FSO Storm Watch Update "Hype, Hypocrisy & Hypotheticals" 10/19/2001

Three important trends are beginning to emerge from the third quarter as more evidence on the economy and corporate earnings becomes known. As pointed out in last week’s Storm Update, the economy was already heading towards recession before the Trade Center terrorist attacks. Since September 11, that trend has accelerated. This is most evident in the economic numbers that are being reported and the third quarter earnings results coming from major companies. Reports this week confirm a trend that was already in place. Our economy is headed for recession and earnings have deteriorated substantially. Secondly, another apparent trend is the bursting of the credit bubble as foreclosures, delinquencies, bankruptcies and defaults begin to surface alongside the deterioration in bank earnings. As the recessionary trend emerges, a third trend is the growing distortion between the physical world of commodities and the paper markets that control them.

As I have written in my Storm Series, the American boom of the last half-decade was a boom fueled by an over-aggressive monetary policy that flooded the markets with credit. An expanding money supply kept the cost of credit below what it would have been due to the ample availability of money through the banking system. With bank coffers overflowing with money, our financial institutions were more than willing to make credit available to consumers and corporations. Banks and Thrifts were eager to loan money for just about everything. Banks aggressively promoted credit cards, installment loans, car loans and home equity loans. Many institutions made loans in excess of homeowner equity. Loans of up to 125% of a home’s appraised value were being promoted. Banks thought with real estate prices rising, eventually equity values would grow to cover rising mortgage debt. Many banks threw credit quality standards out the window and entered the substandard lending market.

During the first half of the year, financial institutions expanded their credit card base worldwide by 18% and in the US it was up over 20%. Sub prime auto loans grew by $100 billion during the same period. During the third quarter, total debt and equity financing grew by 31%, surpassing the $2 trillion mark. Long-term debt issuance rose 60% to $930.5 billion by the third quarter. For investors seeking equity returns, convertible debt issuance climbed 97 percent to $70.1 billion.

Overall debt levels in the US credit markets are expected to rise to $28.3 trillion this year. To match the growing level of credit, derivatives are expected to expand by as much as $1.58 trillion this year. As risk increases in the credit markets, the urgency to buy protection against disasters or defaults is growing faster than debt issuance. Insurance companies have been big buyers of derivatives. The reinsurance industry has been buying credit derivatives to cover their exposed risk in their bond portfolios. Global revenue from credit derivatives is expected to quadruple over the next few years. Banks are expanding aggressively into this market because the profit potential from exotic derivatives provides better profit margins than what is offered from investing in bonds. The market for credit protection is what is driving derivative growth. Besides credit protection, the increasing demand for these complex instruments is being driven by the desire to earn incremental returns above the normal returns offered from investing in bonds. Default rates are accelerating. Everyone wants more protection. By buying derivatives, banks and insurance companies, the main buyers of bonds, can transfer credit risk. But transfer the risk to whom? That risk is increasingly being transferred to banks as the largest issuers of credit derivatives.

As credit growth continues to accelerate, despite weakening economic conditions, it is being fed by a constant influx of money into the banking system and the issuance of securitized debt coming from government sponsored entities such as Fannie Mae and Freddie Mac. Household borrowing by consumers is expected to rise by $661 billion this year at an annual rate of growth of 9.3%. As debt continues to rise, a weakening economy fed by the growth in unemployment, is increasing stress levels in the system. Real estate foreclosures, bankruptcies, and debt defaults are on the rise and becoming ubiquitous. On Monday, Bethlehem Steel filed for Chapter 11 bankruptcy protection. The venerable steel company, founded during the civil war to provide steel for the building of our nation’s railroads could not survive competition coming from inexpensive foreign steel. It is notable that over twenty US steel companies have filed for bankruptcy protection in the past three years.

Corporate Debt Defaults on The Rise
Bankruptcy problems don’t stop with the steel industry. Moody’s sees 284 defaults coming from U.S. and Canadian companies that will miss payments on loans, bonds, and other debt this year. Debt defaults are rising as a consequence of corporations coming under pressure from high debt levels that can’t be supported by declining earnings that are a result of a steadily weakening economy. In its latest credit report, the credit valuation firm predicted that the chances of debt default by North American companies would rise by 4% from 2.9% from last year. The report came in response to the deterioration in U.S. corporate credit quality that has picked up since the September 11 terrorist attacks. Moody’s reported that corporate credit quality has fallen for 14 straight quarters.

