The End by Michael Lewis

Taken from the article:

That’s when Eisman finally got it. Here he’d been making these side bets with Goldman Sachs and Deutsche Bank on the fate of the BBB tranche without fully understanding why those firms were so eager to make the bets. Now he saw. There weren’t enough Americans with shitty credit taking out loans to satisfy investors’ appetite for the end product. The firms used Eisman’s bet to synthesize more of them. Here, then, was the difference between fantasy finance and fantasy football: When a fantasy player drafts Peyton Manning, he doesn’t create a second Peyton Manning to inflate the league’s stats. But when Eisman bought a credit-default swap, he enabled Deutsche Bank to create another bond identical in every respect but one to the original. The only difference was that there was no actual homebuyer or borrower. The only assets backing the bonds were the side bets Eisman and others made with firms like Goldman Sachs. Eisman, in effect, was paying to Goldman the interest on a subprime mortgage. In fact, there was no mortgage at all. “They weren’t satisfied getting lots of unqualified borrowers to borrow money to buy a house they couldn’t afford,” Eisman says. “They were creating them out of whole cloth. One hundred times over! That’s why the losses are so much greater than the loans. But that’s when I realized they needed us to keep the machine running. I was like, This is allowed?”

Fast forward a few years and not much has changed in either MLP’s benefits or their level of awareness to the public. MLP’s are also referred to as publicly traded partnerships. The major benefit of MLP’s comes from taxation since income generated by the MLP is tax free. Since MLP’s have no corporate income tax, MLP’s typically pay very high quarterly dividends. The tax structure of MLP’s was setup by congress in 1987. A person who purchases shares in an MLP becomes a unit holder or one of the limited partners. As a limited partner, you are entitled to a portion of the assets held by the MLP, that in-turn also entitles you the income distribution made by the MLP.

Sometimes a portion of the income distribution made by the MLP is classified as a return of capital to the original investors in the MLP. This classification of income may reduce your cost per share when you buy and sell shares in an MLP. Due to the unique structure of MLP’s, shareholders are mailed a Schedule K-1 at the end of the year that details taxable and non-taxable income, gain, loss, deduction, and credits. Some MLP’s now offer double-digit, after-tax, seemingly stable returns. MLP’s are mainly available in commodities, energy and real estate.

I’m curious if my readers have found any MLP’s tied to precious metals mining or mining royalty assets.

Here is another article, Master Limited Partnerships: A New Way to Shop for Bargains, that discusses some more recent opportunities in MLP’s.

Taken from the article:

Most investors have never heard of, or purchased, shares of a master limited partnership (MLP). But, with many yielding more than 10% and prices at historically low levels, these bargains are getting hard to ignore.

Few investors know that master limited partnerships are publicly traded asset pools. They have the tax benefits of a partnership plus the liquidity of a publicly traded stock.

Because they invest in many different types of assets, most master limited partnerships have significant debts on the balance sheet and have suffered from the credit crisis. But not all debt is bad debt. And their crisis could be your opportunity.

Profit From Master Limited Partnerships In the Energy Sector

I prefer master limited partnerships in the energy sector because their business is easy to understand. The ones that interest me own the pipes that move oil and natural gas from production to marketplace. Some of these companies also process natural gas, and they may even own an oil or gas field directly.

These companies are like utilities for energy production. Without their infrastructure, oil and gas couldn’t move to the consumers who need it. They play an integral part in the supply chain, and this makes their income stream steady and predictable.

The market has unfairly beaten up the prices of these partnerships. And the bankruptcy at Lehman Brothers only made things worse. They were dumping assets even before they went under. As a lender and advisor in this sector, Lehman was a major player in master limited partnerships.

One of my favorite master limited partnerships is Boardwalk Pipeline Partners (NYSE: BWP) - a firm that handles the storage and transportation of natural gas. Its largest shareholder, Loews Corp. (NYSE: L) heavily influenced BWP by assembling the core company assets, and taking the partnership public. It still owns 52% of the shares.

Loews Corp is controlled by the prominent Tisch family - known for their financial discipline. Boardwalk is no exception. It generates consistent cash flows and has limited debt. It has a ratio of long-term debt to capital of only 38%. Yet at a current share price of $16.30, it yields 11.5%.

Boardwalk’s shares have fallen 48% over the past 12 months. But even if energy prices stay depressed, it should rebound when the market sell-off subsides.

The Master Limited Partnership of NYSE: KMP

Another master limited partnership that I like is Kinder Morgan Energy Partners (NYSE: KMP). KMP is the largest independent owner and operator of petroleum-products pipeline in the United States, transporting more than two million barrels a day of gasoline, jet fuel, diesel fuel and natural gas liquids through over 8,300 miles of pipelines.

It is a major transporter of natural gas in Texas, the Rocky Mountains and the Midwest. The natural gas pipelines business segment consists of approximately 14,700 miles of pipelines with transportation capacity of about seven billion cubic feet per day, and working gas storage capacity of about 35 billion cubic feet. They also own or operate additional natural gas gathering, treating and processing facilities.

CEO David Kinder said in the dividend announcement, “While no company is 100% immune to external conditions, KMP continues to demonstrate that our diversified portfolio of stable assets is capable of generating consistently strong cash flow, even in extremely difficult market conditions.”

