FSO Storm Watch Update "Another Hole in the Dike" 10/26/2001

After September 11^th, the world and our country focused on the horrific events that were carried out in New York and in Washington D.C. There was talk of nothing else. After the attacks immediate attention was focused on the tragedy, the amount of lives lost, and the heroism of those who gave aid that others might live. In subsequent weeks, our attention has focused on the economic damage and its impact on the economy. Consumer confidence, retail sales, air travel and tourism all became part of the collateral damage of the attacks. When our financial markets reopened, panic ensued. Federal authorities from the President to the Federal Reserve Chairman to Wall Street gurus had their hands full. As an army of "little Dutch boys", they tried to restore confidence with the investment public, plugging the holes in the dike. The stock market came back. Now we are learning the extent of the damage on corporate earnings.

In my last two Storm Updates, I documented much of the economic damage and reported on the extent of the attack's impact on corporate earnings. As I highlighted in my Storm Perspective Series, corporate earnings were already in decline for the last few years. They peaked back in 1997 and have only risen as a result of accounting chicanery. The extent of this manipulation will become the subject of a soon to be released Perspective that will be lengthy in its scope and coverage of this abuse. Suffice to say for the moment that this gamesmanship is finally getting the attention of the SEC and other economic think tanks.

SEC Investigates Pro Forma Earnings
This week, Harvey Pitt, the new chairman of the SEC, ripped apart the growing trend of companies reporting “pro forma” earnings in their press releases. The new SEC Chairman called the practice ”Unstructured and undisciplined…rejecting the bedrock of all of our financial disclosure requirements…” Pitt said that now is the time to revisit how companies are reporting financial results and recommend changes. The last SEC Chairman, Arthur Levitt, did away with advance disclosure by companies to Wall Street analysts before they were made public to investors. The industry opposed the SEC rules. However, the result of the new rules is that analysts’ earnings forecasts are more accurate. U.S. companies must now release the same information to investors at the same time they give them to Wall Street. Since the SEC’s Regulation Fair Disclosure took effect a year ago, consensus estimates by analysts have risen by 30% in their accuracy. Yet, the abuses in reporting earnings to investors continue.

Levy Institute Reports Earnings Falsification
Again this week, the prestigious Jerome Levy Institute, an economics research firm, contends that corporations have regularly overstated their profits by more than 10% for two decades. In fact according to the Levy Institute, companies have recently accelerated the trend in overstating earnings by 20%. The report infers that companies are lying to investors by deliberately falsifying their financial reports. The report documents abuses that have been highlighted in several Storm Perspectives such as non-recurring charges, writeoffs, and stock options to employees that understate labor expense and dilute shareholder value. The implication of the Levy report is that the stock market is much more overvalued. The S&P 500, which is currently selling at approximately 39 times trailing earnings, could be selling as much as 40-50 times earnings given the amount of expenses that are understated in earnings reports. This means that the bear market is far from being over or it is close to reaching a bottom. The historical trading range for the S&P 500 has been between 12-14 times earnings. In a bear market trough the P/E multiple can get as low as 5-7 times earnings. This implies that the bear market could take the index down to as low as 300-500 before we are through. Calls for an S&P 500 at 1,500 are absurd. It implies that earnings will more than double or that we would have a P/E multiple of 40-50. Given that consensus, earnings for next year have fallen to around $40 dollars for S&P 500 companies. A normal P/E multiple would imply the S&P 500 wouldn’t approach normal valuations until it had fallen to 500.

Policymakers Maneuver to Shore Up Damage
As Washington and Fed officials concentrate on efforts to shore up the economy and the markets they are running into strong headwinds. The Fed is hoping that by injecting vast amounts of money into the banking system, it can reliquify the financial markets. Washington is hoping that fiscal stimulus will aid monetary policy in turning things around in the economy and along with it the stock market. The Fed has its hands full plugging numerous leaks in the dike. They have a problem with keeping the dollar strong given our huge trade and current account imbalances. The Plunge Protection Team led by the Fed is trying to put a floor underneath the stock market through selective intervention into our stock market. There is also the problem with suppressing the metals markets and energy. As these graphs from last week indicate, it is taking huge short positions in the futures markets to keep a lid on the metals and energy from rising.

Rising gold and silver prices and rising energy prices spell trouble for our bond market. They point to inflation ahead of us. Those large injections of money into the financial system via credit will have to find an outlet somewhere. The question is where will the next bubble emerge? I believe it will be in metals and energy. The economics of scarcity will be its root cause. It has been masked by covert intervention that has suppressed its price. It is only waiting an unforeseen event to spring it free from its cage.

