October 18, 2011

Seven Reasons Bank Stocks May Keep Falling

Posted in Banking, Big Banks, Bonds, Capital, community banks, crises, derivatives, Finance, Forward thinking, government, investment advisor, investment banking, investments, local banks, municipal bonds, San Francisco, Stocks, taxes, Uncategorized tagged adviser, advisor, ancora, ancora west, ancora west advisors, bank balance sheet, Banking, Ben Bernanke, Bob Barone, bonuses, confidence, consumer debt, consumption, Debt, devaluing US dollar, economic policy, economics, fair value, FAS 157, FDIC, Federal Reserve, Finance, financial adviser, foreclosure, Home Prices, hostile attitued of FDIC, Inflation/Deflation, job creation, Josh Barone, Joshua Barone, mark to market, Matt Marcewicz, nevada, Obama, Recession, reno, retail sales, Robert Barone, shelia bair, small business, TARP, taxpayer, too big to fail, U.S. Treasury, unemployment at 10:22 PM by Robert Barone

• Occupy Wall Street – while not a cohesive movement, at least part of its birth can be traced to outsized Wall Street salaries and bonuses, especially since the taxpayer saved most of the TBTF banks.  Bank Transfer Day (11/5), the day on which Americans are supposed to transfer their deposits to community banks, is more symbolic than real, as the “Too Big To Fail” (TBTF) banks core consumer deposits are only a small portion of their liabilities and can easily be replaced with no or low cost funding from the Fed or elsewhere.  Nevertheless, Bank Transfer Day is a PR issue for the large banks;

• Margin squeeze – TBTF have used the arbitrage spread between borrowing costs (near 0%) and Treasury yields (2%+) to profit.  And, the purchase of Treasury securities requires no capital under the capital regulations, as Treasuries are “risk free.”   The Fed’s new policy of “Operation Twist” targets  longer term interest rates and squeezes this arbitrage spread;

• Volcker Rule – this has recently been put out for comment by the FDIC.  It severely limits trading profits made for the bank’s own account and is likely to have a big impact on TBTF trading profits going forward;

• Debit card monthly fees – although such fees are a direct consequence of the limitation on debit swipe fees by the Fed under Dodd-Frank, and it was common knowledge that the TBTF banks would find a way to increase fees elsewhere to make up for their losses on the swipe fees, the timing has turned out to be lousy and the TBTF banks are taking a PR hit from the press, and even from the sponsors of Dodd-Frank who clearly knew that there would be unintended consequences;

• Exposure to Europe – According to Michelle Bachmann, the U.S. TBTF Banks have a $700 billion exposure to European Banks.  So, a freezing up of liquidity flows to those institutions may have an impact on the value of such holdings.  It is clear that the Fed and the European Central Bank will intervene with massive liquidity injections if such events unfold.  Nevertheless, the risk of such a freeze up exists.  Furthermore, if contagion spreads because of a Greek default, there is no doubt that the TBTF equities will be negatively impacted.  So far, we have seen the equity prices of these behemoths ebb and flow with the news (or hope) out of Europe regarding their evolving “rescue” plan;

• Mortgages & Foreclosures
• Foreclosures at the TBTF institutions are rising because moratoriums have expired and “robo” issues have been addressed.  In addition, so called “Prime” loans in portfolios (usually “Jumbo” loans – those that are larger than the FNMA limits) are becoming a big issue as there is a clear trend toward rising “strategic” foreclosures.  In fact, Fitch recently downgraded many of these “prime” mortgage pools.  This calls into question the quality of what may be on the TBTF balance sheets in the form of such jumbo loans.  Furthermore, the fact that FNMA and FHLMC reduced their loan maximums on October 1st is destined to have a huge negative impact in states like CA and FL, where the prices of higher end properties will fall due to the unavailability of financing.  So, expect “strategic” defaults to rise rapidly in these states;

