July 27, 2010

Future State

Posted in Banking, Big Banks, Bonds, Capital, crises, Finance, investment advisor, investments, San Francisco, Uncategorized tagged , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , at 7:22 PM by Robert Barone

It took twenty years of over-consumption and living beyond their incomes for Americans to get to their current economic state; the elected officials in Washington, D.C., continue to hunt for a quick fix, one that just doesn’t exist.  Meanwhile, the economy keeps on lurching, and, at the same time, morphing into what it will look like in its future state as we move further away from the financial crisis and deeper and deeper into a slow growth economy.  In the near to intermediate term, the economy will, I believe, display a tendency for more frequent recessions.

The Consumer’s Financial Condition

The consumer is simply carrying too much debt.  In the U.S., consumption represents 70% of GDP, but the consumers’ debt/GDP ratio, which spurted from 100% in 2001 to more than 135% in 2008, still stands at 126%, nearly three years after the recession began.  Much of the 9 percentage point decline is due to financial institution write-offs as opposed to debt repayment, so it appears that the consumer has a long way to go to even get back to the 100% ratio.  Short of the government waiving its wand and pronouncing that all debt is now magically repaid, the next healthy economic upswing must await the healing of household balance sheets.

Unfortunately, to get a healthy consumer balance sheet, savings must increase to repay the debt, which leaves less for consumption.  Lower consumption means slower economic growth with all the attendant implications for employment.  This is known in the economics profession as “the paradox of thrift”.  Thus, to get back to a healthy and sustainable level of economic growth in which new jobs are created and the unemployment and underemployment rate falls will take much longer than we have experienced in any of the post-WWII recessions.  Unfortunately, the politicians want desperately for this to pass quickly, lest the electorate cast them out.  So, they promote ill conceived schemes that wind up only prolonging the agony – like “cash for clunkers” and the “homebuyer tax credit”.  These programs promote more debt which will have to be reduced in the future, so they simply wind up pulling demand forward at the expense of economic growth a quarter or two out, and prolonging the adjustment, as more debt now needs to be worked off.

Headwinds

For the next few years, until balance sheets are healed, economic growth will simply be sub-par.  Below is a discussion of some of the headwinds and their consequences.

  • According to the U.S. Chamber of Commerce and National Federation of Independent Businesses, uncertainty as to economic policies, taxes, the cost of health care, new regulations in the financial reform bill, and the ongoing credit crunch are causing businesses to hold back on hiring.  But, even if this is resolved, the need to work off debt together with the loss of retirement income by the baby boomers will cause them to put off retirement for several years.  This will trickle down to the younger generation who will find it increasingly difficult to find satisfactory employment.  We will see the U6 unemployment measure (which counts the underemployed) continue to maintain a much wider spread against the traditional U3 measure of unemployment that it has over the last couple of decades.
  • The purchase of big ticket items will be significantly impacted.  Houses and cars are the first items that come to mind.  Expect continued downward pressure on home prices, especially the high end homes, until the debt ratios are significantly reduced.  And, don’t expect auto sales in the U.S. to return to their former peaks anytime soon.  It is likely that they will continue to be below the replacement level of 12-13 million units per year required to keep the average age of the U.S. auto stock from climbing further than it already has.  Besides autos and homes, other big ticket items will continue to be impacted.  Travel and vacations will be closer to home; restaurant tickets, on average, will be lower.  So will just about every other consumer discretionary purchase.
  • Financial institutions will continue to struggle.  John Hussman, in his July 12th blog, observed that while financial “operating profits” appear to have recovered (leading to large management bonuses), below the surface, large write-offs and one time charges continue.  And it is quite apparent from the state of the housing industry and from the condition of consumer balance sheets that large foreclosure related write-offs will continue.  Both David Rosenberg (Gluskin/Sheff) and Hussman point out that consumers continue to pay for the items that they absolutely need (their credit cards, cars and even their HELOCs), but many have simply stopped making their mortgage payments.  As a result, they have the cash to spend that they would have used to make those mortgage payments, thus giving consumption the slight lift we have seen in the last couple of quarters.  Sooner or later, however, that cash will have to go to rent as their foreclosures are consummated.  This will inevitably put even more downward pressure on the growth rate of consumption.
  • For the larger financial institutions, write-downs will continue and capital raises will be necessary.  Meanwhile, smaller financial institutions have loan portfolio issues of their own.  These are the institutions that are the lenders to the local communities and to small businesses.  While some of these just won’t survive, the majority that do will be capital constrained, meaning that they won’t be able to increase their loan portfolios.  Unlike their big brother brethren, these institutions have little or no access to raise capital via Wall Street.  Thus, small businesses will continue to experience a credit crunch, and small business expansion, with its commensurate job creation, will continue to be non-existent.  This is clearly shown in the latest bank loan data.  Three years after the recession began, commercial and industrial loans in the banking system continue to rapidly contract.  Furthermore, the new financial legislation looks like it will put a crimp into large bank profits, and, at the same time, increase the already unmanageable regulatory burden on the nation’s community banks.
  • The Treasury has become more and more dependent on the Wall Street banks to finance its exploding borrowing needs.  Because they are considered “safe”, no capital is required for banks to hold U.S. Treasury securities.  As long as the Fed promises to keep the Fed funds rate at 0%, the large banks can “borrow” from each other, from the Fed, or from the public (via deposits) at a near 0% rate and buy the 10 year “riskless” T-Note at 3%.  Why should they make risky loans to the private sector which require additional capital on the balance sheet?  Of course, the artificially “low” deposit rate is borne by the public; this is simply a continuation of the big bank bailout.
  • Changes in state and local government finance are already manifesting themselves in reductions in force (i.e., layoffs), changes in wage and benefit policies, higher employee pension contributions, lower COLAs, and higher taxes and fees on the general population.  All of these actions dampen consumer demand.  It appears from the political climate that voters, at least at the local level, will make sure that their elected officials continue to reduce the cost of government.  And, it is likely that the electorate will send a clear message about trillion dollar deficits, about unchecked entitlement spending, and about general profligacy by Congress at the upcoming mid-term elections.

