A Melman Minute — March 10, 2008

Quite surprisingly, at least given this past Friday’s sharp declines in the world’s financial and currency markets, trading has opened rather quietly in Europe and North America this morning. While Asian exchanges fell modestly, European and North American Indexes tended toward ‘unchanged’ with the notable exception being the TSX, which was down near 100 points shortly after the opening, thanks to declines in metals, banks and oils.

Not surprisingly, those metals which had risen almost vertically in recent weeks, are finally undergoing serious corrections with silver down another 50 cents to about $19.50 (all prices US$); platinum off an additional $100 to near $1,940 and palladium down about $40 to $465. Gold fell sharply as well at the opening, but has already begun to recover, falling first to about $960, but rallying to near $970 by 8:00 AM PDT. Oil fell slightly to about $104.50 while the C$ declined to just over parity with the Greenback.

While we are enjoying at least relative calm in financial markets this morning, information continues to flood the financial media which indicates that the crisis brought about by the decline in American housing is hardly over. In fact, the rate of deterioration may even be accelerating.

A quick review of American residential price action shows that from 2000 to mid-2006, prices soared relentlessly. Homes which were valued at about $150,000 at the turn of the century saw their value rise steadily to over $500,000 in many areas. As the market value of houses soared, so did the borrowing power of homeowners and many people tapped into the rising value of their homes by re-financing their mortgages to take out tens or hundreds of thousands of dollars, money which was spent on the consumer-driven economy.

It was a bonanza for everyone. Homeowners felt richer by the month, retailers benefited from increased consumer discretionary incomes, banks and other lenders grew rich on mortgage origination and refinancing fees and all manner of trades-people from appraisers to carpenters to laborers to roofers to appliance builders to carpet distribution companies enjoyed boom times.

Perhaps the most critically important observation of that time (2000 to early 2006) was the widespread belief that prices had nowhere to go but up. Based on this belief, lenders began to lower their standards markedly to get in on every potential deal in order to continue receiving those fat loan service funds. After all, what did it matter if borrowers couldn’t make the monthly payments out of income? A lender merely offered incredibly beneficial terms for the first year and then planned to re-write the mortgages made to less-than-normally-qualified borrowers (or “subprime” borrowers) based on ever-rising equity thanks to ever-rising prices.

There was yet another important factor at play. Normally, a lender collects payments directly from the borrower during the life of the loan and therefore has a direct interest in the quality of the loan. However, with American real estate, many loans were ‘packaged” and sold to investors seeking high interest yields. These packages were then insured by mortgage insurers such as MBIA or Ambac as being of AAA quality and were then sold to lending institutions around the world.

All worked well until home prices stopped rising on balance in mid-2006. Then they began to fall slightly. Then they began to collapse in formerly hot areas such as Nevada, California, Florida and Arizona. Millions found that there was no newly-created borrowing power in their mortgages and they would have to begin to make their home payments out of regular income. For many, that was mathematically impossible and they began to default in record numbers, first in the subprime category and more recently in previously sound mortgages.

As defaults rose, the value of the loan packages began to fall. Those investors - individuals, mutual funds or lending institutions of one sort or another - who had purchased the loan ‘packages’ found it necessary to write down the value of the packages they held. As these write-downs continued, many institutions began to sell those holdings, which depressed their value further, driving many institutions below normally accepted levels of capital relative to debt.

But all the Fed seems able to do is create new currency to rescue the situation in some manner, driving down the value of the dollar, thereby stoking the fires of inflation, which is putting upward pressure on long-term interest rates, which will ultimately, unless reversed, make the situation much worse.

In the meantime, home prices continue to plunge. For example, the huge Los Angeles metropolitan market has seen the average home value drop from $505,000 in February, 2007 to only $415,000 in January, 2008 - a stunning 18% - and placing hundreds of thousands of homes “under water”, meaning that more was owed on the homes than the homes were worth, creating an incentive for those homeowners to abandon the houses and turn them back over to the lenders.

As an example, please note the chart of Canadian Imperial Bank of Commerce, one of Canada’s five major banks, which has now lost over 40% of its value in the past five months, dropping from over C$100 to the low C$60’s.

There are many ramifications to this entire situation, and we hope to deal with those regularly into the future. Suffice it so say there are no easy solutions being offered at the moment and deep concern prevails in the financial community.

Deep concern, particularly if it turns into panic, has historically been a plus for the precious metals markets.

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.

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