Over the Rainbow
John Mauldin's Outside the Box

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Here is a different view on derivates that can help you with a basic understanding of the problem in the market and a look at gold. This comes from the HCM Market Letter by Michael Lewitt of Harch Capital in Florida.

This is a private letter for his clients and Michael is one smart guy with a deep understanding of the markets, especially the credit markets, and how they work. HCM deals in this world on a daily basis, so they can offer a somewhat inside view of derivatives and that is why it was picked for this week's Outside the Box.

- John Mauldin

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Over the Rainbow

By Michael E. Lewitt
The HCM Market Letter
February 24, 2006

Over the Rainbow

"In the twisted gilt playing-room his secret motions clarify for him, some. The odds They played here were never probabilities, but frequencies already observed. It's the past that makes demands here. It whispers, and reaches after, and, sneering disagreeably, gooses its victims.

When They chose numbers, red, black, odd, even, what did They mean by it? What Wheel did They set in motion?"

Thomas Pynchon, Gravity's Rainbow (1973), (Thomas Pynchon, Gravity's Rainbow (New York: Viking Press, 1973), p. 243.)

Thomas Pynchon's great novel was written more than thirty years ago, but it anticipated today's world in the way that only great works of art are capable of doing. The confusion, paranoia and hidden codes and patterns in which Pynchon describes the Second World War sound eerily like today's financial markets: "Yet who can presume to say what the War wants, so vast and aloof is it...so absentee. Perhaps the War isn't even an awareness-not a life at all, really. There may only be some cruel, accidental resemblance to life." (152) In particular, Pynchon evokes the shadowy world of derivatives that increasingly drives valuations and trading in the cash markets.

As the financial markets increasingly move into the realm of computer models and derivative instruments, the ramifications for the global economy and the lives we lead are only beginning to be understood. Increasing amounts of the world's wealth are being traded indirectly rather than directly, which raises questions that governments, regulators and investors are only beginning to address. While governments still debate free trade in physical goods, the volume of intangible goods being traded without restraint grows at an exponential rate. The question HCM would like to ask is this: who is keeping track of all of the marbles? Who knows where the risks in the systems reside? Does anybody really know what the heck is going on? We will surprise none of our readers by offering the strongly held opinion that the answer is that nobody is keeping track and nobody knows what's going on.

In the December issue of this newsletter, HCM argued that it is useful to think about the explosion of the credit derivatives market as a phenomenon similar to what occurred when the Bretton Woods international monetary system collapsed. In both instances, self-adjustment mechanisms were removed from the economic system that had kept monetary and credit growth in check. In the wake of the elimination of the Bretton Woods system, government budget deficits and current account deficits increased dramatically. The advent of credit derivatives freed speculators from the constraints of the cash bond market, and enabled them to place bets on individual credits regardless of the amount of debt actually outstanding. Freed of those constraints, credit creation was able to grow without restraint. In HCM's view, the credit derivatives market has been a major enabler of the current credit bubble. In the aftermath of the leveraged buyout boom of the 1980s and the CDO boom of the 1990s, offering credit derivatives to hedge funds was like offering alcoholics a nightcap. These instruments have contributed to the creation of credit unrestrained by the necessity of having actual underlying debts to speculate upon. Today, an investor can be a shadow lender (i.e. a speculator) on the debt of a company even if one-hundred-percent of the company's debt is already spoken for by other lenders. A contract can be written that simply refers to that debt, and an entire parallel universe of obligations is created that mirrors what happens in the so-called real world. The latest iteration is Morgan Stanley's introduction of credit derivatives on individual bank loans, which will open a whole new dimension to the syndicated bank loan market.

Without any constraints placed upon it, the parallel universe of credit derivatives has grown to be much larger than the physical universe of bonds on which it is based. As Pynchon might put it, these instruments are not credits themselves, but bear only some cruel, accidental resemblance to credits. HCM has already witnessed that the balance of economic gravity, in what used to be the less-than-investment grade bond market but is now better understood more broadly as the less-than-investment-grade credit markets, has shifted to the larger and more liquid credit derivatives market. The pricing (and therefore current trading value -- to the extent they trade) of junk bonds is heavily influenced by spreads established in the CDS market, which in turn is influenced by arbitrage strategies executed there.