Bear Markets

In the 20th century, in the investment arena, there were three bear markets.  They ranged in duration between 13 and 20 years with an average of 17 years.  The current bear market started in 2000; so, if history is any guide, this one won’t be over until sometime between 2013 and 2020.  Given the fact that the consumer is just beginning to repair his balance sheet, and given the lateness in policy maker recognition that more debt (or money thrown from helicopters) is not the answer, 2013 looks to me to be optimistic.

For the next few years, given the debt constraints on U.S. consumer budgets, the continued high unemployment expectation, the inevitability of growth slowing tax increases, the poor state of housing, continued high write-offs at financial institutions and their capital constraints, and the horrible condition of state and local government finances, it is really difficult to make any kind of a case for healthy economic growth.  Without such growth, equity markets cannot help but languish, like they have for the past 10 years, at least until the time that consumer balance sheets have healed.  There is simply no way around this; and the sooner that policy makers recognize this (like they apparently have done in Europe), the better.

Portfolio Allocations

While we wait for such healing, maybe several years, investors need to adopt an attitude such that “return of capital” is paramount, and “return on capital” is secondary.  Allocations to bonds should be extraordinarily high, say in the 50% to 60% range.  Be selective.  Pick companies with large cash positions, high levels of free cash flow, low debt and ones without unfunded pension liabilities.  Pick muni bonds in a similar way.  Avoid the tendency to move to longer durations for more yield.  While the economics say that low interest rates will be with us for a long time, misguided economic policies, including money thrown from helicopters and structural trillion dollar deficits may cause a loss of confidence in the dollar and in Treasuries resulting in rising interest rates.  Of course, a liberal position in precious metals also protects against such policy blunders.  Bear markets also call for smaller allocations to equities, perhaps as little as 25%.  Again, be selective as indicated above.  Also, choose companies with solid and growing dividends; make sure those dividends are not in any danger of being cut.

Robert Barone, Ph.D.

July 15, 2010

The mention of securities or types of securities in this article should not be considered as an offer to sell or a solicitation to purchase any securities mentioned.  Please consult an Ancora West Investment Professional on how the purchase or sale of securities can be implemented to meet your particular investment objectives goals. Investments in precious metals and similar securities or commodities are subject to risks.  It is important to obtain information and understand these risks prior to investing.

Statistics and other information have been compiled from various sources.  Ancora West Advisors believes the facts and information to be accurate and credible but makes no guarantee to the complete accuracy of this information.
Ancora West Advisors LLC is a registered investment adviser with the Securities and Exchange Commission of the United States.  A more detailed description of the company, its management and practices are contained in its registration document, Form ADV, Part II.  A copy of this form may be received by contacting the company at: 8630 Technology Way, Suite A, Reno, NV 89511, Phone (775) 284-7778.

July 23, 2010

They Call This Financial Reform!

