bizzXceleration: Performance, Value and Profit

The original plan was to put up a post over the weekend looking beyond the rescue package but as the news ebbed and flowed we got distracted more than a bit. And still headed into today with a relatively benign outlook which turned out to be mis-placed. There's been a change of plan since instead of containing the breakout from Stalingrad we've had an ideologically motivated sit-down strike on the part of the troops who're now sulking in their tents. So rather than our normal longish analytical post along with excerpts, charts, etc. we're going to focus on Steve Perslstein's latest column from the Washington Post which is as short, pithy, direct, accurate and honest a description, in ordinary English, as we've read. We've got a lot more to say but we're simply going to start here and pick up more tomorrow, depending on how tonight's drinking goes. BtW - how's your food, water, ammo, fuel and liquor stocks doing ? After you read Mr. Pearstein's elegantly direct assessment we also suggest you consult John Mauldin's latest newsletter for a more detailed explanation: Who's Afraid of a Big, Bad Bailout?

They Just Don't Get It

Oy vey.

That is the technical economic term that best sums up a day in which the House of Representatives refuses to pass a $700 billion rescue plan pushed by the White House and congressional leaders from both parties, Wachovia is taken over in a deal that will have the government potentially owning 10 percent of Citigroup, a few European banks fail, the Federal Reserve and other central banks are forced to inject an additional $300 billion into the global banking system, the Dow Jones industrial average plunges 777 points, and investors everywhere rush to the safety of gold and short-term Treasury bills. The basic problem here is that too many people don't understand the seriousness of the situation. Americans fail to understand that they are facing the real prospect of a decade of little or no economic growth because of the bursting of a credit bubble that they helped create and that now threatens to bring down the global financial system. Politicians worry less about preventing a financial meltdown than about ideology, partisan posturing and teaching people a lesson. Financiers have yet to own up publicly to their own greed, arrogance and incompetence. And leaders of foreign governments still think that this is an American problem and that they have no need to mount similar rescue efforts in their own countries. In the coming weeks and months, all of these people will come to understand how deep the hole really is and how we're all in it together. They'll come to understand that the giant sucking sound they hear is of a massive deleveraging of the global economy and the global financial system as households and governments, businesses and investment funds adjust to living in a world with less debt and more inflation.

And they will come around, reluctantly, to the understanding that the only way to get out of these situations is to have governments all around the world borrow gobs of money and effectively nationalize large swaths of the financial system so it can be restructured, recapitalized, reformed and returned to private ownership once the crisis has passed and the economy has gotten back on its feet.

In the next few weeks, the center of attention here in the United States will shift from the Congress and an exhausted Treasury to the Federal Deposit Insurance Corp., which will now have to rescue any number of failing banks, either by taking them over directly or managing their transfer into stronger hands. It will also shift back to the Federal Reserve and other central banks, which will have to step up their efforts to maintain liquidity in money markets and prevent the credit crunch from taking down hedge funds, businesses, and state and local governments.

These will, alas, be only holding actions. Restoring real stability to financial markets will require the kind of systemic approach and extraordinary government interventions that the public has refused to authorize and finance. In better times, the public might have put aside its reluctance in response to the strong and unified recommendation of political and business leaders. But it is a measure of how little trust remains in both Washington and Wall Street that voters are willing to risk a serious hit to their wealth and income rather than follow their lead.

Posted by dblwyo at 09:49 PM | Permalink | Comments (0)

Not sure about you but re-fighting Stalingrad and watching the Kabuki dancing of the political poseurs is wearing on my nerves. Call it the triumph of the lizard-brained. That's not a pejorative btw but a technically accurate description of how our brains are wired. The neuro-stack is Lizard-brain (ancient), Monkey (very....y old), and "Modern" (the part we think is new, in charge but who's primary purpose is to rationalize the primitive decisions already reached by Mr. Lizard and Madam Monkey). Of course James told us all that over a 100+ years ago and it's been confirmed by modern cognitive neuro-sciences and brain-scanning. For as simple a summary of where we're at that's relatively non-technical check this other post:This is a Rescue, Not A Bailout: And It's Your Life . And for my complete archives laying out the genesis and evolution of this crisis try a quick skim of these two archives:CreditMktsCrisis,Fed & Credit. You might be surprised at how much information has accumulated that's turning out prescient but grossly under-emphasized. That is, I didn't see it blowing up this bad either. Instead we'd like to remind you that beyond today's credit crisis du jour are a host of real economic problems, including a Housing market that has at least two years before recovery from excess and mounting inventories. And a real economy that we warned sometime back was in an accelerating downturn and was now crossing the tipping point all on it's own. (Be Afraid, Very Afraid: Five Things to Know About the Economy) Summarized in the accompanying table which dates from around Feb (we think). (Filtering the Non-Linearities: Sorting the Risk Factors) Take a minute and read it because you'll notice that there's a lot still qued up to be worked thru. A lot indeed. The point here is not to celebrate my own prescience but to highlight the fact that that the machinery available here allows one to be prescient within divine gifts of insight. So instead we're going to focus on recent economics news, which you'll find summarized and excerpted after the break. The two must-skim readings are Mark Faber's outlook which captures our own exactly and the huge warning shot from the Chinese government that it's lost all confidence in US investments. If you don't think that's critically important you need to educate yourself as to what happens if they start drawing down the flow of funds that have kept interest rates low.

First, a little sidetrip back to the crisis. As you no doubt know Th. saw the collapse of Rescue Package talks with more political posturing by some very mistaken Republican ideologs. Fortunately for all of us the markets, including the credit markets, are retaining their strong belief in a package getting passed. Given that short-term credit conditions are turning into a disaster area and already beginning to seriously crimp business and the economy that's amazing and good news. 

The top sub-chart is a short-term SP500 chart that shows us how resilient the markets were, even rising to positive territory today. On a day when many of us were expecting a 300 point drop. We may get a relief rally next week if the bill is passed as promised over the weekend. If you haven't already down so...sell into this and get out. There will be a major downturn in the works.

As you can see looking at the slightly longer-term and second sub-chart which shows the real trend in place. Our anticipation is that as soon as we get past this little excitement, presuming we do, that economic realities will slowly sink in and a real recession will start showing up. Which it hasn't as yet. We're not even down 20% as yet and typically downturns get you 30% and this is likely to be worse. Beyond that, as one of the excerpts points out and we've been saying, earnings expecations have moved from unreal to surreal. We're not sure what the analysts are smoking but we'd like some. So what is the economic news - all of which was bad this week and last, though we spent more time on the crisis than on that big picture ?

Economic Assessments and Outlook

Consumer Spending: Real consumer expenditures are slowing rapidly and are as low now as in '01 and dropping while real retail sales have been declining since Nov07 and recently started dropping faster and have been negative since Jan. Probably a good thing that these YoY numbers aren't reported as people would really get scared. Oh yeah - auto sales continues in the tank and we don't think the industry is prepared for how deep and long this downturn will be. When shorting is restored there's money to be made betting on some BK's in Detroit.

Investment: the next item up moving around the business cycle circle of life is investment. Which as you recall lags consumer spending because it's driven by it. The drop in New Home Sales continues though the good news is the decrease appears to be flattening off at -35% YoY ! Think about that for a minute. Afterwards notice that Industrial Production is headed over into the tank and the recent MtM headlines were a -4.5%. On our charts the downturn has been visible for months. New capital goods orders look much better until you notice that they went in the thank last summer and ask why they picked up ? The answer was a weak...k dollar and exports. A boon soon to be taken away. BtW that decline means that Tech spending is going to take it in the neck (Tech Trends II (Analysis): What're the Drivers and Outlooks).

Future Demand: the main drivers of future demand are growth in real wages and employment. Well guess what real wages have been dropping, not quite like a rock and we're now in our seventh month of employment declines. The net result is their sum is tipping over as well. And we're just started into the real downturn which is NOT visible yet because of normal cyclic patterns. Something that repeatedly escapes the pundits, talking heads and the MSM. We're starting to see some glimmers, e.g. Faber's got it right and more and more of the financial economist community is starting to see the world the way we've been seeing it for months. Halleluah - at long last. At least from an intellectual perspective. From a painful experiences to come perspective not so good. 

Wrapping Up

We'll leave you with this fascinating little chart that looks at some alternative extrapolations of GDP growth over the next ten years. The first is a mild downturn that's the best case we see, the 2nd a more severe downturn if the credit crisis worsens and the third is if it gets really bad, the package doesn't work too well and we catch the no-growth Japanese diseases. Factor these into your planning. We think we're being realistic and have deliberately ignored the Big-D scenario having a desire to keep our dinners down.

 

Credit Crisis and the Economy 

Debt Market Distress Spreads Short-term money markets remained in turmoil, heightening the likelihood the credit pullback will harm the broader economy. Short-term money markets remained in turmoil, heightening the likelihood the credit pullback may harm the broader economy. Inside markets that are hidden to most Americans -- the overnight Treasury repo market, the short-term commercial-paper markets and the floating-rate municipal bond markets -- action was unfolding that will soon affect how companies meet payroll, pay vendors and make investments. These markets allow companies with ample reserves to squeeze out a few extra dollars by investing the cash in securities with life spans of just days or weeks. All that cash helps keep the economy lubricated by distributing money to other firms that need short-term loans to buy inventory or meet payroll. Some distressing signs emerged Thursday from one of the most important of these marketplaces, the commercial-paper market, where companies borrow money for periods of just a day to up to a year. The market contracted by $61 billion in the week ended Sept. 24, its largest decline since August 2007, when investors fled over some of the first warning signs of the subprime-mortgage crisis. In the latest week, banks and other financial companies accounted for most of the decline, as they took $50.3 billion of paper off the market. The decline follows a $52.1 billion shrinkage in the week ended Sept. 17, which reduces the overall market to $1.702 trillion, according to Federal Reserve data. "The world is clearly saying this is a huge problem," said Harjeet Heer, who runs the Global Aggregate business at Baring Asset Management, which manages $17.8 billion in fixed-income assets. These changes already are having affects on a host of companies that are constantly managing their cash positions. Payroll processor Paychex Inc. transmits billions of payroll payments each day for 500,000 U.S. businesses. Last week, Paychex's chief financial officer, John Morphy, moved some of his working cash out of short-term municipal bonds and some money-market funds and into discount notes issued by government-backed Fannie Mae and Freddie Mac, called agency discount notes. "When you're talking about a company like ours, if you've got to be liquid, you'd rather make sure you're liquid and you might give up some return, but you'd rather be safe," said Mr. Morphy.

• Small Businesses Can’t Get Cash

Hey, what about my job? The credit crisis is taking its toll on financial firms, leaving many people on Wall Street out of work and many more uncertain about whether they will lose their jobs in the coming months. But the market meltdown is likely to have an even wider effect on the entire job market, which was weakening even before the historic meltdown of the past few weeks. More than 600,000 jobs have already been lost this year, according to the government. And there are currently over 9.4 million people looking for work in the U.S. Given the recent events roiling the economy, the prospects for job seekers are looking dimmer every day. "Everybody is at risk," according to John Challenger, chief executive of global outplacement firm Challenger, Gray & Christmas. Frozen financial markets mean that banks are putting the brakes on lending. With businesses finding it harder to get financing, that could hinder their growth and lead to more layoffs. That, in turn, compels consumers to curtail their spending, slowing economic activity even more...which leads to more layoffs, Challenger explained. It's a "negative spiral," he said. Beyond the finance industry, many companies have already started cutting back in order to cut costs, Eubank said. Since May, General Motors (GM, Fortune 500) laid off 19,000 hourly workers, Starbucks (SBUX, Fortune 500) cut 12,000 jobs and American Airlines (AMR, Fortune 500) announced it was cutting 7,000 jobs, according to Challenger, Gray & Christmas. Other companies have instilled temporary hiring freezes or put their hiring plans on hold altogether. "Employment expectations are down substantially," according to John Dooney, manager of strategic research for The Society for Human Resource Management. Meanwhile, the employers that are hiring are moving slower and being more selective. Instead of three rounds of interviews, there might be twice as many, Paris said. With the unemployment rate now at a five-year high, according to the latest figures from the Labor Department, experts say it may be a while before an economic turnaround takes hold. According to Challenger, "the economy is going to be very slow through 2009."

• Orders For U.S. Durable Goods Drop 4.5%, More Than Forecast, as Sales Slow Orders for U.S. durable goods fell more than twice as much as forecast in August, a sign that slower sales and tighter credit conditions prompted companies to cut spending.
• New-Home Sales in U.S. Plunged 11.5% in August to Lowest Level in 17 Years Sales of new homes in the U.S. fell in August to a 17-year low, signaling the housing market suffered another setback even before the latest turmoil in financial markets.
• U.S. Initial Jobless Claims Soar to Highest in Seven Years on Hurricanes The number of Americans filing first-time claims for unemployment benefits rose last week to the highest since September 2001 as hurricanes kept residents of Texas and Louisiana out of work.
• U.S. Economy Expanded 2.8% in Second Quarter, Less Than Previous Estimate The U.S. economy expanded more slowly than previously estimated in the second quarter, showing consumer spending was weakening before the credit crisis intensified

Asia Needs Deal to Prevent Panic Selling of U.S. Debt, Yu Says Japan, China and other holders of U.S. government debt must quickly reach an agreement to prevent panic sales leading to a global financial collapse, said Yu Yongding, a former adviser to the Chinese central bank. ``We are in the same boat, we must cooperate,'' Yu said in an interview in Beijing on Sept. 23. ``If there's no selling in a panicked way, then China willingly can continue to provide our financial support by continuing to hold U.S. assets.'' An agreement is needed so that no nation rushes to sell, ``causing a collapse,'' Yu said. Japan is the biggest owner of U.S. Treasury bills, holding $593 billion, and China is second with $519 billion. Asian countries together hold half of the $2.67 trillion total held by foreign nations. China, Japan, South Korea and others should meet soon to seal a deal, said Yu, a former academic member of the central bank's monetary policy committee. The talks should involve finance ministers, central bank governors and even national leaders, he said. Yu said China is helping the U.S. ``in a very big way'' and added that it should get something in return. The U.S. should avoid labeling it an unfair trader and a currency manipulator and not politicize other issues, he said. ``It is not fair that we are doing this in good faith and are prepared to bear serious consequences and you are still labeling China this and that, accusing China of this and that,'' he said. ``China knows what to do. We don't need your intervention.'' The U.S. financial crisis had taught China a lesson and that was: ``Why are we piling up these IOUs if they may default?'' China's economic expansion strategy, which emphasizes export growth that has led to trade surpluses and the accumulation of $1.81 trillion in foreign-exchange reserves, is the main problem, said Yu. ``Our export-growth strategy has run its natural course,'' he said. ``We should change course.'' China should stop intervening in the foreign currency markets and thus allow rapid appreciation of the yuan, he said. While this would cause pain for exporters, China could ease the transition by using its strong fiscal position to aid those who lose their jobs. It also should stimulate domestic demand to offset lower income from overseas sales.

Foreign Economic News

European Services, Manufacturing Shrink at Fastest Pace in Almost 7 Years Europe's manufacturing and service industries contracted at the fastest pace in almost seven years in September as the credit-market seizure intensified and companies scaled back production in response to slowing orders. Royal Bank of Scotland Group Plc's composite index dropped to 47, the lowest since November 2001, from 48.2 in August. Economists had forecast a decline to 47.8, according to the median of 21 estimates in a Bloomberg News survey. The index is based on a survey of purchasing managers by Markit Economics in London and a reading below 50 indicates contraction. Banks are hoarding cash as they struggle with the yearlong credit crisis that has claimed financial institutions including Lehman Brothers Holdings Inc. and with an economic slowdown that is curbing loan growth. Cooling demand is also hitting Europe's biggest manufacturers, with Germany's BASF SE last week announcing it will slash production of polystyrene in Europe. ``The flash PMI data for September make grim reading, showing recession-consistent activity data pretty much across the board,'' said Ken Wattret, an economist at BNP Paribas in London. ``Manufacturing has taken over from services as the main driver of weakness, reversing the pattern in the early stages of the downturn. This is linked to Germany's switch from boom to bust.'' The continued contraction in manufacturing and services industries suggests Europe's economy isn't recovering after shrinking in the second quarter for the first time in almost a decade. The European Central Bank on Sept. 4 cut its 2008 growth forecast to about 1.4 percent. The European Commission also lowered its outlook this month and predicts recessions in Germany and Spain, the region's largest and fourth-largest economies.

• French August Consumer Spending Falls as Slowing Growth Fuels Joblessness

• Ireland Is First in Euro Area to Enter a Recession as Investment Plunges Ireland became the first euro area economy to slide into a recession, as homebuilding and consumer spending slumped and the global financial crisis intensified.

Post-Olympic economic blues Hopes of a rapid recovery in the health of the Chinese economy after the Olympic Games are fading fast on weakening commodity as well as property prices, Citigroup said in a report released Wednesday. "All signs are pointing towards an across-the-board slowdown in the Chinese economy. The particular worrying signs are rapid cuts in steel prices, surging steel exports, deceleration in electricity consumption growth and weakening coal prices," Citigroup Lan Xue wrote in the report. Lan said an unexpected reduction in steel prices for November announced last week by Baoshan Iron & Steel Co., China's largest steelmaker, suggested steel companies weren't expecting any major rebound in economic activities. Baoshan last week announced a reduction of 800 yuan ($117) a ton, or more than 10% over October, in the prices of hot-rolled and cold-rolled steel coils for November, according to reports. China's economic indicators were expected to show an improvement after the Olympics, after industrial production weakened in the run up to the Games last month, partly because the government shut down several polluting factories in and around Beijing. Official data released earlier this month showed that the growth in China's industrial output slowed to 12.8% in August from the same month a year ago, the weakest pace in six years. In July, China's industrial production expanded 14.7%. Lan said "a significant deterioration in the property sector" was believed to be one of the key reasons behind the weakness in domestic demand.

Consequences and Delusions

Faber Says U.S. $700 Billion Rescue Plan Isn't Enough (Update3) The U.S. government's $700 billion bank rescue plan won't be enough to revive the finance industry, said investor Marc Faber, who forecast the so-called Black Monday crash in 1987. The government should buy out struggling home owners, Faber, managing director of Marc Faber Ltd. and publisher of the Gloom, Boom & Doom Report, told reporters on the sidelines of an investor conference in Hong Kong. He's also predicting Chinese economic growth to ``disappoint'' and Indian stocks to decline. ``The U.S. has many problems,'' Faber said. ``It's a period of hardly any growth in real terms in the economy for several years.'' Faber also forecast the Standard & Poor's 500 Index will rally to as high as 1,350 points following the approval of the bailout plan because stocks are ``oversold.'' That level is about 14 percent higher than the gauge's close yesterday. Still, ``I'm not playing that rally,'' he said. ``I'd rather think that stocks are not particularly cheap. We don't have a valuation bubble. We have an earnings bubble. In 2009, earnings will disappoint.'' Faber said he is ``negative'' on China's economic growth, which has slowed for four straight quarters. The economy expanded at 10.1 percent in the second quarter, down from the previous period's 10.6 percent, though still the fastest pace of the world's 20 biggest economies. Industrial production grew in July at the weakest pace since February 2007 and manufacturing contracted in August for a second month, according to an official survey, underscoring government concern that an economic slump is possible. ``Economies like China that grow very rapidly can have significant adjustments,'' Faber said. ``I'm not negative for the long term. It's just that from a cyclical point of view the Chinese economy could turn out to be weaker than what analysts are telling you.'' India is also ``not problem-free,'' Faber said. He forecasts the Bombay Stock Exchange's Sensitive Index, or Sensex, will fall below 10,000. The Sensex is down 33 percent this year. ``I think new all-time highs in markets are most unlikely for the time being,'' Faber said. ``So I'm not particularly interested to play the market at the present time.''

Earnings Reports: The Audacity of Hope Even as politicians remake the Street, its denizens remain optimistic. Collectively, analysts expect S&P 500 earnings to expand by 23.9% in 2009, and that figure has increased slightly since July. Remarkably, Wall Street's consensus on earnings is: "Fine in '09." Even as politicians remake the Street, its denizens remain optimistic. Collectively, analysts expect S&P 500 earnings to expand by 23.9% in 2009, according to Thomson Reuters. What's more, that figure has increased slightly since July, despite the recent intensification of the credit crunch. Such bottom-up analysis, however, will be crushed by top-down pressures. Despite concern about the government flooding the economy with dollars and stoking inflation, disinflation is the more likely near-term prospect, as the private sector deleverages. Consumer spending, which is 70% of gross domestic product, and corporate investment will necessarily suffer. Expecting a big profit rebound makes no sense. Take the financial sector, at the center of the storm. Its collective earnings for 2009 are forecast to be $156 billion. Not only would that represent more than double the expectation for this year, it would imply the sector actually making more in 2009 than in 2007 when, to paraphrase one of its more high-profile casualties, the music was still playing. Views on the consumer-discretionary sector are similarly bullish. Hopes for energy profits also remain strong, reflecting lingering hopes about global economic decoupling; that thesis appears to be coming apart as far as Europe is concerned, at least. As corporate management teams head toward the end of a turbulent year, expect budgets to be recast, reduced expectations to be communicated to analysts -- and the Street's enduring optimism to be dimmed.

Posted by dblwyo at 07:04 PM | Permalink | Comments (2)

Yesterday was a day of political kabuki in the US Senate as Sec. Paulson and Chairman Ben were raked over the coals, tripped, stripped and drug back over 'em again and again and again. It was truly a massive display of unusual bi-partisan unity by every Senator of both parties with nary a display of understanding, sympathy or constructive suggestions. As political theater it was entertaining to the extent that you admire the works of the Marquis de Sade. Whether it will turn out to be unavoidable and useful are really the questions. Put another way given how angry, ill-informed and torch-waving the electorate is was this 1/3 posturing and 2/3 preparation or 1/3 posturing, 5/6 dead serious and 1/6 who knows ? On the answers to that question hinges the fate of the economy, literally.

Market as Proxy

During the bulk of the day I had the chance to listen to the live testimonay and questions on-line while tracking the markets performance and it was amazing. After a very bad Monday Tue. started out flattish and then started falling apart as the level of objections became clear. Then when it looked as if some rationality was setting in and folks had calmed down the markets picked up considerably, much to the relief of the traders who'd bet on a relief rally following Mon's debacle. Alas it was not to be because around 3pm the the stories started to hit and the realities of the kabuki reached a wider audience....call it the kabuki kaboom. By close of business we were down 4+% in the worst 2-day drop in years. So far today things have been oscillating wildly as the Buffet Goldman put faded instantly to be replaced by apprehensive waiting for today's play.

Clearing the Air

Let's try and clear the air a little bit despite the fact that everything you're hearing, reading and people are talking about is largely distorted, serves an agenda that's not necessarily helpful or is just plain wrong. Sadly, for myself in particular, some of the financial journalists and bloggers for whom my respect has been the utmost are among those getting it wrong, being non-contributory or just terminally - implications intended - ideological. You should know who you are and it's rather sad that you don't. Let me give you two acid test questions for all of those "pontificating poobahs of pessimism": 1) if you don't like the proposal what's wrong with it and how would you fix it ? 2) in the timeframe we have before the markets crash and take the economy with it ? 3) if you don't like the plan at all what's your alternative proposal - let it all fail so the devil can sort out the hindmost ? Fortunately there are a few folks who are acting sensibly with names like Gross, Buffett, et.al. And our friends at BNN come thru again with a fair, balanced and reasonable interview.

First off it's not either a bailout or $700B. In fact none of the so-called bailouts are even that from Bear-Sterns to AIG to this "re-capitalization" plan. Nor are the Wall St. fatcats getting rich off of it. In fact many of them are getting wiped out, not to mention the ordinary folks being put on the street. There's a lot more secretaries than poobahs at Lehman or any of these firms. Dick Fuld sold his stock for something like $600K when last year it was worth about $170M. In the AIG case the $85B "bailout" is a loan, the Fed gets 90% of the stock, the CEO was fired and the stockholders were wiped out. And the Fed's getting paid 11% on the money - try and find that sort of return anywhere. When you take each one of these apart the details vary but they are variations on the same theme.

Take the giant bailout for example. The idea is to buy up the bad investments on the banks books because if they sold them at "fire-sale prices" the result would be many would be out of business and credit in the US economy would vanish. I'm not sure how to to make clear what that means - most companies in the US borrow money every day or every week to fund receivables, smooth out payables, finance payrolls while waiting to get paid and all that's just the normal course of business. Most people have car loans, many have mortgages, credit cards and so forth. THAT ALL GOES AWAY. The economy slows down and then stops completely...pretty soon no more car loans...no more auto manufacturing...no more auto jobs....well maybe that's a bad example but you get the idea. We're not talking about rescuing the fat cats we're talking about Joe Boilermaker's job, paycheck, healthcare, and everything else under the sun.

Objections and Consequences 

The major trotted out objections seem to be four: an equity stake, more oversight, help with foreclosure prevention and no golden executive comp. First off this was a proposal on three pages originally put together at Congress's request for them to turn into legislation, which they did, rather quickly and well. With the exception of the adders. Second off some speed was and is of the essence. As Sen. Dodd put it perfectly during his closing comments yesterday, "our legislative process doesn't lend itself to responding to crisis like this". They want weeks and months to carefully craft a package. I'd ask what's wrong with pushing something thru now to keep the markets from imploding while crafting a more meticulous package over the next 2-3 months. By the way for all those asking for fundamental strategic reform of financial regulation Sec. Paulson put forward a comprehensive proposal in March which the Congress has chosen not to act on. Be that as it may as a proposal it was supposed to be emended. As the Sec. testified he's not asking for no oversight and welcomes it. As for controlling executive compensation well enough, bargain that thru. An equity stake - that'd have to be thought thru but the precedents are already in place. Foreclosure prevention - that's populist pork-barrel-rolling at it's worst. First, until housing prices come down to reasonable levels this whole thing will keep breaking out. Second, everybody needs a haircut. And third that's a separate, major issue where the clock isn't ticking away in seconds.  

As a final point consider this - even if we lost every dime of the $700B plus all the prior investments but managed to get economic growth to stay higher than it would be we make money. Put another way we don't end up with 10-12% unemployment and an economy growing at 1% for ten years. Consider the last graphic which shows actual GDP vs Potentil - the gap between them is lost output. To make those differences bigger we also graphed (on the right-hand scale) the YoY growth rates. Now we have an $11T economy. Supposed we get a decline for the next two years of -3%/year (possible but optimistic in a credit collapse), so we have a minimal deadweight loss of -$333B x 2 = -$666B (accidental but meaningful numerology). And suppose we slowly recover for ten years at 1% instead of growing at potential. Let's close with a little worked out table: 

 

 

 At the end of ten years the difference between a mild downturn followed by a return over several years to potential growth and a slightly more severe downturn followed by a Japalaise decade is $2.6T in the last year alone. The total difference over all ten years is -$14T while the net present value is -$9.4T ! In either case that's a lot of lost jobs, people dying in emergency rooms, unbuilt houses and un-educated kids. And that's comparing a good case to a bad one...not the terrible one we're at risk of. Seems to me $700B is a pretty good investment for that kind of return.

Economic Consequences of the Bailout 

Bernanke Says Failure to Pass Bailout Threatens Financial Markets, Economy Federal Reserve Chairman Ben S. Bernanke warned lawmakers that failure to pass a rescue plan to take over troubled assets from financial firms would pose a threat to markets and the economy. ``Action by the Congress is urgently required to stabilize the situation and avert what could otherwise be very serious consequences for our financial markets and for our economy,'' Bernanke said in testimony prepared for delivery today to the Senate Banking Committee. ``Global financial markets remain under extraordinary stress.'' Bernanke and Treasury Secretary Henry Paulson are pushing Congress to quickly approve a $700 billion plan to remove illiquid assets from the banking system. Lawmakers have balked at rubber-stamping the proposal, with Democrats demanding it include support for homeowners and limits on executive pay, while some Republicans question the plan's reach and size. ``At this juncture, in light of the fast-moving developments in financial markets, it is essential to deal with the crisis at hand,'' Bernanke said. Bernanke endorsed the biggest federal intrusion into markets since the Great Depression after failing to stem the credit crisis by cutting the benchmark interest rate at the most aggressive pace in two decades. He has also opened up lending to securities firms and expanded loans to commercial banks. Along with the government bailout, Bernanke supports a regulatory overhaul for a U.S. financial industry upended by $523 billion in losses from the collapse of mortgage credit.

Paulson, Bernanke May Find Painful Parallels in 1990s Nordic Bailout, Bust He says the effort by Finland, Sweden and Norway to save troubled banks in the early 1990s is the closest parallel to the market-rescue plan being engineered by the U.S. Treasury secretary and Federal Reserve chairman. The Nordic effort -- similar in speed and scope to what the U.S. is planning now, though smaller in size -- did manage to end the financial crisis. At the same time, it didn't prevent a deeper recession and surging unemployment in all three countries. ``In the long term, there were benefits, but it took half a decade before they began to show in the economy,'' said Esko Ollila, a member of the Bank of Finland board from 1983 to 2000.

Buffett Calls Credit Crisis an `Economic Pearl Harbor,' Backs Paulson Plan Billionaire investor Warren Buffett, calling the market turmoil ``an economic Pearl Harbor,'' said Treasury Secretary Henry Paulson's $700 billion proposal to prop up the U.S. financial system is ``absolutely necessary.'' ``The market could not have taken another week'' like last week, Buffett told CNBC today, a day after saying his Berkshire Hathaway Inc. will buy a $5 billion stake in Goldman Sachs Group Inc. ``I think it was the last thing Hank Paulson wanted to do, but there's no Plan B for this.'' ``I am betting on the Congress doing the right thing for the American public and passing this bill,'' Buffett said. The economy is ``everybody's problem,'' he said, likening it to ``a bathtub -- you can't have cold water in the front and hot water in the back.'' Berkshire is buying the stake in Goldman, Paulson's former firm, after three of the investment bank's biggest competitors went bankrupt or were forced into emergency sales. He has already agreed to spend at least $25 billion this year to acquire companies, finance buyouts and purchase securities for Omaha, Nebraska-based Berkshire. ``I certainly have a vote of confidence in Goldman and vote of confidence in Congress,'' said Buffett, who is investing in the firm after it lost 40 percent of its market value in the past year.

Libor Rises as Funding Squeeze Worsens After Banks Pay Record Cash Premium Money-market interest rates increased as banks sought to bolster balance sheets amid deepening concern a bailout of financial institutions won't happen quickly enough to ease short-term funding constraints. The one-month London interbank offered rate, or Libor, for dollars jumped 22 basis points to 3.43 percent, the highest level since January, the British Bankers' Association said today. The corresponding rate in euros rose 7 basis points to 4.91 percent and the pound rate also advanced 7 basis points, to 5.91 percent. ``There's no real term funding markets except for central banks,'' said Meyrick Chapman, a fixed-income strategist in London at UBS AG. ``The Libor is meaningless. It's for unsecured lending and there is no unsecured lending as far as I can see.'' Money markets have frozen since the collapse of the U.S. housing market more than a year ago. Efforts by the Federal Reserve, along with central banks worldwide, to revive lending through emergency cash auctions have failed as banks hoard cash and balk at lending to each other on concern more institutions will go bankrupt.

Treasuries Lose Allure for Axa, South Korea Pensions as Bailout Costs Soar Investors outside the U.S., who own more than half of all Treasuries outstanding, say the government's $700 billion plan to revive the banking system will diminish the appeal of the nation's bonds. Treasury Secretary Henry Paulson's proposal, which seeks funds to rescue banks by purchasing devalued securities, would drive the country's debt to more than 70 percent of gross domestic product. The last time taxpayers owed as much was in 1954, when the U.S. was paying down costs from World War II. ``The image of U.S. Treasuries as a safe haven has been tainted by the ongoing financial debacle,'' said Kwag Dae Hwan, head of global investment in Seoul with South Korea's $220 billion National Pension Fund, which holds about $14 billion of U.S. government debt. ``A big question mark hangs over whether the U.S. can deal with an unprecedented amount of debt. That is unnerving all the investors, including me.'' The government depends on foreign money to finance the budget deficit, which UBS AG estimates will increase to $1 trillion next year from $407 billion if the bailout is approved. Investors outside the U.S. own 56 percent of the $4.8 trillion in marketable Treasuries outstanding, up from 42 percent of the $3.4 trillion outstanding five years ago, according to data compiled by the government. U.S. long-term interest rates would be 1 percentage point higher without demand from foreign governments and central banks, according to Professors Francis and Veronica Warnock at the University of Virginia in Charlottesville, who have done research for the Federal Reserve.

Bailout plan draws bipartisan anger in Congress The Bush administration urgently pressed Congress in public and private Tuesday for quick passage of a $700 billion bailout of the financial industry as Democratic and Republican lawmakers vented their anger over a crisis that slid the nation's economy toward the brink. But even before Paulson could speak, lawmakers expressed unhappiness, criticism of the plan and -- in the case of some conservative Republicans -- outright opposition. "I understand speed is important, but I'm far more interested in whether or not we get this right," said Sen. Chris Dodd, D-Conn., chairman of the Senate Banking Committee. "There is no second act to this. There is no alternative idea out there with resources available if this does not work," he added.Sen. Richard C. Shelby of Alabama, the panel's senior Republican, was even more blunt. "I have long opposed government bailouts for individuals and corporate America alike," he said. Seated a few feet away from Paulson and Ben Bernanke, the chairman of the Federal reserve, he added, "We have been given no credible assurances that this plan will work. We could very well send $700 billion, or a trillion, and not resolve the crisis." Dodd and other key Democrats have been in private negotiations with the administration since the weekend on legislation designed to allow the government to buy bad debts held by banks and other financial institutions.

• U.S. Stocks Drop in Worst Two-Day Decline Since 2002 on Bailout Concerns
• Housing Prices Tumble 5.3% in U.S. as Home Loans Become Harder to Get
• Congressional Leaders Push for Changes to Bailout Plan as Opposition Grows

A Day in the Shooting Barrel 

Administration's rescue plan hits speed bump in Congress The biggest financial bailout in American history hit a speed bump Tuesday on Capitol Hill as members of the Senate began to balk at quick action to pass the measure, saying such a massive proposal requires more careful discussion and consideration. While there was no sense that the plan, authored by Treasury Secretary Henry Paulson, was yet in peril, senators suggested at a hearing with Paulson, Federal Reserve Chairman Ben Bernanke and other top regulatory officials that the measure would not be completed by the end of the week and needed extra provisions.Senate Banking Committee Chairman Christopher Dodd said that the plan "is not going to work" in its current form. Sen. Richard Shelby of Alabama, the panel's top Republican, said the plan "is not going to be just rubber-stamped." Lawmakers grilled the two financial chiefs about the huge package and pressed both of them to include other elements such as aid for homeowners and caps on executive pay. Notes of skepticism crept into the statements of congressional leaders. But many legislators were walking a tightrope -- complaining about the plan while promising to take action. Dodd said the Paulson proposal was "stunning" in its lack of detail. "It would do nothing in my view to let a single family save a home. It would do nothing to stop a CEO from dumping billion dollars of toxic assets on the back of American taxpayers," said Dodd. "It is not just our economy at risk but our Constitution as well," Dodd said, because it would allow Paulson to spend $700 billion "with impunity." Paulson’s Testimony on C-Span, Entire Hearing (opening statements are worth listening to; a masterpiece of political theatre, posturing and disingenuousness by one of the principal agents responsible)

• Paulson Says Crisis Spreading; Delay of $700 Billion Plan Would Be `Grave'

Bernanke rides to rescue of Paulson plan The quiet unassuming professor of economics appeared just in time at the crest of the hill and rode to the rescue of the savvy Wall Street tycoon who had his wagons circled in the valley below desperately trying to hold off the opposition. Such was the story line of the extraordinary Senate hearing Tuesday examining the historic $700 billion bailout of financial firms proposed by Treasury Secretary Henry Paulson. Many Congressional hearings are carefully scripted, with both sides prepared well in advance and with the conclusion never in doubt. But other hearings, like this one, contain real drama. The hearing began with Federal Reserve Chairman Ben Bernanke and Paulson forced to listen in stony silence for an hour of withering criticism of the proposal by members of both Republicans and Democrats on the Senate Banking panel. "I haven't had a single phone call in favor of this proposal," announced Sen. Sherrod Brown, Democrat of Ohio. When Sen. Mike Enzi, Republican of Wyoming, vowed that the Paulson proposal would not pass, applause broke out in the audience. Sen. Jim Bunning, Republican of Kentucky, followed up by calling the plan "un-American." When it was the turn for the government officials to speak, Paulson fought back with a tough, take-no-prisoner statement that brought to mind the "the Hammer' nickname that he was given by his colleagues at Goldman Sachs. It didn't play very well with the senators and clearly there was a sense in the room that the plan might be in deeper trouble than expected. But then, Bernanke took the microphone, set aside his prepare remarks, and calmly laid out the benefits of the Paulson proposal in such a way that took the starch out of the opposition. A key point of the critics was that under the plan Treasury must pay more than the market value for the mortgage assets. But Bernanke explained that the mortgage securities have two prices - a "fire-sale price" if the mortgage asset was sold quickly today and a "hold-to-maturity" price if the mortgages were held to maturity. Banks have been paralyzed by this fire-sale price because their precious capital would evaporate overnight. The key to the plan, Bernanke said, was that if Treasury was able to buy the mortgages, it will be able to hold them to maturity. As a result, the fire-sale price could be avoided. This would remove uncertainty, return liquidity, and credit markets should be able to unfreeze, Bernanke said. "This is not an expenditure of $700 billion. This is a purchase of assets. If auctions are done properly...the American taxpayer will get a good value for his or her money and as the economy recovers, most, all, or perhaps more than all, of the value will be recovered over time," Bernanke said. Bernanke warned that the plan was a "pre-condition" for an economic recovery. He said there would be a severe economic downturn with no action. "I believe that if the credit markets are not functioning that jobs will be lost, the unemployment rate will rise, more houses will be foreclosed upon, GDP will contract, and the economy will not recover in a healthy way," he said. Bernanke’s Testimony on CSpan

• Bernanke Tells Congress U.S. Economy Will Shrink If Rescue Plan Not Passed

Americans Oppose Bailouts, Say Obama Would Best Handle Financial Emergency Americans oppose government rescues of ailing financial companies by a decisive margin, and blame Wall Street and President George W. Bush for the credit crisis. By a margin of 55 percent to 31 percent, Americans say it's not the government's responsibility to bail out private companies with taxpayer dollars, even if their collapse could damage the economy, according to the latest Bloomberg/Los Angeles Times poll. Poll respondents say Democratic presidential nominee Barack Obama would do a better job handling the financial crisis than Republican John McCain, by a margin of 45 percent to 33 percent. Almost half of voters say the Democrat has better ideas to strengthen the economy than his Republican opponent. Six weeks before the presidential election, almost 80 percent of Americans say the U.S. is going in the wrong direction, the biggest percentage since the poll began asking that question in 1991. After market chaos this month drove Lehman Brothers Holdings Inc. into bankruptcy and prompted federal takeovers of American International Group Inc., Fannie Mae and Freddie Mac, most survey respondents said financial companies shouldn't expect taxpayers to rush to the rescue.

