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Impending Crash of the US Dollar (November 2009 Update)

If this is your first time at you may want to back up and read the introduction on investing in US stocks (NYSE, NASDAQ) found here.

The Short Version of the Prediction for Twitter Users

In the near future (24 months) the growing stresses on the US Dollar will result in a currency run and collapse to 60% of its 2008 value.

There is a Why, How, When, and What Can You Do About It in the following text but it is safe to say the news is not all bad for the average American but it could be very bad for foreign investors (like Sooty) if they get caught when the currency bubble bursts.

Why the US Dollar is Under Pressure

The "why" is headlined almost every day in the news. . .but it looks like things are getting better so most people are ignoring the problem. The truth is the US economy is in a very bad state and the financial collapse in 2008 was just the first in a series of bad things that are about over the next 24 months. While to rest of the world (lead by China followed solidly by the rest of the BRIC and Europe) will return to pre-crash growth rates in 2010 but the repeated pounding of the US economy will keep it firmly stuck in a 2008 time trap.

When the residential subprime mortgage bubble burst those holding the mortgages quickly discovered they had more debt than assets. Normally this would result in a bankruptcy with the stock holders losing everything and the bond holders losing a bunch but taking over the corpse. There were two things that made the situation so bad the governments had to intervene:

  • The big mortgage holders bought insurance policies called "default swaps" which meant when their mortgages tanked the other side of the insurance policy had to cover the loss (a reasonable precaution). However the other side had not understood the risks properly (they were lied to by the credit rating agencies like D&B) so they under priced the premiums and did not build reserves large enough to cover the losses. When the insurance companies failed all their other insurance policies became invalid and the cascade nearly caused the entire insurance market to fail.

  • The crappy mortgages were mixed into portfolios of mortgages to diversify the risk. This is normally a good idea but these portfolios became an entity in themselves called a mortgage backed securities which were divided up into shares. These shares were "derived assets" that were then sold as if they were real assets which could be packaged with other assets to create new portfolios. With each level of packaging and resale the leverage increased as the amount of real asset became a smaller and smaller part of the derived asset.
  • The reason the government had to step in was that the packaging, repackaging and swap insurance was so wide spread that no one knew where the bad assets were. There was a deep suspicion that all the mortgage backed securities were junk and everyone was holding worthless paper with no backing insurance. If this suspicion was allowed to turn into panic the resulting run would cause the complete collapse of the world financial network. This would have made the 1929 crash look like spilt milk at a tea party. The crash we experienced was bad but the alternative would have been apocalyptic.

    The world governments may have looked a little disorganized throwing $billions at random targets but in fact most of their actions hit the mark. The truth is that the subprime bubble was a one trillion (USD) hole that the world filled with about two trillion dollars in bank buyouts and stimulus plans. Most of the world governments will get their money back and quickly return to fiscal sanity. Britain will probably get half of its funds back but the US and Iceland will have to take the full amount of the bailouts onto the government balance sheet. For Britain and Iceland that was the end of the damage. For the USA there is another three $trillion more to go.

    Three $Trillion More

    There is about a trillion dollars in FIDC covered deposits for TSTS banks (Too Small To Save) that will be failing over the next three years. When a TSTS bank fails the depositors accounts are covered against loss up to $250,000 per customer per bank. So if you had a accounts of $200,000 in each of three different failed banks your $600,000 would be safe. If a TSTS bank failed with no assets and $50 million in insured deposits the new owners would get a check from the FDIC for $50 million drawn on the US Treasury. That check is not backed by any real assets. The US government just "prints" $50 million to cover the check.

    Why are the TSTS banks failing? They have failed mortgages on residential and commercial properties that were not part of the derived assets shell game. In order to try to match the return rates of the big banks they used other tricks to leverage these loans. When ordinary conservative house loans fail there is FHA insurance to cover the loss. These losses are already so high that the FHA is running out of reserves and while it is a private entity it will need government money to make sure it does not fail (one more government bail-out/take-over). TSTSs that stuck to conservative residential mortgages will probably survive. They are like the Canadian banks. The TSTSs that did more aggressive lending will have no loss insurance and no reserves (self-insurance) to cover the shortfall. It is estimated there are over a thousand TSTS banks. . .so between FHA support on the way into bankruptcy and FDIC support after bankruptcy there is about a $trillion needed to deal with the problem.

    There is roughly another $trillion in failed mortgages. Didn't we cover that already? No we covered the mortgage holders and we covered the holders of the derived financial instruments for the TBTF banks (Too Big To Fail). We still have a problem: Joe Main Street bought a $400,000 house and did $150,000 of renovations because he could deduct the mortgage interest against his taxes. Unfortunately he lost his job at the plant and now has no income so the deduction is not much use. What he does have is a $550,000 mortgage on a house that now worth $300,000 and no way to make the payments (some 23% of homes now have negative equity). For a look at the troubled US Consumer read this January 2009 Merrill Lynch USA Consumer in Trouble Report

    To help Joe the government is going to have to take over his mortgage (think Freddie Mac or Fannie Mae) and get his plant reopened. The subsidized mortgages will never pay much interest and with a USD decline the real buying power of the mortgage asset will represent a large loss as a government investment. The closed plant is probably uneconomic so that government investment (probably state and local dollars) will be a complete loss (think Crysler).

