Despite a slight hiccup yesterday, the stock market continues to roll on.  I had thought that perhaps yesterday was a signal that the earnings charade was over.  About halfway through this reporting season, about 80% of all companies reported has “beat” earnings expectations of analysts.  Nineteen per cent have “met” expectations and only one per cent fell below.  As each report on the majors has come out, stocks dutifully rallied as if this was great news.  CNBC trots out every talking head they can get their hands on to keep pumping up this bull market.  

Not one single time have I heard anyone ask the obvious question.  Are the earnings really that good or are the analysts really really bad.  Basically, analysts have missed projections 80% of the time.  That sounds like a huge failure rate.  So why would anyone listen to them?  Because it’s part of the game.  The analysts who estimate various stock earnings are doing so because they are in the universe of stocks they analyze and recommend buy-sell-hold.  In over 90% of the cases, Wall Street analysts have “buy” recommendations on the stocks they follow.  There is no money for Wall Street or their analysts in following “sell” recommendations.  This means the analysts are rewarded for intentionally under-estimating earnings.  By putting out forecasts they know their companies will exceed, they are assured that the stocks will rally following that news.  This means that since they have a “buy” on the stocks, they will be rewarded for their tremendous stock-selection acumen.  This is nothing but pure fraud but one that goes rewarded not punished. 

You think I’m being too conspiracy-theorist?  Okay, then all of Wall Street’s analysts are stupid.  You can’t have it both ways with an 80% fail rate.  Either these analysts are liars or just plain stupid.  Take your pick.   

 More Fraud News 

While we’re on the subject of fraud there’s this.  The home tax credit bill extension is still a work-in-process, but a House subcommittee is holding hearings on how the program has worked so far.  Today’s testimony unfortunately centers on the fraud already unearthed in just a sampling of tax filings.  Fraud has included credit claims from those who already owned a home, investors claiming multiple new “primary” residences under various name combinations, those who never bought a home, and several children as young as four years old!  Now that’s an independent kid.  I can only imagine your surprise that there is fraud in a program that involves free government money.  But this testimony is not likely to derail the lobbying money train that is behind this bill.  

Shameful Politics – As Usual 

Weekly Jobless Claims certainly should have gotten some attention, but it doesn’t seem to have done much.  Claims were expected to remain at 515k, with the chance of a lower number due to the partial holiday last week.  But, new claims rose to 531k.  That isn’t a huge jump, but it isn’t welcome.  There is a bill in Congress to extend benefits in states in which the unemployment rate is over 8.5%, but a small band of Republicans in the Senate are stalling the bill.  They want to attach certain riders to the bill that the Democrats don’t want.  I guess these guys want to see pictures of breadlines on the front pages of their local newspapers.  That’s how close we’re getting.  Benefits are running out for about 300k people each month at this time, and the number will be escalating rapidly with each passing month.  Congress needs to find some other, less immediate issue to use to play out their silly games.

The Dow crossed 10,000 today, and the cheers on the floor of the exchange were much louder than you would expect.  If I were them, I would not want to point out the fact that U.S. stocks have been the worst investment on the face of the earth for the past ten years.  (The Dow hit 10,000 the first time in March of 1999)  Money markets, bonds of all stripes, foreign stocks, gold, oil, and you-name-it have all outperformed stocks.  Yet we continue to allow ourselves to obsess over this market, as well as hitch our retirement wagons to this machine.  The purpose of this machine seems to be to enrich those on Wall Street and in the upper echelons of corporate America.  Wow!  How liberal/socialist/Michael Moore did that sound? 

But think about it.  For all of these years, all other markets outperformed stocks.  Also consider that the U.S. GDP has expanded by roughly 30%.  Yet stocks are flat.  Why?  More competition both here and abroad?  Certainly part of it.  Stocks are simply grossly undervalued?  Highly unlikely looking at what EPS are being projected into the future.  Think about this though.  We know that those at the top of corporations have seen exponential growth in incomes over the years, while employee wages have been stagnant.  We also know that the shareholders of those corporations are also not being rewarded. Where is the money going?   The buck stops at the top – literally.  

Today the WSJ had an article which said that bonuses on Wall Street for 2009 will set a new record!  I don’t mean just better than last year; I mean better than the previous record set in 2007.  This is all coming after the Street managed to pillage the economy and us, the poor villagers.  They didn’t even bother rewarding their long-suffering stock holders with a few pennies in added dividends.  But it gets worse.  Also today, in the NY Times, there was an article regarding how wages and salaries to workers are actually being cut at a pace not seen since the Great Depression!  We’ve had a record setting nine straight months of declining wages.  Overall average compensation to workers is back to 2000 levels.  Just put those two articles from the WSJ and the NY Times side by side and read.  It should become clear what is happening.

The stock market has been the worst performer on the globe for the average investor.  But for Wall Street and the corporate kingpins, the stock market has been a virtual gold mine. 

The type of rally we’ve had this year would normally be attracting investors in droves.  Yet, that hasn’t happened.  There is a tremendous amount of money on the sidelines, which when it moves, has tended to go into bonds not stocks.  Wall Street keeps talking about how that wall of money will send stocks soaring.  Is it at all possible that the money is not coming back to be debased by Wall Street?  Did we all really figure out what Wall Street’s true game is all about?  Nah….we’ll get sucked back in again soon.  Would be nice to think otherwise though.

