Thanks Dr. Bernanke

Dear Dr. Bernanke:

I wanted to write to thank you for helping the price of Gold and to encourage you to keep up the good work. I know you will. I've never been a fan of Gold throughout my investing career, but the Fed's policies over the last 10 years have changed my mind.

I also wanted you to be one of the first to know that I am advising my readers to start putting a significant amount of their money in Gold. I recommend long-dated Gold futures, Gold ETFs (like GLD), and Gold producers (such as NEM, TRA, and CGHRF.PK). I especially like the smaller miners as they have more upside potential.

In spite of the run up, Gold continues to be a great investment. Burgeoning inflation is likely to push the price higher, as markets move from discounting Gold relative to stocks and bonds to putting a premium on it.

If I'm misguided, please let me know. But I trust you'll be there to pump lots of liquidity into the banking system.

I'm confident you will continue to argue that the appreciation of commodities and the weakness in the dollar are not important indicators of inflation. The true indicator is core inflation. The slowdown in housing and the economy will lead to core disinflation in 2008. In anticipation of this disinflation and to prevent the economy from falling into a recession, you and the FOMC will continue to lower rates.

After all, the credit crunch in the banking system is monstrous. The market and the press (in spite of so much talk) are underestimating the threat.

Just two weeks ago, your institution (the Federal Reserve) released a report that got little attention. The report showed that large bank capital had declined by $40 billion since the beginning of August. According to Merrill Lynch economist David Rosenburg, "This has never happened before over such a short timeframe and this is rather serious because such a steep and sudden compression in large-bank capital has the potential to create a negative lending environment...The large banks have been forced to take commercial paper back on their balance sheets and as a result are choking on assets they did not plan on having - thereby tying up regulatory capital." This trend could "significantly inhibit" economic growth.

According to the Financial Times, "Big U.S. commercial banks have seen $280 billion of new debt come on to their balance sheets since the credit squeeze, threatening to undermine economic growth by inhibiting their ability to make new loans. The banks have been forced to take on to their books large amounts of commercial paper and leveraged loans after investor demand for such assets dried up in the summer."

As you probably know, while these numbers sound quite large, they are only the tip of the iceberg. According to Moody's, the credit rating agency, assets held by bank-sponsored special investment vehicles
("SIVs”) were $320 billion in July. Two SIVs announced several days ago that they will be unable to pay their debts. Such moves could force more liabilities onto the balance sheets of banks, further constraining liquidity and possibly even threatening the banks' own solvency.

Through fractional banking and the rules that you set at the Federal Reserve, banks are allowed to have 20 times the amount of liabilities as their net capital. Because SIVs are off-balance sheet, banks can now have even more than 20 times. In addition, many SIVs have their own leverage, sometimes up to 10 times. In other words, only a slight move down in the value of SIV or other assets means that banks could be insolvent.

Dr. Bernanke, you need to move quickly to inject more liquidity into the system. 50 bps is not enough. A lot more interest rate cuts are needed. A lot.

Look at Citigroup as an example. Citigroup has just $65 billion in shareholder equity. Yet Citigroup alone has more than $80 billion in exposure to SIVs and another $80 billion to conduits. According to
the Associated Press, "Citi said it was suspending share buy-backs because its capital ratios had weakened partly due to the large amount of commercial paper and leveraged loans it had taken on."

You must act now. The cycle is viscous. If banks don't have enough capital, they won't lend. If they aren't lending, what will the American consumer do? And what will support housing prices? Houses are already unaffordable. Imagine what will happen if lending dries up even more! And what will keep the LBO, hedge fund, and derivatives markets running?

So please ignore those cynics who don't understand the severity of the problem. Don't worry about the price of Oil, Wheat, or Gold. Let them rise and let the dollar fall. Because the U.S. economy needs $2 billion a day in foreign cash to make up for its overconsumption and lack of manufacturing, more interest rate cuts could send foreigners fleeing the dollar. The dollar could drop by 50%. That's good.
That's exactly what we need to save the banks and housing. Who cares if a further drop in the dollar leads to fleeing capital, a further tightening of credit, and a rise in long-term interest rates? Who do these cynics think where are? Argentina? Please. We are the U.S. and A.

I know you're going to act. After all, PIMCO is now on board with Paulson's SIV plan. PIMCO's support comes as a surprise after Bill Gross, the chief investment officer, criticized the effort as "a little lame" in a television interview. Hmmmm. He must have gotten some assurances that the government hears his call for the Fed to lower rates at least another 100 bps.

Anyway, you know the banking system better than I do. I'm sure you're way ahead of me, and I'm sure you're planning even more interest rate cuts and more core inflation rationalizations.

