January 27, 2014

What’s the Safest Way to Hedge Against Inflation With Gold?

Posted in Ben Bernanke, Big Banks, Economy, Europe, Foreign, gold, investment advisor, investment banking, investments at 11:02 PM by Robert Barone

Until inflation becomes recognized, the investor holding gold as a hedge must have both patience and the ability to hold for an extended period.

Historically, the price of gold protected the purchasing power of the currency invested in it, as the price rose in some reasonable correlation with existing or expected inflation of that currency. But today, the price of gold is set in a speculative market where traders and hedge fund managers make bets, and little or no attention is paid to gold’s traditional role. (See the first part of this article, Why Gold Prices Dropped in 2013.)   According to John Hathaway of Tocqueville.com, in 2010, the physical gold market consisted of 121 million ounces. With a growth rate of about 1.5% per year, there are currently about 127 million ounces in existence, as of Hathaway’s writing. Using futures and options data, and OTC clearing data from the London Bullion Market Association, Hathaway calculates that the paper gold market is 92 times that of the underlying physical market. If each investor in a paper gold ounce believes it is backed by an ounce of physical gold, then each physical gold ounce must have been loaned or hypothecated, on average, 92 times. If everyone decided that they wanted physical possession, which of the 92 paper gold ounce owners really owns the physical metal?
That, of course, explains why it took so long (17 months) for the London banks to deliver the physical gold that Hugo Chavez’s Venezuela demanded. They either didn’t have it and had to purchase it in the open market, or they had to unwind trades where the gold was loaned or pledged as collateral, or both. As for the seven years that it will take for the US Fed to deliver Germany its gold, the only conclusion can be that the web of hypothecation must be long and complex.

Let’s now consider the characteristics of the London financial markets, where gold’s price is fixed twice each day. Nearly every well-known financial calamity over the past 20 years has originated from London offices of major financial corporations. That’s because in the UK, financial institutions have little regulatory oversight. Just think about JPMorgan’s (NYSE:JPM) $6+ billion 2012 loss from its London trading office. We learned from the MF Global (OTCMKTS:MFGLQ) fiasco that client assets can be hypothecated and re-hypothecated an infinite number of times, and that there are no customer protection rules. If you have been wondering what happened to Jon Corzine’s (MF Global’s CEO) clients’ funds, you now have a pretty good idea.

Recently, we’ve seen major UK financial institutions pay hefty fines for manipulating certain commodity prices and for fixing the price of LIBOR, a short-term rate that plays a key role in the world’s financial markets. Apparently, the illegal activity had been going on for years. There are five London banks that control the two daily London gold price fixes. Given the known shenanigans of the London banks regarding LIBOR and other commodities, and the infinite re-hypothecation allowed, how much confidence should we have that the daily gold price-fixing is impartial, that in a crisis or panic the hypothecations can be unwound with every paper claim on gold made whole, or, in fact, that some of the underlying gold even exists in the vaults? As Hathaway says, “It would be hard to imagine that the culture of [London] did not extend to gold.”

There has been a great deal of political angst by Bernanke and Co. over the demand by some members of Congress for a Fed audit, and great political maneuvering to avoid it. Some commentators, like John Williams (Shadowstats.com), believe that the Fed and government officials disdain rising gold prices because that suggests that the government and the Fed are not doing their jobs in maintaining price stability. Hence, Williams believes that heavy selling in 2013 was an orchestrated government intervention. In his January 8, 2014 issue of Hyperinflation 2014 – The End Game Begins, Williams says, “A number of times, very large sell-orders from one customer were placed in the global markets before the open of US trading. For someone looking to move out of gold, orderly sales would make the most sense in terms of getting the best prices. Instead, these actions were designed to pummel the gold markets, and they did.”

Remember what happened to credit default swaps, issued by AIG (NYSE:AIG), just five years ago? Remember what happened to AAA-rated mortgage-backed securities that turned out to have a lot of sub-prime loans? Could something like that happen to the paper gold market?

If it’s discovered that some of the underlying gold has disappeared from the vaults, or in a panic the competing hypothecations for the underlying gold ounces tie up the assets in a long-term court battle, or, as in the case of General Motor’s (NYSE:GM) senior secured bondholders and some depositors in Cypriot banks, it becomes politically correct to single out a class to bear losses, some holders of paper gold could be out of luck. It might be very painful one day to wake up to find that the paper gold investment you thought you had turns out to have not been collateralized.

So, what should gold investors do?

First, understand the difference between hedging and speculating. If it is your intent to hedge against an inflation that you believe will inevitably come due to current worldwide monetary- and fiscal-policy excesses, then the systematic purchase of gold, like mutual fund dollar-cost averaging, is a good practice.

In what form should you hold your precious metal assets? What about the ETFs traded on the exchanges? If you want to keep the gold in your brokerage account, there are some funds or ETFs that say that they hold bullion in a vault and do not hypothecate it. You need to do careful research to make sure this is the case and know if the paper you hold is convertible into the underlying asset. Gold mining stocks are another way, since the gold is there in the ground. Unfortunately, the typical gold mining company continuously dilutes shareholders with new rounds of equity offerings as they continue their search for the “mother lode.” So, research here is also essential.

The safest way, of course, is to hold the gold yourself, i.e., take physical possession and put it into a safety deposit box or in your own safe.  Many Americans are doing this, but the Chinese and Asians are way out ahead in this area. To do this you need to find a reputable gold or coin shop that will sell to you for a reasonable commission, say 3-4%.

Today’s gold investors must also understand that the price of gold is currently a 100% function of hedge fund speculation. In the future, as inflation becomes recognized, this may change, but until it does, the investor holding gold as a hedge must have both patience and the ability to hold for an extended period — oh yes, and the ironclad belief that the laws of economics haven’t changed, i.e., that “this time is different” is a lot of bunk.

 

Robert Barone (Ph.D., economics, Georgetown University) is a principal of Universal Value Advisors, Reno, a registered investment adviser. Barone is a former director of the Federal Home Loan Bank of San Francisco and is currently a director of Allied Mineral Products, Columbus, Ohio, AAA Northern California, Nevada, Utah Auto Club, and the associated AAA Insurance Co., where he chairs the investment committee. Barone or the professionals at UVA (Joshua Barone, Andrea Knapp, and Marvin Grulli) are available to discuss client investment needs.
Call them at 775-284-7778.
Statistics and other information have been compiled from various sources. Universal Value Advisors believes the facts and information to be accurate and credible but makes no guarantee to the complete accuracy of this information.

January 14, 2014

Why Gold Prices Dropped in 2013

Posted in Banking, Big Banks, Economic Growth, Economy, Europe, Federal Reserve, Finance, Foreign, gold, Inflation, interest rates, investment advisor, investments, Robert Barone at 6:39 PM by Robert Barone

Most seasoned investors have some allocation to precious metals in their portfolios, most often gold. They believe that such an allocation protects them, as it is a hedge, or an insurance policy, against the proliferation of paper (fiat) money by the world’s largest central banks. Fiat money is not backed by real physical assets. In concept, I agree with this sentiment. Most investors who invest in precious metals ETFs, such as the SPDR Gold Trust ETF (NYSEARCA:GLD), through the supposedly regulated stock exchanges (“paper gold”) believe that they actually have a hedge against future inflation. In what follows, I will try to explain why they may not, and why their investments in paper gold may just be speculation.

