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Weekend Edition

The Best of The S&A Digest
Saturday, September 8, 2007

We were discussing the LIBOR problem Wednesday night at dinner in Baltimore.
 
We reserved the corner table at Pazo... one of the fancy restaurants in town. We invited a few friends and hosted a potential new hire. Everyone at the restaurant was dressed up. Beautiful women sat at several tables, sipping wine elegantly. And then there was our table: six or eight empty wine bottles and a raging argument about LIBOR...
 
On the way home, I thought we might have wasted the night out. Perhaps we should have spent more time enjoying the food... and less time thinking about global economics. But maybe not. On Thursday, The Wall Street Journal put the LIBOR problem on the front page of its investing section. "The LIBOR hasn't been this far above the base short-term rates set by central banks since the Enron and WorldCom collapses in 2001." This was my point at dinner...
 
What is the LIBOR? Why does it matter? The acronym stands for: London Interbank Offered Rate. It is the annualized rate of interest that banks charge each other to borrow money for extremely short durations. The rate is set by a bank trade association in London... not by politicians in Washington D.C. And the bankers are requiring higher rates, even as politicians are eager for lower rates. Why? Banks are running low on cash. They've made big commitments to fund those huge private-equity deals via the commercial paper market. And the banks that have money are worried that the banks that don't won't be able to repay their interbank loans.
 
The real root of the problem is that English-speaking homeowners have fueled the rapid growth in credit markets for the last 10 years, via huge property bubbles in America, England, and Australia. Suddenly, the underlying value of all of this collateral is suspect. No more refinancing. Much less credit being issued. That's drying up liquidity in credit markets around the world, making the market rate of interest higher. And it will probably get worse: Most adjustable-rate mortgages are based on LIBOR. Higher rates could lead to higher defaults, lower collateral values, and even less lending.
 
 At least it's not as bad as in Venezuela... While LIBOR is rising, we've got a long way to go to catch up with the land of Hugo Chavez. Venezuela's interbank overnight lending rate jumped to as high as 90% after the central bank suspended short-term lending to banks. We've been expecting a currency crisis in Venezuela.
 
 Perma-bear Jeremy Grantham cites high profit margins as a major reason we will see more market declines:
 
"So high profit margins offer multiple supports for the market, but they will certainly decline. They are the most dependably mean-reverting series in finance: If high margins do not attract greater competition, then a wheel has fallen off the capitalist machine. For U.S. and developed foreign markets, fair value (defined as normal P/E times normal profit margins) is about one-third below today's level, and for emerging markets it is about 25 percent lower."
 
 Steve Sjuggerud's latest Confidential report analyzes the entire senior secured lending market... and suggests buying.
 
Several closed-end funds that specialize in this type of lending are trading at discounts to NAV that imply annual returns of 20% or so, assuming liquidity (and confidence) eventually returns to the market. Sjug's not the only one who sees the opportunity: Private-equity groups are scrambling to raise funds to buy these leveraged loans in the belief that banks will have to sell $250 billion of forthcoming senior debt on the cheap.
 
According to our friends at United for a Fair Economy (which we have more appropriately re-named "United for More of Your Property"), CEOs made 364 times more pay than the average worker in 2006.
 
Never fear – the government is here to help. The SEC has faxed letters to 300 companies asking them to explain in detail their executive compensation. Some of the companies in question include General Electric, Coca-Cola, and Pfizer. The companies have until September 21 to respond or explain why they can't, and the information should be made public later this year.
 
We don't know how the whole executive compensation problem (which, yes, we do think is a problem) will be resolved. But there's one thing we know for sure: The government's involvement will lead to more lobbying expenses and more money for Washington a lot faster than it leads to benefits for shareholders.
 
Regards,
 
Porter Stansberry




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