The lender of last resort,  the Bear Stearns and Northern Rock bailouts:  Gold prices tumbled from the February peak of $1011  to trade at times barely above $900 before recovering to the current price if $925. The big story last week was the shotgun match arranged for J.P. Morgan Chase to absorb Bear Stearns,  save it from the embrace of a liquidator and neutralise a risk of systemic failures in the US banking system. The initiative appears to have been a success. This CNBC video gives different  perspectives on the Bear Stearns transaction.    

The Fed and other  central banks have an essential role as lenders of last resort. They have to act if there is a danger of systemic failure in the banking system. When a run started on the Northern Rock Bank in the the UK last year the Bank of England intervened.  Northern Rock has since been nationalised. The Fed’s Bear Stearns bailout appears to have quelled fears of systemic failure. But their action didn’t resolve the mortgage debt crisis that came in the wake of the housing bubble deflating. A symptom was treated. The cancer remains. And, unfortunately,  there are only two ways to treat the cancer. A real recession that rapidly drives prices down to levels people can afford to pay. Or more treatment of the symptoms –  i.e. more cheap money and more inflation until the nominal value of the house is cheap and affordable measured in inflated currency. In 1934 US President Franklin D. Roosevelt was forced to to devalue the dollar to gold by almost 60% to achieve that outcome.

Why the Fed has no alternative other than to print money:  Dr Marc Faber made the case in an October 9^th 2005 article that with US debts as large as they were deflating asset prices ‘would wreak havoc in the economic system and lead to massive defaults and bankruptcies.’  His article ‘ Why the Fed has no alternative other than to print Money’ includes useful graphics and detailed analysis. It is almost three years old but, not only are his arguments as sound now as they were then,  subsequent events have validated his analysis. Marc Faber has since drawn parallels between outcomes for the  Fed’s actions and Zimbabwe’s hyperinflation. 

An inflation reality check:  In a March 2008 article ‘An Inflation Reality Check’  Harvard Professor and former IMF Chief economist Kenneth Rogoff writes that central bankers and economists who claim current high inflation is a ‘aberration driven by soaring prices for food, fuel and other commodities’ are wrong.‘The fact is that around most of the world, inflation – and eventually inflation expectations – will keep climbing unless central banks start tightening their monetary policies.’ For investors who have forgotten the costs of high inflation and how difficult it is to squeeze it out of the system he suggests a meeting in Zimbabwe. Remember, however,  Marc Faber explains high interest rates will wreak havoc with the economic system. There is a circle to square. I can’t see how it will be done without printing more money.

Speculators who bought gold at over $1000 with a view to making a fast buck will be feeling some pain. But while inflation persists the case for gold’s stateless money franchise as a hedge against inflation, currency and financial market risks remains compelling.  

The Humpty Dumty Economy: Headlined ‘The Great Fall : Here comes the Humpty Dumpty Economy’ Barron’s veteran columnist Alen Abelson noted in his Saturday column two weeks back that the Fed was already in the ‘bail out business.’  A  Bear Stearns bailout on different terms to those mooted at the time was effected in extreme circumstances and announced the following Sunday March 16th before Monday trading started on Asian markets . The Fed was the only government agency directly engaged in the transaction but President George W. Bush and Treasury Secretary Paulson signed off on it. The deal was made without the consent of shareholders  and the buyer J.P. Morgan Chase was facilitated with a $30 billion borrowing facility from the Fed. The strong arm action was taken because a Bear Stearns default on debt and derivatives obligations could have started a chain reaction of defaults that would trigger financial market meltdown. 

The Fed has a role as lender of last resort and appears to have done the right thing. On the Sunday when the deal was announced it approved a request by the Federal Reserve Bank of New York to decrease the primary credit rate from 3-1/2 percent to 3-1/4 percent, effective immediately. On Tuesday March it lowered the target for the federal funds rate 75 basis points to 2.25%. But can bailouts by order of a Sheriff and interest rate cuts by order of equity markets  transform Humpty Dumpty to Hunky-dory?

A sinking dollar, low interest rates, and a reminder of October 1931: In a March 13^th 2008 article Northern Trust Director of Economic Research Paul L. Kasriel writes that after the US asset price bubble burst in 1929 the Fed reduced interest rates from 6% to as low as low as 1.5% by May 1931and  explains that after the UK went off gold in 1931 there were fears of a run on the dollar and,  by October 1931,  the Fed had raised rates again to 3.5%. He answers his question ‘What does October 1931 has to do with current Fed policy commenting that ‘….if not a run, there has been a renewed “walk” on the dollar of late…further declines in the dollar could induce an accelerated rate of increase in the prices of imported consumer goods…..further reductions in the U.S. federal funds rate would seem to put additional downward bias on the foreign exchange value of the dollar.’  To prevent a dollar plunge rates may have to go up again as they did on October 1931 .