    The last $trillion is from the fiscal imbalance. The economy has tanked and taxes collected are not covering the cost of services provided at federal, state and local levels. These are not the previously mentioned support for failed financial institutions or social spending on out of work Joes. These are businesses with reduced profits and employees on short work weeks and no overtime pay. Governments are actually leveraged against their GDPs through their tax systems so a small drop in GDP causes a big drop in tax revenue. Even though they have a drop in taxes all levels of government will have to maintain their existing programs to keep the social fabric from falling apart (Joe has a gun). Worse still they may have to provide additional services to deal with social breakdowns their existing programs cannot cover (Joe used his gun).

    How the US Government will Sink the US Dollar

    The dilemma the US government faces is how to deal with the huge costs of digging themselves out of this hole. Until now the choice has been to borrow the money. This covers the shortfall as long as there is someone willing to make the loans. With China, Japan and Saudi Arabia each holding over a trillion USD in loans it turns out America has some real solid friends. How much would your lend your neighbor? Even the best of friends have limits and we are quickly approaching those limits.

    A government has a capability most individuals do not. It can "make" money. They used to print money but the sums are so large for an entity like the USA there are not enough printing presses on the planet to print the number of standard denomination bank notes required. Zimbabwe tried to solve the problem by increasing the number off zeros on their bills then doing a million to one reverse stock split when the numbers became silly. What the US will do is less silly, less dramatic and more beneficial to Joe Main Street.

    Remember double entry book keeping? You bought a truck so on the asset side of the balance sheet you showed the truck as a new asset. On the liability side of the balance sheet you showed the loan for the truck as a new liability and the book value on your balance sheet (assets minus liabilities) did not change. When you made a payment on the loan you reduced the asset "cash" by the amount of the payment and also reduced the loan liability so again there was no change in the book value.

    What the US government has been doing in the past is proper double sided book keeping. They issue a check to buy something (like AIG or GM bailout shares) or they cover depositors of a failed bank through the FDIC. This reduces "cash" and they record the value of the asset on the government's balance sheet to keep the book value unchanged. They sell Treasuries (to China, Japan or Saudi Arabia) to increase "cash" but this adds the loan to the liability side so the balance sheet remains "balanced".

    What the US government is starting to do is single sided book keeping. They issue a check to buy something but do not reduce "cash". They record the asset and this increases the book value on the government balance sheet. They also issue checks to buy back Treasuries that they sold in the past and this reduces the liability side but this time they do not deduct the amount from "cash" so the book value on the government's balance sheet grows.

    There are a number of code words used when these single sided transactions occur. You will see as reports of quantitative easing or increasing the government balance sheet or buying back government bonds. Whatever they are called it is still plain old "printing money" and like a company printing stock certificates it dilutes the value of the US Dollar.

    Detailed Mechanism for the US Dollar Collapse?

    The explanation so far has been about economics but that has been all theoretical. Those pressures will not cause the collapse. It will happen at a weak point. Like a balloon the whole surface does not fail. A tear starts at a defect and spreads. The low interest rate is encouraging business actors in the US economy to make decisions that cause a defect and the collapse will happen at that point.

    People are losing homes and businesses in the US because they were heavily leveraged and depended on stable incomes the keep the game going. When the income or paycheck stopped the downside of leverage was revealed. The US government and Fed are now taking steps to save home and business ownership. The primary tool is a zero interest rate. In the short term this is a good approach and it is working.

    Banks are reissuing loans at very low rates because they can borrow cheap money. Some of these are long term some are even 30 year mortgages. Sensible banks only lead their depositors money. More aggressive banks borrow short term money to make these long term loans. Banks need to stay in business so they will keep issuing low interest loans as long as the Fed keeps the rate at zero. As time passes a larger portion of their loan portfolios will be filled with long term low interest loans.

    The Feb cannot keep the rates at zero forever. The Japanese central bank has kept their rate at zero for ten years but the structure of the Japanese economy is completely different and they could go another ten years before the Yen collapses. When the Fed raises the rate (my guess starting in Spring 2011) it will be gradual. As the rate goes up the spread shrinks between the low interest loans and the higher borrowing cost. Before long the aggressive bank is paying 6% for money to cover a 5% loan. The sensible bank pays depositors 1% to cover their 5% loans so they're okay. Except the aggressive bank is now offering 4% on deposits in an attempt to stay in business. The sensible bank finds its depositors are leaving to get the better rate and now they have to borrow (become more levered) to cover their loans.