Posted in Banking, Big Banks, Bonds, Capital, crises, Finance, investment advisor, investments, San Francisco, Uncategorized tagged , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , at 6:24 PM by Robert Barone

While the financial reform bill passed and will soon be the law, it is hard to comment on any specifics because the real laws have yet to be written.  Normally, when Congress passes new legislation, it is pretty specific in its intent, and Congress leaves it up to those who must enforce the laws to write rules and regulations clarifying Congressional intent.  This time, however, Congress was extremely vague in many areas, giving non-elected bureaucrats carte blanche to write rules and regulations which will become the law!  Still, despite not knowing exactly what we will get, it is possible, at this time, to determine some winners and losers.

Winners & Losers

There are some big winners: lawyers and lobbyists; folks in Congress who will be consulted regarding what the rules and regulations should say; and those who want yet bigger government.  There is a group that will, most likely, come out neutral: Wall Street and the “Too Big To Fail”.  Then there are the losers:  community banks, small businesses, the taxpayer, and those who believe in free markets.

Lawyers and lobbyists will now earn megabucks trying to influence what the rules and regulations (at least 243 of them) will say and to carve out exceptions for their clients.  Imagine the political donations that will now flow to Congressmen who are influential with those non-elected bureaucrats who are now crafting the language.  Wall Street, which has recently pulled back on its political contributions, can be expected to flood Washington with money in order to insure that rules and regulations surrounding such things as the Volcker Rule (proprietary trading) and derivatives do not have a large negative impact on how they currently operate.  At this writing, while I can’t say for sure they will be successful, but having observed the system for many years, I would bet heavily in favor of Wall Street.  This particular piece of legislation will further concentrate the financial system and strengthen what I have referred to in other writings as the “Unholy Washington-Wall Street Alliance”. (For a complete discussion, see www.ancorawest.wordpress.com/2010/06/, the blog entitled The Symbiotic Washington-Wall Street Alliance, June 2, 2010, also published on as The Washington-Wall Street Alliance at www.TheStreet.com on June 1, 2010).

Community banking and small business are the biggest specific losers.  Even prior to this legislation, community banks have been under huge regulatory stress and most now have capital constraints.  But even those with the ability to lend have determined that, with loan loss reserves required against newly made loans and capital required as a cushion, it simply isn’t worth it – just buy Treasuries, which require no loss reserves or capital.  And that appears to be what Washington wants, as it needs every outlet it can find for its burgeoning debt.

The financial reform bill now puts in place yet another regulatory agency, the Bureau of Consumer Financial Protection.  One can be sure that the regulations emanating from this new agency will put a burden on community banks equal to that of Sarbanes-Oxley whose cost, in the middle part of the last decade, had a huge negative impact on their earnings.  As the regulatory noose tightens, small businesses, which have historically relied on community institutions and on the now defunct shadow banking system (non-bank lenders) for much of their credit needs, will continue to face an ongoing credit crunch.  That’s bad news for private sector job creation.

Causes of the Financial Crisis

The initial purpose of the legislation was to address the causes of the ’08 financial meltdown.  Does this legislation adequately address those issues?  There were many contributing factors to the financial crisis, but most agree that three major ones were the sub-prime issues, the overleveraging of capital in the banking system with its attendant “Too Big To Fail” government policy, and the role of the Federal Reserve’s easy money policies of the past 15 years. Let’s look at each of these.

Fannie & Freddie

Fannie Mae (established 1937) and Freddie Mac (1970) operated profitably for most of their lives.  It is widely recognized that it was Fannie’s and Freddie’s forays into sub-prime, at the insistence of the Congress that really fueled the sub-prime bubble.  Without their purchases of sub-prime mortgages, the bubble could not possibly have developed.  Yet, despite the role of Fannie and Freddie, and despite a government conservatorship that is costing the taxpayers about $10 billion each month, not a single word in the 2300+ pages of this legislation deals with these monstrosities.  Think about this: with the complete control of Fannie, Freddie and the FHA (now too approaching insolvency), which are now responsible for 95% of all mortgage originations, with the government’s power, influence over, and alliance with Wall Street, with a new consumer agency that can and will regulate such things as the fees levels on Visa and Mastercard interchange (and, I suspect, eventually such things as ATM fees and other bank service charges), and with their tentacles now edging into the insurance business via this legislation, the whole U.S. financial system is now or will soon be under government control.  Most call this socialism.

