Saturday, May 31, 2008

John Makin's view on the economy

I wanted to share an economic outlook that John Makin published yesterday.

This is another long read(sorry) but well worth it. John Makin is a highly respected economist who has been a consultant to the US Treasury as well as the Congressional budget committee. Here is his full background.

I will highlight some areas that I find interesting. Could there be a global recession on the way?


False Dawn

by John H. Makin
Posted: Friday, May 30, 2008

I see nothing in the present situation that is either menacing or warrants pessimism. . . . I have every confidence that there will be a revival of activity in the spring and that during the coming year this country could make steady progress.–Andrew W. Mellon, U.S. Secretary of the Treasury, December 31, 1929

The bursting of every bubble is followed by statements suggesting that the worst is over and that the real economy will be unharmed. The weeks since mid-March have been such a period in the United States. The underlying problem–a bust in the residential real-estate market–has, however, grown worse, with peak-to-trough estimates of the drop in home prices having gone from 20 to 30 percent in the span of just two months. Meanwhile, the attendant damage to the housing sector and to the balance sheets tied to it has grown worse and spread beyond the subprime subsector.

Of the 130 million U.S. housing units, 18.5 million–almost 15 percent–are empty. This bodes ill for the outlook for homebuilding; house prices; and the balance sheets of commercial banks, investment banks, and American households. In June, Congress will pass the Foreclosure Prevention Act of 2008. This is a symbolic measure that will not become effective until October 1 and, given its cumbersome structure, will provide virtually no relief to the households facing foreclosure that it is designed to help.

At the same time that U.S. house prices are continuing to collapse, the Federal Reserve’s interest-rate cuts to cushion the U.S. credit crisis, coupled with a continued surge of funds into emerging-market nations and a stubborn refusal by those nations to allow their currencies to appreciate and to stop holding domestic energy prices at far below market levels, have pushed the price of oil up by nearly 30 percent since mid-March alone. The rise is sufficient by itself to absorb virtually all of the $115 billion in rebate checks being distributed to Americans in the second quarter. If the jump in food and energy prices leaks into core U.S. inflation (which thankfully has not yet happened), then, as Federal Reserve vice chairman Donald Kohn said with classic understatement on May 20, “We would be facing a more serious situation” concerning inflation. Needless to say, with shaky financial markets and a shaky real economy, the need for the Federal Reserve to respond to an elevated threat of inflation would constitute a “serious situation” indeed.

Relief from Panic

Relief from the acute, panicky phase of the credit crisis, following the Federal Reserve’s March 16 acknowledgement that even Bear Stearns, the smallest of the investment banks, was too big to fail, has been palpable. When someone stops hitting you over the head with a two-by-four, you feel better for a while, even though you may have sustained a concussion.

We have moved on to the potentially more dangerous, chronic phase of the crisis resulting from the end of the U.S. housing bubble. The relief in the financial sector arising from avoidance of a financial meltdown has also translated–at least until the mid-May spike in oil prices–into a modest rally in the financial markets and a lessening of U.S. recession fears. Headline macroeconomic data have, in general, been weak to stable instead of showing acceleration to the downside, with the important exception of housing data, where the fall in prices and sales has quickened. Also, the U.S. stimulus package has already added $40 billion to household disposable income and will add another $75 billion in coming weeks.

The “weak-to-stable” characterization of macroeconomic statistics was perhaps best captured by the April employment report. The headline payroll number, at -20,000, was less bad than the anticipated -75,000. Much like the economy at large, however, the underlying details of the report were weak. The year-over-year growth rate of employment continued to fall–from 0.36 percent to 0.28 percent in April. Employment in construction and manufacturing also continued to fall rapidly. A drop in the length of the average workweek and weak hourly earnings growth caused weekly earnings to fall by 0.2 percent. Although the household survey indicated a drop in the unemployment rate from 5.2 to 5 percent, the increase in household employment masked the drop of 375,000 in the full-time workforce that was offset by 550,000 additional part-time workers. The Bureau of Labor Statistics’ net birth/death adjustment, an assumption about jobs created by small businesses, added 267,000 workers to the overall payroll statistics. Revisions downward of payroll data for the third quarter of last year, correcting overly generous assumptions about uncounted additional workers, will likely be repeated for the subsequent quarter. Any such assumptions strain credulity in view of tightening credit conditions, falling consumer and business confidence, and a drop in overall investment.

Financial markets also took heart from an apparent stabilization of retail sales in April, although overall retail sales dropped at a 2 percent annual rate during the three months ending in April, with a 0.2 drop in April alone. Excluding motor vehicles, where sales are swooning, the annual growth rate of current-dollar retail sales was 2.5 percent over the three months ending in April. That translates into a negative real growth rate of 1 percent, however, allowing for inflation at about a 3.5 percent annual rate over that period.

Overall, optimists concerning the stock market and the economy have taken heart from the relief attendant upon the Fed’s willingness to guarantee the balance sheets of commercial and investment banks and from selected economic data in April that were not as bad as expected.

Problems Ahead

The picture going forward is not as bright. The latest data from the Case-Shiller house-price survey suggest that the underlying problem, the drop in home values, has accelerated. The indicated drop in house prices accelerated to a 25.1 percent annual rate over the three months ending in March–the latest period available. The futures market indicated that the peak-to-trough drop in house prices would exceed 30 percent. That development has been associated with a sharp drop in consumer confidence to levels not seen since 1991, as well as curtailment of home-equity credit lines by banks and a rapid acceleration of housing foreclosures to a pace of about eight thousand per day in April. The Fed’s April 2008 Senior Loan Officer Opinion Survey (released early in May) showed a sharp tightening of lending standards both for households and businesses. This is a direct result of the banks’ need to reduce their balance sheet exposure to the housing sector and, less directly, to households and businesses suffering from the sharp contraction in that sector.

Discretionary purchases of consumer durables have taken the sharpest hit from deteriorating household finances. Domestic vehicle sales fell to a 14.4 million annual rate during April, down at a 21.3 percent annualized rate over the three months ending in April. Domestic vehicles fell even more sharply because of the high concentration of fuel-inefficient vehicles in the domestic fleet. Partly as a reflection of the sharp slowdown in auto sales, U.S. industrial production fell a sharper-than-expected 0.7 percent in April, down 4.9 percent at a seasonally adjusted annual rate over the three months ending then. Some suggested that a General Motors axle plant closure disrupted GM production of trucks and sport-utility vehicles. That seems unlikely to have been the primary cause, given the collapsing sales and rising inventories of vehicles with poor gas mileage. A drive around the outskirts of most small U.S. towns will find–sitting in fields or open lots–unsold pickup trucks and SUVs that dealers have given up trying to sell.

The stimulus package passed by Congress in January has been offered as an antidote to the gloomy picture on consumer spending. But even there, difficulties have emerged. The rise in gasoline prices alone (by more than 30 percent between mid-February and late May) has added well over $100 billion to annual fuel bills, enough to absorb the entire tax rebate being sent to households. The initial indications of the impact of rebate checks are not encouraging. By May 16, nearly $40 billion of tax rebates had been distributed. It appears that some spending in anticipation of the rebate checks may have boosted discretionary retail sales in April, but a high-frequency survey of retail sales conducted by the research firm International Strategy and Investment revealed that in the week ending May 16, the survey result was down sharply by 3.8 points to an index level of 37.8. It may be that a combination of higher energy costs, not to mention higher food costs, and some anticipatory spending will limit the future impact of the earlier-than-expected distribution of rebate checks. With the underlying growth rate of the U.S. economy for the second quarter probably around -2 percent, the net impact of the rebate checks may be to raise that rate to -1 percent. After the rebate check distribution effects wear off, the impact on the growth rate will be reversed, suggesting that the growth rate in the second half of 2008, contrary to the consensus forecast and that of the Federal Reserve, will likely be substantially slower than in the first half.

The Fed’s Dilemma

There is a connection between the necessary, rapid easing of monetary policy by the Federal Reserve and the sharp increase in global food and energy prices that is feeding back onto the United States as a contractionary force by reducing real purchasing power. The currency pegs to the dollar of some large, rapidly growing countries, including China, Russia, and Brazil, in effect make the Federal Reserve the central bank of those countries. Steep cuts in interest rates by the Federal Reserve to help cushion the impact of the bursting of the housing bubble have created a huge inflow of funds in search of returns to these same emerging market countries, as well as India and Middle Eastern oil exporters. The attempt to peg their currencies to the dollar forces those countries to produce rapid increases in liquidity that, in turn, stimulate demand growth for food and energy products. So by pegging their currencies to the dollar, those countries are forcing more adjustment in the United States to higher energy prices. The more the Fed eases to accommodate credit strains in the U.S. economy, the more money floods abroad into emerging market countries and pushes up their energy prices. Beyond that, energy prices are held below market levels by governments such as that of China so that as their economies grow more rapidly, the demand for energy expands even faster without any discipline from higher prices, and so inflation in other sectors rises. The estimated effective oil price inside China is about $60 a barrel–half the full international market price. Rapidly rising inflation and accommodating central banks have resulted in negative real interest rates in most emerging countries–a further spur to more inflation. The corollary is that energy prices have to rise more in the United States in order to slow the global growth of demand for food and energy products.