Bailout battle: Where things stand The battle over the proposed $700 billion bailout of the U.S. financial system continued on Tuesday. Treasury Secretary Henry Paulson and Federal Reserve chairman Ben Bernanke defended the Bush administration's plan before the Senate Banking Committee, but new Democratic proposals have shifted the terms of the debate. Plus, some conservative Republicans have raised concern about the potential cost. The Bush administration's plan would allow the Treasury to buy up troubled assets from financial institutions. The aim is for the government to buy the assets at a discount, hold onto them and then sell them for a profit. The Democrats are considering several add-ons: They want the government to get an equity stake in the companies it helps; more assistance for those at risk of foreclosure; more oversight of the program; and curbs on compensation of executives of participating companies. Help for housing markets: Many experts are skeptical of the plan, especially in its indirect ability to help homeowners. Accordingly, the Senate Democrats' proposal would also require the government to include in the bailout proposal a separate systematic way to keep people in their homes. Democratic add-ons: Democrats have expressed concern about the lack of oversight in the Treasury's proposal. Both Sen. Dodd's and Rep. Frank's plans would create an oversight board for the Treasury program as well as regular updates on the plan's progress. Sen. Dodd would require the government to receive an ownership stake in the companies it helps. That idea would require companies who sell assets to the Treasury to give the government shares in the company.Curbs on executive pay were also proposed in the Dodd plan but not in the Frank plan. Dodd's proposal would set standards on compensation for big wigs from institutions that take advantage of the bailout, including limits on incentives and severance packages.

Non-intrusive Realities 

Cutting Back the Rescue's Price Tag In fact, there are a few reasons why the government's interventions probably won't be quite as expensive as people think. For starters, some experts say it's far from certain that the U.S. government will even need all the money it has budgeted. They say policy makers set their spending limits on the high side to make clear to investors that the government would do whatever it takes to make financial markets work again. And once the government's rescue program begins to establish prices for currently unmarketable securities, the hope is that the market will start functioning again before the U.S. actually has to buy $700 billion worth of them. Regardless of how much the government actually spends, the impact on the budget deficit will be further limited because budget rules allow the government to treat such debt as a "means of financing." Only the anticipated losses on the investments, plus interest costs, would show up as additions to the deficit. Ultimately, as Mr. Bernanke suggested, the government stands to get a lot of its money back on the securities it buys. It can sell them off or hold them as investments, depending on market conditions. Mark Zandi of Moody's Economy.com figures the government might pay out a total of $750 billion in all of its financial interventions -- about half the maximum $1.4 trillion total that has been allocated for the rescue package, the takeover of mortgage companies Fannie Mae and Freddie Mac, the bailout of insurer American International Group Inc. and the housing bill that Congress passed earlier this year -- and will be able to recover most of that. He estimates the total cost to taxpayers at no more than $250 billion, including the losses on the assets plus the interest on the government bonds that must be issued to finance the programs.

Posted by dblwyo at 12:51 PM | Permalink | Comments (0)

Well so much for the promised bailout saving the day. Hopefully you've noticed the Dow was down over 350 pts. today ? Oddly enough up until last We/Th a 350pt. day on the Dow would have gotten my adrenaline going but now...shrug. So, what's next ? That is the question, ain't it ? As usual the general reactions miss the whole point of the situation and the bailout, though fortunately the guys in charge continue to get it and do their best to do the right thing. We'll put it in context by continuing our Stalingrad analogy. We keep beating it to death, so-to-speak, for more than we like it. It's also because the relative timeline implied is probably pretty accurate.

After the break you'll find a bunch of readings to skim that totaled out at six pages just from today's news. The first section has long excerpts from some really key stuff, including Paulsen's editorial on what they're trying to do and an excerpt from his and Bloomberg's Meet the Press appearances. Also in the same section you'll find an excerpt by Ken Lewis on the future of the finance industry, from a speech he gave at the Black MBA association over the weekend. We happened to just catch it live on C-Span and tracked down the link. You'll make no better investment than listening to King Henry, Bloomie and Ken. If you think about what they're saying. We particularly liked Ken's speech because what he has to say about lack of discipline, the rushing consolidation in finance and the need for sound business models are drums we've been beating here for months. We won't bother to list the postings but if you'll skim the Finance Industry archives basically what you've got, or had, was a heck of an opportunity to make a lot of money. BtW - given how poorly the NDX has performed relative to the SPX in the last couple of weeks you could also have made a lot by going in on our negative Technology outlook. Both of which assessments during the times we made were cross-grain to the standard opinions. Among other cases where that's true. And oh yeah, as you'll read below, the Emerging Markets are really going in the crapper and  their troubles are getting worse fast. Again something we've  been flagging since Dec07 six months before the pundits were still talking them up.

Market Performances 

 The composite chart shows a 3Mo S&P on top and a YtD chart on bottom, thru last Friday so today's downturn isn't captured. What we see on the top chart was the swings low getting worse and worse, right up until the bailout rumors arrested what was looking awfully like a market collapse. Today's SPX downturn brings us well back into that down-channel. We'll have to see how it plays out.

Which gets us to the second component. Normally we disinclude the tails on our trendlines when drawing them on these candlestick charts on the theory that the body of the candles captures the main, central tendencies. In this case we added on a dotted red line to show what could have happened and what the downside risk still is.

IOHO what we're looking at is a fundamental shift in investor awareness and outlook, one that's still not completely settled in, but is nonetheless going to be increasingly important. And the reason the Stalingrad metaphor is so apt. You see while we've all been focused on the headline news what's lurking in the background is the continuing acceleration of the economic downturn, which is being ignored still. Despite the fact that we've crossed a tipping point which the present turmoil is all too likely to make worse. Some of the rest of the news excerpts will walk you thru some of the consequences from more reductions in consumer and business spending outlooks to tigether credit to the startling news that the last two major investment banks in the world converted themselves to commercial banks. On any other day that would have been earth-shattering news. Today it's, yeah, so.

Reactions and Outlooks

The reaction of blogospere commenters and authors, some media and the general public is, again IOHO, simply appalling. But given the apparent level of ignorance about how markets and economies work on the macro-scale not surprising given the level of fear and uncertainty. Where the blind rage and desire to blame anybody but them/ourselves could take us however is a very bad place. Because the popular and populist backlash could hamstring the ability to get quick passage of the bailout package. All we need to do right now is keep the wheels on the wagon, 'cause they're sure awfully wobbly. Without that bailout package we're in deep kimchee indeed. In fact we think a major reason for the downturn today was a) the fading of the relief rally as realities returned to the forefront of Mr. Market's consciousness and b) the awareness that the Congress critters are playing posturing games with the bill. The real problem is that they likely have little or no choice given the reactions of their constituencies. Let me quote Mayor Bloomberg: 

We've re-posted an earlier chart illustrating where we're at in business cycle. Like we said, we've started across the tipping point into a more severe downturn. The problem now is to get the Ebolatization of the credit markets halted so we can focus on keeping that downturn from sliding across the lower boundary into something truly painful. That is from slipping across the lower black line into the region bounded by the red one. That is the current clear and present danger...

...and too many people don't get it and aren't acting as if it couldn't happen.

Strategic Situation: King Henry, Big Ben and Ken the Jester

Ten Days Changed Wall Street as Bernanke Saw `Massive Failures'  Treasury Secretary Henry Paulson and Federal Reserve Chairman Ben S. Bernanke had been thwarted all week in their efforts to stabilize U.S. financial markets. Now, early in the evening of Sept. 18, they had a bigger fix in mind, and they went to sell it to Congress. They sat in House Speaker Nancy Pelosi's office, at a wooden conference table adorned with pink roses and white hydrangeas, surrounded by more than a dozen congressional leaders. In the previous four days, Lehman Brothers Holdings Inc. had gone bankrupt. Merrill Lynch & Co. and Bank of America Corp. had rushed into a shotgun wedding. The regulators had pumped $85 billion into American International Group Inc., nationalizing the world's biggest insurer, and were trying to thaw frozen credit markets and prevent economic catastrophe. Earlier that week, lawmakers of both parties had talked about waiting until after the November election to take legislative action. Bernanke, a scholar of the Great Depression, let them have it. ``The credit lines in the American financial system, the lifeblood of the economy, are completely frozen,'' he said, according to Senator Charles Schumer of New York, a Democrat who was in the meeting. Banks had stopped lending to each other overnight, Bernanke said. That threatened to halt all lending in the U.S., forcing businesses to close and idling workers, the Fed chief said. The Fed also was seeing money being moved out of the country. ``You could have massive failures within days,'' he told the group, and it would go beyond the banking system to ``large name- brand companies,'' according to a congressional staff member who attended the meeting and took notes. Politicians leaving the meeting said they were shocked at these portents of Armageddon from the usually understated Bernanke. They left the 90-minute meeting looking shaken, and resolved to act before the election. It was ``as sobering a meeting as any of us have ever attended in our careers here,'' said Christopher Dodd, a Connecticut Democrat and chairman of the Senate Banking Committee. Thus culminated 10 days that rattled markets worldwide and changed the structure of the U.S. financial system. Wall Street firms are shuttering or selling themselves to the most stable bidders. Regulators and lawmakers are moving toward a rescue that could cost more than $700 billion and permanently step up regulation. President George W. Bush said as much in public remarks Sept. 20. ``At first, I thought we could deal with the problem one issue at a time,'' Bush said. ``The house of cards was much bigger and started to stretch beyond Wall Street. When one card started to go, we worried about the whole deck going down.'' The meltdown reached banks on Tuesday, Sept. 16, when the London interbank overnight rate jumped 3.33 percentage points to 6.44 percent. This signaled that banks didn't trust each other enough to make 24-hour loans -- except at a premium -- and overnight more than doubled the cost of borrowing in dollars. The rate was the highest since 2001. The fear gripping the market gridlocked the financial system, including collateralized debt obligations. ``The recent intervention in the markets, nationalization of financial services companies and systemwide RTC-like bailout being crafted in Washington are disconcerting to say the least,'' said Christopher Low, chief economist at FTN Financial in New York. ``Unfortunately, there's not much choice.''

Restoring the Strength of Our Financial System - We have acted on a case-by-case basis in recent weeks, addressing problems at Fannie Mae and Freddie Mac, working with market participants to prepare for the failure of Lehman Brothers, and lending to AIG so it can sell some of its assets in an orderly manner. And this morning we've taken a number of powerful tactical steps to increase confidence in the system, including the establishment of a temporary guaranty program for the U.S. money market mutual fund industry. Despite these steps, more is needed. We must now take further, decisive action to fundamentally and comprehensively address the root cause of our financial system's stresses. The underlying weakness in our financial system today is the illiquid mortgage assets that have lost value as the housing correction has proceeded. These illiquid assets are choking off the flow of credit that is so vitally important to our economy. When the financial system works as it should, money and capital flow to and from households and businesses to pay for home loans, school loans and investments that create jobs. As illiquid mortgage assets block the system, the clogging of our financial markets has the potential to have significant effects on our financial system and our economy. As we all know, lax lending practices earlier this decade led to irresponsible lending and irresponsible borrowing. This simply put too many families into mortgages they could not afford. We are seeing the impact on homeowners and neighborhoods, with 5 million homeowners now delinquent or in foreclosure. What began as a sub-prime lending problem has spread to other, less-risky mortgages, and contributed to excess home inventories that have pushed down home prices for responsible homeowners. A similar scenario is playing out among the lenders who made those mortgages, the securitizers who bought, repackaged and resold them, and the investors who bought them. These troubled loans are now parked, or frozen, on the balance sheets of banks and other financial institutions, preventing them from financing productive loans. The inability to determine their worth has fostered uncertainty about mortgage assets, and even about the financial condition of the institutions that own them. The normal buying and selling of nearly all types of mortgage assets has become challenged. These illiquid assets are clogging up our financial system, and undermining the strength of our otherwise sound financial institutions. As a result, Americans' personal savings are threatened, and the ability of consumers and businesses to borrow and finance spending, investment, and job creation has been disrupted. To restore confidence in our markets and our financial institutions, so they can fuel continued growth and prosperity, we must address the underlying problem.

Treasury Secretary Henry Paulson & N.Y.C. Mayor Michael Bloomberg

MAYOR BLOOMBERG:  Well, I think number one, Hank's the right guy for now.  He knows what goes on on Wall Street, he understands these complex financial instruments in a ways most people do not and most Treasury secretaries do not. So if I had to have one person at the helm today, I would pick Hank Paulson. But I think you got to step back and say what's the real problem here?  There are two crises.  One is the crisis in the financial market, a lack of confidence that almost closed down the financial system this past week and that Hank has to address.  And it's up to the Treasury with the acquiescence of Congress, but to do something quickly.  And nobody knows exactly what they should do, but anything is better than nothing.  You've got to restore the public's belief and the market's belief that we will go on.  And this is not just an American problem, it's financial markets around the world that are all interlinked and they're all collapsing.  The second problem, which is up to Congress, it's a much longer-term problem and may be the genesis of the problem that we have today in the financial markets, and that is that people are losing their homes, deserted homes are destroying neighborhoods, people are losing their jobs.  We have some industries that Congress tried to protect, and instead of protecting them they've caused them to not keep up in a competitive world with new products.  We have an education system that isn't preparing us for the future, and we have a retirement system that's just not going to be there when we need it.  So there's two things here:  One you got to do quickly; one you really need a lot more thought about and that Congress should spend that time debating.  But I don't know that there's time for a lot of the debate now. You can put some safeguards in, but you don't have time to build in the safeguards that you should have for long-term.  And we're paying the price for the last years where we all wanted something for nothing, where we took risks because we were convinced that we would never have to pay, somebody else would pay on the downside, but we'd keep the profit.  Congress has been unwilling to address the fundamentals of this country--an energy policy that makes sense, infrastructure, health care, all of these kinds of things.  So you want something that overnight we can do, what Hank Paulson's been arguing for a long time. Regulation's a good example.  Our regulation in this country is designed for the world of 50 years ago.  We have separate regulation for different industries, except today those industries all do the same thing.  Also, our regulation isn't consistent with regulation around the world.  And every company, every bank, your job, my job, all our jobs depend on commerce and what happens elsewheres in the world.  And we have to find a ways to, to pull together, in Congress not have all of the different oversight committees, in the executive branch not have all the different agencies, and not just think that we're the only ones that can do this, but pull it all together. Paulson's been talking about it for a long time.  But I think it, Tom, it comes out of this instant gratification.  We all were happy when the stock market was going up, we were all happy when there was all this money sloshing around in the economy, and everybody could get a loan whether they could pay it back or not.  When companies went out and bought other companies and people got great bonuses, it was great.  And nobody wanted to say, "Wait a second, this can't go on forever."

Netcast (Sun. meet the press netcast) 

Remarks to the National Black MBA Association Kenneth D. Lewis, Chairman and Chief Executive Officer, Bank of America. Our economy is suffering from several major shocks, and one major imbalance. The shocks include rising energy prices, which are contributing to inflation; and the crash in the housing market, which led to the credit crunch, our financial crisis and upward pressure on unemployment. The imbalance is the ratio of household debt…including mortgage debt… to savings. The crash in the housing market, in hindsight, was inevitable. There were a lot of factors that played a role… think of it as a “perfect financial storm.”  Today, the greatest source of imbalance is household finance. But in past crises, the source has been too much debt leverage in the commercial sector. Either way, as you can imagine, the problem of excessive debt poses a challenge to bankers, for whom interest income is an important source of profit. The banks best able to meet this challenge are those whose business models balance interest income with fee income from services… whose consumer offerings balance loans with investments…and whose wholesale business balances credit with other services like treasury management and investment banking. This week’s events have led some to wonder if we’re close to hitting the bottom of the market. I won’t make a prediction. I will say that the industry, homeowners and investors have been through a lot of pain… and it’s not over. There’s a lot of bad debt out there that still needs to get cleaned out of the system. But it will… and in the meantime… at the risk of sounding like a contrarian… I’d like to put this situation in perspective. There are some obvious lessons learned from this episode. No asset is immune to the bubble effect – even housing. Distribution of risk is not the same as elimination of risk. Maybe most important: There are limits to the positive effects of financial leverage. The ability to increase demand through rising financial leverage can stimulate the economy. But it cannot create unlimited wealth out of thin air. Eventually, economic fundamentals always come back to remind us what’s real and what’s not. To this point, in hindsight, I’d say that the decision to lift leverage limits on investment banks earlier in the decade was, at the least, a contributor to our current situation. We’ve also had some reminders about what’s important for survival. Capital strength and liquidity are important. Diversity of assets, revenues and geography are important. And, obviously, good judgment is critical. Everyone has been hurt by the housing crisis. But good judgment has, more often than not, meant the difference between those who will survive, and those who are already among the missing. What is changing – as I said earlier – is consolidation. The industry is getting smaller. And it should. Even as the number of banks in the country has fallen by half, the financial services industry for the past 20 years has been on a rapid growth spurt. Financial stocks’ share of the market value of the S&P 500 tripled over the past 17 years. And over the past century, financial workers’ share of U.S. income quadrupled. Now, I’m the first one to defend the value that my industry adds to the economy. And much of the industry’s growth comes from exporting financial services to other countries with less-well-developed financial sectors – which, obviously, should continue. But there are limits to how fast and how much the financial industry can grow without distorting market fundamentals. And I think it’s clear that we passed those limits some time ago. So those of us in the industry need to come to terms with a more rational view of the value we add to the economy… and more humility in understanding the limits of the magical powers of finance to create economic value. The result will be fewer overall institutions... but good growth opportunities for those with broad and deep capabilities.

Ken Lewis' Speech on the Future of the Finance Industry

Charting the Outlook

What Happened, What's Next Back from the brink. The U.S. financial system last week was rocked by the biggest crisis since the 1930s -- and the federal government responded with a multi-pronged intervention that is the most sweeping since the New Deal. Over the course of just three days, Americans were shaken to see venerable investment bank Lehman Brothers Holdings file for bankruptcy protection, Merrill Lynch abruptly sell itself to Bank of America and the U.S. hurriedly launch an $85 billion bailout of American International Group, one of the world's largest insurers. Just one week earlier, the government had bailed out mortgage giants Fannie Mae and Freddie Mac. The turmoil has people worrying about the safety of their brokerage accounts, their insurance policies and even their "safe" stashes of cash -- as the problems at Lehman produced losses for investors in at least one money-market mutual fund. In the midst of the financial-industry carnage, the Dow Jones Industrial Average was down more than 8% for the week at one point midweek. But stocks soared Thursday and Friday as the government announced a massive effort to try to keep the financial system from unraveling. Key components: a plan to help financial institutions unload toxic mortgage assets and new federal insurance for money funds. How did all this happen and where do we go from here? We tackle those questions and others below: Q: Will that intervention turn things around?A: The hope is that it will prevent the crisis from spinning out of control and will thus buoy the economy. A revival of the credit markets and a bottoming of the housing market are keys to a revival. The government's debt plan may reduce the level of fear in the market, enabling the credit markets to operate properly. But such a plan wouldn't do anything about the excess supply of homes and the large number of mortgage borrowers in dire straits. Q: So what's the outlook for the economy and the stock market over the next few months?A: Housing could take many months to bottom, and then rebound, analysts say. Meanwhile, economies around the globe could weaken dramatically, something many investors aren't counting on. Still, investors shouldn't get too gloomy. The stock market's decline of about 20% from last fall's peak is close to the average fall for the market in periods of recession, notes Citigroup strategist Tobias Levkovich. "One can suggest that a bottom is near," he says. Adds Peter Brodie, director of investments at a unit of Bryn Mawr Trust: "History has shown that it is crises such as these that create the extreme pessimism required to set the stage for meaningful market recoveries -- and we feel that the resiliency of our economy will again be exhibited as we enter '09." SEC's Cox `Asleep at the Switch' as Paulson, Bernanke Encroach on His Turf

Brave new world for financial markets Before it gets a chance to embrace another round of irrational exuberance, the U.S. financial system will undergo a complete makeover. Besides the cost to U.S. taxpayers, banks will find that the cost of the moral hazard provided by the past week's massive government bailout will be more and tighter regulations. This will occur regardless of who is elected president or which party controls the Congress. Coming down the pike is nothing less than a modification of our capitalist system. You remember capitalism; it says that you are free to enter -- and free to exit -- any business you may want to. It also says that with reward comes risk. It will first be noticed on Wall Street. Now that the chasm between commercial and investment banking is all but closed, look for much more of the Street to be subject to tighter controls. Commercial banks have a conservative business model and are closely regulated, in order to safeguard people's deposits. Besides the existing regulations, look for a slew of new rules to hit the Street, starting with more transparent accounting. The regulators will want to see how much leverage these firms employ and their sources of funding, to name two items at the top of their list. Off-balance-sheet activities will come under the regulators' magnifying glasses as well. Bank regulators may also seek to limit the use of such exotic instruments as credit default swaps, collateralized debt obligations, structured investment vehicles, mortgage-backed securities and other products dreamed up by the Street's financial engineers. And speaking of mortgage-backed securities, don't be surprised if the government puts limits on how many mortgages a bank can sell. Forcing the banks to keep more of their mortgage loans on their books is a great way to ensure that they lend more carefully, going forward. Don't be surprised if investment banks return to being agents (executing trades), as opposed to owners. This, of course, will require less capital. Most commercial banks will have little trouble funding themselves. But the rewards will come down from the stratosphere.

First Wave Ripples

U.S. Stocks Slump on Speculation Financial Bailout Won't Prevent Recession U.S. stocks tumbled, led by banks, retailers and technology companies, as oil jumped 16 percent and investors speculated the Treasury's plan to buy toxic mortgage assets will fail to prevent a recession. The Standard & Poor's 500 Index lost 3.8 percent, erasing almost half of its rally over the previous two days. Sovereign Bancorp Inc., Marshall & Ilsley Corp. and Washington Mutual Inc. sank more than 21 percent, sending the S&P 500 Banks Index to a record plunge, on concern the government bailout will lower the value of mortgage loans they hold. Apple Inc. and Cisco Systems Inc. dragged down computer stocks on expectations slower growth will reduce sales. The S&P 500 retreated 47.99 points to 1,207.09. The Dow Jones Industrial Average slid 372.75, or 3.3 percent, to 11,015.69. The Nasdaq Composite Index decreased 94.92, or 4.2 percent, to 2,178.98. Six stocks retreated for each that rose on the New York Stock Exchange in floor volume of 1.3 billion shares, 45 percent below last week's average. ``They really haven't changed the economic fundamentals at all,'' said Jeffrey Coons, co-director of research at Manning & Napier Advisors Inc. in Fairport, New York, which manages $18 billion. ``We still have a debt-laden U.S. consumer facing falling employment.'' Treasury bonds and the dollar tumbled on speculation the U.S. government is spending too much to save banks after the collapse of Lehman Brothers Holdings Inc., Fannie Mae, Freddie Mac and American International Group. Heating oil, gold and copper climbed as the dollar's biggest-ever slide against the euro heightened the risk of inflation. All 10 industry groups in the S&P 500 lost at least 1 percent.

• Oil Declines as Dollar Rebounds, Paring Record Gain on End-Month Squeeze

New York Loses More Jobs, London Homes Drop as Finance Hubs Race to Bottom The London-New York tug-of-war for bragging rights as the world's preeminent financial center is now a race to the bottom. Six months after Bear Stearns Cos. was bailed out by JPMorgan Chase & Co. and a week after Lehman Brothers Holdings Inc. filed for bankruptcy, both cities are bleeding. While it will take months to determine which will be hardest hit, New York has so far lost more financial-services jobs and London's luxury housing market has taken the first hit. The market value of London's publicly traded financial firms has dropped by 99.4 billion pounds ($182.3 billion) in the past 12 months, cutting their worth by about 25 percent. Their counterparts in New York have lost $477 billion in market capitalization, or 37 percent. In New York, Vincent Alessi, general manager of Bobby Van's Steakhouse on Broad Street, says the same. ``It's tense,'' he says. ``But my bar business is doing great.''

Shaken Consumers, Wary Companies, Banks Stifle Growth, May Extend Slowdown The U.S. economy might be moving from the acute stage of the credit contagion to a chronic one. Even with hundreds of billions of dollars from Washington to keep them solvent, banks facing the prospect of more loan losses may still curb new lending. Debt-laden consumers look set to rein in spending further as job cuts take their toll. And profit-pinched companies are turning cautious on investing and hiring as the rest of the world slows. The plan the Bush administration and Congress are racing to enact is designed to alleviate the crisis in the markets rather than stimulate a sluggish economy. The credit squeeze is prompting some economists to lower their forecasts for the economy. Mark Zandi, chief economist at Moody's Economy.com in West Chester, Pennsylvania, now expects the economy to contract next quarter and in the first quarter of 2009. That would be the first recession since 2001. The consensus forecast calls for growth of 0.7 percent in the fourth quarter and 1.1 percent in the first quarter, according to a Bloomberg News survey of economists completed Sept. 9. The economists saw a 51 percent chance of a recession in the next 12 months. For all of 2008, growth is forecast to be 1.8 percent, the slowest since 2002. Analysts at Merrill Lynch & Co. said Sept. 18 that U.S. retailers may suffer their slowest holiday sales since 1991 as households grappling with higher food and fuel costs cut back. ``Consumers are starting to get the idea that they've got to de-leverage,'' says David Wyss, chief economist at Standard & Poor's in New York. Companies may also be turning more cautious. Industrial production fell in August by the most in almost three years as slower consumer spending prompted automakers to cut back. Almost half of large companies across the globe have curbed technology spending for the next year, according to Cambridge, Massachusetts-based Forrester Research Inc. Firms are feeling the pinch as earnings slow along with the economy. Third-quarter profits of the Standard & Poor's 500 companies may sink the most in seven years, according to analyst estimates compiled by Bloomberg News. Foreign sales -- until now a major source of strength for U.S. companies -- are also hurt by the fallout from the credit crisis as the U.S. slowdown seeps abroad. Japan's government said last week that its economy, the world's second-largest, is weakening. Dell Inc., the world's second-biggest personal-computer maker, said Aug. 28 that ``continued conservatism'' from some U.S. customers was spreading to Western Europe and Asia. Companies are also getting hit by dearer credit. The average yield on the most actively traded investment-grade bonds fell Sept. 19 on Washington's moves to fight the crisis, yet still stood nearly 0.9 percentage point higher than a week earlier.

Commodities Bottom as Speculators Disappear, Paulson's Plan Spurs Demand The worst may be over for commodities after the steepest rout since at least 1956 drove out speculators and the U.S. government unveiled a plan to end the worst credit-market seizure since the Great Depression. The Standard & Poor's GSCI Index of commodities had the biggest three-day gain in 18 years, surging 8.4 percent through Sept. 19, the day U.S. Treasury Secretary Henry Paulson said the government will spend ``hundreds of billions'' to cleanse banks of mortgage-related assets. Crude oil rose 6.8 percent that day, while wheat and copper gained 3.6 percent. ``What the government just did is the end game, and it's going to mean a good rally for commodities,'' said Michael Pento, a senior market strategist who helps oversee $1.5 billion at Delta Global Advisors in Holmdel, New Jersey. ``Six weeks ago, I thought it was prudent to exit most commodities. Now you want to own these things. I'm jumping in twice with both feet.'' Commodities, which had the best first half in 35 years, tumbled so far this quarter as the combination of slowing economic growth and the strengthening U.S. dollar popped the speculative bubble that drove prices to record highs. The Reuters/Jefferies CRB Index of 19 raw materials is down 22 percent since June 30, heading for the biggest quarterly loss since at least 1956, data compiled by Bloomberg show.

Wall Street’s woes are hurting emerging markets  SO MUCH for decoupling. In the wake of Lehman Brothers’ failure, emerging markets have suffered one of their biggest sell-offs in years. On September 18th Russia’s main bourses suspended trading in shares and bonds for a third day in a row after the largest one-day stockmarket fall for a decade; the central bank poured billions into big banks and the money market in a forlorn bid to calm fears. JPMorgan’s emerging-markets bond index fell by more than 5% in the week to September 16th, giving up in a few days all the gains it had made this year. Prices of Argentina’s credit-default swaps, a gauge of credit risk, rose to their highest-ever level. Unexpectedly, the People’s Bank of China cut its benchmark lending rate by 27 basis points on September 15th, to 7.2%, the first cut for six years. These actions reflected a variety of concerns, such as a darkening economic mood in China and political worries in Russia. But they all have something in common: investors may be changing their minds about emerging markets. For the past few years, China, Brazil and others, with their high growth rates and large current-account surpluses, began to seem like desirable alternatives to developed markets. For part of last year, the MSCI emerging-markets index was even trading at a higher multiple of earnings than the index of rich-world shares. That is changing as investors lose their appetite for risk. Merrill Lynch’s most recent survey of fund managers found that they are now holding more bonds than normal for the first time in a decade (indicating a flight to safety). They also have smaller positions in emerging-market equities than at any time since 2001. In the past three months, says Michael Hartnett of Merrill Lynch, emerging-market funds have seen an outflow of $26 billion, compared with an inflow of $100 billion in the previous five years. Falling oil and commodity prices are partly to blame. When these were rising, money poured into Brazil and Russia, which became targets of the “carry trade” (investors borrow in low-yielding currencies and buy high-yielding ones). Now oil prices are falling (dipping almost to $90 a barrel this week), they are undermining the carry trade and forcing Russia to prop up the rouble. Indebted investors are also being forced by their banks to sell as falling prices reduce the value of their collateral.

Fannie, Freddie Subprime Buying Spree May Add $100 Billion to Bailout Tab Freddie Mac Chief Executive Officer Richard Syron stood before investors at New York's Palace Hotel in May last year lauding his company's ``cautious'' avoidance of the subprime-mortgage crisis. What Syron, who was ousted last week, didn't say was that Freddie Mac had been gorging on subprime and Alt-A debt. While it and the larger Fannie Mae bought the safest classes of the mortgage-loan pools, Freddie's purchases totaled $158 billion, or 13 percent, of all the securities created in 2006 and 2007, according to data from its regulator and Inside MBS & ABS, a Bethesda, Maryland-based newsletter used by Federal Reserve researchers. Fannie, which was also seized by the U.S. on Sept. 7, bought an additional 5 percent. The purchases by Freddie and Fannie helped fuel the boom in lending that led to frozen credit markets, more than $514 billion in bank losses and the collapse of two of the country's biggest securities firms. The subprime overhang may determine whether the $200 billion U.S. Treasury Secretary Henry Paulson earmarked for the companies will all be used to rev up mortgage lending. He may have to spend about $300 billion…

AIG Holders Plan Meeting to Trump U.S. Rescue; Willumstad Spurns Severance American International Group Inc. shareholders, opposed to an $85 billion Federal Reserve takeover that dilutes their stakes, plan to meet today in New York City to discuss alternatives. Maurice ``Hank'' Greenberg, the former chief executive officer of the New York-based insurer and one of the biggest stakeholders, will probably be represented at the afternoon meeting, said his lawyer, David Boies, in an interview late yesterday. Attorneys for other investors contacted Boies in the past week about the gathering, he said, without naming them or saying how many will attend. Greenberg, who saw the value of the AIG stake he controls plunge by more than $5 billion this month, has said the takeover might have been avoided if AIG got a bridge loan, tapped private investors and sold assets. Greenberg sent a letter to Willumstad before the latter resigned offering to help and complaining that his earlier offers had been rebuffed.

Goldman Sachs, Morgan Stanley Become Banks, Ending an Era for Wall Street The Wall Street that shaped the financial world for two decades ended last night, when Goldman Sachs Group Inc. and Morgan Stanley concluded there is no future in remaining investment banks now that investors have determined the model is broken. The Federal Reserve's approval of their bid to become banks ends the ascendancy of the securities firms, 75 years after Congress separated them from deposit-taking lenders, and caps weeks of chaos that sent Lehman Brothers Holdings Inc. into bankruptcy and led to the rushed sale of Merrill Lynch & Co. to Bank of America Corp. Goldman, whose alumni include Henry Paulson, the Treasury Secretary presiding over a $700 billion bank bailout, and Morgan Stanley, a product of the 1933 Glass-Steagall Act that cleaved investment and commercial banks, insisted they didn't need to change course, even as their shares plunged and their borrowing costs soared last week. By then, it was too late. As financial markets gyrated --the Dow Jones Industrial Average whipsawed 1,000 points in the week's last two days -- and clients defected, executives at the two firms concluded they had no choice. The Federal Reserve Board met at 9 p.m. yesterday and considered applications delivered that day, said Michelle Smith, a spokeswoman for the central bank. The decision was unanimous, she said. The announcement paves the way for the two New York-based firms, both of which will now be regulated by the Fed, to build their deposit base, potentially through acquisitions. That will allow them to rely more heavily on deposits from retail customers instead of using borrowed money -- the leverage that led to the undoing of Bear Stearns and Lehman.

Ford, Dow execs to announce national summit in '09 Amid the turmoil on Wall Street, leaders from two global companies hard hit by economic and industrial upheavals are expected to unveil plans Monday for a national convention being held next year to discuss the future of manufacturing, technology, energy and the environment. Ford Motor Co. Executive Chairman Bill Ford and Dow Chemical Co. Chairman and Chief Executive Andrew Liveris were scheduled to announce The National Summit after the Detroit Economic Club meeting Monday. The nonpartisan, nonprofit group is convening the summit, which is set for June 15-17 at Ford Field, the home of the Detroit Lions.Beth Chappell, the economic club's CEO, said the idea grew out of listening to leaders who have addressed the venerable speakers' forum during the past couple years. "So many speakers from the platform have this call to action ... and the themes -- technology, energy, environment and manufacturing -- kept coming up over and over again," she said. "This is not about Detroit, this is not about Michigan and this is not about automotive. It's cross-country and cross-industry." Ford and Liveris will serve as the summit's co-chairmen. Ford is the economic club's outgoing chairman, and General Motors Corp. Chairman and CEO Rick Wagoner succeeds him on Monday. Organizers hope the first-of-its kind U.S. gathering, which they say has received sponsorship pledges of more than $2 million from more than 50 organizations, will draw as many as 5,000 leaders and others from business, government and academia. The speaker lineup hasn't been announced, but companies planning to take part include GM, Chrysler LLC, IBM Corp., AT&T, Motorola Inc., Deloitte LLP and Masco Corp. Liveris, who is scheduled to give Monday's keynote address to the economic club about the need for a national, comprehensive industrial policy, has been vocal about industry troubles and the effect on the Midland-based company he leads. Dow this year has announced two sets of wide-ranging price increases in an attempt to offset record costs for energy and raw materials.

Responses, Reactions, Realities ?

