An Open Letter to Clients by wuxiangyu


									                                                                                      John Davies
                                                                      RBC Dominion Securities Inc.
                                                                       1922 Wyandotte Street East
                                                                        Windsor, Ontario N8Y 1E4
                                                                         Telephone: 519-252-3517
                                                                                Fax: 519-252-3672

                               An Open Letter to Clients – Fall 2008

History in the Making

We are living in truly historic times, the likes of which have never been seen. In past letters I
have written about the “sub prime mortgage market” and the accumulation of debt in America.
In this letter I’ll attempt to share with you my thoughts and opinions on where the current
American credit crunch started as well as providing some commentary on what I’ve been up to

Since my last letter the US financial system has been sent reeling under the weight of its debt and
many firms are shells of their former greatness. The companies I am writing about are large
household names in America if not here in Canada. Thankfully, the Canadian banking system is
far different than that of America but because of the sheer size and influence of US financial
institutions, their tentacles are far reaching and influential. We have to be mindful of the
American experience.

That the three biggest players in the complicated world of modern day finance, (JP Morgan,
Bank of America and Citigroup), have so far stick handled around the mine fields is conspicuous
to me. It also happens that these three are the great consolidators of the falling financial
dominoes. Just today as I write this note on October 3rd, Wachovia Bank is being swallowed by
Wells Fargo. I speculate these institutions may be reluctant consolidators as their own direct
counter party risk to failing institutions would overwhelm them; it makes sense that they gobble
them up, with the help of the government, as to do nothing would bring greater grief.

How Did This Happen?

In a phrase, counter party risk. If I owe Bob, and Bob owes Bill and Bill owes Betty and Betty
owes me, we could all be in trouble if one of us, for whatever reason, doesn’t have the ability to
pay. It’s a very simple explanation, that a chain is only as strong as its weakest link, yet very
true. I’ll leave it at that for now as I’ve learned over the years that the thicker this letter, the less
it’s read! There are lots of other ingredients to this recipe such as leverage, lack of regulation
and political will and of course, no fear.

In my humble opinion, the implosion of such companies as AIG Insurance (the largest insurance
company in the world), Lehman Brothers, Fannie Mae and Freddy Mac (just to name a few in
order to save some ink), can trace such devastation to a specific date, August 15th, 1971. On that
fateful day President Richard Nixon ended the gold exchange standard. The standard had been
enacted by the 1944 Bretton Woods Agreement which allowed foreign central banks (like the
Bank of Canada, Bank of England, etc) to turn in $35 US dollars to the US and get an ounce of
gold in exchange for that paper. The agreement is named after a town which is nestled in the
White Mountain National Forest in New Hampshire and led to the formation of the World Bank
and International Monetary Fund in 1946.

Such an arrangement with the nations of the world was logical. Bear in mind that specific point
in history. It was toward the end of World War II and the only major nation that had gotten
through the war relatively unscathed was the US. Great Britain, France, Germany, Japan and
Russia had all been severely damaged if not “broken”. America was in relatively good shape;
they were the world’s largest lender, a democracy and had efficient and transparent markets. Not
to mention the obvious but they had the biggest military complex too. So all in all it made
perfect sense that the richest nation in the world whose currency was based on gold should
readily be accepted as the medium of exchange for goods and services just about anywhere in the

On August 15th 1971, the rules of the game changed. No longer would the Americans surrender
their hard earned gold for thirty five “federal reserve notes” or dollars. Their currency became
one referred to as fiat.

What is Fiat Currency?

According to Wikipedia, The terms fiat currency and fiat money relate to types of
currency whose usefulness results, not from any intrinsic value or guarantee that it can be
converted into gold or another currency, but instead from a government's order (fiat) that it must
be accepted as a means of payment. I look at the term fiat and think of it as an acronym for the
term “Fix It Again Tony” which is, I think, an accurate representation of what the politicians and
bankers are trying to do to the financial system.

My point is that because there is not anything real, concrete or tangible backing the currency, it
allowed the governments and financial institutions to essentially manufacture credit and wealth,
however fleeting, out of thin air. Now it has taken many years to happen and there isn’t one
company or politician to pin this crisis on, but the bottom line is that America has been living
beyond her collective means. And we here in Canada should keep in mind the “American
experience” as we could be adversely effected by what is going on just to the south of us. If
America heads into a recession due to the credit crisis, they will not be in the buying mood that
has seemed endless for the last few decades. The American consumer in part, had kept global
economies steaming along, granted it was with a lot of borrowed money.

