Regular readers know that we have long championed cash — in the form of foreign currency CDs, money funds, and other cash vehicles — and gold as worthy investments in risky times.
Now, as a debt meltdown and credit crunch looms, that advice is more pertinent than ever.
[Editor's Note:The Mother of All Financial Disasters]
Over the weekend, ABC ran an item by Stephen Long, titled, "Credit crash fears surround debt whirlpool." Long highlighted the "revolution in lending," which allows banks and other lenders to ignore the viability of "loan service" when originating a loan.
Instead, the lenders sell the loans to the secondary market, where they are bundled together with other loans. Within the package (usually of some $1 billion), the loans are sliced and diced into segments, each accepting liability for a varying degree of default within the total (so-called diversified) package.
These segments, of varying risk are rated by the rating agencies and sold to investors as "Collateralized Debt Obligations" or CDOs.
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For example, the AAA rated prime slice will only be affected by defaults in excess of some 24 percent of the total package. (Until now, it was considered that this 24 percent level would not be reached under normal conditions).
The lowest rated BBB, "equity" or "toxic" slice, accepts the first 5 percent of packaged default risk. In turn it offers a relatively high yield that is attractive to high-risk, high-return (usually un-hedged) hedge funds.
Once the "toxic" slice has been wiped out, the next slice becomes liable for the next slice of defaults and so on up the chain, until the "prime" slice appears threatened.
As each senior slice is increasingly threatened, their AAA, AA, A and BB rating are subject not only to downgrade, but increasingly likely to be sold by those institutional investors unable to hold them at their newly downgraded status.
Accumulated sales lead to a rapid fall in price and a commensurate rise on the yield on these slices. This forces further downgrades, further sales, and a further price slide. Soon you have a "buyer's market."
The Wall Street Journal recently pointed out that the total of this secondary debt market now sits at some $1.8 trillion — in other words really, really big, even in our modern world of Giga figures.
As we have described several times, a hedge fund can obtain total leverage of some 54 times capital. This is achieved by using its own leverage added to that obtained by investing in Credit Derivative Product Companies (CDPCs) that can, in turn leverage themselves 30 times and who, in turn, invest in CDOs that can be leveraged 15 times.
[Editor's Note:Will the Liquidity Crisis Sink Your Stocks? 12 Ways to Profit.[
As our readers know, hedge funds are largely unregulated and hold many investments, such as private equity, that trade only by "appointment." Due to the inherent difficulty of determining a "market price," most hedge fund investments are held on their books at "cost."
Imagine a world in which CDOs are put up for auction by institutions that are forced to sell them by auction. A market price is suddenly established. It may well be at less than a half of the initial cost. Accounting rules would require the hedge fund owners to mark this new "market" price, taking a 50 percent cut in book value.
Many hedge funds, some of whom may not yet be in trouble, may be forced to mark down their assets, potentially drawing them into a downward spiral of reverse leverage.
The concern therefore, is that the secondary debt market, of some $1.8 trillion, is so large that it makes the Bear Stearns current $20 billion problem a relative drop in the ocean.
This has our regulators really worried. It should also concern our readers.
We note that the Financial Times last week had a front page headline reading, "Banks told to show subprime leniency."
This means that our regulators now see the problem they have watched grow before their eyes as so horrific that they are basically ordering our banks, containing our deposits, to accept the breaking of signed financial contracts on a potentially massive scale. This should concern our readers yet more.
In addition to what we term as the "ground zero" risk of subprime defaults in relatively low income areas, there is also growing risk of ripple effect, like a financial nuclear bomb. Let us explain.
Put basically, subprime lending enabled not just poor, but all buyers to buy in areas that they could not really afford.
This means that high risk loans were made not just in poor areas but in middle income and high income areas. People, for example, who may have stretched themselves financially to keep up with their friends and colleagues.
[Editor's Note:Buffett, Soros, Templeton, Rogers: Learn Their Money-Making Secrets]
Make no mistake, as we have said before, this current housing crisis could turn into a massive bust in other real estate markets, hither to felt to be immune.
Contagion is a real risk in reverse leverage.
We believe that the present problem is a scandal for two reasons.
First, our regulators have sat quietly while grotesque levels of financial greed were financed by a massive increase in liquidity, all assisted by the huge and imprudent, politically motivated increases in money supply and by falsely cheap credit (at below the "true" 6 percent, pre-Clinton calculated CPI inflation rate — see MoneyNews.com of June 29).
Second, as we have quoted in past issues, the Economist recently ran an item citing the value of residential property, in just the developed economies, as having increased by some $25 trillion (based on a liquidity boom), over the past five years, to some $70 trillion!
The Economist went on to say that the $70 trillion was more than the total pooled GDPs of all the developed economies!
Talk about big! The real estate problem is massive. The contagion effect now threatens to affect a $70 trillion real estate market adversely.
On June 29, we published an item titled, "Fear at the Fed," which explained our thinking as to why the Fed should have raised rates this year, but was afraid to do so.
The enormous size of the highly-leveraged subprime markets and the risk of contagion in a massive $70 trillion international real estate market go some way to explaining the fear we feel now permeates the Fed.
This should both concern our readers and also go some way to explaining the reason we have long urged our more conservative readers to accumulate cash and gold.
We believe a credit crunch is coming and that cash may soon prove to be not just a King, but an Emperor.
One side effect of the rush to quality that we foresee will be a possible rise both in U.S. Treasuries and in large cap blue chip stocks over the next few months. However, we feel that both will prove to be "sucker" rallies, in which only the bold should play, on the long side.
Editor's note:
Will the Liquidity Crisis Sink Your Stocks? 12 Ways to Profit.
The Mother of All Financial Disasters
Buffett, Soros, Templeton, Rogers: Learn Their Money-Making Secrets
