It’s been another week of tumult in both the financial and political worlds. This will be another longish article. If I appear to be rambling, please bear with me because I will eventually wrap it up.

            I once had the time and good fortune to read Edward Gibbon’s multi-volume Folio edition of “The History of the Decline and Fall of the Roman Empire.” Considering that I hated history in school, I was surprised to find it fascinating. As a speed reader, I was unable to read it until I slowed my reading speed down to conversation level because some of his sentences were as long as a paragraph. I highly recommend it to anyone with the time – almost impossible in our hasty world nowadays. You’ll find at least one good chuckle of dry British humor on every page.

            One thing that struck me about Gibbon’s history was the lack of dates. At first I was relieved about that; dates were one of the things I hated about textbook history. After a while, I found that it was difficult to get a broad perspective on his history because the lack of dates made it difficult for the narrative to “hang together,” especially since he did not write chronologically but, covered identical areas from a number of different viewpoints. In an early volume he talked about the end of the Merovingian Kings. In a middle volume, he again mentioned the end of the Merovingians and in a later volume they seem to be resurrected one more time only to die yet again.

            Gibbon finished the last volume in 1788. Because of his insistence in using primary sources of information, he is considered by many to be one of the first modern historians. The reason there were so few dates is they didn’t know. Even though the Church began dating a couple centuries after Christ, most documents, records and chronicles which were used by later historians were not dated with a year. Something was written to have occurred eleven years after the fire of London or in the third year of the reign of King Whats-His-Name. Modern historians then tried to piece together various records from different church documents and different countries and different languages to come up with an educated guess for an historical timeline. And, I emphasize the word “guess.”

            The trouble with published works is they take on a life of their own. Once a history text is written and peer-reviewed, it is taken as Gospel and woe unto anyone who questions it. The other problem with history is specialization. Historical scholars specialize in small periods of history and are largely unaware of the details of other periods. If there are duplications from one period to another, many historians are unaware of them.

            There are a radical group of historians who question the accepted historical gospel. One of these is Anatoly Fomenko (Google him) and another is the Chess Grand Master Garry Kasparov. Using economic analysis, mathematical models and astronomical charts, they question the prevailing historical timelines. They have found many apparent discrepancies and duplications. If all the apparent duplications really are duplicates of history, then we are not in the year 2008; we are in fact in the year 980. In other words we haven’t even reached the first millennium, let alone the second. If even half are real duplications then we are somewhere in the fifteenth century. Needless to say, mainstream historians are appalled by the assertions of these “revisionist” historians and refuse to acknowledge, let alone research these apparent errors.

          The good news is we won’t have to worry about the world ending with the end of the Mayan calendar in four years in December of 2012 because that won’t happen for at least another 500 years or more.

            Pardon, this lengthy introduction but, the point I am trying to make is how can we learn from history if we don’t even know what the hell year it is? How can we learn from history if we aren’t willing to admit our mistakes? Insanity is doing the same thing over and over and expecting a different result.

            The Great Depression of the 1930’s was so long ago that most people who were old enough to have learned its lessons are either long dead, or long retired, or out of power, or voices in the wilderness that no one is listening to. The history of the Great Depression is written from a Keynesian viewpoint. Just as history is based on guesswork, flawed judgment and personal bias, so too are our economic models and theories based on political bias and flawed perceptions. Those in power today still cling to Keynesian economic models of the past that require governments to spend their way out of trouble and throw money at a problem until it goes away. The U.S. Fed’s Ben Bernanke has studied the Great Depression and, like many other Keynesian economists, he concludes that the government in the 1930’s failed to provide enough liquidity and thus exacerbated the Depression. Like an Army General, he keeps trying to fight today’s war with yesterday’s tactics.