On February 5, 1981, then Fed Chairman Paul Volcker said that the Fed had made a “commitment to a monetary policy consistent with reducing inflation…” Contrast that with the statement of outgoing Fed Chairman Bernanke on December 18, 2013: “We are very committed to making sure that inflation does not stay too low…”

During 2013, the price of gold fell more than 28% (from $165.17/oz. to $118.36/oz.) despite the fact that other assets like real estate and equities each rose at double-digit rates. It is perplexing that the price of the hedge against inflation is falling in the face of a money-printing orgy at all of the world’s major central banks. Despite the fact that these central banks have fought the inflation scourge for half of a century, suddenly they have all adopted policies that espouse inflation as something desirable. The fall in the price of gold is even more perplexing because there are reports of record demand for physical gold, especially in Asia, and that some of the mints can’t keep up with the demand for standardized product. In his year-end missive, John Hathaway of Tocqueville.com says that “the manager of one of the largest Swiss refiners stated that after almost doubling capacity this year, ‘they put on three shifts, they’re working 24 hours a day…and every time [we] think it’s going to slow down, [we] get more orders…70% of the kilo bar fabrication is going to China.'”

One would also think that the price of gold should be rising because of a growing loss of confidence in fiat currencies. Here are some indicators:

The growing interest in Bitcoin as an alternative to government-issued currencies. One should ask, why did the price of Bitcoin rise from $13.51 on December 31, 2012 to $754.76 on December 30, 2013 while the price of gold fell? As you will see later in this essay, the answer lies in leverage. The gold market is leveraged; Bitcoin is not (at least, not yet).

The volatility that the Fed has caused in emerging market economies by flooding the world with dollars at zero interest is another reason the price of gold should be rising. The Fed’s announced zero-rate policy with a time horizon caused huge capital flows into emerging market economies by hedge funds looking for yield. The inflows caused disruption to the immature financial systems in those emerging markets. And then, with the utterance of a single word, “tapering,” all of the hedge funds headed for the exits at once. The Indian rupee, for example, which was trading around 53 rupees/dollar in May 2013, fell to 69 near the end of August, a 30% loss of value. Such behavior has stirred up new interest on the part of major international players (China, Russia) to have an alternative to the dollar as the world’s reserve currency. Don’t dismiss this as political posturing. It is based on irresponsible Fed policy in its role as the caretaker of the world’s reserve currency. As the world moves toward an alternative reserve currency, the dollar will weaken significantly relative to other currencies, and, theoretically, to gold (and even Bitcoin).

The loss of confidence on the part of some sovereign nations that the gold they have stored in foreign bank vaults is safe. Two examples immediately come to mind: Venezuela and Germany. In August of 2011, the President of Venezuela, Hugo Chavez, demanded that the London bullion banks that were holding Venezuela’s gold ship it to Caracas. (Again, don’t dismiss this as political posturing.) Despite the fact that the shipment could have been carried on a single cargo plane, it took until late January 2012 (17 months), for the London banks to completely comply. One should wonder why. Then, the German Bundesbank asked for an audit of its gold holdings at the Fed. One knows how the Fed has resisted audits from Congress, so why should a request from a German bank meet with any different result? After political escalation, a German minister was permitted to see a room full of gold at the New York Fed. In early 2013, the Bundesbank publicly announced that its intent was to repatriate its gold from the vaults in Paris, London, and New York. We have now learned that it will take seven years for the New York Fed to ship the gold earmarked as belonging to Germany in the Fed’s vaults. One should wonder why such a long delay.

In the face of all of this — unparalleled money printing, the rise in the prices of real estate and equities in 2013, and the creeping suspicions regarding the real value of fiat currencies — how is it that the price of gold fell 28% in 2013? The answer lies in leverage and hypothecation, the modus operandi of Wall Street, London, and financiers worldwide. The paper gold market, the one that trades the ETFs such as the SPDR Gold Trust, is 92 times bigger than the physical supply of gold according to Tocqueville’s John Hathaway. Think about that. It means that each physical ounce of gold that actually exists has been loaned, pledged, and re-loaned 92 times on average. Each holder in the paper gold market thinks that the ounce of paper gold held in the brokerage account is backed by an ounce of real gold. But there are, on average, 92 others who apparently have a claim on the same real, physical ounce.

The answer to the question, why did gold fall 28% in 2013 when, theoretically, it should have risen, is that Wall Street, London, and hedge funds have turned the paper gold market into a market of speculation, where the price rises or falls, not based on the purchasing power of currencies (the hedging characteristic of gold), but on such things as whether or not the Fed will taper, what impact Iranian nuclear talks will have on oil flows, if the interest rates in the eurozone periphery are likely to rise or fall, etc.

In my next article, I will explain how all of this occurred, and what investors who want to hedge and not speculate should do.

Robert Barone (Ph.D., economics, Georgetown University) is a principal of Universal Value Advisors, Reno, a registered investment adviser. Barone is a former director of the Federal Home Loan Bank of San Francisco and is currently a director of Allied Mineral Products, Columbus, Ohio, AAA Northern California, Nevada, Utah Auto Club, and the associated AAA Insurance Co., where he chairs the investment committee. Barone or the professionals at UVA (Joshua Barone, Andrea Knapp and Marvin Grulli) are available to discuss client investment needs.
Call them at 775-284-7778.
Statistics and other information have been compiled from various sources. Universal Value Advisors believes the facts and information to be accurate and credible but makes no guarantee to the complete accuracy of this information.

December 27, 2013

Part II: The Long-Term Outlook – Even a Strong Economy Doesn’t Change the Ultimate Outcome

Posted in business, debt, Economic Growth, Economy, Europe, Finance, Foreign, Inflation, investment advisor, investment banking, investments, Markets, National Deblt, Robert Barone at 4:46 PM by Robert Barone

If you’ve read Part I of this year end outlook, you know that it is our view that the underlying private sector is healthy and, except for the fact that the real rate of inflation is much faster than the ‘official’ rate, we could well have a short period of prosperity.

Unfortunately, our long-term outlook is not as sanguine as our short-term view.  The eventual recognition of the inflation issue, the dollar’s role as the world’s reserve currency, the bloated Fed balance sheet and the resulting excess bank reserves, and the freight train of unfunded liabilities and its impact on the debt and deficit are issues that have large negative long-term consequences.  Remember, the long-term unfolds slowly, and we don’t expect that we will wake up one day to find that all has changed.  Still, the changes discussed below could very well take place over the next decade, and investors need to be prepared.

The Dollar as the Reserve Currency

The dollar is currently the world’s reserve currency.  Most world trade takes place in dollars, even if no American entity is involved.  Because world trade has rapidly expanded over the past 20 years, more dollars have been needed than those required for the U.S. economy alone.  As a result, the U.S. has been able to run large deficits without any apparent significant impact on the dollar’s value relative to other major currencies.  Any other country that runs a large deficit relative to their GDP suffers significant currency devaluation.  Current policy in Japan is a prime example.  A weakening dollar has implications for the prices of hard assets.

In addition, the Fed’s policy of Quantitative Easing (essentially money printing) has disrupted emerging market economies.  Zero rates and money creation caused hedge fund managers to leverage at low rates and move large volumes of money offshore to emerging nations where interest rates were higher.  The initial fear of “taper” in May and June caused huge and sudden capital outflows from those countries resulting in massive economic dislocation in those markets.  In India, for example, the Rupee was pummeled as the hedge fund investors, fearing that interest rates were about to suddenly rise, all tried to unwind their Rupee investments at the same time.  And now that ‘taper’ has officially started and longer-term rates are expected to rise, these issues will continue.  Those countries have all taken defensive measures.  India, for example, imposed taxes on gold imports, which has impacted the gold markets but has reduced India’s balance of payments deficit.

