The
BIG Picture Transcript
February 16, 2008
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Part
1
The
Era of Resource Restraints
Other
Voices: John Williams, Shadow Government Statistics
How
Bad Will It Get? When Will It Be Over?
Part2
Plan
B
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Failure of the Republican Revolution
Dividends
for the Long Run
Part
3
Q-Calls
The
Era of Resource Restraints
JOHN: Here's where we have the grand slam as we put it all together to critical mass, and obviously, if all of the other media were doing their job, we wouldn't have one, but there we are and here we go.
Jim, right now, the markets are focused on I guess what you would call a slowing US economy or the R word – recession – and this is really quite high contrast. Remember the exuberance last year when the Dow hit new highs. It is amazing how fast things turn around from one side to the other. Given the fact that the US economy accounts –for what? – about 25% of world GDP, there are genuine fears that are growing that with our economy slowing down, the rest of the world will slow down as well and then the demand for commodities will slow down and therefore the commodity markets will have topped off. Well, certainly, since the beginning of the year, energy and materials have suffered double digit losses. So we're going to look at the commodity markets today and try to dispel some of the myths showing you other factors that are in here that are not being taken into account.
JIM: Yeah. I think this is one of the big misperceptions that the market has, as you mentioned, if you take a look at the S&P index year to date, although energy has recovered, it’s down about 10% for the year. Materials, another best performing sector for last year, is down roughly about 5%. But I think a lot of the selloff, especially in energy and gold equities, came about because of deleveraging by a lot of leveraged speculators, especially the hedge funds. And more importantly, a lot of the investment banks are curbing their lending to these speculators. So funds that were leveraged started selling or started to unwind that leverage. The two best performing sectors last year were energy and materials, so the specs are taking profits in my opinion. But another myth out there is something that you just hit upon is, wow, if we're the largest economy and our economy is slowing down and global growth is slowing down as a consequence, that's going to mean slowing demand for commodities, which would decrease the need for energy, base metals, steel, iron, ore and other commodities.
However, here is the thing I think the markets aren't looking at a complete picture. Demand is increasing and it's looking more like we're going to see supply constraints in many key markets from energy, especially coal, we're seeing it with platinum with the energy shut down in South Africa and China. We're seeing it also in iron ore, aluminum and steel. Also in the grains and especially in soybeans. And moreover, these supply constraints are going to be long lived in nature. In other words, John, these are things that are not going to be fixed in a quarter or a year and could emerge as a basis for another major ramp up in commodity prices this year.
And if you take a look right now, most of the major commodity indexes from the CRB Index to the Rogers Raw Material Index are at new record levels. And I believe they are heading much, much higher. In fact, this week alone, the CRB Index hit another all time record. It has basically doubled in the last five or six years. [3:27]
JOHN: So basically what you're saying here is there is really a huge misperception in the markets. Another word, it's really a battle for control over the mind set for the commodity markets. I know we've had some various technical views on the commodity markets that are short term bearish as a matter of fact.
JIM: Yeah. The problem as I see it is a lot of these bearish views are coming from what I call a top down macro, more of an industrialized mature economy point of view. All I can say is, John, throw the charts out the window. From a micro or a bottom up point of view and from an emerging industrialized economy viewpoint, we're going to see a lot of the chart breakers this year across the commodity markets wherever you look. You're seeing dislocations, you're seeing rigidities, you're seeing shortages and various knock-on effects.
I mean, most people aren't thinking, “Okay, what do the power shortages in China and South Africa mean?” Well, you know what? Platinum production has been shut down, and that's a very tight market. So instead of a top down macro transmission to the commodity pits, it's happening more from the bottom or the micro-economic side. You look at the gold markets. You now have macroeconomic fears added to the equation. In energy, you have burgeoning demand from key emerging markets butting against tight supplies. I think there are going to be some big surprises in base metals this year that show the resilience to the economic cycle.
Even in a economic downturn commodities, in my opinion, hold the potential to [out]perform a lot of the other asset classes. [5:09]
JOHN: This reminds me a lot of last year when we experienced, remember, warm weather and then oil dropped to $50 a barrel and the experts told us that with a slowing economy, it would drop to $40 a barrel. But instead, we ended up closing at the year to $100 a barrel. So it's the same story this year.
So why don't we take the major commodity markets, discuss the fundamentals driving these markets; and since we're talking about oil, let's start with energy first.
JIM: Okay. Everybody is talking about an economic slowdown in the G7 countries. I mean that's all you hear in the economic headlines: Either it's financial institutions taking losses, it's the year-over-year downturn in real estate sales and prices. And you hear a lot of talk about economic slow down. Especially in the countries like the US, Europe and Japan.
But I think the more relative issue is what's going on in China, India, in the Middle East. I mean if you look at this year alone, Chinese demand growth is expected to accelerate this year. China has energy problems with producing power.
We talked all last year and also on the energy round table about OPEC demand where energy is subsidized by the state. I mean if you're paying 30 or 40 cents a gallon of gasoline, you know, you don't have any concept that we're in a tight market when you have the state subsidizing it. One thing that really also struck me this year is there's an emerging automobile company in India called Tata Motors that's producing cars for $2500. Think of what that will mean to the energy market bringing on almost a whole new class of drivers in that country or elsewhere when they begin to export those cheap cars to emerging markets. I mean this is a very cheap form of transportation. [6:56]
So what we're seeing here in OECD countries will remain weak in terms of energy demand because the economies are weakened. And it's expected that perhaps energy consumption in these countries would decline somewhat, but overall demand – and this is the Big Picture – overall demand globally is going to rise this year between one, one-and-a-half percent. And on the supply side, OPEC is not going to deliver much and non-OPEC production is going to disappoint again. So I expect energy prices this year will be making another record. This will probably be six straight consecutive years of annual energy increases. And you know, John, despite the slowing economy, here we are on a Friday, energy prices are at almost $96 a barrel.
So there are a number of factors that haven't happened. We've seen project delays. And despite rising prices, demand has not declined as the experts told us. And the West has reduced consumption slightly, but you have to offset that and take a look at what 3 ½ billion people are doing on the other side of the planet. So you have strong demand coming from emerging markets and OPEC demand is more than offsetting any slight decreases that we might see and maybe flat consumption demand in the West.
And then the other factor that they're not taking into account is our world's oil fields, which in the major ones that were discovered, what, 40, 50 years ago, we're seeing huge depletion rates, overall about 5%. But think about it: If we lose about 5% of our ability to produce because of depletion, that means you have to come up with more energy just to stay even. [8:45]
JOHN: If that is all the case, why has the Wall Street crowd been so bearish for such a long period of time?
JIM: That is really surprising because when you look at the energy charts, you look at consumption, you know, I think it all stems from that most of the analysts are heavily US-centric, which would make them lean more towards the bearish side.
I mean if you look at the energy markets from the bottom or the micro-side, you begin to think differently. So most of your market commentaries, the stuff you hear on the news, is centered on what is happening in G7 countries. And especially, for example, what is happening to US inventories. It's like inventories in the US are reflective of everything that is happening in the rest of the world. So this US-centric reporting tends to dominate the energy market short term. And this is the news that traders react to. So investors on the other hand are focusing more on the fundamentals. I mean last year three countries with the greatest increase in oil consumption were China, India – and here is a surprise, Saudi Arabia.
