CFTC's New Regulations - The Law Of Unintended Consequences

from WSJ:

By BRIAN BASKIN

U.S. regulators have begun targeting the big-time speculators suspected of artificially inflating prices for oil, natural gas and gold. Turns out some of the big guys happen to be small fry.

Exchange-traded funds, which have become popular as one of the few avenues for small investors to gain direct exposure to commodity futures, are a top target in the Commodity Futures Trading Commission's drive to rein in speculation in oil markets. The CFTC's moves reverse a trend in market innovation that allowed almost anyone to bet on the direction of energy prices along with the likes of Goldman Sachs Group Inc.

And bet they did. Commodity ETFs came into existence in 2003 just as the boom in commodities prices was getting under way. They have ballooned to hold $59.3 billion in assets as of July, according to the National Stock Exchange.

Since the beginning of the year, $22.1 billion has flowed into these funds compared with inflows of $7.3 billion during the same period in 2008. Almost half of the new money that has come in this year has been directed at the largest commodity ETF, which buys gold, amid worries about inflation.

The funds pool money from investors to make one-way bets, usually on rising prices. Some say this causes runaway buying that ignores bearish signs that more knowledgeable investors and commercial hedgers usually heed. The CFTC has said its priority is to protect end consumers of commodities, who would benefit from lower prices that regulators and lawmakers say would result from limits on speculation.

Cutting out individual investors isn't the goal, said Bart Chilton, a CFTC commissioner, in an email. "The Commission has never said 'You aren't tall enough to ride,' " Mr. Chilton said. "I don't want to limit liquidity, but above all else, I want to ensure that prices for consumers are fair and that there is no manipulation -- intentional or otherwise."

Yet the coming regulatory changes are already reshaping this popular corner of the investing world for small investors.

Limiting the size of ETFs will result in higher costs for investors, ranging from individuals to banks and hedge funds with multimillion-dollar positions, because legal and operational costs have to be spread out over a fewer number of shares. It also would render the instruments less desirable, because prices of the shares of closed funds tend to deviate from price moves in the underlying commodity.

Already, U.S. Natural Gas Fund, or UNG, is trading at a 16% premium to gas futures because investors are willing to pay extra for the ability to expose their portfolios to the commodity. The PowerShares DB Oil Fund, which tracks crude futures with no share limit, traded 0.3% above its benchmark commodity Thursday.

This past week, UNG confirmed it wouldn't issue more new shares and said it owns about a fifth of certain benchmark gas contracts, potentially higher than the new limits will allow. Deutsche Bank AG's PowerShares DB Crude Oil Double Long ETN, or exchange-traded note, an ETF-like security similar to a bond, followed suit on Tuesday.

The CFTC said Wednesday that it withdrew exemptions it had granted two Deutsche Bank commodity ETFs years ago on speculative limits on corn and wheat contracts. On Friday, Barclays PLC said it would temporarily suspend any new share issues for its natural-gas ETN.

"What you're really saying is the only people who should be allowed to trade crude oil are oil companies and Morgan Stanley," John Hyland, chief investment officer for the company that manages UNG and the largest oil ETF, told CFTC commissioners in a hearing earlier this month.

He defended his funds as existing "to serve people who otherwise would find it difficult or undesirable to themselves buy futures."

Goldman Sachs and Morgan Stanley are two of the banks seen as most active in commodities trading. They also are likely to feel the impact from the new rules.

Mr. Hyland claims between 500,000 and 600,000 investors in his U.S. Oil Fund and UNG, both of which have come under scrutiny due their sheer size.

Vernon Reaser is one of those investors and says he is frustrated that regulators' actions are essentially discouraging him from accessing commodities markets. "I'm American and am all for stability," said the 43-year-old small-business owner in Houston. While small investors tend to shy away from futures because of high costs and margin requirements, without ETFs, "there's nothing left but futures," Mr. Reaser said.

Smaller funds could spring up to take in investors prevented from joining funds that have run afoul of federal limits, but at a price.

"If they give up on scale and have to drive their expense ratios up ... that just makes it a higher bar for the fund to jump to generate positive returns," said Mark Willoughby, a financial adviser with Modera Wealth Management in Old Tappan, N.J.

Mr. Willoughby recommends that most clients invest 4% to 7% of their holdings in commodities, but said his firm is debating the best ways to do so in light of recent developments.

Investors shut out of ETFs would still have a few ways to track commodity prices, such as a major oil company like Exxon Mobil Corp. Shares of such companies usually, but not always, move with energy prices.

Damn About to Break On New Wave of Foreclosures

also from Mish's blog:

A summary of Second Quarter 2009 Negative Equity Data from First American CoreLogic shows that Nearly One-Third Of All Mortgages Are Underwater.

• More than 15.2 million U.S. mortgages, or 32.2 percent of all mortgaged properties, were in negative equity position as of June 30, 2009 according to newly released data from First American CoreLogic. As of June 2009, there were an additional 2.5 million mortgaged properties that were approaching negative equity. Negative equity and near negative equity mortgages combined account for nearly 38 percent of all residential properties with a mortgage nationwide.

• The aggregate property value for loans in a negative equity position was $3.4 trillion, which represents the total property value at risk of default. In California, the aggregate value of homes that are in negative equity was $969 billion, followed by Florida ($432 billion), New Jersey ($146 billion), Illinois ($146 billion) and Arizona ($140 billion). Los Angeles had over $310 billion in aggregate property value in a negative equity position, followed by New York ($183 billion), Miami ($152 billion), Washington, DC ($149 billion) and Chicago ($134 billion).

• The distribution of negative equity is heavily skewed to a small number of states as three states account for roughly half of all mortgage borrowers in a negative equity position. Nevada (66 percent) had the highest percentage with nearly two‐thirds of mortgage borrowers in a negative equity position. In Arizona (51 percent) and Florida (49 percent), half of all mortgage borrowers were in a negative equity position. Michigan (48 percent) and California (42 percent) round out the top five states.

There are some interesting tables and graphs in the article that inquiring minds are investigating. Here are some partial alphabetical lists.

click on any chart in this post to see a sharper image

Negative Equity Share



Property Values and Loan-To-Equity Ratios



Nevada, not shown has a near-negative equity share of 68.9% and a Loan-To-Value ratio of a whopping 115%!

It is disingenuous to say there are only a half-dozen or so problem states, when the problem states are where people live. It is wrong to treat Alabama and Alaska the same as California or Florida.

Mortgage Facts and Figures - Select States

• California has $2.4 trillion in mortgages debt. 42.0% of the properties have negative equity.
• Florida has $923 billion in mortgage debt. 49.4% of the properties have negative equity.
• Illinois has $447 billion in mortgage debt. 29.4% of the properties have negative equity.
• Arizona has $298 billion in mortgage debt. 51.0% of the properties have negative equity.
• Nevada has $149 billion in mortgage debt. 65.6% of the properties have negative equity.
• Nationwide there is $10.1 trillion in mortgage debt. 32.2% of the properties have negative equity.37.6% of the properties have "near-negative" equity.
  

