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Financial Skeptic Bulletin, 2008

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12 symptoms of  chickens coming home to roost:

  1. The fiasco of suburbia:  the shocking implications of what the rise of prices on oil and natural gas imply for the American way of life. If surburbia residents cut back drastically on consumption, they will bankrupt many chain merchants.  Abandoned strip malls, for example, should not be allowed to fester for years as decaying buildings; rather, they should be converted to higher-density, mixed-use neighborhoods. I think that what we’re about to see is an epochal reversal of the 200 year old trend of populations moving from the small towns and the farms to the big cities. That is going to reverse, and we’re going to see big cities contract substantially, and people moving back to the smaller cities, the smaller towns, and indeed to an agricultural landscape that is going to require a lot more human attention to make productive.

    With oil supplies in decline, it seems at least plausible that a great portion of the resources now spent building sprawl will be diverted to retrofitting and revitalizing small cities. My highest priority is that we have got to revive, repair and restore the American passenger rail system

  2. It looks like slowdown continues unabated, inflation pressures ease and stagflation is less of  the possibility in a short term (Japanese scenario).  The American Economy is in fact tapped  out and world economic growth will slow. S&P 500 might be down more then 10% for a year but bonds might not fare all too well too with the possible exception of TIPS.  The United States has the largest trade deficit in the history of its existence. “We anticipate the economy will slow to virtual stagnation in the second half of the year.” The IMF is now forecasting no growth at all in the US this year, measured from the final quarter of 2007 to the final quarter of 2008.
  3. Global adjustment will be long and painful. As Pol Kasriel noted in May "The economy is in the relative calm of the eye of the business-cycle hurricane. The mortgage credit problems are not over. And credit problems in other sectors are just beginning as the housing recession spreads to the rest of the economy." This was the return of crony capitalism: Lax regulatory standards generated robber barons capitalism behavior on the mass scale.
  4. Dollar is structurally weak. That pressures structurally weak dollar down and inflation up.  It was a Ponzi scheme that later became known as Bretton Woods II, a gravity-defying design that allowed the US to run persistent current account deficits. Maybe Securitization Really was a Triumph of Casino Capitalism and the price needs to paid was just delayed.
  5. Further debasing the dollar might accelerate America's decline "If global inflation rises, as I expect, this process will become even more difficult. The central banks will have less room for maneuver. Fiscal policy is constrained, which leaves the exchange rate as the main tool of adjustment. This would necessitate a weak real exchange rate during the entire period of adjustment. " Interests Rates and Inflation were artificially held down for too long and  now the same game in the credit cards space.
  6. The Fed can address liquidity issues not solvency issues, and we are facing a solvency issue. Fed is not just out of  ammunition it is start to run out of credibility (critical articles about Greenspan and Bernanke is a symptom of a larger problems). The more the Fed eases, the higher long term rates go.
  7. A shift away from rabid consumption was delayed for two decades by dissolution of the USSR and dollarization of the new markets, but now it is eminent.  Cheap Chinese imports, NAFTA & CAFTA have cost, and the main cost is in the USA jobs and stagnant wages. Stagnant wages make the recovery dependent of government spending which are at maximum due to wars in Iraq and Afghanistan and the thin layer of rich which were disproportionately employed in financial sector and as such were indirectly or directly hit by subprime crisis and subsequent semi-collapse of investment banks. Robbing Peter to Pay Paul, using credit cards to pay off debt, creating more debt trying to pay off debt is not a solution of the problem. consumption need to decline substantially.   For half of the population savings are for all practical purposes non-existent outside 401K; the latter are mainly invested in equities and support mutual fund industry and financial speculators. And 50% of subprime loans were not for new houses, but were refinancing of old mortgages.
  8. The Housing Bubble and its extension "consumer bubble" are still deflating and might continue doing so for another 12 to 18 month. Home prices may fall 25-30% from their peak in 2006 and not hit bottom until 2010 ... Falling real-estate values hit homeowners hard. Substantial number of buyers, who bought house one to three years ago are under water.

    Household debt to equity at record levels. Fewer refis to facilitate dis-saving as an illusion of prosperity: consumers who have borrowed to bolster their lifestyles are now caught between debt service and ongoing expenses. Home equity lines cut back. A deteriorating employment market (not-so-bad employment stats masking a fall in the number of hours worked). And the economists' cheer that "inflation has not become embedded" translates into "just because gas and food cost a lot more, don't expect a raise." In March, 2008 consumers had a record $957 billion of credit-card and other types of revolving debt outstanding -- up about 8% from a year earlier, according to preliminary data from the Federal Reserve. In 2007, 18% of workers had taken a retirement-plan loan within the past year, up from 11% in 2006, says a recent survey by Transamerica Center for Retirement Studies.[Now It's Official- Consumers Are Hurting]

    The faltering housing market and generally sluggish pace of the overall economy are taking a toll on the commercial real estate market. Demand for office, industrial and retail space is waning, sending vacancy rates higher and property prices lower. JPM Analyst: House Prices may fall 30%  (Note that nominal prices are off 16.1% according to Case-Shiller, so we are about half way to JPM's forecast)

    Home prices may fall 25 percent to 30 percent from their peak in 2006 and not hit bottom until 2010 ...

  9. The Service Sector Economy has melted down. Financials, which were the locomotive of growth for the last five years or so, are pale shadow of its former self. Banks are now in the process of clearing about $230 billion of loans that they committed to finance acquisitions, sapping their interest in funding new deals. Deleveraging only started.  Large banks mergers might follow. An increasing number of small to medium size banks face high exposure to deteriorating conditions in commercial real estate and construction lending See
  10. Surge in government spending across the board caused by the Iraq war, Afghanistan war and the "War On Terror" still supports the growth of the economy but it is at maximum and cannot be meaningfully increased.   At the same time half of the states are in bad financial shape and run deficits; they need to cut spending dramatically (~30 billions) and those cuts will have additional slowing effect on the economy in late 2008 and 2009.
  11. The gap between the have and have not has dramatically increased and is close to "gilded age"  The Bottom (50%) total population earns just (12.8%) of the total national income, were as the top (1%) earn (21%) of the total national income. Stimulus package  will partially go into gas bills and repayment of existing debt. But overall retailers reported fairly strong sales in May. It looks like $4 gasoline didn't use up the entire stimulus.
  12. 401K accounts will suffer: stocks are still overvalued across the board as earning and growth expectations are not realistic.  For example according to Bloomberg GM, Ford, Chrysler Lose 1 Million in Truck, SUV Sales   401K investors probably should not expect decent returns for several years if not a decade and might need to prepare to a lower standard of living...  
  13. Globalization puts any country at risk, especially in key commodities. And if big players with deep pockets can quickly shift money to exploit the problems, what then? According to some estimates 60% of the rise of the cost of oil night be the result of one such shift. (While I do not agree with this figure, many here apparently do. And if they do, what say they then about free trade?)

Puesto por Financial Times. By Martin Wolf en Febrero 20, 2008 By Martin Wolf

The scenario unfolded is quite different from what Roubili predicted,  but the srises is as severe as he predicted.

Prof Roubini is even fonder of lists than I am. Here are his 12 - yes, 12 - steps to financial disaster.

Best for 2008

The Institutional Risk Analyst A Global House of Cards Interview with Josh Rosner

April 7, 2008

We start this issue of The Institutional Risk Analyst with some final thoughts on the Bear, Stearns & Co (NYSE:BSC) failure and the bailout of the other primary dealers following the Senate Banking Committee hearings last week.

First, we notice that former Fed Chairman Alan Greenspan is defending himself on  against a growing army of detractors. But we repeat that, in our view, the mortal sin of Greenspan and other US regulators over the past two decades was not irresponsible monetary policy, but rather dropping the ball on bank supervision and market structure. We described the ill effects of allowing the liberal academic economists at the Fed's Board of Governors in Washington to set bank supervision policy in a comment in Friday's American Banker.

In particular, in the two decades of Greenspan's tenure, the Fed's Washington staff, other regulators and the Congress allowed and enabled Wall Street to migrate more and more of the investment world off exchange and into the opaque world of over-the-counter derivative instruments and structured assets. This change is described by people like Greenspan and Treasury Secretary Hank Paulson as "innovation," but our old friend Martin Mayer rightly calls it "retrograde."

