Friday, October 14, 2011

Occupy Wall Street: What's Really Going On

What made our country the greatest in the world from 1776 to the 1950's, the 99%, is what is going to bring it back from the final round of absolute destruction that it will soon experience from the decades of reckless behavior of both our politcians and the real decision makers in our country: Wall Street.

From the Washington Post:

One-third of the Obama re-election campaign's record-breaking second-quarter fundraising came from sources associated with the financial sector.

That percentage is up from the 20% of donations that came from Wall Street donors in 2008, and contradicts reports that a growing Wall Street animosity towards the Obama administration may jeopardize his re-election bid.

Seeing The Future By Understanding Credit

I sold real estate in one of the most bubblicious cities in America, Washington D.C, between late 2005 through late 2007.  I feel that my insatiable desire to learn about markets and market history is due to being on the front lines of the most recent financial calamity.  I remember home owners receiving mortgages that would take their total monthly debt payments to $6,000, and only making $3,500 per month.

The greatest lesson that I learned during the process was the impact of debt, or leverage, on the price of an asset.  This was magnified to its highest degree in real estate, an asset that is usually purchased using at least 80% debt.  During the mania, the amount of debt used to purchase real estate rose to 100%. Then closing costs were removed.  Then real estate was even financed at 125% of the purchase price. 

The lowering of lending restrictions allowed more buyers to enter the market.  Greater supply of buyers lead to higher prices.  Then it reached the maximum lending capacity and the levers began to move in reverse.  Lending restrictions began to tighten, lowering the amount of new buyers that could enter the market.  Lower supply lead to lower prices.

It seems so simple today looking back, yet so few people could understand while it was happening. (Including myself until I read a lot of books by people far more intelligent than I)

Now that I have learned this lesson, I try to apply it to future applications.  I ask myself; where could credit be removed from next that could negatively impact the price of the underlying asset it is funding.

The answer lies in the sovereign debt crisis taking place before us around the world.  Government debt now funds a vast majority of the global economy's primary exchanges, and government debt is now slowly being removed, just as subprime mortgage debt was removed in late 2007.

Before we get to the real fun stuff, let's start with Greece because it is easier to apply due to Greece's government spending currently in the process of shutting down.  As the European Union and IMF extend loans to Greece to keep them alive they simultaneously enforce government spending cuts.

So let's say that Greece has $1 billion to spend this year, and it has now been reduced to $700 million in 2012.  The key question as an investor to ask is where you anticipate those spending cuts coming. 

What if it Greece spent $100 million per year providing student loans and that now had to be reduced to $20 million?  What would happen to the price of college education in that country? 

It would collapse.  Less students capable of receiving loans means lower supply of students at the current prices.  Colleges would be forced to lower prices drastically.

What if Greece spent $100 million per year on providing auto loans and that now had to be reduced to $10 million.  What would happen to the price of cars in Greece?

They would collapse.  Do you see how this correlates? 

Now let's take it one step further.  What if you were considering purchasing an apartment building in a college town in Greece?  If the number of students attending the school was about to shrink considerably, what would happen to the monthly rent you could charge?  If an apartment building's value was based on the income a building receives, what would happen to the value of that building?

It would simultaneously collapse.  As would a retail building in that town. 

Now apply this concept to a town in Greece where 60% of workers are government workers.  If 50% of those jobs are removed and the remaining 50% had to take pay cuts, what would happen to the value of real estate in that town?

This is taking place as we speak in Greece.  This is not a hypothetical analysis, but I have one for you.

Close your eyes now and imagine you are in the United States, not Greece.  Imagine that the United States could not run $2 trillion budget deficits annually and we were forced to cut spending to only what we could pay for.  Imagine where the $2 trillion in cuts will come from.

The United States currently pays for:

1. All mortgages in America
2. Financing for apartment buildings
3. Car loans through General Motors
4. Student Loans
5. Defense
6. Medicare
7. Medicaid
8. Social Security
9. Unemployment Insurance
10. Food Stamps

Where will the cuts come from first in that group?  What will the majority of voters ask for when our government spending must contract?  How you answer that question should be a major determinant for how you invest your money today.

I personally believe that the cuts will come from 1, 2, 3, 4, and a large chunk of 5.  I believe that the American people would rather have a social security check, food, and medicine over higher housing, student loan, and car payments.  In fact if you re-read that statement you can see that the government removing themselves from 1-4 will benefit consumers, not harm them. 

This reality is coming to America.  It is math, not science. Our country will not end, but you have to think about how credit will impact the price of assets in the future when someone tells you today is a great time to purchase a home or a retail building.

I'll leave you with a simple example.

What if our government reduced the amount of funding it provided to apartment buildings and reduced the amount of money it provided to student loans?  What would happen to the value of an apartment building at a college campus?

Do you know any publicly traded companies that invest exclusively in student housing? 

I do.

Thursday, October 13, 2011

Government Report Cards

A few charts to review today that show how the citizens and small business owners of this country feel about our Congress' job performance.

The first is the gallup poll showing that 13% of Americans approve of the way Congress is doing its job.  This ties the all time record low.  (81% disapprove)

Then we have the small business owners who create the lion share of jobs in America.  89% believe that the United States economy is headed in the wrong direction. 

The solution they would like from government: over 80% of these small business owners want the government to get out of the way and provide them with more certainty.

Exit John Paulson: Enter Kyle Bass

The mainstream press has picked up again on the story of John Paulson, only it is the exact opposite story that streamed the headlines during 2009.