As a result of such tone deafness on the part of the Fed, and because there now appears to be enough dollars in the world for the current level of trade, the international appetite for U.S. dollars is clearly on the wane.  Japan and China, the two largest holders of Treasury debt, have recently reduced purchases.  Most emerging market nations and large players like Russia and China have vocally called for an alternative to the dollar as the world’s reserve currency.  This movement is alive and well.

The Fed’s Balance Sheet

As the economy expands, the size of the Fed’s balance sheet and the level of excess bank reserves will become a problem.  There are $2.3 trillion of bank reserves in excess of what are ‘required’  under the law and regulations.  (Required reserves for the U.S. banking system are $.067 trillion; so, the system has 34x more reserves than it needs.)  Under ‘normal’ conditions, and the way the system was designed to work, if the economy got too hot, the Fed could sell a small amount of securities out of its portfolio which would reduce bank reserves to the point where banks would have to ‘borrow’ from the Fed.  Because bankers are hesitant to do that, and because the Fed could raise the ‘discount’ rate, the rate charged for the borrowings, the Fed could control new lending and thus the economic expansion.  This isn’t possible today as the Fed would have to sell $2.2 trillion to cause banks to have to borrow.  Such a volume of sales would likely cause a crisis in the financial system, or even collapse.  Today, the only way the Fed has to stop the banks from lending is to pay them not to lend – this is exactly the opposite of the intent of the original legislation and the opposite of how the Fed has worked for most of its 100 year history.

Furthermore, given the growing lack of confidence in the dollar as the world’s reserve currency, if fiscal budget deficits grow in the future, the Fed may end up as the major lender (i.e., lender of last resort) for the U.S. Treasury.  That simply means more money creation.

Unfunded Liabilities-

The U.S. Treasury officially recognizes $85 trillion as the amount of unfunded liabilities of the Federal Government.  Other professionals set this number near $120 trillion.  For comparison, the annual U.S. GDP is about $16 trillion.  The budget deficit reported in the media is a cash flow deficit (tax collections minus expenditures).  The budget deficit doesn’t include promises made for future payments (Medicare, Medicaid, Social Security, government pensions) which have been running between $4 and $5 trillion annually for the past few years.  These amounts simply get added to the ‘unfunded’ liability number.

As the population ages, these payments will have to be made, and the budget may become overwhelmed. (You see the relevance of the remark made above about the Fed being the lender of last resort for the Treasury.)   This is the heart of the debate about ‘entitlements’ that has been front and center for the past decade.

 Solutions (none of which you will like)

 Philipp Bagus is a fellow at the Ludwig von Mises Institute in Europe.  He is well known in Europe for his work on financial issues there.  In a recent paper, Bagus says that there are several possible ways out of the current money printing predicament.  Any one or a combination is possible.  We have put them in an order of most likely to least likely to be used:

  •  Inflation – this is the natural outcome of printing money;
  • Financial Repression – this is current Fed policy; savers and retirees bear a disproportionately large burden as inflation eats at their principle but there is no safe way to earn a positive real rate of return;
  • Pay Off Debt – this means much higher levels of taxation, and is definitely a real possibility.  In Europe, the International Monetary Fund (IMF) has proposed a one-time 10% wealth tax.  As the unfunded liabilities push up the federal deficit, expect such proposals in the U.S.;
  • Bail-In – In ’08-’09 we saw ‘bail-outs’ where the government saved GM, Chrysler, AIG and the Too Big to Fail banks by buying stock or otherwise recapitalizing them.  A ‘bail-in’ refers to the financial system.  Banks and other depositories have liabilities called deposits.  The depositors do not consider themselves ‘lenders.’  But, in a ‘bail-in,’ it is the depositors who lose.  Their deposits are ‘converted’ to equity in the bank.  When they try to sell their bank shares, they find that it will fetch only a fraction of the value of their deposits.  A variant of this is what happened in Cyprus in the spring of 2013.  Because of the distaste the public now has for ‘bail-outs,’ if there is another financial crisis, this is likely to be the method used;
  • Default on Entitlements – when we talk about ‘entitlement reform’ in the U.S., we really mean at least a partial default.  It is likely that some people simply won’t get what they were promised.  We put this low on the list because we have witnessed a political process that won’t deal with the issue;
  • Repudiate Debt – Because the government can simply print money to pay it debts, this is the least likely of all of the possibilities in the U.S.

The long-term issues are serious.  And not addressing them simply means a higher level of pain when addressing them is required.   Remember, these are long-term issues.  They are all not likely to occur at the same time, nor will they simply appear overnight.  The first signs of trouble will occur when markets begin to recognize that the ‘official’ inflation rate significantly understates reality, or that the inflation data become so overwhelming that they can no longer be masked.  Even then, markets may come to tolerate higher inflation, as after 100 years of fighting inflation, the Fed and the world’s major central banks have embraced it as a good thing.

Meanwhile, as set forth in Part I of this paper, the immediate outlook for the economy is upbeat.  Enjoy it while it lasts.

December 20, 2013

Robert Barone, Ph.D.

Joshua Barone

Andrea Knapp Nolan

Dustin Goldade

Robert Barone (Ph.D., economics, Georgetown University) is a principal of Universal Value Advisors, Reno, a registered investment adviser. Barone is a former director of the Federal Home Loan Bank of San Francisco and is currently a director of Allied Mineral Products, Columbus, Ohio, AAA Northern California, Nevada, Utah Auto Club, and the associated AAA Insurance Co., where he chairs the investment committee. Barone or the professionals at UVA (Joshua Barone, Andrea Knapp  and Marvin Grulli) are available to discuss client investment needs.
Call them at 775-284-7778.
Statistics and other information have been compiled from various sources. Universal Value Advisors believes the facts and information to be accurate and credible but makes no guarantee to the complete accuracy of this information.

August 16, 2012

Today’s market not driven by fundamentals – so be careful

Posted in Banking, Economy, Europe, Federal Reserve, Finance, Foreign, investment banking, investments, Italy, Spain, Uncategorized tagged , , , , , , , , , at 8:45 PM by Robert Barone

The Past
 
The stock market always has been considered a “leading” They are “administered” by central banks (the Fed, the European Central Bank, the Peoples’ Bank of China, the Bank of Japan, etc.), which set and manipulate the rates. When interest rates are determined by other than market forces, you can be assured that scarce resources are inefficiently allocated. We need only look to the long period of administered artificially low rates under the Greenspan Fed to realize that such a policy was a major contributor to the housing bubble last decade.

Expectations

Given the recent collapse in basic, fundamental worldwide economic activity (consumption, orders, employment), one must be skeptical of an equity market that continues to, apparently, defy gravity. Investors, or more accurately, speculators, await the next Fed or ECB policy-easing move, not wanting to “miss” the inevitable market updraft that they hope occurs. (Of course, they could be hugely disappointed, as were the initial investors in Facebook!) Could it be that market expectations of such moves already have driven prices up, and the policy-easing moves themselves will be anticlimactic? In market parlance, this is known as “buy the rumor, sell the fact.”

Recent market reactions

Sooner or later, markets will come back to valuations based on the underlying fundamentals. This isn’t the first time that the markets have exhibited extreme sentiment. And it won’t be the last. So, let’s examine some of the recent “policy” issues and data releases in light of market sentiment.
 
• On July 26, ECB President Mario Draghi (“Super Mario”) said, “Within our mandate, the ECB is ready to do whatever it takes to preserve the euro,” adding later, “Believe me, it will be enough.” The market interpreted this as a pledge that the ECB would directly purchase the debt of Spain and Italy, thus reducing pressure on interest rates in those countries. The Dow Jones rose 3.2 percent during the next two days. On Aug. 2, when the ECB met and didn’t announce
anything major, the Dow sold off .7 percent, only to begin a rise again on Aug. 3 when the market realized that Spanish and Italian two-year rates, which is where those two countries are selling new debt, were now falling. Apparently, the markets now believe Super Mario’s words.
 