In a market comprised primarily of exchange traded instruments, there is little or no counterparty risk. OTC trades which reference exchange traded benchmarks are likewise far more stable. By replacing exchange traded securities with ersatz OTC instruments, Greenspan and the quant economists who dominate the Fed's Washington staff have created vast systemic risk that need not exist at all and that now threatens our entire financial system.

BSC failed not because it had too little capital or too little liquidity, but because the thousands upon thousands of OTC trades which flow through the firm's books are bilateral rather than exchange traded. It was the understandable fear of counterparty risk, not a lack of capital or liquidity, which killed BSC. The irony is that the "financial innovation" of OTC derivatives and structured assets takes us backward in time to the chaotic situation that existed in the US prior to the crash of 1929.

Would that the Congress and the Fed had the courage to confront Paulson and the other banksters who have turned America's financial markets into an increasingly unstable, derivative house of cards. If all federally insured commercial banks, mutual and pension funds were required by law to invest only in SEC registered, exchange-traded instruments, the threat of further systemic risk could be eliminated tomorrow. What a shame that neither Chairman Bernanke nor FRBNY President Timothy Geithner said that last week when they appeared before the Senate Banking Committee.

In order to gain some further perspective of the state of the financial markets, this week The IRA talks to Josh Rosner, Managing Director of Graham, Fischer & Co, a New York based independent research consultancy that advises regulators and institutional investors on housing and mortgage finance related issues. Previously he was the Managing Director of financial services research for Medley Global Advisors.

The IRA: So Josh, thank you for making time to speak with us. What did you think of the Senate Banking Committee hearing on Bear, Stearns?

Rosner: When Chairman Christopher Dodd asked the witnesses about whether the government set the price for the JPMorgan Chase (NYSE:JPM) acquisition of BSC, everyone's answer seemed to be "ask Tim Geithner." You saw when Dodd asked Chairman Bernanke about who set the price for the BSC purchase, the response was "ask President Geithner."

The IRA: It also was interesting to see Treasury Undersecretary Robert Steel throwing Geithner under the bus. Our friends in the big media, including Larry Kudlow, were impressed by Geithner, but we found his performance to be one of the scarier episodes we can recall on Capitol Hill in some time. Somebody on the Board of Governors staff needs to quietly explain to Geithner that reserve bank presidents don't have personal views on policy issues, especially when they are in front of a congressional committee on national television. And after the hearing, JPM's Jamie Dimon almost seemed to be laughing when he spoke to Bubblevision Queen Bee Maria Bartiromo and thanked Geithner and Chairman Bernanke for their "dedication."

Rosner: Yup.

The IRA: So what is the Rosner view of the world? The party line in Washington and on Wall Street is that everything's fine and we'll return to normal growth in the second half of 2008.

Rosner: I see troubles radiating outward. What I mean specifically is that there is no functional change in the problems in the mortgage markets. What is really making us feel OK, at the moment, is the fact that banks are destroying shareholder capital and that they are raising new money. That's all well and good, but we still have not changed the underlying reality, namely that most of the losses taken so far are due to mark to market issues. We have not yet really seen the bulk of the underlying credit losses.

The IRA: Ditto. We have been talking about this for six months, but there seems to be a refusal on the part of many observers to accept that the losses reported to date have been primary trading book write downs vs. actual charge offs of loan losses. Citigroup (NYSE:C), for example, did just 120bp in aggregate charge offs in 2007.

Rosner: There is a lack of appreciation or maybe a lack of understanding between these two issues, mark to market losses and actual credit losses, and we need to distinguish between these two issues. I continue to believe that we are going to see further downward pressure on home prices -- regardless of what the Congress believes or intends or manipulates. Unless we actually nationalize the housing industry, there is not much we can do to avoid the downward correction in home values.

The IRA: But haven't we already largely nationalized the home market already? Our interview with Bob Feinberg (GSE Nation: Interview with Bob Feinberg) illustrated that point. During the Joint Economic Committee hearing last week, when Chairman Bernanke appeared prior to the BSC session, Senator John Sununu (R-NH) talked about the various federal government programs already in place for housing. It took him almost five minutes of soliloquy to go through them all.

Rosner: That's right. We have a universe of government programs to encourage home ownership, but we need to reconsider the benefits of getting people into homes and how to craft government policies to make these markets more rather than less stable. Historically home ownership was seen as a way to make better neighbors and stronger communities. We need to go back and look at what aspects of home ownership were responsible for conferring these benefits.

The IRA: For example?

Since the late 1930, home owners generally took out 30-year fixed rate mortgages which were illiquid instruments tied to illiquid assets, namely the home, which required the borrower to make monthly payments of principal and interest into what was effectively a forced savings plan.

The IRA: You're talking about our grandparents. And they basically could not modify the mortgage or even move easily.

Rosner: Correct. Other than moving, they could not extract equity. And when they purchased the house, they could not do so without having a substantial amount of equity going into the transaction. I would argue that it was those features that benefit society and support, from a Washington policy perspective, the social importance of home ownership.

The IRA: And not the ability to turn a house into a speculative vehicle? The folks at the National Association of Realtors will be disappointed to hear you say that. The NAR is running TV ads that claim homes double in value on average every ten years.

Rosner: Right. And there is an aspect of this that nobody in Washington is talking about. Let's go back to the prior model of home ownership. Typically a family bought a home around the time of family formation. So you got married and then you and your wife bought a house. You had your kids in that house. And you had a 30-year fixed rate mortgage and every month you made a payment of principal and interest. That process usually began in the late-twenties to early thirties of a person's life. That meant that at about the age of 60, the home owner was able to have a mortgage burning party. So as they retired, their expenses fell and the value of their unencumbered assets had risen. They had a real asset to supplement their pension, pay for grandchildren's college, etc. Because we have allowed this model to change, the US faces a huge burden in the future that we have not yet even begun to talk about in Washington.

The IRA: You mean financing the last chapters of the American Dream for the boomers a la Dennis Hopper?

Rosner: Yeah. This unfunded burden of caring for retirees has significant implications for the dollar and for the federal budget deficit going out years into the future. Many of today's speculative real estate borrowers will end their working lives with little or no savings and are going to become wards of the state in their retirement years. We have not even discussed that anywhere yet. With an increasingly aging, migratory population, maybe the US needs to look at incentives for rental housing instead of putting all of the policy emphasis behind home ownership.

The IRA: If you look at the idiotic rhetoric coming from political candidates from both parties about "restoring the American Dream," meaning making home prices go up again, it is not hard to imagine a future Congress voting to essentially socialize the US economy in the name of caring for indigent old folks. But let's get back to the current mess. How do you assess the state of the real estate market and the implications of this for financials?

Rosner: We are starting to see an acceleration of the delinquencies and loss rates moving from subprime through alt-a through the prime market. GSEs like Fannie Mae (NYSE:FNM) and Freddie Mac (NYSE:FRE) are in no position frankly to do much to save themselves let along save the market.

The IRA: Agreed. Cap or no, we can't see how either FNM or FRE can lever up to take more risk. Are we missing something?

Rosner: Yup. The GSEs have come up with yet another bright idea to add to their financial woes. Haven't you heard? What FNM is doing, which goes back to the accounting shenanigans, is actually using most of the capital relief granted by OFHEO for their "Home Saver Advance." Most people outside the real estate industry are not following this at all. FNM has now crept out of their secondary market role and into the primary market. We have heard nothing from HUD, OFHEO or the FM Watch folks about this.

The IRA: We are shocked. Go ahead.

Rosner: FNM has announced that they will give a $15,000 loan to borrowers with negative equity so that they can pay down some of their principal balance and therefore refinance into a new mortgage. First of all, this loan is not secured by the property but rather by the personal guarantee of the borrower.

The IRA: So FNM is getting into the consumer lending business? Looks like more mission creep.

Rosner: Basically, yes. It is unsecured debt. So FNM is no longer just operating in the secondary mortgage market but in the primary consumer lending market. Second, what they are really doing is paying that $15,000 because it is cheaper than having to buy defaulted loans out of mortgage pools guaranteed by FNM and cover arrears.

The IRA: Kind of, sort of looks like modification? Or not?

Rosner: No, the GSEs have been doing modification. This is something worse than that. With a bank that modifies loan, someone has to take the loss when the loan re-defaults. Here, FNM and FRE are modifying but without the increased security of the underlying asset. They're actually taking an unsecured exposure.