Having been formed in 1992, Kinder Morgan has now raised dividends for 12 years in a row - an exceptional record for a company that young. In fact, this pipeline giant just announced it was raising its payout again - increasing cash distributions per partnership unit from 99 cents to $1.02. With today’s price of $48.45, this puts its yield at 8.4%.

Master Limited Partnership Investing With An ETF

Another option for master limited partnerships is an exchange traded fund (ETF) that specializes in investing in the energy sector. The master limited partnership & Strategic Equity Fund (NYSE: MTP) holds a basket of energy master limited partnerships, and it’s currently yielding nearly 14%.

Many of these partnerships look incredibly inexpensive and they’re generating steady income. The income they offer will pay you until the share prices recover - perfect for investors looking for an alternative to stocks in this volatile market.

Owning these makes you a limited partner, which allows you to claim a share of the master limited partnership’s depreciation on your tax returns. In addition, they avoid the corporate income tax, on both state and federal levels. You still would owe tax payments ­(just like your other investments), but you suffer no double taxation.

This is why master limited partnerships are not appropriate for tax-deferred accounts - such as an IRA - because you would lose the ability to deduct this depreciation.

If crude oil and gas prices fail to stabilize, then sentiment against these master limited partnerships could stay negative. And that could mean even better bargain shopping down the road…

With the mounting debt faced by the U.S. government, it makes sense to exchange a part of your USD portfolio into a basket of alternative currencies. Long-term the devaluation of the dollar is almost inevitable. For a refresher, please watch this video by Congressman Ron Paul that succinctly covers the subject of a future falling USD.

I recommend basing your alternative currency investments on your perception of the home countries political stability and future economic potential.

In the above two regards, The Australian Dollar is one of the possible hedges for safely protecting your cash holdings. Australia is a politically stable country with a GDP per capita higher than the UK, Germany and France. Australia is rich in many commodities.

Taken from the Australian Government Mines Atlas on Iron:

In 2007 Australia had about 13% of world EDR of iron ore and was ranked fourth after Ukraine (19%), Russia (16%) and China (14%). In terms of contained iron, Australia has about 15% of the world’s EDR and is ranked second behind Russia (19%). Australia produces around 16% of the world’s iron ore and is ranked third behind China (32%) and Brazil (19%).

Taken from the Australian Government Mines Atlas on Gold:

The USGS estimate of world gold reserves of 42,000 t was similar to 2006 According to the USGS, South Africa still has the world’s largest reserve of gold at 6000 t (14.3%), similar to 2006. According to the USGS Australia has the second largest reserve with approximately 12% of the world’s holdings.

Taken from the Australian Government Mines Atlas on Uranium:

Australia has the world’s largest resources of uranium in RAR recoverable at less than us $80/kg U (equates to EDR), with 34% of world resources in this category at December 2007. Other countries with large resources include Kazakhstan with 12%, Canada 11%, South Africa 7% and the Russian Federation 6%.

Olympic Dam is the world’s largest uranium deposit. Based on ore reserves and mineral resources reported by BHP Billiton as at June 2007, Geoscience Australia estimated that the deposit contains 26% of the world’s total resources in RAR recoverable at less than US$80/kg U.

Taken from this page on Australian Natural Resources:

Natural gas fields are liberally distributed throughout the country and now supply most of Australia’s domestic needs. There are commercial gas fields in every state and pipelines connecting those fields to major cities. Within three years, Australian natural gas production leapt almost 14-fold from 8.6 billion cu ft (258 million cu m) in 1969, the first year of production, to 110 billion cu ft (3.3 billion cu m) in 1972. All in all, Australia has trillions of tons of estimated natural gas reserves trapped in sedimentary strata distributed around the continent.

Particularly with commodities prices crashing, Australia is faced with concerns of exasperated negative GDP growth that is fueling the fall in the AUD. With the benefit of large reserves in many commodities, Australia enjoys a small level of self-sustainability not found in many well developed countries. In a world faced by pandemic uncertainties, wars and political instability, the AUD should be a consideration when focused on preservation of capital. If you believe we will eventually emerge from a recession and return to a commodity bull market, Australia’s rich reserves is a future story to focus on for possible currency appreciation.

The AUDUSD chart shows that the AUD has fallen from near parity with the USD at .95 to .67. I would build a position in the AUD at under .65. In the past decade the AUD has traded above .65 for nearly 7 out of the last 10 years. The fall of the AUD has been brutual and is an outlier compared with the performance of other major currencies.

If your long-term view is that the USD will fall, now would be a good time to build an alternative currency portfolio. The AUD has the benefit of high interest rates, with one year deposit rates still hovering in the 3.5-5% range. For multi-year strategies you may want to look at buying Australian Government Bonds. A quick look at Bloomberg.com for Australian Government Bond Rates shows that a 5-year government bond is currently yielding 3.3%.

Compare the above chart to what Bloomberg.com shows for US Government Bond Rates and we see that a 5-year US treasury bond is yielding 1.48%.

“I don’t think there’s anything they [OPEC] can say at this point,” said analyst Stephen Schork, who doesn’t expect a sustained rally in oil prices during the first half of this year.

“They didn’t have control of oil prices when it was on the way up,” he said. “They don’t have control of it when it’s on the way down.”