An awesome, unrelenting descent for the dollar? Back to Barrons Humpty Dumpty Economy column for some predictions: Humpty is going to suffer a great fall. But ‘the pieces most definitely can be put together again. It’s just that it may take quite a few years, or maybe more than quite a few years. And, we should admit, too, that the end result will look more like Humpty Dumpty stuck together with Band-Aids than Goldilocks’ The Fed can’t ‘dispel the toxic cloud that’s enveloping the sub prime mortgage market …ease the tightening vice of runaway rising prices and stagnant income that’s sending the consumer into hibernation, or keep the dollar from its awesome and unrelenting descent.’

The compelling case for gold’s stateless money franchise: The next Goldwatcher blog will be  on the Humpty Dumpty economy patched up in casualty with band aids. A far cry from a Hunky-dory economy. Rather than ending this blog again with the comment that the case for gold as risk insurance is compelling I am closing  with a quote from Financial Times Assistant Editor Gillian Tett’s column on March 16^th giving her take on gold’s stateless money franchise: ‘No wonder so many asset managers have been scrambling to buy in sectors such as government bonds or gold. After all, gold has the compelling attraction of being easier to understand than a mortgage bond; better still, it has existed long before even the Romans.’

 Bailout time:  In his column in the New York Times this morning headlined ‘The B Word’ the economist Paul Krugman writes ‘the unthinkable is about to become the inevitable…. things are falling apart as you read this.’ A few headline points from Paul Krugman’s column follow:

1:        US Taxpayers’ money will have to be used to resolve the crisis whatever US Treasury Secretary Paulson or anyone else may say to the contrary. 

 2:         ‘Between 2002 and 2007, false beliefs in the private sector — the belief that home prices only go up, that financial innovation had made risk go away, that a triple-A rating really meant that an investment was safe — led to an epidemic of bad lending. Meanwhile, false beliefs in the political arena — the belief of Alan Greenspan and his friends in the Bush administration that the market is always right and regulation always a bad thing — led Washington to ignore the warning signs… The result of all that bad lending was an unholy financial mess that will cause trillions of dollars in losses. A large chunk of these losses will fall on financial institutions: commercial banks, investment banks, hedge funds and so on.’ 

3:         ‘The U.S. savings and loan crisis of the 1980s ended up costing taxpayers 3.2 percent of G.D.P., the equivalent of $450 billion today. Some estimates put the fiscal cost of Japan’s post-bubble cleanup at more than 20 percent of G.D.P. — the equivalent of $3 trillion for the United States.’  

 A Wyle E Coyote moment for the $?      

A February 2nd 2008 Goldwatcher posting includes a link to a  video interview with Paul Krugman discussing the risk of a Wyle E Coyote plunge  for the dollar   Krugman didn’t consider that outcome unthinkable  - unlike the prospect we are facing now. A meltdown in financial markets triggered by a bank or major hedge fund default.  Unthinkable until very recently. The Fed is being pro-active as a lender of last resort. increasing borrowing facilities available and cutting interest rates. Unfortunately as interest rates fall so does the dollar. As a result far from the over leveraged debt and liquidity crisis being solved the bank solvency crisis gets more lethal.

A warning on $ devaluation from the 24th February 2008 Goldwatcher posting:   ‘The Goldwatcher alerts readers to the prospect of economic and social problems to an extent resembling those Franklin D. Roosevelt confronted in 1933 with a solution on similar lines - massive dollar devaluation.’

The case for gold remains compelling compelling compelling.

Resource Investor interview with Frank Holmes.

A recent interview conducted with The Goldwatcher’s co-author Frank Holmes by Resource Investor is accessible as video and text.  His answers to some key questions follow:

How much further can gold go? ‘Well, in the longer term, I believe that gold will probably go to $2,000 or higher, and there are several reasons for that. It’s not just one. But all the other commodities have gone through their inflation-adjusted prices of 1980 except for gold and silver.’

