What Can Dentists Do To Protect Themselves?

I know the economic news is bad, how low can it go? The pain we have experienced in these past few weeks cannot continue, but that doesn’t mean we have seen the bottom or that stocks cannot fall from here. And history agrees.

Have a look at the average P/E ratio of the entire S&P 500 index over these three periods of market meltdown:
Period Average S&P 500 P/E Ratio
1977-1982>>>>>>>>>8.27 times
1947-1951>>>>>>>>>7.78 times
1940-1942>>>>>>>>>9.01 times

Compare that to what used to be an average P/E ratio of around 20 times and it's pretty apparent that stocks could fall much, much further than they already have, if they haven’t already by the time of this writing, just by returning to the lows they historically hover around during downturns. It would be useful to know what the average P/E ratio of the S&P 500 was just prior to these three market meltdowns. However, we do know about how much debt the government has had relative to GDP at the time of the Great Crash of ’29. Prior to the 1930s, the total debt in the U.S. was between 150% and 160% of GDP. Now it's close to 350% of GDP and it includes derivatives which it barely did prior to the 1930s.

How can you best protect yourself? Make sure you look at the P/E ratio going forward into this market and watch consumer sentiment.

Now, assuming earnings stay flat, and there is lots of evidence of that:

Manufacturing falls to lowest level in 26 years
The Institute for Supply Management said the index of national factory activity fell to 38.9 in October, the lowest in 26 years. Any reading of less than 40 is considered extremely weak. Economists were expecting 41.5, down from 43.5 in September. "It means we're in a recession, it's as simple as that ... a pretty solid manufacturing recession," said Robert Macintosh, chief economist at Eaton Vance. Reuters (03 Nov.)

Over one million jobs have been lost in the last 12 months. In September, another 159,000 jobs, in October 250,000 jobs disappeared.

Revisiting those historically low P/E levels could easily mean a decline from here, but how much further will it go, a DOW 5,000? When the Dow Jones Industrial Average touched its nominal low of 7,884.82 on October 10th, it had already lost 77% of its value when looked at from a real inflation-adjusted equivalent using 1977 dollars, or about a DOW 2,550. Also, on October 10th, 87% of all stocks on the NYSE hit new 12-month lows.

That kind of downside breadth exhaustion, where more than 50% of NYSE stocks hit 12-month lows at the same time, has occurred only four times — in 1962, 1966, 1970, and at the crash low of 1987.

Each one of those data points was at or within a few weeks of a major bottom.
When looked at in these real, inflation adjusted terms, this also means that the bulk of deflation is already past us. That’s good news for commodities. Of course, I’m not making any recommendations. I'm just taking a long look at history.
As difficult as it is right now, following the "this too will pass" philosophy really does work. The majority of stocks -- are worth much more than a measly 8 - 10 times earnings. The only thing that pushes the average stock to such scary levels is an overdose of panic and that is exactly where we are today.

The next few years are likely to be extremely volatile with all the markets, including real estate as we see-saw between greed and panic in the irrational market dynamic we are in.

What will the Dow Jones Industrial Average look like today? What percentage will it be off its high? In the 26 bear markets since 1900, it has declined more than 50% only twice -- 90% in 1929 and 52% in 1937. (In the tech wreck of 2000-2002, investors lost 78% of their money invested in the average Nasdaq stock.) And then, taking a deep breath and another long look at history, it goes up!

But with the recent increase in the money supply, isn’t that always inflationary? What is happening to gold? The answer is that inflation was yesterday’s problem, today’s is deflation and all that changed in October when global recession became evident and that eliminated any upward movement of prices. Money has to be spent in order to be inflationary, but with so much new money entering the system won’t that contribute to growing the economy? That is the hope and yes, when that happens it will be inflationary and then gold will go up, but that’s looking more long-term, after the panic subsides, meanwhile it is scary out there. Prices for commodities have collapsed, precious metals have experienced the biggest drop in 25 years. As global markets collapse, investors rush to exit for US dollars leaving European and UK banks the most exposed to the emerging economies debt obligations given that 45% of developing world loans originated from Europe relative to only 9% originating from the US and Japan. This bodes well for US currency strength going forward.

BRIC hard hit by crisis; funds see plummeting share prices Investors in funds specializing in BRIC -- Brazil, Russia, India and China -- have taken huge hits throughout the economic crisis, seeing the funds drop 60% or more in share prices. Analysts said BRIC will remain a principal engine of global growth for the medium and long term, but investors looking for short-term gains would do better buying U.S., U.K. or European equities. Telegraph (London) (21 Oct.)

Wall Street, Washington dictate course of global markets
Trading on a global level begins each day in Asia and the Pacific Rim, but more than ever, Wall Street and Washington are the driving force. "The data very nicely and scarily show that the U.S. is dominating the behavior of investors around the world," said Frank Nielsen, executive director of MSCI Barra. "There has been no decoupling of markets at all during this crisis. It all seems to be driven on the basis of what happens day to day in the U.S." International Herald Tribune (03 Nov.)

Global capital flow has shifted direction due to the deterioration of credit and is moving towards less risky assets, and surprise, it is not gold – it is US treasury bills, (not bonds).

Remember back to 1989 when Japanese consumers, after being crushed by the stock market crash and watching real estate investments crumble, weren't interested in borrowing anything at any rate – well, that’s where we are at right now. The fear is that people shun borrowing, lending and investing like they did in Japan. The lesson from Japan, is that it doesn’t matter how much money you throw at the problem, until people start rationally investing in a risk taking approach, nothing moves. In Japan's long bear market, which stretches from 1990 to the present, investors have lost 82% of their money from peak to trough in companies that make up the Nikkei average.

What does this mean for the US dollar? The US dollar has entered a multi-year bull market. The US dollar is the Imperial Currency around the world for investment, backed by the US military and a 14 Trillion dollar economy, nearly 3.5 times larger than China’s. This recent crisis has confirmed this and that for the short-term, relative to gold, it is very valuable paper because investors around the world have put their faith in it as the big elephant in the room. Therefore, the US dollar is King! As the dollar goes up, the value of oil goes down. When global markets are growing and money is flowing, then investors will seek the risk return of developing economies and then the commodities demand will resume.

But until then, why can't the U.S. government simply create more inflation, print more money to pay for it? Because if U.S. government issues bonds to borrow money. It depends on you, or the market on investors, to buy the bonds to loan the government the money, to finance the U.S. government. The U.S. government needs you to hold the U.S. bonds you've already bought. Plus, it needs you to buy more new bonds to finance all the new spending and deficits. In order to raise this money for the government, it must retain your confidence, your trust. To do that, it cannot run the printing presses or destroy your money. Instead, it has to let the deflation and depression run its course. And the biggest question of them all is, do you think the government’s manipulating the currency, writing new laws, and changing the banking structure — will be a match for the power of the markets; consumers, investors and bankers?

Market turmoil ironically boosts long-suffering dollar
In an ironic twist, the currency of the country that created the credit crunch is now a haven for frightened investors, driving the dollar up in value by 15.5% against a basket of currencies since Aug. 1. As stock markets plummeted again Wednesday, the dollar achieved significant gains against its European counterparts, with the pound falling to $1.6242, a five-year low, and the euro dropping to $1.2843, close to a two-year low. International Herald Tribune (22 Oct.)

Gold falls to less than $700 per ounce but rebounds slightly
Gold futures fell $20.50 on Thursday and closed at $714.70 an ounce on the New York Mercantile Exchange. At one point during the day, the metal fell to less than $700 an ounce. The decline was likely because of the rising U.S. dollar and massive fund sales. MarketWatch (23 Oct.)

Turmoil resurrects U.S. dollar as world's reserve currency
The financial crisis has seen investors voting with their cash and buying U.S. dollars, indicating that reports of the dollar's death as a reserve currency were greatly exaggerated. Investors quickly understood that the U.S. is the only nation with the political will to act quickly and the government and private-sector infrastructure to implement necessary policies. Reuters (28 Oct.)

China launches $586 billion economic-stimulus plan
Days before Chinese President Hu Jintao is set to meet with Group of 20 leaders in Washington, the country's State Council announced a spending plan that allocates $586 billion through 2010 to stimulate the economy. Hu is expected to be under greater pressure to play a bigger role in battling the global financial crisis. China plans to spend the stimulus package on projects including roads, airports, railways and the power grid. ClipSyndicate/Bloomberg (10 Nov.) , The Times (London) (10 Nov.) , International Herald Tribune (09 Nov.) , The Wall Street Journal (subscription required) (10 Nov.)