            The Wall Street bailout (that’s what it is – don’t let the spin doctors tell you it’ll help the average American) was finally passed by the U.S. Congress on Friday. It is the latest (but, not the last) attempt to give more money away to solve the “liquidity crisis” which has frozen the banking system. Banks no longer lend to one another because they don’t want to be left holding garbage collateral when the other bank goes broke. However, the problem is not a lack of liquidity of financial institutions as it was during the Great Depression. The problem is insolvency. They hold more garbage securities than the banks are worth. They’re broke. They’re bankrupt and $700 billion is a drop in the bucket, a fart in a hurricane. $700 billion plus a lot of pork for a total of $850 billion represents about 1/10 of 1% of the garbage derivatives held by American financial institutions. 

            There are two ways to remove a bandage: fast and painful, or slow and painful. Politicians, mindful of re-election, usually choose slow and painful. The exception: Sweden, in 1990, took a page from the Austrian School of Economics and let the marketplace have its way with defunct banks. The bandage was removed fast. It resulted in some bank failures followed by a mild recession and a swift recovery. Japan, in the same year, decided to remove the bandage slowly and allowed financial institutions to keep their garbage securities on their books at full value and slowly write them off. That was 18 years ago and Japan is still in recession. Their “lost decade” is turning into a lost generation. American politicians are following the Japanese model. America, however, will not have a long recession like the Japanese but, a long and deep depression. America, in proportion to Japan, is going into the downturn in far worse shape than Japan in 1990. For a while, it was hoped that Europe and the BRIC economies (Brazil, Russia, India & China) had “decoupled” from the American economy, however that hope has been dashed. America, being the world’s largest economy, is dragging the rest of the world down with it.

            The financial meltdown has spread to Europe. Major European banks are failing at an accelerating pace. The European Union, at a time when unity is critical, is slowly tearing itself apart with “beggar-thy-neighbor” tactics. Ireland, just lit the fuse last week. It announced, to the shock of the rest of Europe, that they are insuring UNLIMITED bank deposits at a time when England raised their insurance from 35,000 to just 50,000 pounds. There is now a “silent bank run” in England. However, retail depositors are not lined up in the streets to remove their money like they did with Northern Rock. Instead, companies and large depositors are quietly, electronically transferring their money from England to Ireland. Other European countries have followed suite and raised their deposit insurance. This, in turn, has now started a silent bank run on U.S. banks.

            The economic slowdown in the U.S. will hit Canadians a lot harder than many people think. Unemployment in Canada is rising and will hit hardest those who are heavily indebted with no savings to tide them over. Credit cards with their high interest rates will become even more of a trap. Banks will be charging more for both new mortgages and renewals. It will also be harder to borrow against home equity as house prices fall. In fact, it will be harder to borrow at all, even for those with good credit ratings. Those who do have savings accounts will get less interest and investors will see stock prices falling into a long term bear market. About the only good news is lower gas and home heating oil prices as crude oil prices fall over the next year. Enjoy this while you can before inflation kicks in and sends prices higher again. 

            Many Canadians I’ve talked to believed (hoped?) Canada would be spared from financial carnage. “After all,” they said, “Canada is a resource based country and the world needs our resources.” That was true until last week when commodity prices took a dive. For example, the price of corn is falling and corn requires a lot of fertilizer so farmers will switch to soybeans which need less fertilizer. Potash One, once the darling of the TSX stock exchange when it reached a high of $240 a share, dropped below $100. Unless metal prices turn around, expect mines to close rather than operate at a loss. Another bubble bursts; commodities. In fairness, part of the drop is a result of hedge funds bailing out of commodities because investors in hedge funds are bailing out of hedge funds. These are called redemptions. You’ll hear a lot more about these in future.

          Bubble thinking has become ingrained in our culture since the dot com bubble almost 20 years ago. It was caused by Keynesian economics of easy money; the same Keynesian tactics that governments are still using. Remember, insanity is doing the same thing over and over and expecting a different result. We still haven’t learned from our mistakes. We keep repeating them. We are led by insane politicians and insane economic leaders. After the dot bomb bubble burst, U.S. Fed chairman Greenspan lowered interest rates to provide more easy money which created the housing bubble. Now that the housing bubble has burst, the U.S. Fed is throwing more easy money into the economy. Although assets are falling in value (housing, equities, commodities, etc.) which would normally be deflationary, the amount of money the U.S. Fed is spending greatly outweighs this and will ultimately be inflationary.