Higher food and energy prices feed back negatively onto U.S. and developed economies in two ways. The higher inflation hurts the terms of trade of the developed countries and compresses real wages and profits. U.S. real wage growth has already dropped below zero, while profit compression is becoming more intense as U.S. companies, facing higher input costs, are unable to pass on the higher costs through price increases in a slowing U.S. economy.

The second negative impact of the stimulative policies to ease the credit crisis arises from the commitment of central banks in developed countries to resist infla-tion pressure. The Fed, after its April 30 reduction ofthe federal funds rate to 2 percent, with two dissenting votes in the Open Market Committee against that rate cut, has already signaled a desire to stop easing in the face of higher inflation pressures from higher food and energy prices. The determination of the European Central Bank, the Bank of England, and the Bank of Japan to resist higher energy prices has also been clearly stated.

Meanwhile, the European, Japanese, and British economies are all slowing into midyear. In the United Kingdom, house prices have begun to drop rapidly while the Bank of England has declined to provide any relief, needing instead to focus on higher inflation pressures. While European growth was firm in the first quarter, exports to Asia are beginning to slow, and negative pressure on house prices in areas such as Spain, Italy, and Ireland are exerting further downward pressure on their domestic economies. The Japanese economy, despite strong headline numbers for the first quarter, actually contracted modestly over the previous year. Year-over-year nominal growth of GDP, the most comprehensive measure of economic activity in Japan, where deflation pressures persist, was actually slightly negative at the end of the first quarter, falling 0.4 percent.

The global spillover to higher food and energy prices from the Fed’s aggressive efforts to cushion the negative impact of the collapse in the U.S. housing bubble has created a dilemma for the central banks in developing countries. While real economic activity is slowing, especially in the United States, and that slowdown is exacerbated by what amounts to a tax from higher food and energy prices, central banks have to temper their rhetoric about supporting the economy with statements about elevated concerns tied to rising inflation pressures. The May 21 publication of the minutes of the Fed’s policy meeting on April 29-30 underscored the rise in inflation concerns when oil was at $115 a barrel.

The transmission mechanism whereby easier Fed policies support an accelerated increase in food and energy prices in global markets is a new feature of this cycle that is tied, in turn, to the rapid development of emerging economies. As households in China, Russia, India, and Brazil–to mention the most prominent–become wealthier through the rapid growth of those economies, their demand for higher quality food and for energy accelerates, thereby boosting global prices. In China alone, nominal GDP is rising at a 17 percent rate. The rapid development of those economies makes them attractive destinations for liquidity increases tied, in turn, to easier policies pursued by central banks in developed economies. Beyond that, policies aimed at subsidizing households by capping sensitive prices of food and energy in emerging markets allow demand to grow even more rapidly for those products, thereby restricting supply in global markets and pushing prices up even faster. As one close observer of developments in the emerging markets suggested, “let the U.S. adjust to higher energy prices for a change.”

Risks Rising in U.S. Economy

Taken together, these considerations suggest that the relief from the acute phase of the credit crisis and the attendant rise in optimism about U.S. financial markets and the U.S. economy are waning as we move toward midyear. Now that financial markets have decided that the U.S. recession is over, or will be shallow at worst, it is probably, in fact, just beginning. Higher energy prices, sharply tighter credit conditions, compression of real incomes and profits, and the likely slowdown in capital spending will be difficult to overcome. Meanwhile, the attendant rise in inflation pressure, with oil having reached above $130 per barrel and food prices still rising rapidly, may mean that the Fed is unable to provide the help that it provided to financial markets in the acute phase of the credit crisis.

Still, there are signs that the Fed is not as sanguine about the outlook for the economy and financial markets as some in the private sector suggest. On May 13, Fed chairman Ben Bernanke formally requested that Congress allow the Fed to pay interest on reserves. This seemingly technical step is important. It is the necessary condition to enable the Fed to expand its balance sheet–a step it has not yet taken–while maintaining control of the fed funds rate above zero. This technical step is important because it indicates that the Fed remains concerned about the possible future need for more aggressive steps to cushion the credit crisis and protect the real economy.

The Fed has already agreed to swap five-eighths, or $500 billion, of the Treasury securities on its balance sheet for lower quality mortgage-backed securities (including those of investment banks) to cushion the impact of the credit crisis on the U.S. financial sector. The Fed has probably not failed to notice that, despite these extraordinary efforts, the fall in house prices has continued to accelerate along with foreclosures and vacancies resulting from the abandonment of homes by beleaguered borrowers. As already noted, Congress is crafting a modest effort to slow the pace of foreclosures over the balance of the year, but like past efforts, it involves a cumbersome procedure. Homes facing fore-closure must be appraised and marked down in value in a process that probably leaves many lenders with about seventy cents on the dollar on a distressed mortgage holding. Beyond that, distressed homeowners may cease making payments on existing loans to qualify for the new program. If the Foreclosure Prevention Act is actually passed in June, its modest benefits will not appear in the most distressed areas of housing markets until the end of 2008, given that the legislation will not likely go into effect until October 1. That said, house prices will continue to fall at a rapid rate, while the act, at best, will provide a template for a far more substantial bailout for the housing sector likely to come with the new administration in 2009. Meanwhile, we have to get through the rest of 2008, and that is not going to be easy.

A big question is whether the surge in food and energy prices will ultimately end up being deflationary or inflationary. If, given the likely sharp slowdown of the U.S. economy in the second half of 2008, the Federal Reserve and other central banks are forced to remain on hold or even tighten, as some have threatened because of higher food and energy prices, the negative impact on global growth could be substantial. The signal would be a drop in food and energy prices accompanied by a sharp slowdown in growth in emerging markets that accompanies a sharp slowdown in growth in developed economies. That would be what is called a global recession.

John H. Makin ( is a visiting scholar at AEI.

Friday, May 30, 2008

Welcome to the "John Kerry" Stock Market!

Flip Flop Flip Flop Flip Flop.

TGIF gang.

Well everybody here is how I see it. We now officially have a market that has everyone confused. I haven't seen this many flip flops since the 2000 election.

One minute investors buy stocks thinking that the worst of the credit crunch is behind us, the GDP hasn't hit negative "recessionary" numbers, and the global growth story seems to be alive and well.

The next minute the market sells off because of horrific news like the Case/Shiller housing price report, soaring oil prices, and rising inflation. Throw this on top of almost daily bad news out of the financials, and you have investors starting to question if we really are through the worst of the credit crunch.

Why is everyone so confused?

Because the data on the state of the economy continues to be conflicting. GDP is running below 1%, but its still not in recessionary territory. Some companies continue to beat earnings while others continue to disappoint.

Employent rates seem to still be holding at around 5.1%. Jobless claims are higher than usual, but steady and not increasing. There simply is no clear signal from the data that shows we are in deep do do or coming out of this slowdown. We all can take a guess of where we go from here, and I think you know where I stand(hint: Its not going to be pretty).

Commodities are all over the place. One week it looks like gold is going over $1000, and the next week its crashing due to margin calls and a sometimes strengthening US dollar. A ton of money has poured out of the stock market and flocked into commodities chasing high returns. This has made commodities very difficult and dangerous to trade.

Anyone holding large positions in gold this week are kicking themselves. I think one of the problems the market has right now is its not acting like it has in the past. Historically when inflation soars, gold and health care stocks have been common places to hide.

So far in 2008, health care is the worst performing sector, and gold has been relatively flat since the inflation numbers have risen.

Even the best are confused

The price action in the markets has confused even the best traders on the floor. Take a look at some quotes from Art Cashin's market commentary. This is a subscription service so I have no link. Art is a 40 year veteran trader who is often quoted on CNBC. Here was his take on Thursdays action today.

"Different markets looked at identical facts, or events, and came to very different, even contrary opinions.In Thursday's Comments we had noted that the yield on the Treasury ten year was onthe verge of breaking out above 4.05%.