Treasury's change to tax policy boosts banks, angers lawmakers
While Congress debated the White House's proposal for a $700 billion banking rescue, the U.S. Treasury quietly changed tax policy that resulted in a $140 billion windfall for American banks. Lawmakers did not immediately notice the sweeping change made to more than 20 years of tax policy, but some were furious when the change came to light. "Did the Treasury Department have the authority to do this? I think almost every tax expert would agree that the answer is no," said George K. Yin, the Joint Committee on Taxation's former chief of staff. "They basically repealed a 22-year-old law that Congress passed as a backdoor way of providing aid to banks." The Washington Post (10 Nov.)

Fed won't say which banks got $2 trillion in emergency loans
Bond investors said secrecy from the Federal Reserve regarding its $2 trillion in emergency loans to banks -- including its refusal to identify the banks, the assets being accepted as collateral or the methodology used to value those assets -- is crippling the ability of financial markets to recover. Fund managers said this lack of transparency is a serious problem because "the market is very nervous and very thin." The nation's biggest banks declined to comment on whether they borrowed from the Fed. Bloomberg (10 Nov.)

Asset-backed lending dries up, shuts out commercial mortgages
Regional banks and insurance companies, the primary sources for commercial real-estate finance after credit markets froze, have completely stopped lending for this market, analysts at RBS Greenwich Capital Markets said. Thawing of short-term markets was a welcome first step, but "it is a baby step" that does little for commercial real estate, analyst Lisa Pendergast said. Bloomberg (07 Nov.)

Using probability theories, you are better off using stocks, over bonds to earn an inflation-adjusted return of investment to meet your retirement goals. While this is statistically true, it doesn’t mean it is individually true for you, it depend entirely on what your investment horizon is, market performance when you remove your money, and on how long you live.

The irony here is that the longer you work, the less time you have for retirement. The reality before this current crisis was that 80% of dentists could not afford to retire at age 65 in the same standard of living that they have grown accustomed to. The moral to this story is that you had better like dentistry, because in all likelihood, you are going to need to keep working.

What other markets can you consider? Already, in 2008, one in ten American homeowners has defaulted on their mortgage or lost their home in foreclosure. Nearly two in ten about 7.63 million properties, or 18%, had negative equity in September, according to a report by First American CoreLogic; that means they owe more than their home is worth, many of whom haven’t even begun to pay off the principal in no-money-down, interest only first mortgages that were “given” away.

Experts see danger in near-doubled "underwater" mortgages
About 12 million U.S. homeowners find themselves "under water" -- owing more money on their mortgages than their homes are worth -- compared with 6.6 million at the end of last year. Economists see this as a serious threat at a time when unemployment is rising. Reuters (21 Oct.)


What’s different this time than in 1929 was that the stock market crashed first, then the housing market. People didn’t borrow money to own their homes back then and there were no variable rate mortgages. The big question ahead is what will be the “fair market value” for homes going forward? Where will the bottom be? If the US sinks into depression, then that phase of the housing crisis where home prices rapidly sink in value hasn’t even happened yet, let alone what is going to go on in commercial real estate.

Another irony is that debt is the fuel for expansion by speculation. With debt, prices can be increased beyond sustainable levels ultimately because of greed. We have seen this kind of boondoggle before with the Dutch Tulip mania of the 1630s, South Sea land bubble of the 1700s, and the stock market panics of the early 1900s before the Federal Reserve banking system was established. It’s ironic that it is this same Federal Reserve Banking system combined with deregulation (loss of prudent oversight) that most directly contributed to this mess. Mortgages represent only 42% of the private-sector debt problem in the country; the other 58% comes from consumer debt and corporate debt. An astounding 40% of houses and condos were bought as second homes or investments.

So, today Americans are under huge pressure to sell their homes and second homes due to their other financial burdens ranging from their credit card debts to job layoffs. To make matter worse, Wall Street bundled up their mortgages (their promises to pay often based on no down payment, no income, no proof of assets, and interest-only payments for a few years…) and then resold them as securities that could be traded much like stocks and bonds. These securities, in turn, were bought by banks and investors in the U.S., Europe ( who intern invested in the developing economies around the world with the money assured from these same faulty mortgages, now repackaged as a CDOs, Collateral Debt Obligations), and Asia. To put this in perspective, European banks' exposure to emerging market loans is roughly six times as large as the United States' exposure to subprime mortgage-backed securities. Hence, the makings of the global credit crisis.

IMF running out of money to rescue emerging economies
The International Monetary Fund is burning through its $200 billion reserve fund so quickly that it may have to ask the West for more money or exercise its rarely used power to issue "special drawing rights." The drawing rights allow the IMF to create liquidity by acting as if it is the world's central bank. This was done briefly after the fall of the Soviet Union but has never been systematically used as a policy tool in a financial crisis. Telegraph (London) (27 Oct.)

To give you an idea of the size of this transfiguration, the total amount of mortgages transformed into these CDO securities: $4.8 trillion, that is 60% more than the total value of all the stocks in the Dow Jones Industrial Average. Phew! Then, in just one year — 2006 — $2.4 trillion in new mortgage-backed securities were created, more than triple the amount of just six years prior. Between 2005 and 2008, for example, Fannie Mae (a government mortgage corporation) purchased or guaranteed at least $270 billion in subprime mortgages — high-fee loans to high-risk borrowers. That was more than three times as much as it had bought in all its earlier years combined. So, I guess the speculators showed up in 2006 and bid up credit default swaps (new derivative securities that function like insurance on these bundled bad equity home mortgage loans, CDOs, except you don’t have to experience any loss to benefit from, for example, Lehman Brother’s downfall who you “insure” against this happening to benefit). There is not enough accountability in the system, no oversight.

Newest estimate of default swaps smaller than thought
Data from the Depository Trust & Clearing Corp. provide a clearer picture of the size and nature of the market for credit-default swaps than was previously available. The company said in the first of a series of weekly reports that there is $33.6 trillion in credit-default swaps outstanding on corporate, government and asset-backed securities. The figure is substantially lower than earlier estimates that ran to $50 trillion or more. The New York Times/DealBook blog (04 Nov.)

How do dentists protect themselves in today’s economy with unethical and unregulated markets? First, don’t blame yourself and don’t look back, the world has changed, look at what is happening now. Second, don’t count on the government to save the day, whether though social security, increased oversight, or tax relief. Third, don’t underestimate the depth, speed or duration of this “correction”.

Rating agencies "drank the Kool-Aid," Moody's CEO says
Raymond McDaniel, CEO of Moody's, told Congress that in the run-up to the financial crisis, the three major credit-rating agencies -- Moody's, Standard & Poor's and Fitch Ratings -- were trapped in a race to the bottom, forced to lower standards to maintain market share. Rep. Henry Waxman, D-Calif., chairman of the House Committee on Oversight and Government Reform, said that race was lucrative for the rating agencies in the short run but disastrous for the global economy in the long run. MarketWatch (22 Oct.)

Greenspan says crisis "found a flaw" in his thinking
Alan Greenspan, former chairman of the Federal Reserve, told a congressional committee that he made "a mistake" in thinking that self-interest would force banks and other financial institutions to protect shareholders. He said he wrongly assumed that lenders would carry out proper surveillance of their counterparties. On the other hand, Greenspan said the kind of heavy regulation that could have prevented the economic crisis would also have damaged growth in the U.S. Financial Times (23 Oct.) , The Wall Street Journal (subscription required) (24 Oct.) , BBC (23 Oct.)

What do I mean? Well, this latest rally is sure to be a dead cat bounce but if I am right there are likely to be a few between now and year end. On Thursday, we learned that the U.S. economy actually shrunk in the third quarter; that consumer spending, the discretionary income consumers have available, had plunged to the lowest level since 1947. Not until consumer confidence returns can you expect to be safe in the markets, until then, these are and will be very interesting times.

U.S. consumer confidence falls to all-time low
As the financial crisis settles in, the U.S. is seeing its lowest consumer confidence since the Conference Board index was created more than 40 years ago. It fell to 38 in October from 61.4 in September, far less than the 52 that economists predicted. Consumer spending accounts for about 50% of the country's GDP. Financial Times (28 Oct.)

U.S. economy slides on decreased investment, spending
The U.S. economy contracted in the third quarter to a 0.3% annual rate of growth, the most drastic slump the country has seen in seven years. Contributing factors include decreased consumer spending and lower business investment. "The mortgage meltdown is far from over; the economy and financial markets are still reeling from it," said Janet Yellen, president of the Federal Reserve Bank of San Francisco. Reuters (30 Oct.)

