Tuesday, October 13, 2009

The Financial Markets

I was out of town for most of last week so you'll have to excuse my absence during one of the most important financial news weeks of the year. There's so much to cover I'd like to try and take it in three parts:

1. Financial Markets
2. The Dollar
3. Precious Metals

Let's start with the financial world:

Imagine that you are a bank that lent someone $1 million to buy a home. That home is now worth $600,000, so you are $400,000 "underwater." Other than that loan you have $300,000 in cash set aside as reserves for future losses.

If the borrower were to default on the $1 million mortgage, you would be forced to take a $400,000 write down on your books.

$300,000 - $400,000 = (Negative $100,000)

This means that you are currently insolvent, under water, or on your way to bankruptcy. However you would like to describe it.

This is the current environment for our entire financial system. Everyone is currently underwater, thus there are no new loans being created. Banks across the board are hoarding cash to prepare for the oncoming write downs.

Every second of every day they move further and further underwater as the assets on their books depreciate in value.

We have had a short term rally in the banking sector because as of March of this year, banks can now mark their assets to "myth", not to market. This means that they can say the $1 million home I was just discussing is worth $1 million.

They only have to take the loss when the loan actually defaults. And it will, don't worry about that.

A news headline read today that of the mortgage loans that have not already defaulted that were issued in 2006 and 2007, 60% of those loans are now underwater.

This comes at a time when we are just entering the second wave of option arm loan defaults. The wave that will be larger than subprime and continue through 2013.

A little over two years ago the top tier banks held a total of $2 billion in capital reserves on their balance sheets. That number now stands at over $850 billion. They have this money kept at the Federal Reserve earning .25% in interest as they wait for the oncoming defaults.

CIT this morning announced that they are moving closer to an organized bankruptcy. They are the largest lender in the country to small and midsized businesses. Once CIT goes bankrupt, the oxygen will be cut off to those businesses, and we will finally see the ghost malls and offices.

We live in a world of cause and effect. As the economy worsens, financial losses increase. As financial losses increase, the government feels it needs to go deeper into to debt and print more money to offset these losses.

So this effect becomes the next cause in the domino chain, and its effect?........

The Dollar Crisis is Here

Of course the biggest news right off the top last week was the headline released on Thursday that Saudi oil producing regions were launching a push toward using non-dollar based transactions.

Whether this happens this month, six months from now, or a year from now does not matter. What is important is that it will happen. The rest of the world is moving away from the United States currency, and it is an all out retreat across the board.

Even more important than the Saudi/dollar article was the news a few weeks ago that China has begun to sell bonds denominated in Yuan currency.

China does not need to raise money. They have close to $2 trillion in dollar reserves and they run a massive surplus every year.

This bond issuance serves another purpose. It serves as another outlet for US dollars that have for the last 20 years been recycled back into American assets such as bonds, stocks, and real estate.

When money now leaves the United States it can find a new home in Chinese debt, in a currency that will soon become the world's safe haven.

That is only the beginning of the massive tectonic shifts happening all around us. It seems like we are hearing endless deals between China and Russia for oil contracts moving forward in the future. Both sides seem to have a common goal in the transactions: non-dollar exchanges.

Meanwhile, back in the States, helicopter Ben has our interest rates set at 0%. That means free money for anyone who will take it. Unfortunately, it is having the exact opposite effect. Something called a "dollar carry trade" has formed with our reckless leaders free money policies.

What this means is that someone can borrow dollars to raise money. They can then take that money and invest it in another country, currency, or more recently gold.

Lets say you walk into the bank and ask them for $100 at 0% interest. They say sure. You then take that money, convert it into Australian currency and invest in an Australian company that will pay you 5% per year on your money.

What happens if the Australian dollar doubles in value compared to the US dollar? Your $100 is now worth $200, and in the mean time you've been earning 5% on your money.

The problem for the US dollar is that this transaction is the equivalent of shorting a stock. You must sell the dollars, collect the money, and invest it elsewhere.

Other than the rate you earn, (currently 0%) the other reasons you would invest in a currency would be the strength of the underlying economy supporting it and the likelihood of default from their government.

I don't need to go into details on the strength of our economy. We have unemployment approaching 25%, we have close to 40% of all homes underwater, and we have an economy which is based over 70% on consumption which is just about to completely collapse.

The likelihood of the government defaulting on the debt? They already have. Our government has told the world that they plan on running $1 trillion deficits for the next ten years. They have told the world that they plan on financing the debt with a printing press. They now owe just under $100 trillion including all unfunded liabilities.

No one will get paid back.

Of all the reasons just listed for the coming dollar collapse I'll give you one more, and this is the absolute most important:

Our leaders could care less.

Their actions have shown that not only do they not care, they are doing everything in their power to create the worst possible scenario for American citizens.

So as the financial markets and our economy cause our politicians to make these horrific mistakes, it causes the downward pressure in the value of our currency. This downward pressure is like pushing down on a see saw. So what lies at the other end of the see saw? What is the effect?

Monday, October 12, 2009

Gold Emerges

On the other end of the see saw is the price in precious metals.

Gold and silver have had a spectacular run over the past four weeks. Before going any further I will just say that a pull back in the market is due, and when it comes it will most likely be violent as it has been during the entire secular bull market since 2000.

That being said, a pullback should be met with a smile as this offers the time to add to your positions.

While gold is making new highs and been the darling of the media, silver has quietly moved in the shadow. At $17.75 as of this writing, it is still a long, long, way away from its $52 high in 1980. Adjusted for inflation its high today would be over $110.

Silver will blow past both of those highs in the coming years. There are multiple reasons for this:

1. The rest of the world is already recovering and moving forward without the United States. Australia did not enter recession and raised interest rates last week. China is on fire and is the new growth story of this century. Silver is used both as a precious metal, but also an industrial metal. As the world continues its growth it will demand silver.

2. The current above ground supply of silver is close to all time record lows. There is currently about 2 billion above ground ounces of gold available and about 600 million ounces of above ground silver. This makes silver 3 times rarer than gold when measured in supply. Throughout history we have never seen a scarcity like what is currently present.

3. There is a massive short position by three of the largest banks suppressing the price of silver. Just as the artificial lending market for housing today is keeping home prices up, this artificial short position has held silver lower than its free market value. This short position should not be something to be hated, but cheered. It only adds future upside value to the final price.

As we move forward over the next five years you can expect to see a continued world of cause and effect:

*The US economy falls causing the Government to make mistakes.

*The Government continues to make mistakes causing the dollar to fall.

*The dollar falls causing precious metals to rise.

As you hear about the price of gold in the news, keep your eyes on the metal in the shadows. The next three to five years will be silver's time to shine.