Nevertheless, no amount of liquidity can resolve the solvency problem that exists in Europe’s southern nations. No matter what these politicians do, short of an unlikely fiscal union, the euro will be pulled apart. The northern countries — Finland, Denmark, Germany — have attitudes toward work, debt, inflation and socialism that are diametrically opposed to the attitudes in the Mediterranean countries.
 
So, Europe likely is to remain in a recessionary/slow growth mode for the foreseeable future, and debt issues there will continue to impact capital markets worldwide.
 
• On July 27, the Department of Commerce’s Bureau of Economic Analysis reported that the real GDP grew at an annual rate of 1.5 percent in the second quarter. (The measurement methodology of the price deflator is questionable as it biases the real GDP number significantly upward. While every other indicator of economic activity is declining, it doesn’t seem logical that this one is rising.)
 
The markets had expected a worse report, and breathed a sigh of relief, advancing 188 Dow points that day (1.5 percent). But, even a cursory analysis of the underlying data reveals that the private sector remains in stagnation. In the second quarter, nominal dollar GDP grew by $117.6 billion or by $1.29 billion/day. However, the federal government added $274.3 billion in new debt ($3.01 billion/day). Thus, it took $2.33 of new debt to increase GDP by $1. Would anyone in their right mind sign up for a loan of $233,000 if the lender was only going to fund $100,000?
 
• The Aug. 3 employment report was “stronger” than expected, according to the media, with the Establishment Survey showing new job growth of 163,000. (June’s 80,000 job growth was revised downward to 60,000.) The headline “unemployment rate” went up to 8.3 percent. It was widely reported that the rise of the unemployment rate was due to the fact that fewer people were discouraged and more people entered the labor force. After all, how else could the unemployment rate rise when 163,000 jobs were created? The answer is, after all these years, the media doesn’t know that the headline unemployment rate is calculated using a completely different survey. The Establishment Survey queries 141,000 businesses, while the Household Survey queries 60,000 households. The Establishment Survey adds in a residual factor of about 50,000 jobs per month, created out of nowhere, from what is known as the birth-death model (the BEA assumes 50,000 more new small businesses are created every month than are closed; this is clearly an historical artifact and doesn’t exist in today’s world, but it is still added to the data). The Household Survey actually showed a decline of 195,000 jobs (all of which were full-time jobs) in July, and because the labor force declined by 150,000, the unemployment rate went up. The labor market is nowhere near healthy.

Conclusions

As I said earlier, sooner or later, the markets will come back to what the fundamentals say. I don’t know when that will occur, perhaps after the elections, or maybe not until sometime in 2013, depending on who wins. As I said in a previous column, policy issues are important for markets. Clearly, today, policy appears to be not only the most important factor but the only factor.
 
Because sentiment on Wall Street can change in an instant, investors should remain very cautious. Depending on your own situation, perhaps some profit taking is now in order. Short duration bonds continue to look safe given current underlying economic conditions and likely policy moves.
 
Robert Barone (Ph.D., Economics, Georgetown University) is a Principal of Universal Value
Advisors (UVA), Reno, NV, a Registered Investment Advisor. Dr. Barone is a former Director of the Federal Home Loan Bank of San Francisco, and is currently a Director of Allied Mineral Products, Columbus, Ohio, AAA Northern California, Nevada, Utah Auto Club, and the associated AAA Insurance Company where he chairs the Investment Committee.
 
Information cited has been compiled from various sources which UVA believes to be accurate and credible but makes no guarantee as to its accuracy. A more detailed description of the company, its management and practices is contained in its “Firm Brochure” (Form ADV, Part 2A) which may be obtained by contacting UVA at: 9222 Prototype Dr., Reno, NV 89521. Ph: (775) 284-7778.

July 23, 2012

Time for us to make enlightened policies

Posted in Armageddon, Bankruptcy, debt, Economic Growth, Economy, Europe, Finance, Foreign, recession, Spain, Uncategorized, Unemployment tagged , , , , , , , , , , , , , , at 8:10 PM by Robert Barone

On July 6, the country received another disappointing jobs report. For the month, the establishment survey indicated jobs grew by 80,000; for the quarter, such growth averaged 75,000, about one-third of the 26,000 monthly average for the first quarter. Clearly, the worldwide slowdown in Europe, China, India, Brazil, etc. is having an impact here.
 
Deleveraging and slow growth
 
Let’s be clear. We are in the midst of a worldwide debt deleveraging (i.e., consumers are paying down debt instead of consuming). So, absent another round of sweeping innovation anytime soon (e.g. the Internet), in the natural course of things, economic growth is going to be painfully hard to come by. As a result, it is doubly important that economic policies promote the growth that is available.
 
Policies are key
 
Clearly, monetary policy has led with pedal-to-the-metal and unconventional therapies. On the fiscal side, the Keynesian remedies (huge deficits) have been applied. Together, however, such policies haven’t worked well enough to establish a solid economic foundation, as the recent data prove. For those who study economic history, it is clear that deficit spending alone doesn’t work if government is simply stepping into the role of debtor in place of households, as total debt owed has continued to rise.The scary part is the interest cost of the rapidly accumulating debt when interest rates rise. For those who don’t believe me, just look at Greece, Portugal, Ireland, Spain, Cyprus and Italy in today’s world. Rising interest rates (near 7 percent for the 10-year government issue) make it impossible for states to survive without bankruptcy, a bailout or financial ruin.

 
Policy failures
 
In times like today, when deleveraging is slowing economic activity, government should adopt policies that promote the private sector, because it is the private sector, not government, that is the engine of economic growth. Unfortunately, the following federal policies currently are negatively impacting the private sector:

• Taxes:
Uncertainty surrounding tax policy causes the private sector to take less risk, which lowers investment and job creation. For the last several years, Congress has signaled that significant tax increases are just ahead (currently referred to as the “fiscal cliff” due to occur on Jan. 1, 2013), only to push them back at the last minute for another short period. Nevertheless, the uncertainty persists, and economic hesitancy pervades.
 
• Corporate cash: America’s multinational corporations are flush with cash, and while the politicians chide them for not putting it to work at home, it is their very policies that are to blame. Sixty percent of that corporate stash is held offshore, and it won’t come home because, if it does, 35 percent of it will disappear in taxation. Policies that encourage the return of that cash and its investment at home would spur job creation and economic growth.

• Corporate tax rate:
Having one of the highest corporate tax rates in the world discourages investment at home and makes investment elsewhere more fruitful. Corporate taxes are paid by consumers via higher prices.

• Energy policy: 
Cheap energy is the No. 1 requirement for robust economic growth. Current policies appear to be designed to raise energy prices to spur the development of government selected industries. The result is great waste (e.g. Solyndra) and significantly reduced economic growth.

• Taxmageddon:
The U.S. has a joke for a tax code. Talk about a Rube Goldberg! High, and threatened increased taxes on capital and investment just discourage economic growth. The tax code needs to be thrown out in favor of a broad-based, simple, and fair system.

• The financial system:
Scandal after scandal show how pervasive lawlessness is among the world’s “too big to fail” institutions. So far, no U.S. banker has gone to jail, nor trial, nor has anyone been indicted. Regulatory policy encourages moral hazard (excessive risk taking backed by implicit taxpayer bailouts) and discourages lending to the private sector. All of this reduces economic growth.
 
 

Investing in a deleveraging world 

 
For investors, the markets will continue to show volatility, with market up-drafts occurring when there is a perception of a policy change. For example, the recent hope generated by the late June “European Summit” caused a large rally in the equity markets, as will the hoped for move by the Fed toward more stimulus when and if it occurs. Down-drafts occur when poor economic data cross the tape.
 