While I’m not familiar with Stephen Schork’s historical view on crude oil, a vast majority of analysts have rapidly switched their views on oil to echo the sentiment of the quote above. I remember less than a year ago how analysts cited fundamental demand being the driving force behind crude oil prices and how OPEC would never let the price of oil fall below $80. Analysts cited demand from emerging economies, mainly China and India, as the driving force behind existing physical demand. With prices having collapsed over 70% in slightly over half a year, did more than 70% of the people in China or India stop driving cars? For that matter, will 70% of the people in the world stop driving cars, stop taking airplanes and stop using heating oil? Automobiles, Heating, Airlines etc. will still continue to function and be required since they are a part of our global infrastructure and life needs. Physical demand will be curbed due to a global recession, but some basic demand will always be present. Global crude oil usage definitely hasn’t fallen by 70%+ and isn’t expected to fall by such a wide margin from current use. Roughly five years ago, analysts began harping crude oil prices and they quickly forgot that crude oil traded in the $20 range and below for a solid decade before that.

I do agree with analysts, that there was a necessary premium attached to crude oil prices over fears of political instability and war negatively impacting the supply side of the equation. Those fears are still in the market today. With that premium in place, a smooth and steady rise in crude prices, in lock-step with real physical supply and demand, should have been what we experienced from oil’s initial rise. Financial instruments instead mucked with real market supply and demand.

This all goes to show that speculation above fundamental demand was the driving force behind rising oil prices. All manner of speculation led to structured products that were tied to spot prices and futures contracts. These notes and products almost never entailed some form of physical delivery and often included some form of principal protection so losses were converted into dollar terms. Bankers created products tied to future production by private firms and made bets on spot prices that had nothing to do with taking some form of delivery in a certificate form or storing barrels of oil. The lax regulation among these products is similar to the lax regulation with short-selling. Most shorts don’t have physical shares to deliver when they are required to cover positions and short volumes can exceed the actual number of physical shares available. Fundamental physical demand may not have done so much to drive up prices as some analysts considered. Previously available liquidity and interest in structured products has nearly evaporated causing the current collapse in prices. In many ways the fall in crude oil is the result of forced deleveraging since many people are selling anything they can, including derivative notes and futures contracts, in order to raise cash.

What the Yahoo article quote above also accurately illustrates is that trusted analysts have no better idea apart from you or I what the price of oil will be tomorrow. The price collapse in crude has put tremendous pressure on giant oil trusts like PWE, Penn West Energy, one my previous picks for its enormous dividend payment. Production costs haven’t fallen in-line with the fall in physical prices and until they do I expect that there will be additional operation suspensions and downward pressure on energy related shares.

Once oil prices stabilize in a illiquid market, we will see true market supply and demand without the influence of the highly leveraged credit, structured products and derivatives industry.

Taken from this Marketwatch article, Mark-to-market manipulation:

A movement spurred by bankers including Aubrey Patterson, chief executive of Bancorpsouth Inc. (BXS) , and Wall Street power brokers including Blackstone Group (BX) Chief Stephen Schwarzman are arguing for at least a temporary suspension of Financial Accounting Standards Rule 157.

Patterson and other supporters argued for the rule’s suspension in a Securities and Exchange Commission roundtable Oct. 29. Other critics of FAS 157 included Damon Silvers, AFL-CIO general counsel, and Bradley Hunkler, an insurance executive from Western & Southern Life.
Simply put, these guys want the government to stop requiring mark-to-market accounting so the financial industry can put blinders on to the deep trouble that lies on its balance sheets. Not surprisingly, the proponents of a suspension would also apparently benefit from it.
For guys like Patterson, it would mean his bank wouldn’t have to take big charges each quarter to build reserves. Bancorpsouth increased its reserves by 50% to $16.3 million to gird against loan losses at the end of the third quarter.

For Schwarzman, suspension of the accounting rules might allow banks to start lending willy-nilly again — and that would mean a return of the cheap financing that fueled the private-equity buyout boom between 2005 and 2007. Private equity now must re-fund many of those deals with new loans or debt extended at much higher interest rates.

To learn more about FASB Rule 157 visit: FASB, Summary of Statement 157

Taken from this article, Rethink of rules on value boosts banks

The Securities and Exchange Commission said on Tuesday that managers could use their own judgment when valuing securities in illiquid markets, which means they can use measurements other than actual market prices.

I believe this is utter hogwash. Bank managers should never be allowed to use a measurement other than Mark to Market to value an illiquid asset. This kind of accounting applied to a typical wholesaler would create a huge mis-valued inventory. Lets say I owned a company that sold sportswear, if there was suddenly no market for my particular brand of sportswear, the new accounting rules would allow me to book a subjective value for the inventory assets instead of basing them on true closeout prices.

The new rules will benefit most of the large banks such as JP Morgan (JPM) and Goldman Sachs (GS). I’m not sure if the SEC’s decision is wise, since it will just mask the problem of investor confidence and an on-the-brink failure of the OTC derivatives market. I believe the new rules will also give leeway to possible accounting manipulation. For investors, the rules further obscure our ability to determine the value of a companies equity.

Mark to Market is an important principal behind our financial ecosystem. To read more about Mark to Market, I suggest this article, Financial Crisis: Mark to Market Accounting Demystified.

Taken from the article:

[Mark to Market]…was primarily intended to prevent shady accounting practices that hide underlying liabilities. The Accounting Standards bodies were concerned that companies were keeping “bad” assets on their books instead of “writing them down” to their real value (assigning a new, lower value to the asset). Mark to Market gives investors a much better “picture” of the health of the company if their assets are correctly priced (i.e. market price).