The IRA: Yup, which they will end up eating. The loss given default on these "homeowner saver loans" will be 100%.

Rosner: Yup. And given that re-default rates on modified loans were north of 20% in good times, it will be interesting to see how bad it gets this time around. The GSEs are trying to outrun problems that are faster than they are.

The IRA: You've been speaking to a lot of bankers and government officials outside the US. What is your perspective on the housing credit situation outside the US?

Rosner: Let me circle around to that. The credit problems are spreading into the prime market. They are already visible in the home equity line of credit market. The HELOCs are typically committed lines and frankly people often forget that in some respects, at least in this cycle, the consumer lenders, revolving lenders, credit card lenders, are in a better place that the HELOC lenders. The revolving and credit card lenders can change your available lines overnight and change your rate terms with the same speed. The HELOC lenders cannot.

The IRA: The latest line out of the banks is that they see a growth opportunity in small business credit card lending. The mail solicitations from lenders like C and Advanta that we've reviewed feature terms that encumber the small business as well as the individual, and then kick the rate up to 31% APR the first time you are late. What does a 31% penalty rate say about the probability of default on that portfolio?

Rosner: Yes, except for the fact that it is a terminal probability. What I mean by that is that the last asset which a borrowed defaults on is the primary mortgage…

The IRA: At least it used to be. The FT reported a while back that the 2006 production was the reverse, with borrowers defaulting on mortgages before credit cards or auto loans.

Rosner: No, the mortgage still is the last thing to go into default. The borrowers we've see default already are those with no other resources. Where I think we see the next leg and what I am watching carefully now is that we are seeing the drawdown of committed but undrawn lines of credit by distressed borrowers who are taking cash out of the line to pay first their primary mortgage and then revolving lines of credit. At some point we reach a terminal period where they default on their credit card and then their primary mortgage. I'm not sure it does not go in the other order, but we'll see. That is the reason, I believe, that we've seen a little bit of a slowdown, a respite from a massive spike in defaults, because the borrower who is Alt-A and prime largely, even with the decline in home values, still has access to credit. Consumers do not give up spending of their own volition. They do so only after they have exhausted all other options.

The IRA: Suggesting that we could be headed to a huge uptick in default experience in unsecured and mortgage loans in the not too distant future?

Rosner: Yes, we will see the drawdown of HELOCs until they are exhausted, resulting in an eventual upsurge in defaults on mortgage-related and revolving credit.

The IRA: It is funny you raise this issue because we have been watching the slow decline in Exposure at Default which we calculate for all US banks using The IRA Bank Monitor. There are only two reasons for such a broad, secular trend; either people are using available lines or banks are reducing exposure by cutting unused lines.

Rosner: Right, it is pretty hard for a lot of the banks to reduce consumer lines, both from a contractual perspective and from an operations management perspective. I would be very wary of institutions that have HELOC exposure. For the time being, I would be less concerned with the credit card companies. And then there is the situation in commercial real estate, where the wheels are starting to shake and even fall off the wagon.

The IRA: So let's go overseas for a second. We know you have to get packed and head back to the airport.

Rosner: In the UK, we have already seen a 10% decline in commercial real estate values. And my contacts in that market expect to see a further 10% decline from there. In that context, when you hear reports of further new build in the US commercial market, that only confirms my belief that we will see our market fall as well. For the large international Basel II institutions, none of this is good news. The same global banks with exposure to the US residential and commercial markets also have exposure to the burgeoning problems in the Spanish real estate market, Irish housing problems, UK housing problems, and Italian housing problems.

The IRA: So do we detect the first signs of interest rate ease in the EU?

Rosner: Definitely. I think we are at the front end of the day when you want to be long the dollar and short the Euro. The Spanish mortgage market funds in the repo market, not via deposits. I think that at some point there is going to be significant tension in Europe because the Germans and the French are not going to want to finance Spanish mortgage collateral. This could be the catalyst for a crisis in Europe. Do I think that it will spell the end of the Euro? No. Do I think that it will create a period of uncertainty? Yes.

The IRA: You mean that German and French banks will no longer want to finance Spanish real estate speculation for the benefit of UK retirees?

Rosner: Yes, especially if you remember that the Germans are already going to be licking a lot of wounds. The good news is that the German Landesbanks have no more than 25% of their float to the public. The bad news is that the German federal government is going to have to bail out the state governments.

The IRA: Some of our sources say that the Landesbanks are something like 5x the problems at UBS (NYSE:UBS).

Rosner: Correct. My understanding is that there is one institution with about $50-60 billion in exposure and another has $80 billion. So there is no way that the German government will have sufficient bandwidth to help support the Spanish banks.

The IRA: Maybe Spain becomes the next Iceland?

Rosner: We should differentiate between Northern Europe and the rest of Europe. Where the rest of Europe moves west to get their exposures, Northern Europe mostly moved east. While they have significant exposures to problematic mortgage markets, they don't have the type of exposures to structured assets and so their exposures are not leveraged.

The IRA: To change gears a bit, what is your reaction to the Paulson proposal?

Rosner: As usual, I think the proposal is largely misunderstood. To me this is more about Paulson creating a legacy rather than expecting the regulatory reform agenda to move forward in an election year. The most glaring part that was missing was rating agency oversight. The rating agencies were at the center of the problem with structured assets and continue to be at the center of the problem. Either the SEC must be given new powers to regulate the rating agencies or we need a new regulator, but the silence on this count in the Paulson proposal was striking.

The IRA: Forgive us if we are not surprised. Any final thoughts before you head back to Paris?

Rosner: The housing market woes in the US will not be over before 2010, regardless of what legislative initiatives come out of Washington. The fundamental reason why we are having these problems in the US is that real wages and incomes have not kept pace with home prices since the 1960s and that's what drove demand for these affordability products. Unless the Congress wakes up and let's home prices correct so that we restore some balance between wages and affordability, this problem will remain for years to come.

The IRA: That implies a 40-50% cut in home prices from peak levels and an insolvent US banking system.

Rosner: Yes, long term trends in home prices suggest that we will revert to the peak levels of the previous cycle. That implies that we are going back to the pre-1991 peak home price levels.

The IRA: Yikes. Then you agree with our view that the US government may be forced to take over some of the largest banks?

Rosner: Yes, well, we won't call it nationalization, but in economic terms that is the substance of the situation. One of the striking comments I hear in Europe is that at least with Northern Rock, the Financial Services Authority in the UK screwed up the first time, but then admitted the mistake and publicly nationalized the bank. With Bear, Stearns, the US has nationalized the bank and appointed JPMorgan as conservator, but then US regulators tell the public and the Congress that it was not nationalization.

The IRA: The Fed seems to be incapable of admitting that they screwed up, whether on structured assets or Bear Stearns. I've never heard anyone at the Fed admit, for example, that their active push to allow banks to migrate more and more business over the counter and off exchange has vastly increased systemic risk.

Rosner: The difference between Fed's prior to the Greenspan and the Bernanke Fed is that the former did not see themselves as part of the President's Cabinet

The IRA: Exactly, Bernanke seems completely co-opted by Paulson and the Goldman Sachs mafia that runs the Treasury. Both Bernanke and Geithner seem so weak and lacking in market experience that is almost sad to watch them testify next to banksters like Steel and Paulson.

Rosner: Correct and that is a very dangerous path for the United States.

The IRA: We'll leave it there. Travel safe Josh.

Questions? Comments? [email protected]

Rogoff paper

IMF report

Faber interview

[Jul 29, 2008] - Comment & analysis - Comment - The world cannot grow its way out of this slowdown by Kenneth Rogoff

Inflation threat failed to materialized. Those who bought TIPS suffered substantial losses.

As the global economic crisis hits its one year anniversary, it is time to re-examine not just the strategies for dealing with it, but also the diagnosis underlying those strategies. Is it not now clear that the main macroeconomic challenges facing the world today are an excess demand for commodities and an excess supply of financial services? If so, then it is time to stop pump-priming aggregate demand while blocking consolidation and restructuring of the financial system.

The huge spike in global commodity price inflation is prima facie evidence that the global economy is still growing too fast. There is nothing sinister in this. The world has just experienced perhaps the most remarkable growth boom in modern history. Given the huge cumulative rise in global growth during the 2000s it is little wonder that commodity suppliers have found it increasingly difficult to keep up, even with sharply rising prices.

