One In Five Homes At Risk of Foreclosure

from Reuters:

The page proofs of my upcoming book, “Inflated: How Money and Debt Built the American Dream,” just went back to the editors. One of the benefits of writing a book about U.S. financial history is that it forces you to take a long view of both economics and the political narrative used to describe it. It is the issue of language and labels, in my view, that is making it so difficult for Americans to understand the current state of the economy.
The National Bureau of Economic Research just declared that the “recession” that began in 2007 ended in the middle of 2009, making it the longest downturn since WWII. The only problem is that none of the people who work at NBER today, which is one of my favorite research organizations, are old enough to remember what the U.S. economy was like before WWII; before the age of Keynesian socialism and the use of debt to stimulate growth and employment became standard policy in Washington.
Let’s start with the term “recession,” which itself reflects the assumption that economic growth is always positive and the trend line is always upward sloping. While many economists in the U.S. remain convinced that this is an accurate descriptor, what Americans and many other people of the world need to consider is whether the assumption that the economy will grow endlessly is reasonable.
In the period following the Crisis of 1907 and before the start of WWI, Americans faced a grim economic outlook. Jobs were scarce, product and commodity prices were flat, and the value of farm products and land had been falling for years. The American economy was entirely dependent upon Europe for financing and to buy U.S. products, mostly agricultural and other commodities. The dismal economic scene fed the rise of the Progressive movement in U.S. politics.
WWI provided a sharp relief from this picture of economic stagnation. Employment rebounded, American agricultural prices soared and the value of real estate around the U.S. also rose sharply. With renewed growth came inflation, however, so that by the time that WWI ended, prices for many consumer staples had doubled, but wages did not keep pace. Economic activity gradually slowed as the U.S. made its way through the Roaring Twenties, but many Americans never saw any benefit from this period of speculation and financial excess.
Following the Crash of 1929, the pretense observed by both political parties that all was well in the U.S. economy evaporated into almost twenty years of economic stagnation. While the massive mobilization  for WWII provided the appearance of a recovery, and the period of the Cold War extended this mirage on a sea of public debt and paper dollars, the basic issue of overcapacity remained.
From the 1970s, when the U.S. shifted from defense to housing as the chief driver of American economic growth, the illusion became ever more attractive and, seemingly at least, permanent. But the sad fact is that much of what Americans think was real growth supported by real income and real work was, in fact, the result of deficit spending and reckless monetary expansion by the Fed, first under Alan Greenspan and now Ben Bernake.
In an interview for my book former Fed Chairman Paul Volcker noted:

We live in an amazing world. Everybody has big budget deficits and big easy money, but somehow the world as a whole cannot fully employ itself. It is a serious question. We are no longer just talking about a single country having a big depression but the entire world. If the world as a whole cannot employ everyone who is ready and able to work, it raises some big questions.

Earlier this week in a research note for the IRA Advisory Service, we reported that some of the leading experts in the housing sector believe that the U.S. is less than 25% through the restructuring of defaulted loans on commercial and residential real estate, and that the backlog is growing.  Last week at the AmeriCatalyst conference held in Austin, TX, Laurie Goodman from Amherst Securities predicted that one in five U.S. households remains at risk of foreclosure. If this prediction turns out to be correct, the optimistic view of the U.S. economy and banking sector must be radically revised — and soon.
Just as the housing sector and the related debt was the driver of the U.S. economy over the past several decades, I believe that the deflation of the housing market could spell an equally drastic period of shrinkage in economic activity in the U.S. and around the world.  In order to meet this challenge, both the political and economic communities need to put aside preconceived notions of how the economy should look and begin to develop new language to describe what is really happening to consumers and businesses. Only then can we truly begin the process of working through what is the most serious economic contraction in the U.S. since WWI.

Greespan Warns That Gold Is the "Canary In the coal mine"

Another record high for gold today.

fron NY Sun:

Only days after the former Federal Reserve chairman Alan Greenspan warned that “fiat money has no place to go but gold,” the dollar has collapsed to a new low. The remarks of the former Fed Chairman were made a week ago at the Council on Foreign Relations, causing a flurry of excitement on the Internet. The dollar shed value, dropping to a record low yesterday, within minutes of the Federal Reserve declaring that it was, as characterized by Reuters, “ready to provide more support for the economy and expressing concerns about low inflation.”

It’s amazing to us that this doesn’t seem to be raising an alarm in either the halls of Congress, the administration, or the newsrooms. Kitco News, which is published by the gold dealer, reported the reaction this way: “Around 3:30 p.m. EDT (1930 GMT), spot gold was up $6.90 to $1,285.40 an ounce, compared to $1,272 about 10 minutes ahead of the Fed statement. December gold on the Comex division of the New York Mercantile Exchange was $6.90 higher at $1,287.70, compared to $1,273.30 ahead of time. In after-hours trading following the Fed statement, the December futures went on to a high of $1,290.40; that is a fresh record for a most-active Comex contract.”
Regular readers of these columns know that we prefer not to speak of the “price of gold” but rather of the “value of the dollar.” Kitco’s reporter quoted the managing director of Trend/Max Futures, Zachary Oxman, as saying the Fed “all but confirmed” quantitative easing and predicting that the value of the dollar would fall below a 1,300^th of an ounce of gold by the end of this week and to between a 1,400^th of an ounce and a 1,500^th of an ounce of gold by the end of the year. That would mean that the dollar would have dropped from a 271^st of an ounce on January 1, 2001.
Is Matt Drudge the only editor of a general interest publication who understands the front-page nature of this collapse? This is not about a sudden failure of the mines. Or a sudden manufacturing need. This is about a failure of the Congress to carry out its responsibilities under the Constitution. To suggest that the trend is reversible with an adjustment of interest rates does not address the issue we see. The issue is that there is neither a law or a policy being enforced or followed that references gold or silver as a matter of principle in the way that the Founders of the country understood — and, in the founding Congresses, wrote into law.
We have one recent Fed chairman, Mr. Greenspan, who seems to understand the importance of gold — it, he said at the Council on Foreign Relations, “is the canary in the coal mine. It signals problems with respect to currency markets.” Now we have another Fed chairman who, in Mr. Bernanke, is prepared to testify before Congress that he doesn’t “fully understand the movements in the gold price,” though he does acknowledge that “there’s a great deal of uncertainty and anxiety in financial markets right now and some people believe that holding gold will be a hedge against the fact that they view many other investments as being risky and hard to predict at this point.”

* * *

When we wrote about that testimony in the spring, we called Mr. Bernanke’s answer a classic. “One doesn’t go into gold because, as the be-puzzled Mr. Bernanke seems to suggest, one lacks confidence in, say, ‘other investments,’ soybeans, say, or iron ore,” we suggested. “One goes into gold because one lacks confidence in the fiat currencies.” That’s the point Mr. Greenspan spoke of at the Council. The Congressman who put Mr. Bernanke on the spot then was Paul Ryan of Wisconsin. We suggested at the time that when they next get the chairman back on the Hill they press him about the Founders and their understanding of money, their fear of paper money, their warnings to future generations, and the laws and definitions of the dollar that they put into the national currency. The Founders on the dollar are worth an entire hearing, and by our lights it can’t come too soon.

"He'll just keep printing money until the problem goes away!" Aaron Fennell

Aaron Fennell is the Chief Market Strategist in Canada for Lind-Waldock.Of course, he was speaking of Ben Bernanke.

No Inflation? Would Someone Please Show Bernanke This Chart?

If inflation in commodities is this high now, and the Fed has highlighted that its mandate is to create more inflation, what are the consequences of what the Fed is doing?

REAL U.S. National Debt Closer to $200 Trillion!

from news.com Australia:

THE actual figure of the US' national debt is much higher than the official sum of $US13.4 trillion ($14.3 trillion) given by the Congressional Budget Office, according to analysts cited on Sunday by the New York Post.
"The Government is lying about the amount of debt. It is engaging in Enron accounting," said Laurence Kotlikoff, an economist at Boston University and co-author of The Coming Generational Storm: What You Need to Know about America's Economic Future.
"The problem is we're seeing an explosion in spending," added Andrew Moylan, director of government affairs for the National Taxpayers Union.
In 1980, the debt - the accumulated red ink incurred by the Federal Government - was $US909 billion.