Here are some notable quotes taken from the interview:

“What we are doing here is guaranteeing the devaluation of the dollar.”
“This country is bankrupt and we wont admit it.”
“Eventually the dollar will go bust.”
“We are on the verge of destroying our dollar.”

If our global lenders lose faith in the US Dollar it will no longer carry any worth. I believe a dollar collapse is unlikely, however some degree of hyperinflation has been guaranteed by the Fed’s actions. Lowering the Fed funds rate and printing money at a veracious pace will ease access to credit and has been the formula for recovery since the Greenspan era of the Fed.

Historically, the GBP has fallen under 1.4 twice in the past 16 years. Current levels are a stark contrast to the levels set at the end of 2007, when the GBP traded a bit higher than 2.1. In less than a year the GBP has fallen roughly 23%. I believe there is a possibility that we may revisit the sub 1.4 levels.

This is an extreme oddity, considering that the Fed Funds Rate stands at 1.5% and there is a possibility that the Fed may cut rates to 1%.

Taken from this Reuters Article, US RATE FUTURES-Bets tilt further toward 50 bps Fed cut:

WASHINGTON, Oct 21 (Reuters) - U.S. short-term interest rate futures on Tuesday tilted further toward an aggressive rate cut at next week’s Fed policy meeting, picking up on prospects for an protracted slowdown in the U.S. economy.

For the first time, futures suggest more than a 60-percent chance for the Fed to lower rates by one-half percentage point at the Oct. 28-29 meeting, backing up a similar-sized emergency cut on Oct. 8.

Normally falling interest rates would cause the base currency to fall in value against higher yielding currencies. In the past year when the Fed started dropping interest rates the USD fell against higher yielding currencies such as the New Zealand Kiwi, the Australian Dollar and the Great British Pound.

There is a market expectation that governments around the world, and especially in those with a high yielding currency, will drop rates aggressively similar to the USD.

The USD strength is non-indicative of a Fed Funds Rate of 1.5% and possibly lower. The Fed is now creating and pumping cheap money into the financial system at a breakneck pace. The debt racked up by the credit crises is close to getting out of control and we still haven’t faced the full brunt of a possible OTC derivative collapse. To compound the problem of the influx of new money, the Fed has announced the possibility of a second stimulus package.

Taken from this Forex Article: Mid-Day Report: Dollar Strengthens on Talk of Second Stimulus Package

Dollar strengthens in early US session after Fed Chairman Bernanke said that additional fiscal stimulus package should be considered to help improve “access to credits” by consumers, homebuyers, businesses and other borrowers given the “extraordinarily uncertain” economic outlook. In his testimony to House Budget Committee, Bernanke said that such actions might be “particularly effective” at promoting “economic growth and job creation.” Dollar index soars to as high as 82.92.

The USD Index has broken the 85 level and may well be on its way back to the 90 level. If the USD does break 90, we should see the GBP fall under 150 and possibly 140 if GBP rates are slashed aggressively in the near-term.

Treasury buying mortgage-related assets: $700bn
Potential supplementary stimulus package favoured by Democrats: $100bn
Insuring money market funds: $50bn
Treasury fortifying the Fed’s balance sheet: $100bn
Expansion of temporary swap lines with central banks: $180bn
Loan to AIG: $85bn
Fed purchase of agency discount notes & ABCP: amount not specified
Fed loans through the Primary Dealer Credit Facility: $20bn through Sep 17
Fed’s discount window: $33bn balance
Treasury purchase of GSE MBS this month: $10bn
Potential cost of Fannie/Freddie bailout: $200-$300bn

The grand total of the above list is roughly $1.5 Trillion USD and I’m sure the U.S. isn’t done yet. If the government were to completely bailout Fannie Mae (FNM) and Freddie Mac (FRE), the resulting bill would amount to $5.2 Trillion or double our national debt. My guess is that the total cost of the government bailouts, if a $700 billion package to purchase mortgage backed assets is approved, will run close to $2 Trillion before the end of 2008.

In regards to the subsequent inflation from printing all this new money, Monty Guild of jsmineset.com says:

“INFLATION IS AHEAD OF US AND IT WILL BE A BIG PROBLEM

Not for the next few months, but in coming years, inflation will be a big problem…and we had all better prepare for it. You may be getting tired of hearing us beat this same old drum but if you prepare for the next problem before it arrives, you will be much more financially secure.

The only solution for the current crisis is to liquefy the global economic system and liquefy it to an extreme never before experienced. You think that the mortgage bubble was a big one? Wait until you see the next bubbles.

The U.S., Europe, Australia, Japan, Canada, and others will all join the parade to fiscal and monetary irresponsibility by inflating their money supplies and creating our next big investment opportunity.”

All this new money entering the system to “fix” previous problems will lead to new bubbles and massive inflation. This is a formula that has been repeated in nearly every modern economic crises. Low interest rates and a “fix” of printing new money has lead to bubbles in the past. Look at how we moved from a tech bubble collapse to the problems we face with the credit bubble. I’m not sure how we are fixing a problem by covering it up in the same manner.