There are other signs that the credit bubble is beginning to take casualties. The percentage of high-risk bank loans has increased by 5.72% in the second quarter. This compares to 3.25% in the same period a year ago. Meanwhile, the American Bankruptcy Institute reports that the number of American businesses filing for bankruptcy is expected to surpass the rate filed in 1998. So far this year 20,000 firms have filed for bankruptcy protection. This alarming trend is up from 18,700 through the same period last year.

Real Estate Debt and Delinquency
At the same time that corporate defaults and delinquencies are rising, real estate foreclosures are also increasing. Home foreclosures in the Denver area soared 17.5% in the third quarter. Job layoffs of 25,000 from Boulder and Jefferson counties are starting to impact the housing market. So far there have been 3,020 foreclosures. Bankers expect that number to rise to over 5,000 as layoffs continue to accelerate as the economy weakens. Bankers believe this is the beginning of a cycle as the economy has now entered into a recession. Although no official pronouncement has been made, it is expected that when the government reports its initial third quarter GDP numbers this month, they will show the U.S. economy has “officially” entered into a recession.

Banks Take A Hit
With bankruptcies and loan defaults on the rise; the direct impact on bank earnings is clearly visible. Bank of America reported on Monday that its quarterly net income dropped by 54%. The bank is increasing its loan loss reserves. Net charge-offs for the current quarter rose to $1.5 billion from $434 million a year ago. The bank is exiting the sub-prime real estate market and will take a $1.25 billion charge to exit the business. Bank of America is also exiting the auto leasing business because of the poor credit history of its customers.

Another leading provider of credit cards, Providian Financial reported similar problems. The company offers a variety of credit products from credit cards to revolving lines of credit. In its latest quarter, the company reported lower than expected earnings due to three primary factors: steps taken to strengthen its balance sheet, lower fees and finance charges, and higher than expected credit losses. The financial firm increased its loan loss provisions by $186 million, including a charge of $85 million for estimated uncollectible, accrued finance charges on accounts that are delinquent on payments over 90 + days. The company reported that the managed net credit loss rate in the current quarter is expected to be 10.33%. As a result of its current loan losses, Fitch has placed Providian’s debt on its Rating Watch. Fitch remains concerned over the financial firms asset quality. Fitch believes that Providian will come under pressure to contain its credit losses in its credit card portfolio as the economy weakens further and job layoffs rise.

Source: OCC 2Q Report
CMB = Chase Manhattan Bank. JPM = J.P. Morgan Bank. These two have recently merged.

Other casualties this week include Citigroup and J.P. Morgan Chase. Citigroup earnings fell from $3.48 billion to $3.18 billion in the current quarter, a drop of 8.632 percent. The bank suffered losses of $120 million on stock market investments. The banks insurance unit lost $502 million from insurance claims and another $200 million from the disruption of trading as a result of the September attacks. J.P. Morgan Chase, which derives much of its profits from derivatives and trading, reported that its net income fell from $1.4 billion to $449 million, a drop of 68%. The bank sited losses in its private-equity business and a drop in the value of its equity holdings as responsible for missing its earnings target. We do not know at this time what losses if any the bank suffered from its giant derivatives book, the largest in the banking industry accounting for 60 percent of the derivative holdings of all banks and trust companies in the U.S.

Consumers Turn Cautious
What is clearly emerging from the move towards recession is that consumers are becoming more cautious. Although credit card debt is still growing many Americans have begun to cut back on their pace of credit card borrowing. Mounting job layoffs with an accompanying rise in the unemployment rate and a falling stock market is unnerving consumers. A new trend of frugality is emerging in the wake of the September attacks after a decade long boom of credit excess. However, not all forms of debt are being eschewed. The Mortgage Bankers Association of America reports that as applications for home loans has fallen by 8% since September 11 and home refinancing loans has surged. But even there, a new trend is emerging. Homeowners are choosing to lower their monthly payments instead of taking out equity. People sense danger and are trying to put their financial house in order. The leveling off of consumer debt doesn’t bode well for an economic recovery where economists and politicians are counting on debt-strapped consumers to lead us out of a recession. Consumers are opting to increase their savings and are using debit cards more often than credit. This trend reflects those who are well off or who have secure jobs. The conditions in the sub-par market continue to deteriorate and are responsible for the rise in defaults and in delinquencies.

