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dwot (99.56)

Dominos of Debt

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January 12, 2008 – Comments (8)

Somewhere I read a story about where “the short end of the stick” came from and it was a story about debt.  Some British King borrowed the gold of wealthy people and gave them a stick with a notch representing how much they were owed.  The economy was good as the King spent the money on whatever.  But, the King spent all the gold and had no way to pay it back leaving the wealthy merchants holding the short end of the stick.

True story or not, it does not matter, but what does matter is that unmanaged debt constantly plays a roll in the destruction of economies.  Mexico had huge currency devaluation in the 80s due to debt.  Zimbabwe has no economy left due to debt.  I would argue the things that have happened in Zimbabwe that made it worse were a natural response due to the increasing discrepancy of wealth due to debt and lack of opportunity.  When the divide becomes too great, anarchy takes over. 

When I looked in the African economy and their debt, well, the financial geniuses of the UN pushed all poor countries with debt towards agriculture.  It caused a glut in the market.  I am working from memory here, but the Africa numbers showed that their productivity improved enormously, like maybe double or triple, but 20 years later they were getting only about 30c on the dollar compared to the price when the UN enslaved them to these activities.  They worked harder, and they worked harder, and they worked harder, and they could not meet their debt obligations and their Nemesis UN saviour snapped their whip and directed them to grow and harvest more, further to their detriment in terms of working further down the supply and demand chain.  My read of it shows that they feel there was some kind on conspiracy against them; however, I think it was failure to consider supply and demand economics in the plan and basically have no contingency to deal with that.

But, it was debt that left them to the mercy of ignorant plans.

The US is in bad shape debt wise and I don’t think people appreciate the degree to which this changes the financial landscape going forward compared to people’s experience of how these things worked in the past.

The US has enormous debt per person, to the point that Moody threatening to cut the US’s AAA rating is probably overdue, especially in the light of the fantasy that the US has about 10 years to turn this around.  The US debt is critical.  I doubt very much that economic forecasters are factoring in the premium that the US has enjoyed on its currency and how much for nothing that premium has given the US.

But, Moody's has certainly been proven to be incompetent in rating debt.  Consider MBIA's AAA rating.  A true AAA company demands the best rates for borrowing.  MBIA is having to pay 14% to attract new capital.  Having to pay14% is not a AAA company, but a completely junk level company.  MBIA is but one of the financial issurers that people have used as a hedge against investments, investments that probably ought not have been considered.

I never followed the markets for the 1987 crash, but I have read about something called "portfolio insurance" which lead to the same kind of garbage investment strategies that these mortgage insurers have encouraged.

I have previously posted that I am 100% out of the market and it has to do with not trusting the $681 trillion dollars of these derivative things that I do not understand, but I don't need to understand them to appreciate that even 1/10th of 1% is a $681 billion dollar mistake and 1% is $6.8 trillion dollars.  It is a fantasy to not expect mistakes that we will all pay for and my investment strategy is to do my best to position myself to take the least hit from the greed and arrogance of these idiots.  Being in the market seems like a good strategy to be in the wake of the fallout, whatever that might be.

Well, all of these losses that are hitting the news appear to be from the $1.35  trillion dollar CDO market.  I could be wrong.  Well, eeek, the credit default swaps (CDS) market is $45 trillion...

The market is proving that these made up things are not all that secure and these things are used to hedge risk.  If you are doing something that you feel you need to hedge risk, well, if that hedge disappears, and these CDS things are fragile enough to disappear, just what will you do next?  I don't want to be around for that tsunami, nor do I want to be in the wake.

The more I look, also, the more I see that real estate bubbles are far more tramatic for the economy than other bubbles.  The graph titled "Credit Crazy" in this post shows credit market debt versus the GDP.  You can see what happened with the real estate bubble of the 1920s as well as the rapid rise of debt thanks to bubbleman Greenspan.

Combine the real estate bubble with the grossly increased dependence on foreign debt, well, we are back to the debt problem.  I was looking at Thailand's 1997 crash which made it drop 75% during the year.  Somewhere I read they also had a real estate bubble.

Anyway, things look very bad to me.  And CR has a very good post about the quality of the consumer debt.

8 Comments – Post Your Own

#1) On January 12, 2008 at 1:55 PM, Hezakiah (91.56) wrote:

I greatly enjoy your market commentary dwot!  I remember a while back when Jones Soda was trading at $20+ and you blasted the company's high valuation as completely unjustified.  You certainly hit that one on the head.  And now it seems like you have given a similar prognosis to Goldcorp.  I am curious to see how this one plays out since it seems that you expect GG to produce some shockingly bad financial numbers over the next few quarters; however, as someone else mentioned, this will likely be in the face of what looks to be a huge influx of capitol into gold and gold stocks.

