“To this day, the willingness of a Wall Street investment bank to pay me hundreds of thousands of dollars to dispense investment advice to grownups remains a mystery to me. I was 24 years old, with no experience of, or particular interest in, guessing which stocks and bonds would rise and which would fall. The essential function of Wall Street is to allocate capital—to decide who should get it and who should not. Believe me when I tell you that I hadn’t the first clue…..” More (Portfoli0.com)

You should probably be suspicious about this seemingly innocuous amendment in the new Banking Bill (UK):

Banking Bill
Part 7 — Miscellaneous

Weekly return
Section 6 of the Bank Charter Act 1844 (Bank to produce weekly account) shall cease to have effect.

The 1844 Banking Bill ensured transparency in the operations of the Bank of England. It has been good enough for over 164 years.

The section the new Banking Bill seeks to abolish reads as follows:

“And be it enacted, That an Account of the Amount of Bank of England Notes issued by the Issue Department of the Bank of England, and of Gold Coin and of Gold and Silver Bullion respectively, and of Securities in the said Issue Department, and also an Account of the Capital Stock, and the Deposits, and of the Money and Securities belonging to the said Governor and Company in the Banking Department of the Bank of England, on some Day in every Week to be fixed by the Commissioners of Stamps and Taxes, shall be transmitted by the said Governor and Company weekly to the said Commissioners in the Form prescribed in the Schedule hereto annexed marked (A.), and shall be published….”

Surely it can’t be that they don’t want us to know how fast the Bank of England’s printing presses are going to be running?

>

Q: What are banks for?

A: To make money.

Q: For the customers?

A: For the banks.

Q: Why doesn’t bank advertising mention this?

A: It would not be in good taste. But it is mentioned by implication in references to
reserves of $249,000,000,000 or thereabouts. That is the money they have made.

Q: Out of the customers?

A: I suppose so.

Q: They also mention Assets of $500,000,000,000 or thereabouts. Have they made that
too?

A: Not exactly. That is the money they use to make money.

Q: I see. And they keep it in a safe somewhere?

A: Not at all. They lend it to customers.

Q: Then they haven’t got it?

A: No.

Q: Then how is it Assets?

A: They maintain that it would be if they got it back.

Q: But they must have some money in a safe somewhere?

A: Yes, usually $500,000,000,000 or thereabouts. This is called Liabilities.

Q: But if they’ve got it, how can they be liable for it?

A: Because it isn’t theirs.

Q: Then why do they have it?

A: It has been lent to them by customers.

Q: You mean customers lend banks money?

A: In effect. They put money into their accounts, so it is really lent to the banks.

Q: And what do the banks do with it?

A: Lend it to other customers.

Q: But you said that money they lent to other people was Assets?

A: Yes.

Q: Then Assets and Liabilities must be the same thing?

A: You can’t really say that.

Q: But you’ve just said it! If I put $100 into my account the bank is liable to have to pay it
back, so it’s Liabilities. But they go and lend it to someone else, and he is liable to have to
pay it back, so it’s Assets. It’s the same $100 isn’t it?

A: Yes, but….

Q: Then it cancels out. It means, doesn’t it, that banks haven’t really any money at all?

A: Theoretically……

Q: Never mind theoretically! And if they haven’t any money, where do they get their
Reserves of $249,000,000,000 or thereabouts??

A: I told you. That is the money they have made.

Q: How?

A: Well, when they lend your $100 to someone they charge him interest.

Q: How much?

A: It depends on the Bank Rate. Say five and a-half percent. That’s their profit.

Q: Why isn’t it my profit? Isn’t it my money?

A: It’s the theory of banking practice that………

Q: When I lend them my $100 why don’t I charge them interest?

A: You do.

Q: You don’t say. How much?

A: It depends on the Bank Rate. Say a half percent.

Q: Grasping of me, rather?

A: But that’s only if you’re not going to draw the money out again.

Q: But of course I’m going to draw the money out again! If I hadn’t wanted to draw it out
again I could have buried it in the garden!

A: They wouldn’t like you to draw it out again.

Q: Why not? If I keep it there you say it’s a Liability. Wouldn’t they be glad if I reduced
their Liabilities by removing it?

A: No. Because if you remove it they can’t lend it to anyone else.

Q: But if I wanted to remove it they’d have to let me?

A: Certainly.

Q: But suppose they’ve already lent it to another customer?

A: Then they’ll let you have some other customers money.

Q: But suppose he wants his too….and they’ve already let me have it?

A: You’re being purposely obtuse.

Q: I think I’m being acute. What if everyone wanted their money all at once?

A: It’s the theory of banking practice that they never would.

Q: So what banks bank on, is not having to meet their commitments?

A: I wouldn’t say that.

Q: Naturally. Well, if there’s nothing else you think you can tell me….?

A: Quite so. Now you can go off and open a banking account!

Q: Just one last question.

A: Of course.

Q: Wouldn’t I do better to go off and open up a bank

That’s a lot of cash, and it’s growing every day.

Still, there’s nothing like seeing it. The Voltage blog has posted a pie chart showing the cost of the bailout compared to other massive government plans. It’s a sobering plot, to be sure. Interestingly, they included the (inflation-adjusted) cost of both the Apollo missions and the running total of NASA’s budget since its inception in 1958.

The number they listed for that is 850 billion dollars. That’s a lot of money too, though only about 1/5 of the bailout… and that’s for 50 years of space exploration, one of the costliest endeavors ever undertaken by man. Think of everything NASA has done: gone to the moon, launched countless weather satellites, built a space station (more than one, really), orbited communications satellites, visited every planet in the solar system (Pluto soon, too), visited a handful of asteroids and comets… and don’t forget Hubble, Chandra, Spitzer, Fermi, Swift, Ibex, JWST, Kepler, Copernicus, the OAOs, IRAS, SWAS, SOHO, and many, many more. It’s hard to say how much Hubble cost, but I would guess it’s near 7 or 8 billion bucks by now. That’s only 1% of NASA’s lifetime budget.