Sure enough, Treasuries went right into thetank and yields spiked. Commodities went into virtual freefall. Oil plunged over $3and gold fell more than $20. By mid-morning 19 commodities out of a list of 20,were plunging into an abyss.

Even after oil shot up briefly, following a shocking dropin inventories, it rolled over and rejoined the rout.Traders assumed that the spike in rates was squeezing financing costs for carrying commodities and the squeezed holders were flinging them out the window. The yieldon the ten year moved much higher, past 4.11%.

Soon oil was down over $4 andgold had plunged $23.During all this, the stock market seemed to be taking a completely different andsomewhat conflicting view. They appeared to see the rising rates not so much as aninflation reaction. They seemed to think rates were rising because the economy wasfirming impelling the Fed to hike. Stocks were quickly up. The Dow soared 122points and the S&P was pushing against the 1405 resistance we had mentioned inThursday's Comments.

There was also another hypothesis suggesting a linkage in these reactions – at leaststocks vs. bonds.

This thesis suggested that it might have been an asset allocationswap. It might be folks getting out of their "safety bet" in Treasuries and dumpingCashin’s Comments May 30, 2008Page 2 of 3abthe resultant cash into stocks.

It was a nice theory but the selling in the far larger Treasury market looked so vicious andextensive that its value looked to be many more billions of dollars than were showing up in stocks.

Based on decades ofwatching asset swaps, I suggest that the size and scope of the selling in Treasuries would have produced a Dow rally of300 or 400 points. Since the move was much smaller in both points and volume, I have very strong doubts about it being caused by an asset swap.

The stock rally began to roll over around 1:00 and, by the close, gave back half the gains. It was, all in all, one of the strangest days of trading across markets that I've seen in a long, long time.

Colossal Carnage In Commodities – While the headlines and the pundits are concentrating on the oil plunge, almost to the point of obsession, the whole commodity spectrum virtually collapsed. As noted above, some folks felt the spike in rates (yield) may be putting the squeeze on financing commodity positions slightly in the present and most certainly in the near future.

Another possible negative that might collapse commodities across such a broad spectrum would be a sudden sharp stall of the global economy.Our friend, Dennis Gartman, and a few others suggest the catalyst might be the looming review of trading by regulators,and the imposition of position limits that might occur.

It might be better to cut back at your choice rather than being told to by regulators, which might cause a huge rush to the door.We are not sure whether the cause of the carnage was any one, or all of the above. We only know the collapse was widespread and stunning.

It looked very much like a severe case of one of the de-leveraging spasms that we've seen over the last several months. The whole commodity group must be watched closely over the next several days.

Weekend Reading – If you get a chance go on the web to the Dallas and pull up the recent speech by Dallas Fed President Richard Fisher.

It is titled "Storms on the Horizon".

It should be mandatory reading for every candidate for public office, especially the presidential candidates. It is a readable, yet sobering, view of what may lie ahead. It is well worth reading."

My Final Take:

As you can see, things are happening in this market that confuse even the best of the best on the floor of the market. I guess Art and I are on the same page with Fisher's speech. I posted this speech a couple days ago in full and I advise everyone to read it.

Its going to take some more conclusive data to see where the market goes from here. I believe the data will continue to deteriorate and stocks will take a nosedive. For now, the market seems to want to take a pause and soak everything in.

Have a great Friday!

Housing Prices are Falling faster than during the Great Depression

Good Morning!

This was quite an eye opener this morning. This graph was put together based on the Case-Shiller Index which measures housing prices. As you can see, prices are falling faster than at any time during the Great Depression.

This was from the Economist. Here is the article in its entirety:

America's house prices are falling even faster than during the Great Depression

AS HOUSE prices in America continue their rapid descent, market-watchers are having to cast back ever further for gloomy comparisons. The latest S&P/Case-Shiller national house-price index, published this week, showed a slump of 14.1% in the year to the first quarter, the worst since the index began 20 years ago. Now Robert Shiller, an economist at Yale University and co-inventor of the index, has compiled a version that stretches back over a century. This shows that the latest fall in nominal prices is already much bigger than the 10.5% drop in 1932, the worst point of the Depression. And things are even worse than they look. In the deflationary 1930s house prices declined less in real terms. Today inflation is running at a brisk pace, so property prices have fallen by a staggering 18% in real terms over the past year.

Quick Take:

That 14% drop that was headlined this week in the news is even worse when you factor in inflation. The number then jumps up to 18%.

This will go down as the biggest housing bust in history and its still showing no signs of being over!

The CNBC Pump Monkeys and the April Consumer Spending Data

I was sickened this morning watching the pigmen trying to spin the April consumer numbers as a positive sign that the economy is bottoming. I find this network to be almost unwatchable now. Be very careful when you turn on this station. Its become nothing more than a pump machine for Wall St.

When you watch these Wall St. pros calling bottoms hour after hour on "bubblevision", take what they are saying like you would if you were looking at houses and listening to a realtor tell you "You need to buy now because prices will be going up!".

You would have thought consumers were spending like Paris Hilton at a shopping mall after listening to Squawk Box this morning. Here is the data from Bloomberg:

Some highlights or should I say lowlights:

"May 30 (Bloomberg) -- U.S. consumer spending slowed in April as income gains weakened, a sign the biggest part of the economy may be faltering.

The 0.2 percent rise in spending followed a 0.4 percent increase in March, the Commerce Department said today in Washington. Incomes grew 0.2 percent, bolstered in part by the government's tax rebates, and the Federal Reserve's preferred measure of inflation moderated.

Higher fuel costs, smaller wage gains and lower home values have shaken Americans' confidence, raising the odds that spending will keep slowing. Government tax rebates may only provide a temporary boost to economic growth in coming months."

My Take:

The thing we need to focus on here is when you adjust these numbers for inflation, we are getting poorer and poorer each month.

When incomes are growing at .2% and inflation is running at an annual rate of 4%, we are in the red each month. Some believe inflation is running much higher than the 4% thats now being thrown around.

Our government inflation numbers of the mid 2% range are not even worth discussing due to the fact they exclude food and energy. Its a useless number now in my opinion.

Dow Chemical reported a 40% increase in material costs which has forced them to raise prices by 20%. None of this bodes well for the consumer which is 70% of our economy.

There was very little data released on the economy today so I expect a sideways type trading session. Stocks opened slightly higher.

Until later!

Thursday, May 29, 2008

The Power of Inflation on the DOW

Happy Thursday to all!

I have talked a lot about inflation recently, and I wanted share a couple of interesting graphs that I picked up from

The author of this graph(who was not named) has done some sophisticated calculations on the real return on the DOW since 1924. Including inflation, the DOW has historically returned 1.64%. How bad is that!! Wall St. doesn't like to include inflation when they brag about their outrageous returns over the years when they are talking you into buying stocks.

If you look at history, for ever great run that the pigmen have had of 15-20% type returns, there is a downturn where they get creamed. A good example of this is the 50% drubbing they took on the S&P during the dotcom bust. When all of these deviations from the mean get averaged out including inflation 1.64% is not too impressive is it?

Now what I want you to focus on here is the returns during the last prolonged period of inflation in the 1970's. As you can see the DOW performed WELL below the historical 1.64% average annual return of an inflation adjusted market. In fact, the DOW pretty much got killed throughout the whole period.

Now lets take a look at another chart:

I often talk about the great debt bubble, and both of these graph illustrate how massive this bubble has become. We often talk about housing prices reverting to the mean, and folks, its really no different when it comes to the stock market.

As you can see there is a double top here. We hit it first in 1999(tech boom) and then again in 2008. How did we get back up here? The bull market fueled by the housing boom!! As you can see, the debt party which started in 1994 with the tech debt bubble, pretty much lasted right through the housing debt bubble with a short sharp recession in between.

Well now we have a couple of problems. First we have ran out of bubbles to blow up and we are in debt up to our eyeballs. The second is inflation.

Inflation is back!

This is the bigger problem we have in the future. Almost every economist has admitted that going forward, inflationary forces will be a major headwind for the economy.

A look at the charts above tells you how devastating this can be to an economy.

Itulip has 3 paths back to the mean in the second chart. If path 1 is chosen, we will see a 40% drop in the DOW to get back to the historical mean of 1.64% inflation adjusted growth on the DOW. The other option is the DOW will drop to a lesser degree, and we wait years for the 1.64% growth to catch up to where the DOW sits after more moderate drop. This is doubtful IMO.

Bubbles almost always seem to end violently. Time will tell.

Either way, equities do not look like a very good investment going forward.

More importantly, with the threat of inflation, the risk of a significant drop in stocks is probable when you look at what happened in the 1970's.