• Lawsuits
  • Half of America’s mortgages are on MERS (Mortgage Electronic Registration System), but, in many states, MERS has no standing in foreclosure.  Theoretically every owner of a securitized pool should sign off on each foreclosure in the pool.  There could be hundreds, if not thousands, of owners in these pools.  In addition, many jurisdictions require that title transfers be recorded in county recorder offices.  Since that did not occur, lawsuits are now being developed against the major TBTF players for lost recording/title transfer fees.  The Dallas DA recently sued MERS and BAC for $100 million of such fees.  According to Mark Hanson, since MERS has been operating since 1995, there could be billions of dollars of such thwarted fees.   Because nearly every local governmental entity is hungry for funds, this could catch on like wildfire;
  • Bank of America’s (BAC) $8.6 billion global servicer settlement is in trouble, as NY’s AG Schneiderman says it should be closer to $25 billion, and he is getting support from other states, like CA.  The rumor mill has circulated the theory that if lawsuit settlements become outsized, BAC appears to have the option of bankrupting the old Countrywide unit, which it has kept as a separate legal entity since its purchase in 2008.  Imagine, though, the market reaction to such a move!
  • Lawsuits on mortgage trustees are just starting.  According to Bloomberg, US Bank, Bank of NY Mellon, Deutsche Bank, Wells Fargo, HSBC, BAC and Citibank (C) are the major mortgage trustees.  Bloomberg speculates that since these institutions didn’t underwrite, sell, securitize, service, or ship loans according to regulations, the odds are low that the trust departments got it right.  So far, NY’s Schnedierman has requested documents from Deutsche Bank and Bank of NY Mellon.
  • In early September the Federal Housing Finance Agency (FHFA), the receiver for FNMA and FHLMC, sued BAC, C, JPMorgan Chase (JPM), Barclays, HSBC, Credit Suisse, and Noruma Holdings demanding refunds from these institutions for loans sold to FNMA and FHLMC that were based on false or missing information about the borrowers or the properties.  The FHFA said that the two mortgage giants purchased $6 billion from BAC, $24.8 billion from Merrill Lynch which is now owned by BAC, and $3.5 billion from C.
  • Lawsuits and foreclosure issues are making the TBTF banks sorry they are in the mortgage business.  JPM’s Dimon announced that they are going to be leaving the mortgage business, and BAC announced last week that by year’s end they will stop buying mortgages from correspondents.

Not all of this appears to be priced in the market, so there may be continued downward pressure on the prices of financial stocks, especially TBTF, as events unfold, especially the potentially disruptive forces that Europe may unleash, or the conclusion that the foreclosure and mortgage lawsuits are larger and more significant than currently believed.

Robert Barone, Ph.D.

October 12, 2011

Permalink 2 Comments

September 13, 2011

The “New Normal” May Trump Political Courage

Posted in Banking, Big Banks, Bonds, Capital, community banks, crises, derivatives, Finance, Forward thinking, government, investment advisor, investment banking, investments, local banks, municipal bonds, San Francisco, Stocks, taxes, Uncategorized tagged adviser, advisor, ancora, ancora west, ancora west advisors, bank balance sheet, Banking, Ben Bernanke, Bob Barone, bonuses, confidence, consumer debt, consumption, Debt, devaluing US dollar, economic policy, economics, fair value, FAS 157, FDIC, Federal Reserve, Finance, financial adviser, foreclosure, Home Prices, hostile attitued of FDIC, Inflation/Deflation, job creation, Josh Barone, Joshua Barone, mark to market, Matt Marcewicz, nevada, Obama, Recession, reno, retail sales, Robert Barone, shelia bair, small business, TARP, taxpayer, too big to fail, U.S. Treasury, unemployment at 10:23 PM by Robert Barone

There are two huge issues facing the American economy today.  The first is a government that doesn’t understand why the economy isn’t growing, and, in fact, promotes policies that inhibit such growth, such as overregulation, interference, and the deployment of more debt as the answer.  The second issue is that inability to grow.  The two issues are closely related.

