bizzXceleration: Performance, Value and Profit

Currently the Davos World Economic Forum is underway, and having watched several of the online videos which are available to you (SB: a great resource which you should invest some time and thought in - for example Putin and Wen's critiques of the financial system breakdown were small parts of their speeches, despite headlines, far less harsh than the Westerners themselves and their call for a new integrated economic and financial framework commonly shared very widespread) online. Several recurring themes/memes were (1) find and hang the guilty, (2) re-engineer the system, (3) the downturn's going to be worse than we think so far and (4) the geo-political strains immense (all of which we've been trumpeting for some time) are running thruout the sessions. There's no better horse's mouth sources about on-coming events, trends and changes than this stuff and the reporting is just flat getting it wrong. The vidclip graphic takes you to a session that's among the many you should listen and it's on "What Went Wrong" (click to see if the graphic doesn't work) and is hosted by the Money Honey and includes folks like Stiglitz, Shiller and Blinder as well as many leading luminaries. Listening to ought to scare you because the folks who are at the forefront and were at ground zero basically confirm all our arguments from the previous post (Rescue, Recover, Re-Design, Re-Build: Finance Industry Futures). Sorry if the graphic doesn't look as appealing as it does running :) ! But listen to it anyway (after the start you need to scroll to about 40 min but especially listen to the end. The discussions are the real meat though).

Brave New World and Confidence

The relevence for us is that we will see new national and international regulatory frameworks and the best thinking is that the Finance Industry as we knew it and are still extrapolating forward from will undergo deep structural changes. This is NOT a cyclic downturn it is a structural one and what comes out will look nothing like what we've seen. The readings after the break start by speaking to some of these strategic contexts and trends and then focus on two sectors which will undergo some of the most radical change as de-leveraging proceeds and risk is re-priced and regulatory mechanisms tighten up in new forms. Those sectors are Hedge Funds and M&A. In the last post we talked about the big picture trends and put up a graphic illustrating which sectors were in what kinds of trouble. The key to remember is that the more they relied on over-leverage, under-priced risk and bad operational practices the more vulnerable they are, the harsher the changes will be and the less the new will resemble the old. From that same conference it turns out that our coterie of flat-footed business executives are loosing confidence rapidly and the rest of the world is loosing it even faster in them. How's that going to play in Peoria ? Or more importantly among the stakeholders who went chasing returns in the alternate investment "brave new world" that's dying ?

No More Quoth the Maven, No More

 Well one way to judge that is by looking at long-term finance industry stock prices, here proxied by the XLF industry ETF, as a proxy for what people think of the industry. Not surprisingly not much at all, as shown by the literally abysmal drop into the depths of loss. Go look up Laurentian Abysmal on Wikipedia sometime, or better/worse read about the Challenger Deep. Let's hope we stay Laurentian instead of further challenged (there's several puns there...look it up as they say :) ). Meanwhile look more carefully at the chart, the top of which shows the 10Yr weeklies for XLF along with the 20Wk MA and the bottom two sections show technical indicators (Volume and a MA difference which shows momentum). Now really look at it carefully. From 02 to early/mid 07 finance went up 100% - a pretty good exemplar of a fantasy bubble in a week economy IOHO. So what differential, unique and new huge value add was brought to the table to so far exceed historical performance norms ? Well judging by the 50% drop since then BELOW the 10Yr zero point NONE. And it turns out that the industry lied to us AND itself - these are after all "the smartest guys in the room". Turns out that subsituting financial engineering and loosing sight of fundamentls looks more like the early rockets than Saturn V.

The Devil's Details

Let's consider that down another level of granularity to bring it home. The accompanying graphic provides a list of key bellweather financial stocks showing their status as of mid-day yesterday, relative to their 50Day MAs and 52WK High/Lows. Take a careful look and tell us who you think has turned in an exemplary performance ? Even the best investor of our lifetimes is down almost 40%. Which is a tad better than Jaime Dimon at JPM and enormously better than Lewis at BAC, the architects of the two new megabanks. On the other hand People's Bank of CT is down 24% - a stunning out-performance in this environment. So what does that tell us ? Well PBCT has been conservative, run a good bank and picked it's opportunities. Things Dimon and Warren are known for as well.

We come full circle (Survivor: Search for the Next "Blue Chips" (UPDATE))back to our key themes - good Strategy, great Execution on operational fundamentals, sound Management Systems and Leadership.

And if you don't think it makes any differences then work out what yearly return you got by buying XLF at the end of '02 and buying the inverse in early '07. Hints: try a 2 handle for the first and a 4 handle for the second !

Strategic Thinking and Context

Smart Money Takes a Dive on Alternative Assets  How did the "smart money" get into this fix? As bond yields shrank in the 1990s and stocks shriveled soon after, institutional investors began looking for assets that would generate solid returns no matter what.The solution was "alternative investments" -- hedge funds, real estate, venture capital, private-equity funds and natural resources. Between 2000 and 2002, as stocks collapsed, endowments led by Yale University beat the Standard & Poor's 500-stock index by huge margins thanks to their stake in alternatives. Word got around. In 1995, according to Managing Director Celia Dallas of the consulting firm Cambridge Associates, endowments had less than 10% of assets in alternatives; by 2008, that average had climbed to more than 30%. Some went much further. As of last June, 41% of Columbia University's $7 billion endowment was in hedge funds and 40% in private equity, with only 4% in U.S. stocks, 4% in cash and a piddly 1% in bonds. That is light-years away from the old-time institutional rule of 60% stocks, 40% bonds. So what? Many hedge funds lock up investors' money for as long as three years. The typical private-equity fund makes "capital calls," requiring investors to pony up another 50 cents to 75 cents for every dollar they already have committed. Columbia is on the hook for another $1.6 billion in capital calls through 2012. When all goes well, as it had for years, endowments pay for capital calls with gains elsewhere in their portfolios. Now, however, all isn't well. With no gains to be found, many institutions are short on liquidity just when they need it most. A recent survey of college and university presidents found that 50% have, or will soon, put in a hiring freeze. Nearly 7% admitted selling assets into a bear market; another 9% have been forced to borrow money at punitive rates. Sadly, they didn't have to plunge into a pool that is run dry.

• A conversation with David F. Swensen

All big US banks must go to fix crisis: economist The creation of a government bad bank to buy toxic assets is necessary, but then the government will need to take control of and restructure major banks to fix the system, one economist at the World Economic Forum in Davos told CNBC.com. "They have to do a bad bank," Harvard Economics Professor Ken Rogoff said. But "if that's all they do then it's idiotic." Institutions like Citi (NYSE: c) and Bank of America (NYSE: bac) will have to go, boards will have to be fired and equity stakeholders will be wiped out, Rogoff said. The plan could mirror the one Sweden implemented, where all troubled banks were nationalized, their balance sheets were cleaned up and the good parts of the businesses were sold to the private sector. That solution was "much cleaner," he said. Sweden's banks were effectively bankrupt in the early 1990s, but the government pulled off a rapid recovery that actually helped taxpayers make money in the long run. The government placed banks with troubled assets into a so-called bad bank, where they could be held and then sold when market and economic conditions improved. In the meantime, it used taxpayer money to provide enough capital to allow banks to resume normal lending, but wiped shareholders out in the process. Officials from the Obama administration are holding around the clock meetings with senior Wall Street executives on how to create a new government bank to buy bad assets from major financial firms. However, people with direct knowledge of the talks tell CNBC there is no consensus on how such an entity would work or whether a plan could materialize any time soon or possibly ever.

A Rise in Pessimism in the Corner Office CORPORATE chief executives have lost confidence in the outlook for their companies. And educated elites around the world have lost confidence in the chief executives. Surveys showing those two trends were released this week at the World Economic Forum here, adding to the already glum sentiment of executives gathered for the forum. The survey of chief executives, by PricewaterhouseCoopers, found the proportion of corporate bosses who were highly confident about increasing revenue over the next 12 months had plunged from a year ago in virtually every country. The survey was taken during the final quarter of 2008. Ian Powell, the chairman of PricewaterhouseCoopers’s British arm, said that throughout the world the chief executives interviewed later in the quarter were less optimistic than those who replied earlier. The decline in executive confidence was most notable in China, where fewer than a third said they were very confident. In the survey taken in late 2007, nearly three-quarters of chief executives felt that way.Only in India did a large proportion of chief executives remain confident, but even there the number fell to 70 percent from 90 percent.

“The last downturn was a cyclical downturn,” said Mukesh Ambani, the chief executive of Reliance Industries, an Indian company. “This is a structural downturn. When you have cyclical events, things go up and come down. When you have a structural event, something fundamental changes. Our view is this is going to shake up fundamentals in a whole host of global economic areas.”

The Rise of A New Asset Class I think we're at a watershed moment, what Peter Bernstein defines as an "epochal event," with the very order of the investment world changing as it did in 1929, in '50, in 1981, where a number of things came together - it wasn't just one thing but a number of events happening that conspired to change the nature of what worked in the investment world for the next period of time. It took most people a decade after 1981-2 to recognize that we were in a different period, because we make our future expectations out of past experience. It's very hard for us to recognize a watershed moment in the process. We're going to look back in five or ten years and go, "Wow, things changed." As we will see, it's going to be a change that's going to cost people in their portfolios and in their retirement habits.

Hedge Funds vs Market

Hedge Funds Put Stress on Market Hedge funds are selling billions of dollars of securities to meet demands for cash from their investors and their lenders, contributing to the stock market's nearly 10% drop over the past two days. The Dow Jones Industrial Average fell 443.48 points on Thursday, bringing its two-day drop to 929.49 points, its biggest two-day decline since Oct. 20, 1987. Coming amid steep drops in the retail and auto sectors, the decline wiped out a strong rally that ended on Election Day, and now the market is only 6% away from its lowest close of the year. One of the biggest hedge funds, $16 billion Citadel Investment Group, is being asked by several major banks to post additional collateral to cover big losses on its investments, according to people familiar with the situation. Hedge funds have emerged as the latest serious problem in the global financial system. As their losses mount, they're selling off securities to meet demands for cash from lenders and investors. Compounding the problem is a surge in notices from investors indicating they want out. Some hedge funds have been hoarding cash in preparation for these withdrawal requests. Hedge funds are sitting on a record amount of cash, estimated at about $400 billion, money that eventually could make its way into the market. Other managers are hoping that investors have second thoughts and don't go through with the withdrawals, or are telling their investors that they will sell securities over time rather than dump them as the market falls. But either way, the wave of requests is keeping money out of the market as hedge funds figure out their next moves. Withdrawals from hedge funds and from mutual funds are one factor weighing on stocks, says Mary Ann Bartels, Merrill Lynch's chief strategist. "It's an overhang for the market," she says. The recent rush of withdrawal notices to hedge funds comes as investors, including endowments, pension funds and wealthy individuals, see other investments shrink; in some cases these investors need cash to meet their own obligations. It also marks a sharp reversal of sentiment among these big institutional investors, which jumped into hedge funds and similar investments in recent years. The University of Virginia, with an endowment of $4 billion in mid-October, recently said it plans to sell $400 million of its $1.8 billion in hedge funds in the next couple of years to fulfill commitments to other investments. The result is a downward spiral where hedge funds sell off thinly traded securities such as convertible bonds and corporate loans, driving down their prices, and leading to bigger losses and more demands for cash. Some $4.28 billion worth of corporate loans have been put up for sale in the past month, according to Standard & Poor's. When hedge funds can't meet the demands for cash, lenders seize their assets and try to sell them, further driving down prices and putting more funds in trouble. Even the most established hedge funds are being hit by -- or girding for -- withdrawals from investors.

• Withdrawals May Close 25% of Hedge Funds: New York Post Link
• Record Options Trading Dries Up as Hedge Funds Fold, Volatility Skyrockets
• Sizing Up Hedge Funds

Hedge funds brace for the worst For hedge fund managers, 2008 may yet be the worst year for redemptions in more than a decade. Industry tracker Hennessee Group LLC is projecting about $400 billion in hedge fund redemptions for the year, or about 20% of the industry's total managed assets. An additional 20% drop could come from losses, said Charles Gradante, managing principal at New York-based Hennessee Group. This leaves the industry with about $1.2 trillion in assets at year's end, down from nearly $2 trillion at the start of the year, representing the first year-over-year decline since 1995, he said. Hedge funds, including hedge-funds-of-funds, have been struck with massive withdrawals in recent months, primarily because of investors' need for liquidity, analysts said. Sol Waksman, president of Fairfield, Iowa-based BarclayHedge Ltd., said the greatest redemptions are occurring in the more liquid strategies. Some of the hardest hit managers have long-short equity long, global and managed futures, and merger arbitrage strategies. November redemption numbers are not due until next week, but early indications are that the monthly tally may not be as bad as October's. Singapore-based Eurekahedge estimated $46 billion in redemptions, compared with nearly $63 billion the month before. In many cases, investors seeking to pull out of hedge funds with illiquid strategies — including distressed debt, high-yield bonds and structured finance — are constrained by gates. Fund managers typically restrict the amount and timing of fund withdrawals in order to prevent a run.

Hedge funds' future may lay in the past One possible outline of the future of hedge funds is beginning to emerge from the wreckage of the industry's six-year boom, and it looks very much like the business did in the 1980s, but with lower fees. Several of the biggest hedge funds, including the venerable Tudor Investment Corp, run by Paul Tudor Jones, are returning to their roots as traders of the most liquid currency, interest rate and equity index markets. Both have split off toxic, hard-to-sell assets into special vehicles from which investors cannot withdraw their money. Other funds trading illiquid instruments - credit, structured products and complex derivatives - are stopping investors getting their money back, as they try to defer forced sales of assets. Many are likely to shut down as they eventually pay back disgruntled clients. At the same time, all the strategies that relied heavily on borrowed money are dead in the water as banks cut their lending and regulators pay more attention. It is still early to draw conclusions, but the powerful industry appears to be splitting in two. At one end are the funds that can easily sell their holdings to repay investments, following strategies such as global macro - Tudor's core - and long-short equity trading, which makes up about a third of funds. At the other end will be funds with long lock-ups, more akin to private equity vehicles, which can justify the restrictions on withdrawals by investing in hard-to-trade assets.

The Richest Hedge Funds: John Paulson Strikes Again "You have deterioration in almost every asset class," Paulson says. "You're looking at declines in housing prices, the health of manufacturers and the earnings of various companies. There are rising delinquencies in auto loans and commercial real estate." Paulson, 52, peers over his tortoiseshell glasses. "There's more to come," he warns. Paulson doesn't smile as he says this, even though with each new calamity his bottom line grows. Paulson & Co. funds generated profits of more than $3 billion for the firm in 2007, mostly by betting the housing bubble, swollen with subprime mortgages, would burst. As that year ended, he set his analysts poring over the balance sheets of overstretched financial institutions, including many in the U.K. "We focused on those banks with lots of mortgages," Paulson says. "After those companies fell, we expanded our focus not just to mortgage assets, but to all credit classes." The payoff: Four of Paulson's funds were among the 20 best-performing, and the 20 most profitable, hedge funds for the first nine months of 2008, according to data compiled by Bloomberg, other hedge fund research firms and investors. Paulson's performance was a striking success in a disastrous 2008 for hedge funds. The industry is reeling from convulsing markets, fleeing investors and the most serious credit squeeze since the 1930s. Through September, the average fund lost 10.8 percent, according to data compiled by Chicago-based Hedge Fund Research Inc., putting the hedge fund industry on course to record its worst returns since at least 1990, the year HFR began compiling data. October saw another 6.3 percent decline. Investors are running, not walking, to the exits. TrimTabs Investment Research of Sausalito, California, estimates that September and October redemptions totaled $87.5 billion. Total industry assets, which peaked at $1.93 trillion in the second quarter of 2008, declined 11 percent to $1.72 trillion at the end of the third, according to HFR. Paulson said in mid-November that more than 50 percent of the assets he managed were in cash and that the money he had invested was equally weighted between short and long positions. "You have to get to the corner to see around the corner," he says. "We haven't gotten to the corner." He expects 2009 to reward those who invest in restructurings, strategic acquisitions and distressed credits. In November, Paulson began buying bonds backed by home mortgages, according to an investor. Spokesman Armel Leslie declined to comment. In making his investments, Paulson focuses on straightforward themes. "You have to be simple to have a clear strategy," Paulson says.

The Ponzi Scheme in Every Hedge Fund Bernard Madoff's $50 billion Ponzi scheme continues to rock the financial world. But most hedge funds actually engage in similar — albeit legal — practices in the short run. In the past, these practices helped inflate their gains as well as hedge-fund managers' salaries and bonuses, but recently they helped bring about the failure of many major hedge funds. At the heart of the difference is the distinction between realized and unrealized gains. Gains are realized when assets are liquidated to cash. For instance, if you buy a stock for $100 and it is currently trading at $200, you have made $100 in unrealized gains. If you sell it at $200, you have made $100 in realized gains. Most hedge funds do not regularly liquidate their entire portfolio, so they report unrealized gains to their investors and to the public. (See the top 10 scandals of 2008.) Now comes the murkier part: Many assets — particularly those that unregulated hedge funds can trade — are not as liquid as stocks, so they do not always have a definite price on the market. Since a fund reports unrealized gains, it could easily get away with inflating profits. More specifically, the fund could use the most optimistic models to price its illiquid assets, which include mortgage-backed securities and other swaps. After all, economists disagree about how to value these assets, so the fund is not necessarily being dishonest in its assessment. Madoff never even came close to realizing the gains he reported and paid out to some investors. Yet even funds with fairly accurate estimates of unrealized gains are guilty of engaging in similar Ponzi practices in the short term. Here's why:  Suppose some investors decide to withdraw their money from a hedge fund. The fund must liquidate the appropriate amount of its assets to pay these investors. Say the fund holds large positions in illiquid assets. The fund cannot immediately sell these assets, except at a fatal loss, so it would sell its more liquid assets. Given that the fund is more likely to inflate its estimation of the illiquid assets, it would seem that investors who withdraw early get the better returns over that time period. Sounds a bit like a Ponzi scheme, right?