International Cracks and Leaks Emerging
Because of the events of 9-11, attention has been focused on the U.S. economy and our financial markets. However, there is another leak in the dike that the Fed will need to plug. It is coming from the international system. Economies throughout Asia, Latin America, Europe, and in the Middle East are in trouble. Europe, like the U.S., is headed towards recession. Japan and Indonesia may be slipping towards depression. Latin America’s economies are resting on a precipice.

Argentina
Speculation is growing that Argentina is coming close to defaulting on its $132 billion in government debt. Tax revenues for the government fell by 14% last month, the third straight month of decline. The government is trying its best to avert a crisis by eliminating this year’s fiscal deficit. Argentina’s Economic Minister, Domingo Cavallo, met with Federal Reserve officials in New York yesterday to get advice on a debt swap. Argentina is negotiating a domestic debt swap with local banks and pension funds in an effort to avoid default on its bonds. The government proposes swapping $14 billion of domestic debt coming due for new bonds that pay lower interest rates. Cavallo wants to do a similar swap of the country's international debt held by overseas banks. Cavallo has been negotiating with U.S. banks like Citigroup, which own most of Argentina’s debt. Argentina has already engineered a $29.5 billion swap in June. The Economic Minister is seeking fresh loans from the U.S. and the IMF.

Meanwhile Moody’s and S&P have lowered Argentina’s credit rating this month reflecting deteriorating fiscal conditions for Argentina’s government. It appears that the more likely outcome will be the inevitable default by Argentina on its sovereign debt. The country is already paying interest rates on its bonds that are 19 percentage points higher than other troubled countries such as Turkey. When the default comes, it is likely to ripple throughout Latin America. Neighbors like Brazil will be affected. A big concern is that a default by Argentina throws the economies of the entire region into chaos. This could mirror the 1994 crisis in Asia which began with China’s devaluation and spread to Thailand and other countries in a contagion that quickly grew into a international crisis. It forced the Fed to step in an inject liquidity into the global financial system in order to contain it. That injection of liquidity found its way into our stock market expanding the stock market bubble.

Japan
Another region of the globe that is in trouble is The Far East. Japan’s economy is mired in recession and is in danger of slipping into a depression. Nominal economic growth plunged by a 10% annual rate during second quarter of the year. For close to 12 years, the plight of Japan’s sick economy has been reflected in its stock market. Japan’s stock market is still down over 70% from its high reached back in 1989. Like the U.S. economy in the 90’s, Japan’s market grew in the 80’s at bubble rates because of a lose monetary policy that over inflated the economy through cheap and abundant credit. Since that time, the government has tried the same Keynesian policy prescriptions of the New Deal. High tax rates followed by one stimulus-spending package after another have failed to resuscitate the economy.

Even with interest rates near zero the economy has failed to respond. Economists call it a “liquidity trap”, a phenomenon enunciated first by John Maynard Keynes. A liquidity trap is what happens when demand for credit remains weak no matter how low interest rates fall. People are too scared to borrow money. When the economy is ailing, people sense it and become more cautious. Instead of borrowing money, spending, or investing, they save money instead. Demand contracts and the economy slows down. Consumers don’t spend money. They save. Businesses don’t borrow money to expand plants and equipment. Instead, businesses use lower interest rates to refinance their outstanding debt

The problem for the government is challenging. As it lowers interest rates and injects liquidity into the banking system, the banks can’t use the money. Japanese banks are facing a flight of borrowers. Even with the Bank of Japan holding the key overnight rate at 0.001%, there are no takers. The monetary link between the Bank of Japan, the banking system, and the effectiveness of monetary policy to influence economic events, have broken down. Loan growth has fallen for 45 consecutive months. Even with interest rates at 0.02% on savings, bank deposits continue to grow. Consumers continue to save at these low rates because deflation makes money worth more. Even though it would take money 3,500 years to double at these low interest rates, annual deflation of 1.5% is making up the difference. This is why consumers continue to save rather than spend, thereby contracting the economy even more. The government is calling for Japan’s Central Bank to reinflate the economy in order to alter consumer behavior away from saving to one of spending money. The Governor of Japan’s Central Bank has refused the gambit, claiming reinflation would bring with it even greater dangers like what happened to Germany in the 1920’s

