The worst could yet be to come. Shah Gilani in Money Morning says the $62 trillion market for credit default swaps (CDS) is a ticking bomb.

The derivative instruments – which offer insurance against default – are neither transparent nor regulated. But they are all at risk. And they are already causing huge writedowns in the banking sector…

This from Money Morning:

It used to be that regulators and legislators demanded theoretical, empirical, and quantitative measures of the efficacy of new tradable instruments being proposed by exchanges. What is their purpose? How will they benefit the capital markets and the economy? And, what safeguards will accompany their introduction?

Not any more. In the early 1990s, in order to hedge their loan risks, J. P. Morgan & Co. [now JPMorgan Chase & Co. (NYSE:JPM)] bankers devised credit default swaps.

A credit default swap is, essentially, an insurance contract between a protection buyer and a protection seller covering a corporation’s, or sovereign’s (the “referenced entity”), specific bond or loan. A protection buyer pays an upfront amount and yearly premiums to the protection seller to cover any loss on the face amount of the referenced bond or loan.
Typically, the insurance is for five years.

Credit default swaps are bilateral contracts, meaning they are private contracts between two parties. CDSs are subject only to the collateral and margin agreed to by contract. They are traded over-the-counter, usually by telephone. They are subject to re-sale to another party willing to enter into another contract. Most frighteningly, credit default swaps are subject to “counterparty risk.”

If the party providing the insurance protection – once it has collected its up front payment and premiums – doesn’t have the money to pay the insured buyer in the case of a default event affecting the referenced bond or loan (think hedge funds), or if the “insurer” goes bankrupt (Bear Stearns was almost there, and American International Group Inc. (NYSE:AIG) was almost there) the buyer is not covered – period. The premium payments are gone, as is the insurance against default.

Credit default swaps are not standardized instruments. In fact, they technically aren’t true securities in the classic sense of the word in that they’re not transparent, aren’t traded on any exchange, aren’t subject to present securities laws, and aren’t regulated. They are, however, at risk – all $62 trillion (the best guess by the ISDA) of them.

Fundamentally, this kind of derivative serves a real purpose – as a hedging device. The actual holders, or creditors, of outstanding corporate or sovereign loans and bonds might seek insurance to guarantee that the debts they are owed are repaid. That’s the economic purpose of insurance.

What happened, however, is that risk speculators who wanted exposure to certain asset classes, various bonds and loans, or security pools such as residential and commercial mortgage-backed securities (yes, those same subprime mortgage-backed securities that you’ve been reading about), but didn’t actually own the underlying credits, now had a means by which to speculate on them.

If you think XYZ Corp. is in trouble, and won’t be able to pay back its bondholders, you can speculate by buying, and paying premiums for, credit default swaps on their bonds, which will pay you the full face amount of the bonds if they do actually default. If, on the other hand, you think that XYZ Corp. is doing just fine, and its bonds are as good as gold, you can offer insurance to a fellow speculator, who holds the opinion opposite yours. That means you’d essentially be speculating that the bonds would not default. You’re hoping that you’ll collect, and keep, all the premiums, and never have to pay off on the insurance. It’s pure speculation.

Credit default swaps are not unlike me being able to insure your house, not with you, but with someone else entirely not connected to your house, so that if your house is washed away in the next hurricane I get paid its value. I’m speculating on an event. I’m making a bet.

The bad news is that there are even worse bets out there. There are credit default swaps written on subprime mortgage securities. It’s bad enough that these subprime mortgage pools that banks, investment banks, insurance companies, hedge funds and others bought were over-rated and ended up falling precipitously in value as foreclosures mounted on the underlying mortgages in the pools.

What’s even worse, however, is that speculators sold and bought trillions of dollars of insurance that these pools would, or wouldn’t, default! The sellers of this insurance (AIG is one example) are getting killed as defaults continue to rise with no end in sight.

And this is only where the story begins.

