***** SOURCES OF MONEY FLOWING INTO GOLD & SILVER *****
REAL ESTATE:
Intense controversy has been circulating over the future prospects of the residential housing sector. The inimitable gnome heading our Federal Reserve has shifted the stock bubble toward two crucial credit markets - USTreasuries and Mortgage-Backed securities. The direct result of rock bottom interest rates has been pulling the rug from under the USDollar in international currency markets, and breeding a bubble in real estate and mortgage finance. The markets took the bait, sending large sums of money into peak-valued mortgage bonds. Now the next housing boom has been proclaimed, without realizing a shifting of bubbles from stock to credit. I believe real estate is now posing as a "hard asset impostor" whose value is bound to the ready flow of mortgage funds. Commercial property has been enduring crippled clients, vacancies, and severe writedowns in asking prices. But residential property continues rising. In fact, it far outpaces rental prices, setting up for a decline, as history dictates.
Vast distortions are now being skewed in both the housing and car sectors. Benefiting from structured sources of finance, new house construction and new car production have each distorted the delicate supply & demand equilibrium for their respective industries. Their financing arms buttress sales, but at a huge risk to their entire industries. I refer both to Govt Sponsored Entities (e.g. Fanny Mae) and to publicly traded home builders (e.g. Lennar). Supply of existing houses and used cars has risen to dangerous levels. Unsold residential properties now flood major markets nationwide, in stark contrast to easily financed and quickly sold new homes. Used car inventories are absolutely overflowing. Zero down, zero percent, and hefty cash back deals enable continued new car sales. Car dealers bear the risk for used cars, a depreciating asset which most banks avoid and deny easy credit terms. Such is the nature of distortions created by Structured Finance. Its resolution will be certainly painful and disruptive. Financial Socialism has now implicitly decreed that American home ownership should be institutionally subsidized. Instead, the movement has left households and the financial industry even more vulnerable to cyclical downturns.
The Federal Reserve will continue to support the housing industry, which serves as the bedrock for private citizen wealth accumulation. Homeowners have unwisely leveraged to the hilt with minimal or nil down payments, raided their home equity, and put their nest eggs at risk. All to maintain the consumption patterns gone overboard. In fact, the principal residence now operates as a shaky foundation for the household's own structured finance, which we euphemistically label "bill consolidation." BUT, default on your single big bill, and you lose your home !!! Home equity now finances Mastercards, student loans, vacations, as well as general consumer spending. The Fed can monetize mortgage-backed securities, even subsidize Fanny Mae and the other GSE's. But for how long? Richard Russell put it well last autumn. "Low rates kept home values up in the year 2002. Job losses will undercut home values in the year 2003." Since WW2 every economic recession has centered on the housing sector and car industry. I believe the 2001 recession was not the main act, but a preview of the real deal coming this year.
The upcoming recession is written in stone, to be led by the struggling profitless automobile industry hellbent on easy terms amidst severe overcapacity and the strangle of union labor contracts. Their fall will be compounded by real estate, but only when either the jobless rate rises more than a little, or the mortgage rates rise more than a little. The process will receive an early push from the city, town, municipality, and state fiscal distress. Already the reaction has begun with increases in property taxes. California is the early focal point for these gale-force winds hitting residential property. All in time, as the economy will shed more jobs and the dollar hazard will force longterm rates higher, a certain disruption to the finance arms. When it happens, a torrent of money will exit real estate speculation, will capitalize on the retired nestegg wealth, will swing from owner to renter, and will squeeze out of equity lines of credit. It will find gold in a big way, especially when news spreads about recent leveraged buyers sitting on negative home equity. In fact, I expect negative home equity to crop up as a major story in 2004, in search of a national solution.