Too Big To Fail

On the “Too Big To Fail” front, instead of hard and fast rules about size (either absolute or market share) and capital, the bill establishes the Financial Stability Oversight Council which will “monitor” systemic risks and has the authority (2/3rds vote of its members) to take over and wind down any institution deemed “too risky”. (Whatever happened to due process?)  The Treasury had a similar group prior to the ’08 crisis, and it, along with all of the other government agencies, failed to see the growing systemic risks.  What makes anybody think this group will be any better? And, given that they are composed of agency heads, it is likely that they will be politically influenced.

Furthermore, like the “bazooka” the Congress gave to Hank Paulson in ’08 with the idea that since it existed it would never have to be used (until it was), this solution guarantees that it will be used in the future, and it will be taxpayer money that winds down a mega-bank that decided to take excessive risks in order to earn (and reward themselves with) excessive returns.  On the other hand, if size limits and/or capitalization requirements were appropriate, the government would never need the bazooka.  If institutions never got “Too Big”, then the market could absorb a failure without systemic issues, just as it does every week when the FDIC closes its given allotment of community institutions.

The Fed’s Failures

The Fed, which failed so miserably at seeing the crisis, even when we were in the middle of it (Bernanke, in March ’07, said that sub-prime had been contained) was rewarded by becoming the regulator of all large financial institutions.  In effect, it can now lend money to any institution it deems could cause systemic issues.  In the 1930s, Congress added a mandate to the Fed’s mission, which up until that time had only been “price stability”.  The 1930s mandate added the full employment objective.  Despite the fact that they neither saw the crises coming nor have they been able to accomplish their employment directive, the Congress has now added a third mandate, “financial stability”.  The Fed is not, strictly speaking, a government agency.  It is owned, and some say controlled, by the banking system (the Wall Street banks).  It resists audits and operates in secrecy.  Its easy money policies of the past 15 years contributed as much as any other factor to the financial meltdown.  And to this entity, the Congress has granted considerably more power!

Conclusion

The financial reform legislation solves none of the issues that caused the ’08 financial meltdown.  It completely ignores the Fannie Mae and Freddie Mac cancers.  It institutionalizes “Too Big To Fail”.  It puts a taxpayer safety net under any mega-bank that wants to over leverage.  And it rewards the Fed for its role in the bubble and its failure to even have a clue that Armageddon was upon us.

Robert Barone

July 19, 2010

Ancora West Advisors LLC is a registered investment adviser with the Securities and Exchange Commission of the United States.  A more detailed description of the company, its management and practices are contained in its registration document, Form ADV, Part II.  A copy of this form may be received by contacting the company at: 8630 Technology Way, Suite A, Reno, NV 89511, Phone (775) 284-7778.

July 9, 2010

Bailouts

Posted in Banking, Big Banks, Bonds, Capital, crises, Finance, investment advisor, investments, San Francisco, Uncategorized tagged , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , at 8:59 PM by Robert Barone

The words “Maiden Lane” evoke two completely different reactions when they are spoken at family get-togethers, like July 4th:  1) Great joy and excitement on the part of the female family members imagining a shopping spree at San Francisco’s famous Union Square where a street named “Maiden Lane” sports several high end boutiques; 2) Disgust on the part of the family members involved in the financial sector, as “Maiden Lane” is the name of three LLCs established by the Federal Reserve Bank of New York (FRBNY) and used as vehicles to bailout Wall Street.

“Bailouts” seem to be the norm nowadays, not the exception.  Today, the Fed’s balance sheet is pregnant with the results of such bailouts.  Maiden Lane, LLC, the first one established in March, 2008, to bail out the stock and bond holders of Bear Stearns, holds substandard collateral valued at $28.4 billion.  As of July 1, 2010, no cash has flowed to the Fed from this collateral; so imagine how substandard this collateral must be.  The Fed says it values the collateral at “fair value”, which it defines in its footnotes as “the price that would be received upon selling an asset if the transactions were to be conducted in an orderly market” (Federal Reserve Statistical Release H.4.1, 7/1/10, Table 4).  This could be Fedspeak for “mark to model”.