The Ticking Time Bomb

What is happening in both the stock and credit markets is a direct result of what’s playing out in the CDS market. The Fed could not let Bear Stearns enter bankruptcy because – and only because – the trillions of dollars of credit default swaps on its books would be wiped out. All the banks and institutions that had insurance written by Bear would not be able to say that they were insured or hedged anymore and they would have to write-down billions and billions of dollars in losses that they’ve been carrying at higher values because they could say that they were insured for those losses.

The counterparty risk that all Bear’s trading partners were exposed to was so far and wide, and so deep, that if Bear was to enter bankruptcy it would take years to sort out the risk and losses. That was an untenable option.

The Fed had to bail out Bear Stearns.

The same thing has just happened to AIG. Make no mistake about it, there’s nothing wrong with AIG’s insurance subsidiaries – absolutely nothing. In fact, the Fed just made the best trade in its history by bailing AIG out and getting equity, warrants and charging the insurance giant seven points over the benchmark London Interbank Offered Rate (LIBOR) on that $85 billion loan!

What happened to AIG is simple: AIG got greedy. AIG, as of June 30, had written $441 billion worth of swaps on corporate bonds, and worse, mortgage-backed securities. As the value of these insured-referenced entities fell, AIG had massive write-downs and additionally had to post more collateral. And when its ratings were downgraded on Monday evening, the company had to post even more collateral, which it didn’t have.

In short, what happened in one small AIG corporate subsidiary blew apart the largest insurance company in the world.

But there’s more – a lot more. These instruments are causing many of the massive write-downs at banks, investment banks and insurance companies. Knowing what all this means for hedge funds, the credit markets and the stock market is the key to understanding where this might end and how.

The rest of the story will be illuminated in the next two installments. Next up: An examination of the AIG collapse, followed by a look at how bad things could get, and what we can do to fix the problem at hand. So stay tuned.

Source: The Real Reason for the Global Financial Crisis…the Story No One’s Talking About

As a sign of the times, InBev’s Chief Executive Carlos Brito did it with style – appearing on an interview-style video on InBev’s web site that directly addresses the fears of the legion of Anheuser workers and drinkers – jobs, foreign ownership, brand synergy.

“I think what’s in important here is that Budweiser the beer will continue to be brewed in the same brewers – we don’t have plans to close any brewers – by the same people according to the same recipe,” Brito said. 

The proposed merger, which appraises Anheuser at a 35% premium, is a combination of high performance and common sense, he said.

“This company is going to be the world’s leading brewer,” Brito noted, calling the merger a natural step. “It’s going to be among the top five consumer goods companies in the world.”

InBev’s line of beers includes Stella Artois, Beck’s, Hoegarden and Brahma.

Anheuser is the maker of Budweiser, Busch and Michelob brands. It also owns a 50% share in Grupo Modelo, Mexico’s leading brewer, and a 27% share in China brewer Tsingtao, whose namesake beer brand is the country’s best-selling premium beer.

News of the proposal sent shares of both companies up in morning trading today (Thursday). And that’s a more elemental to the proposal than before now that the long-time Busch family-run brewer owns only 3.5% of the company’s shares.

Instead, the top shareholder is Warren Buffet’s Berkshire Hathaway (BRK.A, BRK.B) with a 5% stake. And with controlling power dispersed, it’s much easier for shareholders to push the deal through.

Anheuser-Busch said in a statement that its board of directors will evaluate the proposal carefully and in the context of all relevant factors, including the company’s long-term strategic plan.

“The board will pursue the course of action that is in the best interests of Anheuser-Busch’s stockholders” and “expects to make its determination regarding InBev’s proposal in due course.”

Beverage Providers Stirring Global M&A

Yesterday, (Wednesday), Merrill Lynch & Co. Inc. (MER) analysts said that Foster’s Group Ltd. (OTC: FBRWY) – Australia’s biggest beer and wine maker – may be a takeover target after it conducts a review of its wine business.

Earlier this week, Foster’s cut its earnings forecast and announced a $730 million write-down of its wine unit, causing Chief Executive Officer and Executive Director Trevor Louis O’Hoy to announce his resignation from his post.

Should Foster’s put itself on the block, it would join Anheuser, InBev and other major global beverage providers that have been on the giving and receiving end of billion-dollar buyout offers.