And mind you, NASA gets less than 1% of the national budget today.

What to make of this? Well, I’m not precisely sure, except to point out that our grandest triumphs, in dollars, only cost us a fraction of our mistakes.

—–

With all respect to Mr Tim Muller who took the time to write his great analysis, I took it upon myself to hope that I would have something worthwhile to share with you on this matter. Allocating blame at the door of the rating agencies whilst correct in part does not allow us to get to the root cause of the problem – they were only acting within a system that is itself flawed and their actions and the actions of others wether the bankers, government and so on were inevitable considering the structure of the system they were working in. What follows is a rationale for understanding what has really happened – only buy understanding the real root cause can we fix this – the problem is much much worse than Mr. Muller thinks:

(My apologies for spelling errors and my frequently poor grammar, I must dash off to work and its very early in the morning – maybe I will edit this later….)

Firstly – We have used flawed economics to drive policy and governance for 70 years

When you go to school and get the your standard issue MBA, or attend programs in economic theory you will be taught theories and standard calculations on premises that are fundamentally flawed….

…The rise of Keynesianism and monetary economics as a consequence of the great depression was music to the ears of all governments who suddenly realized that they were able to please their democratically elected by constantly creating money out of thin air whenever there was an economic downturn  downturn in order to get re-elected and please the masses from their calls for  supporting uneconomic businesses in the name of social justice. As time moved on the populous was increasingly unable to tolerate any economic malady at all (re-allocation of inefficient resources to areas of genuine value and need), consequently more money was pumped into the system in order to continue economic growth unabated and support various uneconomic areas (farming in EU, trade protectionism in general, airlines, car manufacturers etc) in order to ensure voters remained sweet with the powers that be. Keynes and the teaching of neo classical economics effectively prescribes monetary stimulus (injections of cash / government spending etc) in order to “ride out” these aforementioned “difficult times”.

Each time the business cycle comes around, the stress on the system worsens and the money required to ride out the particular downturn is exponentially increased, the gravity from the misallocation of capital is increasingly strong and requires every increasing funds to stop it correcting itself. When money flows into a system that money moves somewhere – currently it is sitting in cash in USD T bills (incidentally with a real return of minus 7%… obviously it wont stay there long) – this is what CAUSES bubbles; the mania and general tomfoolery that accompanies and exacerbates the bubble in question naturally follows from the over supply and over easy credit in the system. Every bubble REQUIRES a bust.

The role of government and their pleasure in spending your money to get re-elected

Politicians enthusiasm of Keynesianism is vital to understand if we are to fix this mess:

The system of global finance and economics that we operate within is based in entirety on trust, there is nothing behind your currency, nittos, nought but trust. As we all know, money was originally a warehouse receipt on gold or silver (for the most part) held in trust by a bank. PEOPLE (not governments – they tend to taketh away….) create value in a system by saving and investing money in capital infrastructure and goods. SAVINGS AND INVESTMENT DRIVE solid economic growth and allow entrepreneurs to predict future demand with relative ease – the situation was relatively stable and vital – in the UK the price of bread, a mans suit, the cost of beer and milk remained almost exactly the same for more than 80 years up to the turn of the 19th century, in itself a period of massive unparalleled economic growth and expansion, the economy was no sloth. Governments working together with the Banks realized that they could harness this otherwise uncontrollable beast and spend on “vital projects” at will by changing the rules regarding the warehouse receipts and thier use….

Banks were given the ability to lend out increasing amounts of money based on the reserve requirements that have been getting smaller for the last 80 or so years, enabling them to take your warehouse receipt or gold / silver in their vault and then use that to issue, say, 10 times that amount to others in the form of credit. This is done in a coordinated fashion to ensure that the inflation is equal across a geographic area, halting opportunities for arbitrage (for example, f the money is inflated in a single bank in New York, it would be possible to get the money first, then dash off to Los Angeles and spend it their on goods and services that have not been adjusted to the amount inflated by the bank allowing them to get more goods for less money).

Money was becoming decoupled from a relatively unchanging basis (gold and silver) to one that was increasingly “fiat”. The removal of the gold standard that had up until this point kept governments in check was underway. Governments would go on to simply print money by selling government  bonds to the market, purchased by prime banks who then go on to lend out an increasingly higher multiple of the face value of the bonds they had purchased and allocating that credit to people that would invest it causing bubbles and a increasing depending of the business cycle. Now Governments were able to create money at will to fund their various desires: war, conflicts, bail outs of uneconomic businesses and friends and of course, the constant unending expansion of its own powers to such an extent that we almost universally expect the Government to “do something” to fix whatever malady is afflicting us at the time. This never ending scope creep of the Governments remit has led to an increasing irresponsibility of the populous and is a cause of a great many social problems as we look to the government first, the government to bail us out of a particular economically challenging time, the government to educate our children, the government to manage our lives in every more personal and intrusive way. A government with the ability to print money – ANY government – is like a teenager with their parents credit card, there are multiple compelling and never ending wants that need to be sated; so they sate them.

So, who pays? The poor and the middle class. The rich are able to get a free ride and make more money from bubbles as they have the ability to take advantage of investing in areas of rising prices and make more money. Inflation has been called “the cruelest tax” for good reason. When a bubble is underway it is inevitably caused by an increase in the money supply somewhere in the system, this money is allocated to an area that is not easy to predict – it could be housing, a new technology, a new geographic are of interest, whatever – people think at the time that this inflation is good thing and espouse how this time its different and how much real value is being created and so on. predictably the bust comes and predictably the government comes charging to the rescue to fix the situation by putting more money into the system that has the short term effect of increasing liquidity and blunting the otherwise increasingly sharp and aggressive downturn but in the long term simply increases the supply of money in the system and leads to yet another bubble and on and on ad infinitum….

