A Melman Minute — February 18, 2008

It is good to be back in the saddle once again after a hiatus to present our workshop and appear on panels at the recent Cambridge House Phoenix Resource Conference. As always, it was a pleasure to visit with our readers and to exchange views about the future of the economy, our world of precious and base metals, and, of course, the onrushing United States Presidential election. (More on that last one tomorrow.)

As we drove through the American West from California through western Arizona and back through California to Oregon and Washington, we could not help but notice a growing fear that the housing crisis had a lot longer to go before it finally hit bottom. People who were so anxious to obtain real estate licenses to sell residential properties now wonder why they cannot make a living as home sales, when compared to one year earlier, have plunged by over 40% in many metropolitan areas. Home prices are declining so fast that many retirees who had been banking on inflated real estate values to finance their dreams for their latter years are now watching their home values plunge - and their dreams diminishing with every downward appraisal.

The loss of confidence is evident in cities such as Phoenix, Las Vegas, San Diego and Sacramento where only twelve months previous, homeowners and investors alike were smacking their lips in glee as they watched their net worth soar. Now it is headed swiftly in the opposite direction.

One consequence of this meltdown that has been hidden from open public view to date could have truly ominous consequences - and that is the loss of revenue to municipal and state governments. Every home sale generates sales tax revenues, title registration revenues, tax revenues on appliances and equipment, income tax revenues for workers and management who build the homes, etc. With sales down 40% in one year - tax revenues are also down a similar amount - and few municipalities or states budgeted for anything so dramatic.

The situation is particularly acute in California which is already facing a $14 billion (all figures US$) budget deficit for this fiscal year and the last thing they counted on was a diminishing stream of revenue. The “solution” the government under Governor Schwarzenegger came up with was to ‘try’ to reduce spending by $2 billion while burying the other $12 billion through smoke and mirrors in the state’s accounting procedures.

We can see two consequences to this growing situation. First, the value of debt offerings by various levels of government outside those coming from the feds in Washington, are vulnerable to devaluation as confidence in the tax-raising ability of those lower levels of government ebbs. In fact, that is already beginning to occur!

Since interest payouts on state and municipal debt occur on a federal income-tax-free basis, those levels of government have always been able to market their debt at a lower interest rate level than federal debt. This has held true as long as the market had confidence in their ability to raise sufficient revenues to maintain interest payments. For example, on $1,000 of federal debt at 5%, a taxpayer paying federal income tax at the rate of 20% would have to pay $10 in taxes on his $50 yield, leaving him with $40 net - or an effective yield of 4%. Therefore, ‘muni’ or ‘tax-free’ bonds, where the buyer would owe no federal income tax on interest income, have traditionally sold at yields of about 80% of federal debt paper. But that is changing.

According to figures just published in the prestigious Financial Times, a dramatic loss of confidence in municipal debt paper has been underway since mid-2007. As has been normal, municipal bonds were selling to yield about 80% of federal paper up to that point, but since then, the loss of confidence in small governments’ taxation powers has been so great that the yield on those bonds has soared to an astonishing one hundred thirty percent of the federal government’s debt instruments. That is unprecedented this century!

Second, this loss of confidence is causing smaller governments to search for every conceivable means of raising new taxes wherever possible. For example, in San Luis Obispo on the Central California Coast, the city government is planning to raise the ‘parking lot development fee’ on new commercial downtown construction to $16,400 from the present level of $12,767 in one shot. This is just one example of what is becoming an on-rushing parade. While these ruses may bring in some funds in the short run, they also make those areas less attractive places in which to reside or do business and the long term consequences of such policies can only be negative.

The market for municipal debt paper is enormous. In the short-maturity end alone, outstanding paper totals one-third of a trillion dollars - and the market value of that debt is now taking a beating. In our opinion, as long as foreclosure rates continue to rise - which they are now doing - and as long as home prices continue to fall - which they are also now doing - the real estate market will not turn decisively higher and we expect these problems will continue to worsen and spread.

This ‘beating’ is negatively impacting any institution which holds this type of debt instrument, including major banks. Perhaps that is one reason why bargain-hunters in the stock of the world’s largest bank have been disappointed, to say the least. As can be noted from the current chart of Citigroup, any bounce in the price of the shares has been short-lived and the stock is once again down to near the lowest levels in many years.

One more concern for the American - and, by implication, the rest of the world’s consumers, to worry about is the sudden and dramatic increase in the price of imported goods which occurred during January, a massive 1.7 percent rise in those prices in that one month. Prices of imported goods are now up a whopping 13.7% from one year ago.

So, not only do American consumers have to contend with sinking real estate values and lowering levels of job growth, but they now have to watch out for sharply rising prices of the goods and services they require.

All of this, in our view, constitutes a growing crisis against which the American government seems to have only one weapon - that is throwing massive amounts of newly-created currency into the financial world. We believe that those policies are working to ultimately provide the background for an explosive and enduring precious metals bull market.

Financial markets in Canada and the USA are closed today so there is little current market news to report. Metals have been quiet in overnight trading,

DISCLAIMER

The information presented above is based on data which we believe to be from reliable sources, but the accuracy of which cannot be guaranteed. Any opinions or predictions contained herein are those of the editor and are likewise offered also for information purposes only.

← All A Melman Minute