(I just posted this commentary on the WesCorp website.  Thought I would use it here as well.  It’s interesting to watch these new bubbles developing.  Make that interesting and scary.  I have other comments I’ll add over the next few days. )

The stock market’s rally in September has sent a strong message to the masses – “It’s not the economy, stupid!”  Most economic statistics took at least a moderate turn for the worse over the past month.  The total weight of evidence is indicating this so-called recovery we’re in the midst of could turn out to be either very weak, very short, or both.  Yet despite the news, bullish stock market traders and pundits found a way to turn things around.  The most glaring example of this was the horrific Unemployment Report released on Friday, October 2.  The Dow closed lower by a whopping 20 points the day of the release but rallied 260 points in the next two days.  Half of that rally was supposedly based on a 25 basis point interest rate increase by Australia’s Central Bank.  So stocks barely move on a monthly U.S. job loss of 263,000 but rally 130 points on a .25% rate increase in Australia?  This is just one example of how Wall Street has decided to ignore economic red flags in order to keep stock prices moving higher.    

Another Downward Spiral Ahead? 

After declining by only 216,000 in August, economists were expecting the improvement in Nonfarm Payrolls to continue in September.  The estimate was for a job loss of 175,000.  Instead we got a job loss of 263,000, and that was the good news.  The report got worse from there.  The average workweek (a key leading indicator for jobs) fell back to the post WW II low of 33.0 hours after appearing to have turned the corner.  Payrolls of temporary workers (another leading indicator) fell again.  I had expected by this time that perhaps the construction and manufacturing industries would have fired enough people to be down to base levels.  But, alas, those sectors each managed to find yet another 50,000+ workers to fire. 

The Unemployment Rate rose to 9.8%, despite another huge fall in the labor pool.  Wall Street continues to say a “jobless recovery” is normal in the early stages, and the Unemployment Rate typically does rise just after the end of a recession.  But the reason the labor pool grows is because “discouraged workers” and others who declared themselves out of the labor pool are encouraged enough to return to job-seeking.  That’s not what is happening this time as the overall participation rate in the labor pool is the lowest since 1986, and the labor pool has continued to shrink.  

The Bureau of Labor Statistics (BLS) wasn’t done there.  They also issued the estimate of annual benchmark revisions.  They do this once a year for a one-year period dating back eighteen months.  This period was for March 2008 to March 2009.  This is when the BLS tells us how much they screwed up reporting Nonfarm Payroll numbers for that time period.  The BLS reported a staggering undercount of job losses of 824,000.  This is likely due to their erroneous birth/death adjustments for new businesses.  The BLS model continued to show job growth in this category despite the recession.  It was clear to all but the brain-dead that the BLS was understating job losses.  But those birth/death adjustments didn’t stop in March of this year.  The BLS has continued to use the same modeling assumptions and has continued to report phantom job growth in that category.  As bad as the job losses have been since March, it’s a safe bet that they have been understated by at least 400,000 jobs.  When you add this whole mess up, you come up with total Nonfarm Payroll losses officially over 8,000,000 since the beginning of 2008.  

As for as the outlook for jobs, I still hope my whole theory of “running out of people to fire” plays out, but I feel we’re in a similar spot as we were in 2008.  In mid-2008, monthly payrolls were declining by about 50k per month and the Unemployment Rate had moved up to 6%.  Based on some of the leading indicators in the job report I said I thought the Unemployment Rate would move to 8-9%.  But I also wrote and warned in presentations the risk was for a spiral in job losses.  Unfortunately that risk was realized, not my “optimistic” forecast. 

After some leveling off in job losses the last few months, I think we’re in the same spot we were a year ago.  The leading indicators and internals in the jobs report have worsened.  Additionally, we have to worry what happens during and after the Christmas season.  Retailers’ expectations aren’t high, and they won’t be disappointed with a very small decline in sales.  A significant shortfall in sales would likely trigger another scale down in operations for retailers and suppliers.  This is what happened last year.  Retailers were concerned about sales going into the season.  During the season they and their suppliers, knowing the consumer was in full retreat, set off on an intense job-cutting spree (over 600k cuts per month November through March). At the end of 2008, I had to boost my top end forecast for the Unemployment Rate to 9-10%.  Then by March I stepped it up to 10-11%.  The risk is growing that the belt loop might have be moved one more notch higher.   

You’ve probably read that adding in discouraged workers and full-timers forced into part-time jobs, we have a true Unemployment Rate of 17%.  While technically we are out of the recession for at least one quarter, we are not out woods on the economy.  But we are actually very fortunate in one important way.  The only thing missing in this environment is newspaper front page pictures of people standing in breadlines ala the Great Depression photos.  And the only reason we’re not seeing those photos is the broad safety net of unemployment benefits in place now unlike in the Great Depression.  In the Great Depression, the Unemployment Rate was estimated at 25% for much of the time.  At 17% we’re not that far away.  Without the safety net we have now we would have pictures of breadlines on our front pages.  Where do you think the stock market would be if that happened?  It’s time to face the facts that until further notice, the only thing our system has going for it is government support.  You might not like it, but it’s all we have now.  

Whether liberal or conservative, no one is happy or unconcerned with the huge deficit growth we’re experiencing.  We all know that we’re piling debt on top of debt for future generations.  Unfortunately, until the job market recovers that’s likely to continue.  Wall Street keeps telling us that job growth doesn’t really matter.  I beg to differ. It matters in many ways.    