A second trend emerging from this week’s report is the continued erosion in corporate earnings. Earnings of companies making up the S&P 500 Index are expected to drop by 22.4% during the third quarter. The combined decline in earnings for the first three and anticipated fourth quarters foreshadow the worst year for earnings in a decade. The results for the S&P companies have been a drop in earnings of 6.1% in the first quarter, 17% in the second, and now a subsequent fall in earnings of 22.4% for the third quarter. Fourth quarter earnings are expected to be down by 11.8% percent. As of last week, 788 companies have issued earnings. To make matters worse, companies are already issuing warnings for the next quarter. The results have been obvious for the last year and half. Corporations are struggling with debt burdens, a weakening economy and a collapse in capital spending. The economic slowdown has spread across all sectors.

This collapse has been visible in the government’s National Income and Profit Accounts. In its latest revisions, profits for non-financial companies were revised down by an average of 23%. Profits for corporations peaked in the fourth quarter of 1997 at $517.5 billion. By the second quarter of this year, they had fallen to $394.3 billion. It is more than likely they have fallen even further this quarter. The manufacturing and technology sectors are leading the decline. As pointed out in last week’s Storm Update, a rise in interest expense, followed by an increase in depreciation charges, is behind the decline. This points more to a structural decline than it does to a simple inventory correction. This trend also indicates that the problems are systemic.

Given the parade of earnings announcements that initially helped to lift the market from its September 11 demise, you would think things are improving. Corporations, along with their accomplices on Wall Street and in the financial media, are trumpeting the better-than-expected results mantra. You would never know that earnings have fallen off a cliff from the way they are being reported in the press. Chief financial officers and their higher ups have grown accustomed to reporting earnings as whatever they want them to be. There is a discrepancy in what companies are required to report in their SEC filings and what they report in their press releases. What we hear the most these days is pro forma earnings which resemble more of the world of make believe than they do any resemblance to actual earnings. We have now entered the world of hypotheticals. We have hypothetical unemployment numbers, seasonally adjusted GDP numbers that are hedonically indexed and seasonally massaged CPI numbers that are shielded from any price increases. Why not hypothetical earnings?

Unmasking The Hypotheticals
A few examples will illustrate my point. Intel reported numbers that were better than expected. Their hypothetical earnings were 10 cents a share based on a profit of $655 million, which excluded various expenses. The numbers released in the press report did not conform to generally accepted accounting principles (GAAP). The actual numbers, which included all expenses according to GAAP, showed that net income fell from $2.51 billion to $106 million. Sales fell 25% from $8.73 to $6.55 billion, while earnings were down 96%. What you heard from the media was that Intel met or beat their numbers.

The situation was similar for Microsoft, which reported its earnings on Thursday. The company beat its third quarter estimates compiled by Thomson Financial/First Call by 4 cents a share. The actual numbers were much different. Microsoft’s actual earnings fell from $2.2 billion a year ago to $1.28 billion, a drop of 42%. The company took a $1.24 billion after-tax investment related charge, reflecting a $980 million investment loss. This actual loss cost the company 20 cents a share in actual earnings. This has happened to many companies like Microsoft that have had to write off investment losses, bad debts or inventories. They are considered to be nonrecurring charges. However, they have had a habit of recurring almost every quarter, which brings up the problem of the definition of what nonrecurring means in the new world of hypothetical earnings.