This represented some 33 per cent of gross domestic product, according to the Congressional Budget Office (CBO).
Thirty years later, based on this year's second-quarter numbers, the CBO said the debt was $US13.4 trillion, or 92 per cent of GDP.
The CBO estimates the debt will be at $US16.5 trillion in two years, or 100.6 per cent of GDP.
But these numbers are incomplete.

They do not count off-budget obligations such as required spending for Social Security and Medicare, whose programs represent a balloon payment for the Government as more Americans retire and collect benefits.
In the case of Social Security, beginning in 2016, the US Government will be paying out more than it is collecting in taxes.

Without basic measures - such as payment cuts or higher payroll taxes - the system could be on the road to bankruptcy, according to officials.
"Without changes," wrote Social Security Commissioner Michael Astrue, "by 2037 the Social Security Trust Fund will be exhausted. There will be enough money only to pay about $US0.76 for each dollar of benefits."
Mr Kotlikoff and Mr Moylan agree US national debt is much more than the official $US13.4 trillion number, but they disagree over how to add up the exact number.
Mr Kotlikoff says the debt is actually $US200 trillion.
Mr Moylan says the number is likely about $US60 trillion.

That is close to the figure quoted by David Walker, the US Comptroller General from 1998 to 2008.

He launched a campaign to convince Americans that the federal spending and debt is a greater threat than terrorism.
But whichever figure is accurate, all three agree that the problem has worsened in the last few years.

They say it is because Congress and the Administration, whether Republican or Democrat, consistently overspend.

Household Net Worth Continues to Plunge

from Reuters:

(Reuters) - U.S. household wealth fell by $1.5 trillion in the second quarter, according to Federal Reserve data on Friday that showed the strain a slow-paced recovery and high unemployment are putting on Americans.
Household net worth fell to $53.5 trillion, well below the $64.2 trillion it had reached at the end of 2007 when the recession officially began, according to the central bank's quarterly flow of funds report.
Declines in the value of financial assets -- especially in stocks and mutual funds -- accounted for much of the decline in second-quarter net worth. Stocks alone were down $1.9 trillion to $14.9 trillion, more than offsetting small gains in other areas like state and local government retirement funds.
Consumers pared debt at a seasonally adjusted annual rate of 2.3 percent, the ninth consecutive quarter in which they did so. Home mortgage debt fell at an annual rate of 2-1/4 percent after a 4-1/4 percent drop in the first three months this year.

Housing Starts Leap 10.5%!

from Marketwatch.com

WASHINGTON (MarketWatch) - New construction of U.S. houses surged in August, the Commerce Department estimated Tuesday. Starts rose 10.5% in August to a seasonally adjusted 598,000 annualized units, much stronger than the 535,000 pace expected by economists surveyed by MarketWatch. This is the highest level since April. Starts in July were revised down slightly to a 541,000 rate compared with prior estimate of 546,000. Starts of new single-family homes rose 4.3% to a 438,000 rate in August, while starts of large apartment units rose 32.2% to 160,000. Building permits, a leading indicator of housing construction, rose 1.8% to a seasonally adjusted annual rate of 569,000.

Morgan Stanley's Perspective on Sovereign Debt Defaults

By Arnuad Mares
September 20, 2010
This is the first issue of Sovereign Subjects, a new Morgan Stanley publication focusing on sovereign risk in advanced economies. In this first installment, we take a broad perspective on government balance sheets and raise several themes to which we will return in more depth in subsequent issues. We encourage clients to provide us with feedback on this new publication.
Debt/GDP ratios are too backward-looking and considerably underestimate the fiscal challenge faced by dvanced economies’ governments. On the basis of current policies, most governments are deep in negative equity.
This means governments will impose a loss on some of their stakeholders, in our view. The question is not whether they will renege on their promises, but rather upon which of their promises they will renege, and what form this default will take.
So far during the Great Recession, sovereign (and bank) senior unsecured bond holders have been the only constituency fully protected from partaking in this loss.
It is overly optimistic to assume that this can continue forever. The conflict that opposes bond holders to other government stakeholders is more intense than ever, and their interests are no longer sufficiently well aligned with those of influential political constituencies.
There exists an alternative to outright default. ‘Financial oppression’ (imposing on creditors real rates of return that are either negative or artificially low) has been used repeatedly in history in similar circumstances.
Investors should be prepared to face financial oppression, a credible threat against which current yields provide little protection.

---

Ask Not Whether Governments Will Default, but How

The sovereign debt crisis is not European: it is global. And it is not over. The European sovereign debt crisis of spring 2010 was a misnomer in more ways than one: there was not one crisis but two. And it will continue well beyond 2010, in our view. The first crisis was, and remains, an institutional crisis of the euro, caused by a flawed multilateral fiscal surveillance framework. Steps have been taken towards a correction of the flaws with a move from peer pressure to peer control of fiscal policy. This is reflected by the acceptance by the Greek, Spanish and Portuguese governments of fiscal measures largely dictated from Berlin and Brussels. The second crisis was, and remains, a sovereign debt crisis: a crisis caused by sovereign balance sheets being overstretched, to the point where insolvency ceases to be merely possible and becomes plausible. This crisis is not limited to the periphery of Europe. It is a global crisis and it is far from over. We take a high-level perspective on the state of government balance sheets and conclude that debt holders have to be prepared to enter an age of ‘financial oppression’.
Debt/GDP has been higher before, so why worry?  As government debt and deficits have swollen to levels for which there exist few recent references, all eyes have turned to a more distant past in the hope of finding some guidance as to what future awaits bondholders. At first glance, history appears to be reassuring, though that is deceptive, in our view. Several advanced countries have experienced debt/GDP levels well in excess of current ones. The US emerged from Word War II with a public debt/GDP ratio of approximately 110%, and the UK with a ratio of 250%. The UK national debt has averaged almost 100% of GDP since its creation in 1693 (see Exhibit 1). Yet the UK government never defaulted through that period. France’s public debt stood at about 280% of GDP at the end of World War II. It did not default either. As a matter of fact France defaulted only once – in 1797 – since the creation of its own national debt in 1789. This is remarkable, considering the number of political, military and economic crises the country went through. So why worry now?
 
Four reasons why debt/GDP misses the point. The problem with these historical comparisons is not the reference: how governments dealt with their war debt burdens sheds useful light on what might be in store for coming years. Rather, the problem lies with the measurement tool: debt/GDP is the most widely used debt metric, but we believe that it is a very inadequate indicator of government solvency. There are four reasons for this:

• Gross versus net debt: First, debt/GDP is a measure of gross indebtedness. It therefore overstates the size of the government’s net financial liabilities, especially when – as has been the case through the crisis – debt is being raised for the purpose of on-lending or acquiring assets. Where measures of net debt exist, they provide an apparently less alarming picture of the government’s balance sheet. The difference can be sizeable (in excess of 17% of GDP in the UK currently, for instance). Good news, however, stops here.
• Missing liabilities: The second flaw of debt/GDP is that it only accounts for part of a government’s contractual liabilities. There exists a broad range of liabilities that are debt, yet are not captured in national accounts. To take one example, in March 2008 the UK Government Actuary Department valued the government’s unfunded civil service pension liabilities – that is, the contractual claims on government accumulated to date by civil servants – at £770 billion. That is 58% of GDP, not captured by the debt/GDP ratio. Debt/GDP does not capture contingent liabilities either.
• It is not GDP but government revenues that matter: Whatever the size of a government’s liabilities, what matters ultimately is how they compare to the resources available to service them. One benefit of sovereignty is that governments can unilaterally increase their income by raising taxes, but they will only ever be able to acquire in this way a fraction of GDP. Debt/GDP therefore provides a flattering image of government finances. A better approach is to scale debt against actual government revenues (see Exhibit 2). An even better approach would be to scale debt against the maximum level of revenues that governments can realistically obtain from using their tax-raising power to the full. This is, inter alia, a function of the people’s tolerance for taxation and government interference. Seen from this angle, the US federal debt no longer compares quite so favourably with that of European governments.