32-37% Of All Mortgage Holders Are Stuck, Unable To Sell

Take a look at that first line. California has $2.4 trillion in mortgages debt. 42.0% of the properties have negative equity. Think Wells Fargo (WFC) sitting on its massive share of California pay-option-arms is "Well Capitalized"? If so, think again.

Now take a look at that last line again. Nationwide there is $10.1 trillion in mortgage debt. 32.2% of the properties have negative equity, another 5.4% are nearly underwater. Counting real estate commissions of 5% or so, 37.6% are effectively underwater right now.

Unless those people bring equity to the table at closing, those mortgage holders are stuck in their houses, unable to sell.

And the situation is about to get worse. It will only take a small drop in the Case-Shiller home price index to put a whopping 50% of mortgage holders underwater, stuck in their houses, unable to sell.

Foreclosure Wave Is About To Hit

The biggest factor in foreclosures and walk-aways is whether or not someone is underwater. If someone with equity always has a chance to sell. The second biggest factor is "skin in the game". Those who put down 20% are far less likely to abandon their properties than someone who put down 10% or less.

In light of the above, and given the preponderance of "liar loans" and low down payments in the problem states, those thinking clearly might be expecting to see a giant wave of foreclosures striking shore right about now. And they would be correct.

Mark Hanson discusses the above theory in “The Foreclosure Wave” — Now a Tsunami of Sorts.

There's plenty of commentary in the article worth reading so please take a look. Here are some charts.

California Foreclosures



Nationwide Foreclosures



California Pent Up Foreclosure Demand



Mark notes "Foreclosure supply (yellow) has been artificially held back, which has allowed the low end of the real estate market to perform very well over the past several months. But the reservoir of foreclosures (blue + pink) is getting full and at some point the dam will crack and break."

Six Reasons the Dam Will Break Sooner Rather Than Later

• The number of people underwater in their mortgages is high and rising fast.
• The reported nationwide unemployment figure is 9.4% with the real unemployment above 16% and rising.
• Wages are falling.
• The jobs market will suffer losses for another year.
• Notices of Default and Trustee Sales are high and rising.
• Social attitudes towards walking away and bankruptcy have changed.
  

In light of the above, those expecting a rebound in home prices and consumer sales, and/or a sharp V-shaped recovery are in Fantasyland.

Elizabeth Warren on What's Headed Our Way

from Mish's Economic Trend Analysis blog:

Elizabeth Warren On The Policy Response

Visit msnbc.com for Breaking News, World News, and News about the Economy

Please listen to that sobering interview, in entirety. It is about 9 minutes long. Elizabeth Warren rips PPIP (the public-private investment plan) to shreds, and questions the policy responses that have still left toxic assets on the balance sheets of banks.

Warren: ".... In addition to what we've got with the toxic assets, we've got a real problem coming on commercial mortgages.... looking ahead to 2010, 2011, 2012 we are potentially looking at 50-60% default rates. This is a very significant problem concentrated with intermediate and smaller banks"

My favorite exchange starts just after the 7 minute mark.

MSNBC: In hindsight was Paulson right? If Congress did not write that $700 billion check would banks have collapsed?

Warren: I have to say I think there would have been some real pain. There are some businesses today that are alive that would have been wiped out. However, I am just not convinced at all that we would have gone into a death spiral"

MSNBC: With the facts he knew at the time, was it the right call?

Warren: (struggling to be polite) "You know, let me say it this way. The question about whether or not the world as we know it has ended, depends on what you think the world is as we know it. If you think the world as we know it, are a handful of huge financial institutions, the dinosaurs that roamed the earth, then you're right. They are not going to exist without huge infusions of government money. On the other hand if what you really believe is that our economy and our world is 115 million American households you start to see it very differently. And you say, you know if the dinosaurs are gone there are still a lot of stuff to be done.

High Praise For Elizabeth Warren

I have high praise for Warren. It takes a lot of courage to say what she did on the record. Moreover, I am certain she is correct about what she hints the real world is: American households and a large consortium of small to mid-sized banks as opposed to a few dinosaurs that ought to be extinct.

Bernanke Saved The Dinosaurs

Bernanke did not "save the world". All Bernanke did was prolong the lives of a few ailing dinosaurs at great expense to US taxpayers.

Elizabeth Warren, not Bernanke should have given a speech at Jackson Hole.

White House Revises Deficit Forecast 28.5% Higher

Politicians tend to release bad news on Friday afternoons because they know that few people are paying attention to the news on the eve of their weekend. Yesterday, the White House released its upwardly-revised forecast for its deficits over the next ten years. It revised the forecast from $7 trillion to $9 trillion, a 28.57% upward revision! Unbelievable!

from 24/7 Wall Street:

The Administration quickly and fairly quietly raised it budget deficit number for the next ten years to $9 trillion from $7.1 trillion, an astonishing 27% increase.

The new estimate is much closer to the number that the Congressional Budget Office posted earlier this year.

One of the reasons for the change is that tax receipts are running below estimates due to the recession. The Administration believed unemployment would peak at 8%.

The shortfall in government revenue could continue for another year or more. The White House budget forecast robust GDP recovery in 2010 and 2011. Many economists expect the improvement will be closer to 2%. Unemployment will almost certainly remain above 9% next year and perhaps even into early 2011.

Tax receipts from businesses are also below forecast. A number of factors, especially consumer spending, have hurt many American companies worse than expected.

The alternatives for fixing the deficit problem are all bad. One is to raise taxes. A much higher burden on individuals would almost certain wound a recovery in consumer spending. Higher taxes on enterprises will make it /more/ likely they will cut more workers. It becomes a vicious cycle which ultimately adds to unemployment.

Another option is for the treasury to sell more debt. The New York Times recently reported that China’s appetite for US debt is falling. The paper writes “Figures released by the Treasury Department this week indicated that China reduced its holdings of Treasury securities by $25 billion in June, the most China had ever sold in a month.” That only leaves the Treasury one option, which is to offer higher interest rates on bonds. That will push up most other interest rates including those essential to the recovery, particularly mortgages.

The only alternative that will work to help the rising red ink is to cut government spending. The Congress and The White House have not shown much interest in that. But, the time is coming when their hands may be forced. That leaves the only open question as what will be what programs will be slashed and which will be preserved.

