Warning: Crisis Ahead

Addison Wiggin – May 31, 2011

  • Distant signals of an impending financial crisis: Hair-raising figures on derivatives, Fed balance sheet
  • Seizing opportunity from crisis: Outsize returns from frontier markets, and how to spot one
  • Welcome to the nightmare: Housing double dip we called seven months ago arrives
  • Smackdown: An exclusive glimpse at a Peter Schiff-Porter Stansberry tiff

   "There is definitely going to be another financial crisis around the corner," says hedge fund legend Mark Mobius, "because we haven't solved any of the things that caused the previous crisis."

We're raising our alert status for the next financial crisis this morning. We already raised it last week after spreads on U.S. credit default swaps started blowing out. Today, we raise it again after seeing the remarks of Mr. Mobius, chief of the $50 billion emerging markets desk at Templeton Asset Management.

Speaking in Tokyo, he pointed to derivatives — the financial hairball of futures, options, and swaps in which nearly all the world's major banks are tangled up.

Estimates on the amount of derivatives out there worldwide vary. An oft-heard estimate is $600 trillion. That squares with Mobius' guess of 10 times the world's annual GDP. "Are the derivatives regulated?" asks Mobius. "No. Are you still getting growth in derivatives? Yes."

In other words, something along the lines of securitized mortgages is lurking out there, ready to trigger another crisis as in 2007-08.

What could it be? We'll offer up a good guess this morning — one the market is discounting.

   Seldom does a stock index rise so much, for so little reason, as the Dow did on the open this morning: 115 Dow points on a rumor that Greece is going to get a second bailout.

Let's step back for a moment: The Greek crisis is first and foremost about the German and French banks that were foolish enough to lend money to Greece in the first place. What sort of derivative contracts tied to Greek debt are they sitting on? What worldwide mayhem would ensue if Greece didn't pay back 100 centimes on the euro?

That's a rhetorical question, since the balance sheets of European banks are even more opaque than American ones. But whatever the actual answer, it's scary enough that the European Central Bank has refused to entertain any talk about the holders of Greek sovereign debt taking a haircut — even in the form of Greece stretching out its payments.

That was the preferred solution among German leaders. But if today's Wall Street Journal is to be believed, the ECB is about to get its way. Greece will likely get another bailout — 30 billion euros on top of the 110 billion euro bailout it got a year ago.

It will accomplish nothing. Going deeper into hock is never a good way to get out of debt. And at some point, this exercise in kicking the can has to stop. When it does, you get your next financial crisis.

   And what of the derivatives sitting on the balance sheet of the Federal Reserve? Here's another factor behind our heightened state of alert.

"Through quantitative easing efforts alone," says Euro Pacific Capital's Michael Pento, "Ben Bernanke has added $1.8 trillion of longer-term GSE debt and mortgage-backed securities (MBS)."

Think about that for a moment. The Fed's entire balance sheet totaled around $800 billion before the 2008 crash, nearly all of it Treasuries. Now the Fed holds more than double that amount in mortgage derivatives alone — junk that the banks needed to clear off their own balance sheets.

"As the size of the Fed's balance sheet ballooned," continues Mr. Pento, "the dollar amount of capital held at the Fed has remained fairly constant. Today, the Fed has $52.5 billion of capital backing a $2.7 trillion balance sheet.

"Prior to the bursting of the credit bubble, the public was shocked to learn that our biggest investment banks were levered 30-to-1. When asset values fell, those banks were quickly wiped out. But now the Fed is holding many of the same types of assets and is levered 51-to-1! If the value of their portfolio were to fall by just 2%, the Fed itself would be wiped out."

Mr. Pento's and Mr. Mobius' views line up with our own, which we laid out during interviews on our trip to China this month.

   "With every crisis comes great opportunity," Mark Mobius continued in his Tokyo talk. When markets are crashing, "that's when we're going to be able to invest and do a good job." Mobius was an early proponent of emerging markets. Nowadays, he's moved on to "frontier markets."

"They are markets that have not yet been 'discovered' by the majority of investors," he explains. "Economic growth in many frontier market countries remains high and is even faster than some emerging markets and exceeds the growth in developed markets by a wide margin.

"The economic drivers across frontier markets are diverse. For example, Botswana, one of the world's largest diamond exporters, is introducing call and data processing centers. On the other hand, Kazakhstan, a country rich in oil and other natural resources, is seeing significant investments in infrastructure development. These varied economic themes across frontier markets ensure a diversified portfolio."

   "Frontier investors seek to make outsized returns by investing in countries before they become popular," adds our friend Doug Clayton, whom we first met in Colombia in March. We then ventured to his home turf in Laos and Cambodia this month. "They are our modern-day pioneers, seeking out places that mainstream investors are hardly aware of, that are quietly in transition toward becoming tomorrow's emerging markets.