• Hedge Funds, Unhinged

Senators Bid to Regulate Hedge Funds Two senior senators introduced legislation on Thursday to impose government oversight of hedge funds. The legislation by Senator Carl Levin, Democrat of Michigan, and Senator Charles E. Grassley, Republican of Iowa, was filed as the Obama administration was preparing a broader legislative overhaul of the regulatory system, including an effort to more tightly regulate hedge funds. State regulators and a panel created by Congress to oversee the $700 billion Troubled Asset Relief Program issued separate but similar regulatory proposals on Thursday. The proposals also seemed to closely mirror many of the provisions that administration officials say will be part of their plan. The regulatory overhaul is one piece of the administration’s effort to restore confidence in the financial system. At the same time, the administration is preparing to propose tighter regulation of credit rating agencies, new federal oversight of mortgage brokers and greater supervision of credit-default swaps, the unregulated financial instruments that experts say contributed to the economic crisis. Lawmakers have also signaled that they intend to take up legislation to more tightly regulate the markets. Meeting with reporters on Thursday afternoon, Senator Christopher J. Dodd, the Connecticut Democrat who heads the Senate banking committee, outlined an ambitious schedule for hearings next month on regulatory issues.

M&A Trends

The New Deal: M&A Game Shifts  M&A is all but dead. Last month, just 397 deals were announced in the U.S., the lowest monthly tally since September 2001, according to Thomson Reuters. The combined value of those deals was $15.5 billion, the lowest since January 2002, when adjusting for inflation. That total also was less than the value of deals that fell apart. The biggest deal of the month -- AT&T's $937 million acquisition of Centennial Communications Corp. -- wouldn't have even ranked in the top 100 deals of 2007. Mergers-and-acquisitions is a cyclical business. But the severity of the current downturn and the disappearance of credit is changing how Wall Street puts deals together. Fear, not opportunity, is moving markets. And with growth unclear, buyers are more focused on what companies are earning now than what they may earn in the future. In Wall Street's deal-making circles, that means buyers will have the edge in negotiations, after years of sellers calling the shots. This could be particularly true in industries such as health care and natural resources, where companies such as Johnson & Johnson and Exxon Mobil Corp. are sitting on piles of cash and can take advantage of weaker rivals. "Companies that have access to cash will clearly have the opportunity to buy things for what look like once-in-a-generation prices," says Mark G. Shafir, Citigroup's global head of M&A. Most companies with cash are hoarding it. Industrials in the S&P 500 alone are sitting on nearly $650 billion in cash, a record. The conventional wisdom is that in such a skittish environment, buyers will turn to stock-for-stock deals, in a way that minimizes their cash outlays. But these deals are proving difficult to pull off because a corporate sale often triggers covenants in the seller's credit agreements, forcing debt repayments. Under normal circumstances, the buyer would refinance the debt. That has become a tough task with the high-yield debt and investment-grade markets largely shut to new issues.

Wall Street's annus horribilis In the worst global economic slowdown for a generation, capital-market activity has contracted sharply (see chart). The volume of initial public offerings has fallen by more than half since last year. Debt markets would be moribund, were it not for government-guaranteed issuance. The net revenues of the 12 firms in the Boston Consulting Group’s investment-banking index tumbled to $6.2 billion in the third quarter, from $27.1 billion a year earlier. There is still money to be made trading currencies, interest-rate products, equity derivatives (popular when markets are volatile) and corporate restructuring. But this is relatively thin gruel compared with the recent past. No wonder market greybeards, including Alan “Ace” Greenberg, a former boss of Bear Stearns, have been queuing up to pronounce the old Wall Street dead. But what will take its place? Morgan and Goldman appear to disagree about the answer. Convinced that the era of big, highly geared bets is over, Morgan has shrunk its balance-sheet from $1.3 trillion to a shade over $750 billion. It expects to earn a return on equity of three to five percentage points less as a result of lower leverage. Retail banking, once mocked as deathly dull at the white-shoe firm, will become its “fourth leg”. Having come so close to failing, Morgan is going all out to win back clients who fled. It says most have returned.

Posted by dblwyo at 12:38 PM | Permalink | Comments (0)

Well it's time to return to the fray since we've "allowed" a natural and necessary focus on the credit and markets crisis and the coupled economic and markets disruptions and downturns to focus our attention. That means it's time to re-focus on business, specifically in our three-part mantra of Economy-Industry-Company that means it's time to return to discussing Industries and Companies. But where to start ? Ai...there's the rub Horatio ! Make no mistake about it, we're facing radical changes in each and every industry, deep structural changes (where structural means very long-term changes in how an industry is put together as opposed to secular changes where an existing structure moves as it would without re-factoring, or cyclic change which represents normal and natural ups and downs). In shorthand STRUCTURAL = TECTONIC, in other words we're facing tectonic shifts in any industry you'd care to name for lots of reasons. The gimmes are Finance and Autos but include Retail, Technology, Pharma, Mediatainment or any other. For example the Retail is enormously over-built and between the downturn and consumers changes in structural behavior there's going to be a lot of downsizings and BKs ! So if we can start any where let's begin with Finance.

Four things MUST happen IOHO: 1) Finance will return to it's roots and no longer absorb the resources and profits it has, 2) the industry will de-leverage, 3) the shadow-banking system will come under the regulatory umbrellas since they can't be trusted without adult supervision and 4) there will be an increased emphasis on operational efficacy as opposed to financial engineering. But bear in mind two other key short- to intermediate-term major factors: 1) the credit crisis is not over and the industry is facing a lot more bad debt without the capital to meet the calls and 2) in particular housing is going to have to be written down to reasonable levels meaning more haircuts for banks/lenders and homeowners. OUCH !!!

Structural Change

The share of national account profits going to the Finance Industry has historically been significant but grew much larger in the '80s and '90s but it took a major jumpshift in this decade. That's over. Hopefully you can peek at this composite chart and readily come to a similar conclusion. Now the question is, to start, what magic new source of value did the Industry create to cause such a dramatic shift around 2000 ? Recent experience would suggest value-add was large and negative. yet finance is an integral and essential part of the modern economy allowing the mobilization of capital for sundry endeavors that would otherwise lack funding. So it'll stay but NOT at this level ! So what happens if it goes back under 20% ? Or, lord forbid, back to the historic norms that might be guestimated in the 15-20% range ? What does that say about the L.T. structural outlook, performance and value/service requirements ? It's a brave new world folks.

Leverage and Operational Effectiveness

If you look at that history what you're seeing is the macro-indicator of lax regulation combined with a worldwide slushing of funds but most importantly LEVERAGE run hog wild. That's going to stop - which means when you break down the Industry be major functional sector and compare each sector by functional component that instead of 30X leverage banks will a) have to make money at 10X, b) so will everybody else and c) they're going to have to enormously improve their operational execution from Marketing to the back office to Product Development to Service. Pray for the day. This chart actually gets to the heart of the matter and illustrates the huge cliff facing JPM, Citi and BA, for example. In fact it started as a diagnostic for Citi but turned out to sever well as a way of blueprinting the strategic requirements and current status of them all. The key enbler will be the management systems - setting objectives and making sure they come to pass. The cardinal failure of Weill and Prince at Citi. It's not necessarily that super-market banks are bad it's that so far bankers have been bad managers. Given JPM and BA's acquisitions we'd better hope they get it right this time !!

Storms, Tsunamis and Quakes

If the credit crisis is turning out to be a never-ending series of perfect storms with a Cat 5 hurricane thrown in the parallel economic downturn will keep rippling thru with increased pressures on consumers and businesses leading to accelerating defaults, BK's and other ugliness. Right now it's estimated (by Roubini among others) that most of the major banks are technically insolvent and have inadequate capital as it is. If unemployment gets to 10% the resulting tsunami of defaults will swamp them. And of course we've just finished talking about the tectonic quakes that will result in huge shifts in the structure of the Industry. We're likely to be facing tight credit for years or longer as a result. The vicious and viscous positive (meaning reinforcing) feedback loops we're about to see accelerate are illustrated in the accompany graphic.

That means that getting the bad assets off the books, re-capitalizing the banks, re-designing the regulatory frameworks and marking to reasonable values are national strategic imperatives.

The question then becomes how will the banks adapt ? AND who's prepared ? 

That's back to our fundamental point last post about looking for blue chips, translated as who's leadership is up to these challenges. So far there appears to be a real shortfall.

Policy vs Breakdowns

Fed Pledges Exceed $7.4 Trillion in Rescue of Companies With Frozen Credit The U.S. government is prepared to provide more than $7.76 trillion on behalf of American taxpayers after guaranteeing $306 billion of Citigroup Inc. debt yesterday. The pledges, amounting to half the value of everything produced in the nation last year, are intended to rescue the financial system after the credit markets seized up 15 months ago. The unprecedented pledge of funds includes $3.18 trillion already tapped by financial institutions in the biggest response to an economic emergency since the New Deal of the 1930s, according to data compiled by Bloomberg. The commitment dwarfs the plan approved by lawmakers, the Treasury Department’s $700 billion Troubled Asset Relief Program. Federal Reserve lending last week was 1,900 times the weekly average for the three years before the crisis. When Congress approved the TARP on Oct. 3, Fed Chairman Ben S. Bernanke and Treasury Secretary Henry Paulson acknowledged the need for transparency and oversight. Now, as regulators commit far more money while refusing to disclose loan recipients or reveal the collateral they are taking in return, some Congress members are calling for the Fed to be reined in.

• Follow the $7.4 Trillion

Fed Commits Up to $800 Billion in New Programs to Unfreeze Credit Markets The Federal Reserve took two new steps to unfreeze credit for homebuyers, consumers and small businesses, committing up to $800 billion. The central bank will purchase as much as $600 billion of debt issued or backed by government-chartered housing-finance companies. It will also set up a $200 billion program to support consumer and small-business loans, the Fed said in statements today in Washington. With today’s announcement, the central bank is starting to use some of the unorthodox policy tools that Chairman Ben S. Bernanke outlined as a Fed governor six years ago. Policy makers hope the initiatives will bring down the interest rates on mortgages and consumer loans, offsetting the withdrawal of private-sector financing. The Fed will purchase up to $100 billion in direct debt of Fannie Mae, Freddie Mac and Federal Home Loan Banks after the yield premiums on those securities jumped. It will also buy up to $500 billion of mortgage-backed securities issued by Fannie, Freddie and Ginnie Mae, a government agency that insures bonds. Fannie and Freddie have about $1.7 trillion of corporate debt outstanding and $4.1 trillion of mortgage-backed securities. Private-sector ABS buyers have either disappeared or have shrunk their balance sheets, contributing to the market’s disruption, officials said. Traditional buyers included the structured investment vehicles, set up by Citigroup Inc. and other banks, that have been wound down in the crisis. Even asset-backed securities that the government already stands behind have been hammered by the exodus of investors.

• Fed Risks `Spitting in the Wind' With $800 Billion Pledge to Thaw Lending

Plan C THE Federal Reserve’s interest-rate target is at 1%. The recession is deepening. And the question is being asked repeatedly: when will America’s economic policymakers start using truly unconventional measures to stimulate the economy? The answer is that they already have. Without making any formal declaration, since early September the Fed has expanded its balance-sheet rapidly to counter the credit crunch. Under the guise of successive new programmes, each with a less memorable acronym than the last, the Fed is substituting its balance-sheet for that of the contracting private financial system to keep the American economy from being starved of credit. This week the central bank and the Treasury unveiled their latest big initiatives. America’s financial system is undergoing a radical reassessment of what are acceptable levels of capital, leverage and interest rates. Some institutions have failed; those that have not are intent on reducing their leverage (ie, their volume of loans for each dollar of capital). The Fed has no hope of stopping this: it is merely trying to slow it down, by providing a home for the assets that the financial sector is shedding. The alternative would be plunging asset values, a complete withdrawal of credit and economic catastrophe. Ben Bernanke, the chairman of the Fed, has repeatedly promised to use “all of the powers at our disposal” to get credit flowing again. This week’s initiatives are another demonstration of what he means. The Fed and the Treasury agreed to guarantee $306 billion-worth of assets belonging to Citigroup (see article). They then created a $200 billion facility to purchase asset-backed securities. Most radically, the Fed promised to buy up to $500 billion-worth of mortgage-backed securities (MBSs) guaranteed by government-sponsored enterprises (GSEs), including the now nationalised mortgage agencies, Fannie Mae and Freddie Mac, and up to $100 billion-worth of their direct debt. The effect was immediate: yields on the securities plunged by 40 basis points, and the 30-year mortgage rate fell from a shade over 6% to 5.8%.

After zero interest rates, where next?  CENTRAL bankers ordinarily strive to be boring. But these are not ordinary times. On December 16th the Federal Reserve unveiled a three-part assault on America’s slump that lit up the news wires like a pyrotechnic display. The Fed’s policy panel, the Federal Open Market Committee (FOMC), announced that it had cut its target for the federal funds rate to between zero and 0.25%, the lowest on record; it indicated it would stay there “for some time”; and having used up its conventional monetary firepower, it promised an unconventional strategy, such as the buying of mortgage-related securities and, possibly, Treasuries to lower long-term borrowing costs. There was in fact less novelty than first met the eye. The actual funds rate, which is charged on excess reserves banks lend to each other overnight, had already fallen to below 0.2% (see chart), well below target, in part because the banking system is awash with unneeded reserves. (The FOMC is now aiming at a range rather than a level because of the difficulty of hitting the latter.) The Fed had already announced plans to buy up to $100 billion of debt directly issued by Fannie Mae and Freddie Mac, the now-nationalised mortgage agencies, and $500 billion of their mortgage-backed securities (MBSs). Ben Bernanke, the Fed’s chairman, had said Treasury purchases were under consideration. But drowning out the specifics was the thundering tone of the Fed’s long statement. “The Federal Reserve will employ all available tools to promote the resumption of sustainable economic growth and to preserve price stability,” it said. Unconventional monetary policy is often called “quantitative easing” because its effect is felt through the quantity rather than the cost of credit. Through an array of lending programmes, the Fed’s balance-sheet has soared from below $900 billion to more than $2 trillion, and is about to grow further.

What Greenspan thinks  GLOBAL financial intermediation is broken. That intricate and interdependent system directing the world’s saving into productive capital investment was severely weakened in August 2007. The disclosure that highly leveraged financial institutions were holding toxic securitised American subprime mortgages shocked market participants. For a year, banks struggled to respond to investor demands for larger capital cushions. But the effort fell short and in the wake of the Lehman Brothers default on September 15th 2008, the system cracked. Banks, fearful of their own solvency, all but stopped lending. Issuance of corporate bonds, commercial paper and a wide variety of other financial products largely ceased. Credit-financed economic activity was brought to a virtual standstill. The world faced a major financial crisis. For decades, holders of the liabilities of banks in the United States had felt secure with the protection of a modest equity-capital cushion, allowing banks to lend freely. As recently as the summer of 2006, with average book capital at 10%, a federal agency noted that “more than 99% of all insured institutions met or exceeded the requirements of the highest regulatory capital standards.” Today, fearful investors clearly require a far larger capital cushion to lend, unsecured, to any financial intermediary. When bank book capital finally adjusts to current market imperatives, it may well reach its highest levels in 75 years, at least temporarily (see chart). It is not a stretch to infer that these heightened levels will be the basis of a new regulatory system.

U.S. Plots New Phase in Banking Bailout The U.S. government, recognizing that the banking crisis is far larger than originally thought, is laying the groundwork for a second phase of its rescue attempt, with plans to purge bad assets that are paralyzing the financial system. Officials at the Treasury, Federal Reserve and Federal Deposit Insurance Corp., in consultation with the incoming Obama administration, are discussing a plan to create a government bank that would buy up the bad investments and loans that are behind the huge losses that U.S. banks continue to report, say government officials. Also under consideration is an additional and giant government guarantee of banks' assets against further losses. The discussions, which are intensifying, show how the rapid deterioration of bank assets is outpacing the government's rescue efforts. Banks are now struggling not only with the real-estate investments that sparked the crisis, but also with the car loans, credit-card debt and other consumer debt that have taken a hit with the faltering economy. The latest government proposals are aimed at attracting private capital back to the banking system, efforts that have until now largely failed. "All of these ideas are designed ultimately to facilitate more lending in the economy," said FDIC Chairman Sheila Bair. "It's essential to get some private capital back into these banks." Goldman Sachs economists estimate that financial institutions and investors world-wide will ultimately realize $2 trillion in losses on U.S. loans, but have recognized only half those losses so far. That scares investors who might otherwise give banks needed capital, and makes banks reluctant to make new loans. Regulators say they worry that the only remaining source of capital for banks is the government. That was underscored by Friday's announcements of deep losses at Citigroup Inc. and Bank of America Corp. At earlier stages of the crisis, these institutions had been considered among the potential deep-pocketed saviors for struggling banks and mortgage lenders.

