Your columns are so precise and well written. Thanks for sharing your thoughts.

Cara Classic

Bill,

Your post today can/should serve as the back cover or prologue. It truly encapsules your writing style, intent, and depth.

That should pretty much sum up what the reader is about to invest in when purchasing your book.

Just my suggestion.

Bill,

Your point regarding the rise of credit derivatives is a good one and perhaps I can shed some further light on the market size, growth patterns and their impact on asset pricing and risk premiums (or the LACK thereof!!)

The structured credit markets today are the fastest growing segment of the capital markets bar none. The market today is sized at over $1 trillion USD and is for the most part unregulated. The structured credit market is comprised of arcane things such as index derivatives as well as collateralized loan obligations of CLO's.

Let's take a look at the CLO market and try to see what its larger implications are for your readers.

A CLO is quite similar to a collateralized mortgage obligation. I suspect many are familiar with mortgage backed securities. The only difference is that unlike the CMO in the CLO the collateral are typically corporate bonds and related bank debt. Whose debt you might ask? Typically bonds and bank debt of companies undergoing a buyout or a going private transaction or bonds/bank debt of companies who have undergone some leveraged recap in order to finance a dividend to public shareholders or private equity owners...

These securities then form the collateral pool against which other securities are issued. (I know it's complicated but I am trying to keep it simple.) Rate hungry buyers all over the world compete to buy the various tranches of these CLO's.

In the past several years there has been an absolute explosion in the issuance of CLO's. Last year for example the FT and WSJ estimate that over several hundred billion dollars of CLO paper was issued. The numbers for 2007 are expected to dwarf the 2006 levels. As hedge funds and BDC's and others all race to get in on this issuance game, the competition for underlying collateral (namely the highly leveraged bonds and bank debt) becomes quite intense indeed. As a result the prices asset managers and arrangers of CLOs pay for underlying collateral goes up driving their yields in the marketplace artificially low. The larger implication is that this forces a compression in the spreads between the 10 year Treasury bill and the high yield and leveraged loan indices. In periods where credit is tight these spreads can average 800 basis points above the 10 year Treasury. Today they hove at a mere 250 basis points over or so. The market is saying no risk. The reality is there is huge risk in several regards. First the collateral underlying these CLO's may be overvalued. Second there is very little in the way of covenants and the like protecting the buyers of the structured credit paper. Thus if there is a problem or two - well it could Katy bar the door....

The massive issuance of structured credit could be one of the factors causing the inversion of the yield curve. That is not an independent thought on my part but we need to consider this point carefully. As credit asset prices get bid up globally, yields fall. And more important historical risk premiums fall. As risk premiums fall asset values of all types get tend to get bid up. I am sure many of the readers are familair with discounted cash flow models and the like. The ways these things such as the (capital asset pricing model)is that an assumption is made for the discount rate used to discount future cash flow streams of the asset. The asset could be timber, royalties of some sort or the cash flow from a traditional corporation. Either way, lower discount rates tends to increase asset values on balance.

The important point is that the incredible growth in structured credit is exerting an important influence on the global capital markets. That influence manifests itself in reduced risk premiums demanded currently by investors (as investors convince themselves "it is really is different this time"), lower interest rates and higher asset values at least initially.

Over time however risk tends to get repriced. In this case there is a strong reverion to the mean. Rates thus tend to rise. Highly levered vehicles tend to plummet in price as do asset values of all sorts.

I apologize for the long post. Hopefully some found it useful. It is a fascinating area that deserves to be watched.

Cheers.

Bill, thanks for the "roadmap." I don't know anywhere else I could get this info. so succinctly.

Noodle, thank you for this post. My take is that all of these credit derivatives etc does the following (1) renders central bankers useless in controlling supply, in that liquidity is created through reduced volatility caused by these instruments and (2) that normal changes in market fundamentals (your reversions to means)(interest rates, forex) can cause huge shudders for those on the other side of the trade for they are leveraged so highly. It is such an event that will cause a credit shock to the world financial markets.