In fact, China India and OPEC accounted for virtually all of the net global oil demand growth that we saw in 2007. And this year is looking more like the same. I mean the common view that a slow down in the OECD GDP growth is going to lead to lower global oil demand is naive and probably woefully simplistic in my view.
As the year ends, I think we're going to find, once again, China, India and OPEC will prove to be the demand drivers for energy this year. [10:24]
JOHN: Well, that means then that much of the West is operating under the old economic paradigm for energy here, which basically means the US and maybe some of the other countries in the West are the major drivers in this. So, many in the West (and this includes most of Wall Street and Washington by the way) don't realize that the paradigm has actually shifted and the dynamics don't revolve completely around the US.
Well, at least it was predominately before, but that's just not the case anymore. That has not penetrated the consciousness of these people on both Wall Street and in Washington. So it seems like much of what occurs in the energy market, to quote Matt Simmons, is based on hope and faith rather than a sober recognition of what's going on in the real world.
JIM: Boy, I tell you, you just summed that one up pretty nicely because if you look outside of OPEC, non-OPEC production keeps disappointing. About one out of three barrels of what has been projected to come onstream of new production has actually materialized. We've seen project delays in the Gulf of Mexico and elsewhere. And most non-OPEC fields are now in decline. I mean if you look at where incremental supply is coming from, outside of OPEC, it's mainly Brazil, Russia and Azerbaijan.
Opposite to these increases, you have declines in Norway, you have declines in Mexico, the North Sea, the North Slope of Alaska, the Gulf of Mexico.
So if you look at this, all of the gains have been largely cancelled out by the declines. And this gets back to this depletion argument that they keep throwing out.
So the demand fundamentals aren't changing much. Oil prices could have periods of softness. You get the shoulder months, for example, you get into March, April and May, the weather starts to get warmer, so you're burning less heating fuel. And then you get into another seasonal factor, the summer driving season for gasoline. Then you have another soft month as you get into the fall before you hit winter. So if you take a look at a lot of this, oil prices have these periods of softness, and it's caused by these misplaced perceptions and these seasonal factors I just mentioned. But the main trend is energy prices are heading higher.
John, every single year you and I have been doing this program since 2001, they have told us every year as the price of energy goes up, they tell us why it's going down. You and I started doing this program in 2001. The price of energy went from 20 to 30. They were telling us it was going back to 20 again. Then we got into the Gulf War period and they said as soon as the war was over, the price of energy was going to come down. It was going to go into the 30s and instead it stayed up in the 40s all of the way up to today. Here we are close to $96 and they are telling us the same arguments: Well, the US economy is slowing down, economic growth is slowing down, there is going to be less demand.
Well, I hate to tell these analysts, there are more consumers out there. And barring a worldwide recession in China, in India, I mean a global major downturn, you're going to see increased consumption of oil. And given the tight supply constraints that we're seeing right now, that only tells me prices are heading higher. [13:52]
JOHN: Yeah. So basically, we expect higher energy prices, which is why in your mind you continue to hold your energy position. And then I would assume that in periods of weakness we experience, you're basically in there buying rather than trying to dump out when things are going down when everybody else is running to sell.
JIM: It absolutely fascinates me, and I've talked about this on the program with a lot of our energy experts, but it doesn't matter who you're looking at. You look at the oil industry and they are pricing these companies like they are cyclical stocks. Exxon just made $41 billion, and yet you're seeing at a time, even if you look at the major oils, companies selling for 8, 9 times earnings, 11 times earnings, 12 times earnings and they are growing earnings.
I mean one natural gas play, their earnings were up 136% in the fourth quarter, and they sold the stock off. I mean it's just absolutely amazing. But I have been, and we've expressed this on the program, I'm a big believer in peak oil. I mean I've read, John, too much. I've studied the issue for more than a decade now. We've interviewed or talked to too many experts on this program, people who have a lot more smarts than I do, and what I read scares the heck out of me. Not so much from the perspective that it's a problem we can't solve. We can if we put our minds to it. What scares me is the apathy of our politicians. I mean you remember in the energy roundtable, I asked our experts, what would you do it you were president or elected president; and you remember Matt's comments, he said “the first thing I’d probably do is cry.”
They are taking us into a crisis by their own biases. You see apathy. And another factor, I think, is ignorance, and their lack of focus. Instead they are focusing on global warming, something that may or may not happen 40 years from now when peak oil is right on our door step. I want to just share a couple of thoughts here.
There is a well-respected analyst by the name of Charles Maxwell. He's with Weeden & Co.. And he put down on record, he wrote a piece called The Critical Look at the Next Three Years in the Oil Industry. And he wanted to get this down as a matter of record. Basically he starts out, and I'm just reading from his piece here. He says:
Forecasting the future has never been much of an occupation in the mind of the public in recent years because there were too many options as to what might happen, and too few of them ever turn out to be right. Though this is obstinately true, you, the reader, have crossed my palm with silver over a life time of oil industry analysis, and professional pride now impels me to stand up and tell you what I see ahead. It is a somber outlook because as a society, we appear to be at the early part of a long term energy cycle in which we are sleepwalking right into the trap of coming shortages accompanied by higher prices and we don't want anyone or anything to wake us up. And the critical turning in this situation is going to be evident, I believe, over the next three years.
And he lays out what is going to happen over the next few years. And he said:
One of the most critical things, and this is exactly what we're seeing right now. He said:
The failure of crude to go into a price collapse will likely be a major tipping point this year.
So what he's referring to is what you and I have just been talking about because everybody says, okay, here we are, we're going into an economic recession –the United States is probably in one, Europe could be in one, Japan is certainly in one – and given an economic recession in typical cycles in the past, as we saw in, for example, the last recession in 2001, oil prices came down around 18 to $20 a barrel. And what Charlie is saying here is, this is going to be the tipping point this year that despite economic weakness, oil prices are not going to collapse. And that's certainly what we're seeing here. And then he goes on, and he says:
Ultimately, what we're going to see is we are discussing a reduction in the freedom of mobility by rationing fuel to a lesser number of car and truck users. It's going to be a harsh eventuality for our society to accept.
And then he goes on here:
The implication of all of these points will take years to work through the real economy. Our democratic traditions are likely to be tested again and again. Slower economic growth brought on by reduced oil supplies will make every other deficiency in our system, medical, educational, transportation and financial, etc, stand out as heavier burdens on civil society.
So he's going on record. He says, look, I want to get this on record. I'm leveling it out to you. I'm sticking my neck out, but this is what I see happening. And it is a rather sobering piece that he put out. [19:10]
JOHN: Of course there is always the question about whether Americans are just ignorant or apathetic, and somebody said, “I don't know, and I don't care.”
So basically we're still in the energy area here. Let's talk about electric power. I think this is critical because as we talk about, say for example, hybrid cars that don't just do like the Prius does and convert electrical energy back into battery power as it’s going downhill or something, we're talking about the type where you would come home and plug things into the socket. Basically, for 50 miles you'd have a charge and when you get home, you just charge yourself up again. The problem is, in order to do that you're going to have to have power companies charge one giant passel of cars.
I don't think anybody is thinking in that direction because we're running into energy crises into a lot of places, as a matter of fact. We're having brown-outs in California. Last week we talked about power shortages in China and South Africa as well, affecting the platinum markets. But that's another whole area of energy, and they are interlinked, but like you say, also, you can't drive down the street with an electric cord attached to your car, so you're going to need some liquid fuels there. But at the same time, if you're going to try these hybrids in 10 years or so, there has to be a change here as well.