So thanks for the good work, and please tell your friends to listen to what I'm telling my readers: "Don't sit there and moan about how the Fed is taking away your savings. Do something about it. Protect yourself and make some money in the process. Buy Gold."

P.S. While you're at it, can you do something to quiet that Greenspan guy? Now that he's out of office, he can tell the truth and it keeps hurting the markets. He's desperately trying to disassociate himself from the inflationary policies of the Fed, in a last ditch effort to save his legacy. Just the other day, according to the Associated Press, "Greenspan suggested it would be best to let SIVs and banks bear the burden of holding bad assets by making them lower prices as much as necessary to sell them, rather than setting up a fund that some see as a bailout for the banks...’What creates strong markets,’ he said, ‘is a belief in the investment community that everybody has been scared out of the market, pressed prices too low and there are wildly attractive bargaining prices out there.’" Doesn't he get it?

The government must do something. You can't be Fed Chairman and sit idly by while a recession occurs. He never did. Why should the burden fall on you?

When asked about his own attempts to bail out the banking industry while he was in office, Greenspan “said the 1998 Fed-sponsored rescue of Long-Term Capital Management worked because it took a set of assets that would otherwise have been dumped at firesale prices off the market, allowing prices to find a true equilibrium. But he said today 'we are dealing with a much larger market.'” Wasn't the entire argument behind bailing out Long-Term that the market effect was so large it threatened global stability? Ah, how short memories are.

A burger, fries, and a small side of contagion please

Here’s something that’s probably not on your Christmas wish list, but should be: a little bit of contagion.

Contagion is a word you don’t hear often, unless you work at the CDC or on Wall Street. Definitions of contagion, according to dictionary.com, include: “the communication of disease by direct or indirect contact” and “the ready transmission or spread as of an idea or emotion from person to person: a contagion of fear.”

Contagion in the investing world (be careful not to ask Santa for disease contagion) is the fear that a run on one stock or asset class will spread into other stocks and asset classes, resulting in a sudden and large drop in market prices. High on the list of moral duties at the Fed and the Treasury is preventing contagion.

Here’s a general guide to how these things work. It’s been going on for a long, long time, so if you learn it now, it may help you your whole life:
• Markets go up and creative bankers invent clever ways to juice returns through “financial innovations” (Enron’s off-balance-sheet entities, liar loans, interest-only loans, negative depreciation loans, CDOs, SIVs, etc.).
• Skeptics call for greater regulation, citing the risk.
• Regulators ignore skeptics, afraid to step in front of an upwardly moving market that is creating wealth for a lot of people. Regulators claim that “free markets” are self-correcting and price assets appropriately (i.e. it is impossible to forecast bubbles).
• Eventually markets go so high that, like Icarus, they are brought down by themselves.
• The peddlers of the “financial innovations” run to regulators for a bailout, citing unprecedented and unforeseen market conditions and the threat of contagion.
• As long as the peddler is not too tainted (e.g. Ken Lay) and the threat of contagion is credible enough, regulators move into action.

In watching Fed and Treasury, look for them to selectively use:
• “free markets” as a justification for not regulating (when markets are going up), and
• “the interest of the greater good” as justification for regulating (when overpriced asset come down and threaten contagion).

Greenspan was the master of this tactic, but Treasury Secretary Hank Paulson is a quick study. Paulson, who has repeatedly argued against regulation of hedge funds and mortgage markets is now calling for government intervention. According to the Wall Street Journal:

“The regulators didn’t have clear enough visibility with what was going on in terms of these off-balance-sheet SIVs,” Mr. Paulson said to reporters…In the short term, Treasury officials said the financial markets were in danger of a large-scale dumping of assets by the banks, which would have hurt capital markets and potentially spilled over to the broader economy [contagion!]. To avoid that, Treasury stepped in to facilitate discussions among the banks…Some have criticized the Treasury for essentially helping big banks avoid the financial pain associated with risky bets that didn’t pan out. The reaction in Washington, though, was more muted. Democrats sought to use the Treasury’s willingness to get involved to bolster their demands that the Bush administration do more to help homeowners who are also suffering from the subprime downturn [more government intervention by the Republicans means the Democrats should get theirs, too].

So what’s my beef with how this world works? Not much, in that knowing about it, I am able to make a lot of money trading various stock and commodity positions in a way that is favorable to me. However, despite the benefit it provides me personally, I wish it didn’t exist. I am concerned about the greater good (wink, wink). My concern centers on inflation.