In March, France’s Pernod Ricard SA won a highly contested auction to buy V&S Group – makers of Absolut vodka and Cruzan rum – from the Swedish government for $8.9 billion.

In January, Carlsberg A/S and Heineken N.V. (OTC: HINKY) agreed to buy Scottish & Newcastle PLC for $15.4 billion.

And late last year, British-owned SAB Miller PLC (OTC: SBMRY) and Canada’s Molson Coors Brewing Co. (TAP), agreed to merge their U.S. brewing operations.

Source: InBev Offers Anheuser $46.3 Billion, a Deal That Would the Create World’s Largest Brewer

It’s infinitely harder to dig up information on small cap, thinly traded companies than it is for stocks that trade on the big board or the NASDAQ.

But what if I told you I was looking at a bulletin board stock that had:

• A $76 billion market cap
• Was the leader in its industry
• Has been breaking new highs all year
• AND could be the buy of the year!

Well, that’s EXACTLY what I’m saying to you today.

When many people think about video games they tend to say, “Oh, that’s just kid’s stuff.” But I bet those are the same people who didn’t know that a game released only several short weeks ago — Grand Theft Auto IV — did more sales in one week ($500 million+) than Spider Man 3!

***********The Chance of a Lifetime***********

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I guarantee you’ll have at least 12 opportunities to double your money just over the year ahead.

The goal: for you to have the chance to make as much in trading profits over the next year to add an extra $150,000-200,000 to your trading portfolio…and for you to get the opportunity to make as much over the next five years to be up well over $1 million above where you’re starting from today.

It’s that simple. But, you have to read this to do it…

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This Isn’t Kid’s Stuff Anymore

Now please understand, I’m not the biggest gamer in the world. I’ll play some quick computer games once in a while and I’m addicted to Brick Breaker (game on my Black Berry), but I’ve never gotten into some of the bigger gaming trends like World of Warcraft, etc.

That is until I received the Nintendo Wii as a gift last summer.

And that’s why when I saw this question on TickerHound, I just had to write this article:

“Which video game stocks would you buy right now?”

Until I played the Wii I wouldn’t have given this topic a second thought. It just wasn’t an industry I was into, even though it was pretty clear that something big was happening here.

But after seeing the Wii in action and watching how friends and family — many of which have NEVER played video games before — got into playing with the system so much, I knew there was an opportunity here.

So I started to dig deeper into Nintendo’s stock and to my surprise the Japanese company had never done a public offering here in the States. Sure, the stock trades under the symbol: NTDOY, but it’s traded on the OTC bulletin board.

In fact, only five years ago this company was trading under $10 per share — today, it’s over $67! That’s a 635% profit for the patient investors out there who had the savvy to buy and hold Nintendo stock.

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25,498% in Just Six Months

Jumper: n. — An unknown Pink Sheets or Bulletin Board stock that’s destined for a transition to a major exchange after a period of steady — or explosive — growth in an overlooked segment of the market.

We got ‘em right here… Check it out…

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So Where’s the Opportunity Today?

Like I said, Nintendo’s new gaming console, the Nintendo Wii, is blowing the doors off the gaming industry right now.

In April 2008, the company sold more consoles than its top two competitors combined: Sony’s (SNE: NYSE) PlayStation and Microsoft’s (MSFT: NASDAQ) Xbox.

Not only that, but Nintendo is continuing to release games and pursue a strategy that isn’t solely directed at the typical gaming market, boys and young men. This company is going after women and seniors as well which is opening up some major opportunities for growth in the years to come.

The stock is pulling back a bit right now but I’d be a buyer as soon as it starts to move to the upside again.

Regards,
Wayne Mulligan

P.S.: For more on what readers have said about Nintendo and other video game investments, check this out…

Source: Could This Stock Be the Best Pink Sheet Play Ever?

