Tuesday, June 30, 2009

June 30 2009: Make the trends your friends

Detroit Publishing Co. 2 cents a glass 1906
Hot dogs 3 cents each or two for a nickel; lemonade 1 and 2 cents a glass
Lunch carts on Broad Street, New York

Ilargi: A lot of press today for the states budget situation. The main focus is California, but there's a group of states not far behind. Arizona, Indiana, Mississippi and Pennsylvania had not agreed on their budgets either. What this all means will differ from state to state, some will arrive at last minute deals, while others will have to try and oversee the legal implications. State governments may have to be shut down, and there are other things that automatically come into effect when the clock strikes midnight, likely different ones in each state. Indiana hasn't missed a budget deadline since the Civil War, while California may not have made one since then. As I said before, it's hard to predict what will happen; a fair amount of chaos seems assured.

One thing I read today made something I wrote about yesterday a lot clearer, on the topic of what the California IOU's will be worth that the state starts printing in a few hours. They're not money.
Merle Thompsen, a landscaping contractor in Reseda, Calif., says he now considers himself fortunate that he didn't win any bids recently to provide services at state facilities. Thompsen says he remembers the last time the state issued IOUs, contractors were given the option of continuing to work or halting projects.

Stopping the work is usually more complicated, requiring contractors to stabilize the site before they leave. "That costs the state more money," he says. "It's almost easier to keep working." Thompsen says he also remembers a secondary market developing where independent financial firms offered to cash in the IOUs for a fee of anywhere from 6% to 20% of the note's value. "It's expensive," he says.

We'll see about all that tomorrow and after.

I had another one of those great headline laughs early this morning, and a few more as the day progressed. Now, I still see BusinessWeek and Bloomberg as reputable news organizations. They may have strayed a bit much lately, but if they’d want to get real, they have the staff and the budget to do so. So I was surprised to see these two headlines literally side be side:

BusinessWeek -
German unemployment declines in June
Bloomberg -
German June Unemployment Rises to Most Since 2007

Soon after that, I saw the following two headlines, somewhat less of a direct contradiction, and not directly due to bungling reporters, but still comedy material:
Financial Times -
UK economy shrinks most in 50 years
Bloomberg -
U.K. Consumer Confidence Increased to 14-Month High

I noticed something funny about this from Bloomberg as well: US Consumer Confidence Fell in June ("unexpected" of course). There was a line in the report that I had to look at twice; see for yourself what the confidence index is based on:
”The percentage of consumers anticipating more jobs in the months ahead decreased from 19.3% to 17.4%, while those anticipating fewer jobs increased from 25.6% to 27.3%."

Did you see that? US unemployment last month rose by 787.000, to a 9.4% rate. The president some two weeks ago said the rate will break through the 10% barrier not late in the year, as he had said merely ten days prior, but "in the next few months". In other words, jobs will be lost, there is no doubt about that whatsoever, none.

Still, only about 1 in 4 Americans anticipate that simple fact, whereas 1 in 5 actually expects more jobs, not less, as even the president does. Over 70% of the American population seems to have no idea what is going on in their country, what has been going on for many months now, and what every single survey says will continue, albeit according to some at a lesser pace.

Sometimes I think this sort of disconnect with what's truly happening has a direct link to the green shoots type of hollow optimism that is to reality what credit is to money. They look about the same, but they're not. One is real, the other isn't.

And perhaps a similar thing is going on with Robert Shiller and his comments today on his own Case-Shiller Index.

Here's something to remember about home prices and the perceived bottoms. Today's Case-Shiller Index reports an 18.1% drop from April 2008. Which is slightly less than the 18.7% annual drop in March. Hence, yes, there will be people calling for a bottom, and they may not even be explicitly lying. BUT: Even if home prices never again fall more than 18.1% annualized, they may still fall 17.5% in April 2010 from numbers reported today. And that will mean that in absolute terms, a home today worth $200.000 will then be worth $165.000, and the owner will have lost $35.000.

Even if there's a bottom in the rate at which prices drop. And anyway, these price drops need perspective: in absolutely dollar numbers, a home would have lost less the past year than the year before even if the percentage had remained the same, since 18% of 100% is more than 18% of 82% (100-18%). Home prices will never go to absolute zero (though they will be close). So the graph of dropping prices will have to move to a point slightly above the x-axis (time) as events progress. Just like this:

Which means prices can't just keep plunging like stones, and expecting them to do so is a mistake. They will follow a downward slope like the one in the graph, where the drop continues long after the largest monthly drop has past. After that point, they can still fall far more than the approximately 34% they have fallen until now. As a matter of fact, I’d say that is inevitable, given what we see with regards to inventory, foreclosures, ARM resets, job numbers and a slew of other indicators.

That's why I am puzzled by Shiller's comments today:
"My guess would be that home prices are going to level off -- they’re not going to keep falling,"

Really? Here's the graph of Professor Shiller's very own index:

Why would the decline stop now, with prices at 2003 levels? And with so many issues, both in real estate and in society at large, unsolved? If and when prices fall hard and fast and the president hands out $8.000 -$15.000 per home purchase (with states adding their share), and goes on TV twice a week saying that the worst is past, then yes, some people will try to buy homes. But take all that away, and what will still be sold? It would make an abrupt halt at 2003 levels highly improbable, for one thing.

Watching Shiller's graph, I am looking at 1997-98 price levels, the far end of a decade long stable trend. And then I see prices at the latest by 2012 breaking through those levels to the downside.

I'm also wondering what is to become of a society where professors become cheerleaders. Then again, he's not just a professor anymore. Don't let's forget that Shiller now has a -substantial- financial interest in how things develop in the real estate market. He started a securities fund today:
"This economic crisis is substantially due to a failure to manage risk adequately," he said. "This is an opportunity to manage these risks." The MacroShares Major Metro Housing Up, an exchange-traded fund that tracks the cumulative change in the S&P/Case-Shiller Composite-10 Home Price Index, started trading today on the New York Stock Exchange[..]

No sign of California budget with deadline approaching
Despite a deadline looming tonight, Gov. Arnold Schwarzenegger and the Legislature were at a loss Monday over how to close the state's massive deficit, and there were no signs a compromise would be reached soon. If no plan is adopted by 12:01 a.m. Wednesday, the state plans to issue IOUs to contractors, vendors, local governments and taxpayers expecting refunds beginning Thursday. The governor plans to force 220,000 state workers to take a third unpaid day off beginning in July; and the state will forfeit more than $3 billion in budget savings through cuts to education that had to be made in the fiscal year ending today.

Before the Legislature adjourned late Monday, Democratic leaders had scrambled to pass a plan to solve the impending insolvency of the Golden State, but the governor fired back, insisting he would not support their budget bills because they included taxes and not enough spending reductions to close the $24.3 billion deficit through June 2010. "I will veto any majority-vote tax increase bill that punishes taxpayers for Sacramento's failure to live within its means," Schwarzenegger said Monday.

Missing tonight's deadline also means the governor and the Legislature would have to come up with about $3 billion in additional budget solutions. That's because in the accounting of competing budget plans by Schwarzenegger and the Democrats both include cutting education spending by about $3 billion in the 2008-09 fiscal year that ends tonight. Simply rolling over the same amount in cuts in the new fiscal year for education would be impossible without suspending the state's constitutional funding requirements under Proposition 98 and losing $10 billion from the federal stimulus package, which requires states to spend a certain amount for education.

Late Sunday, the state Assembly approved a Democratic 14-bill budget package in a simple-majority vote that included a controversial scheme to raise taxes on oil production and tobacco products and reduce an 18-cent state excise tax on gasoline at the pump. Democratic lawmakers then voted in a simple majority vote to raise a new 18-cent fee on gas for local transportation projects. The state Senate passed similar measures Monday over Republican objections that such a proposal is illegal.

But three bills that would immediately help alleviate the state's cash crunch, such as current-year cuts in education and delaying certain payments to schools, were stuck in the Senate without Republican support. The three bills need two-thirds majority support so they can go into effect immediately, rather than 90 days, and while Assembly Republicans supported the bills, GOP lawmakers in the Senate refused to vote for them. Meanwhile, Democratic leaders criticized Schwarzenegger for demanding program changes to address fraud in home health services and welfare-to-work programs for single mothers as part of the budget compromise.

Senate President Pro Tem Darrell Steinberg, D-Sacramento, and Assembly Speaker Karen Bass, D-Baldwin Vista (Los Angeles County), said the governor was demanding the program changes in exchange for his support on the three bills to delay the state's cash crunch by about a month. "I'm a reasonable person, and Karen Bass is a reasonable person. We negotiated an even harder agreement with the governor and the Republicans back in February" to close a $42 billion shortfall, Steinberg said. "But the idea that 'Give me all my reforms, and I will sign (the three bills for) $4 billion in temporary measures?' That's not going to get us where we need to go."

Administration officials said the governor's proposals were part of the governor's attempt at compromise, which included his agreement to scrap his plans to eliminate popular programs such as health care for poor children, a welfare-to-work program for single mothers, and cash grants to college students. "He's trying to solve our problem," said Aaron McLear, a spokesman for the governor. "He's understanding that the Democrats' main concern is the depth of our cuts. The governor has offered another way to solve our problem that does not raise taxes and alleviates some of the Democrats' concerns."

Ten States Race to Finish Budgets
Sharply Lower Tax Revenues Lead to Eleventh-Hour Wrangling, Threats of Shutdowns

Ten states were scrambling Monday to pass budgets before a Tuesday deadline, with a handful -- including Arizona, Indiana and Mississippi -- facing the possibility of partial shutdowns if their legislatures don't act in time. The number of statehouses where budget wrangling has gone down to the wire this year is unusually high, analysts said, and reflects the difficulty legislatures and governors are having coping with income- and sales-tax collections that continue to run far below already low forecasts.

Personal income-tax collections, which account for about 36% of state revenues, dropped 26% in this year's January-April period, according to data collected by the Rockefeller Institute of Government in Albany, N.Y. Sales-tax revenues also have swooned, leaving 48 states with a combined revenue shortfall of $166 billion in the coming fiscal year, according to a report released Monday by the left-leaning Center on Budget and Policy Priorities. "States are in uncharted territory," said Susan K. Urahn, managing director of the Pew Center on the States in Philadelphia, citing "both the precipitous nature and size of the drop in revenues."

All but four states begin their fiscal years on Wednesday, and all except Vermont require that their budgets be balanced. States without budgets in hand include California, Pennsylvania, North Carolina, Delaware, Illinois, Ohio and Connecticut, where Gov. Jodi Rell, a Republican, has said she will veto the budget passed by the Democrat-controlled Legislature. In California, cash is so short that the state controller says he will have to make payments using IOUs unless a budget is passed.

Indiana Gov. Mitch Daniels plans to shut down nonemergency government functions, but will continue to keep troopers on the highways and prisons staffed, said his spokeswoman, Jane Jankowski. "This is all contingency planning," she said Monday. "The governor remains extremely hopeful we will have a budget before midnight tomorrow night." The governor, a Republican, and the Democrat-controlled House have been deadlocked over issues, including education funding. Mississippi Gov. Haley Barbour, a Republican, called the Legislature into special session Sunday to deal with the budget. "Everyone should agree we have an ox in the ditch," he said in a statement.