Paulson was one of only about 15 individuals in the world to utilize the Credit Default Swap as a way of betting against subprime mortgages before they collapsed in price.  His name is the most popular because he used the most money to bet against mortgages and subsequently came away with the largest prize.  It is estimated that his personal take home in 2008 was over $4 billion. (The top CEO's of the largest corporations make about $100 million on a great year)

While he was mostly unknown during 2008, when word got out of his foresight on the crisis money flooded into his hedge funds from around the world.  He now runs one of the largest operations globally in terms of capital under management.

Paulson took this capital back in 2009 and bet on two main investments:

1. A recovery in America and stocks that would benefit
2. Gold

During the rebound in the markets that began in 2009 he once again looked like a genius.  He upped his bets on the recovery and put a tremendous amount of money into bank stocks.  This again continued to look impressive until about 6 months ago when things began to come unraveled.  Banks stocks have rolled over and are now at prices seen at the March 2009 lows.  The stock market has taken a major leg down, and all economic indicators point to a global slowdown and further weakness. 

His name is now the topic of failure and money is exiting his funds at rapid pace.  I only find the topic interesting because I have tracked Paulson closely since his epic rise, and I could not understand why I agreed so much on his gold bet, but I completely disagreed with his bet on an American economic recovery.

This thought was triggered again last night as I was reading the opening chapter of Michael Lewis' new book; "Boomerang."  Lewis is the best selling author of "The Big Short," which was a study of the small group of men that bet against subprime using Credit Default Swaps.

The opening chapter discusses his time not with Paulson, but another financial superstar: Kyle Bass.  Bass in 2008 closed his Credit Default Swaps positions and opened up another trade; something that he told Lewis at the time would be chapter 2 of a crisis that was only just beginning.

He began to purchase insurance on the debt of Greece.  He bought insurance on Greek debt at the same price he paid for subprime debt back in 2006.  This kind of stuff gives me the goosebumps with excitement. 

After purchasing insurance on Greece, he began to buy some for Portugal and Italy, countries that are now imploding as I write this.  If I told you his percentage return he has made on these trades you wouldn't believe me.

The average investor cannot purchase insurance on a country using Credit Default Swaps. (CDS are a derivative that can only be purchased by banks and hedge funds)  After learning this, Michael Lewis asked Bass back in 2008 what the average investor could do to profit on how the world will unfold over the next few years.

His response?  "Buy Gold"

Bass sees the sovereign debt crisis spreading like a virus through Europe and then moving to Japan, then the UK, and finishing with the United States.  He feels that his order may be wrong, but that the ultimate endgame will play out the same.

I could not agree with him more, and I will do my best to provide any interview, paper, or appearance Kyle Bass provides the world moving forward.  With Paulson slipping into the shadows, he is now the gold standard in financial greatness.

Wednesday, October 12, 2011

Nigel Farage Discusses European Bail Outs

Nigel Farage, the lone voice of reason in European politics, this week speaking about the insanity that is the ongoing, rolling, European bail outs.

Debt Consuming Everything

There is so much debt around the world that when you look at the numbers it is like a black hole ready to suck everything into the abyss.  It almost feels as if every layer of the developed western world is insolvent.  The governments, businesses, banks, and citizens have borrowed more than they can possibly pay back.  The first portion of the effect of this insolvency was felt during the credit crisis of 2008.  The second act is playing out before us today.

Center stage is the small government debt of Greece.  It is like a spec of dust on a mountain of toxic waste, but the amount of worry that surrounds it is a shocking glimpse at what lies ahead when we face the real challenges.

Total Greek government debt is $445 billion in size.  This represents over 140% of Greece's GDP meaning they can never pay the debt back without a default or "haircut."  Estimates have that haircut around 60%, which would be a $270 billion loss taken on balance sheets around the world for banks, hedge funds, insurance, and pension funds.

This portion of the debt is not the true problem. It is the CDS market that I discussed in The Real European Crisis Explained.

The goal now of European politicians is to come up with a solution for an orderly Greek default and then to ring fence the contagion to try and keep it from spreading to the next in line: Portugal, Ireland, Italy, Spain.......

I believe that unless the European Central bank is willing to come forth with their own large scale version of quantitative easing (as the United States and the UK have) then the contagion will spread rapidly. 

Their is no political will for it to take place now, but the Greek default is going to rock the markets and banking system around the world.  This will provide the catalyst for the ECB to launch the printing press full speed.

Back here at home, as discussed many times, we face the same government balance sheet issues as Greece only with far more zero's.  However, under our nasty blanket of toxic federal debt, we also have both local and state government insolvency as well as an insolvent banking system.

Harrisburg, PA made the news this week by finally moving forward with their bankruptcy and becoming the first domino to fall.  They will set the stage for bankruptcies to take place in small towns and cities all across the country. 

Our banking system died in the fall of 2008 and is now a walking zombie that is only sucking the life out of the remaining productive economy.  This has been more visual recently with the shares of the Too Big To Fail banks plunging over the past few months.

What comes next?  As always, it is impossible to tell.  The stock market has seen a tremendous rally over the past week and if the former optimism comes back into the market and pushes it higher it will once again be a great shorting opportunity.

The precious metals have again found some footing after the recent waterfall decline, and I believe their greatest value currently lies in the strongest mining shares and silver.

Oil was close to a buying opportunity, as were some of my other favorites such as the Australian dollar, Canadian dollar, and agriculture.  They did not quite get the sell off I was hoping for to reach an attractive entry point. 

It most likely will come.  I believe there is one more deflationary fall ahead, and it will reward those that continue to be patient.

Tuesday, October 11, 2011