Gold Slowly Gaining Ground on the Franc

Though it did play that role in the worst of the financial crisis starting in late 2007, the Swiss currency has failed to maintain its relative purchasing power vis-à-vis gold since 2001 (see gold in Swiss franc terms above).

Since late 2001 when the dollar peaked, the Swiss franc has gained a cumulative 36%. This compares to gold rising a cumulative 130% in Swiss franc terms or from 4.5 to 10.35 now. The Swiss franc has lagged behind gold this decade. That’s not a surprise. Since 2005, all currencies are trailing bullion as the yellow metal continues to rally. Gold hasn’t recorded a losing calendar year since this rally started almost nine years ago.

The Swiss franc is still a good currency – much better than its peers. But in this world of competitive devaluations and the slow death of the post-Breton Woods exchange rate mechanism, the franc is no longer a bastion of strength.

Today, that role has been replaced by gold.

Source: Global Investor: Gold King of the Currency Hill in the 21st Century

Asia, unlike major Western markets, already suffered from an economic depression in 1997-1998 as country after country was sucked into a massive currency and debt crisis smashed into the region.

Asia’s quick response to the crisis – mainly thanks to China – combined with easy credit financing from the West helped to lessen the severity and duration of the blow.

Currently, the FTSE Asia-Pacific Large-Cap Index (excluding Japan) yields 3.8% while the Tokyo Nikkei yields 2.7%. Both sectors yield more than local government bond markets.

The S&P 500 Index currently yields 3% or slightly below the yield on benchmark ten-year Treasury bonds.

Amazingly, Japanese stocks barely yielded 1% for years until the Nikkei began to hemorrhage starting in 2004. Since then, many Japanese large and small-cap companies have boosted dividends over the last five years, including share buybacks.

Some world-class companies in Japan continue to pay attractive dividends, including Canon (3.4%), Nintendo (5.5%), Nippon Oil (3.6%) and Takeda Pharmaceuticals (4.8%).

What’s truly amazing is how for many decades the United States continued to raise dividend payouts while emerging markets paid little or nothing to shareholders. Now that trend is changing amid the worst credit deflation in 75 years…as banks and other companies chop or eliminate dividends to conserve cash.

Dividends in the MSCI Asia Pacific Index are derived from companies in 14 countries with the top ten dividend-paying stocks accounting for about 20% of total dividends paid. In contrast, the top ten dividend stocks in the S&P 500 Index accounted for almost 33% of all dividends paid by that index in 2007.

According to research compiled by the Matthews Asia Pacific Equity Income Fund, between 2002 and 2007 dividends paid by the constituents in the MSCI Asia Pacific Index grew at a compounded annualized rate of 24% compared with 10% for the S&P 500 Index. That trend is accelerating since 2008 as Asian stocks maintain or boost payouts while American companies reduce or eliminate them altogether.

At some point in the future, it’s inevitable that currencies in Asia will be revalued vis-à-vis the American dollar. That makes dividend investing in the Pacific even more compelling as the total return equation grows more rewarding for long-term investors.

Source:  Increasing Dividends, Higher Total Return Mean Asian Equities Might Be Worth a Look

All thanks to the fact that we could soon be facing rising industrial demand and the possibility of supply outages caused by the looming Hurricane season. Not to mention that demand typically rises during the summer as individuals turn up the air conditioning.

There’s no doubt about it; the best risk-adjusted speculation now for commodities investors is natural gas. There’s no other commodity that’s this cheap, this battered and this oversold (see chart below.)

From its high in July of last year, spot natural gas prices have now collapsed a cumulative 74%. In 2009 prices have declined 37%. Crude oil – on the other hand – has been driven higher by big supply cuts by OPEC and Russia earlier this year, seeing prices rise 19% to $53 a barrel.

Over the last several months, natural gas has been hammered as the global economy suffers its worst recession since 1981-82 coupled with soaring gas inventories. Though an extremely volatile commodity, natural gas at these levels has historically been a strong speculation following big bear market crashes.

Canada is home to some of the best natural gas companies, including Encana (NYSE:ECA). The stock is more than 50% below its all-time high and pays a 3.6% annual dividend at current prices.

It’s time to ride natural gas.

At just $3.55 BTUs (British Therman Units) it’s hard to believe prices can head much lower. All the bad news is already baked into gas prices. It’s my favorite energy play right now in Commodity Trend Alert (CTA) – celebrating its 7th year this summer.

