July 2011 - Money Morning - Only the News You Can Profit From

The Debt-Ceiling-Debacle: The Surprising Way a Default or Downgrade Could Crush the Global Economy

If there's a "worst-case scenario" for this whole debt-ceiling debacle, this is it.

After studying everything that could happen due to a downgrade of the United States' top-tier AAA credit rating, and the potential default on its debt, we found a scenario that would result in forced asset sales that are so widespread that global stock-and-bond markets would plunge – and economies around the world would crash.

Tangible evidence that this frightening scenario could really play out surfaced on Monday, when the Chicago Mercantile Exchange (CME) announced it was increasing the "haircut" that it applies to U.S. government debt posted as collateral by traders transacting on the exchange.

The retail investors who didn't just ignore this announcement altogether probably dismissed it as a boring bit of administrative housekeeping by the CME. In truth, however, this kind of re-evaluation of U.S. Treasury securities, widely used as loan collateral, could trigger global margin calls and widespread asset sales. If that occurs, it's only a matter of time before the ripple effects of escalating margin calls could weigh down asset prices around the world.

Let's take a look at how and why this could happen.

The "Haircut" Nobody Wants

Because U.S. Treasury bills, notes, and bonds are considered "risk-free" they are every lender's preferred collateral class.

All of America's too-big-to-fail banks, major securities broker-dealers and giant hedge funds – and most of the world's biggest financial institutions – hold hundreds of billions of dollars of U.S. Treasuries that they use as collateral to borrow in the overnight and term "repo" market.

Traders use their U.S. Treasury securities to borrow more money to buy still more Treasuries, as well as other more-speculative securities. The intention is to leverage the capital they have by borrowing against balance-sheet assets to take on bigger positions.

But what happens if there's no debt-ceiling deal by Tuesday – the theoretical day after which the country won't be able to pay its bills?

The actual answer to that question may not matter as much as the uncertainty that's been created. In fact, even with a deal – meaning there's no default – it's likely the United States is facing a reduction in its top-tier AAA credit rating.

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The Debt-Ceiling Debacle: Another Way Politicians Could Ruin America

John Powell is worried – perhaps even scared.

Powell has watched the whole debt-ceiling debacle unfold down in Washington. He knows that our elected officials literally hold this country's future in their hands. He also knows that our leaders love nothing more than to squander opportunities and currently are poised to foul up our economy even more than it already is.

"Darn right I'm worried," Powell, a Money Morning reader, told us in an e-mail. "It's unbelievable. In 64 years I have never seen Washington so dysfunctional."

In response to some bleak USA Today/Gallup Poll results last week, we asked you, our loyal readers, to tell us how you think Washington has done with the debt-ceiling debacle. Most of you came to the same frightening conclusion: Our politicians' selfish antics have jeopardized our future.

Take Powell, who told us that he feels Washington's political posturing and brinksmanship has been a hindrance to the U.S. economy. But here's what really troubles him: He believes that with the way the system and our leaders currently function, none of this is fixable.

"Politicians are decimating the middle class and creating a new class of poor, banks and corporations are sucking the life out of the economy, and there's 9.2% unemployment – plus those whose benefits have run out – and Washington isn't doing anything to change this," wrote Powell.

Powell isn't alone.

The USA Today/Gallup poll showed that four in 10 of those surveyed thought Washington's job on the debt-ceiling debacle was the worst they've ever seen in their lifetimes.

Two-thirds of respondents said elected leaders in Congress were putting their own political interests ahead of the country's interests – leaving U.S. taxpayers to suffer.

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Retail Currency Investing: The Three Secrets to Success

In the global capital markets, the "forex" (foreign-exchange, or "FX") market is where the real action is.

It trades continuously – 24 hours a day – on weekdays. And it dwarfs the stock-and-bond markets.

Average daily turnover in the global forex markets is greater than $4 trillion. Daily trading volume at the New York Stock Exchange trades about $25 billion, meaning the world's FX market dwarfs the United States' single-biggest stock exchange.

Even the bond market – which includes the average-daily-trading volume of more than $800 billion in the U.S. portion – is eclipsed by its forex counterpart.

In fact, you could combine the daily trading volume from all the world's stock exchanges – and still not equal the daily activity in the worldwide FX market.

Even the bond market – which includes the average-daily-trading volume of more than $800 billion in the U.S. portion – is eclipsed by its forex counterpart.

But as a veteran of this market, it's the stories I get to hear firsthand that fascinate me the most. That's why I so enjoy speaking at the forex conferences that are held all around the world.

Take the last big currency event that we held, where I met a high-tech-firm CEO whom I'll refer to as "John."

When I met John, he was just about to sell his very prosperous business for a rather large sum of money – millions of dollars, in fact.

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The Debt-Ceiling Debate: The Death of the "Risk-Free" Investment

There's an old investing axiom that says "there's no such thing as a free lunch" – which basically tells us we can't earn a profit without taking some risk.

And whether or not the United States defaults on its debt when the federal government hits its debt ceiling on Tuesday, the threat by Standard & Poor's to downgrade the United States' top-tier AAA credit rating means there will also be no such thing as a "risk-free" investment.

