S&A Digest: Inflation Spells Big Gains for Silver

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Get used to bank failures... Are Nat City and WaMu next?... Ackman fixes Fannie and Freddie... Dark pools... Time to abandon the buck?... Gold to silver...

Back in April, before bank failures made headlines, I wrote the following to Extreme Value readers:

After commercial real estate, the next shoe to drop in the crisis will be regional and community banks... Regional and community banks can and do fail, and they're going to start failing at a faster pace this year.

In 2005 and 2006, zero FDIC-insured banks failed. In 2007, three failed, including NetBank, the largest failure in 14 years. IndyMac wasn't even on the FDIC's list of troubled banks. So how many other depository institutions would succumb to a run on deposits?

Well, I hate to sound absurd, but the honest answer is... all of them.

Virtually all of the couple hundred banks I've looked at over the past few months have liquid assets amounting to less than 40% of deposits. Most have around 30%. So, on average, perhaps you don't have dollar bills in the bank. Perhaps they're really 30-cent notes.

The deposit function is supposed to be a warehousing function. It's not supposed to be another way to get leverageable capital. But remember, banks are part of the money creation system, the engine of inflation. They literally lend money into existence out of thin air. That's the essence of fractional reserve banking.

It's very hard for bankers to resist the temptation to participate in the inflation machine, so I doubt more than one or two banks in the country could survive a run on deposits.

IndyMac has $32 billion in assets. And it couldn't survive a measly $1.3 billion run on deposits. Its customers with more than $100,000 in their accounts have received 50 cents on the dollar for their deposits. It's not known if they'll get anything else.

A friend e-mailed yesterday to say he spent the day checking around to see if he had more than $100,000 in any of his bank accounts. National City and WaMu saw fit to issue statements reassuring depositors they're solvent.

National City has cash and other short-term, liquid assets totaling about 17% of its $98 billion deposits, and WaMu has liquid assets totaling roughly 21% of its total deposits in cash and short-term assets. A run on deposits would crush either one of them.

Last week, I spent three days at the FreedomFest conference in Las Vegas. Most of the time, I stood across the aisle from two friendly, intelligent gentlemen doing a brisk business selling shiny objects – gold and silver coins. After Porter scared the daylights out of the crowd with his salty "Welcome to Amerika" speech, I returned to my post, only to watch a small mob form in front of my neighbors' booth.

I spoke with many investors during the three-day event. Most folks wanted to hear about gold, oil, and options trading. They knew surprisingly little of the unfolding financial crisis.

An earnest young man of 24 approached me one day and asked for advice. He looked worried and wanted to know what he should do with the rest of his life, financially speaking. I told him to forget about newsletters, gurus, CNBC, and all the rest of it. Focus the vast majority of his energy and intellect on his career. I told him his career would be his greatest investment, not his stocks, bonds, or house (which is just an expense, and not an investment at all). I saw him a couple more times. He always had that worried look on his face.

Overall, I found the FreedomFest crowd to be a tentative lot. Express a strong viewpoint, and they might cheer you. But they seemed just as inclined to slip out of the room in embarrassment. It was like the speakers were telling plumber jokes at a carpenter convention.

Tom Schatz, president of Citizens Against Government Waste, spoke on CNBC this morning and said Fannie Mae and Freddie Mac have been a problem since 1984. They had no competition and continued to load themselves with debt. When asked if there's a stronger lobby than Fannie and Freddie, Schatz said, "Not one that we're aware of." He claims they are the top donors of soft money to politicians and they spend $6 million to $7 million a year on lobbying.

Bill Ackman, of hedge fund Pershing Square, also spoke on CNBC this morning. He presented a rescue plan for Fannie and Freddie (he's short the junior debt and equity of both companies). Ackman plainly stated Fannie and Freddie do not have enough capital to survive. The companies are levered 129 to 1, and their mortgages are declining in value. They need to have a "fortress balance sheet." When asked if Fannie and Freddie could survive even if things didn't worsen, he said no. Ackman's plan minimizes the risk to taxpayers by letting the common equity go to zero. Ackman said no prudent investor would invest in either company's equity at this point... And if a private investor won't, neither should the government.

Ackman proposed giving debtholders 90 cents of new debt for every $1 they previously owned and the other 10 cents in new equity. Then, the government would guarantee to buy that equity at cost for three years, essentially a three-year put option. Ackman's plan would reduce debt, raise equity, and leave the companies levered around 40 to 1 – at which point he would invest. He says they're great businesses, with plenty of "core earnings power."

Ackman says no one would ever take advantage of the government's three-year put option, once the long-implied government guarantee on Fannie and Freddie is finally made explicit. But imagine if he's wrong. It would become a massive, $1 trillion-plus run on the U.S. dollar – like IndyMac cubed twice over.

Minutes before publication deadline, I heard the SEC is restricting short-selling on Fannie and Freddie...

General Motors is suspending its dividend, cutting payroll by 20%, and selling assets to raise at least $15 billion in the next 18 months. We're just bringing this to your attention... We're sure Porter will jump all over it tomorrow.

New highs: Comstock Resources (CRK).

So many questions... So few answers... Write to us, and we'll do our best to inform and entertain... feedback@stansberryresearch.com.

"What is your take and the ramifications of dark pool trading, to a small trader like I am? Will this be the next axe to hit?" – Paid-up subscriber John Walker

Clark comment: "Dark pools" refer to the liquidity pools available to execute transactions off the floor of the exchange. For example, if Goldman has an institutional order to sell a stock, it may choose to handle it internally by matching it against buy orders from other Goldman clients.

