John Mauldin's Outside the Box : Housing

The China Files (Special Project): Real Estate

John Mauldin — Thu, 15 Oct 2009 15:46:00 GMT

Today I offer you an insightful look at China's real estate market - a "burgeoning bubble" that deserves a close eye as the possibility for breaking increases. Remember the chaos in Japan after their own housing dreamscape got violently yanked back to earth? As investors, we have to recognize opportunities - and know what to avoid. With a global economic crisis - and now surging housing prices in China - investors in any global market need to keep watch on political and economic developments around the world.

Today's analysis comes courtesy my friends at STRATFOR, a global intelligence company. They provide unique and on-the-money analysis and forecasts on all things global, essential for any alternative investment strategy. They've got a free newsletter as well, for which I encourage you to sign up by clicking here - so you're not limited to my caprice.

John Mauldin
Editor, Outside the Box

The China Files (Special Project): Real Estate

October 13, 2009 | 1149 GMT

Summary

The real estate market in China, particularly the residential side, is a burgeoning bubble that is growing bigger and more breakable by the day. Land and housing prices were already rising steadily when Beijing's stimulus package hit the sector in early 2009. Now prices are surging, with developers, bureaucrats and investors cashing in while urban Chinese - once encouraged to invest in home ownership by the central government - become less and less able to buy.

Editor's Note: This analysis is part of a series that explores China's industry, finance and statistics.

Analysis

Origins of the Bubble

Since 1978, China's pace of urbanization has increased dramatically, with the number of middle-size and large cities (those having nonagricultural populations of more than 200,000) growing rapidly. Beginning in 1985, economic reforms implemented in urban areas to make China's planned economy more market-oriented added even more momentum to the real estate boom, with real estate investment increasing by 71 percent by 1987. The government's macroeconomic policy of monetary belt-tightening helped cool this overheated market, which was further tempered by the government's continuing to provide housing for state employees (fu li fen fang, or "welfare housing").

However, when the state significantly cut back on its welfare housing program in 1998, the Chinese perception of personal property changed, and this would have an important impact on the real estate sector. The government began this privatization process by making a private dwelling a "commodity" and granting the purchaser the right to own a newly built house for 70 years. (Likewise, the developer who buys the property on which residential or commercial buildings are to be constructed may own that property for 70 years.) Home ownership in China could now be a sound financial investment.

Thus, the residential real estate market would boom in almost every urban area in China - and particularly in the "first-tier" and "second-tier" cities (only Beijing, Shenzhen, Guangzhou and Shanghai are in the first tier, with more than 20 cities, and mostly provincial capitals or coastal ports are in the second tier). But rising land prices would eventually put housing prices out of reach for the general public. In Dongguan, a coastal second-tier city in Guangdong province, land prices averaged 4,957 yuan ($726.42) per square meter in 2007, a more than 500 percent increase from 2003, while personal disposable income increased 24 percent during the same period (from 20,526 yuan [$3,008] to 27,025 yuan [$3,960] per year).

A 2006 survey conducted by the National Development and Reform Commission showed that the average ratio between housing prices and income was approaching 12:1 in many large and middle-size cities in China (in Beijing it had reached 27:1). Twelve to one is significantly higher than the World Bank's suggested affordability ratio of 5:1 and the United Nations' 3:1. The problem was compounded by the fact that, of the more than 80 percent of Chinese who owned their own homes in urban areas (generally considered cities with populations of more than 20,000), 54.1 percent were making monthly mortgage payments that constituted 20 percent to 50 percent of their monthly incomes.

The Recovery Bubble

Following a temporary drop toward the end of 2007, land prices rose steadily, then began surging again with Beijing's stimulus package and a flood of easy credit in 2009. With much of this money flowing into the real estate sector, major beneficiaries included large state-owned enterprises (SOEs) involved in speculative real estate and housing investment, contributing to the inflating bubble. Among the 10 highest-priced land purchases in major cities in the first half of 2009, 60 percent went to SOEs.

Paradoxically, as the global financial crisis continues, China sees little choice but to loosen its monetary policy even further, fearing the opposite would curtail economic growth and result in massive unemployment, which could lead to social instability. Beijing knows that one of the country's underlying economic problems continues to be an overheated real estate market, but it also knows that the real long-term solution - limiting the flow of cash and credit - could have dire socio-economic ramifications. Meanwhile, real estate developers, government officials and investors continue to speculate on real estate, raising land and housing prices.

As housing prices continue to rise, a parallel trend is manifesting itself - rising vacancy rates in urban areas. A 2009 report by the Shanghai Yiju Real Estate Research Institute revealed that, by the end of 2008, the average vacancy rate for "commodity housing" (as opposed to welfare housing) in Beijing was 16.64 percent, and vacancies reached as high as 30 percent in some districts. Most of these vacant houses, however, are not unsold ones. They have been purchased by investors as speculative investments. While there are fewer and fewer ordinary people who can afford to buy houses, there is still excessive demand for investment housing - pressure that continues to drive up the prices.

This closed loop in the Chinese real estate market is facilitated by the country's political and bureaucratic system. In China, all land is initially owned by the state, and local governments have the sole authority to sell it. And income from property taxes and land sales are a primary source of revenue for local jurisdictions. According to estimates by the State Council's Development and Research Center, tax revenue from the land in some jurisdictions accounts for 40 percent of the local budget. Moreover, net income from land sales accounts for more than 60 percent of the local governments' extra-budgetary revenue. The soft budget and lack of accountability to the people reinforces the local governments' incentive to expand their real estate investments without much concern for cost or impact on public services.

Economic performance also is the prime prerequisite for bureaucratic advancement, which gives local officials the incentive to generate as much revenue as possible through land auctions. And this generally involves a level of collusion - and corruption - among government officials, real estate developers and investors.

One typical strategy is for a developer to buy a big chunk of urban land from the local government but leave the land undeveloped, or build on only a small portion of it, thereby keeping the housing supply limited. Despite various state policies to lower land prices in order to make homes more affordable, local government officials and real estate developers control the land auctions. When a lower sale price is dictated from above, it is easy enough for the local sponsors to officially deem the auction a failure. Even when the developer does build houses on the property, a speculative investor, working hand in hand with the developer and government officials, can bribe both parties to ensure that he can buy all the houses at a low volume price and keep them off the market, thereby maintaining a limited supply and high prices.

Another factor that enters the equation is a cultural one. The Chinese people generally prefer to buy new houses, as opposed to renting homes or buying secondary houses in which people have already lived. Indeed, in urban areas, marriage proposals often include a promise to buy a new commodity house. As a result, the secondary housing market remains very small in comparison (due also to fewer available bank loans for lived-in houses and the complicated process involved in transferring ownership).

All of these factors contribute to the burgeoning real estate bubble - and make it difficult to predict when that bubble will burst. With 70 percent of real estate investment in China coming from bank loans, a dramatic drop in land values could send shock waves throughout the economy. There are already signs of decline. In Shenzhen, one of China's first-tier cities, real estate prices have been dropping for the past two years (30 percent for housing), and many developers and speculators have suffered great losses. The threat looms in other large cities such as Beijing and Shanghai and may be emerging in many second-tier cities as well.

Given the current global economy and the economic balancing act it must maintain domestically, Beijing has few good choices. It must keep enough cash flowing to maintain economic growth and social stability in the short term while tightening credit to avoid a tsunami of bad loans and a market collapse over the long term. Certainly, Beijing does not want to face the kind of collapse in the housing market that Japan experienced in the 1990s, which triggered a financial crisis and more than a decade of economic malaise.

But in China's real estate, as in most sectors of this vast and complex land, implementing and enforcing prudent regulation has never been an easy task

Fear for a Lost Decade

John Mauldin — Mon, 15 Jun 2009 19:02:56 GMT

Before we get into this week's Outside the Box, let me give you a few pieces of data that came across my desk this morning, which will help set the stage for the OTB offering.

Fitch (the ratings agency), in a downgrade of yet another 543 mortgage-backed securities of 2005-07 vintage, gives us the following side notes: "The home price declines to date have resulted in negative equity for approximately 50% of the remaining performing borrowers in the 2005-2007 vintages. In addition to continued home price deterioration, unemployment has risen significantly since the third quarter of last year, particularly in California where the unemployment rate has jumped from 7.8% to 11%... The projected losses also reflect an assumption that from the first quarter of 2009, home prices will fall an additional 12.5% nationally and 36% in California, with home prices not exhibiting stability until the second half of 2010. To date, national home prices have declined by 27%. Fitch Rating's revised peak-to-trough expectation is for prices to decline by 36% from the peak price achieved in mid-2006. The additional 9% decline represents a 12.5% decline from today's levels."

So, what does an aging population do that has seen its retirement nest egg in the form of housing and stocks go literally nowhere for 12 years? You go back to work! David Rosenberg, now with Gluskin Sheff, offers us this insight:

"What really struck us in the employment report of a few weeks ago was the fact that the only segment of the population that is gaining jobs is the 55+ age category. This group gained 224,000 net new jobs in May while the rest of the population lost 661,000. In fact, over the last year, those folks 55 and up garnered 630,000 jobs whereas the other age categories collectively lost over six million positions. This is epic." [See chart below.]

"Moreover, the number of 55 year olds and up who have two jobs or more has risen 1.1% in the last year, the only age cohort to have managed to gain any multiple jobs at all. Remarkable. These folks have seen their wealth get destroyed by two bubble-busts less than seven years apart — the Nasdaq nest egg back in 2001 and the 5,000 square foot McMansion in 2007. Both bubbles ended in tears ... and so close together."

With that as backdrop, what are we to make of the prospects for recovery over the next decade? Not much, if we listen to Professor Paul Krugman of Princeton. He suggests that the developed world could be entering a lost decade, just like Japan after their crash. Let me quickly point out that I routinely disagree with Krugman on a large number of issues. And I usually know why I disagree and believe his policy suggestions are wrong.

That being said, one purpose of Outside the Box is to look at ideas and thinkers that we may not always agree with. Krugman certainly qualifies on that front for me. However, it must be admitted that he is a very smart man. Further, his thinking is important, because it somewhat reflects the thinking of that part of the establishment that is in charge of the Fed and the Treasury. And while we are not getting gloomy long-term forecasts from either the Fed or the Treasury, I find it remarkable that Krugman is less sanguine than his peers. And there is much (certainly not all!) within this interview that I find myself in surprising agreement with. This one made me think as I read and reread it.

If he is correct, the rosy recovery assumptions built into the already bloated budget projections are going to be far too optimistic, not just for the US, but throughout Europe as well. Krugman is interviewed very capably by Will Hutton, a veteran writer and economist for the UK Guardian (a bastion of liberal politics). The direct link is http://www.guardian.co.uk/business/2009/jun/14/economics-globalrecession.

Green shoots? Really? I invite you to read and think about what this interview means for the road to recovery. I will take this up more in next Friday's missive. (Note, I did not write a letter last week. There was a new Mauldin grandchild on Friday, and I decided that some things just take precedence.) Have a great week.

John Mauldin, Editor
Outside the Box

Fear for a Lost Decade

As analysts and media hailed the tentative emergence of green shoots last week, Nobel Prize-winning economist Paul Krugman caused international shock with a prediction that the world economy would stagnate just as badly, and for just as long, as Japan's did in the 1990s. In an exclusive interview, he talks to Will Hutton about his anxiety for the future.

Will Hutton: You are warning that what happened to Japan could happen to the whole world. Japan's GDP at the end of this year will be no higher than it was in 1992 -- 17 lost years. You are saying that this is an ongoing risk, certainly for the North Atlantic economy – – maybe the world economy.

Paul Krugman: Yes. It's not that the risk of the Japan syndrome has receded very much. The risk of a full, all-out Great Depression – – utter collapse of everything – – has receded a lot in the past few months. But this first year of crisis has been far worse than anything that happened in Japan during the last decade, so in some sense we already have much worse than anything the Japanese went through. The risk for long stagnation is really high.

WH: So what is the heart of your pessimism? The bust banking system? A critic would say: "Hold on, Paul Krugman. Japan is a special case. It had an overblown export sector that had become too large for an American market it had saturated. The yen was very, very overvalued. And this interacted with a credit crunch and bust banking system. Its policy response was consistently behind the curve. That's not the story of the United States or the United Kingdom."

PK: The thing about Japan, as with all of these cases, is how much people claim to know what happened, without having any evidence. What we do know is that recessions normally end everywhere because the monetary authority cuts interest rates a lot, and that gets things moving. And what we know in Japan was that eventually they cut their interest rates to zero and that wasn't enough. And, so far, although we made the cuts faster than they did and cut them all the way to zero, it isn't enough. We've hit that lower bound the same as they did. Now, everything after that is more or less speculation.

For example, were the problems with the Japanese banks the core problem? There are some stories about credit rationing, but they are not overwhelming. Certainly, when we look at the Japanese recovery, there was not a great surge of business investment. There was primarily a surge of exports. But was fixing the banks central to export growth?

