Bearish News

Some juicy details are emerging about the Government’s meddling in Bank of America’s takeover of Merrill Lynch. This issue hasn’t gone away quietly, as many skeptics thought it would (myself included).

Potentially Huge Break – Fed Emails About the Deal Leaked

These emails, assuming they’re real, provide a peek into internal Fed discussions about the deal.  More importantly, they reveal that Fed employees clearly knew how toxic Merrill was. Mac Alfried, Senior VP at the Richmond Fed, had this crude assessment of ML, “Merrill is really scary and ugly”.

It seems clear that the Fed knew, at least suspected, how bad the Merrill situation was. Yet they pushed ahead, even  threatening Ken Lewis’ job if he didn’t seal the deal. Bank of America was buying a hot toxic mess in Merrill Lynch, and apparently everybody knew it. So why did the deal go through?

Under the contract, Bank of America seems to have had an out. Scuttling the deal under the Material Adverse Change clause was an option (once they found out how horrific Merrill’s books were). But they were strong-armed into not evoking theMAC clause. Why? The official line was likely, “to prevent a collapse of confidence in banks.” The end result may be the exact opposite.

This excerpt is another shocker:

Just had a long talk with Ben [Bernanke, presumably]. Says they think the MAC threat is irrelevant because its not credible. Also intends to make it even more clear that if they play that card and then need assistance, management is gone. (Forgot to tell him KL [Ken Lewis] is near retirement.) Hopes a Citi-like deal can be done w/o us taking 3rd loss, but if we get away w/ the gov just backstopping $74 that would be cheap given the size of the companies. He’d be surprised if that’s all it takes though.

I’m still digesting all of this, and suggest everyone read the whole thing. Docs like this need as many eyes on them as possible. So scan for nuggets if you’re so inclined.

On a more light-hearted note, Jesse’s Cafe posted their entertaining take on how things went down:

Shotgun Wedding (click to enlarge)

Moving on…  Zero Hedge also posted another juicy tidbit earlier today:

Tim Geithner, Treasury Secretary, supposedly emailed telling BofA that they couldn’t back out of acquiring Merrill Lynch, according to CNBC.

An email by Geithner telling BofA to close the deal would be a proverbial smoking gun, since BofA honcho Ken Lewis has said he was forced into buying the bank and not publicly revealing the poor financial shape that Merill Lynch was in, in the wake of pressure from the government.

If accurate, I don’t see how Geithner can last much longer at Treasury. How could the administration justify action like this by their pick for Treasury Secretary (who was President of the NY Fed at the time)? I wouldn’t worry too much about Mr. Geithner’s prospects, though. It seems inevitable that a bank/hedge-fund would take pity on him (and offer a fat multiple of his old paycheck).

If T3 (turbo-tax timmy, as ZH refers to him) does get canned, it seems likely that he’ll go down as the villian in this mess, or at least the baffoon. A scapegoat is sorely-needed to take the heat for the Bank of America debacle. While he seemingly does deserve part of the blame, the problem surely goes much higher up the food chain than a bureaucrat like Tim.

This is not to say that Ken Lewis is innocent in the matter (of poor judgement, at least). He chose to buy two of the most toxic books on the planet, Countrywide and Merrill Lynch. His eagerness to expand into lucrative markets blinded him to risk. It does appear that he was eventually pressured to follow through with the Merrill deal, after problems became evident. But Lewis was lusting after ML’s wealth-management biz for a while.

Paulson to testify Before Congress

Today brought yet another key development in this case, when it was announced that Henry Paulson will testify before Congress next month. He’ll be grilled on record (and presumably under oath) about about BAC’s acqusition of Merrill. Warning: Don’t get your hopes up. Paulson has a thick teflon coating to protect him from political heat. Goldman Sachs is too entrenched and politically connected for anything serious to happen to one of their own like Henry.  (bloomberg piece)

The majority of economists/analysts remain in the deflation camp. Despite the bleak picture, many seem seem to believe that large-scale monetization of our debt won’t happen. For example, Mike Shedlock, aka Mish, just posted a thought-provoking piece. In it, he scoffs at the idea of hyperinflation in the US. He dismisses it as ridiculous given the size of the problems we face. And he makes a good pitch. Mr. Shedlock is a sharp analyst, evidenced by his huge following on the web.

While I disagree with his deflation view (more on that below), Mish does make some excellent points about the headwinds we’re facing. Plus, it’s always good to audit your own beliefs by listening to opposing arguments. So let’s examine the case for deflation. Central to it are three daunting forces in the US: Rising unemployment, the ongoing annihilation of household wealth, and the debt-collapse of Q1 2009. As Mish says:

Think consumers are about to go on a spending spree after a massive $13.87 trillion collapse in net worth? Think banks are going to start lending with this employment picture and household debt? I don’t and boomer demographics makes the situation even worse. Don’t forget the bleak employment picture. There is no source of jobs.