Do you believe gold shares due for a catch up to bullion right now?:  ’I do. They’ll both correct. Gold’s correcting; the shares will correct. And then I think on the next leg, we’re going to get an overperformance of gold shares.

The other factor that hurt last year, Jon, has been the liquidity crisis. That is, the best performing shares are gold shares, so what do people do? They always sell their best performers to basically deal with their margin calls - hedge funds, etcetera that use gold shares they’ve been steady dumpers. So not only have you had a margin compression, you’ve had to do it as a source of liquidity…

The last thing I want to point out to you, it’s very important for your listeners and readers, is the big sea change that’s taking place in the last couple years - the acceptance of commodities as an asset class. And we saw Calpers recently commit another $500 million towards commodities

 The full interview: Extracts only give give part of the picture. In the interview Frank Holmes deals with rising mining costs, low grades, gold share ETF’S,  junior mining companies and factors that could lead to a gold price correction.

Truth serum:

            After resigning as US Comptroller General to take the appointment David Walker took office yesterday as President and CEO of the Peter G Peterson Foundation. The foundation is our last best hope of the US being steered off what in 2004 the Financial Times’s Martin Wolf called the ‘comfortable path to ruin.’ It has since become a terrifying surge. 

            The Peter G.Peterson Foundation web site is now on line  with bios for Pete Peterson and David Walker.  Politicians won’t welcome the truth serum Walker and Peterson inject into the debate. 

The Pete Peterson Foundation

The mission of The Peter G. Peterson Foundation is: ‘to enhance public understanding of the nature and urgency of selected key sustainability challenges that threaten America’s future, to propose sensible and workable solutions to address these challenges and to build public will to do something about them.The Foundation’s initial focus will be on:

• Unsustainable entitlement benefits. ….. 
• Unsustainable current account deficits, primarily accounted for by unprecedented trade deficits…… .
   
• Unsustainable and ballooning healthcare costs. ….. 
• Unsustainable and gluttonous energy consumption - and its first cousin, global warming.  With less than five percent of the world’s population, America accounts for 25 percent of the world’s consumption of oil.  This gluttonous consumption leaves
  America dangerously dependent on unfriendly and unstable foreign sources of oil and, in some cases, fuels terrorist activities.  Most energy experts agree that, of course, over the longer term, building alternative energy sources is important, but if the energy challenge is to be resolved over the near-to-mid term, it must be resolved, basically, on the demand side through conservation and not the supply side.
   
• Unsustainable competitive gaps in our educational system….. 
• The undeniable, transcendent threat to our collective future: The potential for nuclear and biological warfare materials falling into the hands of terrorists.’

Wtth David Walker contributing to the agenda The Goldwatcher expects the Presidential debate to change gear. Whether or not the US can be wrenched from the path to ruin is another question.  the chances are better now with Peterson and Walker addressing the issues. But the conequences of the US economy hurtling out of control down the path to ruin and dragging the global economy with it keep gold high on the agenda for investors - as evidenced by the gold price that has now breached $1000.

Carlyle Capital bites the dust:  It’s the 13^th  – often an unlucky day. Today’s bad news :  Carlyle Capital have failed to meet margin calls. Lenders are foreclosing on their collateral. They have already defaulted on approximately $16.6 billion. The remaining indebtedness is expected to go into default soon. The Goldwatcher forecast this would happen two days ago in the posting below.  It’s such a pity… a very smart idea. The US Carlyle Group with a London presence conveniently set up a company registered in tax free Guernsey, listed it on the Amsterdam Stock Exchange and leveraged their capital 32 times to buy securities with other people’s money. A textbook hedge fund formula. Run the operation comfortably from London or New York. Establish big lines of credit. Get rich with leverage using other people’s money. And play the market without paying tax.  Carlyle are the first hedge fund  affiliate of a major group to bite the dust in this way. Who is next?

If you have leverage you’re stuffed:  Bloomberg quote a fund of funds manager Alex Allen likening the present crisis ‘to a bank panic turned upside down with bankers, not depositors, concerned they won’t get their money back.’ His message is ‘if you have leverage you’re stuffed.’ At least six hedge funds, totalling more than $5.4 billion have been forced to liquidate or sell holdings since February 15^th according to Bloomberg. This morning’s Financial Times lists another three.

The Fed as the lender of last resort:  Bernanke’s recent expansion of the Fed’s essential role as lender of last resort role in liason with other central banks was a step in the right direction greeted enthusiastically by markets.  The news of Carlyle’s collapse has  killed the rally. $ weakness is now also leading to a further sell off on markets. The essential role of central banks as lenders of last resort is addressed in The Goldwatcher.  Current initiatives will be  the subject of a future blog. 