          Not only has Canada’s commodity bubble burst, but our housing bubble is about to burst. Canadian real estate prices have risen an average of 76% since the beginning of the decade (130% in the West.) In Vancouver at the beginning of the decade, the cost of home ownership took 45% of household income; today it’s 79%. House prices in Canada are starting to fall. They’re down 7% since June. This is only the beginning.

          We like to think we’ll be spared the pain that Americans are experiencing. It’s true that 30% of American mortgages issued in the last 3 years were sub-prime compared to only 5% of Canadian mortgages. However, in 2004, CMHC allowed Canadians to take out mortgages with no money down. Furthermore, the amortization period was extended from 25 to 40 years (recently reduced to 35) and ¾ of all mortgages in the last 3 years were at the longer term. As the credit crunch hits Canada, there’s no guarantee that long amortization periods will still be available when it comes time to renew those 3 and 5 year mortgages. This means monthly payments skyrocket. This means increased foreclosures which will add to the oversupply of housing and driving house prices down further. Once inflation kicks in and the government starts fighting it with higher interest rates we could be faced with 1980’s style 18% mortgages which will further increase house sales and foreclosures and drive down house prices even further. Clever Canadians, we’ve created our own sub-prime time bomb.

         Canadians have also relied heavily on housing to finance their lifestyles with more than $150 billion borrowed against their home equity to pay for renovations, vacations, flat screen TVs and second properties. Ever wonder how your neighbors managed to buy a new house, new car, new this and new that all at once? It’s because they’re probably mortgaged to the hilt. Hint: don’t try to keep up with the Joneses; they’re broke. Also, more than 7% of Canada’s workforce is in the construction sector and the major part of that is housing. As the real estate market winds down, construction workers will be laid off and unable to maintain their mortgage payments, they’ll be forced to sell or go into foreclosure which again depresses house prices and the spiral continues downwards. In addition, there’s a speculative element in Canadian housing that’s hard to pin down with actual numbers. People borrow on their homes to buy another, then rinse and repeat using rent to offset mortgage payments which works well when prices are going up. However, this leverage is deadly when prices begin falling, credit tightens and banks become reluctant to renew mortgages especially when equity exceeds market value. Again, more houses will be put up for sale which adds to the downward spiral.

          If you’re thinking about buying a house then wait for prices to come down. Save your money for a larger down payment (banks in future will demand it.) Then lock in the longest mortgage that you can to ride out the increase in interest rates as governments raise rates to fight inflation.

          Whence gold and the junior stocks? Well, if I had a crystal ball, I’d buy lottery tickets wouldn’t I? Paul Van Eeden, earlier this year sold most of his portfolio saying gold was in bubble territory and he was right as gold, having topped $1,000, fell below $800. As I mentioned in a previous article, he calculated, given the actual monetary (not price) inflation rate of 16% as per John Williams WWW.shadowstats.com that gold should be worth $760 at the beginning of 2008 and $880 by year end. Granted, we’ve seen a lot of volatility this year and I expect that to continue. Gold prices could increase drastically as governments open the easy-money spigots as we’ve seen these past two weeks. The only other safe investment (until we slide off the edge into a full blown depression in which case you want to be out of the stock market altogether) is food stocks according to Don Coxe, BMO Financial Strategist. Monsanto and Mosaic are U.S. stocks so you’d have to be nimble as the U.S. dollar tanks but Potash One and Agrium should be safe bets long term now that they’ve been totally trashed last week. I bailed out of Agrium with a small loss (Whew!) and piled back into Potash One after it dropped below $100 this past week and I hope to hold it long term or at least a month (there is no long term anymore.)  Oh, another thing for those of you in juniors – be prepared for some heavy year end tax loss selling come December so either bail out and pick up bargains or be prepared for a gut-wrenching drop if you’re hanging on for the long term.

