Fear treads unchartered turf - Toronto Star, Business section, September 27, 2008

Last week we were looking for the Maalox. We are now out of it. For years, we, along with many others, warned how the growing mountain of debt, coupled with unparalleled growth in derivatives and complex products, would wind up in a massive debt collapse. Of course we were for the most part considered charlatans, doomsayers or worse. Only occasionally did the mainstream financial press point out essentially the same, even if it was on the back page. Now it is upon us and the creators of this mess are caught like deer in the headlights.

Watching Henry Paulson, Ben Bernanke and George W. Bush look and act like dead men walking is a sight to behold. On August 8, 2007, at the start of this crisis, President Bush declared "the economy is strong," repeating it several times in the same speech. Then on September 15, 2008, he said the same thing, adding that troubled Wall Street shouldn't expect any more rescues from Washington. At the same Paulson said that "what we are going through in the short term doesn't make anything easier, but in the longer term it's going to make things better...." Bernanke often recited the same mantra.

This past week, the tune changed dramatically. Bernanke now tells us that lawmakers are "urgently required to stabilize the situation and avert what otherwise could be very serious consequences for our financial markets and for our economy." Bush warned that the US could slip into "a long and painful recession" and that "the market is not functioning properly" and that "America could slip into a financial panic".

A panic, very serious consequences for our financial markets - these are words more likely to be found on commentary at www.safehaven.com rather than from the mouths of the chairman of the Federal Reserve and the President of the United States. Henry Paulson, the former CEO of Goldman Sachs who was reportedly paid at least $37.5 million in 2005 and is worth over $700 million, was seen down on his knees begging for the bailout (reportedly in front of Nancy Pelosi, the house speaker, where he dropped to one knee imploring her not to "blow up" the bailout deal).

Our world has turned upside down. The doom and gloomers may be looking a little smug these days while the don't-worry-be-happy go out and shop crowd are calling "panic" and grovelling. Well we know what the word "fire" causes in a crowded theatre. A panic. When the rats are looking to be bailed, you know the ship is going down.

There is of course no point in going where John McCain has gone. On September 16, 2008 he declared that "the fundamentals of the economy are strong." This from one of the leaders of the charge to deregulate the financial system. That he was seen suddenly leaving his election campaign to rush to Washington to help save the day can only be described as a crass political manoeuvre. The so-called high level meeting on Thursday at the White House descended into "a contentious shouting match," often with McCain at the centre. Presidential contender Barack Obama was seen more as a reluctant guest.

Ben Bernanke, a student of the Great Depression, believes that the bailout is the only way to go. Recall that during the Great Depression three elements contributed to the collapse. High trade barriers brought on by Smoot-Hawley brought international trade to a standstill, the collapse of the stock market and the hiking of interest rates and allowing scores of banks to fail.

Of course this time they are trying to prevent a stock market collapse (even though it is down around 20 per cent), there are no indications that we could enter into trade wars despite numerous members of congress and others who would love to impose trade duties on Chinese goods amongst other trade restrictions and with this bailout package they wish to prevent too many banks from failing.

Without it, the they say that the US could fall into a still larger financial collapse with unknown consequences. But what are these unknown consequences? The financial system has already written off some $500 billion and it was estimated that there could be upwards of $1.6 trillion in bad debt to write off. Writing off another $700 billion would just get us closer to that number. And if these financial institutions are that weak they should be let go anyway. The good parts of the companies will be picked up by other players. With over 7,500 banks in the USA even letting 10 per cent of them go under would not be the end of the world.

The problem right now is that we are being told that the collapse is simply too big for the market to deal with. For years in the deregulated financial environment the banks, the investment dealers, the hedge funds and even private equity funds leveraged up the system on a sea of liquidity provided by the same Fed led by Bernanke and by his predecessor Alan Greenspan, plus a long period of low interest rates pushed once again by the Fed and the gobs of US dollars recycled back into the US economy as a result of the massive trade deficit. The charge while led by China was practised by many who sold goods to the US, whether it was widgets or oil.

The massive leverage of the financial institutions was created by the ability to recycle these excess dollars, the low interest rates, and the knowledge that it was a game they couldn't lose at. A few got filthy rich while the masses enjoyed the cheap money to buy homes they couldn't afford in the first place. The sub-prime crisis was a small part of the problem, but it was the trigger that started the avalanche of deleveraging. The bailout could just reinforce the perception that "you can't lose" and it will engender another financial bubble and collapse.

Structured investment vehicles (SIVs) were at the heart of the problem at the financial institutions. The "masters of the universe" created them and the deregulated banking environment, the sea of liquidity and low interest rates helped create the massive leverage. With the deleveraging process now in full effect, the opposite is taking place.