History always repeats itself.

Get Ready For Wave 2 of the Credit Crisis

Stocks are moving higher today as everyone breathed a sigh of relief when the GDP number came in a little better than anticipated at .9% Anything under 1% basically is telling you that we have a stagnating economy that is not showing any growth. Here is the GDP news from Bloomberg.

We continue to flirt with dipping into a recession. Why stocks are jumping on this news is beyond me, but in this crazy market I guess I shouldn't be surprised.

I think the second quarter might be a different story. The reason I say this is if you go back to the huge 1st quarter miss by General Electric, they basically said the quarter was fine until March when the credit markets froze up due to the Bear Stearns debacle. I expect some of this to carry into the second quarter.

The gas crisis also hit in the second quarter which should have slowed down the consumer considerably as well. It will be interesting to see if GDP is negative in the second quarter when the numbers come out.

Wave 2 of the Credit Crisis

Here is what I wanted to focus on today. It appears that the debt markets are beginning to panic again. The costs of CDS's(credit default swaps) which are used by financial institutions to insure their debt has doubled since late April, and is now back to the levels of where they were when Bear Stearns blew up. Here is the news from The Telegraph UK.:

The debt markets in the US and Europe have begun to flash warning signals yet again, raising fears that the global credit crisis could be entering another turbulent phase.

The cost of insuring against default on the bonds of Lehman Brothers, Merrill Lynch and other big banks and brokerages has surged over the last two weeks, threatening to reach the stress levels seen before the Bear Stearns debacle. Spreads on inter-bank Libor and Euribor rates in Europe are back near record levels.

Credit default swaps (CDS) on Lehman debt have risen from around 130 in late April to 247, while Merrill debt has spiked to 196. Most analysts had thought the coast was clear for such broker dealers after the US Federal Reserve invoked an emergency clause in March to let them borrow directly from its lending window.

But there are now concerns that the Fed itself may be exhausting its $800bn (£399bn) stock of assets. It has swapped almost $300bn of 10-year Treasuries for questionable mortgage debt, and provided Term Auction Credit of $130bn.

"The steep rise in swap spreads this week is ominous," said John Hussman, head of the Hussman Funds. "The deterioration is in stark contrast to what investors have come to hope since March."

Lehman Brothers took writedowns of just $200m on its $6.5bn portfolio of sub-prime debt in the first quarter even though a quarter of the securities had "junk" ratings, typically worth a fraction of face value.

Willem Sels, a credit analyst at Dresdner Kleinwort, said the banks are beginning to face waves of defaults on credit cards, car loans, and now corporate loans. "We believe we're entering Phase II. The liquidity crisis has eased a little, but the real credit losses are accelerating. The worst is yet to come," he said."

My take:

Gulp. Gee you think maybe this is why the Lehman rumors are swirling again? The cost of CDS's are rising because everyone knows this debt is garbage. No one wants to insure garbage and its going to cost you if you insist on buying it. The CDS's are also rising because the Fed is running out of reserves, and may not be able to afford another bailout..

The financial system is hanging on by a thread and it looks like a second wave is about to hit. However this time its with a weak Fed that has a big fat dose of inflation and $130 oil sitting on its plate.

The 10 year bonds moved up to 4.10% today signaling the bond market has about had it with all of the bad debt and Treasury auctions. As I said yesterday, mortgage rates are going to go through the roof as the 10 year rises.

Get ready everybody. Credit tidal wave #2 is about to hit and there is no one to save the financials this time. !

I expect another blowup shortly and its not going to be pretty.

Wednesday, May 28, 2008

Fed Member Richard Fisher's Shocking Speech

I advise anyone that has children, and cares about this country to read every word of the following speech. Richard Fisher is a key member of the Fed, and his words here are memorable. Thanks to Karl Denninger for finding this link.

The problems that we have in this country are serious, and thay are bravely discussed here by Mr. Fisher. The one area I highlighted is when he discusses interest rates. He couldn't have been more blunt about what will happen if inflation continues to rise.

This is a brave man making a brave speech. Kudos to Mr. Fisher, and I hope everyone reads the whole thing.

I will post the speech in its entirety. I will have no take on this speech. His words say it all. Here is the link.

"torms on the HorizonRemarks before the Commonwealth Club of CaliforniaSan Francisco, CaliforniaMay 28, 2008

Thank you, Bruce [Ericson]. I am honored to be here this evening and am grateful for the invitation to speak to the Commonwealth Club of California. Alan Greenspan and Paul Volcker, two of Ben Bernanke’s linear ancestors as chairmen of the Federal Reserve, have been in the news quite a bit lately. Yet, we rarely hear about William McChesney Martin, a magnificent public servant who was Fed chairman during five presidencies and to this day holds the record for the longest tenure: 19 years.

Chairman Martin had a way with words. And he had a twinkle in his eye. It was Bill Martin who wisely and succinctly defined the Federal Reserve as having the unenviable task “to take away the punchbowl just as the party gets going.” He did himself one up when he received the Alfalfa Club’s nomination for the presidency of the United States. I suspect many here tonight have been to the annual Alfalfa dinner. It is one of the great institutions in Washington, D.C. Once a year, it holds a dinner devoted solely to poking fun at the political pretensions of the day. Tongue firmly in cheek, the club nominates a candidate to run for the presidency on the Alfalfa Party ticket. Of course, none of them ever win. Nominees are thenceforth known for evermore as members of the Stassen Society, named for Harold Stassen, who ran for president nine times and lost every time, then ran a tenth time on the Alfalfa ticket and lost again. The motto of the group is Veni, Vidi, Defici—“I came, I saw, I lost.”

Bill Martin was nominated to run and lose on the Alfalfa Party ticket in 1966, while serving as Fed chairman during Lyndon Johnson’s term. In his acceptance speech,[1] he announced that, given his proclivities as a central banker, he would take his cues from the German philosopher Goethe, “who said that people could endure anything except continual prosperity.” Therefore, Martin declared, he would adopt a platform proclaiming that as a president he planned to “make life endurable again by stamping out prosperity.”

“I shall conduct the administration of the country,” he said, “exactly as I have so successfully conducted the affairs of the Federal Reserve. To that end, I shall assemble the best brains that can be found…ask their advice on all matters…and completely confound them by following all their conflicting counsel.”

It is true, Bruce, that as you said in your introduction, I am one of the 17 people who participate in Federal Open Market Committee (FOMC) deliberations and provide Ben Bernanke with “conflicting counsel” as the committee cobbles together a monetary policy that seeks to promote America’s economic prosperity, Goethe to the contrary. But tonight I speak for neither the committee, nor the chairman, nor any of the other good people that serve the Federal Reserve System. I speak solely in my own capacity. I want to speak to you tonight about an economic problem that we must soon confront or else risk losing our primacy as the world’s most powerful and dynamic economy.

Forty-three years ago this Sunday, Bill Martin delivered a commencement address to Columbia University that was far more sober than his Alfalfa Club speech. The opening lines of that Columbia address [2] were as follows: “When economic prospects are at their brightest, the dangers of complacency and recklessness are greatest. As our prosperity proceeds on its record-breaking path, it behooves every one of us to scan the horizon of our national and international economy for danger signals so as to be ready for any storm.”

Today, our fellow citizens and financial markets are paying the price for falling victim to the complacency and recklessness Martin warned against. Few scanned the horizon for trouble brewing as we proceeded along a path of unparalleled prosperity fueled by an unsustainable housing bubble and unbridled credit markets. Armchair or Monday morning quarterbacks will long debate whether the Fed could have/should have/would have taken away the punchbowl that lubricated that blowout party. I have given my opinion on that matter elsewhere and won’t go near that subject tonight. What counts now is what we have done more recently and where we go from here. Whatever the sins of omission or commission committed by our predecessors, the Bernanke FOMC’s objective is to use a new set of tools to calm the tempest in the credit markets to get them back to functioning in a more orderly fashion. We trust that the various term credit facilities we have recently introduced are helping restore confidence while the credit markets undertake self-corrective initiatives and lawmakers consider new regulatory schemes.

I am also not going to engage in a discussion of present monetary policy tonight, except to say that if inflationary developments and, more important, inflation expectations, continue to worsen, I would expect a change of course in monetary policy to occur sooner rather than later, even in the face of an anemic economic scenario. Inflation is the most insidious enemy of capitalism. No central banker can countenance it, not least the men and women of the Federal Reserve.