MasterCard says Americans chop spending, avoid luxury goods
According to SpendingPulse, a data service of MasterCard Advisors, Americans cut their spending by a lot in October, especially avoiding goods costing more than $1,000. Sales of specialty apparel, women's apparel, footwear, electronics and appliances all fell, and luxury items saw a serious slump. "If you take out the purchases above $1,000, the sector is really down about 10%," said Michael McNamara, vice president of MasterCard Advisors. Reuters (05 Nov.) ct.)

Study suggests election will have little impact on markets
Although politicians do have some influence on the economy, analysts said it likely will not matter much whether John McCain or Barack Obama is in the White House. Instead, they said, stock markets can only rise in the coming year. Many studies have examined the relationship between presidential elections and stock markets. A study by Robert Johnson, managing director of the CFA Institute's Education Division, Northern Illinois University professor Gerald Jensen and University of Wisconsin professor Scott Beyer suggests that the real influence comes from the Federal Reserve's monetary policy. The Associated Press (03 Nov.)

Business groups brace for more regulation
Business groups are preparing for more regulation regardless of who comes out on top of elections in the U.S. on Tuesday. At the same time, they are warning that more regulation could hurt, not help, the already-battered economy. "The pendulum never stops in the middle," said Bruce Josten, chief lobbyist for the U.S. Chamber of Commerce. MSNBC/The Associated Press (02 Nov.)

How do you ensure you won’t run out of money during your planned retirement?
Well, that depends upon when your planned retirement is? If it is within the next 5 years, you are better off out of the market in short-term US treasury bills, sell on the rallies. Your exit timing relative to the markets is another key, otherwise, to best protect your self - keep on working! And remember you are more than what you do, - keep on “being”!

If you are in it for the long-term, remember what history has shown us as to America’s constant growth, and realize, that this growth must continue in the capitalist system, with implied built-in inflation due to this growth which until now, managed between 2-3%, seemed like “the golden point” to avoid run-away inflation and still stimulate enough growth to manage a favorable return, as the history of the stock market attests. So, in this best-case scenario, stay invested, keep your head down, and keep working. And remember, the US economy is a 14 Trillion dollar economy; China’s economy is a 3 trillion dollar economy, and there is a world of difference in magnitudes of scale between them, something that will keep the US economy dominant long into the foreseeable future.

If you find comfort in both my arguments, “stay invested vs. convert to US treasury bills”, then consider, converting 50% of your equity and bond portfolio to cash (US Treasury Bills) selling on the rallies.

The Fed, indeed all central banks' attempts to re-inflate asset prices, should soon begin to have an impact on markets. There is a meeting this week, organized by Bush to call together all the central bankers and decision makers together to re-new the financial system. The rules could change again, as I suspect they will like they did back when the Bretton Woods Conference met previously, in 1944. They took the dollar off the $20/ounce of gold standard, and created the World Bank and the IMF. Then again in 1971 the US went off gold standard entirely and became the world’s currency, the dominant economy involved in all growth economies, and backed by the US military… So, we were a bigger global economic force in the ‘70s than today, however we are still the elephant in the room, and as the elephant goes, so goes the rest of jungle.

G-20 leaders plan to speak with united voice on crisis
At the Group of 20 summit in Washington this week, world leaders will strive to stand united about dealing with the economic crisis. Many observers said their actions may not be as united as their rhetoric. The French want to establish a regulatory regime, but the Americans are wary of the concept. The British are seeking to make the International Monetary Fund more powerful. The Russians oppose the idea. G-20 ministers met in Sao Paulo, Brazil, during the weekend to prepare for this week's meeting and to discuss a global economic-stimulus package, but they did not approve a final plan. The Wall Street Journal (subscription required) (10 Nov.) , International Herald Tribune/The Associated Press (09 Nov.)

The key to working out of this credit crisis at this meeting is coming to an understanding that debt defaults cause deflation; and deflation causes debt defaults. In this crisis, however, it could be competitive interest-rate hikes that emerge as a catalyst for depression. They will do, however, what they can do to lower interest rates. What’s more, in this summit of summits, they need to convince billions of consumers, millions of investors and thousands of bankers around the world to take on more risk!

But how far can all of this go, in the past 2 month we have spent 2.7 trillion in unplanned rescue funds.

Your decisions in the coming weeks could make the difference between a successful career or a lifetime of struggle; I hope I have stimulated you to have a plan, and be prepared to act prudently while being agile. Change is happening so fast with this crisis; just the size of it is mind-blowing:

Just look at how far the U.S. Treasury and Federal Reserve have already gone out on a limb to fight the debt-and-deflation spiral. They’ve loaned, invested, or committed:
1.
$2.7 trillion to bail out the financial crisis, (total rescue money announced), but it’s still not enough.
2.
Based on the Federal Reserve's Flow of Funds report, there are now $52 trillion in interest-bearing debts in the U.S.
3.
Based on estimates provided by the U.S. Government Accountability Office and other sources, it's safe to assume that there are also at least $60 trillion in contingency debts and obligations now starting to kick in — for Social Security, Medicare and other pensions.
4.
Separately, the Bank of International Settlements reports that the total value of debts and bets placed worldwide (derivatives) is $596 trillion in derivatives worldwide (all outside the purview of any established exchange). And so you can see how the leg bone is connected to the hip bone, and how these original US sub-prime mortgages amounted to so much bad debt that began by affecting the original home owners, then the banks, then Fanny Mae, then the Insurance companies got involved on this debt and finally the derivative securities, A.K.A. Collateral Debt Obligations which fueled the speculation and manipulation used by powerful hedge funds and investment houses.
5.
As all this is happening in the background, for the first time, the Federal Reserve's balance sheet exceeded $2 trillion as the central bank continues to lend huge sums of cash to financial institutions to keep short-term funding markets alive. The Fed's balance sheet grew from $1.953 trillion Oct. 29 to $2.058 trillion Wednesday. Banks pulled back on direct borrowing from the Fed's discount window, but the industry remains dependent on the lender of last resort. CNBC/The Associated Press (06 Nov.)

Now, in response to massive government bailouts, and the re-writing of the rules of the game, we’re witnessing a temporary easing of the credit markets, and investors are hoping the worst is over. The market recovery cannot last very long in this environment, and as the global recession takes its toll on financial companies, it’s likely to be followed by a larger, still more powerful wave of debt collapses, for another swoop downward.

If you don’t like this ride, ask yourself, do I really want to participate in another? With all this market volatility right now, surely we have entered a downdraft crisis. Remember, in Oct of 2007, we were in the 1400s; that was one year ago? Have we already corrected to a near bottom? Regardless, the real question is whether or not you think all this financial wizardry is sustainable going forward? Do you think bigger is always better for an economic return, what about a societal return? Who do you want to be beholden to the tax payer or the shareholder? And is what you see in your community positive and healthy? If you are as confused by all this as I am, maybe you might want to consider taking some time away from the markets, and just sit on some cash (Treasury Bills) and wait it out to see if the economic storm of the century establishes itself or not, to see if there is something the governments can do to, to encourage consumers to direct it back out to sea again.

Meanwhile, assuming you get out on a rally and there should be a few rally opportunities between now and the New Year, I offer, it’s better to have a bird in the hand than two in the bush. How to protect yourself in these far from certain markets; how about taking 6 months out, just to see how this all unfolds?

Fannie, Freddie, officials create program to help homeowners
Fannie Mae, Freddie Mac and officials in the housing industry worked out a program to reduce monthly payments for hundreds of thousands of homeowners to 38% of their income, sources said. The parties involved used a combination of interest-rate reductions, extensions and reduced principals to get to the level, which is considered an affordability threshold. The effort is an expansion of initiatives by the Hope Now Alliance. Bloomberg (11 Nov.)

Treasury close to second rescue for Fannie Mae:The U.S. Treasury is on the verge of injecting as much as $100 billion of fresh capital into Fannie Mae, only three months after the government took over the corporation. The Treasury is worried that mortgage rates will soar if Fannie is forced into liquidation, making it enormously difficult for the housing market to climb out of its worst slump since the Great Depression. Analysts said a Treasury infusion for Fannie and Freddie Mac would boost market confidence and eventually help loosen up the mortgage market. Reuters (10 Nov.)

Survey suggests longer, deeper recession in U.S. than expected
A survey of 49 economist by Blue Chip Economic Indicators points to contracting GDP in the U.S. well into 2009, with Britain and Japan also experiencing deep recessions. The economists' median forecast calls for U.S. GDP to fall by 2.8% in the final three months of 2008 and by 1.5% in the first quarter of 2009. They expect feeble a GDP growth of 0.2% in the second quarter next year. MarketWatch (10 Nov.)