In the deleveraging stage no one has the ability to borrow to buy the assets. Banks have now stopped lending to each other as everyone is afraid that whoever they lend to will be the next one to go under. And of course the banks have stopped lending to the corporations and consumers who need the funds to continue their business or supplement their purchases. That the consumer got over-indebted in the first place (also as a result of the easy money) is moot. Quite simply, the credit markets are frozen.

Well, not completely. This past week I received at least two offers from financial institutions to borrow their money for up to six months at very low interest rates. The game continues, at least in some quarters.

With the deleveraging process underway, the bailout should be more properly labelled an economic stabilization plan. Think of the plunge protection team, only more visible. There is panic in the markets because not only can the bad debt not be sold (at almost any price), even the good debt can't be sold unless deeply discounted. With so much cross exposure in the markets it feeds on itself and creates a downward spiral that can be stopped only by drastic measures. There is a slow bank run going on and it is now bleeding money market mutual funds and bank deposits. And as the money bleeds out, the banks are forced to unload even more debt at distress prices or look for new capital that is simply not available.

There is of course no guarantee that this bailout plan will work. We find it highly unlikely that the credit markets will suddenly open up their wallets and start lending again. Simply put there has already been too much damage and many companies and consumers remain overburdened with debt. This bailout program will do little to get the housing market moving again although it may help a little. Foreclosures will continue. At best only the very best credits will be able to continue to access funds. There is undoubtedly a lot further to go in this deleveraging process beyond this $700 billion package.

The flight to safety is on. Capital is fleeing at least initially into US Treasury Bills. Rates on three-month Treasury Bills have fluctuated between zero (apparently one-month T-Bills even went negative one per cent) and about 0.80 per cent. The TED spread, a measure of the spread between what the banks can borrow at - the three-month LIBOR (London Inter Bank Offered Rate) - and three-month US Treasury Bills has leaped from 13 bp in February 2007 to around 150 bp following the breaking of the financial crisis in July/August 2007. The TED Spread now stands at 325 bp after hitting highs of over 500 bp. The TED spread is spelling panic in the financial markets.

On the other side corporations are having extreme difficulty accessing markets. The commercial paper market which is the lifeblood of the corporate and financial sector to access funds has seen a sharp decline over the past several months. This formerly $1.6 trillion market has declined to a $1.4 trillion market and is still falling. This is all a part of the deleveraging process.

Capital is also flowing into gold and we are now witnessing increased demand. The price of gold, after hitting a low of $740 only two weeks ago, has recovered to $882. While this is still well short of the record $1,014 seen in March 2008 we fully expect that level to fall before year end. Quite simply, gold that has no liability is a safer vehicle than US Treasury Bills that are merely debt obligations of the US Government.

And the debt of the US government is going to grow further with this proposed $700 billion bailout. As part of the deal they will purchase the debt at a discount and hopefully obtain the higher quality debt. By purchasing at a discount there is a chance the taxpayer who is footing this bailout might actually make a profit on it. While the banks may be forced to write off more bad debt (they have written off roughly $500 billion already and some conservative estimates put it as high as $1.6 trillion finally) it would provide them with a huge capital injection.

Can a deal be reached? Indications are that a deal is being reached. The deal includes some sort of cap on executive pay, a proposal to add a tax to companies if the proposed bailout did not make back what it had spent over a period of 5 years, and a proposal to insure some bad debt rather than buy it outright thus limiting the amount of funds necessary to disburse. That it has come to this kind of panic is symptomatic of where we came from, and while it might please some who called this disaster years ago to bask in their glory, even we believe that while this has terrible implications for Main Street, the alternative is potentially worse.

And there is no guarantee that it will stop the bleeding. Indeed we are reasonably confident that the stock market has a lot further to fall, but it is not just a straight down panic and this could or should take years to unfold. After the glow of the bailout (or stabilization plan) wears off, the stock market will continue its downward slide. The bailout will not unleash the wave of credit granting that the authorities are hoping for. That will unfortunately take many years to repair.

So just how bad has it been for the stock markets versus other forms of investment over the past several years? Our table below summarizes this (all figures as of September 26, 2008).

Despite the recent problems with gold stocks, they have been the best performers of the decade: up 262 per cent. And note that outside of holding Treasury Bills the only sectors that had gains throughout are oil and gold. And unless you were able to hold oil itself it has been the best performer up 336 per cent. The worst performer was the Tokyo Nikkei Dow, down 33 per cent this decade.

