May

6

More Huge Writedowns, Berkshire Wrap-Up, $5 Gas, The Laffer Curve, and More!

More multibillion-dollar write-downs… banks and brokerages to fire tens of thousands more
Chris Mayer and Dan Amoss with their favorite sound bites from the Berkshire Hathaway annual meeting
Latest ISM data surprise the street… could the service sector be staging a comeback?
Consumers expecting $5 gas by year’s end… which automaker is betting on gas prices staying low
Plus, The 5 is urged to defend our Laffer-bashing… a thorough explanation below

The Swiss bank UBS announced another huge write-down today, to the tune of $19 billion. Investments in “U.S. real estate and certain structured credit positions” have pushed UBS to the top of the heap in Europe. They’ve now registered over $37 billion in subprime-related losses since the crisis began.

The bank reported an overall first-quarter loss of nearly $11 billion.

They’ve also announced they’ll be firing at least 5,500 employees. Coupled with the first 1,500 they fired, the bank has now lopped off 18% of its entire work force.

Head’s keep rollin’ in New York City, too.

Bear Stearns may lay off as many at 10,000 employees — more than 70% of the failed broker’s entire work force. Even their “savior” J.P. Morgan may have to cut as many as 1,500 jobs as a result of integration with the leftover Bear employees.

Morgan Stanley, the U.S.’ second largest broker, is looking to nix over 2,300 employees. The investment house said yesterday it plans to reduce its 47,000 work force by another 5%… on top of the 3,000 they’ve kicked to the curb since October.

Accordingly, financials led the Dow and S&P 500 to small losses yesterday. Bank of America’s recent acquisition of Countrywide is, apparently, in trouble. The nixed Microsoft/Yahoo deal didn’t help the Nasdaq any, either.

But there’s still money to be made, right? Of course, there is.

“We like businesses that drown in cash,” Charlie Munger said at the Berkshire Hathaway shareholder meeting over the weekend, uttering the Munger-Buffett Mantra. When asked what kind of business they would buy during this “credit crisis,” Munger sang a tune that any of Chris Mayer’s readers would recognize: businesses with tangible assets that “sweat” cash.

“We like ideas where you don’t have to carry to three decimal places,” Buffett chimed in, “simple ideas in which the bargains are apparent.”

Berkshire bought PetroChina back in 2002, for example, when it was a $35 billion company that Buffett thought was worth $100 billion. Buffett bought the stock having done nothing more than read the annual report. With that big a gap, it doesn’t matter whether the company was worth $80 billion or $120 billion. There was a wide margin of safety. The best ideas are obvious, and great precision is not required.

“If someone walked in here and weighed 350 pounds,” Buffett suggested, “I might not know he weighed 350 pounds, but I would know he was fat.”

Chris sat through a six-hour Q&A with Buffett and Munger… so you didn’t have to. For full coverage of the Berkshire meeting — and Chris’ list of obviously “fat” investments — check out the latest Mayer’s Special Situations alert.

“In the first quarter of 2008,” adds Dan Amoss, who also attended the meeting this weekend in Omaha, “Berkshire wrote $400 million worth of bond insurance premiums. Buffett said he believed that this figure surpassed the premiums generated by all the other bond insurers combined.

“The amazing thing about that $400 million is most of it came from bond investors who already had coverage from other AAA bond insurers. In other words, municipal bond investors are paying Berkshire high premiums that will result only in losses to Berkshire if both municipalities and bond insurers default.

“That’s how little faith bond investors have in the ability of insurers like MBIA and Ambac to survive long enough to pay claims. Berkshire will, obviously, keep trouncing these two firms in the contest to write bond insurance.”

Please note: If you’re following Dan’s trades in Strategic Short Report, you recently pocketed 97% gains by betting against TCF Financial, a struggling regional bank. If you’re not currently reading the Short Report, you are missing out on some juicy profits ripped right from the front lines of the credit crunch.

Service jobs in the U.S. ticked up a notch in April.