Despite Promises, Federal Spending is Out of Control

In looking at the trends in the Federal budgets, especially over the last decade, one word comes to mind – gold!  Despite all of the hand wringing and promises about spending cuts, it just doesn’t happen.  According to the Wall Street Journal (August 24), CBO projects that total Federal spending for fiscal year 2011 (which ends at the end of this month), will be $141 billion higher than 2010, and even higher than that of 2009 which was supposed to be the temporary spending peak.  The growth in Federal spending just for 2011 will be 4% higher than that of 2010.  Furthermore, exactly one month after the brouhaha over the debt ceiling in which a “temporary” debt ceiling cap some $400 billion higher was enacted, we find that the total debt has again exceeded the ceiling (Zerohedge, Déjà vu All Over Again…, 9/2/11).  Growth in Federal spending over the 50 years ending in 2010 has been at a compounded annual rate (CAGR) of 6.5%, while the growth rate of GDP during that same span was 5.7%.  Everyone knows that continual growth in Federal spending that exceeds the growth in the economy is simply unsustainable.  This, of course, has all come to a head because in the last 10 years, Federal spending grew at a CAGR of 7.1% compared to a CAGR of GDP of 3.9%.

Growth Rate of Entitlements

It isn’t a secret that the biggest issue in Federal spending is the so-called “entitlement” issue (although some object to the characterization of some aspects of “entitlements”, having contributed to Social Security and Medicare for all of their working lives).  Defining “entitlements” as “transfer payments” from the government to individuals, and going back to 1960, we find that such “transfers” were 26% of Federal tax collections.  Since then, those “transfers” have grown at a CAGR of 7.8%, while tax receipts and the economy have grown substantially more slowly, 5.6% and 5.7% respectively.  Thus, in 2010, “entitlement” payments were over 92% of Federal tax receipts.  That percentage was 64% as late as 2007, and has grown because of the demographics of Social Security and Medicare, but more so because of a massive jump in “Income Security” payments (defined by USDebtClock.org as Supplemental Security Income, Earned Income Credits, Unemployment Compensation, Nutrition Assistance, Family Support, Child Nutrition, Foster Care, and Making Work Pay).

Current Trends Mean Exploding Debt Ratios

Table 1 extrapolates current budget, tax and demographic trends using the underlying assumptions shown, most of which are drawn from CBO estimates for 2015 and then extrapolated further.

Table 1: GDP Growth = 3% CAGR

Because CBO assumed that the spike in “Income Security” that has occurred since ’07 would largely dissipate by 2015, the “entitlement” ratios shown in Table 1 all shrink until 2015.  However, despite the low (optimistic) 1.6% growth in per capital Social Security and Medicare expenditures of CBO, the “entitlement” ratios rise rapidly after 2015.  Worse, even under this extremely rosy set of assumptions, including the return of the tax take to 18% of GDP by 2015, the deficit as a percentage of GDP remains unsustainable, and the Debt/GDP ratio rises inexorably.

What Political Courage Means

Given this base case scenario, what do the Washington politicians have to do to fix the situation.  Table 2 uses the same model as Table 1 with the following changes:

• The Social Security and Medicare growth rates are reduced from 1.6% to 1.0% over the forecast horizon;
• The CAGR of the “Income Security” category is reduced from 1.0% after 2015 to 0.5%;
• The CAGR of Defense spending is reduced from 1.7% to 1.0%;
• The CAGR of Federal Pensions is reduced from 2.5% to 0.5%;
• Total Federal spending only grows at a CAGR of 0.5% over the forecast horizon;
• The tax take as a percent of GDP rises to 19%;
• GDP growth remains at a CAGR of 3% over the forecast horizon.

