Friday, September 16, 2011

Lehman Brothers Anniversary

To celebrate the 3 year anniversary of the Lehman Brothers bankruptcy we have the following video to show how Lehman Brothers died through the eyes of Bear Stearns. (Who died 6 months before Lehman)

The video is important in that the exact same event is taking place today throughout the European banking system as they are now losing the most important word in the global economy: TRUST

WHITEBOARD SPECIAL: Lehman Brothers, three years on from Marketplace on Vimeo.

The Real European Crisis Explained

To begin the year I wrote a seven part outlook discussing my thoughts on what 2011 would look like for the financial markets.  One of the parts was the 2011 Outlook: Sovereign Debt, which has been my most viewed post of the year by far due to the tremendous amount of viewers from outside the United States, specifically Greece.

The outlook has tracked events closely as they have taken place over the past 9 months.  (The major difference is that I thought Spain would be targeted by the bond market before Italy.  Italy moved ahead in the sovereign debt race to collapse, but I am confident Spain will soon have its moment in the spotlight)

While the sovereign debt crisis was barely a news event back in January, it is the focus of every financial story today.

The initial shock to the system came in the form of the bonds for the European countries, it has now moved into the second stage: the toxification of the banking system.

Most analysts and investors assume that the greatest danger facing the European banking system is the write downs that will be needed to occur when Greece defaults.  That is a major worry moving forward, but it is a visible danger that banks can see and do their best to work around.

However, behind the scenes in the shadows, there is another hidden danger lurking.  Its unseen nature makes it far deadlier because our financial system is based on trust, or "known knowns" as they are called on a trading floor.

This force has arrived in the form of Credit Default Swaps, or CDS, as you may have read about in the news recently.  Yes, this is the old friend that destroyed the US banking system back in 2008.

A Credit Default Swap is insurance an investor takes out against default on a bond.  They are usually used as hedges to balance a complete portfolio against risk.  For example, if you own $1,000,000 in Greek government bonds, a few months ago you would have been wise to take out an insurance policy to hedge against the possibility of Greek bonds going into default. (I could use a far more realistic and complicated example but this makes it easier for those new to the discussion)

Here is the problem:  CDS contracts are a form of derivatives, meaning they are far less regulated than typical investment options.  They are usually "off balance sheet" items that can stay hidden from both the public and regulator's eyes.  It is the wild west of investing.

To compare 2008 to the present crisis, we understand who Lehman brothers is.  It is Greece.  We can clearly see the danger and insolvency.

What we cannot see is who the AIG is.  Who is the insurance company guaranteeing the debt against default?  It could be a major bank, or it could be a large hedge fund.  Some entity or a large group of entities are holding an enormous amount of Greek, Portugal, Ireland, Spain, and Italian bond insurance.

And the hurricane is about to hit.

Because banks cannot see who the AIG is, they are now looking around and not trusting anyone.  This is causing the financial system to freeze, just as it did in 2008.  The banking system is based on trust.  Most of the lending takes place overnight in something called the repo market.  However, banks now fear that they may wake up tomorrow morning and if the Greek CDS contracts have been triggered, their money would have been left at Lehman brothers the morning of the bankruptcy.

This then triggers another massive round of losses and write downs.

What is most fascinating, and troubling for those who understand how the system works, is that a hedge fund with very limited capital has the ability to write an unlimited amount of insurance (CDS) contracts in the unregulated derivatives world.  (Imagine a hedge fund writing an unlimited amount of home owner insurance contracts for homes on the coast of Florida to protect against a hurricane)

Every year for the past 5 years they have collected and made huge premium income on the monthly payments for this insurance.  If the hurricane hits, which is about to happen in the financial markets, these hedge funds can then just close their doors and walk away with the millions and millions in income they made during the past 5 years.

The taxpayer will then be left to make the banks whole.  This is coming, and it is important to understand it before it takes place so you are not fooled by a politician explaining to you the importance of "saving" the financial system.

Get ready for turbulence ahead.  When the first domino falls, it is going to trigger a panic.  You need to have some ammunition (cash) ready to purchase strong assets that will be going on sale.

