Archive for May, 2008

Launch of new service: Contrarian Investors’ News

Thursday, May 15th, 2008

We would like to announce the launch of a new service: Contrarian Investors’ News. Just what is it?

It is a cooperative stories ranking site for investors, based on coRank. It’s a place where investors submit, share, vote and promote stories that are interesting and important. There, you can share whatever you find interesting on the web and where you can also find what’s interesting from people whose opinion are important to you. Everyone then can vote (rank) up what they liked, or vote down what they didn’t like. You can also leave comments on others’ submissions. Everything on Contrarian Investors’ News is submitted by Contrarian Investors’ News users, and after they submit a story, other people will read it and give it a thumb up or down. If that story receives enough positive votes, it is promoted to the Featured page. Contrarian Investors’ News also offers each user their own “Featured” page, and the stories promoted to their own “Featured” page are determined only by the votes of the people this user has previously selected – these are what we call, the user’s sources (we hope to be the source of many gems for many of you, our dear readers). You can use it to learn or discover new things, talk with others about the stories submitted, meet other people with similar interests, etc.

We intend to use this service ourselves. As you would have already guessed by now, we read a lot of news articles, blogs, opinions, analysis etc everyday. The vast majority never get mentioned in this blog, even the good ones. But now, with Contrarian Investors’ News, you can take a peek at the gems that we are reading ourselves, plus our comments on those gems. You can also contribute your own comments and get involved in discussions!

And by the way, talking about finding gems, we found (via Google) the classic value investing book, The Intelligent Investor by Benjamin Graham, in a freely downloadable PDF format. That physical version of that book cost AU$45 in a Dymocks book shop. Where can you download it? Look up the Contrarian Investors’ News to find out!

Is the credit crisis the end of the beginning?

Wednesday, May 14th, 2008

We will introduce another character today- Satyajit Das. He is a world-leading expert in derivatives and risk management and has a good inside knowledge of the murky world of derivatives. He is best known as the author of the fascinating book, Traders, Guns & Money.

Unlike the mainstream media and market, Satyajit Das is under no illusion that the credit crisis is over. In fact, as he wrote in Nuclear De-Leveraging,

An alternative and, arguably, better view of the current state of the financial crisis is that stated by Winston Churchill: ?… this is not the end. It is not even the beginning of the end. But it is, perhaps, the end of the beginning.?

Why is it so?  The short answer is de-leveraging. As we said before in Why are fantastic stocks sold off in a bear market?,

Today, there are so much leverage in the financial system and by extension, the market. Both retail and institutional market participants borrow and employ leveraged derivates (e.g. options, CFDs, futures, etc). The problem with leverage is that, when the market goes against you, your losses are magnified and you find that you are suddenly short of cash (to repay the debts, obligation, margin calls, collateral, etc). Sometimes, the only way to increase your cash level is to liquidate whatever you have- the good investments along with the bad. If enough people are in the same situation as you, this will result in widespread indiscriminate selling in the market.

As long as the de-leveraging process is confined to only the financial markets, the sell-off in stocks presents an excellent buying opportunity. Unfortunately, according to Satyajit Das’s opinion, the de-leveraging process in the financial market is only the first phase of a much larger process. He believes that this process will spread to the real side of the economy (see Analysing recent falls in oil prices?real vs investment demand on the difference between the financial and real sides of the economy), which means that the person on the street will eventually feel the impact. As we said before in The Great Crash of 1929,

Also contrary to popular impressions, that Great Crash was not a one-day event. It was a series of events that marked the beginning of an even more devastating consequence?the Great Depression. In fact, it took a year after the Great Crash for the average person on the street to feel the effects of the ensuing Great Depression.

If Satyajit Das is right, then in the future, we will look back at the credit crunch as just the beginning events of a greater scheme of things.  Currently, from the looks of things, the first phase is over. The effect is that money has become more expensive (see Rising price of money through the demise of ?shadow? banking system).

