27 February 2009

Gold: Plus Ca Change, Plus Ca Reste La Meme Chose

A good part of the population voted for change but not less than a month into the new administration's term, change is nowhere in evidence. President Bush's Plan A involved the purchase of Wall Street's toxic assets but then Henry Paulson switched to Plan B by buying stakes in the banks themselves. President Obama's Plan C devised two plans, a $2 trillion bank rescue plan which sets up a government controlled "bad" bank and yet another economic stimulus plan. President Obama's much anticipated package was a mixed bag of plans from support for dodgy assets to tax breaks to the de facto nationalization of Wall Street. Creditors and even shareholders will be protected at the expense of the taxpayer - how inclusive indeed. But still nothing seems to work as America stumbles from one rescue to the next. Debt on debt won't work.

Yet despite promises of change, Mr. Obama appears to be pursuing the identical tax cuts and deficit spending policies of his predecessor. Unfortunately the President all but repeats Bush's Keynesian approach of borrowing and spending the country's way back to prosperity, without tackling the underlying causes of the crisis. Even with his stimulus plan, the Congressional Budget Office (CBO) estimates that the deficits will amount to $2.9 trillion over the next three years and Obama's stimulus plan will spend only 20 cents of every dollar in fiscal 2009 (roughly $650 billion will be spent later).

The Audacity of Change

Is it really different this time? Obama's stimulus plan is promising relief when the ink is not even dry on the last bailout package. Sadly, this stimulus package was more political than economic stimulus. Obama's goal is to create or save 3 million jobs when there are no jobs. The US lost 2.5 million jobs last year at a pace not seen since the forties. Adding these jobs only replaces the ones lost and yet unemployment is still rising. So $787 billion later, like his predecessor, the only change to the status quo is no change.

Much of this "seat of the pants" spending is directed to helping the consumer by stimulating the housing sector. The Treasury Department also hopes to attract private money to finance along with the Fed. Since America's GDP is composed of more than 70 percent consumer spending, the government's bailouts are now being redirected to these sectors with an ever increasing role for government. Yet the housing sector has too much capacity and the problem cannot be cured by a pickup in demand. Indeed, there is a one year supply of new homes today that are vacant. The problem is that more debt will not revive the housing sector nor reverse the effects of a burst bubble on Wall Street. Besides, US cars sales are at their lowest in 40 years despite generous cash incentives.

The markets remain frozen and despite, lending or spending almost $3 trillion over the past two years, financial institutions are still grappling with the same problems when the crisis seized up over eighteen months ago. As it happened, by running the printing presses overtime, the government is creating a monumental monetary overhang that raises the inflation risk significantly and even bigger financial instability.

Are the Toxic Assets Really Assets?

Looming in the background are some $3 trillion worth of once highly rated asset-backed securities backed by subprime, credit cards commercial mortgages or complex derivatives that are festering on the banks' books that have yet to be sold or dealt with. A key element missing from Obama's stimulus package is how the government plans to value the toxic (oops legacy) assets that would be rescued under the plan. Unfortunately neither Bush and now Obama can't put lipstick on this pig.

The public purchase of these troubled assets was initially proposed by Paulson but the banks' problems became so troubled that they required funding themselves. Trillions of their impaired assets simply cannot be valued because for many they are worthless today and will be tomorrow. Besides, if written down, who will take the loss? And, why set up a bad bank when there are already "bad banks" out there such as Bank of America and Citigroup for those investors willing to buy them. In buying the toxic assets, the Treasury is pouring good money after bad money of which their value is unknowable, unsecured and in many cases, outright fictitious.

Not only does the valuation issue need to be resolved, but in previous clean-ups such as the Swedish model or the Resolution Trust setup in the eighties to fix the S&Ls, the assets were first acquired by government and then split up into a "good" or "bad" bank with the bad bank holding the insolvent assets. This time it is different. The centerpiece of Obama's "fuzzy" proposal partners with the private sector and leverages the Fed's balance sheet by 10 to 1 or a whopping $1 trillion which is insufficient to finance the growing loan losses anticipated in the $2 trillion or so range. Left unclear is what would happen to the thinly capitalized bank's capital after they transferred the troubled assets and wrotedown the value of any loans which would further erode their precious capital. Or, if the assets were provided with overgenerous valuations or guarantees, who pays the price? They should accept the reality that the banks are insolvent and not too big to fail. Let the banks go and clean-up the remaining banks. Central banks have become central planners.