For many commodities, particularly energy and metals, new supply requires long lead times of five to 10 years. In principle, the demand response is more nimble, but it has been greatly dulled by a wide variety of subsidies and distortions in fast-growing emerging markets.

Absent a significant global recession (which will almost certainly lead to a commodity price crash), it will probably take a couple of years of sub-trend growth to rebalance commodity supply and demand at trend price levels (perhaps $75 per barrel in the case of oil, down from the current $124.) In the meantime, if all regions attempt to maintain high growth through macroeconomic stimulus, the main result is going to be higher commodity prices and ultimately a bigger crash in the not-too-distant future.

In the light of the experience of the 1970s, it is surprising how many leading policymakers and economic pundits believe that policy should aim to keep pushing demand up. In the US, the growth imperative has rationalised aggressive tax rebates, steep interest rate cuts and an ever-widening bail-out net for financial institutions. The Chinese leadership, after having briefly flirted with prioritising inflation (expressed mainly through a temporary acceleration in renminbi appreciation), has resumed putting growth as the clear number one priority. Most other emerging markets have followed a broadly similar approach.

Dollar bloc countries have slavishly mimicked expansionary US monetary policy, even in regions such as the Middle East, where rapid growth is putting huge upward pressure on inflation. Of the major regions, only Europe, led by the European Central Bank, has resisted joining the stimulus party so far. But even the ECB is coming under increasing domestic and international political pressure as Europe’s growth decelerates.

Individual countries may see some short-term growth benefit to US-style macroeconomic stimulus, albeit at the expense of loosening inflation expectations and possibly paying a steep price to re-anchor them later on. But if all regions try expanding demand, even the short-term benefit will be minimal. Commodity constraints will limit the real output response globally, and most of the excess demand will spill over into higher inflation.

Some central bankers argue that there is nothing to worry about as long as wage growth remains tame. True, globalisation continues to shrink unskilled labour’s share of global income. But as goods prices rise, wage pressures will eventually follow. As Carmen Reinhart and I have shown in our research on the history of international financial crises, governments in every corner of the world showed themselves perfectly capable of achieving very high rates of inflation long before they had the assistance of modern unions*.

What of the ever deepening financial crisis as a rationale for expansionary global macroeconomic policy? It is hard to see the argument in emerging markets where inflation is raging, but even in epicentre countries it is becoming increasingly dubious. Inflation stabilisation cannot be indefinitely compromised to support bail-out activities. However convenient it may be to have several years of elevated inflation to help bail out homeowners and financial institutions, the gain has to be weighed against the long-run cost of re-anchoring inflation expectations later on. Nor is it obvious that the taxpayer should absorb continually rising contingent liabilities (such as increased backing for Fannie Mae and Freddie Mac, the giant US mortgage agencies).

Indeed, if financial firms are not going to be allowed to go out of business, how exactly do central banks and regulators intend to effect the shrinkage of the financial industry commensurate with the sharp fall in key lines of business related to mortgage securitisation and derivatives? Perhaps regulators hope firms will shrink 10-15 per cent across the board. But this is seldom how consolidation works in any industry. Rather, the weakest firms go out of business, with their healthy parts being taken over, or pushed aside by better run institutions. Is every failure evidence of a crisis?

The airline industry often goes through periods of excess capacity, with giant companies going out of business or merging. Yet, we have grown accustomed to these traumas and learned to live with them, as in many other industries. Is it right to let the banking industry hold nations hostage each time they experience consolidation? As major central banks extend their discount windows to complex investment banks whose business lines are evolving and churning constantly, “crises” of consolidation are surely going to become more frequent.

For a myriad reasons, both technical and political, financial market regulation is never going to be stringent enough in booms. That is why it is important to be tougher in busts, so that investors and company executives have cause to pay serious attention to risks. If poorly run financial institutions are not allowed to close their doors during recessions, when exactly are they going to be allowed to fail?

Of course, today’s mess was many years in the making and there is no easy, painless exit strategy. But the need to introduce more banking discipline is yet another reason why the policymakers must refrain from excessively expansionary macroeconomic policy at this juncture and accept the slowdown that must inevitably come at the end of such an incredible boom. For most central banks, this means significantly raising interest rates to combat inflation. For Treasuries, this means maintaining fiscal discipline rather than giving in to the temptation of tax rebates and fuel subsidies. In policymaker’s zealous attempts to avoid a plain vanilla supply shock recession, they are taking excessive risks with inflation and budget discipline that may ultimately lead to a much greater and more protracted downturn.

* This Time is Different: A Panoramic View of Eight Centuries of Financial Crises, NBER Working Paper 13882, March 2008

The writer is professor of economics at Harvard University and former chief economist at the International Monetary Fund

[Jul 29, 2008] - Home UK - UK - IMF gloom over 'fragile' markets and global risk By Krishna Guha in Washington

July 29 2008 | FT

Global financial markets are "fragile" and indicators of systemic risk remain "elevated" almost a year into the credit crisis, the Inter-national Monetary Fund said yesterday.

The fund warned credit growth in the US could fall further as a result of continuing financial system stress and warned that emerging markets would be tested as global financing conditions tightened and policymakers tackled rising inflation.

The IMF noted that house prices had softened in a number of European economies including the UK, raising the possibility of further problems in those markets.

The assessment came in the July update to the global financial stability re-port, led by Jaime Caruana, former Bank of Spain governor.

Mr Caruana warned the year-long financial crisis was starting to squeeze lending, "leading to a negative feedback loop between the financial system and the broader economy" as reduced household spending slowed the real economy and prompted further lending cuts in deteriorating credit conditions.

If US house price declines began to level off, that "would remove a key component of the feedback loop", he said. However, he warned "a bottom for the housing market is not yet visible".

The IMF said while likely losses on US subprime mortgages had "largely been acknowledged" in writedowns, financial institutions faced a second wave of losses on other loans. Credit quality "across many loan classes has begun to deteriorate with declining house prices and slowing economic growth".

With mounting inflationary pressure, the fund said, "policy trade-offs between inflation, growth and financial stability are . . . increasingly important".

The IMF reaffirmed its earlier, contentious estimate that total losses in this cycle could total $945bn (€600bn, £474bn) - a number that combines mark-to-market losses on subprime-related securities and estimates of likely losses on loans.

Relative to April, when the fund published its last stability report, it said "systemic strains in funding markets continue" and the "low level of risk appetite remains unchanged". Interbank lending rates "remain elevated", while "long-term funding costs have risen" for financial institutions.

The IMF said financial institutions globally had written off about $400bn since the crisis began last August and that while they had raised substantial amounts of capital, the losses had "exceeded capital raised". Banks also faced problems maintaining their earnings, weakening stock prices and making it more difficult to raise capital.

The fund said policy interventions - mostly by the US Treasury and the Federal Reserve - had so far succeeded in containing systemic risk. But it said the authorities in the US in particular had had to intervene further to preserve financial stability.

It, in effect, endorsed the need for the US to shore up Fannie Mae and Freddie Mac in the short term - saying their failure would have systemic consequences - but said "the policy challenge now is to find a clear and permanent solution" for the troubled government sponsored mortgage groups.

**** [Jul 22, 2008] Faber Says Fannie, Freddie Should Split Up, Not Get Aid

Business is down everywhere. Considerably. For the medium household thing are very difficult right now. Even if oil prices will drop a little bit here. 
Fanny and Freddie should be split in many small companies like Standard Oil of NJ.  Bail out is bailing out of persons who made bad decision on Wall Street at the expense of ordinary investors.

We entered into a completely new period. Great 1982-2007 bull market in financial assets is over and it is over for a long time to come. The Bull market was unprecedented in history. Bust also will be unprecedented in history. We can be in a trading range, yes if Bernanke keeps rate low. Inflation will increase.   Worst case is Inflation is up and interests will go up.  Bernanke rates are below inflation and as long as they stay they will support equity valuations. Can we be in the trending range: yes. The problem will be inflation and rates will go up not because of Fed but due to market pressure. Fed are totally ineffective. Right now mortgages are higher than they used to be when Fed start easing rates. The difference between Depression and today is that commodities were picked in 1921 and were in well established downtrend. Today siltation is that three billion people join the ranks of consumer and that creates substantial inflationary pressures on commodities prices. They are eating and driving around more and that create inflationary pressures.  