In their case, the problems had a lot to do with demography. That made them a natural capital exporter, from older savers, and also made it harder for them to have enough demand. They also had one hell of a bubble in the 1980s and the wreckage left behind by that bubble – – in their case a highly leveraged corporate sector – – was and is a drag on the economy.

The size of the shock to our systems is going to be much bigger than what happened to Japan in the 1990s. They never had a freefall in their economy – – a period when GDP declined by 3%, 4%. It is by no means clear that the underlying differences in the structure of the situation are significant. What we do know is that the zero bound is real. We know that there are situations in which ordinary monetary policy loses all traction. And we know that we're in one now.

WH: So your point is that the crisis in Japan was about excess debt, excess leverage and lack of demand – – reinforced by the fallout from the asset bubble collapsing. They didn't have credit contraction on anything like our scale, but even so, zero interest rates were just unable to turn the economy around.

PK: That's right, that's right.

WH: But an optimist would say that there are signs all around of the traction that you say doesn't exist is working. The stockmarkets in London and Wall Street – – along with most world markets – – are up a solid 20% to 25%. You've got all these improving business confidence indicators. You've got the first signs of the housing market bottoming in both the UK and the United States. This is what the optimists would tell you.

PK: But all of that points to levelling off, rather than an actual recovery. Britain's looking the best among the major European economies because it's got a PMI [purchasing managers' index, a key measure of economic sentiment] that's just above 50. In other words, Britain actually may have stopped contracting – – that's the most positive thing one can say.

Who knows if the stockmarket makes sense or not? It was pricing in the possibility of an apocalypse a few months ago. That possibility seems to have receded, so it makes sense for the markets to come up, but that's not saying that the economy is going to be great. If you do the comparison not with where they were three months ago, but where they were two years ago, then the markets still seem awfully depressed.

I hope I'm wrong but the question you always have to ask is: where do we think that this recovery's going to come from? It's not an easy story to tell.

WH: In your lectures, you drew attention to the importance of stressed balance sheets holding back consumers and business alike in their likely spending ambitions – – and thus dragging back economic activity. Is this going to be a balance-sheet-constrained recovery?

PK: It's probably true that households have been impoverished a lot by the fall of the housing and stock prices. And that it's likely that households, with all of this debt, are going to have trouble spending. And yes, the North Atlantic economy was supported quite a lot by gigantic housing booms. Here in the UK you have had the house price surge without very much construction. Economists have a well-developed theory about how balance-sheet problems can cause financial and economic crises, but we thought of it in terms of third world countries with foreign-currency debt. We didn't realise that there were lots of other ways in which that can happen.

WH: So, one way to think about it is that self-reinforcing financial crises rooted in overstretched, overborrowed companies and governments in less developed countries – – like those in Argentina and Indonesia, which were amazingly destructive in the 1990s and 2000s, but localised – – are now playing out in the developed world?

PK: There are really two stories. One is the Japan-type story where you run out of room to cut interest rates. And the other is the Indonesia- and Argentina-type story where everything falls apart because of balance-sheet problems.

WH: So in a nutshell your story is ...

PK: The "Nipponisation" of the world economy with a bunch of "Argentinafications" playing a role in the acute crisis. But even after those are over, we have the Nipponisation of the world economy. And that's really something.

WH: What was the heart of the Japanese problem? What was at the heart of their 17 years of going nowhere?

PK: Well, my guess is that it was that the balance-sheet problems took a very long time to resolve. And it is difficult to get enough demand in an economy where you have really very adverse demography ...

WH: So, which countries look closest to being Nipponised – – combining balance-sheet problems and ageing populations?

PK: Well, the US doesn't have the same combination. But in Europe, Germany and Italy look comparable. France is better and Europe as a whole is considerably better.

WH: Germany matches Japan to an uncanny degree. You talk about the Nipponisation of the world economy: I'm not so sure. But I would talk about the Nipponisation of Europe via a German economy at its centre in the grip of the same problem – – and that starts to be a global problem.

PK: Germany has huge inadequacy of domestic demand. Their economic recovery in the first seven years of this decade rested on the emergence of gigantic current account surplus.

How is it possible that Germany, which did not have a house price bubble, is having a steeper GDP fall than anyone else in the major economies?

The answer is that they depended upon exporting to the bubble regions of Europe, so they actually got side-swiped by the loss of those exports worse than the bubble regions themselves got hit.

It's Germany on a global scale that is the concern. We worry about the drag on world demand from the global savings coming out of east Asia and the Middle East, but within Europe there's a European savings glut which is coming out of Germany. And it's much bigger relative to the size of the economy.

WH: And on top there is an unique and unaddressed huge potential banking crisis. The Germans pride themselves on their three-legged banking system, but it is incredibly interlinked. The IMF warns that Germany could have to take at least $500bn of writedowns, which its banks have not begun to recognise. German banks hold a trillion dollars – – maybe more – – of maturing collateralised debt obligations that can only be refinanced by crystallising the losses. We've had RBS and you've had Citigroup. Germany's GDP will fall 6% this year – – before the banking crisis has hit it.

PK: Yeah, that's the financial view. Its important to keep track of the financial state of the banks. But one always has to keep track of the real side of the economy, too. It is a hypothesis that the problem is essentially financial. But it is by no means a hypothesis that we know is true.

WH: So even after what we've gone through, you say it's just a hypothesis that the cause of the crisis is financial?

PK: That the cause is primarily financial. Certainly, Lehman and all of that alerted us all. And it did trigger an immediate drop in demand. But the housing bust was going to happen regardless.

The fall in business investment is at least to a large degree a response to excess capacity, which is the result of falling consumer demand and the housing bust. So we don't know.

WH: I think we know more than that. The links between bank capital, loan losses, credit availability and economic activity and asset prices have never been clearer. That was why there was a threat of Depression.

PK: Clearly, re-establishing stability in the financial markets is a necessary condition for recovery. But we're not sure it's sufficient.

WH: That's very scary.

PK: Well, that is part of the reason why I am so depressed.

WH: In one of your lecture charts you seemed to be suggesting that we're 12 months into what you think could be a 36-month period of downturn, albeit at a slower rate.

PK: Easily.

WH: It's quite shocking that you think it will be that severe.

PK: If we measure the 2001 US recession by when the labour market finally started to turn around, it was a 30-month recession. It was really 30 months in before you started to see the unemployment rate come down.

WH: In Britain, there is now a new consensus forming that the government's economic forecasts, which were roundly mocked at the time of the April budget for being wildly optimistic, could be right – – that is, growth will start to resume in 2010, albeit at a very low rate.

PK: Well, the UK has achieved a lot of monetary traction in the way that no one else has through the depreciation of the pound. In effect, you've carried out a successful beggar-my-neighbour devaluation.

WH: So, the United Kingdom might actually get through this in reasonably good shape?

PK: Yeah. That's why I've been watching with an outsider's slight puzzlement, your bizarre political circus.

WH: Darling and Brown deserve more credit than they're given?

PK: If the government can hold off having an election until next year, Labour might well be able to run as "we're the people who brought Britain out of the slump".

WH: So your advice to the Labour Party is: hold steady.

PK: Probably.

WH: Probably?

PK: I don't know enough about the other aspects of politics, but I would guess that the option value is quite high that the economy might actually have turned a corner. That's unique. That's a uniquely British thing. None of the other G7 countries has anything like that.

WH: And that's a combination of our big beggar-our-neighbour devaluation, aggressive monetary policy, successfully recapitalising our banks and our fiscal policy.

PK: There hasn't been very much discretionary fiscal expansion when all's said and done.

WH: Well, there was a £20bn temporary cut in VAT.

PK: Yeah.

WH: Which is non-trivial.

PK: Non-trivial. But not much [other spending], as I understand.

WH: Well, there was bringing forward £3-4bn of capital spending. Perhaps together in a full year the stimulus was 1.5% GDP. Maybe 2% at the outside.

PK: Monetary policy has been more aggressive – – though maybe less than the Fed – – and the depreciation of the pound is a nice thing from a UK point of view.

WH: So you remain committed to the key role of fiscal policy?

PK: Yeah. Fiscal policies are best; certainly something to do to mitigate recession. People say that the Japanese fiscal policy on all that infrastructure was wasted. But it did help sustain the economy and avoid a collapse. Fiscal policy can certainly do that: it gives the credit sector time to rebuild its balance sheets. There's every reason to be expansive around the fiscal side now because even if you're not sure that it provides a long-term solution, avoiding catastrophe is a big thing to do.

WH: If you believe that, is Obama doing enough on fiscal policy?

PK: Well we have a stimulus which is a little over 5% of one year's GDP but some of it is not real – something that was going to happen anyway and not very stimulative. So it's really about 4% of GDP of genuine stimulus, but spread over two and a half years. So, it's actually quite a lot less than what I was arguing for.

WH: So, will it be sufficient?

PK: Well, sufficient to actually restore full employment would probably have to be 5% or more. More than we have would certainly be a good thing. It actually might happen. You know, the buzz I'm getting is that a second-round stimulus might well come on the agenda.

WH: Really? When you say "the buzz you're getting", have you been asked?

PK: Well, it's what you hear from people who talk to people who talk to people.

WH: Who would argue for that? Would it be Larry Summers [director of the US National Economic Council]?

PK: I think Larry. I'm not sure Tim Geithner [US treasury secretary] would be opposed to it. Nor would Chrissie [Christine Romer, director of the Council of Economic Advisers] I'm sure they would be making similar judgements. It is actually a little spooky.

WH: They're all people you know pretty well, who look at the world the same way, use the same tools and framework ...

PK: Yeah. They may be sitting where they are, having some differences. Larry's always more conventional than I am. Sometimes rightly. Sometimes wrongly. But they do operate in the same framework.

WH: How seriously do you take the argument that the growth of public debt on this scale will crowd out the spontaneous amount of growth of corporate and private debt? Is this already happening with the rise in long-term interest rates in the US?

PK: The thing about long-term interest rates is that they are a weighted average of future expected short-term interest rates. Movements in long-term rates are mostly about what people think the short rates are going to be. Look, real rates are barely up at all. What seems to have moved up is the expected rate of inflation, which is still below the Fed target. So it's more like what the markets are doing is reducing their discounting of deflationary catastrophe. WH: how do you see the politics working out in the States and in the UK now? Your praise of Gordon Brown after the banks in October were recapitalised was front-page news. Are you still as well disposed?

PK: I still think his economic policies have been pretty good. They really kind of lost their nerve on fiscal policy, but I do understand it's harder to do it here. I think the UK economy looks the best in Europe at the moment. I have no position on all of the crazy stuff. But I think the policies are intelligent. The fact of the matter is that Britain did manage to stabilise the banking situation. I'm not ecstatic, but I'm not sure I know what I could have done better.

WH: So where are you on the debate about various shape recoveries? V-shaped? L-shaped ? A W-shaped recovery?

PK: There is a possibility that we get some perk-up as the stimulus dollars start to flow and an almost mechanical bounceback in industrial production as inventories are built up. But then we slide down again. The idea that we sort of bounce along the bottom is all too easy to imagine.

WH: Is it just a story about the right dose of fiscal policy? What structural change would you advocate in the economy, to support recovery?

PK: Financial regulation. Rein in that monster. The huge increase in general private-sector leverage is at the core of how we got so vulnerable. We went for 50 years after the Great Depression without any major financial crises, and that, I think, was because we had a financial sector that didn't let people get as deeply into debt as they have now.

WH: So rein in the financial monster and give a fiscal stimulus. So you would leave the American way of doing capitalism untouched?

PK: I'm not that cosmic in this stuff. But it is true that Gordon Gekko [the anti-hero of Oliver Stone's film Wall Street, motto: Greed is Good] went hand in hand with the wave of financialisation. Corporations got more brutal and fiercer.

WH: But it is all connected. Without the leverage, there would have been no Gordon Gekkos. And leverage meant that predator companies had the firepower to launch contested hostile takeovers. The only way to fend off attack, or to make the sums work after an attack, was for companies to be more brutal and fierce – often breaking the promises to staff and suppliers that kept commitment and trust.

PK: All of that is true. I have a more mundane view about what we do. I just want a stronger welfare state and a little bit more social democracy. And some restoration of the labour movement as a counterweight.

I'm not sure – maybe I'm just not thinking about it deeply enough. I guess I've got the same attitude Keynes had, which was he was looking for almost technical fixes. You're looking for ways to fix the parts that have gone wrong rather than replace the whole thing.

You know the human cost of this crisis is vastly worse in America than it is on this side of the Atlantic. So this is a good time to push for a better US social safety net too.

WH: And lastly – you've been critical about Obama. Your view now?

PK: I'm increasingly happy with him. I was unhappy; I think they could have gotten a bigger stimulus coming out the gate. But they've become more forceful. I would have been more aggressive on the banks; we'll see if we need to re-fight that battle later on.

Healthcare is looking really good. I'm getting increasingly optimistic on healthcare reform. Climate change looks like it's going to happen. So my odds that this will in fact be the kind of New Deal I was hoping for are rising. I had my scepticism, but he is smart. He's impressive. And it is such a relief to have somebody whom you can respect in the White House.

