Juggling Dynamite

Over the past several months, I have repeatedly expressed skeptism on the whole “demand is driving commodity prices” rhetoric. I have typically received the most angry emails and comments when I have pointed out that a slowing global economy will naturally demand less commodities and that prices should be going down not up. Well an interesting story this week on revisions now being made to the estimated influence that speculators have had on energy markets over the past many months, see Revised data show speculators controlled nearly half of NYMEX oil futures :
“(Reuters)—A quiet data revision that has boosted by nearly 25% the number of oil futures contracts U.S. regulators think are held by speculators. And that revelation is raising eyebrows in the energy trading community.
The revision means that speculators controlled 48% of the open interest in NYMEX crude oil futures and options as of July 15—compared with just over 38% under the previous classification.
“That’s huge when you look at the numbers,” said Phil Flynn of Alaron Trading in Chicago.
“It changes the whole way you look at the recent moves in this market.”
As oil and other commodities have been falling sharply over the past few weeks, the Canadian dollar has predictably plunged with them: see Party's over for once red-hot Canadian dollar.
It seems that following a lengthy period of utter insanity, natural correcting mechanisms are once again restoring some equilibrium to world markets. There will be more of this to come over the coming weeks and months as those who thought they were “investing” in commodities and the “China story”, will be forced to realize that they were in fact speculating on lots of hope and very little common sense.
As commodities fall, the US dollar is strengthening. This is the logical outcome. Commodity prices were driven to bubble-heights as global masses clamored on to the hate-the-horrible-US bandwagon. And now, the rest of the world is waking up to the reality that they are not better than the US. And in many cases other countries are economically and socially worse off than the US.
China is not the new Saviour. Like the rest of us, their government and people are not brilliant. They were fortuitously ready over the past few years to pump out lots of cheap goods to a western world addicted to spending via low rates and dumb credit. Jeremy Grantham (a fellow money manager who, like me, has been discounted as bearish these past couple of years) was quoted in an interview this week:
“Grantham, who is amazed at how smart investors failed to see the housing bubble and ensuing crisis, is also surprised by those who express little concern about China's centrally planned economy and the strong likelihood of slower growth.
“Why have they become wonderful economists?” Grantham said. “What they have done is they have become wonderfully lucky like the rest of us.”
The odds that China, a major driver of global economic growth this decade, will stumble seem extremely high, he said. A Chinese downturn would send shockwaves through many economies that depend on its voracious demand for raw materials.”
Canada, we have been forewarned.