He exempted Medicaid from the budget deliberations; financing that health program has been a key sticking point in negotiations with the Legislature. If a budget is not enacted by Tuesday night, the matter may end up in court. Attorney General Jim Hood, a Democrat, said in an interview Monday that he is prepared to sue the governor should he try to authorize certain kinds of interim spending in the absence of a budget. The state constitution allows some agencies to spend money to perform core duties, Mr. Hood said, but others would have to suspend some or all operations.

In several states, governors have yet to sign pending budgets, though analysts say they are likely to sign off soon. Many states, especially those with a history of missing budget deadlines, have systems for keeping the government running anyway, said Arturo Perez, an analyst at the National Conference of State Legislatures in Denver. "Not all states come to a grinding halt," he said, noting that some states allow governors to continue operations by invoking executive powers, while in others legislators can pass continuing resolutions to maintain spending. In Arizona, the budget battle is a fight among Republicans. Gov. Jan Brewer wants to ask voters to approve a temporary one-cent increase in the state's sales tax to help cover a $3 billion budget gap.

Legislative leaders announced Friday that a deal had been struck, when she agreed to support their plan to turn the income tax into a flat tax. But the full Legislature hadn't taken up final budget measures by Monday afternoon. The state has no official procedure for continuing government functions absent a budget. The governor has been working on contingency plans, her spokesman, Paul Senseman, said in an email Monday, adding that the Legislature has been preparing resolutions "of various scope" to continue current levels of funding for some period. What about talk of a state shutdown? "As of this hour," he said, "it is merely speculative."

States brace for shutdowns
Time is running out for the legislatures in Arizona, California, Indiana, Mississippi and Pennsylvania to solve budget gaps.

The last time Indiana missed its deadline for passing a budget and had to shut down the government was during the Civil War. But on Monday, as lawmakers raced to hammer out an agreement over school funding, state agencies began preparing 31,000 workers to be temporarily out of a job. Republican Gov. Mitch Daniels has warned residents that most of the state's services -- including its parks, the Bureau of Motor Vehicles and state-regulated casinos -- would be shuttered unless a budget is passed today.

Indiana is one of five states -- along with Arizona, California, Mississippi and Pennsylvania -- bracing for possible shutdowns this week as time runs out for lawmakers to close billion-dollar gaps in their fiscal 2010 budgets. Of the 46 states whose fiscal year ends today, 32 did not have budgets passed and approved by their governors as of Monday afternoon, according to the National Conference of State Legislatures. Although the majority of those are expected to pass eleventh-hour budgets, the fiscal futures of a handful remain uncertain, said Todd Haggerty, an NCSL research analyst. "It's a lot of states that are coming down to the wire," Haggerty said. "It's far more than we've seen in the past, and it's because of the state of the economy."

Since 2002, only five states have been forced to shut down their governments. Some of the closures were brief: In 2007, Michigan's doors were closed for four hours before lawmakers passed emergency measures that bought them time to close a $1.75-billion deficit. "What's different now is that the recession has eroded tax revenues across the country," Haggerty said. Collectively, he said, states are wrestling with budget deficits totaling $121 billion. In California, state finance officials will begin issuing IOUs on Thursday if lawmakers and the governor cannot agree on a way to close a $24-billion shortfall. The IOUs would go to local governments, vendors, taxpayers and college students receiving state financial aid. California has issued such IOUs only one other time -- in 1992 -- since the Great Depression.

In Arizona, which has never missed its constitutional budget deadline, officials are battling over how to resolve a $3-billion gap. Republican lawmakers and the state's GOP governor, Jan Brewer, fought for months over her proposal for a temporary sales tax hike to preserve some government services. In a compromise unveiled Friday, legislators agreed to ask voters to approve the tax in November. But when a key committee was unable to muster a majority Monday for the compromise bill, lawmakers began drafting resolutions that would let the government function for at least a week.

Some services would go dark right away. Over time, the number of agencies still able to operate would shrink. In Indiana, the budget fight revolves around how to allocate the state's shrinking revenues and how much of its $1.3-billion surplus fund to tap. Democrats in the state House and Senate are pushing for more spending on schools, particularly in economically troubled and urban areas. GOP legislators, on the other hand, are advocating that extra funds be directed toward charter schools and that scholarship donors to private schools be given a tax credit.

Another key sticking point is whether to help bail out the Marion County Capital Improvement Board, which manages the sports and convention venues in the state's capital. Lawmakers from outside the Indianapolis area are furious over the idea of state money being used to bridge the board's $47-million budget deficit, rather than spent in a way that would benefit more Hoosiers. By late Monday evening, after months of debate and several budget drafts, legislators left the Statehouse with glimmers of hope that they could avoid a shutdown. "No matter what, we're going to vote on something" today, said a visibly weary House Speaker B. Patrick Bauer, a Democrat from South Bend. "Will it pass? I don't know."

California's Empty Wallet: Turning Crisis into Opportunity
California State Controller John Chiang has warned that without a balanced budget in place by July 1, he will begin using IOUs to pay most of the state’s bills. On June 25, California Governor Arnold Schwarzenegger rejected a plan that would save the state $3 billion by cutting school spending, saying he would rather see the state issue IOUs than delay the funding problem with a piecemeal approach. The state’s total budget deficit is $24.3 billion. 

Meanwhile, other funding doors are slamming closed. The Obama administration has said it will not use federal stimulus money to prop up California; and Fitch Ratings, a bond rating agency, announced that it was downgrading the credit rating of the state, which already has the lowest in the nation. Once downgraded, California’s rating is likely to fall below the minimum level legally required for most money market funds, forcing the funds to sell their California bonds. The result could be a cost of millions of additional dollars in higher interest rates for the state.

What to do? Perhaps California could take a lesson from the island state of Guernsey, located in the English Channel off the French Coast, which faced similar funding problems in the 19th century. Toby Birch, an asset manager who hails from there, tells the story in Gold News:
"As weary troops returned from a protracted foreign war [the Napoleonic Wars ending in 1815], they encountered a land racked with debt, high prices and a crumbling infrastructure, whose flood defenses were about to be overwhelmed . . . . While 1815 brought an end to the conflict on the battlefront, . . . severe austerity ensued on the home front. The application of the Gold Standard meant that loans issued over many years were then recalled to balance the ratio of money to precious metals. This led to economic gridlock as labor and materials were abundant, but much-needed projects could not be funded for want of cash.

"This led to a period of so-called ‘poverty amongst plenty’. . . . The situation seemed insoluble; existing borrowing costs were consuming 80% of the island’s revenues. What was already an unsustainable debt burden would need to be doubled to fund the two most essential infrastructure projects. This was when a committee of States members was formed . . . . The committee realized that if the Guernsey States issued their own notes to fund the project, rather than borrowing from an English bank, there would be no interest to pay. This would lead to substantial savings. Because as anyone with a mortgage should understand, the debtor ends up paying at least double the amount borrowed over the long-term."

To prevent an unwanted inflation of the money supply, the Guernsey States issued the notes with a date due, and on that date the bearer was paid in gold. The money came from rents on the finished infrastructure, supplemented with a tax on liquor. Birch goes on:
"The end result of the Guernsey Experiment was spectacular – new roads, sea defenses and public buildings were established, fostering widespread trade and prosperity. Full employment was achieved, no deficits resulted and prices were stable, all without a penny paid in interest. What started as a trial led to a string of construction projects, which still stand and function to this day. Money was used in its purest form: as a convenient mechanism for oiling the wheels of commerce and development."

Like Guernsey, California is facing "poverty amidst plenty." The state has the eighth largest economy in the world, larger than Russia’s, Brazil’s, Canada’s and India’s.  It has the resources, labor, and technical expertise to make just about anything its citizens put their minds to.  The only thing lacking is the money to do it.  But money is merely a medium of exchange, a means of getting suppliers, laborers and customers together so that they can produce and exchange products.

As has been explained elsewhere, today money is simply credit. All of our money except coins is created by banks when they make loans. The current crisis stems from a credit freeze that began on Wall Street in the fall of 2007, when banks were required to revalue their assets due to a change in accounting rules, from "mark to fantasy" to "mark to market." Banks that were previously considered in good shape, with plenty of capital for making loans, suddenly came up short. Lending fell off, and so did the available money supply. 

Just understanding the problem is enough to see the solution. If a private bank can create credit on its books, so can the mighty state of California. It merely needs to form its own bank. Under the "fractional reserve" lending system, banks are allowed to extend credit – or create money as loans – in a sum equal to many times their deposit base. Congressman Jerry Voorhis, writing in 1973, explained it like this:
"[F]or every $1 or $1.50 which people – or the government – deposit in a bank, the banking system can create out of thin air and by the stroke of a pen some $10 of checkbook money or demand deposits. It can lend all that $10 into circulation at interest just so long as it has the $1 or a little more in reserve to back it up."

The 10 percent reserve requirement is now largely obsolete, in part because banks have figured out how to get around it. What chiefly limits bank lending today is the 8 percent capital requirement imposed by the Bank for International Settlements, the head of the private global central banking system in Basel, Switzerland. With an 8 percent capital requirement, a state with its own bank could fan its revenues into 12.5 times their face value in loans (100 ÷ 8 = 12.5). And since the state would actually own the bank, it would not have to worry about shareholders or profits. It could lend to creditworthy borrowers at very low interest, perhaps limited only to a service charge covering its costs; and on loans the bank made to the state, the state would ultimately get the interest, making the loans essentially interest-free. 

Precedent for this approach is to be found in North Dakota, one of only three states currently able to meet its budget. North Dakota is not only solvent but now boasts the largest surplus it has ever had. The Bank of North Dakota, the only state-owned bank in the nation, was established by the legislature in 1919 to free farmers and small businessmen from the clutches of out-of-state bankers and railroad men. By law, the state must deposit all its funds in the bank, and the state guarantees its deposits. The bank’s surplus profits are returned to the state’s coffers. The bank operates as a bankers’ bank, partnering with private banks to loan money to farmers, real estate developers, schools and small businesses. It makes 1% loans to startup farms, has a thriving student loan business, and purchases municipal bonds from public institutions.

Looking at California’s budget figures, projected state revenues for 2009 are $128 billion. At a reserve requirement of 10%, if California deposited all $128 billion in its own state-owned bank, it could issue $1.28 trillion in loans, far more than it would need to cover its $23 billion budget shortfall. To lend itself the money to cover the shortfall, it would need only $2.3 billion in deposits and about $2 billion in capital (assuming an 8% capital requirement). What Sheldon Emry wrote of nations is equally true of states:

"It is as ridiculous for a nation to say to its citizens, ‘You must consume less because we are short of money,’ as it would be for an airline to say, ‘Our planes are flying, but we cannot take you because we are short of tickets.’"

As a card-carrying member of the banking elite, California could create all the credit it needs to fund its operations, with money to spare.

California May Resort to IOUs
If Schwarzenegger and the Democrat-controlled legislature can't come to terms by July 2, funds for the aged, the jobless, and the disabled will be on hold. What's an IOU worth from the nation's most financially troubled state? Thousands of California businesses, nonprofits, and local governments are about to find out. The Golden State is supposed to finalize its 2009-10 fiscal budget by June 30, but the state's Democrat-controlled legislature and Republican governor are at odds over how to plug a $23 billion funding gap.

A plan passed on June 28 in the State Assembly would result in sharp hikes in taxes and fees as well as cuts in government spending. Governor Arnold Schwarzenegger has said he's in favor of more structural changes, such as reducing the pension plans of future state employees. The State Assembly's current budget plan calls for increases in vehicle registration fees, cigarette taxes, and a 10% tax on oil production in the state. "I will veto any bill that punishes taxpayers for Sacramento's failure to live within its means," the Governor declared on June 29. "It's time for the legislature to send me a budget that solves our entire deficit without raising taxes."