…. except the value of your money is by its very nature destroyed in a way that is invisible to most, especially so for the poor and middle class that hold money in a simple bank account or live hand to mouth. Increases in the money supply cause inflation. Nothing else does this. The poor and middle class pay in terms of devaluation of the currency as they lose their buying power; governments revise the method of calculating inflation to fool us further, but look around you – how is it that 90% of the value of a US dollar has been lost in the last 80 years? How is it that my great grandparents and Grandparents were not rich by any stretch and yet were able to have only one persons salary, live in a decent enough house and have a pretty darned good standard of living while we are conned into believing that we are “better off” when in general both husband and wife almost always have to work in order to simply put food on the shelves and pay the bills?

The current “financial crisis” is not going to be solved by fixing the current system. The current system IS the cause of the problem. The cause of the problem is the control that government has over the supply of our money.  Governments around the world have absolutely no incentive whatsoever to fix it and every incentive to make it far worse by desperately adding liquidity to the flawed system that has led to the destruction of untold amounts of wealth through the propagation and increased viability of bubbles, paid for in the most part by the middle class and poor via devaluation of the money they hold. The trillions of dollars being pumped into the system is just the beginning, bear in mind that a bank gets a billion from the government and is able to use that as reserve in order to lend out huge multiples of the original amount to us that mis-prices the cost of credit leading to further misallocation of capital and inflation…. and on it goes. You get the picture.

Whats really going to happen?

A “coordinated solution” as pumped around currently simply means that everyone on earth will inflate their respective currencies in proportion with each other. The inflation will be spread equally throughout the system – people will mis read this as currencies look as if they are adjusting in value vis a vis each other in a healthy way, there will be a rise in the stock market and people will think that we are on the way out of the problem and the clever guys have saved us again – alas, this time we will not get away with it – inflation will start to ravage the system and we will enter a period of stagnation and rapidly rising prices throughout the world. Governments will be required to come up with more solutions to the rising costs and get wage controls etc that will make matters worse by further misallocating capital, more money will be printed, more inflation will ravage the system. The number of people in developing countries who are starving will increase rapidly as they can no longer afford to eat, the lower middle class in the same countries will demand solutions to increasingly impotent governments by demonstrations that will inevitably turn violent. There will be a backlash against capitalism and free-markets as the media and politicians look to play the blame game with a misinformed and increasingly desperate and angry populous – it has nothing to do with free markets at all and everything to do with incessant, constant government tinkering in the market. The backlash will lead to political volatility and massively increased risk of conflict and war.

in short, things might well get pretty bad, politically, economically and culturally the world our children will live in will be radically different; we have lived in a world of extraordinary waste and naiveté. Sadly all this is inevitable as the incentive structure we have built is inevitably going to consume itself in this fashion as it relies on governments who are run by flawed human beings that are assumed to be perfect and rational in their decisions – in retrospect this is an incredibly foolish and stupid assumption, it really is a demon of our own design, and only after a very painful re-education will we as humans stand up and take personal responsibility for ourselves by removing the ability of governments to control money and take back our freedom and liberty to create real value for ourselves, our families and each other.

Of course I could be wrong and the people who created this mess are the right people to fix it and all will be hunky dorey. Never before has there been so many people at risk of losing so much so its probably smart to be a little prudent.

“…the closest thing to a sure bet is to bet against governments” – Jim Rogers

Disclaimer: Like Mr. Muller I am not a financial advisor. If I was, I would be telling you that the clever guys with Phd’s upstairs have a set of risk metrics and a machines that goes Bing! that allow us to advise you to put money safely into companies like citigroup, bear stearns and AIG because they are cheap. I might tell you that your savings are safer if they are allocated in the stock market in a tracking fund and properly diversified, I may tell you that its a good idea to get another mortgage as historically the prices have always rose and you will increase your net worth greatly and can take advantage of our teaser rates . I would tell you this because I am making fees from your ignorance every time I sell you something and everyone else is doing it. I would advise you to watch CNBC and get a day trading account where you can make your fortune. I would tell you these because my understanding of economics is misinformed and besides, I am at the end of the day a salesman.

Instead I will tell you that I know nothing about what the future holds and that I have no way of telling, no whizz bang model is available to me, or anyone else. Anyone who tells you otherwise is a liar , a fool or possibly a mainstream financial advisor. However, in this particular game of life we cannot sit on the sidelines and do nothing – we must take action and make decisions based on our own experience and research, in this situation the parameters have been set by interference in the market on an increasingly massive scale enabling us to make some obvious conclusions about the direction we are headed that I outlined above. I hope for all our sakes that I am proved to be completely utterly mistaken.

Good luck.

PugilistSwine

Of course this cannot work and it never has. Neo-classical economic theory is fatally flawed from its very first basic premises. They are:

1) People have rational preferences among outcomes that can be identified and associated with a value.
2) Individuals maximize utility and firms maximize profits.
3) People act independently on the basis of full and relevant information.

This entire theory and all the economic policy that is born of it hinges on these three basic premises. The first one is completely ridiculous and obvious to anybody that isn’t a socially inept, ivory tower, academic, economic nerd. (Clearly these guys have never interacted with the female species in person before. Hahaha.) The assumption is that individuals choose the best action according to stable preference functions and constraints facing them. Simply put, if you prefer beer over liquor you’ll consistently drink beer at parties. No flip flopping allowed. No randomizations allowed. No ‘living in the moment’ allowed. This brings me to premise number two. Individuals maximize utility and firms maximize profits. Basically you drink your beer to the point of being pleasantly buzzed and then you stop..