MORTGAGE-BACKED SECURITIES:
The most frightening credit bubble outside the govt securities is clearly the mortgage finance industry. The Fanny Mae portfolio alone is rising 25% per year in credit extensions, with no regulation whatsoever. Appraisal values are requested and delivered. Down payments are optional, with stories far and wide about closing costs handled under the table by buyers. Income verification is either nonexistent or so relaxed as to be meaningless. The 1980 double-tier requirements of 28%/33% for property and total debt service are long gone, having been replaced by a loose 40%/50% guideline of absurdity. Do we even perform home inspections anymore? Loan originators are rewarded with immediate "points," quick to package their newly underwritten mortgages for ready repurchase by Fanny Mae. The process recycles credit for the purpose of keeping the real estate industry fully liquefied. Nobody scrutinizes FNM books or their unusually aberrant new money creation, which make a dent in the overall US Money Supply. Welcome to the world of Structured Finance (see ref#8.) Originators don't care about the quality of borrowers, while investors are shielded from learning about credit worthiness except in the aggregates. It is not even legal to examine the individual mortgage contracts within packages of sold portfolios. The entire real estate sector would falter badly without continued availability of financing funds. The system is totally out of control, yet racing faster every year. Fanny Mae holds almost $5 trillion in mortgages, and few know anything about the quality of those loans. Such is the nature of securitized mortgages. May their buyers beware!
Residential real estate values can come down without doing harm to these securities. However, most factors that weigh down property values also do harm to mortgage-backed securities (MBS). They suffer from refinances when rates fall, depriving owners of their expected originally projected returns. When defaults and delinquencies occur, MBS securities lose value, since returns are cut off or interrupted. When rates rise, they lose value just like any bond instrument. Many investors do not understand the risks involved, and simply chase any security with a "bond" label in this deflationary environment. I believe we have seen the lows for mortgage rates. The still overvalued USDollar threatens the entire bond market now. Currency risk joins the risks of default and delinquency to put a floor on rates. When losses come, and they will, a very large pool of capital will be released. The far greater risk is the unwinding of the Structured Finance Pyramid, which is larger than any tech stock bubble. We have both an archipelago of household pyramids at the micro level, and a monstrous inverted pyramid for the entire mortgage finance industry, each dangerous evidence of Structured Finance gone amok.
Mortgage bond holders will see the lion's share of their money returned upon their sale. The same might not be said about FNM stockholders. Together they supply lenders the funds for home loans, on the opposite side of the table from heavily leveraged home buyers. They will realize many capital gains, unless they invested when rates were at the bottom. Either way, a tremendous amount of money might soon regard their present residence in MBS bonds and FNM shares as highly unsafe, at high risk. The risks may mount higher than many imagine if Fanny Mae has an accident, as I expect it will. She is chartered as a GSE, but many believe the federal guarantee of experienced losses to be unlimited. It is not; rather, the limit is widely reported to be a mere $20 billion. Before this credit bubble is popped, FNM losses could possibly top $1 trillion, inevitably at taxpayers' expense. The risks run much deeper than just some minor losses to individual investors, unaware of MBS risk. An entire derivative monster exists to support and balance the Structured Finance Pyramid. A jump in mortgage rates of 75-100 basis points could distribute shock waves to the pyramid, with unknown consequences. As the story of gold is told, money invested here will find it wants to participate. The Fanny Mae stock price will be a good leading indicator for the breakdown of Structured Finance itself, as smart money departs this credit market niche. We are talking about roughly $7 trillion in mortgages nationally, of which the majority have been securitized as asset-backed bonds in a truly mindless fashion.