There have been numerous earnings reports from other companies that have either met or beat estimates ranging from GM, McDonalds to Broadcom. But the actual numbers were much worse. One company, Novellus Systems, saw its stock rise nearly 25% after reporting pro forma earnings that beat estimates. Pro forma earnings were $35.2 million, which were down 40.6% from a year ago. Actual earnings, which took into account special charges of $71.3 million, were a net loss of $14.0 million. Other tech companies reported similar results. Sonus Networks and Juniper Networks reported losses much less than actual net losses on their income statements. In the case of Sonus, they reported pro forma losses of $11.4 million versus pro forma losses of $5.4 million a year ago. The actual loss, which includes restructuring charges, amortization of goodwill, impairment of assets, stock-based compensation and in-process R&D was $498.2 million. The actual loss per share was $2.81 a share compared to pro forma losses of only 0.06 cents a share. The stock rose 41% in after-hours trading on news of beating expectations. Juniper Networks stock also rose after it beat analysts estimates. The company reported pro forma net income of $32.5 million compared to actual net income, which was a loss of $29.7 million. Last year, the company actually made a profit of $58.1 million. The good news, which drove up the price of the stock, was that its board of directors announced a $200 million stock buyback program over the next two years.

Don’t Be "A Party Pooper"
The gap between GAAP and reported earnings is bordering on the absurd. What is emerging as earnings this quarter is a tribute to the creativity of corporate accountants. A number of companies have hidden poor operating results behind the September 11th terrorist attacks. The Financial Accounting Standards Board (FASB) reversed an earlier decision to allow companies to regard costs relating to the disaster as “extraordinary” and include them as a separate item on their financial statements has been reversed. Companies must include these expenses as routine costs. However the FASB doesn’t control company press statements, which usually includes the pro forma numbers. Unfortunately, analysts and their minions in the media go with the higher pro forma numbers or the story of companies beating estimates. Nobody wants to spoil the party with bad news.

Technology companies, the darlings of media anchors and analysts, are the biggest abusers of this practice. According to an Associated Press study of last quarter’s earnings for the top 100 companies in Silicon Valley, the companies reported pro forma earnings of $10 billion compared to actual earnings, which showed a $71 billion loss. One company, JDS Uniphase, accounted for $50.6 billion of those losses. What has being referred to as “extraordinary” now includes “ordinary” costs of doing business. These include writedowns, writeoffs of intangible items associated with acquisitions, stock option expense, impairment-related and restructuring charges and any other large item or expense that reduces profits. Analysts and professional accountants may understand what these numbers mean, but many investors don’t. All they hear is that companies are beating estimates. These companies have lost a lot of money and they don’t want to be held accountable for these massive losses. Massive losses may make their massive salaries and stock option packages subject to closer scrutiny.

The Oil Market
The final trend emerging this week is the growing divergence in commodity markets between supply and demand fundamentals and actual market prices. This becomes apparent when you examine what has happened to the price of oil and gas and the price of gold and silver. The price of metals and energy has fallen in spite of demand due to huge short positions on the COMEX. I’ll begin with energy where the Paris-based International Energy Administration has estimated that demand for crude will fall by 600,000 barrels to 76.2 million a day this quarter due to a decline in airline travel following the September 11 terrorist attacks. This is about where demand began at the beginning of the year. As the WSJ chart indicates, the demand for oil has risen just about every year over the last two decades as a result from emerging economies.

Demand IS Increasing
What this chart shows is that the demand for oil has steadily risen incrementally over the last two decades. Since the mid 80’s, global oil demand grew from 58 million barrels a day to 76 million by the year 2000. During that same period, non-OPEC oil production grew by only 3.8 million barrels per day. Most of that increase in demand came from the developing economies of Asia, Africa, Europe and South America. While America continues to consume a good portion of the world’s daily production, demand has been mainly flat in comparison to other economies reflecting greater energy efficiency. However, about 80% of the rest of the world still consumes less than 2 barrels of oil per person a year compared to the US where oil consumption is 25 barrels per person of oil per year. US analysts think parochially when demand is determined globally. IEA estimates that worldwide demand will increase by another 19 million barrels a day by 2010 and then increasing by another 19 million in the following decade. To meet this demand, OPEC production would have to increase from 30.8 million barrels of production in 2000 to 44.1 million by 2010 and then rise to 62.8 million by 2020.