 

• Debt/GDP looks at the past. The main problem is in the future: The fourth and largest flaw of debt/GDP is that it is an entirely backward-looking indicator. It only accounts for the accumulation of past deficits. This captured reasonably well the magnitude of the fiscal challenge at the end of World War II because at that time the challenge did indeed result entirely from the past: large wartime deficits had pushed debt ratios higher, but governments were no longer running deficits, nor were there expectations of them doing so in subsequent years.
  By contrast, the accumulation of past deficits now represents only part of the problem for advanced economies’ governments. The other part consists of coping with the large structural deficits opened up by the crisis and compounded by the fiscal consequences of ageing. What raises questions about debt sustainability is not so much current debt levels as the additional debt that will accumulate in coming years if policies do not radically change. Debt ratios do not capture this part of the problem.

Looking beyond debt: valuing government equity. A comprehensive look at government balance sheets provides a much gloomier reading of their solvency. Exhibit 3 shows a stylised representation of the government balance sheet. In addition to financial assets and liabilities appear ‘fiscal’ assets and liabilities. On the asset side is the power to tax, which is the main asset and resource of any government. It can be conceived as a variable rate claim on GDP, where the rate depends on the level of taxation. Its value on the balance sheet is therefore the net present value of all future tax revenues. On the liability side appears a ‘social’ liability, which represents the promise of the government to its electorate to spend resources on defence, justice, education, health and any other existing government policy. Its value is the net present value of all future primary expenditure. The difference between the power to tax and the social liability is the net present value of all future structural primary deficits (by definition, the cyclical component of the deficit should sum up to zero over time).
 
The residual is represented on the balance sheet as the people’s equity, by analogy to a corporate balance sheet. This is effectively the net worth of the government in the broadest sense, and a measure of its solvency. It can be interpreted very simply as follows: if positive, the government can release value to taxpayers by lowering taxes without reneging on its promises to other stakeholders (bond holders and beneficiaries of public services). If negative, the government is insolvent. In other words, some or all of its stakeholders must suffer a loss: either taxpayers (through a higher tax burden), or beneficiaries of public services (through lower expenditure) or bond holders (through some form of default).
Adding the cost of ageing to that of the crisis. An estimate of government ‘equity’ value can be obtained by adding the net present value of all future primary deficits to existing financial debt. Future primary deficits result from two influences:

• Current structural deficits, opened up or aggravated during the crisis by the permanent loss of tax revenues that accompanies a permanent loss of output. This is the part of the deficit that will remain – once temporary stimulus measures are withdrawn and growth has returned to trend – under an assumption of unchanged policies;
• The additional structural deficit that – under the same assumption of unchanged policy – would gradually result from ageing, mostly through a rise in health and pension expenditure.

The fiscal challenge is unprecedented. Exhibit 4 provides illustrative estimates of government net worth under this approach. What matters here is not the exact numbers, which are very dependent on underlying assumptions (see box). What matters is the sign of net worth (negative everywhere), its broad order of magnitude (a large multiple of current or historical debt levels almost everywhere) and the ranking of governments.
 
This depressing perspective on global public finances is not exactly news. The same calculations based on pre-crisis data were not nearly as bad, but not significantly more encouraging either, with most governments already then in negative equity. The crisis has had three noticeable effects nonetheless:

Estimating Government Net Worth: Underlying Assumptions
Our illustrative estimates of government net worth are based on the following assumptions:
Initial debt level: For the purpose of simplicity, consistency and availability of data across countries, we use the projected debt level of gross debt/GDP at end-2010 – even though the correct aggregate to use here is clearly net financial debt. This has no material bearing on the conclusions of the exercise.
Structural deficit: The exact size of the structural deficit is a guesstimate at best – it requires an assessment of potential GDP, a notoriously imprecise concept. Calculations are based on official projections of cyclically adjusted primary deficits in 2011, and we assume that this deficit is unchanged in every subsequent year (as a percentage of GDP). This is consistent with the assumption of ‘unchanged policy’. In practice governments do intend to change policy – and thereby to reduce the size of the structural deficit. In doing so they inflict a loss on taxpayers (if raising taxes) and on other stakeholders (when cutting expenditure). As the purpose of the exercise is precisely to evidence the magnitude of the loss that these will suffer, assuming an unchanged structural deficit at current levels is the appropriate reference point. It is for this same reason that we use as a reference point 2011 and not 2010 data: the latter is still distorted in some countries by stimulus measures, which, being temporary by nature, never constituted a ‘promise to spend’. The removal of the stimulus measure does not therefore inflict on stakeholders a loss as we define it.
Cost of ageing: Estimates of the cost of ageing on public finances – even under unchanged policy – rely heavily on demographic and economic projections. For the purpose of our illustrative calculations, we used long-term projections of age-related expenditure published by the EU and – for the US – by the IMF. For the same reason as above, the reference point is pre-fiscal retrenchment, i.e., the calculation does not take account of the ongoing pension or healthcare reforms decided or being discussed this year in many countries.
Discount rate: The net present value of future fiscal deficits is naturally heavily dependent on the discount rate used. The calculations illustrated in Exhibit 4 assume a discount rate 100bp above the nominal GDP growth rate across all countries.

• It has aggravated the problem everywhere, mostly through a permanent shock to tax revenues and through a transfer of liabilities and risk from the private to the public sector, without a commensurate transfer of resources.
• In doing so, it has intensified the inherent conflict that exists between bond holders and other government stakeholders that all compete for resources that are finite and, crucially, insufficient to satisfy all their claims – to the point where holders of government debt have started contemplating default as a plausible outcome rather than a mere theoretical possibility...
• ... which, in turn, considerably shortened the time available to governments to resolve this conflict one way or the other, with a loss of market access a credible penalty for procrastination.

It is not whether to default, but how, and vis-à-vis whom. What this means is that – as indicated above – governments will impose a loss on some of their stakeholders and have in fact started to do so (across Europe at least). The question is not whether they will renege on their promises, but rather upon which of their promises they will renege, and what form this default will take. From the perspective of sovereign debt holders, this translates in two questions:

• Does their claim on governments rank senior enough relative to other claims to fully shelter them from losses?
• If it does not, what form will this loss take?

Bonds remain the most senior government liability. There are good reasons why government bonds should rank senior to most other liabilities. To mention one: governments need to be able to raise finance to fund public investment as well as to perform their macroeconomic stabilisation role. They cannot issue equity, and cannot credibly issue secured debt. Unrestricted access to unsecured, confidence-based funding is core to their ‘business model’, as it is for banks. This was, historically at least, the main argument for honouring sovereign debt. There are others, not least the consequences of a government default for output and for financial stability when banks own substantial exposure to the sovereign.
Bond holders have been fully sheltered from loss through the Great Recession – so far. This seems consistent with historical experience, both from yesteryear (see Exhibit 1) and yesterday. So far indeed, holders of sovereign debt have been exempt from sharing in the loss of income and wealth that has affected everybody else: shareholders have absorbed direct losses. Homeowners have faced (uneven) losses of property value. Taxpayers have experienced a reduction in their lifetime income through current and prospective increases in taxation. Government employees and other stakeholders are suffering even larger losses through current or prospective reduction in government expenditure. Only holders of senior unsecured debt issued by the largest governments and – in most cases – banks have been sheltered so far.
Can this realistically continue forever? This is ultimately a question of political economy. It is worth noting that, in the case of Greece, public acceptance of austerity measures – cuts in civil service compensation in particular – has become conditional on the perception that the cost of fiscal retrenchment would be distributed fairly across constituencies (hence the very public crackdown on wealthy tax evaders). Whether and when bond holders are asked to share in the common pain – not just in Greece – depends on:

• The intensity of the conflict that opposes them to other stakeholders. As discussed earlier, this is likely stronger than it has ever been; and
• The extent to which the interests of bond holders are aligned with those of the most politically influential constituencies.