Table 2: GDP Growth = 3% CAGR

As is evident from the table, if the Washington politicians can find the courage to make hard decisions around the growth rate of “entitlements” and put itself on a no growth (0.5% – likely less than the rate of inflation) budget (still giving Washington 21.5% of America’s GDP, an historically high number), all of the critical ratios either slow their climb or reverse course.  Yet, even under such a politically unlikely scenario, many would say that even the outcome shown in Table 2 is not acceptable.

The “New Normal” May Trump Political Courage

Critical to this analysis is the growth rate of the GDP.  Clearly, a faster rate than the 3% shown above would have better results.  But a faster growth of GDP implies higher rates of inflation, and it is unlikely that the spending assumptions for Table 2 could be accomplished in an environment with significant inflation.  In real terms, the CAGR of GDP has been 3.1% over the 50 year period ended in 2010, but only 1.6% since 2000.  Recently, PIMCO’s Bill Gross stated that he believes that the U.S. has structurally changed such that nominal GDP growth will average between 0% and 2%.  Literally, this is more of the same anemic growth that we have seen in the U.S. since ’07.

Table 3 embodies the same assumptions as Table 2 except the CAGR of the GDP is reduced to 1%, per PIMCO’s view.

Table 3: GDP Growth = 1% CAGR

Thus, even if the Washington politicians can summon the courage to do what they have never been able to accomplish in the past and slow the growth of “entitlements” and its own profligate spending, the debt and deficit levels remain unacceptable if the economy grows in nominal terms at PIMCO’s “new normal.”  This threatens the U.S.’s status in the world, and certainly the dollar’s role as the world’s reserve currency.

Conclusion

It is imperative that U.S. economic growth return to its historic path of 3%.  And even then, the economic results depend on the level of political courage from the Washington pols.  To accomplish a return to economic health, fiscal and monetary policies must first return to balance.  Fiscal policy must refrain from the gimmicks used in the recent past, like cash for clunkers or homeowner tax credits, which have simply pulled demand forward, and monetary policy must stop monetizing the deficit.  Rather, the encouragement of investment through a rational and sane tax policy (e.g. flat tax or national sales tax), a reduction in government interference in the private sector (e.g., Dodd-Frank, the EPA, and Obamacare), and the use of policy to encourage the development of the nation’s natural resources (e.g., cheap energy) would be a good start to revive the nation’s economy.  But, as an election year approaches, doesn’t the word “gold” ring true?

Robert Barone, Ph.D.

Matt Marcewicz

September 6, 2011

Permalink Leave a Comment

August 19, 2011

The Mortgage Market – An Impediment to Economic Growth

Posted in Banking, Big Banks, Bonds, Capital, community banks, crises, derivatives, Finance, Forward thinking, government, investment advisor, investment banking, investments, local banks, municipal bonds, San Francisco, Stocks, taxes, Uncategorized tagged adviser, advisor, ancora, ancora west, ancora west advisors, bank balance sheet, Banking, Ben Bernanke, Bob Barone, bonuses, confidence, consumer debt, consumption, Debt, devaluing US dollar, economic policy, economics, fair value, FAS 157, FDIC, Federal Reserve, Finance, financial adviser, foreclosure, Home Prices, hostile attitued of FDIC, Inflation/Deflation, job creation, Josh Barone, Joshua Barone, mark to market, Matt Marcewicz, nevada, Obama, Recession, reno, retail sales, Robert Barone, shelia bair, small business, TARP, taxpayer, too big to fail, U.S. Treasury, unemployment at 9:54 PM by Robert Barone

The lack of clarity surrounding U.S. and worldwide economic growth certainly played a big role in the recent Wall Street sell off.  In part, it was precipitated by the “debt ceiling” prank that was played upon the country and the world, especially after the market dissected the deal and found that, through the use of smoke and mirrors, economic growth (and therefore tax revenues) was assumed to be 4%, a growth rate that is hard to fathom, at least for the U.S. and Europe, given the financial landscapes in these two major consuming regions.

