"Contrarian Investing" for 2009: Preparing for Winter

September 7, 2008

Over the past couple years, I've written about "contrarian investing." Mostly, this means things that people don't think of as investments, but can be very, very handy in certain unpredictable-but-not-so-uncommon situations.

January 7, 2007: Be Prepared
December 30, 2007: Contrarian Investments for 2008

I'd recommend a look at Barton Biggs' new book, Wealth, War and Wisdom. Biggs looks at what assets were really valuable during World War II in Europe. Stocks? Not much thrill there when the Russian Army is rampaging through your country. Bonds? Not paid by governments that disappear. Paper money? Har. Even gold is not necessarily so useful. Things that were really valuable, in wartime Europe, were food and warm clothing -- first -- and jewels and land secondarily.

But that would neeeever happen today, right? If you look at the last five hundred years of human history, it was pretty much assured that virtually everyone would experience, at least once during their lifetime: an invading army; a change of government; a famine; a plague; and a hyperinflation. Maybe several.

This "contrarian investing" series has always been for the average citizen. The rich guys have already been preparing for years. Barton Biggs -- who spent thirty years as Morgan Stanley's chief strategist, and now runs a multibillion dollar hedge fund -- says to buy a farm and stock it for self-sufficiency. What are you going to do? Sit on your hands and hope the Biggses of the world save your behind? Farmland is out of our purview here. Our budget is $1000, with some suggestions beyond that but not more than $5000 or so.

I don't really have anything new to add to my previous posts on this subject. That's good. I was pretty thorough. Also, it means you don't have to spend any more money, if you did already. This is insurance that lasts forever.

So, this is more of an update. It's an update now, rather than at the usual end of the year, because maybe -- just maybe -- you won't be able to get this stuff anymore in early January. The banking/payments system in the U.S. is potentially on the verge of collapse. Out of about $6.5 trillion in bank deposits, there are about $2.5 trillion of uninsured deposits, held mostly by corporations and other large institutions that exceed the $100,000 FDIC guarantee. If I were those depositors, I would be asking for my money back. And, if all $2.5 trillion worth did that at once (institutions tend to do things all at the same time), it could be catastrophic. For one thing, it would probably set off the Great CDS Avalanche, with unpredictable consequences. Warren Buffett didn't call it "mass financial destruction" for nothing. Jim Rogers, an investor of some repute, has taken to saying that many people alive today will not see the end of the financial crisis during their lifetimes. He means multiple decades. I think now is the time to prepare for the winter season, which I expect to be an unusually cold winter in North America. So, let's review some things that I'd put on the top of the list right now:

1) Clothing for winter. If you are like most Americans, you probably have about ten times as much clothes as anybody could possibly need. So, you probably have this one covered. However, if you live in a snowy climate, think about what you would need to stay outdoors for long periods of time (for example if you had to walk ten miles in winter), to travel in winter (maybe no plowed roads), and if there was no indoor heating. A big coat, probably, and a warm hat. Long underwear. Good gloves or mittens. Appropriate shoes, like the rubber-bottom "pac" boots made by Sorel or LL Bean. Possibly snowshoes or cross-country skis. Also, probably a decent daypack or similar, to carry clothing for changing weather.

Make sure you have decent spring-autumn clothing too, for extended outdoor use in all weather. This means good shoes for walking long distances (running shoes are fine), good athletic socks, and decent rainwear -- at least a military poncho (CheaperthanDirt.com, $20).

2) Bedding for winter. Assume there is no internal heating. A proper winter sleeping bag, good to -20F, will keep you warm and cozy. You can buy one for less than $100 at Campmor.com. Don't burn the furniture!

3) At least a few weeks of food. How hard is it to buy pasta and canned tomatoes? No need to be silly here, and buy years' worth of food. In a real crisis, it would probably be stolen from you, possibly by the police. There is little reason to use freeze-dried or other specialty products -- and besides, they're sold out for months anyway. Note that the U.S. military is now asking servicemen in the U.S. to stock up for several months.

4) A water purifier. The British Berkfield filters are fantastic, and will work for many years of daily use.

There's also something to be said for establishing some sort of offshore-accessible liquid asset. Bullionvault.com or Goldmoney.com (both are based in the UK) might fit that bill. If it was necessary to leave the country, there's a big difference between arriving somewhere new with $5000 and arriving penniless. Do you think you're going to carry those Kruggerands past TSA's metal detectors?