CORPORATE BONDS:
Yet another vast pool of capital is tied to credit markets, tipping the scales at $6 trillion. The corporate bond market in the United States easily eclipses its stock market, at five times the size. For instance, Ford Motor debt is 15 times its market capitalization. Xerox debt is 23x its mktcap. An endless list could be rolled out to make the point. US corporations are awash in debt. Unlike the USGovt, which can tax its citizens and print money to purchase its own debt issuance, corporations are bound to manage debt more responsibly. When fiscal stress occurs, they must react to their debt levels. They issue new debt, tap the equity markets, straddle the two markets with convertibles, reduce costs, furlough workers, sell off businesses and assets, merge with healthier companies, restructure debt, or simply liquidate in bankruptcy court. Their debt can be downgraded by major ratings agencies such as Standard & Poor, Moody's, Fitch, thereby adding to borrowing costs. Prevailing corporate yields are surely tied to the trend in Treasuries, but not always. Like not now ! The "yield spread" is now critically high, measuring the difference between higher corporates and lower Treasuries. It is a commonly used indicator to measure credit stress within the corporate sector. When lower govt yields fail to generate economic recovery, corporate yields can remain high. When corporate earnings and cash flow experience severe downturns, the first to see a write down is the stock share price. But if stress persists, their bond is next written down, pushing up its yield. Chronically rising yield spreads can trigger derivative events in the highly leveraged futures pits, where swaps and other exotic contracts are created and traded as giant bets of a recovery.
Interest rate swaps are precisely where current risks lie in the private credit market. When the Fed began its belated and reckless cutting of interest rates in January 2001, swaps came back in vogue. (In my opinion, this abrupt policy reversal was a direct admission of failed monetary policy and chronic abuse of debt extensions in the last decade.) General Electric brought the practice to attention, but Bill Gross of PIMCO openly discussed the heightened risks. It seems countless corporations employed swaps to take advantage of lower shor-term rates, thereby offloading their long-term higher rate obligations. Nothing comes without risk though. If and when short-term Treasury yields are driven back up, either by virtue of an economic recovery or by ill-fated pressures from the currency markets, corporations will then be caught in a vise. Their earnings will feel the great impact of sharply higher borrowing costs, a backfire in their swap strategy.
This $6 trillion non-guaranteed credit market represents a truly colossal pool of capital, equal in magnitude to our US Treasuries. Two scenarios each benefit gold. If (when, I expect) things begin to turn sour from USDollar pressures, rates would rise across the curve in defense of the dollar. Investors would seek other safe havens such as gold in a pressure cooker environment. Import component prices would jump, material and energy costs would rise, squeezing corporate profits in an already weak environment. Gold would benefit from the general commodity uptrend, plus the monetary bonus from unrelenting credit stress. If (unlikely, I expect) the economy responds to fiscal and monetary stimulus, credit stress would see some relief, as corporations would be better positioned to meet credit obligations. The yield spread would narrow from restored health to the credit market. Investors would seek out gold as an inflation hedge, protecting themselves from the consequent risk linked to massive monetary expansion. Since January 2000, the MZM money supply has increased over 45% in a desperate nightmarish attempt to save our economy, our monetary system, and our way of life. So far, traction has not been evident. The Liquidity Trap is working overtime. I do not expect sustained traction for a few more years. Until then, money will spill over from the corporate credit pressure cooker and find true safety in gold.
S&P STOCKS:
Stock investors rely on several factors to work in their favor. Rising cash flows typically result in higher earnings, due to the entire economy cycling upward, its industry enjoying its own upcycle, innovative products, management competent enough to streamline costs, the opening of new markets, beneficial regulations, reduced workforce, pricing advantages, among others. The biggest factor for improved profitability is downtrending interest rates, which keeps borrowing costs down and enables favorable stock valuations. Since the spring of 2000, investors have been subjected to a storm of negative factors. Declining sales, rising health costs, underfunded pensions, flooded competition, saturated mfg capacity, liquidating competitive inventory, overextended household consumers, extinct capex by business customers, all have overwhelmed the declining interest rate environment advantage. To summarize, these investors depend upon rising earnings. Prospects for their revival are not promising, a condition which might persist for many more months, even years.