Housing & GDP

Housing is a case in point.  The direct contribution of Residential Fixed Investment to GDP was 4.8% in 1990, 5.2% in 2000, and 6.1% during the housing boom of 2005.  In this year’s first half, it registered 2.2%, the lowest level since records have been kept.  This measure of housing’s impact on GDP significantly understates its importance.  Ancillary to housing are such things as furniture and furnishings, appliances, demand for utilities, demand for other services such as landscape and repair, etc.  Then there is the multiplier impact of the earnings of construction workers as they spend those incomes in the course of everyday living.  It can be said with a high degree of certainty that U.S. economic growth will be weak until housing returns to some semblance of health.  Historically, changes in housing construction have contributed significantly to the business cycle, both to pushing the economy into recession, and to lifting it out.   In most post-WWII recessions, a housing turnaround usually starts before the recession ends.  Given the state of housing today, is it any wonder why the U.S. economy is at stall speed?

The Swinging Pendulum

In 2005 and 2006, if you could breathe, you could get a mortgage loan with little or nothing down and just your word on whether or not you could afford the payments.  But today, just when the economy needs a growing housing sector, the pendulum has swung to the other extreme.  Not only have most mortgage companies disappeared, but the criteria to qualify for those that are still in business are the strictest they have ever been.  In addition, Congress and the states have now placed many obstacles into the mortgage lenders’ paths including the promotion of legal actions against the largest mortgage lenders (or their successors) and the provision of legal aid, in the form of obstacles to the foreclosure process, to underwater homeowners who have quit making payments.

• Bank of America (BAC) has tried to extract themselves from the litigation cesspool resulting from their acquisition of Countrywide with an $8.5 billion global settlement, which still has to be approved by the court. (Just think – BAC purchased this garbage heap without any government assistance – does this say something about BAC management?)  But, NY State’s Attorney General has decided that $8.5 billion is completely inadequate, indicating that the settlement should be in the $22 to $27.5 billion range.  At the same time, AIG is planning to sue BAC for $10 billion on the grounds that the mortgages it purchased from Countrywide were misrepresented (whatever happened to due diligence or buyer beware, especially for “sophisticated” investors?).

• With all this going on, it isn’t any wonder that Jamie Dimon has decided to remove JPMorganChase (JPM) entirely from the mortgage business.  Dimon has proven over the years that he is an industry leader, so, his withdrawal from the mortgage business may be an omen of things to come.

• Meanwhile, states are passing legislation aimed at “helping” consumers, but with vast unintended consequences for the mortgage markets.  Don’t misunderstand – I am not arguing in favor of the mega banks and Wall Street who have significant responsibility for the current state of housing in the U.S.  But, litigation and legislation could have the unintended consequence of further slowing and postponing any housing rebound:

• According to Mark Hanson of M Hanson Research, California recently passed legislation prohibiting second lien holders from filing deficiency judgments in short sales.  Immediately JPM pulled all of their short sale second lien buyout acceptances, which forgive significant second lien deficiencies for a price of $3,000 to $5,000, and is now asking for 50% of the note amount.  This will nullify the short sale and force the first lienholder to foreclose, now giving JPM the right to a deficiency judgment.  Such legislation may have an adverse and unintended consequence of scuttling the short sale market in California, just when real progress was being made.

• Nevada leads the nation in underwater mortgages.  Zillow reports those numbers are as high as 80% in Las Vegas and 70% in Reno.  To deal with this, the last Nevada legislature passed legislation which prohibits a first lienholder from collecting a deficiency judgment on a primary residence short sale.  This means that everyone underwater can walk away without significant consequences and presages even more short sales and foreclosures.  In addition, another law prohibits note holders who purchased mortgage notes at a discount from collecting more than they paid for the note in a foreclosure process.  The consequences of such interference can potentially be disastrous for the secondary mortgage market.  Taken to its logical conclusion, no one would be willing to purchase troubled loans at a discount because the best return possible is just a return of capital.