Instead of working both metals over for a period of days, they did it in one fell swoop. Once the Comex opened in New York, there was an avalanche of selling. And once the 50-day moving averages were broken, tech funds sell stops were triggered and that was that. But they didn’t get gold below $900. The US$ was rising and the oil price was falling long before the bullion banks started selling on the NYMEX, so that’s no excuse.

Silver, of course, suffered the same fate…but the waterfall decline was prettier and steeper. I give them a 9.2/10 on that one. My criteria for any score over 9.5 is a drop of at least a dollar, and it has to be a nearly vertical line…and the straighter the better. My scoring criteria is based on a personally modified set of rules used by the Olympic high diving judges…which I keep in the fridge beside by bottles of blue and red pills.

Open interest for Friday’s trading were as follows. Gold o.i. fell 1,692 contracts and silver tacked on a surprising 2,421 contracts. I don’t know what to make of that. If it all gets reported today, the open interest numbers for yesterday should be quite impressive. Yesterday was not only options expiry for gold, it was the cut-off day for the Commitment of Traders report for this Friday. Will it all get reported then? Don’t bet on it.

Here is what James Turk over at goldmoney.com said this past Sunday in his private newsletter to his clients on what was about to happen in the precious metals market on the Tuesday opening…

OPTION EXPIRY: The following quote is from Letter No. 423 published on April 28th. “Readers will recall from years back how we could regularly count on the gold price falling into option expiry. Most options are written by the gold cartel, given their aim to be short and profit from the contango (the difference between the spot and future months). So at option expiry the gold cartel would drive the gold and silver price lower…so that as many calls as possible would expire out of the money, meaning that the gold cartel would earn the full premium on the options they had written. Therefore it was not chance that the precious metals collapsed again last week just as options were expiring, making sure thousands of calls expired out of the money.

“I’m revisiting this point to remind everyone that this week is expiry for the all-important June options, which have a large open interest. The open interest for Comex gold calls with strike prices from 900 to 930 is 13,905 contracts, representing 1.39 million ounces of gold. As a rule of thumb, I assume that the outstanding options in the over-the-counter market are 10-times greater than the quantity of options on the Comex.

“Right now (based on Friday’s close) the calls on the Comex have an aggregate market value of $21.2 million. If gold closes on expiry at $900 or less, that value completely disappears (as would of course the value of OTC options at those same strike prices also disappear), which is a powerful incentive for the writers of these options to force the gold price lower on expiry. So I expect to see a test of wills this week.

“Will the gold cartel once again be successful in driving gold lower during option expiry? Or will the market overpower the gold cartel? It should be an interesting battle. I don’t know who will win, but we should plan for a gold cartel victory. After all, the results from recent years suggest that they are batting around 0.750 in driving down the gold price at the end of the month, so it is likely they will do so again.”

There were dozens of stories over the weekend worth mentioning, but I can’t mention them all, so I won’t mention any. However, you may find this Bloomberg story about the Titanic of great interest…and amusement! The story is entitled “Titanic Model, With Deck Chairs, Attracts Million-Dollar Bids”. The link is here.

For today’s main offering, I present silver analyst Ted Butler’s latest weekly commentary on the silver market…including his take on yesterday’s slaughter on the Comex. His essay (which is a must read) is entitled “A Few Thoughts on Silver” and is linked here.

Our finances will never be brought into order until Congress is compelled to do so. Making our money redeemable in gold will create this compulsion. – Howard Buffett, father of Warren Buffet – May 4, 1948

What a day yesterday was! Horrific news in all directions! The Dow rolled over into negative territory and…at precisely 12:00 noon…”gentle hands” were there to make sure it stayed positive on the day. If you feeling like you’re living in the movie “Matrix”…you would be right about that. Score one for the PPT.

See you tomorrow.

Casey Research correspondent-at-large Ed Steer is a keen observer of the financial scene and a board member of GATA.org.

Source: And Then There’s This…Wednesday, May 28th, 2008

Why has the price of oil risen so much in the past few months? Is it a supply and demand issue as some believe; or is it because of an out-of-control futures market driven by the proliferation of commodity index funds and rampant speculation, as everyone tries to get in on the rise in commodity prices? This is a very complex issue, with a lot of emotion attached to it.