JIM: Yeah. That was the big thing with the technology boom in the 90s. They thought that energy would be less demanding on our economic system, but we found out all of these devices that we used today, I mean personal computers have become ubiquitous, so there is another appliance that you use in your home. Instead of just a regular television, everybody has big plasma screens, flat panel screens, and you don't watch movies just on television sticking a tape in a VCR; today you're watching it in a DVD player in surround sound. So you're consuming more electricity.
So I think this is one of the reasons why a new theme that we added a couple of years ago is infrastructure. And I think this cycle is set for another boom. The markets have worked off all surplus power capacity that we brought on in the 80s and 90s and are now again in need of a new supply.
There is a moderate amount of power plant capacity coming online, but like oil consumption, demand growth is likely to outpace supply. [21:21]
JOHN: One road block I can see coming is from politicians and environmental groups because they don't want coal, of which we have an abundant amount, even if we could sequester the carbon dioxide,
JIM: Which we can –
JOHN: We can do, the technology is here to do it. Or nuclear. And if we just revise how we're processing spent fuel, the quantity that would have to be stored is really minimal at that point. And also renewables, because you look at all of the efforts that are pointing at every time someone tries to do something, I just read an article yesterday about a big wind farm down in Texas, and sure enough, it's the normal flap from environmental to “it doesn't look very good” – that type of thing.
JIM: And it kills birds.
JOHN: And it kills birds. Although I understand the newer blade units are operating at a much lower RPM, so it solved some of that problem, but we'll see. I can't talk as an expert on that one.
But there is also hydro and wind and solar. And what do you say: You can't quite do this all, and we can't get it running because we're running into so many obstacles, and what's important to recognize given the energy situation we're talking about is the clock is ticking right now. Every day we delay, tick tock, tick tock, you're running out of time. The time to sew your parachute is not when you leave the door of the airplane. At that point you have an emerging crisis you may not be able to avoid; right? And that's what we're doing to ourselves.
JIM: Yeah. The problem is, you know, renewables make great sound bites, but they only provide about 2% of our power. Over 50% of our power comes from coal and another 20% comes from nuclear. And if you're going to exclude those two areas and you want to go to natural gas –a depleting fuel – I mean the whole problem is we're sort of in this limbo period. You have a clear need for new supply because of all of the demand, but yet you have no proven method to attract that supply. Most new power plants coming on stream are natural gas, and natural gas is a depleting resource with a declining production in North America. So despite the efforts to diversify the fuel mix, it's mainly coming from natural gas plants, not a well thought out idea in my opinion.
So if you look at growing demand for electricity, significant capital spending needs by utilities for distribution, transmission and power. And given what we're seeing on rising capital cost, rising labor costs, rising material costs, and significant cost pressures, John, there is just no way that people aren't going to see a significant increase in their utility bill because it's getting more expensive to produce power. It's getting more expensive to build new power plants. And you're talking about billions and billions, tens of billions of dollars of costs that are going to go into creating these new power plants. Otherwise, you know, we're going to experience, as we do periodically every year in California, brown outs. It will just get worse.
What do we do if we start converting the driving fleet over into plug-in hybrids. So okay, where is the electricity going to come from? [24:20]
JOHN: Yeah. That's what we're talking about before. You're going to actually have to provide that energy source somewhere. And can you imagine if the fleet did convert over and everybody was doing that? You know, up in Alaska, when people park, they often times provide electric plugs there because you need to keep heaters going in your car or in some cases people just keep their car running and have a second set of keys because of the cold. They'd never get the car started again in some cases.
But other than that, if we also look at nonpolluting type of sources, especially in the area of C02, you have a limited number of choices: You have hydro, wind power or nuclear. Now, those are your primary, right, that you're going to have right there.
Now, I suspect that looking though at how many power plants are running on natural gas, I mean that's the next hydrocarbon alternative that is still CO2 polluting, but I would expect those prices are going to head higher as well because there is a shut down right now going on in who wants to start building new coal plants.
JIM: Yeah. I mean if we take a look natural gas prices are 8.70. You know, I'm not sure it's clear to me other than political biases why they are looking at a depleting and expensive resource such as natural gas and using that to burn and produce power when other plant types are available.
When demand presses beyond capacity of cheaper plants, the next cost effective group of power plants are usually started. Hydro electric plants are expensive to build, but they are cheap to operate. Ditto that for nuclear and wind and solar. Coal comes next with high up front costs and capital costs, but also fairly low fuel costs.
So we have to look at fuel diversity. To rely on only one fuel only isn't prudent. And that's what we're doing right now. It seems to me a more sensible approach would be to look at coal and nuclear for handling your baseline electricity demand, and then you use your renewables such as wind, solar to handle peak demand because wind power is intermittent. You've got to have wind, and sometimes you don't get it. I can't think of the number of times I've gone sailing. You go out and the winds just die down and there is just nothing out there.
So whatever we do, the trend is very clear: we're going to have to build more power plants. The era of infrastructure spending that we've been talking about is upon us and building new sources of power for electricity is just one element of that. So we're going to need natural gas. Power plants are going to need coal. And nuclear plants are going to need uranium. So there are investment opportunities in all three of those. [26:58]
JOHN: You need a coal plant to use uranium. Oh, well. Just a brief crazy thought.
Let's move on to the next category. A commodity which is base metals. Like energy, the big question hanging over the base metals markets is the economy again. With the economy slowing down, there is less demand for the base metals, whether it is aluminum, copper, lead, nickel, tin or zinc. And what was amazing considering it was just a year ago there was such a premium demand on copper that the construction people were having a hard time getting Romex in on wiring.
JIM: One of the things that we're seeing in base metals – this also applies to energy – is this continued economic gloom, which has caused price to soften since the beginning of the year.
We're running into supply problems. Platinum being one of them. I already spoke about the power shortages, for example, that we're seeing in China and Africa. The other factor is inventories are low globally, and on the demand side, you're still seeing emerging markets have picked up the baton of demand growth from Western countries. [27:57]
JOHN: Well, I suppose like the other areas of commodities, the big issue is what the outlook is for China this year because that's something that, you know, we see articles about China being a power house, but reality, in the minds of people, it hasn't settled in either there.
JIM: You know, I think if there is any risk to base metals, it's probably going to be more important to focus on what happens in China rather than the US. I think what is different in this cycle that analysts are really not focusing on in comparing it to previous cycles, for example in base metals, is that when demand growth slowed, let's say as the economy was heading into recession, it coincided in the past with miners boosting output bringing on more supply because prices were rising. And this led to higher inventories and surpluses, which eventually when the economy slowed down, you’d see prices fall. However, this time around, well, there is obviously acceleration under way in some sectors. Key markets are really tightly constrained with small surpluses and even deficits for some base metals.
We keep talking about South African power shortages. It's resulted in severe cut backs in the mining sector with copper production significantly reduced, for example, in Zambia. You've seen aluminum production hit both in China and South Africa. You've got political problems in Indonesia. You're seeing more governments are becoming rapacious and posing windfall profit taxes on the mining sector. And the mining sector says, “you know what, if you're going to take that much, we won't expand. We'll just keep what we have.”