Investors factor in slowdown, drive oil close to 20-month low
The price of oil fell to a midday low of $58.55 on Wednesday in Asia as decreased consumption of gasoline and other oil products sank in. Commodity strategists said it is obvious that global growth will be "pretty awful" next year and not much better in 2010. Slowing demand for crude in China is a big factor for slumping prices. BusinessWeek/The Associated Press (11 Nov.)

Understanding The Gobal Financial Crisis Upon Us

Bank losses on Fannie, Freddie stock apparently underestimatedAccording to a survey conducted by the American Bankers Association, nearly one-third of U.S. banks hold preferred stock issued by Fannie Mae and Freddie Mac. Nearly all $36 billion of such stock was cleaned out when the Federal Reserve took the mortgage giants over. "The negative impact on banks -- particularly Main Street community banks -- is far greater than regulators first thought," Edward Yingling, CEO of the ABA, wrote in a letter to the Treasury, the Federal Reserve and other banking regulators. Financial Times (23 Sep.)

SEC's Cox says "voluntary regulation doesn't work"Securities and Exchange Commission Chairman Christopher Cox said during a Senate Banking Committee hearing Tuesday that "voluntary regulation doesn't work." He said he is seriously concerned that no government agency has regulatory authority over investment banks. He wants the SEC to be granted authority to require disclosure statements as well as power over products such as credit-default swaps. InvestmentNews (23 Sep.)

Analysis: Privacy in market for credit-default swaps led to problems: No one truly knew the volume of trading in the market for credit-default swaps, possibly leading to overinsurance in the sector. That, in turn, fueled the financial crisis. "The pressure to hedge has led the most liquid contracts to overshoot, in effect pricing in absurd default risks and recovery rates," according to a Financial Times analysis. Financial Times (23 Sep.)

To fund those deficits, we're going to have to borrow an ASTRONOMICAL amount of money. The Treasury just held a record $34 billion sale of 2-year Treasury Notes. That was followed by a $24 billion sale of 5-year Notes, the biggest such sale in more than five years. Those numbers will only go higher with time.

White House, Congress agree on rescue proposal President George W. Bush's administration and congressional leaders came to terms on a $700 billion rescue plan for the financial system. The House and Senate will likely vote on the legislation this week. Many of the plan's mechanics were left to the Treasury, including how much the government would pay for toxic assets and which assets would be bought. The Treasury has 45 days under the bill to issue guidelines regarding those procedures. Read the draft proposal. ClipSyndicate/Bloomberg (29 Sep.) , The New York Times (28 Sep.) , Financial Times (29 Sep.)

In fact, Congress is raising the federal debt ceiling to a whopping $11.3 TRILLION to account for this additional borrowing.

The likely impact: All the additional supply will drive bond prices LOWER and interest rates HIGHER. Heck, 10-year Treasury Note yields have already surged from around 3.4% to almost 3.9%. That will blunt the impact of the bailout by driving financing costs higher on all loans whose rates are benchmarked to Treasuries. I’ll bet they will be lower interest rates soon to counter act this unwanted effect. (Bernanke lowered them on Oct 21st.)

Rescue plan defeated on Capitol Hill; Dow falls 777 points Despite pleas from President George W. Bush and leading lawmakers from both parties, the U.S. House of Representatives voted 228-205 against the $700 billion rescue plan. The development sent markets plunging -- the Dow dropped 777 points -- and left leading lawmakers scrambling. Only 65 Republicans, or about a third of those voting, supported the plan, while 140 Democrats, about 60%, said yes, although many voiced concerns. Both presidential nominees, Sens. John McCain and Barack Obama, supported the bill. ClipSyndicate/Bloomberg (29 Sep.) , International Herald Tribune (29 Sep.) , The Economist (29 Sep.) , The Wall Street Journal (subscription required) (30 Sep.) , Bloomberg (30 Sep.)

U.S. financial ills spread to Europe and beyondAbout a week ago, European leaders rejected calls from U.S. counterparts to join their economic-rescue effort. Now Europe is facing a financial crisis nearly as dire as the American situation. The turnaround of events shows just how quickly problems are spreading. "In this day and age, a bank run spreads around the world, not around the block," said Thomas Mayer, Deutsche Bank's chief European economist. "Once a bank run is under way, it doesn't matter anymore if you have good loans or bad loans. People lose confidence in you." International Herald Tribune (01 Oct.) , Reuters (01 Oct.)


Lack of confidence sends Libor to record levelWhile stock markets around the world suffer steep declines, the overnight dollar Libor surged to 6.88%, an indication that lenders are concerned that money they lend to other financial institutions may never been seen again. "The reason Libor is so elevated is a lack of confidence between counterparties in the financial sector," said Charlie Diebel of Nomura. The situation forced central banks to inject billions into the system. Telegraph (London) (01 Oct.)


Manufacturing contracts faster than expectedThe measure of American manufacturing activity marked its first significant decline of the economic downturn. The index of the Institute for Supply Management has been hovering for most of the year on what economists call "the boom-bust" line." "The headline ISM has plunged into recession territory," said Ian Shepherdson, chief U.S. economist at High Frequency Economics. The New York Times/The Associated Press (01 Oct.)

Credit-card debt may be next to slap finance sectorInnovest StrategicValue Advisors predicted that credit-card debt is the next wave to crash against the financial sector, saying banks will charge off $96 billion in delinquent accounts in 2009, twice the forecast for 2008. Gregory Larkin, senior banking analyst for Innovest, said all of that bad credit is going to surface rapidly, and he predicted that credit-card charge-offs will mimic those of mortgages. MarketWatch (30 Sep.)

SEC extends ban on short salesTo give Congress more time to pass the $700 billion economic-rescue plan, the Securities and Exchange Commission extended the temporary, emergency ban on short selling in nearly 1,000 stocks. The ban will continue until three business days after the rescue package is enacted, if it gets approved. But the ban will not last past Oct. 17. Reuters (01 Oct.) , Financial Times (02 Oct.)

FDIC seeks unlimited-borrowing authorityThe Federal Deposit Insurance Corp. asked Congress for temporary authority for unlimited borrowing. The request was in the U.S. Senate's bailout legislation. The 451-page bill would raise the limit on federal bank-deposit insurance from $100,000 per depositor to $250,000. Reuters (01 Oct.)

Commercial paper sees biggest weekly drop since 2001Data from the Federal Reserve show a stunning $95 billion drop in commercial-paper investment, the biggest weekly reduction in six years. The shrinkage in commercial-paper financing raises fears of serious cash-flow problems for corporate borrowers and banks. Freezing of the market is hitting even highly rated companies, including General Electric and AT&T. Financial Times (02 Oct.)

"Ghost of deflation" haunts marketsAs banks tighten credit, commodity prices plummet and asset values decline, the world may be turning from the dangers of inflation to the risk of falling into a vicious deflationary cycle. "The ghost of deflation could be dragged out of the closet again in coming months," said Joerg Kraemer, chief economist at Commerzbank in London. David Owen, chief European economist at Dresdner Kleinwort in London, agreed, saying, "We are certainly more worried about deflation than inflation." Bloomberg (06 Oct.)
U.S. plans bold moves to shore up financial system

The U.S. Treasury Department plans to invest as much as $250 billion in banks and guarantee newly issued bank debt for three years to battle the financial crisis, officials said. The Federal Deposit Insurance Corp. will guarantee all deposit accounts that do not earn interest. Capital injections will come from the $700 billion rescue package approved earlier this month. President George W. Bush is expected to announce the plan Tuesday. ClipSyndicate/Bloomberg (14 Oct.) , International Herald Tribune (14 Oct.) , Bloomberg (14 Oct.)

Economic slowdown clamps lid on runaway commodity pricesWorld prices for wheat and corn have dropped 40% since spring, oil is down 44%, and metals such as aluminum, copper and nickel have fallen by a third or more, as financial panic brings the commodity bull market to an end -- at least for the moment. This sudden about-face is the brightest news on the horizon for consumers because it puts money into their pockets at a time when they really need it. The New York Times (13 Oct.)

The world is on notice.

Several of the world's Central Banks launched a determined and coordinated attack against the widening global financial crisis by lowering short-term interest rates in unison last week.
The Federal Reserve Bank, the European Central Bank, the Bank of England, Canada, Sweden, Australia, and Switzerland all cut short-term interest rates by a half percentage point.
Across the Pacific Ocean, the People's Bank of China, Australia, South Korea, Hong Kong, Singapore, and Taiwan cut interest rates, too.