Mad as hell - taxpayers lash out "NO NO NO. Not just no, but HELL NO," writes Richard, a reader from Anchorage, Alaska."This is robbery pure and simple," Anna from Denver posted on CNNMoney.com's TalkBack blog this weekend. "It's our money! Let these companies die," added Claudio from Plainville, Conn. After President Bush petitioned Congress Saturday for the authority to spend up to $700 billion to to bail out a financial industry on the verge of collapse, he said the high price tag was not only justified, but essential. But when asked what they thought of the government's proposal, most readers gave an overwhelming thumbs down. "I'm tired of rewarding institutions and people for the bad decisions they have made," said Dean from Madison, Wis. "Sure, it will hurt tax payers if/when some of these institutions fail, but perhaps we need to let that happen. We do not need more big government involved in our lives. Enough is enough." Readers focused most of their indignation on having to foot the bill for irresponsible lenders and borrowers. "Companies, like individuals, should be held responsible for their decisions," wrote Jorge from El Paso, Texas. "This buyout does not address the other problems in the pipeline such as personal credit default and market slowdowns in most industries. No new jobs will be created." Some readers said it was time for the politicians who support the bailout to get the heave-ho come November.

"I will be watching to see which of our representatives vote for this bailout," said R. Kidd in Troy, N.C. "Let the American people see how many we can fire come election time." And many readers, including Danny from Texas said we should stop typing and start dialing the lawmakers who are prepared to give the OK to the bailout. "Call your Congressman. Stop blogging, posting comments, and call your congressman. This is the patriotic thing to do. Let them hear your opinion, show them this is still America and that you will not stand for this!!" But not all readers agreed. Some thought the bailout was an unfortunate but necessary move to rescue our financial system from collapse. For instance, Bill from St. Louis said he changed his mind about the bailout when he realized the consequences of doing nothing. "I was opposed to the bailout at first, but realized that the scope of this thing is global and so massive that the entire global economy could collapse if nothing was done. ...The priority has to be resolving the present crisis of confidence in our economy. Remember, if Wall Street collapses, Main Street will go with it." Andy from Chicago said the cost to the taxpayer will not be what the headline number makes it seem. "This money is not a handout to companies. It's simply giving banks and mortgage companies loans, since the banking system itself is too unstable to raise this kind of capital. And no, the government cannot just use the $700 billion to pay back all the citizens that will be hurt by this. If the companies like AIG fail, the cost will be far far greater than $700 billion. Wake up!!"

Could your employer be the next Lehman? Here's what to do As the Lehman saga reminds us, it doesn't take much bad news these days to sack your employer. When you pick up bad signals on your antennae, be prepared. Don't put your head in the sand. Especially in bad times, when people sense trouble, there's a tendency to look the other way or trust the first thing they hear if it's what they want to hear. Laura asked her manager about the lawsuit, heard a reassuring answer, and didn't look further. Better to ask more questions, do independent research, and monitor industry news and sources. You still may not find out much, but it starts the rest of the preparing process. "Don't be afraid -- take charge, starting now," she said. Realize those closest may not be in the know. If Laura made a mistake, it was in trusting her first-line management. In hindsight, she said, she feels they weren't being dishonest but instead were probably not aware themselves. It's tricky. You don't want to be a nuisance or bypass channels too much. But still, make a few phone calls, keep an ear to the grapevine. It's your career. You have a right. Try to line up another job. Just in case, and it never hurts. Like buying that generator before the hurricane, it'll be easier if you've made your contacts before the job denouement. And you just may find something better. If you get reprimanded for doing this you might not be working in the right place anyway. Take care of your customers. Again, cold turkey, no pay? Laura could have simply walked away. But she spent two unpaid weeks finishing delicate escrow transactions that would be tied up for weeks otherwise. The goodwill helped her bring regular realtor clients along to the next job. When you're facing your own turmoil, this one's easy to forget, but important.

Dodd: Congress must be careful with financial mess Leading congressional Democrats called Monday for a cautious, deliberative approach to stabilizing troubled financial markets as lawmakers confronted this vexing issue with an election-year recess drawing near. Senate Banking Committee Chairman Christopher Dodd voiced confidence in Treasury Secretary Henry Paulson, saying that "we've got the right man" to deal with the problem that has roiled not only Wall Street but international markets as well. But his counterpart in the House, Rep. Barney Frank, accused Paulson of pushing Congress to move too hastily. Dodd, D-Conn., said Monday morning that there will be a division of thought in Congress about how best to proceed on a $700 billion bill the Bush administration is seeking from lawmakers to buy up bad mortgage loans that have been weighing down financial companies since they became engulfed in a severe credit crisis 14 months ago. Meanwhile, the Group of Seven, an organization of the world's leading economic powers, pledged Monday to do all it could to help ease the crisis. The group said in a conference call that it welcomed the extraordinary steps the United States has taken so far. Frank, chairman of the House Financial Services Committee, said that Paulson "is being entirely unreasonable" to expect that Congress will pass a bill right away without examining the proposal thoroughly and adding certain provisions the Democrats want, such as limiting pay for executives of the troubled companies in need of the bailout. "We want to limit those as a condition for giving them aid," Frank, D-Mass., told ABC's "Good Morning America." "If Secretary Paulson would agree to that, we could move quickly." Rep. Christopher Shays, R-Conn., who also serves on the panel, said members "need enough time to debate this" and echoed Frank's concerns about executive pay. "We don't have these great golden parachutes and so on. In the end we're doing it for the taxpayers." Frank said that lawmakers "are building strong oversight" into the measure, including establishing an oversight board that will report to Congress at least monthly. "The private sector got us into this mess," Frank said, "The government has to get us out of it. We do want to do it carefully."

McCain still seeking firm footing on crisis With just four days until the first presidential debate and just 42 days until the November 4 election, Senator John McCain is still feeling for his footing on the financial crisis that seems likely to consume the rest of the presidential campaign. A McCain aide told reporters last night that the Republican nominee would distance himself from Treasury Secretary Henry Paulson’s trillion-dollar bailout plan, saying it lacks “oversight.” And McCain in a “60 Minutes” interview Sunday Night floated the name of Andrew Cuomo, the confrontational Democratic New York attorney general, as the chairman of a tough new Securities and Exchange Commission. The Sunday night proposals were the latest in a series of attempts by McCain to draw a dramatic contrast between himself and President George W. Bush as the campaign appeared to shift decisively away from his chosen turf of culture wars and national security, and toward the economy. Obama, for his part, will have a final chance this week to duct tape McCain to the economic crisis and an unpopular president, and bury him in the flood of bad economic news. But as McCain tries to regain his grip on the campaign narrative, and Obama adopts a more reserved posture his campaign hopes appears “presidential,” both men are struggling with their sheer irrelevance to the fast-moving wrangle between the White House, Congress, and the turbulent stock markets. “The events are bigger than the candidates,” said Phil Singer, a former aide to Hillary Clinton.

• Obama calls financial bailout price tag "staggering"

Posted by dblwyo at 08:24 PM | Permalink | Comments (0)

Well sorry we skipped a day but things got a little distracting. Feeling sorry for myself running without more than three hours/night monitoring Armageddon - my portfolio, not the markets, I mean. Now imagine how the guys doing the real work feel - they've been running that way for months and the last two weeks have taken up the intensity levels to where they must feel like Stalingrad would be a better alternative. Speaking of which we'll take back our comparison - we're not on our way to Kursk, though that'll come. The enemy got new supplies and staged a major counter-attack, broke thru our lines and threatened to devastate our rear-area and throw us back instead. We'll illustrate what we mean by that but let's start with a little dark humor, in the context of things. Don't know if you can make it out so click on the picture and watch the bear get shot out of the tree and bounce off the trampoline. Pretty funny but maybe not entirely accurate. Here's an alternate version with soundtrack and replays and a complementary version of the drunken bear out for a walk. More accurate we'd say and even funnier.

At this point if you're reading this your probably aware that we've had a second "interesting" week in a row but you may not know how interesting. We'd like to read you into the picture, address some of the badly mistaken memes floating around, especially in the blogosphere, and talk a bit about both emergency policy choices & politics and the outlook. We'll save a deeper dive on that for the future though. Unfortunately to tell you why the memes are wrong we need to scare you to death first which will also help you understand the policies and politics as well.

Market Breakdown

The market chart is a composite showing the Dow over two 5-day periods, F-Th and M-F. Up until Th around 3pm the decline in the markets appeared to be accelerating. Good for those of us with bear bets though we ended the week where we'd started, dead on breakeven. If you were just getting here from Mars or farther you'd think nothing had happened last week. Instead of the biggest changes in the US and world financial system since the 1930s. The Dow broke thru 10,500, or -8%, and was accelerating lower. Armageddon indeed until the 3pm news/rumors of a major systemic bailout got out and saved the day and created a gap up on Fri. Notice that after the gap the markets went nowhere. The real problem wasn't in equities though - it was in the credit markets.

 This next composite chart shows you what happened AFTER the world's central banks coordinated a major injection of fund after the takeover of AIG. The 3Mo Treasuries, normally running along with the other short-term rates around ~2%, dropped to ~0%. That's a market collapse rate and came about as funds were pulled from everything and put into the shortest term Treasuries. The good news is that at least everybody thought they'd still work - consider the alternatives to that ! Now these charts may be a little dry, abstract and academic. Let's try and bring it home with a more evocative and emotionally convincing comparison. This next picture is taken from the 1995 movie Outbreak and convey exactly what happens when a case-by-case approach (LEH, MER, AIG, ...) suddenly breaks down into metastasis and turns into a contagion.

 Any questions - 24 hrs, 36 hrs, 48 hrs, kaboom ! Well the lockdown of the credit markets was freezing about that fast and the stakes were, and are, are about as serious as it gets. Are you scared yet ? You should be ? There's a huge outpouring of teeth-gnashing in the blogosphere about socialism for the rich and nothing for the normal folks. Let me tell you - we were all going to be starving in dark and soon if this had spread. This wasn't socialism this was courageous and imaginative performance to the highest standards of public service under enormous pressures and terrible conditions. Be glad these people are smart, skilled and have big brass ones. This is what we mean when we say systemic risk ! Get it now ?

 Burn the Witch, Burn the Witch

One of the other memes making the rounds is that this is somebody's fault and the witch hunters are out in force looking for the guilty to hang. Now don't get me wrong, there's plenty of blame to go around and some very senior and responsible people made some really stupid decisions in the name of greed and hubris. And are paying the penalties. The evil Greenberg, he of the founding of AIG who laid the groundwork for that company's devolution and implosion lost $14B in 24 hrs. Lots of folks suffered and are suffering similar levels of impact. Nor are these bailouts. The proposals on the table will be buying up bad assets to be sure but for mils (= $.00001) on the dollar; even if they're only re-sold eventually for pennies and our return as taxpayers is pennies, our returns will be in the orders of magnitude. Not to mention we get to keep a functioning economy. Everybody's criticizing the dancing bear for how badly it's dancing instead of appreciating the miracle of it being able to dance at all. Nor are anybody's hands particularly clean. Yeah there were regulatory breakdowns but at every link in the chain nobody held a gun to anyone's head and forced them into making greedy and stupid decisions. There's a legal doctrine called last clear chance - who had the last clear opportunity to prevent a disaster. Lots of folks. And you can't regulate away greed, stupidity or humanity. Bear that in mind.

What we need at this point is to keep the wheels on the little red wagon and keep them turning so we have a shot at slowly and painfully working our way out of this mess. The way to judge the politicians and other commentators is not by their finger-pointing and witch-hunting fervor but by their constructive contributions. So far the track record is poor to worse. 

On the other hand the single worst track record and most directly responsible parties are "we, the people". First off those directly involved who made stupid and greedy decisions at every step in the chain of co-dependents. And second all of us who indirectly benefited by consumtion being articially propped up by the Housing ATM so we could all buy more than we could afford. If you'd really like to see real socialism run with this decision that this is all somebody else's fault, nobody is self-responsible and we should burn the witches instead of fixing the problem.

We got ourselves into this mess by tolerating these behaviors, encouraing the systemic leveraging of greed and now are about to repeat the same mistakes in reverse by going with the loudest and easiest to grasp but mistaken correctives. Congratulations - if you keep doing the same things you get the same outcomes as they say. 

Events of the Week 

S&P 500 Plunge Since October Erases 50% of Gain From Five-Year Bull Market The Standard & Poor's 500 Index's 26 percent drop since its October peak erased half of the gains from the five-year bull market and may signal more declines. The benchmark index for American equities, which doubled to 1,565.15 on Oct. 9, 2007, from 776.76 five years earlier, plunged 4.7 percent yesterday after the collapse of Lehman Brothers Holdings Inc. and the government takeover of American International Group Inc. pushed credit costs higher. The drop to yesterday's close of 1,156.39 may point to more losses, because so-called retracements of more than 50 percent typically precede further declines, according to some traders who look at historical prices and charts to make decisions. ``You could get some rally, but I don't think you've made a low,'' said John Roque, a managing director in technical analysis at Natixis Bleichroeder Inc., a New York-based investment bank. ``The whole way down we've consistently seen lower highs and lower lows, and that pattern has yet to be broken.'' Some investors say the market has fallen far enough. The S&P 500 surged 4.3 percent to 1,206.51 today, staging the biggest advance since October 2002, on prospects the government will formulate a ``permanent'' plan to shore up financial markets, while regulators and pension funds took steps to curb bets against banks and brokerages. The S&P 500 tumbled 7.6 percent this week after the government seized AIG and Lehman sought protection from creditors. Writedowns and losses at the biggest banks and financial institutions from the collapse of subprime mortgages and the first nationwide decline in U.S. home prices since the 1930s exceed $500 billion, fueling the almost yearlong retreat by the stock market. Financial companies led the tumble, losing 49 percent as a group in the S&P 500. The S&P 500 surged almost sevenfold from 223.92 to 1,527.46 between Dec. 4, 1987, and March 24, 2000. Once the index posted a 50 percent retracement by falling below the midpoint of 875.69 in July 2002, it took less than three months to reach a low. Once the gains began, they proved short-lived. After the S&P 500 jumped 21 percent between Oct. 9 and Nov. 27, 2002, it plunged 15 percent through March 11, 2003.

Crisis Endgame The story so far: the real shock after the feds failed to bail out Lehman Brothers wasn’t the plunge in the Dow, it was the reaction of the credit markets. Basically, lenders went on strike: U.S. government debt, which is still perceived as the safest of all investments — if the government goes bust, what is anything else worth? — was snapped up even though it paid essentially nothing, while would-be private borrowers were frozen out. Thus, banks are normally able to borrow from each other at rates just slightly above the interest rate on U.S. Treasury bills. But Thursday morning, the average interest rate on three-month interbank borrowing was 3.2 percent, while the interest rate on the corresponding Treasuries was 0.05 percent. No, that’s not a misprint. This flight to safety has cut off credit to many businesses, including major players in the financial industry — and that, in turn, is setting us up for more big failures and further panic. It’s also depressing business spending, a bad thing as signs gather that the economic slump is deepening. And the Federal Reserve, which normally takes the lead in fighting recessions, can’t do much this time because the standard tools of monetary policy have lost their grip. And there’s a lesson there for those ready to hear it: government takeovers may be the only way to get the financial system working again. Some people have been making that argument for some time. Most recently, Paul Volcker, the former Fed chairman, and two other veterans of past financial crises published an op-ed in The Wall Street Journal declaring that the only way to avoid “the mother of all credit contractions” is to create a new government agency to “buy up the troubled paper” — that is, to have taxpayers take over the bad assets created by the bursting of the housing and credit bubbles. Coming from Mr. Volcker, that proposal has serious credibility.

• Gold Coins, Bullion Sales Climb as Investors Seek Shelter From Turbulence
• Putnam, Mellon Spur `Oh, My God' Withdrawals as Money Market Looks Unsafe
• U.S. Treasury Outlines $50 Billion Plan to Back Money-Market Mutual Funds

A2/P2 Spreads Blowout Here is the A2/P2 spread from the Fed's commercial paper report. The A2/P2 Spread hit 280bp yesterday. This is literally off the chart compared to any previous period. 30-day A2/P2 Spread Graphic

Pain Spreads as Credit Vise Grows Tighter The latest outgrowth of the housing crisis, the breakdown on Wall Street, threatens to gradually corrode economic activity on Main Street, mainly by disabling the credit on which so many everyday transactions depend — but also by frightening people. Lenders of all types had already been raising the bar for borrowers, turning away all but the best customers. This week, they became even less willing to part with their money, further crimping budgets and family spending.An economy propelled by easy credit for more than a decade is fraying as credit disappears. American Express, to take one striking example, is reducing the maximum credit limit for half of its tens of millions of cardholders. The credit shock is in some ways reminiscent of the 1973 oil embargo, which “came into people’s lives right away,” said Andrew Kohut, director of the Pew Research Center, the public opinion pollster. Then, Americans were forced to line up for gasoline and turn down their thermostats in winter. Though less visible, the credit squeeze, if it persists, will force businesses and consumers to cut spending more than they already have.“We have moved into a decline in consumer spending, which normally happens only in a major recession,” said Ethan Harris, chief domestic economist at Lehman Brothers. He calls the experience “a slow-motion recession in which economic growth will be near zero for an extended period of time.” Consumer spending accounts for two-thirds of American economic activity and has been slowing as the value of homes falls. Although the economy is not yet in a formal recession, consumer spending in June and July grew only because consumers paid more for the same goods. After factoring in higher prices, they actually bought less.

Terror Attack on US Financials? Details of SEC Short Ban Last night, we discussed the absurdity of banning all short sales. The details of the SEC action have been released (see below). The specifics are a "temporary halt in short selling in 799 financial institutions" until October 2nd.  I have been trying to contextualize this, and I keep coming back to what seemed like a wild theory yesterday that seems a whole lot less wild today. During the day, I had an interesting phone conversation with Joe Besecker of Emerald Asset Management. (We used to do schtick together on Power Lunch, and made for an amusing financial comedy team).  But Joe is a good money manager, a great stock picker, and a thoughtful guy. He raised an intriguing issue: None of the many hedgies he knew were pressing their bets recently. The bear raids on the banks and brokers were NOT a case of piling on by US based hedge funds. And from what he was seeing and hearing about in terms of order flow, the vast majority of the financial short selling the past week or so were being done overseas. It appears that the lion's share of shorting was coming out of overseas bourses such as London and Dubai.It may not be a coincidence that the financial short selling ban is both here and in London. Then there is another coincidence: The huge increase in shorting of the financials occurred on the anniversary of 9/11. And on top of that, the same institutions attacked on 9/11/01 were the ones suffering in recent days. Joe asked the question: Is anyone investigating whether this is a case of financial terrorism? He wanted to know if someone was at least looking into this question (Joe is buds with Jim Cramer, and mentioned it to him, who then omitted to cite in his column that this was Joe's theory, not his own).  Anyway, its an interesting theory, one that seemed kinda out there -- until last night's emergency action. Nothing else really explains the insanity of banning short sales -- except for Joe Besecker's questions. I can think of 3 possibilities:  1) Extreme idiocy and incompetence -- not unthinkable fom the gang that couldn't shoot  straight in DC thse days; 2) Following the impetuous Fannie/Freddie rescue, the timing of this certainly has political overtones. We will see if it gets extended a month from October 2nd to November 5th.  3) Some other factor, possibly financial terrorism.
SEC: Ban All Short Selling

Self-Inflicted Wounds

Roger Cohen: The King Is Dead The leverage party’s over for the masters of the universe. Shed a tear. When you trade pieces of paper for other pieces of paper instead of trading them for real things, one day someone wakes up and realizes the paper’s worth nothing. And Lehman Brothers, after 158 years, has gone poof in the night. We’re witnessing the passing of more than a venerable firm. We’re seeing the death of a culture. For years, accountants, rating agencies and Wall Street executives decided to shoot craps and collect fees. Regulators, taking their cue from a distracted President Bush, took a nap. The two M’s — Money and Me — became the lodestones of the zeitgeist, and damn those distant wars. The biggest single-day market drop since 9/11 reminded me that when trading reopened on Sept. 17, 2001, and the Dow plunged 684.81 points, some executives backdated their options to reprice them at this postattack low to increase their potential gains. So that’s what “financial killing” really means. No better illustration exists of a culture where private gain has eclipsed the public good, public service, even public decency, and where the cult of the individual has caused the commonwealth to wither. That’s the culture we’ve lived with. It’s over now. Some new American beginning is needed.

• Freakonomics: Diamond and Kashyap on the Recent Financial Upheavals

Vintage Whine Accounting rules and short-sellers didn't sink A.I.G. A.I.G sunk itself. The markets are inundated with zombie myths. No matter how many times you stab them through the heart, you just can't kill them. What's taking down these grand financial icons such as Lehman and A.I.G.? It couldn't possibly be that the companies themselves made stupid and shortsighted decisions. So it must be a conspiracy of the short-sellers. It must be some wrong-headed accounting rules and bad regulation. In the wake of the demise of A.I.G., we are hearing them again. If only the insurer didn't have to mark its positions to market, this foolishness would have been avoided and we'd all be celebrating how wonderful the economy is. The S.E.C. has rushed to put up restrictions against short-selling again. For several years, A.I.G. dove headfirst into an insurance-like product called credit default swaps. It wrote hundreds of billions worth of protection mostly on the top slice of mortgage-backed structured financial products. Short-sellers and accounting rules didn't cause A.I.G. to enter the C.D.S. protection business. Each time the company wrote one of those contracts, a grain of sand should have dropped to the bottom of the hourglass until an A.I.G. risk-management official said: "Enough. You can't write anymore." But that didn't happen. Short-sellers and accounting rules didn't make the company put little-to-no capital against these positions. Back when A.I.G. started writing these contracts, the credit-ratings agencies rated the insurer Triple A. Accounting rules didn't prevent the ratings agencies from re-assessing the rating before the crisis. And while it may be hard to believe, short-sellers did not stick their voodoo dolls with their "Maintain the Triple A Rating Until It's Too Late" pins. A.I.G. got into something it didn't understand and didn't protect itself properly. The market-based watchdog—the rating agencies—failed to assess its risk properly. In the market panic, A.I.G.'s counterparties acted rationally to demand more cash, their actions having nothing to do with accounting rules. And the buyers balked.

Ex-SEC Official Blames Agency for Blow-Up of Broker-Dealers The SEC allowed five firms — the three that have collapsed plus Goldman Sachs and Morgan Stanley — to more than double the leverage they were allowed to keep on their balance sheets and remove discounts that had been applied to the assets they had been required to keep to protect them from defaults. Making matters worse, according to Mr. Pickard, who helped write the original rule in 1975 as director of the SEC's trading and markets division, is a move by the SEC this month to further erode the restraints on surviving broker-dealers by withdrawing requirements that they maintain a certain level of rating from the ratings agencies. "They constructed a mechanism that simply didn't work," Mr. Pickard said. "The proof is in the pudding — three of the five broker-dealers have blown up." The so-called net capital rule was created in 1975 to allow the SEC to oversee broker-dealers, or companies that trade securities for customers as well as their own accounts. It requires that firms value all of their tradable assets at market prices, and then it applies a haircut, or a discount, to account for the assets' market risk. So equities, for example, have a haircut of 15%, while a 30-year Treasury bill, because it is less risky, has a 6% haircut. The net capital rule also requires that broker dealers limit their debt-to-net capital ratio to 12-to-1, although they must issue an early warning if they begin approaching this limit, and are forced to stop trading if they exceed it, so broker dealers often keep their debt-to-net capital ratios much lower. In 2004, the European Union passed a rule allowing the SEC's European counterpart to manage the risk both of broker dealers and their investment banking holding companies. In response, the SEC instituted a similar, voluntary program for broker dealers with capital of at least $5 billion, enabling the agency to oversee both the broker dealers and the holding companies. This alternative approach, which all five broker-dealers that qualified — Bear Stearns, Lehman Brothers, Merrill Lynch, Goldman Sachs, and Morgan Stanley — voluntarily joined, altered the way the SEC measured their capital. Using computerized models, the SEC, under its new Consolidated Supervised Entities program, allowed the broker dealers to increase their debt-to-net-capital ratios, sometimes, as in the case of Merrill Lynch, to as high as 40-to-1. It also removed the method for applying haircuts, relying instead on another math-based model for calculating risk that led to a much smaller discount. The SEC justified the less stringent capital requirements by arguing it was now able to manage the consolidated entity of the broker dealer and the holding company, which would ensure it could better manage the risk.
How SEC Regulatory Exemptions Helped Lead to Collapse

How Wall Street Lied to Its Computers  So where were the quants? That’s what has been running through my head as I watch some of the oldest and seemingly best-run firms on Wall Street implode because of what turned out to be really bad bets on mortgage securities. I called some old timers in the risk-management world to see what went wrong. I fully expected them to tell me that the problem was that the alarms were blaring and red lights were flashing on the risk machines and greedy Wall Street bosses ignored the warnings to keep the profits flowing. Ultimately, the people who ran the firms must take responsibility, but it wasn’t quite that simple.In fact, most Wall Street computer models radically underestimated the risk of the complex mortgage securities, they said. That is partly because the level of financial distress is “the equivalent of the 100-year flood,” in the words of Leslie Rahl, the president of Capital Market Risk Advisors, a consulting firm. But she and others say there is more to it: The people who ran the financial firms chose to program their risk-management systems with overly optimistic assumptions and to feed them oversimplified data. This kept them from sounding the alarm early enough. Top bankers couldn’t simply ignore the computer models, because after the last round of big financial losses, regulators now require them to monitor their risk positions. Indeed, if the models say a firm’s risk has increased, the firm must either reduce its bets or set aside more capital as a cushion in case things go wrong. In other words, the computer is supposed to monitor the temperature of the party and drain the punch bowl as things get hot. And just as drunken revelers may want to put the thermostat in the freezer, Wall Street executives had lots of incentives to make sure their risk systems didn’t see much risk. “There was a willful designing of the systems to measure the risks in a certain way that would not necessarily pick up all the right risks,” said Gregg Berman, the co-head of the risk-management group at RiskMetrics, a software company spun out of JPMorgan. “They wanted to keep their capital base as stable as possible so that the limits they imposed on their trading desks and portfolio managers would be stable.”

 Outlook and Response

Fear Returns to the Markets The watchword during much of the current sell-off has been complacency. We had major denial as to the breadth and depth of the problem. Remember back when Housing issues were "contained?" Do you recall that sub-prime "did not matter?" That the "Goldilocks economy" was just fine? Those phrases will go down in history as aphorisms of the clueless, excuses by those who should have known better. Hopefully, someone will hold the perma-bulls, the money-losers, the idealogues, accountable. Meanwhile, as the market panic has now increased to palpable levels, creating a tiny ray of hope: Fear has returned. As the VIX chart below shows, there is some measure of panic. We have now spiked above all of the recent panics of the past 2 years -- but not nearly as much as we have seen in the 2,000, mid-2001, and 9/11. Those 3 prior panics set up the 2002/03 lows 2 years later. The only question for traders is whether or not this sell off is closer to the ones seen over the past 2 years (in which case you can buy 'em here) or more like the 2000- 03 period (in which case we have more selling to go).

• US Financial Crisis: 'The World As We Know It Is Going Down' (Der Spiegel !!)

Worst is yet to come, investment strategist warns An influential investment strategist has a dire forecast for U.S. stocks, credit markets and the continued independence of some of the nation's top financial institutions. Jeffrey Gundlach, chief investment officer at Los Angeles-based mutual-fund company TCW Group Inc., told clients on a conference call late Wednesday that the crisis in credit and housing may not abate for several years and is actually getting worse. In the deteriorating climate he sees unfolding, Gundlach said, the Standard & Poor's 500 Index could fall another 30%, giant Citigroup could become an "AIG-sized debacle," Morgan Stanley would merge with a banking company, Wachovia won't be able to stand alone, default rates on even prime mortgages could soar, and European banks' woes are just beginning. Gundlach based his assessment on a belief that housing prices still face several more years of decline, a protracted slump, he said, not seen since the Great Depression. Moreover, Gundlach said it's possible that home prices could be sluggish until 2022. As a forecaster, Gundlach didn't just climb aboard the gloom-and-doom wagon. He was early to spot the cracks that subprime loans were making in the financial system, and among the first to warn that an era of easy money would come to a bad end. And Gundlach has put his shareholders' money where his mouth is, shunning derivatives and counterparty risk in his bond fund portfolio. That defensive posture should offer protection in the continuing credit storm that Gundlach foresees. In this bleak scenario, an unprecedented -- and growing -- number of home foreclosures, along with mortgage loans that are under water as soon as they're originated and a glaring lack of buyers for even modestly risky assets keeps the financial system under enormous stress.

What would a New Government Entity Look Like?  It appears Paulson and Bernanke are promising to work through the weekend on a comprehensive crisis plan. And the NY Times reports that lawmakers hope to complete the legislation by the end of next week.
But what will the plan look like? First, the goal of the plan is to help recapitalize the banks and keep them lending. Once again the credit markets are frozen, and all indicators of stress are at or near record levels (like the TED spread). It appears even credit worthy borrowers are having difficulties obtaining loans. A number of observers have been comparing the new entity to the Resolution Trust Corporation (RTC). However this new entity would be very different from the RTC in a number of ways. The RTC was created to dispose of assets accumulated from failed Savings & Loans. The new entity, according to the WSJ, would purchase illiquid assets "at a steep discount from solvent financial institutions and then eventually sell them back into the market". With the RTC, the government already had direct responsibility for the assets since they acquired them from insured S&Ls that had failed. The role of the RTC was to liquidate certain of these assets. In the current situation, the government has no financial responsibility for the assets, except for a few exceptions like the assets of Fannie and Freddie, and the NY Fed's assets acquired in the JPMorgan / Bear Stearns deal. The new entity will both buy assets "at a steep discount" and eventually sell the assets. So unlike the RTC, this new entity puts the taxpayers at risk. Paulson Plans to Cleanse Companies of Troubled Assets, Insure Market Funds, Fed and Treasury Offer to Work With Congress on Bailout Plan

• Domino Effect of Takeovers Pushes Bernanke, Paulson to Work With Congress
• The Players Remaking Financial World

Schwarzman Raises the Bar, Buffett Wields Cash in Distressed-Assets Glut Bankrupt Lehman Brothers Holdings Inc. and government-seized American International Group Inc. top the list of distressed sellers seeking buyers for at least $1 trillion of assets. So far, bargain hunters aren't biting. The same uncertainty that erased $3.1 trillion from global stocks in the first four days of this week has all but paralyzed the market for unpaid corporate debt, non-performing mortgages, degraded securities and repossessed real estate. Before takeovers are pursued that help troubled companies bolster capital and pay off creditors, hedge funds and buyout firms that have raised $163 billion this year face roadblocks such as a lack of financing. ``We're raising the hurdles for putting money out there because there are going to be increasingly better opportunities,'' Blackstone Group LP Chief Executive Officer Stephen Schwarzman said in an interview. ``You're most aggressive when you're coming off the bottom.'' Treasury Secretary Henry Paulson, Federal Reserve Chairman Ben S. Bernanke and members of Congress pledged yesterday to fill the void by moving bad debt to a government institution that would sell it. ``The goal of that would be to assure people that there is a way to price the assets,'' said Neal Soss, chief economist at Credit Suisse Holdings USA Inc. in New York. ``Then private investors would gain courage and come back more actively in the markets.''  The winners from Lehman's bankruptcy and AIG's government bailout will be investors such as billionaire Warren Buffett who can buy without borrowing and, in some cases, afford to hold onto their purchases for as long as five years without cashing them in, said Thomas Priore, chief executive officer of New York-based ICP Asset Management, which originated and oversees $13 billion in collateralized debt obligations. Buffett's Omaha, Nebraska-based Berkshire Hathaway Inc. has been involved in eight acquisitions since October, including yesterday's $4.7 billion purchase of Constellation Energy Group Inc. in Baltimore. That compares with six in the previous 12 months, when Berkshire's largest acquisition cost $350 million. The deals were possible because the company had cash on hand totaling $31.2 billion at the end of June. ``The ability to raise capital, no matter who you are, has changed dramatically,'' Richard Friedman, global head of merchant banking at Goldman Sachs Group Inc., said Sept. 16 at the Dow Jones Private Equity Analyst conference in New York. ``People are winning by not losing at the moment. It's going to be eerie for a while.''

Bailout Backlash Against Fed, Treasury Mounting in Congress, Wall Street Amid calls for the government to take stronger measures to stabilize financial markets, some former Federal Reserve officials, lawmakers and Wall Street executives are saying too much has already been done. ``Every time they intervene, they do more harm than good,'' said Peter Schiff, president of Euro Pacific Capital in Darien, Connecticut, a brokerage that manages $1 billion. Critics of the rescues agree that government actions, such as those that prevented the failures of Fannie Mae, Freddie Mac and American International Group Inc., can't postpone the inevitable worsening of housing and financial markets. They say the bailouts by the Fed and Treasury also encourage future reckless risk-taking by investors. Yesterday a group of 100 lawmakers released a letter asking Fed Chairman Ben S. Bernanke and Treasury Secretary Henry Paulson to ``refrain from conducting any additional government-financed bailouts for large financial firms.'' To be sure, only a minority of lawmakers, financial professionals and former government officials have voiced opposition to further rescues. Prominent figures -- ranging from former Fed chief Alan Greenspan and his predecessor at the central bank Paul Volcker to presidential candidates Barack Obama and John McCain -- have called the Treasury and Fed actions necessary. And rather than scaling back its involvement, the government is now considering a wider plan to ease the crisis, New York Senator Charles Schumer said. ``The Federal Reserve and the Treasury are realizing that we need a more comprehensive solution,'' Schumer, a Democrat who chairs the congressional Joint Economic Committee, told reporters in Washington. House Financial Services Committee Chairman Barney Frank said the market turmoil is likely to force Congress and the administration to consider creating an agency to buy distressed debt and mortgages. ``The private market screwed itself up and they need the government to come and help them unscrew it,'' Frank, a Massachusetts Democrat, said Sept. 17.

 

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It's probably time for a little update, especially now that the Dow is down nearly a 1,000 points, the crisis appears to be metastasizing, panic is in the air and blood not quite, other than figuratively, in the streets. Of course there's a lot of figurative blood and people's livelihoods and futures at stake here. And if one goes abroad ripple and local effects have cause food riots and other unrests so figurative isn't totally accurate on a worldwide basis. Now as you may have noticed thruout all the sturm und drang we've tried to let others focus on the immediate while continuing to wrap the flow of events in a strategic context and link them to wider structural concerns. (Continuing Confusions & Crisis: Teetering Giants to Credit to Housing,Keeping Your Head: Understand the Crisis, Navigate the Crisis ?)Which we intend to continue, and so in that spirit our headline. Let me explain.

Between Stalingrad and Kursk 

Just in case you're not a history buff let alone a military history nut like some people the high tide of the Axis advances could arguably be said to be the battles of Midway, El Alamein and the Battle of Stalingrad, still one of the most horrific in history and accurately portrayed we think in the 2001 movie Enemy at the Gate. That could be called, as Churchill did, the end of the beginning. Several months later and after long preparations on both sides the Battle of Kursk was fought and it was THE turning point on the Eastern Front because the Soviets were able to trap a major German offensive thru superior intelligence and strategy, stop it and then reverse it with their own major - and successful - counter-offensive that took away the strategic initiative from the Germans for the rest of the war.

Part of our reasons for thinking we're beyond Stalingrad is that for the 5th or 6th time in a week we've read a major MSM media article that lines up with our thinking and also represents a broader consensus of emerging opinion and understanding. Two of the biggest problems we've faced so far are a lack of grasp of how deep and widespread this overall problem is and pronounced denial in many quarters that either it existed, it applied to the firm in question - that's pretty well resolved in the last two weeks, we'd say - or that it was over and a bottom could be called. The first step in treatment is moving from denial to acceptence, or standing up and saying, "Hi, my name is Mr. Market and I'm a debtoholic". Of course there's treatment and treatment and shuddering thru to expiration with the DT's qualifies as a fix, if not a cure. :)

As you may have noticed we rather like longer posts with pictures and readings to beat a point, or points, to death. After the break you'll find a collection worth your time that samples some key issues and events: the AIG case and why it was so important (the Jubak vidclip is the best simple explanation), the immediate consequences for business in terms of credit contraction and further economic slowing, the ecological shifts in the Finance Industry (when an ecology changes suddenly whole species die out), macroeconomic implications and, finally, deep and major structural reform and recovery of the regulatory framework. With the initial idea of forming an updated version of the Resolution Trust Corporation. And idea that makes sense, is workable, will be challenging, is probably necessary and has the backing of serious political players and some of the most renowned wise elders in the country. Think of it as the pre-planning and intelligence gathering for Kursk and a step we heartily endorse. In fact sidebaring to political implications - this is an acid test for candidate screening IOHO.

Now as it happens, and part of what encourages us, is that none of the readings covers a topic or situation that we haven't been talking about for months. Aside from proving we're not completely nuts it means that a broad view of what we see as the structural breakdowns, systemic risks and necessary correctives is emerging and building rapidly into a common view. Hallaluah ! THAT's the first step indeed. So we won't bother to repeat any of the earlier pictures but strongly urge you to at least read the excerpts. And it also lets us sidestep in a way to focus on the markets outlook. On the other hand given the last two weeks where all this agita has come together in screaming headlines and apparent worldwide market collapses a few stock market charts might be in order to help you get a sense, at least ours, of where things might be headed :) ! 

