Countrywide Financial (CFC) is now just a problem for Bank of America (BAC), but who save General Motors (GM), Ford Motors (F) and Chrysler LLC and their respective lending businesses--GMAC & Ford Credit? These are not insignificant businesses. These companies no longer exist for the purpose of making automobiles. These companies are among the largest issuers of debt instruments and preferred stocks perhaps second only to Fannie Mae (FNM) and Freddie Mac (FRE). Which brings me to my next series of questions. Who save Fannie Mae and Freddie Mac? Their eventual demise seems to be off the table still, but I'm not so sure. Credit spreads have widened again and given how leveraged these company's balances sheets are, I'm not convinced these companies aren't already effectively insolvent. Then there is the ongoing issue of the monoline insurers, MBIA (MBI) and Ambac (ABK) and the dominos that will fall as they fall? Markets convulsed this spring over their impending downgrade by S&P and Moody's. Can the Fed save all of these and perhaps more importantly, all of their counterparties? Then there is the issue surrounding the deteriorating situation at Washington Mutual (WM), the largest U.S. Savings and Loan. Also, what about the U.S. regional banks like Fifth Third (FITB) and National City (NCC) and Keycorp (KEY)? Of course, the situation surrounding Wall Street and Lehman Brothers (LEH) and perhaps many other dire issues goes unresolved. I don't even have to discuss the centerpiece of all of these problems, the ongoing crash of the U.S. housing market and the now severely crippled U.S. consumer. Additionally, it appears that the entire U.S. airline indusrty is also on the verge of extinction from the double-whammy of weakening consumer and business demand and cripling jet fuel costs. And problems aren't just isolated to the U.S. Here in London, we've have caught the contagion. Once deemed immune to the problems in the U.S., emerging stock markets are now down considerably. China's Shanghai Index is now down over 50% from its all-time high. India's Bombay Sensex is down by roughly 1/3rd from its all-time high set last year. Clearly, another fallacy propagated by the bulls, "decoupling" has decoupled with nearly every other one of their flawed theories.

April sales brings May fairytales

The April retail sales figures were among the most highly anticipated economic figures released this week in the U.S. It was reported by Retail Metrics Inc., that April was the best month for retailers since last November. Their index showed an increase of 3.3% year-over year. However, since we saw the earliest Easter in 95 years, thus falling in March this year, it probably makes sense to average the last two months together. Total sales are generally lower in the month during which the holiday falls so some of last month’s sales were probably deferred and pushed into April. March sales results, you might remember, was an abomination. So on the two-month average basis, same-store sales would have increased just 1.1%. Also, the reportedly surprising and robust 3.3% year-over-year gains in April also masks the fact April same store sales included an extra day this year versus the 2007 numbers. This extra day, versus last year, essentially gave retailers an extra 3.3% of "sales time". Therefore, sales were actually flat on a “per-day” basis versus last year's data. When you again take into account that inflation is now clipping along at a pretty rapid pace (just don’t tell the U.S. government), real sales adjusted for inflation, are clearly running negative. Also, remember that sales at gas stations is included as retail sales. My hunch is that more money is being spent on gas and less on designer jeans. Given the rising costs of operating a business on a daily basis, this report, regardless of the rejoicing it elicited among the bulls, cannot be good for margins and earnings. I did not find anything in the retail sale figures, even among those companies that reported "good" results, that instilled a lot of confidence that suggests anything positive for the health of the U.S. economy.

There was much adieu surrounding Wal-Mart's (WMT) better than expected same-store-sales number. But again, this is Wal-Mart, a palce where people that used to shop at Macy's (M) might find themselves if they've since fallen on hard times. So I don't believe we want to root for good numbers out of Wal-Mart. Besides, did anyone notice the ominous quote from its CEO immediately following the release of its same-store sales number? Eduardo Castro-Wright, CEO of the world’s largest retailer, Wal-Mart Stores (WMT), said, "The economy continues to get tougher and the 'paycheck cycle' is more pronounced for customers than in past months. As money gets tighter for them toward the end of the month, sales drop more than we have seen in the past." With April sales, brings May fairytales.

A bull market in selective perceptions

My postings have dwindled to a mere trickle in recent months. Its just not as enjoyable discussing things that have become obvious to even the most delusional market participants among us in stark contrast to the environemnt of last summer and through year-end 2007. But I believe this 1000+ rally in the Dow Industrials, and an even more stout rally in the Nasdaq on a percentage basis, has helped to again move fiction and fantasy to the forefront pushing logic, diligence and facts again to the backseat. Not good.

There was no more clear evidence of this evolving theme when Intel (INTC) released earnings on Tuesday after markets closed in the U.S. It's "better than expected" report and its usual cheerleading by management was quickly construed as being indicative of the worst being behind us and that a shallow drop in asset values from last year's highs to recent lows is all that is required to cure the most obscene, out-of-control, credit bubble in history. To that, I say, not so fast my friends.