Source: Natural Gas: The Cheapest Commodity Speculation

The MSCI World Index and the S&P 500 Index just posted their best monthly gains since April 2003, gaining 10.9% and 9.4%, respectively. Credit spreads or the difference between super-safe Treasury bonds and riskier bonds saw premiums plunge last month while 90-day LIBOR rates rallied from 1.19% on March 31 to 1.02% yesterday.

Indeed, even the most adamant bear would have to consign some flexibility to this rally, which has swallowed most asset classes since March 9. Stocks, non-Treasury bonds, most commodities and REITs have all participated in a broad-based rally over the last seven weeks.

But before popping the champagne, let’s not forget that back in early March stocks were pricing in a depression following a stunning 58% peak-to-trough collapse since October 2007. Banks have led this rally since March 9 (+76%) and the same banks will be responsible for its eventual demise.

My view remains the same since March: This is a bear market rally just like the prior three rallies that occurred from late 2007 until March. Ultimately, we might not break through the March 9 lows this year but the odds remain high that we’ll retest those lows this summer.

Wall Street analysts and many European investment strategists continue to believe that we’re in a new bull market driven by massive government stimulus, cheap valuations and near-zero global interest rates. That might be possible but, in all probability, it’s highly unlikely.

Housing prices are still declining, unemployment hasn’t stabilized, domestic consumption is way down and deflation is officially in town since March for the first time since 1955, meaning companies don’t have the flexibility to mark up their goods and services. Furthermore, no bull currently alive has ever witnessed a credit deflation; it would be unwise to underestimate the scope and duration of credit destruction and the time required to heal business and consumer balance sheets.

A long-time bear that eventually enjoyed his day in the sun starting in late 2007 is Albert Edwards of Société Général in London. According to Edwards, “The current pop in the market is not dissimilar to the many bear market rallies between 1929-1933 where signs of economic stabilization were met with strong 25% rallies, most especially in late 1929 and mid-1931. This optimism was subsequently crushed.”

The above table depicts the long sequence of bear market rallies during the Great Depression. The Dow posted a total of five false rallies until bottoming for good at 41.22 in July 1932. The length of the current rally thus far is seven weeks; from 1929 until mid-1932 the average bear market rally lasted 10.1 weeks, suggesting there’s still some juice left in this upward march. But the Piper is coming.

Back in February and March I also suggested it would be a good time for long-term investors to begin accumulating stocks following the second worst crash since 1929. I still believe March marked a good entry point to add value. Yet I don’t think we’re through the worst yet, either.

The massive up-crash we’ve seen since March has been alarming. Previous bull markets in history have typically been accompanied by some profit-taking and healthy backing and filling; that’s not happening with this rally, which has been characterized by vicious rallies almost every other day without a pause or correction. I don’t like this action.

Meanwhile, it’s hard to be a bear this spring. I find my place at the table is a lonely one as stocks and non-Treasury bonds skyrocket. Still, I’m sticking to my guns and remain heavily under-weighted in stocks; in fact, my net exposure is net short or negatively exposed to equities.

Source: Evil Lurks Behind the Shadows of 1929-1932

In many ways, what’s happening now across Eastern Europe – including Russia – is reminiscent of the Asian economic depression that began in Thailand in July 1997.

Punch-drunk from easy credit in the 2002-2007 period, regional economies aggressively borrowed from abroad, mainly from Austria and other EU members that included leveraged mortgage loans tied to low interest rate currencies like the Swiss franc. That strategy has violently backfired since last summer as investors fled risky assets en masse.

In some East European countries, Swiss franc-denominated mortgages comprised more than 50% of all outstanding mortgage loans. Combined with plunging local currencies, the cost to service those loans has surged, causing foreclosures and defaults to skyrocket.

Auf Wiedersehen Bull Market

After a multi-year bull market against most major currencies since 2002, the euro is now hemorrhaging since last July as Europe’s economic miracle comes undone at lightning speed.

The euro’s decline pales compared to the outright plunge of numerous currencies in emerging Europe, especially since mid-January.

Eastern Europe’s largest economies – core manufacturing hubs for many Western European companies – have seen their currencies crash almost 20% versus the euro already this year, thanks to growing funding concerns amid a rapid acceleration of deflation across local economies. In December, Hungary received assistance from the International Monetary Fund (IMF). Now governments in the region, including the Austrians, are pressuring the European Union (EU), and specifically Germany, to open its vast purse strings to preserve the euro and save Eastern Europe.