So the consequences of all of these factors is that surpluses that typically build in, let's say, the late stages of a cycle, they are not taking place. So we could see higher prices for copper this year, higher prices for tin and aluminum and platinum. And if there is anything that's looking on the weak side with a little bit of a surplus, it would probably be, let's say, lead, zinc or maybe nickel.
And I could probably go on to maybe precious metals next, but gold, silver and platinum –and especially platinum right now with shut down in Africa, but we're going to cover this in our upcoming gold roundtable at the first of the month. [30:17]
JOHN: Okay. So let's move on to agriculture next. It is no secret to anybody who eats and goes to the grocery store that food costs have been – I was going to say slowly, but I think the word is steadily rising at this stage along with energy. I mean the public isn't fooled about this one anymore.
JIM: No. But you know, we typically excluded it as if it was some kind of aberration in the inflation index. You know, if you look at the ag-sector this year, this could probably be a pretty interesting year. I mean the grain sector looks extremely bullish. If you look at soybean prices, they are up already 13% since the beginning of the year. You've got sugar prices up about 16%. You've got copper prices up 5%. And I want to go back just to the last section. Base metal prices, John, this year, aluminum spot prices up 19%. Copper prices up 17. Lead up 19. Nickel up 7. Tin up 2% and zinc up a little over 1%.
But you start the year, to begin with, with low inventories across most of the agricultural markets. You also have rising demand from the emerging world, and then you have this enormous demand coming from the biofuel sector. I mean just look at the energy bill that we passed last year mandating more biofuels. So I would expect as we're looking forward in the year, another year of rising prices. I just mentioned what's happening to some of these since January.
And then on the demand side, you still have robust Chinese demand. You have increased biofuel production; and more importantly is you have low global grain inventories. And you see in the past, when you had larger inventories, they sort of acted as a buffer to the market, and they were used as a shield against supply disruptions.
And let me just share with you some simple statistics. Our supply of corn has fallen from 10 ½ weeks of supply 6 years ago to only 6.8 weeks of supply currently. That's the lowest level we have seen in 33 years. Wheat supply has fallen from almost 14 ½ weeks to 9.4 weeks. And that's the lowest level that we've seen since the USDA started to track and publish inventory data going back to 1960. [32:43]
JOHN: So you would think this would be getting people's attention? Let's listen to a clip from Thursday's Wall Street Journal.
The farming community is becoming cautiously optimistic. As the rest of the economy tightens its belt and embraces for recession, farmers are having the times of their lives. Crop prices are setting records, incomes are up, and some people think that the good times can keep on rolling.
Jim Bauer, a grain trader from Lafayette, Indiana is more cautious. A few weeks ago, he and farmers and supply salesmen Brian and Darren Hefty spent three days talking to farmers in North Dakota, South Dakota and Minnesota. They packed churches and casino halls sometimes drawing crowds as big as 350 people. The message was a cautious one.
On this road show the topic of conversation ranged from the rising price of food to ethanol to world hunger. Farmers shared their thoughts about the exciting times along with the anxieties, fear and often times greed that come along with it.
Farmer: It's an exciting time because as they said in the seminar tonight, it's probably one of the best years -- well, the opportunity to have one of the best years ever is now.
Along with the optimism comes fear. One big fear is the D word. Drought.
-There is a lot of people that are talking about that, you know, global warming and the drought areas becoming expanded and more of a Western part of the corn belt, is probably more susceptible. They are talking about the drought in the southeast. And usually the following year that expands up into the corn belt.
-The situation new ahead is so tight it warrants a lot more, what I call, “look at” in order to make some kind of ascertainment of what they are going to do if we have a big weather problem this summer. It a problem that I think needs to be addressed before it turns into a catastrophe.
Prices have been rising briskly for more than two years. That leaves some farmers feeling cheated if they sell too early.
What's happened in the last 12 months have shaken the self-confidence of a lot of farmers because basically almost everyone is getting better prices than they've ever gotten before, and at the same time, they are saying every decision to sell in the last 12 months has been a mistake.
So how did we get here today?
-Obviously, the farmer wants to provide enough food for everybody, but what happens when we over produce food, a person can only eat so much and then that extra, so we'd have just, you know, surpluses continuously which meant very, very low prices in a commodity market.
-To be able to create a new type of market instead of just food, to be able to have a market that we can grow for fuel was just – is just an amazing new paradigm.
The other revolution in agriculture is a function of population growth and rising incomes in the developing world where meat, eggs and milk are becoming staples, not just luxuries. That's good news for farmers.
Everything is higher right now including food and our inputs too. But farming is fun right now. I've been in it for 50 years and it's a fun occupation right now. I see the overall economy with housing and stuff not doing real well. The farming economy right now, my area, is the best it's ever been.
And while many economists believe the crop prices will stay high for a long time to come, there is a fear in farm country that the price of grain could come tumbling back down.
Farmers are still looking at this thing, like, okay, I went 20 years not making any money. Yeah. I may have made money for a year or two, but chances are, it's going right back to the way it was for the last 20 years where I didn't make anything, so I've got to learn as much as I can today so I can survive when times do get tough again. And those tough times could be coming any time. We don't know. It's still supply and demand, so if we oversupply, the demand, if something happens on either end of that thing, then all of a sudden, corn might go back to $2 again. It might go back to $1.50. Just two years ago, locally for us, it was a $1.30 cents. So that's dramatically different than it was today, and I have no illusions of thinking it couldn't get back down to that again, and that's the scary part.
And what about Jim Bauer, the commodities broker? How is he fairing?
There is so much going on right now and the movements are so extreme that it's really, really almost like an operating room. It's a time of high stress right now.
I'm Lauren Etter reporting for the Wall Street Journal. [37:31]
JOHN: So from a bigger picture, listening to this clip anyway, agricultural commodities look like they are actually in a boom.
JIM: You know what is remarkable about this is that we've experienced -- and here is something to consider -- we've experienced 17 years of record harvests and yet inventory levels remain at record lows. Just think, John, if we were to have years of famine what that would do. And unlike Joseph in the Bible, we haven’t built up surplus storage during the years of plenty. If we have problems with water and problems with energy or have a severe drought hit us or bad weather, think what could happen. I mean if we already have low supplies, low inventories now, think what happens if we have problems. In fact, the amount of arable land has actually declined due to urbanization. I mean you have grain demand is being galvanized by feed and industrial use coming from rising Chinese demand. And now we've got this new factor. We're turning ag products into biofuel production. And that is what is undergirding demand. Meanwhile acreage and inventories continue to decline, so that's why we're especially bullish in wheat, soy beans and corn, and we've invested in all of them since last year. [38:52]
JOHN: Yeah. There were some articles recently. The Economist did a front cover issue on food, as a matter of fact, saying that the era of cheap food is basically over.
JIM: The era of cheap energy is over and the era of cheap food is over. And I think the era of cheap commodities is over because the whole topic of what we're talking about here is resource restraints or scarcity.
I mean it's easy to see why wherever you look whether it's soybeans, you see production short falls, if it's corn, it's high demand. And just think about it logically: Farmers plant more corn and less soybeans than wheat. Because what? Because bio fuels, corn prices are going up, so you can't blame them. You have farmers responding to the marketplace.