Bank Capital

Another drag on the mortgage market, and, in fact on the market for all non-government guaranteed private sector loans, is the push on the part of regulators to drive bank capital levels higher.  Too much leverage along with the repeal of Glass-Steagall certainly played a large role in the global financial crisis, whose second act is currently on stage in Europe.  Bank capital and liquidity ratios are now under close scrutiny, and the Basle III accords will require banks to hold significantly more capital and in purer form.  To “preserve” their capital and meet the stricter requirements, banks will prefer to invest in items exempt from the capital requirements (like government guaranteed paper) rather than placing assets in areas requiring high capital retention.  (The spenders in Washington appear to be quite comfortable with this!)  The unintended consequence here will be fewer “risky” loans, and those that are made will be at much higher interest rates to compensate for the additional capital required.

Qualified Residential Mortgage (QRM) and Qualified Mortgage (QM)

The Dodd-Frank legislation is also in the process of imposing significant restrictions on mortgage lenders.  One Washington lawyer, Laurence Platt, recently remarked that “the natural consequence of QM and QRM is that only the most privileged borrowers in our country will be able to get mortgage loans…”

QRM requires lenders to meet strict underwriting standards, which will be written into Fannie Mae and Freddie Mac guidelines.  Failing that, the lender must retain 5% of the credit risk if the loan is sold or securitized.  QRM requires a minimum 20% down payment and very low debt to income ratios.  The FDIC has indicated that approximately $8.5 trillion of currently outstanding mortgage loans would not have qualified under these guidelines.  Lenders have testified that any non-QRM loan would be very expensive for consumers.

More scary is the QM standard which prohibits such things as negative amortization loans, loans with balloon payments, or loans with terms exceeding 30 years.  But the kicker to QM, as proposed, is that there are severe legal and monetary penalties to lenders if it is determined that the borrower did not have the “ability to repay” at the time the loan was originated.  Even “unintentional” violations can be fined at $5,000/day.  Imagine what the legal profession is going to do to this “ability to pay” standard.  I suspect that the fact that the home went into foreclosure will be a strike against the lender under QM.

Clearly, both the QM and QRM compliance nightmares discourage the reappearance of the small mortgage companies that dotted our landscape just a short 5 years ago.  Only the large institutions can afford the compliance here, and, as discussed above, they have other significant impediments to being in the mortgage business.

Fannie and Freddie Cutbacks

The bankrupt Fannie Mae and Freddie Mac, which currently purchase more than 90% of mortgages made today, are significantly reducing their loan maximums effective October 1.  This can’t be anything but negative for the mortgage markets.  As these two behemoths continue to cost taxpayers billions of dollars every month, sooner or later (certainly not until after the 2012 elections) their losses will have to be addressed.  Fannie and Freddie alone, in the current environment, cannot support a growing mortgage market with reasonably priced mortgages, a requirement for the U.S. economy to prosper.

Where are the Cash Down Payments?

According to Zillow, 26% of mortgages in the U.S. are underwater with some markets significantly higher.  Mark Hanson has made the point several times that when short sales or foreclosures occur, the former homeowner generally has no cash or resources to use as a down payment on another home.  (No wonder apartment REITs are booming!)  This alone culls the pool of potential home buyers.

Conclusion

In the end, the impediments to the mortgage market appear significant: litigation, new consumer “friendly” legislation, higher bank capital requirements, QM and QRM compliance issues, and lower maximum loan amounts from the bankrupt Fannie Mae and Freddie Mac entities are all coming together at once.  The reduction of the availability of mortgage money is a certainty.  In addition, a large swath of consumers with underwater mortgages and those with excessive credit debt burdens simply have no funds for the down payments that will now be required under the Dodd-Frank legislation.  Under such conditions, it is likely that home prices will continue their downward spiral and new home construction will continue at record low levels.