…You never get smashed because a massive hangover clearly does not maximize utility. The third premise states that you will act independently and have all the relevant information to make the best choices. This means that you happily drink your beer and won’t get persuaded to do a round of shots with your friends. You clearly know that one round leads to two and you’ve got to work tomorrow. When your drunken friend gives you a stock tip you act independently and only after you’ve figured out everything humanly possible about the company and the industry. You aren’t at all persuaded by the fact that all your friends jumped on the stock and are making a killing. You stay completely level headed all the time.

The fact that we keep going thru economic and financial manias, bubbles and busts does not seem to deter the economic eggheads that continue to employ these theories literally like zealot Bible thumpers.

You’d figure that the Tulip Mania, South Sea Bubble, Dot Com Bubble, and the current Real Estate Bubble (to name a few) would be more than enough evidence to absolutely destroy all three of these premises.

The truly successful traders and investors of course know all this already. They thrive in a chaotic, irrational and uncertain environment.

“This Economy Does Not Compute [A New York Times Op-Ed by autthor and theoretical physicist Mark Buchanan]:

“A FEW weeks ago, it seemed the financial crisis wouldn’t spin completely out of control. The government knew what it was doing — at least the economic experts were saying so — and the Treasury had taken a stand against saving failing firms, letting Lehman Brothers file for bankruptcy. But since then we’ve had the rescue of the insurance giant A.I.G., the arranged sale of failing banks and we’ll soon see, in one form or another, the biggest taxpayer bailout of Wall Street in history. It seems clear that no one really knows what is coming next. Why?

Well, part of the reason is that economists still try to understand markets by using ideas from traditional economics, especially so-called equilibrium theory. This theory views markets as reflecting a balance of forces, and says that market values change only in response to new information — the sudden revelation of problems about a company, for example, or a real change in the housing supply. Markets are otherwise supposed to have no real internal dynamics of their own. Too bad for the theory, things don’t seem to work that way.

Nearly two decades ago, a classic economic study found that of the 50 largest single-day price movements since World War II, most happened on days when there was no significant news, and that news in general seemed to account for only about a third of the overall variance in stock returns. A recent study by some physicists found much the same thing — financial news lacked any clear link with the larger movements of stock values.

Certainly, markets have internal dynamics. They’re self-propelling systems driven in large part by what investors believe other investors believe; participants trade on rumors and gossip, on fears and expectations, and traders speak for good reason of the market’s optimism or pessimism. It’s these internal dynamics that make it possible for billions to evaporate from portfolios in a few short months just because people suddenly begin remembering that housing values do not always go up.

Really understanding what’s going on means going beyond equilibrium thinking and getting some insight into the underlying ecology of beliefs and expectations, perceptions and misperceptions, that drive market swings.

Surprisingly, very few economists have actually tried to do this, although that’s now changing — if slowly — through the efforts of pioneers who are building computer models able to mimic market dynamics by simulating their workings from the bottom up.

The idea is to populate virtual markets with artificially intelligent agents who trade and interact and compete with one another much like real people. These “agent based” models do not simply proclaim the truth of market equilibrium, as the standard theory complacently does, but let market behavior emerge naturally from the actions of the interacting participants, which may include individuals, banks, hedge funds and other players, even regulators. What comes out may be a quiet equilibrium, or it may be something else.

For example, an agent model being developed by the Yale economist John Geanakoplos, along with two physicists, Doyne Farmer and Stephan Thurner, looks at how the level of credit in a market can influence its overall stability.

Obviously, credit can be a good thing as it aids all kinds of creative economic activity, from building houses to starting businesses. But too much easy credit can be dangerous.

In the model, market participants, especially hedge funds, do what they do in real life — seeking profits by aiming for ever higher leverage, borrowing money to amplify the potential gains from their investments. More leverage tends to tie market actors into tight chains of financial interdependence, and the simulations show how this effect can push the market toward instability by making it more likely that trouble in one place — the failure of one investor to cover a position — will spread more easily elsewhere.

That’s not really surprising, of course. But the model also shows something that is not at all obvious. The instability doesn’t grow in the market gradually, but arrives suddenly. Beyond a certain threshold the virtual market abruptly loses its stability in a “phase transition” akin to the way ice abruptly melts into liquid water. Beyond this point, collective financial meltdown becomes effectively certain. This is the kind of possibility that equilibrium thinking cannot even entertain.

It’s important to stress that this work remains speculative. Yet it is not meant to be realistic in full detail, only to illustrate in a simple setting the kinds of things that may indeed affect real markets. It suggests that the narrative stories we tell in the aftermath of every crisis, about how it started and spread, and about who’s to blame, may lead us to miss the deeper cause entirely.

Financial crises may emerge naturally from the very makeup of markets, as competition between investment enterprises sets up a race for higher leverage, driving markets toward a precipice that we cannot recognize even as we approach it. The model offers a potential explanation of why we have another crisis narrative every few years, with only the names and details changed. And why we’re not likely to avoid future crises with a little fiddling of the regulations, but only by exerting broader control over the leverage that we allow to develop.

Another example is a model explored by the German economist Frank Westerhoff. A contentious idea in economics is that levying very small taxes on transactions in foreign exchange markets, might help to reduce market volatility. (Such volatility has proved disastrous to countries dependent on foreign investment, as huge volumes of outside investment can flow out almost overnight.) A tax of 0.1 percent of the transaction volume, for example, would deter rapid-fire speculation, while preserving currency exchange linked more directly to productive economic purposes.

Economists have argued over this idea for decades, the debate usually driven by ideology. In contrast, Professor Westerhoff and colleagues have used agent models to build realistic markets on which they impose taxes of various kinds to see what happens.

So far they’ve found tentative evidence that a transaction tax may stabilize currency markets, but also that the outcome has a surprising sensitivity to seemingly small details of market mechanics — on precisely how, for example, the market matches buyers and sellers. The model is helping to bring some solid evidence to a debate of extreme importance.