It’s simple really. If bubbles go up (like housing) and then aren’t allowed to come down, the result will be inflation. Housing prices have gone up way too far. By almost any metric, they are overpriced. First time buyers cannot afford new homes. Mortgage payments as a percentage of income are elevated. Owning a house vs. renting one is extremely expensive. Whatever way you look at it, housing is overpriced.

If free markets are allowed to run their course, house prices will come back down, possibly causing a short-term recession, but paving the way for long-term economic growth. It will be painful, quick, and healthy.

But that’s cruel, politicians will argue. People will suffer. Consequently, politicians and regulators are trying to help. Bernanke wants to lower rates to keep the subprime meltdown from spilling over into the broader economy, Hank Paulson wants to save the big banks from suffering major losses, and the Democrats want to help bail out subprime borrowers.

The road to hell is paved with good intentions. Each of these policies is inflationary. If housing prices don’t come down, everything else will have to go up in value. How else will people be able to afford these houses relative to their incomes? Either house prices must come down, or incomes must go up. With banks running into liquidity problems, we’re going to need a lot more help (a.k.a. money) from the government, which means more money supply, more credit, and a weaker dollar – all of which is going to lead to more inflation.

Markets, of course, are starting to get one step ahead of the regulators, driving up the price of oil, food, gold, and more. Oil is already at $87 a barrel and could easily go to $100 or more. Nonetheless, market watchers expect the Fed to lower interest rates again on October 31st.

Until the regulators, led by Bernanke, change their tune and start taking the threat of inflation seriously, it will continue to be advantageous to your portfolio to own:
• oil & gas companies, like Devon Energy (DVN) and SouthWestern Energy (SWN)
• gold companies, like Nemont Mining (NEM), Tanzanian Royalty (TRE [a well-run gold company doing a lot of prospecting in Tanzania]), and GoldHawk (CGHRF.PK [another well-run mining company that started production Oct. 1 at a Peruvian gold mine it acquired for a good price]
• metals companies, like CVRD (RIO), and Liberty Minerals (LBEFF.PK [a Canadian company opening new metals mines]).

If the smaller companies (TRE, CGHRF.PK, and LBEFF.PK) can get their new mines up and running according to plan and without cost overruns, and metal prices continue to move up, their stock prices could do extremely well. These companies are good inflation hedges.

I also continue to like generators of capital, such as Unico America (UNAM), a small California insurance company which trades just under book value (http://seekingalpha.com/article/49078-unico-american-corporation-true-value-again-and-again).

Don’t worry about people claiming that oil and metal prices are already too high. Unless Bernanke gets serious about inflation, prices should move higher. Why? Because interest rates are a lot more accommodative than most analysts are saying. Overall inflation (WITH food and energy) is higher than core inflation. Yet, everyone is measuring by core inflation. I think it’s incorrect to do so.

Core inflation was developed to take out temporary spikes in food and energy. But what if food and energy are on a long-term uptrend and core inflation is on a long-term downtrend (driven by globalization)? If that is the case, one misses the true trends by taking out food and energy. Greenspan recently said that the theory of using core inflation is starting to lose some credibility (he can tell the truth now that he’s no longer in office).

But Bernanke is doing the opposite, arguing more than ever for the validity of core inflation. Bernanke is under tremendous pressure to provide liquidity (via lower interest rates) to the banks. To do so, he must argue that higher oil and a falling dollar are not important. Only core inflation matters.

It seems as if hedge funds are the first to catch onto this inflation theme. Eventually, they will be followed by PIMCO (but don’t hold your breath), and finally coming in last will be Bernanke.

A recent AP article gave clues about the direction he is leaning:

Bernanke once again pledged to "act as needed" to help financial markets [in other words provide inflationary liquidity]…"The further contraction in housing is likely to be a significant drag on growth in the current quarter and through early next year," he said [I believe he’s using weak housing throughout 2008 to justify future rates reductions]…On the inflation front, Bernanke noted that the prices of crude oil and other commodities have been rising and that the value of the dollar has weakened. Oil prices galloped to a record high of $86.13 a barrel on Monday…
Fielding questions after his speech, Bernanke said, "Part of the reason that we have some confidence in inflation remaining well controlled is we expect to see the economy growing more slowly at the end of this year" and early next year [again the weak economy from housing is Bernanke’s justification for the Fed keeping liquidity flowing]. He said Fed policymakers were prepared to “reverse" the rate reduction if inflation turned out stronger than expected [this statement is probably his most important, but is it true?. If core inflation goes above 0.3%, will he backtrack or follow through with this threat/promise and force the economy into a recession? Watch the core inflation number! It’s the most important economic number right now].

To understand the pressure Bernanke is under, and why I believe he and other regulators will continue to flood the market with liquidity (in spite of high oil prices), look at the current state of the real estate markets.