The Financial Commentator on the Economy

John Mauldin — Mon, 04 May 2009 20:04:47 GMT

Late last week a letter from Jim Welsh crossed my desk. I started reading and found myself being pulled through his very thoughtful letter. I have not met Jim, but think this letter is worthy of an Outside the Box.

Jim Welsh of Welsh Money Management has been publishing his monthly investment letter, "The Financial Commentator", since 1985. His analysis focuses on Federal Reserve monetary policy, and how policy affects the economy and the financial markets.

The Financial Commentator on the Economy

Perspective – A way of regarding facts and judging their relative importance.

There are a number of data series that evaluate economic conditions using a diffusion index. A diffusion index will have a value above 50, when a plurality of respondents are positive, and below 50 when a majority are negative. If a diffusion index increases from 35 to 38, it represents a gain of 8.6%, while a rise to 46 from 45 is only a gain of 2.2%. It is natural to think of the larger percentage gain to be more noteworthy. However, the smaller gain is actually more significant, since it will only require a small further improvement, before actual economic growth is achieved. In recent weeks, many economists and market strategists have heralded the end of the recession and the arrival of spring, after spotting a few 'green shoots' of improvement. In most cases, the 'green shoot' was a modest up tick, from a multi-decade low! For instance, the Conference Board's Consumer Confidence Index edged up to 26.0 in March, from 25.3 in February, the lowest reading since records began in 1967.

In February, new home sales were up 4.7% to 337,000, and after that robust increase, were only down 75.7% from their July 2005 peak. In the last three years, housing starts have plunged from 1,823,000 to 358,000, or 80.4%. At the February sales rate, it will take 12.2 months to clear the inventory of new homes for sale, versus 5 months in a healthy market. In the past year, the median price of a new home has fallen from $251,000 to $200,900, a drop of 20%. After retail sales collapsed in the fourth quarter, the inventory-to-sales ratio soared from 1.25 to 1.45, or 16%. Companies were forced to cut production drastically in the first quarter, so bloated inventories could be whittled down. Although the ratio dipped to 1.43 in February, production levels will remain low, until the ratio falls further. The large decline in production will contribute to a fairly weak first quarter, and depress second quarter GDP too.

As noted last month, there is a good chance that GDP will post a positive print in the fourth quarter of this year, and maybe in the third quarter. Most of the 'gain' will be statistical nonsense, but that won't deter most economists from getting excited. In the last 2 years, the 80% plunge in housing starts has subtracted about .9% from GDP each quarter. If housing starts stabilize near February's level in coming months, the .9% hit to GDP will become 0%. If inventories are brought down by the fourth quarter and are in line with sales, the decline of 1% to 2% to GDP from production cuts in the first and second quarter could also improve to 0%. In the fourth quarter last year, personal consumption fell an extraordinary -2.99%, as consumers turned into Grinches.

But consumer spending improved in the first quarter, as government income transfers of $127 billion offset the decline in wages and salaries of $89 billion. In the second quarter, social security recipients will receive a onetime $250 payment in May. Tax refunds are up 11% from last year, and the decline in gasoline prices is also providing a boost to incomes. Consumers will use the extra disposable income to pay down debt, and increase savings and spending. All of these factors should help swing personal consumption to a positive for GDP in coming quarters.

In the second quarter of 2008, GDP grew 2.8%, which is a respectable number. Despite this growth, job losses continued each month, and a self sustaining economic expansion failed to take hold. The most important issue in the next 12 to 15 months is whether the rebound in the second half of 2009 and first half of 2010 will gain enough traction to launch a self sustaining economic recovery. There are many reasons why I remain skeptical.

In the first three months of 2009, more than 2 million jobs were lost, causing the unemployment rate to jump from 7.6% to 8.5%, the highest since November 1983. The unemployment rate increased in March in 46 states, with California, the world's eighth largest economy, hitting 11.2%, the highest since January 1941.

Underemployment, which combines the unemployed, with involuntary part time workers and discouraged workers, reached 15.6%. As noted in recent months, post World War II recessions have on average caused personal income to fall between 4% and 7%, and this one has further to go. Wages and salaries shrank at a 4% annual rate in the first quarter, and according to Deutsche Bank, payroll-tax withholding receipts collected by the Treasury Department are down 8.2% from a year ago. This suggests that personal income growth will remain weak in coming months, and shave more than $250 billion from total income and future demand. Changes in temporary jobs lead reversals in the overall labor market by 6 to 10 months. In 2007, a continuous decline in temporary jobs and hours worked led me to forecast a decline in jobs in 2008. When non-farm jobs fell in January 2008, most economists were shocked, and the stock market sold off sharply. In March, employers cut 71,700 temporary workers, so any real improvement in job growth is many months away.

Most economists are quick to note that unemployment is a lagging indicator, and they're right. But the magnitude of the job losses shouldn't be dismissed so glibly, given the impact they are having on the banking system. The American Bankers Association reported that 3.22% of consumer loans were delinquent at the end of 2008. That is the highest level since the ABA began tracking overall loan delinquency rates in the mid 1970's. And that was before 2 million jobs were lost in the first quarter.

An average of 5,945 bankruptcy petitions were filed each day in March, up 9% from February and 38% from a year ago. The soaring job losses since last September are certainly behind the increase in bankruptcies.

The surge in job losses are working their way up the income ladder, with an increasing number of middle income and upper middle income workers being affected. This is pushing many of those who previously were considered prime credit risks over the edge. Two-thirds of mortgages in the U.S. are held by the best credit risk, prime borrowers. According to the American Bankers Association, 5.06% of prime borrowers have missed at least one mortgage payment. Since prime borrowers are such a large group, this represents 1.8 million mortgages. Although the delinquency rate for sub prime mortgages is up to 21.9%, it only accounts for 1.2 million mortgages.

In the fourth quarter, a number of states mandated a freeze on foreclosures, and a number of banks, not wanting to be a modern day Mr. Potter during the holidays, voluntarily suspended foreclosures. According to RealtyTrac, foreclosure filings increased to 341,180 in March, up 17% from February, and up 46% from a year ago. After the foreclosure moratorium expired in California, notices of trustee sales, which precede foreclosure sales, climbed more than 80% to 33,178 in March from February. Moody's Economy.com estimates more than 2.1 million homes will be lost this year, up from 1.7 in 2008.

Existing home sales have declined 33.3% since peaking in September 2005. The median price has dropped 28.7%, after peaking in July 2006 at $230,900. In February, existing homes sales increased 4.4%, and the median home price advanced 2.4%. The ratio of monthly sales to the inventory of homes for sale was 9.5 months, versus 5 months in a healthy market. However, 45% of the sales in February were foreclosures, and that proportion will remain high in coming months. Since foreclosed sales represent forced selling, the persistently high level of foreclosures will continue to push home prices lower. As home prices fall another 5% to 10% or more, more home owners will realize that their mortgage exceeds the value of their home. An increasing number are simply choosing to walk away, since they have nothing to lose.

According to RealtyTrac, job losses result in a home foreclosure 10% to 15% of the time. If job losses narrow from the monthly average of 670,000 in the first quarter to 325,000, almost 3 million more jobs will be lost before year end. That will translate into another 300,000-450,000 foreclosures, and an unemployment rate of almost 11%. But what if that estimate of job losses is too optimistic?

New research by the Federal Reserve and Boston University of credit spreads of 900 non-financial companies from 1990-2008 predicted changes in the economy 'phenomenally' well. Based on their initial research on low to medium risk corporate bonds with more than 15 years to maturity, the researchers went back to 1973 and found the analysis still worked well. With the massive widening of corporate bond spreads last fall, the researcher's model predicts the economy will lose another 7.8 million jobs by the end of 2009, and industrial production will fall another 17%. In the spirit of optimism, let's assume this 'phenomenal' model is off by 35%, due to the extreme nature of this credit crisis. That still results in another 5.1 million lost jobs, and an 11% drop in industrial production. In that scenario, the unemployment rate climbs to near 12.5%, the underemployment rate breaches 20%, and another 500,000-750,000 foreclosures result.

The International Monetary Fund (IMF) now estimates the U.S., European, and Japanese financial sectors face losses of $4.1 trillion. Banks are confronting losses of $2.5 trillion, insurers $300 billion, and other financial institutions $1.3 trillion. To date, the banking sector has written down $1 trillion of expected losses. The IMF estimates that U.S. and European banks need to raise $875 billion in equity by next year to return to pre-crisis levels.

Over the last week a number of banks have reported first quarter earnings, which was a pleasant surprise. Citigroup said it made $1.6 billion. One of the ways Citigroup achieved this gain was booking a profit of $2.7 billion on the decline in Citi's own debt. Say what? Under accounting rules, Citi was allowed to book a one-time gain equivalent to the decline in its bonds because, in theory, it could buy back its debt cheaply and save $2.7 billion over time. Of course, Citi didn't actually do that. Even though more consumer loans went bad in the first quarter, Citi reduced its loan loss reserve from $3.4 billion in the fourth quarter to $2.1 billion in the first quarter, thereby picking up another $1.3 billion of 'earnings'. And the recent change in mark to market accounting enabled Citi to book an additional $413 million in 'profit' on impaired assets. Without theses one-time adjustments, Citi's $1.6 billion in first quarter profit becomes a $2.8 billion loss.

According to a Wall Street Journal analysis of Treasury Department data, the 19 banks that received tax payer funds made or refinanced 23% less in new loans in February versus last October. Why lend money when all you've got to do is make a few adjustments and make even more money.

Between 2000 and 2008, the major credit card companies increased the number of credit cards issued to small businesses from 5 million to 29 million. During that period, many small business owners increasingly relied on their cards to provide short term financing for their business. Spending on small business credit cards increased from $70.4 billion in 2000, to $296.3 billion, according to the Nilson Report. Over the last 15 months, business bankruptcy filings have risen faster than consumer bankruptcies, with the average charge-off rising to $11,000 from $7,000, according to Equifax, Inc. In response, the card issuers have been aggressively scaling back, and have reduced available credit lines by almost $500 billion. Just another example of how the availability of credit to the economy is evaporating, despite all the Fed's efforts.

Industrial production fell 1.5% in March, and is down 12.8% from a year ago. Capacity utilization fell to 69.3%, the lowest since records began in 1967. As I discussed in detail in January, excess capacity is a powerful dynamic. Companies are forced to reduce or eliminate budgeted investments in new equipment, compete for every dollar of revenue, even if it means accepting thinner profit margins, and reduce costs through job cuts. The amount of excess capacity that has been created by the depth of this economic contraction is unprecedented. What most inflation bugs and investors fail to understand is how long it will take to work off the current over hang of excess capacity. If the output gap grows from the current 7% to 10% next year, Goldman Sachs estimates it could be 2015 before all the excess capacity is used up, and that's if GDP grows 4.75% per year! Ironically, one of the reasons the economy is not likely to grow that fast is that business investment will be weaker than in prior business cycles. With so much excess capacity, businesses won't need to materially increase business investment for the next 2 or 3 years.

The economy needs to create 125,000 jobs each month, just to absorb the number of new entrants into the labor market. If job growth were to average 325,000 per month in coming years, it would still take four years to replace all the jobs lost in this recession. With so much excess labor capacity, wage growth will be weak for the next few years, which will make it harder for consumers to increase savings and spending. The combination of less credit availability, weaker business investment and consumer spending will be headwinds whenever the economy emerges from this recession.

The Untied States is mired in the deepest cyclical contraction since at least World War II, and arguably the depression. Falling home prices led us into this crisis, and home prices are still falling. The financial crisis in 2008 has become the economic crisis in 2009, as more than 2 million jobs were lost in just the first quarter, with another 3 to 5 million likely before year end. With the unemployment rate headed over 10%, and maybe up to 12% next year, the default rate on every type of consumer credit – (prime mortgages, Alt-A mortgages, Option Arm mortgages, sub-prime mortgages, home equity lines, credit cards, auto loans, student loans) – is headed much higher. Commercial real estate values are plunging, and corporate default rates are set to soar. Although every bank will 'pass' the government's stress test, some banks will fail the real world stress test, and need billions more in capital. Sooner or later, the Treasury Department will likely have to go hat in hand asking for more money from Congress for some of the banks. For the first time since World War II, the global economy will contract in 2009, so there aren't many places to hide. Although it is welcome to see a few 'green shoots', in this case, those green shoots are unlikely to yield a bountiful harvest in 2010.

In addition to the daunting cyclical problems challenging the economy, there are a number of significant secular issues I've discussed before that will make it even more difficult for a self sustaining recovery to develop in 2010. Between 1982 and 2007, the amount of Total debt grew from $1.60 to $3.53 for each $1.00 of GDP. This was made possible as the cost of money fell from 15% to 20% in 1982 to the generational lows of the last few years. As interest rates fell, consumers were able to take on more debt, without their monthly payments increasing very much.