A third example is a model developed by Charles Macal and colleagues at Argonne National Laboratory in Illinois and aimed at providing a realistic simulation of the interacting entities in that state’s electricity market, as well as the electrical power grid. They were hired by Illinois several years ago to use the model in helping the state plan electricity deregulation, and the model simulations were instrumental in exposing several loopholes in early market designs that companies could have exploited to manipulate prices.

Similar models of deregulated electricity markets are being developed by a handful of researchers around the world, who see them as the only way of reckoning intelligently with the design of extremely complex deregulated electricity markets, where faith in the reliability of equilibrium reasoning has already led to several disasters, in California, notoriously, and more recently in Texas.

Sadly, the academic economics profession remains reluctant to embrace this new computational approach (and stubbornly wedded to the traditional equilibrium picture). This seems decidedly peculiar given that every other branch of science from physics to molecular biology has embraced computational modeling as an invaluable tool for gaining insight into complex systems of many interacting parts, where the links between causes and effect can be tortuously convoluted.

Something of the attitude of economic traditionalists spilled out a number of years ago at a conference where economists and physicists met to discuss new approaches to economics. As one physicist who was there tells me, a prominent economist objected that the use of computational models amounted to “cheating” or “peeping behind the curtain,” and that respectable economics, by contrast, had to be pursued through the proof of infallible mathematical theorems.

If we’re really going to avoid crises, we’re going to need something more imaginative, starting with a more open-minded attitude to how science can help us understand how markets really work. Done properly, computer simulation represents a kind of “telescope for the mind,” multiplying human powers of analysis and insight just as a telescope does our powers of vision. With simulations, we can discover relationships that the unaided human mind, or even the human mind aided with the best mathematical analysis, would never grasp.

Better market models alone will not prevent crises, but they may give regulators better ways for assessing market dynamics, and more important, techniques for detecting early signs of trouble. Economic tradition, of all things, shouldn’t be allowed to inhibit economic progress.

TGR: Can you start off by telling us what’s going on?

FH: Based solely on global economic indicators, commodities should be in a cyclical bear market with no bottom in sight. But there’s intense pressure on policymakers to fill the deflationary …..

….vacuum that’s been created by both Main Street and Wall Street. Main Street’s plummeting housing prices stretched the limits of the financial system, but lawmakers in an election year will find it easier to blame Wall Street than Main Street.

TGR: Both sides are at fault.

FH: The abuse of leveraging is the biggest culprit. Mike Milken spoke at a conference I attended last week in Hong Kong. He said that at the height of his career he was leveraged 4-to-1. Goldman Sachs now is leveraged 20 times, so a 5% mistake would wipe them out. The combined impact of Sarbanes-Oxley, FAS 157 (mark-to-market regulations) and leverage abuse has cost New York its position as the world’s financial capital. No one expected this escalation of write-downs.

When Warren Buffett bought General Re Insurance in 2002 he warned about notional valuations because he tried to sell some of the derivatives, and lost billions of dollars. He called derivatives “weapons of mass financial destruction.” Everyone ignored him, and the derivative market increased 500% in five years.

TGR: Wow.

FH: If you make a 2% mistake in the $500 trillion derivative market, that’s $10 trillion. What’s $10 trillion? Well, the world’s total GDP is $50 trillion. The total amount of U. S. dollars in circulation is roughly $15 trillion. A 2% mistake wipes out 20% of the world’s GDP.

We’re actually experiencing huge deflation—in housing and on Wall Street. It’s not inflationary yet. The Paulson package is a stopgap measure that could lead to inflation. This meltdown is just like 1974 or the Depression of the 1930s, not the 1987 quick crash. It continues to destroy confidence. Another thing that propelled this meltdown to more disastrous proportions was the rule that removed the uptick rule for short-selling.

TGR: What will fix this situation?

FH: That’s a good question. Adding untested regulations is dangerous, and the law of unexpected consequences is often negative. The combination of Sarbanes-Oxley, FAS 157 and the no uptick rule for shorting basically became toxic and led to the destruction of Lehman Brothers and Bear Stearns. Also, “ideas” like printing more money and the debasement of currency do not solve the credit crisis and are not good long-term solutions.

The dollar’s not going to collapse due to loss of Asian support. All countries will support the dollar. The reason is that they can’t afford for it to fall too far because then suddenly the U. S. would be exporting products and not importing. All the currencies will slowly debase themselves against gold and keep the dollar as the currency for global trade.

It appears we are now going through that inflection point moving from deflationary forces to an inflationary cycle. We had a little bit of run-up in inflation when oil ran to $150 a barrel, which was very excessive. What didn’t make sense was the fact that gold didn’t rise along with oil. On the historic 10-to-1 ratio, gold should have gone to $1400 to $1500. That leads to suspicions that a few people were manipulating the price of oil because gold failed at $1,000 per ounce. On another note, it is important to remember policymakers will do everything in their power to create liquidity and, historically, liquidity is bullish for commodities. However, our research suggests it’ll take several quarters before this will affect commodity prices.

TGR: Will the market stagnate until this liquidity flows through and moves the commodities up?

FH: You’ll have to be a very selective buyer for another couple of quarters. The price correction should lose downward momentum and create a “U” shaped bottom as the capital markets begin to reflect the policies being implemented.

TGR: When you say the price correction will lose its downward momentum, do you mean this wholesale sell-off of everything?

FH: Right.

TGR: We saw yesterday that Goldcorp (TSX:G) (NYSE:GG) was down 16%.

FH: That downward momentum will start to slow.

TGR: When you say commodities, do you mean gold?

FH: Asian economic activity has a big influence on the purchase of gold. At the London Gold Bullion Traders Conference in Kyoto, I was amazed to find the magnitude of the shortage of gold and silver coins. In Germany, they aren’t having the crisis we’re having here, but Germans were lining up to buy gold.

TGR: Do they have supplies?