Market Perspectives: Short to Long-term

 Let's start with some relatively immediate history - a composite chart that looks at the last five days combined with the last three months. The last three days opened with gaps downward which was and wasn't surprising. But chatting along with the trader geeks, a fun and knowledgeable bunch of guys btw and a good place to learn (Matt Trivisonno’s Blog), we all agreed Tu. night that We. was do for a bump up. Boy were we surprised. Now as it happens everybody was well positioned or put themselves there, did very well yesterday and had a great time. After all for these guys volatility is their friend. And their surprise was several orders of magnitude less than that of the general population or the financial community for that matter. Largely because they don't let believes get in the way of seeing the facts as they are. The 3Mo chart at the bottom would suggest a new downtrend is being established and, since it was busted, has farther to run. What I think we're seeing is the emergence of a new view of things that's replacing the old denial sentiment. This is why using the market as a gauge of general attitudes is important. If true it bodes well for the future.

But like I said "we" trader-geeks (I'm only a lurker and occasional commenter, not a contributor) were surprised and this next composite chart perfectly illustrates why. The whole theory of technical analysis is that patterns emerge and tend to repeat because of statistics and internal market forces. If for no other reasons than so many market participants use them in one form or another that they constitute a significant part of the market :) ! One pattern is the tendency to follow certain natural long-term and rhythmic, almost wave-like patterns, where a major advance is followed up by a retreat to a certain level. And if that level is breached then on to the next and so on. It works pretty well until it doesn't. We've been in a cyclical bull market since ~'02 that turns out to be part of a larger, longer bear. That market ran up from the trough in '02 to the fall of '07 and as of Tu. night had fallen back 50% of the way - one of those natural stopping points and the reason we all expected, given no change in sentiment, to see a week-long bounce back up to 1220-1230. Which we started to see but boy did it fade. If it had worked out we'd have gotten the bottom chart which shows where the bounce up might have been, possibly back up to 1270 or so at my most optimistic. But that didn't happen ! And the next level down is/was the 68% level, cause a close of 1156 blow right thru that 50% line. You sense a theme emerging here ? I hope so.

Let's try and drive some more nails home by taking a really long-term view so you can see the stagnant market we've been living in since ~'99 or so. This composite chart shows the SP500 from 1950 to now adjusted and unadjusted for inlfation on top and adjusted compared to GDP on bottom. There's a whole wealth of socionomic history embedded in those charts. But first notice that the market's been flat over the period we mentioned unless you adjust in which case it's never been as good. To look at the top you'd think we'd had a real bubble but looking at the bottom a complementary story emerges. The economy drove the markets right along until '75 when all our past sins caught up with us and the markets seriously under-performed until they started to play catch up in '95...two decades of malaise to pay down the excesses (fiscal, monetary, social and otherwise) of the '60s and early '70s ! Think of it. Now where we go from here needs more discussion but with major structural changes in Finance, an economy likely to be in malaise for a couple of years and below potential for several after that we certainly don't anticipate a return to the boom years. Which means you really need to re-think your standard model of investment planning btw. The old buyem n ridem model is dead as a doornail but nobody's telling anybody yet. (Bears of the Apocalypse I: Long-term Market Performance Perspectives,Bears of the Apocalypse II (LT Econ): Who's Fault is this Mess ?)

Summary and Perspectives

Before Kursk there was a lot of work to do and an RTC initiative would, if put in place be the pre-positioning to fight it. What we're in is basically a plumbing repair job where some broken pipes need replacing, some kinked ones needs straightening, a couple of new pumps need to be added and then a whole bunch of de-clogging of the septic messes needs to be done. Before we all catch something from it. But the Fed and the Treasury are doing a great job with the hands they were dealt and the tools they've got or been able to build. But we need to rip out and replace all the plumbing as soon as we've got the immediate problems far enough under control. And to keep beating the metaphors to death it's the plumbing that helps make the house livable but it ain't the house, the economy is. And there's a lot of repair work needed there as well. Major repair, reconstruction, additions and new developments IOHO ! Some more things to think about for this election.

Understanding the Breakdowns: AIG 

Layman's Explanation of AIG vs Bear vs Lehmann I got called yesterday from the producers of The Daily Show, who asked for an explanation of this understandable to the "lay person." Here is what I said to them:• Lehman Brothers was like the little kid pulling the tail of a dog. You know the kid is going to get hurt eventually, and so no one is surprised when the dog turns around and bites the kid. But the kid only hurts himself, so no one really cares that much.• Bear Stearns is the little pyro -- the kid who was always playing with matches. He could harm not only himself, but burns his own house down, and indeed, he could have burnt down the entire neighborhood. The Fed stepped in not to protect him, but the rest of the block. • AIG is the kid who accidentally stumbled into a bio-tech warfare lab . . . finds all these unlabeled vials, and heads out to the playground with a handful of them jammed into his pockets.

Why AIG matters Credit ratings companies Standard & Poor's, Moody's Investors Service and Fitch Ratings all downgraded AIG shares after the close of trading Monday, leaving the insurer scrambling to find capital and stave off insolvency. While that move sent shudders through the markets once more on Tuesday, an outsider could be forgiven for asking why an insurance company is so critical to the financial markets. The problem is that AIG has been selling insurance against the very calamity that is now engulfing the markets. Some of that insurance took the form of credit-default swaps on mortgage-based securities, a transaction in which AIG basically guaranteed the income stream from the mortgage securities. (That isn't the company's only exposure, but it is an important one.) In the event of a substantial default, AIG is obligated to pay the buyers of the swaps. "If AIG is not resolved (Tuesday) morning, then when do we stop this?" Paul Mendelsohn, chief investment strategist at Windham Financial Services, told MarketWatch.com. "The assets they would have to shed are mind-boggling. We can't let this thing fail. They take everything with it."

• Does market hinge on AIG?
  

AIG Bailout: $85B in Loans, 80% AIG Taxpayer Owned Here are 4 items regarding the AIG bailout that are worth thinking about: 1) AIG is the world's biggest insurer. AN uncontrolled bankruptcy would have dramatically exacerbated the current recession -- possibly turning it into a depression; 2) The NY based firm was also a huge Credit Default Swap insurer/underwriter. The tems of CDS require collateral to be posted, depending upon such factors as credit rating and credit spreads;As home prices fell, spreads widened, and companies went down, AIG's collateral requirements went up significantly. 3) Hence, this is more of a liquidity problem than an actual insolvency. This is the first bailout that adhered to Walter Bagehot's dictum "Central Banks should lend freely at a penalty rate;"  4) Moral Hazard, successfully avoided in the Lehman Brothers bankruptcy, was put aside given the massive size of AIG -- if any firm was TBTF -- too big to fail --  it is AIG. Here's a few excerpts from major media -- WSJ:

That the government would prop up AIG financially offers a stark indication of the breadth of the insurer's role in the global economy. If it were to have trouble meeting its obligations, the potential domino effect could reach around the world.For one thing, banks and mutual funds are major holders off AIG's debt and could take a hit if the insurer were to default. In addition, AIG was a major seller of "credit-default swaps," essentially, insurance against default on assets tied to corporate debt and mortgage securities. Weakness at AIG could force financial institutions in the U.S., Europe and Asia that bought these swaps to take write-downs or losses. AIG's millions of insurance policyholders appear to be considerably less at risk. That's because of how the company is structured and regulated. Its insurance policies are issued by separate subsidiaries of AIG, highly regulated units that have assets available to pay claims. In the U.S., those assets can't be shifted out of the subsidiaries without regulatory approval, and insurance is also regulated strictly abroad.

Consequences for the Economy

What does the 500 point meltdown mean for business? What yesterday's 500 point implosion means, is Wall Street is slowly coming around to the notion that the US is in the midst of a nasty recession. (Finally!)  Because yesterday was merely the realization of losses that had already occurred. This is first and foremost a consumer recession. And a very nasty one at that. This does impact business, but not directly and not right away. Obviously any business that sells directly to the consumer is hurt. Thousands of storesare closing this year, and if you sell anything related to housing or autos you're hip deep in it. But plenty of businesses sell to other business, so they are only impacted via the daisy chain of relationships, and at some point there is a business that is touching the consumer. Banks have tightened credit and in some cases have raised rates, but again this primarily hits the consumer.   Most businesses are too scared to be aggressively expanding their business, and inventory is shrinking, so most don't need to be borrowing. If I was a business owner, I would worry about taxes and inflation. Prices are out of control, and if you can't raise your prices your margins are being pinched. 

GM, Domino's, Novell Say Wall Street Woes May Ripple Through U.S. Economy Executives at companies from General Motors Corp. to Domino's Pizza Inc. and Qwest Communications International Inc. say the credit crunch triggered by Wall Street's upheaval is rippling through the U.S. economy. Debt costs surged and stocks tumbled today on concern more financial institutions will collapse, closing off financing to companies and consumers. Lending tightened further this week after Lehman Brothers Holdings Inc. filed for bankruptcy, Merrill Lynch & Co. was taken over by Bank of America Corp. and the government assumed control of American International Group Inc. ``Lending has come to about a screeching halt as the industry itself is trying to sort this out,'' said David Brandon, chief executive officer of Domino's Pizza in Ann Arbor, Michigan. He said his company doesn't currently need access to debt markets. Costs for GM, UBS AG and Sears Holdings Corp. to borrow in the short-term commercial paper market jumped today, and yields over benchmark rates on investment-grade bonds are at record levels. The U.S. government, saying it wanted to prevent further market turmoil, agreed late yesterday to lend AIG as much as $85 billion in exchange for a 79.9 percent stake in the company.

Crisis Hits Firms Big and Small Wall Street's financial crisis has rippled across the business landscape, raising borrowing costs for corporate giants, squeezing companies that rely heavily on loans and making it harder for small enterprises to find capital and close sales. Among the hardest hit was Constellation Energy Group Inc., owner of Baltimore Gas & Electric Co. Constellation appeared headed toward a shotgun wedding Wednesday with a joint-venture partner, Électricité de France SA, as its stock plunged and worries grew about its ability to finance its commodities-trading business. (Read more about Constellation.) Fears of continued fallout from the credit crisis also dragged down the stocks of other power companies that rely on financing to trade energy contracts, including Sempra Energy, Calpine Corp., Edison International and AES Corp.In the giant market for commercial paper, a reliable source of low-cost, short-term funds in normal times, the cost of borrowing shot up Wednesday. Traders said most lenders were unwilling to extend credit beyond a single day. Sears Holdings said it paid 3.6% Wednesday, about three-tenths of a point more than a day before, to sell $3 million in 30-day commercial paper. Ford Motor Credit Co., the finance arm of Ford Motor Co., paid 7.5% for overnight borrowings, according to one trader, who said the rate would typically be several percentage points lower. General Electric Co., rated one of the safest borrowers, paid 3.5% for overnight borrowing, about 1.5 percentage points more than would have been normal, this trader said.The average rate for one- to four-day commercial paper with top credit ratings was about 5.2% Wednesday, versus 4.6% the day before, and ranged from 1.8% to 7.2%. Money-market funds, which usually are steady buyers of commercial paper, are worried about holding all but the safest assets. They were investing most of their money in risk-free Treasury bills. 

Ecological Change in the Finance Industry 

The K-T Boundary Okay, boys and girls, today we start a new class project. Now that Lehman Brothers and Merrill Lynch have disappeared as independent investment banks over the past few days, it is time to determine whether the investment banking industry as we know it is entering a new era. The vaporization of Lehman Brothers at the point of impact of the Chicxulub subprime meteor¹ and the absorption of the Thundering Herd into the gaping maw of Ken Lewis's petty cash account have left us with only two independent i-banks of any materiality, Goldman Sachs and Morgan Stanley. Those two were last seen limping around the tropical forests of southern Wyoming, so it is presumed by knowledgeable commentators that they have survived the weekend's events. In any event, I am a realist when it comes to industry structure, not an idealist. I believe people and firms will try all sorts of ways to exploit the current market upheaval, including utilizing different (and the same old) organizational forms. As you might expect, Goldman Sachs' CFO insisted today on their earnings call that it does not want to buy a commercial bank or sell itself to one and that all is for the best in this best of all possible worlds for the Teflon Investment Bank. (Although he would have to say that, wouldn't he?) Other than plummeting stock prices, there seem to be few hints that Morgan Stanley or Goldman Sachs are not long for the planet. As far as anyone can tell, they are not insolvent or illiquid, but one could have credibly said the same about Bear Stearns or Lehman a few days before they kicked the proverbial bucket. If I had to venture a guess—you didn't think I wouldn't, did you?—I would say that we will see a repopulation of the middle of the industry over time. At the top end, in size and revenues—but not necessarily prestige or reputation—we will continue to see hedge fund-i-bank hybrids flinging their balance sheets about and trying to be all things to all people. Most of these will be combinations of commercial banks and investment banks, but there may still be a place for a Goldman Sachs or a Morgan Stanley if they remain religiously devoted to careful risk control. Such firms should be successful, at least among the clients who truly need the services they deliver. The current market environment, and the current systemwide flight from risk, may mean that these banks will have to settle for lower returns on equity, and their bankers will have to settle for lower compensation, than they have been used to in the recent past. If this is the case, you will see higher-profile investment bankers—"rainmakers" who can write their own ticket (or persuade others they can)—bleed out of such leviathans into smaller, more prestigious advisory boutiques, where they can eat what they kill. You may see some independent boutiques grow in size, and become credible competitors to Lazard and the in-house M&A factories of larger banks. But for this to happen, we will need to see an institutionalization of advisory boutiques which has been lacking to date.

Worst Crisis Since '30s, With No End Yet in Sight The financial crisis that began 13 months ago has entered a new, far more serious phase. Lingering hopes that the damage could be contained to a handful of financial institutions that made bad bets on mortgages have evaporated. New fault lines are emerging beyond the original problem -- troubled subprime mortgages -- in areas like credit-default swaps, the credit insurance contracts sold by American International Group Inc. and others. There's also a growing sense of wariness about the health of trading partners. The consequences for companies and chief executives who tarry -- hoping for better times in which to raise capital, sell assets or acknowledge losses -- are now clear and brutal, as falling share prices and fearful lenders send troubled companies into ever-deeper holes. Expectations for a quick end to the crisis are fading fast. "I think it's going to last a lot longer than perhaps we would have anticipated," Anne Mulcahy, chief executive of Xerox Corp., said Wednesday. The U.S. financial system resembles a patient in intensive care. Fed and Treasury officials have identified the disease. It's called deleveraging, or the unwinding of debt. At least three things need to happen to bring the deleveraging process to an end, and they're hard to do at once. Financial institutions and others need to fess up to their mistakes by selling or writing down the value of distressed assets they bought with borrowed money. They need to pay off debt. Finally, they need to rebuild their capital cushions, which have been eroded by losses on those distressed assets. Goldman Sachs Group Inc. economist Jan Hatzius estimates that in the past year, financial institutions around the world have already written down $408 billion worth of assets and raised $367 billion worth of capital. But that doesn't appear to be enough. Every time financial firms and investors suggest that they've written assets down enough and raised enough new capital, a new wave of selling triggers a reevaluation, propelling the crisis into new territory. Residential mortgage losses alone could hit $636 billion by 2012, Goldman estimates, triggering widespread retrenchment in bank lending. That could shave 1.8 percentage points a year off economic growth in 2008 and 2009 -- the equivalent of $250 billion in lost goods and services each year. Few financial crises have been sorted out in modern times without massive government intervention. Increasingly, officials are coming to the conclusion that even more might be needed. A big problem: The Fed can and has provided short-term money to sound, but struggling, institutions that are out of favor. It can, and has, reduced the interest rates it influences to attempt to reduce borrowing costs through the economy and encourage investment and spending. But it is ill-equipped to provide the capital that financial institutions now desperately need to shore up their finances and expand lending. But both on Wall Street and in Washington, there is increasing expectation that U.S. taxpayers will either take the bad assets off the hands of financial institutions so they can raise capital, or put taxpayer capital into the companies, as the Treasury has agreed to do with mortgage giants Fannie Mae and Freddie Mac. One proposal was raised by Barney Frank, the Massachusetts Democrat who is chairman of the House Financial Services Committee. Rep. Frank is looking at whether to create an analog to the Resolution Trust Corp., which took assets from failed banks and thrifts and found buyers over several years.

Macroeconomic Implications 

U.S. Economic Outlook is Gloomy The next U.S. president will be confronted with slow growth, high unemployment and an economy teetering toward recession, say 51 private economists surveyed by The Wall Street Journal. If they are correct, pumping up the economy will the first challenge facing either Democrat Barack Obama or Republican John McCain. That is likely to place tax cuts and government spending high on Washington's agenda, and push back costly measures such as reforming health care and fighting global warming. The Wall Street Journal's latest monthly survey paints a gloomy picture of the outlook through the first half of 2009. The economy is on course to post four straight quarters of annualized economic growth below 2%, the longest stretch of subpar growth since the 2001 recession. The respondents saw a 60% chance of an outright recession, expect the economy to shed 19,000 jobs a month for a year, and say the jobless rate, which jumped in August to 6.1%, will keep rising, to 6.4% by midyear, passing the 6.3% seen after the last recession. The worst stretch will be the next few months, the economists say, coming as elections shift into high gear. Annualized growth in the gross domestic product is projected at 0.7% in the fourth quarter. A few months ago, forecasters thought the economy would be growing at a much faster clip by then.

Greenspan: Economy in 'once-in-a-century' crisis The U.S. credit squeeze has brought on a "once-in-a-century" financial crisis that is likely to claim more big firms before it eases, former Federal Reserve chief Alan Greenspan said Sunday. Greenspan told ABC's "This Week" that the situation "is in the process of outstripping anything I've seen, and it still is not resolved and it still has a way to go.""Indeed, it will continue to be a corrosive force until the price of homes in the United States stabilizes," Greenspan said. He predicted that would not happen until early 2009, and said the odds of U.S. recession have gone up in recent months. "I can't believe we could have a once-in-a-century type of financial crisis without a significant impact on the real economy globally, and I think that indeed is what is in the process of occurring," he said. While recent declines in the prices of oil and food may help avert a recession, he said, "I wouldn't put my money on it." The financial crunch already has claimed investment bank Bear Stearns, spurred the federal seizure of mortgage giants Fannie Mae) and Freddie Mac and left century-old Wall Street institution Lehman Brothers clinging by its fingernails after suffering nearly $7 billion in real estate-related losses. Federal regulators and Wall Street executives were holding weekend crisis talks aimed at resolving the Lehman situation without further shock to the financial sector. Greenspan, who left office in 2006, said he expected more failures before the crisis eases. While regulators "shouldn't try to protect every single institution," he said, companies should be kept from failing "in a sharply disruptive manner" to prevent further shocks.

• World Economy May Face `Japan-Like' Stagnation, Singapore Wealth Fund Says

Regulatory  Reform

U.S. Poised for Bigger Role  Federal officials are looking at how to tighten regulation of the credit-card industry and whether to double prospective loans to bail out the auto industry to $50 billion. In the coming years, they will examine how to regulate greenhouse-gas emissions from industries across the economy and how to remake the mortgage giants so they no longer can run up enough debt to threaten the economy. The latter could involve creating yet another government entity to carve up Freddie's and Fannie's assets and sell them to investors. The year-old financial crisis has bolstered the role of the government in markets. Beyond staging outright rescues, the Federal Reserve is scrutinizing the capital and liquidity positions of investment banks, reconsidering rules for vast but obscure parts of money markets and derivatives markets, and acting as backstop to a huge swath of Wall Street's day-to-day trading. Treasury officials are pushing banks to build new markets, such as so-called covered bonds, which are popular as mortgage financing in Europe. The struggle between market forces and government control is as old as the country. Alexander Hamilton and Thomas Jefferson squared off over the role of the government in promoting early industry. For two decades after Ronald Reagan's election in 1980, markets were clearly in the ascendancy. Even the savings-and-loan collapse of the 1980s, in which the government spent $125 billion seizing failed S&L's and selling off their loans, didn't shake the widespread conviction that market forces should be lightly restrained, if at all.

• Jesse Eisinger on Deregulation and Credit Crisis

Notes and Reflections on Regulatory Reform: Earlier this year (2001/2003), particularly in spring to summer, there looked to be a major sea change developing in the general market regulatory regimes. However the push for improved regulation has died down or been subsumed by other pressures. As well as what appears to be some very clever political maneuvering. Part of the decreased interest lies in everybody being overwhelmed by the magnitudes and quantities of the shocks and malfeasance. People appear to simply be too tired to continue to pursue things. Another part of it has to do with the still-born attempts are ‘re-regulation’. For example the Oxley-Sarbanes bill, the SEC reform, the Accounting Standards board, and Spitzer’s efforts. Most of these are rapidly amounting to little or less. However the roots of the changes in regulation go back much farther. Most of the major efforts, e.g. Telecom, Energy, Accounting, the split between banking and finance, that have ‘failed’ so miserably this last two years can be traced back to legislative efforts in the early to mid-90s. And many of the legislators now clamoring for new reforms were part of the charge then. And so benefited. Much of the impetus for further de-regulation are rooted in a belief in the efficacy of pure markets that were and are part and parcel of the ideology of the ‘anti-government’ revolts of the 80s. Yet another example of pendulum swings. As more and more taxes were collected and appeared to do less and less the need to reduce the size of government was increased. As a result we’ve hamstrung fiscal policy. But then, at the time, some cutbacks were required. We tested to it’s limits the concept that blind government spending would lead to major changes contrary to the way things actually worked. As the pendulum has swung back however we’ve potentially thrown the baby out with the bath water because certain kinds of regulation are essential, e.g. legal systems and private property. And very few modern markets and industries are in fact purely competitive; rather their structures are such as to require some regulation, e.g. monopolies and/or oligopolies. And there is also the issue of public welfare thru standards, e.g. pollution, etc. Having thrown the baby out with the bathwater we have two sets of economic problems. First, in the short-run the level of trust and credibility in large enterprises is extremely low. As a result the willingness of the market, i.e. the majority of investors, to get back in is going to depend on the quality of their earnings; and if they continue to think the books will be cooked they will continue to be reluctant. Second, we’ve now tested the limits of regulatory regimes on the other side and found them wanting. So the question is what level of regulation is required for different situations and what’s the best mechanism for achieving our goals.

Resurrect the Resolution Trust Corp. We are in the midst of the worst financial turmoil since the Great Depression. Absent bold action, matters could well get worse. Neither the markets nor the ordinary diet of regulatory orders, bank examinations, rating downgrades and investigations can do the job. Extraordinary emergency actions by the Federal Reserve and the Treasury to date, while necessary, are also insufficient to resolve the crisis. Fannie Mae and Freddie Mac, the giants in the mortgage market, are overextended and now under new government protection. They are not in sufficiently robust shape to meet all the market's needs.The fact is that the financial system needs basic, long-term reform, but right now the system is clogged with enormous amounts of toxic real-estate paper that will not repay according to its terms. This paper, in turn, is unable to support huge quantities of structured financial instruments, levered as much as 30 times. Until there is a new mechanism in place to remove this decaying tissue from the system, the infection will spread, confidence will deteriorate further, and we will have to live through the mother of all credit contractions. This contraction will undercut the financial system, and with it, the broader economy that so far has held up reasonably well.There is something we can do to resolve the problem. We should move decisively to create a new, temporary resolution mechanism. There are precedents -- such as the Resolution Trust Corporation of the late 1980s and early 1990s, as well as the Home Owners Loan Corporation of the 1930s. This new governmental body would be able to buy up the troubled paper at fair market values, where possible keeping people in their homes and businesses operating. Like the RTC, this mechanism should have a limited life and be run by nonpartisan professional management. Such a stabilizing mechanism would accomplish four much-needed tasks:

• Resolution Trust Plan Is Floated Staring down the worst financial crisis in decades, U.S. lawmakers are strongly considering whether they need to dust off a 1980s-era plan to help save the banking industry and stabilize the economy more broadly. Both Democrats and Republicans have shown interest over the past two days in the idea of creating a government corporation to help deal with the toxic assets that have already brought down financial behemoths Bear Stearns Cos. and Lehman Bros., and forced the government to take over Fannie Mae and Freddie Mac.

Comment on Crisis: Necessary Steps  With the DOW off over 500 points yesterday, Lehman in bankruptcy, the Fed rescuing A.I.G. tonight, the viability of WaMu and others institutions in doubt, Fannie and Freddie placed in conservatorship, a major money market fund halting redemptions, it might seem like the credit crisis is spiraling out of control. And there are definitely more problems to come. Many banks will fail - especially small and regional banks with excessive concentrations in construction & development (C&D) and commercial real estate (CRE) loans. And the recession is getting worse with rising unemployment, declining personal consumption expenditures, declining industrial production and falling business investment. Economies of many other countries are in or close to recession. The Fed even cautioned on slowing U.S. exports today for the first time. Foreign stock markets are crashing: the Russian stock market was halted today after declining 17%. The Shanghai composite index is off about 2/3 from the peak.The situation appears grim. This crisis might have first become visible to Wall Street and the Federal Government in August 2007, but this crisis has been unavoidable for several years. If action had been taken in 2004 or 2005 to curtail the loose lending practices, the problem wouldn’t be so severe, but the crisis would have still occurred. The damage had already been done. Unfortunately the U.S. failed to prevent this crisis, and now we have no choice but to pay the price for the cleanup. The good news is the U.S. is finally taking the necessary steps towards eventually resolving the crisis. Clearly we are closer to the eventual bottom today, than say in 2005 when very few people believed a housing bust and credit crunch were on the horizon. Unfortunately the bottom still isn’t in sight. There will be more grim news, perhaps for another year or more. And there is definitely some possibility of a systemic financial collapse (see Professor Roubini’s excellent discussion of the downside risks). But unlike observers that believe this only marks the end of the beginning, I believe there is a chance that these events mark the beginning of the end of the crisis.

Posted by dblwyo at 02:15 AM | Permalink | Comments (0)

The title is a play on Kipling's poem If which we've quote before. Isn't it amazing how truly wise Rudyard is beginning to appear now that the rest of us are beginning to live in a troubled world like he experienced. But rather than rolling to your gun and blowing out your brains before the Afghani women come out to cut you up we'd suggest there are still some alternatives. Which start with understanding what's going on on several fronts, then developing a plan for how to re-position yourself and then executing that plan and sticking to it thru the chaos until it's time to "keep you head", in the sense of both keeping it figuratively - perhaps literally for those with more at stake than they should have risked - and in the sense of keeping a clear head. We will continue to do our best best to help with the latter by providing our best tools, analysis and assessments in the search for "what's really going on here".

On that note a friend's reaction to yesterday's posting was that he understood my analysis earlier in the year but thought my take was greatly exaggerated. As of yesterday morning my credibility has apparently risen a smidgeon in his view. Despite the fact that just about everything that's going on was discussed months ago, if not last year, in some detail with charts and everything. Now let's be absolutely clear because there are 2-3 critical lessons here. First, that apparent prescience is not the result of any particular virtue of mine but of having the right toolkit to understand and interpret the trends swamping us. With the right "Dashboard" it is indeed possible to monitor things.(Data, Dilemmas, Dashboards and Decision,Dashboards for the Real World: Economy, Markets, Industry, Company). As long as we're on the topic of  training yourself to  keep a clear head Mr. Kipling has some simple but profound  wisdom to share  on that subject as well:"I Keep Six Honest..."

Second, as many of the readings below make clear almost everybody on the inside lurches from surprise to surprise. Sterling and stunning examples of the lack of a clear head IMHO - that is in believing what you want to believe and distorting the signals to fit pre-conceptions until they rise up to bite you. Third, as several examples show, it is more than possible to have anticipated this and/or to take advantage of it.(This One's for Jay: Investing Strategies for a Dicey Market). Which we hope some of the readings will highlight.

Speaking of which they're broken up into a current tracking the crisis cluster, the longer-term consequences for the fundamental re-shaping of the Finance Industry and the BofA/MER merger. Now in several of these the best take on the state of things is a video clip which we haven't collected entirely for fun. Where they're included they're there because we think you'll benefit from taking the time to watch and think about 'em. That said there are three that IOHO are must watches: Meredith Whitney on CNBC on the state of play who compresses so much into a few minutes that you'd better take note. Jim Jubak on why the AIG problems are the single most important determinant of the next few weeks and a straight-forward explanation. And the Lewis/Thain interview which if you want to understand what went on, why, the outlook and the re-engineering of the financial industry that's underway listen carefully to those.(Finance Ind II(Readings): Fundamental Breakage in the BM ,Markets and Financials:4 Year Crunch, Broken BizzMods). When we said broken business model, a phrase that we notice is now rather widespread though we don't recall hearing it prior to our first flights ;), that may be a little to dry and abstract. Listen to Thain and Lewis and understand what throwing out broken ones and replacing them means for firms, employees, business partners and industries.

Bon Appetit' 

Crisis & Consequences Tracking

 Wall Street's troubles are yours, too The common threads among Lehman, Merrill and AIG - and

at dozens of other financial firms across the nation - start with their dealing in securities tied to the U.S. mortgage market, and their rapid expansion in recent years via the use of leverage. All three firms have taken billions of dollars of mortgage-related writedowns: Lehman recently announced a nearly $4 billion third-quarter loss, while Merrill has taken tens of billions of dollars in losses on collateralized debt obligations, the risky debt Wall Street was peddling during the height of the housing boom. Over the past three quarters, AIG has recognized some $25 billion in writedowns tied to the firm's promises to guarantee the mortgage-backed debt issued by others. But if the firms made bad bets on mortgage-related securities - and all three made lots of them - something else that's striking is the degree to which the companies simply expanded their balance sheets in a bid to grab lush profits without taking precautions to make sure they could shoulder any losses that arose. But the debt Wall Street was selling turned out to be less than safe - hundreds of bond issues have been downgraded as U.S. house prices began tumbling after a years-long runup - and it soon became apparent the firms had, like the investors in their mortgage-backed bonds, failed to take adequate precautions. The expansion of leverage at all the Wall Street firms has been startling. At the end of 2003, Lehman had $13 billion in shareholder equity - a measure of net worth - and $312 billion in assets, which meant the firm had about $24 in assets for every dollar of equity on its balance sheet. By the end of last year, Lehman's shareholder equity had risen to $22.5 billion, a 73% increase. But assets soared to $691 billion, a 121% increase - giving it nearly $31 for every dollar of equity. Lehman's rising leverage has been much discussed as the firm's shares plunged into the teens and then into the single digits this year. But the same story has played out at Merrill, where assets doubled to $1.02 trillion in 2007 from $480 billion in 2003, even as shareholder equity only crept higher, to $32 billion from $29 billion. And while Goldman Sachs especially, and Morgan Stanley to a lesser degree, have stood out as better-managed during the turmoil of the last year, it's not clear those firms will be able to avoid investors' wrath. Assets on Goldman's balance sheet nearly tripled over the past five years, hitting $1.12 trillion in assets at the end of 2007 against $403 billion in 2003, while shareholder equity merely doubled, to $42.8 billion from $21.6 billion.

Whitney On Wall Street's Future  Weighing in on Bank of America's latest deal and the future of Wall Street, with Meredith Whitney, Oppenheimer & Co. and CNBC's Maria Bartiromo. 

Investors Avoid Panic, Start Looking for Bargains Investors again refused to panic Monday at another wave of seemingly devastating news from the financial sector. Yes, the major indexes were off more than 2 percent each. But with the avalanche of brutal news over the weekend--bankruptcy at Lehman Brothers, the takeover of Merrill Lynch, American International Group under pressure to raise capital--the damage under normal circumstances would be profound. The market behavior amid a credit crisis that seemed to have no bottom had market pros baffled. "It's the worst I've ever seen," Dave Rovelli, head of US equity trading for Boston-based Canaccord Adams, said of the uncertainty in the current market climate. "If you were to say that we'd have Lehman, Fannie Mae and Merrill, AIG, everything that happened in the last week and we still haven't retested the lows of July 15, the lows we set back in (the collapse of) Bear Stearns, I would say you're crazy. I would think the Dow would be back at 10,000. I think it's unbelievable." Wall Street's resilience seemed to rest with a few key factors: A general sentiment that because investors were well aware of Lehman's troubles they were already priced in, and optimism that the rest of the problems were the market's way of clearing away the detritus of the financial fallout.

• Zandi on the Financials Crisis  Shedding light on the financial fallout on Wall Street, with Mark Zandi, Moody's Economy.com chief economist

Meltdown shakes up Wall Street's workers The financial hurricane that whipped through Wall Street Monday suddenly made the Street, long a source of fabulous wealth, look uncertain and scary. In New York, where a half-million people work in finance, nearly everyone was shaken, from hedge fund billionaires to secretaries from Queens.Lehman, the fourth largest investment bank in the U.S., filed for Chapter 11 bankruptcy reorganization Monday, the same day Merrill Lynch was bought by Bank of America Corp. in a snap deal for roughly $50 billion. Meanwhile, American International Group Inc., the world's largest insurer, and Washington Mutual Inc., the nation's largest thrift bank, were rumored to be close to ruin.The roughly 25,000 workers at Lehman, as well as many of the 60,000 at Merrill, face a double whammy: Many will lose their jobs and the companies' plunging share prices likely wiped out much of their net worth. In brief interviews, workers in New York who requested anonymity described themselves as shocked and devastated."We really didn't see this coming. We thought some bank would buy Lehman," said Duo Ai, who worked in research in Lehman's London office. "Any other option would be better than this."The consensus in finance was that this would just be one more in a succession of grim days following the mortgage bust.

AIG Plunges After Cut in Credit Rating Jeopardizes Effort to Raise Capital American International Group Inc. fell 43 percent in early New York trading after the insurer's credit ratings were cut, threatening efforts to raise funds to keep the company afloat and roiling global financial markets. S&P lowered AIG's long-term counterparty rating three grades to A- because of ``reduced flexibility in meeting additional collateral needs and concerns over increasing residential mortgage-related losses,'' the rating company said yesterday. Moody's cut AIG's senior unsecured debt two grades to A2. Fitch Ratings today lowered its assessment to A from AA-. ``I don't know of a major bank that doesn't have some significant exposure to AIG,'' said Kenneth Lewis, chief executive officer of Bank of America, in a CNBC interview. An AIG collapse would ``be a much bigger problem than most that we've looked at,'' he said. AIG fell $2.06 to $2.70 at 7:25 a.m. before the official open on the New York Stock Exchange, after plunging 61 percent yesterday. AIG's market value has shrunk 93 percent since peaking at almost $190 billion at the end of 2006, when it ranked among the world's five biggest financial companies.

• Does market hinge on AIG?  If American International Group can find the capital it needs, it will end the current panic. If it can’t, look for more selling -- especially in Asia, says Jim Jubak.
• Overnight Interest Rate Doubles as Banks Hoard Cash on Failure Speculation
• Downgrade of AIG Drives Up Bond Risk on $441 Billion Derivatives Concerns

 Re-shaping the Finance Industry

Bloomberg Video Clips

Roubini Says U.S. Financial Industry Facing `Disaster' September 14 (Bloomberg) -- Nouriel Roubini, an economics professor at New York University, talks with Bloomberg's Bernard Lo from New York about the turmoil in financial markets and outlook for the sale of Lehman Brothers Holdings Calyon's Keeble Expects `Dysfunctional' Interbank Market September 15 (Bloomberg) -- David Keeble, head of fixed-income strategy at Calyon, talks with Bloomberg's Mark Barton in London about today's surge in Treasuries and the outlook for the interbank market after Lehman Brothers Holdings Inc. filed for bankruptcy and Bank of America Corp. agreed to purchase Merrill Lynch & Co. for about $50 billion. The yield on two-year Treasury notes dropped below 2 percent for the first time since April today Mobius Says Merrill Deal Signals Bottom for Markets September 15 (Bloomberg) -- Mark Mobius, executive chairman of Templeton Asset Management Ltd., talks with Bloomberg's Catherine Yang about the impact of Bank of America Corp.'s possible purchase of Merrill Lynch & Co. and Lehman Brothers Holdings Inc.'s bankruptcy on financial markets, and Mobius's investment strategy. Bank of America agreed to buy Merrill Lynch in a deal that values the 94-year-old firm at about $44 billion, two people familiar with the deal said. Marc Faber Says Lehman Bankruptcy `Not A Terrible Event' September 15 (Bloomberg) -- Marc Faber, managing director of Marc Faber Ltd. and publisher of the ``Gloom, Boom & Doom Report'' newsletter, talks with Bloomberg's Mark Barton from Chang Mai, Thailand, about Lehman Brothers Holdings Inc. and the outlook for stocks. Lehman, the fourth-largest U.S. investment bank, succumbed to the subprime mortgage crisis it helped create in the biggest bankruptcy filing in history.