This is the first time that central banks have moved in unison since the September 11 terrorist attacks, and I think it is just the start of global government efforts to keep the global economy from further deterioration. Then, over this past weekend, we saw additional coordination from the U.S. and European Central Banks: The Fed, the European Central Bank, the Swiss National Bank, and the Bank of England all saying they would provide unlimited U.S. dollar funds to financial firms.


2 kinds of investors

Academics and economists deal in a world populated by rational investors. Unfortunately, we live in a world populated by behavioral investors. Rational investors look at the turbulence in today’s markets and calmly evaluate the potential risks and rewards of remaining invested. Rational investors do not confuse certainty with safety. They recognize that, although the principal value of funds invested in Treasuries and CDs may be certain, after factoring in taxes and inflation, the return they receive on their “safe” portfolio they realize that it may fall woefully short of what they need to maintain their standard of living in retirement.

This is not so for behavioral investors. They see the frightening headlines and are bombarded minute by minute on the radio, television, and internet with financial crazy making. The result is all too often a growing panic that leads them to seek the mythical “safety” of dumping stock and running to cash. Which one are you?

A bit of perspective

If the Central Banks were our kids, we'd be taking their credit cards away. They are spending us into the poor house!

Sure, Wall Street is at the rotten root of this crisis. Their toxic debt is poisoning the global economy and financial system. But there's plenty of blame to go around.

It makes you wonder just how big that $700-billion bailout package will need to be, now that they've expanded it from buying toxic debt to buying preferred shares in banks. All this new spending is in addition to the $1.8 trillion in total government bailout money since the financial crisis started.

Maybe we won't get those higher prices in gold right away, because investors are scared of deflation.

On the other hand, throwing trillions and trillions of dollars at the system is inherently inflationary.
Do you think Beijing thinks that the dollar's status as a reserve currency is soon going to be history. Just like the pound sterling lost its status as the world's reserve currency in the early 20th century.
Beijing's bank is overflowing with money. In fact, at nearly $2 trillion, China has the largest foreign reserves of any country in the history of the planet.

That's why they're going to back the yuan with gold ... loads of it. China has already started purchasing small amounts of gold.

Economists say U.S. housing market nowhere near bottomHome prices across most of the country are likely to continue falling through the end of 2009, economists said, and in some markets may keep falling even longer, depending on how bad the slowdown gets. In the hardest-hit states such as Arizona, California and Florida, the story is the same: More houses are going up for sale while escalating interest rates on mortgages, falling wages and rising unemployment are putting pressure on an already-diminished pool of possible buyers. The New York Times (15 Oct.)

IMF raises estimate of losses from crisis to $1.4 trillionIn its quarterly report on global capital markets, the International Monetary Fund increased its estimate of losses from the financial crisis to $1.4 trillion, up from $945 billion in April and $1.3 trillion last month. The IMF also estimated that major global banks will need approximately $675 billion in capital in coming years. "The combination of mounting losses, falling asset prices and a deepening economic downturn has caused serious doubts about the viability of a widening swath of the financial system," the IMF said in its assessment. International Herald Tribune/Reuters (07 Oct.)

Consumer borrowing sees first fall in more than decadeConsumer borrowing fell at an annual rate of 3.7% in August as households scaled back their use of credit drastically, according to the Federal Reserve. This is the first time that consumer borrowing fell in more than 10 years. Although economists expected a $5.25 billion increase in August from July, borrowing was instead down $7.88 billion, totaling $2.58 trillion. The New York Times/The Associated Press (07 Oct.)

The government is throwing everything ... and I do mean EVERYTHING ... at the credit and mortgage markets. But rates on 30-year fixed loans aren't going down. They're going up.

How can rates be going up when the economy is tanking and the government is throwing everything it can at the banking sector and credit markets?

Because bond investors are dumping the heck out of bonds — and when bond PRICES fall, bond YIELDS (interest rates) rise.

Why are investors selling bonds? Well, they just learned that the budget deficit soared to $454.8 billion in fiscal 2008, which ended September 30. That was more than double the $161.5 billion deficit in 2007 and the highest in the history of the country.

Politicians and policymakers would like you to think they can make things better, drive mortgage rates down, save the banking sector, and return us to the happy-go-lucky, reckless lending days of 2003-2007. But they can't. Well, they can and just today they lowered rates by another ¼ point… but the bond market is pushing back and saying loud and clear: "We can see the writing on the wall, there will be too much supply of future government bonds and too little demand, they are out of there."

Federal deficit takes back seat to stabilityConfronted with a hugely expensive economic crisis, Democratic and Republican lawmakers alike elected to pay the bill for a bailout by borrowing money rather than cutting spending or raising taxes. The problem lurking in the shadows is that while borrowing is relatively inexpensive in a weak economy with plummeting interest rates, the cost will become a much heavier burden when growth returns and interest rates climb. The New York Times (19 Oct.)

Job losses hurt every corner of U.S. economyLayoffs are spreading beyond the financial and home-building sectors to every corner of the economy, with the situation likely to worsen as the holiday season approaches. A survey of more than 100 chief financial officers and other senior executives found that 58% expect to reduce payrolls next year, while a majority plan to cut operating costs by at least 5%. A four-week moving average of new U.S. government jobless claims hit its highest point last week in seven years. Reuters (17 Oct.)

Bernanke backs another stimulus packageCongress would be wise to start thinking about another fiscal-stimulus package to pull the U.S. out of a long downturn, Federal Reserve Chairman Ben Bernanke said. Predicting an economy "likely to be weak for several quarters," Bernanke explicitly endorsed for the first time another stimulus package. For months, Democrats have been pushing for a second round of stimulus measures, targeted to domestic construction projects, expanded food stamps and broader federal spending to help states pay for growing health care costs for the poor. Reuters (21 Oct.)

And so it goes…

Moral Suasion and the Markets

Note: As most of you regular readers know, I have taken to the habit of posting clips of important news to your financial future at the beginning of my post. Because of the recent events there is quite a run-up from August 05, my last posting to this post. These clips are a fascinating story unfolding of to the lead up to the biggest market collapse since the Great Depression. See the financial storm brewing. After these news clips is my commentary. For those of you new to this blog, the current theme about the economy began in April of ’08. To get an in depth analysis of what is going wrong and why the rules are changing, begin in April.

Inflation outpaces rise in U.S. consumer spendingConsumer spending grew by 0.6% in June, but that gain was wiped out by inflation rising by 0.8%, the biggest monthly increase since September 2005. "That real consumer spending is down two-tenths in June is not a good thing in and of itself, but it also is a bad thing for what it means for third-quarter consumption," JPMorgan Chase economist Michael Feroli said. The New York Times (05 Aug.)

U.S. home prices could fall additional 33%, analyst saysU.S. home prices could fall by an additional one-third before mortgage lending resumes with gusto, a widely respected analyst said. "Home prices are going to fall much more than people expect," Oppenheimer analyst Meredith Whitney said. CNBC (04 Aug.)

What sounded alarmist a year ago is fairly accurate nowAs the Financial Times continues its look back over the credit crunch that began one year ago, it delves even further back into the recent history of investment banking, hedge funds and how the financial industry has changed. "This has been a very deep and unusual crisis that involves the unwinding of a decade of excess. The impact on the financial sector has been 7 on the Richter scale (a 'major' earthquake), as dramatic as anything for 25 years," said Bill Winters, co-head of the investment bank at JPMorgan Chase. Financial Times (04 Aug.)

IMF reduces forecast for growth in BritainThe International Monetary Fund dashed Alistair Darling's hopes for a quick recovery of the U.K. economy by lowering its forecast for growth and by warning of two more years of economic woes. Additionally, the fund said rising inflation gives the Bank of England little room to adjust monetary policy to bolster growth. The IMF also said the Treasury is on course to reach next year the national-debt limit of 40% of GDP, in a warning to the chancellor that he won't be able to borrow his way out of economic pain. The Times (London) (07 Aug.)

Credit crisis persists as banks take more hitsThe credit crisis continues to affect some of the biggest banks on Wall Street. UBS, Citigroup and Merrill Lynch have taken massive write-downs, and investors are still worried about more subprime costs. Although lower oil prices have lifted stocks, it apparently will take more than cheaper energy to boost consumer spending and business. CNBC/Reuters (12 Aug.)

U.S. health care expenses expected to jump 10.6%Health care costs in the U.S. are predicted to increase 10.6% next year. Employers have lowered many costs of health coverage with sizable investments in wellness programs that help prevent expensive critical care. FinancialWeek (12 Aug.)

Federal Reserve's concern about inflation continuesThe Federal Reserve said inflation is still a top concern, even as energy prices fell recently. Given the unimpressive growth rate, plus inflation, a recession is still possible for the U.S., although some officials see declining oil prices as keeping inflation under control. Reuters (12 Aug.)