And just one grain, soybeans for example, Chinese demand has been rising by an average of 12% a year over the past decade. They've got a lot of people over there. And if you look at soybean production, it has gone from 186 ½ metric tonnes of production in 2003 to over 220 tonnes projected for this year. So that is down from 236 tonnes last year. So despite a 20% increase in production, the weeks of supply has remain unchanged or down slightly.
So what we're seeing in the bean sector is lower global production amid record demand, which has led to a large drawdown in stocks. In wheat, we've seen Argentina's exports drop 10% year over year. Canada's exports dropped 26% year over year. European exports down 35% year over year. The only people that are increasing their exports are Russia and the US. We're only two countries. And yet despite the increase that we've seen in production, you're looking at the lowest levels of inventory we've seen in almost 30 years now. [41:01]
JOHN: It's really sobering to see the direction we're taking on this. There is a whole series of potential crises forming but there is no focus on it, like you said, from Wall Street or from Washington, either way. And we don't have time in this segment to cover the whole commodity sector that we're talking about.
And you know, coffee and sugar also look good too. Not just to me personally. But I mean as far as a commodity. Where can investors get information on this area or learn more about it, as a matter of fact?
JIM: Well, you know, you start out with the Bible for commodity investing, which is the Annual CRB Commodity Year Book. Right now, you can get the 2007 CRB book is out there, and I think the 2008 book, which will give us statistics for 2007, that will be available in June of this year. And then if you really want to get into this sector and really learn about it, there is a couple of books out there, one by Jack Schwager called Fundamental Analysis Of The Futures Market is a must read. You can follow that up with Schwager’s Technical Analysis Of The Futures Market and his third book, The Complete Guide To The Futures Market. Those are three books.
If you want something a little bit lighter, less technical, then I would recommend highly Jimmy Roger's book, Hot Commodities. Rogers really does a good job in understanding commodity fundamentals. [42:24]
JOHN: Well, that's it for this segment, and if we summarize everything that we've been discussing here, basically you think commodity prices are heading higher and that this bull market, which I know you've been writing about for the last seven years, is far from over.
From what we discussed it looked like it really does have many years to run before we're going to see the inevitable downturn in the market. You're listening to the Financial Sense Newshour at www.financialsense.com.
I'm Andy Looney. Did you ever try to call for help with some large company or bank, or worse Medicare or a credit card? Did you ever get one of those recorded computer voices? I call them automated voice attendants or AVMs. I did. It was crazy. You know like when they want you to speak Spanish. I don't speak much Espanol. Do you? I don't. I'm unolingual. Then they try to get you to explain your problem in words that the computer will recognize. Words like, I have a billing question, or I need to make an appointment.
The only thing the computer doesn't recognize is I want to speak to a real person, which is what I really wanted. Don't you? I didn't get one. Then the computer asked if you meant to say, I want to schedule a payment. When I said no, the computer thought I said dos, and I got Espanol by mistake. You know, the computer doesn't recognize [Spanish] either. Did you understand what I said? I didn't.
My uncle Freddie wanted to get his snow blower repaired, but when he said snow blower, the computer blew his call off to Alaska. What is with that? You've got to be very careful what you say to a computer. Yo soy Andy Looney for [Spanish], or is that Cinco De Mayo?
Other
Voices: John Williams, Shadow Government Statistics
JIM: Well, there’s a lot of talk today that given the nature of the economy that we are heading for deflation; non-bank borrowed reserves are in negative territory. And some are saying the SOMA account which has dropped in the last month that the Fed is actually drawing money from the system. Yet, if we take a look at popular measures of money supply, whether it’s M3, M2 or MZM, they are all going up.
And joining me on Other Voices this week is John Williams from www.ShadowStats.com. And John, I want to begin with this story. Let’s begin with non-borrowed bank reserves which are negative, the first time we’ve since this for decades which would tell me from a technical point of view that the banking system is insolvent. Take us through those numbers and what are they telling us?
JOHN WILLIAMS: Let me start first by defining or telling what the Fed’s definition of non-borrowed reserves is, which is total reserves – that’s what the banks put up in addition to the cash they have in their bank vaults to support as back up for the deposit accounts and such that are in the money supply – It’s the total reserves, the borrowing of the banks from the Federal Reserve. And right now the banks have just put out numbers Thursday night which show on a not-seasonally-adjusted basis which is the way that you have to look at these numbers, that for the last two weeks the non-borrowed reserves were something like a negative 20 billion dollars. The banks are borrowing at this point $20 billion more from the Fed than is needed to meet their reserves. And that’s extraordinary. You mentioned that hasn’t happened in a long time. I’ve gone back and looked at the historical record as best they have it and you’ve seen nothing like this since I guess it was March of 1933 when Franklin Roosevelt declared a banking holiday, and even then the net-borrowed reserves didn’t go negative but the borrowing got up to maybe 46% of total reserves. There may have been a time back around World War I and all the financial disruptions there, it might have happened but you’re back basically then to the founding of the Fed. What we’re seeing here is effectively unprecedented.
And what happened – the reason that we have this – is because of the Fed’s establishment of what they call a temporary auction facility (they call it TAF) where the banks can offer certain assets to the Fed, the Fed will say we’re going to put out $30 billion, make an offer of what you want to put up here, they auction off that $30 billion. The banks supply collateral and end up borrowing from the Fed. This is through the discount window. Now, the discount window is usually for troubled banks. The way the system would work, more often than not, is that on a given day a number of banks will have more reserves on deposit with the Fed than they actually need and there will always be banks that will be short. But what the banks do is those that have the excess reserves tend to lend it to those that don’t. That’s the Fed Funds market. The rate that’s charged overnight is the Federal Funds rate that the Fed keeps targeting at the moment. But what happened as this current financial crisis broke and the question of the solvency of banks – major banks – came to a head is that banks were not lending money to each other overnight; they were afraid maybe the bank might not be there tomorrow morning to get repaid. And what the Fed did was to set up this special facility to lend directly to the banks that needed funds for their reserves. It was because the banking system in its normal functioning had ceased to function in terms of the overnight credit market. It was not working. And even Mr. Bernanke in his testimony last week indicated that was an ongoing problem – that was the purpose of this facility. But right now, with the Fed lending more than their total reserves suggests 1) they’re going beyond funding just reserve requirements, but it does indicate there is a very serious problem, that it’s expanding. The Fed recently lowered the loan size that they make so they could get to smaller banks. There’s a major solvency crisis in place with the banking system.
Now, what you have to keep in mind is that Mr. Bernanke is an inflationist. He’s made that clear from way back. He doesn’t like deflation. He would fight deflation and he’s a student of what happened during the Great Depression. The Great Depression you had a terrible deflation along with the collapse in economic activity and the two were tied together. The reason that you had the deflation was that the banking system collapsed. The Fed effectively let it happen. And in the process, the collapse of the banks, you had a collapse in the money supply, which pulled down the overall economic activity and deepened the Depression. So I think what we’re seeing now with Mr. Bernanke is that he’s in the preventative mode here. He’s trying to keep the banking system afloat. And if you go back to comments he made in 2002 when he got the nickname of Helicopter Ben, he basically said that the Fed can always create enough money to create inflation. And if they had to that’s what they’d do. But right now he’s trying to prevent a collapse in the money supply. The money supply is not shrinking. People are misreading the tables there. There’s a fairly easy explanation to it. [50:37]
JIM: Let’s get to that topic next because you had the SOMA account really spike up towards the end of the year. It’s come down a little bit since then and you’ve got all these people out there telling people the Fed has taken money out of the banking system, they’re trying to collapse the system. And my goodness, this is so misplaced.