Next, another process is currently under way- the returning of bad quality assets into the bank’s balance sheet. As we explained before in What is SIV?,

The recent deterioration in the credit market is severely disrupting the SIV funds because of the high cost of obtaining short-term funding. As a result, many of the lenders have to buy back the mortgage assets from the SIV, resulting re-loading those mortgage asset into its balance sheet.

As Satyajit Das said,

High inter-bank rates and the deceleration in bank lending reflect, in part, banks husbanding their cash resources to accommodate the involuntary increase in assets.

In addition to this return of bad assets to their balance sheet, the banks also have to contend with losses incurred by the write-down of bad debts. What will happen then? As we said before in Banking for dummies,

As you can see by now, the banking business is a balancing act of managing a portfolio of assets and liabilities. Since the banking industry is a highly regulated one, there are rules for them to follow in this balancing act.

Now that the banks’ balance between assets and liabilities are out of equilibrium, what will happen? To restore balance, banks will have to raise capital (i.e. issue shares for cash) and/or cut down on lending and/or sell assets. Indeed, central bankers and foreign sovereign wealth funds have been very ‘helpful’ in this balance restoration process (see Central banks & pawnshops and Why did the foreigners bail out cash-starved financial institutions?).

As Satyajit Das continues,

The new capital noted above will merely restore bank balance sheets. Growth in lending and assets will require additional capital. The banking system?s ability to supply credit is significantly impaired and will remain so for the foreseeable future. Credit is clearly being rationed in the global financial system. If the banks are not able to re-capitalise, then the contraction in credit supply will be sharper.

Guess what will happen when the supply of money and credit contracts sharply? This is what we call “deflation” (see What is inflation and deflation?). During deflation, businesses and individuals have to de-leverage. Already, this process is already under way in Australia. When reading the mainstream newspapers, you will get to read numerous reports that credit is tightening. For example, take a read at Debt down as rates hurt in the Sydney Morning Herald,

The value of debt taken on by consumers and businesses slumped in March as higher interest rates continued to bite, according to figures published yesterday.

An economist at Lehman Brothers, Stephen Roberts, said the decrease in credit use was further evidence of the global credit crunch rippling through the broader economy as companies and consumers wind back their exposure to debt.

In Australia, with total private debt to GDP ratio of around 170%,  you can be sure that there will be more de-leveraging in the private sector to go.

This is the beginning of the next phase where the real economy is affected. In the next article, we will show you how this phase will unfold.

Start of banking decline?

Monday, May 12th, 2008

Just a few weeks ago, in Reserve Bank of Australia entering the landlord business, we reported that the Reserve Bank of Australia (RBA) was entering the landlord business by lending out thin-air money in exchange for mortgage bonds as collaterals. Today, we find this news report, CBA shores up its defences,

The Commonwealth Bank is manoeuvring to get a helping hand from the taxpayer by packaging $15.6 billion of its mortgages to swap for cash from the Reserve Bank.

This is a move to shore up liquidity and a move which all banks are now pondering. Either that, or it is off to the stockmarket to raise capital.

The point is that Australia’s biggest bank, Commonwealth Bank of Australia (CBA) is getting itself ready to borrow money from the pawnshop (see Central banks and pawnshops) should the need arises.

And also, today, the stock market was electrified by the surprise marriage proposal between Westpac and St George banks. Is this the bottom for banks? We doubt so. It seems that Australian banks are expecting tougher times ahead and are building up fortifications in anticipation of it.

Unemployment rate & recessions

Sunday, May 11th, 2008

We would like to give special thanks to one of our readers, dt, who supplied us with these charts regarding historical unemployment rate and period of recessions:

Free Image Hosting at www.ImageShack.us

 

Free Image Hosting at www.ImageShack.us

 

 

 

Note: The 2 graphs are hosted at ImageShack and is not part of our web site.

According to the Investopedia,

The unemployment rate is considered a lagging indicator, confirming but not foreshadowing long-term market trends.