Financial oppression as an alternative to outright default. Outright default is not the only way to impose losses on creditors. Financial oppression – the fact of imposing on creditors real rates of return that are negative or artificially low – can take other forms: repaying debt in devalued money (e.g., through unanticipated inflation), taxation or regulatory incentives on institutions to purchase government debt at uneconomic prices, for instance (see also “Default or Inflate or…”, The Global Monetary Analyst, February 24, 2010). Repaying debt in devalued money is particularly effective when the initial stock of debt is high – as it is now. Distorting prices in the government’s favour is particularly effective when the financing requirement is high – also a situation we face now and for years to come.
History is not so reassuring after all. Financial oppression has taken place in the past as an alternative to default in countries that are generally considered to have a spotless sovereign credit record. Examples include: the revocation of gold clauses in bond contracts by the Roosevelt administration in 1934; the experience by then Chancellor of the Exchequer Hugh Dalton of issuing perpetual debt at an artificially low yield of 2.5% in the UK in 1946-47; and post-war inflationary episodes, notably in France (post both world wars), in the UK and in the US (post World War II). Each took place at a time when conflicting demands on finite government resources were high, and rentiers wielded reduced political power.
 
The interests of bond holders are no longer perfectly aligned with those of the most powerful constituency. Exhibit 5 shows the rapid increase in the age of the median voter in large western European countries. In principle, having governments and policies shaped by older voters ought to be favourable to bond holders, because bonds are more likely to be held by the old than the young and policies that would harm bond holders would often also harm the old (inflation for instance redistributes wealth from the old to the young). The first problem with this argument is that the constituency of the elderly is also the biggest competitor to bond holders because of the considerable size of the direct claim it has on the government balance sheet in the form of pensions, social security and health insurance, etc. The more reluctant they are to relinquish these claims, the higher the risk for bond holders. The second problem is the dilution of bond ownership, which results in lesser alignment of the interest of bond holders with older voters: even in the UK, where the domestic and pension industry has traditionally dominated the gilt market, its ownership of gilts has decreased in recent years from around 60% to 40% of the market excluding Bank of England purchases), to the benefit of foreign investors.
No insurance against financial oppression at current yield levels. Against this background, it seems dangerously optimistic to expect that sovereign debt holders can be continuously and fully sheltered from partaking in the loss of wealth and income that has affected every other group. Outright sovereign default in large advanced economies remains an extremely unlikely outcome, in our view. But current yields and break-even inflation rates provide very little protection against the credible threat of financial oppression in any form it might take. Note that a double-dip recession would not invalidate this conclusion: it would cause yet further damage to the governments’ power to tax, pushing them further in negative equity and therefore increasing the risks that debt holders suffer a larger loss eventually.

Warren Buffett Got a Bailout? $95 BILLION Worth!

Worse still, $7 billion went into his personal pocket!

Fed pours $5.2 Billion Into Stocks Today

from Zero Hedge:

Today's POMO is over, and the result is a whopper: Brian Sack has just injected a record for QE Lite $5.2 billion in stock, in order to complete all the elements of today's orchestrated Obama Town Hall meeting, during which the president is now fully expected to announce that he not only managed to end the recession singlehandedly (what an opportune time for the NBER to announce its results), but that stocks are now ripping every single time he appears on TV (same goes for gold, oil, and pretty much everything else: and furthermore, Treasurys are unchanged, refuting all of Mr. Pisani's BS about capital reallocation in process). $5 billion today, add another $6 billion on Wednesday and Friday, lever up 30 times and you have some $300 billion in free buying given to the Primary Dealers so they can ramp the S&P to 1,150 by the end of the month. Job well done Mr. President. Too bad nobody but Wall Street and a few HFT prop desks care about the stock market any more.

NBER Announces Recession is OVER! (last year!)

Tell that to the American People!

From the NBER: "The Business Cycle Dating Committee of the National Bureau of Economic Research met yesterday by conference call. At its meeting, the committee determined that a trough in business activity occurred in the U.S. economy in June 2009. The trough marks the end of the recession that began in December 2007 and the beginning of an expansion. The recession lasted 18 months, which makes it the longest of any recession since World War II. Previously the longest postwar recessions were those of 1973-75 and 1981-82, both of which lasted 16 months."

POMO Stock Buying -- Right on Time!

Malaysia Begins Dumping Dollars

from Zero Hedge:

Overnight gold hit a fresh all time record as increasingly more people make their own decision to go back to the gold standard, away from endless currency dilution, and away from the dollar as reserve currency. Curiously, the latest salvo in the case of the latter came from Malaysia which, courtesy of the FT, we learn has "bought renminbi-denominated bonds for its reserves, marking a significant advance for Beijing’s attempts to internationalise the use of its currency, pitched by Chinese policymakers as a long-term rival to the US dollar." While relatively under the radar, this development will have huge implications for global capital flows: as Credit Agricole's Dariusz Kowalczyk, says, "the central bank’s move is also expected to herald further diversification into Chinese government securities by other Asian countries. This brings the renminbi’s credibility to a whole new level. It will have a domino effect, starting among China’s trading partners in Asia. Then it will gradually spread globally." Of course, it also shows that what China does to Japan by buying up its bonds, the world can do to China. However, in exchanging the renminbi for the dollar as global reserve currency of choice, Beijing will be more than happy to allow this, even as the US, its infinite budget deficit, and its outright lack of a budget, grows increasingly isolated.
More from the FT:

The Malaysian central bank refused to comment on the move, saying that it never discusses the composition of its reserves, which amounted to M$311bn (US$100bn) at the end of August, which was then equivalent to US$95bn.

However, people with knowledge of the transaction said it had taken place recently and was thought to have been accompanied or followed by purchases by other Asian central banks, although none of these has yet been identified.

In August, China opened its domestic interbank bond market to foreign central banks that have access to renminbi through a series of bilateral currency swaps totalling Rmb800bn ($120bn).

The agreements, signed since 2008, are with Argentina, Belarus, Hong Kong, Iceland, Indonesia, Malaysia, Singapore and South Korea, although there are no details about how many of these swap lines have actually been activated. Commercial banks such as HSBC and Citigroup that have accumulated renminbi through cross-border trade settlement were also told last month they would be able to invest in China’s interbank bond market, although none has yet been given formal approval.

The decision to allow some central banks to invest in the domestic bond market is part of a push by Beijing to increase the international use of the Chinese currency. An expanded role for the renminbi would be a threat to the position of the US dollar, although many economists believe it will be years before it becomes a major reserve currency, given China’s tight financial market controls.

To be sure, our idiot politicians are sure to welcome this move as it will lead to further appreciation of the CNY, and more dollar destruction, which presumably will make the export of US-based financial innovation cheaper. Which of course, when faced with $10 trillion in budget deficits over the next decade, which will need about $15 trillion in incremental debt issuance, is completely irrelevant. Instead of focusing all its attention on the one thing that matters, i.e., making US Treasury debt purchases as attractive as possible for as long as possible, the US is now happy to throw future bond buyers under the bus, just so a few incumbents can get reelected on a myopic campaign promise. In the meantime, follow the price of gold: it speaks volumes about what the world thinks of the current reserve currency system.

Gold Reaches Still Another New High

That's four new highs in five days!

John Hussman: Leading, Lagging, and Coincident Indicators

from HussmanFunds:

"Series that represent early stages of production and investment processes (new orders for durable goods, housing starts, or permits) lead series that represent late stages (finished output, investment expenditures). Under uncertainty, less binding decisions are taken first. For example, hours of work are lengthened (shortened) before the work force is altered by new hirings (layoffs)."

Victor Zarnowitz and Geoffrey Moore, "Sequential Signals of Recession and Recovery"
Journal of Business, 1982

Last week, we got a fresh set of economic indications from the Philadelphia Fed Survey. While the market evidently took relief from the modest uptick in the composite index to -0.7, a quick look at the component indices suggests a worsening of economic conditions in the latest report. Specifically, the Philly Fed new orders component fell to -8.1 from -7.1, which is the third month in negative territory. While there was a slight uptick in the index for number of employees (to 1.8 from -2.7), the better leading measure is the average employee workweek, where the index weakened to -21.6 from -17.1.