The deflation camp has a solid case at first glance. The picture is bleak indeed. In a truly laissez faire economy, equities would utterly collapse, making this 40% drop look paltry. Unemployment and wages would plummet, resulting in dramatic deflation. As companies fail and people lose their homes, a horrific deflationary spiral would ensue. But there’s a gaping hole in this argument: Our economy is far from lassaize faire. It’s arguably one of the most manipulated and subsidized in the world.

Some in the deflation camp seem to believe our government will allow a massive collapse to happen, without attempting a clumsy (and likely counterproductive) rescue. Printing money is a key component of any government bailout/rescue. Most deflation articles fail to address this, specially these aspects: what effect quantitative easing will have, and whether the Fed will reign in money supply when it’s required. More on that later. First let’s look at just how awful the economic picture is. Knowing the size of the problem is key to understanding how drastic Gov/Fed will need to be, if they are to have any effect at all.

Things Are Really, Really Bad

De-leveraging has barely begun. California is on the verge, the first of many states. Boomers are retiring, medicare costs will skyrocket. The wave of mortgage resets in Alt-A Loans in 2010/11 will be a nightmare (bigger than sub-prime). The case for deflation seems clear, but only if you remove the Fed and Gov intervention from the picture.

Don’t forget, the same players who got us into this mess are still in control. Their response will be predictably bad. For proof, look at the way things have been handled so far. Their answer to a debt crisis is more debt, re-flating the bubble. And the size of this problem is unprecedented:

Don’t forget the $99 trillion in unfunded healthcare and retirement obligations (wsj). It’s no surprise that some are positioning themselves short equity/long cash. Short is probably not a bad place to be for the very near future. But like it or not, inflation will eventually benefit debt-laden companies with good cash flow (they get to pay off their debts with devalued currency). That’s a horrible model, but it seems inevitable.

Governments find the temptation to “fix” these collapses irrestible. And those fixes result in reverse-Darwinism. Companies that should fail don’t, upsetting the entire equilibrium of the invisible hand. For those who think that our leaders will act prudently, and ignore the temptation of inflate, I urge you to recall some of the Gov/Fed actions that got us into this mess:

• Keeping interest rates so low for so long
• Increasing bank leverage to 40x, repealing Glass-Steagll
• Unsustainable deficit spending to fund war/military budgets
• Shifting of mortgage risk to the public via GSEs like Fannie and Freddie
• Allowing elected officials to be openly bribed by instutions they regulate

Will Gov and Fed Stand Idle as Disaster Strikes?

If Mish and others are right, we’re not anywhere close to true recovery. A bigger crash is inevitable, and all we have done is postpone it.  I happen to agree. Where we differ is on how the government and Fed will respond. I don’t think they will act to curb inflation when the time comes. Given the size of the problems we face, they will eventually be forced to monetize our debt.

Richard Fisher, head of the Dallas Fed, is probably the loudest “inflation hawk” they have. And even he is making the deflation case. So the Fed, like always, is focused on the immediate future. Since inflation is not an immediate concern, they put it off , essentially saying “we’ll cross that bridge when we come to it”.

In a recent WSJ interview, Mr. Fisher attempted to soothe worries about hyperinflation. While it is reassuring to hear Mr. Fisher say the Fed won’t monetize our debt, he is a black sheep, an anomaly among Fed Presidents. And even he doesn’t sound convinced:

I think the trick here is to assist the functioning of the private markets without signaling in any way, shape or form that the Federal Reserve will be party to monetizing fiscal largess, deficits or the stimulus program [from this wsj piece, a must-read]

Without signaling? Why not say, “While assuring them that we are committed to not monetizing our debt. We’re not going to do it, period.” Because he’s only one voice, and hugely outnumbered. I like Fisher, he seems like one of the smarter Fed guys. When the time comes to pull in the reigns, his voice will surely be drowned out.

How far will they go to stave off massive economic turmoil; a collapse on the scale that Mish and others forsee? Very, very far. No government wants the it to happen on their watch. The digital printing presses are likely getting warmed-up.

Inflation: Easier to Swallow

Politically, inflation is infinitely more palatable than the alternatives. Voters loathe tax increases, and rightly so. Yet we have also become dependent on ever-expanding programs like medicare. Something has to give, and I think inflation is the easiest option.