Absent a last-minute resolution of the budget stalemate, State Controller John Chiang says that starting on July 2 he'll begin issuing IOUs to thousands of recipients of state funding—everyone from college students to landscapers who work at government facilities. The so-called registered warrants will be promises that the state will pay the money back as soon as it has the cash. The state projects that will happen by October, even though Chiang says California faces a $3 billion cash shortfall in July that will jump to $6.5 billion by September.

"Unfortunately, the state's inability to balance its checkbook will now mean shortchanging taxpayers, local governments, and small businesses," Chiang said. This would be only the second time since the Great Depression that the state has had to issue IOUs to state contractors. Similar notes were issued during a budget impasse in 1992. In February, Chiang's office delayed payments of state tax refunds to ease a midyear budget crunch. A compromise plan of tax hikes and spending cuts allowed the state to keep going, and those owed refunds were paid within a couple of weeks.

California's finances have taken a hard hit in the recession because of falling real estate, income, and sales taxes. As usual, it's the folks who need help the most who'll suffer. According to the controller's Web site, the largest number of IOUs will likely go out to counties that provide assistance to the aged ($590 million), people out of work ($495 million), and the developmentally disabled ($363 million). Jean Hurst, a lobbyist for the California State Association of Counties, says county governments are talking to banks and other lenders, who may agree to cash the IOUs in exchange for the interest the state promises to pay on the notes.

"That will be key to our survival," Hurst says. "We're seriously concerned about the cash-flow situation at the local level. We don't have the funds to float the state." The State's Pooled Money Investment Board, which invests the state's short-term funds, will set the rate for the warrants at an emergency meeting on July 2. But even the promise of interest on the money is a problem for businesses that will likely be paid much less than what it costs them to borrow money."We could be losing money just from a financing perspective," says John Riley, operations manager at Sacramento Technology Group, which provides high-tech products and services to the state.

Jonathan Brown, executive director of the Association of Independent California Colleges & Universities, says his 75-member colleges will likely receive IOUs for tuition reimbursement under a state program called Cal Grants. He says the schools will keep students enrolled and hang on to the warrants until they can be redeemed. The cash crunch is likely to be severe at state universities that receive much more of their funding from Sacramento, he says. Many have already had to cut staff and eliminate programs because of the state's budget woes.

"It's causing them some real heartburn," Brown says. Merle Thompsen, a landscaping contractor in Reseda, Calif., says he now considers himself fortunate that he didn't win any bids recently to provide services at state facilities. Thompsen says he remembers the last time the state issued IOUs, contractors were given the option of continuing to work or halting projects. Stopping the work is usually more complicated, requiring contractors to stabilize the site before they leave. "That costs the state more money," he says. "It's almost easier to keep working."

Thompsen says he also remembers a secondary market developing where independent financial firms offered to cash in the IOUs for a fee of anywhere from 6% to 20% of the note's value. "It's expensive," he says. California's budget woes have frequently put State Controller Chiang, a first-term Democrat who had previously kept a low profile, at odds with the well-known governor. Just how tense things have gotten can be seen on the list of commonly asked questions about the IOU program on the controller's Web site. Question No. 24 is: "Who can I call to complain about this?" The answer: The governor's telephone number is (916) 445-2841.

Home Prices Drop at Slower Pace, Consumer Confidence Retreats
U.S. home prices continued their multiyear tumble in April, according to the S&P Case-Shiller home-price indexes, which showed their third-straight month of slightly smaller declines. Meanwhile, U.S. consumer confidence retreated in June, especially regarding expectations for the economy six months from now, a report released Tuesday said. Seventeen of 20 major metropolitan areas posted home-price declines of more than 10% from a year earlier, with the Sun Belt continuing to be hit hardest. Nationally, home prices are at levels similar to the middle of 2003.

David M. Blitzer, chairman of S&P's index committee, said the pace of residential real-estate decline slowed in April. "While one month's data cannot determine if a turnaround has begun, it seems that some stabilization may be appearing in some of the regions." As of April, the 10-city index is down 34% from its mid-2006 peak and the 20-city is down 33%. The two indexes have fallen every month since August 2006, 33 straight. The indexes showed prices in 10 major metropolitan areas fell 18% in April from a year earlier and 0.7% from March. In 20 major metropolitan areas, home prices also dropped 18% from the prior year and 0.6% from March.

Eight regions reported a slight price increase in April from a month earlier, and 11 of the 20 areas saw a smaller decline compared with March. Month-to-month gainers were led by Dallas, which posted a 1.7% gain, and Denver, which grew 1.5%. Las Vegas fared worst, dropping another 3.5%. For the 13th straight month, no region was able to avoid a year-over-year decline. Phoenix and Las Vegas were again the worst performers, with drops of 35% and 32%, respectively. San Francisco followed with a 28% drop. Phoenix is down 54% from its peak in June 2006. Dallas has been the least hurt, down 9.6% from its June 2007 peak. The news comes after last week's data from the National Association of Realtors showing existing-home sales improved again in May, but falling prices and bloated supply continue to keep a housing sector recovery slow.

The Conference Board, a private research group, said its index of consumer confidence for June fell to 49.3, from a revised 54.8 in May, which was originally reported as 54.9. The current month's reading was well below economists' expectations of 56.0, according to a Dow Jones Newswires survey. The present situation index, a gauge of consumers' assessment of current economic conditions, slipped to 24.8 from 29.7 in May, originally reported as 28.9.
Consumer expectations for economic activity over the next six months fell to 65.5 from 71.5 in May, first reported as 72.3. "The decline in the present situation index, caused by less favorable assessment of business conditions and employment, continues to imply that economic conditions, while not as weak as earlier this year, are nonetheless weak," said Lynn Franco, director of the Conference Board Consumer Research Center. "Looking ahead, expectations continue to suggest less negative conditions in the months ahead, as opposed to strong growth."

Consumers were more downbeat about the current employment situation. The percentage who think jobs are plentiful fell to 4.5% in June, from 5.8% in May and 14.1% a year ago. The percentage of respondents who think jobs are hard to get rose to 44.8% in June, from 43.9% in May and 29.7% in June 2008. The employment outlook also turned more pessimistic. The percentage of consumers expecting more jobs in the months ahead fell to 17.4% in June, from 19.3% in May, while the share of those anticipating fewer jobs rose to 27.3% from 25.6%.

House Price Crash Rate Finally Beginning To Ease
Good news! The rate of the price decline in the housing crash has finally begun to ease. Bad news! Prices are still falling 18% year over year. Specifically, in April, according to the Case Shiller index, the rate of decline in nationwide house prices eased slightly in April--to 18% from 19% in March. The rate of decline has hovered around 19%-20% for the last several months. And prices have now declined a staggering 33%-34% from the peak. As we've noted over this period, before house prices can start recovering, they have to stop falling. And the first step toward prices stopping falling is a decline in the RATE at which they are falling.  And we are finally beginning to see that.

But we're still talking about an astonishing rate of collapse. And we're still looking at a peak-to-trough decline of at least 40% and probably closer to 50% nationwide, which would be unprecedented. And even today, with prices down 33%-34% from the peak, prices are still above fair value. So the folks who use this slight moderation in the rate of decline to spin tales of a "bottom" or, worse, a "recovery" are smoking something. Prices have at least another 10%-15% to fall, and they'll likely be falling for at least another year or two.

Yale's Shiller Sees 'Striking Improvement' in Rate of Home-Price Decline
Home prices saw a "striking improvement in the rate of decline" in April and trading in funds launched today indicates investors believe the U.S. housing slump is nearing a bottom, said Yale University economist Robert Shiller. "At this point, people are thinking the fall is over," Shiller, co-founder of the home price index that bears his name, said in a Bloomberg Radio interview today. "The market is predicting the declines are over."
Home prices in 20 major U.S. metropolitan areas fell in April at a slower pace than forecast, the S&P/Case-Shiller home- price index showed today.

Today’s Case-Shiller numbers are the latest sign that that the worst of the housing slump may be passing. Sales of existing homes posted gains in April and May, while housing starts jumped in May from a record low. "My guess would be that home prices are going to level off -- they’re not going to keep falling," Shiller said in a separate interview with Bloomberg Television. Still, it’s "hard to predict" a speculative market, and "I am not optimistic that we’re going to see any sharp rebound."

The index decreased 18.1 percent from a year earlier following an 18.7 percent drop in March. Economists predicted the index would drop 18.6 percent, according to the median of 33 responses in a survey conducted by Bloomberg. The measure fell 19 percent in January, the most since the data began in 2001.

"These numbers are really showing that there’s been a change in mood," said Karl Case, a professor at Wellesley College and another co-founder of the index. "For these numbers to go up in eight states, I was quite taken aback." Home prices rose in eight of the cities measured on a monthly basis, led by Dallas, where home values rose 1.7% percent from the previous month. Values also gained in Denver, Cleveland, the District of Columbia, San Francisco, Boston, Atlanta and Seattle. Prices were down from this time last year in all 20 cities in the index.

Shiller said the decline in housing prices may be less steep by year-end. "At this rate, it’ll be down 12 percent and I suspect it will be down less than that because of the improvement that we’re seeing," Shiller said. The Case-Shiller index has been falling for the last three years. The gauge declined 0.6 percent April from March, the smallest monthly drop in the since June 2008. Shiller said that the MacroShares Major Metro Housing Indexes might help avoid future upheavals in the housing market, by allowing investors to hedge against falling home prices.

"This economic crisis is substantially due to a failure to manage risk adequately," he said. "This is an opportunity to manage these risks." The MacroShares Major Metro Housing Up, an exchange-traded fund that tracks the cumulative change in the S&P/Case-Shiller Composite-10 Home Price Index, started trading today on the New York Stock Exchange with a value of $19.40 at 2:06 p.m. New York time. The MacroShares Major Metro Housing Down, which allows investors to take the opposite position, betting that home prices will fall, traded at $30.87.

US Home-Loan Delinquencies Double on Least-Risky Mortgages
Delinquency rates on the least-risky mortgages more than doubled in the first quarter from a year earlier as U.S. efforts to help homeowners failed to keep pace with job losses that pushed more borrowers toward foreclosure. Prime mortgages 60 days or more past due climbed to 2.9 percent of such loans through March 31 from 1.1 percent at the same point in 2008, the Office of the Comptroller of the Currency and the Office of Thrift Supervision said today in a report. First-time foreclosure filings on the loans rose 22 percent from the fourth quarter, the report said.

"I’m very concerned about the rise in delinquent mortgages and foreclosure actions," Comptroller of the Currency John Dugan said in a statement with the report. President Barack Obama’s plan to create "sustainable, payment-reducing modifications is a positive step that should show significant benefits in the coming months," Dugan said. Obama’s program, unveiled Feb. 18, aims to help as many as 4 million homeowners by modifying loans and calls for Fannie Mae and Freddie Mac to refinance mortgages for as many as 5 million borrowers who owe more than their houses are worth. Foreclosure filings surpassed 300,000 for a third straight month in May, according to RealtyTrac Inc., and the U.S. economy has shed about 6 million jobs since the recession began in 2007.