Implications for Nevada
 
The policy prescription doesn’t end at the federal level. It is also relevant at the state and even local levels. Nevada has been challenged to attract new businesses now that gaming is widespread.The tax system in Nevada could be such a strength, especially when compared to what is going on in California. CNBC ranks Nevada 18 in “Business Friendliness,” but 30 in “Cost of Business.” Two things are critical: 1) The Legislature must stop threatening new business taxation every two years when it meets. The uncertainty this breeds prevents businesses from relocating here.

2) Policymakers must identify those businesses that would benefit from such a philosophy. There might be several categories that would so benefit, but one immediately comes to mind (maybe because I have worked in it all my life) — financial and intangible asset firms. This category includes managers of investments, hedge funds, trusts, patents and trademarks, insurance companies and services, banking and subsidiary finance companies. While these firms are usually small, their salary levels generally are high. A University of Nevada, Reno study indicates that salaries in these firms average $88,000, twice the state’s average.

Jon Ralston, a political columnist and host of a daily political commentary show seen locally, recently criticized the Apple move, saying that they will grow “astronomical profits” but that the state won’t benefit much because the number of jobs is small. But its move, along with those of Microsoft (which now employs several hundred), Intuit (also a large employer), Oracle and others, appears to recognize that Nevada, indeed, has something to offer now. If the state attracts enough of these companies, there will be plenty of tax revenue generated. The state should play to its current strengths and make sure its policies protect and nurture those strengths.

 
 
Robert Barone (Ph.D., Economics, Georgetown University) is a Principal of Universal Value
Advisors (UVA), Reno, NV, a Registered Investment Advisor. Dr. Barone is a former Director of the Federal Home Loan Bank of San Francisco, and is currently a Director of Allied Mineral Products, Columbus, Ohio, AAA Northern California, Nevada, Utah Auto Club, and the associated AAA Insurance Company where he chairs the Investment Committee.
 
Information cited has been compiled from various sources which UVA believes to be accurate and credible but makes no guarantee as to its accuracy. A more detailed description of the company, its management and practices is contained in its “Firm Brochure” (Form ADV, Part 2A) which may be obtained by contacting UVA at: 9222 Prototype Dr., Reno, NV 89521.
Ph: (775) 284-7778.
 

March 15, 2012

Markets Hooked On Liquidity Drug From Central Bank Pushers

Posted in Banking, Ben Bernanke, CDS, Economy, Europe, Federal Reserve, Finance, Foreign, government, investment banking, investments, ISDA, QE3, recession, sovereign debt, Uncategorized tagged , , , , , , , , , , , , , , , , , , , , , , , at 10:04 PM by Robert Barone

From early last October to the end of last month, the S&P 500 rose 25%; amazing for an economy that is struggling to stay out of recession.  Then again, the equity markets are hooked on the liquidity drug.

When Federal Reserve Chairman Ben Bernanke, in his recent semi-annual testimony before Congress, did not hint that QE3 was just around the corner, the market sold off.  When the European Central Bank broke its traditional role as lender of last resort and morphed into a gift giver to its member banks (to the tune of more than a trillion dollars), much like our Fed, the equity markets soared.

Money printing can’t go on forever, can it?

In every historical context, whenever the equity markets have a run up not based on economic fundamentals, eventually, they return to what those fundamentals dictate.  And here are some of the underlying economics:

  • There is no doubt that American manufacturing is undergoing a renaissance.  Labor costs in Asia are on a steep rise while wages here have been stagnant for several years.  Shipping costs, quality control and culture are other factors.  But, manufacturing represents less than 12% of GDP.  It, alone, cannot drive significant economic growth.
  • Gasoline prices are up more than $.60/gallon year to date with talk of $4.50 gas by summer. That cost/gallon is already here in some markets. Every penny increase drains $1.5 billion annually from other consumer discretionary spending.  That’s about $90 billion so far for 2012.  And what happens to gas prices if the Middle East flares up again?
  • While the first quarter is far from over, early data suggest a much softer than expected GDP.  Retail sales have been soft except for automobiles (pent-up demand or just a rush to buy fuel efficient vehicles ?).  Consumers (70% of GDP) have shown no real income growth for many quarters, and incomes are tumbling in Europe.  Inventories appear to be on the high side given the level of demand.  So additional production won’t be forthcoming.
  • Despite a reinstitution of 100% depreciation for capital equipment, much of that demand was pulled into 2011, as the business community was uncertain as to whether or not the tax break was going to be reinstated in 2012.    The state and local government sector is still in contraction, and, given the slowdown evident in the rest of the world, exports aren’t likely to add to GDP.  Of course, the market may like the softer side of GDP, as it likely ensures another dose of the liquidity drug from the money czar, Bernanke, the king of money printing.
  • Europe is sicker than the markets have priced in.  The hoopla around the Greek bailout is just another can kicking.  Because the Greek populace hasn’t accepted the idea that they have lived beyond their means for the past decade, austerity won’t be successful.  Politicians who promise to end the austerity are likely to be elected.  Eventually, Greece will need to have their own currency which can fluctuate in value vis a vis other currencies with commensurate interest rate levels.
  • It is rare that all of Europe is in recession at the same time.  The current market expectation is that Europe’s recession will be mild.  But, don’t forget, Germany’s biggest export clients are other European countries.  In fact, as a general rule, all of Europe’s economies export heavily to each other.  Being in recession together is going to have a large impact on those exports.  In addition, if the Euro remains at its current lofty level (above $1.30), it will be more difficult to export to non-EU countries.
  • The determination by the ISDA (International Swaps and Derivatives Association) that Greece officially defaulted on its debt when it invoked its recent legislatively passed “Collective Action Clause” to force investors to take losses is actually good news for the other so-called troubled European sovereigns (Portugal, Spain, Italy, Ireland) because it assures private sector investors that if they buy the so-called troubled foreign sovereign bonds, hedge them with Credit Default Swaps (CDS) and a Greek style default occurs, they will be paid at or near par value.  If the CDS payout had not been triggered, the private sector investors would view the purchase of such sovereign debt as having significantly more risk, and that would result in a much higher interest cost of that sovereign debt to the issuing countries.  In addition, it would throw the whole CDS concept into confusion, potentially impacting even the higher quality sovereigns like, Germany, the U.K., Canada, Australia, and even the U.S.
  • This is not to say that the world is now safe from financial contagion, as, in the context of world markets, Greece’s default is an expected and well prepared for event. The real worry should be if Spain (debt > $1 trillion) and/or Italy (debt> $2 trillion) default.  In addition, the CDS market is not transparent, and no one knows where the CDS obligations lie.  While a Portuguese and/or Irish default would have about the same individual impact as that of Greece (economies slightly smaller and not as indebted), we should worry that a rolling set of smaller defaults would eventually cause a major CDS insurer to fail due to the cumulative impact of the several defaults.  After all, it is likely that the CDS insurers who dabbled in Greek CDS, are also involved in CDS insurance of the other high debt European countries.  And, if a significant CDS insurer defaults (e.g., an institution similar in size and stature to AIG in 2009), we could, indeed, have contagion.
  • But even ignoring Greece for the short term, the ECB’s LTRO 1 and 2 appear to make Europe’s banks even more vulnerable.  Unlike the Fed, which purchased questionable assets from bank balance sheets and put them on its own, the ECB has not followed suit.  In fact, it stepped in and, by force majeure, inserted itself as senior to other bondholders holding the exact same Greek bonds, thus avoiding any losses in its own portfolio.  That makes losses for the private sector even greater.  Worse, it sours potential investors in European sovereign debt, seeing that they cannot easily quantify their risks as they can’t know how much of the same sovereign debt they own may be owned by the ECB.  This partially reverses the positive impact that the triggering of the CDS default will have on the European sovereign debt market.
  • Finally, the LTROs may make European banks even more insolvent than they are now, as they have been encouraged to take the cheap ECB funding and purchase European sovereigns for the interest spread (by Basle II and III rules, the debt of the European sovereigns is “riskless” and requires no capital backing on a bank’s balance sheet)!  Further sovereign debt crises, e.g., Portugal, Spain, or Italy, will eat away at already scarce European bank capital.  Contagion could very well result.

