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Sub-Prime Thinking
By Bill Bonner | Published  07/25/2008 | Currency , Futures , Options , Stocks | Unrated
Sub-Prime Thinking

Our old friend Paul van Eeden is explaining why the price of gold may be overpriced.

"Gold is money," says Paul, "and almost only money." So, you can forget supply and demand. To figure out what the price of gold should be, simply look at what it will buy, in comparison to other currencies. The only time gold leaves its "theoretical value" - as measured by what it will buy - is when speculation drives it up or down beyond what it is really worth.

Paul is certainly right. Based on what it will buy, gold should be only about $800. But speculators look ahead…and so do we. And our guess is that gold is going to become a lot more interesting to speculators. It's above its current "theoretical value" because inflation rates are rising. Investors want to protect themselves. And if inflation rises further, gold will shoot up more.

But, "the real threat you face is located east of one ear and west of the other," says another old friend, Rick Rule. "The subprime economy and the problems it brought us are the result of subprime thinking. A few years ago, there were billboards in Southern California offering to loan people 125% of the value of their houses. Now I ask you, is it a good business to loan more than the collateral is worth to people who can't pay the money back so they can buy over-priced houses? No, of course not. It was subprime thinking."

Rick says that taking the food and energy out of the consumer price index is also sub-prime thinking.

"The measurement of goods and services that the government uses to describe the growth in the economy, calculate productivity and make inflation-adjustments was a total fraud," says Rick.

"Other shoes are going drop," he continues. "Credit cards, for example. They also lend money to people who often can't pay it back. Say, a guy wants to buy a big TV set and can't afford to pay for it. So, he uses his credit card, figuring that it will be easier to pay for it a year later, after paying an additional 18% interest. Then they put millions of these loans together and sell them to a pension fund.

"Or take the loans for leveraged buyouts. It seemed like a great business when sales and profits were rising. But when earnings go down, it becomes hard to service all that debt. In effect, we allowed the Wall Street tycoons to do the same thing as the moron who bought a house he couldn't afford.

"But there are still bankers out there who know what they're doing. They've got a big advantage now…they've got money and others need it. And it's always a competitive advantage when your competition is brain dead. Now there are opportunities in the financial services sector, but you really have to do some real non-sub-prime thinking to find them…and have the courage to the act upon it."

Meanwhile, back to the financial news. Moody's Economy.com:

"U.S. household finances are deteriorating rapidly under the strain of increased debt and falling home prices, threatening the health of the U.S. economy, according to a new research from Moody's Economy.com, a division of Moody's Analytics.

"Household credit quality is rapidly eroding, and overleveraged households are at the heart of the economy's problems," said Mark Zandi, Chief Economist for Moody's Economy.com. "The mounting losses on household debt are straining financial institutions and will keep the economy struggling to grow for the remainder of this year and well into 2009."

But over on Wall Street, the big banks have been staging a major rally, while gold and oil have been falling. Oil was down to $124 the last time we looked. And gold dropped $25 on Wednesday. Wall Street, meanwhile, has come back from the dead - or so it appears.

"Was that the bottom?" Everyone wants to know. Many investors think it was. And they think they can take advantage of it by buying the big banks - run by the same dumbbells who packaged sub-prime loans and sold them to their best customers…and who lost fortunes for their stockholders while paying themselves millions in bonuses.

"More subprime thinking," says Rick.

Bill Bonner is the President of Agora Publishing. For more on Bill Bonner, visit The Daily Reckoning.