FH: No, but they have gold in the kilo bars. Everything is sold as soon as they get it.

TGR: I tried to buy some Swiss 20 Francs today and couldn’t find any.

FH: People are paying a large premium for small coins, and the purchase of safety deposit boxes is on the rise. People have been actually stuffing dollars in them, along with gold. It’s not really a 1980-style mainstream panic. People are continuing to buy. The growth of gold ETFs attests to that. Now let me try to explain some of these huge price swings in commodities, equities and emerging markets.

Your readers might be interested to know that banks all have this software called VAR, or Value At Risk. It triggers an alarm indicating a need for more capital due to escalating debt defaults. You’d think that banks would go to their prime brokerage arm and rein in hedge funds trading mortgages and de-leverage them because that’s where the risk is. Your business model says, “I have defaulting mortgages, so I need to be sure our hedge fund and prime brokers aren’t having similar problems.”

TGR: Right.

FH: Well, the banks reacted by calling every hedge fund and de-leveraging all asset classes, equities, banks and commodities. So, starting August 12, 2007, some of the S&P stocks moved 15% in a day internally. This same margin call has now taken place about four times this past year. U.S. banks in Japan yanked loans to small cap companies, so those guys were scrambling to replace those loans. Situations like that are happening everywhere and they illustrate the long reach of this credit crisis.

A lot of emerging marketing investors got their noses bloodied when the U.S. called for its loans to be repaid. They will not be so quick to repeat that mistake. This ripple effect is hurting businesses. That is a concern that I heard over and over. Fortunately, the governments of emerging markets have huge surpluses and are better equipped to handle this crisis than they were in the 1990s.

All of this is good for commodities and gold rises in step with commodities. When inflation erupts everywhere, then gold will take off on its own with a bigger move.

TGR: When will that happen exactly?

FH: Over the next two years gold will be well over a $1,000, maybe running up to $2,000. The number-one Asian analyst, Chris Wood, is advocating a 30% gold exposure to institutions. Now, this is the number-one brokerage firm in Asia and their research is excellent.

TGR: What’s the name of the firm?

FH: CLSA-Asia Pacific Markets. It recommends a portfolio allocation of 30% gold:15% gold bullion and 15% unhedged gold stocks. When an analyst of his stature advises putting 30% of your portfolio into gold, you have to take note. We tell our clients to put a maximum of 5% into bullion and no more than 5% toward gold equities.

TGR: Doug Casey’s latest missive rounded it up to 30% too.

FH: The significance here is that the institutional side is getting on board with gold. That’s a big deal.

TGR: Because the gold market is so small compared to the market caps these institutions deal with, even a small change in percentage would make a huge difference.

FH: All the brokers are getting their marching orders simultaneously. What happens is that non-correlated assets begin to correlate as people seek liquidity. So everyone’s saying, “I have to get cash.” It’s important to remember that brokers were leveraged 20 times and low-income house buyers were leveraged 99 times. This creates a chain reaction and knocks down the commodities. Several of these hedge funds have blown up, and if our holdings are similar to theirs, they’ve hurt us.

We went into this correction with a big cash position back in June, and we never expected such a huge correction, but our models were showing that it should be 20% to 25% cash. Then we start to nibble as things get clobbered, but they continue to get clobbered.

TGR: Yes.

FH: Last week the markets hammered every stock with liquidity. Many funds have been hit by this problem. Margin calls are driving this. It has nothing to do with the demand for gold or the supply and discoveries.

TGR: But that should work itself out fairly quickly by the end of the year.

FH: It was estimated that by the end of the year there would be $22 billion of resource stocks coming out.

TGR: Do you mean coming out of the hedge funds?

FH: Yes. Hedge funds have been forced to shut down. It’s really interesting to look at the TSE Venture Index. When the asset-backed paper problems happened last summer, retail sponsorship dropped dramatically. The U. S. went through something similar in February when suddenly the small caps and mid-caps started losing liquidity. What we noticed was that the auction rate paper is exactly ten times the size of Canada’s asset build paper crisis—$330 billion versus $33 billion. It was just before tax season, so a lot of American investors had to scramble for cash by redeeming their equity funds to pay their taxes.

TGR: Do you follow Richard Russell’s Dow Theory Letters?

FH: You mean regarding the relationship between the Transports and the Dow Industrials?

TGR: Yesterday both were down so Dow Theory now confirms that we are in a bear market.

FH: Yes.

TGR: What happens to gold stocks in a bear market?

FH: Whether you have big deflation or big inflation driving the bear market, gold does well. If it’s just a normal cyclical inventory recession or whenever interest rates are above the CPI rate, gold doesn’t do well. Today, the Fed’s funds are below the CPI rate and the printing presses are busy.

TGR: So, what are we in now?

FH: I think we’re at the tipping point moving from deflation to inflation.

TGR: So, we’ve been on the negative side of that.

FH: We saw gold run to $1,000 twice because of deflation, not inflation. Massive liquidations are deflationary. Collapsing housing prices are deflationary. The price of oil running up was inflationary but it was triggered by the dollar deflation and gold moved with it. In the ’30s, when you had a big deflationary cycle, gold was the best asset class. In the ’70s, when you had a big inflationary cycle, gold was the best asset class.

TGR: Right.

FH: In the ’90s when there was no big inflation or deflation, gold just meandered along.

TGR: So when do you think we will reach that tipping point from deflation to inflation?

FH: The money supply has basically been flat for the past three months. The correlation of commodity price action and emerging market money supply has an R-squared value over 80—highly correlative. We track the G-7 countries versus the E-7 (the seven most populated emerging countries in the world with available data) and track their money supply. The money supply has not been growing rapidly. We need to get the money supply up and this will happen with the $700 billion bailout. So, we’re going through a transition over the next couple of months.

TGR: When will gold respond?