"Job losses have mounted and even those with good credit that were able to get a prime mortgage are having a harder time making monthly payments with a loss of income," said Celia Chen, an economist at Moody’s Economy.com in West Chester, Pennsylvania. Serious delinquencies on prime loans, which account for two-thirds of all U.S. mortgages, rose to 661,914 in the first quarter from 250,986 a year earlier, according to the report. Overall, mortgages 60 days or more past due rose 88 percent from last year, the report said.

Mortgages modified to help struggling borrowers stay in their homes fail within nine months more than half the time, the report said. About 53 percent of mortgages modified in the first quarter of 2008 were 30 or more days delinquent after six months; 63 percent were in default after a year. As lines of credit deteriorate, home prices are moderating. The S&P/Case-Shiller home-price index for 20 major U.S. metropolitan areas fell 18 percent in April from a year earlier, the smallest decline in six months. "When home prices are down, many homeowners have negative equity, not just subprime borrowers have trouble but prime borrowers do as well, and foreclosures are more likely," Chen said.

About two-thirds of mortgage modifications by servicers used two or more techniques to make loan payments more sustainable, the agencies said in the report. About 70 percent of the workouts added missed payments and penalties to the outstanding balance. About 63 percent involved interest-rate reductions and about 25 percent extended the life of the loan. Only 13 percent of modifications froze interest rates, and about 2 percent included a principal writedown. "Serious delinquencies are a leading indicator of increased foreclosure actions in the future," the report said.

Fannie Mae and Freddie Mac, the government-controlled mortgage-finance companies, lagged behind private industry in the quarter, the report shows, as the U.S. spent February and March retooling underutilized anti-foreclosure programs. About 14 percent of loans modified were initiated by Washington-based Fannie Mae and McLean, Virginia-based Freddie Mac, the data shows. Private investors accounted for 55 percent, while loans held by national banks made up 31 percent, according to the data, which includes residential mortgages serviced by national banks and federally regulated thrifts.

The data shows 5.9 percent of the 21.8 million Fannie Mae and Freddie Mac loans serviced by national banks or thrifts were at least days 30 days late, in foreclosure or subject to bankruptcy, compared with 3.2 percent a year earlier. The report covers the performance of 34 million loans totaling $6 trillion, the agencies said.

Americans Suckle On The Government's Teat
Americans are saving and paying off credit card debt at levels not seen in years, but where's that money coming from? Increasingly, it's not coming from work. As today's chart (via David Rosenberg) demonstrates, a staggering proportion of American personal income now comes straight from government transfer payments -- welfare, unemployment, etc. And thus the process of household debt becoming government debt takes place.

Obamageddon — 2012
Empire America is on the verge of collapse. Its social, economic and political systems are failed and failing, observes Trends Research Institute Director, Gerald Celente, in the Summer Trends Journal. "The measures taken by successive governments to save the politically corrupt, morally bankrupt, physically decrepit giant from collapse have served to only hasten its demise. While the decline has been decades in the making, the acceleration of ruinous policies under the current Administration is leading the United States — and much of the world — to the point of no return," says Celente.

The "green shoots" sighted by Field Marshall Bernanke this past Spring were a mirage. The 2010 economic "recovery" predicted by the same experts, authorities and financial boy scouts and cheerleaders who didn’t see the economic crisis coming is pure delusion. By 2012, even those in denial and still clinging to hope will be forced to face the truth. It will be called "Obamageddon" in America. The rest of the world will call it "The Greatest Depression."

We'll Need to Raise Taxes Soon
Only five months after Inauguration Day, the focus of Washington's economic and domestic policy is already shifting. This reflects the emergence of much larger budget deficits than anyone expected. Indeed, federal deficits may average a stunning $1 trillion annually over the next 10 years. This worsened outlook is stirring unease on Main Street and beginning to reorder priorities for President Barack Obama and the Democratic congressional leadership. By 2010, reducing the deficit will become their primary focus.

Why has the deficit outlook changed? Two main reasons: The burst of spending in recent years and the growing likelihood of a weak economic recovery. The latter would mean considerably lower federal revenues, the compiling of more interest on our growing debt, and thus higher deficits. Yes, the President's Council of Economic Advisors is still forecasting a traditional cyclical recovery -- i.e., real growth of 3.2% next year and 4% in 2011. But the latest data suggests that we're on a much slower path. Probably along the lines of the most recent Goldman Sachs and International Monetary Fund forecasts, whose growth rates average about 2% for 2010-2011.

A speedy recovery is highly unlikely given the financial condition of American households, whose spending represents 70% of GDP. Household net worth has fallen more than 20% since its mid-2007 peak. This drop began just when household debt reached 130% of income, a modern record. This lethal combination has forced households to lower their spending to reduce their debt. So far, however, they have just begun to pay it down. This implies subdued spending and weak national growth for some time.

In a March 27 forecast, Goldman Sachs estimated average annual deficits of $940 billion through 2019. If this proves true, deficits would remain above 4% of GDP through the next decade and the national debt would reach a whopping 83% of GDP, a level not seen since World War II. The public is restive over this threat: In a recent Wall Street Journal/NBC News poll, Americans were asked which economic issue facing the country concerned them most. Respondents chose deficit reduction over health care by a ratio of 2 to 1.

Mr. Obama and his economic advisers understand this deficit outlook and undoubtedly view it as unsustainable. They also understand that increasing deficit concerns complicate their efforts toward universal health-insurance legislation, which is clearly a top priority of this administration. According to the Congressional Budget Office, which released its latest forecast June 16, such legislation would mandate more than $1 trillion of new federal spending over 10 years. Winning support for that much new spending -- in the face of record deficits -- will be a challenge.

This explains why the president is stressing the importance of a deficit-neutral bill. In other words, that any new spending be fully offset by a combination of Medicare and Medicaid cuts and new tax revenues. Key Senate leaders have echoed this requirement. Fully financed legislation probably will emerge after a lengthy struggle. The poor budget outlook may impel the administration to follow up health-care legislation with an effort to fix Social Security. The shortfall in Social Security's trust funds -- which adds to the long-term deficit -- is much smaller than the companion problem in Medicare funding. Public anxiety over deficits may make this fix possible now even though it has been elusive for years. If this could be done, confidence in Washington's capacity to address its debt challenge would rise.

But even with a Social Security fix the medium-term deficit outlook will be poor. Sometime soon, perhaps in 2010, Main Street and financial markets will exert irresistible pressure to reduce the deficit. The problem is the deficit's sheer size, which goes way beyond potential savings from cuts in discretionary spending or defense. It's entirely possible that Medicare and Social Security will already have been addressed, and thus taken off the table. In short we'll have to raise taxes.

Today, the U.S. ranks next to last among the 28 Organization for Economic Cooperation and Development nations in total federal revenue as a share of GDP. Our federal revenues represent 18% of national output, down from 20% just 10 years ago. That makes the mismatch between our spending and our revenue very large, producing the huge deficits we face. We all know the recent and bitter history of tax struggles in Washington, let alone Mr. Obama's pledge to exempt those earning less than $250,000 from higher income taxes.

This suggests that, possibly next year, Congress will seriously consider a value-added tax (VAT). A bipartisan deficit reduction commission, structured like the one on Social Security headed by Alan Greenspan in 1982, may be necessary to create sufficient support for a VAT or other new taxes. This challenge may be the toughest one Mr. Obama faces in his first term. Fortunately, the new president is enormously gifted. That's important, because it is no longer a matter of whether tax revenues must increase, but how.

On giving Goldman a chance
by Matt Taibbi

After my Rolling Stone piece about Goldman, Sachs hit the newsstands last week (unfortunately the piece is not yet up on the magazine’s web site, so I can’t link to it yet — but it is out in print), I started to get a lot of mail. Most of it was thoughtful and respectful criticism, although there was an amusingly large number of people writing in impassioned defense of their right, under our American system, to be ripped off by large impersonal financial companies.

"If my pension fund is buying [crap mortgages] from Goldman, and my pension fund loses lots of value, that’s not Goldman’s fault," wrote one reader. "No one is forcing anyone to buy anything. The only thing Goldman is guilty of is making profits." I’m not even going to go there — the psychology of a human being who would take the time to actually write in a complaint like that is so bizarre that it would take more time than I have today to even begin discussing it. One other complaint that I will address quickly, though, is the notion that I didn’t tell Goldman’s side of the story.

"Not exactly a balanced approach," complained one reader. "You should take an ethics class. You have to give the other side a fair shot." Actually I did contact Goldman and gave the bank every opportunity to respond to the factual issues in the article. I’m bringing this up because their decision not to comment on any of those questions was actually pretty interesting.

We figured ahead of time that Goldman was probably not going to respond to many of the allegations in the article, since its MO in the past with regard to hostile journalists has usually either been to make bald denials or to simply avoid comment (that’s when they’re not using the carpet-bomb litigation technique, as in the case of GoldmanSachs666.com). So what I decided to do the first time I approached them was to send a short list of simple factual questions. If the bank decided to engage us and educate us as to its point of view on these simple questions, we would send more queries and expand the dialogue.

Given this, I tried to make that first list of questions as basic as possible.  I asked if Goldman would have turned a profit in Q1 2009 if it hadn’t orphaned the month of December 2008. Then I asked if Goldman had made changes to its underwriting standards during the internet boom years; if Goldman’s position was still that the steep rise in oil prices last year was due to normal changes in supply and demand; and if it could explain its 1991 request to the CFTC to have its subsidiary J. Aron classified as a physical hedger on the commodities market.

Citing various sources, I also noted that some people had complained that its move to short the mortgage market in 2006 even as it was selling those same types of instruments proved that the bank knew the weakness of its mortgage products, and asked if the bank had an answer for that. And I asked if the bank supported cap-and-trade legislation, and if it was fair to say (as we planned to in the piece) that the bank would capitalize financially if such legislation was passed.

I intentionally put a lot of yes/no questions on that list. If the underlying thinking behind any of those questions was faulty, it would have been easy enough for them to say so and to educate us as to the truth. Instead, here is the response that we got:
"Your questions are couched in such a way that presupposes the conclusions and suggests the people you spoke with have an agenda or do not fully understand the issues."

You have to have swallowed half a lifetime of carefully-worded p.r. statements to see the message written between the lines here. That this is a non-denial denial is obvious, but what’s more notable here is that they didn’t stop with just a flat "no comment," which they easily could have done. No, they had to go a little further than that and — and this is pure Goldman, just outstanding stuff — make it clear that both I and my sources are simply not as smart as they are and don’t understand what we’re talking about.

So the rough translation here is, "No comment, but if you were as smart as us, you wouldn’t be asking these questions." So now word filters through that Goldman has issued yet another statement in response to the piece, this one by amusingly-named mouthpiece Lucas Van Pragg. Again, the company does not take issue with any of the facts in the piece — not one. Here’s what he says:
"Taibbi’s bubble case doesn’t stand up to serious scrutiny either. To give just two examples, even with the worst will in the world, the blame for creating the internet bubble cannot credibly be laid at our door, and we could hardly be described as having been a major player in the mortgage market, unlike so many of our current and former competitors. Taibbi’s article is a compilation of just about every conspiracy theory ever dreamed up about Goldman Sachs, but what real substance is there to support the theories? We reject the assertion that we are inflators of bubbles and profiteers in busts, and we are painfully conscious of the importance of being a force for good."