Tonight, I want to talk about a different matter. In keeping with Bill Martin’s advice, I have been scanning the horizon for danger signals even as we continue working to recover from the recent turmoil. In the distance, I see a frightful storm brewing in the form of untethered government debt. I choose the words—“frightful storm”—deliberately to avoid hyperbole. Unless we take steps to deal with it, the long-term fiscal situation of the federal government will be unimaginably more devastating to our economic prosperity than the subprime debacle and the recent debauching of credit markets that we are now working so hard to correct.

You might wonder why a central banker would be concerned with fiscal matters. Fiscal policy is, after all, the responsibility of the Congress, not the Federal Reserve. Congress, and Congress alone, has the power to tax and spend. From this monetary policymaker’s point of view, though, deficits matter for what we do at the Fed. There are many reasons why. Economists have found that structural deficits raise long-run interest rates, complicating the Fed’s dual mandate to develop a monetary policy that promotes sustainable, noninflationary growth. The even more disturbing dark and dirty secret about deficits—especially when they careen out of control—is that they create political pressure on central bankers to adopt looser monetary policy down the road. I will return to that shortly. First, let me give you the unvarnished facts of our nation’s fiscal predicament.

Eight years ago, our federal budget, crafted by a Democratic president and enacted by a Republican Congress, produced a fiscal surplus of $236 billion, the first surplus in almost 40 years and the highest nominal-dollar surplus in American history. While the Fed is scrupulously nonpartisan and nonpolitical, I mention this to emphasize that the deficit/debt issue knows no party and can be solved only by both parties working together. For a brief time, with surpluses projected into the future as far as the eye could see, economists and policymakers alike began to contemplate a bucolic future in which interest payments would form an ever-declining share of federal outlays, a future where Treasury bonds and debt-ceiling legislation would become dusty relics of a long-forgotten past. The Fed even had concerns about how open market operations would be conducted in a marketplace short of Treasury debt.

That utopian scenario did not last for long. Over the next seven years, federal spending grew at a 6.2 percent nominal annual rate while receipts grew at only 3.5 percent. Of course, certain areas of government, like national defense, had to spend more in the wake of 9/11. But nondefense discretionary spending actually rose 6.4 percent annually during this timeframe, outpacing the growth in total expenditures. Deficits soon returned, reaching an expected $410 billion for 2008—a $600 billion swing from where we were just eight years ago. This $410 billion estimate, by the way, was made before the recently passed farm bill and supplemental defense appropriation and without considering a proposed patch for the Alternative Minimum Tax—all measures that will lead to a further ballooning of government deficits.

In keeping with the tradition of rosy scenarios, official budget projections suggest this deficit will be relatively short-lived. They almost always do. According to the official calculus, following a second $400-billion-plus deficit in 2009, the red ink should fall to $160 billion in 2010 and $95 billion in 2011, and then the budget swings to a $48 billion surplus in 2012.

If you do the math, however, you might be forgiven for sensing that these felicitous projections look a tad dodgy. To reach the projected 2012 surplus, outlays are assumed to rise at a 2.4 percent nominal annual rate over the next four years—less than half as fast as they rose the previous seven years. Revenue is assumed to rise at a 6.7 percent nominal annual rate over the next four years—almost double the rate of the past seven years. Using spending and revenue growth rates that have actually prevailed in recent years, the 2012 surplus quickly evaporates and becomes a deficit, potentially of several hundred billion dollars.

Doing deficit math is always a sobering exercise. It becomes an outright painful one when you apply your calculator to the long-run fiscal challenge posed by entitlement programs. Were I not a taciturn central banker, I would say the mathematics of the long-term outlook for entitlements, left unchanged, is nothing short of catastrophic.

Typically, critics ranging from the Concord Coalition to Ross Perot begin by wringing their collective hands over the unfunded liabilities of Social Security. A little history gives you a view as to why. Franklin Roosevelt originally conceived a social security system in which individuals would fund their own retirements through payroll-tax contributions. But Congress quickly realized that such a system could not put much money into the pockets of indigent elderly citizens ravaged by the Great Depression. Instead, a pay-as-you-go funding system was embraced, making each generation’s retirement the responsibility of its children.

Now, fast forward 70 or so years and ask this question: What is the mathematical predicament of Social Security today? Answer: The amount of money the Social Security system would need today to cover all unfunded liabilities from now on—what fiscal economists call the “infinite horizon discounted value” of what has already been promised recipients but has no funding mechanism currently in place—is $13.6 trillion, an amount slightly less than the annual gross domestic product of the United States.

Demographics explain why this is so. Birthrates have fallen dramatically, reducing the worker–retiree ratio and leaving today’s workers pulling a bigger load than the system designers ever envisioned. Life spans have lengthened without a corresponding increase in the retirement age, leaving retirees in a position to receive benefits far longer than the system designers envisioned. Formulae for benefits and cost-of-living adjustments have also contributed to the growth in unfunded liabilities.

The good news is this Social Security shortfall might be manageable. While the issues regarding Social Security reform are complex, it is at least possible to imagine how Congress might find, within a $14 trillion economy, ways to wrestle with a $13 trillion unfunded liability. The bad news is that Social Security is the lesser of our entitlement worries. It is but the tip of the unfunded liability iceberg. The much bigger concern is Medicare, a program established in 1965, the same prosperous year that Bill Martin cautioned his Columbia University audience to be wary of complacency and storms on the horizon.

Medicare was a pay-as-you-go program from the very beginning, despite warnings from some congressional leaders—Wilbur Mills was the most credible of them before he succumbed to the pay-as-you-go wiles of Fanne Foxe, the Argentine Firecracker—who foresaw some of the long-term fiscal issues such a financing system could pose. Unfortunately, they were right.

Please sit tight while I walk you through the math of Medicare. As you may know, the program comes in three parts: Medicare Part A, which covers hospital stays; Medicare B, which covers doctor visits; and Medicare D, the drug benefit that went into effect just 29 months ago. The infinite-horizon present discounted value of the unfunded liability for Medicare A is $34.4 trillion. The unfunded liability of Medicare B is an additional $34 trillion. The shortfall for Medicare D adds another $17.2 trillion. The total? If you wanted to cover the unfunded liability of all three programs today, you would be stuck with an $85.6 trillion bill. That is more than six times as large as the bill for Social Security. It is more than six times the annual output of the entire U.S. economy.

Why is the Medicare figure so large? There is a mix of reasons, really. In part, it is due to the same birthrate and life-expectancy issues that affect Social Security. In part, it is due to ever-costlier advances in medical technology and the willingness of Medicare to pay for them. And in part, it is due to expanded benefits—the new drug benefit program’s unfunded liability is by itself one-third greater than all of Social Security’s.

Add together the unfunded liabilities from Medicare and Social Security, and it comes to $99.2 trillion over the infinite horizon. Traditional Medicare composes about 69 percent, the new drug benefit roughly 17 percent and Social Security the remaining 14 percent.

I want to remind you that I am only talking about the unfunded portions of Social Security and Medicare. It is what the current payment scheme of Social Security payroll taxes, Medicare payroll taxes, membership fees for Medicare B, copays, deductibles and all other revenue currently channeled to our entitlement system will not cover under current rules. These existing revenue streams must remain in place in perpetuity to handle the “funded” entitlement liabilities. Reduce or eliminate this income and the unfunded liability grows. Increase benefits and the liability grows as well.

Let’s say you and I and Bruce Ericson and every U.S. citizen who is alive today decided to fully address this unfunded liability through lump-sum payments from our own pocketbooks, so that all of us and all future generations could be secure in the knowledge that we and they would receive promised benefits in perpetuity. How much would we have to pay if we split the tab? Again, the math is painful. With a total population of 304 million, from infants to the elderly, the per-person payment to the federal treasury would come to $330,000. This comes to $1.3 million per family of four—over 25 times the average household’s income.

Clearly, once-and-for-all contributions would be an unbearable burden. Alternatively, we could address the entitlement shortfall through policy changes that would affect ourselves and future generations. For example, a permanent 68 percent increase in federal income tax revenue—from individual and corporate taxpayers—would suffice to fully fund our entitlement programs. Or we could instead divert 68 percent of current income-tax revenues from their intended uses to the entitlement system, which would accomplish the same thing.

Suppose we decided to tackle the issue solely on the spending side. It turns out that total discretionary spending in the federal budget, if maintained at its current share of GDP in perpetuity, is 3 percent larger than the entitlement shortfall. So all we would have to do to fully fund our nation’s entitlement programs would be to cut discretionary spending by 97 percent. But hold on. That discretionary spending includes defense and national security, education, the environment and many other areas, not just those controversial earmarks that make the evening news. All of them would have to be cut—almost eliminated, really—to tackle this problem through discretionary spending.