Against the sagging euro, many of the regions’ once fast-growing economies in East and Central Europe are now in the midst of significant economic contraction and sharply declining currencies. Credit spreads have surged, credit default swaps are widening and rapidly dwindling foreign-exchange reserves in the region threaten market capitalism, which until recently served as a model for emerging economies in the post-1991 Communist era.

Austrians Plea for Euro-zone Bailout

A fresh full-scale banking crisis affecting Western European institutions is now accelerating this month, with Austrian banks on the hook for €278 billion ($354 billion) to Eastern Europe – the largest exposure among euro-zone members. Western banks are saddled with $1.6 trillion dollars’ worth of Eastern European loans, mostly tied to banks in Austria, Germany, Italy, France, Belgium and Sweden, according to the Bank of International Settlements.

Austrian bank losses are enormous and the cry for help couldn’t be louder.

Austria has been the most aggressive investor in Eastern Europe over the last decade. Local banks rank as the largest investors in the Czech Republic, Hungary and Romania (US$142 billion dollars) with several Austrian banks now attempting to secure government guarantees – including Raiffeisen Zentralbank, one of the largest lenders in the region along with Erste Bank.

Emerging European Collapse

Whereas the Austrians – harboring strong historical trading ties to the region – were heavily exposed to Eastern European banks, Swedish banks lent heavily to the Baltic Republics.

Lithuania, Latvia and Estonia are also fiercely contracting since October, with banks struggling to maintain solvency. Other countries in the region – including Ukraine – are barely solvent and require additional IMF funding while Kazakhstan’s largest bank saw a run on its deposits earlier this week. The list goes on and on, with several other markets in trouble as funding gaps widen in an environment of tight credit and shrinking bank capital.

Teutonic Shift as Euro Must Survive

Germany, the euro-zone’s largest economy measured by output, is now at the forefront of the crisis since earlier this month. Over 25% of Germany’s exports head to Eastern Europe – a vital market for her multinationals. As the region heads quickly into a full-blown fiscal and currency crisis, Germany, and possibly even France might have to bail-out the former Soviet satellite states that are part of the wider European Economic Area (EEA).

German finance minister Peer Steinbrueck breached the subject on February 18, stating, “some of the 16 euro nations are getting into difficulties and may need help.” He went further, adding, “Germany would act if fellow euro members got into financial trouble.”

The markets are screaming for an Eastern European rescue and fast. Thus far, European deficits have ballooned with more than US$1.5 trillion dollars committed to fiscal spending packages, including bank rescues and partial or full government bank nationalization.

Credit spreads for the most troubled economies in the region continue to rise vis-à-vis German bunds – the euro-zone’s largest and most liquid government bond market. And it’s not just Eastern Europe that’s feeling the pain; several high deficit countries in the euro-zone, including Greece, Ireland, Italy, Portugal and Spain have seen their financing costs rise on the heels of credit downgrades or failed bond auctions.

Inevitably, the Germans will finance most of a pan-European rescue for the weakest economies, especially those already part of the single currency euro-zone. That’s because the euro’s viability is at stake; the Germans would rather keep the most vulnerable euro-zone members a part of the single currency.

The consequences of losing one or more euro-zone members would imply higher funding costs for healthier members while probably devastating the economies of those members that abort the euro as financing costs skyrocket.

The endgame for the Europeans is inevitably higher long-term interest rates for all government bond markets. Like the United States, the Europeans will spend a record sum of capital in 2009 and 2010 to fund unprecedented fiscal spending plans and bank bailouts. This includes the Germans, who have now abandoned their mantra of fiscal responsibility to save the euro-zone from near financial ruin.

Germany might have been reluctant at first to participate in a broad-based European rescue effort. That tone has decidedly changed since January as the Merckel government unloads a tirade of spending ultimately leading to the first German budget deficit in decades.

Now Europe watches and waits for the Germans to come to the rescue. The future of the euro depends on Berlin’s quick response.

Source: Euro Bull Market Declared Over as Eastern Europe Crashes: Will They Be Saved?

Oil prices now trade at a five-year low.

If oil prices overshot on the way up to US$147, then the opposite is certainly true today with prices at US$36 a barrel. At some point, crude oil will bottom; the odds of a spectacular bounce occurring is highly likely as global governments spend trillions of dollars at the same time to desperately boost economic growth in 2009-2010.