Household debt has increased from $.44 in 1982 to $.98 for each dollar of GDP in 2007. However, there is no more relief coming from lower rates, so consumers are going to have to pay for their debt from income. From the mid 1990's until 2007, most consumers had the luxury of believing that their homes and 401Ks would provide most of what they would need for their retirement. The saving rate fell from over 8% 15 years ago to near 0% in 2007. The last 18 months has convinced them they need to increase their savings. The saving rate has rebounded to near 4% in the last six months, which is one reason why the economy has been so weak. As debt levels increased over the last 25 years, GDP was boosted as consumer's bought cars, bigger homes, second homes, went on nice vacations, and basically lived the good life. However, since 1966, each dollar of additional debt has given the economy less of a boost. In 1966, $1 dollar of debt boosted GDP by $.93. But by 2007, $1 dollar of debt lifted GDP by less than $.20.

The message from these facts is fairly clear. Debt levels are high, and any increase in interest rates will impose a bigger burden on the economy and quickly stunt growth. Consumer debt is already so high and interest rates are so low that it will be difficult for consumers to add debt. This means economic growth will be far weaker than the debt induced growth of the last 25 years. As consumers increase their savings, GDP will be lowered by .70% for each 1% consumers increase their saving, since consumer spending represents almost 70% of GDP. In addition, the banking system remains crippled. Lending standards are high and are not coming down with the economy remaining weak. The need for additional capital will lower future lending by several trillion dollars, as banks work to repair their balance sheets and lower their leverage ratios from 30 to the low teens. The securitization markets provide more credit than the banking system, but they remain on life support. Credit availability will remain constrained well into 2010, which represents a headwind than will mute some of the lift from fiscal stimulus.

The diminishing boost given to GDP from each additional $1.00 of debt since 1966 strongly suggests that adding more debt will not return the economy to prosperity. I am reminded of a movie from the 1950's, 'The High and the Mighty'. It starred John Wayne and Robert Stack and was about an airline flight from Honolulu to San Francisco. During the flight, one of the engines fails, but they are past the point of no return, so they must try to make it to San Francisco. Over the last 60 years, the United States has used a combination of fiscal stimulus and monetary policy to soften each recession and spur the subsequent recovery, with a fair amount of apparent success. From 1982 until 2007, the U.S. only experienced two shallow recessions that each lasted just 8 months. This stretch of 25 years may be the best 25 years in our economic history. But much of this prosperity was bought with debt, as the ratio of debt to GDP rose from $1.60 to $3.50 for each $1.00 of GDP. Sometime in the last 25 years, we passed the point of no return. Unfortunately, Hollywood won't get to write the script on how this ends.

E. James Welsh

Setting the Bull Trap

John Mauldin — Wed, 07 Jan 2009 23:00:48 GMT

Yesterday I sent you an Outside the Box from Paul McCulley who supports the government and Fed activity (in general) in the current economic crisis. Today we look at an opposing view from Bennet Sedacca of Atlantic Advisors. He asks some very interesting questions like:

Shouldn't the consumer, after decades of over-consumption, be allowed to digest the over-indebtedness and save, rather than be encouraged to take risk?
Shouldn't companies, no matter what of view, if run poorly, be allowed to fail or forced to restructure?
Should taxpayer money be used to make up for the mishaps at financial institutions or should we allow them to wallow in their own mistakes?

I think you will find this a very thought-provoking Outside the Box.

John Mauldin, Editor
Outside the Box

Setting the Bull Trap

by Bennet Sedacca

Bull Trap: A false signal indicating that a declining trend in a stock or index has reversed and is heading upwards when, in fact, the security will continue to decline.

You got to know when to hold 'em
know when to fold 'em
Know when to walk away
and know when to run.
You never count your money
when you're sittin' at the table.
There'll be time enough for countin'
when the dealings done

–Kenny Rogers, The Gambler.

Is the Ultimate Bull Trap Being Set?

Long time students of the market will tell you that "the crowd is usually wrong at the extremes". Judging by what I see, hear and read in the media, the current consensus is that stocks bottomed on November 20^th-21^st, an economic recovery will begin in the second half of 2009, corporate bonds are a buy, stocks are cheap and the stock market is now discounting all the bad news. This is surely a sign that the worst is likely behind us.

Even though I was looking for a low in the S&P 500 around 750 (it bottomed around 740 on November 21^st only to close at 800 the same day), I continue to believe that was a low point, but not THE low point for this bear market. We were large buyers of Mortgage Backed Securities during the Wall Street de-leveraging and have been rewarded with handsome gains, although we began to take some profits on Friday where appropriate.

Corporate bond spreads have tightened during a slow holiday season as well as spreads in CMBS (Commercial Mortgage Backed Securities). Corporate spreads may or may not tighten further as I believe there will be a wave of issuance at every level - Government, Emerging Markets, Corporations, Municipalities, etc. Treasury yields have crashed as the Fed has taken the Federal Funds Target Rate to a range of 0-0.25%.

Stocks have rallied even more to S&P 931 and could possibly make a run at 1,000- 1,100 if "performance anxiety" sets in among those portfolio managers that are afraid to miss the rally. We are not afraid of missing the rally because we are absolute return investors and have the luxury of having missed the big down move from nearly 1,600. The managers that are subject to performance anxiety are the same group that managed to a market benchmark only to get tattooed during the downturn.

The Fed is punishing savers and the Prudent Man by manipulating interest rates to zero. You can sit in cash and earn zero or you can be forced out on the risk spectrum just so you can keep up with inflation or your benchmark.

Forcing money into risky assets is perhaps the most dangerous experiment ever done, and is so large in scale and so unprecedented that we have no idea how it will end. I expect it to end poorly and with hyper-inflation. The funneling of assets into risk is masking the deteriorating fundamentals and giving the appearance of a market that has bottomed. But this is sleight of hand, an illusion

The Fed has declared a war on savers, a war on prudence and provided the ultimate Moral Hazard Card-and with our money no less. They are also setting up the ULTIMATE BULL TRAP-a trap so large that when it is sprung, perhaps as early as the end of the first quarter/beginning of second quarter that there will only be sellers left.

Why is the Federal Reserve Punishing Prudence?

Prudent—Wise in handling practical matters; exercising good judgment of common sense. Careful in regard to owns own interests; provident. Careful about one's conduct; circumspect.

-Webster's Dictionary.

Prudent Man Rule—an investment standard adopted by some U.S. states to govern the action of those responsible for investing money for other people. The fiduciary is required to act as a prudent man or woman would in regards to investing monies of others.

-Bloomberg Financial Definition.

Ever since 1995, the Federal Reserve and other authorities have been assisting in the birth of the largest debt bubble in our nation's history. Money supply has grown exponentially, weak businesses have been formed and failed, the consumer is leveraged up to their eyeballs, regulation is poor, and savings have dried up. Further, the brokerage/investment banking industry has been pummeled beyond recognition; lifelines have been given to everyone from poorly run banks to poorly run auto manufacturers. Esoteric securities have been relocated from the balance sheets of reckless banks and brokers to the U.S. Treasury, FDIC and Federal Reserve. Investors worldwide watched $30 trillion of stock market equity disappear in the past year while home prices have cratered by better than 25%. What other goodies do we have?

Unemployment on every front is rising. market that has bottomed.
Tax receipts are down and State Governments are suffering.
The debt market, except that artificially supported by the Government is closed.
Earnings estimates for the S&P 500 are down 60% year-over-year.
Stocks (using the Dow as a proxy) are at the same level they were 10 years ago.
Industrial Production around the globe is imploding.

I could go on and on and on and on, but there really is no point. I could show 25 graphs or more of what is wrong with America's economy and for that matter, much of the rest of the global economy and global markets.

Here is the magical question: "why is there is so much bad news, and is it fully discounted in prices?" If so, "why are the Fed, FDIC and Treasury Department so desperate to drive down interest rates to zero, buy troubled assets, ruin what used to be an efficient debt market in Mortgage Backed Securities, Corporate Bonds and Preferred Stock?"

There seems to be two distinct markets that have developed for debt—one that the U.S. Government stands behind with all of OUR money and the one that exists in the "free market".

Before I show a few examples of why prudence is being penalized and why I believe it will be a deadly trap for those that fall in it, allow me to share with you the most recent release from the Federal Open Market Committee to give you a sense of their desperation.

FOMC Statement December 16, 2008

The Federal Open Market Committee decided today to establish a target range for the federal funds rate of 0 to 1/4 percent.

Since the Committee's last meeting, labor market conditions have deteriorated, and the available data indicate that consumer spending, business investment, and industrial production have declined. Financial markets remain quite strained and credit conditions tight. Overall, the outlook for economic activity has weakened further.

Meanwhile, inflationary pressures have diminished appreciably. In light of the declines in the prices of energy and other commodities and the weaker prospects for economic activity, the Committee expects inflation to moderate further in coming quarters.

The Federal Reserve will employ all available tools to promote the resumption of sustainable economic growth and to preserve price stability. In particular, the Committee anticipates that weak economic conditions are likely to warrant exceptionally low levels of the federal funds rate for some time.

The focus of the Committee's policy going forward will be to support the functioning of financial markets and stimulate the economy through open market operations and other measures that sustain the size of the Federal Reserve's balance sheet at a high level. As previously announced, over the next few quarters the Federal Reserve will purchase large quantities of agency debt and mortgage-backed securities to provide support to the mortgage and housing markets, and it stands ready to expand its purchases of agency debt and mortgage-backed securities as conditions warrant. The Committee is also evaluating the potential benefits of purchasing longer-term Treasury securities. Early next year, the Federal Reserve will also implement the Term Asset-Backed Securities Loan Facility to facilitate the extension of credit to households and small businesses. The Federal Reserve will continue to consider ways of using its balance sheet to further support credit markets and economic activity.

I find it slightly ironic that I chose red, white and blue to highlight the text of the FOMC release as I do not believe what I am witnessing in the financial markets is anything close to patriotic. In fact, I find it distasteful, dangerous and Socialistic. Think for a moment about where the Fed is heading with their policies. It is the opposite of a free market, absent of "Laissez faire" and one right out of Ayn Rand's Atlas Shrugged.

Laissez faire—the theory or system of government that upholds the autonomous character of the economic order, believing that government should intervene as little as possible in the direction of economic affairs.

If you read the paragraph from the FOMC statement highlighted in red and add to that all of the new programs and bailouts paid for by "We the People", it leads me to the following questions.

Shouldn't the consumer, after decades of over-consumption, be allowed to digest the over-indebtedness and save, rather than be encouraged to take risk?
Shouldn't companies, no matter what state they reside in from a political point of view, if run poorly, be allowed to fail or forced to restructure?
Should taxpayer money be used to make up for the mishaps at financial institutions or should we allow them to wallow in their own mistakes?
Shouldn't free markets be free?
When did Socialism make its way to our shores?
How do we choose who is bailed out and who loses?
Shouldn't we place blame on the politicians, bureaucrats and other "decision makers" and put skilled people in place that know how to run the businesses?
Shouldn't investors, led blindly down the primrose path of "buy and hold, diversify and don't open your brokerage statement except once every 10 years" be allowed to follow the Prudent Man Rule?

Again, there are many questions to be asked, many with answers that no one wants to put in print. When will people stand up like in the movie Network when Howard Beale, played by Peter Finch, screams, "I'm mad as hell and I'm not going to take this anymore!!!"

I have a feeling that once the rally in equities and credit (no matter how long it plays out) ends, we will realize that the patient has only been shot up with adrenaline as opposed to good old-fashioned bed rest.

Risk taking, in a laissez faire world should be replaced with risk aversion for a period of time. Consumers that over-consumed should be allowed to strengthen their balance sheets for the next cycle and increase their savings. Companies that have been kept afloat, bailed out, nationalized, stuck in conservatorship, have become part of my national portfolio whether I like it or not, unless it actually poses systemic risk (which I am not at all in favor of), should fail. Period. After all, where is MY bailout?

A Few Examples of the "Not-So-Free-Market"

The picture above is of 30 year Fannie Mae 4 ½% mortgage pools. Note the recent 13% spike as the Fed announced that they would be buying Mortgage Backed Securities in order to stabilize the mortgage market. In a free market, these securities would be many points lower, but because there is an artificial bid (yep, with our money) investors are forced to look elsewhere toward risky assets.

The chart above may be confusing, but it is actually rather simple—it is the screen that our Head Trader and I look at all day in the land of Mortgage Backed Securities. If you focus on the middle row section, you will note that 7% Freddie Mac (FGLMC) pools trade at the same price as Freddie Mac 6% pools and lower in price than 6 ½% pools. This is yet another example of how the markets have become so disorderly and difficult to trade. But for the icing on the cake, feast your eyes on what the Prudent man would invest in during times of rebuilding one's balance sheets, Treasury Bills.

Yes folks, cash is now officially trash. If you buy 1 month Treasury Bills, you are rewarded with a yield of a gigantic 0.02% per year. That's right, 2 basis points per year. I suppose people with more than enough money can keep it invested for an entire year and make nothing or they can succumb to the pressure of, "I can't make zero forever if I want to retire."

Now, imagine that you are a professional money manager that is paid 1% a year to invest other people's money. If you feel that being prudent is to sit in cash, and attempt to charge a fee, the math is simple—0.02% per year minus any reasonable fee is a negative return. This is forcing many people out on the risk spectrum at precisely the wrong moment, when risks are the highest ever.