          Now that the U.S. Congress has passed the Troubled Asset Relief Program (TARP) also known as “the Bailout” and what I call a pay-off to Hank Paulson’s Wall Street buddies in return for their greed and stupidity …. has it saved the world? In one word: NO! The stock market briefly rallied on Friday after it was passed and then turned back down before the end of the day. Neither investors nor the average American is as stupid as the financial and political elite think they are (as Congressmen will discover during the election next month.) Investors took one look at the billions of dollars of pork that Congress skimmed off the package (now increased to $850 billion) and realized how out of touch the politicians are to the financial crisis that is spiraling out of control. Even John Mauldin (see my article last week) the perennial optimist and mainline stooge has admitted in his newsletter today ; “The “Bailout Plan” was passed. Will it work? The answer depends on what your definition of “work” is. If by work you mean no more government intervention and no further costly programs and a functioning market, then the answer is no.” D’ya think maybe he’s setting up the U.S. taxpayer for the next theft, I mean, bailout? As I’ve said several times; this is an election year and the U.S. government has NEVER applied tough financial medicine in an election year. That makes this the “Perfect Financial Storm” because by the time the government DOES apply the tough medicine it will be too late (it already is) as conditions have already spun out of control.

          No one is sure what the bailout will do for the wide TED spread – this is the difference between interest rates for 3-month U.S. Treasuries and 3-month Eurodollar – Treasury Euro Dollar (TED) – and a high spread is a measure of financial fear. Also, the LIBOR (London InterBank Offered Rate) – the benchmark interest rate at which banks lend to one another is typically a fraction of a percent over the central bank rate. Now rates are 3% higher; a sign of tremendous fear. It is doubtful that the bailout will affect either of these rates. However, buried within the details of the bailout is a provision allowing the U.S Federal Reserve to pay interest thereby giving the Fed the ability to expand its balance sheet indefinitely without driving interest rates down to zero. You won’t hear about this in the mainstream media. Also, you can bet there’s a lot of frantic activity going on behind closed doors. Time will tell what to make of the Fed’s new power. Oh, and you can bet it will be highly inflationary. Whatever they do, they have to bring these rates down this week or all hell breaks loose.

          What about Warren Buffett sinking $5 billion into Goldman Sacs …. didn’t that save the world? Sorry, Sunshine, but that’s another fart in a hurricane. Incidentally he also sunk another $5 big ones into GE. Buffett didn’t get rich by giving his money away to charity (although he’s trying awfully hard to do that now.) He got rich by being a shrewd vulture. He demanded and got “special preferred shares” i.e. he’s guaranteed now matter what happens PLUS he earns a handsome 10% a year so after about 6 years he’s doubled his money.

          I’ve been listening to Don Coxe’s weekly broadcast for a long time. He’s older than dirt and has seen it all. However, Friday’s message left me very unsettled. I’ve never heard him so unsure of himself. He had a lot of questions and few answers. I’ve never heard him say “I don’t have the answer to that” so many times in one session. I’m not sure what to make of that but it doesn’t sound good.

          This might be out of the blue (no pun intended) but he again mentioned the lack of sunspot activity. The normal solar cycle typically lasts between 11 and 13 years and ends when sunspots diminish to almost nothing and a new cycle begins as sunspots begin to increase. The new cycle began at the beginning of the year. In the last 9 months there has been only one brief sunspot. Astronomers have been watching sunspots for more than 400 years. There have NEVER been so few sunspots for so long a period of time. Also, NASA says that in 50 years of watching solar activity, they have never seen so little solar wind for so long. No one knows what to make of this. NASA is not drawing any conclusions other than to say the effect will be DRASTIC. Historically, periods of low sunspot activity mean a cold fall and a very cold winter but, no one knows what no activity means. Interestingly, the British economist Jevons (1835 – 1882) presented a statistical study relating business cycles with sunspots. His reasoning was that sunspots affected the weather, which, in turn, affected crops. Crops changes could then be expected to cause economic changes. Low sunspot activity predicted financial crises. So, if you haven’t stocked up on long-term food, now’s the time.