The economy is not responding to over two years of monetary stimulation. Next we will witness more desperate attempts at fiscal stimulation in what will resemble last resort. I doubt that will succeed either, except temporarily. Debt levels are absolutely suffocating; business capacity is largely idle; finished products are too much in excess; worker incomes are increasingly insecure; pricing power is nonexistent; and China continues to undercut on price as it captures market share worldwide. As long as official policy emphases sustained consumption, versus savings and capital investment, both monetary and fiscal stimulus is doomed to offer only a rowboat in a dangerous ocean storm. Increased debt is the tainted river supplying this very consumption, only to magnify stagnation on the demand side. Oh well, the end of the road of the Keynesian Monetarist Economic model will do that. Sooner or later, stock investors will give up on this dead-end game. Disgusting earnings reports still feature deceptive or fraudulent profit-loss statements. Debt-ridden balance sheets will dissuade investors on an ever-increasing basis, since they are evidence of barren book value. The public remains sadly ignorant to the perils of a post-bubble economy, where entire debt systems are calibrated to prices that no longer exist. Rising material and import prices will combine with higher energy and employment costs to further squeeze corporate profits in an environment which has seen no pricing power whatsoever. Such are the winds of deep recession, not recovery. Nobody seems to anticipate this among the press & media. Pundit "experts" might even pathetically welcome the return of price inflation, mistakenly believing it to herald a return of pricing power. It will not.
Precious metals mining stocks will soon find broad appeal to investors, as gold & silver metal prices continue their march north. This will enable a massive short squeeze on the cartel, which has dabbled their short game during the last few months in precious metal mining stocks. In time, the precious metal stock group will realize sizeable momentum. Capital will repeatedly attempt its typical cyclical return from bonds back home to stocks. We have now seen numerous such attempts. In time, patience wears thin. Precious metal stocks will grant more reliable share price gains, while mainstream stocks (whether techs or "old economy") will continue to meander or whipsaw, neither course encouraging investors. Stock investors will increasingly turn to mining stocks, since they will make money. Right now, the metals lead the PM stock indexes. This aberration will change after education of stock investors. The teacher is losses and stagnant returns. The entire pool of money invested in US Stocks will gradually discover gold in the equity market.
NEW UNITED STATES GOLD-BACKED DOLLAR:
Jim Sinclair has taken the courageous stance of openly advocating and predicting an eventual gold-convertible USDollar. Necessarily, the present USDollar must either go through a near-death experience or be formally retired. I believe it will be retired in the face of a magnificent worldwide monetary crisis, with our declining abused bloated indebted currency at the epicenter, around which a strained global system revolves, saturated with dollars. I have elaborated in my first article upon the monumental forces and dynamics behind the USDollar Decline Vicious Circle. As the dollar declines in value, the many unchained powerful feedback effects will systemically show the way to further declines. Review the article (see ref#1) for a more detailed discussion of complexities. The key to the phenomenon lies in the dynamics of change. Many naïve observers of the economy and financial markets hail the onset of a lower dollar. But to their peril, they overlook how devastating the declining effect is on every facet of our economy and markets, as well as the world economy. The stock market, Trez bonds, corporate bonds, inflation rate, mortgage rate, supplier costs, import prices, energy costs, corporate profits, consumer spending, refinance cash outs, economic growth -- all these are detrimentally affected by a declining dollar. The vicious circle works like a revolving weapon, issuing blows to each listed economic factor with each repeated cycle. We simply depend too much on foreign capital, to the tune of almost $3 billion per day. I believe the destructive cycle will not end until a crisis develops and mushrooms. Each cycle ratchets up the destructive force, ensuring the next cycle's inevitable arrival, leading to a crescendo in the near future. The dollar declines act much like a debt downgrade, reducing the required cash flow in the debt-based economy for financing the debts themselves. Each round intensifies, putting greater pressure and strain on each debt component, setting up the next round of declines.