As I've emphasized in recent weeks, the U.S. economy is still in a normal "lag window" between deterioration in leading measures of economic activity and (probable) deterioration in coincident measures. Though the lags are sometimes variable, as we saw in 1974 and 2008, normal lags would suggest an abrupt softening in the September ISM report (due in the beginning of October), with new claims for unemployment softening beginning somewhere around mid-October. It's possible that the historically tight relationships that we've reviewed iin recent weeks will not hold in this particular instance, but we have no reasonable basis to expect that. Indeed, if we look at the drivers of economic growth outside of the now fading impact of government stimulus spending, we continue to observe little intrinsic activity.

The strongest forces driving economic expansion during a post-recession recovery phase is expansion in credit-sensitive expenditures such as housing, durable goods (such as autos) and gross investment, and in particular, inventory rebuilding. While capital expenditure for upgraded information technology is the clearest bright spot in recent GDP reports, it also represents a very small share of the economy. Other credit-sensitive classes of expenditure continue to face strong headwinds.

It is also important to understand that while consumption represents roughly 70% of economic activity, it is by far the least volatile component of GDP, particularly when durable goods are excluded. The main sources of fluctuation in GDP growth are credit-sensitive expenditures and inventories. Given the recent buildup of inventories and the expenditures on autos and home buying that were brought forward by programs such as cash-for-clunkers and the first-time homebuyers' credit, we are likely on the downside of those bursts of spending. For that reason, it appears likely that the positive growth of GDP in recent quarters will have relatively poor follow-through. A careful examination of sub-components of GDP growth leaves little reason to expect actual economic activity to deviate from what is already suggested by weak leading indicators.

If we observe both an improvement in those leading indicators and an improvement in market internals, our evaluation of investment conditions would be more constructive. For now, however, we remain defensive about risks that still appear significant.

On the housing front, last week's comments from Rick Sharga, the V.P. of RealtyTrac, are worth noting - "We're on track for a record year for homes in foreclosure and repossessions. There is no improvement in the underlying economic conditions. Whether things fall precipitously depends on government and lenders controlling the inflow of new foreclosure actions. If the market is left to fend for itself, you may see more serious price depreciation."

Lender Processing Services concurred, with its senior V.P. noting "Loans that have been delinquent for a historically long period of time are just now beginning to move through the pipeline. As of July 2010, the average length of time a loan in foreclosure had been delinquent was nearly 470 days. Now, after the intensive efforts of the last year or two, remaining home retention options appear to be exhausted and servicers are beginning to process more of these seriously delinquent loans."

My view remains that the underlying condition of the U.S. housing market is one of deep insolvency. The Treasury, Fed and the FASB have effectively made a policy out of opaque disclosure, so that at least the deterioration in the housing market is slow to appear on the balance sheets of major banks and financials. At present, the FASB allows "substantial discretion" in the valuation of mortgage-backed securities, which I suspect are being carried at a higher level than the value that the underlying cash flows (mortgage repayments) can actually support. Given that there is little pressure to disclose losses, and that mechanisms are in place (at least until the end of 2012) for the Treasury to bail out the entire flow of bad mortgages that funnel through Fannie Mae and Freddie Mac, it's not clear whether the growing mountain of delinquent and unforeclosed mortgages will provoke an abrupt crisis. My own expectation is that fresh economic pressure would provoke contagious pressure on the housing market to an extent that would be difficult to obscure.

That said, if the U.S. economy averts a period of fresh economic weakness, we could instead observe a more drawn out period of stagnation and price pressure. Ultimately the bad assets have to be placed on the market, which suggests further price pressure in the next few years. Weak labor conditions would also contribute further mortgage deterioration. Long-term, deficit-led inflation might be able to avert mortgage losses as home values gradually rise above the principal balances, eroding the real value of the debt, but this appears very unlikely in the immediate few years.

On the subject of inflation, I should emphasize that while I expect inflation pressures to be contained for several years, the impact of massive deficit spending should not be disregarded simply because Japan, with an enormously high savings rate, was able to pull off huge fiscal imbalances without an inflationary event. We may be following many of the same policies that led to stagnation in Japan, but one feature of Japan that we do not share is our savings rate. It is one thing to expand fiscal deficits in an economy with a very elevated private savings rate. In that event, the economy, though weak, has the ability to absorb the new issuance. It is another to expand fiscal deficits in an economy that does not save enough. Certainly, the past couple of years have seen a surge in the U.S. saving rate, which has absorbed new issuance of government liabilities without pressuring their value. But it is wrong to think that the ability to absorb these fiscal deficits is some sort of happy structural feature of the U.S. economy. It is not. It relies on a soaring savings rate, and without it, our heavy deficits will ultimately lead to inflationary events.

Hyperinflation is a much different story, and as I've said before, I am not in that camp. This doesn't exclude the possibility that enough policy mistakes will change that, but for now, my inflation outlook is flat for several years and then accelerating in the second half of this decade.

As Peter Bernholz notes in Monetary Regimes and Inflation (an economic study of inflation, including more than two dozen cases of hyperinflation), "The figures demonstrate clearly that deficits amounting to 40 per cent or more of expenditures cannot be maintained. They lead to high [inflation] and hyperinflations, reforms stabilizing the value of money, or in total currency substitution leading to the same results. The examples of both Germany and Bolivia suggest that at least deficits of about 30 per cent or more of gross domestic product are not maintainable since they imply hyperinflations... [In nearly all] cases of hyperinflation deficits amounting to more than 20 per cent of public expenditures are present."

At present, U.S. federal expenditures are about $5 trillion, versus about $4 trillion of revenues, and GDP of about $14.6 trillion. So the federal deficit is running at about 20% of expenditures, but less than 7% of GDP. This is not a profile that is consistent with hyperinflation, but it is also not a benign policy. Continued deficits will have substantial economic consequences once the savings rate fails to increase in an adequate amount to absorb the new issuance, and particularly if foreign central banks do not pick up the slack. We're not there for now, but it's important not to assume that the current period of stable and even deflationary price pressures is some sort of structural feature of the economy that will allow us to run deficits indefinitely.

Finally, given probable economic pressures and continued strong demand for default-free instruments, the likelihood of sustained upward pressure on bond yields remains limited here. At some point, probably years from now, we'll face a likely sustained increase in bond yields. We're often asked how that sort of environment would affect the Strategic Total Return Fund, given that we don't short bonds, and we don't buy "inverse floaters" or the like. A simple answer is that just as poor valuations and weak market returns have kept us from taking much exposure to stock market risk during the past decade, while the S&P 500 has gone nowhere, rising interest rates will limit the ability to profit from interest rate exposure. Water can't be squeezed from stones. Frankly, however, the returns of the Strategic Total Return Fund since its inception have not been dependent on a great deal of interest rate exposure in the first place. Even our present portfolio duration of 4 years is well below the average duration of the bond market.

So to a large degree, I expect we'll simply continue what we normally do, which is to vary our exposure in proportion to the expected return/risk profile of the various markets and security groups that we invest in. Markets rarely move in a straight line, and there is typically enough cyclical fluctuation within secular trends to present many opportunities to vary market exposure and portfolio duration. We have the ability to invest in a range of assets such as inflation protected securities, precious metals shares, and foreign currencies, as well as utility shares and other assets. An extended period of rising interest rates is likely to produce a bias toward shorter portfolio durations rather than longer ones. However, I don't expect that economic cycles would be eliminated, and to that extent, I don't expect that we'll be at a loss for opportunities to vary our investment exposures over the course of those cycles.

Market Climate

As of last week, the Market Climate for stocks remained characterized by unfavorable valuations, mixed market action, increasing bullish sentiment (approaching levels of overbullishness), and clear overbought conditions. As we've observed for months now, the stock market is still trading between widely followed support and resistance levels, with the S&P 500 bouncing off of the higher end of that channel last week. My primary concern is still the "recognition window" that I believe we have entered. The next several weeks will be important. As noted above, however, if leading measures of economic activity improve and internals improve, we'll be willing to accept a moderately more constructive position, but even here, our latitude to do so is somewhat restricted by valuations that are historically rich. As always, our intent is to align our position in proportion to the return/risk profile we expect. There's a moderate positive range that we'd be willing to operate within if we observe improvement in various economic measures, but for now, the evidence continues to warrant a strong defense. Both the Strategic Growth Fund and the Strategic International Equity Fund are tightly hedged.