Okay, let’s look at that bit piece by piece. Van Pragg takes issue with the bubble argument by citing two "examples" of the case not holding water, the first being:
"… the blame for creating the internet bubble cannot credibly be laid at our door…"

I kept waiting for the "because…" clause here, but there wasn’t one. He just says so and leaves it at that. Now there is obviously some measure of hyperbole in solely blaming Goldman Sachs for something like the internet bubble, or any of the other recent Wall Street disasters, for that matter. But you’d have to be absolutely crazy (and you wouldn’t need "the worst will in the world," either) not to accept the notion that Goldman shouldered a significant portion of the blame for the internet mess.

They were, after all, the leading underwriter of internet IPOs during the internet boom years. In 1999, at the height of the boom, they underwrote 37 internet companies, most of which had little or no history and were losing money at the time of the launch. By late 1999 Goldman was underwriting one out of every five internet IPOs. They were repeatedly caught and punished for manipulating the prices of their IPOs, either via laddering or spinning. Van Pragg doesn’t deny any of this, and just blithely says that one can’t credibly blame them for the internet bubble. I’m almost insulted by the lameness and half-assedness of that comeback, but that might be part of the point, to be insulting. He moves on:
::…and we could hardly be described as having been a major player in the mortgage market, unlike so many of our current and former competitors."

Again, not to beat this into the ground, but in 2006, at the height of the housing boom, Goldman underwrote over $75 billion in mortgages, over $59 billion of which were non-prime. That represented 7% of the entire market, which seems like a pretty "major" slice to me. It is true that they did not jump so completely ass-first into the market as Lehman and Bear did (note Van Pragg’s bemused reference to "former competitors"), but if you read the piece, we noted why that doesn’t take them off the hook at all.

Because while their "former competitors" (one of whom is clearly "former" in large part because a former Goldmanite, Hank Paulson, elected to save Goldman’s hide instead of Lehman’s) were dumb enough to hold their mortgage paper and be sunk by it, Goldman shorted their own crap, which means (and I know I’m repeating myself here) they knew that what they were selling was a loser. So while they maybe weren’t the biggest player, they were still a major player, and one can easily make the case that they were the most obnoxious player, given that they dove into this muck with their eyes wide open, unlike so many other idiots on Wall Street.

In the middle of this weirdly substanceless retort, Van Pragg then goes on complain about the lack of substance in the article, makes the predictable charge that the piece was a compendium of invented conspiracy theories, then moves on to "reject" the notion that the company inflates bubbles and profits in busts (about that last part: I recommend checking out Goldman’s profit/bonus numbers in 2002, 2008, and 2009 to date. I’m not sure how they can refute the notion that they have profited during the recent financial calamities).

Lastly, he says that the bank is "painfully conscious" of the importance of being a force for good, which I noted with amusement is not quite the same thing as saying that that bank is a force for good, or wants to be. So to sum up, this all translates as:
"Taibbi’s bubble case doesn’t hold water. To use just two examples, Taibbi’s internet bubble case doesn’t hold water, and we didn’t sell as many mortgages as Lehman Brothers. Taibbi’s article is a compendium of every other story about Goldman that doesn’t hold water. We reject these theories that do not hold water, and are aware of the difference between right and wrong, making us legally sane according to the law."

I’m aware that some people feel that it’s a journalist’s responsibility to "give both sides of the story" and be "even-handed" and "objective." A person who believes that will naturally find serious flaws with any article like the one I wrote about Goldman. I personally don’t subscribe to that point of view.

My feeling is that companies like Goldman Sachs have a virtual monopoly on mainstream-news public relations; for every one reporter  like me, or like far more knowledgeable critics like Tyler Durden, there are a thousand hacks out there willing to pimp Goldman’s viewpoint on things in the front pages and ledes of the major news organizations. And there are probably another thousand poor working stiffs who are nudged into pushing the Goldman party line by their editors and superiors (how many political reporters with no experience reporting on financial issues have swallowed whole the news cliche about Goldman being the "smart guys" on Wall Street? A lot, for sure).

Goldman has its alumni pushing its views from the pulpit of the U.S. Treasury, the NYSE, the World Bank, and numerous other important posts; it also has former players fronting major TV shows. They have the ear of the president if they want it. Given all of this, I personally think it’s absurd to talk about the need for "balance" in every single magazine and news article. I understand that some people feel differently, but that’s my take on things.

Wall Street to Log Best Quarter Since Crisis
The securities firms still standing on Wall Street are about to close the most lucrative quarter since the credit crisis erupted. And instead of relying on risk and leverage to drive profits, companies such as J.P. Morgan Chase & Co., Goldman Sachs Group Inc., Morgan Stanley and Bank of America Corp. are getting back to basics, with a strong performance from trading and underwriting. Investor confidence in the debt markets fueled issuance of $1.5 trillion globally from the start of the second quarter through Monday, according to Dealogic. That was slightly lower than in the first quarter, but the latest results showed a rebound in high-yield issuance.

Equity offerings reached nearly $260 billion during the second quarter, which ends Tuesday. That is almost four times the amount recorded during the first quarter, and the highest since 2008's second quarter, Dealogic said. In trading, the gap between bid and offer prices on fixed-income assets remained wide through most of the quarter, boosting profits from buying and selling these securities. Fixed-income trading is one of the main earnings drivers for big Wall Street firms.

"The banks are making money the old-fashioned way, by making markets," said Douglas Sipkin, an analyst with Pali Capital in New York. But the fact that Wall Street firms still can find ways to make money is tempered by doubts about how long the turnaround will last. "The pace is just not sustainable," Mr. Sipkin said. Much of this quarter's equity issuance came after banks rushed to raise nearly $90 billion following the government's stress tests. There also was a backlog of issuers taking advantage of the market's upturn since early March, not necessarily a major shift in sentiment, said David Trone, an analyst with Fox-Pitt Kelton.

"There was pent-up demand, and they issued at any cost, and now that's starting to peter out," he said. "The underwriting fees are really going to pop, but that phase is over." Meanwhile, the income potential on fixed-income trading has shown signs of narrowing in recent days. And Wall Street is heading deeper into the traditionally sluggish summer months. When second-quarter results are announced in late July, the signs of recovery will be obscured by one-time accounting issues at some banks and securities firms. Companies that repaid the government's bailout money have said they will take a one-time charge to reflect their payment.

Inflation Fears Seem to Be, Well, Inflated
The bond vigilantes have apparently gone on summer vacation. Yields on long-term Treasury debt had risen sharply in the past several weeks on fears that a big increase in debt-fueled government spending would push up inflation. Bond investors registered their concerns by selling Treasurys. But a funny thing happened on the way to Zimbabwean hyperinflation: People started buying Treasurys again, raising prices and pushing yields, which move in the opposite direction, lower. The 10-year Treasury note ended trading Monday yielding 3.490%, the lowest since May 29 and well off its 2009 peak of 3.94%.

"The market got overdone," says Miller Tabak strategist Dan Greenhaus, who says investors overestimated the speed and strength of an economic recovery. "There was a leap right from economic stabilization to incredible inflation pressures and outsized economic growth." The recent Treasury rally could be undone by this week's barrage of economic data, including Wednesday's manufacturing index from the Institute for Supply Management and Thursday's jobs report. Any hint of unexpected economic strength could encourage investors to dump Treasurys.

But their performance last week in the face of record $104 billion of debt issuance plus the Federal Reserve's Open Market Committee meeting shows Treasurys may have staying power. Given the Fed's heavy and unpredictable hand in the market lately, buying Treasurys ahead of a Fed meeting is a little like trying to sneak a doggy biscuit away from a sleeping pit bull. But investors couldn't get enough. Those likely included China, whose top central banker suggested this weekend that the No. 1 holder of Treasurys wouldn't sell anytime soon.

Bond buyers were also undeterred by the Fed's decision not to increase Treasury purchases, a program designed to keep interest rates low. There is a school of thought that believes the Fed's purchases were having the opposite of their desired effect, pressuring rates higher by raising inflation fears. Yields also can stay low, notes Goldman Sachs economist Jan Hatzius, because few businesses or consumers are trying to borrow these days. That lack of competition could keep Treasury prices high and yields low.

Citi raises card rates on millions
Citigroup has sharply increased interest rates on up to 15m US credit card accounts just months before curbs on such rises come into effect, in a move that could fuel political anger at the treatment of consumers by bailed-out banks. People close to the situation said that Citi, which is about to cede a 34 per cent stake to the US government as part of its latest rescue, had upped rates on between 13m and 15m credit cards it co-brands with retailers such as Sears and Macy’s.

Citi’s rate increases emerged on the day the government proposed legislation to create a new regulator with sweeping powers on consumer protection and a week after the bank was attacked by some politicians for raising employees’ salaries. Holders of co-branded cards who failed to pay their balance in full at the end of the month saw their rates rise by an average 24 per cent – or nearly 3 percentage points – between January and April, according to a Credit Suisse analysis of data from the consultancy Lightspeed Research.

Citi declined to comment but people close to the bank said the figures were in line with internal data. Citi’s move came as the economic downturn caused record defaults among US card users and prompted many issuers to raise rates, both to cushion their losses and pre-empt the new restrictions set to come into effect in February. However, Citi’s increases have been larger than those of its main rivals, according to Lightspeed, which tracks about 12,000 US credit card accounts.

Carolyn Maloney, Democratic representative for New York, the author of the new rules that will sharply constrain lenders’ ability to raise rates for risky borrowers, criticised Citi’s move. “It’s hard to tell if rate hikes on existing balances being put in place now are the result of prior bad business decisions or getting in under the wire of the new law,” Ms Maloney told the Financial Times.

How a Loophole Benefits GE in Bank Rescue
General Electric, the world's largest industrial company, has quietly become the biggest beneficiary of one of the government's key rescue programs for banks. At the same time, GE has avoided many of the restrictions facing other financial giants getting help from the government. The company did not initially qualify for the program, under which the government sought to unfreeze credit markets by guaranteeing debt sold by banking firms. But regulators soon loosened the eligibility requirements, in part because of behind-the-scenes appeals from GE.

As a result, GE has joined major banks collectively saving billions of dollars by raising money for their operations at lower interest rates. Public records show that GE Capital, the company's massive financing arm, has issued nearly a quarter of the $340 billion in debt backed by the program, which is known as the Temporary Liquidity Guarantee Program, or TLGP. The government's actions have been "powerful and helpful" to the company, GE chief executive Jeffrey Immelt acknowledged in December.

GE's finance arm is not classified as a bank. Rather, it worked its way into the rescue program by owning two relatively small Utah banking institutions, illustrating how the loopholes in the U.S. regulatory system are manifest in the government's historic intervention in the financial crisis. The Obama administration now wants to close such loopholes as it works to overhaul the financial system. The plan would reaffirm and strengthen the wall between banking and commerce, forcing companies like GE to essentially choose one or the other. "We'd like to regulate companies according to what they do, rather than what they call themselves or how they charter themselves," said Andrew Williams, a Treasury spokesman.

GE's ability to live in the best of both worlds -- capitalizing on the federal safety net while avoiding more rigorous regulation -- existed well before last year's crisis, because of its unusual corporate structure.
Banking companies are regulated by the Federal Reserve and not allowed to engage in commerce, but federal law has allowed a small number of commercial companies to engage in banking under the lighter hand of the Office of Thrift Supervision. GE falls in the latter group because of its ownership of a Utah savings and loan.