The crisis will center on the USDollar decline, which I believe will enter a slow-motion freefall. As the Fed enforces a ceiling on long-term interest rates, forestalling damage to corporate balance sheets and homeowners, they will dismantle the very mechanism to limit the extent of the dollar decline. Naïve observers again do not anticipate such an outcome. They make faulty assumptions on foreign willingness to stand pat and absorb continued and growing losses. They will not. Making matters worse, rising rates together with a falling dollar can deal a double loss to foreigners. High dollar valuation and low foreign labor costs have dispatched manufacturing capacity abroad for a wide range of sectors. Mfg operations have actively shipped to Asia, and assembly plants to Mexico, where labor and plant cost offer big cost advantages. When the market process shifts the strong dollar policy into reverse, all hell breaks loose. The internal mechanisms are absent on the monetary side, with a rate ceiling. They are also absent on the economic side; the apparatus has been exported for 20 years. The United States has neither the monetary nor the economic mechanisms necessary to effectively stem the upcoming uncontrollable USDollar Decline. We have witnessed evidence in a trade gap that continues to yawn wider. Only a gold monetary role will halt the decline.
Sinclair expertly articulates a gold-backed dollar, a new dollar, which would (will) enjoy the support of a partial cover clause. Alan Greenspan himself has spoken in less than his usually cryptic style on the possible return of gold to a monetary role. As Jim Turk reports, each ounce of gold in the US Reserve matches up with over $32,000 of US money supply ($8500 billion versus 260 million oz gold.) If a 5% cover clause were enacted, the USGovt purchases would find balance near $1600 per ounce of gold. Furthermore, official govt sources would be required to continue purchasing gold in order to keep pace with additions to the money supply expansion. A new $400 billion in annual monetary expansion would necessitate the purchase of $20 billion in new gold reserves, which amounts to more than 50 million oz. While this revolutionary step would certainly send the gold price to new heights, it would issue a much stronger signal. We would immediately see rampant competition for scarce gold resources, sending the price above the eventual point of equilibrium. Pressures on the relatively tiny annual gold supply would be utterly overwhelmed. The gold price would far surpass estimates of equilibrium, then settle back.
Given the history of gold tied in ratio to silver, I expect both precious metals to soar in value. Silver was once valued at a 16:1 ratio with gold in the Bimetallic Standard. The current ratio of 78:1 heaps disrespect on this unique metal with astounding technological properties. Convergence in time toward the historical 16:1 ratio will surely come about.
Other major currencies would (will) not necessarily follow suit to create a gold-backed euro or yen. Deeply troubled and endangered currencies would be forced to react in this extreme manner. Other nations such as China will choose instead to back their currency with gold, when positioned advantageously. One can see that only the best and worst positioned nations will back their currency with hard asset reserves !!! Private investors worldwide would enter into competition with the USGovt for that gold. The price of gold would enter the stratosphere. Again, naïve observers actually claim that gold would stabilize in price, since the USGovt would need it to stabilize. What utter shallow baseless nonsense drivel ! I expect gold will rise 10-fold, just like in the 1970 decade, when govt intervention failed to curb the market reaction to widespread currency debasement. Investors worldwide would force official govt buyers to pay up. Once more they overlook the dynamics of change. The USGovt would purchase massive amounts first to stabilize the dollar. It would continue buying every single year as monetary expansion continues its longstanding patterned model. The end result would be a magnificent transformation of the gold (and also silver) market, announcing sustained and regular gold demand, reversing 30 years of the official policy to put gold under foot. The USGovt might talk about legally capping the gold price, but we are talking about world markets, where US Law cannot apply. The impact on Asian Central Banks replenished with gold would change the face of the geopolitical and economic structures.
Gold would (will) stabilize only after the abuse of the currency ceases, only if stability is achieved, and not until it is achieved. Until the dollar currency stabilizes, one should expect gold to rise. If the Fed printing press can issue new dollars in limitless fashion, as Bernanke boasted, then gold also has corresponding limitless upside potential. Newton's Third Law of Motion dictates it - "within an equilibrium, every action invokes an equal and opposite reaction." Transition from old fiat dollar to new convertible dollar will be replete with risks and accidents and jolts from air-pockets, probably with high levels of resentment and distrust. This is the world reserve currency, the monetary standard, standing in denomination of 75% of world banks reserve assets.