In bonds, the Market Climate remained characterized by moderately unfavorable yield levels and favorable yield pressures. The Strategic Total Return Fund continues to carry a duration of about 4-years, and we are maintaining a range of 15-20% of assets allocated between precious metals shares, foreign currency exposure and modest holdings of utility shares.

...And the Dollar Drops!

Grains Bust Loose

Beans are now up 20 cents in evening trading!?

from Arlan earlier this evening:

Follow-thru buying continues in the grains; Money chasing chart signals now; corn up 8, beans up 17, wht up 7

"...there are only two kinds of paper money - those which are already worthless and those which are going to be worthless"

"Before it can be exchanged, wealth must be created. Wealth cannot be created out of thin air. By definition, an economic good is “scarce”. If it were not, there would be no such thing as economics or exchange. Neither would be necessary because no effort or choice in the face of alternatives would be required in order to provide the GOODS which further our lives. Before we can talk about money and the VITAL role it performs, we must stress this point. Money is NOT wealth, it is the means by which wealth is exchanged amongst those who produce it. Paper money is not suited to this function...

The paper money “price” of Gold will last as long as the attempt to make paper money “work” lasts. In the end, Gold will no longer have a “price” because it has reverted to its role as MONEY. Whenever and wherever that happens, that nation can return to the production of wealth - rather than “money”.

 -- Bill Buckler

Pension Bubble to Pop?

Many of America's largest pension funds are sticking to expectations of fat returns on their investments even after a decade of paltry gains, which could leave U.S. retirement plans facing an even deeper funding hole and taxpayers on the hook for huge additional contributions.
The median expected investment return for more than 100 U.S. public pension plans surveyed by the National Association of State Retirement Administrators remains 8%, the same level as in 2001, the association says.
The country's 15 biggest public pension systems have an average expected return of 7.8%, and only a handful recently have changed or are reconsidering those return assumptions, according to a survey of those funds by The Wall Street Journal.
Corporate pension plans in many cases have been cutting expectations more quickly than public plans, but often they were starting from more-optimistic assumptions. Pension plans at companies in the Standard & Poor's 500 stock index have trimmed expected returns by one-half of a percentage point over the past five years, but their average return assumption is also 8%, according to the Analyst's Accounting Observer, a research firm.
The rosy expectations persist despite the fact that the Dow Jones Industrial Average is back near the 10000 level it first breached in 1999. The 10-year Treasury note is yielding less than 3%, and inflation is running at only about 1%, making it tougher for plans to hit their return targets.
Return assumptions can affect the size of so-called funding gaps—the amounts by which future liabilities to retirees exceed current pension assets. That's because government plans use the return rates to calculate how much money they need to meet their future obligations to retirees. When there are funding gaps, plans have to get more contributions from either employers or employees.
The concern is that the reluctance to plan for smaller gains will understate the scale of the potential time bomb facing America's government and corporate pension plans.
"It's unrealistic," John Bogle, founder of mutual fund giant Vanguard, says of the return assumptions in place at most pension plans.
Pension funds at companies in the S&P 500 faced a $260 billion shortfall at the end of 2009, according to Standard & Poor's. Estimates of the fund deficits faced by state and local governments range from $500 billion to $1 trillion.
Some plans are beginning to trim their return forecasts.
Earlier this month, New York State Comptroller Thomas DiNapoli said he would reduce the expected rate of investment return for his state's pension system, the third-largest in the nation, to 7.5%, from 8%.

The country's two biggest plans—the California Public Employees Retirement System, or Calpers, and the California State Teachers' Retirement System, or CalSTRS—both are undergoing reviews of projected investment returns that could lead to reductions later this year.
Many plans have held onto an 8% return expectation though thick and thin. Such return assumptions partly reflect the heady years of the 1990s bull market. Public pension plans posted a median, annualized return of 9.3% over the past 25 years, but just 3.9% over the past 10, according to consulting firm Callan Associates.
The Oregon Public Employees Retirement System has had an 8% assumption since 1989. Its actual return averaged 10.7% annually from 1970 through 2009. The Teachers Retirement System of Texas has had a similar expectation since 1986, with an annual return of 9% return since then.
A spokeswoman for the Texas system said it doesn't change assumptions "in response to short-term situations," and currently "sees no reason to change our investment-return assumption." A spokesman for the Oregon system said there are no special plans to review its return expectation.
The challenge for many plans, given investment horizons that can stretch out 50 years, is gauging which time period to look at when charting a future course.
George Diehr, vice president of the Calpers board, said in May that the question is whether the credit crisis has "dramatically altered long-held assumptions about investing in the world's financial markets. Are investors in for a sustained period of meager or below-market growth? Or will the traditional business and economic cycles, the ones investors have grown accustomed to over the past couple of decades, return?"
The outcome of Calpers's ongoing review "hangs on how we answer that question," a spokesman says.
Depressed stock prices aren't the only thing putting pressure on potential returns. Plummeting bond yields mean that plans' fixed-income portfolios will likely earn less in the future. A lower inflation outlook means that funds will have to generate greater real returns to meet their return targets.
Funds use a so-called discount rate to estimate the size of future obligations to retirees, and thus the contributions needed to fund them. Corporate plans use a discount rate based on corporate bond yields. But government plans use their expected return rate on all investments as their discount rate.
The higher the discount rate, the smaller a fund's pension obligation. That gives public plans another big reason to hesitate before cutting their expected return rates.
The Colorado Public Employees Retirement Association showed in its 2009 financial report the impact of reducing the rate. Using a 8% expected return rate, the plan faced a $23.4 billion deficit, based on market values, at the end of 2009. If the rate was cut to 6.5%, the shortfall would jump to $34 billion.
Meredith Williams, the Colorado plan's chief executive, says cutting the rate "creates pain." Nevertheless, Colorado at year-end of 2009 cut its return assumption to 8%, from 8.5%. Mr. Williams says the rate may be lowered again later this year.
Others have been more hesitant. In 2009, Matt Smith, state actuary for Washington state, recommended that its retirement system cut its return expectation to 7.5%, from 8%. That advice was rejected by the state's pension-funding council.
Mr. Smith says he thinks Washington and other states eventually will lower expected returns, but that it will be a slow process because reduced assumptions "will increase the cost of pension benefits, and right now the budgetary environment is a big obstacle to that."

Pension plans say they take a decades-long view of potential returns. "We can't knee-jerk our way through this. Funding a retirement system is a long-term proposition," says David Stella, secretary of Wisconsin's department of employee trust funds. Last year Wisconsin's plan reviewed its expected return rate of 7.8% and remains comfortable with it, he says.
Companies have found out the hard way that their options are limited. From 2005 to 2009, S&P 500 companies with pension plans expected to generate about $475 billion in returns. The actual returns were only about $239 billion, a 50% undershoot, according to Jack Ciesielski of the Analyst's Accounting Observer.
In recent years, some funds have tried to boost returns by shifting funds out of stock and into alternative investments such as hedge funds or private equity.
Some find this approach too risky. This summer, the Virginia Retirement System cut its expected investment rate to 7%, from 7.5%, giving it the lowest assumption among the nation's 15 largest pension systems. The shift began in 2005, when the plan's board cut the rate to 7.5%, from 8%.
"There was a general thinking that equity markets were unlikely to repeat the period of the 1990s," explains director Robert Schultze.
The alternative was to take more risk, he says, but the board didn't want to "stretch or be swinging for the fences" to meet higher investment expectations.
Other plans, he predicts, will follow suit. "I just think people are going to be coming off that 8% view," he says.