Unlike other major lenders participating in the debt guarantee program, including Bank of America, Citigroup and J.P. Morgan Chase, GE has never been subject to the Fed's stress tests or its rules for limiting risk. Also unlike firms that have received bailout money in the Troubled Assets Relief Program, or TARP, GE is not subject to restrictions such as limits on executive compensation. The debt guarantee program that GE joined is administered by the Federal Deposit Insurance Corp., which was reluctant to take on the new mission, according to current and former officials who were not authorized to speak publicly. The FDIC also initially resisted expanding the pool of eligible companies, fearing it would add more risk to the program, the officials said.

Despite those misgivings, there have been no defaults in the loan guarantee program. It has helped buoy confidence in the credit markets and enabled vital financial firms to raise cash even during the darkest days of the economic crisis. In addition, the program has raised more than $8 billion in fees. "The TGLP program has been a moneymaker for us," FDIC chairman Sheila C. Bair has said. "So I think there have been some benefits to the government and the FDIC." For its part, GE said that it properly applied for and qualified for the program. "We were accepted on the merits of our application," company spokesman Russell Wilkerson said.

The current good fortune of General Electric, ranked by Forbes as the world's largest company, has roots in the Great Depression, when it created a consumer finance arm so that cash-starved families could buy its appliances. What grew from those beginnings is now a powerful engine of profit, accounting for nearly half of its parent's net earnings in the past five years. GE may be better known for light bulbs and home appliances, but GE Capital is one of the world's largest and most diverse financial operations, lending money for commercial real estate, aircraft leasing and credit cards for stores such as Wal-Mart. If GE Capital were classified as a banking company, it would be the nation's seventh largest.

Unlike the banking giants, GE Capital is part of an industrial company. That allows GE to offer attractive financing to those who buy its products. At the height of last fall's financial crisis, GE's cash cow became a potential liability. As credit markets froze, analysts feared that GE Capital was vulnerable to losing access to cheap funding -- largely commercial paper, or short-term corporate IOUs sold to large investors. Company officials projected confidence. "While GE Capital is not immune from the current environment," Immelt said in October, "we continued to outperform our financial-services peers." Behind the scenes, they urgently sought a helping hand for GE Capital. One key hope was a rescue plan taking shape at the FDIC.

The program emerged during a hectic weekend last October as regulators scrambled to announce a series of rescue efforts before the markets opened. They found a legal basis for the program in a 1991 law: If a faltering bank posed "systemic risk," then the FDIC, the Fed, the Treasury secretary and the president could agree to give the FDIC more authority to rescue a failing institution. The financial regulators applied the statute broadly, so it would cover the more than 8,000 banks in the FDIC system. The FDIC hurried to approve the program Oct. 13. "This was crisis management on steroids," said a person familiar with the process. "A lot was made up on the fly."

The author of the systemic-risk provision, Richard Carnell, now a law professor at Fordham University, says it was intended to apply to a single institution, and that in their rush to find legal footing for unprecedented new programs, regulators "turned the statute on its head." The FDIC launched the program Tuesday, Oct. 14, the same day Treasury officials announced large capital infusions into nine of the country's banking giants under TARP. That day, the FDIC also expanded its deposit guarantees to a broader range of accounts.

Within days, the FDIC held conference calls with bankers to explain the program. Agency officials explained that not all companies that owned banks were eligible. "The idea is not to extend this guarantee to commercial firms," David Barr, an FDIC spokesman, said during one of the calls. GE was watching closely. Though GE Capital owned an FDIC-insured savings and loan and an industrial loan company, they accounted for only 3 percent of GE's assets. Company officials concluded that GE couldn't meet the program's eligibility requirements.

So the company requested that the program "be broadened," GE's Wilkerson said. GE's main argument was fairness: The FDIC was trying to encourage lending, and GE Capital was one of the country's largest business lenders.GE deployed a team of executives and outside attorneys, including Rodgin Cohen, a banking expert with the New York firm Sullivan & Cromwell. "GE was among the parties that discussed this with the FDIC," along with the Treasury and Fed, according to FDIC spokesman Andrew Gray. He said the details about eligibility "had not been specifically addressed" in the beginning.

Citigroup, the troubled banking giant, also was pressing for an expansion of the FDIC program. Though Citigroup was included in the debt guarantee program, its main finance arm, Citigroup Funding, appeared ineligible. Fed Vice Chairman Donald L. Kohn wrote to the FDIC's Bair on Oct. 21, arguing that debt issued by Citigroup Funding should be covered "as if it were issued directly by Citigroup, Inc." Two days later, the FDIC announced a new category of eligible applicants -- "affiliates" of an FDIC-insured institution. Bair explained that "there may be circumstances where the program should be extended" to keep credit markets flowing. That meant "certain otherwise ineligible holding companies or affiliates that issue debt" could apply, she said.

GE Capital now was eligible. GE Capital won approval to enter the FDIC program in mid-November with support from its regulator, the Office of Thrift Supervision. The company used the government guarantee to raise about $35 billion by the end of 2008. By the end of the first quarter of 2009, the total reached $74 billion, helping to cover the company's 2009 funding needs and about $8 billion of its projected needs for 2010. Despite government support, GE lost its Triple-A rating for the first time in decades this year and was forced to sharply cut its dividend. But the outlook could have been much worse.

The debt guarantee program has "been of critical importance" to the fiscal health of GE Capital, said Scott Sprinzen, who evaluates GE's finance arm for the Standard & Poor's credit-rating company. He said the FDIC program enabled GE to "avoid an exorbitant price" for its debt late last year. GE has not disclosed how much the company has saved because of TLGP backing. Like other companies in the program, GE pays the FDIC fees to use the guarantees -- a little more than $1 billion so far. But as Bair explained to bankers last fall, the fees, while "healthy," are "far below certainly what the cost of credit protection is now in the market."

Not every finance company has had that peace of mind. One of GE's competitors in business lending markets, CIT Group, a smaller company, has had a harder time raising cash. It has been unable to persuade the FDIC to allow it into the debt-guarantee program, at least in part because of its lower credit ratings. A recent Standard & Poor's analysis cited CIT's "inability to access TLGP" as a factor in the company's declining financial condition.

Two weeks ago, the Obama administration said it would seek to eliminate the Office of Thrift Supervision and force companies like GE to focus on commerce or banking, but not both. That could require the industrial giant to spin off GE Capital. Last week, Immelt said GE had no intention of doing that. "GE is and will remain committed to GE Capital, and we like our strategy," he said in a memo to staff. In its proposal to overhaul financial regulation, the Treasury Department pointed out that some firms operating under the existing rules, including collapsed companies such as American International Group, "generally were able to evade effective consolidated supervision and the long-standing policy of separating banking from commerce."

GE's Wilkerson said the company generally supports regulatory reform but thinks that it should be permitted to retain its structure. "Bank reform has historically included grandfathering provisions upon which investors have relied," he said, "and there is no reason this settled principle should not be followed here." He said the company "didn't have any choice" but to have OTS as its regulator. The company also objects to the Treasury's proposal to force firms to separate banking and commerce because that issue "had nothing to do with the financial crisis," Wilkerson said.

Wilkerson said GE has remained profitable and avoided some of the exotic financial products that contributed to losses at other institutions. He also said that GE performed an internal stress test this year and found that its capital position was "quite strong by comparison to the banks." The FDIC has been working to wean financial institutions off the program. The TLGP originally was slated to end in June, but at the Treasury's request the FDIC agreed to extend it until Oct. 31.

Some participants have stopped using the program, but GE Capital continues to do so for the overwhelming majority of its debt. Much of the $340 billion in debt will come due in 2012, the year the FDIC guarantees expire. At that point, known in banking circles as the "cliff," the agency will have to make good if companies such as GE are unable to honor their obligations. FDIC officials say they are comfortable that the agency has collected more than enough money to cover potential losses.

UK economy shrinks most in 50 years
The UK economy shrank by the most in more than half a century in the first three months of the year, according to revised figures which were much weaker than originally estimated. The 2.4 per cent decline in gross domestic product was sharper than the 1.9 per cent initially calculated, the Office for National Statistics reported, and was greater than the 2.1 per cent fall expected by economists. About half the revision was due to the introduction of new construction sector data and the rest was bacause of more complete services sector figures showing a sharper decline.

Not since 1958 has the quarter-on-quarter decline in GDP been greater, while the 4.9 per cent drop compared to a year earlier was the largest since records began in 1948. "‘You’ve never had it so bad’ seems the most apt summary of the state of the UK economy in Q1," said Ross Walker, economist at RBS. "Although to some extent this is ‘old news’, it does serve to emphasise the size of the hole out of which the UK must climb." The precipitous decline in GDP in the first quarter reflected the fallout after the credit crisis escalated dramatically from September of last year onwards and highlights the depth of the recession that the UK has been suffering. But since the end of the first quarter there have been growing signs that the economy is stabilising.

Manufacturing output actually grew in March and April, while survey data suggested the economy has returned to growth.The respected economics thinktank, the National Institute for Economic and Social Research, said it thought the economy began to grow again in April. "The survey data suggest we have at least stopped digging, but the economy remains on course for a lacklustre pace of recovery," Mr Walker said. The Bank of England has warned that the economy faces a slow recovery, as banks remain fragile and lending weak.

The output of the construction was revised down to show a 6.9 per cent decline from the first estimate of a 2.4 per cent drop. However, the fall in output was actually less severe than the 9 per cent fall that a more recent ONS revision had suggested, which had led many to expect GDP to be revised down sharply. Services output, which makes up about three quarters of the UK economy, was revised down to see a drop of 1.6 per cent rather than the 1.2 per cent orginally reported.

"Revisions to GDP are larger than usual, reflecting greater uncertainty in measurement during a period of rapid change in economic activity," the ONS said. The GDP figures confirmed that the recession began in the second quarter of last year, after the economy shrank by 0.1 per cent in the April to June period, rather than the 0.0 per cent decline originally reported. The economy contracted by 4.9 per cent from its peak in the first quarter until the first quarter this year. That is worse than the 2.5 per cent drop in the 1990s recession, but less than the 5.9 per cent fall in the early 1980s recession.

Despite the dramatic contraction in the economy rating agency Fitch reconfirmed the top triple-A rating on the UK’s sovereign debt at stable - along with the US, France and Germany - refusing to follow rival Standard & Poor’s which recently changed the UK’s debt outlook to negative. The household saving ratio fell to 3 per cent from 4 per cent in the final quarter of last year, as households’ real disposable income dropped by 2.4 per cent due to lower earnings, but consumption did not fall as sharply.

Business investment fell by 7.1 per cent during the quarter. Inventories made a smaller drag of 0.4 percentage points out of the 2.4 per cent fall in GDP, compared to the previous estimate of 0.6 percentage points. "The UK national accounts ... underline the fact that the economic recovery is built on very fragile foundations," said Capital Economics. "With the annual rate pulled down from -4.1 per cent to -4.9 per cent, average GDP growth in 2009 now looks likely to be -4 per cent or weaker rather than the -3.5 per cent we previously expected. "Note too that the breakdown is not pretty, with the renewed fall in the household saving ratio from 4 per cent to 3 per cent underlining that the adjustment in the household sector has a long way yet to go."

U.K. Consumer Confidence Increased to 14-Month High
U.K. consumer confidence increased to the highest level in 14 months in June as shoppers became more optimistic that the recession is past its worst, GfK NOP said. An index of sentiment rose 2 points to minus 25, the strongest result since April 2008, the market researcher said in an e-mailed statement today in London. The gauge of confidence about the economic outlook for the next year climbed 8 points to minus 8.