"What the most interesting frontier markets have in common are rapid growth rates, unleveraged economies, cheap expanding forces due to youthful demographics and underutilized natural resources. Usually, their physical infrastructure is getting better every year, not deteriorating, like in the West.

"How can you tell a frontier market from an emerging market? If it is easy to raise money for them, or they have an ETF or are heralded on a mainstream magazine cover, they are no longer a frontier market. Seek out the places that McDonald's hasn't entered yet. But don't worry if Coca-Cola or 3G phone operators have preceded you; they are early-frontier investors and don't lessen your opportunity.

"Our favorite frontier markets right now include Cambodia, Laos, Bangladesh, Sri Lanka, Bhutan and Haiti. Fortunes will be made in each of these places over the coming decades — even as other fortunes are drained away in the developed world."

   Back in the States, the housing double dip we first suspected on Oct. 26, 2010, is now "official." The Case-Shiller home price index fell 0.8% in March. The year-over-year decrease is 3.6%. The index is now lower than its previous bottom in April 2009.

And that's the headline number, tracking 20 major metro areas. Prices fell year over year in 19 of those 20 areas, and the exception should be no surprise — Washington, D.C.

The national number is even worse. For the better part of three years, we've been reporting this number and saying home prices were "back to 2003 levels." Now it's 2002. On a chart, the double dip looks like this…

With 3.7 million homes on the market today — not counting the ones the banks are keeping off the market and thus their balance sheets — we ought to be back to 2001 levels by 2012.

   Consumer confidence slumped last month. The Conference Board's index drooped from a revised 66 in April to 60.8 last month.

The Street was counting on a small increase, presumably because gas prices have leveled off recently. But the survey revealed people are gloomy about job prospects — yet another ill omen for the monthly unemployment numbers, due Friday.

   The Greek talk is driving the euro to a three-week high against the dollar, currently $1.438. The dollar index, which bounced above 76 a couple of times last week, is down to 74.6.

   Crude oil has surged more than 2% today. A barrel of West Texas Intermediate goes for $102.90.

The business press is fishing for explanations — the slightly weaker dollar, garden-variety turmoil in the Middle East, a leak in a pipeline running from Alberta down to the terminal at Cushing, Okla. While each of these news items might be a catalyst for this particular bump in prices, we're reasonably confident they're only flashes in a long-term trend up.

   Gold is the immovable object as the month of May winds down. The spot market traded lightly yesterday, extending into more-active trading today, the price rock steady at $1,539.

   China's gold stash grew nearly 30% last year. The State Administration of Foreign Exchange just released its annual balance sheet. The gold reserve grew from $371 billion dollars in 2009 to $481 billion in 2010.

Still, that amounts to a mere 1.65% of China's total forex reserves. As we've mentioned several times this year, China aims to grow its gold stash at least as large as that of the United States.

That would mean expanding it by a factor of eight. A 30% increase in one year is just the beginning… and it's one more reason we contend that even with prices up sixfold from when we first started recommending it in 1999, it's not too late for you to own gold now. You can find specific suggestions on how to make it happen in this presentation.

   A decade ago, under delusions of idealism, we spent about a year commuting from Baltimore to Washington, D.C., putting in some time at the Cato Institute. Among the surprising things we learned, libertarians of various stripes and organizations tend to have one thing in common: They despise one another.

Our business, publishing independent financial advisories, was born, back in the late 1970s and early 1980s, from the very same think tank world. And, it seems carries, with it the same navel-gazing egomaniacal characteristics as its progenitor.

Over the holiday weekend, we found ourselves on the recipient list of an email spat between Peter Schiff and our colleague Porter Stansberry. It started with this…

Apparently, of late, as funny as this might sound, Schiff has decided to self-anoint as a consumer advocate.

A couple of weeks ago, he went after the National Inflation Association, accusing it of accepting payments from shadowy third parties to pump junior mining shares… which those third parties would then dump.

After that became a minor Internet sensation, Schiff says his listeners asked him to check out Mr. Stansberry, because of his enormously well-received presentation, launched six months ago.

"While Porter has, in fact, made several good calls throughout his career, including calls on Fannie, Freddie and GM," Schiff concludes, "a review of his newsletters from January 2006 to December 2008 contradicts his claim that he predicted the financial crisis of 2008."

"What's up with this guy?" Porter asks in his email. "Life is hard enough for anyone in this business without having the people on your side of the battle misrepresenting your track record.

"And, Peter, unlike you, when I decide to criticize your firm's track record, when I round up the hundreds of investors you wiped out by exposing them to foreign stocks and foreign currencies, which collapsed in 2008, I will have the decency to at least call you first and give you a chance to respond, in print, to the claims they are making."

"The difference between me and Porter," Mr. Schiff replies, "is that is my clients lost money in 2008 because I did predict the financial crisis. However, in making that prediction, I incorrectly assumed my clients could protect themselves by owning nondollar assets.