Are you sitting the market out because of risk aversion?  You seem intensely, but also rationally, bearish on the outlook of the U.S. economy/stock market.  Yet that does not mean there is no money to be made.  Why do you not look to profit off of your research by shorting (or buying puts) on some of the especially potent B.S. you come across (JSDA, GG, ...)?  I understand that playing it safe might be the smarter decision given your financial situation, but it has got to be tempting.

I also would recommend that in the future you start submitting some of your more refined blog entries to Seeking Alpha.  While this might not carry any tangible benefits for you, the blog is widely followed and I am confident that your work would gather a substantial following there, as it has here on CAPS.

 

Thanks for you insightful comments, and good luck to you. 

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#2) On January 12, 2008 at 5:33 PM, MakeItSeven (35.31) wrote:

People have been talking about the housing ATM and its illusory wealth effect in recent years.  Ten years from now, when the US debt rating gets downgraded from AAA, its interest payment approaches a trillion a year due to both higher debt and higher interest rate, and the country is on the brink of collapse just like all the subprime home borrowers we're deriding right now, then a new term will be "the United States  ATM" and its citizens are responsible in selling out the country to get the tax cuts to buy their favorite trinkets. 

The excuse from these people is that they don't want to pay for government wastes, or for all the welfare programs to support the lazy people.  That's the biggest lie believed by the largest number of people.  If you go to the Congressional Budget Office
and look at the welfare spendings for  Food Stamps, Family Support, and Child Nutrition then altogether they cost just a little over one third of the interest payment on the national debt incurred by George W Bush alone; or 1/8th of the defense budget (the bloated and biggest waste which they do support).   It's like standing and watching your house burned down without doing anything because you claim there are a few cock roaches in the house.  Their logics is simply unreal.

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#3) On January 12, 2008 at 9:03 PM, anchak (99.87) wrote:

I am not so bearish ...but the issue of debt has been really troubling me....long term it means some real tough times for the US....if you think about it.....you need an asset valuation spike to pay down carried debt - US did just the opposite of that in the Housing boom - it has definitely brought the world economy to great heights - but most of this is held is long forwards....maturity matters...so question is there optionality ie all people( creditor nations) coming calling at the same time.....if that happens the outcome is foregone. Its the same with portfolio/mortgage/default insurance. There are lot of good , smart people who work in these organizations - and they all know that insurance is all about VaR , however no-one prices at VaR - that would be taking all risk(practical) out of the equation - so you price at the mean or something a little higher - but then market forces take over - times are good everybody is willing to discount risk - now nobody will touch it....I am thinking risk is almost binary - based on environment , its either at marginal discount to median or right up there with VaR levels. Smooth continuity never surfaces - which makes it so difficult to price.

Anyway, my personal hope is the feedback loop with global companies in the US - essentially if the machine is continuous and complete - hopefully surplus from one part will flow thru to make up for deficit in the other - and remember , great thing with leverage ,all it requires is a trickle to carry it forward almost perpetually, till some geo-political shock breaks the loop and then the payment calls happen.

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#4) On January 12, 2008 at 11:01 PM, MakeItSeven (35.31) wrote:

Anchak,

It's not about whether creditor nations asking for their principals back, it's about the US inability to make the interest-only payments. 

David Walker, the US Comptroller and head of the GAO, predicts that in 30 years the US government budget will not be able to pay for the interests on the debt, SS, and Medicare, just those three items alone.   Of course, the whole "United States ATM" system will collapse long before that.

And more and more of the money resulted in economic activities in the US will be siphoned off into other countries right now (as in the Citibank and Merrill Lynch deals) instead of being recirculated within the domestic economy so it will only get worse.

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#5) On January 12, 2008 at 11:29 PM, anchak (99.87) wrote:

MakeitSeven ....I do not necessarily disagree ...however, I/O debt servicing is still some what of an planable event ....the internal ones also I guess can be modeled ( SS, Healthcare based on current trends).....My concern is a reset ( same underlying principles as we see in ARMs) due to rights of soverign creditors able to call....I am not sure.

Your point is right about the value repatriation due to off-shore investments - question is how much will the US global giants be able to do that in the consumer arena in these nations also - that is the balancing piece - balance is key - otherwise the applecart has to topple eventually.