One of my readers wrote saying he is a real estate agent, and that volume is off 2/3 from normal. “And prices are soft,” he wrote. “The lenders will only provide an equity loan at 80% of value [if you have a credit score in] the 750 fico range…if not forget it. When purchasing you need 725 [fico] and 20% down…who has 20% in savings for a down payment? Not many…this is a huge problem and the main reason homes are not selling. Not many can qualify under the new standards!”

Another reader, also a real estate agent, wrote:

There are going to be a massive amount of foreclosures. About 47% of homes on the market here are vacant. Many of these same sellers did refinancing, pulling huge amounts of cash out of these homes, leaving them with negative equity in the face of falling prices. In effect, these homes were sold to the banks and eventually the home debtors will walk away with their cash. Thanks to the new Mortgage Debt Forgiveness Act, there will be little impact from this fraud [compare that to Paulson calling for more government action!]. However, the lenders will continue to tighten and those defaulting will be out of the home market and credit market for seven years. When I drive through a prospective neighborhood, I try to ascertain the yearly median income. I multiply that times three to get a neighborhood sales price range. Here in Phoenix, we need to come down 40 - 50% more [again, either housing prices must come down or incomes must go up]. Since I have lived in the same home for 30 years, I know this is pretty accurate for my own neighborhood. Like you say, sellers are reluctant to drop price. We have a long way to go.

Unless housing is allowed to run its course, the government will only cause inflation, or more likely stagflation,. So although you probably didn’t think you wanted it, you might want to add a little contagion to your Christmas list.

In case you don’t believe me, here are some final thoughts on stagflation from Wikipedia (emphasis added):

Stagflation…a term…used to describe a period of out-of-control price inflation combined with slow-to-no output growth, rising unemployment, and eventually recession. Stagflation is a problem because the…principal tools for directing the economy…offer only trade offs between growth and inflation. A central bank can either slow growth to reduce inflationary pressures, or it can allow general increases in price to occur in order to stimulate growth. Stagflation creates a dilemma in that efforts to correct stagnation only worsen inflation, and vice versa. The dilemma in monetary policy is instructive. The central bank can make one of two choices, each with negative outcomes. First, the bank can choose to stimulate the economy and create jobs by increasing the money supply…but this risks boosting the pace of inflation. The other choice is to pursue a tight monetary policy…to reduce inflation, at the risk of higher unemployment and slower output growth. In neo-classical economic theory, stagflation is rooted in the failure of the overall market to allocate goods and services efficiently. The root cause of this is generally thought to be excessive government regulation…Stagflation in the U.S.A. was defeated by the then Federal Reserve chairman, Paul Volcker, who sharply increased interest rates to reduce money supply from 1979-1983 in what was called a “disinflationary scenario.” Starting in 1983, fiscal stimulus and money supply growth combined to create a sharp economic recovery which is in line with standard macro-economic models; however, there was a five-to-six-year jump in unemployment during the Volcker disinflation. It appears that Volcker trusted unemployment to self-correct and return to its natural rate within a reasonable period, which it did.

Paul/Volcker in 2008!

More on housing not being over yet

Wow! This is truly astounding. This FT article really is scary. I've been pessimistic about housing and finance companies, but this latest information is truly shocking.

Say goodbye to a couple of homebuilders. Expect the dollar to fall further. Hold on to those oil & gas, gold, and metals stocks.

The financial meltdown ain't over yet!

From the FT:

Big US commercial banks have seen $280bn of new debt come on to their balance sheets since the credit squeeze, threatening to undermine economic growth by inhibiting their ability to make new loans.

The banks have been forced to take on to their books large amounts of commercial paper and leveraged loans after investor demand for such assets dried up in the summer.

David Rosenberg, economist at Merrill Lynch, said that this amount had risen to $280bn since the start of August.

He added that according to data from the Federal Reserve, large bank capital - represented by net assets - had declined by $40bn since the beginning of August. "This has never happened before over such a short timeframe and this is rather serious because such a steep and sudden compression in large-bank capital has the potential to create a negative lending environment," he said.

If left unchecked, this could "significantly inhibit" economic growth, he added.

European banks are facing similar pressures with many observers expressing concern at the ability of some smaller lenders to handle the potential strain on their balance sheets.

Fears over the effect of the credit squeeze on US bank balance sheets was one factor behind the US Treasury's encouragement of the creation of a "super fund" to take on the assets of troubled investment vehicles.

The three top US banks - Citigroup (NYSE:C), JPMorgan Chase and Bank of America - this week unveiled plans for a fund that would buy up to $100bn of mortgage-backed assets from structured investment vehicles.

