This from Money Morning:

The plethora of bank and corporate bailouts, stimulus plans and interest-rate cuts that the U.S. government has produced over the last three months can only lead to one outcome: The U.S. dollar has to decline.

During the crisis so far, the dollar in general, and U.S. Treasury bonds in particular, have been regarded as a “safe haven,” making the dollar strong and pushing long-term U.S. Treasury rates downward. In the New Year, however, this is likely to change – the weight of the added supply of dollars in circulation will be too great for the greenback to shrug off.

Back in November 2007, when I wrote about the U.S. dollar becoming the “Bernanke peso,” I suggested that the dollar – then trading at $1.50 to the euro – would get weaker. Alas, I was wrong: It is currently trading at $1.29 to the euro, although it did reach $1.60 in May. However, I recommended buying not euros, but yen. The chaos of 2008 has reversed the decline in the dollar against the euro, but not against the yen, which has reached Yen 92.8 = $1 compared to a rate of Yen 114.8 = $1 when I wrote the piece. A gain of 24% against the dollar is not bad, and indeed I defy you to find a stock market that has done as well over that period.

The fundamentals tending to weaken the dollar remain. The U.S. trade deficit was $57.2 billion in October, which annualizes to $700.3 billion – down but a little from the 2006 peak of $758 billion. Although the recession and recent sharp decline in the value of U.S. oil imports will reduce the U.S. trade deficit further – perhaps to $500 billion annually – there is still no reason why foreigners should continue to so highly rate the currency of a country that is running a $500 billion balance-of-payments deficit, and a $1 trillion budget deficit.

After a pause during the summer, the U.S. money supply has begun rising again rapidly. The excess money has flowed into Treasury bonds, sending the yield on the 10-year bond down to a recent 2.71%. The distortion in the market can be shown by the yield on the 10-year Treasury Inflated Protected Securities (TIPS), which was 2.44%; that combination of prices said that investors expect U.S. inflation to average a mere 0.27% annually over the next 10 years.

Clearly that’s nonsense; the explanation is that yields on long-term Treasury bonds have been driven far below their economically appropriate level. In other words, U.S. Treasury bonds are currently benefiting from a bubble, and like the bubbles that we’ve seen in Japanese stocks, real estate, U.S. tech stocks, the American housing market and global commodities, this bubble, too, will ultimately burst.

The budget deficit in the 12 months through to September was $455 billion, but that’s expected to expand to close to $1 trillion in the year to September 2009 – and that’s even before President-elect Barack Obama’s stimulus plan, which is expected to cost at least $500 billion, and could possibly cost that much a year over several years.

If that’s surprising, consider this: The U.S. budget deficit was $237.2 billion in October 2008, a record monthly figure. That puts a huge strain on the U.S. Treasury Department’s financing capacity, and will probably result in the U.S. Federal Reserve printing yet more money, since the alternative would be for the huge amounts going into Treasuries to choke off demand for private investment – not the desired objective. With more money being printed, inflation is likely to soar and the dollar to weaken.

Net foreign purchases of long-term U.S. securities declined to $793 billion in the 12 months to September 2008, from $1.03 trillion in the previous year. Of those purchases, Treasury bonds and notes represented $385 billion, up from $192 billion in the previous year, while purchased corporate bonds shrank from $447 billion to $168 billion.  Thus, the “flight to quality” has so far been enormously helpful in enabling the U.S. Treasury to finance its growing budget deficit; in October and November it will doubtless have been even more so.

Once the inflow into U.S. Treasuries slows, or the huge volume of Treasuries issued simply overwhelms it, the dollar will weaken and Treasury yields will rise. At that point, there is likely to be a stampede for the exits from the Treasury bond market, which will be self-reinforcing. As a wise investor, you could prepare for this stampede in four ways:

• First, you could have a modest holding of the Rydex Juno Fund (MUTF:RYJCX), the price of which is inversely linked to T-bond prices (the fund shorts Treasury bond futures.). The fund has had a poor record since its inception in 2001, and it probably makes little sense to put too much money in it. However, given the scenario we’ve sketched out here, the fund will do a lot better in 2009.