Indonesia
In the same region, Indonesia is ready to implode from a maelstrom of political and financial problems. Its banking sector has collapsed and the country is struggling to rebuild it. The country's interest expense on outstanding debt is almost as great as its GDP. The IMF has lent the country billions, while promising further aid, and yet this injected capital has been countered by an exodus of investor capital. Last year $9 billion left the country. The government has had to increase interest rates to keep capital from exiting. The currency of the country the rupiah has depreciated to 11,000 rupiah to the U.S. dollar. The rising interest rates in the country further exacerbate the problem by raising the cost of servicing its $72 billion in debt. Indonesia, at one time considered to be one of the rising economic powers in Asia and one of the Asian Tigers, has seen its economic growth rate dwindle. Furthermore, the country's government is on shaky grounds and in danger of being toppled by Muslim extremists. It may take an end to democracy and the installation of a military dictatorship to save it from collapse. Indonesia, like Argentina, is close to defaulting on its debt.

Troubled Waters
Other countries in the region are on the IMF sick list. The IMF has issued a downbeat forecast for the economies of Korea, Singapore, Taiwan and Malaysia. The only strong economies in the region are China and India. China is benefiting from robust foreign investment. India is also the beneficiary of strong foreign corporation investments in high tech manufacturing. The problem for the IMF is that its patient list keeps growing. The IMF report for October 19, 2001 indicates the IMF has standby arrangements with 14 countries ranging from Argentina to Uruguay of $46.289 billion, of which $28.686 billion has been withdrawn leaving only $23.154 in the account. The IMF has additional arrangement with 7 other countries like Columbia and Yemen for $54.358 billion, of which $38,331 has been used and $28.754 billion still available. These figures don’t include additional assistance for poverty-inflicted countries of $4.656 billion. Currently approximately $2.3 billion of interest payments due the IMF are in arrears.

No Safety Raft Around

The current problem for the Fed and the IMF is there doesn’t appear any region of the world that is strong enough to lead troubled economies out of recession. Unlike past crises in 1994 in Mexico, in 1997 in Asia, and in 1998 in Russia, the U.S. economy was strong enough to lead other troubled regions out of recession. By lowering interest rates, injecting liquidity into the financial system, and by opening ups its borders to imports the U.S. led the economic rebound. Now it is the U.S. economy that is heading into recession and there is nobody big enough to pick up the slack. As the graph on the right indicates, the U.S. trade imbalance has been shrinking, but is still in terrible shape. It places pressure on the U.S. financial markets, which are heavily dependent on foreign capital to finance its current account deficits. Over the last decade, as other regions of the globe ran into economic difficulties, the U.S. financial markets have been the chief beneficiary as foreign capital entered the U.S. looking for a safe haven in a flight to quality. Much of that money went into our stock and bond markets with foreigners now owning major portions of our outstanding Treasury debt as well as sizable holdings of U.S. stocks and corporate bonds.

Will The Dollar Hold?
The problem for Washington is confidence in the dollar, which is based on U.S. economic strength and U.S. military muscle. The problem Mr. Greenspan faces is to maintain the illusion of economic strength. Foreign investor selling of the dollar has been restrained by the belief of an economic recovery. The dollar's fate hinges on the prediction of an economic recovery and along with it a recovery in our financial markets. There is a real danger if this event doesn’t materialize quickly. The safe haven status that the U. S. has enjoyed has changed since September 11^th. The one apparent weakness that becomes readily apparent is the enormous sums of U.S. foreign debt. Foreign investment in the U.S. has risen to $9.4 trillion as of the end of last year. This compares to U.S. held foreign investments of $7.2 trillion. The difference between what we own and what we owe is greater by $2.187 trillion.

Europe On The Prowl
Foreign investors are big investors in our stock market in addition to being large owners of our Treasury debt. Foreign companies are still buying U.S. companies. Recently RWE.AG of Germany bought out American Waterworks, the largest water utility in the U.S. for $4.6 billion. Other European companies have been active in acquiring U.S. assets. Europe is merging as the land of potential predators. With strong balance sheets and plenty of cash ($40 billion) and a weakening dollar, European companies have been on the prowl in the U.S. The U.S., which is borrowing close to $3 billion a day to fund its trade and current account deficit, is heavily dependent on outside capital. Europe now accounts for two-thirds of total private holdings of U.S. stocks and bonds. There is a great danger lurking behind our dike. If foreign investors lose confidence, they could begin to pull that money out which would collapse our bond and stock markets. Or they could simply dump their dollars in exchange for real assets. One scenario is deflationary, while the other is inflationary. No one knows the outcome to that story. It all revolves around a great confidence game played by the Fed.