Putting lipstick on a pig If nothing else, we've learned recently that if you put lipstick on a pig, it's still a pig. Presumably that has always been true - unless of course the pig in question was a subprime mortgage derivative, circa 2006. Then it was quite possibly a "runaway bargain," a "great time to buy," or an "opportunity in a market that's only going to go up." Still a pig, you say? Well, how is it that no one noticed the legions of bankers, ratings agencies, and real estate professionals bearing lipstick? You might have expected ratings agencies to see the problem, but instead they became part of it. Complex securities are often priced from models that assume, in what may be the apogee of wishful economic thinking, that the underlying assets will behave exactly as they have historically. That has always been a weakness of model-based valuation, but it's particularly problematic when the securities are new and untested.As for the Wall Street bankers who should have known better, they were mesmerized by the beauty of their creations. They forgot that those sophisticated securities were built from millions of mortgages that required someone to make payments every month. And in the real world, not the mathematical one, a lot of those loans were made to people who never had any plausible chance of repaying them. When the complexity of a security (lipstick, anyone?) has the effect of decoupling its value from that of the underlying asset, it can be very difficult to know what that security is truly worth. When no one knows what anything is worth anymore, it's easy to inflate an asset bubble. And when it's easy to inflate an asset bubble, someone inevitably will, because all the players have incentives to do so. The way people are paid on Wall Street encourages them to pursue immediate returns at the expense of longer-term stability. Prudent managers might store capital in boom times to deal with the inevitable downturn. But given the ethos of returns-no-matter-what, available capital is capital that will be put to work. In the words of former Citigroup CEO Chuck Prince, "When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you've got to get up and dance. We're still dancing." Well, nobody's dancing anymore.

Change Arrives, With a Sense That Wall St.’s Boom Times Are Over As the tectonic shifts within the American financial industry shook the world’s markets on Monday, many experts predicted that events of the last 72 hours heralded a new period of painful change for Wall Street. The predictions were sobering. Investment banks will be smaller. Their profits will be leaner. Jobs in finance will be scarcer. And the outsize role of Wall Street in the nation’s economy will shrink. That is the extreme case. But as investors tried to comprehend the abrupt downfall of two of Wall Street’s mightiest firms — Lehman Brothers, which spiraled into bankruptcy, and Merrill Lynch, which rushed into the arms of Bank of America — even optimists said the immediate future would be difficult. Treasury Secretary Henry M. Paulson Jr. and the Federal Reserve are paving the way for the few strong survivors to lead an industry turnaround, while letting the weaker ones fail or be subsumed by larger rivals. “We’ve gone from a golden era of banking and financial services,” Kenneth D. Lewis, the chief executive of Bank of America, said in a press briefing on Monday, as the bank he heads prepared to buy Merrill Lynch. “It’s going to be tougher,” Mr. Lewis said. “There are going to be fewer companies, and we are going to have to be better at what we do.” The last gasp of the broker-dealer

Future of Financials  Discussing the future of financials, with Liz Ann Sonders, of Charles Schwab, and Joe Clark, of the Financial Enhancement Group

Paulson On Crisis Treasury Secretary Henry Paulson answers questions about the financial crisis at a news conference

BofA and  Merrill: Brilliant, Gusty  and  Risky

Bank of America/Merrill Deal Bank of America CEO Ken Lewis and Merrill Lynch CEO John Thain discuss Bank of America's plan to buy Merrill Lynch.

BofA's Ken Lewis on Merrill Lynch Insight on why the deal between Merrill Lynch and Bank of America is a strategic opportunity of a lifetime, with Ken Lewis, Bank of America CEO

 

 

Posted by dblwyo at 07:11 AM | Permalink | Comments (0)

O.K. time to move on, at least in a sense. The LEH collapse crisis continues, has received continuing press coverage (pick - WSJ, FT, AP, Yahoo, Bloomi, Reuters.....) and pretty good blog coverage (CalculatedRisk, BigPic of course) and we've provided some running updates. And the MER, AIG, WhamU (WM) sagas are boiling along merrily in the not to distant background. This is going to be an interesting week - got water, first aid and ammo stocked up ? As is our wont we're going to wrap this moment to moment agita in some other news and some really big picture context. After the break there's a bunch of excerpts starting with another good WSJ story on the metastasis of this whole mess (this is, to our intellectual delight and investment chagrin) about the fifth major MSM story that gets it right.

This is IOHO the most important few things to take away from this you need to think about and internalize:

1. This is continuing and is systemic, that is everything's tied together into an ecological system that is under-going widespread pressure. Now we're not talking mass extinction here but continuing serious to severe problems.

2. Most of the key financial, business and market players continue to lurch from surprise to surprise having substituted their decades of experience and the derived rules of thumb for thinking when the structural patterns have changed. The MSM major stores are very good indicators that those broken mental models of reality are getting shaken and stirred but not replaced. That's dangerous.

3. This is unnecessary. Many key outside players (Roubini, Feldstein, Krugman, Rogoff, Hartzius,....) have been sounding warnings since this time last year. Fortunately both the Fed and the Treasury after initial periods of fugue when they were under-estimating the severity have been proactive, insightful, ballsy and fast. And are basing their actions not on immediate invention but on several years of worrying about this sort of breakdown so they've been better prepared than most.

4. And it doesn't mean one can't "dance of top of the turbulent waves" by following good business practice. It just means that most chose kookaid and self-delusion over discipline. As the excerpts on Berkshire's Clayton Homes, who live by selling modular homes to sub-prime borrowers, and Harvard Endowment's continued superior performance prove. Dare we re-mention all the stuff we've been throwing up on good business performance, again ? (Using the Palantir: Beyond Fear to Performance and Returns) .

In addition to the WSJ strategic overview the next section reviews the next set of emerging problems that are cropping up as, for example, commercial loans deteriorate, junk bond spreads climb again, the demand for Fed Window borrowings goes up among regional banks - who've been avoiding it because of the stigma of distress. And this is going to go on for a while. What these stories tell us is that while we've ONLY been living thru the consequences of the fallout from sub-prime and the associated de-leveraging in the financial markets that other major credit problems are about to accelerate. Thereby moving us into a set of "feedback loops" between deteriorating economic conditions, tightening credit, more bank losses and a further weakening. Associated graphics from prior posts are embedded with the excerpts btw.

In addition to those problems, which could be described as the 2nd level consequences of the first big "rock in the pond" from sub-prime we're about to see two more big boulders rock over and create more tsuanmic waves. Commercial Real Estate is beginning to turn down and with it the associated loan losses are rising as well. And we're moving beyond sub-prime to the onset of major problems with resets in the Alt-A markets which will lead to more down-pressures in Housing sales and prices. Again things that STILL aren't being widely factored in in general, though obviously a lot of good people have been sounding warning bells for some time. So be forewarned about more ripples spreading out from those as well.

Financial & Market Crisis Overview

A Financial Drama With No Final Act in Sight A lot of smart people have tried to call the bottom on Wall Street this year. So far, they have all been wrong. Since the financial crisis first hit in August 2007, markets — and the financial industry — have gone through a series of swoons, each more dizzying than the last. Last week, the crisis reached a new pitch, as Lehman Brothers, the fourth-largest United States investment bank, struggled to avoid joining Bear Stearns on the trash heap, and Washington Mutual, the largest savings and loan, saw its shares briefly fall below $2. Now even Wall Street’s professional optimists have given up predicting exactly when their industry might stabilize. One senior executive at a top investment bank, speaking anonymously so he could speak freely, recently observed that the crisis was entering its “19th inning,” with no ending in sight. Until now, the cataclysm in the banking and securities industry has damaged but not derailed the rest of the economy and the Fed and the Treasury signalled last week that they were not ready to bail out Lehman Brothers with taxpayer money. Economists generally predict that the United States will grow slowly over the next few months but avoid a deep recession, especially if oil prices fall further, easing pressure on consumers, and exports remain strong. But as the Wall Street crisis moves into its second year, the risks to the overall economy are increasing. While the economy grew during the first half of the year, businesses are cutting jobs and consumers reducing spending. In August, the unemployment rate reached 6.1 percent, compared with 4.7 percent less than a year ago. Yet the picture may not be entirely bleak. When the chaos finally ends, Wall Street will almost certainly be smaller and more risk-averse. That change could eventually put the economy on firmer footing. This year’s crisis appears to mark the end of a bubble in the financial markets that has lasted nearly two decades. The speculation began in technology stocks in the 1990s and turned to real estate, commodities and private equity buyouts this decade. Along the way it powered the New York City economy and helped drive income inequality nationally. While the stock market has not been as frenzied this decade as it was at the end of the 1990s, rampant speculation took over many other financial markets, Mr. Wieting said. “In the last couple of years, financial activity became less related than we’ve seen before to real economic developments,” he said. A Drama With New Twists and Turns

Credit Contagion

Wall St. Goliath Teeters Amid Fear of Wider Crisis Fearing that Lehman Brothers is only days away from collapse, government officials and senior Wall Street executives met on Saturday to try to arrest a downward spiral that might imperil other financial institutions. For a second day, the group convened at the Federal Reserve Bank of New York in Lower Manhattan, but the situation remained fluid, and the talks were set to resume on Sunday morning . Adding urgency to the meeting were growing concerns that other big financial institutions like the insurance giant American International Group and the nation’s largest brokerage firm, Merrill Lynch, might face a similar crisis and also need billions of dollars in capital to strengthen their businesses. The group discussed the financial condition of other firms beyond Lehman and the overall state of the markets. The spreading troubles were the latest sign that even the government’s extraordinary interventions into private enterprise during the last year have not been enough to halt the unraveling of storied companies that were widely viewed as unassailable until recently. In fact, Lehman and other companies have said for months that they had a handle on their troubled assets tied to real estate. But their share prices have continued to sink. As a result, many investors are no longer sure what these financial companies are worth, and they do not want to invest in them until they do. At the same time, many hedge fund managers and other traders have profited handsomely from bets that these stocks would fall in value.Companies that took the biggest risks and used debt aggressively to build their businesses were the first to stumble as the credit market began to sink, and now healthier companies are coming under pressure. Loans that were considered far better than the subprime mortgages, which kicked off the panic, turned out to be only marginally safer.

Bank of America Says Losses Shift to Commercial Loans  Bank of America Corp., the biggest U.S. consumer bank, said credit weakness is spreading to commercial borrowers from residential customers and loan losses probably will deepen in the third quarter. Home builders unable to repay their loans are contributing to deterioration among commercial borrowers, said Brian Moynihan, head of the global corporate and investment banking unit, at a New York conference today. More than half the Charlotte, North Carolina-based bank's $13.4 billion in loans to builders are considered troubled, 19 percent are not paying interest and losses are likely to mount, Moynihan said. Bank of America's commercial loans were $335 billion as of June 30, and a home-builder portfolio that accounts for less than 4 percent ``won't create major pain for us, but it's going up,'' he said. ``It's not pretty.'' The company is able to charge higher rates on its loans as businesses seek to borrow from companies with strong capital positions, Moynihan said. The investment banking unit will have a ``choppy'' quarter as turmoil in the credit markets delays companies from raising capital or making acquisitions, he said.

Corporate Bond Traders Lose `One-Night Stands' in Credit-Market Seizure Trading in the corporate bond market has fallen a third after averaging $26 billion a day in the first eight months of 2007, according to Federal Reserve data on primary dealers. That means Gevry, who used to flip corporate debt for as much as a $50 profit on a $1,000 issue, has to focus on long-term investments. The biggest bond dealers, including JPMorgan Chase & Co., and Citigroup Inc., aren't committing as much cash to boost corporate-bond trading. That's because they're shoring up their capital after the collapse of the subprime-mortgage market spurred about $506 billion of writedowns and losses. While corporate-bond trading is shrinking, average daily trading in government securities has risen to about $584 billion this year from $560 billion in the same period of 2007, Fed data show. The decline in corporate-debt trading, known in market parlance as illiquidity, is prompting fund managers to demand higher compensation to buy new bonds, driving up borrowing costs for companies, including American Express Co. and Verizon Communications Inc., and reducing returns on existing securities. Yields on investment-grade bonds, those ranked at least Baa3 by Moody's Investors Service and BBB- by Standard & Poor's, reached a record 3.22 percentage points above U.S. Treasuries last week, according to Merrill Lynch & Co.'s U.S. Corporate Master Index. The debt is little changed in 2008, Merrill data show, on pace for the worst year since 1999.
Junk Bond Distress Levels Surge to 5-Year High, Signaling Europe Defaults

Fed May Increase Lending to Banks, Brokers as `Mother of Year-Ends' Nears The Federal Reserve may have to increase the cash it provides to banks and brokers, already a record, to help them balance their books at the end of the year. Six bank failures in the past two months and rising concern about Lehman Brothers Holdings Inc.'s capital levels pushed lenders' borrowing costs to near a four-month high yesterday. They may climb further as companies rush for cash to settle trades and buttress their balance sheets at year-end. ``This could be the mother of year-ends,'' said Brian Sack, vice president of Macroeconomic Advisers LLC in Washington, who used to serve as head of monetary and financial market analysis at the Fed. ``The markets will need extraordinary actions to get through it.'' One option is for banks and brokers to increase the loans they take out directly with the Fed; the central bank reports on the figures today. Officials could also offer options on its biweekly loan auctions or introduce special repurchase agreements to straddle the end of the year, economists said. When policy makers sought to head off a potential funding crunch with the year 2000 changeover, they auctioned liquidity options to the primary dealers of U.S. Treasuries. Traders in the forward markets, where financial instruments are sold for future delivery, are pricing three-month cash from December to March at 90 basis points over expectations for the federal funds rate. That's up from 85 basis points at the start of the week and an average of 7 basis points average in 2006. ``If banks are unwilling to lend to other banks, then they are unwilling to lend to you and me,'' says Stan Jonas, chief executive officer at Axiom Management Partners LLC, a New York investment firm. ``The market anticipates that we will be in a heightened state of credit risk.''

Fed Direct Loans Lose Stigma as Commercial Banks Push Borrowing to Record Commercial banks that a year ago rebuffed a Federal Reserve program to provide cheaper cash may be increasingly dependent on it. Borrowing from the Fed's discount window hit record levels in six of the past eight weeks, and reached $23.5 billion as of Sept. 10, Fed data show. By comparison, lending averaged just $779 million a week in the three months after New York Fed President Timothy Geithner urged banks to use the program. The increasing use of the funds risks delaying banks' disposal of nonperforming assets and capital raising. It also may make it tough to restore the rate on the loans to the historical 1 percentage point premium over overnight funds, analysts said. The Fed has lowered the rate nine times since August 2007.

Finance Industry Consequences

Hedge Funds Get Rattled As Investors Seek Exits  With anxiety about hedge-fund woes gripping the market, funds have their own fear: their investors. Some investors, particularly what are known as "funds of funds," are demanding their money back and may ramp up requests in the weeks ahead. That has prompted hedge-fund managers to sell securities to raise cash. "As the hedge fund investor base broadens, hedge fund portfolio management...slips out of the hands of the portfolio managers and into the hands of the investors," wrote Andrew Redleaf, who runs Whitebox Advisors, a Minneapolis hedge fund with about $5 billion under management, in an August client letter. "It is no insult to the investors to say that this worsens performance." Funds-of-funds select hedge funds on behalf of pension funds, wealthy individuals or other investors, and charge a layer of fees on top of the hefty fees levied by hedge funds themselves. They often ask hedge funds for the option to redeem money as often as monthly and get good terms because they can bring in big chunks of cash at once. Some put in withdrawal notices to keep their options open, though they may ultimately decide to leave the money. Investors know that it can pay to be the first out the door of an underperforming hedge fund because as other investors cash out, the fund sells its holdings, pushing down prices. Many investors themselves have borrowed funds to juice their returns and when leverage amplifies their losses they can end up more eager to pull out.

Warren Buffett's happy housing story Not every subprime lender is drowning in red ink. Berkshire Hathaway subsidiary Clayton Homes, the nation's largest maker and financer of prefab and mobile homes, has been a bright light in a mortgage market that has generated $500 billion in write-downs since the start of 2007. In 2003, Warren Buffett acquired Clayton, a family-run business based in Maryville, Tenn. In a memo, obtained by Fortune, to Berkshire Hathaway's (BRKB) board of directors, Buffett pointed out how well Clayton's loan portfolio has held up, even though 45% of the company's loans are to borrowers with subprime credit scores. The company's loan delinquency rates have been stable: On June 30, 2004, the rate was 3.26%; last year it was at 3.5%; and now it's 3.82%. (In comparison, the delinquency rate in the traditional housing market is around 6.4%.) Annual credit losses are running steady at a reasonable 1.5% of the loan portfolio. And Clayton's foreclosures have actually dropped from two years ago, from 5,823 to 4,588. What's behind the portfolio's strength? Clayton is more careful about lending because it keeps all loans on its own books rather than offloading them to others by means of securitization. As Buffett wrote, "When we make a mistake in making or buying a loan, it costs us money, not some buyer thousands of miles away who ends up with an RMBS, CDO, or (horror of horrors) a CDO squared." Another important fact is that Clayton has banked on homebuyers who can afford their monthly payments and who purchased their houses for shelter, not for speculation. Clayton also avoided the mortgage industry practice of enticing buyers with low initial payments, followed by much higher payments a few years down the road. Most notably, Clayton's customers aren't likely to walk away from a house simply because it has lost value.

Harvard Endowment Returned 8.6% Harvard's endowment returned an impressive 8.6% for the fiscal year, but CEO Jane Mendillo says volatility will bring challenges. "We're cautious about returns for the next few years," says Jane Mendillo, age 49, who took over on July 1 as president and CEO of Harvard Management Co., the company that runs the endowment's money. The returns for the nation's largest endowment fell within range of preliminary expectations of 7% to 9%. After taking into account annual distributions to the university and new gifts, the endowment's value rose to $36.9 billion from $34.9 billion. The 8.6% return compares to a median return of negative-4.4% among the 165 large institutional funds measured by the Wilshire Trust Universe Comparison Service. Over the past 10 fiscal years, Harvard has an annualized return of 14%, compared with the median fund return of 6.1%.She said that the strong performance over the past year in a tough investment environment endorsed the Harvard approach, which relies on internal money managers in addition to outside managers. The model "enables us to be more nimble than other funds," she says. Harvard's staff, for instance, pursued a strategy of purchasing credit-default swaps to shield the fund from wild market swings. Harvard's 2008 returns got a big boost from a category it calls "real assets," which includes commodities, timber, agricultural land and real estate. That category gained 35.8%. Harvard put 8% of its assets in commodities last fiscal year, and despite the recent selloff in most commodity prices, it is maintaining that 8% allocation. Bond investments, in particular a 21% return from foreign bonds and inflation-indexed bonds' 20% return, also were a big part of the returns. While some of the endowment's outside hedge funds did well, the collapse of Sowood Capital Management undercut those gains. Harvard lost about half of its $975 million investment in Sowood, which was founded by former Harvard endowment manager Jeffrey Larson, and sold its portfolio to Chicago-based hedge fund Citadel Investment Group.

Next Housing Tsunamis

The CRE Bust: Quick Overview This morning the WSJ and the NY Times had articles on Mall troubles. See WSJ: Mall Glut to Clog Market for Years and NY Times: A Squeeze on Retailers Leaves Holes at Malls. This should come as no surprise. Historically investment in non-residential structures lagged investment in residential by 5 to 8 quarters. The reasons are pretty clear - the commercial builders (for malls, offices, lodging, etc.) don't build until the residential is in place, and the commercial build cycles are usually longer than residential. From the American Institute of Architects: Architecture Billings Index Continues in Negative Territory. “As a leading economic indicator of construction activity, the ABI shows an approximate nine to twelve month lag time between architecture billings and construction spending.” The key here is that the index fell off a cliff in early 2008, and that there is "an approximate nine to twelve month lag time between architecture billings and construction spending". We should expect weaker non-residential structure investment in the second half of 2008 and throughout 2009. From the Fed: The July 2008 Senior Loan Officer Opinion Survey on Bank Lending Practices. Of particular interest is the increase in tighter lending standards for Commercial Real Estate (CRE) loans. This graph compares investment in non-residential structure with the Fed's loan survey results for lending standards (inverted) and CRE loan demand. Note that any reading below zero for loan demand means less demand than the previous quarter. This is strong evidence of an imminent slump in CRE investment. This graph based on data from the Federal Reserve shows the delinquency rates at the commercial banks for three key categories: residential real estate, commercial real estate, and consumer credit cards. Commercial real estate delinquencies are rising rapidly, and are at the highest rate since Q1 '95 (as delinquency rates declined following the S&L crisis). It should be no surprise that investment in CRE will decline in the 2nd half of 2008 and in 2009.
Investment: Residential vs. Non-Residential

Foreclosures in U.S. Reach Record in August as Housing Crisis Cut Prices U.S. foreclosure filings rose to a record in August as falling home prices made it harder to sell or refinance homes to pay off the mortgage, RealtyTrac Inc. said. Owners of 303,879 properties, or one in 416 U.S. households, got a default notice, were warned of a pending auction or foreclosed on last month. That was the most since reporting began in January 2005. Filings increased 27 percent from a year earlier, about half the annual pace of previous months, because of high default totals in August 2007, the Irvine, California- based seller of foreclosure data said in a statement today. The worst housing slump since the 1930s shows little sign of abating. Home prices in 20 U.S. metropolitan areas declined 15.9 percent in June from a year earlier, according to the S&P/Case- Shiller index. Prices may fall another 10 percent through the end of 2009, according to analysts at Lehman Brothers Holdings Inc. August filings were 11 percent higher than the previous record of 273,001 set in May, according to RealtyTrac. Filings rose 12 percent from July. Bank seizures, the last stage of the foreclosure process, known as real estate-owned or REO properties, more than doubled from a year ago to 90,893. Defaults rose 10 percent and auctions rose 7 percent from August 2007, said RealtyTrac, which has a database of more than 1.5 million properties. There are 3.9 million unsold existing single-family homes, the most since at least 1982, according to the Chicago-based National Association of Realtors. There is an 11.1 month supply of existing unsold homes at the current sales pace, up from 4.6 months in September 2005, the Realtors said. Financing is difficult to obtain, and borrowers must put down 20 percent to 30 percent of the purchase price, said Mark Goldman, senior loan officer at Windsor Capital Mortgage in San Diego. About 90 percent of borrowers at his company get 30-year, fixed-interest-rate loans, he said.

Alt-A Mortgages Pose Next Risk for U.S. Housing Market After Subprime Rout Homeowners lured by low introductory rates to Alt-A mortgages, which typically require little or no proof of a borrower's income, may fuel the next wave of foreclosures and further delay a recovery from the worst housing decline since the 1930s. Almost 16 percent of securitized Alt-A loans issued since January 2006 are at least 60 days late, data compiled by Bloomberg show. Defaults will accelerate next year and continue through 2011 as these loans hit their three- and five-year reset periods, according to RealtyTrac Inc., an Irvine, California-based foreclosure data provider. About 3 million U.S. borrowers have Alt-A mortgages totaling $1 trillion, compared with $855 billion of subprime loans outstanding, according to Inside Mortgage Finance, a trade publication in Bethesda, Maryland. Of the Alt-A borrowers, 70 percent may have exaggerated their income, said David Olson, president of mortgage research firm Wholesale Access in Columbia, Maryland. Risks extend beyond banks and consumers to Washington-based Fannie Mae, which owned or guaranteed $340 billion of Alt-A mortgages in the second quarter, equal to about 11 percent of its total single-family mortgage credit book of business. The loans accounted for half of the company's second-quarter credit losses, according to a regulatory filing. Alt-A holdings at McLean, Virginia-based Freddie Mac were $190 billion, or 10 percent of its mortgages, in the second quarter, according to the company's Web site.

 

Posted by dblwyo at 09:50 AM | Permalink | Comments (0)

What a week, actually what a two weeks. There's so much going on it's hard to pull it together and wrap some common threads and themes around it all. But the bottom line is that the Credit Contagion Metastasis (Cramer's Anniversary: Continuing Credit Metastasis and Economic Outlook) we've been talking about for months (and it seems months and months...usw.) is about to collect the scalps of some more victims. In actual point of fact the size and magnitude of what's going on now is tremendous and scary but this is NOT AS BAD as things were in Mar. when BSC imploded and it looked like markets were going to collapse until the Fed found the magic tools and the right way to use them. Which is not to say that these aren't dire situations and you could see some very unpleasant surprises come Monday morning that are about as serious as it gets.

UPDATE: here's how serious this is in case you didn't get it:

• Masters of the Univers Meeting to Save Us: Lehman Deal Could Come Tonight As High-Level Talks Continue
• $5T in Exposures:How big are Lehman, Merrill, and AIG?

Update 2:

No Deal Reached Yet for Lehman The outlines of plans to determine the fate of Lehman Brothers Holdings Inc. emerged today even as it became increasingly clear that a clean sale of the entire firm to a big bank would be too difficult to execute. A sense of optimism that a rescue could be arranged today dimmed as a growing sense of gloom descended on Wall Street.

 

BUT, and seriously here's the good news in bad situations, this is the working out of the confluence of all the breakages we've been talking about: risk re-pricing, de-leveraging and broken Finance Industry business models. And that's not a light at the end of the tunnel it's the headlamps of the next crisis and breakdown coming down the tunnel. With last weekend's take outs of the world's largest financial institutions on whom the health of US and world economies was utterly dependent one would hope we'd get some breathing room. But beyond Frannie, Lehman (LEH), Washington Mutual (WaMu or WM), Merrill (MER) and AIG appear to be lined up right behind. And then who knows - though we'll find out. There was a small irony in all this - in reviewing my AIG problems clipping files they start with the '05 criminal charges that were partly the aftermaths of the last bubble bursting and associated shady dealings and led on to two years of write-downs, management changes, etc. etc. Nobody can catch a break. If you stop to think about it these guys had barely sobered up and hadn't repaired the damages from the last party when they starting drinking the koolaid again. This time we seem to be more prepared to face realities. Take a look a the chart which shows the Finance ETF (XLF), LEH, WM, MER, and Citi (C). Notice how extraordinary it is. The XLF was down over the last three months but the walking dead men were down 30-40%, which is outrageous though accurate. JUST in the last week they've all essentially collapsed, much the way Frannie (FNM, FRE) did last week and BSC did in March. In other circles when your market value goes to zero they call
that bankruptcy ! :)

Markets Reactions: Jaded But Not Faded

Let's start by taking a look at this very simple but very meaningful 10-day chart of the SPX and see what it can tell us. In case you forgot week before last began with a holiday which for market and economy watchers faded into a horror show - except for those of us who've been anticipating the onset of realities for some time. Confirmed with last Fri's unemployment numbers but subject so far this year to Kubler-Ross stage 1 Denial. Now this week was about as wild and woolly as it gets for going nowhere. All the daytraders were looking for a bump up Mon post rescue and didn't get it, unlike all priors. Instead we got some very odd days with huge opening gaps down that recovered by the end of the week. Yet at the same time we didn't get the kind of rallies we got earlier in the year. Reality check ? WTF ? What's going on here ?

Reality Setting In ?

Consider that last point because it gets to the heart of things and will define how they evolve from here. When the first metastatic crisis set in around January and we were all about to be taken out by BSC's collapse the Fed a) stepped in for a rescue but b) created a whole raft of innovative new intervention instruments that got the completely frozen markets working again. Like we said at the time that cleared the pipes but didn't mean there wasn't a lot of sewage to keep draining. (Credit Meltdown, Economy and Consequences: Putting the Pieces Together) But if you look at the yellow circle the markets thought it did. And again in mid-July when Frannie was going under for the 2nd time, the Treasury stepped in, and don't forget MER said it was all.....l right now (thank you Dave Mason) and we were back to the races. Notice each time that the recovery before the next binge is shorter and shallower though. And then we reach this very week. And there's hardly any recovery at all. Though if reality were truly at K-R Stage 2, Acceptance, we'd be moving on to figure out how to cope. So don't be surprised if there are some more Koolaid consumption episodes. The stuff is really addictive. But we think we're seeing some serious attempts by Mr. Market to go cold turkey and detox. One step at a time.

Speaking of De-Tox

Let's take a slightly shorter timeframe and see whether or not that detoxification program is beginning to set in. Like we said the bear market rally was pretty short and shallow in comparison to March's. If you take a look at this chart you can see where the rally was decisively busted apart, initially on the economic news. Yet in the intervening two weeks we've had huge swings for what amounts to a sideways market. So don't be surprised at some bounces while the toxins are sweated out. But what we think we're seeing is a fundamental shift in mental outlook here. Dr. Pangloss is in the process of being booted out of the building...at long last and at least 18 months over-due.

Beyond the Veils of Delusion 

The Buddhists have it right though - the world is filled with pain and it is inescapable. Whether it turns into suffering depends on your head - if all you can do is see the pain then you'll be consumed by the suffering. If you accept the pain for what it really is, don't deny and don't get hooked by the perverse pleasures of the suffering or looking for the "drugs" to offset you can keep your balance and figure out a way to cope.

And to our great delight we think that process of seeing the world as it really is and what needs to be done to cope with it is getting wider recognition and acceptence. First of the 12 Steps, eh ? Our reference points are the several articels we've made a point of drawing your attnention to recently that, for the first time in months, perhaps years, see the world the way we're seeing it. And this evening's WSJ had another which is as good a summary of the various feedback cycles that are feeding on one another. Heavens - soon we'll all be systems analysts together. (News Alert: Vicious Credit, Economy, Market Cycle Spotted) This one was so important we excerpted big chunks but it's as good an encapsulation as anything we've read. Also in the readings you'll find running softclips on LEH, WM, and AIG. Who as we speak are in the process of following BSC, FRE and FNM off the cliffs. Sadly that's not the Acapulco waterline below but rocks. The tide's out. 

Strategic Situation Assessment 

Options for Battling Crisis Narrow A year into a credit crisis that started with troubled mortgages to sketchy borrowers, the financial system is reeling once again, casting a pall over a widening array of financial institutions just days after history-making efforts by policy makers to contain the problem. With the share prices of Lehman Brothers Holdings Inc., Merrill Lynch & Co. and other financial firms on a roller coaster, the crisis could be entering a critical stage. The Federal Reserve has already slashed interest rates to counteract a deepening credit freeze and instituted its broadest expansion of lending facilities since the Great Depression to keep financial markets functioning. Over the weekend, the nation's two main mortgage finance firms -- Fannie Mae and Freddie Mac -- were placed under government control. Federal officials and market players are struggling with the same issues: Why haven't the steps taken so far calmed the system? What can policy makers do next? Should the U.S. government let a big institution fail rather than stage another potentially costly bailout? Lehman, one of Wall Street's last big independent firms, saw its stock plunge 42% a day after the company unveiled a plan to shrink itself as a way to ride out the crisis. It is now in talks to be sold altogether, though it's not clear there will be takers. But other measures of financial conditions are as bad as they were back in March, when the Fed and Treasury arranged the abrupt takeover of Bear Stearns by J.P. Morgan Chase & Co. For instance, junk bonds now yield 8.55 percentage points more than safe Treasury bonds, a spread that is about as wide as it was in March. These spreads widen as investors become more fearful about risk. Banks are also finding it more costly to fund themselves. Wells Fargo & Co. of San Francisco, which has weathered the crisis better than most peers, was forced this month to promise higher-than-expected yields on debt securities it issued in order to lure nervous investors. Last month, Citigroup Inc., American International Group Inc. and American Express Co. all faced weak demand for bond issuances that pushed up the yields they had to pay.

Three problems are behind the latest wave of trouble. First, the economy shows signs of weakening as stimulus from federal tax rebates wears off. A survey of 51 economists for The Wall Street Journal projects that consumer spending will contract in the third quarter for the first time in 17 years. Lower energy prices are helping, but might not be enough to counter the heavyweights of the housing crunch and job cuts. Second, households and financial institutions aren't finished with a painful process known as deleveraging, in which they reduce their reliance on debt. These two processes -- deleveraging and soft consumer spending -- can feed on each other, something economists call an adverse feedback loop. Deleveraging puts downward pressure on home prices. That, in turn, forces financial institutions to deleverage more. In the same way, falling home prices squeeze households, which forces them to cut back on spending and puts off a housing recovery, further weighing on home prices. The government's many interventions have been designed to break this feedback cycle. But such efforts increasingly show signs of running up against their limits. "There's no trend of improvement. It's not improving even slowly," says Laurence Meyer, a former Fed governor and now vice chairman of Macroeconomic Advisers LLC, an economic-forecasting firm. A third wrinkle is that financial firms are having an increasingly hard time raising the capital they need to hasten the process of deleveraging. In the past year, sovereign-wealth funds and others have poured billions of dollars of fresh capital into Lehman, Merrill Lynch, Citigroup and others. Stung by mammoth losses on those investments, many investors are now balking. Sovereign-wealth funds, many of them facing criticism at home over the investments, have stayed on the sideline as Lehman and other firms have struggled to raise capital.

Frannie 

'Franron' bailout: Good plan, bad news I would like to share my belief -- and this may shock folks -- that Hank Paulson has actually crafted a pretty good plan for Fannie Mae (FNM, news, msgs) and Freddie Mac (FRE, news, msgs), aka "Franron." That, given the bad hand he was dealt. We've all known for a long time that the government would stand behind the mortgage giants when push came to shove. And in this particular case, the Treasury secretary's plan comes with some pain. As proposed, these government-sponsored enterprises, or GSEs, will eventually have to reduce the size of their balance sheets in a dramatic way. When you compare this inevitable bailout to what Federal Reserve chief Ben Bernanke pulled with the merger of JPMorgan Chase (JPM, news, msgs) and Bear Stearns, using the Fed's balance sheet, you can see that this one is far more palatable. In sum, the Treasury took a harder and more sensible tack than I'd feared it would. (I'm sure some people will disagree, but that's how I see it.) However, the Franron bailout basically isn't good news for the economy. It's only the avoidance of more bad news, because future problems at GSEs will be less likely to deepen the freeze of the financial system. We landed where we knew we'd be one day, with Franron as a de facto ward of the taxpayers Some thoughts on the market action: I found last Tuesday's market slide, as well as the subsequent action, to be rather ominous. And I wasn't alone in that view. A couple of friends who are astute market observers, with more than 30 years in the business, said Tuesday felt like the Friday before the crash of 1987, as it did for me. On that score, it's worth passing along a point made Wednesday by well-known market watcher and author Justin Mamis: Every time the Fed or Treasury has taken some action since the August 2007 rate cut, it has produced a substantial rally that's run for months or weeks. But Monday's Franron-bailout rally was just a one-day wonder, and the market was walloped the next day. Mamis thinks that was very important. Quoting him directly: "It makes yesterday's disaster all the more dangerous. They should have followed through, as they had on each of the previous news-related rebounds, but collapsed instead . . . and collapsed not just because of Lehman (LEH, news, msgs); the commodities were even weaker. If there is further follow-through downward today, the selling is likely to accelerate. . . . Of course, they don't have to do it all at once; they don't have to do it this morning or today. But when they do! . . . " In summing up, Mamis said: "That's a precursor message . . . that there is more selling yet to come."

Lehman

Lehman Reports Loss, Plans Auction of Neuberger Stake, Real Estate Spinoff Lehman Brothers Holdings Inc., reporting the biggest loss in its 158-year history, said it will sell a majority stake in its asset-management unit, spin off commercial real-estate holdings and cut the dividend in an effort to shore up capital and regain investor confidence. Lehman rose in early New York trading after posting a $3.9 billion third-quarter loss on $5.6 billion of writedowns. Analysts surveyed by Bloomberg had predicted a $2.2 billion loss. The company said it aims to complete the asset-management sale in an auction, without naming potential bidders. The real- estate spinoff is expected to be completed in the first fiscal quarter of 2009, according to a statement today. ``They are saying `we are fine now,' and that's buying them time to negotiate for that additional capital,'' Brad Hintz, an analyst at Sanford C. Bernstein in New York and former Lehman finance chief, said in a Bloomberg Television interview. ``They will need capital as part of the spinoff.'' Pressure on Lehman's Richard Fuld, the longest-serving chief executive officer on Wall Street, mounted yesterday after talks with Korea Development Bank ended, sending the shares tumbling 45 percent. Fuld is striving to convince investors that the fourth-largest U.S. securities firm will stem losses as housing prices decline. He and his management team also must keep clients and employees from leaving the company. ``I hope Lehman doesn't succumb this time either because we're running out of investment banks,'' said Sean Egan, president of Egan-Jones Ratings Co. ``And it takes 100 years to create a good one.''

• Lehman's Survival Hinges on Fuld's Reluctant Sale of Neuberger Fund Unit
• Brad Hintz Says Lehman to Need Capital for Asset Spinoff
• Fed-Loan Access Gives Lehman Brothers Breathing Room Bear Stearns Lacked Lehman Brothers falls 35% after talks with a Korean bank end. BNN interviews Dick Bove, analyst with Ladenburg Thalmann about Lehman and other banks, which are tumbling today.

Lehman Races to Find Buyer  The crisis gripping the nation's financial system deepened, with Lehman Brothers Holdings Inc. racing to sell itself over the weekend and other major U.S. institutions scrambling to show they have the financial wherewithal to ride out the crisis. Potential buyers of Lehman were heading toward a standoff with federal officials Friday. Firms weighing offers for the battered investment bank sought financial assistance, while Treasury Secretary Henry Paulson has insisted he won't support a government-led bailout, people familiar with the situation say. The weekend's negotiations over Lehman's fate could define the next chapter of the government's handling of the crisis. Because Lehman does business with several other Wall Street firms, the damage from a failure there could have widespread effects. It was precisely that concern that prompted the U.S. in March to orchestrate the sale of Bear Stearns Cos. to J.P. Morgan and limit the bank's exposure to bad assets on Bear's books. Potential buyers of Lehman want a similar deal, but the Treasury Department looked unwilling on Friday to step in with financial backing. Mr. Paulson and Federal Reserve Chairman Ben Bernanke don't see a need to structure a Bear-like rescue. In large part, that's because Lehman has been able to borrow money to roll over its short-term debt by accessing the Fed's discount window, an emergency facility it extended amid the Bear bailout. As of late Friday, Bank of America Corp. was seen as the likeliest buyer, but Lehman and its investment bankers also were meeting with other potential bidders, including Barclays PLC and HSBC PLC, both of the U.K. Other parties were looking only at pieces of Lehman, with Goldman Sachs Group Inc. interested in some of the securities firm's huge real-estate portfolio.