• Second, you should have bond, cash and stock holdings in foreign currencies, particularly the euro and the yen (but not British pounds sterling; with a housing bubble and a bloated financial sector, Britain has many of the same problems as the United States). Aside from foreign-currency-denominated stocks and bonds, you may want to consider a foreign-currency-deposit account through EverBank, which offers foreign-currency certificates of deposit (CDs), albeit at low interest rates, at present – only 1% on a 12-month Euro CD for example. [Editor’s Note: EverBank also offers a product called the EverBank Asian Currency Portfolio. Readers can find out about all the bank’s products by contacting the folks at EverBank’s World Currency desk at (800) 926-4922. Be sure to mention product ID #12534. We should also mention that Money Morning has a marketing relationship with Everbank, but that’s only because we believe in its products.]

• Third, you should hold some gold, which is likely to profit from a dollar collapse – for example through the SPDR Gold Trust fund ETF (NYSE:GLD), which has ample liquidity, with $17.6 billion outstanding, and which tracks the gold price directly.

• Fourth, you may make a modest (no more than 1% to 2% of your portfolio) speculation in currency options, which are traded on the Philadelphia Stock Exchange. Since the yen has already enjoyed a considerable run against the dollar, the best speculation might be to purchase out-of-the-money euro call options, which will rise in price once the dollar starts falling against the euro. Personally, I prefer to buy the longest possible options available, to give the market time to move in my direction. So, I would go for the September 140s (PHLX: XDEIH), giving nine months to maturity at a strike price about 8% out of the money (the euro being currently at $1.29). Currently these are trading at $4.55 offered, so you would have to pay $455 for each 10,000 euros on which you purchased an option.  Your break-even would thus be $1.4450. If the euro is trading above that level next September, you would gain, so if it matched its May peak of $1.60, you would make $2,000 per contract. If it was below $1.40, you would lose your investment of $455 per contract.

Source: With Billions in Bailout Funds Flowing, the “Peso-fication” of the Dollar Continues

“One market bubble may be an accident;” begins an article in the Financial Times, “two in the space of a decade begins to look like carelessness.”

In our view, the bubbles in housing and debt were the result of neither accident nor carelessness. They were the result of Fed policy.

The Fed thinks it has two mandates: to preserve the value of the U.S. dollar…and to maintain full employment. The two are as incompatible as a sanctimonious governor and the Emperor’s Club. At some point, you have to choose. What’re you going to be – a governor or an emperor?

Fed governors chose the easy path – they chose to try to boost up the economy…and let the dollar go to hell. That’s why the greenback has lost half its value against major foreign currencies since the beginning of this century. And it’s why we have had two major, related asset bubbles so far this decade – one in housing and the other in housing debt. And it’s why we have also had a credit crisis…from which we now seem to be emerging.

People are beginning to put two and two together – to make the connection between the Fed’s aggressive attempts to put more money and credit in circulation and the asset bubbles. And now that they’ve got their slide rules out…they’re wondering about the oil price too…and gold…and food…and consumer prices…

…and now, in this moment of high anxiety, the whole world turns its weary eyes to Paul Volcker. Like France recalling the old Hero of Verdun – Marshal Petain – in ‘42, the press goes to Volcker and asks his opinion.

The latest Bloomberg report:

“Volcker, who engineered a surge in interest rates to 20 percent when battling consumer price gains 18 years ago, said ‘there is some resemblance to where we are now in the inflation picture to the early 1970s.’ The Fed failed to contain a pickup in prices at that time, spurring the acceleration of inflation later that decade, he said.

“‘If we lose confidence in the ability and the willingness of the Federal Reserve to deal with inflationary pressures’ and buttress the dollar, ‘we will be in real trouble,’ Volcker said. ‘That has to be very much in the forefront of our thinking. If we lose that we are back in the 1970s or worse.’

“Consumer prices rose 3.9 percent in April from a year before, compared with an average rate of 2.7 percent over the past decade, a Commerce Department report showed today. Volcker said there’s ‘a lot more inflation’ than reflected in government figures.”