As stated at the beginning of this piece, housing has historically led the economy out of recessions.  Not this time!  Without a healthy housing sector, economic growth is significantly constrained.  Under these circumstances, the idea of 4%, or even 3%, economic growth reappearing in the U.S. anytime soon is a dream only Washington politicians can harbor.  The reality is that without a healthy housing sector, even 2% long term growth seems like a stretch, and the economy will remain vulnerable to outside shocks.

Robert Barone, Ph.D.

August 15, 2011

Permalink 1 Comment

July 13, 2011

Gold – Is it a Bubble?

Posted in Banking, Big Banks, Bonds, Capital, community banks, crises, derivatives, Finance, Forward thinking, government, investment advisor, investment banking, investments, local banks, municipal bonds, San Francisco, Stocks, taxes, Uncategorized tagged adviser, advisor, ancora, ancora west, ancora west advisors, bank balance sheet, Banking, Ben Bernanke, Bob Barone, bonuses, confidence, consumer debt, consumption, Debt, devaluing US dollar, economic policy, economics, fair value, FAS 157, FDIC, Federal Reserve, Finance, financial adviser, foreclosure, Home Prices, hostile attitued of FDIC, Inflation/Deflation, job creation, Josh Barone, Joshua Barone, mark to market, Matt Marcewicz, nevada, Obama, Recession, reno, retail sales, Robert Barone, shelia bair, small business, TARP, taxpayer, too big to fail, U.S. Treasury, unemployment at 9:23 PM by Robert Barone

Is the price of gold too high?  Too low?  Is it in bubble territory, ready to drop rapidly?  Think about what bubbles are – you know there is a bubble when everyone is trying to participate.  For example, during the dot.com bubble, my tennis pro was buying and selling options several times per day!  I knew we were in a bubble.  I even told him so.  And, during the housing bubble, all of the chatter at cocktail parties was about flipping houses as a side business.  I knew we were in a bubble (just didn’t know how frothy it really was!)  People say to me all of the time when I talk about gold: “I would love to own gold, but its price is just too high.”  Hmm!  Too high relative to what?

The price of gold certainly can be fickle.  After all, unlike other commodities that are essential inputs into some vital process (e.g. the production of energy or food), besides some very minor industrial applications, gold really has few practical uses (jewelry and art excepted).  There is nothing intrinsic in gold to give it value.  There is no cash dividend or earnings.  It goes up and down in value at the whims of investor demand.

Gold does have three characteristics that make it unique: 1) it is rare and hard to find (all the world’s gold is estimated to fit into two Olympic sized swimming pools); 2) it doesn’t change form – all of the gold ever mined is still with us as gold; 3) it cannot be “produced” via the combination of other materials.  Thus, its supply is well defined and increases very slowly and at great expense.  Thus, it is perfect as a medium of exchange or a store of value.

We all know what makes the demand for gold go up – distrust in fiat currencies, and government deficits resulting in paper money printing.  And that, of course, is why gold is rising in value today.  As long as that goes on, the price of gold will keep on rising. So, what could happen to make it fall in value?  I have listed several things below which could happen – I will let you be the judge of their likelihood:

• The U.S. and the rest of the developed world (Europe) stop running fiscal deficits and stop printing money.  There is an immediate opportunity for this to begin in the U.S. if the GOP and Obama Administration can agree on significant spending cutbacks.  This means entitlement reform.
• The U.S. economy magically finds its feet and its growth rate increases such that the unemployment rate begins to rapidly fall without additional monetary or fiscal stimulus.  Interest rates would be rising too.
• As a subset of the above, housing prices find their bottom and begin to rise with home sales and new home construction picking up.
• The dollar reverses is slide as the premier world reserve currency and becomes demanded because of its intrinsic strength, not just because it is better than all of the other bad alternative currencies (e.g., the Euro). (This requires fiscal and monetary discipline and a reduction in both public and private debt loads.)

As long as gold is viewed as the ultimate monetary unit, its value will increase (decrease) with the debasement (strength) of the fiat currencies.