I would also add:

5) A mountaineering headlamp, batteries (including rechargeables), and both plug-in and solar battery chargers. These you can also get from campmor.com. For about $100, you can have enough light to work with, pretty much indefinitely. In addition to the rechargeables, you might add some lithium AA batteries, just in case. Because, when you really need it, the rechargeables need to be recharged. Have you noticed that? The lithium AAs last longer than alkalines, work in cold weather (alkalines are severely compromised below freezing), and have a 20 year shelf life. The Eneloop brand rechargeables (try amazon.com) are apparently the ones to get these days.

6) Heirloom seeds. "Heirloom" seeds are traditional varieties that are real plants, ie, they are capable of generating viable seeds and reproducing. A lot of agriculture today depends on hybrid or genetically-modified seeds that must be purchased each year. Guess what happens if the seed producer can't deliver? Mass famine, pretty much. There are some indications that "guerrilla gardening" -- farming of small plots in urban and suburban areas -- could be big in the next couple years. It's how Cubans got through their "special period," and Russians too. Tough to do if you don't have any seeds. In a famine situation, it's better to be a net food producer. More cheap insurance. Keep seeds in a cool dry place, but don't let them freeze. www.heirloomseeds.com. The Complete Garden Package #2 has 254 varieties of vegetables and herbs, packed with a silica gel insert for long-term storage. $315. Renew every three or four years. For asian varieties, try kitazawaseed.com.

Food, water, light and warm clothes. You'll make it a few weeks at least.

* * *

John Mauldin has made a list of recent funding rates for financial institutions:

Lehman Brothers--11-13%.
Merrill Lynch--11-12%.
Morgan Stanley--9-10%.
Citigroup--9 1⁄2 -10 1⁄2%.
CIT Group--12-15%.
Fannie Mae/Freddie Mac---15%
Keycorp--11-13%.
National City--13-15%.
Wachovia--10-12%.
Zions Bancorp--13-15%.
GM/GMAC--not possible.
Washington Mutual--not possible.
Ford--not possible.

Remember how these things work: they borrow at low interest rates, and lend at higher interest rates, and make money from the spread. This is done with lots of leverage. Their business models vaporize when they have to borrow at such high rates -- and there is a lot of refinancing of debt coming up for these guys before the end of the year. This is the "slow death" model of banking collapse, although, with spread inversion of this magnitude, it won't be very slow. Let's say you're borrowing at 10%, and lending at 7%. That's a 3% negative spread. Now, lever that up 10x. That's a 30% loss to capital, per year, not counting your regular expenses -- another 1% of assets typically, so that's a negative 4% ROA and a -40% ROE. Also, this further motivates the aforementioned non-insured depositors to get out, or at least rotate into the debt paying 10%+. If you were sitting on $2.5 trillion of uninsured deposits paying perhaps 2%, and you had the option of withdrawing your money at any time and getting 10%+ from the same institution, wouldn't you take it? Remember, these are not the First Texas Bank of Armadillo County. This is Citigroup, Wachovia, GMAC, Morgan Stanley.

Funding of the U.S. government is becoming a hot topic. If the U.S. federal government starts backstopping everyone in sight (the natural implication of the preceding paragraph), it will take a lot of money. I figure $2 trillion is possible by the end of 2009, not including regular-budget deficit spending. Normally, the U.S. government sells debt (issues Treasury bonds), which doesn't affect the money supply any more than if a corporation issued bonds. However, there are rumors that the U.S. government is already running into funding problems, and has already started to fill the gap by printing money. Of course, they wouldn't be reporting this in any official statistics. If the U.S. government has already hit the printing-money stage, new cashflow demands of $2+ trillion would have to be met mostly by the printing press as well. That would send the currency into oblivion. Remember, this is just a rumor.

"Rumor" also has it, though this is pretty much confirmed as far as I am concerned, that the U.S. dollar skyrocket move in August was the result of coordinated central bank intervention. This implies something which is quite dire: the central banks of the world are still buying into the dollar-centric arrangement that developed after World War II. What if central banks were competitive instead? They wouldn't be supporting the dollar. They would be trying to offer a dollar alternative, like a gold-linked currency, which could become more popular than the dollar over time. They would be saying "the Roman Empire is a goner, we are your alternative." They wouldn't be propping up the Roman empire. To some extent the euro has done this, but the euro is still basically tied to the dollar. Dollar support also means euro weakness -- specifically, keeping the euro from going over $1.60. This is because of the trade consequences of a radical decline of the dollar vs. the euro, and also the problem of domestic economic weakness in the eurozone. The ECB, reflecting the politics of the eurozone, doesn't want the euro to be an independent alternative to the dollar -- an alternative which could potentially hold its value as the dollar sank into oblivion, with $2 to the euro, $5, $10, $100, $1000 etc. To make a long story short, if this pattern is maintained, all the major currencies in the world would go down with the dollar. Combine that with what I just mentioned regarding money-printing in the U.S.