Looking at the GDP of Europe relative to China, if one includes all of the European Union countries and those closely related, Europe’s economy is about twice the size of China.  If China’s GDP growth went from 9% to 3%, the equity markets would certainly have a huge sell off.  But, it is likely that Europe’s GDP will fall from about 1.5% in 2011 to -1.5% in 2012, maybe even more than that.  Do the math!  This is equivalent to a Chinese hard landing.  As the European recession unfolds, the equity markets are likely to wake up.

Free Special Offer: 22 Super High-Yielding Dividend Stocks

Speaking of China, a slowdown is clearly developing.  They actually ran a trade deficit for the first two months of 2012 signaling a real slowdown in exports.  Retail sales have been softer than expected and the real estate bubble there appears to be in the process of popping as property sales and prices are plunging.  No wonder the government recently lowered its official growth forecast from 8% to 7.5%.  This is not to say that China, itself, is entering a recession, but a slower growth rate there (2nd largest economy) in combination with growth issues in the US (largest economy), Japan (3rd largest), and a significant recession in Europe bodes ill for worldwide growth and will eventually play out in the equity markets.

The profit implications for multinational corporations of the severe recession in Europe, and a slowdown in China and elsewhere are significant.  Analysts have continued to forecast rapid earnings growth and high profit margins even in the face of rising energy and food costs and stagnant U.S. and falling European incomes.  Using such rosy profit forecasts makes the market look undervalued.  However, a 15% – 20% profit decline is normal for a recessionary world.  If you plug that in, the equity markets look overvalued today.

Wasn’t it somewhere around this time last year that the equity markets were also priced for perfection?  Didn’t we hear that the economy had achieved “escape” velocity and that the recovery was about to accelerate?  And, didn’t the market sink when the economy fizzled and needed the QE2 liquidity drug injection?  In fact, the S&P 500 ended 2011 at exactly the point where it began, with a lot of volatility in between.  So far, 2012 appears to be following 2011′s path.

Robert Barone and Joshua Barone are Principals and Investment Advisor Representatives of Universal Value Advisors, LLC, Reno, NV, an SEC Registered Investment Advisor.

Statistics and other information have been compiled from various sources. Universal Value  Advisors believes the facts and information to be accurate and credible but makes no guarantee to the complete accuracy of this information.

Universal Value Advisors, LLC is a registered investment adviser with the Securities and Exchange Commission of the United   States. A more detailed description of the company, its management and practices are contained in its “Firm Brochure”, (Form ADV, Part 2A). A copy of this Brochure may be received by contacting the company at: 9222 Prototype Drive, Reno, NV 89521, Phone (775) 284-7778.

Robert Barone (Ph.D., Economics, GeorgetownUniversity) is a Principal of Universal Value Advisors (UVA),Reno,NV, an SEC Registered Investment Advisor.  Dr. Barone is a former Director of the Federal Home Loan Bank of San Francisco, and is currently a Director of Allied Mineral Products, Columbus, Ohio, AAA Northern California, Nevada, Utah Auto Club, and the associated AAA Insurance Company where he chairs the Investment Committee. 

Information cited has been compiled from various sources which UVA believes to be accurate and credible but makes no guarantee as to its accuracy.  A more detailed description of the company, its management and practices is contained in its “Firm Brochure” (Form ADV, Part 2A) which may be obtained by contacting UVA at:9222 Prototype Dr.,Reno,NV 89521.  Ph: (775) 284-7778.

 

March 13, 2012

Greece Default Declaration Stabilizes CDS Markets

Posted in Banking, Bankruptcy, Big Banks, Bonds, credit default swap, debt, derivatives, Economy, Europe, Finance, Foreign, government, International Swaps and Derivatives, investment advisor, investment banking, investments, ISDA, Nevada, sovereign debt tagged , , , , , , , , , , , , , , , , , , , , , , , , , , , , at 3:10 PM by Robert Barone

NEW YORK (TheStreet) — The determination by the International Swaps and Derivatives Association that Greece officially defaulted on its debt when it invoked its recent legislatively passed “Collective Action Clause” to force investors to take losses is actually good news for the other so-called troubled European sovereigns like Portugal, Spain, Italy and Ireland.

The ISDA determination assures private sector investors that if they buy the so-called troubled foreign sovereign bonds, hedge them with credit default swaps and a Greek style default occurs, they will be paid at or near par value.

If the CDS payout had not been triggered, the private sector investors would view the purchase of such sovereign debt as having significantly more risk, and that would result in a much higher interest cost of that sovereign debt to the issuing countries. In addition, it would throw the whole CDS concept into confusion, potentially impacting even the higher quality sovereigns like, Germany, the U.K., Canada, Australia, and even the U.S.

According to the ISDA, about $3.16 billion of Greek debt is covered by the CDS (4,323 swap contracts). On March 19, an auction will be held which will set the “recovery” value on the Greek bonds. The difference between that recovery value and par will be the payout of the CDS.

For example, if the auction results in a recovery value of 20%, then the CDS payment will be 80%, or about $2.5 billion. This is not a large amount in the context of world markets, and it would be a surprise if any viable CDS issuer will be greatly impacted, although it does appear that Austria’s KA Finanz, the “bad” bank that was created in 2008 when Kommunalkredit Austria AG was nationalized and given all of the “distressed” assets, will be stuck with CDS losses in excess of $550 billion which will require the Austrian government to step up with a significant capital injection.

The “non-eventness” of the CDS payouts is a result of the fact that there has been a long lead time for the issuers to adjust their risk portfolios to deal with the likelihood of a Greek default. Over the past year, the amount of Greek debt covered by the CDS has halved. Compare this to the Lehman default of $5.2 billion where there was almost no lead time between the emergence of the Lehman issue and its bankruptcy filing.

It was the lack of such a lead time that caught CDS issuers, like American International Group(AIG), with no time to adjust their risk portfolios, and required government intervention to prevent a domino default effect. With Greece, no such domino effect is expected although there is always the possibility (albeit low) of a surprise. We will know that soon after the March 19 auction when settlement must occur.

This is not to say that the world is now safe from financial contagion, as, in the context of world markets, Greece’s default is an expected and well prepared for event. The real worry should be if Spain, with a debt of about $1 trillion and/or Italy with a debt of about $2 trillion default.

In addition, the CDS market is not transparent, and no one knows where the CDS obligations lie. While a Portuguese and/or Irish default would have about the same individual impact as that of Greece (economies slightly smaller and not as indebted), we should worry that a rolling set of smaller defaults would eventually cause a major CDS insurer to fail due to the cumulative impact of the several defaults.

After all, it is likely that the CDS insurers who dabbled in Greek CDS, are also involved in CDS insurance of the other high debt European countries. And, if a significant CDS insurer defaults (e.g., an institution similar in size and stature to AIG in 2009), we could, indeed, have contagion.