Yes, dear reader, the battle between inflation and deflation has been noisy and indecisive. But the real cost of this war hasn’t even begun to register. Unbeknownst to most observers, almost a whole generation of wealth building has been wiped out. Wages are back to levels of the ’70s. Stocks have gone nowhere in 10 years. And houses are headed back to levels of the mid-’90s.

On this last item, we have some news headlines. Foreclosure filings rose 65% in April, from the year before. In California, foreclosures hit a new record high. And land prices in Las Vegas, away from The Strip, are down 24% from a year earlier.

Toll Bros. (NYSE:TOL) says its sales will go down 30% in this quarter. Mortgage fraud cases are up 31%, says the FBI. And in England, realtors say the market is the worse they’ve seen in 30 years.

How cometh these things to pass? Fed governors have been enjoying their own emperors’ club, if you know what we mean. They’ve had their cake – and eaten it too. Until now, they could cut rates and increase the money supply, and still hold their heads up look Americans in the eye: “Do you see any inflation? We don’t see any inflation.”

Alas, the rumors are out…the receipts are turning up…and people are appalled. They’re turning on Alan Greenspan, in particular. We opined years ago that Greenspan’s reputation was inversely correlated to the price of gold. As gold rose, Greenspan’s stock went down. As you will see, below, this trend probably has further to go.

Even Ben Bernanke has disavowed his former boss – saying that the Fed can and should spot bubbles and lance them before they get too bad. But while Bernanke talks tough…he has shown himself unwilling to make Volcker’s tough choice. Between protecting the dollar and keeping the bubble pumped up, Bernanke has chosen the pump, not the lance.

*** Yesterday, we mentioned the oil market. Today, we slide in deeper.

You’ll recall, dear reader, some time ago we guessed that the feds’ efforts to keep consumers consuming were essentially inflationary…and that the inflation they caused would tend to go more into gold and oil than into economic growth or asset prices.

Since then, the price of oil has shot up over $100. Yesterday, it hit a new record at over $126, before falling back to $124. Gold, meanwhile, has traded above $1,000 – and now is correcting in the mid-800s.

This is already a major adjustment. It comes along with a major adjustment in the purchasing power of the dollar, generally. Americans’ global purchasing power has been cut in half. The value of their assets – on the world market – are only half what they were during the Clinton years. And the value of their most precious asset – their time – has also been greatly reduced.

This is why you see so many Europeans in the United States…America is a cheap place to visit. It’s also why U.S. export industries are reviving; the country has become a low-cost producer for many things; it is now a place where richer nations can consider outsource production.

All of this has gone almost ‘according to plan’ – that is, it is pretty much what we guessed would happen.

But now, we have to ask: are these adjustments enough?

You’re expecting us to say ‘no,’ aren’t you? Instead, our answer is ‘maybe.’

But that’s not the case at all.

You see, the bubble and subsequent crash were inevitable under the current system of housing finance. Fundamental changes must be made.

Standard and Poor’s recently projected the likely future loss rate on the $650 billion of subprime-mortgage-backed securities that are still out in the marketplace. From that we can estimate the losses S&P is projecting on the actual mortgages themselves.

According to S&P, senior AAA-rated bonds will pay out about 60% of principal, junior AAA-rated bonds about 35%, AA-rated bonds about 5% and lower-rated bonds nothing at all. Since about 75% of subprime mortgage-backed securities were AAA rated, we can calculate that S&P thinks subprime mortgages will eventually return about 40% on the original principal amount.

That’s a startling number.

Losses Still to Come

If you had a portfolio consisting entirely of 100% loan-to-value mortgages, on which the appraisals were accurate but a large percentage of the borrowers had poor credit, and house prices were destined to drop between 20% and 25% over the next few years, you’d expect to lose 25% – or perhaps 30% – of principal, but still manage to keep 70% to 75% of your money.