Maiden Lane II, III, AIA Aurora, and ALICO Holdings are the collateral now on the Fed’s books associated with the AIG bailout.  Note that the collateral, valued again at “fair value” ($64.4 billion), is far less than the $182 billion it took to save AIG.  As a reminder, the FRBNY, for reasons known only to God and a few other god-like individuals, decided to pay AIG’s credit

Table 1: Selected Balance Sheet Entries Federal Reserve Consolidated Statement, 7/1/10

Fed Balance Sheet Entry Bill $ Comments
Maiden Lane, LLC $28.4 Guarantee to JPM of Bear Stearns’ portfolio
Maiden Lane II, III $38.9 Current carrying values of collateral for AIG bailout Part I
AIA Aurora &

ALICO Holdings

$25.5 Current carrying values of collateral for AIG bailout Part II
Total $92.8

default swap counterparties at par despite the fact that the market value was closer to 40%-60% of par (for a complete discussion of the circumstances surrounding these decisions, see The Unholy Washington-Wall Street Alliance, at https://ancorawest.wordpress.com/2009/11/, written in November, 2009).  Table 2 shows who benefitted.  Note that foreign banks received $48.2 billion.  If the assets they held were worth 60% of par value (as AIG was certain to fail), America’s taxpayers involuntarily gave these foreign banks a gift of more than $19 billion.

Table 2: Major Recipients of Par Payment of AIG’s Credit Default Swaps

Foreign Banks Bill $ American Banks Bill $
Societe Generale $11.9 Goldman Sachs $12.9
Deutsche Bank $11.8 Merrill Lynch $  6.8
Barclays $  8.5 Bank of America $  5.2
UBS $  5.0
BNP Paribas $  4.9
HSBC $  3.5
Dresdner $  2.6
Total $48.2 Total $24.9

Table 2 also shows that three major American institutions received $24.9 billion of which $10 billion was a gift from an unaware American taxpayer. (It should also be noted that States received $7 billion as holders of AIG paper.)

The Fed’s Venture into MBS

Looking further into the Fed’s balance sheet, there is an entry for $1.1 trillion of mortgage backed securities.  These are not carried at market values.  The Fed says these are carried at the “current face value of the securities which is the remaining principal balance of the underlying mortgages”.  The reason that the Fed gives for carrying them at face value is that they are “guaranteed by Fannie Mae, Freddie Mac, and Ginnie Mae” (H.1.4, 7/1/10, footnote 4).  As a result of not reporting these at market value, the quality of these assets is unknown.  But, what we do know is that Fannie Mae and Freddie Mac are bankrupt.  Late last December (Christmas Eve day), the Treasury announced that they would guarantee Fannie and Freddie debt through 2012.  Without knowing whether such a guarantee will be continued after 2012, it doesn’t appear appropriate to be carrying such mortgages at face value and relying on the bankrupt institutions’ guarantees.  (At this time, it appears that continuing Congressional support is likely, but it isn’t certain, and 2 years can be a long time in the political arena.)  What would the accounting profession and the SEC do to a listed company that carried debts of financially troubled companies at face value when market values exist?

The Ultimate Cost of Fannie and Freddie

Since Fannie and Freddie have now appeared in the discussion, the American taxpayer, to date, has contributed $145 billion to their support.  Technically, Fannie and Freddie have borrowed these funds at a 10% interest rate.  The $14.5 billion annual interest bill amounts to more than their combined revenue streams in their best years.  Estimates for the eventual cost of Fannie and Freddie vary between $290 billion and $1 trillion.  Given the state of the housing industry and its prospects for the next few years, the higher number appears to be more realistic.  Table 3 is a tally of the bailouts to date.  While taxpayers might get some of this back via the collateral and perhaps some eventual debt repayment, most of this is a loss. That is, a loss to taxpayers.

Table 3: Tally of Bailouts

Bill $ Comments
Bear-Stearns $    29
AIG $  182
FNMA & FHLMC $1000 $145 to date
Citigroup $  306
TARP $  490 Out of $700
GM & Chrysler $    57
Total $2064

Such losses should have been taken by the stock and bond holders of the financial institutions, the auto companies, and holders of Fannie and Freddie debt (including foreign holders like the government of China).  While on the hook for these bailouts, American taxpayers have received no direct benefits.

A Better Use of Bailout Funds

It is nearly universally agreed that housing led the way into the current economic morass (some blame the Fed for overly easy money and the Congress for pushing Fannie and Freddie to make mortgage loans to those who couldn’t afford them).  Yet, even after the bailouts, CoreLogic reports (February, 2010) that 24% of all homes with mortgages (confirmed in May by Zillow’s 23% estimate) are underwater.  According to CoreLogic, that’s 11.3 million of the 47 million homes.  With no home equity to tap, any underwater homeowner who becomes unemployed or underemployed or has an emergency is highly likely to face foreclosure.  And, in many cases, people who can afford their payments are opting for “strategic defaults”, i.e., just walking away.