Douglas A. McIntyre

FDIC Is Penniless

from Reuters:

Sheila Bair has moved with impressive alacrity to shutter failed small and medium-sized banks. But she is still held hostage by the too-big-to-fail four.
Over the last eight days, her agency has been particularly busy, handling the two largest bank failures of the year. Last Friday it was Colonial Bank, today it will be Guaranty Bank.
With $25 billion and $14 billion of assets respectively, Colonial and Guaranty are the sixth- and 10th-largest failures in the history of the FDIC. Still, they pale in size compared to the biggest banks.
Bank of America Merrill Lynch, which had $2.3 trillion of assets at the end of the second quarter, is nearly 100 times larger than Colonial. JPMorgan Chase, with $2.1 trillion, and Citigroup, with $1.8 trillion, are nearly as big. Wells Fargo had $1.3 trillion, 100 times more than Guaranty. These amounts don’t include hundreds of billions of dollars of off-balance sheet assets.
Yet even Colonial and Guaranty are large enough to give the FDIC indigestion. Its deposit insurance fund had just $13 billion as of March 31. The 56 failures since then will cost it an estimated $16 billion, including nearly $3 billion for Colonial. (That amount excludes Guaranty – the FDIC should provide an estimate for those losses later today.)
It’s an unsettling thought if you have money in a bank. Officially, FDIC backs $4.8 trillion worth of deposits. If you include “temporarily” insured deposits, the total is $6.3 trillion. Yet the insurance fund protecting these deposits is going broke. Soon, the FDIC may have to draw on its credit line at Treasury.
It’s not surprising, given the sorry state of the Deposit Insurance Fund and the gargantuan heft of the big four, that FDIC is taking a bifurcated approach to bank resolutions.
Bair has moved decisively to close small and medium-sized banks. With the monsters, she not only assisted in their bailouts — providing federal insurance for their debt even as she already insures their deposits — she also sponsored their continued growth — putting WaMu in the hands of JPMorgan and pushing Wachovia into the arms of Wells Fargo.
Not that she had much choice. The biggest banks are far too big for her to resolve. One way to measure this is deposits in failed banks as a percentage of GDP.

(Click chart to enlarge in new window)

In 1934, the worst year for bank failures during the Depression, the total was 6.4 percent. In 1989, the most expensive year for the FDIC during the S&L scandal, it was 2.5 percent. Last year, the figure was 1.6 percent.
But the 2008 figure excludes Citi, BofA and Wachovia, which properly should be dumped in the failure bucket. Citi and BofA were goners without bailouts while Wachovia failed and fell into the arms of bailout recipient Wells Fargo. When you include those three, deposits in failed banks jump to 15.7 percent of GDP for 2008.
The FDIC, which was created to protect society from deposit runs, is no longer able to fulfill its mission because the biggest banks have grown far beyond its grasp.
That’s why these banks need to be downsized dramatically. A tax on assets is a good idea, but not enough. To break them up, Washington should limit the deposits in any single bank to a threshold far below what the big four currently hold.

FDIC Is Penniless

from Reuters:

Sheila Bair has moved with impressive alacrity to shutter failed small and medium-sized banks. But she is still held hostage by the too-big-to-fail four.

Over the last eight days, her agency has been particularly busy, handling the two largest bank failures of the year. Last Friday it was Colonial Bank, today it will be Guaranty Bank.

With $25 billion and $14 billion of assets respectively, Colonial and Guaranty are the sixth- and 10th-largest failures in the history of the FDIC. Still, they pale in size compared to the biggest banks.

Bank of America Merrill Lynch, which had $2.3 trillion of assets at the end of the second quarter, is nearly 100 times larger than Colonial. JPMorgan Chase, with $2.1 trillion, and Citigroup, with $1.8 trillion, are nearly as big. Wells Fargo had $1.3 trillion, 100 times more than Guaranty. These amounts don’t include hundreds of billions of dollars of off-balance sheet assets.

Yet even Colonial and Guaranty are large enough to give the FDIC indigestion. Its deposit insurance fund had just $13 billion as of March 31. The 56 failures since then will cost it an estimated $16 billion, including nearly $3 billion for Colonial. (That amount excludes Guaranty – the FDIC should provide an estimate for those losses later today.)

It’s an unsettling thought if you have money in a bank. Officially, FDIC backs $4.8 trillion worth of deposits. If you include “temporarily” insured deposits, the total is $6.3 trillion. Yet the insurance fund protecting these deposits is going broke. Soon, the FDIC may have to draw on its credit line at Treasury.

It’s not surprising, given the sorry state of the Deposit Insurance Fund and the gargantuan heft of the big four, that FDIC is taking a bifurcated approach to bank resolutions.

Bair has moved decisively to close small and medium-sized banks. With the monsters, she not only assisted in their bailouts — providing federal insurance for their debt even as she already insures their deposits — she also sponsored their continued growth — putting WaMu in the hands of JPMorgan and pushing Wachovia into the arms of Wells Fargo.

Not that she had much choice. The biggest banks are far too big for her to resolve. One way to measure this is deposits in failed banks as a percentage of GDP.

(Click chart to enlarge in new window)

In 1934, the worst year for bank failures during the Depression, the total was 6.4 percent. In 1989, the most expensive year for the FDIC during the S&L scandal, it was 2.5 percent. Last year, the figure was 1.6 percent.

But the 2008 figure excludes Citi, BofA and Wachovia, which properly should be dumped in the failure bucket. Citi and BofA were goners without bailouts while Wachovia failed and fell into the arms of bailout recipient Wells Fargo. When you include those three, deposits in failed banks jump to 15.7 percent of GDP for 2008.

The FDIC, which was created to protect society from deposit runs, is no longer able to fulfill its mission because the biggest banks have grown far beyond its grasp.

That’s why these banks need to be downsized dramatically. A tax on assets is a good idea, but not enough. To break them up, Washington should limit the deposits in any single bank to a threshold far below what the big four currently hold.

Original article.

Delinquencies, Foreclosures Still Rising

Meanwhile, Ben Bernanke declares victory!

New 2009 High for Stocks

Dollar Down

New 2009 High for Crude Oil

Stocks Rise Despite More Bad Mortgage News

Nearly 1/10th of all homes in America are now in default! However, home sales reached a 10-month high! Stock markets are shrugging off the bad news in favor of the good news! This is typical, since the underlying trend is up. Stocks are close to a new high for the year, and probably will reach a new high today! Commodities are rising solidly today!

Treasury Bull Market -- But Why?

If the stock market is solid and the recession is over, then why are treasuries higher 9 of the past 10 days? Dr. Brett Steenbarger suggests that an ill wind may be blowing, and that investors are worried.

Winds Shift Away from Emerging Markets

Aug. 21 (Bloomberg) -- Global emerging-market equity funds posted the highest outflows of 2009 in the third week of August, while China equity funds had their worst week since early in the first quarter of 2008, EPFR Global said.

Funds investing in developing nation stocks globally lost $946 million in the week ended Aug. 19, the research company said. Asia excluding-Japan funds lost $810 million, the most in 24 weeks, while Latin America and Europe, Middle East and Africa stock funds saw “modest inflows,” EFPR added.

Pensions: A Looming Crisis?