While we have taken some profits as mentioned earlier on, we remain rather fully invested in higher coupon mortgage backed securities that we feel have a low chance of being refinanced and will provide an adequate (4-6%) return while we wait for the dust to settle.

Summary—Why Will the Bull Trap Hurt so Many Investors???

As I have mentioned many times, markets are clearly driven by fear and greed. At Atlantic Advisors we operate without regard to market benchmarks. To guide our investing, we don't begin by looking at the construction of market benchmarks, instead we ask ourselves, "in the absence of a benchmark, what would you buy?" This leads into buying only securities that we believe have the best risk/reward profile and away from those that are not attractive, even if they are part of the benchmark.

Most money managers are driven by "beating the benchmark"; no matter how imprudent it may be to do so. Like Kenny Rogers sang in "The Gambler", "you have to know when to hold 'em and know when to fold 'em." Knowing when to fold 'em or play it close to the vest, while everyone around you is partying is perhaps the most difficult task we face as investors. I am fully aware of the Fed's goal to both "save the system" and "force everyone out on the risk spectrum", but I have seen this play before.

I believe very strongly that investors who believe that they must be invested in risky assets at the expense of prudence will rue the day that they did so. As it relates to stocks, when I consider the risk/reward ratio with equities at 22 times earnings (using 931 S&P 500 and $42 in earnings in 2009), I cringe when I hear people say that stocks are cheap.

What about municipal bonds? Pundits are declaring municipals cheap relative to Treasury bonds. Treasuries are not a good barometer as they are being manipulated lower in yield. With the insurers like MBIA and AMBAC gone, and little if any research available on the nearly 50,000 issuers out there, and downgrades coming like Noah's Flood, I cringe to think that they are attractive as well.

When I consider junk bonds, with new issuance at zero (a whopping one new issue was completed in the 4^th quarter of 2008), they may seem cheap relative to Treasuries, but with the window for new money issuance closed, and money scarce, who will the buyers be? Expect a record high default rate in junk bonds in 2009-2010.

As for preferred stocks, I am cautious there as well as I wouldn't be surprised to see Uncle Sam exercise his muscle and step in to tell banks that they CANNOT pay common OR preferred dividends. Such is the life of Socialism.

In sum, I think many investors are being forced into taking risk so as to avoid a zero return when they actually would rather play it safe.

Again, we remain conservatively invested with a trading attitude towards the best of breed companies and sectors, those that do not need Federal assistance to stay in existence.

Once last thing - please check out the chart below to see what the government has purchased for our national portfolio. Lovely. Just Lovely.

A Daily Snapshot Of Market Moving Developments

John Mauldin — Mon, 22 Dec 2008 18:21:17 GMT

Have you done your Christmas shopping yet? Research shows that more of us are putting it off in expectations of better prices. In other words deflationary expectations! The prices I have seen while out shopping the past few weeks are simply amazing. I have to admit to have made a few purchases for some items that I was not planning to buy just yet because prices were off by 60% or more. A few days ago a friend came in sporting a new black cashmere sweater top with jeweled embroidery and quite fancy. She said she got it at Saks. But the real story is that when she walked into Saks looking for a present for her kids they handed her a coupon with a 30% off any one item from whatever price it was already marked down. That top? At one point it was almost $500. She bought it for $75. I have to confess that made me worry about retail sales and future unemployment. I like low prices, but I like profitable companies and employment. I went and talked to a Saks salesperson a few weeks ago who had been there 25 years and asked if they had ever discounted like that before Christmas and he said never. It was Saturday in New York and the place looked busy. I asked why? And he said, "The store is empty during the week." And I bought a few sweaters at 60% off. Tiffani just got some presents from J Crew at over 60% off. Before Christmas! How many readers have seen the same sales? And yet shopping is down?

As a side note, this year most of the kids and in-laws are all going to get a Visa gift cards so they can take advantage of what I think are going to be even better sales after Christmas. It is not that Dad put off his shopping to the last minute (which I did) but the kids are really looking forward to finding their special items on sale. I wonder how many more are doing that?

This week we look at David Rosenberg's latest missive. While listing a number of negative data points, the thing to watch for is all the deflationary news. I have been pounding the table for YEARS that deflation is going to be the problem, and there would be massive stimulus from the Fed to fight it. We are now coming to that inflection point. Rosenberg is one of my favorite main stream economists and the North American Economist for Merrill Lynch. I would say enjoy this week's Outside the Box, but it is not enjoyable reading, but you should read it anyway.

Have a Merry Christmas. And enjoy the after Christmas sales! All the best,

John Mauldin, Editor
Outside the Box

A Daily Snapshot Of Market Moving Developments

North America: Morning Market Memo
by David A. Rosenberg

Overseas Overnight Market action Outside of Japan, which rallied 1.6% on speculation that the BoJ would buy corporate debt to ease credit risk, equity markets across Asia were weaker across the board. The Hang Seng sank 3.3%, or -505 points, to 14,622. India's Sensex was off 1.7% while China's Shanghai Composite dropped 1.5%. The Korean Kospi, however, fell just 0.1%. In Europe, equity markets are trading lower and off about 0.8% in the aggregate. US equity futures, however, are pointing to a higher open across the major indices. Bonds are trading mixed across the globe, with yields down 2-4 bps in Europe but up a bp in the US. JGBs were down a bp to 1.2%. On the commodity front, we see that gold is rallying, up $6.50 an ounce to $844.75.

On the data front

This is a truly global recession. We learned overnight that Japanese exports collapsed 26.7% year-over-year in November; that's the biggest drop on record. Shipments to the US plunged at an unprecedented 34% year-over-year rate. Meanwhile, imports into Japan sank 14.4% year-over-year in a sign of weakening domestic demand. A similar story out of Thailand, where exports dropped 18.6% in what was the biggest drop in at least 16 years. In China, interest rates were cut for the fifth time in three months. The key one-year lending rate was cut 27 bps to 5.31%. The reserve requirement was cut 50 bps to 15.5% for big banks and 13.5% for smaller ones. Chinese policymakers are trying to head off social unrest. Take a look at page A8 of today's WSJ, "China Faces Unrest as Economy Falters." For a read of how another BRIC nation has hit a wall in the face of a deepening global recession, turn to page A10 of today's WSJ, "India's Textile Industry Unravels."

Across the pond, signs of deflation abound. Germany's import price index dropped 3.4% MoM in November on top of a 3.6% drop in October. This was well below the consensus estimate, which was looking for a 2.5% decline. In France, producer prices plunged 1.9% in November on top of a 0.9% decline in October, well below the consensus, which was looking for a 0.9% drop for the month. Meanwhile, European industrial orders dropped 4.7% MoM in October on top of a downwardly revised 5.4% decline in September. This took the year-over-year rate to -15.1%, which is the the worst on record. We also see that German consumer confidence remained essentially unchanged at 2.1 in January from 2.2 in December.

The next bailout: commercial real estate

Now that the auto-makers have secured a $17 billion bailout, the next group heading to Washington for government assistance is property developers. Take a look at the front page of today's Wall Street Journal, "Developers Ask US For Bailout as Massive Debt Looms." Developers are warning policymakers that office complexes, malls, hotels and other commercial real estate are headed into default and bankruptcy. According to Foresight Analytics, some $350 billion of commercial mortgages will be due for refinancing over the next three years. And, with credit virtually unavailable, borrowers will have give up the property to lenders.

Whiffs of deflation in pharmacies

Take a look at page B3 of today's WSJ, "Pharmacies Fight Tough Battle on Generic Prices." In response to a discount prescription drug program from Wal-Mart, retail pharmacies like CVS, Caremark, Walgreen's and Rite Aid have started to aggressively promote their discount drug programs.

Breaking News Today's events

It is quiet today with no economic data released. Tomorrow, we'll get the final take on third quarter GDP, which is expected to remain at -0.5% QoQ annualized. The U of M index of consumer sentiment is due as well and expected to drop to 58.7 in December from 59.1 in November. New home sales are expected to drop again to 415,000 units annualized in November from 433,000 in October. Existing home sales are up too and expected to drop to 4.93 million units annualized in November from 4.98 million units in October. On Wednesday, we'll get the personal income and outlays report. Personal income expected to come in flat in November while spending is expected to drop 0.7% MoM in November on top of a 1% decline in October. The core PCE price index is expected to drop to 2% YoY in November from 2.1%. Durable goods round out the week and are expected to drop 3% MoM in November after a 6.9% collapse in October. Ex-transportation orders look to drop 2% too after a 5.4% plunge in October.

Making it up as he goes along

The latest news out of the Obama economics camp is that the upcoming fiscal plan will create 3 million jobs instead of the 2.5 million pledged just a few weeks ago. It begs the questions: How does the government "create" jobs anyway? What jobs? Where will they come from? Doesn't the government really help create and nurture the backdrop for the private sector to generate employment and economic growth? See "Obama Expands Recovery Plans As Outlook Dims" on the front page of the Sunday NYT. Indeed, 3 million jobs sounds good and makes for front page headlines, but it would be useful to see a line-item list of where these bodies are going to come from and whether they have the skills to build new ports, medical infrastructure, mass public transit infrastructure and expanded electricity grid and "green" technologies.

Let's do the math

We have 1.2 million unemployed construction workers. We have 123,000 unemployed architects and engineers. We have 83,000 unemployed machinery workers. We have 145,000 unemployed transportation-related workers. So that brings us to barely more than 1.5 million of a labor pool the government can tap into for all the new building activity. But the bulk of the joblessness is in financials (up to half a million), retail/wholesale (1.2 million), leisure/hospitality (1.3 million) and health/education (1.2 million). And if investment bankers, shopkeepers, bell captains and medical chart technicians have anything in common it is that they don't have much experience in shovel-ready activities.

Urban renewal in Obama's fiscal package

As an aside, we published a report two weeks ago highlighting the need for urban renewal as part of Obama's fiscal package - and it looks like somebody in Washington shares our view. See "Top Democrat Seeks to Boost Mass Transit's Share of Funding" on page A4 of the weekend WSJ. This is a secular theme. Another place we can see Obama's infrastructure program touch is the nation's levees, where repairs have lagged. See the front page of today's USA Today for more, "Most Levee Repairs Lagging."

Deflation risks are intact

Households have lost over $7 trillion in terms of net worth in the year ending 3Q, and it looks like this wealth destruction will top $10 trillion when the 4Q Fed flowof-funds data come out (that already exceeds the entire $4 trillion loss during the tech wreck). For a great synopsis, see "A Deflation Maelstrom In the Making" on page 11 of BusinessWeek. Friday's WSJ (page B1 - "Retailers Drop Prices to Avert a Flop") was filled with stories of how merchants are discounting more now than they were on Black Friday. Macy's has cut the prices of its diamond earrings from $800 a pair to $249 and the GAP just sliced another 60% off its already discounted clothing prices (as Bloomberg News reported over the weekend) and we are supposed to be consumed about deflation fear. Really? As a sign of how consumers are delaying their purchases in anticipation of even lower prices, only 47% of shoppers have completed their holiday activity versus 53% a year ago. We regard this as evidence that deflation expectations are creeping in.

And one of the conditions for deflation is, of course, wage flexibility, and everywhere we look, we see an increasing number of companies cutting back on their wage bills. FedEx is just one example - slashing wages for 35,000 employees by 5% (that is 16% of the company's workforce), including a 20% base pay cut for its Chairman and CEO (plus no company contributions to 401k plans in 2009). We also see that Nortel, Eastman Chemical, Newell Rubbermaid, Agilent Technologies, Atlas World Group, and AK Steel Holding have all cut wages and salaries in the past few weeks. According to Watson Wyatt Worldwide, another 6% of companies also plan to cut wages and benefits and 23% intend to reduce the size of their staff in 2009. Also have a look at the front page of "In Need of Cash, More Companies Cut 401(k) Match" - again, the labor market is definitely deflating. Not only that, but these cuts to 401(k) contributions are going to accelerate the process towards rising personal savings rates in coming quarters and years - again, a highly deflationary development and we are not sure that there is an appropriate response to this given that the savings rate is already at rock bottom levels of around 2%.

Moreover, the national labor market has frozen to such an extent that labor mobility has contracted significantly - see "Data Show Drop in Americans On the Move" on page 27 of the FT. Also have a look at front page of today's New York Times, "More Companies Cut Labor Costs, Without Layoffs." Companies are implementing four-day workweeks, unpaid vacations, wage freezes and pension cuts but keeping their headcount. Finally, take a look at page 13 of today's Financial Times, "Christmas Shutdown in Silicon Valley." What is usually limited to traditional manufacturing industries like auto has now hit tech. Companies across Silicon Valley are shutting down until after the holidays to cut back on spending. In spite of the forced time-off, some workers will be required to use up part of their holiday entitlement or if they don't have vacation days, take unpaid leave.

Historians may title this era GDII

As we said, historians may look back on this era and title it GDII: After all, look at how people are behaving - one of the newest fashions is renting movies about the Great Depression, or that have a similar theme like the "Grapes of Wrath" and "It's a Wonderful Life". See "Reality Can be Escaping, Too" on the front page of the Sunday NYT's Week in Review section.