Supply IS Decreasing

Regardless of what future estimates grow to be, most of that supply can come from only one region of the world which is the Middle East. It is doubtful whether OPEC could fulfill that gap in demand. Something investors and analysts don’t understand is the issue of depletion. Western oil supplies and production are now in steep decline. This makes us ever more dependent on a hostile and unstable region of the world for our major source of energy. The incidence of higher gas prices at the pump or stories about tight supplies are not isolated events fabricated by oil companies to drive up prices. They are facts that portend what is ahead of us. Supply-side shocks will become more frequent. The big and easy recoverable reserves have been discovered and are now running out. After decades of uninterrupted economic growth, we are no longer finding enough oil to meet demand. Nor should we delude ourselves that more money poured into exploration and development will solve the demand imbalance. The world is consuming non-OPEC oil at the rate of about a billion barrels every three weeks. We are not finding and replacing those barrels consumed with new reserves. All of the non-OPEC sources of oil from the North Sea to China and Mexico are in decline.

OPEC is making up the world’s demand imbalance. The cartel is serving as a swing oil producer similar to the Texas Railroad Commission on which it was modeled. During the early 30’s, the Commission developed a system whereby it would act as a swing producer in order to stabilize world oil markets. Saudi Arabia is acting in much the same way today as the Texas Commission did 70 years ago. In the process of acting as swing producer OPEC is getting more adept at managing its production levels in order to balance and achieve higher prices. OPEC has already cut production this year on several occasions and will do so again if the price keeps dropping due to slower demand growth or the shorting of oil by traders and commercials.

Natural Gas Mirrors Oil Imbalance
The situation for natural gas is similar to oil. The only difference is the fact that with gas a major supply source is located in our own backyard. The demand for natural gas is expected to rise by 30 TCF by 2010. The building of new natural gas-fired power plants is driving the demand. Capacity increased by 26,000 megawatts last year. This year capacity is expected to expand by 37,000 megawatts. There are close to 300,000 megawatts of new gas-fired plants on future order.

With natural gas, the amount of drilling rigs has risen from 600 rigs three years ago to 1,000 rigs by the end of August. Despite a near record completion of 19,700 natural gas wells, we have not surpassed the record set back in 1981 of 20,166, which was the peak of our drilling boom. Given the huge sum of investment made, and the increase in the number of rigs operating and wells completed, there has been no significant increase in supply. The investment and drilling boom has merely kept pace with demand. The North American gas industry is about to confront a combination of events that will lead to another supply and price shock similar to last winter when Henry Hub prices for gas crossed $10 per mcf. The gas industry is facing its first true shortage of deliverable reserves in history.

The sudden drop in natural gas prices has hidden this fact, which has been the result of huge commercial short positions as shown in this graph. The rationale for lower prices has been in the increase in inventories approaching this winter. Gas storage levels are about 18-20% higher than last year at this time and about 10% higher than the five-year average. However, the amount of natural gas in storage over the last few years has declined due to just-in-time inventory management. The amount in storage is not much larger that what has been the norm over the last decade in order to have a supply cushion in case of a severe winter cold spell. During a cold snap natural gas consumption leaps by 25-30 bcf/ day over average winter use. A two-week cold front could easily empty 500-600 bcf from storage.

Year	Storage
1989	3,268
1990	3,426
1991	3,369
1992	3,220
1993	2,978
1994	3,075
1995	2,996
1996	2,800
1997	2,886
1998	3,176
1999	3,073
2000	2,699
2001	3,300?

In the United States, the gap in demand versus supply has been made up by Canadian imports. Without Canadian imports, the US would have faced a natural gas crisis long before last winter. The problem for America is that Canada has reached or is close to reaching its production capacity. Everywhere on the horizon the supplies are shrinking. Natural gas decline rates have accelerated dramatically on-shore, in Texas, the Gulf of Mexico and in Western Canada. What we know for certain is that demand for natural gas is increasing by virtue of the fact that almost all new power plants being built are gas-fired. In fact we are now creating a new cycle of shocks by relying exclusively on natural gas for new power generation. Instead of just winter cold snaps, we will now have to worry about summer heat spells when natural gas air conditioners can quickly consume supply.

Supply & Demand Problems Ahead for Natural Gas
The future supply shocks we are heading for is one reason why natural gas producers are buying other companies to shore up their reserves. Insider buying supports what the industry already knows: There are no major oil and gas deposits left to be found. The easily recoverable reserves have already been discovered. Lower prices in natural gas are setting us up for the next supply shock. The natural gas rig count has declined to 953 from over 1,000 in August. The land rig count has fallen by 14 in the latest week to 1,005. Right now all we know is that traders have taken on huge short positions and the price has fallen. We are also at war with military and political instability on the rise in the Middle East.