Big Bailout on the Way

The $700,000,000,000.00 bailout, (by the way, that’s billions-I’m putting all of those zeros in for
visual effect), may not be enough. When we look backwards in the rear view mirror years from
now, trillions upon trillions of dollars may have been required. Even today as the US is in debt
in excess of $10,000,000,000,000.00 (that’s 10 trillion), the spigot is wide open flowing a
seemingly endless supply of solutions veiled in terms previously not found in our day to day
vocabulary. Things like “term auction facility”, “troubled asset relief program”,
“conservatorship” and “resolute trust” are all fancy terms for government bailouts orchestrated
by bands of politicians and bankers whose self inflicted dilemma has gone way beyond the once
revered offices of Wall Street.
That investment banks and insurance companies, mortgage financiers and home builders have
been rocked by this massive credit crunch is no doubt staggering, it is more heart breaking when
you put colour behind the statistics. For many a foreclosed house there is a distraught family
who has lost a home. Unemployment figures are rising and could perhaps even be under-
reported. In some northern Michigan communities a friend of mine said that it’s not only houses
for sale but people have perpetual sales of things they can drag to the curb like ATVs (you know
those four wheeled off road vehicles), trailers, motorcycles and old lawn mowers.

I was recently in California for an oil conference where there are plenty of houses in the unsold
column and the number is growing with uncomfortable regularity. There is a “foreclosure tour”
conducted each weekend by an enterprising real estate agent. All you have to do is hop on the
bus and check out the bargains; but be careful as today’s bargains could easily look over priced

Energy and the ASPO Conference

I arrived home from the aforementioned ASPO Conference on Wednesday the 24th which had
been held in Sacramento. ASPO is an acronym for the Association for the Study of Peak Oil.
My associate Erin and several friends came along for the event which was held at the Hyatt
across the street from the Capital Buildings. There were about 450 people in attendance
comprised of people from all walks of life including scholars and teachers, politicians and
bureaucrats, investment types and experts in energy and oil. Some had travelled great distances
to attend the event that covered the peak oil story (it’s really a peak liquids story), alternative
energies such as wind, solar and geothermal, and more conventional energies such as coal and
nuclear. The consensus seemed to be that we will go into a supply decline and that the exact
timing wasn’t very important. The issue is getting ready for its ultimate arrival and
implementing a strategy quickly so as to help circumvent the negative impact that would likely

We had dinner on the Monday evening with Nick Barisheff who manages the BMG Bullion
Fund (formerly the Millennium Bullion Fund), and Jim Puplava who is the President of Puplava
Securities in San Diego. He is also the webmaster of Financial Sense, a website dedicated to
covering all things financial. There is a broadcast section where Jim interviews authors and
experts from various disciplines. Many of you have listened to his shows over the years and if
you’re not familiar with Jim, I have a link at my site, The show from
September 27th has an insightful interview with an expert credit analyst, Doug Noland, who has
chronicled America’s debt problems and there is also coverage of some of the presentations from
the 2007 ASPO conference (the 2008 conference material was not yet available).

It is possible there could be some near term declines in demands for energy via the recessionary
forces building in line with the credit crisis. It does not, however, negate the fact that the world
could have significant challenges over the decades ahead if we don’t get on with the job of
electrifying the transportation system. If the peak oil wolf isn’t at the door, I think he’s in the
neighbourhood. This is exceptionally important not just from an investment perspective but it
will likely have an impact on our society.

Where Do We Go From Here?

At times like this, clients wonder if there is anything that they should be doing. Some people are
fearful and want to sell while others embrace it as an opportunity to add to investments that are
seemingly on sale. Warren Buffett has been in the news lately as he has stepped to the plate
setting up deals first with Goldman Sachs and then General Electric. Warren has a famous line
that states, “Be fearful when others are greedy and be greedy when others are fearful.” In other
words, sell when everyone else is buying and buy when everyone else is selling. Intellectually
we know it makes sense to do that but fear intersects logic, rendering the consummation of such
deals dysfunctional.

I believe that although portfolios and markets are inherently volatile, a balanced portfolio of
fixed income and equity investments is most prudent for the long term. Necessities will always
be in demand, whether its food and water, or health care and energy. At times like these it may
be appropriate to review financial plans to ensure it still reflects short, medium and long term

House Keeping

The only date I expect to be out of the office over the next few months is November 7th.

There is a possibility, however remote, that I’ll be attending the New Orleans Investment
Conference which is November 13th through the 17th. The main attraction for me is that Dr.
Marc Faber, one of the great economists of our time, will be participating.

Should you have any questions or concerns, especially during this volatile time, please give me a
call at 519-252-3517. I can also be reached at

I thank you again for your time and attention.


John D Davies, CFP

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