Since the beginning of this year stock markets are down generally 16 to 22 per cent depending on the index. The exceptions were short-term US Treasury Bills, gold and 10-year Treasury Bonds. Three-month Treasury Bills are skewed by the recent flight to safety that has seen yields fall sharply, and both the T-Bills and the Bonds remain well below the inflation rate of 5.2 per cent. Oddly, the Dow Jones Transportation Index is also up on the year despite the rise in the price of oil. A true anomaly in a year that has generally seen the stock markets fall.

One interesting aspect is that during the early part of 2008 gold and the gold stocks soared as the financial crisis unfolded. Following early difficulties the DJI rallied while gold and the gold stocks fell back. The DJI topped in May 2008 and as the market began to fall again gold and gold stocks put on a feeble rally that topped out in mid July 2008. This set up the massive attempt to talk up the US Dollar and support the market to prevent an all out collapse. There were even hints from the monetary authorities that they might hike interest rates to combat inflation. As a result once gold and gold stocks broke supports a mini panic set in. Since the next phase of this financial crisis has unfolded the DJI and the broader stock market has fallen while gold and the gold stocks have recovered sharply.

Since hitting a low close of 262 on September 11, the HUI is up 25.5 per cent. Gold is up 19.1 per cent while the DJI is down 2.5 per cent. Only the efforts of the Federal Reserve with its massive infusions of cash have probably prevented a more severe meltdown. Other markets such as the S&P 500 and the NASDAQ have suffered more. This bailout plan then is the latest manifestation to save the market.

While the mini-panic in gold and gold stocks (oil stocks also suffered) was painful, when one puts them in perspective over the past several years, these are the areas that stand out the most, setting aside just holding cash (i.e. T-Bills). With a financial panic underway and a silent run going on in the banks (see the recent collapse of Washington Mutual), the authorities are desperate to do something. In order to prevent an all-out collapse in the financial markets the Federal Reserve has allowed the banking system to access the Fed window in an unprecedented manner, averaging some $188 billion a day over the past few weeks.

But bailout or no bailout, gold and gold stocks are going a lot higher. No matter how one looks at this crisis, the conditions have never been more bullish for gold. The current pause is merely a bull consolidation. If the bailout goes ahead it has the potential to be inflationary, which is positive for gold. If it fails, the deflationary cycle that will follow will also be positive for gold, as it was in the 1930's (gold was fixed at $20 at that time but gold stocks soared). The fiat currency system will come under extreme pressure and the calls for a new Bretton Woods (which had gold as a base for the system) will get louder. We are already well aware of numerous calls for a new Bretton Woods but they are emanating from Europe, although there are US economists involved. Calls will also continue to end the US Dollar as the world's reserve currency.

There are shortages in the gold market as demand has soared. Mints cannot keep up with demand and are experiencing shortages. Krugerrands, Gold Eagles, Maple Leafs and others are trading at premiums to spot or melt. Mine supply has been declining for years and the low prices currently on many junior mining exploration stocks will discourage all but the hardiest to continue to search for new finds. Very few new mines have come on stream over the past number of years and it takes a decade or more to progress from drilling to production.

While cash is great and we agree that investors should have cash, it pays nothing, as the current low rates for T-Bills will attest. The bullish conditions for gold could lead to gains even better than the great gold bull of the 1970s, when gold rose over 2,000 per cent in 9 years.

The nightmare on Wall Street continues. But investors should not be putting their heads in the sand and hoping it goes away. Some combination of cash, gold, gold stocks and even selective oil and gas stocks (they too remain in a bull market), especially the oil and gas income trusts and even the odd preferred shares of Canadian banks (much stronger than US banks), and even some agriculture exposure could still make a strong portfolio in this financial crisis.

Are we about to enter another Great Depression? Well, listening to the panicky statements of Bush and Paulson (and Bernanke, to a lesser extent) over the past week or so it would sound as if we will if they don't get their bailout. Even we don't believe (not yet anyway) that we could hurtle into another Great Depression, but the US in particular and Canada to a considerably lesser extent are headed for a recession that will probably see standards of living drop and especially in the US the creation of a Latin American type of society with a small but powerful very wealthy class and a huge lower middle class and lower class. The middle class will be squeezed.

The world is making great leaps forward and there are more people living or striving to live a middle-class life then ever before, but financial mismanagement, wars for oil and even eventually for food and water threaten to erode those gains. The bailout is an attempt to start putting the financial house in order but we have a long way to go.

And now the pharmacy is open, and I am off to replenish my Maalox supply.

Note: Chart created using Omega TradeStation. Chart data supplied by Dial Data.