Note who benefitted from the taxpayers’ $2 trillion financed bailout – it certainly hasn’t been the taxpayer himself.  In his July 5th daily Breakfast with Dave blog, David Rosenberg of Gluskin/Sheff indicated that “the amount by which mortgage balances exceed the value of real estate for those in default or near-default could be as much as $2 trillion”.  What if the $2 trillion used for the bailouts had been used to directly benefit underwater homeowners and the financial institutions at the same time?  If, instead of giving the money to Wall Street, each of the 11.3 million underwater homeowners received, on average, a $182,000 reduction on their mortgage, the housing market wouldn’t be in the state it is in today.  (Process: Homeowners apply for the difference between their mortgage balance and an appraisal; Treasury sends the pay down directly to the financial institution.)  This could have prevented most foreclosures and strategic defaults and could have energized the housing market.  Both taxpayers and the financial institutions could have directly benefited.

Some will object that this favors that certain population segment that made a judgment error and took on too much debt.  I argue that this segment is victimized by economic conditions in the same way as those who lose their jobs during recessions are victimized by economic conditions.  This year, we are giving the unemployed $14 billion in unemployment benefit disbursements (BLS forecast, May, 2010).  Furthermore, “earmarks” on legislation channel taxpayer funds to the benefit of very narrow and specific groups.  So, the singling out of a segment of taxpayers to receive benefits isn’t something new.

JPM’s Generosity

In June, one of my clients was forgiven a substantial portion of the loan on his primary residence by JPMorganChase (JPM).  It appears that JPM is doing this for the sub-prime and Alt-A loans it inherited from its FDIC assisted purchase of Washington Mutual (WaMu).  In my client’s case, a $250,000 principal reduction was given on a $937,000 principal balance (originally owed to WaMu).  The mortgage holder did not communicate with JPM or ask for any consideration, and had always been current on the loan.  The existing interest rate was 2.5% (variable rate loan).  In exchange for the principal reduction, JPM asked for a 5.0% fixed rate 25 year amortizing loan.  The client’s monthly payment stayed the same.

Recall that JPM received a large amount of FDIC assistance.  (While FDIC insurance funds are technically not directly from the taxpayer, they are indirectly, as banks raise their fees to pay for regulatory expenses.)  This action by JPM appears laudable.  After all, the shareholders of JPM appear to have gained from FDIC assistance.  So, some give back appears appropriate.  However, let’s not so quickly attribute this to JPM’s generosity.  JPM “purchased” WaMu’s assets at a huge discount to face value.  While I do not know the exact terms, let’s, for the sake of this example, assume 60% of face.  So, JPM was holding my client’s mortgage on its books at a $562,000 value.  Under accounting rules, JPM could only recognize a “profit” after my client had first paid down the $562,000 carrying value.  That would be 12 years away at the current payment.  JPM knows this homeowner is underwater, and, while they probably wouldn’t lose money if a foreclosure occurred, they would have foreclosure expenses and market wait time.  But, by forgiving $250,000 of the $937,000 balance (or 27%) but doubling the interest rate, JPM immediately recognizes more interest income on its financial statement (i.e., 2.5% of $937,000 = $23,425 while 5.0% of $687,000 = $34,350).  In addition, my client can now sell that home at market (about $800,000).  If the home does sell, the client ends up with some equity, and JPM recognizes an additional $125,000 in income ($687,000 principal balance less $562,000 carrying value).  No foreclosure.  No downward pressure on the neighborhood’s home prices.  Everybody wins!

The way the bailouts were done, it takes this kind of circumstance to actually get an appropriate outcome.  Had the $2 trillion in bailout funds been used to benefit the underwater homeowners to begin with, I doubt the housing market would be in its current funk.  As a nation now committed to bailouts, the operative rule ought to be, “any use of taxpayer money must directly benefit taxpayers”.

Robert Barone, Ph.D.

July 6, 2010

The mention of securities or types of securities in this article should not be considered as an offer to sell or a solicitation to purchase any securities mentioned.  Please consult an Ancora West Investment Professional on how the purchase or sale of securities can be implemented to meet your particular investment objectives goals.

Statistics and other information have been compiled from various sources.  Ancora West Advisors believes the facts and information to be accurate and credible but makes no guarantee to the complete accuracy of this information.

Ancora West Advisors LLC is a registered investment adviser with the Securities and Exchange Commission of the United States.  A more detailed description of the company, its management and practices are contained in its registration document, Form ADV, Part II.  A copy of this form may be received by contacting the company at: 8630 Technology Way, Suite A, Reno, NV 89511, Phone (775) 284-7778.