Greenspan/Superman
Mr. Greenspan has managed to convince foreign and U.S. investors of a new U.S. paradigm. An economy that is more productive and profitable has attracted foreign capital into this country and financed our trade and investment deficits. That illusion is important for the Fed to maintain. Recent economic revisions on GDP growth and productivity have erased much of that new paradigm theory. What is keeping hedge funds and other investors from selling the dollar is the recovery illusion. If it doesn’t materialize, the dollar is headed for big trouble. Foreign institutions and hedge funds have held back from shorting and dumping the dollar for fear of a recovery. The longer that recovery is postponed the more likely that fear of bailing out of the dollar will evaporate.

Default Risk Widens The Cracks
This is what must worry the Fed, as it must now deal with another emerging crisis in Argentina, Indonesia, and in Turkey. A likely default by Argentina of its sovereign debt would create the need for additional liquidity in the financial system. Much of Argentina’s debt is owed to large U.S. banks like Citigroup. The possible debt default in Argentina is bound to widen credit spreads -- something that happened when Russia defaulted on its debt in 1998. The result of widening credit spreads after Russia’s default caused Long Term Capital Managements derivative bets to implode. Credit derivatives at the seven largest U.S. banks were $39.631 trillion as of the end of the second quarter of this year. One can only wonder if those banks have incorporated 9-11 or the possibility of emerging market debt defaults into their derivative models. Most derivative models are based on the Black-Scholes option-pricing model. The Black-Scholes model defines risk in terms of price volatility. Most models allow for 1-2 standard deviations away from the bell shaped curve.

Watch The Banks
What happened on September 11^th must have been 8-10 standard deviations away from the curve at the edge of the tail. It is probably one reason why banks such as J.P. Morgan Chase’s profits fell as sharply as they did during the third quarter. This bank accounts for 60% of all derivatives inside the U.S. banking system. It is one bank to keep your eyes on. J.P. Morgan Chase can be likened to the "Titanic" of derivatives. It is headed for dangerous waters with the biggest icebergs being the U.S. dollar and the price of gold. A rise in gold prices and a drop in the dollar could jeopardize interest rates by driving them up. It is a major risk for the bank, which owns positions that could be severely impacted by either event. In addition to being the largest holder of interest rate derivatives, it also owns large positions in gold derivatives. As of the end of the second quarter, the newly merged bank had a derivative portfolio of $29.1 trillion of which 85.7% consisted of interest rate contracts. J.P. Morgan Chase also owned $55.9 billion in gold derivatives, an amount that dwarfs the actual physical market or the annual production of gold.

Rank	Bank Name	Total Derivatives (in millions)	Total Assets (in millions)	Derivatives to Assets	Total Credit Exposure to Capital Ratio	% Held for Trading
1	Chase Manhattan Bank	$14,464,305	$377,116	38.4x	442.4%	99.1%
2	Morgan Guaranty Tr, NY	$9,627,937	$185,762	51.8x	873.7%	99.9%
3	Bank of America	$7,365,876	$584,284	12.6x	114.5%	98.7%
4	Citibank	$5,085,044	$382,106	13.3x	190.6%	97.6%
5	First Union National Bank	$1,138,653	$231,837	4.9x	55.5%	83.7%
6	Bank One National	$819,537	$101,229	8.1x	83.6%	99.7%
7	Fleet National Bank	$388,708	$166,281	2.3x	20.6%	74.8%
Source: Comptroller of the Currency For more in-depth discussion , read The Perfect Financial Storm: Financial Storms Heading Towards The U. S. Economy, Part 9

Rank	Bank Name	Total Derivatives (in millions)	Total Assets (in millions)	Derivatives to Assets	Total Credit Exposure to Capital Ratio	% Held for Trading
1	Chase Manhattan Bank	$17,376,298	$412,248	42.1x	529.2%	98.8%
2	Morgan Guaranty Tr, NY	$11,961,778	$201,033	59.5x	1,153.3%	99.9%
3	Bank of America	$8,248,564	$563,844	14.6x	125.3%	98.8%
4	Citibank	$5,541,322	$392,181	14.1x	182.6%	98.8%
5	First Union National Bank	$1,605,497	$227,646	7.1x	61.2%	91.3%
6	Bank One National	$753,444	$142,293	5.2x	63.5%	99.6%
7	Bank of New York	$356,480	$74,128	4.8x	30.1%	98.2%
Source: Comptroller of the Currency

