Commodities slammed, Option ARMs and Euro GDP Shrinks

Gold, Oil Slump, Leading Commodities Plunge to Four-Month Low (August 15 - Bloomberg)

Aug. 15 (Bloomberg) -- Gold plunged below $800 an ounce, heading for the biggest weekly slide in more than 25 years, and oil, wheat and sugar slumped as the dollar's rebound reduced the appeal of commodities after a six-year boom.

The Reuters/Jefferies CRB Index of 19 commodities tumbled as much as 2.7 percent to 379.07, the lowest since March 20, as silver, soybeans and corn lead the drop. A rally this month in the U.S. currency has curbed the appeal of dollar-priced raw materials as a hedge against inflation, and demand for commodities may be hurt as an economic slowdown spreads.

This has been an absolutely brutal week for commodities, especially gold and silver, which are my personal favorites. To say that this has been a brutal week for me, too, would not be a stretch. You see, I love to analyze things, and when things line up and make sense, I’m happier than when they appear to be nonsense.

Consider the happy coincidence that, in this same week, we saw inflation surge to a 17 year high and commodities take their biggest weekly plunge in 25 years. I mean, who writes these scripts? Further, the explanation that a 4% rise in the dollar explains a 25% drop in some commodities simply stretches credulity past the breaking point.

Something else is afoot, that is plain. The most compelling explanation to me is that central banks, seeking a higher dollar and lower inflation, kicked this whole run off, but that it is now morphing into something they did not intend. If one or more major hedge funds has not been destroyed in this run (not to mention a few thousand farmers and silo operators), I will be shocked. It could have some ripple effects that will begin to show up in the next few weeks.

Unintended consequences; it’s the law.

Asteri's Goldman Says Credit Crisis `Only Now Beginning' (August 15 – Bloomberg)

The above is a link to a radio interview between a Bloomberg host and Mr. Goldman, who is a lively and clear orator. I really liked the way Mr. Goldman made clear that the so-called "credit crisis" is no such thing…yet. The credit crisis has not yet arrived, because major banks are contractually obligated to provide lines of credit to companies that are busy drawing those down. The credit crisis erupts when those loans are due to be renewed. He claims that banks do not have the balance sheets they need to extend that credit, and therefore, the worst effects remain in front of us.

Ticking time bomb (August 14 – Economist)

OPTIMISTS, look away now. Prices in America’s housing market may have slumped, but the pain for a significant subset of homeowners has barely begun. Even at Barclays Capital, which spotted some of the improvements mentioned in the previous story, there is still concern. The bank’s Nicholas Strand says that roughly 1.4m households, most of them in California, hold a particularly nasty type of adjustable-rate mortgage called the “option ARM”. Although the overall value of option ARMs is lower than that of subprime loans—some $500 billion, according to Mr Strand, compared with about $1 trillion in subprime loans—their sting is more venomous.

The option ARM allows borrowers to pay less interest than the formal rate for a limited period (the vast majority of customers choose this option). In return, the unpaid interest is added to the original loan, a process soothingly called “negative amortisation”.

Last year, I said that you’d be hearing a lot more about Option ARMs in the future. Well, here come the stories. They are an even larger disaster in the making, due to their curiously inappropriate design, which lets banks record the payments the homeowners are not making as profits, even as the loan balance simultaneously climbs. But that’s just for a while. Then the mortgage payment will be ‘recast’ to a new, higher level. These recast amounts will continue to grow larger and larger until they peak in 2011 at 80%.

That’s right, the average payment on the average Option ARM will be 80% higher than today’s payment, roughly coinciding with the bottom of the housing bubble. Bad combo.

Given that the vast majority of people with Option ARMS have elected to make the minimum payments, the negative equity on these loans will make the subprime losses look enviously low.

ECB slammed as Europe crumbles (August 15 - Telegraph)

The economies of Germany, France and Italy all contracted in the first quarter and may now be in full recession, shattering assumptions that Europe would prove able to shrug off the effects of the credit crunch.

The picture is darkening so fast in Spain that Prime Minister Jose Luis Zapatero cancelled holidays and called his cabinet back to Madrid yesterday for the first emergency session of its kind since the Franco dictatorship. The crisis meeting agreed to a €20bn (£16bn) blitz on public works, tax cuts, and a mortgage rescue to halt the downward spiral.

One of the ‘reasons’ given for the dollar rally is that the US economy is still expanding, while the European economy is declining. As you know from watching Fuzzy Numbers, the US GDP is overstated by a very large amount, and, if calculated the same way as that in Europe, it would actually be far lower.

The other defect in the GDP calculation that I didn’t go into is that the effects of borrowing are not canceled out of the GDP calculation. Here’s an example: If you and your neighbor both earn $100,000, but your neighbor borrows an additional $100,000 and spends that, should we count your neighbor's “GDP” as being twice as large as yours? Of course not. Similarly, the fact that the US is borrowing over a trillion dollars a year from the rest of the world really ought to be backed out of the GDP number, but it is not. I guess that’s okay in some people’s minds, because it will be backed out in the future when the loans have to be repaid, but it badly distorts the health of the economy in the short term.

All the best,

Chris