In 2005, the credit markets had to deal for the first time with several large "real world" defaults of companies whose credits were active topics of speculation in the credit derivatives markets: Collins & Aikman, Delphi Automotive, and Calpine Corp. None of these bankruptcies caused a market blow-up. In the case of Delphi Automotive, the outstanding credit derivatives contracts were reportedly (the numbers are never precise in this arena, which is one of the surest signs that something is amiss) ten to fifteen times the volume of the actual outstanding cash bonds. Since there was obviously no way to deliver a sufficient number of cash bonds to close out the outstanding amount of derivatives contracts (such an amount of cash bonds did not exist!), an auction was held and a cash settlement mechanism was established. (In the case of Delphi, before the auction the cash bonds traded up to a price of about 70 as investors bid them up in (well-founded) fear of a shortage. The bonds have since traded down to the 50s.) This has been viewed as an important (and positive, if you listen to Wall Street's propaganda officers) development in the derivatives market because it removed one of the bugaboos that were often raised by worrywarts like HCM, who were worried about how these contracts were going to be settled in the event of a large default.

But can things really be this easy? Can the markets willy-nilly write these derivatives contracts in whatever volume they choose and then simply close them out in cash without any adverse consequences? In The King Report (February 14, 2006), Bill King argued that the cash settlement device is a bad idea: "This would not only [be] absurd but [be] further evidence that US solons see the 'new economy' as rank, egregious speculation in financial instruments. Physical settlement acts as a regulator and moderates speculation. Many derivatives are already a multiple of the risk that they are supposed to mitigate. Cash settlement insures that risk will increase by some factor AND those derivative holders with either the most cash or stones will force the settlement to occur on terms that are beneficial to them but artificial to the market." In other words, the cash settlement solution seems to reduce systemic risk by solving the settlement problem in large default situations. But by removing that risk, it introduces a further element of moral hazard into the system by encouraging market participants to believe that the system is foolproof (or near foolproof, i.e., it hasn't met a problem -- yet -- that it can't solve). This just leads to higher and higher volumes of speculation until the system encourages the creation of a problem it can't handle (General Motors?) and then all bets are off.

It seems to HCM that if discipline is going to be brought to this market, it will have to come from the Prime Brokers or the regulators. Expecting hedge funds and other market participants to police themselves would be like putting Saddam Hussein in charge of the United Nations weapons inspections program for Iran.

General Motors

Perhaps the inevitable General Motors bankruptcy will be the straw that breaks the camel's back. (Accounts managed by Harch Capital Management, Inc. are short both General Motors stock and bonds.) On February 16, 2006, The Wall Street Journal ran an article entitled "GM Debt Poses Challenge to Derivatives Market." "The car maker has about $30 billion in debt. Traders estimate more than $200 billion in credit derivatives are linked to GM. But because such derivatives don't trade on an exchange, nobody knows for certain how much credit default swap protection has actually been written on GM. And nobody can say with confidence that they even know who is on the other side of the trades that they have entered into. Such uncertainty is one reason that, since last year, regulators have asked participants in the fast-growing market to get their operational act together. That encompasses everything from dealing with a backlog of unconfirmed trades to figuring out who their counterparties are when one side transfers contracts to another party...Four years ago, the derivatives market was a fraction of the size of the underlying corporate bond market. Today, it is estimated at $12.5 trillion, more than twice the underlying market's size, and it continues to expand rapidly."

Bill King's view? "The Street better hurry and finalize an agreement to settle GM CDS for cash. If the derivatives market exacerbates a possible GM bankruptcy by some multiple, the numbskulls up on Capital Hill will be forced to act. And those numbskulls will act indignant and assert that they were unaware or misled. And they will look to demonize somebody because the system[ic] problems caused by derivatives could be a multiple of the problem caused by a GM bankruptcy." (The King Report, February 23, 2006) The wise men in Congress may squawk all they want, but they will not be able to say with any credibility that they weren't warned about a GM bankruptcy. Moreover, they may try to point the finger at others, but the policy failures that will have been partially responsible for this sad ending must be laid right at their doors: failed energy policies; failed pension and healthcare policies; failed industrial policies.

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And sure enough, another warning was sounded on February 21, 2006, when Moody's Investors Service dropped GM's credit ratings another notch further into junk territory and expressed concern about GMAC's stand-alone rating. Joining Standard & Poors, which had already used the "B" word, Moody's warned that GM could face bankruptcy if it is unable to reduce its costs. "The downgrade reflects increased uncertainty that the company will be able to achieve all of the steps necessary to establish a competitive wage, benefit and supplier cost structure outside of bankruptcy...Moody's remains concerned that in the absence of material progress in reducing its UAW-related cost burden through negotiations, GM could resort to bankruptcy as an option to reduce this burden." GM should heed Moody's warning, and do it sooner rather than later. The unions are going to play this situation out as long as they can, and in the end the result is going to be the same -- the "B" word.