Consensus still loves equities and despises bonds

See Barron's for more on the 'groupthink' theme - every single strategist surveyed (outside of us) sees the 10-year note yield backing up next year from current levels (page M12). The consensus is 3% for the end of 2009. As for equities, the Roundtable (see page 23) is at 1,045 for the S&P 500 (which would be +15 from here). Nobody is lower than 975 (Rich B's prediction) so +10% is at the low end of the entire spectrum. Health care was cited as a 'favorite sector' by 10 of the 12 pundits, and at least one of utilities/staples/telecom showed up on the top list of two-thirds of the respondents. So the view seems to be that we are going to have a bounce next year, led by ... the defensives. Interesting.

We don't understand why so many are bearish on rates

What we truly don't understand is why it is that so many folks are bearish on interest rates when in fact we need a sustained period of very low yields to help blaze the trail for the next sustainable economic expansion: After all, isn't it good news that, because of Mr. Bond's strength and resolve, we now have the benchmark 30-year fixed-rate mortgage at the lowest level in at least 37 years (5.27%)? Mortgage rates are now down 7 weeks in a row (it does the beg the question, however, as to why it is that mortgage applications for new purchases slid at a 20% annual rate in November and are off in 9 of the past 10 months). And despite the best affordability ratios in 35 years, what did we hear from Lennar last week - that its order book collapsed 46% in the past year and backlogs are down 67%. Maybe the classic affordability ratios that use conventional mortgages don't tell the complete story - because nonconventional mortgage rates have lagged with jumbo loans still costing 6.9%.

Homebuilders pressuring Washington for a bailout

As the bailouts pile up, we thought that the best read of the weekend was from the Weekend WSJ - see page W1 ("Is the Medicine Worse than the Illness?"). And now we see that the homebuilders are pressuring Washington to provide first-time homebuyers with a $22,000 tax credit. It's as if there is now a pervasive belief that there is a bottomless pit of cash ready to be put to use to correct all the excesses of the past decade from financials, to autos to builders. It's amazing that we could have let so many tech companies go belly up in the last cycle but have gone this route of accelerating rescue packages this time around. At least in the last cycle, we were running balanced budgets as opposed to trillion-dollar deficits. What does concern us is the risk to civil liberties when bankruptcy judges can alter contracts, the government can force banks to accept public capital injections (Jamie Dimon said on CNBC he didn't want or need Paulson's help), the government by fiat can bring mortgage rates down as opposed to market forces, the government tells lenders how to price their credit card business (since when did a piece of plastic become a right instead of a luxury?).

The major risks for 2009

We continue to believe that trade protectionism, competitive devaluations and military conflicts are the major risks for investors for 2009 - this is, after all, the most broadly based global recession (according to the IMF, not just us) in the post-WWII era: Ecuador defaulted on its foreign debt. Since the G20 meeting in Washington in October, five of those countries - Russia, India, Indonesia, Brazil and Argentina - have announced their intentions to raise import tariffs or otherwise restrict trade. Russia has announced plans to raise tariffs on autos; India has already lifted duties on iron, steel and soy; Brazil and Argentina are putting together a case within Mercosur for boosting external tariffs. Vietnam just raised taxes on steel imports to 12% from 8%. The EU said it may reimpose duties of 79% on a paper-binder component in retaliation against China. French President Sarkozy has established a $7.5 bln fund to invest in domestic companies so as to avoid foreign takeovers. China has reinstated export rebates and now we see that US steel, textile and paper markets intend to file complaints against Chinese imports, and did anyone notice that this auto-bailout excludes foreign companies?

It's all about self-preservation. We think that for anyone who missed it, the article on the front page of Friday's NYT is a worthwhile read ("After 30 Years, Economic Perils on China's Path"). Russia also cannot be regarded as a stable data point either as it just posted its first monthly budget deficit in November and the sovereign debt was just downgraded by S&P for the first time in a decade (Friday's WSJ reports says "public panic is one of the Kremlin's greatest fears"; the NYT reports that "as Beijing worries about strikes and mass layoffs even in some of the its most prosperous areas, official tolerance of political dissent has seemingly narrowed".) Gold will be an important hedge against policy missteps

Gold, in our opinion, is going to be important hedge against such policy missteps in 2009; and not only gold, but security of supply and government procurement policies may end up putting a floor under the beleaguered commodity complex earlier than a lot of folks think. As the chart below attests, there is a pretty good link between government spending as a share of GDP and the CRB index, because governments don't buy clothing or jewelry but they do buy "material".

And as for gold, the chart looks good against a vast majority of currencies and has broken out against Sterling. See chart below.

As we said before, the new growth engine for the economy is government spending, which is already on the rise and set to take out the prior high of over 23%. After all, when you are in trouble, you go to family members for help first. Uncle Sam.....?

The Six Lessons from Last Week's Action

John Mauldin — Mon, 01 Dec 2008 22:19:58 GMT

This week we look at a short but excellent summary of the state of the current economic crisis. I always enjoy reading David Rosenberg, the North American economist of Merrill Lynch. He has a no-nonsense style that is refreshing from most mainstream economists. The reality is that things continue to deteriorate. Today's stock market action shows that we are not of the bear market woods just yet. Rosenberg gives us a few reasons why.

John Mauldin, Editor
Outside the Box

The Six Lessons from Last Week's Action

By David Rosenberg, North American Economist,
Merrill Lynch

1) Expect the worst recession in the post-WWII era

First, this is going to be the worst recession in the post-World War II era, in our view. The ECRI leading indicator hit a record low for the fifth week in a row – down to - 29.2 as of the November 21st week versus -28.2 the week before. This index, which leads real GDP by two quarters with a 70% historical correlation, is getting further and further away from the prior all-time low of -19.8 that defined the worst recession of the post-WWII era and saw a six-quarter consumer recession coincide with a 45% peak-to-trough decline in the stock market. Perhaps the fact that this bear market is proving to be even more severe is symptomatic of an economic downturn that will also prove to be deeper and more prolonged. After the flurry of data released just before Thanksgiving, we are now tracking close to a 4.5% QoQ annualized fall in real GDP in 4Q. This would be the largest pullback since the 1982 recession, and we see a similar contraction in the first quarter of 2009.

2) Capex is in a steep decline

Second, capex is in a very steep decline right now. Durable goods orders dropped 6.2% in October, the third decline in a row. Over that time frame, orders have plunged at a 39% annual rate, which is unprecedented. The retrenchment has spread to the tech sector, where order books were expanding at a 7% annualized rate over the three months to June. Currently, that same three-month trend has swung to a negative 13% annualized rate.

3) Consumer spending down sharply; savings rate is soaring

Third, consumer spending fell 1% in October, which was a near-record decline. This, in fact, was the fourth straight monthly decline, which is unprecedented. The savings rate is soaring; it leapt to 2.4% from 1.0% in September, in a sign of heightened risk aversion and cash preservation, and is a shift that we believe should be seen as secular, not merely cyclical.

This was a conclusion that came through loud and clear in the Conference Board's Consumer Confidence Index, principally in the spending intention components of the survey. Auto buying plans dropped for the third month in a row to a record low in October while home-buying plans fell to their lowest level since the 1982 recession. Consumer plans to buy a major appliance fell to a 14-year low as well – down for three months in a row. During this four-month period of unprecedented consumer retrenchment from July to October, spending on discretionary items collapsed at an average annual rate of 18%. Even spending on groceries has declined 6%, toiletries are off by 6% and utilities are down 3%. So, even some of the classic staples are being curtailed.

The only areas that have posted increases in spending over this unprecedented four-month decline in spending have been pharmaceuticals (+7%), telecom services (+3%), medical care services (+5%) and mass transit (+26%) – all other forms of transportation, from rail to bus to air fell at a 19% annual rate.

4) Obama planning a $700 billion fiscal package

Fourth, we learned this week that President-elect Obama's economics team is planning a fiscal package as big as $700 billion over the next two years. We are going to wait for the details to see how this is going to impact our base case macro forecast. Suffice it to say that the cornerstone of the stimulus this time around will likely be infrastructure, not tax rebates. The key for investors is where these outlays will be concentrated, which, in turn, means identifying the areas of the capital stock that have been the most underinvested in recent years. After sifting through the data, we believe that the prime candidates will be hospitals, waste management services and passenger transit.

5) Housing market is not close to bottoming out

Fifth, we learned that the housing market is nowhere close to bottoming out. New home sales dropped 5.3% in November to a 433k annualized rate – the worst since the 1982 recession. Even though sales are now down 69% from the July 2005 bubble peak of 1.39 million units, we believe builders have not been aggressive enough in curbing production because the most critical variable of all, the unsold inventory backlog, rose to 11.1 months' supply from 10.9 in September.

Need to see inventory backlog drop to 8 months' supply

The reality is that even though single-family starts have dropped to 26-year lows of 531,000, they are still running 23% above the prevailing level of new home sales. The worst the inventory-sales ratio ever got in the early 1990s real estate meltdown was 9.4 months' supply. We are currently 18% above that level and almost 40% higher than the 8 months' supply we would need to see before calling an end to the housing deflation phase.

Another 15-20% decline in home prices likely from here

As we saw last week, the Case-Shiller index fell 1.85% MoM or at a 20% annual rate. All 20 cities were down both sequentially and YoY. Home prices are now down a remarkable 22% from the 2007 peaks. With the unsold inventory sitting at the third highest level of the past three decades and mortgage approvals for new home purchases falling to their lowest level in nine years, we believe the laws of supply and demand point to a further 15-20% decline from here. So, of all the things that happened last week in the market, retailing stocks up 17%, the bank stocks up 26%, tech up 9%, the one development that probably has the greatest chance of being reversed is the 60% surge we saw in the homebuilding group.

6) Fed has switched December meeting to a two-day affair

Sixth, we learned that the Fed is going to make the December FOMC meeting a two-day affair instead of one (December 15-16). The market is already sniffing out a 50 basis point rate cut. However, now that the Fed has de facto embarked on the process of quantitative easing, perhaps the need for a two day meeting is to iron out a more aggressive plan to revive the credit markets and the economy. The only areas that have posted increases in spending over this unprecedented four-month decline in spending have been pharmaceuticals (+7%), telecom services (+3%), medical care services (+5%) and mass transit (+26%) – all other forms of transportation, from rail to bus to air fell at a 19% annual rate.

As Chairman Bernanke suggested in several speeches he gave back in 2002 and 2003, one of the deflation-fighting strategies would likely involve Fed action to nurture lower rates at the longer end of the yield curve. Perhaps this prospect is behind the rally in the 10-year note yield and long bond to cycle lows. This would fit in very well with our ongoing strategy of focusing on equity sectors that have income-generating characteristics like utilities, health care and telecom services; these sectors also screen very well in a negative nominal GDP growth environment.

Survival of the Unfittest

John Mauldin — Mon, 04 Aug 2008 21:09:20 GMT

It is indeed a very interesting time in which to live, especially watching the financial markets. The disconnect among authorities, regulators, companies and investors is almost too much to comprehend. There are no precedents for the turmoil we are in. This week we read an essay by a name familiar to readers of Outside Box, Michael Lewitt of Hegemony Capital Management (www.hegcap.com). As usual he offers us some very cogent comments on the continuing efforts by those in authority to bail out the system, along with insights on the deal by Merrill and the woes at GM. It is a very interesting letter, so I will stand aside and let Michael jump in.

John Mauldin, Editor
Outside the Box

Survival of the Unfittest

by Michael Lewitt

"Can we doubt (remembering that many more individuals are born than can possibly survive) that individuals having any advantage, however slight, over others would have the best chance of surviving and procreating their kind? On the other hand, we may feel sure that any variation in the least degree injurious would be rigidly destroyed. This preservation of favourable individual differences and variations, and the destruction of those which are injurious, I have called Natural Selection, or the Survival of the Fittest."

- Charles Darwin, The Origin of Species (1859)

Honest to God, HCM is trying to find the light at the end of the dark tunnel that the U.S. economy and financial markets have become. But every time we turn around, regulators and other power brokers continue to avoid making the hard choices necessary to deal with the problems at hand. As a result, the practices that led the current credit crisis are being preserved, and changes that could lead to more stable and healthy markets are being pushed into the future (perhaps forever). The last month has provided so much grist for this mill that we hardly know where to begin, but begin we must. Our survey of what can only be described as a regulatory wasteland begins with the SEC's misbegotten short-selling legislation.

Regulatory Malfunction

On July 21, 2008, the United States Court of Appeals for the Third Circuit overturned a $550,000 indecency fine against CBS for airing singer Janet Jackson's wardrobe malfunction during the 2004 Super Bowl halftime show. The court ruled that the Federal Communications Commission had "capriciously departed" from its policy over the past 30 years of policing the airwaves with "practiced restraint" when it imposed the fine. Importantly, the court stated that, "[l]ike any agency, the FCC may change its policies without judicial second- guessing. But it cannot change a well-established course of action without supplying notice of and a reasoned explanation for its policy departure." This demand for consistency and fair warning in the law has been absent from enforcement of the nation's securities laws for many years, resulting in botched prosecutions, inconsistent regulation, and damage to the system.