Addiction to Debt

And where will the Treasury find all those dollars in order to pay for the world's first trillion deficit? There is only one answer. The Treasury has been printing money and flooding the banking system with cash without sterilizing the monetary consequences. Since August, the Fed has tripled its balance sheet by taking on the toxic assets of Wall Street and acquiring stakes in banks. And despite spending trillions to restore consumer confidence, the economy is still sinking. Moreover, government revenues have slipped as the private sector copes with the meltdown so the budgetary deficit itself will be even bigger. Easy money is not the panacea.

America's dream was built on cheap credit and the US is going even deeper into debt to dig itself out of its economic hole. Multi-year trillion dollar deficits and dollar debasement will not solve this crisis since the cure for the credit bust is not more credit.

The root of the current crisis lies in excessive debt, cheap money and the monetary excess that led to a boom and the inevitable bust. Following the Second World War, public debt stood at 100 percent of GDP to finance the rebuilding of America. America's public debt to GDP ratio could approach 60 percent next year up from 38 percent today. However, including housing-related private debt, the ratio of private and public debt to gross domestic product was a whopping 358 percent in the third quarter, surpassing the peak in 1933.

To finance this growing deficit the US Treasury must issue record debt. Already yields on 10 year Treasuries rose to almost 3 percent up from just over 2 percent at yearend. The rise in yields has pushed 30 year mortgages up, causing the Fed to consider capping rates by purchasing debt as they did in the Great Depression.

America's Ponzi Scheme

Today's bailouts replaces private consumption with government consumption and Americans still have not figured out who is to pay for big brother's largesse.

Governments have unlimited powers of money creation. The Treasury issues bonds and the Fed purchases them (quantitative easing) by putting money in the system by explicitly printing money. The funds then go to pay for bailouts, SUVs and even Obama's inauguration.

While the US is still a creditworthy borrower, foreigners no longer appear to have the capacity nor desire to allow the Americans to continue to subsidize their consumption with borrowed money in a now capital starved global economy. And China, with more than $1 trillion of American debt is spending its cash hoard instead domestically to revive its own economy. And by calling China a "currency manipulator", newly minted Treasury Secretary Geithner masks his problems. Despite a 20 percent revaluation of the yuan since 2005, the US trade deficit has worsened each year. America needs less rhetoric from its policymakers and more dollars. Creditor nations like China and Japan who already own trillions of dollars of US denominated debt, will lose confidence in America's ability to repay its debt and its addiction to debt. With only five percent of the world's population, America accounts for some 25 percent of the world's debt.

Billions were lost in the collapse of Bernie Madoff's biggest Ponzi scheme. The pyramid scheme collapsed like others under its own weight of greed. But the government itself is running a bigger Ponzi scheme than Madoff. To finance its debts, the Federal Reserve has resorted to monetizing the debt in a Ponzi-like scheme.

To keep their homes, millions of ordinary taxpayers borrowed from institutions solely for the purpose of repaying another without the remotest expectation to repay the loan they arranged. Similarly, the United States is borrowing billions and now trillions from creditor nations when there is also no hope of repaying the loans until the next round of funding. Now with the bursting of the greatest credit bubble in history, the government is attempting to reflate this bubble, by "quantitative easing" in which the Fed increases its balance sheet by printing money. And since the government has little hope of paying off the debt, the printing of money itself devalues that debt but risks higher inflation, which ironically reduces the debt as if repaid by another source.

The widening gap between the drop off in future revenues and its growing expenses in the wake of the global meltdown dictates as in all Ponzi schemes, the government must get new investors to buy out current obligations. In getting Peter to pay Paul, they are also hoping that the old investors get paid from the new investors so that they will not be the bag holders. The last one holding the paper eventually loses. As in a game of musical chairs, countries like China and Japan were the early investors and are banking on the government to create new investors. Bernie Madoff's Ponzi scheme failed in a widely publicized crash, but the failure of Wall Street exposed an even bigger failed Ponzi scheme today with its failed CDOs, subprime mortgages, and soon to be defaulted credit default swaps. Foreign central banks were stung in the last go around and the American taxpayer will be stung from this go around as those IOUs come home to roost. After all, who is going to lend to a bankrupt county that is using Ponzi-like schemes to finance its consumption?