Thanks Bill for your clear thought. I agree completely about the tight situation, even if everyday I see it can go on further to my surprise. And banks in Italy keep on offering loans to my company to place somewhere their big cash. Anyway, we have a finance blog in Italy that I like too www.cobraf.com and the author today wrote many things similar to yours. Maybe he's reading, too :) Since I liked what he wrote, I hope he will not get offended if now I place here the translated sumup of his view that I share, and that I found very interesting. Here it is:
American GDP was +3,5% last quarter, good and beyond expectations; Fed says that economy is good and inflation is almost good. Everybody's happy, stocks go up. But analyzing the GDP change, investments are -2% and consumers once again made the difference.
Why in a sound economic environment with high earnings, do companies reduce investments and on the contrary they use cash to make buyback of shares and acquisition of companies?
In the meanwhile government spending grows, personal savings are even more negative, private debt is huger every day, and real estate boom is over. Things cannot go on this way for long. Then there is a suspicious datum about import-export: for the first time in 5 years exports give a positive contribution to GDP. But how come that America, Asia (except for India), Japan, Germany, Russia, Opec, Brasil are all growing thanks to export?!? Who is importing it all?!? Just Australia, Great Britain and Spain?!?
Negative investments, high level of consumer debt and government spending: where is it all going to end?

Another inflation story:
http://cbs13.com/topstories/local_story_031203127.html
Thieves stole guardrail from freeways to cash in on the high price of aluminium!!!

I echo your view on gold. But without a war, I cannot see how gold can go to more than $900. Currently, I believe that gold will not make a significant final top here, but continue its bull market beyond 2007.

Hi Bill and Folks,

FWIW, I'd be careful getting long Oil/Energy at this juncture, we are seeing a negative breadth divergence in this latest advance in XLE, OIH, etc.. It looks exactly like the positive breadth divergence that manifested while the 1/11 lows were being made (compared to the 1/5 low) ... This is calling for a short term top in XLE, OIH. That coupled with the fact that both are approaching their upper Bollinger bands and the 50 day simple moving averages makes them both a little dangerous for initiating new longs.

Good Trading,
Ralph
http://blog.successfulonlinetrading.com/

Hi Leisa,

You raise an excellent and interesting point regarding the role of the central banks. The creation of these structured credit vehicles occurs beyond the control of the Fed and related central banking authorities. The sheer size and growth patterns of the structured credit markets ensures that they will play a very meaningful role in the shape of the yield curve. The question is whether the structured credit markets are becoming the tail and the dog. We shall see.

On your second point risk always gets repriced. It is simply a question of when. High yield securities normally are priced at 400 bps over the corresponding 10 year Treasury. We are well under that spread now indicating a period of great risk. The cause of the mean reversion remains unknown. We simply don't know but years of market history suggests it will come and catch everyone by surprise.

Causal factors could include things such as geopolitical instability (think IRAN), currency instability, ruptures in the US sub prime housing market (Bloomberg has an excellent article today on their website regarding this part of the structured credit markets). Right now, risk is being thrown to the wind. But that will change - it always does.

One other thing to keep in mind is that many of these structured credit vehicles themselves are heavily leveraged 10x or 20x to 1. It is the leverage that provides the issuer with return. So if you think about it there is leverage on leverage. Small changes to the integrity of the collateral pools will have an enormous impact on both the issuers and buyers of these securities.

Cheers.

various sites estimate what M3 really is now, and in fact the money supply is still exploding
http://nowandfutures.com/key_stats.html

unfortunately all the gold and silver stocks will become as suspect as any other stock, by being a fiat paper item same as any other

Excellent. Thanks, Bill.
This is one I will take down notes from for future reference.

I notice Marc Faber, who has a good record in forecasting market trends, also believes this year will see a serious decline (likely soon) in the values of ALL asset classes, including precious metals (with gold to be bought back again after the correction), and certainly global stock markets will be going down.

I'm enjoying the gold ride for now, while bracing for the worst.