China, which is the world’s second-largest consumer of oil after the United States at 9.4 million barrels per day, is now importing the lowest amount of crude oil this decade amid a softening economy. U.S. demand has also declined sharply to less than 19 million barrels per day.

Did Crude Overshoot on the way down to US$36?

According to the International Energy Agency (IEA), oil consumption in 2009 will decline to its lowest levels since 1982.

The IEA cut its demand outlook last week as the global economy continues to deflate since the fourth quarter. The Paris-based agency now projects oil consumption will decline by 570,000 barrels per day to 84.7 million barrels. Just 12 months ago, the world sat on a net supply deficit of about one million barrels.

More than any other nation, China has seen the largest spike in net oil consumption this decade. Chinese oil consumption has increased by 3.2 million barrels per day since 2000, accounting for a third of the total increase in global demand.

The Chinese are also in the midst of their biggest expansion of credit in history following the passage late last year of a US$541 billion dollar stimulus package. That spending should at least boost short-term demand for oil assuming consumption in the United States is also supported by the government’s recent passage of the $878 billion fiscal spending package.

Even the biggest bears will concede that concerted global government spending will buy at least a few quarters of economic growth later this year or in 2010 – and that should boost oil prices. Combined with additional supply cuts by OPEC and a host of cancelled exploration and development projects over the last few months, oil prices are bound to bottom shortly.

The above chart shows oil prices dating back to 1997. In 1998, amid the tail end of the Asian economic crisis and the Russian debt default, oil prices bottomed at an incredible $10.50 a barrel. Ten years later, at its peak, oil climbed a cumulative 1,300%.

I think it’s highly unlikely we’ll see 1998 prices again, unless another major bank fails or worse, a major sovereign borrower defaults in this cycle. This remains a possibility in a brutal deflationary environment.

Yet, if the time to buy an asset is when prices are low and in near disrepute, then crude oil fits that bill right now. When the time comes to buy oil, look to the oil futures or oil futures related ETFs. They’ll give you much more bang for your buck than most oil stocks.

Source: Depressed Oil Prices Approaching Speculation of a Lifetime

This from Sovereign Society:

The odds are growing that one or more sovereign borrowers in East and Central Europe will default in 2009 unless the financial hemorrhaging stops. Local banks in these markets have been battered, currencies have declined sharply, liquidity is running dry and stock markets have collapsed.

With global markets once again reeling from the next chapter of disastrous bank-related earnings and the prospects of full government nationalization on the horizon in several countries, another blow to investor confidence might be around the corner: a sovereign government default.

According to the Financial Times, global bond issuance in 2009 will reach an all-time high of more than US$3 trillion dollars – three times greater than last year. In the United States, the Treasury will auction almost US$2 trillion dollars to fund monster fiscal spending packages and bailouts; in Europe issuance is expected to reach more than US$1 trillion dollars.

Euro-zone Failed Auctions

Several European countries in the euro-zone have struggled to meet bond auctions, including the world’s second-largest fixed-income market – Germany.

Since October, Germany has failed to meet its bond auction targets on four separate occasions, either reducing or scrapping government bond auctions altogether amid poor investor demand.

Investors are growing nervous because of the unprecedented funding requirements for European fiscal spending in 2009 as the financial system yearns for a wave of fresh capital amid bank equity deflation. The United Kingdom has announced the first initiative to collateralize all toxic bank assets with implicit state guarantees – a first at this stage of the credit crisis.

Elsewhere in Europe, countries like Austria, Spain, Belgium, Italy, Holland and Ireland are struggling as interest rate spreads versus German bonds continue to soar. Rising spreads mean investors are growing more risk-averse and demand higher interest rate compensation compared to Germany – the regional safe-haven market.

The euro-zone is now awash in bond supply as countries race to sell debt to finance fiscal spending packages and increasingly, bank bailouts that will probably result in government nationalization of the battered financial services sector.

HSBC Credit Swaps Cheaper than Most European Governments

The cost of credit protection measured vis-à-vis credit default swaps (CDS), which protect lenders from an issuer defaulting, have soared over the last several weeks for the United Kingdom, Italy, Spain, Greece and Ireland among others.

It now costs more to protect against a default in several European nations than it does to insure against HSBC – the world’s biggest bank. That’s a major 360-degree shift in investor sentiment because 12 months ago, the tables were turned in favour of sovereign governments.