FH: There’s been a six-week lag with the money supply, the same with NASDAQ. If the money supply spikes, there’s a 70% probability that within six weeks the NASDAQ will start to rise.

TGR: Why would an increase in the money supply impact NASDAQ?

FH: People have more cash to spend.

TGR: So they’re moving into the NASDAQ?

FH: Yes. The money supply has one of the highest correlations to the gold commodity as a whole. When you look at stocks individually, the number-one driver is the production per share growth. After that, it’s cash flow, and then reserves. You can eliminate 80% to 90% of all the noise by calculating production and the cash flow.

TGR: What would you tell someone who has just inherited a million dollars?

FH: I’d put 5% into gold bullion and 5% into unhedged gold stocks.

TGR: Unhedged producers?

FH: Yes, and if you want to go down to the smaller caps like Jaguar (JAG. TO), that’s where you get your biggest potential returns.

TGR: Can you share a few names on your list of unhedged gold producers?

FH: We like companies that have a royalty business, such as Royal Gold (RGLD). We also look at those with the strongest per-share-growth rates coming over the next 12 – 18 months. That list includes Agnico-Eagle Mines (TSX:AEM), Kinross Gold (KGC-NYSE; K-TSX), and Goldcorp—all of which have very healthy growth profiles relative to the Newmonts of the world. Goldcorp isn’t a pure gold play, because it also produces a high percentage of base metals. But we expect that within two years those base metals will really start taking off.

TGR: Is that prediction based on anticipated growth in China?

FH: Yes. China has structurally gone through a quiet phase, but the government has policies in place that are designed to invigorate growth. As that growth starts to pick up steam over the next six months, you’re going to see increased demand for the basic commodities. Of course, the economy is spending a lot of money for infrastructure right now, and that might put a temporary lag on commodities.

TGR: But you believe China’s growth will drive the commodities market higher?

FH: Yes. The credit crunch created by the collapse of U. S. financial institutions will slow things down for a while, but ultimately, China will grow.

TGR: What other companies do you like?

FH: Unless they have two grams of gold (per ton) or a million ounces, junior explorers have been drifting lower and lower. Historically in situ reserves have traded at one-tenth of an ounce of gold. So, if gold is $600, then your reserves are worth $60 per ounce. When gold was $300, they were worth $30. That was the model for determining a fair market cap for junior explorers. With gold at $850, these companies should be worth $85 per ounce of reserves, but they’re not. This amazes us. And when one of these companies is bought out, it’s usually paid more than the ten times ratio. But valuations are now drifting down to $40 and $35 per ounce. So the market is basically valuing a company that has 8 million ounces as if it had only 4 million ounces.

TGR: This is a short-term phenomenon, right?

FH: Yes.

TGR: So, when this situation changes, how quickly will producers and majors start buying up the juniors?

FH: That’s a different point. The seniors are going to buy only those juniors that have two grams of gold per ton or a million ounces. The other juniors will just work their way out of the system or go bankrupt.

TGR: What other criteria do you use to evaluate juniors?

FH: We ask some simple questions:Is the CEO technically competent? That is, is he a geologist? If not, that may be okay, but does he have a broad network to make up for that lack of technical knowledge? Does he know the newsletter writers, like Doug Casey, for instance? Does he know the investment bankers?

We’ve found that if the CEO does not know the Street, and doesn’t know the newsletter writers, it doesn’t matter if he’s a geologist or an engineer. There’s going to be no liquidity in the company’s stock, unless there is a multimillion ounce discovery with a grade of greater than 2 grams per ton. But if you have a company whose CEO knows lots of newsletter writers, gets lots of coverage, knows the value in the Street and gets research for it, that company is going to have a higher price-to-book valuation, which makes it a much more attractive investment.

TGR: Anything else you look for?

FH: Financing is crucial. Companies that are rapidly spending money are going to run out of cash in about six months. The market undervalues them until they have financing in place.

TGR: Can you give us a few companies on your list that meet your criteria?

FH: Moto Goldmines (TSX:MGL), which is in the Congo, is in that category, though they face geopolitical risks. The company has more than 10 million ounces and more than five grams per ton. Another one is Gabriel Resources (GBU:TO), which has a large asset in Romania.

TGR: Both of these companies have some geopolitical risks associated with them.

FH: They do. But if they satisfy the criteria, these are the ones that the big mining companies will be acquiring.

To learn more about investing in natural resources, you might want to take a look at industry veteran Frank Holmes’ new book, The Goldwatcher: Demystifying Gold Investing. Holmes is CEO and Chief Investment Officer of U.S. Global Investors, Inc., a registered investment adviser that managed more than $5 billion in 13 no-load mutual funds and for other advisory clients as of June 30, 2008. U.S. Global specializes in the natural resources, emerging markets and global infrastructure sectors. Its funds have received numerous awards and honors during Holmes’ tenure, including more than two dozen Lipper Fund Awards and certificates. Holmes is a much-sought-after keynote speaker at national and international investment conferences. He is also a regular commentator on the financial television networks CNBC and Bloomberg, and has been profiled by Fortune, Barron’s, The Financial Times and other publications. In addition, Holmes was selected as the 2006 mining fund manager of the year by Mining Journal, a leading publication for the global natural resources industry.

Andrew Lahde, manager of a small California hedge fund, Lahde Capital, burst into the spotlight last year after his one-year-old fund returned 866% betting on the subprime collapse. Last month, he took his ball and went home. Tired of the stress, he closed the fund.

Enjoy:

Dear Investor:

Today I write not to gloat. Given the pain that nearly everyone is experiencing, that would be entirely inappropriate. Nor am I writing to make further predictions, as most of my forecasts in previous letters have unfolded or are in the process of unfolding. Instead, I am writing to say goodbye.

Recently, on the front page of Section C of the Wall Street Journal, a hedge fund manager who was also closing up shop (a $300 million fund), was quoted …..