I hope that gives you some idea of just how large the problem is. And just to drive an important point home, these spending cuts or tax increases would need to be made immediately and maintained in perpetuity to solve the entitlement deficit problem. Discretionary spending would have to be reduced by 97 percent not only for our generation, but for our children and their children and every generation of children to come. And similarly on the taxation side, income tax revenue would have to rise 68 percent and remain that high forever. Remember, though, I said tax revenue, not tax rates. Who knows how much individual and corporate tax rates would have to change to increase revenue by 68 percent?

If these possible solutions to the unfunded-liability problem seem draconian, it’s because they are draconian. But they do serve to give you a sense of the severity of the problem. To be sure, there are ways to lessen the reliance on any single policy and the burden borne by any particular set of citizens. Most proposals to address long-term entitlement debt, for example, rely on a combination of tax increases, benefit reductions and eligibility changes to find the trillions necessary to safeguard the system over the long term.

No combination of tax hikes and spending cuts, though, will change the total burden borne by current and future generations. For the existing unfunded liabilities to be covered in the end, someone must pay $99.2 trillion more or receive $99.2 trillion less than they have been currently promised. This is a cold, hard fact. The decision we must make is whether to shoulder a substantial portion of that burden today or compel future generations to bear its full weight.

Now that you are all thoroughly depressed, let me come back to monetary policy and the Fed.

It is only natural to cast about for a solution—any solution—to avoid the fiscal pain we know is necessary because we succumbed to complacency and put off dealing with this looming fiscal disaster. Throughout history, many nations, when confronted by sizable debts they were unable or unwilling to repay, have seized upon an apparently painless solution to this dilemma: monetization. Just have the monetary authority run cash off the printing presses until the debt is repaid, the story goes, then promise to be responsible from that point on and hope your sins will be forgiven by God and Milton Friedman and everyone else.

We know from centuries of evidence in countless economies, from ancient Rome to today’s Zimbabwe, that running the printing press to pay off today’s bills leads to much worse problems later on. The inflation that results from the flood of money into the economy turns out to be far worse than the fiscal pain those countries hoped to avoid.

Earlier I mentioned the Fed’s dual mandate to manage growth and inflation. In the long run, growth cannot be sustained if markets are undermined by inflation. Stable prices go hand in hand with achieving sustainable economic growth. I have said many, many times that inflation is a sinister beast that, if uncaged, devours savings, erodes consumers’ purchasing power, decimates returns on capital, undermines the reliability of financial accounting, distracts the attention of corporate management, undercuts employment growth and real wages, and debases the currency.

Purging rampant inflation and a debased currency requires administering a harsh medicine. We have been there, and we know the cure that was wrought by the FOMC under Paul Volcker. Even the perception that the Fed is pursuing a cheap-money strategy to accommodate fiscal burdens, should it take root, is a paramount risk to the long-term welfare of the U.S. economy. The Federal Reserve will never let this happen. It is not an option. Ever. Period.

The way we resolve these liabilities—and resolve them we must—will affect our own well-being as well as the prospects of future generations and the global economy. Failing to face up to our responsibility will produce the mother of all financial storms. The warning signals have been flashing for years, but we find it easier to ignore them than to take action. Will we take the painful fiscal steps necessary to prevent the storm by reducing and eventually eliminating our fiscal imbalances? That depends on you.

I mean “you” literally. This situation is of your own creation. When you berate your representatives or senators or presidents for the mess we are in, you are really berating yourself. You elect them. You are the ones who let them get away with burdening your children and grandchildren rather than yourselves with the bill for your entitlement programs.

This issue transcends political affiliation. When George Shultz, one of San Francisco’s greatest Republican public servants, was director of President Nixon’s Office of Management and Budget, he became worried about the amount of money Congress was proposing to spend. After some nights of tossing and turning, he called legendary staffer Sam Cohen into his office. Cohen had a long memory of budget matters and knew every zig and zag of budget history. “Sam,” Shultz asked, “tell me something just between you and me. Is there any difference between Republicans and Democrats when it comes to spending money?” Cohen looked at him, furrowed his brow and, after thinking about it, replied, “Mr. Shultz, there is only one difference: Democrats enjoy it more.”

Yet no one, Democrat or Republican, enjoys placing our children and grandchildren and their children and grandchildren in harm’s way. No one wants to see the frightful storm of unfunded long-term liabilities destroy our economy or threaten the independence and authority of our central bank or tear our currency asunder.

Of late, we have heard many complaints about the weakness of the dollar against the euro and other currencies. It was recently argued in the op-ed pages of the Financial Times [3] that one reason for the demise of the British pound was the need to liquidate England’s international reserves to pay off the costs of the Great Wars. In the end, the pound, it was essentially argued, was sunk by the kaiser’s army and Hitler’s bombs. Right now, we—you and I—are launching fiscal bombs against ourselves. You have it in your power as the electors of our fiscal authorities to prevent this destruction. Please do so. "

The Fed, Treasuries, and Mortgage Rates

It was an interesting day in the markets even though gains were modest. Tonight I want to discuss treasuries, mortgage rates, and the Fed's dilemma. I know this sounds really exciting!(not) However, I think you will find it helpful in terms of understanding whats going on in the markets right now.

There is a ton of maneuvering going on behind the scenes as the Fed tries to prevent this debt bubble from bursting. The easy first response from the Fed when this crisis first hit was to slash rates, and provide a ton of liquidity to the financial system. The Fed hoped that this would stimulate lending and borrowing and keep the economy going.

So how did that work?

As we all know, the results are not impressive. So what have been the repercussions of the Fed cuts?

In a nutshell: Higher food inflation, a weaker dollar, $130 oil, and mortgage rates that are basically within a 1/4 point from where they were when the rate cutting began. Pretty impressive isn't it? Ha Yea right.

The Fed decided to switch gears after this experiment failed and started providing liquidity by other means. Examples of this are the discount window where the financial institutions including investment banks could use AAA bonds as collateral to borrow cash at a discounted rate.

They also started up Lending Facilities that allowed the banks to use other forms of AAA debt like student loans for collateral to borrow additional money.

So where are we now?

Well throwing all of this liquidity into the system has its reprocussions. We have created a whole set of problems that has really put the Fed in a bad spot. With liquidity comes inflation. This is problem number one.

Problem #2: You can't throw all of this liquidity at the financial system without paying for it. The Fed does this through holding auctions and selling things like 2 and 5 year treasury bonds. There is a $60 billion dollar sale that began today.

So how are the auctions going?

From the looks of Bloomberg today demand looks to be slow. The central banks of the world are growing tired of buying these Treasuries that continues to get devalued by inflation and our weak dollar.

As a result, the yields must rise in order to make them attractive to investors. Here are some highlights from Bloomberg:

May 28 (Bloomberg) -- Treasuries fell, pushing the 10-year note's yield above 4 percent for the first time since January, as a measure of durable-goods orders unexpectedly rose and the government's two-year note sale was met with tepid demand.

Bonds extended their losses after the auction of $30 billion of the securities drew a higher yield than bond-trading firms forecast and attracted the lowest level of demand since February from a group that includes central banks. The government will sell $19 billion of five-year notes tomorrow.

The yield on the current two-year note rose 12 basis points, or 0.12 percentage point, to 2.62 percent at 4 p.m. in New York, according to BGCantor Market Data. It was the highest level since Jan. 11. The price of the 2.125 percent security due in April 2010 fell 7/32, or $2.19 per $1,000 face amount, to 99 2/32.

The benchmark 10-year note's yield increased 11 basis points to 4.03 percent. It's the highest level since Jan. 2. The security's rate is 1.40 percentage points higher than that on two-year notes, compared with 1.54 percentage points when the government held the last two-year note auction on April 23.

In the government's sale of two-year notes, indirect bidders, the category of investors that includes foreign central banks, bought 22.4 percent of the auction. In the past six sales, the group bought 24.9 percent on average.

Fed Rate Outlook

Futures on the Chicago Board of Trade indicated a 73 percent chance the central bank would increase its target rate for overnight lending between banks by at least a quarter- percentage point in December, compared with 55 percent odds a week ago."

Final Take: The Fed's Dilemma

The fact that the 10 year has risen to over 4% is a huge red flag! This is not good because its going to push mortgage rates higher. The reason the 10 year is moving higher is because the Treasury is handing out money like candy, and they need to raise cash in order to continue to do this.

The massive spending of cash by the Treasury comes at a price. The bond market then pushes the 10 year yields higher as a way to protect itself. We are at a 7 month high on the 10 year rate according to CNBC. It closed at around 4.00%.