The Power of Zero 

Last month I brought up the potential of the real inflation to fear was inflation in asset prices, or new bubbles in other words.  Low rates, or the power of zero as I call it, are making this all possible again. Of course our stock market seems overvalued, but it has a ways to go to reach bubble status.  Still it bears watching.  But it’s more than stocks.  Since late April the Dow has rallied almost 2,000 points.  Yet treasury rates are currently at the same levels prevailing in April.  Some of that is due to the fact some very large money managers believe that deflation will ultimately win out, but much of it is simple due to the power of zero.  

Banks are adding to their treasury portfolios at a record pace. While there is no credit risk there is interest rate risk.  But banks aren’t alone, leveraged players around the globe have returned to playing the yield curve in leveraged transactions.     

More aggressive managers have foregone buying lower-yielding treasury securities and have been buying more distressed assets, our friends the “toxic assets.”  It was clear that at least through March of this year, many mortgage-related securities were being grossly undervalued due to the lack of demand in the market.  That’s when the Treasury stepped in with the PIPP program designed to buy toxic assets off of bank balance sheets. You might recall at the time that the goal of the Treasury was to have the program up and running by July of this year with the eventual goal of buying up to $1 trillion in toxic assets.  The Treasury has just announced that some of the partnerships are finally in place after a three-month delay.  Based on the capital received, the total potential purchases of these partnerships are $12 billion.  That’s quite a shortfall from $1 trillion.  There are a number of reasons why this program can be labeled a failure, but maybe it should just be labeled as unnecessary instead.  

Since the time the program was announced there has been a dramatic improvement in the market prices of some of these “toxic assets.”  Clearly there are exceptions.  Securities originally rated below AA and those already taking losses aren’t improving.  But some of the grossly undervalued one-time AAA securities have soared in value.  As an example, the price on one particular AAA went from 30 to 70.  Those partners for the Treasury PIPP program have seen potential returns plummet, and banks are in no rush to sell any asset rising in price regardless.  

The PIPP story is emblematic of the major turnaround we’re seeing in distressed asset values.  That sounds like a good story until you consider that the actual underlying performance of the mortgages is deteriorating at an ever-increasing pace for most mortgage types.  At WesCorp, we can attest that mortgage pipeline characteristics have not improved.  Yet the power of zero is helping to drive demand for the most risky of assets as well as treasuries.  Another debt bubble debacle is in the making. 

In last month’s epistle I wrote that I felt the Bernanke Fed would be unwilling to risk sending a message to the markets that the Fed would act against dangerous bubbles.  I still believe that, but we might have seen some glimmer of hope on that front.  At least three Fed officials have recently stated that the Fed might need to start tightening before it was obvious, meaning before the Unemployment Rate declined.  While they stopped short of stating this might be necessary due to asset bubbles, I think the implications were strong.  This is still Bernanke’s Fed, but at some point in time a divided Fed could emerge. 

Bernanke has resisted this whole line of fighting asset bubbles saying the Fed could not necessarily identify a developing asset bubble.  To that, Mr. Bernanke, I say – something I can’t say here.  Bernanke apparently believes the Fed can identify the dangers of inflation in the Consumer Price Index, which has multiple inputs and components, but they can’t discern an unsustainable surge in the price of a single asset class.  Doesn’t add up to me.   

I’m not ready for the Fed to tighten just yet, although it would be fun to watch the reaction in the marketplace.  It would be hilarious watching all the color drain from Jim Cramer’s face. But the further that asset market values get out of alignment with the realities of a weak, job-starved economy, the more we might need to Fed to fire a warning shot.  They don’t need to raise interest rates.  They can just shut down some lending facilities (mostly unneeded now anyway), change reserve requirements, force margin changes on secured lending, or just increase the margin requirement on stock borrowings.  Go after the banker-speculator where he lives.  We can’t stomach Lehman II.  

Dwight Johnston

In the previous post, I wrote about the circumstances in which the Fed should tighten or at least dangle that threat.  I didn’t give this much of a chance of happening, but maybe we heard the first shot across the bough this week.  Although the FOMC statement stayed away from addressing how and when they might reduce some liquidity facilities, the very next morning they announced the schedule for winding down two such facilities.  The Fed said it was not policy-related.  The facilities were meant to be temporary and were no longer needed.  But the Fed said they would be creating a new permanent facility.

But on Friday, something far more interesting came out.  Fed Governor Warsh published an op-ed in The Wall Street Journal regarding some sort of eventual tightening.  At first I dismissed it as just the usual Fed posturing, but on reflection perhaps it was more pointed.  This is what he said: “In this environment, market participants and policy makers alike should steer clear of ironclad policy prescriptions. Nonetheless, I would hazard the view that prudent risk management indicates that policy likely will need to begin normalization before it is obvious that it is necessary, possibly with greater force than is customary, and taking proper account of the policies being instituted by other authorities.”

“Whatever it takes” is said by some to be the maxim that marked the battle of the last year. But, it cannot be an asymmetric mantra, trotted out only during times of deep economic and financial distress, and discarded when the cycle turns. If “whatever it takes” was appropriate to arrest the panic, the refrain might turn out to be equally necessary at a stage during the recovery to ensure the Federal Reserve’s institutional credibility.”