This week I try to give you an understanding of why oil prices have risen and whether they are likely to stay at such lofty heights or maybe even fall! And we look at a very odd statistic: where are all the tankers? There are some very unusual things happening in the oil patch. If you are currently exposed to the energy or commodity markets, or are thinking about it, I believe you will find this letter of interest. At the end of the letter, I also tell you how you can personally see that help gets to the victims of Cyclone Nargis in Myanmar. It is a desperately needy situation. There is a lot to cover, so we will get to the essay right after this quick note.

I have talked for the past few months about why I feel we may be in for a tough investment environment and a Muddle Through Economy. I think in this type of market cycle it is important to increase your portfolio allocation weighting to noncorrelating investment strategies. I work with Steve Blumenthal and his team at CMG to help investors find managers who can take smaller minimums and who have such alternative strategies. We are creating a platform of managers that you can access for your personal portfolio. I recently completed a special write-up on Eric Leake of Anchor Capital, an investment advisor I am particularly impressed with. For the last 12-1/2 months, he is up 16.77%, in comparison to the S&P 500 index that is down -2.08% (net of fees from April 30, 2007 through May 15, 2008). Equally impressive is that he has generated this return while being uncorrelated to the S&P, and with lower volatility than the market.

You can get this report and others I have written by going to https://cmgfunds.net/public/mauldin_questionnaire.asp and filling out the form. If you are a manager and would like to be considered for the platform, drop a note to PJ Grzywacz at pjg@cmgfunds.net. And if you are an investment advisor and would like to see the managers that are on our platform and determine whether they might fit into your client portfolios, we do have a program to work directly with you.

And as always, if you have a net worth of over $2 million, I strongly suggest you go to www.accreditedinvestor.ws and register there. My partners in the US (Altegris Investments), London (Absolute Return Partners) and South Africa (Plexus) are experts in alternative investment strategies, including hedge funds and commodity funds. We have a very strong selection of funds in a wide variety of styles to help you diversify your portfolio. (In this regard, I am president and a registered representative of Millennium Wave Securities, LLC, member FINRA.) And now, let’s jump into the oil patch.

Those Nasty Index Speculators

Are institutional investors in the form of large commodity index funds the reason behind the current rise not just in oil prices but in the prices of seemingly all commodities? Michael Masters, a long-short hedge fund manager, in testimony before the Congressional Committee on Homeland Security and Governmental Affairs, said:

“You have asked the question ‘Are Institutional Investors contributing to food and energy price inflation?’ And my unequivocal answer is ‘YES.’ In this testimony I will explain that Institutional Investors are one of, if not the primary, factors affecting commodities prices today. Clearly, there are many factors that contribute to price determination in the commodities markets; I am here to expose a fast-growing yet virtually unnoticed factor, and one that presents a problem that can be expediently corrected through legislative policy action.”

You can read the entire testimony at http://www.mcadforums.com/forums/files/michael_masters_written_testimony.pdf, but let’s hear the basics of his argument:

“What we are experiencing is a demand shock coming from a new category of participant in the commodities futures markets: Institutional Investors. Specifically, these are Corporate and Government Pension Funds, Sovereign Wealth Funds, University Endowments and other Institutional Investors. Collectively, these investors now account on average for a larger share of outstanding commodities futures contracts than any other market participant.

“These parties, who I call Index Speculators, allocate a portion of their portfolios to “investments” in the commodities futures market, and behave very differently from the traditional speculators that have always existed in this marketplace. I refer to them as “Index” Speculators because of their investing strategy: they distribute their allocation of dollars across the 25 key commodities futures according to the popular indices – the Standard & Poors – Goldman Sachs Commodity Index and the Dow Jones – AIG Commodity Index.”

These index funds are composed of a number of commodities. While oil is the biggest component of the various funds, they also have exposure to grains, base metals, precious metals, and livestock. When you buy one of these funds you are buying a basket of commodities.