Earlier in January, the rating agencies downgraded Greek and Spanish debt and other countries, including Italy, Belgium, Ireland and the United Kingdom might be next. A credit downgrade implies rising funding costs for government borrowers as the market places a higher interest rate premium on sovereign debt.

While funding gaps lurk for countries sporting bloated debt-to-GDP ratios, others in the emerging markets are in worse fiscal shape with the IMF already bailing-out three countries over the last six months.

Debt-to-GDP Ratios Surge in Eastern Europe

While the financial panic gripping the industrialized nations has been frightening, particularly for Western governments, the scope of the disaster is now beginning to threaten the ability of some countries to service their debt burdens in the emerging markets. That’s because many countries in East and Central Europe have amassed a mountain of short-term debt obligations, threatening debt servicing as local currencies plunge.

In many ways, the current funding crisis among weaker emerging European borrowers is similar to what occurred during the Asian economic crisis starting in 1997. Most nations in the region also accumulated massive short-term debts denominated in dollars.

Many currencies in the emerging markets have crashed since last July, raising their cumulative debt-servicing costs and limiting their ability to raise fresh capital from global investors. This is especially the case in the Baltics and the Balkans.

In 2008, Ecuador and the Seychelles defaulted on their debt.

Since last fall the IMF or International Monetary Fund has bailed-out Iceland, Hungary and Ukraine. More countries might be next in the emerging markets and quite possibly, even in the euro-zone.

According to Deutsche Bank, combined current account deficits and debt of Eastern and Central European countries is around 18% of GDP or gross domestic product compared with only 8% in Asia and Latin America. Some countries are now in the danger-zone with explosively high debt ratios, including Estonia, Latvia and Lithuania.

Credit Spreads Point to Danger, Possibly Default

In the euro-zone, Ireland, Greece, Portugal and Spain maintain the highest credit spreads over German bonds in late January ranging from 3.39% for Greece to 1.73% for Spain.
Indeed, investors have demanded higher interest rates to compensate them for rapidly rising deficits in these and other euro-zone countries.

Yet the credit spreads in Europe are kids’ stuff compared to recent developments in the emerging markets.

Ukraine, which has already received IMF aid, must rollover approximately US$30 billion dollars of funding this year while Hungary requires US$15 billion dollars. The spreads on Ukrainian dollar-denominated debt compared to benchmark U.S. Treasury bonds is now 24.4% – only second to Ecuador’s 32.7%, which has technically defaulted in 2008. Other countries with soaring borrowing premiums include Argentina and Venezuela.

Avoid Emerging Market Debt

Not all emerging market sovereign borrowers are threatened by default. Some countries, like Brazil, probably hold better risk-adjusted returns than most industrialized countries over the next 12 months. Brazilian credit spreads have risen as well since last year but remain at a respectable 3.31% above Treasury bonds and are still rated investment-grade.
Yet for most emerging market bond issuers, the cost of raising capital is certainly on an uptrend in an environment of shrinking trade surpluses, rising deficits and a full-fledged recession in key export markets.

Investors should avoid emerging market debt as risk of default spreads and raises funding costs for even some of the safest credits. Spill-over is already breaching the haul of several leading issuers.

The J.P. Morgan Emerging Markets Bond Index now yields 9.42% or 682 basis points (6.82%) more than Treasury bonds. That yield spread peaked last October at 12.21% at the height of the panic. Yet it would seem plausible that spreads will rise again as one or more sovereign borrowers in this asset class default. Many of the highest indebted borrowers, including Ukraine, have amassed huge amounts of short-term debt that must be refinanced.

The best time to buy emerging markets is amid a full-blown panic. Though we’re not at the point of maximum pessimism yet, investors will eventually feast on double-digit yield spreads as defaults increase in 2009.

Combined with crashing or weak currencies, this is not the time to be a hero in emerging market debt as default risk heightens.

Source: The Next Shoe to Drop Might be a Sovereign Borrower

This from The Sovereign Society:

Does market-timing work? Better yet, does it matter if you’re a long-term investor dedicated to stocks or other asset classes? Don’t most investments appreciate over time?

The evidence suggests that knowing when to enter and exit a market can make all the difference in the long run.

Investment pros ranging from Warren Buffett (Berkshire Hathaway) to John Bogle (Vanguard Funds) chastise market timing. Hedge funds – which charge high fees to time entry and exit points in global markets – failed miserably in 2008, posting an average 18.3% loss according to Hedge Fund Research. Worse, only several U.S. mutual funds actually earned a profit last year while the remaining 8,500 or so suffered 40%-plus losses.