This sounds a lot like the Fed wants the message out there that they will have the courage to act sooner rather than later.  Just as important, the message is that they won’t make the Greenspan mistake of tightening at a “measured pact.”

Will they in fact do anything if faced with an asset inflation bubble?  Who knows.  But at least they did see the need to get some sort of warning out there on record.  Clearly Fed officials are devoted readers of my blog.

I haven’t posted in a while since there really hasn’t been much new to add that I didn’t say in my previous blog.  Stocks are continuing to move higher on pure momentum.  News, whether good or bad, seems to impact stocks.  It is a steady drip, drip, drip — that is, if things can drip up.  I still contend most of this is fueled by the power of 0% money.  Zero percent money encourages investors with money to take additional risks to earn something more, and nothing is wrong with that up to a point.  But we’re not really seeing a flood of money from traditional individual investors.  In fact, stock equity funds actually fell in August.  The ability to borrow at 0% is what is truly fueling the market.  I talked about this in my latest post, and I think you’re going to start hearing more about it — now that we are the cheapest place on earth to borrow.

I stand by the statement that I fear the creation of a dangerous bubble in stocks, some commodities, and lesser quality debt.  Left unchecked, I think things could implode again with 12-24 months.  And this time, I don’t think Bernanke or Humpty-Dumpty could put it back together again.

A subtle squeeze may be due

So, what should the Fed do about this, if anything?  I think the Fed should tighten – sort of.  I know coming from me that sounds insane given the state of the economy.  And, quite frankly, it would be political suicide for the Fed to start raising rates this soon, although I fail to see what damage a token rate increase of 50 basis points or so would do.  But they could certainly send a subtle message to the markets that they will not stand idly by (as they have in the past) and watch dangerous, over-leveraged markets develop all over again.  They could reduce their various borrowing facilities.  They could stop buying mortgage debt.  And, they could do various subtle things through open market operations.  While there would be no overt tightening, the markets would certainly get the message that the gravy train of 0% borrowing wouldn’t last forever.

Will the Fed be willing to be so bold?  Not at this time.  I do think it’s too early for that.  My preference would be for the stock market to cool, and some of the players in leveraged debt lose money on risk positions.  Not too much, though.  Just enough to remind everyone that the economy needs to catch up with the markets at some point in time.

How extreme is the disconnect between the markets and the economy?  David Rosenberg recently wrote that after past recessions and bearish stock markets, the recovery in stock prices equivalent to what we have seen this time has been realized, on average, three years after the trough of the recession and only after job growth has reached at last one million.  This time, we are perhaps three months from the trough, and we’ve lost 2.5 million jobs in the six month period.  Again, what makes this so dangerous is that this market miracle is being produced on borrowed money.

As mentioned in my post below, it has been over a year since Lehman, AIG, Fannie, Indymac, etc.— and absolutely nothing has been done by the government or regulators to prevent another taxpayer funded debacle in finance.  In fact, the government has almost enhanced the atmosphere that can produce a repeat.  If it weren’t so dangerous, it would be downright laughable.  Even The Daily Show gets it.  A couple of nights ago they had a clip of President Obama speaking about Wall Street and how we “need” to have regulations in place to prevent a repeat and how they are “working” on changes.

So where are the grown-ups?  Nowhere in sight.  But I’ll start the drumbeat for the Fed to tighten right here, right now.

The following post is an article I just finished for the Wescorp web site, but I decided to post it here as well.

In last month’s Longer-term Commentary I discussed the difference between reality and perception, reality being the world regular people like us actually live in and perception being Wall Street’s fantasy land.  That disconnect shows no signs of letting up.  Over the past month, stocks have continued to push higher (with a minor setback last week) while more and more people continue to join the unemployment lines and incomes shrink.

No Longer “Less Bad”; Just “Not Worse”

The only thing positive about the latest Nonfarm Payroll number was the headline which read “August Nonfarm Payrolls decline less than in July.”  Beyond that headline, the details of the report were a bust.  First, the Bureau of Labor Statistics (BLS) increased the jobs lost in prior months by 49k.  Effectively, that made August payrolls a decline of 265k instead of 216k.  Second, the Unemployment Rate rose from 9.4% to 9.7%.  A rise in the Unemployment Rate can actually be a good thing at the end of a recession if the increase is the result of a bigger labor pool.  As job conditions improve, people are encouraged to at least re-enter the job hunting market and this temporarily increases the Unemployment rate.  But this rise in the Unemployment Rate was not due to labor pool adjustments by the BLS.  The jump to a 26-year high in the Unemployment Rate was the result of true job losses, not a labor pool adjustment.

The two leading indicators in the report that are important to watch also disappointed.  The workweek, which finally rose by .1% for the first time in July, failed to budge further in August from the post-WW II low.  Even the separately reported factory workweek failed to rise, despite the assumption that industrial production is rising on re-building of inventories.  The second leading indicator, temporary workers, was expected to finally turn positive after a string of declines stretching back eighteen months.  Unfortunately, that string grew to nineteen months as another decline was recorded.