JOHN WILLIAMS: That’s nonsense. The Fed again, if anything –and I’ll come back to this – I’ll contend that the Fed will create any amount of money that it will have to create to keep the system afloat and to keep it going. And that generally means more money growth, greater liquidity in the system and higher inflation. That’s where this all ends up. But if you look at the chart that’s been floating around on a lot of the internet blogs that shows this plunge in the SOMA account, that’s first of all, the charts shows seasonal patterns in it: you get to the end of the year, the system needs certain liquidity with all of the holiday shopping and such. If you look at the top line – the total line – of all the open market portfolio, basically in January you’re at the same level as you were back in December. If you look back at the components – the standard SOMA accounts – that plunges. But what’s offsetting that is this TAF account that’s exploding. It’s a one-for-one set-off. The Fed is trading off assets that it owns otherwise for the lending that it’s putting in place for the banks. It keeps the overall level of their portfolio the same, it’s just a shift in components. It’s not the reserves are collapsing or anything like that. The reserve levels are normal, they’re stable, they’re just being funded by the Fed as opposed to the banking system and therein is a real problem. It is working so far, you have not had major bank failures; the system appears to be reasonably stable although there continue to be signs of difficulty and I’m sure the Fed will do its best to again address any way that it has to the problems that could threaten the financial system. Of course, in that addressing the problems, again, you tend to create new problems with money growth and inflation risk. [52:59]
JIM: You know, that’s the thing that stands out. And if you listen to his testimony on Thursday I mean he basically said, “look, we’re going to do whatever we can.” He’s basically saying, “I’ll drop helicopter drops if I need to.” And if you look at MZM, M2 and John, you track M3 which is no longer reported but the M3 figures, what rate are they growing at right now?
JOHN WILLIAMS: Well, for the month of January we’re estimating it at 15.2% which is the highest it’s been since Nixon closed the gold window back in 1971. The record level of growth in M3 – it’s not that old of a series, it only goes back to the late 50s or so – you have what was something over 16% and I can tell you in terms of the numbers which were published yesterday or Thursday on the money supply, if those levels for the first couple of days of February held, you could see 16% money supply growth in February. It’s beginning to surge again. We had a little bit of a dip in December. I think it had got up to 15.4 and then it came down to 15.1 and now it’s 15.2 and it’s heading higher. All of a sudden we’re beginning to see a surge in the broad money components.
And when it gets to trying to predict inflation the most important indicator you can take from the money supply is the broadest measure. And that makes sense: that’s a measure of the total liquidity. [When ] people have money, they tend to spend it. If they don’t have money they don’t. And when they spend the money that tends to be inflationary. It’s not the monetary base (which is reserves plus currency) it is no longer the measure it once was in terms of what’s driving the system because there are a lot of accounts such as the institutional money funds that have no reserve requirements behind them. So where the monetary base has been fairly steady – it’s not plunging which it would be if the Fed were trying to contract the system – it is not at all inconsistent with what is happening with the broader money measures which are up right now at near record levels. Again, the broader measures are what indicates inflation not the narrow measure. [55:08]
JIM: John, something else that is very disconcerting is a couple of years ago just before Bernanke came in, I think, they stopped reporting M3. They said because it was getting too costly to provide. And when I see the numbers that you’re reporting at record levels now I know why they don’t want the markets to know that. Now, starting March 1st, due to budgetary constraints the Economic Indicators Service will be discontinued effective March 1st of this year. What are they trying to do here?
JOHN WILLIAMS: It’s strange where they find the areas to cut their spending. But surely more of a summary service of economic data published by the government. The basic economic series are still being published as far as I know. It’s just that it’s not going to be as easily as available to the public and is apparently a very popular site. [56:01]
JIM: What do you think their motivation here is? You’re talking about an organization that can print money so there are no budgetary constraints. So what are they trying to accomplish here?
JOHN WILLIAMS: Well, unlike the Fed where I don’t think they wanted the public to see what was going to happen to M3 growth, if this were the reporting of the GDP or the CPI you could say they don’t want people to see the reporting of the recession or reporting of higher inflation. But those numbers are still going to be reported. They’re just not coming through that particular service. And I’ll contend among other things that where they’ve taken care of the GDP is it’s very heavily manipulated. It tends to overstate economic growth; the CPI, again, has been heavily manipulated over time with methodological changes that understates inflation. They do the same thing with the unemployment numbers. The unemployment rate that’s now around 5% really would be over 12 ½% if you used the original unemployment methodology and the way most people would consider unemployment. They’ve gimmicked the numbers enough – at least at that end – that there’s no need not to report them. If they were ceasing to report retail sales or something like that, that would be an effort to maybe hide the recession because you are seeing the recession now in the retail sales numbers. If you take inflation out of the year-to-year growth in retail sales it’s negative. December, which is the month of the year that retailers base most of their business on, after adjustment for price changes was negative year to year. And January’s was negative year to year too. You don’t see that outside of recession. We’re in a recession, we have been for probably a little bit over a year but the markets are very slow to pick it up, and the politicians and Wall Street they don’t start talking about it until it’s absolutely certain and usually six to nine months after the case. [57:55]
JIM: It’s absolutely amazing. Are they just basically saying here, “look, we’re going to make it hard for the public to get information in terms of how bad things are.” I mean it’s absolutely amazing. This almost reminds me of 1984. Maybe what we’ll do is we’ll just get happy numbers every month.
JOHN WILLIAMS: The popular reporting is moving that way. On the other hand, Jim, it keeps both of us in business. What can I say?
JIM: Well, John, you bring up a good point. As we close, why don’t you give out your website and talk about your newsletter because in the world where you can’t get good, straight numbers, I think your newsletter is vital for investors.
JOHN WILLIAMS: Thanks. My website is www.shadowstats.com. And if you go to it you’ll find in the upper right hand side of our webpage a series of what are called primer articles. It gives you the background of the basic economic reporting for the key series where the series have been manipulated or have strayed over time. We have available archives of a lot of material that’s been written that describes where economic and inflation reality is. We have a page that shows graphically our estimates of alternate measures of the CPI, the GDP and the ongoing M3. And of course, anyone who’s interested in subscribing to the current newsletter and the latest Outlook we’re always happy to have subscribers. All of that material and details on subscribing are available at shadowstats.com. [59:32]
JIM: Well, I’ll tell ya, a very essential newsletter at a time when you can’t get straight talk from government. John, thanks for coming on the program and clarifying this nonsense about deflation and the Fed taking money out of the system when we all know it’s just the opposite. I want to wish you a great weekend and please come back and talk to us again.
JOHN WILLIAMS: Sure will, and thank you, Jim, I appreciate being with you. [1:00:12]
How
Bad Will It Get? When Will It Be Over?
JOHN: We spent the last four weeks talking about that parallels between today and the Great Depression. And today, just like back then, we're in a full blown financial crisis. And so the question a lot of our listeners have is, is this the big one?
But, Jim, I know you don't really think this is the big one right now. That catastrophe really takes major policy mistakes which we could be moving towards, but we're not at it yet. We really believe this event is probably, what, two years off, and as we've been saying here on the program, we really see a crisis window developing, which frames the years 2009 to 2012 because there is a whole series of converging problems like the oil crisis we've talked about and the financial crisis and other political issues that are all going to happen in that window. And they are not necessarily predictable as to how they are going to exactly come together when they do.