NEW ARGENTINA SILVER-BACKED PESO:
The Argentine nation, currency, economy, banking system, and society are in total ruins. The entire economy has been victimized by their imprudent decision a decade ago to peg their peso versus the USDollar. Harsh requirements for IMF assistance led to reduced govt spending, hastening the economic collapse. Its leaders must chart a new course, paying no heed to further American influence. Urgent action must be taken to prevent a continued breakdown of its entire social fabric, leading to certain chaos. If not, it will revert to a feudal society with lords and fiefdoms dictating their own laws. We have the perfect environment for a nation of some importance to step forward, defy the system based upon dollar hegemony, and create a silver-based peso. Some label this call as a long shot. The result would (will) be remarkable, as a new monetary and banking system could be replenished with the hard asset silver, purchased with whatever scarce capital can be scraped from the wreckage floor across a once proud land. This country is loaded to the gills with silver. It can and it will turn to silver to buoy its revival. A new silver standard is coming. How appropriate, in a nation whose name means "Little Silver."
Argentina will likely resurrect itself from ruins, serve as a laboratory reconstruction model, and potentially lead the world by example with a new silver-convertible peso currency. I withheld this prediction from the January article. I give my call at least a 50-50 chance of happening. China has at least two years before it will carry out the same revolutionary step, but with gold convertibility for the yuan (renminbi) instead. If either nation undertakes this bold action before the United States, then pressure for creating a gold-backed USDollar will be unstoppable. Argentina has colossal silver deposits in numerous locations across a sizable land mass. Their government is perfectly positioned to be a major purchaser of its local silver deposits to rebuild an embryonic new currency. Restoration of its banking system and economy would follow. I believe social and political forces will rule the day that dawns on a silver-backed peso. Mexico and Bolivia could follow the lead taken by brave bold leaders from Buenos Aires. In time, a currency backed by its plentiful native silver will be seen as the only alternative.
A select few Canadian junior mining firms are perfectly positioned right now, owning substantial Argentine silver mine deposits. Their development will be encouraged by local leaders, would aid the creation of jobs, building real wealth throughout the land. Identification of promising mining firms will be addressed in a corollary to this article in the near future. Cardero Resource Corp leads the pack.
REFERENCES:
- Jim Willie CB: "25 Reasons Why Gold Will Rise" (Nov 12, 2002)
- Jim Puplava interview of Ian Gordon: "The Kondratieff Winter" (July 2002)
- Jim Sinclair: "Gold to be Remonitized!" (Jan 24, 2003)
and "Gold's Role Redefined" (Feb 1, 2003)
- Jim Willie CB: "A Statistician's Indictment of Economists" (Dec 2, 2002)
- John Murphy: "Gold Bull Market is Based on More than Iraq" (Jan 27, 2003)
- Clive Maund: "Gold, the HUI and XAU" (Jan 13, 2003)
- Jim Willie CB: "Predictions for the 2003 Year - Bear Claws" (Jan 27, 2003)
- Jim Puplava interview of Doug Noland: "Structured Finance & The Bifurcated Financial System"
(Jan 25, 2003)
Jim Willie CB is a pseudonym used since 1998 on Silicon Investor. Jim works as a statistical analyst for a private consulting firm engaged in consumer packaged goods marketing research. He holds a Ph.D. in Statistics. His career has stretched over 22 years, involving work at Digital Equipment Corp in manufacturing consulting and marketing research, and work at Staples in retail forecasting analysis. Visit his free fledgling website to read other articles and material, as well as to enjoy light-hearted satire, under the name: " www.GoldenJackass.com ." Many links appear for significant articles written by other authors. Future works are planned, including a mock interview of Sir Alan Greenspasm, director of the reactive inflationary pendulum.
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