There is also some chitchat that certain governments have no intention of being a vassal state in the Roman Empire while the Roman Empire enjoys its slide into oblivion. Plans for new gold-linked currencies are already in place. My advice for these ambitious statespeople: you must understand that the operating mechanism for a successful gold-linked currency is the adjustment of supply. Read my book, if you haven't already. Driving a car can be very helpful and convenient when you know how to drive, and very dangerous if you do not know how to operate the machine. I would really prefer it if gold was not further blamed for the stupidity of certain bureaucrats who failed to do their homework.

* * *

How would the U.S. government "backstop" the banking system? Probably the most sensible method is to apply an explicit US government guarantee to ALL bank debt, or at least those of the nationalized entities which would have otherwise gone bust. That would allow banks to fund themselves (borrow money) at low, Treasury-like rates. As a result, the government would effectively nationalize the banking system. Common and preferred shareholders, and subordinated debt holders, would (should) be wiped out. One advantage of this method is that it is all "off balance sheet", an oh-so-popular methodology these days. It would allow the government to issue as little debt as possible, thus alleviating the funding (money-printing) issues. This would also mean the government would be on the hook for essentially all the mortgage-related losses in the entire banking system, possibly about $2 trillion. Indeed, it would probably become about $3 trillion, because non-performing assets would be liquidated at "mysteriously" low prices to government cronies, a rather nice way of stealing from the taxpayer without anybody noticing. I suppose some people would complain that the financial system and the government are stealing the taxpayer's money. But, stealing the taxpayer's money is what they have been doing every day for the last hundred years. So, there is really nothing new there. Where do you think all that tax money goes? The transfer payments (Social Security and Medicare) are paid directly from payroll taxes, and have been running surpluses since inception. The rest goes to the military, corporate subsidy, pork projects, outright theft, and the National Park System. A lot goes to pay debt service, the debt having been accumulated through the funding of the military, corporate subsidy, pork projects and theft (something tells me the National Park System didn't get much of the moolah.) The sheep are used to getting shorn, but when the shearer goes from left-to-right instead of right-to-left, as the sheep have become accustomed to, the sheep go "baa baa."

* * *

I figured it wouldn't cost much to bail out Fannie and Freddie, maybe $100 billion. I chose this -- admittedly very rough -- figure because the GSEs have all the good mortgage debt. All the ex-GSE debt is the bad stuff: subprime, Alt-A, jumbo, ARMs, neg-ams, option-ARMs, high LTV, HELOC, interest-only, etc. etc. The GSEs have all the tasty sirloin: the low LTV, 30 year fixed fully amortized, etc. Not everyone has 90%+ LTV mortgages. There are some people (believe it or not) that have really been paying down their mortgages diligently for many years, and have perhaps 30% LTV today. The people who refi-ed at lower rates, but didn't cash out, for example. Or, the people who bought a house, enjoyed some appreciation, and then rolled all the equity into a new house when they moved or traded up. The way it was supposed to work. Now, let's say a mortage has 30% LTV today (not the original purchase price, but compared to today's prices). For whatever reason, the mortgage goes into default. The mortgage holder can sell at a profit, so the mortgage probably wouldn't go into foreclosure. Also, even the 90%+ stuff has mortage insurance (PMI), so the GSEs were really seeing 80% LTV at inception. So, we shouldn't apply loss rates for the ex-GSE paper (all the bad stuff) to the GSE paper (all the good stuff).

However, it turns out the GSEs themselves took on tons of garbage. "Mr. Mortgage" , a mortage industry insider, says that he counts $1.2 trillion of subprime and Alt-A exposure on the GSE balance sheets, plus another $1.0 trillion to $1.5 trillion of higher-grade stuff that will perform much like Alt-A and subprime. That's $2.5 trillion in total. Applying a 50% foreclosure rate and a 60% loss rate, that's about an $800 billion loss for the GSEs, even assuming their better-quality holdings are fine. I think those estimates are high, but on the other hand I expect much more extensive declines in house prices, so maybe that's about right. Also, like I said, whenever the government is involved, the loss rates have a funny way of approaching 100%.

Read Mike Morgan's experiences with "REO failure" at Fannie Mae