This new financial reality will alter the global-investing landscape forever.

And though it will put a hurting on hedge funds, investment banks and the rest of Wall Street, the death of the risk-free investment may prove beneficial to those of us who are America's ordinary retail investors.

Let me explain …

Modern Portfolio Tomfoolery

A central assumption of modern financial theory (also known as "modern portfolio theory," or MPT) is about to collapse: From Aug. 2 forward, there will no longer be such a thing as a "risk-free" investment. Banks and hedge funds will be turned upside down, but even those of us who regard modern portfolio theory as mostly rubbish will discover that the financial markets have started to function in very different ways.

Modern financial theory was originally developed at Carnegie-Mellon and the University of Chicago in the 1950s, and since then has become a dominant element of every Wall Street operation (helping Wall Streeters make boatloads of money, as a result).

One of the core precepts is that there are such things as "risk-free" investments, in which an investor's principal is 100% safe – not 99.5% safe, but 100%.

For example the Capital Asset Pricing Mode (CAPM), a central theorem of modern financial theory, says there is a "frontier" of optimal investments, and that investors can achieve any mix of risk and return on that frontier by combining risky and risk-free investments (or, to increase risk, leveraging themselves).

Similarly, the Sharpe Ratio, used by professional investors in hedge funds and pension funds, evaluates securities and portfolios by the "excess return" generated over a risk-free investment. That helps money managers determine whether they are paid sufficiently for their risk. In options theory, the Black-Scholes model assumes the ability to "delta hedge" an option by buying or selling the underlying security, and borrowing or investing the proceeds at the same risk-free rate.

Finally, risk-management theory assumes the possibility of eliminating risk from portions of the portfolio, so that the Basel bank regulatory systems, for example, weight Treasury securities of Organisation for Economic Co-operation and Development (OECD) governments at zero. That allows banks to hold unlimited quantities of Treasuries, without having to allocate capital to those holdings.

The Death of the "Risk-Free" Investment

If U.S. Treasuries are not AAA-rated, then they are not risk-free – pure and simple.

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OGX Petroleo e Gas Participacoes SA (PINK: OGXPY) Could Be the Next Exxon Mobile

OGX Petróleo e Gás Participações SA (OTC PINK: OGXPY) is probably the biggest oil and gas company you've never heard of.

That's understandable, considering it has not yet produced a single barrel of commercial oil. But this Brazilian company could soon be on par with the likes of Exxon Mobil Corp. (NYSE: XOM), CNOOC Ltd. (NYSE ADR: CEO) and state-owned local rival Petroleo de Brasileiro SA (NYSE ADR: PBR).

Since its initial public offering (IPO) in 2008, OGX's resource base has more than doubled from 4.8 billion barrels of oil equivalent (boe) to 10.8 billion boe. It has drilled 52 wells in the last 20 months, with a success rate of over 90%, as it prepares for its first commercial production this fall.

OGX's first long-term well test is expected to produce about 20,000 barrels of oil a day starting this fall. And the company already has ordered the long lead items needed to ramp up production to 150,000 boe per day by 2014. From there, OGX is expected to ramp up its production to 1.4 million boe per day in 2019.

In simple terms, this oil and gas company is conducting the largest private sector exploratory campaign in the history of Brazil.

So it's time to buy Petróleo e Gás Participações S.A. (**).

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'Washington Math' Adds Up to the Debt-Ceiling Deadlock

If you've been wondering why your elected officials in Washington can't reach a basic compromise to break the debt-ceiling deadlock, consider this: They can't even get their numbers straight.

Not only do the competing Democratic and Republican plans differ on what counts as a spending cut, the Congressional Budget Office (CBO) has disputed numbers in both plans.

Perhaps most galling – fiery rhetoric to the contrary – is that the plans actually differ very little.

With "Washington Math," there's no such thing as a definitive answer.

Congress has until Aug. 2 to raise the federal debt ceiling beyond the $14.3 trillion limit; after that the government won't have enough money to pay 40% of its bills. But the fuzzy numbers, questionable arithmetic and political posturing have created an impasse that threatens to push the United States over a financial cliff.

What do we mean by fuzzy numbers? Read on.

Senate Majority Leader Harry Reid, D-NV, has proposed a plan that would save $2.7 trillion over 10 years, raising the debt ceiling by the same amount. That would allow the United States to borrow until 2013.

But Speaker of the House John Boehner, R-OH, has dismissed half of Reid's package – the $1.1 trillion in savings from winding down the wars in Afghanistan and Iraq – as imaginary.

"The Senate is struggling to pass a bill filled with phony accountingand Washington gimmicks," Boehner said Monday night in his response to the primetime speech made by U.S. President Barack Obama.

Boehner's own plan was supposed to save $1.2 trillion over 10 years and raise the debt ceiling far enough to allow about six months of borrowing.

The Democrats took no issue with any of Boehner's proposed savings, but on Tuesday the CBO did. The nonpartisan agency determined that Boehner's plan would in fact save only $850 billion.

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