The Cold, Hard Numbers on the Credit Crunch
RealtyTrac shocked Wall Street with the most explosive news imaginable:
U.S. home foreclosures skyrocketed an astonishing 55% in July ...
One in every 464 American homes went into foreclosure last month alone ...
A staggering 750,000 abandoned homes are now begging for buyers nationwide — a clear sign that prices will continue to plummet and that ever-increasing numbers of homeowners will walk away in the months ahead ...

Fed Loan Officer Survey Shows Widespread Tightening!
Every quarter, the Fed releases a report called the "Senior Loan Officer Opinion Survey on Bank Lending Practices." It quantifies how many banks are tightening standards, and on which types of loans. The third-quarter survey was conducted in July; 52 domestic banks and 21 foreign banks with operations here in the U.S. responded.

Some 74% of banks surveyed said they're tightening standards on prime mortgages, up from 62.3% in the second quarter of 2008. A net 84.4% said they were cracking down on nontraditional financing, up from 75.6%. And a net 85.7% said they were tightening on subprime loans, up from 77.7% a quarter earlier.

These numbers are off the charts. The previous record for the home mortgage category was 32.7% in 1991. So in plain English, you have more than twice as many banks tightening standards now than EVER before.

* The trend is spilling over into commercial real estate. This is no longer just a subprime mortgage crunch. In fact, it's not even a residential real estate crunch. The Fed's commercial real estate (CRE) figures prove it.

A net 80.7% of survey respondents said they were tightening standards on CRE loans. That was up from 78.6% a quarter earlier and the highest on record.

* Consumer credit is tougher to come by. The story is the same for credit cards, auto loans, boat loans, and other forms of consumer credit. Some 66.6% of lenders said they were tightening standards on credit card borrowers. That was up from 32.4% a quarter earlier and the highest since the Fed began collecting data in 1996. 67.4% are making it tougher to get other consumer loans, up from 44.4% and another record. Money and Markets by Mike Larson August 15, 2008

Economists: Taxpayers likely to bail out Fannie, FreddieThe consensus of 53 economists polled by the Wall Street Journal is that there is a nearly 60% chance that U.S. taxpayers will have to prop up Fannie Mae and Freddie Mac. The main mortgage-finance providers in the U.S. should be pushed to raise capital privately, said seven out of 10 economists surveyed. One in three said Freddie and Fannie should be nationalized and then sold off in smaller chunks when the housing market recovers, the newspaper reported. Bloomberg (15 Aug.)

Gas more expensive than cars for U.S. consumersIn May and June, U.S. dollars spent on gas surpassed money spent on cars and parts for the first time since 1982. The last time gasoline was such a large component of personal spending was in September 1982 during an energy crisis set off by the 1979 Islamic revolution in Iran, the second-largest oil producer of OPEC. Record prices at the pump have decreased U.S. gasoline demand, at a five-year low, and also affected consumer spending, including auto sales. Bloomberg (15 Aug.)

Concerns mount with U.S. inflation still on the riseMany were betting that slowing consumer demand coupled with declining energy prices would help smooth inflationary pressures, but last month saw U.S. consumer prices rise twice as fast as predicted, in the largest surge since 1991. This situation further emphasizes the predicament of the Federal Reserve as it tries to balance the risks of increasing cost of living with growing unemployment, the credit crunch, and a weakened consumer. Financial Times (14 Aug.)

Signs of economic slowdown pile up in Asia, EuropeGermany's economy is contracting, the Bank of England offered a dismal outlook and Japan seems to be near a recession. More bad economic news is expected in Europe this week. Although commodity prices are starting to come down, consumers are feeling the pressure from financial crises in the U.S. and elevated inflation. Experts said the U.S. economic slowdown is spreading through Europe and Asia. International Herald Tribune (14 Aug.)

Shrinkage of U.S. money supply causes further concernWith the U.S. money supply seeing its most acute contraction in modern history, there is a more heightened risk than ever of a severe economic slowdown. This comes on top of the current credit crisis and at a time when overall debt burden in the U.S. economy is at record levels. The acuteness of the drop, versus the absolute level, is what monetarists find most disturbing. Telegraph (London) (19 Aug.)

Former IMF economist predicts failure of large U.S. bankFormer International Monetary Fund chief economist Kenneth Rogoff expects to see a large U.S. bank fail in the next few months, estimating more trouble for the U.S. economy. "I think the financial crisis is at the halfway point, perhaps. I would even go further to say, 'The worst is to come,'" he said at a financial conference. Rogoff also said the Federal Reserve was wrong to slash interest rates as "dramatically" as it did. Reuters (19 Aug.)

Freddie Mac's bond sale underscores severity of crisisFreddie Mac paid a yield of 4.172%, 113 basis points over Treasuries, on a five-year debt issue to raise $3 billion. It is the highest risk premium that Freddie has paid, highlighting the severity of the U.S. housing crisis. Investors have demanded higher yields because of uncertainty in the market as well as questions about moves that the government might make regarding the government-sponsored enterprise. Financial Times (20 Aug.)

U.S. walks tightrope between inflation, recessionThe U.S. is battling inflation and a recession simultaneously as higher costs for food and energy affect nearly all products, increasing consumer prices. Some economists see the slowdown as an antidote for inflation; others see inflation as a continuing threat. Options for the average American are that either inflation will reduce their buying power or rising prices will spell the end of some jobs and businesses. The New York Times (19 Aug.)

SEC plans to broaden short-selling ruleThe Securities and Exchange Commission aims to propose a new short-selling rule in upcoming weeks, broadening an emergency order -- covering 19 financial stocks -- that ended last week. SEC Chairman Christopher Cox said the proposal "will focus on marketwide solutions" and possibly require more transparency in disclosing to the public significant short positions in stocks. Reuters (19 Aug.)

Cramer of CNBC suspects insider trading of Fannie, Freddie: CNBC's Jim Cramer called for a suspension in trading Fannie Mae and Freddie Mac stocks on the grounds that insider information was circulating. Cramer blamed the Securities and Exchange Commission and the New York Stock Exchange for not taking action when it seemed obvious that insider trading was happening. CNBC (20 Aug.)


Gold becomes solid as oil prices climb, dollar dropsThe combination of a falling dollar and higher oil prices has raised gold's appeal as the precious metal is expected to have its largest weekly gain in seven years. "In the short term, at least for another month or so, gold will stay in this consolidatory phase of rebounding on price drops and falling when gains get too much," said Lin Yuhui of China International Futures. "These movements will largely continue to be driven by movements in the U.S. dollar and crude oil." Bloomberg (22 Aug.)

Libor-OIS spread indicates credit crunch to continueThe spread between the three-month London interbank offered rate for dollars and the overnight indexed swap rate is at 77 basis points, up from 24 basis points in January. By mid-December the spread is expected to widen to 85 basis points. Alan Greenspan, former chairman of the Federal Reserve, said the spread should indicate when the markets have returned to normal. According to forward markets, that won't be for quite some time. "It's like an ongoing nightmare and no one is sure when we're going to wake up," said Stuart Thomson, a money manager at Resolution Investment Management. "Things are going to get worse before they get better." Bloomberg (25 Aug.)

Banks, firms pay more to raise money in bond markets Dismal economic conditions around the world, increasing default rates and concerns about the health of financial institutions are forcing yields to rise as bond investors demand higher spreads. According to Lehman Brothers, risk premiums for investment-grade companies and banks in the U.S. recently reached their highest level since the 1990s. Spreads in Europe and Asia for some investment-grade companies have hit 10-year highs as well. ClipSyndicate/Bloomberg (22 Aug.) , Financial Times (24 Aug.)

Central bankers acknowledge uncertainty of crisis: At the gathering of central bankers and other economic experts in Jackson Hole, Wyo., this weekend, the consensus was uncertainty as to how the credit crisis and other woes will ultimately affect the global economy. Policymakers from around the world seem conflicted as to whether resilience in the global economy will win out or if the worst is yet to come. Financial Times (24 Aug.)

Analysis: U.S. economic woes hinge on home buyersThe difference between a mild downturn of the U.S. economy and a severe recession depends on the ability and willingness of consumers to quickly return to the housing market, according to this Reuters analysis. In order for home prices to be in balance with incomes and rents, economists say they need to drop another 10%. However, prices could fall even further if Fannie Mae or Freddie Mac meltdown, or if private lenders tighten requirements. Depending on how far home prices fall, the U.S. could suffer a consumer-led recession. Reuters (25 Aug.)