In this post, I am going to expand on watching CDS (Credit Default Swaps) with banks. What CDS can tell you is how much money a person is willing to pay to insure the debt of a bank. The healthier a bank is, the lower the premium will be to insure its debt. If a banks financial situation sours, the higher the premium will be to insure its debt.

Monitoring CDS is essential to determining the health of our financial investments. With the rapid falling value of bank equities, it pays to look at CDS as an early indication of whether a bank may go out of business. CDS tied to banks are one of the most heavily traded form of derivatives.

In addition to reading traditional news media, waiting for earnings results, and for a bank to announce whether or not it has additional write-downs, you should watch CDS as it can give you a glimpse at trading activity between people who may have advanced daily knowledge of a banks operations. The CDS market is laxly regulated in comparison to common equities trading.

Let’s look the current CDS premiums for some of the worlds major banks.

Looking at the CDS premium for Lehman Brothers on 9/12 before it collapsed, we can see that figures grew well above the levels of HSBC (HBC) and JP Morgan Chase (JPM). The list above can be viewed as a most healthy to least healthy list of banks.

This also demonstrates that traditional media unfairly lumps “Banks” into one simple category. A well diversified bank like HSBC with strong retail banking, commercial banking and wealth management divisions is different from an investment bank that mainly derives its revenue from dealer-broker, trading desk, underwriting and structured finance offerings. When determining possible continued or new investment in bank equities and bank debt offerings, it pays to give CDS premiums a quick glance to see an immediate outlook on a banks health.

For further information about the CDS market, please read Credit Default Swaps: Evolving Financial Meltdown and Derivative Disaster Du Jour. In the article, the author Dr. Ellen Brown says, “CDS are private bets, and the Federal Reserve from the time of Alan Greenspan has insisted that regulators keep hands off.

The sacrosanct free market would supposedly regulate itself. The problem with that approach is that regulations are just rules. If there are no rules, the players can cheat; and cheat they have, with a gambler’s addiction. In December 2007, the Bank for International Settlements reported derivative trades tallying in at $681 trillion - ten times the gross domestic product of all the countries in the world combined. Somebody is obviously bluffing about the money being brought to the game, and that realization has made for some very jittery markets.

“Derivatives” are complex bank creations that are very hard to understand, but the basic idea is that you can insure an investment you want to go up by betting it will go down. The simplest form of derivative is a short sale: you can place a bet that some asset you own will go down, so that you are covered whichever way the asset moves.

Credit default swaps are the most widely traded form of credit derivative. They are bets between two parties on whether or not a company will default on its bonds. In a typical default swap, the “protection buyer” gets a large payoff if the company defaults within a certain period of time, while the “protection seller” collects periodic payments for assuming the risk of default.”

I believe we are facing a global derivatives problem of $1,140 trillion and upwards. To echo the sentiments of my previous article, monitoring the health of your investments, especially if they are related to financial services, is of paramount importance in times of crises. Based on the CDS list, I have a stronger feeling that Intel (INTC) will be around, instead of Washington Mutual (WM) in the future.

Currently out of the top 5 investment banking firms in the U.S., (Goldman Sachs (GS), Morgan Stanley (MS), Merrill Lynch (MER), Lehman Brothers and Bear Stearns), only two will remain in business going into the fall of 2008. The source of all of this is of course the over leveraged nature of investment banks. At the end of 2007, Lehman Brothers was leveraged 31:1. Lehman turned $1 into $33 through the magic of leverage. On a mark to market basis, every bank with exposure to complex CDO (Collateralized Debt Obligations) and derivatives is prone to an amazing loss of value at staggering speeds.

It’s important to understand what mark to market means. Investopedia states mark to market as “The act of recording the price or value of a security, portfolio or account to reflect its current market value rather than its book value.”

In a bullish market, the investment banks and stock market participants valued portfolio’s of mortgage securities and other derivatives far greater than its book value. In a bearish market, a portfolio of these securities falls far below book value. Since most investment banks trade on margin a drop in mark to market forces the investment bank to write down the value of the security or portfolio as a defensive measure against even greater losses. A rapid drop in mark to market can also force a margin call as some hedge funds for example do not have sufficient additional collateral to protect against the margin call. Creditors who have lent money to investment banks will require certain margin and capital ratios and will refuse to extend additional credit to funds or investment banks as the value of their assets dwindle.

Holding a portfolio of CDO’s and MBS (Mortgage Backed Securities) was a threat to investment banks since the beginning, due to the difficult nature of determining the actual owners of the collateral behind the security. A mortgage portfolio was often divided into pieces and packaged into MBS products, then sold and repackaged several times into other securities. The investment banks were essentially playing a game with each other with the lack of regulation and reporting in the structured finance market.

Holding a portfolio of common equities is much easier to value in comparison to CDO and MBS assets since you can take into account traditional valuation methods such as earnings and cash to debt ratios. Interestingly MBS were regarded as rock solid since the collateral behind the mortgages, physical property, was previously regarded as good as cash. With the fear of mortgage defaults, MBS values are falling faster than the actual physical property values. This has lead to recent buying by private equity funds seeking to buy distressed mortgage backed assets for pennies on the dollar.

What we have witnessed with CDO’s and MBS doesn’t stop there, similar problems exist for the entire OTC derivatives market. As stated by this Market Watch article: Buffett and Gross warn: $516 trillion bubble is a disaster waiting to happen.