Below, I've sliced and diced the total hoodwink pulled off by Intel this week, the most obvious of all misinterpreted earnings reports of the week, that combined with others, gave apparent cover for the delusional bulls to throw a party not seen since last fall when the fumes of the LBO bubble were still fueling markets. But before I concentrate on Intel's disingenuous report and cheerleading, Google and JP Morgan deserve at least some credit for last week's manic ramp job in stocks. Google's (GOOG) revenues beat analyst estimates by $110-million in its latest quarter and said that "paid clicks" grew 9-percent versus just 2-percent expected. They also beat earnings estimates. Fine. Just as Intel did (see below), the company successfully lowered the bar just enough to easily leap over it. However, the company's quarterly tax rate, which had ranged from 25 percent to 27 percent last year magically dropped to a just 24-percent accounting for a good portion of the bottom line beat. Clearly, Google's growth in coming quarters is banking on its international business, which now totals 55-percent of revenues. International business, in my opinion, is going to just lag the massive problems being encountered by the U.S. economy and banking on the rest of the world being unaffected by the severity of the prolonged problems in the U.S. (decouple) will be a losing wager. Furthermore, testament to how quickly rampant speculation seems to have been revived thanks partly to the Fed's recent largess, based on this single report, whether it was there slowing, but not as bad as expected growth rate; its better-than-expected bottom-line, gratis partly due to an unusually low tax-rate; or its $110-million beat on its top-line, thanks entirely to currency translation, Google's was rewarded with an increase in its market-cap with an additional $28-billion--253-times the $110-billion that revenues surpassed expectations!?!?!

So Google played a part last week in getting the bulls unduly lathered-up, but so did JP Morgan (JPM), after its bad number was simply not as bad as expected and new financier, extraordinaire, Jamie Dimon, said the credit-market crisis is nearing an end. Of course, anyone that gets a $29-billion "stop-gap" from the U.S. Federal Reserve must be pretty smart, right. Let me just say that anyone that has used the self-serving talking-points of Wall Street titans in recent years as an investment guide has also suffered pretty catastrophic losses. Remember Bear Stearns' CEO Alan Schwartz' protestations of a liquidity problem days before essentially needing to be bailed out by the Federal Reserve? I would expect nothing different from Mr. Jamie Dimon, business partner of Ben Bernanke and the U.S. Federal Reserve. Needless to say, markets are still pretty gullible as you can see.

But back to Intel-- Intel leapt over its lowered bar on Tuesday and markets went on a pretty wild ride along with the shares of Intel. Before recounting what the company said this most recent Tuesday night, April, 17th, 2008, let's recap what the company revealed to us roughly five weeks prior on March 4th, which had obviously been long forgotten:

Intel lowered its profit forecast on March 4th, "blaming a steep drop in prices for memory chips for the shortfall." It said, "Slumping prices for NAND flash memory had depressed profits more than anticipated. " The company also warned in its March 4th press release that its gross profit margins would come in at 54 percent instead of the previously forecast of 56-percent. The company said its other guidance had not changed, including its expectation of $9.4 billion to $10 billion in revenue for the quarter.

That was March 4th. On Tuesday, April 15th, Intel essentially matched what they had warned us about 42-days prior. The world's largest maker of microprocessors posted a 12% drop in its first-quarter profit, year-over year, as warned. Earnings per share came in at 25-cents per share versus last year's 28-cents per share, as warned. Originally, in February, Intel estimated earnings of 34 cents for this quarter before its March 4th warning. Margins came in even lower than what they previously had warned at 53.8% versus 54% expected. Okay, close enough.


But again, perception is more important than reality on the Street of Dreams. The company predicted that margins would recover to 56%, plus or minus a couple of points, in the second quarter. Intel also projected second-quarter revenue between $9 billion and $9.6 billion. The $9.3 billion midpoint of that range compares with average analyst estimates of $9.23 billion. Also, as CEO Paul Otellini exemplifies how hope springs eternal and trumps reality, when he said that his company was seeing "absolutely no impact from economic headwinds." Apparently by warning on March 4th that earnings and margins had deteriorated was just his way of not showing-off, given how humbled his buddies in the financial sector must be feeling.

So the 25-cents per share number reported on Tuesday, April 15th, was 35% lower that what folks expected as recently as March 3rd (pre-warning) when the stock closed at $20/share. For his masterful handling of what appears to be a deteriorating business situation, Otelli and shares of Intel were rewarded with a 10% gain in his stock's price since before its March warning.

Moreover, it appears that Intel is back at its balance sheet shell game: Cash, Cash Equivalents & Short-term Investments have dropped from $15.36-billion to $13.69-billion; Receivables increased from $2.57-billion in December to $2.722, even as Revenues dropped from $10.7-billion to $9.67-billion, sequentially. Inventories had been coming down for most of last year but were essentially flat since its last quarter. Also, mysteriously, it's balance sheet item, called Other Long-term Assets, perhaps some of which includes factored receivables, are now going Chernobyl, mushrooming from $3.75-billion a year ago to $5.7-billion last quarter.

Given Intel's record of mis-forecating, and half-truths, it's amazing to me to see how markets still give any credence whatsoever on their forward guidance and Otelli's predictions. Again, the reaction this week in shares of Intel and by extension the entire market is further evidence that what we really have is a bull market in selective perceptions and an inclination to want to believe in fairytales, such as Goldilocks while simultaneously crowding-out logic and diligence.