There is no way the federal budget can be stretched enough to bail out the pension funds. This hints at potential future trouble.

from Bloomberg:

Aug. 20 (Bloomberg) -- U.S. pension funds contributed to the record $1.2 trillion that private-equity firms raised this decade. Three of the biggest investors, state pensions in California, Oregon and Washington, plunked down at least $53.8 billion. So far, they only have dwindling paper profits and a lot less cash to show the millions of policemen, teachers and other civil servants in their retirement plans.

The California Public Employees’ Retirement System, the Washington State Investment Board and the Oregon Public Employees’ Retirement Fund -- among the few pension managers to disclose details of their investments -- had recouped just $22.1 billion in cash by the end of 2008 from buyout funds started since 2000, according to data compiled by Bloomberg. That amounts to a shortfall of 59 percent. In total, they haven’t reaped a paper gain from funds formed in the past seven years.

Trade... or Fade?

I use volume indicators to help me determine if I should follow the momentum and enter an existing trend, or if I should fade the market and trade in the opposing direction. Both volume and trend must be in harmony for me to take the trade.

Composition of Continuous Commodity Index

I like this graphical representation, because it shows how balanced the index is.

Get Your Ben Bernanke Action Figure Today!

Natural Gas Seasonal Factor

This chart is from the EIA (Energy Information Administration, an agency of the U.S. government), and shows the seasonal pattern for natural gas storage. Prices would obviously move in the opposite direction. Storage capacity tends to peak around October, with gas in storage falling after that. It tends to begin rising again about April when Spring arrives and consumption of natural gas for heating wanes. This is no doubt due to winter consumption. The gray area is the five-year average range, and the red line is the current year's value.

Weekly Farm Futures Tech Analysis 8-19-09

The Buzz - August 19, 2009 from Farm Futures on Vimeo.

Deficits -- A Picture Worth a Trillion Dollars

Crude Oil Stored On the Seas

There is a kind of oceanic traffic jam out there among very large crude carriers (VLCCs), with something like 7% (according to Lloyd's) of them storing crude oil off the coast of Europe, Asia, or North America in anticipation of higher prices later this year. Such are the joys of contango -- higher forward prices making it profitable to store petroleum for future sale -- but it is a huge gamble. If the people contracting for such VLCCs are wrong, their carrying costs mount and it becomes likely that they just dumb the product on the markets, further depressing prices.

Check the following figure (from EA Gibson) of the current storage situation for both petroleum and clean products, like gasoil:. While crude sea storage has declined from its peak earlier this year, clean products are floating out there is ever larger amounts.

"I Don't Think the Worst is Over...," Larry Summers

The above quote was from an unguarded moment in and interview with the Financial Times.

Backwardation and Contango Explained

Commodity ETFs have exploded in the past couple of years as commodity prices boomed, busted, and now seem ready to boom again as global demand picks up. As part of a long-term allocation, commodities helped smooth portfolio returns from equities in the past, which has also pushed more investors into this unfamiliar territory in an attempt to get greater diversification and avoid another disaster like 2008. Unfortunately, as with every other hot product, we have begun to see an ugly side to some of these ETFs. This primer will walk through what has caused some of the recent poor performance and how to avoid it in the future.

Two Basic Flavors
Commodity ETFs and ETNs come in two basic flavors. A handful of funds such as SPDR Gold Shares (GLD

Sponsored by:

GLD) , iShares Silver Trust (SLV

Sponsored by:

SLV) , and ETFS Silver Trust (SIVR

Sponsored by:

SIVR) , track the spot prices of their commodities, which are the market prices for immediate delivery. These ETFs can track the spot prices because they hold large stockpiles of the underlying commodity. If they need to redeem shares, they can sell off the gold or silver at spot prices to meet redemptions. Unfortunately, gold and silver, along with the other expensive metals such as palladium and platinum, are some of the only commodities that can be tracked in this manner.

Agricultural commodities would perish if stockpiled. Industrial metals such as nickel and copper would take up far too much warehouse space, making their storage costs prohibitive. As for energy commodities, just try and store $1 billion of natural gas at $3.50 per thousand cubic feet. You would need more storage space than 4,700 Minnesota Metrodomes (or for our international readers, more than 2,000 new Wembley Stadiums) to hold it! A billion dollars worth of far more valuable crude oil, which currently trades around $60 per barrel, would require eight of the largest supertankers to store. Clearly, these other commodities require a less direct method of investment.

Instead of directly buying oil, corn, natural gas, or aluminum, ETFs that track these commodities use derivatives. In particular, they track futures prices for those commodities. These futures are contracts that promise to deliver the underlying commodity for a specific price at a specified time in the future, and they trade on major exchanges for a variety of possible delivery dates. Changes in the futures prices do not perfectly match those of the spot price, but typically provide a good proxy. If futures prices rise too far above the spot, commodity producers will sell at the futures prices and hold their production back from the current market, pushing them back into balance. Unfortunately, this arbitrage mechanism can sometimes fail investors in commodity futures.

Backwardation and Contango
The prices of futures contracts relative to the current market price exert a heavy influence on the returns of commodity investments for anyone who does not produce or physically store the commodity. Futures traders have coined two terms that describe the possible price breakdowns of a given commodity market: backwardation and contango.

When a market is in backwardation, the commodity futures sell for a lower price than the current market price. In general, it also describes a state of affairs where futures prices go lower as the expiration dates move further out. For example, soybean futures for September 2009 delivery currently sell at $9.90 per bushel. The futures for March 2010 delivery sell for $9.60 per bushel and the September 2010 delivery contracts sell for $9.30 per bushel. Buying a bushel of soybeans further and further out in time costs less money, possibly because we are providing insurance for soybean producers who will accept lower future prices in exchange for greater certainty. When we hold a futures position, the price for a given contract approaches the spot price of the commodity as our delivery date gets closer.

For investors who buy futures rather than the physical commodity, a commodity in backwardation provides better returns over time through something called the "roll yield." Let's continue using the soybeans example.

Assume that you buy contracts to receive 100 bushels of soybeans in March 2010 for $960. (In reality, the exchange-traded contracts are for 50,000 bushels each, but we will make this assumption so the math is easier.) Also, let's assume that the price of soybeans and the relative discounts for buying a given time in the future remain the same. In six months, someone who held a stockpile of soybeans will have no return on their investment (in fact, they will have some losses due to the cost of storing the soybeans). However, the discount on our soybean futures relative to the spot price will have shrunk to the equivalent of the old September 2009 contracts from six months ago, so our futures are now worth $990. We gained $30 just from the "roll" of the futures prices as each contract moved closer to the higher spot price. Selling our March 2010 futures, we can then buy contracts to receive 103 bushels of soybeans in September 2010 (as those contracts would now have appreciated to a price of $9.60 a bushel), reinvesting the gains from our roll yield.