July 6, 2010

Prepare for Bargains

Posted in Banking, Big Banks, Bonds, Capital, crises, Finance, investment advisor, investments, San Francisco, Uncategorized tagged , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , at 5:43 PM by Robert Barone

The bond market knows it.  The equity markets now appear to have an inkling, but haven’t quite digested all the facts.  I am talking about the almost certain economic growth slowdown or the high and rising probability of a double dip (the economy falling back into recession).  The last time we had a growth slowdown was in the fourth quarter of ’02.  The recovery was somewhat perky in early ’02, but by the fourth quarter, Real GDP growth was essentially non-existent (+.08).  Technically, the economy didn’t double dip.  In the post-9/11 economy, the equity markets, as measured by the Dow Jones Industrial Average (DJIA), peaked at 10,635.25 on March 19, ’02, the same quarter as the peak in the economic growth rate.  The DJIA then fell a total of 31.5% to 7,286.27 (October 19, ’02), reaching its trough in the same quarter as the trough in economic growth.  Using end of quarter data, Table 1 shows that the DJIA fell 11.2% in the first quarter of slowing growth, and another 17.9% in the next slower quarter.

The current situation has similar characteristics, at least, so far.  Fourth quarter ’09 GDP grew at a 5.4% rate, but growth slowed in the first quarter of ’10 to 2.7% and, given the data presented in this paper, is likely to have slowed further in the second quarter.   And the market has followed a similar pattern, peaking early in the second quarter at 11,205.03, and standing, at this writing (June 29), after one quarter of slower growth, some 11.9% lower.  Note in the table that in the first quarter of growth recession in ’02, the market fell 11.2%, and as growth continued to recede, losses mounted.  If current growth continues to slow or actually turn negative, then, using the ’02 experience, the market would fall to somewhere around 7,675.  While I can’t say for sure where the market is going, I do know from the data presented below, that this economy appears to be significantly weaker than the economy was in ’02.

Table 2 is a comparison of selected economic indicators in today’s economy and that of the fourth quarter of ’02, during the height of that era’s growth recession.  As can be seen from the table, except for manufacturing ( a relatively small part of today’s U.S. economy), all other indicators are significantly weaker.

Let’s begin with housing.   There is no doubt that it is tanking again after the expiration of the first time homebuyers’ tax credit.  It appears that the government’s cash giveaway programs only serve to pull demand forward.  This was evident in “cash for clunkers”, and it certainly

Table 1: Economic Growth and Market Performance

Date Real GDP Growth rate % Change in DJIA Date Real GDP Growth rate % Change in DJIA
12/31/01 1.4% 13.3% 09/30/09 2.2% 15.0%
03/31/02 3.4% 3.8% 12/31/09 5.4% 7.4%
06/30/02 2.1% -11.2% 3/31/10 2.7% 4.1%
09/30/02 2.0% -17.9% 6/29/10 ? -11.9%
12/31/02 0.1% -4.0% (10/09/02)

Table 2: Comparison of Current Situation to ’02 Growth Recession

Economic Indicator Current ’02 Experience
Housing Starts 590k  (May/10) 173k (IV/02)
New Single Family Sales 300k (May/10) 1026k (IV/02)
ISM Manufacturing Index 59.7 (May/10) 49.7 (IV/02)
Motor Vehicle Production Index 73.1 (May/10) 102.3 (IV/02)
Mining Oil & Gas Production Index 170.8 (May/10) 96.2 (IV/02)
Capacity Utilization Index 74.7 (May/10) 75.0 (IV/02)
Capital Spending as a % of GDP 9.4% (I/10) 10.2% (IV/02)
10 Year Treasury Yield 2.96% (June 29, ’10) 4.0% (IV/02)
Fed Funds Rate .2% (June/10) 1.44% (IV/02)
Federal Deficit as a % of GDP 8.8% (I/10) 3.2% (IV/02)
Unemployment Rate (U3) 9.7% (May/10) 5.9% (IV/02)
Unemployment Rate (U6) 16.6% (May/10) 9.4% (IV/02)
Help Wanted Index 10.0 (May/10) 39.7 (IV/02)
Charge-Offs – residential 2.39% (I/10) 0.14% (IV/02)
Charge-Offs – total 2.96% (I/10) 0.95% (IV/02)
Commercial RE Delinquency Rate 8.60% (I/10) 1.61% (IV/02)
Total Loan Delinquency Rate 7.36% (I/10) 2.57% (IV/02)