Robert Barone, Ph.D.

July 13, 2011

Permalink Leave a Comment

July 12, 2011

Italian Contagion

Posted in Banking, Big Banks, Bonds, Capital, community banks, crises, derivatives, Finance, Forward thinking, government, investment advisor, investment banking, investments, local banks, municipal bonds, San Francisco, Stocks, taxes, Uncategorized tagged adviser, advisor, ancora, ancora west, ancora west advisors, bank balance sheet, Banking, Ben Bernanke, Bob Barone, bonuses, confidence, consumer debt, consumption, Debt, devaluing US dollar, economic policy, economics, fair value, FAS 157, FDIC, Federal Reserve, Finance, financial adviser, foreclosure, Home Prices, hostile attitued of FDIC, Inflation/Deflation, job creation, Josh Barone, Joshua Barone, mark to market, Matt Marcewicz, nevada, Obama, Recession, reno, retail sales, Robert Barone, shelia bair, small business, TARP, taxpayer, too big to fail, U.S. Treasury, unemployment at 9:17 PM by Robert Barone

Just a couple of weeks ago, with the supposed “solution” to the Greek crisis, many market participants thought that the politicians had bought at least several months of relief from the European debt crisis.  But, just as the markets attacked the stocks of both Morgan Stanley and Goldman Sachs after the failure of Lehman, it should have been expected that the markets would go for the European Monetary Union’s (EMU) jugular, Italy.  And, it didn’t take long.

Too Big To Bail

Logically, Italy’s debt was always going to be the issue that determined the EMU’s fate.  That is because Italy’s sovereign debt outstanding is over €1.6 trillion (compared to €345 billion for Greece, and €150 billion for both Portugal and Ireland), its debt/GDP ratio is a punishing 120%, and its estimated annual funding needs will run at roughly €250 billion.  That annual funding need is larger than the other European PIGS (Portugal, Ireland, Greece and Spain) combined.  Because the remaining capacity of the ESFS (European Financial Stability Facility) is just €320 billion, it is not big enough to finance Italy’s borrowing needs for more than a year, much less deal with Ireland, Portugal and Spain.  Thus, Noruma Securities had dubbed Italy as “Too Big to Bail” (TBTB).  In the end, it would be up to Germany and France, the two biggest economic powers in the EMU, to save Italy, the third biggest economy.  That would require a commitment of more than €500 billion, or about 10% of their combined economies, a figure that is probably not politically doable.

Nonchalance

While there appears to be some concern in the financial markets about the European debt issues, the markets appear nonchalant about it.  The “contagion” so far appears to be limited to some of Europe’s banks and to the markets for PIIGS debt (Portugal, Ireland, Italy, Greece and Spain).   For example, the VIX for U.S. equities is barely off its lows.  Our belief is that this situation is much more serious than embodied in the current market reaction, and the “contagion” could easily spread worldwide:

• A selloff in Italian bonds could put pressure on the Italian banking system (which holds 6.33% of Italy’s sovereign debt according to JPMorganChase), which could lead to fears of insolvency.  This, in turn could lead to bank runs and perhaps some failures.  But it surely would require government intervention (perhaps nationalization) and capital raises (if possible);
• Any resulting bank bailouts would add more debt to an overburdened Europe, thus exacerbating an already critical debt situation;
• But, the most dangerous “contagion” is most likely in the Credit Default Swap (CDS) arena which is extremely difficult to quantify because it remains unregulated.  As with Greece, any default runs the risk of triggering CDS payments.  And, it is not known if the CDS counterparties have sufficient capital to pay in the event of a default by Greece, much less Italy.  For all we know, there may be another AIG out there, or perhaps a CDS event may fatally wound a large systemic worldwide financial institution.

Our view is that this situation is much more dangerous than the markets have priced in.

Robert Barone, Ph.D.

Matt Marcewicz

July 12, 2011

Permalink Leave a Comment