This is BAD BAD BAD for housing because the 10 year bond rate is used to set many different mortgage rates. If the Fed continues to spend like a drunken sailor, then it risks spiking rates severely in the bond market.

This could DESTROY the housing market with higher mortgage rates. People can't afford to buy these homes at the current rates. Push rates to 8-9% and you will see a housing crash with virtually zero activity.

So what alternative does the Fed have?

The alternative is to start pulling liquidity from the system. They know that the financial system is in jeopardy if the 10 year rate continues to rise because housing will come to a come to a standstill. The banks are teetering on insolvency as it is and the Fed realizes a housing crash could be the final nail in the coffin.

So how does the Fed pull liquidity from the system?

The Fed can start pulling liquidity from the system by not touching interest rates or increasing them slightly and let equities take a tumble. They could even try to force a sell off. The reason they would do this is if equities drop, people will fly into treasuries out of fear which will then keep the treasury bond rates low due to high demand. This would then allow for the cheap lending to continue.

They could also pull liquidity out by changing what they accept at the discount window. I don't see this as a viable alternative because it would put too much pressure on the banks.

The one thing they know for sure is they cannot afford to let borrowing rates rise. The 10 year must not rise much above 4%. If the Fed has to stop spending spending and sacrifice the stock market in order to do it then that's the cost of doing business.

The risk of popping the debt bubble through higher borrowing rates is a bigger risk to them versus saving the financials through bailouts in the equity markets. The spending must stop now or we face a severe inflationary crisis with soaring interest rates.

The days of the Fed being a backstop to financials like Bear Stearns are over. They have spent $700 billion dollars and its forcing rates up in the bond market.

So the Fed faces a tough choice. Do you keep the liquidity flowing and risk inflation along with soaring interest rates to save equities, or do you pull liquidity out in order to keep borrowing rates low and protect the dollar and the debt bubble at the expense of the stock market?

Tough choice isn't it?

Subprime Investors Fight Back: Here come the Lawsuits!

Well we had an interesting development overnight ladies and gentleman. It appears that the investors who bought certain types of subprime AAA rated securities want their money back!

The Wall St. Journal reported this bomb today ,and the effect of this development is far reaching and very bad news for the lenders. Folks, the lawsuits from this housing bust are going to go on for years.

Here are the highlights from the article. First, take a look at the Countrywide graph from the article showing the rapid rise in bad loans that Countrywide has been forced to eat because the lending standards were so bad.

Some highlights from the WSJ:

"Already burned by bad mortgages on their books, lenders now are feeling rising heat from loans they sold to investors.

Unhappy buyers of subprime mortgages, home-equity loans and other real-estate loans are trying to force banks and mortgage companies to repurchase a growing pile of troubled loans. The pressure is the result of provisions in many loan sales that require lenders to take back loans that default unusually fast or contained mistakes or fraud.

Countrywide Financial Corp., the largest mortgage lender in the U.S., said in a securities filing this month that its estimated liability for such claims climbed to $935 million as of March 31 from $365 million a year earlier. Countrywide also took a first-quarter charge of $133 million for claims that already have been paid.

The fight over mortgages that lenders thought they had largely offloaded is another reminder of the deterioration of lending standards that helped contribute to the worst housing bust in decades.

Such disputes began to emerge publicly in 2006 as large numbers of subprime mortgages began going bad shortly after origination.

Repurchase demands are coming from a wide variety of loan buyers. In a recent conference call with analysts, Fannie Mae said it is reviewing every loan that defaults -- and seeking to force lenders to buy back loans that failed to meet promised quality standards. Freddie Mac also has seen an increase in such claims, a spokeswoman says, adding that most are resolved easily.

Additional pressure is coming from bond insurers such as Ambac Financial Group Inc. and MBIA Inc., which guaranteed investment-grade securities backed by pools of home-equity loans and lines of credit. In January, Armonk, N.Y.-based MBIA began working with forensic experts to scrutinize pools it insured that contained home-equity loans and credit lines to borrowers with good credit. "There are a significant number of loans that should not have been in these pools to begin with," says Mitch Sonkin, MBIA's head of insured portfolio management.

In a lawsuit filed in December in Superior Court in Los Angeles, units of PMI Group Inc. alleged that WMC Mortgage Corp. breached the "representations and warranties" it made for a pool of subprime loans that were insured by PMI in 2007. Within eight months, the delinquency rate for the pool of loans had climbed to 30%, according to the suit. The suit also alleges that detailed scrutiny of 120 loans that PMI asked WMC to repurchase found evidence of "fraud, errors [and] misrepresentations."

PMI wants WMC, which was General Electric Co.'s subprime-mortgage unit, to buy back the loans or pay damages. Both companies declined to comment on the pending suit."

Final Take:

We are in the beginning stages of seeing the fallout from this housing bust, and the buyers of the AAA subprime crap sandwiches want blood. As you can see above, the investors are now going through these securities loan by loan looking for anything such as: Fraud, loans that didn't belong in a certian securitization due to risk, and an overall lack of quality standards.

Notice the one pool of loans with WMC had a 30% default rate within 8 months! This is called lending to anyone with a pulse!!!

Of course now the monolines like MBIA and Ambac believe they may have now found an "out", and are climbing over each other to jump aboard this legal train.

The monolines see this as an opportunity to get out of many of the contracts that they made with the lenders to insure this AAA crappola. The liability of insuring these securities has threatened their AAA ratings as well as their survival.

PMI is suing for the same reasons. To get out from the liability.

Expect every investor that got stuck with these AAA subprime mortgage pools to look over every loan with a fine tooth comb looking for away to get paid back. They realize that at the peak of the market, the lenders made many bad loans that should have never been done, and then stuck them into AAA securities where they never belonged.

Countrywide already has $1 billion in estimated liability on loans that are so bad, they will be forced to take them back from the investors that they sold them too and eat them. Imagine how many more are on the way?

Notice how the court battles are also spreading into home equity loans and other real estate loans. Its only going to get worse. Many subprime loans haven't even reset yet!

The amount of greed and fraud that resulted in this housing bust runs far and wide, and the courts will be tied up with this for years trying work this all out.

Anyone that still thinks Bank of America wants any part of Countrywide needs to get their head examined!

Countrywide will end up being the poster child for all that was wrong in the housing market the past 10 years.

Tuesday, May 27, 2008

$12 a Gallon Gas Possible? Dr. Hirsch Thinks So

Since oil is the focus of the market right now, I thought everyone would like to get some more insight on oil from the experts. I was surprised to see such a bearish piece like this on CNBC. This is from May 20th so its pretty current information.

Maybe we should be enjoying the $4 a gallon gas we have right now. It looks like gas could go much higher. We better find an alternative source of energy fast or we are in for a rude awakening!

Case Shiller/New Home Sales/Consumer Confidence

Good Morning

Well we had a triple witching hour of news that came out early this morning. Lets start with the Case-Shiller Index and new home sales. Surprise, Surprise, home sales continue to decline at a record pace. Here is the scoop on both numbers from Bloomberg:

"May 27 (Bloomberg) -- Home prices in 20 U.S. metropolitan areas fell in March by the most in at least seven years, pointing to weakness in the housing market that will constrain economic growth.
The S&P/Case-Shiller home-price index dropped 14.4 percent from a year earlier, more than forecast and the most since the figures were first published in 2001. The gauge has fallen every month since January 2007.

Prices continue to slide as record foreclosures put more homes on the market and stricter lending standards make it harder to get loans. Falling home values are slowing consumer spending, threatening to halt the six-year expansion.

``Many households are putting their home-buying plans on hold, given the expectations that the house price corrections will persist,'' Celia Chen, an economist at Moody's in West Chester, Pennsylvania, said before the report. ``The housing downturn remains in full swing.''

New Home Sales:

Sales are up slightly in April from the horrendous 17 year low that we had in March. I wouldn't get to excited about this increase. This is the spring selling season and the fact we are selling new homes at a 500,000 rate is not promising. From the same article:

New-Home Sales Rise

A government report showed new-home sales unexpectedly rose in April after readings for the prior month were revised down. Sales increased 3.3 percent to an annual pace of 526,000 from a 509,000 rate the prior month that was the lowest in 17 years, the Commerce Department said today in Washington."

My take:

Well housing prices are still accelerating to the downside. There seems to be no end in sight for the housing crash. Bubbleland(CNBC) was having a difficult time trying to find any way to spin the Case-Shiller report positive. Housing continues to look dismal and is affecting consumer sentiment.