However, we are going to cover here today how big the current crisis is, how bad it will most likely get and what everybody wants to know is when is it going to be over.
JIM: Next Friday.
JOHN: Good. Okay. I'm going out. I'll meet you at Starbucks. Which one? You know, I was in Seattle over the weekend, Jim. Do you know you are never out of sight of a Starbucks around there. It's like Red Cross or something like that. You go into the men's room at the airport. My God, this is Starbucks in the men's room or something like that. You know? But back to where we are. Anyway.
How bad is this going to get, and how many cups of Starbucks will I need to get through this?
JIM: Well, originally when the crisis broke out last August, the estimates first started is losses would amount somewhere between 200, 250 billion depending on who you were reading. But then as the crisis began to unfold and worsen as one domino knocked down another, it was CDOs, then it's Alt A problems, and then it's credit default swaps, it's monolines. And so the problem, it began to worsen. It did not get better. A lot of people criticized the Fed for acting too late. Regulators and congressmen were asleep. So the latest estimates put this crisis with losses between 400 and 500 billion –so roughly twice what they are estimating back in September and October of last year. Of this amount, roughly globally, we have seen 175 billion that has been realized and reported, so assuming the government swings into a bail out mode with Plan B, something we're going to talk about in the next segment, we're probably about halfway through this process. [1:02:49]
JOHN: Okay. So it's obvious, though, I mean having said that we're halfway through it, without looking panicky, our government has finally awakened from the slumber. Now, whenever have you ever known Congress and or the White House to work so closely together to pass a stimulus package this quickly? The last time everybody was on the same band wagon yelling and screaming that we need to get something through that I remember was NAFTA; and that was right after the Republican revolution election but before the new Congress was seated.
JIM: Well, it's no secret. The most important thing that you have to understand here, this is an election year where most of Congress is up for reelection. And I think what they hope is when voters receive their checks, they are going to remember their congressmen when they walk into the voting booth in November. So the stimulus package is, really, John, more about preserving the jobs of Congress than it is about creating jobs in the economy.
I mean this thing, in terms of economic stimulus does very little. In fact, in terms of creating jobs in the economy, it was interesting because they did a survey of people: “Okay. If you get this rebate check, what are you going to do? Are you going to spend it? Are you going to save it?” About 19% of Americans polled said they are actually going to spend the money, and it was amazing because that was similar to what happened when we did rebates in 2001 and we did rebates in 2003. [1:04:14]
JOHN: You know what's amazing is I think you touched on something that has been gelling in my mind, and that is listen to how the politicians are all talking about revenues, etc. They are talking as if the welfare of the government is the same as the welfare of the American people. In other words, if they have their budgets and their money, then the American people are well off. That's not necessarily true, and you really have to make that as a distinction. That's why you never hear talks of cut backs, etc.
But, this is an election year, the silly season is here. And on my Julian calendar, the Julian date tells me that we have to go in silly season...262 days to go before we can breathe a sigh of relief or at least put our seatbelts on before the next Congress is seated and so on and so forth.
Maybe one of the reasons they are saving a lot of the money is they know, and they've already told us what they are going to do, and everybody needs to understand before elections, all of the politicians rush towards the center to look, quote, moderate, end-quote, and then after the election is over, they do what they darn well please. And that's important.
So basically, we know they are going to raise taxes. They've already told us they are going to do that. Some of these plans, I actually calculated how much a small business, Jim would pay. I worked out a small business making $250,000 would pay about 63% of its income, a small business owner in total taxes to the state, to Medicare, FICA and income tax. It's flabbergasting.
I mean the first thing these small businesses do is they lay people off. You know that. The mom and pop shops don't have the buffer in there that they can handle this. [1:05:47]
JIM: We're going to get into this and once we have a clear cut candidate in both parties, then, John, instead of these platitudes, these slogans change. Okay. What kind of change? What is that going to mean for me? They are going to have to start getting more specific.
Obama got into specifics. He's talking about that probably two trillion in tax hikes, $300 billion a year in new spending programs, so a lot of these specifics are going to start coming out from each candidate because up until this time, they have all been trying to distinguish themselves from one another, and they've been going with slogans.
Well, that's great, change is great, but what kind of change and what does that change mean? How is that going to impact me? Who is going to pay for this change? Those are the hard questions that are going to start surfacing as we get closer to the election. And that's probably the topic for another program. [1:06:43]
JOHN: Maybe the reason they are saving money, like we said, is that after the elections they know they are going to raise everybody's taxes, but the credit crisis is an area of focus, so how confident are you that these numbers, can these losses get bigger, and a follow-up question is what happens to these numbers if the US economy drops down into a recession?
JIM: Well, I believe, as do others, that we're already in a recession, whether they admit it or not. I mean they can always -- you heard in that last segment with John Williams how they are not even going to report the economic data. So the reason that we've seen governments spring into action here this quickly is if the economy worsens, these numbers get much higher, so the rate cuts by the Fed are going to continue. There are going to be bail outs and more stimulus programs. I'm predicting, John, the stimulus program they just passed, that isn't the last. “Okay, this appeases the voters and hopefully we get to keep our jobs. Now, let's look at maybe a long term stimulus program that maybe actually does something.”
So what they hope to do now is mitigate many of the problems of a recession and perhaps shorten its duration, which will allow them to postpone the day of reckoning perhaps another year or two. But what worries them now, and John Williams and I discussed this in the last segment is the solvency of our nation's banking system. The elephant in the room that nobody is really talking about here is that technically, the banks are insolvent. [1:08:15]
JOHN: Nah. That would never happen.
You'd better explain that one because that's a pretty big bite for somebody to swallow.
JIM: Well, banks are required to keep reserves anywhere from 3 to 10% in cash to pay depositors depending on the type of accounts that they hold.
JOHN: Okay.
JIM: Okay. So this reserve money is used to process checks, electronic payments through the federal reserve and to meet unexpected cash flows. These reserves can either be held as cash on hand, or as a reserve balance at the regional reserve Federal Reserve bank or both. Right now, these reserves referred to as non-borrowed reserves at the Fed have actually gone negative by over 10 billion; or I think John said the more updated figure is close to 20 billion right now. And that's the first time, John, that we have seen this happen since 1959. And the difference between these total reserves and non-borrowed reserves is nearly identical to the current size of the TAF – about 50 billion dollars. In other words, the Fed is directly financing the reserve requirements of the US banking system. Banks appear, at least right now, they are unwilling to lend reserves overnight. Instead, they are preferring to borrow directly from the Fed. And since it began, the TAF program in December, the Fed has injected 130 billion into the financial system since December.
The program was designed to relieve pressure on interbank lending by providing another venue to obtain financing. And what we've heard from the Fed, and especially Bernanke this week, the Fed will continue conducting these bi-weekly auctions through the TAF program as long as necessary to keep the banking system functioning and solvent. Indeed, the Fed has said, “this is a new tool that we've come up with that we're going to add to our arsenal for fighting deflation.” [1:10:17]
JOHN: You know, overall, Jim, this does not sound good.