Gordon Long: The Jaws of Death

from Gordon Long's Tipping Points:

Click to Enlarge

PRESERVE & PROTECT

 

The Jaws of Death

Click all charts to enlarge

 

The United States is facing both a structural and demand problem - it is not the cyclical recessionary business cycle or the fallout of a credit supply crisis which the Washington spin would have you believe.

 

It is my opinion that the Washington political machine is being forced to take this position, because it simply does not know what to do about the real dilemma associated with the implications of the massive structural debt and deficits facing the US.  This is a politically dangerous predicament because the reality is we are on the cusp of an imminent and significant collapse in the standard of living for most Americans.

 

The politicos’ proven tool of stimulus spending, which has been the silver bullet solution for decades to everything that has even hinted of being a problem, is clearly no longer working. Monetary and Fiscal policy are presently no match for the collapse of the Shadow Banking System. A $2.1 Trillion YTD drop in Shadow Banking Liabilities has become an insurmountable problem for the Federal Reserve without a further and dramatic increase in Quantitative Easing. The fallout from this action will be an intractable problem which we will face for the next five to eight years, resulting in the 'Jaws of Death' for the American public.

 

The ‘Jaws of Death’ is the crushing squeeze of a shrinking gap between incomes and a rising burden of the real cost of debt burdens. Many may say there is nothing new in this, but I would respectfully disagree. There is a widespread misperception of what is actually evolving that stops voters from forcing politicians to address America’s substantial underlying dilemma.  It also stops investors from positioning themselves correctly.

 

Any solutions of real substance are presently considered political suicide. It is wiser to wait for a crisis event to unfold. As White House Chief of Staff and a primary Obama political strategist, Rahm Emanuel has said on numerous occasions: “You never want a serious crisis to go to waste”. It doesn’t take much intelligence to understand this also implies looking for a crisis as a political shield, for example from an almost insurmountable political problem such as a generational reduction in the US standard of living.

 

Before I delve into misperceptions of the ‘Jaws of Death’ and a reduced US standard of living, we need to briefly consider for a moment whether this is a planned outcome or just happenstance? President Franklin Roosevelt said:

“Nothing in politics happens by chance”.

 

Being in business I have always been very watchful of a slightly different variation of the same theme:

 

“Strategy is something that happens to you while you are looking the other way”.

 

Maybe Mark Twain said it better than both of us:

 

“It ain’t what you don’t know that gets you into trouble. It’s what you know for sure and just ain’t so!”

 

My point is that there is a strong possibility that the ‘Jaws of Death’ is an orchestrated plan to reposition America’s standard of living. A plan not for the good of Americans but for the good of the banks and those that control the $630 Trillion unregulated, off shore, off balance sheet, OTC derivative market. It is no secret that America’s standard of living is no longer viable, as evidenced by a continuous and chronic deterioration in the US Balance of Payments, Trade Deficit and Current Account funding. It must be addressed and this may already be happening in a stealth fashion.

 

What the above suggests is that we need to address what is perceived as ‘truisms’ but in fact are not;  what is perceived as reality versus what is perception. These subtleties are the veils that hide the real dangers from us.

 

 

THREE MISPERCEPTIONS

 

1-    1- Housing

 

Consider President George W. Bush’s ‘ownership society’ where it was heralded, along with the previous Clinton administration, that every American should own his/her own home. It is fair to say that our society bought into this ‘hook, line and sinker’.  I used to hear the following statements endlessly, and disputing any of them fell on deaf ears with blank stares, as though you were an idiot to even challenge them.

 

THE MANTRA	BEHAVIOURAL RESPONSE
“Housing and Real Estate are the best investments you can make”	Residential Real Estate became the public’s ‘savings’ strategy (in most cases their sole savings strategy).
“My house is my retirement nest egg. I will sell it and move into something less expensive when the time comes”	Residential Real Estate became the Public’s  Retirement Strategy and source of financial security.
“We have made a lot of money on the appreciation of our house”	The Emotional Wealth Effect justified increased spending on vacations, hobbies and luxury items (through increased debt).
“Money is so cheap my financial advisor suggested I should take out  a Home Equity Loan as a wealth ‘extraction’ strategy”	Perceived low rates justified spending and increasing debt. Home Equity Lines of Credit & Loans (HELOCS) exploded.
“They aren’t making any more land!”	A sense of urgency was created that if you didn’t quickly take on horrendous levels of debt you would never be able to afford your piece of the American dream.

 

I can’t remember how long it has been since I have heard any of these statements.  How quickly accepted fact is found to be mistaken. Without this false mantra being sold to the public we would never have had a CDO driven financial crisis. Consider for a moment who is responsible for orchestrating this false belief system that the financial collapse was built on? Our government's misguided public policy certainly holds some responsibility for this.

 

2005	2010

 

“The public and majority of investors are always wrong.”

 

What we now face is the reality that jobs have disappeared and housing has fallen in an almost mirror image of unemployment as shown by housing starts below.

 

 

According to a recent 3,400 households’ survey by Fannie Mae, a more realistic attitude towards homeownership has emerged as the American dream of owning a home has lost its allure. Only 67% felt housing was any longer a safe investment and 33% said they were likely to rent in the future. The Wall Street Journal recently cited an interesting illustrative example of shifting psychology in which a 26 year graduate student walked away from his down payment to purchase a condo because he felt homeownership was an “economic trap” and “being mobile and adaptable to the job market was far more important than homeownership”.

 

The National Association of Realtors is starting to show signs of panic because this shifting psychology is moving legislators to reconsider federal subsidies for homeownership. It has reacted by launching a campaign on the “value of homeownership”. I wonder if the National Association will get the same look I did when I questioned the housing statements listed above.  Oh how quickly things change!

 

2-    2- Inflation / Deflation

 

I am continuously troubled by the inflation – deflation debate. One of a number of issues in these debates that concerns me is no one ever defines ‘time’ in their analysis and predictions. Without time specified we could have inflation, then deflation, (or visa-versa) for exactly the reasons that both opposing views meticulously articulate. Maybe even more blatant is that seldom do analysts consider the possibility that we could have both. This is the school that I am a believer in.

 

I predict that over the next few years we will have inflation in the things we NEED and USE. These are the items we buy and consume every week, the items we buy and not finance, and the items we need ready and recurring cash for. Food, energy, consumables, and basic services are examples.

 

We will have deflation in the things we WANT and OWN. These are the items we strive for that we perceive will move our lives to an even higher standard of living. They are primarily assets like: housing, real estate, financial instruments, boats, exotic cars, art, collectibles, etc. - often the items we finance.

 

It may be as simple as Maslow's Hierarchy of Needs; until our survival needs are met we won’t move towards the ultimate state of self actualization. We won’t think of luxury goods when we are hungry, cold and tired. But what is pushing us towards the ‘survival’ end of Maslow’s spectrum? If we live on debt and it becomes harder to secure or service, then this will accomplish that shift, despite new debt being cheaper than it previously was.

 

Money supply which is a driver of monetary inflation and deflation is now negative, as shown by the broader M3 money supply (which is no longer reported by the government). This illustrates that despite massive monetary intervention, forced deleveraging of mal-investments has come home to roost.

 

3-    3- Credit Availability versus Credit Demand & Debt Servicing

 

Thirdly, only a few years ago interest rates were considered low and widespread refinancing was occurring. Home equity loans were all the rage to buy new boats, campers, vacation homes and every other imaginable toy that cheap money was felt to afford. Advertising was replete every evening with 0/0/0 financing offers: Zero down payment, zero payments for 48/60 months and zero interest. Who could refrain from taking advantage of these incredible offers?

 

 

Well guess what? Interest rates are now significantly lower and the products you bought previously are in most instances now even cheaper; yet few are clamoring for them.  At the marina where my boat is moored, you can’t give away a boat; where only a few years ago no one could get a mooring or slip for their newly purchased boat.  What has changed is we can generally no longer service our debt loads at even present historic 50 year low interest rate levels. Heaven forbid rates should go up!

 

The central issue may be not about whether rates go up, but rather if the above outlined housing weakness, concurrent inflation/deflation and weak credit demand persist for a protracted period.

 

I would like to show you exactly what this means if these trends persist, by using a fictional family as a way of illustrating what is now in store for the public.