In Australia, with such unprecedented high levels of debt, rising unemployment rate can have very serious repercussions on the economy (see Aussie household debt not as bad as it seems?).

Connecting monetary inflation with speculation

Saturday, May 10th, 2008

One of the common explanations we find in the news media for high oil prices is that they are the speculators’ fault. In our previous article, Price fluctuations and hoarding, we have a better word to describe such speculative activity- hoarding. Speculators (or rather hoarders) are blamed for bidding up the price of oil, resulting in a global price inflation scourge. Many economists call such price inflation as ‘cost-push’ inflation.

But in reality, there is a deeper underlying cause for such price inflation. As we quoted Marc Faber in Marc Faber: Bernanke Policy Will ?Destroy? U.S. Dollar,

As the US began their aggressively loose monetary policy from September 17 2007 by cutting interest rates from 5.25% to 3% [, Marc Faber said,]

What is the result? I tell you what the result is! The stock market in September 17 by the S&P is down 10%, the US dollar is down 10%, gold and oil are up 40%. Well done Mr. Bernanke!

How does monetary inflation (see Cause of inflation: Shanghai bubble case study) lead to speculation? At the root of speculation lie human decisions for improving one’s lot in life. The ultimate aim of the economy is to satisfy infinite wants with finite resources. With all these mal-investments accrued over the years, it has come to the point that too many resources are wasted in ends that are either (1) cannot be completed or (2) unwanted. As we said before in Why does the central bank (RBA) need to punish the Australian economy with rising interest rates?,

Therefore, in order to put the economy back into a sustainable growth path, consumptions and investments have to slow down in order to allow for the economy to catch a breather for the rebuilding of its capital structure. The rebuilding of capital structure is necessary for the economy to replenish its resources for the future so that growth can continue down the track. Unfortunately, this rebuilding itself requires resources now. Therefore, current wasteful consumptions have to be curtailed and mal-investments have to be dismantled to make way for the rebuilding.

Thus, by further inflating the supply of money and credit in the financial system at such a time, there comes a situation whereby there are excess liquidity without adequate avenues for appropriate investments.

To understand this idea, put yourself in a position of a person with excess wealth in US dollars to invest in. Where can you invest your wealth to give yourself a real return in an economy that is in recession with serious price inflation? With asset price deflation and a credit crunch, there are not many financial assets to park your wealth in. At least in Australia, with rising interest rates, cash is an option. But in the US, with short-term interest rates lower than the price inflation rate, cash is not an option. Even long-term Treasury bonds are not good enough. In the end, the most attractive option would be to hoard commodities that have good supply/demand fundamentals. But if too many people are in the same boat as you, such hoarding will only result in further rise in prices.

So, is there any wonder why there are speculations (or rather, hoarding) in commodities?

Can “weak US dollar” be partially blamed for rising oil prices?

Thursday, May 8th, 2008

Yesterday, we questioned the validity of using fiat money as a unit of measure for the value of a commodity. Today, we will look at idea that the “weak US dollar” is one of the scapegoats for rising oil prices.

Frequently, we hear from the media explaining that one of the ’causes’ of rising oil prices (and by extension, inflation) is due to the “weak US dollar.” But notice one thing: oil prices had been rising in all currencies, not just in terms of US dollar. This leads us to one basic principle: everything else being equal, a falling US dollar has no effect on oil prices measured in non-US currencies. Of course, in the real world, everything else is not equal- oil prices rises to different degrees in terms of other currencies too, including the Australian dollar. In that case, can the rising in oil prices in terms of non-US currencies be attributed to supply/demand fundamentals?