….as saying, “What I have learned about the hedge fund business is that I hate it.” I could not agree more with that statement. I was in this game for the money. The low hanging fruit, i.e. idiots whose parents paid for prep school, Yale, and then the Harvard MBA, was there for the taking. These people who were (often) truly not worthy of the education they received (or supposedly received) rose to the top of companies such as AIG, Bear Stearns and Lehman Brothers and all levels of our government. All of this behavior supporting the Aristocracy, only ended up making it easier for me to find people stupid enough to take the other side of my trades. God bless America.

There are far too many people for me to sincerely thank for my success. However, I do not want to sound like a Hollywood actor accepting an award. The money was reward enough. Furthermore, the endless list those deserving thanks know who they are.

I will no longer manage money for other people or institutions. I have enough of my own wealth to manage. Some people, who think they have arrived at a reasonable estimate of my net worth, might be surprised that I would call it quits with such a small war chest. That is fine; I am content with my rewards. Moreover, I will let others try to amass nine, ten or eleven figure net worths. Meanwhile, their lives suck. Appointments back to back, booked solid for the next three months, they look forward to their two week vacation in January during which they will likely be glued to their Blackberries or other such devices. What is the point? They will all be forgotten in fifty years anyway. Steve Balmer, Steven Cohen, and Larry Ellison will all be forgotten. I do not understand the legacy thing. Nearly everyone will be forgotten. Give up on leaving your mark. Throw the Blackberry away and enjoy life.

So this is it. With all due respect, I am dropping out. Please do not expect any type of reply to emails or voicemails within normal time frames or at all. Andy Springer and his company will be handling the dissolution of the fund. And don’t worry about my employees, they were always employed by Mr. Springer’s company and only one (who has been well-rewarded) will lose his job.

I have no interest in any deals in which anyone would like me to participate. I truly do not have a strong opinion about any market right now, other than to say that things will continue to get worse for some time, probably years. I am content sitting on the sidelines and waiting. After all, sitting and waiting is how we made money from the subprime debacle. I now have time to repair my health, which was destroyed by the stress I layered onto myself over the past two years, as well as my entire life — where I had to compete for spaces in universities and graduate schools, jobs and assets under management — with those who had all the advantages (rich parents) that I did not. May meritocracy be part of a new form of government, which needs to be established.

On the issue of the U.S. Government, I would like to make a modest proposal. First, I point out the obvious flaws, whereby legislation was repeatedly brought forth to Congress over the past eight years, which would have reigned in the predatory lending practices of now mostly defunct institutions. These institutions regularly filled the coffers of both parties in return for voting down all of this legislation designed to protect the common citizen. This is an outrage, yet no one seems to know or care about it. Since Thomas Jefferson and Adam Smith passed, I would argue that there has been a dearth of worthy philosophers in this country, at least ones focused on improving government. Capitalism worked for two hundred years, but times change, and systems become corrupt. George Soros, a man of staggering wealth, has stated that he would like to be remembered as a philosopher. My suggestion is that this great man start and sponsor a forum for great minds to come together to create a new system of government that truly represents the common man’s interest, while at the same time creating rewards great enough to attract the best and brightest minds to serve in government roles without having to rely on corruption to further their interests or lifestyles. This forum could be similar to the one used to create the operating system, Linux, which competes with Microsoft’s near monopoly. I believe there is an answer, but for now the system is clearly broken.

Lastly, while I still have an audience, I would like to bring attention to an alternative food and energy source. You won’t see it included in BP’s, “Feel good. We are working on sustainable solutions,” television commercials, nor is it mentioned in ADM’s similar commercials. But hemp has been used for at least 5,000 years for cloth and food, as well as just about everything that is produced from petroleum products. Hemp is not marijuana and vice versa. Hemp is the male plant and it grows like a weed, hence the slang term. The original American flag was made of hemp fiber and our Constitution was printed on paper made of hemp. It was used as recently as World War II by the U.S. Government, and then promptly made illegal after the war was won. At a time when rhetoric is flying about becoming more self-sufficient in terms of energy, why is it illegal to grow this plant in this country? Ah, the female. The evil female plant — marijuana. It gets you high, it makes you laugh, it does not produce a hangover. Unlike alcohol, it does not result in bar fights or wife beating. So, why is this innocuous plant illegal? Is it a gateway drug? No, that would be alcohol, which is so heavily advertised in this country. My only conclusion as to why it is illegal, is that Corporate America, which owns Congress, would rather sell you Paxil, Zoloft, Xanax and other additive drugs, than allow you to grow a plant in your home without some of the profits going into their coffers. This policy is ludicrous. It has surely contributed to our dependency on foreign energy sources. Our policies have other countries literally laughing at our stupidity, most notably Canada, as well as several European nations (both Eastern and Western). You would not know this by paying attention to U.S. media sources though, as they tend not to elaborate on who is laughing at the United States this week. Please people, let’s stop the rhetoric and start thinking about how we can truly become self-sufficient.

With that I say good-bye and good luck.

All the best,

Andrew Lahde”

Answer — Yes, as I see it the authorities are doing whatever they want. I’m more inclined to hold actual gold coins. The SEC now disallows shorting in 799 financial equities, an amazing turn of events. Now with central banks all over the world releasing vast quantities of fiat money, it’s entirely possible that gold will embark on a major rise. If this happens, it will throw suspicion on all fiat currency which is the last thing the central banks want. Under these conditions, it would not surprise me for the Fed and the SEC to halt all trading in gold, and the easiest place to monitor such an edict would be GLD. In 1933 the government ordered in all gold held by the US population. I can’t see that happening, but I can see all trading halted. This would throw gold into the black market and make it very difficult to price or sell your gold. In France, people are forbidden to take any gold out of the country. Remember, gold is the enemy of fiat paper, and in that there is a story. Rising gold throws suspicion on ALL fiat and central bank issued currency.