Gold as a hedge against the concequences of 3 vicious circles :  Professor Lawrence Summers, a former US Treasury Secretary, finds there are three vicious circles menacing financial markets. ‘A liquidity vicious cycle - in which asset prices fall, people sell and therefore prices fall more; a Keynesian vicious cycle - where people’s incomes go down, so they spend less, so other people’s income falls and they spend less; and a credit accelerator, where economic losses cause financial problems that cause more real economy problems.Three vicious circles with potentially extreme outcomes make the case for gold’s stateless money franchise

COMPELLING    COMPELLING     COMPELLING.

A  vicious cycle of de-leveraging:  The U.S.  mortgage market is short of about $1 trillion in capital according to Paul Miller,  an analyst at U.S. brokers  Friedman, Billings, Ramsey. His findings are commented on in a  Marketwatch report.  Miller estimates that $11 trillion of outstanding U.S. mortgage debt is supported by only about $587 billion of equity. That’s a leverage ratio of 19 to 1 and explains why  interest rates on 30 year fixed mortgages are rising at the same time as the Fed slashes interest rates on Treasury bonds. The anomaly discussed in The Goldwatcher 29^th February posting : Absent Minded Professor Bernanke’s Dilemma

Gold fund manager Eric Sprott is reported in a Bloomberg article commenting: ‘We’re in a systemic financial meltdown. There are probably 10 companies that are broke that are still trading — banks and financial institutions’’  

We need to think of the consequences of the failure of even one major bank or financial institution. Carlyle Capital are already in the spotlight. Could it be the beginning of the end of the reign of the dollar and debt financed global growth? 

 Carlyle Capital’s Ponzi scheme: The Wall Street Journal reports  Carlyle Capital had $670 million in investor funds and borrowings that boosted its portfolio of bonds to $21.7 billion. Leveraging capital funds with 32 times as much borrowings in an unstable market looks like a Ponzi get rich quick scheme using other people’s money. Lenders have now made margin calls that Carlyle can’t meet. The Wall Street Journal report the fund’s biggest lenders at year-end 2007 included Citigroup Inc. with repurchase agreements totalling $4.7 billion.  Fitch credit rating agency have already placed Citygroup Inc on ‘negative watch’ indicating the possibility of a downgrade in future. Citigroup analysts have concluded that unless Carlyle Capital  provides additional financing it could face bankruptcy. The Group are holding crisis talks and claim ‘the challenges facing Carlyle Capital will have no measurable impact on any other fund sponsored by the Carlyle Group.’ The tooth fairy must have told them that. The truth fairy would have told them otherwise. The force of gravity brings high flyers back down to earth with a thud.  Carlyle will be no exception. 

No surprise that oil traded at $108 yesterday: John Williams’s Shadow Financial Statistics includes a special report with comments today on The Fed increasing its term auction facility (TAF) for troubled banks to $100 billion with a further $100 billion offered in term repos.  The good news is that technically Bernanke’s  Fed can prevent a systemic banking collapse. The bad news is ‘the un- containable inflation that will follow.’ Williams tracks the growth in M3 – a measure no longer reported by the Fed - and finds that following the introduction of Bernanke’s term auction facility money growth has reached a historic high of 16.8%. No surprise then that oil reached a peak of $108 yesterday.

Abysmal news for the dollar – good news for gold: John Williams concludes  ‘the news here literally is abysmal for the U.S. dollar and promises much higher gold prices. With a long-term outlook, gold is a buy at $1,000 per troy ounce. It also will be a buy when it hits $10,000 per troy ounce.” No friend of the money printers Dr Marc Faber, who contributed the preface to the The Goldwatcher,  has no doubts about the dreadful consequences Benrnake’s Fed will have on the dollar. Or on  the shining prospects for gold.  In this video clip of a recent Bloomberg interview he pulls no punches.  He has the dollar on death watch.