Moody's warning was hardly surprising. A little more unexpected, perhaps, was what the rating agency had to say about GMAC. In a separate statement, Moody's said that the finance company's stand-alone credit rating had weakened from the investment grade level to the mid-Ba level -- a less-than-investment-grade rating. As our readers undoubtedly know, GM has been trying to sell GMAC for many moons, and a transaction announcement has been imminent for so long that it has given the word "imminent" a bad name. The import of Moody's statement, however, was that its analysis of a post transaction, stand-alone GMAC would begin at the lessthan- investment grade level, which could pose a serious obstacle to a transaction that was initially designed to preserve GMAC's investment grade rating and protect the finance arm's rating from GM's deteriorating auto manufacturing business. As one Moody's analyst put it: "The longer the process takes, the more evident it seems that the deal challenges come to the fore." That's another way of saying that when it rains, it pours. In the days after this announcement, GMAC's bonds traded down to a four-month low as investors grew increasingly concerned that a sale of the unit would not restore its investment grade rating.

In the February 20, 2006 edition of Fortune ("The Tragedy of General Motors"), reporter Carol J. Loomis suggests that a GM bankruptcy will be a major event for the U.S. economy and, more importantly, for the U.S. psyche:
"It is the instinctive wish of most American businesspeople, even those unlikely to be directly affected, that General Motors not go bankruptcy. True, some people will say, 'They had it coming to them.' But the majority will be more practical, telling themselves that the company is so central to the economy, so sprawling in its commercial reach, that bankruptcy -- 'going into chapter,' as restructuring folks say -- is ominous almost beyond contemplation. And yet the evidence points, with increasing certitude, to bankruptcy....Bankruptcy isn't going to occur next week. But down the road -- say, past 2006 -- its probability is high."
A GM bankruptcy, which HCM views as inevitable (with Ford soon to follow), will be such a monumental psychological event because it will toll the death knell of the American industrial model. No longer will politicians and business leaders be able to defend a system that includes prohibitively expensive legacy costs (healthcare, pensions), uncompetitive union demands (i.e. work rules, uneconomic wage and benefit packages), and a dysfunctional tort system. It is obvious to a child of elementary school age that the system is broken; it is a true American tragedy that it is going to take the bankruptcy of an American business icon to force the point home. And even then, in today's political and economic system, there is no guarantee that anything more than a band-aid will be applied to the problem while America's industrial system is allowed to slide further into the abyss.

Typical of the "stick your head in the sand approach" approach to the problem is a recent article by Forbes writer Jerry Flint. In a column called "Bankruptcy, Shmankruptcy" (February 13, 2006), Mr. Flint writes: "Enough already on General Motors and bankruptcy. I am tired of the B-word. GM isn't going bankrupt this year. GM isn't going bankruptcy next year; 2008 is so far off that even Bill Gates could be bankrupt by then. It's dangerous to go three years out, but no. I wouldn't expect GM to go bankrupt in 2008, either." Mr. Flint's reasoning is, unfortunately, non-existent. He points to a turnaround at Chevrolet last year -- he reports that it outsold Ford last year. That's like saying that the second-to-last-place team beat the last place team. He points to the $19 billion of cash that the company has on its balance sheet, but he forgets to look at the left side of the balance sheet, where hundreds of billions of dollars of liabilities reside. Finally, he resorts to patriotism: "I've written this before and I'll write it once more. The graveyards, and the ocean bottoms, too, are full of men who underestimated American courage and determinism." HCM is as patriotic as the next guy, but it's going to take more than patriotism to save GM. It's also going to take more than $19 billion, especially when the company is losing billions of dollars a year. HCM is certain that Mr. Flint has the ability to remain optimistic far longer than our readers have the ability to remain solvent if they follow his advice.


Even tangible signs of wealth are being repackaged into financial instruments. The Financial Times wrote on February 13, 2005 that, "Ideanvestors in gold-backed tracker funds now own about $18bn worth of bullion -- more than the Bank of England and many other central banks. The gold tracker funds have tripled their holdings of the precious metal to 429 tonnes of gold since the start of November and have become one of the top dozen holders of gold in the world." The following chart shows the rise in the price of gold since the streetTRACKS Gold Trust (GLD) was introduced to the U.S. stock markets on November 18, 2004. (4 Each share represents one-tenth of an ounce of gold (less the trust's expenses of approximately 0.4 percent annually). In the interest of full disclosure, the author owns GLD personally or in trusts over which he has investment authority. Readers should note that there are other similar vehicles such as the iShares Comex Gold Trust (IAU) in the U.S. and others on foreign markets as well.)