• Talking Business: In Search of One Bold Stroke to Save the Banks
• Bailout Is a Windfall to Banks, if Not to Borrowers

U.K. Plan Underscores Depth of Crisis  The U.K.'s latest bank-rescue effort initially backfired Tuesday, helping drive its currency to historic lows while aggravating fears about the stability of the country's banks and the fate of the government's finances. Rather than reassure markets, the giant new bailout plan announced Monday by Prime Minister Gordon Brown underscored the depth of the crisis faced in one of the world's largest financial centers. The pound slid nearly 5% Tuesday to an all-time low against the yen, according to Morgan Stanley, and to a seven-year low against the dollar. Bank shares fell steeply on fears that the government will be forced to nationalize banks, after it already injected £37 billion ($53.48 billion) into its three largest. Lloyds Banking Group led the way down among bank stocks Tuesday, dropping 31%. Throughout Europe, meanwhile, prices of government bonds fell -- reflecting growing concerns that a number of governments will be dragged further into costly efforts to prop up their banking systems. European Union finance ministers warned that governments are running out of room to spend to boost their economies because of rising public debt -- even as Germany, the region's largest economy, said its gross domestic output would shrink 2% this year. Investors are increasingly on guard against the prospect of rating downgrades on government debt after ratings company Standard & Poor's downgraded Spain and Greece in the past week. S&P has affirmed the current ratings of the U.K., Germany and Italy, and Trevor Cullinan, sovereign ratings analyst at Standard & Poor's in London, says Britain's credit rating could withstand spending a total of £83 billion on direct capital injections into its banks -- including the £37 billion already injected. But investors are fretting the mounting cost of U.K. bailouts could eventually lead to a downgrade.

U.S. Considers New Rescue Options  Shares of the biggest names in American banking plunged Tuesday as some investors feared that the government would need to nationalize the most deeply wounded financial institutions, wiping out stockholders. The hours-old administration of President Barack Obama is expected to move swiftly to try to stabilize the financial system by pumping more capital into weakened banks and buying bad assets. Nationalization appears to be a last resort, but other options on the table move the U.S. in that direction. In one idea under consideration, the government could buy convertible securities from financial institutions, an approach that could ultimately leave the government owning large chunks of many firms' common shares. Shares of U.S. banks were down about 20% to their lowest level in more than a decade. Shares of Citigroup Inc. fell 20%, to $2.80 a share. Bank of America Corp. shares were down 29%, to $5.10. The low-single-digit prices of Citigroup and Bank of America shares are a sign that investors are deeply worried about the viability of the industry, from the largest national banks to smaller regional players. (Please see articles on pages C1 and C2.) Shares of State Street Corp. fell 59% on Tuesday after the normally staid bank reported nearly $9 billion in unrealized losses. The decline of State Street shares was worrisome because the bank is considered low-risk and plays a crucial role managing cash for big companies and investors. State Street, which remains profitable, said the losses came from declines in its investment portfolio and its exposure to investment vehicles that issue asset-backed securities. Obama administration officials are sorting through a menu of options as they prepare efforts to clean up bank balance sheets and put them in a better position to lend. Discussions have also advanced on creating a government-backed institution that would buy and hold banks' bad assets, as well as a plan to provide government guarantees on bank holdings. Analysts say that until the Obama plan is unveiled, investors appear to be bracing for the worst-case scenario.

Lawmakers Weigh Bad-Bank Plan Top U.S. House and Senate Democrats are taking a wait-and-see approach to the Obama administration's potential plan to create a "bad bank" to buy up toxic assets, though there remains a sense of urgency for policy makers to put something in place fast.Still, Mr. Geithner said he hopes to announce a comprehensive plan to stabilize the financial sector "relatively soon." He also sought to reassure the financial markets about the possible nationalization of certain U.S. banks, saying that "we'd like to do our best to preserve" the private banking system. There has been increasing chatter in Washington that policy makers plan to dedicate some portion of the roughly $350 billion remaining from the TARP to buying up troubled assets. The approach could be twofold: allowing the government to purchase the assets through a "bad bank" and then guaranteeing the assets against further losses.The bad-bank portion of the program could involve the government creating an entity to purchase the assets from financial institutions, while raising money by selling government-backed securities. Shares of banks and other financial companies jumped in response to the reports of the plan. Wells Fargo & Co. shares were up more than 25% in afternoon trading. Shares of two banks that have required two bailouts from the government, Citigroup Inc. and Bank of America Corp., were up more than 15% and 10%, respectively. The rescues of Citigroup and Bank of America could provide a partial model for policy makers. In both cases the government, and by extension taxpayers, are on the hook for billions of dollars of potential losses after the banks take the first hit. The Citigroup rescue alone included protection for more than $300 billion in assets. Mr. Frank said one benefit of creating an entity to buy up the assets would be that the government could be more aggressive in dealing with foreclosures. Because a major portion of the toxic assets the government would likely own are mortgage-backed securities, it would give policy makers leverage when trying to implement foreclosure-mitigation plans that have been stunted by MBS investors unwilling to agree to rework the terms of struggling mortgages.

Central Banks Are Creatures of Financial Crises Since the beginning of the financial crisis in 2007, the Federal Reserve has come to the rescue so many times that even seasoned central-bank watchers have trouble keeping track. It has injected more than $1 trillion into the financial system. It has backstopped corporate short-term lending. It has cut its overnight target rate from 5.25% in August 2007 to between zero and 0.25% -- the lowest level in the Fed's 95 years. Since it can't lower rates any more, it has begun effectively to print money in an attempt to bolster the economy. But its actions don't seem so extraordinary from the perspective of three centuries of central-banking history. Central banks have been built on financial crises, with each major tremor expanding their role. And today's economic convulsions foreshadow more changes to come at the Fed. If it wasn't for crises, central banks might not exist. In Britain, after years of civil war and the ouster of King James by William III in 1688, the country's public finances were in tatters, with tax collection falling short of what the government needed to pay its bills and lenders unsure about the stability of the government. The Bank of England, one of the first central banks and for centuries the most important one, was founded in 1694 to purchase government debt and curtail the funding crisis. The establishment of the Bank of England came at the beginning of a great societal shift, when new ideas were challenging old doctrines, and rising world trade was giving new power to merchant classes. But the expansion in commerce and banking also made financial crises more prevalent. Speculative bubbles led to spectacular market crashes.

Systemic Dysfunction

The Reckoning: On Wall Street, Bonuses, Not Profits, Were Real As regulators and shareholders sift through the rubble of the financial crisis, questions are being asked about what role lavish bonuses played in the debacle. Scrutiny over pay is intensifying as banks like Merrill prepare to dole out bonuses even after they have had to be propped up with billions of dollars of taxpayers’ money. While bonuses are expected to be half of what they were a year ago, some bankers could still collect millions of dollars. Critics say bonuses never should have been so big in the first place, because they were based on ephemeral earnings. These people contend that Wall Street’s pay structure, in which bonuses are based on short-term profits, encouraged employees to act like gamblers at a casino — and let them collect their winnings while the roulette wheel was still spinning. “Compensation was flawed top to bottom,” said Lucian A. Bebchuk, a professor at Harvard Law School and an expert on compensation. “The whole organization was responding to distorted incentives.” Even Wall Streeters concede they were dazzled by the money. To earn bigger bonuses, many traders ignored or played down the risks they took until their bonuses were paid. Their bosses often turned a blind eye because it was in their interest as well. For Wall Street, much of this decade represented a new Gilded Age. Salaries were merely play money — a pittance compared to bonuses. Bonus season became an annual celebration of the riches to be had in the markets. That was especially so in the New York area, where nearly $1 out of every $4 that companies paid employees last year went to someone in the financial industry. Bankers celebrated with five-figure dinners, vied to outspend each other at charity auctions and spent their newfound fortunes on new homes, cars and art.The bonanza redefined success for an entire generation. Graduates of top universities sought their fortunes in banking, rather than in careers like medicine, engineering or teaching. Pay was tied to profit, and profit to the easy, borrowed money that could be invested in markets like mortgage securities. As the financial industry’s role in the economy grew, workers’ pay ballooned, leaping sixfold since 1975, nearly twice as much as the increase in pay for the average American worker. “The financial services industry was in a bubble," said Mark Zandi, chief economist at Moody’s Economy.com. “The industry got a bigger share of the economic pie.”

• It Was Good to Be a Mortgage-Related Professional . . .

The Madoff Economy The financial services industry has claimed an ever-growing share of the nation’s income over the past generation, making the people who run the industry incredibly rich. Yet, at this point, it looks as if much of the industry has been destroying value, not creating it. And it’s not just a matter of money: the vast riches achieved by those who managed other people’s money have had a corrupting effect on our society as a whole. But surely those financial superstars must have been earning their millions, right? No, not necessarily. The pay system on Wall Street lavishly rewards the appearance of profit, even if that appearance later turns out to have been an illusion. Consider the hypothetical example of a money manager who leverages up his clients’ money with lots of debt, then invests the bulked-up total in high-yielding but risky assets, such as dubious mortgage-backed securities. For a while — say, as long as a housing bubble continues to inflate — he (it’s almost always a he) will make big profits and receive big bonuses. Then, when the bubble bursts and his investments turn into toxic waste, his investors will lose big — but he’ll keep those bonuses. O.K., maybe my example wasn’t hypothetical after all. We’re talking about a lot of money here. In recent years the finance sector accounted for 8 percent of America’s G.D.P., up from less than 5 percent a generation earlier. If that extra 3 percent was money for nothing — and it probably was — we’re talking about $400 billion a year in waste, fraud and abuse. But the costs of America’s Ponzi era surely went beyond the direct waste of dollars and cents. At the crudest level, Wall Street’s ill-gotten gains corrupted and continue to corrupt politics, in a nicely bipartisan way. From Bush administration officials like Christopher Cox, chairman of the Securities and Exchange Commission, who looked the other way as evidence of financial fraud mounted, to Democrats who still haven’t closed the outrageous tax loophole that benefits executives at hedge funds and private equity firms (hello, Senator Schumer), politicians have walked when money talked. Meanwhile, how much has our nation’s future been damaged by the magnetic pull of quick personal wealth, which for years has drawn many of our best and brightest young people into investment banking, at the expense of science, public service and just about everything else? Most of all, the vast riches being earned — or maybe that should be “earned” — in our bloated financial industry undermined our sense of reality and degraded our judgment.

The Weekend That Wall Street Died The titans of Wall Street faced the biggest gambles of their professional lives this year -- and blundered to varying degrees. Read how these executives misjudged dangers facing their institutions and financial markets. As Mr. Fuld waged his increasingly desperate bid to save his firm that weekend, the bosses of Wall Street's other three giant investment banks were locked in their own battles as their firms came under mounting pressure. It was a weekend unlike anything Wall Street had ever seen: In past crises, its bosses had banded together to save their way of life. This time, the financial hole they had dug for themselves was too deep. It was every man for himself, and Mr. Fuld, who declined to comment for this article, was the odd man out. For the U.S. securities industry to unravel as spectacularly as it did in September, many parties had to pull on many threads. Mortgage bankers gave loans to Americans for homes they couldn't afford. Investment houses packaged these loans into complex instruments whose risk they didn't always understand. Ratings agencies often gave their seal of approval, investors borrowed heavily to buy, regulators missed the warning signs. But at the center of it all -- and paid hundreds of millions of dollars during the boom to manage their firms' risk -- were the four bosses of Wall Street. Details of these CEOs' decisions and negotiations, many of them previously unreported, show how they sought to avert the death of America's giant investment banks. Their efforts culminated in a round-the-clock weekend of secret negotiations and personal struggles to keep their firms afloat. Accounts of these events are based on company and other documents, emails and interviews with Wall Street executives, traders, regulators, investors and others.

Risk Mismanagement (****) There are many such models, but by far the most widely used is called VaR — Value at Risk. Built around statistical ideas and probability theories that have been around for centuries, VaR was developed and popularized in the early 1990s by a handful of scientists and mathematicians — “quants,” they’re called in the business — who went to work for JPMorgan. VaR’s great appeal, and its great selling point to people who do not happen to be quants, is that it expresses risk as a single number, a dollar figure, no less. VaR isn’t one model but rather a group of related models that share a mathematical framework. In its most common form, it measures the boundaries of risk in a portfolio over short durations, assuming a “normal” market. Given the calamity that has since occurred, there has been a great deal of talk, even in quant circles, that this widespread institutional reliance on VaR was a terrible mistake. At the very least, the risks that VaR measured did not include the biggest risk of all: the possibility of a financial meltdown.

The End of the Financial World as We Know It (****) What’s interesting about the Madoff scandal, in retrospect, is how little interest anyone inside the financial system had in exposing it. It wasn’t just Harry Markopolos who smelled a rat. As Mr. Markopolos explained in his letter, Goldman Sachs was refusing to do business with Mr. Madoff; many others doubted Mr. Madoff’s profits or assumed he was front-running his customers and steered clear of him. Between the lines, Mr. Markopolos hinted that even some of Mr. Madoff’s investors may have suspected that they were the beneficiaries of a scam. After all, it wasn’t all that hard to see that the profits were too good to be true. Some of Mr. Madoff’s investors may have reasoned that the worst that could happen to them, if the authorities put a stop to the front-running, was that a good thing would come to an end. The Madoff scandal echoes a deeper absence inside our financial system, which has been undermined not merely by bad behavior but by the lack of checks and balances to discourage it. “Greed” doesn’t cut it as a satisfying explanation for the current financial crisis. Greed was necessary but insufficient; in any case, we are as likely to eliminate greed from our national character as we are lust and envy. The fixable problem isn’t the greed of the few but the misaligned interests of the many. OUR financial catastrophe, like Bernard Madoff’s pyramid scheme, required all sorts of important, plugged-in people to sacrifice our collective long-term interests for short-term gain. The pressure to do this in today’s financial markets is immense. Obviously the greater the market pressure to excel in the short term, the greater the need for pressure from outside the market to consider the longer term. But that’s the problem: there is no longer any serious pressure from outside the market. The tyranny of the short term has extended itself with frightening ease into the entities that were meant to, one way or another, discipline Wall Street, and force it to consider its enlightened self-interest. The credit-rating agencies, for instance.

Fair Game: The End of Banking as We Know It Clearly, the entire financial industry is in the midst of a makeover. And while no one wants to call it nationalization, perhaps we can agree on this much: The money business as we have come to know it over the last two decades — with its lush salaries, big-swinging risk-takers and ultrathin capital cushions — is a goner. Got that? Toast. Toe-tagged. And that’s a good thing, because maybe we can go back to a banking model that is designed to do more than simply enrich the folks at the top of the enterprise while shareholders and taxpayers absorb all the hits. Banking, because it oils the crucial wheels of commerce, has a special standing in our world. That will always be the case. But in exchange for that role, our country’s leading bankers might have approached their jobs with a sense of prudence and duty. Instead, a handful of arrogant greedmeisters blew up their institutions and took our economy off the cliff along the way. It’s too soon to say how much taxpayer money will be spent trying to rebuild banks hollowed out by bad lending practices. Paul J. Miller, an analyst at Friedman, Billings, Ramsey, thinks that the nation’s financial system needs an additional $1 trillion in common equity to restore confidence and to get lending — the lifeblood of a thriving and entrepreneurial free-market economy — moving again. “This industry made a lot of money by taking a business line with 20 percent return on assets and levering it up 30 times,” Mr. Miller said. “But no more. Banks are going back to being the boring companies they should be, growing roughly in line with gross domestic product.”  Clearly this means that the rip-roaring performance of financial services companies and their stocks isn’t likely to return anytime soon. Because these companies’ earnings fed both the economy and the stock market in recent years, a more muted performance has considerable implications for investors, consumers and the economy. FOR example, since 1995, according to Standard & Poor’s, earnings of financial concerns have accounted for 22 percent of profits, on average, among the S.& P. 500 companies. That performance is almost double that of the next largest contributor — the energy industry. In 2003, earnings among financial companies peaked at 30 percent of total profits generated by the S.& P. 500; back in 1995, financial company earnings accounted for 18.4 percent of the total. Of course, many of these earnings were ephemeral and have since turned to losses. But while the companies were reporting the profits, their stocks roared. Between 2003 and the peak in 2007, the American Stock Exchange financial services index essentially doubled. At the peak, financial services companies dominated the S.& P. 500 index, accounting for 22 percent of its market value in 2007. With many of these stocks in free fall, that figure is now just 12.5 percent. 