Goldman saves itself from paying exchange fees and keeps a bigger portion of the commission for itself. To the extent they provide more liquidity, dark pools benefit investors. More liquidity means tighter bid/ask spreads and a more fluid market.

To the extent dark pools are used to hide the identity of buyers or sellers, that's where the potential for a blowup exists. Since trades are done off the exchange floor, buyers and sellers can be anonymous. That opens up the potential for insider trading, rumor mongering, etc... And it's in this area where there is potential for abuse.

"1. If the SEC is after shills, rumor-mongers, and 'front-runners,' then why don't they round up the entire staffs of CNBC, FOX Financial News, and most of the damned media – especially that owned by Murdoch and the rest of the right-wing machine...

"2. I'm still in an orgasmic haze from the 100 puts I bought in fre and fnm. I haven't taken any viagra but I'm foaming at the mouth for more action. I want to buy SLV but it isn't option-able. And I like using options to limit potential losses or falling into short-term hype traps. Any silver equities that trade close to the value of the metal that have options?" – Anonymous

"When we spot a negative trend on the DOLLAR ITSELF, how is it ever possible to profit? Even if I buy an inverse dollar fund, that earns an equal percentage amount of the dollar decline... it would still give me 2 DOLLARS for every one I shorted. But it still has no point since now I'VE GOT 2 WORTHLESS pieces of paper!! In other words if I buy SLV, short the dollar, and buy good long term companies whose earnings grow with inflation... they will all still go up in my brokers account IN DOLLARS!!!!!!!!!!!! SO WHATS THE POINT??????????????" – Paid-up subscriber Mr. Barnatan

Ferris comment: You raise an interesting question. At what point do we stop hedging a bad currency and abandon it altogether?

Regards,

Dan Ferris

Medford, Oregon

July 15, 2008

Inflation Spells Big Gains for Silver

By Ian Davis

Would you be disappointed with a seven-year gain of 710%?

Well, what if you found out a similar investment would have returned 1,481%?

If you had bought gold in 1973, this is the exact situation you would have faced in 1980. Between 1973 and 1980, the price of gold went up 710%. As for the 1,481% gain... that came from silver.

You see, the late 1970s were a period of rampant inflation. The Consumer Price Index (CPI), a common measure of inflation, rose an average 8.2% per year over the seven-year period. Over the last 60 years, the normal rate of inflation has been only 3.8% annually.

And right now, I think we've got a similar setup...

Inflation in the U.S. is soaring once again. So far this year, we're on track for a 4.1% increase in the CPI... And it's going to continue to get worse. High commodity prices are trickling down, forcing manufacturers to raise their prices.

In the face of this rampant inflation, Americans will abandon the dollar and turn to their old friends, gold and silver.

For almost as long as civilization has existed, gold and silver have dominated the currency markets. In fact, before 1900, the U.S. dollar was pegged to both gold and silver. Back then, one ounce of gold was worth $20.65, and an ounce of silver was worth $1.29.

Today, almost all currencies are "fiat" currencies (meaning they are not linked to any underlying asset). However, central banks still hold large amounts of gold as a store of value. The U.S. central bank, for example, holds 78.2% of its reserves in gold.

So gold is still being treated as money... at least by central banks. Silver, on the other hand, is not.

Just look at the ratio between the prices of gold and silver, which Porter has covered before. When both metals are being used as currency, the ratio of their prices is about 16. Meaning gold is 16 times as expensive as silver. This was true for hundreds of years leading up to 1900, after which many countries abandoned their silver pegs.

Because central banks and citizens abandoned their silver, since 1900, the price of gold has been, on average, 52 times the price of silver. All the silver being produced was funneled into jewelry and industrial uses. And it more than met silver demand. Prices fell.

So why did silver outperform gold in the late 1970s?

With the rise of inflation, investors lost faith in the U.S. dollar. They then turned to gold and silver as alternative ways to hold money. Once again, silver became a currency... And the ratio between gold and silver (which had soared above 32) returned to around 16.

The following chart shows the ratio of gold to silver going all the way back to 1832.

When Silver is Monetized, the Gold-to-Silver Ratio Falls

As you can see, silver appreciates versus gold every time the U.S. goes through a monetary crisis. When gold and silver are both considered currencies, the ratio of their prices returns to around 16.

But why 16? If demand for gold and silver were identical, and we mined silver at 16 times the rate we mined gold, then a ratio of 16 would make sense.

But gold isn't 16 times as scarce as silver. According to the U.S. geological survey, we only mined 8.2 times as much silver as gold last year. This makes the high premium that gold demands even more unusual...

So it must be demand. Demand is currently higher for gold because it is already considered a store of wealth. Central banks use large quantities of gold to back their reserves. Demand for gold shouldn't change much. But the demand for silver will increase as investors begin to use it as another way to diversify out of the dollar. This is what will bring down the ratio.

And demand for silver is already on its way up. The ratio has already fallen from 81.4, its peak reached in 2003. Inflation is climbing, just like it did in 1973... And silver is starting to become a legitimate alternative to holding U.S. dollars. So I believe the current ratio of 53.7 will fall even farther. And history shows it should fall to around 16.

In order for the ratio to reach 16, silver would need to rise by 235.6%. Sounds like a good investment to me.

If you want to invest in silver, you can buy a silver ETF, iShares Silver Trust (SLV). Silver is much more volatile than gold, so be careful with your position size... And don't be scared off if silver corrects.

Good investing,

Ian Davis

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