WaMu

Washington Mutual, National City Lose Suitors as New Accounting Rule Looms -- Washington Mutual Inc. Chief Executive Officer Alan Fishman, who sold the last bank he ran, may not be able to repeat the feat because new accounting rules for devalued loans are driving away buyers. At least three potential acquirers ended talks this year to buy either Seattle-based WaMu or Cleveland's National City Corp., according to two bankers involved in the talks. A sticking point, they say: a rule change that will force acquirers to compute a target's assets at market prices instead of deriving values from measures including the purchase price. The Financial Accounting Standards Board's change, effective in December, may delay consolidation in an industry saddled with more than $500 billion in writedowns and credit losses. Loan prices may drop by about 30 percent from their valuation at maturity, said Robert Willens, a former Lehman Brothers Holdings Inc. accounting analyst and executive who teaches at Columbia Business School. ``The new rule will curtail M&A by making it too expensive,'' said Willens, who also runs a tax consulting firm in New York. ``With loans fetching their greatest discounts since the Great Depression, it sharply reduces the value of a target's assets. That will force an acquirer to raise additional capital in this very difficult environment.'' The new rule isn't the only obstacle to bank mergers. Plunging home prices and rising defaults have punctured mortgage securities, forcing lenders to conserve cash. U.S. markets remain ``volatile and fragile,'' and bankers are reluctant to lend because of increased risk, Deutsche Bank AG Chief Executive Officer Josef Ackermann said at a Sept. 5 conference in Canada.

AIG

AIG's Willumstad May Dismantle House That Greenberg Built to Stop Bleeding American International Group Inc. Chief Executive Officer Robert Willumstad may sell consumer- finance and reinsurance units as he chips away at the company Maurice ``Hank'' Greenberg built over 38 years. Willumstad, 63, has to convince investors there's an end in sight to the writedowns that caused the largest U.S. insurer to post three quarterly losses totaling $18.5 billion, analysts said. Central to that is selling or shutting down the unit that sold credit-default swaps, the protection for debt investors that plunged in value as the securities they guaranteed declined. He has said he will unveil a turnaround strategy Sept. 25. Willumstad, the former Citigroup Inc. president named CEO in June amid investor uproar over a stock slide that has reached 70 percent this year, has said there are ``no quick fixes'' for New York-based AIG. Selling units acquired by Greenberg, who ran AIG until 2005, may be necessary as losses from the swaps -- responsible for more than $25 billion in writedowns during the three previous quarters -- depletes capital and puts AIG at risk of credit downgrades. Businesses that may be sold include American General Finance Corp., the division that makes home and auto loans, said Citigroup analyst Joshua Shanker. The unit generated $2.89 billion in revenue last year, about 2.6 percent of AIG's total. Other candidates include AIG's U.S. variable-annuity business, and a 59 percent stake in reinsurer Transatlantic Holdings Inc., he said.

• Optique's Fitzpatrick Discusses AIG, Financials

AIG May Hold Analyst Call As the endgame plays out for Lehman Brothers Holdings Inc., pressure is rising on two other financial behemoths to take action to convince investors to stick with them. On Friday, credit-ratings firm Standard & Poor's threatened to downgrade American International Group Inc., citing the significant decline in the company's share price and the increase in credit spreads on the company's debt. Meanwhile, AIG will likely hold an analyst call Monday morning and could announce a series of steps aimed at reassuring investors, including possible asset sales, a person familiar with the matter said. A rapid plunge during the week in the price of AIG shares -- the stock fell more than 30% on Friday alone -- coupled with equally worrisome signs for the insurance giant in the debt markets, appeared to increase the heat on management to act. News of AIG's plan marked a turnaround in tone for the company, which just Thursday had maintained it was sticking with its schedule to unveil by late September the strategy of new chief executive Robert Willumstad. The company's stock has fallen steadily in recent weeks and is now down 79% this year. Meanwhile, shares of securities firm Merrill Lynch & Co. fell 38% in the four trading days since concerns emerged about Lehman's viability as an independent company when talks to sell a stake to a Korean bank ended. While both Merrill and AIG were roiled as Lehman-generated concerns rippled through the market, each has distinct sets of problems. The concerns about Merrill center on its holdings of the same kinds of assets, commercial real estate and residential mortgages, that required write-downs by Lehman. Those write-downs fueled the need for Lehman's own restructuring plan, announced on Wednesday. Investors also are concerned that Merrill, despite having purged itself of most of its exposure to toxic mortgage assets, could have the weakest balance sheet of the three major independent securities firms that would remain after the demise of Bear Stearns in March and a sale of Lehman. The other independents are Goldman Sachs Group Inc. and Morgan Stanley.

Posted by dblwyo at 07:44 PM | Permalink | Comments (0)

Well judging from the readership stats it's not entirely clear that my light-hearted approach to the rather serious subject of major earnings problems got the attention it really deserves. (Using the Palantir: Beyond Fear to Performance and Returns) Or perhaps my approach was too calmly and judiciously phrased and too ponderously charted. No matter, with that superb senseof timing and decorum for which our British cousins are world renowned as John Cleese amply demonstrated in "a Fish Called Wanda" the Economist has come to my rescue with a simple, not very subtle and very pointed dissection of the situation.

Defined as what happens when the economy weakens, the dollar rises, exports drop off and foreign earnings go in the tank ? Their answer is beautifully encapsulated in the cartoon as Atila's hordes raid Wall Street. Well, you can't say you aren't being warned both with my own modest efforts and the authority of the world's best business publication. Let me let them speak for themselves from here - and continue after the break in a longish excerpt:

American corporate profits: A turn for the worse

The outlook is deteriorating even for the best-performing firms, let alone the troubled ones

"…anyone tempted to hope that falling energy costs will mean higher profits for other American firms should think again. To the extent that oil prices are falling because of slowing global growth—the likeliest explanation, despite the flap earlier this year about the role of speculators—then they are likely to be an indicator of falling profits across the board. As oil prices tripled between 2002 and 2007, aggregate corporate profits doubled. Both reflected strong global demand, points out David Rosenberg, an economist at Merrill Lynch. He says the recent decline in energy prices is a “symptom of demand destruction” that has dire implications for overall profitability. Mr Rosenberg has just written a gloomy report identifying “four horsemen” that will do their worst to American corporate profits: thinner profit margins; paying down debt as tighter financial conditions take their toll; lower energy prices; and a combination of slowing growth outside America and a stronger dollar. He predicts 7% falls in profits for firms in the S&P 500 both this year and next."

This relative health was largely due to high energy prices, which benefited energy firms such as Exxon Mobil. They now account for 20% of S&P 500 profits, up from around 5% five years ago. Profits have also been buoyed up by strong demand from overseas, especially emerging markets. Domestic-based American non-financial firms have seen their profits decline at an annualised rate of almost 14% during the past six quarters, says Mr Barnes. But the profits of overseas subsidiaries of American non-financial firms have risen for 22 consecutive quarters, typically showing double-digit annual gains; they now account for 50% of the total profits. Already countries that represent half of American exports, including big trading partners such as Japan, Canada, Germany and France, have posted at least one negative quarter of GDP growth, says Mr Rosenberg. As the global economy slows, the boost from abroad seems likely to weaken. Add to that the fact that the dollar has been rising like a homesick angel ever since The Economist’s Big Mac Index pronounced it too cheap in July, and it seems certain that this will be a disappointing quarter for many internationally leaning American firms. Moreover, several economists predict that the recent rise in the dollar is the start of a long-term trend. “American companies are simply not prepared for this,” says Wolfgang Koester of FiREapps, a provider of software for managing currency risks. “They took the free ride on the falling dollar, and by and large are not hedged against its rise.” The more the dollar rises, the more it will help foreign firms that export to America, which have had to work hard in recent years. For instance, Airbus, Europe’s aviation giant, has struggled because it relied on dollar revenues to cover its euro costs. If the dollar stays where it is until the end of the year and global growth in industrial production slows to 2% from 4.5%, the growth in overseas profits of American firms would slow to 2.5% in 2009 from 21% this year, Mr Barnes calculates. If the dollar were to rise by another 5% in trade-weighted terms, and global growth were to fall to zero, overseas profits would drop by 7%.

Mr Rosenberg is gloomier than most economists because he expects America’s GDP to shrink over the coming year, whereas the consensus is that it will continue to grow, albeit modestly. Wall Street’s equity analysts, by contrast, predict an increase of more than 20% in S&P 500 profits in 2009. They assume that the fortunes of financial-services firms will improve and America’s economy will grow. But profit growth of over 20% is typically associated with a rise in GDP of around 4.5%, and it has never occurred with GDP growth of less than 3.2%, which is roughly twice the consensus forecast for next year, says Mr Rosenberg. He suspects that equity analysts, who are having one of their least accurate years ever, are too busy trying to forecast profits for this quarter to correct their outlook for 2009. Although Exxon Mobil can live with earning profits at a slightly slower rate, a growing number of firms are struggling to turn any sort of profit or even to bring in enough money to pay their debts. Moody’s, a rating agency, recently raised its forecast of defaults on high-yield corporate bonds to 7.4% over the next 12 months. The actual default rate over the past year is 2.65%—and 4% at an annualised rate so far in 2008—up from a low of 0.96% in 2007. The number of debt issues that are distressed (ie, are yielding at least 1,000 basis points more than Treasury bonds of a similar maturity) has soared to 27% of those in the main Merrill Lynch high-yield index, up from 1% last year.

The list of troubled firms has now extended far beyond the housebuilders and building-supplies firms that were the first casualties of the subprime-mortgage crisis to include retailers, casinos, publishers and cable-TV companies, points out Martin Fridson, a veteran observer of corporate bonds. Companies with distressed debt now include such household names as Delta Air Lines, Clear Channel, Toys “R” Us and Reader’s Digest. There would already have been more high-profile bankruptcies, points out Mr Fridson, except that at the peak of the credit bubble some of today’s more troubled firms managed to borrow “covenant lite” debt that makes it harder for creditors to demand their money back. But that seems likely to delay only briefly the arrival of the Grim Reaper.

Posted by dblwyo at 07:32 PM | Permalink | Comments (0)

We've left the longish post on the Economic outlook up and undisturbed for a while since it seemed to be drawing a lot of attention but it's time to move beyond the unpleasant outlook and ask so what ? In Lord of the Rings the Palantir where the great seeing stones crafted to allow someone with the skills to see beyond the local, if they had the will, power and the discipline to not let their vision be distorted. We're going to take our best shot at that and ask what does this all mean for current and future business performance - and the short answer is that anybody can be a hero in good times but now we're going to find which companies are being well-run and which were drifting on the tide or worse.

And we're going to do that in two ways - first by laying out the arguments for what to look for and the linkages between the economy and business outlook and second by putting another collection of readings up split into General Business information, Retailing and Retailers, the Auto Industry and Other Industries/Companies. As this week's market actions show we're crossing several perceptual tipping points where the normal Fed intervention being followed by yet another bear market rally has been replaced with a cold dose of realities. Today for example, while the main indexes were up they faded rapidly at the end of the day after having fallen the prior two. And the Financials who've been the mainstay of hallucinogenic behavior actually fell today. Given that the nationalization of Frannie was succeeded by the near collapse of Lehman and WaMa and others are tanking the only surprise is why it's taken so long. Our answer is that many of the Palantir gazers were seeing what the Dark Lords wanted them to see and not reality. That reality is composed of the links between the economy and profits, the links between good business practices and profits, the split of valuations between current and future value and the nature of good practices that maximize opportunities.

Profits and the Economy 

Given a weakening economy that's about to get weaker and the growing awareness of that fact along with continued denial what is the link ? The links between GDP, Corporate Profits and the Markets should be clear from these charts showing the YoY changes back to 1980. With the most recent GDP release we got Q208 data and Profits are down -7% ! What's more this is the sixth quarter in a row that they've been dropping and the rate of decrease is accelerating. Worse this isn't just a Finance problem. Non-financial profits dropped -17% in Q2 after having dropped -8% and -11% in the prior two quarters. If anybody thinks earnings, valuations and PEs aren't in trouble you can probably stop reading now as the Dark Lord will completely distort your vision.

Profits, Performance and Business Practices

Obviously the Frannie, LEH, BSC, WaMA, etc. etc. stories are poster children for why one should run a prudent and disciplined business with good control and management practices. But did you know that the Auto Industry is asking for $50B in government loans under the guise of transitioning their product mix to more energy efficient models ? Or that with cliff-diving sales the risks of Bankruptcy are rising daily ? Probably but pay attention anyway. What you may not have heard is that the Retail Industry as a whole is so over-stored and under-executed that a huge shakeout and consolidation will emerge that will change much of the landscape. And create enormous opportunities for turn-around specialists and the Private Equity investors. Now we've been flapping our gums forever about poor corporate performance and the lack of disciplined and systematic approaches but McKinsey, Stamford and the London School of Economics just releases the results of a worldwide study of 4,000 firms that finds almost exactly what we've been saying by anecdote and onesie/twosies. Since they make all our main points let's just let them: 

"The spread of management performance between firms, even those of similar size operating in the same industry sectors in the same regions, is very broad, sug­gesting that management excellence is a matter of internal policy and not just the business environment. The techniques of good management are well known and in the public domain so the fact that they are so poorly disseminated suggests either that successful implementation is elusive or that it is not a priority for many firms. We also found the managers interviewed had little idea of the overall management performance of their own organizations. …Overall, regional differences accounted for only 9 percent of the difference in management practice. Performance differences between companies in the same country were far larger than any regional variations and there is substantial overlap between regions (Exhibit 5). The best 20 percent of firms in India, for example, performed better than the average US firm and 75 percent of US firms are worse managed than the top 10 percent of Indian firms…. We found this lack of self-awareness striking. It suggests to us that the majority of firms are making no attempt to compare their own management behavior with accepted practices or even with that of other firms in their sector. As a consequence, many organizations are probably missing out on an opportu­nity for significant improvement because they simply do not recognize that their own management practices are so poor. Multinational companies have been forced to take a systematic approach to management. Only by having strong, effective management practices in place have they been able to replicate the same standards of performance across different regions, cultures and markets. Today, they are reaping the benefits of this effort in terms of higher productivity, better returns on capital and more robust growth. The same benefits are easily accessible to other organiza­tions, wherever they operate. Yet surprisingly few firms have made any attempt to gain an insight into the quality of their management behaviors. Those that do so give themselves the opportunity to access rapid, cost-effective and sustainable competitive advantage."

Long-term Value

Jim Jubak comes thru for us again with yet another superb column on how to sort the winners from the losers in this macro-mess. The first filter is figure out who's making money and will continue to do so in the downturn. BUT the second filter is to find the real jewels who have either a major sustainable advantage or, even better, an opportunity re-invest in the business because those advantages combine with the downturn and the competitive environment to ensure that these folks can get higher ROIs by investing their resources in their own future growth. Sometime ago another study was done that separated Enterprise Value into current and future value. It's summarized in the graphic but the gist of it is this. Current value is the portion of EV due to current operationaly profitability while FV is the portion due to these future investment opportunities. Withe downturn valuations and PEs will be dropping, and from our analysis potentially dropping like a rock. That means that current EVs will appear to drop as well. Which in fact is a huge, perhaps unique and certainly scarce long-term Buffett-like investment opportunity. The trick of course is to find those companies with such prospects. 

Building a Palantir

The original Palantir was apparently pretty hard to make and there was a limited supply. Now we're not going to tell you it's not a lot of hard work but we think we can offer a leg up. For one thing in various posts on Industries and Companies, e.g. Dell, WMT, HD, we've suggested some candidates with some fairly deep backup detail. And Mr. Jubak is in the business of providing candidates as he does in the excerpt below and the prior column; as well as others. We'd suggest tracking him as much as anyone; in fact a great place to start is with his target portfolios of Jubaks 50 Best and Future 50 and walk thru your own P-analysis. The details of which we've gone thru a time or three as well. But just as reinforcment and to try and bring some of the details, as well as get some use out of a graphic we built which a "friend" immediately labeled the "seeing-eye" we offer up the accompanying picture. Since our framework is called BizzXcleration we prefer to call the "seeing eye stone" the Bizzball. And while we're not sure it's magic we are convinced that over time learning to look into creates a lot of magic opportunities for future return. What we've tried to do is list, categorized and relate structurally all the major elements of the effective business in a new way we haven't offered up before.

So as you wade thru, or skim over, the readings after the break take your Palantir Bizzball with you. And if you don't dig into many of them right now we think you ought to pay very careful attention to Jubak's columna and the BNN interview the head of A.T. Kearney's Retail Practice who lays out the strategic future of the industry as clearly and quickly as anyone we know of. 

General Business Practices

The 'Same Ol' Is Actually Good Enough for Many  Do common management techniques such as setting targets, monitoring performance and "lean" manufacturing actually help companies become more productive and profitable? An extensive new study suggests the answer is yes. That result may be unsurprising. But management experts say the study, covering more than 4,600 midsize factories in 12 countries, is among the first to test the notion statistically. Researchers from Stanford University, the London School of Economics and consulting firm McKinsey & Co. interviewed plant managers and examined financial data. They found U.S. factories to be the best-managed and most-productive, though the authors sound warnings for the U.S. as well. The link between management techniques and productivity appeared everywhere, from industrialized economies such as Germany and Japan to rapidly rising China and India. Moreover, the countries with the best-managed and most-productive factories also had the highest per-capita income. Outside experts say the study could prove a big step in propelling the art of management -- now related largely by anecdote -- to a more scientific approach. "It's pioneering work," says Josh Lerner, a professor at Harvard Business School who wasn't involved in the study but who calls it "a real innovation in the study of management." The study contains other intriguing results: There is more variation within each country on use of management techniques than among different countries. Roughly 15% of the plants in China and India scored better than the average U.S. factory; the worst-run U.S. factories scored worse than the average Chinese or Indian plant. Multinational companies scored better than purely domestic firms everywhere. The authors say multinationals seem to play a key role in spreading good management techniques. U.S. factories, for example, adopted lean-manufacturing techniques pioneered by Japanese companies such as Toyota Motor Corp. Competition forces managers to improve, or watch their companies die. Companies reporting the most competitors scored better and were more productive. Countries with large numbers of companies that scored poorly were also considered the least competitive. Across the globe, managers think they are doing a good job -- often incorrectly. There was little correlation between how managers assessed their firms' management techniques and their scores on the survey. "Most managers are worse than they think they are," says Nick Bloom, a Stanford economist and lead author of the study.

Multinationals' Profits Might Fall Multinational companies in the U.S. that are accustomed to the tailwind of a weakening dollar are about to find out what it is like to sail in currency doldrums. For much of the past six years, and particularly in the past two quarters, the dollar's infirmity has helped pump up the results of U.S. companies with operations abroad. That is because revenues earned in other currencies have converted back into more dollars. Against the euro, for instance, the dollar has lost ground compared with a year earlier for eight quarters in a row. Now the currency tides are shifting. The dollar's slide has ceased and even moved into reverse. The buck is up 12% versus the euro and 6% against a broader group of currencies since mid-July. That means what had been a bonus for companies is rapidly turning into a burden, producing a jolt for investors. Some of the foreign sales volumes that would have translated better into dollars "will go from a major tailwind to no wind whatsoever, to potentially a headwind," says Tobias Levkovich, chief U.S. equity strategist at Citigroup. A glance at recent earnings reports shows the extent of the boost. Toy maker Mattel Inc. reported that out of an 11% rise in sales in the second quarter over the prior year, five percentage points came from favorable currency moves. Tech company Hewlett-Packard Co. said half of its 10% rise in sales was attributable to currency shifts in the quarter to the end of July. At fast-food company McDonald's Corp., revenue actually would have fallen 2% in the second quarter of 2008 over a year earlier if the impact of currency translation were excluded. With the currency bump, however, revenue increased 4% in that period. Currencies also contributed almost a quarter of the improvement in earnings per share.

• Northern Trust Week in Review The new export orders index fell to 44.5 in August from 47.5 in July. The latest reading is a cycle low mark and matches the level seen in October 2001 when the economy was in a recession. The export orders index is an indication that exports may not give a lift to headline real GDP in the second-half of 2008 to the extent seen in the first-half of the year.

5 stocks for riding the rebound But slowdowns in the economy and downturns in the financial markets do have one good result: The bad times test companies, their managements and their strategies, and they separate the good companies from the bad. In good times, every CEO looks like a genius, and every strategy seems like a winner. In bad times, we learn who truly earns that huge paycheck and bonus, and which strategies will deliver the goods. Most of all, though, the bad times tell investors which companies have identified such juicy opportunities for growth that they feel they just have to invest even in dicey times like these. Identifying such companies and buying their stocks is the best, simplest and lowest-risk way to make money in the stock market -- hands down. Why is it so important? Because companies that generate generous amounts of profits and reinvest those profits at superior rates of return put compounding to work for themselves and for their investors. A company that generates billions in profit but doesn't have an attractive opportunity to reinvest that cash will return that cash to shareholders as a dividend or by buying back shares, which increases the price of existing shares. In today's column I'm going to tell you about five companies that are passing the test of today's bad times. All are putting a substantial part of their profits back into their businesses, compounding the returns for shareholders, and all are sticking to their growth strategies even though times are tough.

Borrowing Binge Weakens European Companies, Risking a Prolonged Recession A decade of investing more than they've earned in profits has loaded corporations in the 15-nation euro area with debt, leaving them a thinner cushion than their U.S. and Japanese counterparts as the world economy slumps. Companies including France's Renault SA and Thomson SA are under pressure to curtail hiring and capital spending to meet rising interest payments as weaker growth squeezes their profits. That increases the threat of a prolonged slowdown for the euro-area economy, which contracted in the second quarter for the first time since the single currency began trading in 1999. Economists at Deutsche Bank AG predict investment will shrink in 2009 for the first time in seven years, leaving the economy to grow just 0.1 percent for the year while the U.S. expands 1 percent. For Europe's non-financial corporations, the gap between profits and investment rose to 4.5 percent of annual output last year, compared with 3.6 percent for their counterparts in the U.S., Citigroup Inc. estimates. Exclude companies in Germany, where earnings still outstrip investment, and the gap swells to 6.6 percent.

Retail and Retailers 

From 500K to 5K Feet: Retail Sales to Retailer Performances The next graphic is a Yahoo Finance tracking portfolio of key Retailer stocks which tells us whether or not that outlook is reflected in the market veiws. After the break you'll find a decent-sized collection of stories on earnings and outlooks which would strongly suggest that it does NOT. The other thing we'd suggest looking at is not just the daily changes, which are interesting for very short-term sentiment, but where those stocks sit in relation to their 50-day MA's and highs and lows for the year. TGT for example is above its' 50da and significantly below the year high while WMT, on the strength of its' relative performance (entirely earned IOHO again) is barely below it's high. LOW's is doing well and HD surprisingly so. Yet if our economic analysis is correct there are going to be some unpleasant surprises in store for all of these companies and their investors. The trick will be to sort thru them and find the good performers. Which in many cases means those who have re-thought their operations, strategies and execution. As WMT did and as HD is beginning to do, very well, when you dig into it. On the whole, however, we don't see that a reasonable view of the economic future is reflected in these prices. So if that takes us from 100K to 10K feet of altitude the next step is to get down as close to the ground as we can manage. Which requires examining each retailer in some detail - which is for some other time. Sears on the other hand has seen the penalities of substituting financial engineering for operational acumen come full circle. Now that's a stock we'd steer well clear of for a long time to come !

• September Retail Sales How successful were those back-to-school sales? BNN speaks with retail specialist Dean Hiller, partner, A.T. Kearney.

Retailing Stocks Look Ready for a Sale Retailing stocks are primed for a closeout sale. Shares of retailers have climbed more than 11% since July 15, even as the Standard & Poor's 500 has risen just 2%. So-called specialist retailers, including Target, Best Buy and AutoZone, are up more than 20%. What is behind the sharp moves? Investors, seizing on the recent drop in energy prices, are beginning to anticipate an improved economy by next year led by a re-energized consumer. That would lead to healthier profits for retailers. Still, August sales data, released Thursday, showed disappointments for department stores, apparel retailers and others. Without Wal-Mart Stores' sales growth, retail sales fell 0.1% in August. But even if the slowdown ends next year, it is hard to see why big-time profits will materialize. Easy lending helped drive discretionary spending in recent years. Now credit-card, mortgage, home-equity and other kinds of lending has become more restrictive, and it probably will be for the foreseeable future. Gasoline prices are 33% higher than a year ago, unemployment is rising and the global economy is slowing, so there is little reason to think consumer pressures are actually easing. The performance of retailers may be better than some feared, but it is still weak. Here is the dirty secret about the recent rally: Much of the buying isn't coming from retail-focused investors sensing a turnaround. Rather, some hedge funds are closing out commodity trades and international plays and searching for something that might work, if only for a few weeks.

Sears Second-Quarter Profit Declines 62% as Lampert Fails to Revive Sales Sears Holdings Corp., the biggest U.S. department-store company, reported second-quarter profit that fell more than some analysts estimated after shoppers trimmed spending on appliances and clothing. Full-year earnings excluding some costs will not exceed last year's, Hoffman Estates, Illinois-based Sears said today in a statement. The shares fell in early U.S. trading. Sales at stores open at least a year dropped at both Kmart and Sears domestic locations. The results indicate that Chairman Edward Lampert's company reorganization earlier this year has yet to gain traction as consumers contending with surging food and fuel costs head to Wal-Mart Stores Inc. for purchases of non-essentials

Behind Sears' Results: Squishy Math When companies hit hard times, it pays to keep a close eye on their financial reporting for signs they may be overstating their strength. Take Sears Holdings' second-quarter results. Alongside slumping sales and earnings, there was a bright spot: a sizable drop in selling and administrative costs. That contributed to a 4.2% pop in the stock price when earnings were posted Aug. 28. But Sears subsequently released a filing with the Securities and Exchange Commission showing the expenses in question were substantially reduced by insurance payments relating to a matter from March 2000. That is hardly a recurring source. Arguably, it should have been flagged in the earnings release, especially because another one-time gain, a reversal of legal reserves, was clearly broken out. The numbers involved aren't a trifle. Sears, led by Chairman Edward Lampert, said second-quarter selling and administrative costs fell $46 million year-on-year, excluding the reserve reversal. The retailer added that the $46 million drop came "mainly as a result of our focus on controlling costs." But the subsequent SEC filing said the insurance payment reduced selling and administrative expense at Sears-branded U.S. stores by $23 million, which is more than 12% of companywide second-quarter operating income of $187 million.

Banking on the economic bust As the economy struggles, the resale industry has thrived. Not only are cash-strapped consumers discovering that selling their unused or unwanted items is a great way to pad their pockets, but heading to secondhand shops to buy discounted goods can also save a substantial amount of money. "It's a win-win situation for the buyer who is getting what they need used and the seller who is making a little extra money," Marsha Collier, author of the book "eBay for Dummies," said of the growing secondhand marketplace. That adds up to big bucks for those in the business of bringing secondhand buyers and sellers together. And though used clothing has always been a retailing niche, stores that cater to new corners of the secondhand marketplace are springing up. Once Upon A Child, Play it Again Sports, Plato's Closet and Music Go Round are just a few of the other growing franchises out there that sell new and used children's clothing, furniture, toys, musical instruments and sporting equipment. Generally, items are bought for a fraction of their cost and resold for about half of the retail price. A customer can sell their $1000 treadmill to Play it Again Sports for $250 to $300 and the sporting goods store will resell it for about $500. Steve Murphy, president of franchising for Minneapolis, Minn.-based parent company Winmark Corp., credits the economic slowdown as a major contributor to the company's recent success. "More people are looking to get money for their goods to help pay for gas or buy milk," Murphy said. The past two quarters have been Winmark's best in its history, with revenue up 50 percent this year over the same time period a year ago, the company said.

The Allure of Plain Vanilla As the economy sputters and consumers look to save money, the privately held supermarket chain Aldi is suddenly emerging as a major force in the grocery business. LIKE its reclusive German founders, the supermarket chain Aldi doesn’t do much to draw attention to itself. Its stores are small and spartan, with minimal décor and a limited selection of products. They are often found in nondescript shopping strips and lack the flashy signs and window displays of some competitors. Grocery carts cost a quarter apiece, which is refundable after the cart is returned. But as the economy sputters and consumers look to save money, the privately held Aldi is suddenly emerging as a major force in the grocery business, one that some predict could one day rival Wal-Mart.What makes Aldi so special is that, quite simply, its prices are cheaper than just about anyone else’s, including Wal-Mart’s. The company said recently that prices of its private-label products were 16 percent to 24 percent below those at discounters and big-box stores, and 40 percent less than those at traditional supermarkets. While the chain’s format might perplex some shoppers who are used to a much broader selection, Aldi officials have maintained that the advantage of shopping at its stores — cheap prices — quickly becomes clear. . In 1979, Theo Albrecht bought the Trader Joe’s chain, which shares Aldi’s small-store format, its reliance on private-label brands and its reputation for value, albeit in a hipper and more upscale way. An Aldi spokeswoman said that the brothers were not involved in the company’s United States operations. But their reputation as relentless economizers infuses the chain, whose name is short for Albrecht Discounts.

Halston Alters Its Approach to Design  Halston's growing pains are surfacing following a wave of private-equity investment in fashion firms over the past few years. Now, many of these investors, hoping for significant returns and faced with a difficult retail environment, are changing the business model of American fashion: Rather than building a business around a particular designer, they are promoting a more investor-friendly strategy in which designers are put on a short creative leash and the brand reigns supreme. Chief Executive Bonnie Takhar says that the brand now is changing its strategy. Halston no longer will have a creative director overseeing the design of the collection and acting as the face of the brand. The company now has eight designers distributed among three units: ready-to-wear, shoes and handbags. Halston, whose namesake created the pillbox hats worn by Jacqueline Kennedy in the 1960s and later caused a sensation when celebrities like Bianca Jagger and Liza Minelli wore his sexy designs, has had a checkered past. It has been owned by six different companies and has had a revolving door of seven designers since Mr. Frowick died in 1990. Halston hadn't put on a fashion show since 2003. But store buyers were so bullish on the promotional firepower of its new management, which also included Tamara Mellon, founder of the Jimmy Choo footwear line, and Hollywood stylist Rachel Zoe, as a creative consultant, that about 50 retailers agreed to buy the first collection sight unseen -- a rare feat in today's economy. Hilco, one of the largest retail liquidators, had never invested in a luxury brand before Halston. Hilco Consumer Capital CEO Jamie Salter said the firm, which has recently been buying up apparel brands, had been looking for a luxury label to enhance its portfolio. Mr. Salter and Jeffrey Hecktman, chairman and chief executive of Hilco Trading, admit to being impatient with the Halston investment at first. Hilco wanted to quickly look for licensing partners for categories that Halston couldn't manufacture itself, such as eyewear and fragrances. When presented with a lucrative licensing deal to create a Halston-branded denim line, Mr. Hecktman and Mr. Salter were in favor of it. But Ms. Takhar and Ms. Mellon persuaded the board to reject it, because "it wasn't going to follow the DNA of the brand," says Mr. Salter.Indeed, Ms. Takhar insisted from the start that she wanted to build a luxury brand with long-term staying power, as opposed to a fashion brand that could be in one season and out the next. "We are building the business of fashion, not a fashion business," she told the board at its first meeting in the summer of 2007 at Halston's then-vacant Manhattan headquarters, according to those who attended the session.

Auto Troubles Escalating 

Back to Bizzness: Escalating Troubles for Auto Industry The executives of Detroit have been wrestling with the consequences of decades of bad decision making - struggling might be a better word. They've trimmed up their legacy costs by taking retirees off the healthcare gravy train and re-negotiated their labor agreements. They're also downsizing to reduced total sales and much smaller market shares, among other major moves we'll talk about. Unfortunately they didn't anticipate as bad a downturn as they're getting and left key decisions very late in the game. It wasn't until about late Spring apparently that they true magnitudes of the downdraft came to them. This chart shows YOY% changes and absolute auto sales for two timeframes. The first strategic oopsie was that these guys set themselves up for a 16million unit sales year with the downside being 15mil when you read their annual strategy presentations. They started to change that to 14mil with a headge in some cases, primarily Chrysler's team, for 13mil. Well as you can see those were wildly optimistic. One of those key announcements is that all the majors will start making smaller cars in the US and will do so rapidly by first selling marks they're already making in Europe while they invest in and ramp up domestic manufacturing capabilities. Two things struck us as really total astonishing about this. First, that they could make announcements with such short timeframes for serious transitions, which imply they've had the capabilities for years but have avoided committing to them. And second that they waited until the wall was knocked down on them and ignored the handwriting for as long as they could. On a strategic and operational basis they're facing three clusters of challenges. First, they've got to survive the next 3+ years, not 1-2 like they keep saying, and find the financial wherewithal to keep themselve alive. That by itself looks extremely unlikely, at least for all of them. Can you spell bankruptcy - which would be a disaster for them and us. Second they have to start selling and then making decent sized, high-quality and appealing small and mid-size cars asap. Preferably in 3-5 years or sooner. Third, in the long-run, they need a complete re-tooling of operations, development and the product/market mix which again requires money they haven't got

Slowdown in car sales in China and India threatens global market A sudden slowdown in car sales in China and India is threatening to shrink the global auto market this year, promising tougher times for an industry leaning on the two most populous countries to pick up the slack in the West. Early this year, industry executives had been optimistic that demand in the world's 2nd- and 11th-largest car markets would charge ahead, despite fallout from the U.S. credit crisis.But inflation, led by soaring fuel costs, and other economic problems have caught up with car consumption much faster than expected. In July, car sales in China rose 6.8 percent from the year before, the slowest pace in two years, while sales in India fell for the first time in about three years. And while soaring fuel and commodities prices have powered a faster-than-expected sales increase in areas rich in resources, like Russia, Brazil and the Middle East, that has not been enough to make up for struggling demand almost everywhere else."China is almost three times the size of the Russian car market, so for every 1 percent reduction in Chinese sales you need a Russian rise of 3 percent to offset that," said Adam Jonas, auto analyst at Morgan Stanley. Within a few short years, China has turned into one of the most competitive auto markets from one of the most lucrative, suggesting that even Russia, where foreign car sales grew 40 percent in July, could soon go down a similar road. The unpredictable pace of growth underscores the importance of having a well-balanced regional portfolio, something that all big players are working on. Based on first-half sales, the world's top three automakers, Toyota, General Motors and Volkswagen, relied on the mature North American, Japanese and European markets, excluding Russia, for up to two-thirds of their total sales. For quick growth, heavy exposure to the fastest-growing BRIC markets, especially China, is still key - a mix that favors GM, Volkswagen and Hyundai. Its North American and general financial woes aside, GM is a formidable force in BRIC markets, ranking first in Russia and China and third in Brazil. Volkswagen is a close second in both Brazil and China while it has plans to beef up sales rapidly in Russia. Toyota has yet to make headway in India and Brazil, while it is now No. 3 in China, behind General Motors and Volkswagen, climbing from nowhere five years ago. Hyundai of South Korea is the world's fifth-biggest automaker thanks to its big presence in China, India and Russia. But analysts say the real race lies ahead. The bulk of vehicles sold in Brazil and India are of the low-end variety, cars like Renault/Dacia's hit model Logan, the kind that most top automakers still do not have.

Investments Are Faltering in Chrysler and GMAC Stephen A. Feinberg, one of the country’s most powerful — and secretive — financiers, hoped to make a fortune out of the detritus of the American auto industry. Instead, he seems to be losing one. Mr. Feinberg’s giant investment fund, Cerberus Capital Management, is racing to salvage multibillion-dollar investments in Chrysler, the smallest of the Detroit automakers, and GMAC, the financing arm of General Motors. But for Cerberus, named after the mythological three-headed dog who guards the gates of hell, the news keeps getting worse. On Wednesday, Chrysler, which owns the Jeep and Dodge brands, said its sales in the United States fell by a third in August — nearly twice the industry average — as the downturn in the auto business dragged on. Honda eclipsed Chrysler as the nation’s No. 4 seller of cars, and Nissan is closing in fast. The same day, GMAC, in which Cerberus holds a 51 percent stake, said it was trying to stanch the bleeding from a business that was supposed to be immune to the ups and downs of the car industry: home mortgage lending. GMAC and its home loan unit, Residential Capital, announced that they would dismiss 5,000 employees, or 60 percent of the unit’s staff, and close all 200 of its retail mortgage branches. Now, Mr. Feinberg’s purchase of Chrysler and his deal for GMAC have knocked Cerberus down a peg. “Early on, in the Cerberus deal for Chrysler, when it first did these auto industry investments, the story was about how big and influential these funds are, that they think they can buy these iconic industrial companies,” said Colin C. Blaydon, director of the Center for Private Equity and Entrepreneurship at the Tuck School of Business at Dartmouth College. “So far, it does not seem to be working out well for them.”