In 2008, the S&P 500 Index plunged 38.5% – its worst year since 1931. The MSCI World Index, a composite of global mature market common stocks logged its worst year since its inception in 1969 – down 42%. Within the emerging markets universe – including New Frontier countries with esoteric markets like Vietnam, Bahrain and Croatia – not a single bourse recorded a profit, according to MSCI Barra.

Ten Years and Counting…

Investors can’t time the market consistently. And that applies to both individuals and professionals. But does it really matter? The answer is a resounding “Yes!”

Investors who purchased the S&P 500 Index at the height of the last bull market in March 2000 are still licking their wounds almost ten years later.

A US$10,000 investment in the S&P 500 Index in 2000 would be worth $7,000 through December 31, 2008. That’s a 30% decline and confirms America’s “Lost Decade” as it pertains to stock investing.

Despite the dollar’s big decline since 2002, which boosted the value of foreign shares when measured in dollars, the MSCI World Index turned an original US$10,000 in 2000 into US$8,007, a 20% loss. So much for passive long-term investing…

Timing a Depression Low

Yet the same investor who plunked US$10,000 into the S&P 500 Index back in 1982 – the last secular bear market low – would have seen their original investment grow to more than US$150,000 through December 2008.

What’s even more amazing is how market timing paid off in spades even during the Great Depression. An investor with the dreadful foresight of investing US$10,000 back in October 1929 in the Dow Jones Industrials Average (Dow) would have seen his investment crash to just US$1,400 by June 1932 or a massive 86% wipe-out. Yet again, timing the market paid off brilliantly starting that same year when the U.S. market hit a low for the cycle.

From its bear market low of just 41.22 in June 1932, the Dow skyrocketed all the way to 194.40 by late 1936 – a whopping 372% return, excluding dividends. By 1937, however, the Dow began to fall apart again and crashed 33% before finally bottoming in 1942.

Yet under FDR, the market seemed to gain traction by rallying a cumulative 121 points or rising four consecutive years starting in 1933. Once again, timing the market made a huge difference.

An investor who purchased the Dow in mid-1932 would still have earned a profit through 1942, the year the market finally bottomed.

But the poor unsuspecting investor who came aboard in September 1929 would have waited until 1955 to break-even. Waiting 26 years to recover your capital isn’t exactly the Field of Dreams; yet that’s exactly what might be in store for those investors who bought stocks at the height of the dot.com bubble in early 2000.

Bear Market Bottom still Lies Ahead

I’m not convinced the November 20 low was the ultimate bottom in this bear market. It might be another in a series of intermittent lows since stocks peaked in October 2007.

Stocks might appear to be cheap against all valuation measures, including government bonds, inflation, T-bills and risk, including the VIX Index. But it’s hard to make a compelling case for equities when corporate earnings will remain hostage to a crash in domestic consumption, a freefall in residential housing and soaring unemployment. Valuations alone don’t terminate bear markets.

The Mother of Buying Opportunities

Sometime over the next 12-18 months the stock market will form “the” bottom. That event will mark the greatest entry point for stock investors in more than 27 years, possibly longer. And just like 1932 when the market hit its low point investors will sow the seeds for humungous long-term profits.

Timing the market does make a big difference. The historical evidence strongly suggests that knowing when to buy or sell stocks can either make or break the individual investor. History also tells us that stocks are likely to muster a massive calendar year rally or more under President-elect Obama, similarly to FDR starting in mid-1932.

Source: Market-Timing and the Mother of Market Bottoms

Until they finally create an entity to bundle toxic and mostly illiquid assets, the credit crisis will continue. Thus far, the Treasury has simply handed out tens of billions of dollars directly to banks whom remain reluctant to lend as the economy heads deeper into the financial abyss.

Back in October 2008 – at the height of the global crash – Treasury boss Hank Paulson provided hope that he would finally tackle the clogged mortgage-backed securities crisis affecting global capital markets. Investors demanded the creation of an entity to place bad assets under one roof. But the Treasury has since made a U-turn, changing its original plans.

Mortgage securitization is largely responsible for this crisis. Since 2001 Wall Street spearheaded a bull market in residential lending through the creation of mortgage-backed securities. Indeed, Wall Street – and not traditional banking – was indirectly responsible for more than 70% of all real estate loan origination.