"Porter's clients, on the other hand, lost money in the financial crisis because he had no idea the crisis was coming and recommended a traditional portfolio of mostly large-cap U.S stocks."

Schiff got into a similar tangle in early 2009 with the former editor of our own Survival Report, "Mish" Shedlock. Having disinvited Mr. Schiff from our Vancouver conference last year for similar ungentlemanly conduct, we can only assume he enjoys confrontation… or knows a good train to hitch his wagon to when he sees it.

[Ed note. "More than 30 years ago, we began our career publishing newsletters," Bill Bonner writes in the preface to the 2009 edition of Financial Reckoning Day, entitled "Confessions of a Newsletter Man."

"Those were the days! They were even more fun than they are today. Years of television, heavy-handed regulation and waiting in line for airport security have taken much of the lightheartedness out of American life. In its place, a kind of earnest timidity has settled over the 50 states. Everything is forbidden, or else it is compulsory — especially in the financial markets."

For an entertaining — and increasingly important — retrospective of the newsletter business 30 years on, we invite you to read the preface… and then continue through the entire book.]

   "This struck me as a derogatory comment about the approval process requirements for drugs," a reader writes after we discussed the FDA's "safe and effective" standard applied to a new treatment for pancreatic cancer. "If you intended to take a shot at 'bureaucracy,' then you should pick a more deserving target.

"I have been battling an 'incurable' cancer for more then a decade — and as a result of my readings, I'm a little more familiar with the hurdles and requirements to have new treatments and chemicals approved.

"The ethical hurdle that proposed treatments must pass to be approved for use against a cancer is whether the benefits against the particular cancer are worth the risks. That is — does it provide a significantly better result than existing protocols?

"Not a easy process to go through, but when you understand the risks (and from personal experience, I can assure you that there is no free lunch when fighting cancer), it is imperative that there be a stringent drug testing and evaluation process to protect patients from needlessly risky cancer protocols without justified potential benefits."

The 5: "You present a surprisingly narrow and one-sided perspective of the drug regulatory issue," responds Patrick Cox, who's been studying these issues for the better part of his adult life. "There is a massive library of academic work examining the risks involved with greater and lesser regulatory oversight. When the costs of greater or lesser regulation are honestly weighed, I believe the preponderance of evidence makes it clear that drug regulation, in total, causes more harm, morbidity and mortality than lack of drug regulation.

"Thousands of case studies are available showing that the FDA is causing pain and death by withholding treatments. A good example comes from a diet drug from our own portfolio. An increase in mouse cancer rates of 2.3-2.5%, well within the margin of error, caused the FDA to ban a drug that reduces body fat by an average of 7-8%. If you calculate the increase in cancers and other diseases caused by obesity of that magnitude, you quickly understand that the FDA's incentives are perverse.

"I also subscribe to the theory of 'regulatory capture.' The current regulatory system requires, typically, that many years and a hundred million dollars are spent getting approval for a drug. Startups cannot pay that cost, so they are forced to partner with Big Pharma.

"The theory of regulatory capture explains that Big Pharma is the true customer of the FDA, which erects barriers of entry just high enough to assure that existing players are not displaced by upstarts. So we see the difference in price between effective nutraceuticals such as anatabine and Lipitor. Lipitor costs thousands a year, due to development and regulatory costs. Anatabine, which is more effective, costs pennies a day because it is not technically a drug, but a food product.

"My view is that Milton Friedman was correct, the FDA should be the ultimate peer-review agency, charged with gathering and generating data about drugs (and devices), but that all decisions about treatments should be left to doctors and patients. Freedom, however, is scary, and many people would prefer to be killed by a known well-meaning state bureaucracy that denies treatments than by the unexpected side effects from an unknown drug."

   "I beg you" writes a reader, " please do a Google search for the phrase 'frosty nuggets' (in quotes)!"

Ah yes, we wrote on Friday, "The wheels of Big Government and Big Pharma move slowly. Glacially, in fact. Look at these frosty nuggets from this week alone…"

"Addison, we hardly knew ye!"

The 5: Well, we have gone on record saying we learned how a free market operates in reality — as opposed to "in theory" — by going on the road with the Grateful Dead in the late '80s and early '90s. You can draw any medicinal conclusions you need to from there.


Addison Wiggin
The 5 Min. Forecast

P.S. "It's a good time to own stocks that find and produce oil and natural gas," writes our Dan Amoss. "Better still, if you can a find small oil and gas company that's expanding production, yet trades at a cheap valuation, you have one that could perform nicely even in a tough market environment."

Dan recommended an "undiscovered, undervalued investment in oil and natural gas projects" to his readers on Friday. He sees an easy double… and this morning, it's still below his buy-up-to price.

Learn how he found it… and how you can snag a discount on Dan's premium advisory… right here.


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