Who Is Lord Keynes?

There is much debate about using public funds to plug a capital hole too big to fill in any single way with public or private funding. Mainstream economists continue to push for a prescription of Keynesian-inspired spending in the belief that throwing good money after bad will somehow reverse the downward spiral. Amazingly, most money managers today do not even know about Lord John Keynes. Keynes was a British economist whose ideas and theories enjoyed a following thirty years ago. Old-fashioned Keynesian economic theories are enjoying a revival as justification for the recent bout of public spending and tax cuts. In Keynes' 1936 book, "General Theory of Employment, Interest And Money", he argued it was better for government to use fiscal policy to stimulate economies suffering from a lack of demand. Keynes advocated regulating the economy through investment, not consumption by using low rates of interest and cheap money.

In only a few weeks of his inauguration, the Obama administration unveiled the greatest increase in government spending in history. It is our belief that government spending whether for reduced taxes, pork barrel spending or infrastructure spending is still government spending. Today having exhausted monetary policy measures, the government has revived Keynesian economics to justify priming the pump. The Fed has even resorted to using unorthodox tools to stimulate the economy and is hinting of more. Many forget that it was Keynesian economics and the reckless spending spree that led to runaway inflation and double digit interest rates in the seventies. Ironically, it was Paul Volcker the now Chair of Obama's Economic Recovery Advisory Board that had to deal with the consequences of Keynesian economics by sending rates to double-digit levels to conquer inflation in the eighties.

Modern Day Underworld

Three decades ago, the banks provided $3 out of every $4 of credit worldwide. The debt to capital leverage then was a robust 8:1. Today, the share of the big banks has shrunk to only $1 out of $4 of credit world-wide and the leverage ratio is a more robust 20:1. Securitization filled this vacuum and the private equity and leveraged hedge funds provided more loans to the credit markets than the banks. The combination of computing and mathematics created fancy structured products like collateralized debt obligations (CDOs) or credit default swaps (CDS) which replaced bonds and equities. These "made in Wall Street" securities allowed investors to gamble on prices or defaults and leverage grew exponentially, outpacing economic activity. There were even CDS securities that insured against the default of CDOs. Mortgages were "sliced and diced" into securities, backed by paper and resold to investors around the world. Rating agencies gave their seal of approval and these funny money derivatives exploded into such size, that Warren Buffett called them, "financial weapons of mass destruction".

A largely unregulated "shadow banking system" made up of money markets, hedge funds, financial conglomerates and private equity funds came into existence. This modern underworld evolved into a mammoth leveraged over-the-counter (OTC) system and provide the credit that forever changed the banking and credit market scene and is the source of our problem today. Because today, there is no real value for many of these products nor is there any idea of their attendant risks and what is actually left are trillions of illiquid, leveraged and thus toxic paper - a legacy indeed for the next generation.

As a consequence, the trillions of bailouts have had little effect because this modern day financial system was rooted in debt. Government funds have largely been directed to the big banks rather than this much bigger underworld of securitized products and unregulated players. Not wanting to miss the rewards of this alternate banking system, the banks created conduits and special entities to create and trade these derivatives. Ironically, it was those vehicles that sank America's banking system. The disappearance of many of the participants has left a large hole in America's financial system hurting liquidity which cannot be plugged by just a few trillion dollars.

Be Careful What You Wish For

Shareholders were at one time happy when managements' interests were aligned with their own but soon discovered that the same group gave themselves princely bonuses and stock options, turning shareholders into bag holders. Indeed in 2007, bonuses on Wall Street exceeded the bailouts last year. Bankers became promoters of the new and improved structured products based on flawed arithmetic formulas that spawned ever newer derivatives, the lifeblood of the shadow banking system. With the implosion of the bubble, Wall Street's icons have disappeared. But now, the survivors are lining up at the public trough and just don't seem to get that by accepting taxpayer monies, there are strings attached and they must adhere to conditions, new codes, morals and even salary caps. And one by one, they must endure a public flaying over their role. The buccaneers have been hoisted on their own petards or in one case, commode.