Economists: Inflation tops credit crunch as greatest threatA survey of the members of the National Association of Business Economists showed inflation to be the chief concern, ahead of the mortgage and credit crises. Of the respondents, 15% see overall inflation as the greatest threat to the economy, and 16% find energy prices to be the greatest short-term threat. CNN (25 Aug.)

White House to keep pushing for stronger yuanThe Bush administration said it will continue pressing China to allow the yuan to appreciate more quickly. The yuan has strengthened 6.7% this year against the U.S. dollar and has appreciated 17% in the past two years. Bloomberg (26 Aug.)

Banks report second-lowest quarterly earnings since 1991Banks posted their second-lowest earnings performance since 1991 for the quarter from April to June, the FDIC reported. Earnings for the quarter tumbled 86.5%, from $36.8 billion a year ago to $5 billion this year. MarketWatch (26 Aug.)

British pound sliding toward $1.50 against dollarThe British pound could fall as low as $1.50 against the U.S. dollar in the next few years. The pound fell to $1.8386, the first time it slid to less than $1.84 since mid-2006. The decline came as the economic slowdown continues and foreign investors increasingly pull out of Britain's economy. Telegraph (London) (26 Aug.)

Canada doesn't meet forecast for quick growth in Q2Canada's economy apparently grew less quickly in the second quarter than the Bank of Canada predicted. In July, policymakers forecast that GDP would expand at an annual rate of 0.8% in the second quarter. The bank gave no new expectation for growth. The Globe and Mail (Toronto) (26 Aug.)

Retail stock ownership in U.S. falls to record lowRetail investment in U.S. stocks has hit a record low, showing that institutional investors will play a bigger role in domestic equity markets. At the end of 2006, the last year for which figures were available, individual investors owned 34% of all shares and 24% of stock in the top 1,000 companies, and institutions held 76% of the shares, up from 61% in 2000, according to a report. Financial Times (01 Sep.)

U.S. takes over Fannie, Freddie to stabilize mortgage market Source: CNBC The U.S. government placed Fannie Mae and Freddie Mac in a conservatorship Sunday and replaced their CEOs in a drastic move to stabilize lending in the mortgage market. Treasury Secretary Henry Paulson said the rescue is necessary because allowing either company to fail would trigger worldwide market turmoil. "This turmoil would directly and negatively impact household wealth: from family budgets, to home values, to savings for college and retirement," Paulson said. CNBC (07 Sep.) , The New York Times (registration required) (07 Sep.) , Financial Times (08 Sep.) , Bloomberg (07 Sep.)

In July, consumers borrowed about half as much as forecastConsumers in the U.S. borrowed about $4.6 billion in July. The median estimate of 35 economists surveyed by Bloomberg News was an increase of $8.5 billion in consumer credit for the month. Consumers borrowed $11 billion in June. "A slowdown in the supply of credit is one of several factors that we think argues for a slowdown in consumer spending," said Zach Pandl, a Lehman Brothers economist. "There will be a period of weak consumer spending ahead." Bloomberg (08 Sep.)

Former Fed official calls Fannie, Freddie takeover a "stopgap": The government's seizure of Fannie Mae and Freddie Mac is an attempt to keep them running into next year, when the new president and Congress can determine their future. "Some of this is a stopgap to try to prevent the mortgage market from falling apart," said William Poole, former president of the Federal Reserve Bank of St. Louis. Poole also said it is "an unacceptable situation" to have a shareholder-owned company with taxpayers covering risks. Bloomberg

Interbank lending dries up over renewed fearsInternational money markets are once again under severe pressure as fears about the financial system were renewed with the bankruptcy of Lehman Brothers and other developments. "Sentiment is incredibly negative. It is getting much harder to raise money with the cost of funding getting more expensive," said Dominic White of fund manager Morley. "Banks are reluctant to lend out cash in this climate. It is difficult to predict whether the strains will increase or ease, but it is likely to remain difficult for some time for most institutions that want to raise cash with this much uncertainty." Financial Times (15 Sep.)

Analysis: Fed may cut interest rate after drama on Wall StreetFederal Reserve officials met Monday after the weekend's dramatic events in the financial industry and discussed an interest-rate cut, possibly in conjunction with other central banks. Before the latest turmoil on Wall Street, most officials speculated that the next move would be a rate increase. But after the weekend's events, there are concerns about a downward spiral, and a rate cut is more likely. Financial Times (15 Sep.)

Fed loosens emergency-lending standards in Lehman's wakeThe Federal Reserve dramatically loosened standards for emergency loans to investment banks to head off concerns in Monday's markets about fallout from Lehman Brothers' Chapter 11 filing. The central bank said it will not offer cash to potential buyers of Lehman. Meanwhile, 10 major banks worldwide agreed to contribute $7 billion each to an emergency fund that could be used if any of them faces problems similar to those facing Lehman. The New York Times (15 Sep.)

Central banks prepare to counter potential financial turmoilIn the wake of the U.S. banking crisis, the European Central Bank and the Bank of England announced that they are prepared to intervene in financial markets if necessary. "The ECB stands ready to contribute to orderly conditions in the euro money market," the ECB said. The Bank of England said it will carefully monitor the sterling money market. The ECB also announced that it will offer markets unlimited overnight liquidity. Financial Times (15 Sep.)

SEC to strengthen rule on short sellingThe Securities and Exchange Commission plans to move forward on creating permanent regulations for abusive short selling. The SEC will likely underscore the short-selling rule as well as shorten the time in which traders must buy back stock if they fail to deliver a security by the settlement date. The plans came about after Lehman Brothers was forced to file for bankruptcy and the U.S. government took over Fannie Mae and Freddie Mac. Reuters (15 Sep.)

Regulators propose rule changes to deal with crisisRegulators at four U.S. agencies proposed rule changes this week to stabilize financial markets and beef up the balance sheets of financial institutions. Regulators and the White House decided to ease accounting rules to help the banking industry cope with issues that some experts said stemmed from deregulation. The Securities and Exchange Commission issued guidelines for propping up money-market accounts and imposed new short-selling limits. The New York Times (free registration) (17 Sep.)

Voters, businesses appear to welcome more regulation: The Federal Reserve's rescue plan for AIG, coupled with a similar plan by the Treasury Department for Fannie Mae and Freddie Mac, could mark the end of 30 years of deregulation by the federal government. The government's involvement in financial markets follows similar shifts in food safety, airlines and trade and signals that increased regulation is now more acceptable to businesses and voters. BusinessWeek (18 Sep.)

CDS market to take hit from Lehman's bankruptcyMarkets are about to see just how accurate Warren Buffett's statement is about derivatives being "financial weapons of mass destruction," as fallout from Lehman Brothers' bankruptcy begins. The Economist explained how a bankruptcy of this size may affect the market for credit-default swaps, an arena that grew in recent years to a $62 trillion behemoth. The Economist (18 Sep.)

Emerging markets saddled with backlog of maturing debtDuring the next year, emerging-market economies will need to refinance about $111 billion of bonds, raising the likelihood of defaults and other problems. "Many corporates and banks in the emerging markets are highly levered without cash to fall back on. These will struggle should they need to raise money in the markets," said David Spegel, ING's global head of emerging markets strategy. "The bond and loan markets are much harder to access now, and it could get worse, which means there will be defaults." Financial Times (21 Sep.)

Moral Suasion and the Markets

Bigger than the dot-com bust? Yeps. Bigger than Black Monday in 1987? Yes. Bigger than the oil shock of the 1970s? Yes.

Well, this has been quite a year for your portfolio! If you have been following this blog since April, you understand what has happened and why. Simply, Government has created an empire of debt that has to be managed. Clearly, it has been mismanaged. People are responsible, and herein is the problem. “We” keep changing the rules to worship a GROWTH economy, rather than a SUSTAINABLE one. Good stewardship of the land, the sky and the seas is what “we” don’t do. “We” don’t hold ourselves accountable to the value of sustainability. We buy and sell our way into the value of a short-term growth economy at the expense of our children’s future, don’t “we”?

That’s the way this system works, like it always has, until it doesn’t. Don’t we continually change the rules to serve special interests where the rich get richer, and you know the rest? Don’t we invest for a gain in value, and don’t we look first at an investment’s financial return, and then the fundamentals to answer the question, is it sound? Do we ever ask if it serves our environment sustainability criteria first? If it does, then it follows that it would also stand to benefit the good of our communities, the infrastructure of our society, as well as individual shareholder value.
There is a disconnect between our ability to comprehend a financial economy in the context of an environmental one. This is not only GREEN but it is social responsible behavior to our future generations. The core problem is that it is our nature to “misplace” our values when it comes to the ethical choices we make in the name of the dollar first.