Michael Boskin: Investors Want Clarity Before They Take Risks The current situation was created by a perfect storm of mutually reinforcing trends and major policy mistakes: loose monetary policy (years of negative real interest rates in a growing economy); socially engineered housing policy; poorly implemented regulation; the rapid growth of leverage, opaque and technically deficient derivatives, and the shadow banking system; lax investor diligence and bank supervision; poor governance and misaligned incentives; and outright fraud. The low interest rates subsidized massive short-term borrowing, led investors to reach for yield, increased demand for allegedly safe securitized mortgages, drove up housing prices, and reinforced the ever-looser lending standards championed by government. Loans for subprime mortgages, credit cards, autos, commercial real estate, and private-equity financings were made on the projection or hope by banks, businesses and households that strong economic growth, rising housing prices and easy short-term credit would continue forever. Credit-market debt soared relative to GDP. Subprime loans tripled. Home prices rose 45% more than rent or income. Private equity and asset-backed-securities issuance quadrupled. We now have a giant margin call and painful deleveraging following the mother of all credit cycles. The resulting widespread insolvency in financial institutions was magnified by the over-the-counter derivatives subject to counterparty risk creating uncertainty about who was or might quickly become insolvent. The tardy Treasury and Fed recognition, ad hoc bailouts, and letting Lehman fail added confusion. Private capital fled and even interbank lending froze. What needs to be done to ease the economic and financial crisis? The first order of business is still to recapitalize the banking system, with equity injections and a Resolution Trust-like, toxic-asset removal program. The first $350 billion was not enough to repair the balance sheets of financial institutions that needed to raise $1 trillion before the height of the financial crisis (although former Treasury Secretary Henry Paulson is correct that it prevented a worse contraction of lending). More rapid, transparent, efficient triage -- closing insolvent, non-systemically important institutions and merging marginal ones with healthy ones -- is required. That's what eventually made our Resolution Trust Corporation solution to the savings-and-loan crisis work, along with selling the acquired assets off in large blocks. Exhorting the banks to lend -- when examiners are in their offices telling them not to -- cannot work. Hammer out an approach consistent with FDIC resolution procedures. Include a sensible circuit breaker for the pro-cyclical interaction of bank capital rules and mark-to-market accounting. But beware the law of unintended consequences, such as restrictions on banks causing private capital flight or foreclosure relief creating millions more delinquencies.

Talking Business: In Search of One Bold Stroke to Save the Banks

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

Now that the Inaugural is past us it's time to really "look forward" to the New Year, in as much as you can. The reality is that we all will one way or another - that is voluntarily or not. If you haven't gathered our view is more than a tad bleak since our anticipation is for more bad economic news with the downturn continuing into 2010 and future growth rates lower than potential. Further we see the problems spreading and worsening worldwide and none of this being factored into valuations and earnings estimates. The saddest fact is that none of this foreseeable tsunami was factored into business management decisions and performance, with some notable exceptions. Earlier today we had an e-chat with an old colleague about his management not only being caught flat-footed and now in emergency response mode but also making blind and panicked short-term tactical decisions. As it happens noone is immune to the pains we are all experiencing and the risks of more are widespread, but some enterprise are reacting better than others and are better positioned. After the break you'll find some selected readings on those exemplars who are well-positioned, including Wal-Mart, MickeyD's, Cargill and Rolls Royce.

Considering the Exemplars

Before you skim those readings you might want to take a gander at this interview with Lee Scott of WMT on Charlie Rose. And listen carefully please. Among the many pearls of wisdom you'll hear is a key one - although not quite phrased this way. That key is that WMT was locked into it's old business habits and wasn't listening to it's customers. Once they started listening they stopped, thought and re-factored themselves. But that process didn't start last year - it started at least four years ago. And in the process WMT halted excess store growth and reduced it's capital budgets, re-thought product management and store operations and started focusing on value delivery. Whether you know it or not this represents a huge shift from the paradigm that drove them from their founding. The old driving philosophy was growth and efficiency - now it's profitable growth, control, effectiveness and profitability. And last year's results speak for themselves. We try and capture that in this composite graphic summarizing their strategy from their last major annual analyst presentations. The more extended discussion of WMT's whole re-factoring is here ( Time to Sell WMT ? I: Thinking the Unthinkable) and serves IOHO as a good example of somebody talking the right talk and walking the right walk.

Keys to Survival and Prosperity

 WMT's current relative prosperity results from fundamental strategic and operational changes they committed to years ago. The same is true for other major companies we've looked at in prior posts (check the Enterprise Performance and Company archives) like HPQ and HD. They all illustrate the same key challenges being met. Executive management is subject to several conflicting pressures. It must first balance off the short- and long-run requirements for health, sacrificing neither for the sake of the other. At the same time it must establish a balance between strategy and operational capabilities. Strategy without execution is fantasy while execution without strategy is thrashing.

In this environment executive management is faced with many tough choices. But the all too common one is to make the "easy" tough choice and meataxe costs and heads on the basis of immediate cost savings rather than doing the hard work, the hard thinking and the morally difficult work of thinking thru the best balance. Finding places where you want to be and don't and then reinforcing the former even at the expenese of the latter. In terms of the accompanying graphic that means establishing an overall strategy for each of your major functional areas and then translating that into operating plans, resource plan and accountability controls that are continuously monitored against the real-world. Not what we'd like it to be. Our exemplars are the companies that have translated this conceptual framework into real-world actions. Now you need to find them.

Tough work indeed.It will separate the winners from the losers.

So, whether you're an employee, a business partner or an investor find those "Buffetesque" companies who are not reacting with panic, whose management is exhibiting skill, calm and courage and will survive as well as possible in this continuing unpleasantness as well as be better positioned for the future.

UPDATE: Reading this morning's mail just got a Booz & Co. newsletter that eventually led me to a recent survey of their which is sadly syngergistic with our points here and in the prior post on the dismal outlook for all the flat-footed executives. Whereas we're relying on news, our network and anecdotes they did a worldwide survey. The results are startling indeed. A more complete excerpt along with a pointer to a dloadable discussion is now included in the readings. Frankly we don't think the news could be worse. We also would refer you to our prior post on the outlook for enterprise performance: Let the Triage Begin: Business Performance vs "Stupid Is" ; as well as, of course, the complete archives which attempt to beat this topic to death - apparently "meaninglessly" in terms of behaviorial changes.

Business Exemplar Readings

Identifying The Blue Chips, Post-Meltdown Across many industries, the nation's most reliably profitable companies are looking more black-and-blue than blue-chip. Longtime stalwart General Motors Corp. is idling near bankruptcy court. Companies from Alcoa Inc. to Intel Corp. to Wal-Mart Stores Inc. are cutting profit projections. And while government support has stabilized giant financial concerns like Citigroup Inc. and American International Group Inc., can an entity that's eating at the bailout trough really retain its blue-chip-ness? The question is entirely serious. Blue chips are the bedrock of our stock portfolios, the shares we most need to believe in. We buy them hoping they will be as safe and solid as any stock can be, freeing us up to chase riskier, higher-yielding investments. No more. So many big names have tumbled and the short-term outlook is so dreary that it's hard to have confidence in today's giants of industry. But stock-market professionals believe that there are still a number of blue-chip stocks. Some are relative newcomers, like Cisco Systems Inc. and Intel Corp. But investors shouldn't count out yesterday's favorites. either; AT&T Inc., for one, has endured setbacks in the past but is now on many lists of top stocks. Here's what the market pros look for: Macro chips: Along with cash flow and a strong balance sheet, many managers weigh the big economic picture. This has to do with not only the prognosis for the company's business but also its capacity to respond to changing conditions. Derek Young, portfolio manager of the Fidelity Strategic Dividend & Income Fund, says investors need to regularly re-evaluate their holdings. "Markets change, companies change, and opportunities change," he says. John P. Calamos Sr., chief executive and chief investment officer at Calamos Investments, which owns 97 stocks in its Blue Chip Fund, tries to identify where business is going in the next few years. On the Calamos short list: infrastructure world-wide, health care and the kind of global reach that Nike Inc. and Coca-Cola Co. offer. Management strength can help in a crisis. True blue chips have managers who have earned investors' trust and "have the integrity to report what you need know to evaluate the business," says Mr. Adelmann of Denver Investment Advisors. Brand chips: Morningstar, the financial-research firm, looks for companies with a strong competitive advantage -- an "economic moat" -- such as the low prices of Wal-Mart or the market share of Campbell Soup Co. or Microsoft Corp. "No business is in a great position today given the environment," says Paul Larson, a Morningstar equity strategist and editor of the StockInvestor newsletter. But, he says, "if a company has a competitive advantage, it's going to survive a lot longer than a company that doesn't have it.".

Wal-Mart, Others See Tough Months Ahead Retailers led by Wal-Mart Stores Inc. warned of lower sales and profits in months to come as grim declines in December store sales emphasized the toll the plunge in consumer spending is having on the U.S. economy. Disappointing December sales punctured hopes for a turnaround in spending amid bad jobs and earnings reports from major companies. The Labor Department released statistics showing the number of Americans drawing unemployment benefits rose to 4.6 million for the week ended Dec. 26, the highest since 1982. Demand for jobless benefits crashed online benefit-enrollment systems this week in North Carolina, Ohio and New York, and caused long delays elsewhere. In another worrisome sign for consumer spending, the rapid expansion of credit that helped fuel spending in recent years continues to reverse. The Federal Reserve said Thursday that total consumer credit outstanding declined 3.7% in November, to $2.57 trillion. It was the second month in a row that credit on consumer cards and loans for cars and education fell, and the largest percentage drop in a decade. As Americans reduce debt loads and companies tighten lending standards, they are contributing to the broad downturn at department stores, restaurants and auto dealers. Retail sales declined 1.7% in December from a year ago even as retailers resorted to sharp discounts to attract credit-strapped consumers. Combined with even drearier November figures, holiday sales fell 2.2%, according to the trade group International Council of Shopping Centers. It was the worst holiday showing since the industry group began collecting data in 1970. Markdowns allowed retailers to keep inventories from climbing, but dramatically reduced their profit margins. In addition to Wal-Mart, Macy's Inc., Gap Inc. and American Eagle Outfitters Inc. were among the chains that forecast diminished quarterly or annual profits when reporting December sales. Target Corp. said markdowns would pressure profits.

At McDonald’s, the Happiest Meal Is Hot Profits It wasn’t too long ago that McDonald’s, vilified as making people fat, was written off as irrelevant. Now, six years into a rebound spawned by more appealing food and a less aggressive expansion, McDonald’s seems to have won over some of its most hardened skeptics. The chain has managed to sustain its momentum even as the economy and the restaurant industry as a whole are struggling. Month after month, McDonald’s has surprised analysts by posting stronger-than-expected sales in the United States and abroad. As of November, the latest data available, the company had delivered 55 consecutive months of increases in global same-store sales. During a year when the stock market lost a third of its value — its worst performance since the Great Depression — shares of McDonald’s gained nearly 6 percent, making the company one of only two in the Dow Jones industrial average whose share price rose in 2008. FROM the time when Ray Kroc decided to franchise the McDonald brothers’ fast-food concept in 1955 and transformed the way Americans eat, he preached the motto of quality, service, cleanliness and value. McDonald’s incorporated those goals into its mission statement as it became a ubiquitous purveyor of burgers and shakes. By the mid-1990s, however, McDonald’s was struggling to find its identity amid a flurry of new competitors and changing consumer tastes. The company careened from one failed idea to another. It tried to keep pace by offering pizza, toasted deli sandwiches and the Arch Deluxe, a heavily advertised new burger that flopped. It bought into nonburger franchises like Chipotle and Boston Market. He also helped to write an internal playbook, what McDonald’s now calls its “Plan to Win,” that barely fits on a single sheet of paper — a text that is treated as sacred inside the company. It lays out where McDonald’s wants to be and how it plans to get there, all of this revolving around the “five P’s”: people, products, place, price and promotion. While the five P’s smack of corny corporate speak, company officials maintain that they profoundly changed the direction of McDonald’s and have given employees — from the chief executive to the store manager — a framework for prioritizing what they do. For instance, the company’s mission was changed from “being the world’s best quick-service restaurant” to being “our customers’ favorite place and way to eat,” said Larry Light, who was the company’s global chief marketing officer at the time. That shift in emphasis forced McDonald’s employees to focus on quality, service and restaurant experience rather than simply providing the cheapest, most convenient option to customers. It also recognized that consumer patterns had changed — more snacking, more drive-through — and McDonald’s needed to adapt. Bob Goldin, executive vice president at Technomic, a food industry consulting firm, said the McDonald’s rebound had been singular because of its simplicity: “execute the basics, flawlessly.” He described the McDonald’s strategy as “three yards and a cloud of dust,” adding that “it’s not revolution stuff.”

Cargill's Inside View Helps It Buck Downturn Cargill Inc., one of the most powerful food companies in the world, reported strong earnings Tuesday, showing how it uses inside information, perfectly legally, to prosper in its bread-and-butter agricultural-trading businesses. Earnings jumped 25% in the quarter ended Nov. 30, compared with the year-earlier period, even though a Cargill division that, among other things, invests in the financial markets reported its first loss in a decade. The results capped the company's best year ever, even as farm prices nose-dived, along with the global economy, contributing to the most volatile commodity market in years. Cargill, the largest private company in the U.S. in terms of revenue, has wide-ranging interests, buying and selling wheat and corn, chartering cargo ships and structuring complex derivative investments for hedge funds. Its customer list ranges from McDonald's and Coca-Cola, to Egypt's grain ministry. Wearing multiple hats gives Cargill an unusually detailed view of the industries it bets on, as well as the ability to trade on its knowledge in ways few others can match. Cargill freely acknowledges it strives to profit from that information. In a sign of how Cargill motivates employees to share information, the company adjusted its pay system a few years ago to reward agribusiness units and traders for advising each other about crop-disease outbreaks or shifting demands of fast-food chains. Pay is based partly on revenue generated by tips like these. In contrast to stocks, commodities trading is the only major U.S. market where companies are allowed to act on inside information to manage risks others might not know about. In fact, that is how futures markets were designed.

Coming in from the cold  Over the past couple of decades or so Rolls-Royce has transformed itself from a lossmaking British firm into the world’s second-biggest maker of large jet engines. In doing so, it has deliberately blurred the lines between making things and offering services. Its experience indicates that Britain can do both after all. To optimists it may even suggest a British manufacturing renaissance. The country’s manufacturing output has been growing over the years, but its share of GDP has been falling (as in other rich countries—see chart 1). Employment in manufacturing has been in decline. Only a handful of big manufacturing firms still exist. Some, such as BAE Systems, a defence company, rely on the government. And although industries such as carmaking survive, they do so almost entirely in foreign ownership. Britain remains the world’s eighth-biggest exporter of goods, but its share of global markets has shrunk to a little more than 3%, far behind America, China and Germany (see chart 2). In services it ranks second. Rolls-Royce’s triumph was not to build a slightly better engine and thus earn a temporary technological edge, but to design a completely different one. Remarkably, it did so from a position of weakness. Until the late 1960s the market for big jet engines was dominated by Pratt & Whitney, with a share of about 90%. Rolls-Royce played a bit part, making engines mainly for European aircraft manufacturers. These were losing, bit by bit, to America’s biggest aircraft-makers, which had the benefit of a much larger domestic market and substantial military orders. Rolls-Royce realised that unless it could develop a large jet engine that would fit an American-made airliner, its sales of jet engines would collapse within a decade. It bet everything on two revolutionary technologies.

Job Fears Make Offices All Ears While workplace eavesdropping has been going on for ages, fears about layoffs and corporate restructuring have left employees more attentive to what's going on around them. And as employees resort to eavesdropping, human-resources professionals say they are encountering cases of rumor-spreading in the workplace more frequently. After mass layoff announcements this fall, Society for Human Resource Management found that 23% of human-resource professionals surveyed have encountered significantly more cases of eavesdropping in the workplace over the past 12 months. Meanwhile, 54% reported a sharp increase in gossip and rumors about downsizing and layoffs in their workplaces. Companies are now taking measures to curtail the eavesdropping problem. Dynasound Inc., an Atlanta-based company that makes sound-masking technology, has seen sales increase by 141% over the past two years. Tom Keonig, president of Dynasound, said in recent months there has been an increase in interest in the company's eavesdrop-prevention equipment, which masks the intelligibility of conversations or keep private conversations from escaping boardrooms and other sensitive areas. With the financial turmoil, "Companies don't want anyone to know what their survival plans of which downsizing, outsourcing and closing plants might be part of," Mr. Koenig said.