So Many Holes, It's Beginning to Look Like Swiss Cheese
This is what must keep the Fed up late at nights. There are simply too many holes in the dike that need to be plugged. The stock market needs to be kept propped up, the economy needs to be turned around, gold and silver and energy prices need to be suppressed, emerging debt defaults need to be contained from spreading into a worldwide contagion, and the dollar needs to be kept from falling. It is a monumental task that keeps getting bigger with each new crisis. The Fed has fought each crisis as it always has by injecting vast amounts of money into the financial system as shown by the various forms of measuring money from MZM to M-3. There must come a point however when a limit is reached as to the world’s ability to absorb dollars. Up until this point, crisis always occurred in someone else’s backyard. Now they have shown up on our own shores. They began to appear in our stock market beginning last year. They are now visible in our economy and in our credit markets. The dollar has been spared up until this point but for how much longer?

M1 Includes Currency, Demand Deposits, Now Accounts, Credit Unions and Nonbank Travelers Checks (in billions)
M2 Includes M1, Overnight Repos by Commercial Banks, Overnight Eurodollars, Savings Accounts,
Times Deposits Under $100,000, and Money Market Mutual Funds (in billions)

Pressure is Building Behind The Dike
The question is what takes its place? There is no economy or currency strong enough to replace the greenback. This is one reason why I believe the precious metals markets are beginning to stir. Heavy short selling and gold dumping by certain central banks are suppressing the price of gold and silver. Greenspan understands this. Having been a student of Ayn Rand, Greenspan knows the importance of gold. If he loses the confidence game, then the fiat dollar system, which has dominated the global economy since the end of Bretton Woods, could come to an end. This is the battle the Fed chairman fights. It is the battle between paper and physical metals. It is a game the U.S. has played and won for three decades. It was almost lost at the end of the 70’s under Carter. Paul Voker and Reagan helped to restore confidence in the dollar. The Clinton Administration jeopardized the dollar by its return to Keynesian economics of spend and inflate. The Clinton Administration also initiated the gold-carry trade as part of its strong dollar policy, which necessitated keeping the price of gold suppressed. Those policies of inflating the banking system with abundant and cheap credit created an economic and stock market boom. However, history teaches us that busts always follow credit booms as leverage is unwound. It is this very process that is now unfolding. It is against this historical tide that that Greenspan Fed now battles against. It is a battle for the survival of the dollar and the institution of the Fed itself. No one knows this more than Mr. Greenspan having been an ardent student of monetary history.

As this chart below indicates, there have been different cycles in the financial markets over the last century. There have been times when intangible paper assets such as stocks and bonds have reigned supreme. There have been other times when the markets shift to tangible assets represented by metals, energy, real estate and other forms of hard assets. That cycle has varied throughout the century. Credit booms and monetary expansion usually lead to advances in paper assets. Busts often follow those booms. As governments attempt to fight the deflationary bust that accompanies credit booms, they try to inflate their economies through monetary and fiscal policies. This may lead governments to abandon the fiscal discipline demanded of governments by a gold standard. They try to find cause to discredit gold, claiming that adhering to the gold standard is part of the problem. Once the monetary unit is no longer tied to the value of gold, the government can then debase the currency by expanding the monetary base through printing money. The fiat system that follows leads to monetary disorder. It has been this way throughout history. In the end, people always return to gold. It is the only currency that has permanent value.

Attempts by governments to abandon gold’s discipline have led to financial disorders throughout history. The 20^th century has plenty of examples that illustrate this point. There was the feeble attempt by the British to restore the pound's value during the 20’s. That was followed by the American experiment under Roosevelt’s New Deal, which led to abandoning the gold standard and the immediate devaluation of the dollar in 1933. The abandonment of the gold standard led to the trade wars of the 1930’s, which eventually led the way to war. Today, we have the same thing going on in the world’s financial system through the process of currency devaluation. The peso crisis of 1994, the Asian crisis in 1997, and the Russian ruble devaluation in 1998 are recent examples. Now we are about to experience another round of devaluations that could erupt if Argentina defaults on its debt. For Mr. Greenspan it will become another hole in the dike that will have to be plugged. ~ JP

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	Storm Watch Update ANOTHER HOLE IN THE DIKE cracks, leaks and pressure points seen in global economics by Jim Puplava www.financialsense.com October 26, 2001