The kids and I did a day trip yesterday to Casa Loma in Toronto. I had not been in years and now that they are almost 9 and 10 they were able to take in a good deal of the historic story. I was reminded again of the epic nature of human behaviour, cycles and money.
Sir Henry Pellatt, the dreamer behind the “castle”, left his studies at Upper Canada College when he was seventeen to pursue a career in commerce in the family business. By the age of 23 he became a full partner in his father's stock brokerage firm, from that time on known as Pellatt and Pellatt.
In the same year that Thomas Edison developed steam-generated electricity, Sir Henry realized that supplying electricity could be extremely profitable. He founded the Toronto Electric Light Company in 1883. By the time he was thirty, the Toronto Electric Light Company enjoyed a monopoly on the supply of street lighting to the city. Copious amounts of easy money were now flowing to Sir Henry.
In 1892 we are told by his bio, Pellatt's father retired, “enabling Sir Henry to invest with more risk.” Cue the red flags.
“By 1901, Sir Henry was chairman of 21 companies with interests in mining, insurance, land and electricity. In 1902, he and his partners won the rights to build the first Canadian hydro-generating plant at Niagara Falls. He was knighted in 1905 for his military service with the Queen's Own Rifles.”
Surely he was now too big to fail?
His bio goes on: “Pellatt's Midas touch continued through most of his business life. In 1911, armed with a fortune of $17 million, Pellatt drew up plans to build his dream castle with Canadian architect E. J. Lennox.”
The plot thickened. Those of us building “dream homes” beware. The castle took more than 3 years and 3 million dollars to complete. It had a live-in staff of 40 and took more than $50,000 a year (in 1914!) for maintenance and up-keep. At the time the average house in Toronto was valued at $2,500. The Pellatt’s lived large in the castle for 9 lavish years. But cycles were changing and Pellatt was unprepared.
The bio continues: “To finance expansion, Pellatt and Pellatt went further and further into debt. The one sure source of income from the monopoly of electrical power vanished when political decisions allowed for public ownership of electricity. In a futile attempt to restore his wealth, Sir Henry turned to land speculation.”
Unbeknownst to Sir Henry, now he had that quintessential recipe for financial disaster: years of easy income engender lavish spending; continued in the face of declining income; increasing debt; intensified risk-seeking and financial speculation.
Sir Henry did not take into account the effects of World War I and the secular shifts that were taking place in markets and investor sentiment. During the war Canadians put their money into war bonds, not homes. After the war the economy slumped, tilting Pellatt and Pellatt into bankruptcy. The company owed the Home Bank of Canada $1.7 million – or in today's terms $20 million.
During the preceding good times, the banks had wildly over-levered themselves. Now they began to crumble into bankruptcy along with their biggest clients. Several bank heads were arrested and taken away from their mansions in handcuffs. Sound very familiar?
“With his stock worthless and his business debts out of control, Sir Henry was forced to auction off his prized possessions for a fraction of their worth and to abandon his dream of a noble castle.”
In the end, we are told, Sir Henry died penniless. Although he undoubtedly also left a legacy of great philanthropy and charitable works. Perhaps most importantly, I think, Sir Henry left the rest of us an incredible, enduring, allegory of human behaviour and money. His story can inspire us to reach for our dreams. And he serves as a wonderful inverse mentor about what not to do.
“So?” I asked my kids as we walked back to the Subway. “What’s the moral of Sir Henry’s story do you think?” They both chimed in: “Don’t build houses that are too big. Don’t spend too much even if you are rich. And don’t borrow lots of money.”
Lessons we would all do well to live by. We are grateful to Sir Henry for the reminder. If you get the chance, do visit Casa Loma. Sit there in his garden and take it all in.

The US Congress created mortgage sponsor Fannie Mae in 1938 as part of President Roosevelt’s plan to revive the economy during the Depression; Freddie Mac was launched in 1970. The agencies are now the chief providers of mortgage financing; they own or guarantee about 80% of US mortgages originated this year. In Canada, they are the equivalent of our own Canada Mortgage and Housing Corporation.
Yesterday US Treasury and Federal Reserve officials announced plans to back the failing companies, and it is estimated that the bailout could cost taxpayers $25 billion:
“Speaking Tuesday in New York, Treasury Secretary Henry Paulson said the stability of Fannie and Freddie are the key to easing uncertainty about U.S. financial markets.
Members of Congress are currently working out a deal that would allow Uncle Sam to help Fannie Mae and Freddie Mac in an emergency. The deal would revise supervision of the agencies and allow the government to insure up to $300 billion in refinanced mortgages.
Congress plans to include $4 billion in the bill to help local governments buy and rehabilitate foreclosed houses. President Bush opposes this provision but backs other sections of the bill; it’s not clear whether he’ll sign it into law or veto it as threatened.
The Congressional Budget Office, a nonpartisan agency, says a temporary measure to back Fannie and Freddie could cost taxpayers as much as $25 billion.”
This legislation is a war-time-like-measure showing desperation on the part of the US government in trying to shorten the housing depression and the worst economic recession in decades.
But many American tax payers are finally outraged and taking to the streets in protest of the intervention proposal.
Watch this clip for a good overview: **Red Alert**Rape by Congress Imminent.
The problem with seeing the truth is that it then begs the question: what changes are we all prepared to make to our spend-thrift habits and credit-pushing institutions to clean up this mess and get back on track?