Why Companies Are Making the Wrong Moves A new survey conducted in December 2008 by Booz & Company of 828 senior managers across the globe finds that companies—whether financially weak or strong —are struggling to make the right moves in the current economic environment, with many wavering in their confidence of leadership’s ability to navigate the crisis. According to the survey, 40% of senior managers doubt that their leadership has a credible plan to address the economic crisis, while an even greater number—46%—are not sure that their leadership could carry out the plan, credible or not. Additionally, one-third of all CEO and CXO-level respondents do not have confidence in the plans that they presumably wrote themselves. Further, a remarkably high number of hard-hit companies—65%—are not doing enough to ensure their own survival, such as accelerating efforts to dispose of assets or secure external funding.  Among companies that state they are financially strong, one-quarter are not taking advantage of opportunities to improve their position in the crisis. While more than half (54%) of the managers expect their companies to emerge from the crisis stronger, the survey finds their optimism doesn’t square with their balance sheets; there is a disconnect between many companies’ financial/competitive position and strategic response. The Booz & Company survey explored how well corporate executives are handling the global economic crisis, the actions they are taking and the impact on the companies’ social responsibility agendas. Respondents represented companies from many major industries. Thirty-seven percent of the respondents were CEOs or people who reported directly to CEOs; another 24% were two layers below the CEO. Geographically, the survey captured responses from managers in 65 countries. The Booz & Company survey concludes that, in many cases, companies are not following the course that is best suited for them. Respondents’ companies were categorized by Booz & Company as either strong (characterized by both financial and competitive strength), stable (strong financially but weak competitively), struggling (weak financially but strong competitively), or failing (weak in both areas). Based on an analysis of responses, Booz & Company found:

Recession Response: Why Companies Are Making the Wrong Moves 

 

Posted by dblwyo at 02:21 PM | Permalink | Comments (0)

The alternative title for this post might have been "Still Inside the Box" since recent market action could be taken, as we are tending to do, as being still trapped into a sideways trading range. In fact one could make a pretty good case that our last two market-related posts (The 1,000 Yard Stare: Beyond Terminal PTSD in the Markets, Time for Triage: What Bear Rally ?) - despite some of the most tumultuous markets in six decades - have held up amazingly well. Just for the record you might want to skim back to check up on us. We think we're "in the box" because the markets are wrestling with a) the continuing credit crisis and it's implications, b) the earnings outlook and c) valuations, i.e. PE ratios. While the V-shaped recovery is has gone the way of the dodo as our last two econ posts discuss, there's still a more sanguine outlook than there should be IOHO. In that case the questions become where away - which in turn means what are the earnings outlooks based on economic realities, what are valuations appropriate to this brave new world and now what do we do ? We say inside the box because when you look at the Sept collapse, the Lehman bankruptcy, we see the sudden grasping of the truth of how bad it is. The mid-Nov collapse when Citi almost bought the big one was apparantly worse but when you change the scale from days to weeks (and note that the timelines changed as well please - read carefully) you can see the LEH cliff was much bigger and never recovered from while the Citi bump was just that. Which also tells us that the markets have a lot of confidence in systemic risks being better under control. Which is also reflected, BtW, in the credit markets. A detailed discussion for another time and place however.

On that latter question two observations/suggestions. After the break you'll find a collection of reading excerpts wrestling with those same questions that we've carefully culled over the last several weeks. We recommend diligent attention to them all. And we draw your attention to the accompanying chart on investment returns from the AAII. Back around '01 we suggested that buy-n-hold wasn't going to be viable and instead careful strategic picking plus cycle-based trading was going to be the new "black". We think the case is now well established.

Speaking of Earnings

Analysts have frantically been pulling down their earnings estimates for '08 and '09 but we're still not sure they've entirely got it right. The composite graphic at right puts two charts from John Mauldin's newsletter together to show how this has been working plus a table built from S&P's running on-line earnings updates. Note Mauldin is drawing from S&P but getting the reported (after-tax) estimates while the other table is operating earnings, so they aren't directly compareable. Directionally however it's very...very revealing. Based on our assessments the earnings estimates have further to drop. The other interesting thing to note is what's the implicit PE Valuation ? At $42/share and Friday's close of 950 that's a PE of 22+. Now tell me the market is still over-valued !!!

Speaking of Valuations

We've spent quite a bit of time before on relating earnings to the economy and that outlook to appropriate PE measures so we won't repeat all the arguments and machinery. Feel encouraged to skim the archives for more details and explanations. We do want to repeat a key chart from those discussions and link them to the last couple of posts on the domestic and worldwide economic outlook however. The composite graphic at right provides two tables built around the Grahm-Dodd valuation formaula so you can zoom in as you like while the chart translates it into earnings growth. Pick your area and check the details in the tables. For example at a 5% interest rate and a 22+ PE we'd need to see earnings growing at 10%. That's not next year btw, that's sustainably for at least the next five and preferably 10. Now what in either of the last two posts (pointing at Roubini, the Fed or the IMF) suggests economic growth consistent with 10% earnings growth ? In the long-run earnings and economies have to and do grow together -except for this last abberational period when profits were historically high because of under-investment and very weak hiring.

One More Nail: Shiller's LT PE Estimates

Prof. Robert Shiller of Yale (he of "Irrational Exuberance" and other prescient punditry fame) has put together some long-run estimates of financial data since the 1870s, including PE ratios. And he makes his results, papers and data available on-line in case you want to check up on either of us. Which we've taken the libery of re-producing here and adding two PE averages to - one with and the other without the Tech Bubble influences. With the average is 16.3 and without it's 14.9, so let's say 15 all around. Rather a far cry from 22, wouldn't you say ? That would suggest quite a bit of correction to go (btw - Shiller gets his estimates from looking at trailing 10 year data). His chart would also seem to indicate that long-term secular bear markets are accompanied by drops in PE far below the mean as well.

So put all the pieces together. At a 15 PE ratio and earnings of $42 we get an appropriate SP500 target of around 650. But is a 15 PE still optimistic according to the G-D analysis ? IF interest rates stay around 5.5% and profit growth is in the range consistent with the economic outlook of 2-4% then a PE in the 10-12 range would be more appropriate. Sadly and scarily that would put the appropriate SP500 reading in the 400-500 range. Which is not at all out of the question as we've shown in the earlier posts taking long-term looks at the technicals.

Markets Readings

The market's crystal ball is broken I can't remember a time when views on the short- and long-term direction of stocks, the financial markets and the global economy were so thoroughly at odds. One of these views is going to turn out to be very wrong. Either the next 10 years will look much like an attenuated version of the current crisis, or they will show this crisis to have been just that, a crisis, and the major investing themes of the past 10 years will reassert themselves as the drivers of the global economy and financial system. I'd bet the short-term view of the long-term future, which is so dominant right now, will turn out to be, well, shortsighted. If I'm correct, then long-term investors are going to see a huge pop when the crowd swings in their direction. All they have to do is survive until then. Not an easy task when the turn is so unpredictable and the day-to-day punishment is so unrelenting. Normally, bear markets are punctuated by rallies that suck investors in from the sidelines before failing and inflicting more losses. Not this bear market. It just goes down and down and down. From Oct. 1 through Nov. 24, the Dow has managed back-to-back daily gains just twice. Long-term investors -- and not just Warren Buffett -- see the current market collapse as a buying opportunity. On Nov. 19, a day the S&P 500 dropped more than 6%, Norway's $300 billion sovereign wealth fund announced that it was increasing its allocation to stocks to 60% from 40%. "These market circumstances suit us very well," Executive Director Yngve Slyngstad said. "We are a large buyer in a market with more sellers than buyers."  The fund, which invests Norway's oil and gas revenue for the day when the oil and gas run out, is the second-largest sovereign wealth fund next to that of the United Arab Emirates. But the short-term money is selling, which in this case means hedge funds and their investors. Hedge fund investors pulled a record $40 billion out of the funds in October, the most since Hedge Fund Research started compiling figures in 1990. Hedge fund managers have been selling, too, and some of the industry's biggest funds are now 50% in cash. How's that for divergence? Of course, you could argue that that kind of divergence is exactly what you'd expect in a bear market. It's just business as usual in these unusual times.

10 picks for income investors, The 10 best stocks for 2009

Company woe To look ahead, look back to 2002. NO MATTER what happens in 2009, financial markets can surely not be as turbulent as they have been in 2008. The virtual demise of the independent investment bank, the rescue of Fannie Mae and Freddie Mac, the halving of global share prices—these were sufficient shocks to last investors for a decade. If 2008 was dominated by a financial crisis, 2009 seems likely to be the year when the bad news comes from the economy and from the non-financial corporate sector. All the forward-looking surveys, such as the purchasing managers’ indices, have been gloomy for months. The surprise indicator compiled by Dresdner Kleinwort, an investment bank, indicates that both European and American data have been a lot worse than expected. On the corporate side, everyone expects profits to fall but analysts’ forecasts do not yet reflect that likelihood. And everyone expects the default rate on bonds (and loans) to rise, but nobody yet knows which companies will fail. All this leaves investors with a big dilemma. The equity market has made several attempts to rally during this crisis, dating all the way back to August 2007. On each occasion, the rally petered out because the “climactic event” (for example, the collapse of Bear Stearns) proved to be a false dusk. Investors may have decided, like the Who, that they won’t get fooled again. Valuations have now reached levels that proved to be bargains in the last 30 years. The London market, for instance, is trading on a single digit price-earnings ratio. The question that has been raised, however, is whether the last 30 years are a good yardstick. In the 1940s and 1950s, it was common for equities to yield more than government bonds, as they now do in Europe and America. Perhaps we have gone back to that era. If we have, then current valuations may not be cheap at all.

Dow 5,000 Redux What is fair value for stocks? Are they now cheap? You can certainly make that argument by comparing valuations based on past performance. But repeat after me, 'Past performance is not indicative of future returns.' The investment climate of today is almost certainly going to be quite different than that of the 80's and 90's. Thus, to expect stocks to repeat the performance of the last bull market in a climate of government intervention, deleveraging and increased regulations may not be realistic? This week Bill Gross, the Managing Director of PIMCO (and one of my favorite analysts) moves away from his familiar neighborhood of bonds and offers a few thoughts on stock market valuations. This is not a lengthy read, but it is one you might want to read twice, as the concepts are important. And not just for stocks but for investments of all types. Let me first announce a fundamental premise with which I think all rational investors would agree: I believe in stocks for the long run – but only if purchased at the right price. That statement packs a real punch. It says that capitalism is and will remain a going concern, that risk-taking – over the long run – will be rewarded, but only from a starting price that correctly anticipates the economy's growth and its share of after-tax corporate profits within it. Acknowledging the above, let's look at a few basic standards of valuation that historically have stood the test of time, to see if at least the price is right. My transgenerational stock market outlook is this: stocks are cheap when valued within the context of a financed-based economy once dominated by leverage, cheap financing, and even lower corporate tax rates. That world, however, is in our past not our future. More regulation, lower leverage, higher taxes, and a lack of entrepreneurial testosterone are what we must get used to – that and a government checkbook that allows for healing, but crowds the private sector into an awkward and less productive corner. Dow 5,000? We don't have to go there if current domestic and global policies are focused on asset price support and eventual recapitalization of lending institutions. But 14,000 is a stretch as well.

The Ugly: P/E Multiple Assuming a 5% earnings growth rate for the next five years (I do not think we will have 5% growth for the next five years for reasons detailed later), the current AAA corporate yield predicts a 15x P/E multiple, much lower than the current P/E ratio implied by either backward or forward looking earnings (roughly 19x and 22x each based on S&P earnings estimates). But what annualized earnings growth should we expect over the next five years? Not 5% according to dblwyo for the following reasons:

If the economic outlook is for 2-2.5% growth on average over the next five years (IMF) at best and we presume a 5% yield a PE multiple of 10-12 becomes appropriate. Given that the markets were held up by leverage applied in one form or another (buybacks, housing ATM,et.al.) consider a go-forward regime where a 15 historical average PE is inappropriately optimistic!

Agreed, but I'll let each of you use any figure you want... the next chart shows what inputs are needed for the model to spit out the "inappropriately optimistic" 15x P/E multiple or the unreal 22x forward P/E. With the current 5.2% AAA Corporate Bond Yield, earnings need to be at least 5% to justify a 15x P/E multiple (as detailed above), which would still imply equities are currently overvalued by 30%. For current equity valuation (22x), we need 9% growth... FOR EACH OF THE NEXT 5 YEARS. A more likely outcome that gets us to our current market valuation is for AAA corporate bonds to continue the recent rally. However, based on a 2.5% earnings growth rate, the rate needs to approach a measly 2.5% AAA yield. Highly unlikely...

10 investing basics from Buffett Last year's market madness didn't just flush away $7 billion in wealth. It also washed away a lot of investors' confidence and left them stumped about the best position to take now. "Somewhere between cash and fetal," quips one pessimist. In such downbeat times, let's consider a dose of optimism, wisdom and insight: the basics as taught by that perennial investing Yoda, Warren Buffett. For new investors or those now starting over, there's good news here because Buffett's investment success comes from some easy-to-grasp human qualities as much as sophisticated expertise in balance sheets. Buffett would be the first to say his homespun and positive philosophy played a big role in his becoming the richest person in the world (before he gave most of his loot away). Changing your basic psychology can be tough, so new investors may have a leg up here because they don't have ingrained bad habits. But for anyone, a psychological makeover is worth the effort if you hope to recover your losses in the market's next leg up -- and then make the right moves for the rest of your life. My tour of the essence of Buffett's wisdom starts with the simple psychological lessons taught by the master, many of which are applicable in life outside investing.

This is the year to buy ETFs We don't know who the winners will be in the end, but exchange-traded funds will let you catch the (eventual) gains after another tough year. This year is not going to be a pretty one. There is going to be a lot more bad news.The markets won't get better, though they probably won't get much worse. Bad news has already depressed the markets, so I really don't feel there is a lot more downside for the market as a whole. A friend of mine described the current economy as a plane crash from three feet. Last year, when we were flying at 30,000 feet, the ride down was gut wrenching. But now we are flying three feet off the ground at almost stall speed with full flaps; how bad could a crash be? Among individual stocks, expect a slew of mergers, acquisitions and bankruptcies. Many of the companies you may have been following won't exist at the close of business December 2009. The credit markets, meanwhile, won't really be lending until late in 2009. Companies will be cutting payrolls, and every round of layoffs will result in another round of home foreclosures, since no one seems to keep a six-month emergency fund any more. Housing inventories will swell to record levels, and new housing starts will fall. Travel budgets, inventories and work in process will be cut to the bone, and only goods already sold or under contract will be produced. Look for a lot of bad debt write-offs, and expect a lot of defined benefit pension plans to announce they are underfunded and cannot meet their obligations to those who have already retired. Many city and county governments will become insolvent, and even some states may be in trouble. Property tax defaults will increase. Sales tax revenues will decrease. But where does that leave the average investor? You have lost faith in the brokerage research departments. Mutual funds and money managers didn't protect you. Your defined contribution plans have taken a big hit. These are the very reasons I think investors will flock to broad-based and broad-sector exchange-traded funds, or ETFs. If you invest in an S&P 500 Index ($INX) fund and 20% of the companies merge or go bankrupt, then 100 growing companies from an S&P 400 mid-cap fund will be elevated to take their place. Buy the indexes and you can buy the growth wherever it is found. If you can't decide who will survive in the financial sector, you don't buy individual companies. You buy a financial sector ETF and let the sector shake itself out. ETF's can be judged on their raw performance.

10 Outrageous Claims 2009 True to Saxo Bank’s now annual tradition, we in Strategy and Research are delighted to present our “10 Outrageous Claims” for 2009. The primary reason for doing this “Black Swan” exercise every year is to counter-balance human psychology, which is usually skewed towards optimism. We tend to be somewhat more pessimistic in our Yearly Outlook than the average analyst in the market, and believe that it is important for the investor to always factor in the less likely scenarios (as perceived by the market). Please keep in mind that this is more of a thought exercise than a set of outright predictions – we do not consider the chances are better than 50-50 for all of these claims.

Ten Non-Predictions For 2009: Part 1 1) Last year's lows in the S&P will NOT hold. Consensus looks for 2009 earnings to be roughly the same level as 2008. This looks too high. The economic environment in the US and the world is not the worst since the early 80's, it's the worst since the 1930's. And while the end of the Great Moderation will bring with it the end of the uber-leveraged business model, that model will go out with a bang rather than a whimper. The growth of leverage in US corporation can be seen in the chart below; observe how during the period of relative macroeconomic stability (1982-2006), each recession brought about a steeper drawdown in corporate earnings from the cyclical peak. Macro Man expects a substantially deeper drawdown than during the previous recession, both because of the continued unwinding of leverage in certain sectors and because of the execrable macro backdrop. Ultimately, this should lead to 2009 equity lows modestly below 2008's.

10 key trends for investors in '09 If you hope to make any serious money in 2009, you're going to have to beat the stock market. After netting out a grim first half of the year and a recovery in the last quarter, the major indexes will be lucky to show a 6% gain for the year. That kind of number will be a huge disappointment for investors looking to recover from what Wall Street has begun to call the lost decade. Over the past 10 years, the returns from investing in a stock market index, such as the Standard & Poor's 500 ($INX), have been squat. No, make that negative squat. The overall stock market lost money in that period. Fortunately, you don't have to go to the ends of the earth to beat the index. I'm going to tell you about a strategy to do just that in this column. It's not complicated. You can do it at home. And it's been shown to work over the past 11-plus years. It's the strategy that I've used for the Jubak's Picks portfolio, and it's the strategy I explain in my new book, "The Jubak Picks," which hits bookstores today. As of Dec. 22, the Jubak's Picks portfolio was beating the total return on the S&P 500 over 10 years by 184 percentage points. It's simple: Put more money into the hot sectors of the market as they heat up. Sell those sectors when they get too hot. And put very little money into the sectors that are cold or cooling.

