Is the Worst Over?

Over the past several months, events have unfolded much as we had predicted. The impact of years of lax and excessive lending in the U.S. residential real estate market finally started to come to light in the form of accelerating delinquencies and foreclosures. All it took to expose the weakness of the financial system was a U.S. housing market that was no longer rising. Large areas of the credit market dried up, spreads widened and banks began to take enormous writedowns. A credit crunch commenced and spread around the world.

The policy response of the central banks was immediate and profound. The U.S. Federal Reserve, the Bank of England and the European Central Bank, among others, embarked upon programs of radical intervention, providing immense amounts of liquidity to the financial system. In the case of the Federal Reserve, illiquid and possibly worthless mortgage-backed securities have been accepted as collateral and lending facilities have been opened for investment banks for the first time since the Great Depression. Bear Stearns was rescued from insolvency by a forced marriage to JP Morgan, which was financed by the Federal Reserve. The gold price sprinted through $1,000...and then fell back as the market concluded that central bank policies had prevented a financial meltdown.

Where are we now? Is the worst over? Many commentators and analysts tell us that the housing market has bottomed (again), that credit markets have stabilized and are on the mend, and that the recession that hardly anyone acknowledged a few weeks ago is now almost over, having proven to be both shallow and short. Stock markets have rallied on this view while gold has fallen into a trading range 10% below its highs.

In our view, the worst is not over. The bottom is not in. Let's step back and remember how we got here. We are witnessing the conclusion of the greatest credit bubble in history. An unusually long period without a serious recession, accommodative central bank policies and financial innovation supported by bizarre credit rating practices enabled a proliferation and accumulation of debt that has warped every aspect of our economic and financial behaviour. Unwinding these excesses will do more than damage bank balance sheets and displace marginal homeowners.

The economic boom of the last 25 years has really been a credit boom fueled by, and symbiotically fueling, asset inflation. Yes, there has been real growth led by technological advances and the integration of the Third World into the global economic system. But these real developments have provided the cover for an even more consequential use of excess credit to speculate in financial assets, with ever larger amounts of leverage to enhance returns (the Wall Street strategy). Households have also participated in the asset inflation by speculating in housing and borrowing against their homes to overconsume. Households have depleted their cash balances, increased their liabilities and dropped their savings rate to zero during a period of declining real incomes (the Main Street strategy).

The Wall Street and Main Street strategies have two factors in common � an enormous increase in leverage and a deployment of credit into non-productive activities. Only a small percentage of the excess credit has been invested in businesses that generate the cash flow to service the debt. Both strategies require rising asset prices, low interest rates and lax lending standards to continue.

And continue they must. In our view, the current situation is a giant Ponzi scheme, in which evermore credit is required to repay the existing debt and interest. The underlying economy cannot support the load, even if we do not have a serious recession.

U.S. debt in all forms rose $7.86 trillion in the eight quarters ending in December 2007, bringing the total to $48.8 trillion. Nominal GDP rose $1.38 trillion over the same period to $14.1 trillion. The U.S. is adding $5.70 of new debt for every dollar of nominal GDP growth. This ratio has been accelerating over the past 25 years...and must continue to do so if the U.S. is to avoid a debt collapse of immense proportions. We refer here to the U.S. situation because of its central importance to the global economy and financial system, but similar problems exist throughout the developed world.

In our view, central banks are willing to go to any lengths to prevent de-leveraging and a consequent debt deflation. They understand the need to re-inflate the credit bubble and the outlines of their response are already evident. Even more interesting was the decision by the SEC in late March to suspend SFAS 157. This accounting rule was brought in after many years of immense efforts to require financial institutions to mark to market their assets on an ongoing basis. This rule was in effect for less than a year. Regulators have basically told the banks to stop writing down illiquid and non-performing assets until they have rebuilt their balance sheets and income statements. Nothing could make the severity of the current situation any clearer.

But if the central banks of the world are focused on preventing a de-leveraging of the financial system, democratically elected governments are focused on preventing a de-leveraging of the consumer. And here the problems are even larger and more difficult to resolve.

The housing crisis has not bottomed. At the end of March 2008, an estimated 8.8 million American homeowners had mortgages greater than the value of their properties. More than three million homeowners were behind in their payments while one million were in the process leading to foreclosure. These staggering totals are at the leading edge of a wave of resets of the two-year teaser rates that became immensely popular in 2006. These teaser rates were never intended to reset - the assumption was that house prices would continue higher and easy credit would also continue, enabling borrowers to refinance before the resets. But home prices are falling, the mortgage market has frozen up and the resets are about to release a surge of defaults. A recession will only make the problem worse.

In our view, the stage is set for a massive program by governments to forestall a consumer debt crisis and resulting severe recession. Over the next year, we predict a major effort to bail out Main Street (it is an election year in the U.S.), which will transfer the credit-creation process from Wall Street and the private sector to the public sector. The recent removal of capital and lending limits for the Government Sponsored Enterprises (Fannie Mae and Freddie Mac) point the way. The consequences for our free market economy are frightening to contemplate. After all, there is no problem that government cannot make worse.

We foresee a period of rising public credit creation and public debt, rising inflation and inflation expectations, widening interest rate and credit spreads, slower growth, lower earnings and lower price-earnings ratios a period where gold outperforms other asset classes. In this environment, gold will also outperform commodities such as oil and steel, which have driven up capital and operating costs for gold miners and reduced their profit margins despite the higher gold price. Gold equities should then once again provide leverage to the gold price, with Seabridge well positioned due to its industry-leading gold ownership per common share.