Ford: Small Cars Can Be Profitable -- Ford Motor Co. is expressing new confidence about the auto maker's ability to sell new small cars at a profit in the U.S. market, citing new data about how Americans are beginning to value premium features and dynamic design over vehicles desired simply for their size. Jim Farley, Ford's global vice president for marketing and communication, said in a presentation to journalists here that the new Ford Fiesta, the company's latest stab at a small, global car, was "core to the DNA of the company and a catalyst" for necessary change. "Small is big," Mr. Farley said, employing a new mantra for Ford that the company hopes will help return the auto maker to profitability. He acknowledged that Ford faces many challenges. Mr. Farley said that the introduction of the Ford Fiesta compact to the U.S. market scheduled for 2010 was actually well-timed, despite critics who question whether the auto maker needs to move faster. The Fiesta is slated to be manufactured in Mexico starting in early 2010 for the U.S. market. The new multiplant development effort in Mexico represents a $3 billion U.S. investment, including the support of local suppliers. "We have to re-establish trust in the brand," Mr. Farley said of Ford. "I'm glad we have so long for this vehicle to come to the U.S. because I have a ton of work to do to re-establish people's trust."

• Ford Speeds to Tailor European Cars For U.S. Crowd

Unpopular Models Slow Down GM A few months ago, General Motors Corp. flooded the prime-time airwaves with commercials introducing the G8, a big, powerful sedan that is supposed to re-energize GM's Pontiac brand. But the ad blitz hasn't had much impact. In August, GM's 2,712 U.S. Pontiac dealers sold only 1,915 G8s -- not even one per dealer. GM has problems on many fronts, including high gasoline prices, falling truck sales and billions in losses. The G8 illustrates one problem that's often overlooked: The auto maker's lineup contains many vehicles that deliver barely any bang for the buck. Ron Harbour, a partner at the automotive consulting firm Oliver Wyman, said each model, even if only a variation of another vehicle, requires some engineering effort. Producing models in small numbers lowers manufacturing efficiency. Every vehicle needs its own documentation, manuals and brochures. Dealers have to be trained to service each model and have to spend money to keep them in stock. And each vehicle needs a certain amount of advertising and promotionFrederick "Fritz" Henderson, GM's president and chief operating officer, has ruled out closing or selling any of GM's eight brands besides Hummer, which GM has put up for sale. But he hasn't ruled out getting rid of some of its slow-selling models. Ford Motor Co. and Chrysler LLC have made simplifying their model lineups a central part of their turnaround plans. GM's trouble with slow-selling models is closely related to another problem: weak brands. Pontiac, Buick, Saturn and Saab are such small players in the U.S. market that whole swaths of car shoppers don't even consider them. Each of those four brands was outsold in the U.S. market in August by Kia Motors Corp., the Korean maker that specializes in low-priced cars.

Detroit's Blackmail Attempt Is Beyond Shameless It was only a matter of time, unfortunately. And now that Michigan is an election-year swing state and Detroit's auto makers are posting sales declines topping 20% each month, the time has arrived. The issue of a government bailout for General Motors, Ford and Chrysler is moving to center stage. Barack Obama has said yes to this proposal early on, and last week John McCain climbed on board. So much for change and fighting pork-barrel spending. We're moving beyond moral hazard here, folks, and into a moral quagmire. At least the Chrysler bailout of 1980 was structured so that taxpayers could reap a reward for taking a financial risk on the company's future. That's not what's happening now.

Other Industries and Companies

Demand Changes Steel Industry The global scramble for raw materials is changing the shape of the world's steel industry: Iron-ore miners are becoming steelmakers, and steelmakers are becoming ore miners. In an effort to gain independence from the mining giants that control the world's iron ore and have raised prices more than 80% this year alone, a growing number of steelmakers are shopping for their own iron-ore mines. Meanwhile, several ore miners are seeking to cash in more directly on the world's growing demand for steel. "The main difference between now and, say, 10 years ago is that there is no excess capacity in the market," says John Anton, a steel economist for Global Insight, an economic consulting company based in Waltham, Mass. "For one company to get what it needs, it now has to outbid another company." The trend toward controlling production from the raw materials to finished product, known as vertical integration, harks back to the way the steel industry operated decades ago, when it was common for steelmakers to own their own mines. In the U.S., the practice fell by the wayside in the face of competition from foreign steelmakers. The thinking was that the best way to fend off competition from abroad was to focus on steelmaking, which historically was more profitable than mining iron ore. The swing back toward vertical integration is most evident in Brazil, which has vast reserves of iron ore that remain either untapped or up for grabs. "Brazil is the strategic place for the steel industry," says Lakshmi Mittal, the chief executive of Luxembourg-based ArcelorMittal, the world's largest steelmaker by production. "It has the raw materials. It has the market. It has the growth." In the past month, steelmakers and miners have announced major investments in Brazil's fast-growing economy. ArcelorMittal said it would pay $810 million for the Brazilian iron-ore assets of Oslo-listed London Mining PLC and agreed to develop a port facility to ship iron ore, while a consortium of Japanese steelmakers joined the bidding fray for a collection of Brazilian mines owned by Cia. Siderúrgica Nacional. Also interested in those CSN mines are steelmakers from China, India and Russia. Meanwhile, Brazil's Cia. Vale do Rio Doce, the world's largest iron-ore miner by volume, said last month that it planned to build a $5 billion steel complex. The mill, to be completed by 2013, would have about 2.5 million tons of capacity, with most of the output targeted for domestic use. Several other smaller iron-ore producers have indicated they also want to move into steel production.

Daewoo Shipbuilding Shows Subprime Woes Overwhelming Drillers' Order Surge Builders will likely see new orders decline 40 percent this year as buyers can't get credit and slowing commodities demand reduces the need for investment in new vessels, Sydney-based Macquarie Group Ltd. said in an Aug. 28 research note. Credit losses and writedowns at banks and securities firms stemming from the collapse of the subprime mortgage market last year have exceeded $512 billion. That is making it more difficult for shipping lines to finance for vessel purchases…Shippers ordered $76.3 billion worth of vessels in the first seven months of 2008, 45 percent less than a year earlier, according to Clarkson Plc, the world's largest ship broker. ``Once financing becomes a problem, that could be seen as indication that things are really getting bad fast,'' NH-CA Asset's Park said. While orders for Daewoo Shipbuilding's deep-sea drilling ships and rigs more than doubled to $3.37 billion in the first seven months, the surge may be overwhelmed by European shippers scrapping orders as subprime woes that began in the U.S. spread across the Atlantic, said Ki at CJ Asset.

U.S. Firms Help Chinese Jetmaker Western companies are playing a prominent role helping China become a serious new competitor in the global aerospace industry. About half of the equipment on the ARJ21, the first regional jet made by government-run AVIC I Commercial Aircraft Co., is made by U.S. companies. The 90-seat aircraft represents China's latest bid to eventually challenge Boeing Co. and European Aeronautic Defence & Space Co.'s Airbus in the market for bigger planes. A twice-delayed maiden flight is now scheduled for Sept. 21. Even the U.S. government is involved. The Federal Aviation Administration, citing safety and the participation of so many U.S. firms, opened a bureau in Shanghai last year to help the Chinese win certification for the ARJ21 to fly in the U.S. Canada's Bombardier Inc., which makes competing regional jets, is angling for a role in ACAC's development of a larger version of the aircraft. It has said it expects to invest $100 million in the larger jet, citing parts-sharing and cost-saving potential for its own jets. The world's aerospace companies are eager to gain a foothold in a market where air traffic is expected to grow 8.9% annually by Boeing's forecast. Their participation could help China do in aerospace what it has done in industries ranging from toys to cars: move from a basic fabricator to a global competitor.

Bombardier Beats Boeing's Returns as Airlines Save Fuel With Turboprops -- Bombardier Inc., the world's third- largest commercial-aircraft maker, may widen its share performance gap over Boeing Co. with turboprop planes. The higher fuel prices that hurt sales of Boeing's biggest jetliners are spurring orders for Bombardier's 74-seat passenger planes and commuter-rail equipment, sending the two companies' shares in opposite directions. Bombardier has gained 35 percent in Toronto trading this year as Boeing has dropped 25 percent in New York. Turboprops were fading into commercial-aviation history a few years ago. They owe their revival to a doubling of fuel prices since January 2007 and 30 percent greater efficiency than jets. New planes are also quieter than earlier models. The turboprop market will remain ``strong'' over the next decade with demand for 1,500 planes, John Moore, ATR's head of sales, said in an interview. The company expects to deliver about 60 aircraft this year with revenue of as much as $1.3 billion. Bombardier projects deliveries of 2,300 turboprops in the next two decades.

Stent Investigation Undermines J&J, Abbott, Boston Scientific Income Goals A $1.8 billion market for metal tubes used to clear blocked arteries outside the heart may be upended by a U.S. probe into marketing practices by Johnson & Johnson, Boston Scientific Corp. and Abbott Laboratories. The Food and Drug Administration says the device makers have already curtailed what the government views as improper sales practices since the Justice Department notified them of the inquiry earlier this summer. The companies are seeking new studies to justify implanting similar stents in veins and arteries, and face a slowdown in sales that have reached $900 million with the unauthorized uses. While the FDA approved the stents only for clearing bile ducts in liver cancer patients, unsanctioned uses for keeping veins and arteries unclogged increased revenues 10-fold, according to research published in the American Journal of Therapeutics. At that rate, J&J in June estimated a $1.8 billion market for the stents by 2012, which now seems unlikely

Outsourcing the Drug Industry At first glance, companies such as Jubilant and Piramal may seem too undeveloped -- or perhaps just too culturally remote -- to rub shoulders with the world's top pharmaceutical makers. But judging from all the deals taking shape in India, they may have a critical role to play in the industry's future. In recent months, Western executives have been flocking to India's hastily built science parks, looking for allies in the never-ending quest to develop blockbuster treatments. With little fanfare, they've started a process that could lead to wide-scale outsourcing of drug research to Asia. Five Western companies have formed drug discovery partnerships with Jubilant, including Eli Lilly (NYSE:LLY - News), Amgen, and Forest Laboratories (NYSE:FRX - News). Lilly is also partnering with Piramal, as is Merck (NYSE:MRK - News). Every month deals are signed with India's elite pharmaceutical companies. The goal is to take promising compounds discovered by the multinationals, run tests to weed out the weakest candidates, and develop some of the others into marketable drugs. Eventually the Indian partners also hope to rack up scientific breakthroughs that lead to entirely new medicines for diseases such as Alzheimer's, cancer, or diabetes. Looking beyond India's potholed streets and poverty, Western drug executives say they've forged a powerful model for research collaboration. The timing is no accident. Despite spending billions at home on technologies to turn gene-based discoveries into new medicines, pharmaceutical companies are struggling to come up with revolutionary products that will pull them out of a five-year slump with virtually no revenue growth. In desperation, the drug giants are paying hefty premiums to swallow biotech companies -- witness Roche's $44 billion bid to purchase Genentech (NYSE:DNA - News) in July. What the multinationals now seek from India is the same combination of brainpower and cost savings that made the subcontinent a leader in software and computer services. Some Western companies are volunteering to share intellectual-property rights on new discoveries and even divvy up the profits.

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Let's weave the some of the rest of the story into this growing tapestry. We started with Plunge Protection Team's rather predictable, long-predicted and necessary efforts to rescure Frannie which naturally led to a discussion of markets. BtW the rescue and/or re-engineering of Frannie has been in the cards and on the national policy agenda for years, literally, but not acted on until a crisis has allowed the people who know better to do something. And from the markets we're naturally led to the economy, rather the reverse of our usual order. Yet revealing all the same. There are more than five things about the economy for you to know but five is a re-memorable number and spans the range. 1) The Frannie rescue was vital, though you wouldn't think so from the number of conspiracy theorists ranting in the blogosphere or in the MSM. We found, finally, some balanced discussion and included it in the readings besides our own. But, 2) the rescue doesn't save Housing from a further downturn nor prevent a recession; instead it lets the market machinery keep working and the normal cyclic recession proceed (again nicely covered in the readings with some stuff you need to pay attention to).

Which leads to 3) the Employment report last Friday which was very weak and in conjunction with a proper understanding of the GDP tells us that we are indeed crossing the tipping point into a more severe downturn. There was a huge furor in the MSM and especially in the blogosphere where the conspiray theorists were having a field day over vast and evil minions doing us harm to disguise things because of the arcana of the GDP Deflator. It'd be funny if major investment strategists and the front-pages of major business publications hadn't been in their chanting and dancing with them. We did our best to defuse and debunk all that (postings listed in the readings) as did some other bloggers with real Ph.D.'s in economics but to little avail. One of the best posted a takedown of Shadowstats and got almost a 150 impassioned comments instead of his normal 10-15, none of whom paid any attention to his analysis. Believe what you like but planets circle suns and economies move in cycles and the government data can be improved but is as good as it gets for the price and is not distorted. That same author is cited a second time because his economic models indicate a 95% probability that the employment report means we are in a recession and a 15% probability that ,as we've been saying, we're crossing into a more severe recession ala 1980. Which leads us to....

Employment and Economic Outlook

 Employment dropped by -84K jobs and was the eighth month in a row of decreases. More importantly from our view was that this was the third month in a row where the YoY change was negative, -.21%, and the decrease appeared to be accelerating. Even scarier it was the six month where the Unemployment rate grew by double-digits, 31.4%, and the growth really jumped. The prior three months the rats were 24%, 22% and 23%. If that's not scary enough for you then combine it with our other favorite metric of future demand, real wage changes, which have been going down for 10 months in a row and have recently sharply increased their rates. The last three months saw decreases of -1.4%, 2% and 2.6% !!! Put 'em together and you end up with the bottom sub-chart for Wages + Employment.

Economy vs Markets

We won't repeat the GDP charts which we spent so much time on but the links and readings will take you back. Likewise we won't repeat the conceptual charts on the nature of the business cycle which are included and repeated in many of those postings. Instead we'll point to 4) the fact that sentiment in the markets appears to have shifted enormously and the underlying economic realities are sinking in. There's a variety of ways to show this and we've, literally, just had the largest field test since the days of the Great Depression with the rescue of Frannie. Just stop for a minute of historical crogglement if you would - there's been nothing like this in almost 80 years ! Consider Is the Plunge Protection Team Losing Power? orCheckmate?.  Two excellent blog posts from EconPic Data and MacroMan providing different views of the PPT and its' efficacy. Or not, as the case may be. We've recently come to like short-term market charts, having been in-directly tutored by Matt Trivisonno and his community (The Fan-Fred Short-Squeeze Rally,he Fan-Fred Rally - Day 1 of 1). Take a look at this 4-day SP500 chart and notice that Monday opened with a huge gap up which faded away almost to nothing until late in the date when you got what Matt argues is a short-squeeze buying. In any case the biggest financial intervention in US history short of the shutting down of the First Bank of the US by Andrew Jackson led to a 1-day whimper. The Tech stocks even dropped ! And right now Asian markets are down as are the futures. We may get some more uptick this week but the back of rosy sentiment is broken. Mr. Market is really beginning to get it !

Oil and Currencies

Which leads us to to 5) the fact that the Dollar and the Oil puts are kaput. In other words, while we may see more rise in the dollar that'll fade as the economic realities sink in and the US recovers first meme dies a natural death and goes to Memehalla with the de-coupled brethren. But it also doesn't mean that we'll see the return of the precipitous declines in the dollar either. Which puts paid and settled to the jump in exports that's been holding the economy together for three quarters and to the 1/2 of all earnings that've been due to currency conversion effects. A phenomenon that even the WSJ just discovered on its' front page in the last few days (Multinationals' Profits Might Fall ). In fact the runup in the dollar appears to be running out of steam about the 32% line. Which then takes us to the price of Oil - notice the inverse relationship. Even if we get another big drop, say to $80, which sounds wonderful now that establishes a new floor to a long-term, up-trending trading range where the ceiling could easily end up being $200/barrel. All in all very expensive energy is here to stay for a long time but hopefully, gad that sounds perverse in this context, we're only looking at 20% annual increases and not 80% self-induced runups.

After the break you'll find an extensive collection of readings digging deeper into these topics. You ought to be particular attention of those mentioned but not discussed to Housing where we're a long way from a bottom, let alone the beginnings of an upturn. Figure at least another two years and 15-20% in price declines potentially. We also didn't discuss the int'l situation much since it continues to deteriorate rate and we've dug into it before. In the excerpts you'll find that posting coupled with ones on Japan and Latin America. And finally there's a geo-politics section which we can no longer afford to ignore. British Petroleum "settled" it's differences with its' Russian partners much the way that the Georgians have reached an accommodation with the Russian government. If anyone thinks Russia will be a viable place to do business we have some rubles for sale, literally. Meanwhile the aftermath of the Doha collapse is still with us as regional trading agreements proliferate, metastasize and threaten the infrastructure of globalization. That one's serious but not urgent and it is work-outable :). But still a major reversal of thirty years...well actually more like 55 since the Treaty of Rome which first got the GATT going and which led to the WTO. Wow, do we live in exciting times or what - the things that've shaped your lives and you didn't know existed are unraveling right in front of us !

Economic Situation

Why cheaper oil signals trouble The commodities bubble appears to have popped, but keep the champagne on ice. Food and energy prices are coming down in part because of a global growth slowdown that could also cool the red hot U.S. export sector - the major bright spot in an economy still struggling with a massive housing bust. If prices keep sliding, year-over-year inflation numbers - after hitting a 17-year high last month - could soon look much healthier, reducing fears that the Federal Reserve may have to raise interest rates to stamp out rising inflation expectations. But if an ebb in inflation fears is welcome, the source of that shift could be more problematic. "Several major economies are on the brink of recession," economists at Societe Generale wrote Wednesday. They went on to say that the once popular notion of "decoupling," which held that global growth was so strong that a U.S. slowdown needn't spread elsewhere, now looks dated. As do the inflationary pressures that accompany rapid growth. If the growth party is over around the world, the U.S. export boom will quickly fizzle. Certainly it has become clear that the ills afflicting the American economy - a consumer burdened by heavy debt taken on in years of outspending current income - are far from unique to these shores. A pullback by some of its overseas customers offers the latest bit of unhappy news for the U.S. economy, which this year has continued to grow - if only tepidly - in large measure thanks to slowing imports and rising exports. But Merrill Lynch economist David Rosenberg notes that 85% of the revision came from an upward estimate to net exports and a lower estimate for inventory liquidation. The halo effect from exports could already be wearing off. Rosenberg says the second-quarter GDP data showed U.S. corporate profits from foreign sources dropped 15% from first-quarter levels, due to softer worldwide economic conditions. He expects to see more of the same in coming quarters, as foreign profits slip under the pressure of a stronger dollar, which increases the price of U.S. goods overseas. Meanwhile analysts at UBS note some of the recent export gains may be fleeting because the U.S. has been a major exporter of agricultural goods. While the U.S. has benefited from higher prices of corn, wheat and other farm products, a slide in those prices could trim the gains.

• GDP, Jobless Claims, Markets, Oh My: Still Tipping Over !
• Conspiracy Theory vs Real Data: Another Sidetrip to Realities, Markets vs Economy: Dangerous Memes vs Realities
• LT Business Cycle De-construction: Time to Pay the Piper, Bad Times, Worse Outlook (Updated): Economy Readings and Reflections

Shadowstats debunked I've yet to find someone who has been able to reproduce the claims made by Shadow Government Statistics about the extent to which government agencies are grossly misreporting the U.S. inflation rate. Apparently, neither has the Bureau of Labor Statistics, as detailed in an article by BLS economists John Greenlees and Robert McClelland in the latest issue of Monthly Labor Review. There's much more in the BLS article on this and related questions such as hedonic price adjustment and owner's equivalent rent. Why do people continue to give credibility to an operation like Shadowstats? Now that's something that I'd like to hear explained.

• The Government's Macroeconomic Series: X-Files, Dilbert, or Resource Constraints?, The GDP Deflator and the Inflation Rate

Payrolls in U.S. Fall More Than Forecast; Jobless Rate at Five-Year High The U.S. lost more jobs than forecast in August and the unemployment rate climbed to a five- year high, heightening the risk that the economic slowdown will worsen. Payrolls fell by 84,000 in August, and revisions added another 58,000 to job losses for the prior two months, the Labor Department said today in Washington. The jobless rate jumped to 6.1 percent, matching the level of September 2003, from 5.7 percent the prior month. Workforce reductions at companies from UAL Corp. to Gannett Co. are adding to the woes of Americans hurt by lower home values, scarcer credit and higher prices. The report may fuel concern that consumer spending, the biggest part of the economy, will decline and bring the expansion to a halt. Stock-index futures dropped, Treasury notes climbed and the dollar pared gains. Payrolls were forecast to drop 75,000 after a previously reported 51,000 decline in July, according to the median estimate of 76 economists surveyed by Bloomberg News. Estimates ranged from declines of 40,000 to 150,000. The jobless rate was projected to remain at 5.7 percent. Slide in hiring plans is worst in 20 years, Manpower says

Rising unemployment Is there anything good to say about today's report from the Bureau of Labor Statistics that the U.S. unemployment rate jumped up to 6.1% while seasonally adjusted nonfarm payrolls declined by another 84,000 jobs? Well, here's one thing. It gives us some real clarity as to just where the economy stands. Sure looks like a recession when you inspect a graph the unemployment rate, doesn't it? And it also looks like a recession from the perspective of a model of unemployment dynamics that I published in 2005. If you use that model to analyze the latest unemployment numbers, you'd calculate the current probability of being in a recession at 95%. That model distinguishes between a mild recession and a severe recession, with the graphs above combining the two. In fact, the August unemployment report leads to a 14% probability that we just entered the "severe contraction" phase. The last time we had a one-month filter probability of that regime higher than that was October of 1982. So I don't see any way to slice today's report other than to say, at least as far as the employment numbers are concerned, the U.S. is now definitely in a recession. And if you won't take my word for it, you can hear pretty much the same thing from Brad DeLong, Justin Fox, William Polley, Paul Krugman, and the various economists quoted by WSJ Real Time.

Saving Frannie 

A Delicate Balance in Fannie/Freddie Action The levees in New Orleans held fast as hurricane Gustav landed last week, sparing the city from the physical devastation experienced under Katrina. And had the levees fallen, the human tragedy would have been significantly reduced as most of the population had already been evacuated from the city. This situation stands in stark contrast to the devastation that a deleveraging hurricane continues to wreak in the US and other parts of the world. Unlike New Orleans, the levees of the global economy have broken, one after another. Also unlike New Orleans, a significant part of the global economy still lies in the path of this hurricane. Having caused havoc in the financial and housing sectors, the damage now encompasses sinister economic storms that are starting to rage in employment, consumption and investment in the US and abroad. This is the third time this year that the US authorities have made a big policy announcement on a Sunday. Will this latest announcement prove more effective? The answer ultimately boils down to two big issues… First, the success of the action depends partly on whether it “crowds in” capital from both domestic and foreign sources. This is key to stabilising markets and drawing a line under the process of global economic decline. Here, a commitment of the government’s balance sheet is necessary but not sufficient. Since the US government is already running a growing fiscal deficit and the country as a whole has a current account deficit, its balance sheet must be supported by other capital inflows, especially on the part of foreign holders of US debt who have become increasingly skittish in recent weeks. Second, the action must be part of a broader policy response that has both a domestic and international dimension. In this regard I have been impressed by the repeated observations of officials from countries that previously experienced the brutality of deleveraging hurricanes, particularly in Asia in 1997-98. Noting the piecemeal nature of US policies in the past year, they stress the importance of a holistic response from the authorities, including meaningful co-ordination of an often-diffused domestic policy apparatus and explicit, timely and targeted international support. This means, at the minimum, alleviating the housing problem in other stretched jurisdictions. If, however, the conditions are not met, the global economy will experience further significant devastation that will go well beyond housing and the financial sector. In this scenario, consumers residing in highly leveraged economies such as the US and the UK will feel even sharper and more prolonged pain, followed by those in several emerging economies.

• Fannie, Freddie rescue to offer just a quick fix
• We're Losing the Broader Economic Struggle

Housing

Price to Rent Ratio I think price to rent ratios are helpful, but have flaws. I wouldn't use median house prices because the mix of homes impacts the median price. Also the Credit Suisse projection of prices declining for another 12 to 18 months is based on prices continuing to fall at the current rate. Historically, during a housing bust, price fall slowly at first, then decline more rapidly for a couple of years, and then slowly for several more years until the eventual bottom. Right now we are in the rapid price decline phase. So I'm still expecting prices to fall for some time (although I expect price declines to start to slow), with a price bottom in the 2010 to 2012 period in the bubble areas, and perhaps sooner in other areas (less bubbly areas and certain low end areas). One thing is pretty certain - as long as inventory levels are elevated, prices will continue to decline. And right now the inventory of existing homes (especially distressed properties) is at an all time high. A Few Housing Themes, ARM loans turn poisonous

U.S. House Price Decline Could Be Worse than Great Depression, Says Economist Shiller-Home price declines are already approaching those in the Great Depression, when they plunged 30%t during the 1930s. With prices already down almost 20%, it's not a stretch to think we might exceed that drop this time around. There are about 10 million homeowners whose debt is higher than their home value, which has broad implications for how Americans feel about their wealth and spending habits (read: more pressure on consumer spending). The current hopeful consensus -- that house prices will bottom soon and then begin to recover -- is most likely a dream. Housing markets don't usually have "V-shaped" recoveries. And even if house prices stabilize in nominal terms, after adjusting for inflation, most homeowners will continue to lose money.

Housing: It's about prices ...  In real terms (red line), the Case-Shiller National Home price index is off 25% from the peak. Real prices are now back to the Q4 2002 level (nominal prices are back to mid-2004). This suggests real prices, based on the Case-Shiller index, could fall substantially, perhaps 15% to maybe even 30% more. This decline would probably be some combination of falling nominal prices and more inflation. And prices could definitely overshoot to the downside. The third graph shows the price-to-income ratio and is based off the Case-Shiller index, and the Census Bureau's median income Historical Income Tables - Households. Using national median income and house prices provides a gross overview of price-to-income (it would be better to do this analysis on a local area). However this does shows that the price-to-income is still too high, and that this ratio needs to fall another 20% or so. Once again this could be a combination of falling prices and rising incomes (Note: this uses nominal incomes, and even if real incomes are stagnate or declining, nominal incomes are rising). So by these three measures, prices have a ways to fall. The final graph shows the 'months of supply' metric for existing homes for the last six years. Months of supply increased to 11.2 months. A normal range is 5 to maybe 8 months. Until the months of supply decreases to the normal range, prices will continue to fall. How much longer will prices fall? How much further will prices decline? No one knows, but these graphs suggest we still have a ways to go.

International Economic Situation

Hurtin Worldwide:Outlook, Countries, Commodities & Geo-politics Let's get the week's collection(s) - emphasis plural there's so much but it all interacts together - on the international situation up as part of the context. After the break you'll find some rather harsh views on the worldwide outlook setting up some specific country news, including Japan, Hong Kong, India and China. In these two parts there are several critical harbinger stories you need to think about. But the overall foundation or context is defined, courtesy of Northern Trust in the accompanying chart. While all of that chatter about the rest of the world beginning to lead its' own separate existence was going on last year the US was an increasing share of the world's GDP. Now that flattened out in terms of growth but still left the US economy, i.e. US consumer excess consumption, as a driving engine of growth. As it's been tanking so does that source of growth. One key part of which is Oil where the increasingly dominant characteristic is things we've talked about before. First off the world oil majors command less and less of the world's oil reserves which means that oil is increasingly insulated from pure market forces and more and more managed, at least in part for geo-political reasons. Second, wherever it's at Oil is increasingly hard to get to and it takes more and more investment to both find it and produce it. Third more and more of the world's reserves are sequesterred behind political barriers which, in turn, has adverse impacts.

• What Your Global Neighbors Are Buying How people spend their discretionary income – the cash that goes to clothing, electronics, recreation, household goods, alcohol – depends a lot on where they live. People in Greece spend almost 13 times more money on clothing as they do on electronics. People living in Japan spend more on recreation than they do on clothing, electronics and household goods combined. Americans spend a lot of money on everything.

Japan's tortoise-like economy  THE surprise resignation of Japan’s prime minister, Yasuo Fukuda, has once again left the world’s second-largest economy rudderless—just as it seems to be drifting dangerously towards the rocks. Although America is the centre of the world’s financial troubles, Japan’s economy appears to have been hit harder: its GDP fell sharply in the second quarter, whereas America’s continued to expand. Indeed, many economists expect Japan’s economy to shrink again in the three months to September, which on the rule of thumb of two consecutive quarters of decline, would imply a recession. You might conclude that without radical reform Japan will continue to underperform. However, a more thorough health check suggests that Japan’s economy is actually in better shape than it looks, and its downturn may be shorter and shallower than those in America and most European economies could be. Japan’s long-term growth rate has undoubtedly been strangled by the lack of reform. Yet its economy is now in better shape than for many years. Japan’s GDP is likely to grow faster than both America’s and the euro area’s over the next year. If so, 2009 will be the fourth year running that Japan’s GDP per head shows the biggest increase of the three. And that is not only because its population is shrinking.

Economic Growth Slowing In Latin America Improvements in fiscal management in many Latin American countries and the use of budget surpluses to pay down public debt have helped to cushion the region against deteriorating international economic conditions. According to a report by the Economic Commission for Latin America and the Caribbean (ECLAC), the region will continue to expand next year and, for the first time in 40 years, will complete a seven-year cycle of average per-capita gross domestic product growth of over 3% per year. Slower growth. However, higher inflation, declining current account surpluses and deteriorating terms of trade are causing the region's growth to slow. ECLAC estimates it will reach 4.7% this year, down from 5.7% last year, before slowing to 4% next year. This reflects a number of factors. Growth variations. Behind this forecast, there are wide differences among individual countries. Although these differences are partly the result of domestic policies, they also reflect the vulnerability of Latin American countries (LAC) to weaker growth in industrialized countries: --Manufactured versus commodity exports. In LAC as a whole, 45.2% of exports are basic commodities, and 54.8% correspond to manufactures. However, this distribution varies significantly by sub-region, with manufactures accounting for only 25.3% of South America's exports and 14.8% in the case of the Caribbean. Partly as a result, ECLAC expects South America to expand by 5.6% this year and 4.5% next year, ahead of the regional average. At the other end of the scale, manufactures account for 74.1% of Mexico's exports, rendering it more vulnerable to weaker demand in industrialized markets and, particularly, the U.S.

Oil 

Gustav knocks out Gulf oil production Hurricane Gustav has shut down nearly all crude oil production and 82% of natural gas production in the Gulf region, according to a Department of Energy report issued Monday. The department offered a fresh look at the hit the storm delivered to the U.S. oil industry - chronicling an extensive stoppage in refinery output, crude delivery, and production of oil and natural gas. According to the report, 96.2% of crude oil production has been shut down in the Gulf of Mexico, equal to 1.25 million barrels per day - or 25% of U.S. daily output. Three oil delivery pipelines in the Gulf have been shut down, totaling 2.6 million barrels of daily capacity. One expert predicted the industry will be able to absorb the hit to production as long as the storm did not significantly harm the infrastructure. It's not yet known the extent of the damage to the energy infrastructure that, if any, Gustav has caused. … oil companies said they will begin to assess the damage as soon as it is safe to return to the offshore rigs. Shell predicted Tuesday would be the earliest it could send crews back to its Gulf operations. Of 32 Gulf Coast refineries, which process crude oil into usable gasoline, 12 have completely shut down and 10 have reduced activity. The reduction in refinery operations resulted in 5.5 million barrels less daily capacity. That will mean less gasoline on the market for consumers. But with slumping U.S. demand for fuel, the market may be able to weather the storm. Gustav hits U.S. economy, Winter heat crisis looms, little relief seen

Oil to Extend Drop With US in Recession, Faber Says Oil will likely drop further in the next three to six months, according to investor Marc Faber, who reiterated his forecast that the second half of 2008 won't be ``favorable'' for commodities. The decline in crude, which today slid to a five-month low, is a ``symptom'' of economic slowdowns in the U.S. and Europe, Faber, who forecast the so-called Black Monday crash in 1987, said in an interview with Bloomberg Television from Bangkok. ``In the U.S., if statistics were compiled properly, the economy would be in recession, same in Europe,'' said Faber, 62. ``Oil coming down is a symptom of economic weakness, not a symptom of strength. All I can say is we peaked out in commodity prices.'' Crude and gold led a decline in commodities today as Hurricane Gustav spared the U.S. Gulf states the destruction caused by Katrina and Rita in 2005. Economists forecast U.S. economic growth will slip to 1.5 percent this year from 2 percent in 2007, according to a Bloomberg survey. The S&P GSCI index of 24 commodity futures has dropped as much as 7 percent in two days, to the lowest level since April 2. Oil is trading at a five-month low, 27 percent below the record $147.27 a barrel reached July 11.

Oil at $80 a Barrel? The souring U.S. and global economies, alongside a strengthening dollar, are weighing heavily on oil prices, analysts say. Oil prices have slid so far and so fast that the retreat has led analysts to predict further puncturing of what they call a speculative bubble. Many analysts don't see a floor at $100, but rather at levels as low as $70 or $80. Oil traders and some analysts have been blaming high oil prices on rising demand from developing economies, but now troubles in the U.S. economy are spreading across the globe. In addition to a gloomy economic environment and lower demand, a strengthening dollar is also behind oil's recent drop. Since July 15, the dollar has gained 8.5% against the euro.

Ugly Geo-politics

BP, Investors Settle Dispute Over Russian Venture TNK-BP; Dudley to Leave TNK-BP CEO Robert Dudley will step down by the end of the year, the partners said today in e-mailed statements. The shareholders will also examine selling shares in a unit of TNK- BP Ltd., to boost the company's market value, and will bring three independent directors onto the board. BP rose as much as 4.9 percent in London trading, the biggest gain since April 29. The accord leaves BP with its stake in the 50-50 venture intact while acceding to demands by the Russian billionaires for a more independent board. TNK-BP accounts for almost a quarter of BP's global output and reserves and Russia is the world's second-largest oil exporter. The dispute hit TNK-BP's output and discouraged investors in the Russian stock market, contributing to a 30 percent decline in the Micex index this year. The Kremlin has emerged as the winner in previous squabbles in the Russian energy industry, as then-President Vladimir Putin sought to strengthen the state's control over assets. Last year, Royal Dutch Shell Plc sold a controlling interest in its $22 billion Sakhalin Island oil and natural gas project to OAO Gazprom, the state-controlled energy company. Shell's move came after a government environmental watchdog threatened to revoke permits and stop work at the project. OAO Yukos Oil Co. was bankrupted after the government claimed more than $30 billion in back taxes. The company's founder, Mikhail Khodorkovsky, is serving eight years in a Siberian labor camp. Rosneft, under Sechin's watch, acquired many of Yukos's assets in government auctions to pay the tax claims. For President Dmitry Medvedev, who took office in May, TNK- BP was the first big test of his energy policies. Medvedev was chairman of Gazprom for six years as the gas producer and pipeline owner grew to be the third-largest company in the world by market capitalization. The TNK-BP dispute is part of a wider global trend in which state-controlled energy companies are battling international rivals for access to oil and gas. Clashes with foreign investors may hobble Russia's ability to tap its energy. The country's oil output has begun to fall this year -- to 9.8 million barrels a day in August from a peak of 9.9 million in late 2007. For much of the past decade, Russia was among the biggest contributors of new global supply.

How bad are regional trade agreements?  by saying “no”. Kamal Nath, India’s trade minister, helped kibosh a breakthrough in the Doha round of global trade talks by refusing to compromise over demands for safeguard tariffs to protect more than 200m Indian farmers. To be fair, Mr Nath did not bear sole responsibility. China joined him. And America chose to put the interest of its farmers (who account for less than 1% of its GDP) above those of the liberal trading system it helped to create. Now Mr Nath has said “yes”. On August 28th India agreed a free-trade agreement with the ten fast-growing countries in the Association of South-East Asian Nations. ASEAN also announced a second big regional deal, with Australia and New Zealand. Coming so soon after Doha’s collapse, the two agreements sent a powerful message. The global trade talks may have stumbled, but regional pacts are pushing ahead, particularly in the fastest-growing part of the world economy. According to the World Trade Organisation (WTO), over 200 regional and bilateral agreements are in place with many more under negotiation. More than 100 came into force during Doha’s seven exasperating years. That is disturbing. Every trade deal should be measured on its own merits. But, for all their political appeal, bilateral and regional deals are never a substitute for progress at the WTO. Multilateral trade rounds are the foundation of the trading system because they are based on the “most favoured nation” principle—that any tariff cuts offered to one country must be offered to them all. Regional and bilateral deals are based on discrimination. They lower tariff barriers between their signatories, but not everyone else. Discrimination means that, although regional deals create new trade among their members, they may also divert it from lower-cost outsiders.