Posted by dblwyo at 07:51 AM | Permalink | Comments (0)

We've spent a bunch of time on the US economic outlook and the news, as you'd expect, continues to move from bad to worse. We say that because it's no longer necessary to use a fine-tooth comb to sort out the downturn as we did earlier this year, e.g. with the High-Frequency Indicators (which is one reason we haven't posted on them in a while). Now it's all pretty obvious. Let's shift gears to the rest of the world. Back in the day we laughed and poo-pooed the de-coupled these because it ignored two things. The nature of business cycles and their international linkages plus the relative size of economies. The argument for example that Chinese domestic consumption would become the new engine of worldwide economic growth is and will be species beyond credibility for decades to come. Making it shows the shallowness of the analysts involved grasp. But that's no longer the problem. Accelerating worldwide downturns are. Worse, especially given the speed, depth and likely duration of this downturn on a worldwide basis we're rapidly moving out of mundane considerations like millions of people out of work and into strategic geo-politics. As in social-political collapse as a rising risk factor.

Developed Economies

 The IMF recently issued it's bi-annual World Economic Outlook in October and immediately issued another major revision that took the forecasts down in November. Think about that for a bit. This is an organization that thinks in terms of decades and 2X per year updates are rapid turn-around. The accompanying graphic shows their l.t. outlook thru 2013 for the developed economies as a whole and the specifics for the US, Japan and Germany with growth rates of 2.5, 2.3, 1.7 and 1.7% respectively. That's after an intermediate term recovery and then another wind-down. You really need to think about what that means for the long-term outlook for Employment, earnings and valuations. You'll find plenty of more detailed ammo for this barrage in the readings on several key countries. So much for the European schadenfreude that this was "just" a US problem.

Developing Countries

They also issued outlooks for the Developing Economies which have also been revised downward though not as extensively. The estimates for the BRICs, et.al. being much more problematic because of data and analysis shortfalls. However evern what appear to be good numbers aren't. In China for example anything below 8% starts to loose ground to the necessary new job creation which is the under-pinning of the social bargain the Communist Party has implicitly struck with the populace. Dissent has been rising for several years and increased rapidly over the last. Yet these numbers may be far too sanguine, to say the least. Several estimates for China are ranging downward toward 5%, or even 0%. At those growth rates one must ask serious questions about the stability of the Chinese socionomic system. India and Brazil are going to experience similar downturns but it's likely their socio-political sytems are somewhat more robust and resilient. Russia on the other hand is in the process of committing demographic and economic suicide. Instead of using their recent energy and commodity based riches to invest in education, infrastructure and new productive capacity it's instead been squandered on geo-political adventurism. One has to assess the risks for a Russian implosion over the next decade as high and rising as a result.Take a careful look at the accompany chart and the readings below and ask yourselves if the world is prepared for the rapidly developing strains. And bear in mind how coupled things are. For example dropping US consumer demand has decimated Chinese exports which has, in turn, curtailed German and Japanese exports to China. China btw has  been Japan's largest trading partner over the last several years. Or think about Australian, New Zealand and Brazil agricultural and commodity exports to China. Poof. OUCH !!

Geo-political Implications

 Like we said there are many readings excerpted below that highlight the overall outlook and specific country and regional news and information. Inclued are the addresses for the IMF WEO from Oct and Nov plus the associated databases. We particularly call your attention to the Data Mapper tool with which you can do your own explorations. But the readings start with two recent US government strategic assessments. The first is the Joint Operating Environment from US Forces Command and the other is Global Trends 2025 from the National Intelligence Council. Summaries of which are also excerpted. Based on these extremely well-received, broadly built and widely published studies the consensus of our policy-makers is that a jaundiced view of the stresses and strains for the world system is going to be appropriate for a long time to come. In fact it's rather fair to compare the period we've been in and will be facing to the immediate post-WW2 environment where an entire new world system had to be architected. We seem to be in much better shape in that we aren't facing an exinstential threat to our existence ala the USSR AND our decision-makers are more broadly aware of this shared view, rather than operating blind. Nonetheless if you skim these reports, which we strongly urge you to do, and then compare them to the accompanying graphic as a blueprint you'll find that each line item gets a check for high stress.

Geo-politics

Joint Operating Environment 2008 The processes propelling globalization over the next two decades could improve the lives of most of the world’s population, particularly for hundreds of millions of the poorest. Serious violence, resulting from economic trends, has almost invariably arisen where economic and political systems have failed to meet rising expectations. A failure of globalization would equate to a failure to meet those rising expectations. Thus, the real danger in a globalized world, where even the poorest have access to pictures and media portrayals of the developed world, lies in a reversal or halt to global prosperity. Such a possibility would lead individuals and nations to scramble for a greater share of shrinking wealth and resources, as occurred in the 1930s with the rise of Nazi Germany in Europe and Japan’s “co-prosperity sphere” in Asia.

Global Trends 2025: A Transformed World The international system—as constructed following the Second World War—will be almost unrecognizable by 2025 owing to the rise of emerging powers, a globalizing economy, an historic transfer of relative wealth and economic power from West to East, and the growing influence of nonstate actors. By 2025, the international system will be a global multipolar one with gaps in national power2 continuing to narrow between developed and developing countries. Concurrent with the shift in power among nation-states, the relative power of various nonstate actors—including businesses, tribes, religious organizations, and criminal networks—is increasing. The players are changing, but so too are the scope and breadth of transnational issuesimportant for continued global prosperity. Aging populations in the developed world; growing energy, food, and water constraints; and worries about climate change will limit and diminish what will still be an historically unprecedented age of prosperity. Historically, emerging multipolar systems have been more unstable than bipolar or unipolar ones. Despite the recent financial volatility—which could end up accelerating many ongoing trends—we do not believe that we are headed toward a complete breakdown of the internationalsystem, as occurred in 1914-1918 when an earlier phase of globalization came to a halt. However, the next 20 years of transition to a new system are fraught with risks. Strategic rivalries are most likely to revolve around trade, investments, and technological innovation and acquisition, but we cannot rule out a 19th century-like scenario of arms races, territorial expansion, and military rivalries. This is a story with no clear outcome, as illustrated by a series of vignettes we use to map out divergent futures. Although the United States is likely to remain the single most powerful actor, the United States’ relative strength—even in the military realm—will decline and US leverage will become more constrained. At the same time, the extent to which other actors—both state and nonstate—will be willing or able to shoulder increased burdens is unclear. Policymakers and publics will have to cope with a growing demand for multilateral cooperation when the international system will be stressed by the incomplete transition from the old to a still-forming new order.

World Outlook

Latest Roubini Article for Foreign Policy: "Warning: More Doom Ahead" Last year’s worst-case scenarios came true. The global financial pandemic that I and others had warned about is now upon us. But we are still only in the early stages of this crisis. My predictions for the coming year, unfortunately, are even more dire: The bubbles, and there were many, have only begun to burst. The prevailing conventional wisdom holds that prices of many risky financial assets have fallen so much that we are at the bottom. Although it’s true that these assets have fallen sharply from their peaks of late 2007, they will likely fall further still. In the next few months, the macroeconomic news in the United States and around the world will be much worse than most expect. Corporate earnings reports will shock any equity analysts who are still deluding themselves that the economic contraction will be mild and short. Severe vulnerabilities remain in financial markets: a credit crunch that will get worse before it gets any better; deleveraging that continues as hedge funds and other leveraged players are forced to sell assets into illiquid and distressed markets, thus leading to cascading falls in asset prices, margin calls, and further deleveraging; other financial institutions going bust; a few emerging-market economies entering a full-blown financial crisis, and some at risk of defaulting on their sovereign debt. Certainly, the United States will experience its worst recession in decades. The formerly mainstream notion that the U.S. contraction would be short and shallow—a V-shaped recession with a quick recovery like the ones in 1990–91 and 2001—is out the window. Instead, the U.S. contraction will be U-shaped: long, deep, and lasting about 24 months. It could end up being even longer, an L-shaped, multiyear stagnation, like the one Japan suffered in the 1990s. As the U.S. economy shrinks, the entire global economy will go into recession. In Europe, Canada, Japan, and the other advanced economies, it will be severe. Nor will emerging-market economies—linked to the developed world by trade in goods, finance, and currency—escape real pain. What constitutes a “recession” will depend on the country in question. For China, a hard landing would mean annual growth falls from 12 to 6 percent. China must grow by 10 percent or more each year to bring 12 to 15 million poor rural farmers into the modern world. For other emerging markets, such as Brazil or South Korea, growth below 3 percent would represent a hard landing. The most vulnerable countries, such as Ecuador, Hungary, Latvia, Pakistan, or Ukraine may experience an outright financial crisis and will require massive external financing to avoid a meltdown. For the wealthiest countries, a debilitating combination of economic stagnation and deflation might happen as markets for goods go slack because aggregate demand falls.

IMF's Loans Surge to $41.8 Billion in November, `Busiest' Month in History The International Monetary Fund this month lent more money to cash-strapped governments than it has in the past five years combined. The IMF agreed this month to $41.8 billion in loans, approving $16.4 billion for Ukraine, $15.7 billion for Hungary, $2.1 billion for Iceland and $7.6 billion for Pakistan. Financing is in the works for Serbia, Turkey, Belarus and Latvia, turning eastern Europe into a regional ward of the IMF the way Southeast Asia was a decade ago. Facing a decline in relevance and revenue just a year ago, the IMF under Managing Director Dominique Strauss-Kahn is getting a lift from the global credit crisis. Demand for its loans is rising in nations suffering from weaker export sales, banking industry turmoil and deteriorating investor confidence in the developing world. “This has arguably been the busiest month in the IMF’s 62- year history,” said Simon Johnson, former IMF chief economist and now a senior fellow at the Peterson Institute for International Economics, in Washington. “It seems incredible that just six months ago the main shareholders of the fund -- the G-7 nations -- said the IMF was out of the lending business.” IMF disbursements peaked at $26.6 billion in 2002, according to the fund’s records that date back to 1984. The Washington-based international lender was formed by world economic powers in the mid-1940s to create a pool of money for countries in crisis.

Food Prices Will Rise Next Year, Causing Export Bans, Riots: Chart of Day Food prices will rise next year, prompting a revival of protectionism from food-growing nations and risking a renewed bout of rioting, according to Jochen Hitzfeld, an analyst at UniCredit SpA in Munich. “Agricultural commodities will outperform the broad commodity indices in 2009,” Hitzfeld wrote in a research note this week. “If key crop-producing countries then impose export bans again and speculators drive up prices via physical stockpiling and futures contracts, new food unrest is even conceivable in the second half of 2009.” The CHART OF THE DAY shows food prices for the past 10 years as measured by an index compiled by UBS AG and Bloomberg that tracks at least 13 foodstuffs, including wheat, soybeans, sugar, cocoa and coffee. The index has declined 35 percent since peaking in July.

World Economic Outlook Report,World Economic Outlook—Update, World Economic Outlook Database (see also the Data Mapper tool)

 

Countries/Regions

Brazil Caught by Credit Squeeze Forcing Farmers to Cut Coffee, Corn Yields The collapse of global credit markets that is pushing the U.S., Europe and Japan into simultaneous recessions for the first time since World War II also threatens farmers in Brazil, the world’s biggest grower of coffee, oranges and sugar cane, the second-largest producer of soybeans and third-biggest of corn. Smaller harvests in Brazil may increase costs of commodities next year, said Andre Pessoa, an analyst at Agroconsult who conducts the country’s broadest crop survey. “When we look ahead, we see demand continuing to grow, while supply will face difficulties,” Pessoa said in an interview from the Florianopolis, Brazil-based company. Futures contracts in Chicago show corn will jump 18 percent by the end of 2009 to $4.175 a bushel and soybeans will gain 2.2 percent to $9.02 a bushel. Coffee will rise 10 percent to $1.258 a pound, according to contracts in New York. Reduced fertilizer use will lower Brazil’s soybean output as much as 2.7 percent, while corn may decline 7.3 percent, the government said Nov. 6. Brazil’s coffee harvest may drop 26 percent next year, said Lucio Araujo, the commercial director at Cooxupe, a cooperative representing 11,000 growers in the Guaxupe region. Brazilian growers were short of at least 15 billion reais needed to invest in crops, Agriculture Minister Reinhold Stephanes said Oct. 9. Banks and financial companies worldwide, suffering from $969.5 billion of losses and writedowns since the start of 2007, are restricting credit as they struggle to replenish reserves, according to data compiled by Bloomberg. The growth of Brazil’s economy, Latin America’s biggest, may be cut in half next year after credit dried up and slumping commodity prices pared export revenue, Central Bank President Henrique de Campos Meirelles said Nov. 21. He didn’t provide a specific forecast. The expansion will slow to 4.9 percent this year and 3.6 percent next year, from 5.4 percent in 2007, according to a Bloomberg survey of 12 economists.

China Is `Heart of Global Slowdown' as Property Slump Stalls Driver of GDP House prices in Shanghai, Shenzhen and Guangzhou are plunging, and the global economy may grind almost to a halt next year because of it. Construction of homes, offices and factories fell at least 16.6 percent in October after rising 32.5 percent a year earlier, according to Macquarie Securities Ltd. That's squeezing an economy already slowed by recessions in the U.S., Japan and Europe that have cut demand for exports. Building is the biggest driver of China's expansion, contributing a quarter of fixed- asset investment and employing 77 million people. The central bank cut its key interest rate by the most in 11 years last week and the government said “forceful” measures were needed to arrest a faster-than-expected economic decline. Without more rate cuts and government spending, China is unlikely to contribute the 60 percent of global growth Merrill Lynch & Co. forecasts for next year, further slowing the world economy. “China is now at the heart of the global slowdown,” said Jim Walker, chief economist at Asianomics Ltd., an economic advisory firm in Hong Kong. “It means that global growth is probably going to be dragged down close to zero next year.” Walker, voted best regional economist in an Asiamoney magazine brokers' poll for 11 years through 2004 when he worked for CLSA Asia Pacific Markets, estimates China will grow zero to 4 percent next year, with a 30 percent chance of a contraction.

• Unexpected Drop in China’s Imports and Exports

Japan fell into deeper recession in third quarter Japan fell into a deeper recession in the third quarter than first thought, the government said Tuesday, as exports weakened, domestic demand fell and companies bracing for a prolonged downturn pared inventories.The Cabinet Office said that Japan's economy shrank at an annual pace of 1.8 percent in the July-September period, compared with its original estimate of a 0.4 percent contraction. The figure was much worse than market expectations for a 0.9 percent decline in gross domestic product, underscoring the severity of the slump that the world's second largest economy is mired in. The data also confirms that Japan slipped into recession in the third quarter after GDP contracted an annualized 3.7 percent in the April-June period. A recession is commonly defined as two consecutive quarters of negative growth, though many economists using other parameters say that the current downturn actually began in late 2007.

Russia Wrestles With Ruble Collapse It is amazing how things change in a few months. In September, Russia was on top of the world, the returning global power. Today, it is slipping into obscurity. If it did not have nuclear weapons, most would not even care what happens. Russian economic growth in this decade was completely driven by rising commodity prices, mainly of oil and gas. As the global economy goes into recession and commodity prices either decline or remain at today's levels, Russia will relive the horrible 1990s when it defaulted on its debt and suffered from a severe inflation. Think of Russia as a very large oil and gas producing company that is run for the most part by a government that makes General Motors' (nyse: GM - news - people ) and Ford's (nyse: F - news - people ) management and autoworkers' unions look like progressive thinkers. Over the last five years, Russia de-privatized (a clever euphemism for "stole") oil assets from private investors and has been milking petro cash flows from now state-owned oil companies. The government is simply not equipped to manage projects that have a multidecade life. Russia underinvested in exploration and development of oil and gas in the last decade and that is why its oil and gas production is declining. Communism failed for a reason: Government is a horrible capital allocator. The time horizon and time in office of a government bureaucrat is much shorter than the horizon of an oil company, therefore when choosing between drilling holes in the middle of nowhere that will increase oil production years down the road or raising benefits to retirees, retirees win. But it gets worse. As oil prices rose, the Russian government decided that it did not need the West anymore. It felt that the contracts it signed with BP (nyse: BP - news - people ) and Royal Dutch Shell (nyse: RDSA - news - people ) in the 1990s--when oil prices were much, much lower and no one wanted to invest in Russia--were not advantageous anymore. Using deceptive legal practices, it unilaterally renegotiated those contracts muscling away lucrative projects from these companies.

Credit Is Issue for Gas Field The global credit crisis could delay the launch of Russia's giant Shtokman natural-gas field, according to the chief of the project's operator. Russian gas monopoly OAO Gazprom owns 51% of Shtokman Development, a joint venture with France's Total SA and Norway's StatoilHydro, which own 25% and 24%, respectively. Located in icy waters more than a thousand feet beneath the Barents Sea, Shtokman is estimated to hold 3.8 trillion cubic meters of gas, or enough to meet U.S. demand for six years. Early estimates of costs to develop the field top $20 billion, and the consortium expects as much as 70% of the development cost for the project's first phase to be raised from capital markets. "We hope that the financial crisis will be over by the time we enter the market," said Mr. Komarov, who was appointed to his post by Gazprom. The massive Arctic project will remain economically viable if oil prices stay around $50 or $60 a barrel, he added. The consortium hopes to raise the first funds next year, when it plans to approve a final investment plan for the project's first phase. Total and StatoilHydro declined to comment. Production at the field, which was discovered in 1988, has already been delayed several times. At its last estimate, Gazprom expected gas output to start in 2013, with production of liquified natural gas to begin a year later.But in July, Benedikt Henriksen, chief of StatoilHydro's industrial relations in Russia, said timely development of the field would depend on the choice of subcontractors, expressing doubt that Shtokman would start in 2013. While agreeing that the credit crunch may slow Shtokman's timetable, some analysts suggest the project's original plans were unrealistic. Jonathan Stern, director of gas research at the Oxford Institute of Energy Studies, said he "was always skeptical that Shtokman will be delivered on time, given the incredible difficulty of the project." Mr. Stern said he had expected the project to be completed toward 2020, or at least not before 2017. Western energy giants including ConocoPhillips and Chevron Corp. had hoped to participate in the development of Shtokman before Russia surprised everyone in 2006 by saying it would develop the field on its own. But last year, after years of negotiations, Gazprom chose Total and StatoilHydro to help. However, terms of the alliance were unusual for the oil industry and unfavorable for Gazprom's junior partners. To date, neither has been able to book reserves from Shtokman, which, for the time being, belongs entirely to Gazprom. The consortium plans to produce 23.7 billion cubic meters of natural gas a year in the first phase of development.