In the words of Pimco’s bond fund king Bill Gross: “What we are witnessing is essentially the breakdown of our modern-day banking system, a complex of leveraged lending so hard to understand that Federal Reserve Chairman Ben Bernanke required a face-to-face refresher course from hedge fund managers in mid-August.”

I’ve written about derivites in a past article in which I said:

Because derivatives are just contracts, just about anything can be used as an underlying asset. There are even derivatives based on weather data, such as the amount of rain or the number of sunny days in a particular region.

Estimates vary on the potential total economic risk derivatives present. I like to use the largest figure I’ve found. As of December 2007, The Bank of International Settlements estimated that the amount of listed credit derivatives, i.e. tradable in some form through an exchange, stood at roughly $548 trillion. The amount of OTC derivatives was estimated at $596 trillion notional value. This brings the total derivatives estimate by The Bank of International Settlements to 1,140 trillion.

With the possibility of a global financial meltdown it’s important to educate yourself on how to anticipate the failure of a business or bank. You need to know what is, and what isn’t at risk. It’s definitely not enough to read the news, since the figures you need to watch are often found buried in balance sheets.

-On the top of my list is leverage and in a bear market less is better. This applies to all businesses and banks.
-High capital reserve ratios. The more cash a bank has the better.
-Diversified currency base. A bank or business holding a variety of foreign currency reserves has a better chance to hedge Forex risks, enhance liquidity and security.
-Low exposure to derivatives and complex structured finance products.
-A diversified business model to protect against falling earnings. It’s better to seek-out banks and businesses that have a variety of income streams.
-Operation in international markets. If a bank is limited to business in the U.S. or Europre for example, it is at greater risk at suffering a loss from an economic downturn.
-For banks you must have a careful watch of CDS (Credit Default Swaps). A credit default swap is the cost to guarantee a banks debt.

In examining where the potential risks are, we can help protect our own investments and determine which investments are safer bets. As we look at Asian banks for example, we can see that state owned Chinese Banks are flush with RMB and far less exposure to derivatives. Many chinese banks have diversified lines of business and derive income from retail banking services, an early credit card market with low penetration and a growing wealth management divisions. European banks such as UBS (UBS) also enjoy many of the same advantages in a far different geographical location.

Forbes published an article today titled: “UBS Likely To Avoid Lehman’s Fate” The Forbes author goes on to say:

“The reason for this lies in UBS’ diversified business model, which brings in a relatively safe stream of profits from wealth management and private banking–despite that its investment banking division is in meltdown. This in turn has helped the bank avoid the kind of crisis in confidence faced by Lehman Brothers Holdings (nyse: LEH - news - people ), which threw in the towel and filed for bankruptcy over the weekend as its shares tanked and its credit default spreads widened.”

“Credit default spreads for UBS are still relatively low,” said Dirk Becker, an analyst with Landsbanki. “They are still in the region where they can stay in business.”

Chinese and European banks are of course getting sold off along with the fall in financial markets. Investments in ETF’s that do hold these securities offer an opportunity to cycle out of U.S. financial equities if you decide that your portfolio should include a portion in the financial services sector.

With all of the bad news emerging from U.S. financial markets, I can’t help but draw the conclusion that the USD is due for a major fall in value. The U.S. literally doubled its national debt with the bailout of Fannie Mae (FNM) and Freddie Mac (FRE). We are printing dollars at an exceedingly rapid pace, the Fed has expanded its loan window to distressed investment banks and now we may be faced with another quarter point interest rate cut. All of this is dollar negative. As we watch the financial turmoil unfold and wait for markets to repair themselves, you may have already looked at currency diversification as part of your investment strategy. Before making money, capital preservation has and will always be of the upmost importance.

Over the past 400+ articles, I’ve mostly posted my buys and sells, with exact prices. This is to establish accountability and to form a track record. I’ve always said, regardless of how a person finds their stock picks, all that matters is performance in B&W. It doesn’t matter if you employ throwing darts or advanced quant analysis. The best written article and in-depth analysis is worthless if it consistently loses you money in investing.

My approach has always been basic and straightforward. Buy cash rich companies with low debt or entire sectors that have been shorted due to unfavorable market conditions. I know that my own track record is far from perfect, however I have the same conviction and passion for each investment I make even if the last was losing.

In the market, a loss is never a loss until you sell. If you are confident you bought a stock at good value you will be able to sleep well at night and won’t be afraid to buy more at low prices. You never buy more just because the price drops, you buy more because the company continues to be a good value. If the company stops being a good value, you cut your losses and sell, regardless if the price is high or low.

I do see a crash coming and with the same accountability I am going to post my targets as I always have.

My price target for gold is $1,100 by the first quarter of 2009. My top picks continue to be Yamana Gold (AUY) and Barrick Gold (ABX).

My favorite base metals stock is Lundin Mining (LMC). I’ve written in detail about the stock in the past, so use the search function on my blog. Today the stock is trading in the mid $6 range. I fully expect LMC to break $10, a 50% gain, in the next 6-12 months.