Unemployment claims rose less than economists forecast in May, and business surveys have indicated that the economic slump is starting to abate. Bank of England officials say that the credit squeeze threatens to delay a recovery and data yesterday showed net mortgage lending rose at the slowest pace since records began in 1993. "Confidence still remains fragile as uncertainty about the strength of any recovery and an increase in unemployment all mean that consumers remain wary," Rachael Joy, an analyst at GfK, said in the statement.

Four out of five indexes used to compile the confidence report rose on the month, including measures reviewing and predicting personal finances and the general economic situation. The only decline was on the gauge showing the climate for major purchases, which fell four points to minus 26. GfK questioned 2001 people from June 12 to June 21. U.K. house prices rose 0.9 percent in June after climbing 1.3 percent the previous month, Nationwide Building Society said today. Claims for jobless benefits rose in May by 39,300, a third less than economists forecast, the smallest increase since July last year.

Still, the broader unemployment measure using International Labor Organization standards increased to the highest since November 1996 in the three months through April. U.K. gross domestic product shrank 2.4 percent in the first three months of the year from the previous quarter, the most since 1958, the Office for National Statistics said today.

The Bank of England kept the key interest rate at a record low of 0.5 percent this month and reiterated its program to stoke economic growth by buying 125 billion pounds ($207 billion) of bonds with newly created money.
Deputy Governor Charles Bean told lawmakers that the worst of the economic contraction may be past and consumer spending has been "more resilient than one might have expected." At the same time, Governor Mervyn King said he feels "more uncertain now than ever" on the strength of the economic recovery as officials work to resolve problems in the banking system. He affirmed forecasts that the economy won’t return to growth on an annual basis until the second half of 2010.

Sterling Crisis Looms as U.K. Unraveling Points to Budget Cuts
The state of the U.K. economy fills British financial historian Niall Ferguson with foreboding. "The probability of a real sterling crisis is around one in three, and the probability of major tax hikes and cuts in public spending is roughly one in one," the Harvard University professor says. Ferguson’s concern stems from the deterioration in the U.K.’s public finances, which prompted Standard & Poor’s to warn on May 21 that the country could lose its AAA debt rating.

The firm estimated the cost of propping up Britain’s banks at 100 billion pounds ($166 billion) to 145 billion pounds and said government debts could double to almost 100 percent of gross domestic product by 2013. Chancellor of the Exchequer Alistair Darling said on April 22 that this year’s government deficit would hit 12.4 percent of GDP. Alan Clarke, a London-based economist at BNP Paribas SA, expects it to reach 17 percent of GDP in 2010.

"We’re not Iceland or Ireland, but we’re closer to them than we are to the U.S.," says Ferguson, author of "The Ascent of Money: A Financial History of the World" (Penguin, 2008). Iceland had to borrow from the International Monetary Fund to avoid default after its banks collapsed in October; Ireland this year may have the steepest economic contraction of any industrialized nation since the Great Depression.

Britons can expect to face spending cuts in coming years in all areas, including social security and health care, says Nigel Lawson, who was chancellor of the Exchequer under Margaret Thatcher from 1983 to 1989. Political chaos is complicating the financial crisis. In May, the Daily Telegraph reported that lawmakers had been reimbursed for expenses such as moat cleaning and massage chairs, leading at least 15 to say they won’t stand for reelection. With his popularity plunging, Labour Prime Minister Gordon Brown then suffered the indignity of six cabinet ministers quitting in one week in early June, including two caught up in the expenses scandal.

Brown now trails Conservative leader David Cameron by 8 to 22 points, according to 21 polls in May and June. By law, Brown must call an election no later than June 2010. "Our public finances are easily the worst we’ve ever had in peacetime," Lawson, 77, says. "The amount of borrowing the government will have to do as a result of the deficit is very worrying." He says yields on U.K. debt will have to climb to attract buyers.

The government must sell about 900 billion pounds of gilts over five years, Clarke says. He estimates that the Bank of England will buy a third of these gilts to pump money into an economy mired in its worst recession since World War II. The government may struggle to find buyers for the rest, he says.

Ferguson cites as a warning signal the rise in the yield on 10-year gilts, which was 3.6 percent yesterday, up from 2.9 percent in March. "Bond investors have real doubts about the fiscal stability of the U.K., and they want some kind of risk premium," he says. Andrew Bosomworth, a fund manager in Munich at Pacific Investment Management Co., agrees with Ferguson that a weakening of the pound is likely. "In a worst-case scenario, there could be a run on the currency," he says.

The U.K.’s expansionary fiscal and monetary policy -- it is simultaneously boosting spending and buying its own debt -- bothers Bosomworth. So does the possibility the government will have to help pay for further bank losses. "I’m not panicking, but those are real material risks," he says. "It’s a very fragile situation." Ferguson takes no solace from the pound’s recent rally against the dollar. While it climbed to $1.66 yesterday from $1.37 in March, it’s still down 22 percent since November 2007.

"The big difference between the two countries is that the U.S. issues the world’s No. 1 currency and is regarded, partly for that reason, as a safe haven," Ferguson says. "The U.K. used to be, but we’re not anymore. That means we have much more currency risk here." The U.S. is one of the 18 countries that S&P rates AAA. The U.K. is the only country on that list with a negative outlook from the firm.

Bad as it is, the fiscal mess is unlikely to end in disaster, says Ben Broadbent, U.K. economist at Goldman Sachs Group Inc. "We had debt of over 200 percent of GDP after World War II and we didn’t default," he says. "I don’t look at the public borrowing numbers alone and think there’s a big risk of default or a currency crisis." Broadbent is less concerned about looming bank losses than about the recession’s impact on government tax receipts, particularly from the battered financial and housing industries.

The price of credit-default swaps on U.K. sovereign debt has surged as investors try to protect against a deterioration in creditworthiness. The cost of the five-year contract rose to 81 cents per $100 of insured debt on June 26 from 14 cents a year earlier. "I don’t think the U.K. is going to default," Ferguson says. Still, debasing the currency has some of the same effects as defaulting on interest payments, he says, because it erodes the value of the money the government uses to repay its creditors.

The current crisis has stirred memories of 1976, when sterling collapsed and the U.K. had to borrow from the IMF. Meghnad Desai, emeritus professor at the London School of Economics and a Labour member of the House of Lords, says the situation is far less perilous this time because many other countries have heavy debts and face similar recessions. "In the 1970s, the British economy was out of kilter with other economies," Desai says. Given the size of the U.S. fiscal deficit, he says the dollar could prove more vulnerable than the pound.

That may be little consolation for Brown. The Labour leader is loath to make himself more unpopular by cutting spending and raising taxes to tackle the deficit, says George Magnus, senior economic adviser at UBS AG. "This government has got itself into a policy vacuum until the next election," Magnus says. "I don’t expect them to do anything of significance to stabilize public finances."

Lawson, who expects Cameron to succeed Brown, urges Britain’s next leaders to make deep cuts. "It’s essential they take very tough action straight away," says Lawson, who slashed spending in the 1980s. "The question is: How tough are they prepared to be? How much initial unpopularity are they prepared to ride through?" Historian Ferguson sees no alternative to such stringency. "It has to happen," he says. "This kind of red ink implies both spending cuts and tax hikes that could make the 1980s look like a teddy bear’s picnic."

Treasury Set to Unveil PPIP; Ross, GE Capital Participate
The U.S. Treasury is planning to roll out its long-awaited Public-Private Investment Program (PPIP) plan, aiming to unveil it on Wednesday. The program is likely to include as many as nine participants. CNBC has confirmed that two firms will be Wilbur Ross's Distressed Real Estate/debt fund and a joint venture between GE Capital and private investor Angelo Gordon & Co. As many as seven other firms will likely participate.

Other firms widely expect to be named include Pimco and Blackrock. The PPIP has gone through a long gestation process, interviewing many prospective investors and scaling back its scope, which at one point was hailed as a $1 trillion endeavor. It now looks to do business worth around $50 billion.

Markets initially rallied when Treasury Secretary Timothy Geithner announced back in March, a two-pronged plan to offer government financing to lure investors into buying bad loans and toxic securities from banks. The hurdles and stumbling blocks PPIP has encountered highlights two of the main problems the U.S. economy faces — the piles of bad debt sitting on the books of banks and the dilemma of how to price this debt. This is despite the fact that mark-to-market rules have been softened. Banks are still loathed to let go assets at fire-sale prices.

But as long as these toxic assets stay on the books, they saddle banks with losses and constrict their ability to lend. And that's where the government hopes PPIP will step in, offering enough public money to entice banks to sell.

FDIC Rules on Takeovers May Press Buyout Firms for More Capital
The Federal Deposit Insurance Corp. will announce rules on July 2 for bank takeovers by private- equity firms that may force the buyers to pledge more funds should the lenders falter, people briefed on the matter said. The rules are still being debated within the FDIC, the agency that oversaw the sale of BankUnited Financial Corp. to firms including Blackstone Group LP and Carlyle Group in May, the people said, speaking anonymously because the talks in Washington are private. The FDIC said it would issue guidelines as it courts private-equity firms and heeds calls from politicians to monitor their stewardship of banks.

"It’s a tough place for the FDIC to be," said Steven Kaplan, a professor at the University of Chicago Booth School of Business. "They would love to get the extra capital in, but there are fears. They’re worried that private capital can exacerbate the risks." Buyout firms, grouped together as clubs of minority investors, pumped more than $1 billion into U.S. banks in May after financial companies worldwide racked up almost $1.5 trillion of writedowns and credit losses in the past two years. The FDIC has closed 45 U.S. banks so far this year.

The rules would outline capital levels the banks must maintain, how long buyout firms must hold investments and requirements to recapitalize lenders under the so-called source of strength doctrine, the people briefed on the matter said. Most worrisome to private-equity firms may be expanding the source of strength doctrine, which requires a bank’s owner to support an ailing lender, to minority investors such as private- equity firms in a club. The FDIC is considering expanding so- called modified obligations to buyout firms acting as a club, the people said. Each firm’s commitment could be limited on a proportional basis to their stake, they said.

Another option to ensure adequate capitalization would be an agreement that the buyout firms wouldn’t stand in the way of new third-party capital recapitalizing the banks, the people said. The guidelines are also likely to set two years as the minimum period for private equity firms to own banks before selling them, and to set a level for the capital ratios they must maintain. The rules may also create so-called cross guarantees between banks with common owners and clarify existing rules behind transparency, including how much private-equity firms must disclose about their other investments, as well as their own investors.

Blackstone and Carlyle, the two largest private-equity firms by assets, and smaller groups including Lightyear Capital LLC and Colony Capital LLC are analyzing investments in dozens of healthy and ailing banks. Buyout managers have an estimated $400 billion in committed yet unspent capital. Announced private-equity deals dropped more than 60 percent last year to $211 billion, according to data compiled by Bloomberg. Private-equity firms formed groups to buy BankUnited, Florida’s largest lender, as well as IndyMac Bancorp, both of which were seized by the FDIC. Firms including Lightyear and Fortress Investment Group LLC also collaborated on an investment in another Florida lender, First Southern Bancorp, in May.

Senator Jack Reed, the Rhode Island Democrat who chairs a subcommittee overseeing the securities industry, has been wary of welcoming that capital into the banking system. "Senator Reed and other watchdogs have effectively pressured the regulators by saying private equity is welcome but needs proper safeguards," said Patricia McCoy, who teaches banking and securities regulation at the University of Connecticut School of Law in Hartford. "For a regulator, the danger of not proposing sufficient guidelines is that Congress creates a law that’s less flexible and out of their control."