          I’m afraid this week will be another interesting week. Something you haven’t heard in the mainstream media is the Options settlements of the CDSs (credit default swaps) and related counter-party risk of Fannie Mae, Freddie Mac and Lehman Brothers. These settlements are due because all three are technically bankrupt. No one is sure what the outcome will be. It will be the biggest test of derivatives yet and could further freeze or altogether crash the credit markets. We’ll know by the end of the week. Tighten your seat belt.

          Every week, the financial and economic situation gets worse. You will hear a lot more about “deleveraging.” This is financial institutions selling off their assets to repair the damage on their balance sheets caused by crumbling mortgage-related securities. The more assets they sell the more it worsens the balance sheets of other institutions triggering more forced sales in a never-ending downward spiral. We’ve never seen it this bad before. It’s going to get a lot worse. Overall debt is now more than 300% of GDP – higher even than during the Great Depression. If consumers start saving now it will reduce sales even more and the downward spiral accelerates even faster. We are way past the point of no return. To make matters worse, we haven’t even begun to feel the effects yet of failing commercial estate, car loans, corporate debt and student loans. Tighten your seat belt AND put on your crash helmet.

          On the other hand, we’ve been through depressions before. They’re painful but not everyone was out of a job. And, Canada has more safety nets than a lot of other countries and we’re a lot more civilized than much of the world. We’re about to find out how important that is. Also, to help put things in perspective, no one (except me and a few other cranks) will officially use the “D” work. Don’t forget that even during the worst of the Great Depression, it was NOT called a depression; it was called “hard times.” It wasn’t labeled the “Great Depression” until more than a decade later. You need to climb out of a hole to see how deep it is. At this point, we’re still digging.

            Recommendations: same as in previous articles, the fundamentals haven’t changed – get out of debt, keep a month’s worth of cash and at least that much food on hand, buy some gold and/or silver, etc. etc. plus a couple new ones:

–       get along with your family as you may end up moving back in with them or they with you (hey, Sunshine, if you want happy fantasy then you better watch Disney)

–       Also, there are already some great bargains in the U.S. on eBay but, I expect they’ll get a lot cheaper yet.

–       Also, keep a paper record of your bank accounts and/or broker and/or other securities i.e. either have them send you monthly statements or print them daily or weekly online. Databases and networks can get knocked out, frozen, shut down or altered. You need records for claims.

–       Don’t keep valuables in safe deposit boxes. In the past, government security watched while you accessed them and confiscated whatever was the flavor of the month. Also in some States (especially California) they are already opening and confiscating anything that is “inactive” and that could be less than a year. Good luck getting it back.

–       Expect “bank holidays” to prevent runs on banks, first in the U.S. then spreading to Canada. The top five Canadian commercial banks have $800+ billion of credit default swaps on their books, which is several times their entire market capitalization. Posters to be used in the event of bank closures have already been sent to major U.S. banks according to some insiders.

–       Some U.S. major gas stations no longer accept credit or debit cards, so keep cash on hand in case it spreads

–       If you keep valuables at home, don’t use the “hollow book” trick. Robbers know about it.

–       Don’t keep valuables in only one spot. If you’re forced at gun-point to give up valuables you only have to be relieved of part of your stash but you’ll lose everything if you have it in one spot.

– Don’t keep it where service personnel will find it i.e. plumber, electrician, meter reader, etc.  

–       Keep your mouth shut about your valuables such as gold and silver. Don’t tell friends, neighbors, not even your kids.

It’s getting difficult for me to continue these articles on a weekly basis but, so much has been happening so fast lately that it can’t be done less often. These articles take up a lot of my free time. A weekly article like this takes 10 to 12 hours or more to research, write and edit. The longer ones take two or three times as long. I’m doing it because I’ve had some positive feedback and I feel obliged to share the things I’m learning. Eventually, things will spin out of control altogether and there won’t be much more to write about once we hit bottom. I can’t say I’m looking forward to it but, it will be good to be relieved of this self-imposed burden.

Gerold
Oct. 5, 2008

Disclaimer: I’m not an investment advisor and these articles are for commentary only. For specific advice you should consult your own investment professional.

Your comments are WELCOME! Lengthy comments may time-out before you’re finished so consider doing them in a word doc first then copy and paste to “Leave a Reply” below.