I would like to remind readers that the first time I bought Yamana, Pan American Silver and Silver Wheaton some continued to drop from my purchase price almost 30%. In retrospect, I saw the value in strong earnings and smelled a good value brewing. All of the stocks above returned 40% or greater for me in a matter of months. I see the same opportunity today in precious metals stocks. It will not be a smooth ride given the volatility in precious metals. Unusual volatility means strong swings in both directions. The farther it falls the faster it will rise as a sector. There are plenty of precious metal stocks, especially juniors and mid-tier producers that are trading as if gold were in the $600-$700 range and silver were in the $12-$14 range. In light of the strong earnings almost the entire sector is undervalued and soon Wall Street will come to realize and report about it. There is real possibility of war between Israel and Iran. There is a real possibility of economic disaster. There is strong threat of inflation. All of these are positive for precious metals.

I am going to start entering positions in July and hopefully 2008 will be another top notch year for myself and fellow Raw Greed readers. Gradual accumulation and diversification is key. A year from now those who have the conviction to buy will be happily rewarded.

Finally, I will share a thought left to me by the former CIO of General Motors Asset Management. He asked me, “is an entrepreneur risky?”. His answer was solidly no. An entrepreneur fully believes in what they are doing or they wouldn’t do it at all, so they are not risk takers. A conservative entrepreneur and those who are fully accountable should be followed carefully. Individual investors are very much mini-entrepreneurs putting their money to good use.

Disclaimer: The author currently holds a long position in Lundin Mining.

Here are a few factors to consider:

1) The Fed may increase interest rates in the near future. An increase in rates is bullish for the dollar and necessary to fight inflation. An increase would add tremendous pressure to an already fragile housing market by making payments on adjustable rate mortgages more expensive. Increases would also make borrowing more expensive and would restrict access to already tight credit. The potential impact of rate increases is unknown.

2) Any failure in the derivatives market would signal the beginning of an imminent crash. Estimates vary wildly over the total value of the derivatives market. The Financial Times recently estimated that the size of the derivatives markets stood at roughly $450 trillion dollars. As of December 2007, The Bank of International Settlements estimated that the amount of listed credit derivatives, i.e. tradable in some form through an exchange, stood at roughly $548 trillion. The amount of OTC derivatives was estimated at $596 trillion notional value. This brings the total derivatives estimate by The Bank of International Settlements to 1,140 trillion.

Taken from Investopedia:

[A]…derivative itself is merely a contract between two or more parties. Its value is determined by fluctuations in the underlying asset. The most common underlying assets include stocks, bonds, commodities, currencies, interest rates and market indexes. Most derivatives are characterized by high leverage.

Futures contracts, forward contracts, options and swaps are the most common types of derivatives. Because derivatives are just contracts, just about anything can be used as an underlying asset. There are even derivatives based on weather data, such as the amount of rain or the number of sunny days in a particular region.

Due to the complex structure of derivatives it becomes very difficult to evaluate the underlying assets of many derivatives. Problems in the industry could lead to massive derivative writedowns by banks. Derivatives could form an extension of the collateralized debt obligation (CDO) and mortagage backed security (MBS) problems that fueled most of the recent writedowns by financial institutions. If there are too many sellers and not enough buyers in the derivatives market, investments become stagnant and pose the possibility of devaluation if anxious sellers seek to cash out.

My guess is that the derivatives estimate from The Bank for International Settlements is the most accurate. Taken from The Bank of International Settlements website: The Bank for International Settlements (BIS) is an international organization which fosters international monetary and financial cooperation and serves as a bank for central banks. The bank was established on May 17th, 1930 and is headquartered in Switzerland. BIS is the world’s oldest international financial organization and currently includes 55 member central banks.

3) Leverage is out of control. As we learned from the Bear Stearns Crash, leverage can turn against you very quickly. Bear Stearns leveraged 11.8 billion to control a balance sheet of 395 billion. Carlyle Capital leveraged its balance sheet 32 times to own $21.7 billion in mortgage backed securities, primarily AAA-rated bonds guaranteed by Fannie Mae (FNM) and Freddie Mac (FRE). Carlye Capital’s portfolio was backed by just $670 million in equity. The problem of leverage is prominent by all major big balance sheet banks such as Goldman Sachs (GS) and JPMorgan Chase (JPM) is very real as they provide access to credit and frequently loan money between each other. Any devaluation of assets or calls for more collateral on loans could lead to forced margin calls and major additional writedowns for banks.

4) Credit ratings on bond insurers Ambac (ABK) and MBIA (MBIA) fall. Ockham Research wrote on February 28th, 2008:

“Citigroup (C), Wachovia (WB), and UBS (UBS) among others need to keep Ambac healthy as the ripple effect from an Ambac bankruptcy would be massive. Oppenheimer estimates that the major banks have $70 billion of exposure to Ambac and the bonds they insure.

Clearly, Ambac losing its credit rating of AAA or declaring bankruptcy would be catastrophic. If the worst were to occur it would make the housing crisis pale in comparison. The banks act as underwriters for billions of dollars in corporate bonds of which Ambac and MBIA are the two main insurers.”

Banks like UBS (UBS), Citigroup (C) and Merrill Lynch (MER) buy bond insurance as a hedge from Ambac and MBIA. If the insurer were to go out of business, 100% of the default risk is exposed to the bank. Banks have taken insurance on trillions of dollars of collateralized debt obligations and other mortgage backed securities. The potential impact of bond insurers going out of business for banks is tremendous. Market Watch is reporting that Ambac’s drop from AAA to AA is going to cost UBS, Citigroup and Merrill Lynch an estimated additional $10 Billion in new writedowns. This is money that the banks can’t afford to continue losing.