When you had a foreclosure, there would be costs involved that increased your loss. On the other hand, some of the borrowers would be able to make their mortgage payments, leaving you with no loss at all. Thus, if subprime mortgages are expected to return only 40%, almost half of them must have had some fraud involved, either by the borrower, the mortgage broker or the appraiser.

Let’s now turn to actual housing prices. The S&P/Case-Shiller Home Price Indices of home prices in the Top 20 urban markets dropped a bigger-than-anticipated 12.7% in the 12 months that ended in February – the worst showing since the index debuted in 1991. What’s even more alarming, however, is that the decline is accelerating. In February alone, prices dropped 2.7%  – the equivalent of a 28% decline if this rate persisted for the entire year.

That should have alarmed both homeowners with large mortgages and mortgage market participants – if prices were to drop 30% to 40%, instead of the generally expected 15% to 20%, even prime home mortgages would get in trouble and the losses would be appalling – in the range of multiple trillions of dollars.

Since the first-quarter vacancy rate in U.S. housing – owner-occupied and rental – increased to 2.9%, the highest level in 50 years, we may indeed be approaching such a bearish scenario.

However, when you look at factors like the ratio of house prices to incomes, it becomes obvious that the problem is not the current drop, but the previous rise. Since World War II, the average house price was 3.2 times the average income. By 2006, however, the average house price had jumped to 4.5 times the average income. With house prices outrunning incomes in that way, mortgage financing was bound to become more and more risky, and a substantial drop was eventually inevitable – to take prices from 4.5 times income to 3.2 times would require housing prices to plunge 29%. And that doesn’t even consider the possibility that prices might overshoot on the downside. 

The principal reason for the excessive rise in house prices and the high level of fraud was the housing finance system. In the modern system, the originator of a home mortgage loan is paid a fee on the origination, and never has to worry again about the credit risk on that loan, which is passed off to investors through a process known as “securitization.”

Because securitization separates the mortgage originator and the actual investor, the investors – often foreigners – have no idea of the actual underlying quality of the loans that they’re purchasing.

The mortgage broker’s incentive is to maximize loan volume – pretty much regardless of whether or not the borrower can afford the loan. Falsification of documents, suborning of appraisers, and other similarly reprehensible machinations becomes a normal course of action in such a situation, as does turbo-charging the housing market to valuation and sales levels it cannot sustain. A system in which prices are forced up to unsustainable levels and fraud is rampant is broken, and needs to be replaced with something better.

It (Once) Was a Wonderful Life

Years ago, the United States had a superior home-financing system; it was extolled in the 1946 Jimmy Stewart movie, “It’s a Wonderful Life.” Home-mortgage loans were made by local institutions to borrowers whom they knew personally. The system had some inefficiencies. For example, if the housing needs in a particular area expanded rapidly, there might be a shortage of funds, so that mortgages would be unavailable. However, banking is mostly national today, so local funds shortages would be less important, although there would probably be a corresponding decline in personal knowledge of the borrowers.

It’s not true that the Jimmy Stewart system of financing home mortgages was less efficient than today’s: That’s a myth put out by Wall Street, which has been one of the chief beneficiaries of the recent shenanigans. (Riddle me this: Do you think that “George Bailey” – Jimmy Stewart – ever got a million-dollar bonus?).

If you look at the U.S. Federal Reserve statistics on U.S. interest rates (which started recording home mortgage rates in 1972), you will discover that in 1972-78 – when the Jimmy Stewart home financing system was still mostly in place – 20-year Treasury bonds yielded an average of 7.41%, while 30-year fixed rate home mortgages yielded 8.49%, a differential of 1.08%. In 2000-06, an equivalent period that predates the recent worries about credit risk, 20-year Treasuries yielded an average of 5.28%, while home mortgages yielded 6.50%  – a differential of 1.22%. 

Thus, the “spread” of home mortgage interest costs over Treasury bond yields, the most appropriate measure of home mortgage costs, has widened by 0.14%. That may not sound like much until you realize that it’s an effective cost increase of 13%. Where did that increase go?

While some lawyers made money, too – what did you expect – it’s largely Wall Street that would rather you didn’t think about that question.