One of the purposes of these pages is to give information in an understandable way to those who are not burdened with a PhD in economics or financial engineering.  Those benighted souls will have to deal with their disabilities on their own.  We try to make complex facts, concepts and ideas simple and reasonably understandable.

There is a great deal of depth we could provide on the subjects about which we write.  In our view, few would be willing to wade through the verbiage, even if they had the interest in understanding the details, hence our interest in simplicity and brevity.


A great deal of the worldwide stock market declines from October 2007 to March 2009 occurred due to the existence of financially engineered products (derivatives) and the removal of mechanisms that used to make short selling more difficult in the U.S.  Many of the financially engineered products aided in short selling (making bets on lower markets), by removing some of the complexity and restrictions of traditional short sales.  Financially engineered products were also created to make speculation on the long side (bullish speculation) easier.  Additionally, these derivatives allowed for tremendous leverage to be employed.

We first warned about derivatives and the inherent counterparty risk in our Clients and Friends memo dated May 22, 2003, and we have warned about them repeatedly since that time.

In effect, derivatives amplify volatility, thus making up and down moves more pronounced.  This increase in volatility is a characteristic of an investment process that has changed dramatically in the last ten years, and which will continue to be with us in the foreseeable future.  In our March 22, 2004 commentary, we wrote "It is not difficult to see the havoc that a meltdown or partial meltdown in derivatives would do to the world financial system."  Clearly, that has come true at least as badly as we had feared.

What are the outcomes?

1. A decrease in the effectiveness of the buy and hold strategy of investing.  Massive volatility will create more volatile and larger declines, which are terrifying to traditional buy and hold investors.
2. An increase in short term trading of stocks.
3. More volatile fluctuations in currencies will lead more astute investors to seek out investment alternatives such as bonds in foreign currencies.
4. The collapse or destruction of many currencies due to the banking systems’ commitment to derivatives.
5. The rise of gold as the only truly reliable global store of value and currency.


The obvious main point is that derivatives have created a financial disaster, and investors must avoid the many toxic assets (derivatives) are floating around the world financial system.  As governments move to restructure their banking system, they will devalue their currencies, thus increasing the attractiveness of gold and other hard assets (platinum, silver, and real estate), but also of stocks in good companies and industries, which can grow through a period of currency depreciation.

China insists on financial system overhaul

From AFP, MEDELLIN, Colombia

March 29, 2009-Chinese Central Bank Governor Zhou Xiaochuan again urged for international financial reform in the face of the global economic crisis.

Speaking at an Inter-American Development Bank meeting in the northwestern Colombian city of Medellin, Zhou said that current fiscal and monetary measures were useless if the international financial system is not overhauled.

He said financial reform and measures for international development banks like the International Monetary Fund (IMF) and the World Bank would likely be discussed at the upcoming G20 summit of developing and industrialized nations on Thursday in London.

"Up to now we have participated in some working groups which focus on coordinating effort to overcome the negative impact of the financial crisis," Zhou said.

"The second (effort) is maybe financial sector reform, including regulatory reform, and I think we also expect there may be some reform agenda for international financial institutions, including the Fund, the Bank and other development banks."

Zhou stressed the importance of savings, saying China’s financial crisis had encouraged savings in Asian countries.

He also called for tougher regulation of international financial institutions. The issue of the world currency reserve is expected to be raised at the G20 summit.

The banking chief this week called for a replacement of the dollar, installed as the reserve currency after World War II, with a different standard run by the IMF.

Zhou suggested the IMF’s Special Drawing Rights, a currency basket comprising dollars, euros, sterling and yen, could serve as a super-sovereign reserve currency, saying it would not be easily influenced by the policies of individual countries.

IMF managing director Dominique Strauss-Kahn welcomed Zhou’s comments and said that talks on a new world reserve currency to replace the US dollar were "legitimate" and could take place "in the coming months."

But US Treasury Secretary Timothy Geithner defended the dollar as a key global reserve currency in Washington.

Chinese Vice-Premier Wang Qishan on Friday stressed the importance of reforming the IMF to give more weight to developing countries, and said this issue must be taken up at the G20 meeting.

Wang also said in an article in The Times that China would contribute more resources to the IMF as part of a wider effort to boost the fund’s lending power.


This program has some hope of success, but only if large hedge funds and mutual funds are willing to stand in and buy…and the banks are willing to agree on the prices.  We think the hedge funds and mutual funds will step in, as the Congress appears to love them, and is handing them something close to a blank check.  The banks will sell in order to raise capital.  Remember, many of their losses have been supported by loans from taxpayers.

In the recent hearings, Congress has flamboyantly exhibited their disdain toward bonus recipients at AIG.  It seems to be a different story if you run a giant hedge fund.  Instead of making a $1 million bonus, a big hedge fund operator might make $100 million, or up to several billion dollars each year.  The large hedge funds will be allowed to get government money, to potentially make immense profits by buying toxic assets for a distressed price, from large banks (who are subsidized by taxpayers).  In other words, they will buy the assets from U.S. taxpayers, and later resell for profits.

Could this congressional largesse be partially due to the fact that the hedge fund uber-rich…is a strong group of donors to politicians, while the wage earners at the banks, even the big wage earners are not in a position to make the big political donations any more?  The truth is that much of the money going to politicians for their re-election coffers in the U.S. and other countries, has been from financial institutions.  Draw your own conclusions.


In several past memos, we have pointed out how the ideas of Paul Volcker are being ignored, while Tim Geithner’s prescription for a solution in the U.S. is being adopted.  In our opinion, this is because Volcker’s plan does not benefit big financial institutions as much as the Geithner plan.

The political situation in the United States has in recent years become more similar to a third world country, where the banking interests have huge influence in government.  We pose a question.  Do you think that the third world countries have more, or less, financial crises than developed countries where banking interests have less power?  The answer is, of course, they have more.

We do not like to be so cynical.  Perhaps it is that we are from California, where our former Governor Jerry Brown once said while in office that he…"was against money grubbing congressmen…and every type of bought and paid for politician."  On this issue Jerry Brown shares the same view as more and more Americans.


Obviously, we hold to our themes.  We plan to buy gold, oil, and agriculture related shares on dips; and remain wary of financial institutions.  China, which is proving to be more insulated from the world banking problems, also seems to be a good long term investment.

Thanks for listening.

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