Citigroup, which manages $80bn of assets in such vehicles, has bought some of the vehicles' commercial paper.

On Monday, Citi said it was suspending share buy-backs because its capital ratios had weakened partly due to the large amount of commercial paper and leveraged loans it had taken on.

According to Moody's, the credit rating agency, assets held by bank-sponsored special investment vehicles fell to $320bn from $395bn in July.

"The large banks have been forced to take commercial paper back on their balance sheets and as a result are choking on assets they did not plan on having - thereby tying up regulatory capital and in turn possibly leading to a reduction in credit extension," said Mr Rosenberg.

He pointed out that 30 per cent of the growth in the debt that US households took on was backed by asset-backed investors.

Why the housing slump isn't over yet

For years, I bored my friends with talk that housing was in for a downturn. No one believed me, and people urged me to buy in before I was shut out of the market.

Despite the obvious slowdown in housing, I continue to sing the same tune. I've been doing a lot of reading this weekend about the housing market, and I've concluded that we still have a long way to go before housing reaches bottom.

Why? The main reason is that in spite of all the whining and moaning about the housing slowdown, prices haven't come down that much (maybe 10%) and affordability is still very low by historical standards.

Here are some other reasons to be wary of housing:


- There is a ton supply out there (supply is at a record, and 2x its normal rate over the last several years). It has just skyrocketed and it is not going down.

- Affordability for new home buyers is still at lows.

- More people own houses than ever before (meaning fewer buyers out there).

- The Fed will have trouble lowering interest rates in the face of $85 oil and a Euro of 1.42.

- Credit standards are tightening, meaning fewer mortgages and therefore fewer buyers.

- A large amount of ARMs are still resetting, with a tremendous amount due to reset in the second half of 2008. ARM resets are leading to more foreclosures, and therefore even more supply.

- Homebuilders are under enormous pressure with debt coming due and therefore will be willing to dramatically lower their prices.

- The economy seems to be softening, with economists raising the chances of a recession.

- Cap Rates (the income from rents) are still very low, making housing an unattractive investment.

- All of the above is leading to a change in the mentality towards housing. It is going from something people want to own to something to be wary of. This change in attitude towards housing can take a long time to set in and have a tremendously negative effect on pricing.

Frankly, the only bright spot I see in housing is that the weak dollar is leading to more foreign buying of U.S. real estate (in places like New York), but the effect of this buying is minimal compared to the other negatives. I just don't see other positives.

I think owners are stubborn and resistant to lower prices. Therefore, the market is not correcting itself quickly. The slowdown is likely to last several years.

Until Cap Rates are higher than Mortgages Rates (meaning it actually pays to be a landlord), I think the market will continue to head down. Unfortunately, we're not even close to having attractive Cap Rates.

I wouldn't be surprised if a major homebuilder declares bankruptcy in the next 6-12 months. I also wouldn't be surprised if homebuilders and banks start to move to more aggressively clear inventory, which will lead to big price declines.

Recommending UNAM again

Shhh. Here's a little secret.

There is a stock I've owned for 5 years. It's gone from $4 a share to over $11. And you know what? It's STILL trading under its book value of $11.80.

This company is Unico American Corp. (symbol UNAM), which trades at 10x earnings and generates around 10% ROE. It's kind of like a bond yielding 10%, backed by book value and with upside potential.

UNAM is a California property & casualty insurance company. UNAM is conservatively managed, with very disciplined underwriting. Several quarters ago, UNAM's book value and shares got a boost, as loss estimates were marked down thanks to good underwriting. Here's how UNAM states it: "Despite the increased competition in the property and casualty marketplace, the Company believes that rate adequacy is more important than premium growth and that underwriting profit (net earned premium less losses and loss adjustment expenses and policy acquisition costs) is its primary goal." Now that's the smart way to run an insurance company. So don't be fooled by the declining sales numbers. They are intentional and investor friendly. It's tough not to chase business, but it's the right thing, as UNAM's stock price proves. In addition, UNAM has not chased risky assets like CDOs. Rather they remain conservatively invested in short-term treasury bonds.

Their market cap is under $65 million, yet their latest 10Q shows $146 million in assets (mostly short-term treasuries) and shareholding equity of $64 million (which is the real thing, coming from retained earings, not from goodwill or other funny stuff).

The subprime market fallout caused this stock to move down from $14. However, this stock has absolutely no exposure to the financial crisis. If anything, it will benefit, as there might end up being less competing capital in the insurance markets.

It's hard to find value in today's market. But if you invest in UNAM, you're likely to find true value, again and again.