We’ve now hit an extraordinary string of twenty months of job losses totaling almost seven million workers.  Roughly six million workers that want or need full-time work are only employed part-time.  The workweek remains down by .9 hours since 2007, which is equivalent income of roughly 3.5 million workers.  The Unemployment Rate of 9.7% is now up a huge 5.1% since December 2007.  The average post-Depression recessions resulted in an unemployment rate increase of 2.3%, with the worst coming in 1980-1981 with a 3.1% jump in the rate.  Despite the money from the fiscal stimulus package going to states, we’re now finding that states are just beginning to be forced to cut back as state revenues are falling faster than anticipated.  Most states, like California, are trying to limit job cuts.  But in doing so, they are reducing the incomes of workers by 15% through the use of furloughs.  In a recent Los Angeles Times article, the writer interviewed a number of state workers that have job stability but are living paycheck to paycheck, and now those 15% smaller paychecks don’t cover all of the mortgage payment and monthly bills.

As I said last month, yes, the recession is almost certainly over “technically.”  We’ll have one or two quarters of positive growth as the result some inventory re-building (cars and more) and a smaller trade gap.  What seems to be lost on Wall Street is that the “technical” end of the recession might very well result in no job gains at all.  If consumer spending continues to contract, production levels will merely retreat to past lows.  Only if consumers begin to spend again will this recession end in more than just “technical” terms.

But in this current economic and financial environment less income to spend is almost secondary to the importance of less income to pay mortgages and other consumer debts.

Bank Worries Behind or Ahead?

With the rally in financial stocks, it’s assumed on Wall Street that the financial sector is in the clear.  Oh sure, the FDIC closes an average of four banks every weekend, but at least the big boys are okay.  But the danger is very real that, even if we don’t have to worry as much about the top ten, we have to worry more about the rest of the banking industry.  The FDIC admitted as much by announcing their list of “problem banks” has jumped from just over 200 to over 400 in the last quarter, and these aren’t just small banks.  There are a number of larger regional banks.  In fact the last two big failures, Colonial and Guaranty Bank, had assets totaling $40 billion!  As in all recent bank failures, the event didn’t cause a ripple as the FDIC smoothly transitioned the good assets to other institutions while retaining the bad assets.  But what happens to the other good institutional buyers as these failures escalate.  At some point in time, the quality banks will run out of capital to take over the failures.  This might be why the FDIC has recently lowered the capital requirements for private buyers to buy failed banks.

The reason it would be wrong to assume we no longer have to worry about bank losses is that credit quality has deteriorated at an alarming pace – in the prime borrower category.  Subprime mortgage delinquencies seems to have leveled out at something over 25%.  Horrific to be sure, but “not worse.”  What is worse is that prime borrowers are now delinquent on mortgages at a record level in excess of 9%, and the numbers are escalating at a rapid pace. What makes this more alarming than the subprime numbers is the fact that 80% of all mortgages were considered “prime” at issue, and financial institutions typically kept more of those on their books.  This is especially true in second mortgages.  Many banks, especially regionals, sold off prime first mortgages in order to hold more seconds at higher rates.  Prime defaults will not reach the level of subprime but, given that prime mortgages constitute more that four times the volume of subprime, it’s a huge concern.  At the same time, all forms of prime consumer debts, including credit cards, are exhibiting deteriorating performance.

Why?  See the section above on jobs and income.  The job losses started mostly with lower income workers but have clearly stretched into all income levels.  Even medical workers, teachers, state workers, etc. are no longer immune.  When workers with “prime” credit scores lose their jobs, this category of workers typically will have some resources to continue to pay bills until new employment is found.   The problem now is that they are using up all of those resources because the time between jobs is at the worst (most time) level since the Depression.  You’ve read the stories.  They are agonizing to read but no longer uncommon, nor do they represent rare, isolated cases.

So let’s say you lost your job one year ago when businesses began the major blood-letting of jobs.  You weren’t too worried at first but now, not only are you running through your savings, but you’re faced with perhaps dipping into your 401k.  Looming ahead is the end to your unemployment benefits.  What do you do?  You look at your mortgage payment – the biggest bang for the buck.  You look at the real estate section and see that you’re roughly 125-150% LTV.  Why keep paying?  You know from your neighbor’s experience you won’t lose your house for six months or longer.  I think you can see where this is going.  This is happening all across the U.S. with ten states showing Unemployment Rates of over 10% and another fifteen just below that level.  It seems almost inevitable that we will see another wave of big mortgage-related losses over the next twelve months.

Want more reasons to worry about banks?  How about the fact they haven’t even begun to recognize future losses on commercial real estate lending.  This lending sector is especially important to regional banks.  It’s not even a secret any longer that loan loss reserves on commercial real estate  loans are well short of any reasonable projections; it’s a common topic in most business journals.  But the concerns are being dismissed because “it’s a small part of the market.”  Where have you heard that before?  The $3 trillion commercial market is smaller than residential but hardly insignificant.  The apologists continue that recovery experience is higher in commercial real estate (arguable), and that banks can easily handle the losses.  I might give that some credence if commercial real estate was the only problem area.  Unfortunately, commercial real estate is merely joining its ugly siblings, residential mortgages and consumer debt.

There is a lot of talk about banks not lending.  But banks are lending – just not to you or small businesses.  It seems banks have decided to start lending again to hedge funds and private equity funds against “distressed assets.”  Yes, those are the same assets that were “prime” in 2007, the last time banks loaned against them.  A well-respected bank analyst recently reported that banks are not only loaning against these assets, they are also loaning to allow the level of leverage that existed just after the collapse in 2007.  Banks counter by saying that more leverage is reasonable because market values have already been market down so drastically.  In other words, there is little risk in the low-valued assets.  Unless these assets are priced at $0.00, there is still risk.