 

THE SMITH FAMILY DILEMMA

 

The Smith family bought into all this mantra by purchasing a home. All their peers were doing it. Their family kept asking them why they hadn’t bought a home; and if they didn’t, they would surely never be able to afford one. They felt pressured to take on the debt obligations. Unlike many, they were relatively conservative and bought a home with a small down payment, securing a $200,000 mortgage at 6.5% fixed for 5 years. The mortgage was possible because they absorbed Private Mortgage Insurance (PMI) payments into their monthly budget. The family income was $50,000 annually. These are all nominal prices. To adjust for real values, we need to subtract the inflation rate from the mortgage rate. Inflation helps the Smith’s get ahead over the leveraged housing asset. The higher the inflation rate above 6.5% the more they win. The drawback is that their $50,000 income diminishes in real value. The salary therefore needs to be adjusted for real terms by subtracting the inflation rate from the $50,000.  Here are the theoretical results for various Deflation, Inflation and Hyper-Inflation scenarios.

 

Click to Enlarge

 

                                                                                                           

As bad as the above theoretical charts look, it is actually worse in reality.  Why? Because as the pressures mount on unemployment, underemployment and competition for jobs, money becomes tougher and harder to earn. As disinflationary pressures shift to deflationary pressures, housing prices fall faster than the overall inflation/deflation rate. As a matter of fact they fall substantially faster. The following table represents the same numbers for the Smith family, but I have adjusted for the variance in house prices falling faster than the overall deflation rate. This is where it gets really scary.

 

Click to Enlarge

 

 

What the charts tell us is that if present Monetary and Fiscal Policy is anything other than totally successful in arresting deflation and creating balanced inflation in both what we USE and OWN, we are in serious troubles. Any imbalances will be a disaster as shown on our charts. A failure to stop deflation will be devastating to those who are in highly leveraged assets.

 

If after reading the former example of the Smith Family you discarded it because you strongly believe elevated inflation is around the corner and you are a highly leveraged home owner, let me take you through a brief quiz published by The Daily Bell  to further test your understanding of reality: “The Great Housing Bamboozle: A Look Behind The Numbers Shows Home Ownership To Be A Horrible Investment”.

 

Family A, an average American couple, buy the average American home in 1980. They pay the average American price ($76,400) and take out the average American mortgage. 29 years later, they sell the home to another couple for the 2009 average American price of $270,900. How much did they profit from the sale (assume the mortgage has been paid in full)?	A: $194,500
According to the BLS, cumulative inflation from 1980 to 2009 was 160.36%.  a) What is the simple inflation adjusted value of the house?  b) How much of Family A’s profit was the result of inflation and,  c) How much was their profit after inflation?	a) $198,915.04 ($76,400 * 2.6036)   b) $122,515.04 ($198,915.04 – 76,400)   c) $ 71,984.96 ($270,900 – $198,915.04)
Well, there is one other factor we should probably consider: the effect interest rates had on the value of the Family A’s “investment”. After all, refinancing the house at ever lower interest rates is how they paid for that boat in the driveway, a marina slip and everything else that went with the new boat. God knows it wasn’t their ability to earn more.   Question #3 –The average 1980 mortgage was 14.005% APR (13.74% with 1.8 pts.) and the couple that bought it, Family B, got 5.1015% APR (5.04% with 0.7 pts plus cool cash from Uncle Sam). Their 30-year fixed mortgage payments are $1471.10. a) How big a mortgage would that payment get if interest rates were the same as in 1980? b) How much of the Family A’s “profit” can be directly attributed to the change in interest rates?	a) $124,206 (you’ll need Excel to calculate this)   b) $146,694 ($270,900 – $124,206)
Question #4 –So there you have it. 74% of the Family A’s gain can be attributed to the 9% drop in interest rate. When you strip out the interest rate effect, the house underperformed inflation by more than 60% over 30 years (and that’s excluding all other costs associated with the American dream), which of course means this wasn’t actually an investment at all.   How many Americans understand this?	A: Not many. Somehow the mathematical realities of the US housing market have completely escaped the education-loving American public as they continue to assume that the next thirty years will yield results similar to the last thirty. Utterly freaking impossible. We can’t drop mortgage interest rates 9% again (currently 4.4%), but we should expect houses to continue to underperform inflation.

 

 

WHAT ARE THE CHANCES OF HOUSING FALLING FURTHER?

As I mentioned previously, attitudes towards housing as an investment have changed. There has been enough written on the housing decline but surprisingly little on how much further it is likely to go or whether it should be considered an investment at all.

 

Even after massive assistance in the form of HAMP, over $1T of government purchases of Government Agency debt, 50 year low interest rates and Quantitative Easing, the Federal Reserve’s monetary policy and the US fiscal policy has been unsuccessful in reversing the housing decline. New Sales, Housing Starts and Building Permits continue to deteriorate as housing inventories once again resume their climb with untold amounts of ‘shadow’ inventory still being held back from foreclosure by the banks.

 

Karl Case, the co-founder of the S&P/Case-Shiller home-price index, believes “a common mistake of the housing bubble years was the desire to own something that goes up in value rather than to own something you can afford”. He feels “more Americans need to view homes as durable goods, such as cars, and not primarily as investments”.

 

Housing is not coming back soon and I suspect we are still in the middle stages of a longer term housing correction. Historically, major financial distortions always return to at least retest their long term trend support. By various comparisons we still have a fair ways to go over the next two years.

 

 

PEOPLE ARE STILL HURTING – IT ISN’T GETTING BETTER!

 

A recent convention in Palm Beach Florida attracted over 50,000 people, estimated to be holding 25,000 problem mortgages. This is after the government placed Fannie and Freddie in conservatorship and bought over $1T in agency mortgages to keep the US mortgage system from imploding.

 

 

FHA will soon be in a similar untenable position as the government has become the holder of almost all new US mortgage product. If this is not sustained, despite it being a near impossibility to do such, US housing may not just fall further but collapse.

 

CONCLUSION

 

“The great enemy of the truth is very often not the lie – deliberate, contrived and dishonest – but the myth – persistent, persuasive and unrealistic.”

 John F. Kennedy

1962 commencement address at Yale University

 

Americans must face the hard reality that the US is now in decline and rapidly relinquishing its hold as the world’s dominant industrial power.  A serious failure in political leadership to recognize this and act upon it, along with misguided public policy legislation, has hastened the decline.

 

What this means is that America’s standard of living, which has almost been assumed as a birthright, is now in jeopardy and for the middle class is already in full erosion. America, like all great powers in decline, has become complacent and apathetic with an unjustified sense of entitlement. Americans somehow believe that bad things cannot befall America, as though it is preordained to always be a preeminent power with the corresponding highest standard of living.

 

The facts are that we are at the precipice of a crushing decline in our standard of living due to fifty years of wasteful spending and bad public policy. We are near or now possibly past the point of no return without bold and rapid change. We need change that can only come from the public’s understanding of what change specifically is required and not just a political billboard proclaiming the ‘change’ mantra at election time.

 

As we move more and more towards a “have” and “have not” society where the middle class is disappearing and the government is involved in all aspects of our lives and economic well being, we are becoming acutely aware that America is now different. Our perceptions of what America is no longer matches the reality around us on a daily basis. The middle class in America is rapidly disappearing.

 

DISTRACTION	REALITY
Inflation lies ahead due to all the Government money printing. Deflation lies ahead due to deleveraging and banking problems.	Deflation & Inflation both lie ahead. - Inflation in what we NEED and USE - Deflation in what we WANT and  OWN
Unemployment is a temporary problem due to a protracted recessionary recovery.	Employment is a long term chronic problem that is structural in nature.
Credit Availability will re-ignite the economy.	Easy credit is the hole we must dig ourselves out of.
Bank Lending is the problem.	Borrowing is the problem – insufficient collateral and qualified borrowers.

 

Like housing being a good investment, much of what we hear or believe are false perceptions. We are distracted by these contrived and orchestrated misperceptions from the hard reality in taking the actions required to make real needed change. The US Standard of Living is now on the line.

 

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