The Institute for Supply Management (ISM) surprised investors yesterday when its Non-Manufacturing Index rang in at 52, up from 49.6 in March. The wonks who forecast these things expected a decline to 49.3.

As you may already know, when the ISM index crosses 50 moving up, that indicates a period of expansion. Below 50 and going down signifies contraction. Since the service industry comprises 73% of the U.S. economy, market cheerleaders are heralding the ISM’s report as a sign of a defiant turnaround for the economy.

Many oil traders read the ISM report as such and pushed oil back through $120. Stronger service economy… stronger demand for oil, their theory goes. Buy!

But we forecast oil going through $120 yesterday. Nagging supply disruptions and a weak dollar… our theory goes.

Either way, oil at $122 a barrel is a stark reality this morning.

Gold rallied along with oil yesterday. The precious metal is up over $30 this week and sells for $880 and change as we write.

94% of Americans expect to pay $4 per gallon for gas by the end of the year. Another 78% of those surveyed by CNN wouldn’t be surprised to see $5 at the pump before 2009.

Heh… and you thought we were gloomy.

The national average price for gas remains $3.61 today, a cent off its all-time high.

Chrysler is promising all new car buyers $2.99 gas for the next three years. This morning, the struggling automaker unveiled their latest (and potentially ruinous) marketing campaign: Buy a new car or truck and Chrysler will include a gas card that locks in a $2.99 per gallon price for the next three years.

There’s some fine print, naturally. The card is good for only 12,000 miles per year… you can buy only 87 octane or E85 fuel… and not all cars apply.

Still, let’s do the math.

Let’s say you buy yourself a shiny new Chrysler Aspen. It gets, at best, 19 miles to the gallon. Should gas go up to $5 a gallon, as 78% of Americans now believe, you’ll be saving around $1,250 annually. Chrysler would be losing the same amount.

Should gas prices stay the same, or miraculously drop below $3 a gallon, there’s no doubt this will go down as one of the luckiest, and likely profitable, auto-selling campaigns in history.

But seriously, pricing gas futures into the cost of the product? Just how desperate is Chrysler?

The dollar index shed about half a point yesterday and this morning barely clings to 73. As such, the euro has battled back about a cent, and is now at $1.55. The pound and yen are largely the same, at $1.97 and 104, respectively.

It’s not just rappers and supermodels anymore. Even drug dealers are shunning the dollar.

The euro, says Reuters, has become the currency of choice among international drug traffickers. Both the U.N. and DEA told the agency that “a kilo of coke brings in two times as much in Europe as it does in America.”

Accordingly, South America is becoming awash with euro notes: “Nine of 10 travelers who carried the $1.7 billion euros that came into the United States during 2005 did not come from Europe. They came from Latin America.”

We wonder what percentage of those have coke residue on them.

“I read in your letter yesterday,” writes a reader, “that Americans think the economy is more of an election issue than a war.

“Hello, am I missing something here? The war is, was and will be at the root of our economic devastation as a nation. The wastes and plundering of U.S. taxpayer dollars that are unaccounted for are of staggering proportions — let alone the war contracts. The state of the economy is exactly the kind of smoke screen they need to put up prior to an election to distract people from understanding the economic tragedy this war has created and is costing every American (and future generations) more than can be put in simple words.”

The 5 responds: The $3,000,000,000 war, while certainly a foreign policy faux pas, doesn’t hold a candle to the Medicare Part D benefit, enacted not long after “shock and awe” began. That program alone is projected to add nearly $8 trillion to the federal debt in less than five years.

“Why you don’t like Laffer is a mystery,” writes our last reader. “It is important to look at the actual revenues from tax changes, and not just look at what the deficit does during the period of time after them.

“The CBO and static analysts told Kennedy that tax cuts would lead to deficits. They were wrong. Revenues actually went up, while real GDP growth tripled.

“Capital gains tax cuts have been similar nearly universally in the U.S. and around the world on an empirical basis. The CBO and static analysts in government and economic circles told Reagan’s advisers that cutting the capital gains rate from 50% to 20% would slash the revenue to government from this tax. They were wrong, and Laffer was right.