We got from $9 to $145. The long term outlook for oil is higher prices.  The market remains very tight when supply cannot be increased meaningfully. Again, Supplies cannot be increased meaningfully. At the same time he looks negative commodities for the second half of the 2008. Demand is down for key commodities and it is possible that oil will be down $30 to approximately $100. Faber is negative on industrial commodities for the second half for 2008. the whole sector deserve some preventive selling might be appropriate. Steel prices also can come down substantially. He recommends to short US Steel. It is very cyclical industry. Credit growth slowed dramatically from  annual 12% at the beginning 2007 and then it slowed down to 4%. He never see such credit deceleration in his life. That will have very negative impact on the economy.

We have huge dollar accumulation in sovereign money funds. Chinese want to buy into safe and large companies and particular resources companies.  For their economic well-being this is of paramount important.  Resource related sector will still be very attractive for Asian and especially Chinese.

If you look global synchronized boom it was unprecedented. China driving commodity price. The bust should also be unprecedented. The worst case scenario is a huge bust with slow growth and high inflation for a long period.  Stagflation due to central banks. 

I recommend you to go to some Mid-East fast growing cities and see what will happen to them. Economy outlook for the next 12 to 16 month is very negative.

July 23 (Bloomberg) -- Investor Marc Faber, publisher of the Gloom, Boom & Doom Report, talks with Bloomberg's Carol Massar from Chicago about the future of Fannie Mae and Freddie Mac, the global economy, and the outlook for stocks and commodities. Faber said Freddie Mac and Fannie Mae should close down their business or split into private companies and not get government aid. Bloomberg's Julie Hyman, Erik Schatzker and Ellen Braitman also speak. (Source: Bloomberg) 

[Jun 29, 2008] Envisioning a world of $200-a-barrel oil - Los Angeles Times

Prediction failed to materialize, but point about 401K is well taken...

Although white-collar workers may be able to telecommute, they could also take a serious financial hit because soaring energy prices tend to wreak havoc on the stock market. The explosion of 401(k) plans and similar retirement accounts in the last few decades -- and the decline of traditional pensions with guaranteed payouts -- have tied workers' financial futures more closely to stocks than they were during the 1970s oil shocks. A prolonged Wall Street downturn could mean a no-frills retirement, or none at all.

[Jun 26, 2008] In Reversal, Older Employees Keep Working in Downturns

naked capitalism

Economic Policy Institute discusses a troubling pattern. Historically, when the economy went south, a larger proportion of workers retired early. It isn't clear whether they were offered packages, were sacked, or left for other reasons (say their job was redefined and they no longer enjoyed it), but the point is they left the workforce.

Now we see a change: the laborforce participation of older workers increases in bad times. And since underemployment still counts as employment, some of this cohort no doubt includes individuals who lost their jobs and still need a paycheck, but are bringing in less income than before.

From Monique Morrissey at Economic Policy Institute: ...

[Jun 25, 2008] FOMC: Upside Risks to Inflation by Barry Ritholtz

It looks like the U.S. needs to deal with a systemic financial crisis and, simultaneously, rising prices in resources that were once priced very low: energy (you need to add 50% of defense spending to the oil bill to get closer to real cost), raw materials, to a certain extend, food,  and, possibly, water.

The well-parsed FOMC statement remains too cheery on growth, not concerned enough about inflation -- and is totally irrelevant.

What matters is whether the Fed can tighten or loosen rates or not -- and they apparently cannot. The Fed has painted themselves into a box, with a recession, housing collapse and credit crunch on one side, and $140 Oil, rampant food and other inflation on the other.

What's a jawboning Fed Chair to do? As little as possible . . .

[Jun 25, 2008] Mish's Global Economic Trend Analysis Things That Have Not Yet Happened

Here's my take: Before we can say the worst is over or the danger has passed, the storm has to reach shore first. With that in mind I thought it might be interesting to look at a few headlines of things that are going to happen but have not happened yet.
  1. Bank Failures: Bigger U.S. bank failures may be coming – FDIC

    Future U.S. bank failures linked to the downturn in the real estate market may include "institutions of greater size" than in the recent past, Federal Deposit Insurance Corp Chairman Sheila Bair said on Thursday.

    I talked about the expected wave of bank failures in Too Late To Stop Bank Failures.
  2. Monoline Fallout: Citi, Merrill, UBS Face Monoline Losses, Whitney Says We have yet to see the fallout from the downfall of the monolines (Ambac (ABK) and MBIA (MBI)) but we will.
  3. $500 Billion Option ARM Crisis Coming Up : Option Arms - The Next Real Estate Crisis
    By April, 2009, hundreds of thousands of option ARM mortgages will begin resetting, bringing on a fresh wave of foreclosures. According to Credit Suisse (CS), monthly option recasts are expected to accelerate starting in April, 2009, from $5 billion to a peak of about $10 billion in January, 2010. Today, outstanding option ARM loans in the U.S. total about $500 billion, about 60% of which were sold to California homeowners, according to Credit Suisse. Option ARMs were especially popular in the state, where they were heavily marketed during the boom by such companies as Countrywide Financial (CFC), Washington Mutual (WM), and Wachovia (WB). "Most of the public is thinking that the subprime thing is over, but this is another thing waiting," [said Chandrajit Bhattacharya, vice-president and mortgage strategist at Credit Suisse Securities].
    By the way, that article is not contrary to what I presented in Greenspan Conundrum In Reverse. The problems with Pay Option ARMs are negative amortization, falling home prices, and payment shock. Those are far bigger problem right now than the risk of rising interest rates on regular ARMs that are about to reset.

    Bernanke has minimized the fallout from ARM resets by slashing interest rates. Negative amortization, falling home prices, and payment shock problems are another matter altogether. I have expected an acceleration of Pay Option ARM problems for quite some time. The storm is about to hit.

  4. Additional Problems:
    • A rising unemployment rate. I expect 6% by the end of the year and 7% or higher in 2009-2010.
    • An imploding commercial real estate.
    • Rising junk bond defaults.
    • Rising numbers of foreclosures and bankruptcies.
    • Rising credit card defaults.
  5. Economic Picture Worsening. The economic picture is worsening across the board. And not just in the US but in the UK and Europe as well. A housing bust is now underway in the UK. Inquiring minds may wish to consider UK Housing Market Seizes Up. In the meantime, Until Things That Have Not Happened Yet Do Happen, it defies credibility to suggest that danger has faded.
  6. Impact of the Highly Improbable: The above is a discussion of "the known". There is also a huge risk factor from a Black Swan Event.
    Last May, Taleb published The Black Swan: The Impact of the Highly Improbable. It said, among many other things, that most economists, and almost all bankers, are subhuman and very, very dangerous. They live in a fantasy world in which the future can be controlled by sophisticated mathematical models and elaborate risk-management systems. Bankers and economists scorned and raged at Taleb. He didn’t understand, they said. A few months later, the full global implications of the sub-prime-driven credit crunch became clear. The world banking system still teeters on the edge of meltdown. Taleb had been vindicated. “It was my greatest vindication. But to me that wasn’t a black swan; it was a white swan. I knew it would happen and I said so. It was a black swan to Ben Bernanke [the chairman of the Federal Reserve]. I wouldn’t use him to drive my car. These guys are dangerous. They’re not qualified in their own field.”

    In December he lectured bankers at Société Générale, France’s second biggest bank. He told them they were sitting on a mountain of risks – a menagerie of black swans. They didn’t believe him. Six weeks later the rogue trader and black swan Jérôme Kerviel landed them with $7.2 billion of losses.

    So not only is there the risk of the known, there is also risk of the unknown. Bernanke and Paulson have factored neither into their Pollyannaish statements. Talk from both of them is getting more ridiculous by the minute.

[Jun 19, 2008] RBS issues global stock and credit crash alert By Ambrose Evans-Pritchard

The Royal Bank of Scotland has advised clients to brace for a full-fledged crash in global stock and credit markets over the next three months as inflation paralyses the major central banks.

"A very nasty period is soon to be upon us - be prepared," said Bob Janjuah, the bank's credit strategist.

A report by the bank's research team warns that the S&P 500 index of Wall Street equities is likely to fall by more than 300 points to around 1050 by September as "all the chickens come home to roost" from the excesses of the global boom, with contagion spreading across Europe and emerging markets.

Such a slide on world bourses would amount to one of the worst bear markets over the last century.