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#6) On January 13, 2008 at 1:01 AM, MakeItSeven (35.31) wrote:

Question is how much will the US global giants be able to do that in the consumer arena in these nations also

How does that factor in the fact that the US government will essentially go bankrupt soon ?   I'm not worrying about the corporates or the top 1% in this country, I'm talking about the fate of the country itself,  exactly because of the "US global giants" and the super-rich refuse to pay their dues.   Can we knock on their doors and ask them to contribute a few trillion dollars when the country collapses ? 

As for the taxes these global giants will bring back by repatriation, the American Jobs Creation Act of 2004 had already borrowed against the future to get more tax revenue (by providing a window to reduce the tax rate from 35 percent to 5.25 percent).  Even that artificial boost did not help improve the budget deficit picture for the year it was enacted and hundred of billions of dollars were repatriated.

As for the interest payments as plannable events, according to David Walker, the only plan we have is for the train to plunge off the cliff:

David Walker is a prudent man and a highly respected public official. As comptroller general of the United States he runs he Government Accountability Office, the GAO, which audits the government's books and serves as the investigative arm of the U.S. Congress. He has more than 3,000 employees, a budget of a half a billion dollars, and a message he considers urgent.

"I'm going to show you some numbers…they’re all big and they’re all bad," he says.

...

"What’s going on right now is we’re spending more money than we make…we’re charging it to credit card…and expecting our grandchildren to pay for it. And that’s absolutely outrageous," 

 ..

What would happen in 2040 if nothing changes?

"If nothing changes, the federal government's not gonna be able to do much more than pay interest on the mounting debt and some entitlement benefits. It won't have money left for anything else – national defense, homeland security, education, you name it," Walker warns.

Walker says you could eliminate all waste and fraud and the entire Pentagon budget and the long-range financial problem still wouldn't go away, in what's shaping up as an actuarial nightmare.

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#7) On January 13, 2008 at 1:26 AM, dwot (99.56) wrote:

Hezakiah, the financials have already been bad, half of what was expected, which is about where I projected it.  The analyst wasn't even close.  And if you read the report, he values it at 2x NAV to come up with the $36 target.  NAV is what it is expected to earn over its life.  Why would you double the fair value you calculate for it?  Why would you buy something trading at a premium to fair value?

At this point Goldcorps financial reports should start to improve.  Gold is finally up to a price to absorb the massive share holder dilution so that it might earn about 60-70c/share on existing production.  With increased production, 70-80c.  If you looked 4 quarters before glamis merger Goldcorp's best 4 quarters was $1.21/share.

The Penasquito project is starting soon.  I am just having a look.  In 17 months the feasibility study changed to adding 69% more capitial costs and 72% to the sustaining capital costs to increase the production by 30% per year, but also increase the mine life by 12%.  It actually doesn't look like it will do much for earnings in 2008, 60,000 oz gold, 2 million ounces of silver, maybe $80 million in revenue.  Goldcorp has been borrowing again so that will easily be eaten by the production costs and interest costs.

$1.5 billion in initial capital.  Looks like about $372 million operating costs per year when you calculate it from their cash costs, but when you look at the spread they have it works out to $681 million.  I figured out that the $118/oz that they attribute to the cost of gold production actually included lead cash costs, which is an average of 92 million pounds per year.  The sustaining capital is about $30 million per year.  It looks like about 60-65% of the revenue for this one would come other metals.  The number never seem to "add" up.

The strip ratio average is 2.79.

They were debt-free in 2005.  A company with about 10 operational mines should be able to develop another mine from cash flows, but instead they've added almost a billion in long term debt.

Another point that is interesting is that they project to recover  about 7.1 million ounces of gold yet their reserves have 12.4 million ounces for this project, so that is about 57% recovery of reserves.  When people value these things they tend to do something like: 42 million ounces at $900/oz is $38 billion dollars of gold in the ground.  This one property has about $5 billion of gold in the ground that isn't recoverable.

I haven't looked super closely, but it does look like this property could boost eps by about 30-35c/share in 2009.  The costs they are projecting look low.

I just noticed that last July they sold 25% of the production to Silver Wheaton for $485 million and $3.90/oz -- and debt has increased to about $1 billion from deb-free in 2005.

Goldcorp has just been downgraded by RBC.  They now have 49c eps for 2007 and 85c for 2008.  I think it comes in more like $0.44 to $0.46.

Good analogy MakeItSeven

anchak, the debt should trouble everyone. 

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#8) On January 13, 2008 at 1:49 AM, dwot (99.56) wrote:

I don't think David Walkers models take into consideration the level of household debt and how sluggish that will make the economy, nor does the model work in the dividends and such that will be leaving now beause of the sell-offs.

With so many older people the budget should have an enormous surplus to deal with the social needs.  The government couldn't manage the bills with retirements top light. 

 

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