Finally, I’ll end my ranting about financial worries with this forgotten fact.  Think way back, say three or four months ago.  Remember the government’s vaunted “stress tests?”  Those were the tests that told us we didn’t have to worry about our biggest banks.  The base case showed “only” another $599 billion in losses was at risk.  Remember what the base case was based on?  I didn’t either.  The base case forecast for the Unemployment Rate, which drives the loss assumptions for obvious reasons, was 8.4% in 2009 and 8.8% in 2010.  Those were rates that produced the $599 billion loss.  We’re at 9.7% and climbing.  Yet, we’re not hearing anything about how that might impact the losses ahead for banks.  That story is buried by reporting on the happy events in Wall Street World.

The Real Danger of InflationI still think it’s too early to spend a lot of time arguing about inflation – in the traditional sense of rising prices for goods and services.  We’ll start that argument sometime in the next six months or so.  But there is an inflation concern emerging in something else – asset prices.  From 2002 onward, there was concern in the economic community that leaving rates so low for such a long time would result in inflation.  Of course that didn’t happen in the traditional sense.  But leaving rates so low for so long did result serious inflation in asset prices of houses and stocks.  Let’s also not forget that the low rates allowed for what was effectively inflation in the value of less quality debt.

Leverage borrowing exploded as low short-term rates vs. returns in other markets resulted in huge gains.  The huge gains in asset prices made everyone (especially lenders) feel there was no risk, which in turn led to more leverage and less concern about credit quality or much of anything else for that matter.  We know how that story ended.

It’s entirely possible that the stock market could continue to run ahead.  So far at least, mediocre economic improvement from near-depression like lows has not been a deterrent, nor has lack of revenue growth. (Earnings have grown, but that is due to slashing costs and people not growing revenues.)  As long as analysts and pundits keep the expectations bar on the ground, it’s easy to hop over.  And make no mistake about it; low interest rates this time is what is attracting risk capital and leverage.  It’s not a sudden surge in confidence by big time players in the economy, real estate market, or anything else.  It’s cheap money.  Even for non-leveraged investors, low rates provide an incentive to move toward greater risk.  The problem is this can go too far, as we all well know.  And don’t count on recent experience to necessarily deter anyone.  Remember, “it’s different this time” is a phrase that always seems to work on Wall Street. It’s easy to imagine a runaway stock market and collapsing credit spreads as investors interpret the stock market’s upward movement as reflecting the underlying fundamentals of the future of the real world.  In fact though, we’re a long way from correcting our debt problems.  But risk concerns could once again become a casualty of asset-inflation.

Unfortunately, this runaway asset-inflation scenario is not too farfetched.  The Fed is almost powerless to raise the cost of money to pop a burgeoning asset bubble, given an Unemployment Rate of around 10%.  That would only happen if Ben Bernanke is replaced by Paul Volker.  More importantly, while there has been a lot of talk about the regulatory changes for all financial institutions, there have been no meaningful regulatory changes adopted and implemented.  Perhaps even more important is the fact there has been no adoption of any changes about compensation at financial institutions.  There has been a lot of talk, and in this case talk is not cheap.  As long as it remains in the “talking” stage, financial institutions are free to do what they will – and they have, as evidenced by bonuses disclosed at Morgan Stanley and Goldman just to name two.  So those running major institutions are looking at a landscape where the appetite for risk is ramping up again, higher stock prices has muted all discussions of concerns and open challenges to management decisions, and a window to rack up another round of huge bonuses.  If you asked me a few months ago if it was possible to return so quickly to an era of big leveraged risk taking and big Wall Street bonuses, I would have said “absolutely no way.”  But I have underestimated Wall Street again.  Maybe that’s why I’m on Overland Court instead.

There are two points to take away from this.  First, the stock market is not the economy.  Just as the stock market and the home prices did not reflect reality at the peak in 2007 (and we all paid the price), we are at risk of repeating the error.  I know you’re tempted to want to recover all your lost 401k value in a short period of time, but this could be just setting us up for an even greater fall.  Let’s hope the stock market stays grounded until the economy eventually catches up. Second, if another asset bubble does in fact form, we’ll need to use that window to prepare for the next meltdown.

Knowing My Place

Over the past few months, I’ve often felt remorse when I’ve written about what I’ve viewed as negative developments.  In fact, if you look back at previous articles, I’ve tried to present potential positive outcomes as well just the negative, though you always knew where I stood.  In the last couple of months, I’ve felt even worse about it because it seems that everyone is so upbeat these days.  It’s happy talk all the time on CNBC, The Wall Street Journal and business magazines are full of positive articles on everything but the government, the economists’ consensus has swung completely around to a very bullish economic outlook, and investor sentiment is back to the most bullish since 2007.  The Nonfarm Payroll number gave us a classic example of the psychology.  Stocks ended the day higher by 100 points as the consensus viewpoint gelled around the belief  that the number was probably the last bad number –  given that the economy was really taking off.  CNBC also resorted to bringing on one guest economist who expressed concern about the report only to be shouted down by three who weren’t bothered.  That was the programming game played so often in 2006 and 2007 should anyone dare to question the housing market’s invincibility.

But this from this month on, I’ve determined to stop feeling guilty.  The relentless message from Wall Street is nothing but the positive.  I can see the potential positive outcome as well, but I still view the risks to a more negative outcome as far greater.  So, I know you’re well covered on getting happy news, and I’ll unashamedly continue to try to fairly present the risks ahead.  No more apologies.