The roll yield can also cut the other way and hurt the returns of investors in commodity futures. This happens when the futures prices for a given commodity are in contango, which means that futures contracts sell at a higher and higher premium to the current spot price as you buy further in advance. Right now, the primary example of a commodity in contango is natural gas.

Natural gas sold for $3.12 per million British Thermal Units, or mmBTUs, on the spot market at the end of August 17. The September 2009 contract for delivery sold at a modest premium with a price of $3.15 per mmBTU. However, the October 2009 contract offers natural gas at a price of $3.51 and the November 2009 contract sells for $4.37. These massive premiums for future delivery currently occur because natural gas is so hard to store and many extractors are shutting down gas rigs rather than keep producing at today's low prices. However, they can also destroy returns on futures investments relative to the spot price.

An investor who cannot take physical delivery of natural gas will not be able to hold the futures contract until expiration. Instead, they must sell the nearest month contract as it nearly expires and put their money into another futures contract further out. United States Natural Gas (UNG

Sponsored by:

UNG) maintains its position in natural gas by always rolling from the nearest month contract (currently September 2009) into the next month out (October 2009). At today's prices, selling a position of 100 September 2009 contracts would buy a position of only 90 October 2009 contracts due to the premium paid as we move further out on the futures curve. Thus, rolling futures positions in a commodity trading in contango steadily erodes the size of your exposure as you constantly buy further-out contracts at a premium, only to see that premium fall away as the futures price approaches the spot. Contango produces a negative roll yield that eats into any potential price gains on the underlying commodity.

Because the near month natural gas contract trades at a premium of 3 cents over spot prices, and the second month out trades at a premium of 39 cents, an investor rolling from the former into the latter would need natural gas prices and all the corresponding futures prices to move up by 36 cents between now and mid-September (a 12% gain over current spot prices in one month) just to break even. In light of this, the recent poor performance of United States Natural Gas should come as no surprise.

Later this week, we will write a second article that digs into the details of the largest commodity ETFs, looking at how susceptible each one is to losing money when commodities trade in contango. While early products to market followed extremely simple rules that have led to disastrous negative roll yields, newer generations of commodity-tracking products use more complex algorithms to avoid the trap. Please check back for Part Two of this article if you ever plan on investing in this surprisingly complicated asset class.

Original article.

Finance Committee Congressman: Social Security Insolvent!

from Tuscaloosa News:

TUSCALOOSA | “Social Security could face a deficit within two years,” U.S. Rep. Spencer Bachus predicted here Tuesday. “The situation is much worse than people realize, especially because of the problems brought on by the recession, near depression.

“That’s not been on the board — people don’t seem to know that,” Bachus, the ranking member of the House Committee on Financial Services, said in a wide-ranging interview with the Tuscaloosa News Editorial Board. “What this recession has done to Social Security is pretty alarming.

“We’ve known for 15 years that we were going to have to make adjustment to Social Security, but we still through that was seven or eight years down the road,” he said. “But if things don’t improve very quickly, we’re going to be dealing with that problem before we know it.”

The solvency of Social Security, which provides pensions for people over 65, has not played a major role in the current debate over health care in Congress and Bachus, a Vestavia Hills Republican who represents part of Tuscaloosa County, said it will not likely be addressed in any health care bill the House eventually passes, although if a Social Security bail out is needed, it will invariably impact government health care programs.

In the debate over health care, Bachus said that he could support a bill that includes privately-administered health “co-ops,” along with the elimination of fraud and waste in existing government programs like Medicaid and Medicare.

The creation of health care “co-ops,” or non-profit health cooperatives run by members, is an idea that has gained momentum as Democrats and President Barack Obama seems to have moved away from the idea of a “government option,” which would be a government-run alternative to private health care now offered by for-profit insurance companies.

“I can not vote for a bill that has the government intruding into the private sector, subsidizing health care and eventually putting the insurance companies out of business,” he said.

As for the looming Social Security crisis, Bachus said options are just now beginning to be discussed.

“We could raise the retirement age, or in the worst case, cut back on some benefits,” he said. “But that is something we are just now beginning to get a handle on.”

Bachus visited The News the morning after a standing-room-only crowd of 2,000 people attended a health care public forum he hosted in Birmingham Monday night.

Unlike some town hall meetings that have turned chaotic across the county as members of Congress have returned to their districts during the August congressional recess, Bachus said there was “only a little friction” between opponents of various health care proposals advanced by the Democratic majority in Congress and those who support those proposals.

“I think everyone was for the most part civil and we had a lot of people just agree to disagree,” he said. “But you can tell that health care is an issue that has energized the country, because I have never had a town meeting with 2,000 people. And we even had to turn away a lot of people because of fire department regulations.”

Natural Gas Price Continues to Sink

Mandate to Force Health Insurance Premiums to Double

self-employment costs of Obama's mandates:

from Nebraska Farm Bureau:

The Obama Administration's proposal to mandate certain kinds of health care coverage could increase the cost of health insurance for farmers and ranchers and other self-employed individuals in Nebraska and the nation by more than100 percent, Nebraska Farm Bureau warned Monday (Aug. 17).

A large majority of food producers are self-employed and many buy their own health insurance without the benefit of being part of a group, Farm Bureau President Keith Olsen said. A 2007 survey conducted for the U.S. Department of Agriculture¹ found that 46 percent of Nebraska's farmers and ranchers purchased their health insurance on an individual basis directly from an insurer. "If a farm or ranch family can obtain health insurance through a spouse's off-farm job, that's usually the route they go," Olsen said. "But that approach isn't available to everyone.

"The primary issue we continue to worry about is the affordability of health insurance," he said. Responses from Farm Bureau members surveyed online last week showed a monthly health insurance premium ranging from $500 to $1,000-plus a month for a high-deductible, family policy. Most of those surveyed had deductibles of about $5,000.

The proposals now moving through Congress include the concepts of "Guarantee Issue" and "Community Ratings," Olsen said. Guarantee Issue requires insurers to provide health insurance coverage to anyone at any time, or forces them to renew policies they would prefer to drop. Community Rating limits premium differences across policies and requires insurers to charge uniform premiums regardless of age, health conditions, etc.

"Requiring compulsory health insurance in the form of an individual coverage mandate or forcing insurers to cover everyone will mean higher insurance premiums," Olsen said.

Currently only New York, New Jersey and Massachusetts have both Community Rating and Guaranteed Issue laws on the books; these states have the most expensive individual insurance markets in the country, he said.

A 2008 study conducted by researchers from MIT, the Brookings Institution and Brigham Young University ² found that implementation of Community Rating and Guarantee Issue resulted in premium increases of 108 to 227 percent for high-deductible family policies.

"While the New Jersey insurance market is quite different from ours, we can reasonably expect to see significant premium increases for Nebraskans who purchase health insurance directly from insurers," Olsen said. "If New Jersey's experience applies here, premiums for high-deductible policies could range from $1,040 to $2,080 a month, rather than the current, already-high $500 to $1,000."