Exxon Mobil posts record $39.5 billion profit for 2006.......This may seem crazy, but it's a stunning reality.
Could explain why the US is over in Iraq securing the oil exports for the big corporations.

we're at lowest level ever in owners equity in their real estate...high level of mortgage obligations to personal income ratio...household cash very low
http://safehaven.com/article-6819.htm

deacon31, the consumer is about to get more cash to spend/leverage. The minimum wage in America is about to go up 40% in the next 26 months. If the gas prices can somehow be kept low, this bubble might just grow more skin and keep growing. It seems like it is a race between consumer spending and credit supply.

http://tinyurl.com/2amqso
Minimum Wage Bills at a Glance

The Associated Press
Thursday, February 1, 2007; 6:32 PM

NYUgrad,

I think you have a point there, but I am inclined to think that those on minimum wage typically are not flush with cash, but just barely keeping their heads above water. They are typically renters, not owners, and they are not especially likely to invest. If the middle or upper classes were getting a cash infusion, I'd agree that it might cause either real estate or equity bubbles to gain a new life, but I tend to think that raising the minimum wage will, at most, decrease the number of delinquencies and increase some spending in consumer staples. I could be wrong, but that's my gut feeling.

Jeff

>

Yes, it is frightening.

But, I have to say that never until this year did I really understand how the market climbs a wall a worry. It is too easy for me from my experience and education to not be a natural hand-wringer. And frankly, it is hard for a market novice such as myself to parse out what is the perennial hand-wringing market screen saver vs. the in your face "this-is-f'n-nuts" shouts from the well grounded. The GDP number v. the ISM numbers are incongruous to my small mind.

I agree with both of you as i make income on those renters. But if the min wage sector keeps spending their new wealth and over borrowing on credit cards, GDP may stay lifted temporarily, walmart target bestbuy mastercard might lift, etc.

My core positions are my rental incomes and junior gold miners right now. When Bill mentions that we have more time to get into gold that also tells me this bubble is going to get bigger for a little longer than expected. And i doubt its my tenants who are lifting the markets right now.

But I totally agree this is not going to last long. i hope i have the cash when it pops to load up. have a good evening everyone.

Regarding XOM: I remember when they were the first company to have sales of $5 billion--it was a landmark. Now to to see that their net income is ~8x's that is sobering (plus it makes me feel old).

If I recall the roundtable articles in Barrons over the past couple of weeks, Mr. Faber thought the downturn would occur by mid-year, which fits Bill's timeframe. He likes Singapore as a play once we hit bottom - sounds quite plausible since the bubble in Chinese equities is certain to be pricked with this impending downturn.

ALOHA !!

You guys rising labor costs is classic "inflation" ... How can that be good for anything other than gold?

As a business owner rising costs cause me to cut back my overhead, otherwise I have to raise the price of my goods I produce to cover the higher cost of production. That makes my product less competitive in the global markets. Less sales means less revenues and less profit. What good is higher minimum wages when employers start laying off workers? A worker who is laid off cannot spend and in fact becomes unemployed and joins the growing numbers on US government welfare!

How in the World did increased consumer spending ever become an economic asset? Only in "Wonderland" can spending equal true wealth !!! Saving or having the ability to "save" is true wealth ... without "savings" SPENDING IS DEBT!!! Last I looked the average American has no savings ...

ALOHA !! With regard to sustained POG at $1000USD leading to gold producers hedging ...

I believe only fools would hedge in the face of rising government spending. Wars are very expensive and therefore highly inflationary ... That is a given and a proven historical reality. We are in WW3 mode militarily and WW3 mode financially with the retiring baby-boomers coming in 2008. None of those events will result in less US Dollar printing ... the brakes are gone along with the M3 number! Without a complete and sudden 180 degree about-face in worldwide government spending and printing I would see no reason that the POG would stop at $1000USD and therein no reason to hedge future production against rapidly rising production costs. Besides even $1000USD POG is very cheap in terms of 1980 dollars(adjusted for inflation). The only reason the POG is this low is due to the manipulation of central banks selling their physical supplies. What happens when central bank supplies run out? When the IMF actually starts selling gold(a BIG "if")you will know the central banks are out of gold ... They have been out of silver for a long time now ...

How many major gold producers have already made that mistake or have now gone under? The hedge books of Barrick, Anglo, Placer Dome, Golden Star and Sons Of Gwalia come to mind ... Hedging at $1000USD I believe would be a mistake under continual unlimited governmental monetary inflation policies.

It all comes down to the purchasing power of fiat monetary systems of which every major worldwide currency is fiat money. If I were an Arab oil shiek why would I trade my finite resources for "in-finite" paper dollar IOUs? There is now a movement of physical gold and silver out of the bullion banks of the COMEX and LME to Dubai ... I wonder why? Where's the LOVE?