If you’d like to see somebody—lots of somebodies, if I had my wish–go to jail for their role in creating the lob al financial crisis, then $8 million looks cheap. That’s the budget for the Financial Crisis Investigation Commission. If, just for starters, some of the folks responsible for the massive fraud at two of Washington Mutual’s California office, went to jail I’d think the money well spent. Especially if one of those folks was Kerry Killinger, the CEO at Washington Mutual who received $103 million in compensation from 2003 to 2008.
According to internal Washington Mutual documents the fraud rate for mortgages from those two offices was 58% and 83%, respectively. There are no internal documents showing that the company ever addressed that problem.
But for investors constantly looking over their shoulders to see when the next bubble is going to pop and devastate portfolios, then that $8 million in a waste of money.
And that’s because the investigation is looking in the wrong places for an explanation of the second bubble to hit U.S. financial markets in less than a decade.
The investigation will uncover:
Greed. It’s always with us.
Arrogance. Wall Street breeds it. Masters of the Universe, indeed!
Bad judgment. Corruption. Pay offs. Wishful thinking. Lies of omission and commission.
Need I go on?
But none of this cavalcade of human sins would have been enough without one essential ingredient. The mix needed to contain something that would magnify greed, arrogance, bad judgment, corruption, wishful thinking and more until they were powerful enough to just about take down the global financial system.
Identifying that ingredient and watching it at work now tells us that 1) unfortunately, we haven’t seen the last bubble in our lifetime, and 2) shows us that we’ve done just about nothing to make sure that a bubble and its bursting isn’t in our relatively near term future.
What’s that ingredient? Cheap Money.
It’s still at work in the global economy right now.
Let’s take a single instance in the global iron ore mining industry.
That sector is a sweet place to do business right now. Iron ore miners have just negotiated an 80% to 100% price increase for 2010 through 2011.
Steel makers aren’t especially happy with that price increase but none of them has the clout to go upside the Big 3 iron ore miners—Rio Tinto (RTP), BHP Billiton (BHP), and Vale (VALE)—that control more than 80% of iron ore export market. Even China’s steel makers—even though China is the biggest steel producer in the world right now—don’t have the size and power to take on the iron ore oligopoly.
But China itself does. And China seems determined to bust the iron ore trust—if not this year, then the next or the next or the next.
So on April 1 China Railway Materials Commercial, a state-owned steel trader, put up $258 million for a 12.5% stake in African Minerals (AMLZF). That money should be enough, African Minerals says, to fund the first phase of production at its Tonkolili mining project in Sierra Leone. China Railways Materials has also agreed to buy ore from African Minerals for 20 years.
African Minerals, which until August 2007 was known as Sierra Leone Diamonds, is an exploration stage company. It does have a report from a consulting company, SRK Consulting, of an iron ore resource of 10.5 billion metric tons. Besides that resource, the company has the potential for 800 million metric tons of hematite iron ore. (The larger resource is magnetite.)
The company has also completed a lease agreement and is in the process of completing engineering studies to refurbish (remember Sierra Leone saw a brutal civil war from 1991 to 2002) or build rail and port facilities so the company can get the ore to market.
I’m not in any position to comment on the quality or quantity of ore at the Tonkolili project, but from the perspective of global cheap money two things leap out at me about this deal.
First, the $258 million that China Railway Materials paid for its 12.5% stake in African Minerals works out to a market valuation of $2.06 billion for a company that hasn’t yet mined a ton of iron ore. For comparison Brazilian iron ore giant Vale (VALE) with $23 billion in annual sales has a market cap of $177 billion. Outside the iron ore industry Canadian molybdenum miner Thompson Creek (TC) with $373 million in sales has a market capitalization of $1.9 billion.
Second, you certainly can’t say that African Minerals isn’t ambitious. The company expects Phase 1 of the Tonkolili project to produce 45 million metric tons of iron ore a year. That would, as the company points out in the presentation on its website, http://www.african-minerals.com/Corporate/Company/Corporate_Presentations/Corporate_Presentation_-_September_2009/File.aspx?id=845 , would vault Sierra Leone into the top ranks of global iron ore exporters. With exports of 45 million tons, African Minerals would leap ahead of South Africa in total exports (33 million tons in 2008) and North America (40 million tons in 2008). It would trail only India (100 million tons of exported iron ore in 2008), Brazil (270 million tons), and Australia (330 million tons).
With that kind of production and export volume maybe African Minerals is cheap at $2.06 billion. Even before the recent price increase iron ore mining was a very profitable business. Vale shows trailing twelve month net profit margins of 28.5%. That compares to a net profit margin of 16.8% at copper and gold mining giant Freeport McMoRan Copper & Gold (FCX).
But this is where cheap money comes in. In the run up to the tech bust in 2000 and in the run up to the housing bust in 2007, cheap money chasing outsize returns inflated the supply of tech stocks (especially the supply of shares of companies without much in the way of sales) and of houses, now cheap money is inflating the future supply of iron ore.
African Minerals isn’t the only company that’s raised big money to expand global iron ore production in Africa. In Guinea Rio Tinto has raised $1.35 billion from Aluminium Corporation of China (ACH) to develop iron ore deposits at Simandou.