I am guilty of this. I want more… stuff. And it is easy for me to enjoy these tangible things, even if I know that they don’t serve the environment or my children’s future in a friendly and sustainable way. I want more return too. Oil is an obvious example of this trade off between the short-term positive return from the financial investment and the long-term negative return to the environment. Additionally, our short-term thinking colludes with our short-term greed and then there is at some level, a sell out to the value of sustainability. There is no surprise that the current market mess is in the financial sector and that it is in the Empire of Debt.

This current market crisis is precisely why those who espouse the virtues of a free market - need regulation, most especially, short-term speculators! Because short-term speculators in the market are allowed without regulation, to take enormous leveraged positions ($57.9 trillion), they threaten to undermine the very system that ironically supports them and gives them the freedom and power to do this. Today, with that power unchecked and with a government policy of deregulation all the way back to Regan economics we have this problem, 30 years in the making.

Guess what is the quick, politically expedient short-term solution? Why it is massive infusions of inflationary new capital, $1 trillion in more debt to still more future generations and while all this is preoccupying our attention, there is the negative consequences to our environment that we think we don’t have to be responsible to till we take care of our current problem. Am I right?
Philosophy and history lessons behind us, if you have your money in some financial institutions you may be thinking, how did this happen. Well, it relates to the collapse of the home mortgage market and derivatives. These are essentially bets on interest rates, foreign currencies, stocks or specific events like the bankruptcy of a particular company. The interest rate-related bets are by far the biggest. But the bets on bankruptcies — called credit default swaps — are the fastest growing and the most volatile.

These derivatives were originally designed to help hedge investments reduce risk — like insurance policies. But in practice, they've been increasingly used to leverage investments, increasing the risks of participants, again, all for short-term gain.
For a relevant explanation I defer to Mike Larson. In his most recent email he writes and explains this.

“It's been quite the eventful week on the bailout front. The Treasury and Federal Reserve drew the line at Lehman Brothers, allowing the fourth-largest broker in the U.S. to file for bankruptcy.
Then a couple days later, the Fed backtracked and arranged an $85 billion bailout of American International Group. The idea is to keep AIG afloat while it sells assets to raise money.
As I've been discussing for a long-time, crummy residential mortgages ... troubled commercial mortgages ... and all kinds of other souring loans are causing a huge chunk of the problems in the banking and brokerage industry. But in the case of AIG, something else is at work. It's an obscure kind of contract that, behind the scenes, is wreaking havoc throughout the financial industry.

And I want to talk about these "CDS" — or Credit Default Swaps — today.

How Credit Insurance Works
I'm sure you know how traditional insurance works. After all, you have some combination of homeowners insurance, life insurance, auto insurance, and maybe even a policy on an RV, a boat, or a motorcycle. You pay a monthly, semi-annual, or annual premium to an insurance company. And the company invests that money to generate returns. If a catastrophe strikes — you get in a car crash, your house burns down, or you die — the insurance company pays you or your heirs a lump sum of money.

It's a pretty straightforward business.

But in the past few years, many Wall Street firms, hedge funds, and companies like AIG plunged headlong into the Wild West World of CDS.

CDS operate like insurance on a bond or other security. Let's say you're a portfolio manager who owns $100 million in XYZ Corp. bonds. You read the paper, and you see that the industry XYZ is in is faltering, with sales declining and profits falling.

As a result, you might be concerned about the possibility that XYZ will default on the bonds you're holding. But for one reason or another, you don't want to sell your bonds and move on. So instead, you go into the market and buy CDS to protect you against the possibility of default.
You — the credit protection buyer — would pay periodic premiums (just like you and I do on life or car insurance) to a credit protection seller. If XYZ does NOT default, then the seller just collects his premiums and makes a decent return. If XYZ does default, then the seller either takes the bonds off your hands, paying you face value (regardless of where they're trading), or he pays you a cash settlement that makes you whole.

Either way, you as the buyer are protected from catastrophic loss — just like a homeowner is protected from catastrophe by his policy when his home burns down.

The Flaws in the System
Sounds good, right? But here are the problems...

First, CDS aren't highly regulated like the traditional insurance market is at the state level. In fact, the CDS market isn't really regulated at all. "Complacency is now unprecedented and regulators are asleep at the switch. The Securities and Exchange Commission says it has no direct supervision of trading in credit derivatives. The Commodity Futures Trading Commission also says it isn't responsible. The International Swaps and Derivatives Association (ISDA) says the industry can policy itself. We're not so sure."

Second, the CDS market exploded in size over the past several years. According to the British Bankers Association, the CDS market expanded from just $180 billion in 1996 to a stunning $20 trillion a decade later. That's a 111-fold expansion in this esoteric, opaque market. And by all accounts, it continued to grow LAST year as well — to a whopping $57.9 TRILLION, according to the Bank for International Settlements.

Third, the CDS market morphed into a vehicle for massive speculation on corporate credit rather than a way to hedge downside risk. Investors started buying CDS on companies with worsening credit — expecting those contracts to rise in value — and selling CDS on companies with improving credit — expecting to record a gain as those contracts declined in value.

Fourth, the quality of counterparties in the CDS market deteriorated substantially. What do I mean? When you bought your last homeowners or life insurance policy, you probably checked the credit rating of the company selling that policy. After all, what good is insurance if the company standing behind it can't make good on claims?

The problem is that more and more CDS were being bought and sold by hedge funds and other thinly capitalized companies during the boom days. This excerpt from a recent Minyanville column pretty much sums up the problem:

"A hedge fund trader once told me that they insured/sold 50 times their capital in CDS with the counterparty being a very large, well-known investment bank. "When I asked him if he was worried about that kind of leverage, he responded by saying that is the bank's problem because if he is wrong about writing all these insurance policies (in the form of CDS), they can only lose their investment capital in the fund." Comforting, eh?

The Fallout is Spreading
So how does AIG fit into all this?

Well, it sold protection on a mind-boggling $441 billion of fixed income securities. $441 billion! According to Bloomberg, almost $58 billion of those contracts referenced securities tied to subprime mortgages. That's what really brought AIG to its knees — the exposure to the CDS market.

Who else has massive exposure to credit derivatives?
According to a Fitch Ratings report from last year, the top five counterparties on CDS contracts (as of 2006) were:
Morgan Stanley,
Goldman Sachs,
JPMorgan Chase,
Deutsche Bank, and
ABN Amro.

It's impossible to know exactly how these institutions are positioned, how those rankings have changed since then, and so on. What we do know is that this garbage paper is spread throughout the system, that the underlying securities that CDS insure are plunging in value, and that the financial tally from this whole mess is rising month in and month out.

To understand why, put yourself in the shoes of a senior derivatives trader at a big firm like Morgan Stanley (which has $7.1 trillion in derivatives on its books and about $10 billion in capital).

Let's say you're personally responsible for $500 billion in derivatives contracts with Bank A, essentially betting that interest rates will decline. By itself, that would be a huge risk. But you're not worried because you have a similar bet with Bank B that interest rates will go up. It's like playing roulette, betting on both black and red at the same time. One bet cancels the other, and you figure you can't lose.

Here's what happens next...
Interest rates go up, reflecting a 2% decline in bond prices. You lose your bet with Bank A.
But, simultaneously, you win your bet with Bank B.

So, in normal circumstances, you'd just take the winnings from one to pay off the losses with the other — a non-event.

But here's where the whole scheme blows up and the drama begins: Bank B suffers large mortgage-related losses. It runs out of capital. It can't raise additional capital from investors. So it can't pay off its bet. Suddenly and unexpectedly ... You're on the hook for your losing bet. But you can't collect on your winning bet. You grab a calculator to estimate the damage. But you don't need one — 2% of $500 billion is $10 billion. Simple.

Bottom line: In what appeared to be an everyday, supposedly "normal" set of transactions ... in a market that has moved by a meager 2% ... you've just suffered a loss of ten billion dollars, wiping out all of your firm's capital.

Now, you can't pay off your bet with Bank A — or any other losing bet, for that matter.
Bank A, thrown into a similar predicament, defaults on its bets with Bank C, which, in turn, defaults on bets with Bank D. Bank D has bets with Morgan Stanley as well ... it defaults on every single one ... and it throws your firm even deeper into the hole.”

And so it goes, until it doesn’t! Enter the Fed bailout, yet again, this time we are in for a one trillion dollar bailout, increasing liquidity in the system for the short term. Again, this is short-term, inflationary and we haven’t even talked about commercial real estate foreclosures, energy prices or the environment, they are next. Keep you power dry and keep smiling… until next time.