Maneuvering in The Metals Markets
The metals market mirrors oil and natural gas. In a letter to the President of the New York Mercantile Exchange, silver analyst Ted Butler alerted exchange officials to a dangerous situation that now exists on the COMEX. According to the most recent Commitment of Traders Report, as of October 5, 2001, large commercial hedgers had increased their net short position by 175 million ounces to 225 million ounces net short. In three weeks, their short position increased by 350%. According to the recent COT Report, large commercials now make up 80% of the entire short position. According to Butler, the additional 175 million ounces of silver sold short is more than any country can produce in over two years. This short position is even more troublesome in that 4 or less traders are holding the bulk of this short position. Posing as hedgers, it is doubtful that a need to hedge that much silver for industrial use has risen in the last few weeks. Are there that many more pictures being taken as a result of the September Trade Center attack? The situation is even more precarious when you consider that a third of the COMEX inventory lies buried underneath the Trade Center. The buried silver represents 25% of the known silver bullion inventory in the world.

Let’s Do The Math
The situation is precarious. A well-heeled investor or hedge fund could buy up the entire COMEX supply with a small amount of capital. The COMEX warehouse has 100 million ounces of silver in inventory. With only 70 million ounces of silver available for delivery on the COMEX, the other 30 million ounces lies buried underneath the Trade Center. It would take only 14,000 contracts to take down the entire COMEX silver supply. Each silver contract consists of 5,000 ounces of silver. At today’s closing price of $4.40 an ounce, a buyer paying cash for a contract would have to pay $22,000 for one contract. ($4.40 x 5,000 ounces) In order to buy all 70,000,000 ounces, it would take only 14,000 contracts at a cost of $308,000,000. If the buyer bought on margin as many futures contracts are sold, it would take only $30.8 million assuming 10% down and 90% margin. That kind of money is chump change for hedge funds and sophisticated investors. It surprises me that no hedge fund or person of means has thought of this when the shorts’ vulnerability is so obvious. It would not take much to squeeze the shorts. Given the uncertainty of war, any unforeseen event or rogue wave could trigger their demise.

Unfortunately for silver shorts, they lack the convenience of large stockpiles held in the vaults of central banks to bail them out of their predicament. Outside long-term investor Warren Buffett’s holdings, there are no known reported stockpiles laying around to bail out the shorts. The only thing that could save them is for the New York Mercantile Exchange to change the rules like they did when the Hunt Brothers tried to corner the market. Only this time around, it is the shorts that are trying to corner the price. A day is coming when the price of silver will rise. The demand/supply deficit points to silver’s scarcity. I believe that when that day arrives, we will see what happened in Japan when the price of palladium rose. The Japanese Commodity Exchange (TOCOM) changed the rules to stop buyers from taking delivery by requiring cash buyers to post 2-3 times the amount of the actual cash purchase price of palladium. The CFTC has similar rules known as congestion whereby they could alter the rules to prevent or slowdown delivery.

Storm Tactics: Course Adjustment
Because of this dangerous and precarious position that Exchange officials have allowed to take place, I’m changing one of my recommendations made in my Storm Series regarding investments in silver. I recommended unhedged silver companies or investment in physical silver. In regards to the actual metal, I had originally recommended getting registered warehouse receipts when using the futures market. Given the situation that now exists on the COMEX, I recommend taking possession and delivery of all silver purchases. If you are buying large quantities, I would find a safe and reputable place to store it. Leaving it at the COMEX, given today’s enormous commercial short position, is not prudent.

There is a great disparity between the world of paper and the physical market for commodities. It has been distorted beyond fundamentals due to the ability of paper leverage to control vast amounts of oil, natural gas, silver or gold. To become more familiar with the real world of energy or metals, there are various web sites that can keep you abreast of the real facts that underlie these markets. By doing your own research and visiting these sites, as Paul Harvey points out, you’ll hear “the rest of the story.” ~ JP

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	Storm Watch Update HYPE, HYPOCRISY AND HYPOTHETICALS three trends that will take us deeper into recession by Jim Puplava www.financialsense.com October 19, 2001