And Africa isn’t the only continent seeing an iron ore boom. Companhia Siderugica Nacional (SID), Brazil’s third largest steel maker, is expanding its Casa de Pedra mine, which produced 17.1 million metric tons of ore last year, at a cost of $3 billion. The mine, according to the Financial Times is could produce as much as 70 million tons of iron ore a year. A start-up minerMMX Mineracao e Metalicos (MMXMY) raised $509 million in its IPO in 2006. China’s Wuhan Iron and Steel bought 21.5% of the company for $682 million. That valued the company at $3.2 billion.
A new iron ore mine isn’t going to produce iron ore tomorrow. Wall Street analysts predict that iron ore supply will stay tight for another two to three years. But that’s just more time for more money to flood into the sector, bid up stock prices, and fund new mines that will eventually overwhelm the market with supply. Between them, African Minerals and expansion at Case Pedra will add almost as much iron ore o global supply as India now exports.
By the time that all these new mines come into production, the days of 80% price increases will be long gone.
It’s not hard to reach that conclusion. So (aside from our native brilliance) why can we see that and the company’s funding these projects can’t?
Because the logic of cheap money makes it really, really easy to leave common sense at the spreadsheet door.
Think about cheap money from the perspective of the person or country that holds it for a moment. It’s actually a big problem. You’ve got lots of money to invest, but most of the available investments don’t pay very much.
So, for example, one of the cheap money causes of the most recent financial crisis was a desperate search by investors—from pension funds to central banks—for yield. Safe government bonds didn’t pay but diddly. Corporate bonds paid diddly-plus but they weren’t very safe. And it wasn’t possible to ignore the problem. For many of these investors accepting low returns would mean putting more cash into a pension fund or similar investment instrument to generate required future payouts.
Under those circumstances the mortgage-backed securities cobbled together by investment banks looked like a godsend. The carrier a higher rate of return and Wall Street and the rating companies said that because they were backed by pools of mortgages, they were as safe as government bonds.
In their heart of hearts many investors knew it wasn’t true, but the incentive to believe turned sceptical Dana Scullys into a legion of Fox Mulders.
The particulars of cheap money are different this time but the logic is dishearteningly similar.
The world is still awash in cheap money. Unlike the run up to the mortgage debacle, this time the money is in the hands of national governments—China’s foreign currency reserves hit $2.4 trillion last month—or sovereign wealth funds acting on behalf of national governments.
Yields on safe investments such as U.S. Treasuries are even lower than they were before the mortgage debt crash. A two-year Treasury paid 1.08% on April 14 and a 10-year Treasury paid 3.82%.
Yields that low were okay as long as the crisis kept fear high but now that investors are willing to take risk again they’re on the prowl for something better.
Anybody who sits down with a spreadsheet will quickly wind up questioning about whether the risk-adjusted returns on a Sierra Leone or Guinea start up iron ore mine are really better. But remember that cheap money has a way of distorting analysis so that it comes out the way you want.
This time around the holders of the cheap money don’t have Standard & Poor’s, Moody’s (MCO), and Fitch Ratings telling them that their strategy is safe and low risk—and after their performance in the run up to the global financial crisis these big investors wouldn’t believe them anyway.
But they do have another out: They can tell themselves that the rate of return doesn’t matter since they’re making strategic investments essential to their country’s future. So China can invest in oil, and iron ore, and thermal coal because these are strategic raw materials even if the return on capital is really, really low. Saudi Arabia can build out a chemical industry even if the prospects for making a profit are pretty close to nil once you realistically look at how much capacity is coming on line in the sector. But the investment is creating jobs and diversifying the country away from its dependence on pumping crude.
Even before the financial crisis I wrote that the world had a profit problem. In a world with cheap money on the hunt for higher returns, any company that showed an above average profit margin on a product or market would face relentless attack by competitors—well-funded competitors—who wanted in on the profits. During the economic recovery, I’d been arguing that we’re looking at a low profit or even profitless recovery for the same reason. (See my post http://jubakpicks.com/2010/01/19/get-your-portfolio-ready-for-the-profitless-global-economic-recovery/ )
That’s a problem for any company. Look at the wave of competitors attacking Apple’s (AAPL) iPhone and those lining up to go after the iPad—if it turns out to be profitable enough.
But if you’re a market-based company facing competition from other market- based companies, you’ve got a chance to fend off the attack using superior products, services that lock in customers, or constant innovation. After all your competitors are financially rational. They aren’t about to through money into the game if the returns don’t justify it.
It’s different, I’d argue, in those sectors where the competitor is from cheap money players that can potentially convince themselves that low returns are strategically justified. If you’re a General Motors (GM) or even a Toyota (TM) going up against national car companies funded by a government that is convinced it has to have a car industry, then I don’t know how you can win. Same would go for steel and memory chips among older industries, and solar cells, wind turbines, and high-speed trains among new industries.
Among commodities the list is even longer–oil, iron ore, potash, and thermal coal to mention just three—but the dynamic is different because it takes so long to get a new mine into production. In these sectors rather than seeing profits relentlessly ground down, I think you’re looking at a volatile boom bust cycle or prices and supply that may take three to five years to play out. In many of these commodities I think we’re in year two or three of the cycle. So no reason to run and hide yet. But be sure you remember that what you own are indeed cyclical stocks.
Full disclosure: I own shares of Vale and bonds of Freeport McMoRan in my personal portfolio.