Another boring attack on Gordon Brown’s 1999 gold sale:

Today’s Guardian runs a full page feature with a political attack on Gordon Brown for selling gold at an average price of $275 in 1999.  It’s a re-run of a politically inspired full page feature published by The Sunday Times on 15th April this year. A Goldwatcher blog in response challenged the Sunday Times polemic on Gordon Brown’s mistake  There’s really nothing to add to that blog now, but it’’s useful to highlight a few points and add few comments:

Accessible and comprehensive analysis from Frank Holmes:  Frank Holmes, CEO and CIO of US Global Investors and the co author of The Goldwatcher,  presents an interactive page  ‘What’s Driving Gold’ tracing the factors behind the gold price surge. He finds a unique situation where all drivers for gold are pointing to higher prices.  In another  presentation ‘Gold Opportunities and Challenges’ he details the supply and demand factors and global macroeconomic influences that have led to demand for gold exceeding supply. 37 slides illustrate the key points. In a presentation ‘What’s Driving Energy’ he again finds a situation where all the critical drivers are pointing to higher prices.

$1000 as a psychological barrier: Is $1000 a psychological barrier for the market or a price level meaningful  in relation to either production costs, potential mine production,  gold sold back into the market or the competitiveness of gold for jewellery?  Over 70% of gold goes into the jewellery industry where the market is commercially price sensitive. However price levels set by investors are always higher and more unstable than those set by grass roots jewellery demand.

in a Bloomberg interview today with gold only about 1% below $1000 James Vail, a Vice President and Portfolio Manager with Ing Investment Management,  comes to similar background conclusions to those I reach  in The Goldwatcher book. Inflation is real and its going to be here for a long time. Global insecurity and rising inflation are supporting demand for gold. Further,  power outages in South Africa are causing  a fall in South African production.  He sees gold consolidating round $1000 and then moving higher.  Based on the current price of oil he sees $1300 on the horizon and  adds that with ‘all that’s going on in the world gold has taken on a life of its own.’  

CalPERS - another booming voice supporting commodities:  In a February 29^th posting Frank Holmes commented on the $240 billion California Employees Retirement System, America’s largest pension fund’s recent announcement that after first investing in commodities in a small way last year it may increase its exposure to as much as $7.2 billion through 2010. Holmes concludes: ‘Having an organization of CalPERS’ size and stature making the bullish case for commodities—it applies not just to energy, but also metals and soft commodities—adds a booming voice to the choir.’ 

The biggest short term downside catalyst for gold:   In a question and answer session arranged by the Financial Times last year  James Burton, the Chief Executive of the Gold Council and the gold mining industry’s spokesperson, was asked:  ’What is the biggest short term downside catalyst for the price of gold?’ He replied :  A stronger dollar.

Not much for Mr. Burton to worry about now ….. but never say never.  The Goldwatcher will be monitoring developments.

Until the Titanic hit that iceberg everyone enjoyed the cruise: It was the most important development so far in the run up to the US Presidential election. But it didn’t make the headlines here or even in the US.  Effective Wednesday 12^th March David Walker, more correctly the Hon David Walker,  has resigned as the country’s Comptroller General and head of the General Accountability Office.  Billionaire Pete Peterson is staking a billion dollars to back his efforts to jolt American voters out of their fool’s paradise and face up to ‘undeniable, unsustainable and untouchable’ threats to the nation’s future and to future generations. With the baby boomer generation starting to retire from January this year,  to fund entitlement payments and their medical costs, taxes must be increased and spending and benefits reduced. Or,  within a few decades,  the US  will be wiped out financially. The present fiscal trajectory is unsustainable. The country can’t grow its way out of the problem. A video of a recent interview with Walker spells out the dire numbers that have to be faced. The succinct introduction to his wake up call is that the passengers on the Titanic were having a wonderful cruise until the very moment the ship hit the iceberg.

Truth serum to resist a banana republic dollar:  Pete Peterson, an octogenarian American billionaire, grandee politician, investment banker and author heads and funds the Peterson Institute think tank. He brands the US Social Security Trust Fund an oxymoron. There’s no trust and there’s no fund. His book Running on Empty:  How the Democratic and Republican Parties Are Bankrupting Our Future and What Americans Can Do About It  has gone unheeded up to now. But on March 12^th  when David Walker takes office as President and Chief Executive of the Peter G. Peterson Foundation that’s all going to change.  

David Walker’s analysis  and Pete Peterson’s book are both discussed in The Goldwatcher in the Chapter on The Economic Consequences of 9/11 and George W. Bush. The alliance between Walker & Peterson was made in heaven. Politicians won’t welcome the dose of truth serum they introduce in the debate. The rest of us should celebrate. We need an America that runs its affairs as the leader of the free world should. Not an America run by politicians and others determined to make the country  into a banana republic and the dollar worthless.