Such increases would make private health insurance unaffordable for many farmers and ranchers, he said. "They can't pass cost increases on to their customers the way other businesses can.

"We share the Administration's goal of reining in health care costs, but we would rather see health care reform that improves and builds on the current health care delivery system," he said.

Wherewith GDP Growth?

from John Mauldin's Outside the B0x:

Daily Observations from GaveKal

We are hearing concerns, from some clients and friends, that the brutal corporate cost-cutting seen in the wake of the subprime crisis will delay the recovery, because this trend is killing the US consumer. In other words, how can one spend if he has lost his job or fears as much, or has seen his work hours drastically reduced, taken a pay cut, or expects his company pension system is about to implode? For us, this all boils down to a crucial question: do we need consumption to pick up in order to achieve a rebound in growth? The answer to this question very much depends on whether one accepts a Keynesian view of the economic process, or a Schumpeterian (or classical) view. We hope our readers forgive us, but we are now going to have to get a tad theoretical....

* In a Keynesian view, consumption is the motor of growth. If companies slash their payrolls, consumption contracts and we enter into a vicious cycle in which the subsequent decline in demand leads to a second wave of cuts, which then leads to a further decline in consumption, and so on and so forth. The Keynesian cycle may have been useful from 1945 to 1990, but in the past 20 years, globalization and just-in-time technologies have changed the nature of corporate management, which is why we believe a classical, capital-spending led view of the economic cycle will reassert itself.

* In a classical view, as exemplified by "Say's law" and reinforced by Schumpeter, corporate profitability is the cause, not the consequence, of economic growth. Thus, Schumpeter would see the current cycle as the destruction phase in the creative-destruction processes that propel the economic cycle. Capital and labor are currently moving from the sectors in decline (e.g., McMansions) to the sectors in expansion (e.g., tech, alternative-energy infrastructure, etc.). Once momentum in the growth sectors overwhelm the decaying ones, then macro growth resumes. Under this framework, consumption kicks in at the end of the cycle (for more on this, see the very first paper published by GaveKal, Theoretical Framework for the Analysis of a Deflationary Book).

Within our firm, Charles is the major proponent of the Schumpeterian view, and this thinking was apparent in his and Steve's recent ad hoc, A V-Shaped Recovery in Profits. Due to the quick reflexes that new technologies allow, corporates are managing their cash flow better than ever. Rarely ever, for instance, have companies (ex-financials) remained in such strong positions during a recession, which is yet another reason why we believe that capital spending, rather than consumption, will spark the recovery.

Indeed, the scale at which corporates have been able to cut costs and return to profitability, has laid the groundwork for a deflationary boom of epic proportions (which would be a major surprise for those who fear an easy-money inflationary nightmare). Of course, there is a major threat to this deflationary-boom scenario-and that is the increased government intervention we are seeing in most corners of the world. If government intervention manages to kill off return on investment capital, as it did in the 1930s, then the current opportunity will go up in smoke. Regular readers know we tend to err on the side of optimism; at this point we still hold out hope that a major lurch to a big-government era can be resisted-as exemplified, for example, by the unexpectedly strong fight we are seeing against the health-care bill, or the ability of so many US financials to pay back their debt to the US Treasury, thus lowering the extent of government influence on their business decisions. Thus, in our view, a period of deflationary boom is the likeliest scenario, and investors should focus on sectors and countries that will see the largest resurgence in capital spending.

---

Growth in "Potential GDP" Shows Limited Potential

By John P. Hussman, Ph.D.

Historically, two factors have made important contributions to stock market returns in the years following U.S. recessions. One of these that we review frequently is valuation. Very simply, depressed valuations have historically been predictably followed by above-average total returns over the following 7-10 year period (though not necessarily over very short periods of time), while elevated valuations have been predictably followed by below-average total returns.

Thus, when we look at the dividend yield of the S&P 500 at the end of U.S. recessions since 1940, we find that the average yield has been about 4.25% (the yield at the market's low was invariably even higher). Presently, the dividend yield on the S&P 500 is about half that, at 2.14%, placing the S&P 500 price/dividend ratio at about double the level that is normally seen at the end of U.S. recessions (even presuming the recession is in fact ending, of which I remain doubtful). At the March low, the yield on the S&P 500 didn't even crack 3.65%. Similarly, the price-to-revenue ratio on the S&P 500 at the end of recessions has been about 40% lower than it is today, and has been lower still at the actual bear market trough. The same is true of valuations in relation to normalized earnings, even though the market looked reasonably cheap in March based on the ratio of the S&P 500 to 2007 peak earnings (which were driven by profit margins about 50% above the historical norm).

Stocks are currently overvalued, which – if the recession is indeed over – makes the present situation an outlier. Unfortunately, since valuations and subsequent returns go hand in hand, the likelihood is that the probable returns over the coming years will also be a disappointingly low outlier. In short, we should not assume, even if the recession is ending, that above average multi-year returns will follow.

That conclusion is also supported by another driver of market returns in the years following U.S. recessions: prospective GDP growth. Every quarter, the U.S. Department of Commerce releases an estimate of what is known as "potential GDP," as well as estimates of future potential GDP for the decade ahead. These estimates are based on the U.S. capital stock, projected labor force growth, population trends, productivity, and other variables. As the Commerce Department notes, potential GDP isn't a ceiling on output, but is instead a measure of maximum sustainable output.

The comparison between actual and potential GDP is frequently referred to as the "output gap." Generally, U.S. recessions have created a significant output gap, as the recent one has done. Combined with demographic factors like strong expected labor force growth, this output gap has resulted in above-average real GDP growth in the years following the recession.

The chart below shows the 10-year growth rates in actual and potential GDP since 1949 (the first year that data are available).

The blue line presents actual growth in real U.S. GDP in the decade following each point in time. This line ends a decade ago for obvious reasons. The red line presents the 10-year projected growth of "potential" real GDP. This line is much smoother, because the measure of potential GDP is not concerned with fluctuations in economic growth, only the amount of output that the economy is capable of producing at relatively full utilization of resources.

One of the things to notice immediately is that because of demographics and other factors, projected 10-year growth in potential GDP has never been lower. This is not based on credit conditions or other prevailing concerns related to the recent economic downturn. Rather, it is a structural feature of the U.S. economy here, and has important implications for the sort of economic growth we should expect in the decade ahead.

The green line is something of a hybrid of the two data series. Here, I've calculated the 10-year GDP growth that would result if the current level of GDP at any given time was to grow to the level of potential GDP projected for the following decade. This line takes the "output gap" into effect, since a depressed current level of GDP requires greater subsequent growth to achieve future potential GDP. Notice here that even given the decline we saw in GDP last year, the likely growth in GDP over the coming decade is well under 3% annually - a level that we have typically seen in periods of tight capacity (that were predictably followed by sub-par subsequent economic growth), not at the beginning stages of a recovery.