What To Do

The non-partisan Congressional Budget Office (CBO) projected a record deficit of a $1.2 trillion this year, even before the cost of Obama's nearly $787 billion package and of course entitlements. Bailouts today are only down payments. So what to do?

To get out the deep economic hole, America needs to rid itself of its spendthrift ways, encourage investment, thrift and savings. America must reduce its dependency on cheap energy and tackle global warming. Central banks need to try other ways than the age-old familiar tools that led to bubbles and inflation. Governments, for example, could reduce or eliminate the capital gains tax which would encourage sustainable investment. And to pay for the loss of taxes, reduce deficit spending.

Where to start? Start by reducing America's dependency on expensive energy that allows America's competitors and enemies to accumulate dollars that are often used against America's interests. Start by killing subsidies, equalization payments and other pork barrel spending. Start by allowing institutions to fail.

What Not To Do

In 1933, the unemployment rate was 25 percent and in January of that year the credit system collapsed as economic output fell even more steeply. Investors are clinging to the historic parallel of Mr. Obama with the election of FDR. Common in both times was the need to restore confidence. Italy and Japan then had modest deficits, but a move to competitive devaluation gave each a trade advantage, which brought the introduction of the much reviled Smoot-Hawley bill and trade barriers. Today, Mr. Obama's stimulus package has similarly stoked the embers of protectionism this time with a "Buy America" clause.

The US has a current account deficit of almost 8 percent of GDP, but its problem is not of exporting so much but that they import too much. In 1930 the US had a large manufacturing base but today the economy is largely service based and even with the decline in the dollar, exports will not reduce the deficit that much. As a consequence, the erection of protectionist-type barriers is ineffective and will only antagonize America's creditors. Indeed, the threat of a loss of the United States' coveted AAA rating like Spain or Iceland is looming since all face the same predicament, of a downward spiralling over-leveraged financial system.

The Need For A New Currency

With the shift to Keynesian deficit financing, politicians are following the path of least resistance, fiat currency debasement. The dollar is the world's reserve currency backed by America's balance sheet which is now stretched from Keynesian-style bailouts. But the purchasing power of the dollar is collapsing as trillions of dollars are created every few months.

America's problems began when President Nixon went off the gold standard in August 15, 1971. No longer backed by gold, the greenback was instead backed by the government's balance sheet. In the eighties, the dollar sank amid a heavy bout of deficit spending and the subsequent spike in inflation required an expensive devaluation. This time, it is not inflation that is undermining the dollar, but the growth in debt which will lead to another currency devaluation, driving more assets out of dollars. The bottom line is that without the discipline of gold, the dollar is being devalued by first a series of burst asset bubbles and now a debt bubble. Furthermore, by guaranteeing trillions of dollars of private indebtedness, more money is being printed to finance even bigger fiscal deficits. And of course, in the process of deleveraging the private sector, the government has transferred more liabilities onto its own books. What we are really seeing is a transfer of private debt to public debt and that too has limits.

New Economic Order?

Without a reserve currency, the global financial system is dysfunctional. Trust itself has fallen by the wayside without which there is no money, exchange rates and capital flows. What is needed also is a revamp of our institutions such as the International Monetary Fund (IMF) and World Bank to give recognition to rising powers such as China allowing them to play a bigger role in the new economic order. The Americans must recognize that their trillion dollar deficits must be financed which cannot be sustained by sucking up the savings from other global markets.

Although China has the world's largest reserves that country has only 3.7 percent of the IMF quotas or "voting rights" and fast growing India has 1.9 percent. Meanwhile the US has 17.1 percent of the IMF's quotas. There can be no restructuring unless the creditors are allowed a seat at the table. Since the IMF has inadequate resources to help out troubled governments, the best start will be to expand the quotas to many of the emerging countries particularly those with large reserves. Also, since China's trillion dollar cash hoard is largely made up of US Treasuries, the country could protect its reserve position by buying gold with some of its US dollars. Gold is denominated in dollars and such purchases would protect China against a declining dollar.

Gold Is an Antidote to Our Problem

Today, the public is worried. The World Gold Council reported that investment demand for physical gold increased 25 percent in the fourth quarter last year. If the current trend continues, inflation is a certainty with positive implications for hard assets like commodities and negative implications for the dollar.

Gold is a good thing to have. The modern financial system is bust. Financial alchemy is past. The shadow banking system is in need of unwinding. The age of leverage is done.