Under TARP’s (Troubled Asset Relief Program) original mandate, the Treasury would apportion a sizable share of the original $700 billion dollars of tax-payer funds to place busted mortgage-backed assets into a separate entity, similar to the 1989-90 Resolution Trust Corporation (RTC) vehicle created to bundle bad loans. The RTC worked to help banks and Savings & Loans to finally separate bad loans and clear the way for economic recovery following the last real estate bear market.

But since October, Paulson has backtracked. Instead of dealing with the crux of the current credit crisis affecting counter-party trust and bank balance-sheet transparency, or the lack thereof, Paulson decided instead to disperse TARP funds directly to banks. Now most banks that have tapped into TARP won’t lend capital to a credit-starved economy. And in some cases, this has resulted in widespread hoarding whereby financial institutions are using TARP money to boost their balance sheets capital ratios. That’s not what the original plan sought to achieve.

Toxic assets include bonds backed by mortgages, including complex mortgage-backed securities, auction-rate securities backed by student loans and potentially a blizzard of other securities tied to commercial mortgages, credit card loans and auto loans. The size of these bad loans continues to grow, compounded by rising defaults made worse by an economy that is rapidly contracting since September.

Meredith Whitney, who ranks as the most accurate bank analyst predicting this credit-inflicted deluge since 2007, predicts banks will be required to fork over even more capital as loan-losses continue to rise. This will only delay any recovery in battered bank balance sheets since the initial TARP objective has been changed.

To be sure, several segments of credit have markedly improved since late November, including the TED Spread, LIBOR, investment-grade corporate bond spreads and even a series of new corporate investment-grade and junk debt issuance since December. But the bad assets still plaguing the American and European financial systems have not been addressed.

Bad assets must be segregated, identified and isolated from the financial system in order to improve institutional counter-party confidence and transparency. The credit crisis remains alive until this primary objective is tackled, if at all, by the next Treasury Secretary.

Source: TARP’s Original Mandate MUST be Executed

This from Sovereign Society:

In December, investment-grade corporate debt soared over 15% as credit spreads plummeted following a crash in September and October.

If you’re debating an investment in high quality bonds then it’s not too late. The Dow Jones Corporate Bond Index yields 7.04% or 460 basis points or 4.6% more than benchmark ten-year Treasury bonds. Twelve months ago that spread was barely 2%, or 200 basis points. Treasury bonds are expensive while corporate debt is cheap.

When comparing the relative risk-reward scenario of stocks versus bonds, I think high quality debt is the optimal asset allocation choice. Any healing in the markets will start with credit, not common stocks.

Stocks will not lead a recovery in 2009. Though a bear market rally remains highly probable – stocks are up 22% since the November 20 low – risk remains high despite a 40% plunge last year. That’s because corporate earnings have fallen off a cliff since the fourth quarter and consensus estimates for the first half still appear too bullish.

Even in a best-case scenario for stocks, volatility will remain prevalent and that means a box of Rolaids for most investors.

Why take a chance on stocks this year amid the great economic “unknown” when you can tap into 7%-plus yields on corporate debt with the scope for big capital gains if bond prices rise? The tradeoff makes sense.

Even the largest financial services companies or banks are now backstopped by the federal government. Spreads on these bonds are even wider than non-financial corporate debt and have the implicit guarantee of Uncle Sam since October. For example, Bank of America’s January 2011 notes provide an effective yield of 6.03% or 514 basis points more than Treasury bonds.

High-yield bonds, or junk bonds, got smashed to pieces in 2008 suffering their worst year on record – down 25%. Junk debt now yields 13.8%, according to the Merrill Lynch High Yield 100 Index. But as the corporate default rate climbs sharply from 3% now to 10% or more this year it’s hard to imagine junk bonds can muster a significant rally. Historically, junk bonds don’t appreciate when the default rate is climbing.

The stock market can continue to rally this year, similar to 1932 when it more than doubled in a short period of time following an 86% crash from 1929 to March 1932. Yet even after doubling in 1932 from March to late June the Dow finished the year down 15%. Talk about a wild market!

It makes more sense to me as an investor to buy high quality corporate bonds in 2009. You get paid nicely to wait for a recovery in bond prices while stocks remain hostage to great economic uncertainty and more, including regulatory changes, rising unemployment, geopolitical tensions and, most of all, a deep bear market in residential housing.

Source: Healing starts with Credit, not Equities in 2009