"Cash is the key safe haven. This is about not losing your money, and not losing your job," said Mr Janjuah, who became a City star after his grim warnings last year about the credit crisis proved all too accurate.

RBS expects Wall Street to rally a little further into early July before short-lived momentum from America's fiscal boost begins to fizzle out, and the delayed effects of the oil spike inflict their damage.

"Globalisation was always going to risk putting G7 bankers into a dangerous corner at some point. We have got to that point," he said.

US Federal Reserve and the European Central Bank both face a Hobson's choice as workers start to lose their jobs in earnest and lenders cut off credit.


My hats off to RBS. Finally someone has an accurate view of global economic conditions and actually puts it on the record. I'm an American who works on the trading floor. I can only say the FED has keep the markets afloat since last September and time is running out soon! The financial deleveraging process coupled with a consumer led recession will surely take it's toll on the global mkts.

The largest problem remains the CDS exposure by major banks and hedge funds. Look at the non-borrowed reserves data on the St.Louis FED website. It won't be long before the US FED is in checkmate.

Greedy international bankers,...Architects of their own demise!

Posted by J.Livermore on June 24, 2008 3:15 AM


Look, when somebody is trying to short the markets and getting their brains beat in because they are on the wrong side of the trade they run to the press with the most irresponsible comments they can make in hopes of getting out without getting crushed by a rally. If Bank of Scotland was such a great predictor of economic conditions, how come they how come they had writedowns of 12 billion dollars?

Guess they just didn't see that one coming. I rest my case. My advice: Sell Bank of Scotland and buy Goldman Sachs.

Posted by Lordrobot on June 23, 2008 9:20 AM

[Jun 1, 2008] Long View: Investors should look to lady luck to provide By John Authers

"applying evolutionary biology to markets. Trends work themselves out, creating long periods when the markets appear to be in balance, followed by periods of confusion or regime change as a new “fittest” paradigm emerges."
May 30 2008 |

Last week, I was asked to give a speech on the big picture for markets. This had me worried.

Like everyone else, I do not know where the markets are going next. A truly “big” picture of the markets, with so many people involved in them across the globe would be unmanageable – at least in a few PowerPoint slides.

Most important, I am deeply suspicious of people who, to borrow a phrase from Philip Coggan, my predecessor writing this column, think they have “the answer”. Few days go by without an e-mail from someone who is convinced there is a single key to predicting the markets, and that they alone possess it.

So, to be clear: I do not have “the answer”. But I found the exercise useful. Here is an attempt to capture the big picture of markets.

First, is there an answer? Prevailing wisdom for decades has been that markets are efficient, incorporating all available information and that prices of securities will exhibit a “random walk” in response to new items of news.

Everyone knows that markets can be inefficient in the short term, and efficient markets theorists found anomalies – such as the outperformance of small stocks, and of “value” stocks that look cheap.

But the fact that these anomalies can be exploited suggests the market tends toward some kind of equilibrium – and in the very long term stock markets do move in line with the economy. Hence the comment by Burton Malkiel, writer of A Random Walk Down Wall Street, that “short run changes in stock prices cannot be predicted. Investment advisory services, earnings predictions and complicated chart patterns are useless”. Beating the market is solely about luck.

An intellectual reaction against this has been brewing for years, as economists apply findings about psychology to markets. The credit crisis may have been a tipping point. Rather than tweaking the efficient markets hypothesis, now people want to replace it.

The investor George Soros has a theory, based on philosophy, that markets are reflexive. Actors’ opinions about the market have an impact on the market, creating “a two-way reflexive connection between perception and reality that can give rise to initially self-reinforcing but eventually self-defeating boom-bust processes, or bubbles”.

Soros suggests markets are never in equilibrium, and that there is money to be made by following trends until their extinction.

That raises another idea, applying evolutionary biology to markets. Trends work themselves out, creating long periods when the markets appear to be in balance, followed by periods of confusion or regime change as a new “fittest” paradigm emerges.

These are good reasons to expect markets to move in cycles. And critically, history confirms the insights of theory.

Earnings and profit margins tend to move in cycles and revert to the mean. They entered last year’s turbulence at historically high levels, implying they were ready for a fall.

Multiples of earnings also show a strong tendency to revert to a norm, providing we follow Benjamin Graham, the father of value investing, by looking at cyclical multiples – a stock’s price compared to its average earnings over a 10-year period. On this basis, multiples were ridiculously high at the peak of the technology bubble in 2000, but failed to get back to the norm before rising again. Stocks still look historically expensive compared to earnings that look likely to fall.

Then we must take commodity prices into account. A theory that goes back to Nikolai Kondratieff, a Marxist revolutionary killed by Stalin, suggests that commodities move in decades-long cycles. Subsequent history suggests it has an element of truth – materials prices tend to roar forward for a decade, and then be stable for a decade or so. Stocks gain when commodities are falling, but are flat to down when they are rising – as is happening at present.

Put all of this together, and there is reason to think that the market is ready for a “regime change” and that stocks are unlikely to rise.

Now, crucially, add some common sense. The US has been on an epic borrowing binge that never looked sustainable. The fall in US house prices is without precedent, at least at a national level. And central bank surveys confirm what might be predicted – that banks are tightening the supply of credit, which will restrict the economy and stock prices.

So the big picture is that we should expect much more pain before stocks resume a forward march.

The winners – there will be some – may be those who in Darwinian fashion adapt best and survive.

But even the new theories suggest we are in a period of uncertainty – not part of a predetermined pattern.

And we should not jettison the Random Walk theory altogether. All of this big picture might just already be reflected in prices (although that looks unlikely given the rally of the past two months). And the winners in this cycle may, after all, just be lucky.

[Apr 29, 2008] Has the Financial Industry's Heyday Come and Gone

Is this end of Wall street investment Banks speculative binge ? "But the role of finance -- the businesses of borrowing, lending, investing and all the middlemen in between -- may be ebbing, a shift that would redefine the U.S. economy. "

For the past three decades, finance has claimed a growing share of the U.S. stock market, profits and the overall economy.

But the role of finance -- the businesses of borrowing, lending, investing and all the middlemen in between -- may be ebbing, a shift that would redefine the U.S. economy. "The role of finance in the economy is going to come down significantly in the coming years," says Carlos Asilis, chief investment officer at Glovista Investments, a New Jersey money manager. "From a societal standpoint, we got carried away with finance.

... ... ...

Mr. Philippon argues that the surge of financial activity that began in 2002 created an employment bubble that is now busting. His model suggests total employment in finance and insurance has to fall to 6.3 million to get back to historical norms, and that means losing an additional 700,000 jobs in the sector.

[Apr 28, 2008] Are Low Interest Rates Fueling Price Inflation-

Mish's Global Economic Trend Analysis

My Comment: Banks and brokers may be trying to get their houses in order, but the emphasis should be on trying. They are not succeeding. A wave of commercial real estate defaults is coming (see Shopping Center Economic Model Is History). And on top of that wave will be a wave of credit card defaults. Target wrote off a stunning 8.1% of credit card debt in March (see Card Losses Soar at Target, Bank of America). Furthermore the walk-away crisis is just picking up steam. This is more like the eye of the hurricane than anything else.

... ... ...

My Comment: The idea that the credit crunch is over is pure fallacy. The Fed Funds Rate is 2.25%, LIBOR is 2.91% and Citigroup is raising money at 8.4%, Merrill Lynch is raising money at 8.625%, and Bank of America is raising money at 8.125%.

... ... ...

My Comment: That cash is being burnt up like mad as is the destruction of capital that is fueling the issuance of preferreds. Those thinking "the bottom is in" and buying now are going to regret it later.

[Apr, 27 2008] Global adjustment will be long and painful by Wolfgang Münchau

April 27, 2008 |

So this crisis is about to end, right? There are two failsafe ways to justify a solid dose of optimism: define the crisis in a sufficiently narrow way; and, even better, look at the wrong crisis. In that spirit I am happy to state my optimism about the prospective end of the subprime crisis.

But this would be disingenuous. It is no accident that our multiple crises – property, credit, banking, food and commodities – have been happening at the same time. The simple reason is that they are all part of same overriding narrative. The mother of all these crises is global macroeconomic adjustment – a rare case, incidentally, where the word “crisis” can be used in its Greek meaning of “turning point”.

It is a huge global macroeconomic shock. How long the financial part of the crisis will go on will depend to a large extent on how bad the economic part of the crisis gets.