The latest example of regulatory malfunction in the financial markets is the SEC's limitations on selling short the stocks of 19 financial firms. Readers should understand that this stopgap measure will have absolutely no impact on the underlying value or the long-term stock prices of these companies. This is merely a political bone being thrown to those who would sooner blame short-sellers for the credit crisis than the institutions (and the individuals responsible for mismanaging them) who acted in a wholly irresponsible manner. Leon Cooperman, one of this generation's great investors and a man always willing to speak his mind, described the situation very frankly in a recent interview in Barron's: "The financial economy is in disarray and that is really a result - and you can quote me on this - of imprudent financial activity by the commercial banks and investment banks. They levered themselves up. They did things that were foolish. They should be ashamed of the way they conducted themselves, and now they have to right that, and they are de-leveraging."¹

By engaging in selective protectionism of a few favored companies rather than re- imposing the uptick rule and treating all companies equally, the SEC furthered the appearance of favored treatment for large institutions that raises serious moral hazard concerns and dampens confidence in U.S. financial markets. The following is the list of the 19 firms that the powers-that-be decided were worthy of special protection from market forces:

BNP Paribas Securities Corp.
Bank of America Corporation
Barclays PLC
Citigroup Inc.
Credit Suisse Group
Daiwa Securities Group Inc.
Deutsche Bank Group AG
Allianz SE
Goldman, Sachs Group Inc.
Royal Bank ADS
HSBC Holdings PLC ADS
J.P. Morgan Chase & Co.
Lehman Brothers Holdings Inc.
Merrill Lynch & Co., Inc.
Mizuho Financial Group, Inc.
Morgan Stanley
UBS AG
Freddie Mac
Fannie Mae

Among the more interesting aspects of this list is the fact that more than half the names are non- U.S. firms enjoying the protection of the U.S. regulators and the fact that some large U.S.-based firms that are clearly being pummeled by short-sellers are missing from the list (i.e. Wachovia Corp., AIG International Group, Inc., Washington Mutual). The ostensible basis for inclusion on the list - status as a primary dealers plus Fannie and Freddie - speaks to the reactionary nature of the rule-making. Finally, this desperate measure is yet another example of the capitalism-for-the poor, socialism-for-the-rich economic model that American financial authorities have adopted over the past two decades.

As has been widely noted, the SEC effectively restricted "naked short selling" several years ago but failed to adequately enforce the rule. ("Naked short selling" involves selling short shares of stock that one has not borrowed or determined are borrowable. As The King Report points out, SEC Release 34-50103 dated July 28, 2004 states that Rule 203(b)(3) "requires any participant of a registered clearing agency...to take action on all failures to deliver that exist in such securities ten days after normal settlement date, i.e., 13 consecutive settlement days. Specifically, the participant is required to close out the fail to deliver position by purchasing securities of like kind and quantity." A "threshold security" is defined as a stock experiencing an unusually high number of fails to deliver. A "fail to deliver" is a failure to actually deliver shares that have been borrowed to effect a short sale and are most commonly associated with "naked" short sales. Rule 203(b)(3) is the rule that the SEC has failed to enforce with sufficient teeth, effectively allowing "naked" short selling to run rampant.)

As a result, when it announced that it would enforce the rule selectively with respect to a select number of financial stocks that had been battered by short sellers (ignoring the fact that a number of these companies had posted tens of billions of dollars of losses due to gross mismanagement and deserved to be sold), the agency effectively admitted that it had been failing to enforce its own rules. The SEC's announcement predictably sent holders of naked short positions scrambling to borrow stock while other short sellers ran to cover their positions in these and other financial stocks in anticipation of a rally in these shares. The result was a historic rally in financial shares that was given a boost by the bailout of Freddie and Fannie but was wholly unrelated to any improvement in the underlying businesses of the companies whose stock prices rose so sharply.

The real question is why the SEC did not reinstitute the uptick rule, which, in one of the those coincidences that you can't make up, was repealed on the same day that the Bear Stearns' hedge fund problem came to light, June 13, 2007. Re-imposing the uptick rule on all stocks rather than trying to protect a handful of financial stocks from the verdict of the market would seem to be a far more enlightened method of regulation. HCM has made this point before, writing in April (The HCM Market Letter, April 1, 2008, "How To Fix It") the following:

"Short selling is an absolutely legitimate way to invest or hedge a portfolio. The SEC made a major error when it repealed the [uptick] rule last year. The repeal of this rule increased downside volatility exponentially and contributed to the ability of quantitative and other computer-driven selling to push the market lower based on technical rather than fundamental investment considerations. The SEC should reinstitute the [uptick] rule immediately." (emphasis in original)

In addressing concerns that short-sellers are unfairly targeting financial stocks, the SEC had a choice about how to proceed. By taking the path it did, it appears to have continued an unfortunate tradition of enforcing rules that are already on the books but that practitioners have practiced with relative impunity because regulators have allowed them to. The King Report noted that the New York Stock Exchange fined and censured J.P. Morgan Chase, Citigroup, Daiwa Securities, Goldman Sachs and Credit Suisse two years ago for failing to enforce rules against naked short selling.³ Apparently these penalties (which were a couple of million dollars) were insufficient to end the abuses, and the fines were treated as just another cost of doing business.

Wall Street firms that lend stock and bonds to short sellers earn enormous profits from such activities. According to a recent article in the Financial Times, "US prime brokerage firms, most of which are owned by big Wall St. banks, will reap revenue of $11 bn this year" from lending stock to facilitate short-selling.⁴ Accordingly, the securities industry has very little interest in seeing any crackdown on short-selling. Fines of a couple of million dollars are hardly sufficient to dissuade them from ignoring the rules when they stand to earn billions of dollars from the activity in question. As distasteful as it is to see the largest financial institutions in the world thumb their noses at the rules, it is even more discouraging to see the regulators allow them to do so.

What most disturbed HCM about the SEC's decision was the fact that it is just the latest example of the beggar-the-poor, boost-the-rich policies that the American financial authorities have followed over the past two decades. HCM understands perfectly well that allowing financial institutions to fail is not a viable policy either politically or economically. But while the government acted literally overnight to protect Goldman Sachs and Lehman Brothers and 17 other financial institutions and their already wealthy executives, Congress took much longer to debate and pass a mortgage rescue plan to help the millions of less fortunate homeowners who are on the verge of losing their homes. There is obviously an enormous difference between an agency's ability to issue a rule overnight and Congress's ability to legislate, but at some point - and that point is coming sooner rather than later in HCM's opinion - the American people are going to ignore that distinction and ask why Wall Street continues to get bailed out before Main Street. There is nothing pre- ordained about the policy choices that are being made. As Professor Lawrence E. Mitchell writes in his recent book, The Speculation Economy, "modern American corporate capitalism is the result of human choices. It is a system we maintain out of choice. It is a system that has ramifications beyond the economic that have helped to embed social norms of individualism that interfere with the cooperation necessary for a successful economy and a thriving society. It is within our power to change it, to modify its rough edges or to accept it as it is. But these choices can only be made with understanding."⁵ Smoothing out the rough edges is a very mild version of what needs to be done. What needs to be done is to make difficult policy choices that will necessarily involve the infliction of pain on certain constituencies that have thus far been protected from the consequences of their own sins.

HCM is not proposing that the authorities stand by with their hands in their pockets while firms like Fannie Mae and Freddie Mac or Bear Stearns face collapse. What HCM is arguing, however, is that such rescue plans should not provide protection for the shareholders of these companies. The minute the U.S. government was compelled to open the discount window to the investment banks, it should have made it very clear that there would be no support for the shareholders of these companies. Bear Stearns' shareholders received $10/share more than they deserved when that company was bailed out by the Federal Reserve and J.P. Morgan Chase.

This leads to a conclusion that was discussed several months ago in this publication (The HCM Market Letter, April 1, 2008, "How To Fix It"). Since it is apparent that we are not prepared to allow certain firms to fail, then we must take steps to limit their ability to endanger the system in the first place. This requires rules that impose limitations on financial institutions' leverage; eliminates their ability to conceal assets and liabilities in opaque off-balance sheet entities; restricts asymmetric compensation schemes that reward insiders for taking indecent risks with their firms' capital at the expense of shareholders and ultimately taxpayers; and adopt economic and monetary policies that encourage productive investment rather than speculation. This is no small order, but it is eminently achievable. Moreover, it is absolutely necessary if American capitalism is going to continue to flourish and maintain the confidence of the keepers of the world's capital in the years ahead.

Sticking One's Head In The Sand

In April, HCM wrote the following about the egregiously leveraged off-balance sheet entities known as Structured Investment Vehicles (SIVs) that inflicted so much damage on the global financial system (The HCM Market Letter, April 1, 2008, "How To Fix It"):

"Off balance sheet entities should be outlawed immediately, plain and simple. If first Enron and now the SIVs haven't taught us the necessary lessons about hidden liabilities, the system probably doesn't deserve to survive. Speaking as someone with extensive knowledge of these off-balance sheet entities, it would not be difficult to render them extinct relatively easily. It would be doing the world a favor."

On July 30, the Financial Accounting Standards Board (FASB) reluctantly caved in to pressure from the very institutions that created these off-balance sheet monstrosities and agreed to delay for one-year (a period that will undoubtedly become extended if the financial industry remains under pressure a year from now) the introduction of rules that would have forced banks to consolidate more off-balance sheet vehicles onto their balance sheets. FASB Chairman Robert Herz did not go gently into the good night, however, admitting, "t does pain me to allow something that has been abused by certain folks, to let that go for another year." Mr. Herz also noted that he was "chagrined" by what had been uncovered about these vehicles as the new rule was being prepared, noting that a combination of poor reporting and lax enforcement had led to the current situation.

The FASB was caught between a rock and a hard place. The reality is that banks can't absorb additional liabilities onto their balance sheets at the current time without violating capital rules. These institutions are barely capable of remaining solvent as it is. They are continuing to report massive write-offs and are experiencing tremendous resistance when they try to go back to the well to raise additional capital. Accordingly, requiring the addition of what may amount to several trillion dollars of off-balance sheet liabilities onto banks' balance sheets is simply inconceivable at the present time because it would automatically render several of the world's largest financial institutions (including several on the protected species list from attacks from short-sellers) instantly insolvent. But giving banks a one-year reprieve may simply buy them time to develop other strategies to keep these assets hidden in the opaque shadow banking system.

Moreover, regulators need to assure global investors that no new vehicles of this type will be permitted to be formed in the future. News that the new rule has been delayed suggests that the balance-of-power still lies with institutions that remain too large to fail and can still lord it over regulators by pointing to the catastrophic consequences that hard-and-fast accounting standards will unleash on the financial industry. But the result is that the system sticks its head in the sand for another year as it prays for a recovery in the value of the trillions of dollars of highly complex and illiquid securities (many of them derivatives). HCM would wager heavy money that we have not heard the last about delaying adoption of this rule.

Merrill Lynch: The Dundering Herd

Merrill Lynch & Co. Inc.'s decision to dump $30.6 billion of mortgage securities at an average price of $0.22 on the dollar barely a week after its quarterly earnings announcement (which itself included a $10 billion write-down on such securities!) raises more questions than answers about the firm and the prospects for credit markets to recover from their current crisis. Merrill Lynch agreed to sell these securities to Lone Star Funds for $6.2 billion, yet barely two weeks earlier the sale the firm had valued those identical securities at $11.1 billion. Moreover, the sale is structured in such a way that Merrill Lynch is financing 75 percent of the transaction. This means that Lone Star is on the hook for the first $1.7 billion of losses, and then Merrill Lynch will eat any losses beyond that. In other words, another $0.05 drop in the value of these securities would leave Merrill Lynch back on the hook for more losses. Either this will prove to be one of the most desperate transactions done in the annals of the current credit crisis, or John Thain knows something the rest of us don't want to know about the real value of the toxic waste he just sold to Lone Star. At the same time, Mother Merrill announced the sale of 380 milion new shares of stock to raise $8.5 billion in new equity capital. The issuance of additional shares at current prices triggered a make-whole provision in an earlier share sale to Singapore's state investment agency, Temasek that cost Merrill Lynch $2.5 billion. Temasek, the firm's largest shareholder, turned around and reinvested this $2.5 billion in Merrill's new share offering along with an addition $900 million. These announcements not only left Merrill Lynch shareholders severely diluted but, if they had been paying attention to the quarterly earnings call, deluded.

This transaction may constitute one of the oddest corporate announcements in recent memory.⁶ First, it suggests that Merrill Lynch's quarterly earnings announcement was grossly inaccurate since, with respect to these assets alone, the firm's valuation was apparently off by a factor of 40 percent. Second, it raises serious questions about the values all financial firms are placing on their mortgage securities. Either Merrill is alone in mis-marking its book by 40 percent, or other firms are grossly over-valuing their holdings and will be forced to report large write-offs in the third quarter. What is particularly troubling (but gives the anti-quantitative HCM a wonderful dose of schadenfreude) is the enormous gap in valuations that different firms (i.e. Lone Star and Merrill Lynch) can apparently derive from securities that are allegedly valued according to mathematical models whose precision is such that they would have problems hitting the side of a barn.