• Gazprom, Once Mighty, Is Reeling, Europe begins to feel gas pipeline pinch

Why Russia's woes should worry you As financial markets and governments worldwide hope for a brighter year, one big country's troubles threaten to send the global economy tumbling into a deeper hole. Is there some wild card out there that could make the global economic mess even worse? For months now, my attention has focused on Russia. The country is big enough, and its problems serious enough, that it could take the global crisis to a new level of danger. The good news is that Russia is in much better shape than it was the last time it shuddered into crisis, in 1998. The bad news is that Russia's current problems bear an eerie resemblance to those that took the country into default, led to the fall of a once-popular political leader and forced the U.S. Federal Reserve to organize a bailout in order to prevent a panic in the global financial markets. Let me quickly summarize the last crisis: (…)Ending Russia's crisis doesn't require a 180-degree turn in the economy, the Russian stock market or the ruble. What's important is the pace of the fall. If the ruble declines in a slow and measured fashion, if the economy looks like it's headed for a recession instead of a deep plunge into panic, and if stocks fall slowly enough that the stock market can stay open, the crisis will be manageable. And Russia will remain one of a very large group of countries coping with a global economic and financial crisis rather than becoming a wild card with problems big enough to threaten the global economy. Because the speed of the decline is critical, the first quarter of 2009 poses the greatest risk. If the crisis in Russian financial markets, Russian banks and the ruble turns into a rout in the first quarter, then Russia's problems are on the way to becoming the world's problems. Watch the ruble: Some currency experts think there's a chance it could fall 20% to 30% in the first quarter of this year. That would constitute a rout.

‘McBritain’ Almost Twice as Risky as McDonald's: Chart of Day Investing in U.K. government debt is almost twice as risky as buying bonds sold by McDonald’s Corp., based on prices in the credit-default swap market. The CHART OF THE DAY compares the cost of protecting against a decline in the creditworthiness of the two borrowers. U.K. protection became more expensive on Sept. 29, when the pound suffered its biggest one-day loss against the dollar in 16 years after the government took control of Bradford & Bingley Plc, Britain’s biggest lender to landlords. Britain risks being viewed pejoratively as a banana republic “apart from the technical disqualification that we have a monarch and so cannot be a Republic, and it’s too cold to grow bananas anyway,” says Sean Corrigan, who helps oversee about $8.5 billion as chief investment strategist at Diapason Commodities Management SA in Lausanne, Switzerland. McDonald’s, the world’s largest restaurant company, said yesterday that global sales rose 7.7 percent in November. The marketing icon for the Oak Brook, Illinois-based company famed for its burgers is a clown figure called Ronald McDonald. “Talk about ‘McBritain’ is an insult to Ronald’s outfit,” Corrigan said.  Separated At Birth?

Hedge Fund Britain Sterling -- never far from the heart of U.K. political debate -- is back on the agenda with a vengeance. The U.K. currency now stands at an all-time low against the euro, with one euro worth 87.79p compared to 71.91p a year ago, and against the dollar has fallen to $1.47 from $2 a year ago. How much lower can it go? That depends on what is driving the declines. Already, the pound has fallen further than can be explained by economic conditions. Sterling's 25% drop in 18 months on a trade-weighted basis is its biggest depreciation since the 1970s and leaves the pound trading at a 5% to 15% discount to fair value based on purchasing power parity. But the alternative explanation -- that sterling is a victim of "Hedge Fund Britain," with London cast as "Reykjavik-on-Thames" -- doesn't really work either. According to this theory, the pound is falling because investors are spooked by the scale of the U.K.'s gross foreign liabilities, now approaching 500% of gross domestic product thanks to a combination of government borrowing plus the debts of the banking industry. As with any highly leveraged entity, it is said, the U.K. presents a substantial refinancing risk. But the evidence for this is patchy. So far, there has been no sharp rise in gilt yields that would suggest a government funding problem. While the banking sector's foreign liabilities are large at around three times GDP, they are still well below Iceland's seven times -- and would be lower still if one strips out the debts of foreign banks based in the U.K. that are no responsibility of the U.K. government. What's more, the bulk of these overseas liabilities are matched by assets that can be readily financed under existing central bank liquidity schemes. In fact, it is the asset side of the U.K. balance sheet that provides the better explanation for sterling's weakness. That's because the U.K.'s overseas assets are skewed toward riskier assets, such as equities and bonds. The collapse in world markets over the past 18 months has reduced the value of these assets, turning the U.K.'s net asset position negative.

The Irish Economy’s Rise Was Steep, and the Fall Was Fast Everything, it seems, has grown worse here. The recession started earlier and its bite has been deeper. Housing prices have fallen by as much as 50 percent. Bank shares have plummeted by more than 90 percent. Unemployment is approaching 10 percent. The roots of Ireland’s fall date to more than 20 years ago, when a clutch of economists, politicians and civil servants put their heads together in this very pub and planted the philosophical seeds for the Irish economic miracle. Known widely as the “Doheny & Nesbitt School of Economics,” these beery musings soon became government policy that chopped taxes in half, sharply reduced import duties and embraced foreign investment — a radical transformation that gave birth to the Celtic Tiger and perhaps the most open and vibrant economy in Europe. But beyond the glow of this sudden efflorescence that made Ireland the fourth most-affluent country in the Organization for Economic Cooperation and Development, a housing bubble had begun to form. Low interest rates, a wave of inward immigration and a bank lending spree drove housing’s share of the economy to 14 percent, the highest in Europe, from 5 percent, according to research done by Finfacts, a financial Web site that analyzes the Irish economy. Ireland’s policy makers, like their counterparts in the United States and Britain, were seduced by record tax inflows and a full-employment economy. They paid little heed to the lonely voices that warned of the crash that finally came over the summer, when interest rates in Europe began to rise. Banks that had steered more than 60 percent of their loans toward property stopped lending, and asset values plummeted. Ireland’s Slowing Economy

World Bank Cuts Forecast for East Asia '09 Growth The World Bank slashed its forecast for economic growth in East Asia next year given the waning demand in major economies for the region's goods. In its half-yearly East Asia and the Pacific assessment -- excluding Japan, Australia and New Zealand -- the World Bank said the region is likely to grow 5.3% next year and 6.5% in 2010. That would follow estimated growth of 7% this year. "Challenges facing the East Asian economies have multiplied during the course of 2008, spelling hard times in 2009," the Washington-based organization said, noting the drop-off in import demand in the world's major economies and a big decline in commodities prices. In April, it had forecast regional growth of 7.4% next year. The World Bank noted that many countries have cut interest rates and introduced fiscal packages to support their economies. It warned, though, that fiscal stimulus packages need to be timely and delivered through appropriate vehicles to be effective in boosting growth. Governments need to also be aware that companies and commercial banks will remain under financial stress that will probably worsen as economic activity slows, defaults accelerate and balance sheets deteriorate. Given that, short-term measures to boost liquidity and ward off pressure on balance sheets will need to be complemented by medium-term efforts to improve banking and financial supervision, the report said.China will continue to play a key role in shaping the region's growth profile in the medium term and the country's buffers against the financial crisis -- including hefty international reserves, and fiscal and current-account surpluses -- are "impressive," it said in a separate report on the global economy. China's economic growth is expected to fall to 7.5% next year from 9.4% this year but bounce back to 8.5% in 2010. The World Bank expects India, the region's other main growth engine, to expand 5.8% next year and 7.7% in 2010.The multinational body warned there are risks to its current outlook for the region. The main one is that an extended recession or sluggish growth in the major global economies could slow demand for Asia's goods. The World Bank now expects Japan's economy to contract by 0.1% next year, followed by growth of 1.5% in 2010; the U.S. economy is likely to shrink 0.5% next year and grow 2% in the subsequent 12 months.

As U.S. Buys Less From China, Germany Suffers The United States, with its credit-driven economy, has long ensured that others, notably China, Germany and Japan, have been able to pile up trade surpluses. That dynamic has shifted, with Americans paring purchases at a ferocious rate. “As the American consumer now capitulates, the export bubble is the next to go,” the chairman of Morgan Stanley in Asia, Stephen Roach, said. “Export-led economies around the world are in for a very tough rebalancing.” In Germany, the world’s largest merchandise exporter since 2003, sales to other countries drove growth for the last five years. But in the third quarter, the slump in exports helped push Germany into recession. Virtually all economists expect 2009 to be a lost year for Germany, which will pay a heavy price for the downturn. The retrenchment bears out what Mr. Haeusgen is seeing, that there is a strong correlation between the Chinese prosperity that rested in part on American profligacy, and German sales to China and elsewhere. Germany’s industrial exports feed a Chinese economy that itself is fed by American demand for goods. Jacques Cailloux, chief Europe economist at Royal Bank of Scotland in London, has established a strong correlation between Chinese exports to the United States and German exports to China. The American trade deficit in 2007 was $708.5 billion; Germany’s $288.5 billion surplus and China’s $262.2 billion excess represent much of the other side of that equation.

Posted by dblwyo at 07:23 PM | Permalink | Comments (1)

Welcome back to the New Year. In case you haven't noticed we've taken a bit of a hiatus - partly due to laziness and other workloads but also from a reluctance to put up the economic news, which is unrelievedly bad across the bad. Which doesn't mean we haven't been following and collecting the news as is our wont - just that we chose to exercise some holiday spirit and postpone posting. But the time is at hand. After the break you'll find our usual collection, largish this time of course, covering the strategic outlook, Housing in particular (though looking back to Oct clippings which were "merely" confirmed by the abysmal November data and the continuation of the cliff-diving) and some key indicators. The later in particular indicate that not only is the credit crunch continuing but it's metastasizing into other areas, e.g. consumer credit, and will worsen in '09. And employment will similarly follow the normal lag structure and is starting off its' own cliff. While we discuss this more below some of the prior posts lay out a similar story with other charts you may want to refer back to (It's Back: Welcome to the Downturn for Real,Storm Flags Flying: State of the Evolving Downturn,Fragilities Exposed: Downturn, World Economy and Re-Balancing,Let the Triage Begin: Business Performance vs "Stupid Is").

Economic Outlook: Expectations vs Realities

Two of the saddest and most dangerous memes running around, IOHO, are the fact that so many have been caught so flat-footed and still don't see the tsunami wave cresting, nor the ones behind it. The consequences for ill-prepared businessess were the heart of our Forest Gump post ("Stupid Is"). And second the gap between the consensus surveys and what's likely to happen. The "Blue Chip" surveys talk to very competent finance industry economists who suffer from a major defect - they're prisoners of models that presume normal cyclic downturns and recoveries. Well this is anything but normal, partly because of the credit problems and partly because of accumulated problems in the core economy. Instead of consensus we'd point you instead at folks who addin some seroius judgment like Noural Roubini or Paul Kasriel instead of relying on flawed mis-speification of their models. We've tried to capture as much of this as we can manage in the accompanying graphic which combines a long-term look back at GDP, Consumption and Investment with prior graphics on the Business Cycle and a conceptual depiction of where we're at in the cycle.

Credit Crisis and Outlook

A key part of the problem is that Consumers make their spending decisions on the basis of likely future income plus wealth. The primary indicators of future income are changes in Employment plus Real Wages. The latter took a slight bump up because of the sharp downturn in Inflation but the former is just beginning to tip over rapidly and severely. So the W+E delta is still negative ! Which forbodes very poorly for future spending. A major consequence of declining income and dropping expectations is an accelerating drop in consumer spending. Which will in turn further slow the economy and worsen credit conditions. And then of course there's Housing where we still have a long way to go in reaching the bottom of the price declines. Until/unless we perform the same sort of surgery on mortgage valuations for all the toxic garbage that's still on those books this slow unwinding will continue to infect the system. If you'd like a graphic analogy consider this a case of severe combat wounds where gangrene has set in and is no longer treatable by anti-biotics. Which leaves us no alternative but surgery ! OUCH indeed. The accompanying graphic tries to conceptually illustrate the resultant negative feedbacks that in process - a vicious cycle if you will. And as the Business Cycle graphic shows as Consumer spending declines businesses will further restrict their hiring and reduce their capital spending. Not that either was very good at any time in the last ten yars !!

Wealth Destruction

On the wealth side that's even worse as you can see in the accompanying graphic. US consumers have experience the greatest decline in their net worths in the post-war period. $Trillions of wealth in assets and housing have been "destroyed". Of course that's a problematical argument since much of that percieved wealth was artificially created by bad credit decisions and leverage. On the other hand it was the foundation for holding up consumer spending so Voila', here we are in yet another vicious feedback loop. In the longturn the over-consuming US public is likely to undergo a major shift in spending habits because cheap and easily available credit will be reduced in availability. And because we're likely to shift to a more savings oriented, frugal and fearful outlook. Which is a good thing in the long-run because people are reminded that economic stabilities and growth are outcomes not givens. Unless, as Keynes observed, "we're all dead" before we reach a happy new equilibrium. The net long-term result will be reduced growth in consumer demand and a very slow and difficult recovery.

The bottom line of which is that both '09 and '10 are likely to see continuations of the downturn followed by an extended period of slow growth. In fact the IMF just recently revised it's October World Economic Outlook and foresees US growth. In fact after peaking at 3.1% in 2011 they are prognisticating a very weak rate of 2.3% growth in 2013 !! In other words this won't be a very robust recovery, it'll take a while and will likely be followed by a period of sustained low growth. Just FYI we need 3.3-3.5%/year for reaching full potential where unemployment doesn't rise. That means that for the next five years the IMF anticipates the US growing at less than potential - with all that implies about employment, consumption and socio-political pressures.

Economic Outlook

The Six Lessons from Last Week's Action First, this is going to be the worst recession in the post-World War II era, in our view. The ECRI leading indicator hit a record low for the fifth week in a row – down to - 29.2 as of the November 21st week versus -28.2 the week before. This index, which leads real GDP by two quarters with a 70% historical correlation, is getting further and further away from the prior all-time low of -19.8 that defined the worst recession of the post-WWII era and saw a six-quarter consumer recession coincide with a 45% peak-to-trough decline in the stock market. Perhaps the fact that this bear market is proving to be even more severe is symptomatic of an economic downturn that will also prove to be deeper and more prolonged. After the flurry of data released just before Thanksgiving, we are now tracking close to a 4.5% QoQ annualized fall in real GDP in 4Q. This would be the largest pullback since the 1982 recession, and we see a similar contraction in the first quarter of 2009. Second, capex is in a very steep decline right now. Durable goods orders dropped 6.2% in October, the third decline in a row. Over that time frame, orders have plunged at a 39% annual rate, which is unprecedented. The retrenchment has spread to the tech sector, where order books were expanding at a 7% annualized rate over the three months to June. Currently, that same three-month trend has swung to a negative 13% annualized rate.

`Great Recession' May Just Be Starting as Job Losses Mount, Credit Shrinks

U.S. Consumers Seen Facing ‘Liquidity Squeeze’: U.S. consumers are headed for a “liquidity squeeze” as banks grow more reluctant to provide mortgages and shrink credit-card lines, according to Meredith Whitney, an Oppenheimer & Co. analyst. “A new era in the overall financial landscape” is unfolding in which many households will have to cut debt, she wrote in a report today. The CHART OF THE DAY displays two indicators of consumer indebtedness, the amount of mortgage loans outstanding and credit-card lines from commercial banks. Both reached plateaus this year as housing prices dropped and unemployment rose. “The entire mortgage market hit a wall,” Whitney wrote, adding that home loans probably fell last quarter. There hasn’t been a drop since the second quarter of 1982, according to the Federal Reserve data cited in the chart. The Fed will release third-quarter figures later this month. Whitney also projected that banks will reduce unused credit- card lines by 45 percent during the next 18 months. That works out to $2.13 trillion, based on the total credit lines available from all lenders insured by the Federal Deposit Insurance Corp. as of June 30, according to the report. “We are now beginning to see evidence of broad-based declines in overall consumer liquidity,” she wrote. Along with a rising jobless rate, the reductions will bring “a pronounced downshift in consumer spending.”