The economic part of the story started more than a decade ago with a liquidity-driven global boom. Property, credit and equity bubbles were all part of this.

So was a Ponzi scheme that later became known as Bretton Woods II, a gravity-defying design that allowed the US to run persistent current account deficits. The dollar surplus in the newly industrialised countries was recycled back to the US and European markets, where various categories of asset prices were driven up and banks lured into excessive risk-taking. It could not last, and did not.

If excess liquidity was the ultimate cause of this crisis, the real estate sector was its most important driver. Experience shows that housing cycles are long and symmetrical: downturns last as long as upturns. We also know from the past that house prices undershoot the long-term trend on the way down, just as they overshoot it on the way up. You can see this quite easily when you look at long-run time series of inflation-adjusted house prices for several countries.

The last property downturn in the US and the UK lasted some six years. This is not a prediction of what will happen this time, more like a best-case scenario – because this bubble has not only been more intense than previous ones; it has also bubbled on for longer.

But even if we take six years as an estimate of the peak-to-trough period, that means the housing downturn will last until 2012 in the US and a couple of years longer in the UK. It is difficult to see how either of these countries could grow close to trend as long as the housing market is in recession.

When you look at the global macro side, you are looking at similar timescales of adjustment. An important part of the adjustment will be a rise in the US and UK household savings rates. That, too, might take several years to accomplish, during which period economic growth could be below trend.

The really important question about the US economy is not whether the official recession starts in the first or second quarter, but how long this period of economic weakness will last overall. In Japan and Germany macroeconomic adjustment of similar scale took more than 10 years, starting in the 1990s. Even if you believe that the US is structurally stronger, the country will probably not replenish its savings in a couple years.

If global inflation rises, as I expect, this process will become even more difficult. The central banks will have less room for manoeuvre. Fiscal policy is constrained, which leaves the exchange rate as the main tool of adjustment. This would necessitate a weak real exchange rate during the entire period of adjustment.

Obviously inflation would make everything worse, and our future scenarios will depend critically on the inflation outlook. A rise in inflation might alleviate the pressure on some mortgage holders, but is not a good environment for a country to build up savings. If higher inflation were tolerated by the central bank, it would clearly prolong the macroeconomic adjustment process. If it were not tolerated, interest rates would go up and we might experience a re-run of the 1980s. It would get a lot worse before it got better.

Either way, adjustment would take time. Would you really want to predict that under any of those scenarios, the worst was already over for a fragile financial sector? There may be no global financial meltdown. But our multiple crises could easily return with a vengeance, like one of those bloodstained villains in a horror movie who rises to fight his last battle.

It will end at some point, but several pockets of the financial market remain vulnerable in the meantime: US government bonds (under an inflation scenario); US municipal bonds (if the downturn is severe and long); several categories of credit default swap; credit card debt securities among others.

Our macroeconomic adjustment is not going to be as terrible as the Great Depression. But it might last longer. There will be time for optimism, but not just yet.

Send your comments to [email protected]

[Apr 3, 2008] False ideology at the heart of the financial crisis by George Soros

It looks like intangible reputational damage from subprime mess far exceed direct losses. As Soros aptly said: "We need new thinking, not a reshuffling of regulatory agencies. The Federal Reserve has long had authority to issue rules for the mortgage industry but failed to exercise it. For the past 25 years or so the financial authorities and institutions they regulate have been guided by market fundamentalism: the belief that markets tend towards equilibrium and that deviations from it occur in a random manner."
Financial Times

The proposal from Hank Paulson, US Treasury secretary, for reorganizing government regulation of financial institutions misses the point. We need new thinking, not a reshuffling of regulatory agencies. The Federal Reserve has long had authority to issue rules for the mortgage industry but failed to exercise it. For the past 25 years or so the financial authorities and institutions they regulate have been guided by market fundamentalism: the belief that markets tend towards equilibrium and that deviations from it occur in a random manner. All the innovations – risk management, trading techniques, the alphabet soup of derivatives and synthetic financial instruments – were based on that belief. The innovations remained unregulated because authorities believe markets are self-correcting.

Regulators ought to have known better because it was their intervention that prevented the financial system from unraveling on several occasions. Their success has reinforced the misconception that markets are self-correcting. That in turn allowed a bubble of excessive credit to develop, which extended through the entire financial system. When the subprime mortgage crisis erupted it revealed all the weak points. Authorities, caught unawares, responded to each new disruption only after it occurred. They lacked the ability to foresee them because they were in the thrall of the market fundamentalist fallacy. They need a new paradigm. Market participants cannot base their decisions on knowledge, or what economists call rational expectations. There is a two-way, reflexive interaction between the participants’ biased views and misconceptions and the real state of affairs. Instead of random deviations, reflexivity may give rise to initially self-reinforcing but eventually self-defeating boom-bust sequences or bubbles.

Instead of reshuffling regulatory agencies, the authorities ought to prepare for the next shoes to drop. I shall mention only two. There is an esoteric financial instrument called credit default swaps. The notional amount of CDS contracts outstanding is roughly $45,000bn. To put it into perspective, that is about equal to half the total US household wealth and about five times the national debt. The market is totally unregulated and those who hold the contracts do not know whether their counterparties have adequately protected themselves. If and when defaults occur, some of the counterparties are likely to prove unable to fulfill their obligations. This prospect hangs over the financial markets like a sword of Damocles that is bound to fall, but only after some defaults have occurred. That must have played a role in the Fed’s decision not to allow Bear Stearns to fail. One possible solution is to establish a clearing house or exchange with a sound capital structure and strict margin requirements to which all existing and future contracts would have to be submitted. That would do more good in clearing the air than a grand regulatory reorganization.

The other issue is rising foreclosures. About 40 per cent of the 6m subprime loans outstanding will default in the next two years. The defaults of option-adjustable-rate mortgages and other mortgages subject to rate reset will be of the same order of magnitude but occur over a longer period. With single family home sales running at an annual rate of 600,000, foreclosures will overwhelm the market and cause prices to overshoot on the downside. This will swell the number of homeowners with negative equity who may be tempted to turn in their keys. The fall in house prices will become practically bottomless until the government intervenes. Cutting foreclosures should be a priority but the measures so far are public relations exercises.

The Bush administration has resisted using taxpayers’ money because of its market fundamentalist ideology. Apart from a bipartisan fiscal stimulus, it has left the conduct of policy largely to the Fed. Yet taxpayers’ money will be needed to reduce foreclosures. Two proposals by Democrats in Congress strike a balance between the right to foreclosure and discouraging the exercise of that right. One would modify the bankruptcy laws allowing judges to modify the terms of mortgages on principal residences. Another would provide Federal Housing Administration guarantees that would enable mortgage holders to be paid off at 85 per cent of the current appraised value. These proposals will not solve the housing crisis, but go to the heart of the issue. They should be given serious consideration.

[Mar 26, 2008] There is No 'New Deal' in Today's America by Anatol Lieven, New America Foundation

October 4, 2005 | The Financial Times

Serious reformist thinking is largely absent -- not only from the political parties but also from the mainstream media and most think-tanks.

The media and think-tanks are also largely disabled by their links to political and economic interests. In the wake of Katrina, the mainstream US media won praise for finally daring to criticise the Bush administration. But there is little sign of their readiness to analyse deep flaws in the US system. The exceptions are race and poverty, issues raised so glaringly by Katrina that only a totalitarian system could avoid mentioning them.

Among the fundamental issues absent from public discussion is the political patronage system, in the areas of jobs and financial allocations. Strong criticism has been directed at the Bush administration, quite rightly, for its appointment of unqualified political cronies to senior posts. What no one asks is why the US, alone among developed countries, has such an extensive system of political appointments to vital and highly technical government jobs. Such questions would be considered to reflect lack of patriotism. More importantly, the political parties cannot raise this issue as they are both dependent on patronage to raise funds and gain support. The think-tanks cannot discuss it because too many of their members dream of becoming assistant deputy something or other after the next elections. But at least the media should be able to talk about this.

Similarly, both Congress and the Democratic politicians of Louisiana have been criticised, quite rightly, for senators' colossal diversion of scarce federal funds to pork-barrel projects in their states--something that contributed directly to the disaster in New Orleans. But no one asks why the US system allows opportunities for pork-barrel politics on this scale.