appears to be the case in housing.   New home sales in May fell 33% to an annual rate of 300,000.  This is the lowest in recorded history dating back to 1963.  The previous low was 341,000 in April, ’09, at the height of the financial crisis.  The chart of this series from ’05 on is truly breathtaking.  The line looks like a 60 degree cliff with a low level plateau in ’09 and then a resumption of the precipice.  The median price of homes is down 10% from last December, and a new home sold in May had been sitting in builder inventory for a record 14 months.  Further, building permits, a leading indicator of future housing activity, fell nearly 6% in May from April.  A huge percentage of Americans are upside down on their mortgages; bank charge-offs of residential mortgages set new records every quarter.  And, the resetting of a record number of 5/1 ARMS and Alt-A loans over the next two years will continue to push foreclosures higher.

The community banks, and especially the 791 on the FDIC’s endangered list, will continue to bleed as the Real Estate depression continues.  With no end in sight for foreclosures, and with consumption and income flat to down, commercial real estate will also continue in the doldrums.  Note the Commercial Real Estate Delinquency Rate shown in Table 2.  Because they hold high levels of these impaired loans in their portfolios, the capital levels at community banks is severely constrained, and they have little capacity to loan.  Thus, small business, the engine of job creation in the U.S., continues to face a credit crunch.

No wonder the unemployment rate remains stubbornly high.  As can be seen in Table 2, both measures of unemployment are significantly higher than they were at the end of ’02.  If memory serves, the growth recession back then was said to be caused by a “jobless recovery”!

Recently, Congress failed to extend unemployment benefits beyond the current 99 weeks (that’s almost 2 years!), so the consumption available from those benefits will no longer occur.  The anti-business policies of the Obama Administration (higher taxes, higher health care expenses, increasing regulatory burden, etc.) serve to depress hiring.   In May, the private sector created only 41,000 jobs; because of demographics 125,000-150,000 are needed just to keep the unemployment rate constant.

State and local governments will also be putting upward pressure on the unemployment rate.  The public has become acutely aware of the large discrepancy between public sector wages and benefits and those of the private sector.   With voters up in arms, tax revenues tanking in many localities, and unions unwilling to give back previously negotiated wage and benefit gains, layoffs appear to be the only solution.

As stated above, the industrial and manufacturing portion of the economy appears to be the strongest.  Unfortunately, the turmoil in Europe will certainly impact exports as government austerity programs take hold and the dollar strengthens relative to the euro.  Mining and energy industries appear to be doing well.  But auto production, relative to the ’02 experience, is in the doldrums.  This isn’t really news given flat incomes and high debt levels of consumers.

In the bond market, the yield on the 10 year Treasury has fallen to below 3% from over 4% in early April.  So, it is over 100 basis points lower today than it was in IV/02, at the end of that era’s growth recession.  A good argument can be made that today, we are just entering a growth slowdown period, so the 10 year yield may fall even further.

In its May Federal Open Market Committee press release, the Fed downgraded the language characterizing the economic recovery.  In addition, a study by the San Francisco Fed concluded that it is unlikely that the Fed will raise the fed funds rate until at least 2012, maybe later.  Thus it appears that the central bank see a growth slowdown coming.

Art Laffer recently wrote an op-ed piece in which he said that the Reagan tax cuts passed in 1981 were delayed until 1983.  As a result, in 1982, the recovery was flat as entrepreneurs held back on economic activity until they could take advantage of lower tax rates.  And, in 1983, economic growth exploded.  Laffer says the opposite is about to take place.  Knowing that tax rates will be going up in 2011 (Bush tax cuts expire), entrepreneurs will pull forward as much economic activity as possible into 2010, and 2011 will feel the consequences.

With the Fed funds rate near zero, the federal budget deficit at $1.5 trillion and more than 10% of GDP, the widely held perception that the “stimulus package” did not work, and with the public up in arms over structural deficits, it appears that the arsenal of policy tools is nearly empty.  Only quantitative easing (i.e., money printing) is still available to the Fed.  Thus, there appears to be little on the horizon that could reverse any of the trends discussed herein.  As the reality of a growth slowdown sinks in, the equity market could react badly, as it did in ’02.  Usually, the underlying trends fester for awhile, and then an event triggers a rush to the exits.  Markets, of course, always overreact.  So, I expect we will see bargains in equities in the next few months.

Robert Barone, Ph.D.

June 29, 2010

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