And naturally Merrill Lynch's announcement, which included a highly dilutive share sale to compensate for the multi-billion capital loss suffered by the firm, led to a rally in the firm's stock price. Let us get this straight - the firm admits that it grossly mis-marked its book, reports a(nother) multi-billion dollar loss, announces a hugely dilutive stock offering, and the stock rallies? Makes perfect sense to us. And people wonder how and why the financial markets continually fall into crisis!

Fannie and Freddie

Merrill Lynch' actions raise a more serious question, however, which is why investors would bet on a recovery in financial institutions at all at this point in time? The reason to do so, it seems, lies more in a bet on what public officials will do than on whether these companies are worthy investments or will have any future value. Investors betting on a turnaround in financial shares are really betting on whether government officials are going to allow these companies to fail. Thus far, it appears that the answer is a resounding "no." The government has demonstrated that it will do everything in its power (and sometimes more than its power expressly permits) to prevent failure. The question, of course, is whether the size of the problems at some point will exceed even the government's grasp.

The bailout of Fannie Mae and Freddie Mac is particularly bizarre in this respect. The very fact that a bailout was necessary demonstrated beyond a shadow of a doubt that the entities were insolvent and that the public shareholders should have lost all of their money. The only reason these two companies were not forced to declare bankruptcy is that the U.S. government agreed to stand behind their obligations. Yet the stocks continued to trade at a value greater than zero and will not be wiped out by the government support plan. Yet the real shareholders in terms of bearing the biggest risk of loss in these companies are no longer the holders of the publicly traded shares but the American taxpayers, who are effectively guaranteeing the companies' multi-trillion dollar obligations. Accordingly, the taxpayers should be the ones who received any gains on the equity value of these dinosaurs as they are restructured to operate in the future.⁷ Just because government officials state that they don't "expect" such guarantees to be called upon doesn't erase the fact that such obligations are in place and must be honored. To put it politely, Treasury Secretary Paulson and Congress effectively picked the pockets of the American people by denying them the upside on their new investment in Fannie and Freddie.

And despite passage of the bailout plan, investors in the agencies are not necessarily out of the woods, as HCM suggested earlier this month. On July 9, HCM warned that investors should be cautious in betting on the unsecured obligations of Fannie and Freddie, writing "investors should not presume that a federal bailout will provide a lifeline to all of the companies' investors....subordinated debt holders also should not expect protection in a bailout that would not only be unprecedented in size but also cast the United States' balance sheet and currency in a wholly unfavorable light." (The HCM Market Letter, July 9, 2008, "The Deepening Crisis"). HCM's cautiousness contrasted sharply with the statements and actions of bond giant PIMCO, which has effectively bet the ranch on the debt securities of Freddie and Fannie based on a belief that the government would never permit these institutions to fail. But sure enough, proving once more that even paranoids have enemies, S& P announced on July 25 that it was placing Fannie and Freddie's subordinated debt and preferred stock ratings on CreditWatch Negative. This was based on the fact that the language in the government plan "increases the likelihood that subordinated debt holders and preferred stockholders would face greater subordination risk. This heightened risk is not incorporated into [S&P's] current subordinated debt and preferred stock ratings on Fannie Mae and Freddie Mac. We may lower these issue ratings one to two notches at the conclusion of our review of the final legislation."⁸ We very much admire the individuals at PIMCO, but we are entering uncharted territory and recommend investors act with an extra degree of caution. It wouldn't be the first time that investors learned the hard way that a security that was deemed riskless turned out to be nothing of the sort.

Demolition Derby

The slow motion death of the American automobile industry is almost too painful to watch. The flood of bad news coming out of Detroit has literally swelled into a tsunami in recent days, and there is no end in sight.

First came another credit rating downgrade. On July 31, Standard & Poor's did another number on the industry. In three separate reports, it downgraded General Motors Corp. and GMAC LLC, Ford Motor Co. and Ford Motor Credit Co., and Chrysler LLC and DaimlerChrysler Financial Services Americas LLC (DCFS). The stated rationale for these downgrades (S&P could have chosen a dozen reasons) was basically concern over shrinking cash flows and liquidity at all three companies and their finance arms. While S&P can hardly be blamed for stating the obvious, the rating agency probably didn't go far enough in continuing to rate the automakers ‘B-,' one notch above the once infamous CCC+ level. In today's world, of course, a CCC+ rating no longer bears the stigma that it once did, but in the case of these companies, it is only a matter of time before they bear the insignia of insolvency that such a rating portends. The world is witnessing a classic case of an industry in denial. Rather than taking the truly radical steps necessary to address its problems, Big Auto's management is still engaging in incremental change in the hope that it can buy itself enough time to effect a changeover to more fuel efficient models. Unfortunately, these executives are doing nobody any favors by delaying the inevitable balance sheet restructurings that are going to be a necessary component of the endgame for their industry.

Just prior to S&P's move came the effective collapse of the automobile leasing industry. In the days prior to the S&P downgrade, the automobile financing industry came totally unglued. This is the latest indication of how severely credit is being rationed at all levels of the U.S. economy. Chrysler Finance was the first of the Big Three automakers' finance arms to announce that it would stop extending automobile leases. This decision, which is nothing less than catastrophic for Chrysler's vehicle sales despite unconvincing protests to the contrary by the privately-owned carmaker, was due to the fact that leasing has been rendered unprofitable by Chrysler Finance's rising borrowing costs and the plunging residual value of Chrysler's gasguzzling vehicles. Chrysler debt is trading at levels that suggest an imminent bankruptcy filing.

GMAC and Ford Motor Credit are not expected to eliminate leasing entirely but are likely to severely cut back on auto leases since they can't make any money on these transactions. Wells Fargo has also withdrawn from the business of financing car leases. Other financial institutions are sure to follow.

The dramatic reduction in the availability of auto financing will be another nail in the coffin of the American automobile industry (at some point the coffin will have so many nails in it that it won't need any wood). Leases account for roughly 26 percent of annual auto sales. Just as subprime mortgage financing led many consumers into homes that they couldn't afford, low-cost auto leases allowed many people to lease cars to which they otherwise wouldn't have had access. Leases also led many consumers to replace their vehicles in a much shorter period of time than they ordinarily would have done, leading to higher auto sales. Automobile manufacturing and financing is a significant component of the American economy, and we are watching it being deconstructed piece-by-piece before our very eyes. The economy is seeing the dark side of what happens when financial engineering creates false demand for consumer goods that is unsustainable on a fundamental basis.

Finally, on the last day of July and first day of August, GMAC and GM issued two lackof- earnings releases that not even the happy faces on financial television could spin in a positive way. On July 31, GMAC released its second quarter 2008 results, a loss of $2.5 billion (that would have been much worse without $1.55 billion of lease support payments that GM is obligated to make to GMAC under risk-sharing and support agreements dating from 2006.) GM reported that it has $30 billion in North American leases, including $12 billion in SUVs and $6 billion in other trucks. If current trends hold, GMAC is looking at further multibillion writedowns on these vehicles. Residential Capital LLC contributed $1.9 billion of losses to GMAC during the quarter compared with a $254 million loss a year earlier. HCM will leave it to others to try to find a silver lining at GMAC. The hard truth is that the deterioration of every aspect of this company is accelerating.

Not to be left out in the cold, on August 1, GM announced a grotesque $15.5 billion loss for the second quarter of 2008 ($27.33/share on an $11.00 stock price for those who are still counting such things). Global sales plunged by 18 percent during the quarter, with U.S. sales fading by 16 percent through June. July trends continue to point sharply downward, and the effective elimination of leasing by GMAC can only further reduce sales. A significant portion of the loss was attributable to charges for attrition programs (i.e. job reductions), an adjustment to its reserve for its former parts-maker Delphi Corp., and a $2 billion loss attributable to lower residual values for leased vehicles. But at this point, HCM would seriously discount the one-time nature of these charges, which continue to hit GM's balance sheet with depressing regularity as the company continues to try to dig out from the detritus of its past business structure and history. Backing out these so-called one-time charges left GM with a $6.6 billion quarterly loss, which was still 450 percent larger than analysts projected (which is further evidence that nobody, and HCM means NOBODY, has a clue about how GM is going to survive as a going concern).

The latest news out of Detroit makes it abundantly clear that the endgame for the Big Three is going to be massive bankruptcy restructurings. One would hope that politicians in Washington, particularly the two Presidential candidates, would begin formulating national energy plans that include restructuring plans for the American automobile industry. No viable energy plan will meet this country's needs without creating the proper tax and other economic incentives to build fuel-efficient vehicles. Rather than continuing to be one of the problems that lie at the heart of the American economy, the recovery and revitalization of the auto industry could be a major component of an economic and energy policy that could lead this country out of the difficult times we are experiencing and are doomed to repeat unless we take some bold steps right now.

Footnotes:

1 Barron's, July 28, 2008, "The Market's Down, Not Doomed," p. 35.
HCM/August 1, 2008

5 Lawrence E. Mitchell, The Speculation Economy How Finance Triumphed Over Industry (San Francisco, Berrett-Koehler Publishers, Inc., 2007), pp. x-xi.

6 Christopher Wood calls attention to a similar announcement by the National Australia Bank (NAB), which wrote-off nearly 90 percent of its US conduit loans, which consisted of 10 CDOs consisting of two "super senior" strips and eight AAA senior strips (in layman's terms, mortgage-related securities). See GREED & fear, 31 July 2008. The Merrill Lynch and NAB write-offs contrast with much smaller writeoffs at other institutions holding the same type of instruments and suggest that future write-offs remain likely and large.
HCM/August 1, 2008

7 In this respect, we are reminded of a statement by Joseph A. Schumpeter: "The only realistic definition of stockholders is that they are creditors (capitalists) who forego part of the legal protection usually extended to creditors, in exchange for the right to participate in profits." See Joseph A. Schumpeter, Business Cycles (McGraw-Hill, New York: 964), p. 79.
HCM/August 1, 2008

8 Standard & Poor's, Research Update: Fannie Mae and Freddie Mac Ratings Placed on CreditWatch Negative; Senior Debt Rating Affirmed, July 25 2008.
HCM/August 1, 2008

Your wishing he was still fishing analyst,

John Mauldin

What Do They Know?

John Mauldin — Mon, 01 Oct 2007 16:42:00 GMT

Introduction We are in a world far different than the one I learned about in economic text books. As I have written, the shadow banking system of hedge funds and CDOs, CLOs, PIPES, etc. have created a new financing economic reality far different than...(read more)

The Ongoing Impact of the Housing Sector

John Mauldin — Mon, 27 Aug 2007 16:50:00 GMT

Introduction Who should we blame for the problems in the credit markets? This week in Outside the Box my good friend Barry Ritholtz takes on the task of pointing his prodigious finger at the guilty parties. As he notes, there is plenty of guilt to go...(read more)

Quarterly Review and Outlook: Second Quarter 2007

John Mauldin — Mon, 16 Jul 2007 18:12:00 GMT

Introduction This week in Outside the Box, we take a closer look at the bond market and its underlying drivers. HMIC's Van Hoisington and Dr. Lacy Hunt anticipate lower inflationary pressures on account of faltering consumer spending and further deterioration...(read more)

Knights of the Round Table: Mapping out the Markets

John Mauldin — Mon, 02 Jul 2007 18:14:00 GMT

Introduction This week in a very special Outside the Box we have an investment outlook tour de force. My friend and South African business partner Dr. Prieur du Plessis gathered a group of some of the more interesting investment managers in the industry...(read more)

Grim Reality

John Mauldin — Mon, 09 Apr 2007 20:29:00 GMT

Introduction As I glanced over at the TV in my office this morning, the latest news on the ticker wire was that American Home Mortgage Investment Corp. (AHM) is trading down over 16%. While the company is not of any particular importance to me, it spurred...(read more)

Quarterly Review and Outlook - Fourth Quarter 2006

John Mauldin — Mon, 08 Jan 2007 22:18:00 GMT

Introduction On Friday, I wrote my annual forecast, " The Goldilocks Recession ," on what investment themes I expect in the coming year. This week's Outside the Box will follow up on the subject with an excellent piece written by Van Hoisington...(read more)

Festivus Flow-of-Funds Stocking Stuffers

John Mauldin — Mon, 18 Dec 2006 22:20:00 GMT

Introduction One of my favorite economists, Paul Kasriel, wrote an excellent article last Friday in his weekly commentary, "The Econtrarian." Not only is it a great "outside the box" analysis but it also follows up to and illustrates...(read more)

Near a Bottom in Housing?

John Mauldin — Mon, 06 Nov 2006 22:44:00 GMT

Introduction I touched briefly on the subject of housing in my Friday letter, "Thoughts from the Frontline" (you can view it here ). Data from across the country points to a number of trends including declines in both new construction and existing...(read more)