Currencies 

Dollar Bears' Mea Culpa Makes Ben Bernanke No Liability in Global Slowdown Federal Reserve Chairman Ben S. Bernanke has gone from a dollar liability to an asset, sparking a rally that even bears say shows few signs of ending. While the U.S. Dollar Index fell to a record low in March as the Fed cut interest rates at the fastest pace in two decades, traders now anticipate lower borrowing costs will help America recover from a global economic slowdown before Asia or Europe. Investors bought four times as many dollars in August as the average over the previous 12 months, according to Bank of New York Mellon, a custodian for more than $23 trillion in assets. Traders who a month ago doubted there was anything Bernanke could do to keep the greenback from depreciating in the face of a widening budget deficit, mounting credit market losses and falling consumer confidence are embracing the currency. The 6.4 percent gain against the euro in August was the best monthly advance since Europe's common currency was introduced in 1999. Futures traders are making the biggest bets on the dollar versus six major trading partners since 2005.

Yuan Gets Lift Off of Euro The Chinese yuan is still moving up -- but now, the euro is bearing the brunt of the gains. The Chinese currency's rise against the U.S. dollar has stalled in recent weeks, as local exporters increasingly criticize the government's policy of currency appreciation for hurting their profit margins. The yuan actually fell about 0.2% against the U.S. dollar in August, a rare reversal of its mostly upward trend since a de facto peg was dropped in July 2005. At the same time, the U.S. dollar has rallied strongly against most major currencies. Because the yuan hasn't moved much against the dollar, those gains also pushed the yuan's value upward against other currencies. The yuan rose 6% against the euro during August, reversing a long decline. It also gained against the Japanese yen and the Korean won. That turnaround has led many watchers of China's tightly managed currency to predict officials will limit the yuan's future gains against the dollar to protect exporters. But the recent movements also seem to be a sign that the central bank is finally following its own prescription of setting the exchange rate "with reference to a basket of currencies." Since Europe is now China's largest trading partner, it is perhaps not surprising that its currency is no longer being managed solely against the U.S. dollar. Callum Henderson, head of foreign-exchange strategy for Standard Chartered PLC, says Chinese authorities appear to still have a policy of appreciation against major currencies. The Chinese yuan's effective exchange rate, a measure of its value against all trading partners, rose 2.4% in August, picking up from the pace earlier this year, according to estimates by the Bank for International Settlements.

Main Bank of China Is in Need of Capital China’s central bank is in a bind. It has been on a buying binge in the United States over the last seven years, snapping up roughly $1 trillion worth of Treasury bonds and mortgage-backed debt issued by Fannie Mae and Freddie Mac. Those investments have been declining sharply in value when converted from dollars into the strong yuan, casting a spotlight on the central bank’s tiny capital base. The bank’s capital, just $3.2 billion, has not grown during the buying spree, despite private warnings from the International Monetary Fund. Now the central bank needs an infusion of capital. Central banks can, of course, print more money, but that would stoke inflation. Instead, the People’s Bank of China has begun discussions with the finance ministry on ways to shore up its capital, said three people familiar with the discussions who insisted on anonymity because the subject is delicate in China. The central bank’s predicament has several repercussions. For one, it makes it less likely that China will allow the yuan to continue rising against the dollar, say central banking experts. This could heighten trade tensions with the United States.The central bank has been the main advocate within China for a stronger yuan. But it now finds itself increasingly beholden to the finance ministry, which has tended to oppose a stronger yuan. As the yuan slips in value, China’s exports gain an edge over the goods of other countries. The two bureaucracies have been ferocious rivals. Bankers estimate that $1 trillion of China’s total foreign exchange reserves of $1.8 trillion are in American securities. By buying United States bonds, the Chinese government has been investing a large chunk of the country’s savings in assets earning just 3 percent annually in dollars. And those low returns turn into real declines of about 10 percent a year after factoring in inflation and the yuan’s appreciation against the dollar. The yuan has risen 21 percent against the dollar since China stopped pegging its currency to the dollar in July 2005. Still China finds itself hemmed in. If it were to curtail its purchases of dollar-denominated securities drastically, the dollar would likely fall and American interest rates could soar. China spent more than one-eighth of its entire economic output last year on foreign bonds, and then picked up the pace during the first half of this year. Chinese officials have suggested in recent comments that they are increasingly interested in stopping the yuan’s rise, and thus are willing to continue buying foreign securities to support the dollar. In fact, the yuan weakened slightly against the dollar last month after 26 consecutive months of gains. Along with Treasuries, China has invested heavily in mortgage-backed bonds from Fannie Mae and Freddie Mac, the struggling mortgage finance giants that are sponsored by the United States government. Standard & Poor’s estimates China’s holdings at $340 billion. Graphic: The High Cost of Intervening in Currency Markets

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We left the Frannie implosion and failout posting up for the weekend on the hope that you'd pay careful attention to it, though we updated it a while ago with some recent news and analysis summaries worth your time to go look at. They are really good, useful and comprehensive. However, playing to strengths, we haven't found anybody else who wrapped this disaster in the bigger picture of the credit market, economic consequences and regulatory implications. But, judging from their statements, those are the things that Paulson, Bernanke, Franks, et.al. have at the forefront of their thinking....so it might behoove you keep them in mind. Nor linked all that to the continuing triumph of fantasy over rationality in thinking about the Finance Industry as a whole.

In any case next week is going to be as wild and woolly as last week was but for "slightly" different reasons. In fact as we write the futures markets are up almost 3%, ~ 250 bps on the Dow (YahooFinance Futures); and many of the major Asian markets are up 3-4% on the rescue news. Imagine that. It may take a while for that to all settle out and we'll have to see how things trade Monday and thruout the week. But that said this'll be a perfect, perhaps, last-ditch opportunity to unload anything you wnat to unload. Or learn to be a trader and experiment with the short game. As good a summary of what's been going on and the trader's outlook is Matt Trivisonno's blog post:The Fan-Fred Short-Squeeze Rally . Be sure to read the comments...in fact if you want the straight skinny on the market action for a day that's the goto guys. For the big picture review of last week though there's no better place to turn than Prieur du Pleiss'sWords from the (investment) wise for the week that was (September 1 – 7, 2008).

After the break you'll find the normal readings grouped into the onset of a new reality in terms of performance and outlook, the situation with respect to valuations and PEs and some very good stuff from Jim Jubak on investment strategies to start thinking about. We were particularly enchanted with many major MSM (WSJ, NYT, FT,...) stories on the increasingly bleak outlook for stocks for reasons we've largely been analyzing since at least Jan. And even more enchanted with equally mainstream discussions of the huge continuing disconnects between very high PE Ratios, the economic and market outlook and forward earnings estimates that give new meaning to fantasies and a good experience in the '60s (remember...live better chemically). Around here all we can say is "wow, deja vu'...all over again". But just for fun we listed the pointers to some key prior posts on some machinery that helps out here. 

 UPDATE: Fannie, Freddie rescue to offer just a quick fix Many investors applauded the government's decision to rescue mortgage-investment giants Fannie Mae and Freddie Mac and some predicted at least a short-term stock-market rally. But analysts questioned whether this will provide more than a temporary fix for the ailing economy and for financial markets.

A rather startling WSJ story that mirrors our arguments so closely we started wondering what we've missed. A MUCH longer excerpt after the break. In any case it reinforces every single point we made below and was apparantly written over the weekend !

Update2: Foreign Markets Russian Stocks Fall on Fears of a Slowdown, Woes Hit Once-Spared Mideast Stocks, Hong Kong among 5 indexes declining to 52-week lows

Market Review

 The composite chart shows the SP500 above and the NDX below with each having a technical overbought/oversold indicator above it and a momenturm indicator below it. We all "knew" the SP was getting tired as the Merrill fantasies that kicked off the July bear rally faded but we didn't expect last week's collapse. What we think happened is that, despite the amazing and badly interpreted GDP number that payroll and unemployment numbers confirmed the pronounced and accelerating weakening of the economy. Which puts to bed to whole 2nd half rally notion as reality started to sink in. We'll pick up the whole economic thing but wanted to start your week with Markets building on the Frantic rescue package. Similarly reality has snuck..oops we mean sunk...in on the Tech outlook. But boy did it sunk....after ignoring everything while the SP deteriorated Dell's announcement that worldwide IT spending was tanking took all the air out of those sails. If our assessment of the economy is correct (remember YoY GDP growth of 2.5% and 2.2% and x-trade of 1.1% and 0.4% for Q1/Q2 !) we're just really crossing the tipping point and you ain't seen nuttin yet !

Dangerous Memes, the Dollar and Oil

 Interestingly though US markets have been the best relative performers on the return of re-coupling with a vengeance. Which means on the one hand that the dollar has leaped not on fundamentals or technicals but on a short-term attitudinal shift (btw - this means the tanking of US foreign earnings !) based on the continuing worldwide slowdown vs a US that "might" recover first. If you look at the top chart you can see the impact of demand destruction on oil prices. Unfortunately it looks like that downtrend is approaching a limit now. What that really tells us is that yes, there was demand destruction but that on a $150 price maybe $30 was speculative excess and $20 a perceived scarcity premium. It also tells us that a new bottom on oil might get put in technically in the $100-105 range. Even if the bottom turns out to be $80-90 that's still above last years high price. We're looking at a new long-term low in a trading range where oil demand  >> supply for a long-time. Similarly while the Dollar may keep rising once the realities of a more serious US slowdown sink that'll reverse as well. Though not likely to as severe a downdraft as we've had over the last several years. So much for foreign earnings and currency conversion benefits. See this vidclip from Jubak: Has oil bottomed out?

Relative Sector Performances

Speaking of fantasies, irrationality, earnings, outlooks and PEs you need to take a look at the differences between the different sectors and understand how they've performed. And what a real downturn might do to them. Here we've created a 3-part chart comparing Finance (XLF), Con.Disc. (XLY), Industrials (XLI), Energy (XLE) and Technology (XLK) over three months, YTD and since the Oct07 top. The one thing that stands out for us to start with is that most of the market downturn has in effect been a major bear market in financials, not in any other sector per se. The second thing is that all the bear market rallies have been when somebody somewhere believes it's all kissed and made better and Financials rally and take the markets up with them. In fact if you look at the last three months the big jump in the whole thing was around Jul14, which just coincidently is when MER told us it fixed its' problems, again. Of course a week later they told us they were just kidding and they had to raise more capital. So believe what you will but a) if the economy turns down earnings estimates are weigh....weigh too high, b) PEs are running in the 25 range which is a real bull market figure...not the historical average nor the 6-10 justified by the outlook and a real correction in the markets would be 30% down not 10-15% we've got so far. Hmmm....now just suppose that all we've seen is the fallout from credit and finance problems. Then suppose that the economic data says we're crossing a real tipping point into a real economic downturn. Then ask yourself what that might mean for the markets.

The Last "Downturn"

Just for fun let's take a look back at the last busted bubble. You'll notice on first blush that the cases are similar except that burst bubble led to only a real downturn in Technology. Which might argue for more of the same except for a couple of minor details. First, there hasn't been an equivalent bubble in any sector this time that needs to be popped - it's over in Housing and well disguised. Secondly because of Housing (and leverage) we had a very mild downturn where GDP fell slightly and not for long and Consumption barely fell at all. So there was no pain and not much gain in the other sectors.

We consider it much more likely that we'll see a repeat, at least, of the '90 downturn or worse. Say the '80 downturn. In other words, something where we get GDP growth in the -2 to 0% range for a couple of quarters. Followed by low growth in the 1% +/- range for a long time. What'll that world look like in the markets ?

If that comes to pass then you can expect to see something more serious in the markets in general and the so-far immune markets in particular. On the other hand we could be wrong about the economy but we'll take that up with our next post. If we aren't wrong then the relative sector performances that we've seen so far make no sense on the fundamentals.

Just to review the bidding then we started the weekend wrapping Frannie with a set of big picture consequences to set the stage for this review of the markets. Which will then lead us to the Economic situation. However if you'd like to review the prior bidding a bit try these: Markets vs Economy: Dangerous Memes vs Realities, GDP, Jobless Claims, Markets, Oh My: Still Tipping Over !.

Market Performance & Outlook

On Wall Street: Bleak reality of US stock markets  One of Wall Street's tenuous beliefs is to sell stocks in May and not to return to the market until late October. This week, as the major US indices returned to official bear territory, defined as a fall of more than 20 per cent from their peaks, cashing out in May when stocks had bounced from their lows in March looks to have been prescient. What has confounded many of the equity optimists in the last few days has been the failure of a long-desired catalyst. The price of crude oil has fallen 25 per cent since mid-July. That helped for a while, but on Friday the S&P 500 was approaching its mid-July closing low of 1,214, having traded above 1,300 as recently as Tuesday. Not so long ago, equity investors were hanging their hats on a big slide in oil as they saw rising petrol prices acting as an onerous tax on consumers. The peak in oil near $150 a barrel was accompanied by a decline of nearly 15 per cent in the S&P between May and July to its lowest level since October 2005. The tumble in oil has also been matched by a strong rally in the US dollar against its major rivals. The credit and housing infection from the US has now affected the global economy. Although the US is by no means close to entering remission, the dollar is now considered a safe haven. Falling house prices and rising foreclosure rates will maintain the pressure on bank's capital, erode consumer spending and deal a compelling blow for earnings. September and October have often been tough months for equities and this year we also face the prospect of a tight Presidential election. As Lehman Brothers struggles to find new capital, there is growing concern about upcoming third-quarter earnings. Not surprisingly, however, most analysts remain fairly optimistic about earnings. But Albert Edwards, global equity strategist and long time bear at Société Générale makes a salient point. "We have now reached the point in the cycle where companies reach the end of the road on earnings manipulation and have to admit to their shareholders how bad things really are, sending reported profits diving." He expects "a combination of economic and reported profits slumping will catalyse the next equity downleg". Before Halloween closes the door on October, investors can be forgiven for thinking the horror show engulfing equities has yet to climax.

Hopes Fade for Second-Half Stock Rally A sustained rebound for stocks may not be in the cards until the middle of next year. Even then, expectations are limited as the problems in the markets continue to spread. Credit markets have been signaling heightened strains for U.S. stocks and bonds in recent weeks. Even after recent declines, oil prices are up more than 55% from a year ago, and gasoline prices are still near record highs. The employment outlook is getting worse. Corporate earnings, while proving more resilient than many pessimists had predicted, remain under pressure. After months of a slowing U.S. economy, the summer brought evidence that others around the globe were beginning to struggle, especially in Europe. That threatens exporters and undercuts profits at big multinational companies, which had been one of the few bright spots for stock investors. Early this year, it looked like global economies were decoupling -- that overseas markets could sustain their growth even as the U.S. faltered. Now, as the pressure spreads, some of world's biggest companies are scaling back their forecasts. The outlook is disappointing those who had hoped that by this time of the year, the Fed's aggressive interest-rate cuts that began in 2007 and eventually totaled 3.25 percentage points would be giving a lift to the economy as well as the battered housing market and struggling banks. After a disappointing start of the year for stocks, a second-half rally would vindicate early forecasts for full-year gains and ensure that bonuses are paid. Instead, home prices haven't hit bottom, and banks are still tightening lending standards. Many believe the job market is only in the early stages of a downturn. The unemployment rate for July was the highest in four years, and job losses continued for the seventh straight month. Many think forecasts for a big bounce in corporate profits later this year -- which would support a rally -- are overly optimistic. Analysts have been slashing third-quarter forecasts. Companies in the Standard & Poor's 500-stock index are now expected to post growth in operating earnings of 2.4%, down from the 13% forecast at the beginning of July. In the second quarter, earnings fell a worse-than-expected 22%, according to Thomson Reuters. For the fourth quarter, analysts are sticking with forecasts that earnings will jump 60% from a year earlier, in part because of an expected bounce-back from depressed year-earlier levels on financials and consumer stocks. But that consensus forecast would take profits to record highs, which many feel is unrealistic given the economic environment and pressures on margins.

• Asian stocks fall amid political turmoil

Stock Market Performance Round-up: Going Nowhere Fast … global stock markets were dancing to the same despondent tune during August. Gloomy sentiment about credit woes and a worsening global economic picture dampened investor sentiment, resulting in a down-month for most markets. Although the MSCI World Index (-1.6%) managed to hold its mid-July trough, the MSCI Emerging Markets Index (-8.2%) was less fortunate and recorded fresh lows for 2008. The biggest loser for the month was the Russian Trading System Index, which declined by 16.3% on the back of increasing concerns about the broader implications of Russia’s confrontation with Georgia, governance issues and lower oil prices. Talk of government’s economic stimulus measures in China failed to gain traction from investors, resulting in the Shanghai Composite Index (-13.6%) occupying the second-last position in the monthly rankings. Thanks to Brazil, yet another BRIC country made it into the bottom three as the slide in commodity prices negatively impacted the Bovespa Index, pushing the benchmark 7.2% into the red.The relatively stable performance of the Bombay Sensex 30 Index and an overall improvement towards the end of the month saved the SPDR S&P BRIC 40 ETF (BIK) from an even worse performance. Not a single index registered a gain for the first seven months of 2008. Declines in China (-54.4%), Hong Kong (-28.2%) and Russia (-28.1%) are nothing short of a crash.

Fannie, Freddie rescue to offer just a quick fix Many investors applauded the government's decision to rescue mortgage-investment giants Fannie Mae and Freddie Mac and some predicted at least a short-term stock-market rally. But analysts questioned whether this will provide more than a temporary fix for the ailing economy and for financial markets. Although the government bailout doesn't help Fannie and Freddie shareholders, whose stock has lost most of its value, bonds would be safe and the government-sponsored agencies would avoid failure. If the bailout permits the two companies to free up more money for mortgages, that could drive down mortgage rates and make it easier for people to buy homes. But the rescue isn't likely to prevent home foreclosures, nor will it wipe away the huge inventory of unsold homes. Of even greater concern to investors, U.S. economic troubles already have spilled over into Europe, Japan and the developing world. Even after the rescue, the slide into a global economic slump is likely to continue, with outright recessions in some big European countries and, quite possibly, the U.S. Signs are spreading that the world economy is getting worse, whether Fannie and Freddie are rescued or not. When oil, gasoline and other commodity prices started falling in July, stock investors celebrated in hopes that the lower prices would boost consumer spending and speed recovery. Lately, they have changed their view, seeing falling commodity prices as another symptom of global economic distress -- along with rising unemployment and mounting home foreclosures in the U.S., and softening economic growth from Europe to Asia. Because stocks are beaten-down again, some investors predict a bounce this week, fueled by the Fannie-Freddie news. The question is whether the rebound will last. The current economy is quite different than during the recession of 2001, when consumers, who represent 70% of U.S. economic demand, stayed strong and kept borrowing and spending. The 2001 recession was driven by corporate cutbacks following the technology bubble's bursting in 2000.This time, consumers are cutting back on spending. Not only are auto sales down, but total miles traveled are falling for the first time in two decades, Lehman reports. Some economists now worry that the recession could be worse in Europe than in the U.S. And while much of the developing world could escape outright recession, those economies could see sharp slowdowns in growth, pushing up unemployment and hurting their newly affluent consumers.

Earnings and  Valuations

World-Beating U.S. Stocks at 25.8 Times Earnings Means Rally Can't Persist The best already may be over for the U.S. stock market this year. The Standard & Poor's 500 Index, which had the worst first half since 2002, added 0.2 percent this quarter, the only gain among the world's 10 biggest markets in dollar terms. Shares in the benchmark index for American equity climbed to an average 25.8 times reported profits, the highest valuation in five years. The last time that happened, the S&P 500 fell 38 percent. Money managers at Federated Investors Inc., Russell Investments and Morgan Asset Management, which oversee a combined $600 billion, said the gains won't last because corporate profits will fail to meet analysts' estimates. Wall Street forecasters, who were too optimistic about earnings for the past four quarters, predict income at America's biggest companies will grow by a record 62 percent in the final three months of 2008, according to data compiled by S&P. ``The market is pricing in the expectation of a good quarter, but we just don't see it,'' said Philip Orlando, who helps manage $350 billion as chief equity market strategist at Federated in New York. ``The fundamentals are going to be poor, earnings are going to be bad, and there are going to be more huge writedowns. We think stocks probably need to work 5 to 10 percent lower over the next month or two.'' World stock market valuations, earnings growth

Why the Bear Is Alive and Well IF there’s a silver lining to bear markets, it is that they make stocks cheap for the next wave of investors. But so far in this downturn, it isn’t working out that way. Based on the price-to-earnings ratio, stocks have actually become more expensive even as share prices have come tumbling down. In fact, the P/E ratio for the Standard & Poor’s 500-stock index, based on earnings over the previous four quarters, has risen to just over 24 from around 19, according to S.& P. Though share prices are off by about 20 percent since the market peaked on Oct. 9, 2007, corporate earnings —the “E” in the P/E ratio — have fallen even further. In the first quarter this year, earnings of the S.& P. 500 sank 17.5 percent, according to Thomson Financial. But the index, excluding dividends, itself declined 9.9 percent. And in the second quarter, corporate profits declined by an estimated 22 percent while stock prices fell by a much more modest 3.2 percent. Christopher N. Orndorff, head of equity strategy at Payden & Rygel, an asset manager based in Los Angeles, said, “the lack of P/E compression has created a headwind” for stocks. Historically, bull markets emerge from bear markets after stocks sink to attractive levels for investors. Since 1938, the average P/E for the S.& P. 500 at the start of new bull markets has been 13, according to Standard & Poor’s Equity Research. That’s considerably lower than the current level of 24. Also, corporate earnings have been shrinking since last summer. When earnings decline this way, P/E ratios can be volatile — and even misleading, said Duncan W. Richardson, chief equity investment officer at Eaton Vance, the asset manager in Boston.The last time profits were in decline — at the beginning of this decade — P/E ratios kept climbing even as stock prices fell during the bear market of 2000 to 2002. Eventually, though, that trend reversed. OF course, Wall Street earnings projections have been way too optimistic in recent quarters, and David A. Rosenberg, the Merrill Lynch economist, thinks that they may still be too rosy. In a recent economic commentary, he says Merrill is expecting S.& P. 500 earnings to continue to decline through 2009. In fact, he says he thinks profits of the S.& P. index will come in at around $63 a share next year. That’s down from the $68 he is forecasting for this year, and a far cry from the $100 that Wall Street is expecting for 2009. Using his projection, the market’s forward P/E would be nearly 20, not 13. If he’s right about earnings, it may be a while before a new bull can emerge.

• Profits, Earnings, PEs and Outlooks: Why You Should Reall....lly Care

Investing Strategies

Meet the market's next winners But what if, despite the market's nearly daily swings recently from commodity doom to commodity boom, the future belongs to neither of these either/or scenarios? What if we're looking at neither a commodity collapse nor a resumption of the commodity rocket but instead a period of slower, more moderate increases in commodity prices? In other words, a world where oil and iron ore prices climb 20% in a year instead of the 80% or so we saw from mid-2007 to mid-2008? Then I think we're looking at a very different group of winners -- one that's pretty much off everyone's radar right now. Which, of course, raises the possibility that these stocks could actually deliver a profit to investors over the next six to 12 months. That possibility is enough to get my attention. After all, there isn't much of anything going up now that the bear market looks like it's resumed its hold on stocks. What are these stocks? The shares of those companies that have the power to raise prices because they are leaders in their sector, with products and brands that customers want even if they have to pay more for them. The same companies that fell behind because commodity prices climbed so quickly that they weren't able to raise their prices quickly enough. A slowdown in the rate of commodity price increases would give these companies a chance to see their price increases catch up with rising costs. And that would produce a jump in profit margins just when everybody is expecting margins to fall further. The result? Positive earnings surprises at these companies at a time when nobody else is delivering better-than-expected earnings per share. That's not a guarantee of a climbing stock price in a bear market when investors can sell off both the good and the bad. But it is a chance to own fundamental good news in a stock market and economy in which good news has become increasingly rare.

• Why Buffett is smarter than you

How to share in the dollar's surge The dollar's recent rally has been amazing: Since July 14, when the U.S. currency traded at $1.5914 to the euro, it has climbed about 10%. That's the dollar's best price against the euro since last October. Against a trade-weighted basket of currencies, the dollar hit an 11-month high this week. That has set off a major sell-off in everything from gold to oil to corn -- all the commodities that traders were buying earlier this year to profit from a declining dollar. And it's made the U.S. stock market the best-performing major financial market in the world since mid-July. That, of course, has led to a chorus of calls from Wall Street analysts and stock market gurus to buy dollars -- by buying U.S. stocks -- and to sell commodities, foreign stocks and currencies such as the euro, yen and British pound. What should you do? Do you jump on the bandwagon, selling overseas stocks and anything with the whiff of commodities about it and buy U.S. stocks to profit from the resurgent dollar? Or do you use the sell-off in gold, oil and other commodities and in overseas markets to load up on those assets? If you're a short-term trader willing and able to time and profit from trends that last for three to six months or so, jump on the dollar rally. I think good times for the U.S. dollar could last three to four more months. The dollar could well climb an additional 10% during that period. If you're a longer-term investor, I think you use this rally in the dollar as a buying opportunity in overseas equities and commodity-related stocks. From this perspective, the recent rally doesn't change the long-term downward trajectory for the U.S. currency. The dollar is still in a trading range against the world's currencies marked by lower lows at the bottom and lower highs at the top. And from this perspective, oil and other commodities are still in a long-term trend that points toward higher prices.

Posted by dblwyo at 09:01 PM | Permalink | Comments (0)

A little earlier this evening an interesting and very major story just came out on the WSJ online that Fannie and Freddie are about to have the Treasury impose a "rescue" plan of some sort or another. We'll see what happens over the weekend but it looks like the long-delayed other boot (Paul Bunyan's spare) is about to be dropped. This is good news and bad news. You might want to review a little history (Bad Times, Really Bad Behavior, Bad Trouble: Fannie/Freddie and Perdition Road). This is ironic since the markets, after reacting in what we consider a properly rational way to an abysmal employment report, rallied back today to close in positive territory for the non-tech businesses. Guess what - it was the Financials, the Homebuilders and Consumer Discretionary that were up. All the things that a metastasizing credit credit crisis and an accelerating slowdown are going to hurt the worst. The continued triumph of delusion over analysis IOHO. Ironically in the after-hours markets the Frannie Twins were down about -20%+ ! Though to be fair, if very confused, XLF was up almost 5% and XHB up almost 3%. Clearly the weekenders think Frannie is toast but it bodes well for the financials and the homebuilders. BtW Barry Ritholz has obviously been up and reading as his excellent summary of the news is here: Roundup: Fannie & Freddie Bailout. His opinions about socialist bailouts are another thing IOHO.

Weekend Updates and Summaries: BigPicture, CalculatedRisk and Matt Trivvsanno & crew have come thru with summaries analysis and consequences that you should have in you reading lists.

BigPicture: Fannie & Freddie Weekend Wrap Up/Linkfest,Treasury Takeover of GSEs: 10 Key Points

CalculatedRisk: Fannie & Freddie Thoughts

Matt  Trivisonno: The Fan-Fred Short-Squeeze Rally

Update2: More interesting news below in the readings section detailing the behind the scenes on the Frannie rescue AND the impact on the Housing markets. Plus an assessment of widespread the problems with banking capital shortfalls are. Confirm our themes and "worsen" them in essence.

Let us try and disabuse everyone of those notions  that  a) a Frannie bailout is pork-barrel politics, b) that the Financials are /will be in good shape and c) it's safe to get back in. And do so by complementing all the news roundups with our usual focus on the  structural context and consequences. In other words , what's the lay of the land and what's the weather therein.

State of the  Credit Markets

 Starting by looking at the state of the credit markets using some of our standard indicators. What you see here are three different credit/money market measures the can tell us quite a bit about what's going on. First up is the spread between FedFunds and 10Yr Treasuries - which mixes instruments a bit - but is still telling us that the Yield Curve is "market favorable". That is short-term money is cheap, which generally encourages investing because borrowing is inexpensive. And longer-term money ain't that expensive at around 4% and dropping. But the really interesting thing about that spread is the abrupt switch around Nov. from no spread, indicating a flat/inverted yield curve and tight short-term money, to now. In this puzzle-palace world the short-term drop was Fed policy at work but why the long-term rates are staying up is....dollar ?

More interesting though is the spread between 3Mo Treasures and corporate commercial paper, which is still very elevated over last year and appears to be rising. An indicator that there's still a lot of fear and uncertainty in the market. Finally is the inflation-adjusted monetary base which tells us the effective supply of money is growing or shrinking. Normally it shrinks during downturns and this time is no exception ...except it's been shrinking longer and farther than the economy's been downturning so far ! The reason - it's called credit tightening. In other words the credit markets are working but under enormous pressures. If you'd like to see a really cool and implicitly informative history of how the yield curve works and relates to the markets try this: Dynamic Yield Curve. And in case you're wondering why you care Wikipedia has a decent, thorough and balanced description.

Frannie's Failures and Consequences 

After the break you'll find a largish collection of readings that bear on all this from the news that the Chinese banks have backed away from Frannie, for what now seem like sound, rational reasons. Which makes the rates they have to pay to borrow higher, funding harder to get and so on. Which leads us to one of the gray-headed potential triggers - though it's been months/years in the making. Bill Gross's latest newsletter talked about a financial tsunami freezing up and then collapsing the markets and specifically the need to rescue Frannie on Thur. But he wasn't alone - Paul Volcker, perhaps the most respected central banker in seven decades, came out flatly the same day and said the system is broken, more write-offs are coming and we need to re-engineer it. He further added he's never seen a crisis this complex or painful.

Our fear is that once we move beyond the perennial Pollyannas and into more realistic territory there's still a limited grasp of what a breakdown in Frannie, let alone the whole system, would mean for the economy. Shucks...:) We're not even sure we get it and we've been flapping our gums for months. Certainly if the XLF keeps getting run up like this though our fears of a major breakdown are very far afield from the common understanding. In other words there's still a lot of piping to pay for and Bill and Paul are telling us the bill's coming due. 

There's a bunch of other readings we think are worth your time including some more on the lingering after-effects and some very good discussion, similar to questions we've raised but now done in a wider venue by somebody who's very knowledgeable, about the future down-sizing of the industry. Plus some interesting stories of folks who have been or are navigating these storms thru what we'd call business acumen, guts and discipline. 

The one story though we really urge you to click thru, read, download think about is Robert Solow's review of Kevin Phillips book on "Bad Money". His shrill polemic against the Finance Industry. While there's a lot wrong he apparently didn't bother to figure out what worked but dug up some 100 year old anti-capitalist conspiracy theory stuff from William Jennings Bryan and his "cross of gold" speeches and re-furbished them. Now we're not denying there's a lot broken and a lot of malfeasant behavior since we've been arguing that as well. What Solow - btw, one of the best 100 economists of the last sixty plus years and a Nobel winner - does is is take you on a detailed tour and analytical dissection of the industry and the roles it plays and why it's so necessary. While also discussing what's wrong and thoughts about fixing it. 

Final Words: Frannie, Systemic Risk and Malfeasance

There's a lot of words being bandied about that this is yet another example of socialist intervention in the markets. Instead they screwed up, let them fail. Well this is disingenous at best and also ignorant both of how one thing leads to another and what underpins markets. Here are some things to think about that'll help you correct that.

1. First put out the fire and save the women and the children, don't lock the door because they aren't correctly dressed to appear in public.

2. Use this crisis to make structural repairs that regulators, the Fed (Greenspan) and others have been trying to make for years, if not decades, as Frannie increasingly spiraled out of control thru lobbying and corruption of Congress to protect its' interests and in the name of greed.

3. We all benefited from that greed and wallowed in it. The only thing that held up the US economy after the '01 downturn was Housing and what drove housing was debt securitization. There is no single one of us who's investments, incomes, jobs and general well-being didn't benefit some way or another. Old sayings come to mind...either when you eat at the King's table be loyal to your salt...or bring your own taster. Or both.

4. As the chart makes clear a Frannie failure would turn a nightmare Housing market into a catastrophic collapse and be a systemic threat to the entire financial system. BSC was a Sunday park stroll as compared to the Mongols' visit to Baghdad in comparison. But that's not the worst of it - because the full faith and credit of the US government was involved and exploited the credit-worthiness of the US Treasury was and is at stake and the Chinese have fired more than one public warning shot. For a fuller discussion of the consequences Jim Jubak does a beautiful job: The huge threat to the US economy

5. Markets don't exist in a vacuum but rely on a whole host of hidden infrastructure from a legal system to enforce contracts to security forces to make sure that one is free to trade and exchange as well as to defend the property you're trading and filing law suites over. The financial markets wouldn't exist without the regulatory framework that's been evolved to ensure their smooth, orderly and honest functioning over the last eight decades. That machinery is creaky and aging and needs a major overhaul. But to pretend it doesn't exist nor that it isn't in the public interest is ill-informed, to say the last (again we refer you to Solow's review).

With all the ideological ranting and raving you'll make better decisions if you understand the organic dependency of markets on government instead of pretending it doesn't exist. With that in mind here's the readings to back up some or all of those assertions.

Frannie Into the Fire

China Pulls Back From Fannie, Freddie China's big banks, having trimmed their holdings of U.S. mortgage-related debt, are facing increasingly difficult decisions about how to invest their sizable foreign-currency holdings. Amid jitters about the future of Fannie Mae and Freddie Mac, China's four biggest listed banks have pared back their holdings in debt related to the two U.S. mortgage giants. At the end of June, the four banks held a combined $23.28 billion of debt issued or guaranteed by Fannie and Freddie. That's a small fraction of the trillions of dollars outstanding, but the reductions attracted interest as a possible gauge of broader sentiment toward such securities. In earnings conferences in recent days, several Chinese banks said they had trimmed their Fannie and Freddie portfolios since June. Bank of China Ltd., by far the largest holder of Fannie and Freddie securities among the four big banks, said it had sold or allowed to mature $4.6 billion of the $17.3 billion it held as of June 30 -- which was down from more than $20 billion at the end of last year. The shift away from Fannie and Freddie debt further reduces an already dwindling array of attractive foreign-currency investment options, with meager returns on low-risk instruments like U.S. Treasuries and continued instability in major stock markets. Because most developed economies are expected to slow further this year, the global investment climate is unlikely to improve soon, analysts said. China's banks have significant overseas funds to deploy. Bank of China had $240 billion of overseas assets at the end of June, while the other three big lenders had a combined total of $219 billion. Some analysts said they see merit in Chinese banks expanding their foreign-currency loan businesses. They have lots of liquidity as many Western institutions are squeezed by the credit crisis, so the Chinese banks may be able to pick up market share in lending to attractive companies.

Plan Near for Fannie, Freddie The Treasury Department is close to finalizing a plan to help shore up mortgage giants Fannie Mae and Freddie Mac, according to people familiar with the matter. Precise details of Treasury's plan couldn't be learned. The plan is expected to involve a creative use of Treasury's authority to intervene in the two companies, which it won earlier this year, and could involve a capital injection into the beleaguered giants. The plan also includes a management shakeup at both companies, according to one person familiar with the plans. Daniel H. Mudd, chief executive of Fannie Mae, and Richard Syron, his counterpart at Freddie Mac, are expected to step down from their posts. An announcement could come as early as this weekend. Some details are still being worked out, which means terms of the arrangement could change. Treasury's move would represent perhaps the most significant intervention by the government in the financial industry since the housing bust touched off turmoil in the credit markets a year ago. From the $168 billion economic-stimulus package in February through the bailout of investment bank Bear Stearns Cos., the Bush administration and the Federal Reserve have taken an increasingly aggressive stance in responding to what has become one of the worst financial crises in decades. The likely move would mark a remarkable comedown for two of Washington's most powerful and feared institutions, known for their financial clout and no-holds-barred lobbying prowess. Fannie and Freddie shares, which were up during the regular session Friday, dropped 25% and nearly 20% respectively in the after-hours session. Treasury's likely plan is supported by Federal Reserve Chairman Ben Bernanke and James Lockhart, chief of the two companies' regulator, the Federal Housing Finance Agency, according to people familiar with the matter. On Friday afternoon, Messrs. Syron and Mudd were summoned to a meeting at the offices of the agency. Also attending were Mr. Bernanke and Treasury Secretary Henry Paulson.

`Financial Tsunami' to Engulf Markets Unless Treasury Steps In, Gross Says The U.S. government needs to start using more of its money to support markets to stem a burgeoning ``financial tsunami,'' according to Bill Gross, manager of the world's biggest bond fund. Banks, securities firms and hedge funds are dumping assets, driving down prices of bonds, real estate, stocks and commodities, Gross, co-chief investment officer of Newport Beach, California-based Pacific Investment Management Co., said in commentary posted on the firm's Web site today. ``Unchecked, it can turn a campfire into a forest fire, a mild asset bear market into a destructive financial tsunami,'' Gross said. ``If we are to prevent a continuing asset and debt liquidation of near historic proportions, we will require policies that open up the balance sheet of the U.S. Treasury.'' The government needs to replace private investors who either don't have the money to buy new assets or have been burned by losses, Gross sa