December 13, 2011

How MF Global Almost Got Away With Everything

Posted in Banking, Big Banks, Europe, Finance, Foreign, investment advisor, investment banking, investments, sovereign debt, Stocks, Uncategorized tagged , , , , , , , , , , , , , , , , , , , at 4:39 PM by Robert Barone

The MF Global (MFGLQ.PK) story is just another chapter in the continuing saga of the legal fleecing of America by a financial system joined at the hip in an “Unholy Washington-Wall Street Alliance.”

The rules of the game are such that the managements of large Wall Street entities are allowed to gamble with assets entrusted to them by an unsuspecting public. If the bets are successful, the spoils flow entirely to the management and the firm, with nothing going to the clients whose assets are at risk. On the other hand, if the bets fail, the clients take the entire loss! Unfair? Of course.

But, as you will see if you keep reading, MF Global’s client assets will not be “found,” and, worse, unless the NY attorney general becomes incredibly creative, no one is likely to go to jail because no laws appear to have been broken. MF Global is just another piece of evidence that the current financial system is addicted to and permits excessive leverage and is deeply flawed.

Until this is recognized and fixed, the financial system will continue to be besieged with crises spawned by Wall Street greed. There are likely other, yet to be discovered, atrocities lurking in the shadows.

Asymmetrical Borrowing Rules

It appears that MF Global, as well as every other major US investment banking firm, has taken “advantage of an asymmetry in brokerage borrowing rules that allow firms to legally use client money to buy assets in their own name,” Christopher Elias notes in a recent Thomson Reuters article.

Simply put, MF Global borrowed money, and, using that borrowed money, purchased the debt of the European periphery (Italy, Ireland, Greece, Spain, and Portugal) at very attractive yields. The borrowings and the debt purchased had the same maturity date, so the proceeds of the debt maturities were to pay back the borrowings. MF collected the difference between the low rate it paid on the borrowings and the high rate it received on the debt.

The euro debt it purchased was guaranteed by the European Financial Stability Facility (EFSF). To get the low rate, MF had to pledge collateral. So, it pledged the euro debt, and as additional collateral, it borrowed and pledged its clients’ assets, which assets it held as custodian. Looks like a no-brainer! So thought Jon Corzine and Co.

Margin in the US

In the US, a client with an account at a broker-dealer can place his assets in a “margin” account. The client is then allowed to borrow against those margined assets. There are rules for this called “margin requirements.” Generally, speaking, the value of the assets assigned to “margin” must be greater than the amount borrowed by a factor set by the Federal Reserve under Regulation T.

If the market value of the assets assigned to “margin” falls in value to the point where the margin requirement ratio is violated, a “margin call” is generated. The client either has to assign or pledge more assets to “margin,” or reduce the borrowing via a cash deposit. If the client fails to do either of those in the time allotted by regulation, usually three business days, the assets that were pledged to “margin” are liquidated (sold out) and the proceeds are used to offset the borrowings until the required margin ratio is satisfied.

Of relevance, clients who assign their equities to “margin” (the only other alternative is called “cash”) so that they can borrow against them also automatically grant their broker-dealer the right to “lend” their assets to another investor who wants to “short-sell” that particular asset because a short-seller must first “borrow” existing stock in order to “sell” it. The broker-dealer makes money by lending out equities in margin accounts to short-sellers. The everyday American investor is unaware of this, and earns nothing.

Leverage

So, how did MF Global lose client assets? In the US, broker-dealers can use margined assets as a funding mechanism, i.e., by borrowing those assets themselves and using them as collateral to borrow. But in the UK, those same borrowed assets can be pledged several times over (called rehypothecation), resulting in very significant leverage. That is, the client assets stand behind several borrowings rather than just one.

Buried somewhere deep in the legalese of the account forms (you know the pages and pages of legal gobbledegook that nobody reads because one has to be an attorney to understand it), the clients gave MF Global the right to transfer those client assets to its UK subsidiary and to “borrow, pledge, repledge, hypothecate, and rehypothecate” those assets.

According to the Thomson Reuters article cited above, such language is common in most large US broker-dealer agreements. That language allows the large broker-dealers to circumvent US law and take advantage of UK law where rehypothecation (leverage) is allowed.

The Impact of Margin Calls

For MF Global, the unanticipated “tail” event occurred. (“Tail” events are only supposed to occur very infrequently. However, in an unstable financial system, they occur often.) When the value of the European periphery debt declined this past fall (even that guaranteed by the EFSF), margin calls occurred. MF Global would have been okay if it hadn’t used so much leverage.

The leverage magnified the margin calls to such an extent that all of the client assets weren’t enough to meet the margin calls. All of the collateral, including the euro debt (at bargain basement prices) and the client assets were sold to offset the borrowings. The clients’ assets are gone. They are not going to be “found.”

Conclusion

No laws appear to have been broken. No one is likely to go to jail. But, as you can see, the financial system is deeply flawed and is rigged in favor of Wall Street and against the ordinary investor. The causes of the financial crisis that appeared in the US in 2009 have not been resolved, only papered over (with money printing). In order to have a “fair” and healthy financial system, the excessive use of leverage, such that success leads to untold wealth for the managers and failure is directly borne by unsuspecting clients or taxpayers, must be changed.  Until this occurs, we will continue to experience such debacles. And the volatility caused by them will continue to keep the financial system unstable and limit economic growth.

Robert Barone  and Joshua Barone are Principals and Investment Advisor Representatives of Universal Value Advisors, LLC, Reno, NV, an SEC Registered Investment  Advisor. Statistics and other information have been compiled from various sources. Universal   Value Advisors believes the facts and information to be accurate and credible but makes no guarantee to the complete accuracy of this information.  Universal Value Advisors, LLC is a registered investment adviser with the Securities and Exchange Commission of the United States.   A more detailed description of the company, its management and practices are contained in its “Firm Brochure”, (Form ADV, Part 2A). A copy of this Brochure may be received by contacting the company at: 9222 Prototype Drive, Reno, NV 89521, Phone (775) 284-7778.

December 7, 2011

Severe Europe-Wide Recession Likely for 2012

Posted in Banking, Europe, Finance, Foreign, government, investment advisor, investment banking, investments, sovereign debt, Stocks, taxes tagged , , , , , , , , , , , , , , , , at 8:25 PM by Robert Barone

NEW YORK (TheStreet) — Given the speed at which markets move, and given the volatility that accompanies the hopes and fears that occur when the key European leaders meet to try to make progress on the European debt crisis, it is somewhat risky to try to describe what will happen to the European Monetary Union (EMU) in 2012. Something that I write today, in early December, could be obsolete as early as next week. So, I will approach this with what I consider to ultimately be the most likely scenario, why it is most likely, and where the remaining dangers lie.

There are two opposing forces in Europe regarding the approach that should be taken to resolve the crisis:

  • Those that want the European Central Bank (ECB) to act just like the U.S. Fed and rapidly expand its balance sheet, either to support a strengthened European Financial Stability Facility (EFSF), or directly. The ECB has no mandate in its charter to do this;
  • Those that want the causes of the crisis, overspending and out of control deficits via entitlement and social welfare spending, to be addressed. While these folks appear to be the minority among the political class, their strength lies in the fact that the politicians representing the economically strongest EMU member, Germany, hold this view.

As an aside, some have wondered why the euro has kept its value high vis-à-vis the U.S. dollar. It is precisely because the ECB hasn’t significantly expanded its balance sheet while the U.S. Fed has. In fact, the big worldwide market rally on Nov. 30 due to the “coordinated” central bank policy of insuring liquidity for Europe’s banks, was a “dollar” policy, i.e., dollars, not euros were made available. So far, the ECB appears to have remained faithful to its mandate as the guardian against inflation, and nothing else.