The situation is clearly better than it was at the 2007 economic peak, where probable 10-year economic growth dropped to the lowest level in the recorded data, but again, the likely growth rate is still below 3% annually over the next decade even given the economic slack we observe.

Aside from a gradual recovery of the "output gap" created by the current downturn, there is no structural reason to expect economic growth to be a major driver of investment returns in the years ahead. With valuations now elevated above historical norms, there is no reason to expect strong total returns on an investment basis either.

The primary element that is favorable at present is speculation – excitement over the prospect that the recession is over. Investors are presently anticipating the good things that have historically accompanied the end of recessions (strong investment returns and sustained economic growth), without having in hand the factors that have made those things possible (excellent valuations and a large output gap coupled with strong structural growth in potential GDP).

Stocks Collapse Further on Open

Crude Oil Cave-In

Gold Loses Its Glitter

Dollar Driving Higher

Amazing!

Stock Market Downside Breakout?

Wow! The Dow overnight is Dow 170 points! That a big drop! Could this the be beginning of a much-needed correction? Note on this chart of the S&P 500 futures, that we have broken out below the bottom Bollinger Band that has held throughout the month of August! Cahen says this pattern has an 86% probability of continuing in the direction of the breakout.

Commodity Current

from Bloomberg:

Gold Declines for a Second Day as Dollar's Advance Versus Euro Saps Demand Gold declined for a second day as the dollar advanced against the euro, eroding demand for the metal as an alternative investment, and commodities dropped.

Crude Oil Trades Near Two-Week Low as Supply Gains Counter Hurricane Risk Crude oil fell to the lowest in more than two weeks as reduced demand and rising stockpiles in the U.S. will ensure adequate supplies during the North Atlantic hurricane season.

Copper Extends Fall From 10-Month High After U.S. Confidence, Stocks Slump Copper fell for a second day, extending a decline from a 10-month high, after U.S. stocks dropped, renewing investors’ concern that the metal’s rally isn’t justified by economic prospects.

Rubber Futures Decline as Much as 3.2% as Oil Price Slump may Curb Demand Rubber futures in Tokyo declined as much as 3.2 percent after crude oil prices slumped.

Copper Limit Down

Aug. 17 (Bloomberg) -- Copper and zinc futures in Shanghai dropped by the daily trading limit following declines in London prices.

Copper fell 5 percent to 47,790 yuan a metric ton and zinc tumbled 5 percent to 14,465 yuan a ton

Digging Into the Unemployment Numbers

from John Mauldin:

The Statistical Recovery

The unemployment numbers came out last Friday, and Steve Liesman of CNBC did several interviews live from Leen's Lodge in Maine. I postponed an hour of fishing to be on air with Martin Barnes (of the Bank Credit Analyst) to comment on the numbers. Everyone seemed quite excited that the US lost "only" 247,000 jobs. However, it is still almost twice as large as a year ago, and at that time 128,000 lost jobs seemed pretty bleak. However, comparing it to the average of 692,000 lost jobs per month in the first quarter, those looking for good news immediately started talking about how a recovery is around the corner.

The unemployment numbers are some of the most seriously revised numbers in all of government data. The first monthly estimate is notoriously imprecise. Why people make investment decisions based on this release is beyond me. As I mention continuously, because of seasonal adjustment factors, the unemployment numbers understate job losses in a recession and also understate job gains in a recovery. About the most we can get from the current data is the broad trend. Admittedly, the trend is getting better, but we are still in a hole and no one has stopped digging.

What we can see is that we are down 6.7 million jobs since the beginning of 2008! We have roughly eliminated the job growth of the last five years. And that does not take into account the 150,000 new jobs that are needed each month just to maintain the employment rate because of the increase in population. It took 55 months once the 2001 recession was officially over to get back to the previous employment peak. That is 4.5 years, gentle reader, and we are further down now and faced with massive deleveraging. It is going to take a lot longer this time. Let's look at some of the reasons why.

I took a different tack in the CNBC interview. I pointed out that even though it is possible (likely?) we will see a positive number for GDP for the third quarter, it is not going to feel like a recovery for quite some time.

By the middle of next year (2010), when I think we will finally hit an unemployment bottom, we will be down close to 8 million jobs, wiping out all the jobs created since the middle of 2004. Unemployment is likely to be more than 10%, unless they keep playing games with the number.

A Recovery Statisticians Can Love

What I mean by that remark is that the unemployment number went down even though we lost 247,000 jobs. How can that be, you ask? Well, the government assumes that if you were not looking for a job within the last month, then you are not unemployed; therefore, on a statistical basis the number of people unemployed went down by 400,000. (There are 2.3 million such discouraged workers.) More in a minute on the problem that will cause down the road.

Assume that we will need 9 million jobs over the next five years (150, 000 jobs a month for 60 months) and add the 8 million lost jobs. That means we have to add 17 million jobs in the next five years to get back to the 4.5% unemployment of 2007, let alone the under-4% we saw in 2000.

That means we need to grow employment by about 12% over the next five years. But it's worse than that. What is known as U-6 unemployment is over 16%. There are another approximately 8.8 million people who are either working part-time but want full-time jobs or are among the 2.3 million discouraged workers as mentioned above.

(The definition of U-6 unemployment from the BLS web site: "Marginally attached workers are persons who currently are neither working nor looking for work but indicate that they want and are available for a job and have looked for work sometime in the recent past. Discouraged workers, a subset of the marginally attached, have given a job-market related reason for not looking currently for a job. Persons employed part time for economic reasons are those who want and are available for full-time work but have had to settle for a part-time schedule." http://www.bls.gov/news.release/empsit.t12.htm.)

Let's make the assumption that the part-time workers want to go to full-time (which they say they do). Typically employers will increase the hours of part-time employees before adding new workers. That will be a major drag on potential job growth. It is the equivalent of creating at least 4 million jobs, except that no new jobs are created. Plus, those who want jobs but are not looking will come back into the market if jobs are available. That adds another 2 million. Now we are seeing the need for 23 million new jobs in five years, to get back to the "Old Normal."

That is an increase of 15% total employment from today's levels over the next five years. That type of jobs growth will only happen with significant economic growth. Normally, you should expect the economy to rebound to at least 3% trend GDP growth. That is what has happened historically. But we are not in the Old Normal. We are entering the era of the New Normal, where looking back at historical trends will prove to be misleading at best.

On average, and VERY roughly, you would think you would need a minimum of 15% real GDP growth over five years to get us back to what we think of as acceptable levels of unemployment. Actually you would need more, as productivity growth lessens the need for more workers. Oh, and add in the Boomer-generation workers who are not going to retire because they now cannot afford to.

(I think we will be lucky to have 10% real GDP growth in the next five years, for a host of structural reasons that we will be going into below and over the next few weeks.)