But wait a minute! What is the meaning of “weak US dollar?” Can we interpret the meaning of “weak US dollar” to mean that the supply of US money and credit has been expanding at a faster rate than the supply of its non-US counterparts? Well, consider this fact: the supply of non-US money and credit has been expanding at an arguably greater rate than the supply of their US counterpart. For example, Australia’s money supply increased 21.6% (see Australia?s monetary growth update?February 2008) while the US money supply was estimated to be significantly below that figure (the US no longer publish figures on their M3 money supply). Putting aside the argument of which nation’s money supply has been increasing at a faster rate, this is the basic point: the supply of fiat money and credit of all nations have been increasing. In other words, high oil price is not just a problem of the “weak US dollar.” As we said before in What if the US fall into hyperinflation?,

Now, in this age of freely fluctuating currencies, the currency?s value is a relative concept. For example, a falling US dollar implies a rising Australian dollar. Therefore, one way to ?maintain? the value of the US dollar relative to the Australian dollar is to devalue the Australian dollar. Perhaps this is the route that central bankers will concertedly take to instil ?confidence? in the US dollar in order to create the illusion that the US dollar is still a reliable store of value? Well, they can try, but growing global inflation and skyrocketing gold price relative to all currencies will be tell-tale signs of such a dirty trick.

We can include oil prices in the last sentence of the above-quoted paragraph. Thus, we believe that global monetary inflation is one of the major contributing factors in accentuating the rise in oil prices, in addition to the fundamental supply/demand factors. It is an error to blame it on the “weak US dollar.”

In the next article, we will connect monetary inflation with oil price speculation.

Oil at $40 or $200?

Wednesday, May 7th, 2008

Yesterday, Goldman Sachs analysts predicted that oil can hit US$200. As this news article, New ‘super-spike’ might mean $200 a barrel oil, reported,

With $100-a-barrel here for now, Goldman Sachs says $200 a barrel could be a reality in the not-too-distant future in the case of a “major disruption.”

Goldman on Friday also boosted by $10 the low end of its 2008-2012 projected range for crude to $60 a barrel — significantly lower than current prices, to be sure, but a possible mark for oil if “normalized” trends return to the marketplace.

Mind you, those Goldman Sachs guys predicted US$100 a couple of years ago and no one believed them. This time round, people take their forecasts more seriously.

At the same time, Citigroup analysts predicted that oil will hit US$40 within 2 years.

Why is there such a vast difference in the price forecast of oil?

Is it possible for oil to fall in demand so drastically that its price falls to US$40? Can its demand surge so hight till its price hits US$200? If one asks such questions, it shows a fundamental error in thinking. You see, the underlying assumption behind these questions is that the US dollars is an immovable yardstick of measurement. The truth is, the US dollar is as elastic and twang as rubber band. With deflation, the US dollar shrinks, and with inflation, the US dollar stretches (see What is inflation and deflation?). As we said before in How is inflation sabotaging our ability to measure the value of things?,

If you want to measure the length of a box, you may use the ruler to do it. The reason why a ruler can do such a job is because its length is reasonably consistent for the foreseeable future. Now, imagine that ruler is as elastic as a rubber band. Do you think it is still a useful tool to measure the length of the box? An elastic ruler is useless because you can always make up the measurement of the box to whatever you please just by stretching the ruler such that the edge of the box is aligned to any intended measurement markings in the ruler.

Now, let come back to measuring the value of oil. Since oil is priced in US dollars and if the supply of US dollars can be expanded and contracted at will by the Federal Reserve, how useful do you think it is as a calibration for measuring the value of oil?

Can oil fall to US$40? Yes, it will take an acute deflation of money and credit in the global financial system to result in that. If you wonder how such a deflation will look like, the Great Depression is the best template. Can oil surge to US$200? Sure, other than Chinese and Indian demand (see The Problem that can throw us back into the age of horse-drawn carriages), monetary inflation can lubricate the upward slide of oil prices.

If you notice, the mainstream media is catching on to this understanding too. They are starting to blame rising oil prices on the weak US dollar. Speculators and ‘investors’ are also blamed. But there are a couple of things they do not see. What are they? Keep in tune!

Is it a liquidity or solvency crisis?

Monday, May 5th, 2008

As you would have read by now, Warren Buffett declared that

The worst of the crisis in Wall Street is over. In terms of people with individual mortgages, there’s a lot of pain left to come.