Most Likely Scenario

The U.S. Fed tripled the size of its balance sheet with some apparent success at keeping its financial system from collapsing and, until now, those actions appear to have had no apparent large unintended consequences. There has been some moderate inflation officially reported (and disputed by some), and some believe that the Fed’s balance sheet expansion has been behind the rapid rise in commodity and food prices. But given the apparent success in staving off financial collapse with such policies, the most likely scenario is the first one outlined above, i.e., the use of the ECB or some structure around it (including the EFSF and the International Monetary Fund (IMF)) to directly purchase or partially guarantee the sovereign bonds of the peripheral countries.

>>Saving Euro a Tall Order, Even for Germany

The “bazooka” theory appears to apply here. As long as the market knows that the ECB has a bazooka (the power and authority to print euros), and is willing to use it, it won’t have to. As U.S. Treasury Secretary, Hank Paulson found out in 2009 that the “bazooka” theory doesn’t always work. Time and again, the capital markets have demonstrated that they are much more powerful than any central bank or sovereign treasury.

Verifiable Austerity

The most likely scenario, then, is an emerging consensus in Europe as follows: Through a series of bilateral agreements to avoid having to get 17 separate countries to approve changes to the treaties that govern the EMU, a painstakingly long process, the offending peripheral countries (Italy, Portugal, Spain, and perhaps, Ireland) may agree to some level of verifiable austerity with benchmarks and external audits. In return, Germany and its political allies will permit the ECB to expand its balance sheet either by directly purchasing the sovereign debt of the peripheral countries, or by making credit available to the EFSF or whatever structure emerges.

Once again, as an aside, under this scenario, you can expect the value of the euro to fall relative to other currencies. Of course, if the U.S. Fed embarks on QE3, the euro’s relative value to the dollar may well hold.

Recidivism?

Of course, once the crisis atmosphere passes and things settle down, under this most likely scenario, the peripheral countries may not feel the pressure to continue with their promised austerity. Don’t forget, politics plays a large role and austerity often leads to political defeat for those politicians who negotiated it. Already we have seen political changes in Greece, Italy and Spain as a result of this crisis.

Perhaps these countries will follow Greece’s lead and hire Goldman Sachs to help them issue off the books debt so that they have the appearance of complying with their austerity promises. That could very well buy several years, as it did for Greece. (Ireland appears to be an exception. After their bailout, they appear to have abided by their austerity promises and have made great progress in addressing their fiscal and economic issues. Then, again, none of Ireland’s shores touch the Mediterranean Sea.)

Issues Remain

So, as we enter 2012, the stage is set for some calming over Europe’s sovereign debt and the solvency of Europe’s banks. Mind you, it may be a rocky road over the near term to get there including setbacks and lots of uncertainty and market volatility. The biggest issues will likely revolve around the magnitude of the guarantees and the capacity of the guaranteeing entities. Nevertheless, the most likely scenario is coming into clearer focus.

Unfortunately, this scenario, or any other one that emerges, means recession in Europe, most likely severe recession. This has implications for markets worldwide, as Europe’s economy matches or exceeds the size of the U.S., depending on which countries you include. Once again, the recession, coupled with the austerity measures, may change the political backdrop such that the populations of some of the peripheral countries may well want to exit the EMU.

While 2012 may bring calmer conditions, even if the most likely scenario is executed, the future of the euro and the EMU is still not assured. It rests on the effectiveness of the fiscal controls. If EMU members retain sovereignty over their fiscal policies, then there has to be some mechanism to expel fiscal offenders from the EMU in an orderly manner. Without this, we may well see a replay of this crisis within the decade. Let’s hope there is enough political courage to include such measures.

Robert Barone  and Joshua Barone are Principals and Investment Advisor Representatives of Universal Value Advisors, LLC, Reno, NV, an SEC Registered Investment  Advisor. Statistics and other information have been compiled from various sources. Universal   Value Advisors believes the facts and information to be accurate and credible but makes no guarantee to the complete accuracy of this information.  Universal Value Advisors, LLC is a registered investment adviser with the Securities and Exchange Commission of the United States.   A more detailed description of the company, its management and practices are contained in its “Firm Brochure”, (Form ADV, Part 2A). A copy of this Brochure may be received by contacting the company at: 9222 Prototype Drive, Reno, NV 89521, Phone (775) 284-7778.

 

November 30, 2011

Why Central Banks’ Action Could Make Matters Worse

Posted in Banking, Big Banks, Bonds, Capital, community banks, crises, derivatives, Europe, Finance, Foreign, government, investment advisor, investment banking, investments, sovereign debt, Stocks, taxes tagged , , , , , , , , , , , , , , , at 9:47 PM by Robert Barone

NEW YORK (TheStreet) — Over the past 18 months, we have witnessed the emergence of what has become known as the “European Debt Crisis.” Capital markets have become increasingly concerned over the sovereign debt of the European peripheral countries and the solvency of the financial institutions that hold much of that debt. You can tell from the 10-year borrowing rates shown in the table below exactly where the concerns reside.

Solvency issues manifest themselves in liquidity issues. Looking at the table, you can see that investors are hesitant to lend to the lower tier without significant compensation for the credit risk they know they are taking. The solvency issue also plays havoc with the ability of the banks to access the short-term capital markets for their everyday liquidity needs. And, in some cases, especially among the banks in the lower tier countries in the table, those liquidity strains are huge.

If you were a Greek citizen, for example, wouldn’t you go to your bank and withdraw all of the euros you could and put them in your mattress? That is, in order to protect yourself from the prospect of waking up one morning to find that your account was no longer denominated in euro, but in “new drachma” converted on a 1:1 basis, and the free market value of that “new drachma” was such that it took 4 to purchase 1 euro? So, the silent run currently occurring on Greek banks is not surprising.

>>The Real Reason Behind the Central Bank Scramble

A similar phenomenon is beginning to happen to the continent’s banks. This is showing itself in the form of an unwillingness of financial institutions to lend to each other and a severe tightening of the private sector money markets.

So, the coordinated move of the central banks announced today is a reaction to the near shut down of the money markets and it makes liquidity available to the continent’s banks. But, this is not the end of the story because this move only addresses the symptoms (the resulting liquidity issues), not the cause (the solvency issues). As we know in America, the Savings and Loan Industry in the 80s was able to access the money markets in $100,000 increments due to FDIC insurance. As a result, the solvency issues weren’t addressed early when they were relatively small. But, eventually, they had to be dealt with.

Thus, the move by the central banks, by printing money and making it readily available to the banks, only postpones the inevitability of having to solve the solvency issues. It buys time. The tradeoff is twofold:

1) it increases inflationary pressures;

2) it allows the solvency problem to continue to fester, and perhaps, become even worse.

The sovereign nations have two choices: inflation or austerity. They would choose the former except for Germany’s resistance. That story is still being played out. For the banks, significant recapitalizations must occur. We are likely to see a lot more drama played out on this issue, especially if one of the larger institutions has a misstep or is attacked by the marketplace as we saw in the U.S. in 2009.

Robert Barone  and Joshua Barone are Principals and Investment Advisor Representatives of Universal Value Advisors, LLC, Reno, NV, an SEC Registered Investment  Advisor. Statistics and other information have been compiled from various sources. Universal   Value Advisors believes the facts and information to be accurate and credible but makes no guarantee to the complete accuracy of this information.  Universal Value Advisors, LLC is a registered investment adviser with the Securities and Exchange Commission of the United States.   A more detailed description of the company, its management and practices are contained in its “Firm Brochure”, (Form ADV, Part 2A). A copy of this Brochure may be received by contacting the company at: 9222 Prototype Drive, Reno, NV 89521, Phone (775) 284-7778.