In String of Bad News, Omens of a Long Recession Despite months of rescue efforts, hundreds of billions of dollars in government spending and an avant-garde apparatus of financial tools, the American economy has only worsened, and at a faster rate than nearly anyone predicted. This recession, which officially began in December 2007, now appears virtually certain to be the longest downturn — and possibly most severe — since the end of World War II, as evidenced last week by a demoralizing rat-a-tat of grim reports on jobs, sales and public confidence. The reports signaled that even after 11 months, more than the entire length of the last two downturns, this recession has only now entered its fiercest phase, and economists say the pain will not end soon. Instead, Americans retrenched even further in November, sending sales at the nation’s retailers tumbling to the weakest level in more than 35 years and leading the Detroit automakers to record their worst sales in a quarter-century. Manufacturers have not seen conditions this bad since 1982. The decline in spending is likely to continue, depriving the economy of its primary growth engine, as layoffs continue to mount. Half a million Americans, from financial analysts to factory workers, were dismissed in November alone. Rarely has a labor downturn affected such a broad swath of income levels. Most frightening of all is that the worst job losses may be yet to come. If history is any guide, millions more Americans could lose their jobs before businesses start to expand again. “Up until mid-September, a plausible scenario was that it would be a short and shallow recession,” said Edward Yardeni, the investment strategist. “After mid-September, it became quite obvious that that was wishful thinking.”

Merrill's Rosenberg Inspired by Farrell, Kindleberger in Foreseeing Crash David Rosenberg drew on inspiration from market-rules theorist Robert Farrell and asset-bubble historian Charles Kindleberger to predict the economy’s demise this year. Rosenberg, the chief North American economist at Merrill Lynch & Co. in New York, by January had already called the recession that this month was officially declared to have started in December 2007. He also said the Federal Reserve would lower its main interest rate to 1 percent by year-end, one-third of the median estimate of economists surveyed by Bloomberg News; by October, policy makers brought the rate to that level. Rosenberg, 48, refused to trust his computer models, sensing that the end of the credit and housing-market booms would cause a deeper rout than most analysts thought. Now, he predicts the carnage will cause a 2.5 percent contraction in gross domestic product in 2009, and sees historians calling the current era “GDII,” a reference to the Great Depression. “We came off a prolonged period of prosperity that was fueled by excessive leverage and an asset bubble of historical proportions,” Rosenberg said in an interview. “Either you believed that this was sustainable or you didn’t. I came to the conclusion that this was going to end very badly.” It all came down to the premise that the downturn in housing was going to have a lagged and severe impact on everything from economic growth to interest-rate spreads and stocks. Personal savings, Rosenberg’s “key metric,” would head higher as Americans tried to repair tattered finances resulting from the slumps in property values and stock prices. That’s where Rosenberg differed from the majority in his profession, who he said were using terms like “contained” to describe the impact of the subprime mortgage crisis, or “resilient” when talking about consumer spending, which had risen for a record 17 years. “You have to have your models, but you have to question the results,” Rosenberg said. “You have to ask yourself: Where could the model be wrong this time? Bubbles go further than you think, but they do not correct by going sideways,” he said, quoting the fourth of “10 Market Rules to Remember,” by former Merrill analyst Farrell. The severity of today’s housing bust, and the resulting collapse in credit, indicate that the U.S. won’t soon emerge from the already yearlong recession, according to Rosenberg. “What we know about periods of asset deflation and credit contraction is that the impact on the economy tends to last for years not quarters,” he said, projecting housing is likely to contract through the end of 2009.

In 2009, Economy Will Depend on Unlocking Credit The problem, as Mr. Bagehot observed, is trust — or rather, the lack of it. Even after receiving millions, in some cases billions, of dollars from the government, banks are reluctant to lend money. Crucial parts of the financial system have stopped functioning. The exuberance of the boom, which led bankers to make loans to people who could not repay them, has given way to a seemingly intractable fear of making any loans at all. How long this situation lasts will determine the immediate course of the nation’s economic life. Will the recession, already a year old, drag on through 2009 — or even longer? Will the stock market revive soon or shrivel further? What of the beleaguered housing market? The answers to those questions will depend on the availability of credit in all its forms — home mortgages, personal and business loans and bonds sold by corporations, states and municipalities. For now, many banks are hoarding money rather than lending it. Their holdings of cash have nearly tripled to just over $1 trillion in the last three months, according to Federal Reserve data. In the capital markets, bond investors who embraced risk in good times have abandoned all but the safest of investments. Many have rushed to buy ultra-safe United States Treasury securities, driving the yields on those investments to historic lows. Once the credit markets stabilize, bankers hope, investors will start buying other types of debt, unlocking the flow of credit. A big worry is the future of securitization, a key mechanism of modern banking that enables banks to bundle loans and bonds into securities for sale to investors. This crucial market is moribund now that many of its creations have plunged in value. Some question when, or if, certain areas of securitization will revive.

Nouriel Roubini Says Worst Still Is Ahead of Us: Unfortunately, the worst is ahead of us. The entire global economy will contract in a severe and protracted U-shaped global recession that started a year ago. The U.S. will certainly experience its worst recession in decades, a deep and protracted contraction lasting at least through the end of 2009. Even in 2010 the economic recovery may be so weak -- 1 percent growth or so -- that it will feel terrible even if the recession is technically over. There also will be recessions in the euro zone, the U.K., continental Europe, Canada, Japan and the other advanced economies. A hard landing for emerging-market economies may also be at hand. Among the so-called BRICs, Russia will be in an outright recession in 2009. Growth in China will slow to 5 percent or less, representing a hard landing for a country that needs expansion of close to 10 percent to move 10 million to 15 million poor rural farmers into the urban industrial sector every year. Brazil will barely grow in 2009. Even India will experience a sharp slowdown. Most other emerging market economies will suffer a similar hard landing. This severe global recession will morph into a stag-deflation, a deadly combination of economic stagnation/ recession and deflation. In the advanced economies, with aggregate demand falling below growing aggregate supply, slack in goods markets will lead to deflationary pressures as companies’ pricing power is restrained. Likewise, rising unemployment will constrain labor costs and wage growth. These factors, combined with sharply falling commodity prices, will cause inflation in advanced economies to ease toward negative territory, raising concerns about deflation. Deflation is dangerous as it leads to a liquidity trap: nominal policy rates can’t fall below zero, so monetary policy becomes ineffective and even quantitative easing may not work. Falling prices mean that the real cost of capital is high and the real value of nominal debts rise. This leads to further declines in consumption and investment, thus setting in motion a vicious circle in which incomes and jobs are squeezed, aggravating the fall in demand and prices. As traditional monetary policy becomes ineffective, other unorthodox policies will continue to be used: policies to bail out investors, financial institutions, and borrowers; massive provision of liquidity to banks in order to ease the credit crunch; and even more radical actions to reduce long-term interest rates on government bonds and narrow the spread between market rates and government bonds. Some Forecasters See a Fast Economic Recovery, 2008: Annus Horribilis, RIP

Housing and the Economy

U.S. Home-Price Decline Accelerates, GDP Shrinks as Crisis's Grip Tightens The decline in U.S. house prices accelerated in September and the economy shrank in the third quarter at a faster pace than first estimated as the grip of the credit crunch tightened. The S&P/Case-Shiller home-price index fell 17.4 percent from a year earlier. The Commerce Department said gross domestic product dropped an annual 0.5 percent as household spending slid the most since 1980. While consumer confidence rose this month, the Conference Board’s gauge remained near the lowest on record. “The economy is turning down pretty dramatically,” Treasury Secretary Henry Paulson said at a press conference in Washington to outline new government efforts to unfreeze credit. “It’s very important that lending continue to be available.” Today’s reports underscore concerns that the economy is at risk of a contractionary spiral as lenders cut back credit, causing spending to fall and companies to slash investments and payrolls. The Treasury and Federal Reserve today began two new programs to bring down interest rates on mortgages and consumer loans, committing at least $800 billion. Stocks climbed on the Fed’s plans, with the Standard & Poor’s 500 Stock Index rising 0.7 percent to close at 857.39, posting its first three-day gain since September. Treasuries rose after the central bank’s proposal to buy up to $600 billion of debt issued or backed by housing-finance companies spurred some investors to buy government securities as a hedge. Economists anticipate that the drop in GDP worsened in the current quarter because of the deepening credit crunch. The collapse of Lehman Brothers Holdings Inc. in September triggered a renewed bout of turmoil, forcing the Fed to step up as a lender of last resort.Existing Home Sales in October, Existing Home Sales (NSA),Mortgage Rates in U.S. Decline Most in Seven Years With Push From Fed Plan

Existing Home Sales: Turnover Will Slow This is another reminder that the only reason existing home sales appear to have "stabilized" is because of the high number of REO sales. Sales excluding REOs have plummeted. I've argued before that REO resales are real sales and should be included in the NAR statistics, but I suspect these REO buyers might hold these properties longer than recent turnover would suggest. If these are owner occupied buyers, they have probably been waiting to buy, and they have saved a down payment and qualified under the tighter lending standards. They probably won't sell until they can make a reasonable profit to buy a move up home - and it will probably be a number of years before prices recover.If they are investors, they are likely buying REOs for cash flow - not appreciation, unlike the speculators in recent years - and these investors will probably hold the properties for a number of years too. This suggests to me that turnover will slow further.Case-Shiller House Prices: Free Falling, Price-to-Rent Ratio, House Price-to-Income Ratio,

More on New Home Sales First, here is a long term graph of new home sales and inventory from the Census Bureau.Although home builders have sharply reduced housing starts - and are now starting fewer homes than they are selling (reducing inventory) - new home sales have fallen rapidly too. It has been a race to the bottom! Also - New home sales in October might be at the lowest level since 1982, however adjusted for owner occupied units, the current year is the worst on record. In 2008, sales through October (before revisions) have totaled 436 thousand. This is slightly ahead of the pace in 1991 (432 thousand sales through October). However sales have slowed in the 2nd half of 2008, and it appears that annual sales will be below the 509 thousand in 1991. This would mean sales would be the lowest since 1982 (412 thousand). Of course the U.S. population and the number of households were much lower in 1982. In 1982 there were 54.2 million owner occupied units in the U.S., in 1991 there were 61.0 million, and there are approximately 76 million today. If we use a ratio of owner occupied units to compare periods, the low in 1982 was 412 thousand X (76/54.2) = 578 thousand units (based on the number of owner occupied units today). The calculation for 1991 gives 634 thousand units (to compare to today). By this measure, 2008 is the worst year for new home sales since the Census Bureau started tracking new home sales (starting in 1963).October New Home Sales: Lowest Since 1982

House Prices vs. PCE This graph compares the YoY change in real house prices with the YoY change in real PCE. For this limited data set (house price data is only available since 1987) the YoY changes move somewhat together, although house prices started declining before PCE during the current economic downturn. This difference in timing could be because of homeowners withdrawing equity from their homes (the Home ATM) even after prices first started falling. However recent data shows that the Home ATM is now pretty much closed - and as expected consumption has started to decline sharply. Based on this general relationship, I wouldn't be surprised to see the YoY change in real PCE fall to -4% or so at some point next year. 

Meltdown far from over, new mortgage crisis looms The full scope of the housing meltdown isn't clear and already there are ominous signs of a new crisis -- one that could turn out the lights on malls, hotels and storefronts nationwide. Even as the holiday shopping season begins in full swing, the same events poisoning the housing market are now at work on commercial properties, and the bad news is trickling in. Malls from Michigan to Georgia are entering foreclosure.Hotels in Tucson, Ariz., and Hilton Head, S.C., also are about to default on their mortgages. That pace is expected to quicken. The number of late payments and defaults will double, if not triple, by the end of next year, according to analysts from Fitch Ratings Ltd., which evaluates companies' credit. That's bad news for more than just property owners. When businesses go dark, employees lose jobs. Towns lose tax revenue. School budgets and social services feel the pinch. Companies have survived plenty of downturns, but economists see this one playing out like never before. In the past, when businesses hit rough patches, owners negotiated with banks or refinanced their loans. But many banks no longer hold the loans they made. Over the past decade, banks have increasingly bundled mortgages and sold them to investors. Pension funds, insurance companies, and hedge funds bought the seemingly safe securities and are now bracing for losses that could ripple through the financial system. "It's a toxic drug and nobody knows how bad it's going to be," said Paul Miller, an analyst with Friedman, Billings, Ramsey, who was among the first to sound alarm bells in the residential market. Unlike home mortgages, businesses don't pay their loans over 30 years. Commercial mortgages are usually written for five, seven or 10 years with big payments due at the end. About $20 billion will be due next year, covering everything from office and condo complexes to hotels and malls. The retail outlook is particularly bad. Circuit City and Linens 'n Things have sought bankruptcy protection. Home Depot, Sears, Ann Taylor and Foot Locker are closing stores. Those retailers typically were paying rent that was expected to cover mortgage payments. When those $20 billion in mortgages come due next year -- 2010 and 2011 totals are projected to be even higher -- many property owners won't have the money.

Key Indicators

U.S. Durable-Goods Orders, Consumer Spending Tumble as Recession Deepens U.S. business investment weakened last month and consumers are retrenching worldwide, reports today showed, heightening pressure on policy makers to take stronger steps to combat the credit squeeze. Americans cut spending by 1 percent in October, the biggest drop since the last recession in 2001, while British households slashed expenditures last quarter by the most in 13 years, government agencies said today. A U.S. Commerce Department report showed orders for durable goods slumped twice as much as forecast as domestic and foreign demand dried up. The intensifying global economic downturn spurred China's central bank to cut its benchmark interest rate by the most in 11 years today, while the European Union proposed $259 billion in stimulus measures. In the U.S., President-elect Barack Obama held his third press conference in as many days to name former Federal Reserve Chairman Paul Volcker as an economic adviser. ``It's about as bad as the 1970s and 1980s,'' said David Hensley, director of global economic coordination for JPMorgan Chase & Co. in New York. ``We're looking at back-to-back very deep'' slump in the global economy this quarter and next.  The decline in personal spending in the U.S. last month followed a 0.3 percent drop in September, the Commerce Department said today in Washington. Adjusted for inflation, spending fell 0.5 percent, a fifth consecutive decrease. The last time price-adjusted spending dropped as many months in a row was in 1990-91.

EU Proposes $259 Billion Plan to Stimulate Economy, Limit Effect of Crisis

Charge-Offs Start to Shred Card Issuers  More credit-card holders who fall behind on their payments are eventually defaulting, deepening losses for thousands of banks that issue plastic. The worsening trend indicates that charge-off rates among credit-card issuers, which stood at more than 6% in the third quarter, are poised to rise more than expected in the fourth quarter and into next year. That means additional misery for financial firms already besieged with losses on everything from soured mortgages to bad bets on capital markets. Card-industry executives are worried about escalating "roll rates," a term that refers to the percentage of cardholders who go from merely late on their payments to not making them at all. Among cardholders who are between 60 days and 89 days overdue, about 20% of such card balances eventually are being charged off by card issuers as uncollectible, according to Auriemma Consulting Group Inc., a Westbury, N.Y., financial-services consulting firm. The percentage is up by about a third from last year, before the U.S. economy tipped into recession. The problem can be even worse for bundles of outstanding credit-card balances that are securitized by some of the largest issuers.

Credit Card Companies Take What They Can Get After helping to foster the explosive growth of consumer debt in recent years, credit card companies are realizing that some hard-pressed Americans will not be able to pay their bills as the economy deteriorates.  So lenders and their collectors are rushing to round up what money they can before things get worse, even if that means forgiving part of some borrowers’ debts. Increasingly, they are stretching out payments and accepting dimes, if not pennies, on the dollar as payment in full. “You can’t squeeze blood out of a turnip,” said Don Siler, the chief marketing officer at MRS Associates, a big collection company that works with seven of the 10 largest credit card companies. “The big settlements just aren’t there anymore.” Lenders are not being charitable. They are simply trying to protect themselves. Banks and card companies are bracing for a wave of defaults on credit card debt in early 2009, and they are vying with each other to get paid first. Besides, the sooner people get their financial houses in order, the sooner they can start borrowing again. So even as many banks cut consumers’ credit lines, raise card fees and generally pull back on lending, some lenders are trying to give customers a little wiggle room.

No-Layoff Policies Crumble  The deepening recession is prompting layoffs at long-established employers that avoided job cuts in previous downturns. These layoffs demonstrate both the severity of the current recession and the continued erosion of workplace norms that once shielded many U.S. workers from permanent job loss. Several of these employers are in hard-hit industries. Employment in the car rental and leasing sector, for example, fell 3.3% in October from a year earlier, according to the U.S. Bureau of Labor Statistics. Gentex Corp., a Zeeland, Mich., automotive supplier, conducted its first layoffs in 34 years this month amid plunging car sales. Declining gambling revenue prompted the Little River Casino in Manistee, Mich., to dismiss 100 of its 950 employees in November, the first layoffs in the resort's nine-year history. Some workplace experts say such layoffs show that the stigma associated with permanent job cuts -- unthinkable to many employers three decades ago -- continues to decline. They say companies find it easier to let go of workers when rivals and other employers also are eliminating jobs. Kevin Hallock, a professor at Cornell University's School of Industrial and Labor Relations, says as layoffs become more common, managers may find it easier to discount the human and business costs. He recalls a group of senior executives who broke into tears after announcing their company's first layoffs. When Mr. Hallock returned to the company six months later, the same executives were discussing another round of job cuts in "the starkest economic terms."

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