GLD has become the easiest way for investors to speculate on the price of gold without physically owning the metal. HCM would argue that it is hardly a coincidence that the price of gold has risen in the wake of the issuance of GLD shares. The Financial Times points out in the same article: "The surge in gold prices to $574.50 a troy ounce, the highest level since 1981, has been partly fuelled by investors buying into the gold-backed funds. They are a relatively new investment...that has made it easier for more investors to buy gold." By making it easier to invest in or speculate on the price of gold, these instruments have attracted and will continue to attract more money to this asset. Not only individual investors, but also institutions such as pension and mutual funds and hedge funds are investing in these instruments. While the price of GLD is limited to the price of one-tenth of an ounce of gold, HCM has to wonder what will happen to the price of the "underlying," as traders like to say, if GLD continues to attract mountains of money.

While gold has traditionally been considered an inflation hedge, it has risen in value during a period when inflation pressures have been muted. HCM continues to believe that deflation poses a greater threat than inflation. The forces of globalization that are keeping wage and benefit costs in check continue to overwhelm inflationary pressures caused by higher energy prices and lax U.S. monetary policy. Recent inflation data has remains benign despite some troubling headline numbers. Core PPI (excluding food and energy) rose only 1.5% year-over-year in January, the slowest increase since July 2004. While the headline numbers have been higher and may cause the Federal Reserve to overshoot in its current tightening efforts, core inflation remains very manageable, as shown in the chart below (borrowed from Christopher Wood's GREED & fear report).

So if inflation is under control, why has gold increased so dramatically in price? As our friend Christopher Wood has written, gold is the antidote for a world in which the U.S. dollar is being debased every day by fiscal and monetary policies that are gutting the United States' manufacturing base. Gold is the anti-Google, the anti-credit derivative, the anti-hedge fund credit arbitrage trade, the anti-LBO. Gold is what will be left when everything else blows up. That is why some of the smartest and most original market observers on the scene today like Christopher Wood and Marc Faber suggest that gold could reach a multiple of its current value (Mr. Wood has used a target price of $3600 per ounce).

In the most recent issue of The Gloom, Boom & Doom Report (February 3, 2006), Dr. Faber included a fascinating chart (shown immediately above) of the Dow/Gold Ratio from 1900-2004. As the chart shows, with the Dow trading at above 11,000 and gold hovering at $550 per ounce, we happen to be in a period where both tangible and intangible assets are trading at relatively high levels. The Dow/Gold Ratio has been much lower -- i.e. stocks (intangibles) have traded low while tangibles (gold) have traded high -- at many times in the past, while there have been few times when the Dow/Gold Ratio has been higher than it is today (really only the last five years). In other words, only in the last five years have stocks traded high with gold also trading at a reasonably high level. This is, to say the least, unusual, and is another illustration of the fact that many economic and market relationships are not behaving in traditional ways. Another example of this has been the 10-year Treasury bond, whose yield today is lower than it was when the Federal Reserve started raising interest rates over 300 basis points ago. The point is that there are forces at work in the economy that are distorting traditional price movements and relationships between asset classes. This is creating a lot of opportunity, as well as a lot of risk, if one believes, as HCM does, that relationships will return to the mean or at least in the direction of the mean. The Dow/Gold Ratio is one of those relationships that doesn't necessarily come to mind when investors wake up in the morning, but it is one worth thinking about from time to time as a useful comparison of investors' views of tangible value on one hand and intangible value on the other.

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I trust you enjoyed this edition of Outside the Box and I should note that my firm and affiliates do not do any business with Harch Capital.

Your driving a GM vehicle analyst,

John F. Mauldin


John Mauldin is president of Millennium Wave Advisors, LLC, a registered investment advisor. All material presented herein is believed to be reliable but we cannot attest to its accuracy. Investment recommendations may change and readers are urged to check with their investment counselors before making any investment decisions.

Opinions expressed in these reports may change without prior notice. John Mauldin and/or the staffs at Millennium Wave Advisors, LLC and InvestorsInsight Publishing, Inc. (InvestorsInsight) may or may not have investments in any funds, programs or companies cited above.


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Posted 02-27-2006 9:54 PM by John Mauldin