5) The Fed is printing money at an ever quicker pace. I’ve covered most of this in my previous article on How to Predict the Price of Goods. An increase in the money supply helps to alleviate access to credit and offers additional available cash to banks in the form of Fed loans. Increases also lead to an inflationary economy and possible drop in the dollar.

6) Inflation is out of control. Basic necessities like food and energy prices have skyrocketed 300% or more in recent years.

7) Eli Hoffman reported that financial performance of mutual funds in 2008 may be worse than the year of the .com crash. Eli writes that “As of January, 2007, nearly 1,400 mutual funds were earning 15% or more. This January, just 270 funds hit that number — an 80% decline. From December 2000 to December 2001 — the bursting of the tech bubble — the 12-month drop was only 57%.”

There are many situations that may play out. The extreme economic collapse would be a failure of the banking system that would mean massive bank runs and a large devaluation of the dollar. Since the risk of an economic crash is very real, and may be the worst since the great depression, I am continuing to recommend cycling into physical assets and a diversified portfolio of non-cash assets.

Food for thought: Stocks and bonds are held in a clearing account by your bank or brokerage. If a bank run causes you to lose your money, eventually your stocks and bonds will be returned to you since technically they can be delivered in the form of stock certificates and paper contracts. Picking the correct recession resistant investments will be key to preserving capital in the event of an economic crash.

The good news is that if we are able to quickly emerge from a recession, every post economic recovery has lead to higher wages and asset appreciation. This has been true all the way from the Great Depression to the .com lead recession.

*Disclaimer: The author does not own a position in any of the stocks above.

The beginning of hyperinflation is evident from the chart below. Of the 30 cars below, it now costs $114 to fill up a Toyota Sequoia SUV in California. The Toyota stands firmly in the middle of the list, with 21 out of the 30 models costing more than $100 to fill up.

I firmly believe that we are looking at the value of money dropping 10 times in the next decade. I believe $100 will be worth roughly $10. There is simply too much new money being printed by the Fed competing for the same goods. If we look at our emergence from the 2001 recession, we already saw the cost of property, luxury goods, travel and in some cases food increase 300-400%. Now that we are entering a new recession, when we recover the price of goods should again dramatically increase. Holding cash at the moment is the worst possible thing a person could do. I suggest buying anything, from stocks to property that you believe is a reasonable quality investment. When we emerge from a recession, stocks, property, and a variety of other investments will adjust themselves to reflect the true value of future dollars.

There will come a time when a $1,000,000 a year salary will be as common as a $100,000 a year salary today. The problem is no one sees it coming. It typically happens in a short time-frame and catches investors off guard. Many of us ignored the opportunity to buy property or stocks in 2001 when prices were low. Many of us will now miss the chance to buy property or stocks in 2008-2009.

Raw Greed’s investing has been focused on identifying trends in advance and setting up strategies to take advantage of oversold conditions. Five years ago, I was buying in and out of technology and airline stocks. For the past three years, I have been buying in and out of precious metals stocks. I believe that we are approaching a mania phase for energy and precious metals. In the next year or two I am guessing that I will exit precious metal stocks and start to invest in financial and home building stocks.

At the moment there are an incredible amount of deals in the market with some sectors off a staggering 70% or greater. Good and bad stocks, bonds and property have been lumped together and sold off. I don’t believe we have hit a bottom yet, but I do believe we are approaching one. Since no one knows when the exact bottom is, I believe investors should begin to build their positions while the economy is slumping. The old saying “the baby will be thrown out with the bath water” is going to apply very soon. Investors will may have a chance to buy GE, General Electric Company or HD, The Home Depot, Inc. at a P/E under 10. Insurers like AIG, American International Group, Inc. and financials like LEH, Lehman Brothers Holdings Inc. and C, Citigroup, Inc. are all down in the 60-70% range compared to year ago highs. If these stocks were to slide another 20-30%, we would firmly be 80-90% off from year ago highs indicating a permabear mentality.

It seems that whenever a person decides to buy a stock in a slumping market, the stock will keep falling, causing some degree of fear and angst. Investors should take comfort in knowing they paid .10-.20 on the dollar for a stock that will likely survive and thrive when the economy recovers. There may be another Bear Sterns collapse in the meantime, so diversification is key. Lets say you took a dollar and broke it into 10 varied investments that were down 80-90%. If one were to go out of business you would be left with 9 investments that will likely return multiple times your cost as we emerge from a recession. If you are buying .10-.20 on the dollar, only one out of your ten investments has to recover halfway from year ago prices to bring you to a breakeven point to prevent loss from one going out of business. The chances are solidly in favor of the investor who can look past the bearish mentality.

I have no idea if companies like AIG or Lehman Brothers will ever drop to the point where I can buy them .10 on the dollar compared to year ago prices. At the moment, I am going to consider beginning to build a position in these stocks as we are down 60-70%. This range is my initial buy-in with aggressive buying at .10 on the dollar.

At the moment there are people forced to pay $168 to fill up a Chevy Suburban 2500 in California. I’m not sure how much longer can this last until all the new money the Fed is printing goes towards increasing salaries. The recent economic relief checks have been completely absorbed by a months driving for some households. Once we recover and people are able to afford paying $100+ to fill up it will be too late for investors to capitalize on the missed chances. The lost money just by sitting on the sidelines will be very real.

*Disclaimer: The author does not own a position in any of the stocks above.