Dwight Johnston

Too big to fail?

Yesterday the FDIC released its report on problem banks, and the number is well over 400.  Maybe the answer to reducing the number of problem banks is to just have fewer of them.  Today there is an article in The Washington Post about the “too-big-to-fail” issue for banks.  Basically, the issue is we’re there.  Concentration is greater than it’s ever been and getting worse.  B of A and JPM now each have over 10% of domestic deposits.  Three banks — Wells, JPS, and Citibank — have more than 50% of all mortgage issuance and almost 70% of all credit card issuance.  It’s time that Washington stop talking about whether too-big-to-fail exists or not.  It’s time to accept it and figure out how to properly regulate these beasts.  They simply cannot play by the same rules as they once did, when in theory they would have been allowed to fail if they took too much risk.  To allow them to conduct business as they see fit and pay themselves as they see fit, knowing they are untouchable, makes no sense at all.  Effectively, the U.S. taxpayer is taking on all the risk of their operations from this point on.  Stock holders could lose some money in the event of a new crisis, but the big losers would be the U.S. taxpayer.  These are the Banks of America.

I wrote the above comment a bit earlier today, and before I had time to post it to the blog a new story on Bloomberg popped up that illustrates the danger of the above.  Bloomberg is reporting that big bank lending to leveraged funds is surging. The funds are investing in distressed commercial loans and distressed mortgage-backed securities.  Stop me if this sounds familiar.  The banks are lending to these funds and taking the assets as collateral, as these funds leverage up.  There’s more. . . the rate of leverage they are allowing is the highest since 2007.   A spokesman for Citibank actually had the nerve to say the banks were just responding to pressure from Washington to lend money to aid the economy.  I assume he told that big lie with a straight face.  I don’t think that’s the type of lending Washington had in mind.  Of course the banks are outraged that they are being questioned on this – this time it’s different!  Again, stop me if you’ve heard that before.  This time they are loaning against assets that have already declined in value and unlikely to decline further.  What?  Have they hit $0.00?  That’s the only sure bottom.  This is not only bad news, it’s an outrage.   I would like to think that Sheila Bair or  Geithner would do something about this or at least tell us why this is okay.  But that ’s probably too much to ask.

Okay, I was wrong.  No, I’m not throwing in the towel on a big second dip for the market and the economy.  I might be forced to do that, but I’m waiting until we get past September and October.  What I was wrong about was Bernanke.  After his first six months on the job, I thought he was the wrong guy and wouldn’t serve a second term.  President Obama took care of that today by reappointing Bernanke for a second term.

This is way ahead of schedule, but the controversy and conversations regarding his reappointment were already beginning.  Obama apparently has enough controversy.  A recent WSJ poll said 42 of 43 economists said Bernanke should be reappointed, and this might have pushed Obama to make the early move while it is still being viewed as the right thing to do.  Someone should have clued Obama in on how lousy economists’ consensus polls are in predicting the future.

As you no doubt know if you’ve read anything of mine in the past, I’m not a Bernanke fan.  He could not have stopped the wheels that were in motion when he took office in February 2006, but I think his failure to recognize and warn of the coming danger was a contributing factor to the ultimate extent of the devastation.  Even worse, either he lied to the American public or he was just miserably uninformed and unaware when he kept insisting in 2007 that any problems were limited to subprime.  Those are two huge strikes in my book.  Add to that his many failed programs during the crisis with his buddy Treasury Secretary Paulson, and that makes strike three in my book.  But, the stock market is in rally mode now and all is right in the world – the Wall Street world at least.  Wall Street is dictating that Obama make this move so as not to rock their boat.  I wish Obama had shown a bit more foresight and been willing to go against conventional Wall Street wisdom.

Here’s one more thing to think about.  With the stock market still in rally mode, the target of 10,000 is squarely in sight.  As you know, I thought this was possible though not likely and certainly not justified.  But, it is looking more likely now.  What is interesting is how celebratory the mood is on Wall Street as this milestone approaches.  Do you realize that the Dow first crossed 10,000 over ten years ago!  So, we’re supposed to celebrate the wonder of Wall Street that gave us a 0% rate of return for more that ten years?  Still think buy and hold is the way to go?

Some of you might think my cynicism about the forces on Wall Street is a product of my advanced years.  That might be a contributing factor.  Being a grumpy old man has benefits.  But there were a couple of things just today that illustrate why I have grown increasingly disdainful of all elements of the Wall Street machine.  First, Existing Home Sales rose more than economists had forecast.  Frankly, economists were underestimating the forecast.  The sales were mostly in June (closing in July), and we already know that June was likely the high point of activity.  We also know that the foreclosure buying frenzy was at full force.  The numbers today merely confirmed what we already knew.

But the talking heads on CNBC said nothing about the drop in median prices being more than expected.  That story got buried.  Buried even deeper was something more significant.  Despite the higher sales level, the number of unsold existing homes on the market surged by one of the highest amounts on record for a single month.  In other words, the supply of homes rose much more than demand.  That is not the formula for a housing bottom.  But that story got no airplay at all.  I’ve also gone to other sites to read interpretations by business writers and economists, and I haven’t found a mention of that anywhere.