Why would an investor want exposure to a long-only index of commodities? Perhaps for portfolio diversification, as commodities are uncorrelated with the rest of the portfolio, or as a way to play the growing demand for commodities of all sorts from emerging markets, as a hedge against inflation, and so on. Mainline investment consultants began to suggest a few years ago to their clients that they get into the commodity market on a buy and hold basis, just like they do with stocks and bonds.

And they have done so in a very large way. As the chart below shows, at the end of 2003 there was $13 billion in commodity index funds. By March of this year, that amount had grown 20 times, to $260 billion. Masters also shows that this corresponds with the stratospheric rise in commodity prices. In many commodity futures markets, index speculators are now the single largest participant.

I spend a lot of time researching tiny, over-the-counter companies. Many of which are too small to mention here. After crunching the numbers, reading the reports, and listening to the calls, I sometimes check out the message boards. If for no other reason than to have a chuckle. People on those things crack me up.

Anyways, on almost every single one, there is a string of comments about the company jumping to a major exchange. Message boarders love the idea that their tiny stock will be flooded with institutional money the minute it hits a major exchange. That makes perfect sense. But what they don’t realize is only 2% of OTC companies ever graduate to a major exchange. So, the odds of your company doing it are slim.

However, if you look past the message boards and evaluate management, balance sheets, and competitors, you do have a better chance of finding that next jumper. [On a side note, my colleague, Greg Guenthner, has perfected this. In less than a year, one out of every four of his OTC picks have jumped or are already approved to do so. To get in on that, check this out… ]

Sometimes, the message boarders are right. Their stock may graduate to the NASDAQ, and then they might see huge gains. It does happen. However, not all jumpers are like that. In fact, many do something quite a bit different from what most believe…

Falling Down After the Jump

In Dan Haltzclaw’s The Little Black Book of Microcap Investing, he studies this very subject. His findings are actually pretty shocking. According to Haltzclaw, over 90% of all recent jumpers see their share prices fall by an average of 33% in the first one to four months.

That’s not what the message boarders think. They honestly believe that the minute their stock jumps, all their problems will be over. Haltzclaw’s findings disprove that notion pretty handedly.

Here is a quick chart of one of these average jumpers:

But, that’s not the end of the story. In fact, it’s really the beginning of a much larger story…

**********Only a Few Days Left **********

Your Guest Pass Expires Monday

The Wall Street fat cats don’t like that we’re giving away this special guest pass into the “millionaire’s market,” and that’s why this offer can’t last forever.

This may be your only chance to ever see inside the market that allows members to withdraw $810 or more a week directly into their retirement account.

We’re waving the million-dollar membership fee, so don’t miss this special opportunity. Click here for more…

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Second Stage of a Jumper

It’s not that institutional money doesn’t ever come to these companies. Of course it does. Just not right away, as the message boarders seem to think. Why? Well, there are a lot of people that want to dump their shares too. Chances are, in the time between the graduation announcement and the jump, investors (most likely message boarders) are buying up a lot of new shares. When this happens, it gets other shareholders nervous. They see that they are sitting on nice gains, and want out. So, the stock gets listed, and early investors bail.

This usually starts a free fall for a few months until it levels back out. When that happens, we have a buying opportunity.

In his book, Holtzclaw found that six months after graduation, investors bring the share price back up to the graduation price. So, if you have a company that falls 50% after it jumps, and you buy it, chances are it will go up 100% to where it was trading at before. Brilliant! But, it’s not as easy as that…

Some stocks don’t follow this trend at all. Some just continue to go down, while others go up much more than just to the graduation price. Finding the right ones is not easy. It takes time and effort.

But it’s worth it. Investors of Transmeridian, after it initially slumped, go to realize gains of 333%!

We’ll keep looking for the next Transmeridian. When we find it, we’ll let you know…

Sincerely,
Jim Nelson

P.S.: Greg Guenthner and I spend a considerable amount of time diligently studying everything — management, balance sheets, growth rates, cash flow, etc… By doing this, we’re the first to find the right time to buy these second stage jumpers. To get in on this research, you should read this now…

Editor’s Note: As always, send any questions or comments to us at jim@pennysleuth.com.