US inability to compare itself to other countries also applies to discussion of global warming and energy conservation. After Katrina, these issues cannot be ignored. But the US public cannot be told how isolated internationally America is on this question. Media discussion too often takes the form of a rigged debate in which scientific evidence for global warming is set against scientific opponents of this thesis--despite the fact there is broad international support for the first position while the second is held essentially by isolated individuals.

If a crisis on the scale of 1929-32 strikes the US now, the country would not find an FDR with a New Deal programme to run against the Republican's Herbert Hoover. It would have a timid, ineffective Hoover for the Democrats running against a Republican Calvin Coolidge, a hidebound defender of the worst aspects of the existing system. If that had been the choice in 1932, the very foundations of the American state would have been in peril

Free Markets vs. Cronyism

March 4, 2008 | Sudden Debt

I will be on a short trip, so posting will be sporadic for the next few days. Before I go, I want to clear something up, concerning my views on extremism in free markets and their zealot acolytes.

Free markets (in this case financial markets, since they are my area of expertise) without tight regulation to even out the playing field as much as possible, rapidly deteriorate towards crony capitalism, i.e. a particularly virulent form of junglenomics. US financial markets were the envy of the world because a whole array of professional regulators (SEC, NASD, NYSE, FRB, etc) stood ready to send in the feds and bodily carry out manacled perps, in full view of their co-workers and the cameras.

No, it didn't always work out as it should have and many a big fish swam away leaving the minnows to fry in the pan. But mostly it worked, and the markets were the better for it. This is no longer the case and dominant positions now exist (or existed) unchecked in most markets and crony capitalism makes itself evident in many aspects of the US economy (Enron, for example).

Some people sadly still confuse freedom with total lack of regulation, thinking oversight interferes with a "natural" right to do as they please. In that case, their proper place is up in the mountains with the rest of the wild animals (Aristotle had something to say about them, people who do not wish to participate in a cohesive society and be bound by its rules). Others place absolute faith in the invisible hand, thinking it will even out everything all by itself. To my mind, they belong to the Flat Earth Society.

No doubt, they in turn will paint me a "commie", showing a complete lack of understanding about what communism is all about. Well, both communism and absolute laissez-faire don't work - in practice - because they both disregard human nature: man is no saint. He will no more gladly share everything he has with his fellow than he won't fall prey to unfettered greed for individual gain.

Free market capitalism is not antithetical to the common good - quite the contrary; it is just that human nature will always be governed by extremes of fear and greed and behavior must be governed by checks and balances, for everyone's benefit. Likewise for democracy, which can all too easily deteriorate towards mob rule or fascism, a fact understood very well by the writers of the Constitution. It is extremism that I rail against, not freedom.

Bottom line: excellence in market regulation leads to better and freer markets. And please... do not confuse quality with quantity, from either perspective: more is not better, but neither is less. Smarter, more effective, more efficient... that's better.

See you all soon.

The Rising Risk of a Systemic Financial Meltdown: The Twelve Steps to Financial Disaster

Nouriel Roubini | Feb 05, 2008

Why did the Fed ease the Fed Funds rate by a whopping 125bps in eight days this past January? It is true that most macro indicators are heading south and suggesting a deep and severe recession that has already started. But the flow of bad macro news in mid-January did not justify, by itself, such a radical inter-meeting emergency Fed action followed by another cut at the formal FOMC meeting.

To understand the Fed actions one has to realize that there is now a rising probability of a “catastrophic” financial and economic outcome, i.e. a vicious circle where a deep recession makes the financial losses more severe and where, in turn, large and growing financial losses and a financial meltdown make the recession even more severe. The Fed is seriously worried about this vicious circle and about the risks of a systemic financial meltdown.

That is the reason the Fed had thrown all caution to the wind – after a year in which it was behind the curve and underplaying the economic and financial risks – and has taken a very aggressive approach to risk management; this is a much more aggressive approach than the Greenspan one in spite of the initial views that the Bernanke Fed would be more cautious than Greenspan in reacting to economic and financial vulnerabilities.

To understand the risks that the financial system is facing today I present the “nightmare” or “catastrophic” scenario that the Fed and financial officials around the world are now worried about. Such a scenario – however extreme – has a rising and significant probability of occurring. Thus, it does not describe a very low probability event but rather an outcome that is quite possible.

Start first with the recession that is now enveloping the US economy. Let us assume – as likely - that this recession – that already started in December 2007 - will be worse than the mild ones – that lasted 8 months – that occurred in 1990-91 and 2001. The recession of 2008 will be more severe for several reasons: first, we have the biggest housing bust in US history with home prices likely to eventually fall 20 to 30%; second, because of a credit bubble that went beyond mortgages and because of reckless financial innovation and securitization the ongoing credit bust will lead to a severe credit crunch; third, US households – whose consumption is over 70% of GDP - have spent well beyond their means for years now piling up a massive amount of debt, both mortgage and otherwise; now that home prices are falling and a severe credit crunch is emerging the retrenchment of private consumption will be serious and protracted. So let us suppose that the recession of 2008 will last at least four quarters and, possibly, up to six quarters. What will be the consequences of it?

Here are the twelve steps or stages of a scenario of systemic financial meltdown associated with this severe economic recession…

[Feb 20, 2008]Roubini 12 steps to financial disaster.   By Martin Wolf  

Feb 20, 2008 | Financial Times

"I would tell audiences that we were facing not a bubble but a froth - lots of small, local bubbles that never grew to a scale that could threaten the health of the overall economy." Alan Greenspan, The Age of Turbulence.

That used to be Mr Greenspan 's view of the US housing bubble. He was wrong, alas. So how bad might this downturn get? To answer this question we should ask a true bear. My favourite one is Nouriel Roubini of New York University 's Stern School of Business, founder of RGE monitor.

Recently, Professor Roubini 's scenarios have been dire enough to make the flesh creep. But his thinking deserves to be taken seriously. He first predicted a US recession in July 2006*. At that time, his view was extremely controversial. It is so no longer. Now he states that there is "a rising probability of a  'catastrophic ' financial and economic outcome"**. The characteristics of this scenario are, he argues: "A vicious circle where a deep recession makes the financial losses more severe and where, in turn, large and growing financial losses and a financial meltdown make the recession even more severe."

Prof Roubini is even fonder of lists than I am. Here are his 12 - yes, 12 - steps to financial disaster.

These, then, are 12 steps to meltdown. In all, argues Prof Roubini: "Total losses in the financial system will add up to more than $1,000bn and the economic recession will become deeper more protracted and severe." This, he suggests, is the "nightmare scenario" keeping Ben Bernanke and colleagues at the US Federal Reserve awake. It explains why, having failed to appreciate the dangers for so long, the Fed has lowered rates by 200 basis points this year. This is insurance against a financial meltdown.

Is this kind of scenario at least plausible? It is. Furthermore, we can be confident that it would, if it came to pass, end all stories about "decoupling". If it lasts six quarters, as Prof Roubini warns, offsetting policy action in the rest of the world would be too little, too late.

Can the Fed head this danger off? In a subsequent piece, Prof Roubini gives eight reasons why it cannot***. (He really loves lists!) These are, in brief: US monetary easing is constrained by risks to the dollar and inflation; aggressive easing deals only with illiquidity, not insolvency; the monoline insurers will lose their credit ratings, with dire consequences; overall losses will be too large for sovereign wealth funds to deal with; public intervention is too small to stabilise housing losses; the Fed cannot address the problems of the shadow financial system; regulators cannot find a good middle way between transparency over losses and regulatory forbearance, both of which are needed; and, finally, the transactions-oriented financial system is itself in deep crisis.

The risks are indeed high and the ability of the authorities to deal with them more limited than most people hope. This is not to suggest that there are no ways out. Unfortunately, they are poisonous ones. In the last resort, governments resolve financial crises. This is an iron law. Rescues can occur via overt government assumption of bad debt, inflation, or both. Japan chose the first, much to the distaste of its ministry of finance. But Japan is a creditor country whose savers have complete confidence in the solvency of their government. The US, however, is a debtor. It must keep the trust of foreigners. Should it fail to do so, the inflationary solution becomes probable. This is quite enough to explain why gold costs $920 an ounce.

The connection between the bursting of the housing bubble and the fragility of the financial system has created huge dangers, for the US and the rest of the world. The US public sector is now coming to the rescue, led by the Fed. In the end, they will succeed. But the journey is likely to be wretchedly uncomfortable.

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