Consumer Confidence Report:

The news wasn't any better here folks. Dropping housing values and inflation combined with the virtual disappearance of home equity loans is making the consumer feel pretty bad. Consumer confidence fell to 57.2 which was a 15-1/2 year low and was lower than forecasts.

Take a look at the chart below to see how dependent consumers were on using their home equity to spend like drunken sailors.

Aren't these number shocking? 1 out of 3 cars bought in California were bought using a home equity loan. Amazing.

I wouldn't want to be a car dealer right now. Especially with higher gas prices. Unless you are selling hybrids, auto sales is a bad place to be.

This chart is a great snapshot of how the consumer must be feeling without their home equity loans. Banks are pulling these loans right and left in all of the bubble areas. Meredith Whitney predicts the dollar value of the home equity loans being yanked from homeowners will be in the trillions over the next year.

Think this will leave a mark on the consumer? Ummm let me guess...uhh yea.

Bottom Line:

The news isn't getting any better folks. The Case-Shiller was in line with expectations so stocks bounced a little on this news. Stocks were also a little stronger because the dollar strengthened and oil prices dropped a few bucks.

I expected a little bounce today because we seemed a little oversold from the slaughter last week. This is just a temporary bounce IMO.

The housing data is bleak, oil is at $130/barrel, and consumer confidence is at 15-1/2 year lows. As long as these things stay in place, stocks are going nowhere.

Hold off buying that house! Prices are still dropping. Remember NO KNIFE CATCHING including foreclosures!!! There were no signs in the Case-Shiller report that housing is stabilizing. Stay on the sidelines. Much better deals lie ahead!!

Monday, May 26, 2008

World Markets/UBS Warns of more Trouble/UK housing

I hope everyone enjoys a nice BBQ today!

Although we are closed today, there was a lot of action in the world markets in reaction to our selloff last week. The Nikkei in Japan was down over 300 points and the Hang Seng was down 2.5%. Stocks in Europe were also in the red.

One of the key reasons for the drop was UBS's announcement. They came out today and said that further writedowns are coming, and admitted they still have considerable exposure to bad mortgage securities. Wow what a shocker..Not!!

Here are some of the highlights:

May 26 (Bloomberg) -- UBS AG, the European bank hardest hit by the U.S. subprime contagion, fell the most in more than two months in Swiss trading after saying it may face more losses from mortgage securities.

UBS declined 1.74 Swiss francs, or 5.8 percent, to 28.20 francs in Zurich, the biggest slump among the 59 companies on the Bloomberg Europe Banks and Financial Services Index. UBS has dropped 43 percent this year, cutting its market value to 61.4 billion francs ($59.9 billion).

``UBS will have to fight against negative news flow for at least several more quarters,'' said Rolf Biland, who helps manage about $3.1 billion, including UBS shares, as chief investment officer at VZ Vermoegenszentrum in Zurich. ``The U.K. housing market is almost as overheated as in the U.S., and could lead to losses for banks.''

The bank still has more than $45 billion in U.S. mortgage-related assets, $8.6 billion in leveraged finance commitments and $10.4 billion in U.S. student loans on its books.
The company hasn't said how much it holds in non-U.S. mortgage securities."

My Take:

The final paragraph that I highlighted shows you how much more potential damage is on the way.

How much do you want to bet that the majority of the $45 billion in mortgages in UBS's portfolio is mainly comprised of subprime loans. Is that a capital raising call that I hear? I am sure its coming soon. Dilution is on the way UBS shareholders!

The analyst above said the bad news could be flowing out of UBS for several quarters. I thought the worst was already behind us? As you can see boys and girls, we have a long way to go to get through this credit crunch.

Also, notice the last line of the highlights. They won't admit their exposure to non-U.S. mortgage securities. Looks like a second punch to the gut is coming from the European housing market.

Spain's housing market is crashing, and it looks like the UK market is right behind them(see below).

UK Housing Market starting to buckle?

It looks like we are not alone when it comes to housing bubbles. Housing prices in the UK have now dropped for the eighth straight month.

Some Highlights:

"May 26 (Bloomberg) -- U.K. home values fell for an eighth month in May and will probably drop further, Hometrack Ltd. said.

The average cost of a residential property in England and Wales slipped 0.5 percent to 172,200 pounds ($341,000), the London-based research company said today in a statement. Prices fell 1.9 percent from a year earlier, the biggest decline since November 2005.

``The `buyers' strike' continues,'' said Richard Donnell, director of research at Hometrack, in a statement. ``Pricing looks set to remain under downward pressure over the coming months.''
Bank of England Governor Mervyn King predicted this month that property values are ``likely to fall further'' and said there is a risk that the U.K. economy may contract.

Home buyers are paying more for mortgages after the global credit squeeze prompted lenders to curb lending. U.K. banks increased the cost of home loans with a 5 percent down payment to the highest in more than eight years in April, failing to pass on the Bank of England's three interest-rate cuts since December."

Final Take:

Sounds familiar doesn't it? Its becoming clearly evident that this may become a global slowdown versus just a United States problem. Housing is falling, and the high priced Euro is hurting manufacturing because goods are now too expensive to export. Europe is also facing the same high inflation that we are.

The global growth story is what the bulls have been hanging their hat on. If Europe and the US stop consuming then how are countries like Asia and India going to continue to grow if there is no one to buy their cheap goods? Asia's manufacturing is the key driver of their economy.

It now seems apparent that European banks like UBS are going to get clobbered by housing on both sides of the Atlantic. I wouldn't be surprised if a bank blowup happens overseas first.

The one/two housing punch could result in a KO.

It will be interesting to see how the US markets react to the world wide sell off and UBS/UK housing news.

We seem a little oversold from last week so I wouldn't be surprised to see a little bounce. However, with $130 oil, it will likely be mild. Longer term, a big sell off in equities is probable because the bad news simply isn't priced in to stocks.

The average drop in equities during a recession is 28% and we are nowhere near these levels. I predict this will be a severe recession so the potential for a larger sell off is definitely there.

Until next time!

Sunday, May 25, 2008

California Home prices down 32% vs. April 2007

The average home price in California is down 32% in April of 2008 versus April of last year. Here is the whole piece from Bloomberg:

"May 23 (Bloomberg) -- California home prices tumbled 32 percent in April from a year earlier as ``distressed'' properties and a lack of financing cut demand, the state realtors group said.
The median existing home price fell to $403,870, the California Association of Realtors said in a statement today. Sales increased 2.5 percent, ending 30 months of consecutive year-on-year declines. Homes priced under $500,000 accounted for 64 percent of sales compared with 40 percent a year earlier.

California had the second-highest U.S. foreclosure rate in April, one for every 204 households, and the most foreclosure filings for the 16th consecutive month, RealtyTrac Inc., a seller of default data, reported on May 14. Sales increased in northern and southern California last month as buyers purchased discounted properties that had been in some stage of default, DataQuick Information Systems said this week.

``Both tighter underwriting standards and the ongoing effects of the credit/liquidity crunch continue to constrain sales,'' William Brown, president of the association, said in the statement."

My Take:

Isn't this staggering? Imagine buying a home and realizing a year later that the biggest investment you ever made in your life is now worth a third less.

Whats scary is prices are still deteriorating and we still can't see a bottom. The reason California is having such a hard time is most of the houses there are priced over $417,000 which puts them in the jumbo loan category.

No bank wants anything to do with jumbo loans because they consider them to be more risky. This is why the interest rates on a jumbo are now around close to 8%. Many Californians stretched to buy these houses by using loan products like subprime which are no longer available in today's mortgage market.

This spells disaster if you bought a home with a subprime product and it cost you $417,000. I predict many of these homes will not be sold until they get underneath the 417k category.

You need to assume most of these buyers don't have the money to short sell these houses at $417,000 or below, so expect most of them to walk away are get foreclosed on.

The reason I say this is because these buyers wouldn't have used a subprime loan if they had the cash for a solid downpayment. Anyone with the money to really afford such a house would have used a conforming loan.

When you realize many of these houses are now in the red by $100,000 or more, its easy to see how this will end very badly.

The fact that 64% of home sales in '08 were under $500,000 in the article above versus only 40% last year is starting to bear this out. Expect the under 500k number to continue to rise.

Bottom Line:

Housing prices will continue to decline in California because there are still many more subprime loans that still have not reset. As a result, there will be more foreclosures which will result in higher inventories. This combined with tougher lending standards will continue to push prices down further in 2008 and beyond.

I still wouldn't be buying foreclosures in California. As long as prices are accelerating to the downside, you will be catching a falling knife.

This is an easy way to get cut!