–American musicologist Alan Lomax traveled all over the American South in the first part of the 20th century to record the folk music of men like Woody Guthrie, Jelly Roll Morton, and Muddy Waters. He met Huddie Leadbetter (Leadbelly) in Texas and put together an album. In the liner notes to the album, he described Leadbelly as, “the toughest man on the toughest chain gang in the toughest prison in Texas.”

–We read the line in the transcript of radio interview on ABC National Radio with American Anarchist Robert Wolff. It made us think of Dr. Kurt Richebacher, “the toughest economist on the toughest beat during the toughest time in monetary history of the last 50 years.”

–So if yesterday’s Daily Reckoning was a tough slog for you, we’ll take a slightly easier path today. But we’re still going to talk capital, and what Australian assets might be rising in value.

–First, we didn’t have to get far in the headlines this morning to see the issue of just what capital really is come up. “The U.S. Securities and Exchange Commission will require investment banks to disclose their capital and liquidity levels after the agency was criticized for regulatory failings in the wake of the Bear Stearns collapse,” reports Jesse Westbrook at Bloomberg.

–The SEC will require Wall Street firms to report on their capital and liquidity levels in, “terms the market can readily understand and digest.” Aha! So we will now know who has more dodgy assets than real capital. Of course, we already do know quite a bit.

–A new accounting rule last November required banks to report their assets in three categories, from easiest to sell and value (Level 1) to hardest to sell and value (Level 3). We also know that all five major U.S. investment banks (Goldman, Merrill, Bear, Morgan Stanley, and Lehman) have level three assets that are at least double the capital listed on the balance sheet.

–Write-downs in Level three assets directly affect a bank’s capital. It might not seem like such a big deal at first. After all, at Merrill Lynch, Level three assets represent just 8% of the firm’s total assets. The trouble is that in the first quarter of this year, Merrill saw its Level three assets grow to US$82.4 billion-up 70% in just three months.

–It’s not just Merrill, either. Goldman Sachs reported that its Level three assets grew by 39% in the first quarter to over US$78 billion. Those assets are just 8.1% of the firm’s total assets. But again, they exceed by a large margin the firm’s capital base. The same is true of Lehman Brothers. And let us not mention that total liabilities for these firms are many, many times greater than stockholder’s equity.

–In an unrelated development, shares for all five investment banks were down on Wall Street.

–Seriously, with so many assets parked on Level three, with their ability to attract new capital infusions from foreign investors suspect, and with conditions in the American consumer economy so dire…what utterly oblivious investor would consider financial shares “good value”? When your assets are really liabilities waiting to be born, your capital hangs by a slender thread.

–Australia probably has its fair share of balance sheet problems, both at the household and corporate level. We read in today’s Age, via professor Steve Keen, that “At the bottom of the 1990s recession…Australia’s debt was about 78 per cent of GDP. It is now 165 per cent. That’s more than doubled over the past 15 years. In 1892, he says, debt peaked at 104 per cent of GDP and in 1931 it peaked at 77 per cent.”

–Buying assets with borrowed money is a dangerous game.

–What about buying assets that haven’t yet been produced? Yesterday we referred to the structural revaluation in global oil markets. But we probably should have said global energy markets.

–Origin Energy’s Grant King hasn’t responded formally to last week’s unsolicited $12.9 billion bid from British Gas. But he too is suggesting that it’s time to rethink how investors value energy assets.

–King, according to today’s Financial Review, told investors at the Macquarie Securities conference yesterday that his company, “should be valued as a resources stock on a discounted cash flow basis rather than on the typical price-earnings multiple for a utility.” Using discounted cash flow to value resource companies is itself a bit of a challenge. We prefer, at least with gold companies, to use the more common market-cap/ounce of proven reserves.

–This metric tells you clearly whether a share is over or undervalued based on actual gold in the ground. How useful this metric is to something like coal-seam-methane is another question. Some commodities are more capital intensive than others. Some, like oil, begin producing cash flow right away, while others don’t throw off as much cash right away…but have longer, more predictable operating lives.

–There are different ways to value an asset. But the biggest factor is whether the asset is going up in price. Australia has that going for it. Most of its resources are increasing in price, and thus in value. We’ll have more on Australia’s coal-seam-methane projects for you tomorrow.

–How about a question on…yes…capital!

Dear DanLove to read the Daily Reckoning. But you need to explain to me why a factory is the ultimate capital asset . Why not an office that produces services…income for other workers, profits for shareholders and taxes for governments? You seem to suggest that the US needs its factories back. But surely it has a comparative advantage in providing services?Regards

B. M.

–Bob makes an interesting argument, one for which we do not have a full rebuttal. Services can increase productivity, greater output per person. This is one way economies grow without causing inflation. But we’d suggest that an entire economy that trades in services is not possible…or definitely not beneficial for average wages and incomes.

–As Wal-Mart replaced General Motors as the largest employer in America, the average wage for Americans took a historic turn lower. To some extent, this is just a product of the globalisation of labour. Adding China and India to the mix has driven wages down everywhere.

–Our main point, though is that service jobs don’t contribute as much to actually providing the goods that satisfy people’s material wants now and in the future. If you don’t make things people want and trade them for a profit, then someday in the future, what’s on your shelves here in Australia (or America) is going to be determined by the buying preferences of Chinese consumers.

–Obviously there are some global brands which have a great appeal to consumers all over the world. Apple will probably sell a lot of iPhones in China, for example. But where will the profits go? Apple’s profits will go its shareholders and its employees. But you can’t have an economy full of company’s that rely on brand image, styling, and intellectual capital.