“Within two years of the cuts in capital gains taxes from 50% to 20% (top rate), capital gains realizations had nearly tripled and Laffer was proven correct — government revenue from capital gains taxes actually rose with the lower rate. But the real impact was not just on government coffers, but was on growth — capital investment and real GDP growth both soared to the highest levels since the Kennedy tax cuts.

“The late ’80s capital gains tax increases were supposed to help cut the deficit. The CBO argued (again using less-than-useless static analysis) that raising capital gains taxes would help cut the deficit — and like Obama and Clinton, they believed that raising tax rates on capital gains would increase government revenues from capital gains taxes. Capital gains taxes were raised back to 28%. Realizations of capital gains COLLAPSED from nearly $400 billion to around $160 billion the first year and fell to under $100 billion the next year…

“Has there ever been a period when raising capital gains taxes (that already existed) have led to consistently higher tax receipts from the tax? Never. But in each of the three times capital gains taxes have been cut, they’ve led to increased tax receipts from capital gains.”

The 5 responds: It’s not so much Laffer we don’t like. In fact, he’s a very charismatic guy. And his ideas are good, in theory. We advocate keeping capital gains taxes low ourselves.

But the Laffer curve is insidious. Laffer argues that keeping taxes low is the ultimate way to put more money in the hands of the federal government. That’s a mistake. And not just for your obvious libertarian, small-government, personal liberty reasons. In our opinion, the Laffer curve does something much worse: It encourages the ne’er-do-wells in Congress to disregard deficit spending… even those who claim to be fiscally responsible.

Republicans have historically accused the Democrats of being the “tax and spend” party. The Laffer curve has allowed the core faction of the Republican Party to become, in the words of Pete Peterson, the “borrow and spend” party.

You point out that government receipts rose during the Reagan years. That much is true. But the national debt rose even faster. When Reagan got into office, the national debt was $994 billion. By the time he left office, it was $2.7 trillion. The numbers the current administration has posted are too obscene to print here in The 5.

“Addison, I’m not a debt guy,” Laffer told me in his office in Nashville when we were interviewing him for I.O.U.S.A.

In order for the Laffer curve to optimize revenue for the government — even if that was a laudable goal — you would still need a strong currency and a strong economy to grow your way out of the deficit. Mr. Laffer didn’t want to discuss the dollar, either.

With the economy growing at an annual rate of less than 2% right now… it’s going to take one heck of a long time for the optimal tax rate to address the existing liabilities of the U.S. government, let alone the promises the government has already made to the retiring generation of baby boomers. Your currency — your standard of living — is what suffers in the end.

If you’re going to keep taxes low — which we agree is a good idea — the deficit spending culture in Washington has to go. Laffer’s ideas let the “tax cuts at any cost” ideology flourish… but have done nothing to help rein in spending. In fact, with the current administration, it has done just the opposite.

Regards,

Addison Wiggin
The 5 Min. Forecast

P.S. It’s worth pointing out that Arthur Laffer was one of two members of the Nixon administration who opposed closing the “gold window” in 1971. He tells a funny story about being in the room when then secretary of the Treasury John Connally told Valery Giscard d’Estaing, then president of France, that the U.S. would no longer exchange France’s dollar holdings for U.S. gold.

“You can’t take the dollar off the [gold standard],” d’Estaing reputedly said. “Do you know how many millions of dollars France has?”

“Hell, Giscard,” Connally said, putting his Texas boots on his desk while chomping on an unlit cigar, “we got a lot more dollars than you do.”

For posterity’s sake: The other guy who thought it was a bad idea to dismantle Bretton Woods was Paul Volcker.

P.P.S. We got a chance to reconnect with our old friend Bill Meyer this morning. Bill hosts a radio program on KMED in Portland, Ore.

Bill’s been keeping tabs on us since we first published Financial Reckoning Day, back in 2002. “Back then,” Mr. Meyer said this morning, “everyone thought you and Bill Bonner were nuts, Addison.”

Heh.

We may be going to hell in a bucket, Bill, but at least we’re enjoying the ride. Thanks for everything.

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