We believe Obama will be good for gold, but bad for the dollar as he inflates the cost of debt away.

Obama's policy prescription is to print our way out of the financial hole which will lead to currency debasement. Inflation is next. Inflation allows the government debt to be repaid, in devalued dollars causing a massive transfer of wealth from savers to borrowers. Inflation of credit and then prices allows Obama to repudiate the mountain of debt with devalued dollars.

What remains is a need for a resurrection of trust and honesty. Needed is a light on the shadow banking system with a deleveraging process and time for the system to absorb the as yet unquantifiable losses to come. Needed is transparency and Wall Street to become a vehicle for capital building not destruction. Needed is an emphasis on capital preservation instead of short term speculation. Needed is the bankruptcy of the "too big to fail" entities.

Part of the solution for the current crisis is to remove the potential cause of future crises - the build-up of debt. Paper money is done. Needed is a new currency of trust.

We continue to believe gold is the antidote to our problems. There are too many dollars being printed and devaluing debt significantly raises the inflation risks. Inflation is the product of excess money creation. We believe the rising deficits must be financed and US creditors will no longer accept devalued dollars in exchange for their currency or inflation. Gold will continue to rise in value as long as the United States keeps printing more money than the economy can use.

Gold Is the New Currency

Gold is thus the new currency. Gold's rise is inevitable. As such, we also suggest the introduction of a basket of currencies with gold as an anchor. Moreover, the usage of gold today as backing for an asset backed security like the International Monetary Fund Special Drawing Rights (SDR) is already in existence. The IMF, the third largest official holder of gold on behalf of its member countries is also in need of funding. Created in 1969, SDRs are international assets whose value is tied to a basket of widely traded foreign currencies. The International Monetary Fund can issue SDRs to member countries or increase member profits which would supplement reserves and provide needed liquidity. The IMF proposed to sell 403 tonnes of gold in 2007 to fund itself but needed is congressional approval which is unlikely amid today's climate. More likely we believe is the growing usage of gold.

We suggest the creation of a new asset-backed security, but this time backed by a real asset, gold. Good money will always drive out bad money. The United States is the world's largest holder of gold at 261 million ounces or 8,133 tonnes representing 77.2 percent of their reserves. The Fed could issue gold backed debentures, using its holdings as backing which would both create needed liquidity and trust in its already weakened financial system. Alternatively we could modify and expand the usage of SDRs. The bottom line in that gold will become the new currency.

Gold is within a few percent of its all time high and despite the fall in jewellery demand, physical and investment demand has picked up. Today, the gold exchange traded funds (ETFs) are now among the top ten holders of gold in the world. Meanwhile the supplies of gold are declining as mine costs continue to rise and central banks themselves have opted for gold's safe haven characteristics for preserving worth. When will the Chinese decide to buy gold? It is only a matter of time, simply because they are not going to keep on buying deflated dollars.

Gold is a finite currency, its value against the dollar must rise. After all it has already hit record highs in sterling, yen and euros. Keynes once called gold "a barbarous relic". Gold is a barometer of investor anxiety and today there is much. Gold will hit $2,000 an ounce this year. Again Keynes will be shown to be wrong.

Gold Recommendations

Gold stocks finally revived led by the senior producers like Barrick whose market cap makes it the largest company on the TSX today. Gold stocks still lag bullion but are enjoying a resurgence as investors seek safe havens. Since the October Lehman collapse last year, the Toronto gold index has actually returned more than 100 percent. During the same period, bullion has risen 30 percent demonstrating shares' superior leverage to the gold price. We continue to recommend Barrick as the go to institutional favourite, we believe that with a new CEO, Barrick will continue its acquisition ways, since it is cheaper to buy ounces on Bay Street than to explore. We also like the growth midcap producers like Agnico Eagle who will triple its production as well as more junior Eldorado for its strong balance sheet and growth profile. Since there are so few mega ounces deposits left to be developed we also like Detour Gold and silver players MAG Silver and more junior Excellon. As for the junior exploration stocks which have been largely neglected and pounded by tax loss selling, there are opportunities as this group will likely enjoy a revival around the March PDAC when exploration results are released. Producers such as Aurizon and Detour Gold are expected to attract attraction and will likely be involved in M&A activity.


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