Unemployment will be rising for at least another two quarters and probably through the middle of next year. That should not surprise us too much, as unemployment kept rising for almost two years after the last recession, which many dubbed "the jobless recovery." The recession ended in 2001, but as the graph below shows, the unemployment rate rose until the middle of 2003.

We may have a "statistical recovery." The numbers may be positive for a variety of reasons only a statistician could love, but it is not going to feel like a recovery to the rest of us. Maybe that is why consumer confidence took another hit today, dropping to its lowest level since March, helping to drive the market down.

The economists at economy.com, who normally have a bullish tinge to their writing, said it succinctly: "Confidence will struggle to gain ground in the months to come, as consumer budgets remain stretched. Little wage income, prospects for reduced bonus payments, reduced access to credit, and no capital gains are all constraining consumers' ability to meet their financial needs and recover from the sharp drops in wealth they have experienced. Many consumers are struggling to pay their debts. Supports are coming from reduced layoffs, equity market gains, and stimulus such as the cash for clunkers program, but that is proving inadequate to lift spirits so far. It will likely be some time before conditions turn enough for confidence to improve decisively. Key drivers of confidence include developments in the labor and housing markets and the path of energy and equity prices."

(My friend Bill Bonner described the Statistical Recovery as being just like a female impersonator. He is just like a real woman in every way, except for the essential ones.)

The consumer's sense of discomfort is shared in executive suites across the country. "Chief Executive Magazine's CEO Index, the nation's only monthly CEO Index, dropped to 63 in July, after showing gradual improvement. All components of the index are down, with Employment Confidence taking the largest hit...

"What's worse is that pessimism over employment is reaching new heights. The Employment Confidence Index declined 25 percent with 57 percent of CEOs expecting continued decrease in employment next quarter. Over 95 percent rate the current employment environment as bad -- the highest level for 2009. Less than 5 percent think employment conditions are normal and virtually no one (0.4 percent) thinks they are good." (The Bill King Report)

A Few Thoughts on the Housing Market

Bill also sent me a link to a very interesting survey of the real estate market. Those in the real estate business will find this of value, although it makes for grim reading. (http://www.campbellsurveys.com/AgentSummaryReports/AgentSurveyReportSummary-June2009.pdf)

Three (of the sixteen) of their summary bullet points stood out:

Think about that for a minute. Two-thirds of home sales are either foreclosures or banks taking a loss on the mortgage. Of the remaining 36%, only 10% are as a result of something we could call a normal selling process. And that is nationwide. There are lots of places where foreclosures are low. Reading this report anecdotally, there are large areas (California, Nevada, Arizona, Florida) where almost the only housing action is distressed or forced sales, that is, sales at a significant discount to original asking price.

Look at the chart below from Rick Sharga at RealtyTrac. Today we learned from them that foreclosures set a new monthly record of 360,149 properties that received a default or auction notice or were seized last month. One in 355 households got a filing, the highest monthly rate in RealtyTrac records. Many hard-hit areas have rates higher than 1 in 39 homes! Foreclosures are now running about six times higher than just four years ago.

And there is little relief in sight. There is typically about one foreclosure for every 6-10 jobs lost. It will be higher this cycle, as so many homebuyers are underwater on their mortgages and have little incentive to try and keep up payments while they are unemployed. Further, there are 500,000 REO-owned homes that are not on the market as of yet (what Sharga calls shadow inventory), and a wave of foreclosures will result from option ARMs and Alt-A loans resetting next year. Note: July's record numbers are not in the chart below.

John Burns gives us the next graph, which is an estimate of foreclosures for the coming years. (www.realestateconsulting.com)

Notice that he estimates more foreclosures next year than this year, with very little relief until 2014! This does not bode well for housing prices, which are a big factor in consumer sentiment, which is a big factor in consumer spending.

It does mean that renters can find some very good deals, as there are now areas (like Phoenix) where it is cheaper to buy smaller homes than to rent. Remember the statistic above that first-time home buyers are 43% of the market and investors another 29%? Lower prices make housing more affordable, and with the government incentive programs for first-time buyers really working (for once), the lower end of the housing market may actually stabilize sooner than the overall market.

As I wrote almost two years ago, the housing market will not bottom before 2011 and maybe into 2012. We just built way too many homes in our exuberance; and with tightening lending standards (as there should be) the number of people who can qualify for a mortgage is down, although (again) falling prices make homes more affordable. The median price in California is down by 60%. (Although I saw today where Bill Gross bought a tear-down on the water in Newport Beach for $23 million. That will help the average some.)

Homeowner vacancy rates are close to 3% of total homes, which is well over 2 million homes. Many of these are not yet on the market.

Retail sales were down in July. And that was with Cash for Clunkers in full force. The headlines said that economists were shocked. Really? Consumers are saving more, and actually paying down credit-card and bank debt. We will go into those details more next week, as it is getting close to time to hit the send button.

Some Thoughts from Maine

Last weekend I got to go to Leen's Lodge at Grand Lake Stream in Maine (www.leenslodge.com - highly recommended) to meet with 35 economics types and their friends. This is a very knowledgeable group, with a lot of well-known names. We fish in the morning, meet at a campsite for lunch (drink wine and eat what we caught), fish some more, go back to the lodge, eat a gourmet meal and drink some more wine, and then go on talking. This goes on for 2-3 days. I throw my diet to the wind, and pay for it over the next month, but it's worth it.

On Friday Steve Liesman and some local guides bring out their guitars and entertain, with a lot of loud, if somewhat off-key, singing from the crowd. (Liesman, by the way, really can play the guitar quite well.) On Saturday night we bet on the future of the markets and events - typically small amounts, and lots of side bets. This year I won five out of six side bets I made last year.

As usual, bets were all over the board. But a few interesting ones surfaced. David Kotok and George Friedman offered rather (for this crowd) large sums to take on all comers that Bernanke would not be reappointed. I took part of that offer, as did a number of others (for the record, the Fed economists at the meeting do not bet and were quite closed on the topic). I was surprised at the intensity of that debate. This is a well-informed crowd when it comes to Fed policy and actions, and if this question is (politely) contentious among friends in July of 2009, what will it be like in the latter part of the year, when Obama has to make the appointment (Bernanke's appointment is up in January of 2010)? And among those who do not get along? This could be a very noisy appointment process.

A few years ago (2006 and 2007), I was repeatedly told I was "too bearish." Now, my Muddle Through prediction was seen either as overly optimistic or the most likely scenario by a large number of attendees. The concerns about the credit markets are still quite strong, with many thinking we will be facing banking problems for years. There were more than a few who bet that Citibank will not be around in its current form by this time next year. (I did not take that bet.)

A number of participants saw a double-dip recession as a distinct possibility. I think it is a probability in 2011 as the Bush tax cuts expire. If Congress moves up the increase in taxes to 2010, which is what the House Democrats want, that recession could start in 2010.