The American public is largely complacent. As long as you don’t raise their taxes or slash their benefits, rebellion is unlikely. But if you jack up taxes or cut spending on the scale required to fix this problem, we may see serious social unrest. It’s really that big of a problem. Which is why I remain in the inflation-camp. For more on the effects of continued government intervention, see “Beware Bears: More Bailouts and Inflation Loom”.

Disclosure: No positions in any stocks mentioned.

The Econ world is abuzz with debate over this Krugman piece from 2002. Some argue that he was advocating a housing bubble, and others steadfastly defend his positions (and the pillars of Keynesian Econ). I’ll post excerpts from experts from both sides of the argument. This is shaping up to be a poignant real-world showdown between Keynesian Economists (represented by Nobel-prize winning economist Paul Krugman) and those from the Austrian School (like Mark Thornton from Mises.org). Ding, ding, ding:

Arguing that Krugman Advocated a Bubble:

Mark Thorton over at Mises.org highlights 3 quotes from this time period (2001-02) to demonstrate that Krugman did, in fact, appear to push for re-flating the tech bubble. This is the most damning, to me:

That is, I’ve always believed that a speculative bubble need not lead to a recession, as long as interest rates are cut quickly enough to stimulate alternative investments. But I had to face the fact that speculative bubbles usually are followed by recessions. My excuse has been that this was because the policy makers moved too slowly — that central banks were typically too slow to cut interest rates in the face of a burst bubble, giving the downturn time to build up a lot of momentum. That was why I, like many others, was frustrated at the smallish cut at the last Federal Open Market Committee meeting: I was pretty sure that Alan Greenspan had the tools to prevent a disastrous recession, but worried that he might be getting behind the curve.

However, let’s give credit where credit is due: Mr. Greenspan has cut rates since then. And while some of us may have been urging him to move even faster, the Fed’s four interest-rate cuts since the slowdown became apparent represent an unusually aggressive response by historical standards. It’s still not clear that Mr. Greenspan has caught up with the curve — let’s have at least one more rate cut, please — but the interest-rate cuts do, cross your fingers, seem to be having an effect.

Below is another strike against Krugman’s case (to the Austrian Econ crowd, at least). He made this comment in October 2001. There’s more, plus good commentary to be found at the original Mises.org piece:

In time this overhang will be worked off. Meanwhile, economic policy should encourage other spending to offset the temporary slump in business investment. Low interest rates, which promote spending on housing and other durable goods, are the main answer. But it seems inevitable that there will also be a fiscal stimulus package”

Seems like a pretty good argument that Krugman was pro-bubble back then. He was urging Greenspan to act “even faster”. He is advocating both low interest rates and financial stimus to get us out of the recession. He’s still banging the massive-stimuli war drum today. In the 2002 piece first mentioned, however, Krugman does appear to be hinting that Greenspan played a role in the tech-bubble.  How can he note this as a negative, while simultaneously pushing for interest-rate cuts and stimuli?

After reading the various arguments, it seems that Mr. Krugman was conflicted at the time. But he saw no good alternative to re-flating. Here is the opposing argument preferred by Paul Krugman himself (he linked to it in his rebuttal).

Arguing That Krugman Did Not Advocate a Housing Bubble:

Arnold King, Econ PHD from MIT, defends the 2002 piece saying:

1. Krugman was mainly expressing pessimism. He was not cheerfully advocating a housing bubble, but instead he was glumly saying that the only way he could see to get out of the recession would be for such a bubble to occur.

2. In the event, we had a housing bubble and we got out of the recession. To me, this raises the question of whether a distorted recovery is better than an undistorted recession. That question might be asked in the context of fiscal stimulus as well–at what point do the distortions of the stimulus outweigh getting out of a recession?

3. I personally do not think that Greenspan caused the housing bubble. I do not believe that monetary policy and short-term interest rates are as all-powerful as many economists do. What I was writing in August of 2002 was this.

4. Paul Krugman and Brad DeLong thought that Greenspan kept rates too high in 2002. This makes them poorly positioned to criticize Greenspan now for keeping rates too low. I am pretty sure that Brad is guilty of this hypocrisy. I believe that Paul is not.

Was Krugman just being sarcastic? I guess it’s possible. But it’s important to note that Kling does not believe monetary policy are as powerful as economists like Paul Krugman do, and doesn’t blame Greenspan for the tech-bubble. So counting him as a strong supporter of Krugman’s overall argument is a stretch. But Kling is an MIT guy, with a PHD in Econ. So he’s a lot more book-smart than I will ever be. But the Austrian argument makes more sense to me, in this case.