As this Bloomberg article, Buffett Says Credit Crisis Ebbs for Wall Street Firms (Update4), reported,

Warren Buffett, chief executive officer of Berkshire Hathaway Inc., said the global credit crunch has eased for bankers, and the Federal Reserve probably averted more failures by helping to rescue Bear Stearns Cos.

Clearly, the market is in agreement with Warren Buffett, with the stock market rallying in the belief that the worst of the credit crisis is over. So, could the credit crisis be just a liquidity problem? Or is it a more serious solvency issue? What is the difference between the two?

Well, let’s use the pawnshop analogy from our previous article, Central banks and pawnshops. Let’s suppose that Tom had a big mortgage debt, recurring bills to pay and a nice well-paying job and no savings. Let’s say he resigned from his job to take up another well-paying job. The only catch is that in between these two jobs, there was a period of 2 months where he would draw no wages. Since he had no savings, this will mean that he would be unable to pay his bills and his mortgage debt repayments. Not to worry, Tom went to the pawnshop and pawned his gold jewellery for cash to pay his bills and mortgage debt. Then when his new job starts, he will draw out his salary to repay his loan from the pawnshop and redeem his gold jewellery. Tom had a liquidity problem. Fine.

What if, Tom was retrenched from his job and for the next 12 months, could not find another job? He could pawn his gold jewellery, but as long as he did not have a job, he would not have any hope of repaying his loan from the pawnshop in order to redeem his gold jewellery. The next month arrived and he had to pay that month’s bills and mortgage repayment while his gold jewellery was still stuck at the pawnshop. Tom is getting more desperate. Perhaps he can pawn his silver jewellery? Fortunately, the pawnshop was as willing as the Fed. It accepted Tom’s silver jewellery for the same amount of cash as the previous loan. Tom was saved for another month. Obviously, Tom had a solvency problem. That’s bad.

So, is the credit crisis a liquidity or solvency issue?

Central banks and pawnshops

Sunday, May 4th, 2008

Nowadays, if one is desperate for short-term cash, he can always tap his credit card for a cash advance at the local ATM and be charged exorbitant interest rates. In the past, in the days of our parents’ and grand-parents’ generation, cash desperate people would go to the pawnshops. To qualify for a loan at the pawnshop, one had to surrender his valuables as collaterals. It is only after one repaid the loan (plus interests) could one redeem his valuables.

This is what central banks do to banks. As this news article report, Fed expands auction, accepts wider collateral,

The Federal Reserve, along with other central banks, said Friday that it was increasing the funding it is providing to banks and announced that, for the first time, it was willing to accept bonds backed by auto loans and credit cards.

The Fed’s original statement can be found here,

In addition, the Federal Open Market Committee authorized an expansion of the collateral that can be pledged in the Federal Reserve’s Schedule 2 Term Securities Lending Facility (TSLF) auctions. Primary dealers may now pledge AAA/Aaa-rated asset-backed securities, in addition to already eligible residential- and commercial-mortgage-backed securities and agency collateralized mortgage obligations…

Using the pawnshop example, when a bank borrows money from the central bank, they do so via a repurchase agreement (or “repo”). In repos, banks have to surrender their assets (see Banking for dummies for more on what bank assets are) as collaterals to the central bank. After some time, the banks have to pay back the money plus interest in order to redeem their assets.

Traditionally, the Fed would only accept the highest quality assets, US Treasury bonds, as collaterals. But due to the credit crisis, the Fed (along with other nations’ central banks- see Reserve Bank of Australia entering the landlord business) is lowering the standards of collaterals to include top-rated residential and commercial mortgages. The Fed’s most recent statement indicates that they are lowering the standards even more (to auto loan and credit-card bonds). Using the pawnshop example, it’s like the pawnshop lowering the standard of the pawns that it will accept, say from gold jewellery to silver jewellery.

How much lower can it go?

New way to subscribe

Saturday, May 3rd, 2008

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