When the time comes to buy, I will review exactly where I feel the opportunity is greatest.

Efficient Government Spending

Wednesday, September 14, 2011

Update On Gold's Relative Value

I believe Gold will enter a mania sometime this decade and once again be considered "expensive" to purchase.  The question is how do you know when that point has arrived?

A simple tool is to look at the price of gold relative to the money supply.  In 1980 the price of gold rose so rapidly that is could fully back the entire money supply in existence, and for a few months it was worth more than the paper money supply.

At this point gold could have been considered "expensive" and it was time to sell.

So where are we in relation today?  The following graph shows where gold would need to rise today to back the recent paper currency creation by our Federal Reserve: $10,000 per ounce. (Click on chart for larger visual)


An even easier chart to follow is how far away we are from the fully backed black line. 


When we cross back over it will be time to sell your gold and purchase other assets that will be inexpensive such as stocks or real estate.

Until then, enjoy the pull backs and hope the price falls lower.

Sunday, September 11, 2011

China's Empty Cities

Another incredible look into China's real estate bubble.

Paradigm Shifting: Greece 1.0

The situation playing out in Greece continues to be fascinating to observe, not only because of the implications for the markets in the short term, but its impact on how investors, politicians, and economist's paradigm will shift when they see a simple real life case study to compare with their text books.

Greece, like many businesses, countries, and individuals around the world began to grow rapidly over the past few decades due to the excessive debt they applied to their balance sheet.

If a company currently makes $50,000 per year in sales and they decide to borrow $3 million in 2012 to expand operations then their organization will grow rapidly if that money is put to work.

If your next door neighbor makes $50,000 in income and decides to borrow $3 million in 2012 to purchase a new car, house, and travel, then his lifestyle will grow rapidly.

Money is borrowed from future savings.

Debt does not have to be bad.  In fact, when used correctly and intelligently, it is an important part of the global economy and growth. 

For example, money that I invest into my personal company to cover expenses, marketing, and payroll usually provides me a return between 30 to 50 percent.

If I could borrow money at 10 percent interest to expand operations, and get a 30 percent return on that money, should I borrow it?

Maybe.  If I could not sleep at night because I was worried about having debt, that would negatively impact my business so the answer would be no. (I would take the money)

The same goes for purchasing a real estate investment.  If you borrow a million dollars from the bank with monthly payments of $5,000 in interest and your property provides a monthly return of $8,000 after all expenses, should you purchase the property?

Maybe.  There are many factors involved such as the building's appreciation potential moving forward.

So what is the secret when it comes to debt?  The answer is cash flow. 


Intelligent investors do not fear debt, they understand that they need to build a business model or investment that can support the cost of using leverage.

This should all seem like common sense, so why am I spending so much time discussing it?

Because when these simple examples are applied to government spending, everyone believes that the rules are different.  They believe that just like Newton's laws in science, the laws of economics and finance no longer apply.

The implosion in the small country of Greece is shattering this paradigm.  It is causing investors to rethink their models the way home prices falling did in 2006.

What is most fascinating today is that looking at the fiscal state of Greece vs. the United States they are almost identical.  In many ways the United States is far worse on paper.

Yet investors, with the opportunity to watch what is taking place in Greece right before their eyes, still believe that the United States will never experience a debt crisis.

There is almost no comparison in history to the magnitude of this ignorance.  Most bubbles popped unexpectedly in the past with very few signs of warning to the untrained eye.  To compare it to our most recent housing bubble that imploded in 2006 and caught many Americans by surprise, imagine if Greece had an almost identical implosion in their housing market back in 2004 that impacted the global financial system.  A clear blueprint of what was coming.

This inability to differentiate continues to provide opportunities for investors.  Financial advisers today are telling their clients to rush to the safety of US treasury bonds.  I believe that 3 years from now an investor would have been better served in gold.

We will soon find out if the laws of economics apply to the bankrupt United States.  The average portfolio around the world today contains .75% of its composition in gold related assets.  Bonds represent over 50% of most portfolios.

What would take place if only 3% of that bond composition shifted to gold in a market that is tiny in physical size?  We would then find out if the laws of supply and demand applied to this market as well.