Krugman also defended himself in this rebuttal, “I was on the Grassy Knoll, Too” today in the NY Times. His explanation is short, and he links to the Kling piece:

Guys, read it again. It wasn’t a piece of policy advocacy, it was just economic analysis. Update: A gracious, sensible explication from Arnold Kling.

Palladium is one of the lesser-known precious metals. It has some unique attributes that set it apart from the “big three”: gold, silver, and platinum. So if your goal is to have a diversified portfolio of precious metals, investing in palladium can be a good choice.

Before you go out and buy bullion/coins, it’s important to realize that palladium prices are quite volatile, and fluctuations are more dependent on industrial demand than metals like gold. In 2001 the price of palladium peaked at over $1100 per ounce. It currently trades around $250. A drop like that will pique the interest of contrarian investors, and cause heartburn in more conservative ones. Rightly so, on both counts. It’s a more speculative play, and therefore research/homework is required. Consult a professional you trust if you aren’t comfortable. This chart shows palladium prices from 1992-present:

Palladium is a member of the platinum metals group, and has many industrial uses (more below). I would classify it as among the riskier metals, but the potential upside is great. It may prove to be a good hedge against an inflation-fueled recovery. As the world continues to print money in an attempt to stimulate industry/consumers, demand and inflation could increase dramatically. This may in turn cause commodities like palladium to rise significantly, as governments artificially goose the markets. I don’t like this scenario, but am positioning myself for the possibility.

What is Palladium used for?

The primary industrial use of palladium is in the manufacture of Catalytic Converters (devices that clean automotive exhaust). This unique metal converts harmful gases, like carbon monoxide, into more benign ones like carbon dioxide. The decline in car sales is partially to blame for the fall in palladium prices. But with governments worldwide artificially stimulating auto-sales, palladium could see a spike in price as demand rebounds (temporarily, at least).

Growing Popularity In Jewelry

Palladium is also widely used in the jewelry market. It’s an essential ingredient of white gold, and is used as a cheaper alternative to platinum. Palladium is very similar to platinum, but a bit less dense. It makes fine jewelry, and is starting to replace its more expensive cousin as the base metal used in engagement rings and other products. It’s easy to see why jewelry-makers and consumers like palladium: It sells for around $250/ounce compared to platinum at $1250/ounce.

It is also widely used in the fields of electronics, dentistry, and medicine. According to Wikipedia:

Palladium is found in many electronics including computers, mobile phones, multi-layer ceramic capacitors, component plating, low voltage electrical contacts, and SED/OLED/LCD televisions. Palladium is also used in dentistry, medicine, hydrogen purification, chemical applications, and groundwater treatment. Palladium plays a key role in the technology used for fuel cells, which combines hydrogen and oxygen to produce electricity, heat and water.

How to invest in Palladium?

Coins or Bars are the most common methods. The Royal Canadian Mint produces beautiful .9995% pure palladium coins that are legal Canadian tender. But they’re pretty hard to find these days. A more accessible option is palladium bars from reputable mints like Pamp Suisse. I recently bought some of these 1 oz bars from Apmex.com, an online metals dealer I’ve had good experiences with (no relationship/interest/payola). They had the best prices I could find for small-mid level buyers like me. From what I’ve seen, they ship what is promised, and do it on time.

What about Palladium Stocks?

There are very few pure-plays in the palladium mining world, so investing in common stock is much more difficult than gold/silver. The only equity pure-play that I know if is North American Paladium (PAL). It’s a very small company, and recently had to shut down production because of low palladium prices. Supposedly they’re going to restart soon. I don’t own PAL, or know anything about the mgmt, so do your research before buying and realize it’s a very speculative play.

Russian Stockpiles of Palladium – Potential Problem?

Some of the most productive palladium mines in the world are located in Russia. And their government has not been very forthcoming about levels of production or stock. Some people think Russia’s stockpile of the metal is more sizable than the market assumes, and that it may continue dumping metal on the market to generate cash during a lull in oil prices.

However, it is in Russia’s best interest not release too much metal at once into the market, to make sure prices stay at profitable levels. Price could go down much further if demand continues to decrease as supply increases. Russia doesn’t have a monopoly on palladium by any means. There are mines operating in many countries (such as South Africa). So we’re not looking at a DeBeer’s type of situation here. But it is a factor to consider when investing. If the Russian government/corporations were to sell substantially more metal on the open markets, things could get nasty for spot prices of palladium.

More info:

• Jewelry professionals/buffs discuss the pros and cons of palladium and platinum
• Palladium article in Wikipedia
• ‘Sell Platinum, Buy Palladium’ – Bloomberg

Disclosure: Long Palladium, Gold, and Silver Bullion. No positions or interests in other companies/stocks mentioned. Price chart from of Kitco.com.