    This is the small defect in the wall of the balloon. Pressure on the US dollar will cause it to drop a little, the inflation rate will go up a little, and the Fed will increase their rate to compensate. The increasing rate will put more banks in peril until a cascade of failures begins. The US Government will take over these banks and print money to insure the depositors are whole and the loans are safe. News of the growing number of bank failures will put added pressure on the US dollar. When the short sellers smell blood the whole thing collapses.

    What Will It Look Like When the US Dollar will Collapse?

    Nassim Taleb in the The Black Swan provides a very convincing argument that most significant events happen suddenly and often unexpectedly. He was one of the authors of the mathematics used to evaluate derivative risk and when he saw a problem with the math he predicted a crash and personally made a lot of money when it happened. One of his key points is illustrated by a graph in the book:

    The crash in the USD will have a similar pattern...everything will be okay until it is not. The pressure will gradually build but the USD will remain solid then some random event or hedge fund bet will start a cascade which will lead to panic and a run on the currency.

    On a Friday afternoon the dollar will be worth a dollar. Early on the Monday morning the value will have dropped 30% and appear to be in free fall (could be a Wednesday afternoon and Thursday morning - my crystal ball needs cleaning). Hurried phone calls will result in a massive purchase of USDs by international banks and by the end of the day the USD will only be down 20%.

    Overnight phone calls and meetings will develop a defensive plan but the next morning the USD will have dropped another 20% as panic sets in. Over the next week currency controls and an international effort will bring the USD back to a 20% drop but the sell pressure on the USD will be enormous.

    Over the following year the USD will be allowed to drop 30% at a "managed" rate. Many contracts written in USDs will be rewritten in more stable currencies like the Euro or the Chinese Yuan. This will free more "transactional" USDs that will flood the market and put more downward pressure on its value. Over the next couple of years the drop will level out at 40% so the USD will have about 60% of its 2008 value.

    So what Friday (or Wednesday) is that going to be? Take a look at the turkey graph. Thanksgiving is coming but the turkey having no facility with calendars has no idea when it will be. We my friends are the turkeys and I am telling you I can see cranberries being harvested so we will soon be cooked.

    What Can You Do About a USD Collapse?

    If you an American you can do two things: rejoice and re-elect Barack Obama.

    I'll do the re-elect part first. The world likes Barack. The currency crisis is coming no matter who runs the country but fallout for the average American critically depends on how the world reacts to a falling USD. If the American government is disliked as much as the Bush administration the world will say "Screw you" and everyone will devalue their currencies in lock step with the USD. The US economy will remain in desperate shape but it will be compounded by massive inflation. It will be back to the 1930s. If Obama remains in power the world will allow the USD to fall without any major retaliation. So on to the rejoice part.

    Why rejoice? The falling USD will mean all foreign imports will become much more expensive; gold will go to $1600, oil will go to $150, wheat will go to $500, and pretty much every USD based price will get multiplied by 1.6 (so far so good no? Read on).

    It also means a $30,000 imported Toyota will rise to $50,000 but the same model made in the San Antonio Texas plant from US steel by US labor will still cost $30,000. Which one would you buy? More important those cheap Chinese auto imports (don't kid yourself...they are coming) will have trouble competing with US made cars.

    It means GE which has half its operations in foreign countries will bring home 60% more profits as those foreign sales are converted to USDs. It also means they will pay much larger taxes. A Bush administration would cut the tax rate to keep the tax take constant. An Obama administration will use the windfall to rebuild the broken US balance sheet.

    It means eco-friendly wind, water and solar power will be able to compete against imported oil. The resulting technological advances will be built in the US and exported to the world.

    This is a pretty rosy picture painted by Sooty who is a loyal Canadian. Actually since the USA is Canada's largest trading partner what is good for the US is usually good for Canada. Just a friendly warning to my American friends: don't do something stupid and fall in love with a strong USD. Your best bet is a weak USD just ask the Chinese based on their experience with the Yuan over the last twenty years.

    What Can an Investor Do About a USD Collapse?

    Now you can go to the US Stocks page and read Sooty's investment advice on non-US stocks on US exchanges. . . or go to Sooty's Black Swan Investing page to help you find other catastrophic events to make money on.

    The short story on US Stocks for Twitter users:

    Don't hold USD assets or US stocks without foreign operations. Do hold good foreign stocks on US exchanges, they will rise as the USD falls.

    Post Script: The Downside If Sooty is Wrong About a USD Collapse

    It is unlikely that Sooty is catastrophically wrong. That would mean the USD would rise against other currencies. No one is predicting a rise in the USD. If you bought a bunch of non-US investments in 3 years you are likely to show a rate of return that is comparable to the equivalent US companies. You might have even done a little better if you bought BRIC companies because everyone is predicting a more rapid GDP growth in BRIC than in the US economy.

    If you want to measure this advice set up two play portfolios with US and non-US scenarios. Then you can compare how today's "best choices" survive. Setting up the portfolios today will avoid the Monday Morning Quarterback Syndrome when 3 years from now you feel like complaining "if I had bought USA TofuBurgers in 2009 I'd be rich now".