JIM: No. It really doesn't. It just shows how things have progressively worsened since when this crisis first erupted last August. It began with falling real estate prices, which led to rising delinquencies and foreclosures, which have spilled over into structured vehicles that we called CDOs, SIVs, commercial paper, ABS, CDS, monoline insurers, the auction rate securities. I mean, you name it, it's just like it has become a domino effect, and it has just rippled through the whole system.
JOHN: Okay. You'd better explain some of these terms for our listeners because it's important that they get their minds wrapped around exactly what the status is here.
JIM: Okay. You think of this. Banks make loans. Okay. In the past, banks would make a loan, the loan would go on the bank's book. But we developed through the progression of the financial industry securitization. So you might have a bank take a whole pool of mortgage loans that they made, and they would package them together, sell them to Wall Street. Wall Street would package them in a CDO, and then what would happen is they would break up these CDOs into different tranches. In other words, the top tranche received the AAA rating, and then the ratings would go all of the way down to BB and then there was something called the equity tranche.
And if, for example, let's say that the people started to foreclose, that would hit the equity tranche first. And this was how, John, they took something that was subprime, which was junk bond rating, and they would turn it into an AAA rating. That was the magic of the markets (and you remember the skit that we played with the Two Johns.) But a CDO is a collateralized collection and pool of securities such as mortgages. It could be corporate bonds, corporate loans or any kind of asset-backed security: Car loans, etc. They were packaged into securities, and then they were broken up into different tranches.
If I can use an analogy, think of this as a ship, and, you know, it strikes an iceberg. The lower decks, the water floods in first and then eventually as more water comes in, it works its way up to the upper decks. Well, the upper decks were on top. That's what received the AAA rating. And it was unlikely that, for example, 100 percent of a mortgage pool would default, and so that's why they got these AAA ratings.
So those are what we would call a CDO.
And then we have another area called credit default swaps. And it was done as sort of, think of it as bond insurance. You own a bond. Let's say it's a lower quality bond – a corporate bond for example. You were worried about it defaulting, so you would go out and buy protection from somebody that was selling you bond insurance protection. You would make a payment to the seller of the protection and then the seller would make you whole if the bond defaulted.
The problem was the market became the primary method for the investors to speculate on corporate credit without having to buy or sell the underlying debt instruments or loans. So the CDS market made it much easier to short a corporate debt, which was difficult or impossible in the cash corporate bond market.
And, John, a lot of these people that were selling these CDS default swaps, unlike an insurance company, which let's say insures your home or insures your car, they have to set aside reserves. A lot of these institutions, whether it was a hedge fund, they weren't required to set aside reserves, so if the corporate bond market goes into default as the economy weakens, this could lead to a crisis. You've had people like Bill Gross that estimates that the losses could be as high as 250 billion from this. So those are credit default swaps.
Then you had things like SIVs, which a bank would go out and borrow money in the short term end of the market, and then they would go in and buy longer term bonds. And they would make the difference on the profit spread, and of course that was paid to investors. Then you had the monoline insurers who wrote insurance on bonds. And the typical business was written on municipal bonds and about 62% of the business was written on, let's say, debt guarantees for public finance (mainly municipal bonds) with about 38% being structured finance, largely CDOs and ABSs. And that’s where these companies got in trouble.
Another thing that has just blown up recently is called an auction rate security. An auction rate security is an unusual type of long term bond that behaves like a short term bond. And it was sort of the keystone of modern finance and it was routinely used for everything from college student loan programs to municipal road and bridge projects. And they were a long term bond, but the interest rate was reset over shorter periods of times so if the interest rates increased, the rate on the bond would increase. And people were using these, John, as cash instruments.
And the problem is all of a sudden buyers stopped showing up for these instruments and some of these issues really dropped like lead, almost like the mortgage backed securities. I mean you've had companies from 3M to US Airways take huge writedowns. Bristol-Myers Squib took an impairment charge of 275 million. There was a story in the Wall Street Journal this week where the debt crisis hits a dynasty and they were taking about the Mahar [phon.] family that sold their business for a billion dollars. Their advisor told them they wanted safe securities, and they gave it to three different brokerage firms. One firm they gave it to was Lehman and Lehman put almost the majority of the amount that was given to them into these auction rate securities. And the family has lost almost 286 million dollars on these things.
So this is structured finance, and it was great when assets were going up, the Fed wasn't raising interest rates. But remember one of the things that we used to say on the program: Whenever the Fed goes through a rate raising cycle, something breaks either in the economy or in the markets. And this is what we're seeing as the Fed raised interest rates, we're seeing this whole thing break down. [1:16:58]
JOHN: That's actually the indicator, believe it or not, that they are sort of looking for. Have we done it too much? And when something breaks, you go: Too much! And then they figure out what they are going to do after that.
So getting back to the loss numbers then, let's look at that.
JIM: Well, there is a number of detailed reports out there, from a number of respected analysts and the figures that they are talking about that – and there is pretty much a consensus building around a 400 to 500 billion dollar figure, which sounds much worse than it really is when you consider the total size of the mortgage market. Now, the one thing I want to point out is as many of these reports have, is this figure is a moving target and could get bigger depending on the length and the severity of the recession.
But the numbers look somewhat like this: If you take a look at subprime mortgages, it's estimated that there is about 1.3 trillion of subprime mortgages out there. They are anticipating a 30 to 40% default rate and a 55 to 65% recovery rate.
Remember, when somebody defaults on a mortgage, let's say they owe 100,000, the bank will sell the house, repossess it and sell it for a loss, but they'll recover maybe 65, 70% of the mortgage. So they are estimating losses in this area could be between 160 and 200 billion. Then you have the Alt A market. That's about 1.1 trillion, and they are anticipating between 10 and 15% default rates in that area with about a 75% recovery rate. So that pegs it to around 30 to 50 billion in losses. So just in subprime and Alt A, you've got 200 to 250 billion in losses.
And then you have asset-backed securities and the CDOs, which add anywhere from another 150 to almost 250 in losses. And that's where you get to this number that we're talking about that here, this 400 to 500 billion in losses. [1:18:58]
JOHN: So the extent of the losses, then, really depends on whether we can limit the damage of a recession because in a recession, the economy contracts. And then people who are meeting their mortgage payments lose their jobs. They end up defaulting on their mortgage payments. So looking at these losses, who is really holding the hot potato when everything come to a stand still?
JIM: From a lot of this, and remember, this market is somewhat opaque. It's not transparent. That's one of the problems of mistrust that you have and why the system isn't functioning. But overall, most banks including investment banks are net long protection, meaning they've hedged. Unhedged insurance companies, hedge funds, pension funds are probably net short. The best example of this is the monoline insurers. According to a study done by Barclays, the monoline insurers have about 2.1 trillion in debt with 62% of that in public finance, mainly municipals; and 38% is in structured finance, the CDOs and asset backed securities.
They have collectively probably about a 13 ½ billion exposure to subprime; S&P's latest estimate is about 13.6. But then you have firms like Pershing Square which estimates the losses for the monoline insurers could be somewhere in the neighborhood of 23.2 billion.
And you have several scenarios that some of the firms have outlined in terms of what is the best case, what is the worse case. The best case is that these monolines are successful in raising enough capital to maintain their AAA rating because if their rating drops from AAA down to AA or A, that means the bonds that they insured, their ratings also drop.
A second scenario is where the monolines can't find the capital. This would mean an end too underwriting new business; they could no longer offer clients or upgrade to AAA status.