The second example was in the release of the state unemployment figures for July.  Those are usually released about two weeks after the national number, which was 9.4% in July.  The report was ugly.  The number of states now recording 10% or greater unemployment rates rose from ten to fifteen.  California hit an all-time high UR of 11.9%.  So, how was this reported?  It got exactly zero mention on CNBC, and Bloomberg buried the story for at least a couple of hours after the release.  But the NY Times takes the cake on this one.  They gave the story a big lead headline and story.  But this how their writer chose to spin it. . . The headline and entire first paragraph were about the small declines in the unemployment rates of seventeen states.  Here’s a quote: “The unemployment rate fell in 17 states and the District of Columbia last month, a positive sign.”  Technically, that is a factual statement.  But, what he failed to mention until later in the article was that the unemployment rate rose in 26 states!

The psychology of this market is, of course, wildly bullish now, and this sort of sloppy reporting and analysis is the norm — not the exception.  Of course, the sad fact is that it’s not just sloppy, it’s downright dishonest.  Maybe if the market keeps trading higher and higher, no one will get hurt and all will make money without realizing the minefields we’re walking through.  If that sounds okay to you, better think again.  The seeds of disaster sown and signs of the collapse of stocks, housing, and credit were not unknown during 2005-2007.  But Wall Street wanted no part of that discussion to receive a fair hearing.  On those rare occasions when sources like CNBC would bring on a dissenter, they would make sure there would be two or more cheerleaders with louder voices to shout down the Gloomy Gus.  We hear over and over that “no one could have seen this coming” as an excuse.  The fact is that a bunch of folks saw this coming — maybe not to the full extent of the devastation, but there were a number of Chicken Littles out there.  However, the Wall Street machine easily overpowered the doubters.

After the crushing blow that Wall Street’s geniuses and the rest of the Wall Street machine (media being a big part of it) delivered to the world, you might think they would have been humbled and turned over a new leaf.  While the numbers of people on the payrolls of the street are smaller, it seems the survivors are going for the gusto.  Now there will actually be fewer slices of the Wall Street bonus pie, and they have chances to really score big and make up for that horrible six months or so in which their bonuses were being threatened.

Cynical?  You bet.  Join me, won’t you?  However, if I start sounding like Howard Beale in Network, just tell me to cool it.

One more thing, and then I’ll shut-up and try to get happy over the weekend. There was another contributor to the Wall Street party today, and that was Ben Bernanke.  His quote that “Prospects for return to growth in the near term appear good.” was splashed all over television and news services.  This is the very same Ben Bernanke, not an impostor, who said as recently as July 2007 “The problems in the subprime are contained to a small part of the market.”  Genius.

Although the National Bureau of Economic Research (NBER) probably won’t declare when the recession ended until almost a year afterwards, the economic community has more or less settled the issue already.  You might think that a recession is still going on since the end hasn’t been declared, but you would be wrong.  To the vast majority of the economic community, it’s not a question of if the recession is over; it’s a question of when it ended.  June is now the month economists believe will eventually be declared as the month this current recession ended.  Goldman Sachs is just the latest house to tag that month.

In the spring of 2008, there was no official recession, but in speeches and commentaries I voiced my opinion that we were in one regardless of the lack of the “official” tag of recession.  There were too many people losing jobs, earning less, and falling behind on bills.  To me that is the definition of a recession.  I wasn’t completely alone in that view, but there weren’t many on that side.  It wasn’t until August 2008 that the NBER said, “Well son-of-gun. A recession did start in December 2007.”  That might not be direct quote, but that was the drift.  Americans knew we were in a recession long before economists.

Several economic numbers today are in fact turning up from some extreme lows.  Various housing numbers, Industrial Production, et al look better than they did six months ago.  That alone will constitute the definition of “recovery” in economic terms.  But I feel as strongly now as I did in 2008 that this is irrelevant.  All I know is that delinquencies and foreclosures are escalating, salaries and wages have been flat for a record setting eight straight months, high earning job sectors (manufacturing, construction, and finance) are still firing workers, once secure teaching and state worker jobs are disappearing around the country, and only some “modeling” assumptions by the BLS is keeping the Unemployment Rate below 10%.  Last but not least, let’s assume that August payrolls contract by another “great” 250,000.  If so, this will mean that since the recession “ended” in June, we will have lost almost another one million jobs.

Here is one other thing to leave you with – the latest delinquency figures.  I posted this on the web site today.   The Mortgage Bankers Association just reported that at the end of the 2nd quarter, delinquencies (30-days or more) rose to another new record high of 9.24%.  Homes in various stages of foreclosure rose to a huge 4.3%.  This means the total number of mortgages in the U.S. that are in some trouble is over 13%!  Think about that. One in eight homes on your block could be in trouble.  The MBA also reported the deterioration was most pronounced in the prime market, as job losses are taking the toll.  Sure glad investors and others are gobbling up foreclosed property, because there’s more where those came from.  But the news was mostly ignored by the street under the theory that economic conditions have improved since the end of June and some foreclosures will be avoided.  I suppose as long as you don’t consider job losses and declining incomes a problem for housing, the pundits are right.

So celebrate, along with Wall Street, the “end” of the recession.  But as long as jobs and incomes remain under pressure, the economy will remain vulnerable to even minor shocks and institutions’ balance sheets will continue to deteriorate.  I’ll save popping the champagne cork until I see the job market turn around.  Of course, nothing will stop me from drinking wine.