Reed wrote a letter in May to regulators including FDIC Chairman Sheila Bair asking them to set forth their rules around private-equity investments in banks. In a June 5 response, a copy of which was obtained by Bloomberg, Bair pointed to the BankUnited and IndyMac deals and "significant conditions to these two private equity transactions, including capital maintenance and resale restrictions."

The BankUnited agreement included a provision that prevents a sale of a controlling interest in the bank for 18 months. Bair reiterated the agency’s intent to issue "generally applicable policy guidance" on private-equity investments. In a handwritten postscript next to Bair’s signature was written, "Good chatting with you. We will get this right."

FHFA's Lockhart on CNBC
James Lockhart the Director of FHFA was on CNBC this morning. I thought he did a pretty good job of representing the FHFA perspective on things. He certainly did not do a good job speaking as an advocate for the taxpayers who are supporting the $10 billion per month of losses at his Agency.

Mr. Lockhart referred to the commitment by the Fed and Treasury to purchase $1.25 Trillion of Agency MBS as a, "pretty significant commitment". Like that was not such a big deal and maybe that number should be upped. A little perspective, this ‘pretty’ significant effort is the largest single commitment every made by our country. It is equal to 10% of the National Debt and 10% of our GDP. It is a biblical sized commitment that runs the risk of destroying our financial system if we are not very careful. Mr. Lockhart should not trivialize what is happening. He most certainly should not be looking for an extension of the Fed’s largess.

On Agency credit standards he remarked, "The standards of two years ago were appalling."

On capitalization he said, "The Agencies were allowed 100% leverage. Even a flawless portfolio was a risk."

Mr. Lockhart became the Director of OFHEO in June of 2006. He is a very smart man who knows D.C. from the inside. In 2006 there were dozens of warning signs that the Agencies were running amok in both the size of their portfolios and the credit quality of assets they were acquiring. The Agencies bought over 1 trillion of Sub Prime and Alt A mortgages during that period. They did that using the excuse that the wanted to ‘expand market share’. This proved to be one of the all time worst decisions. We need to understand that those "appalling’ credit standards were in place while he was the top cop.

Mr. Lockhart knows his numbers. He knew them in 06 when the Agencies were running that 100% leverage he referred to on television this morning. Where was OFHEO, the predecessor regulator to FHFA, while this ludicrous level of leverage was being created? There were many observers in that period that saw the writing on the wall. No doubt but that Mr. Lockhart saw it as well. Two months before the Agencies went into receivership he said they were ‘adequately capitalized’. Today he says they were running on 100% leverage.

He made several references to the broad housing market. He referred to the market as bumping along the bottom. It was his view that there may be some "choppiness" ahead but he was clear that the worst was behind us. The chief regulator of $6.5 Trillion of mortgages should not be a cheerleader. He should be protecting the downside, not forecasting the upside. The biggest mistake by D.C in the past twenty-four months is that they have consistently underestimated the severity of our problems.

In support of his position that the RE market has stabilized he pointed to FHFA’s own tracking system for measuring home prices that has showed no change for months. That was a mistake. FHFA’s price measuring system is flawed. At this point just about everyone knows it. Treasury did not use it in the stress test process. They chose to use the more credible Case Schiller index. The FHFA price survey has grossly understated the fall in home prices in the real economy. Mr. Lockhart is aware of that fact.

In response to a question Mr. Lockhart stated, "The Agency Charter prohibits FNM and FRE from acquiring loans that exceed 80% loan to value." That is a true statement, but what he failed to say is that insurance lobbyist created a carve out where non-conforming loans with up to 100% debt to equity are permitted provided an insurance company stands for a first loss of 20%. Mr. Lockhart failed to mention that over 20% of the Agencies portfolio is filled with these over leveraged loans. He failed to mention that none of the insurance companies that provide the enhancements meet the credit ratings that are required by that same Charter he refers to. He failed to mention that this category of his portfolio is producing 3 times the default rates as 80/20 mortgages do. He also failed to clarify that under his regulatory responsibility is the Federal Home Loan Banks. These banks have no limitations in their charter on loan to value. Anyone who watches television knows FHLB is pumping out $100billion per month of 97.5% LTV loans into the market.

The Agencies gambled with the people’s money. They arbitraged the countries AAA rating. They represent the greatest systemic risk that we face. They have not changed a bit since going into receivership. They are still running 100% leverage. They are losing $10 billion per month. They are still making high-risk mortgage loans. They still are 85% of the new mortgage market. There is no exit strategy in place to end this nightmare. A new cop is required to re-establish the confidence we need.

BIS calls for global financial reforms
Financial products should be regulated like medicine in future, the Bank for International Settlements, said on Monday as it advocated sweeping reforms to financial instruments, markets and institutions. The central bankers’ bank had previously given the most accurate warnings about the impending financial crisis. In its annual report on Monday it called for an overhaul of financial regulations, economic policy and the structure of the global economy.

It advocated big reforms to markets to limit bilateral trading between banks and instead introduce central counter parties, with trading on regulated exchanges. It said institutions, particularly banks which posed a risk to the financial system, should also be subject to higher requirements to hold bigger buffers of capital against a future crisis. The authorities should strive to increase those buffers in good times. It also recommended “a scheme analogous to the hierarchy controlling the availability of pharmaceuticals”, with a sliding scale topped by the safest products available for everyone to purchase, and tailed by financial instruments deemed illegal.

Although the BIS was clear that these reform suggestions were for the future, it said it was vital that thought be given to the ongoing structure of the financial system while the patient was still on life support. Efforts so far, it concluded, had been a “messy mixture of urgent treatment designed to stem the decline, combined with an emerging agenda for comprehensive reform to set the foundations for sustainable growth”. It highlighted two main risks: first, that not enough will be done to ensure a durable recovery from crisis; and second, that the emergency action to stabilise the financial system will undermine efforts to build a safer system.

The report was particularly scathing in its assessment of governments’ attempts to clean up their banks. “The reluctance of officials to quickly clean up the banks, many of which are now owned in large part by governments, may well delay recovery,” it said, adding that government interventions had ingrained the belief that some banks were too big or too interconnected to fail. This was dangerous because it reinforced the risks of moral hazard which might lead to an even bigger financial crisis in future.

Outside the financial system, the BIS warned that economic management also needed to change. The huge increases in public deficits were “at serious risk of overshooting even in the economies with the most room for debt expansion” and would be difficult to restrain. The authors of the report also had little confidence in central bankers’ ability to raise interest rates quickly enough when recovery comes. “Because their current expansionary actions were prompted by a nearly catastrophic crisis, central bankers’ fears of reversing too quickly ... increase the risk that they will tighten too late,” they said.

Debt is capitalism’s dirty little secret
Just why is there so much debt in the Anglo-Saxon world? Bankers and regulators know well that it is in nobody’s long-term interests to have allowed borrowing to escalate to a position where the US now owes far more, as a multiple of the economy, than at the start of the Great Depression. The answer is capitalism’s dirty little secret: excessive lending was the only way to maintain the living standards of the vast bulk of the population at a time when wealth was being concentrated in the hands of an elite.

The amount by which the elite has benefited is startling, and illustrates the problem with lightly regulated free markets: the rich get much richer while the rest do not get richer at all. According to Société Générale economists, the inflation-adjusted income of the highest-paid fifth of US earners has risen by 60 per cent since 1970, while it has fallen by more than 10 per cent for the rest. As was recently pointed out in the New York Review of Books, the Walton family, of Wal-Mart fame, is wealthier than the bottom third of the US population put together – about 100m people.

These are staggering statistics, confirmed by measures such as the US and UK’s ever-rising Gini coefficients, which estimate income disparity. Another way of putting this is that the share of profits in gross domestic product is at a 100-year high, or was until very recently. Put simply, the benefits of economic growth have gone into the pockets of plutocrats rather than the bulk of the population.

So why has there been no revolution? Because there was a solution: debt. If you couldn’t earn it, you could borrow it. Cheap financing was made widely available. Financial innovations such as the asset-backed securities market aided this process, as did government-sponsored agencies such as Fannie Mae and Freddie Mac. Regulators welcomed it all while perhaps taking insufficient account of the moral hazard problem it posed: that ever-increasing leverage meant the authorities had to keep interest rates low, otherwise the debt burden would cripple consumption. This prompted more leverage, which exacerbated the problem.

A walk in any low-income area in the UK confirms this. There are BMWs in the driveways, satellite dishes on the roofs and furniture delivery vans on the streets. In both Britain and America the jobless were encouraged to buy their own homes. No one begrudges anyone else the right to own a home or buy luxury goods. The problem is that the luxuries need to be paid for out of earnings and the houses out of equity topped up with an affordable amount of debt.

The question is whether the debt load – total US credit market debt outstanding was $53,000bn (€38,000bn, £32,000bn) at the end of March, or 3.7 times GDP – is at all sustainable and, if not, how it can be lowered without sinking the economy. Those pushing extra debt in an effort to boost the economy via increased consumption point to the scale of assets backing the debt. The net worth of US households, including their houses and after counting debt, was $50,000bn in March, according to the Fed. Not a bad tally for 306m people: $165,000 each. However, the cost of servicing this debt as a proportion of income, even with record low rates, is at a 30-year high, above 15 per cent, as incomes have stagnated and the total level of debt has risen.

The debt burden has to come down, which means more saving and lower economic growth for many years to come. Along the way inflation is likely to return, probably sooner and more violently than most expect, which will prompt investors to demand a higher return and make it even harder for governments to tackle the debt. At best the debt will fall slowly over many cycles and simply trim otherwise resilient growth. At worst it could cause growth to lurch upwards before tumbling again, with all the attendant uncertainty that entails.

At this point, no one can know which is more likely. I incline to the more benign view because of the size of household assets but, if the dollar’s reserve currency status should come under serious attack, rates would have to rise to defend it and that could itself cause a consumption crisis. What can be done?

First, although it is not ideal, we should not be too hasty about abandoning the capitalist model. It is less bad than any other system yet invented. But we should redouble our efforts to increase productivity through innovation and creating new markets; simply squeezing lower-income workers is a bad option, which helped get us into this mess in the first place. This requires investment in education and research.

Second, we have to learn to live within our means. This means spending less than we earn, perhaps doing without the BMWs, flat-screen television sets and leather sofas.

Third, we should be careful in distributing the higher tax burden that we will inevitably have to bear over the coming decade. Very high marginal tax rates did not work in the 1970s and will not work now. That said, income disparity at current levels is a political time-bomb that needs to be dealt with. Finally, we should all come to terms with the fact that these are structural issues needing structural solutions; they need to be enforced over a longer time period than any one government’s term. So we need a new political consensus, one aimed at reducing overall debt levels while reducing inequality by encouraging education, entrepreneurship and investment in innovation.

Eurozone inflation turns negative
Eurozone annual inflation has turned negative for the first time, complicating the job of the European Central Bank as draws a line under emergency measures to tackle continental Europe’s recession. Consumer prices in the 16-country eurozone were 0.1 per cent lower in June than the same month a year before, according to Eurostat, the European Union’s statistical office. It was the first time eurozone annual inflation had fallen below zero since comparable records began in 1991.

Inflationary pressures in continental Europe are now lower than at anytime since at least the early 1950s, according to calculations by some economists. The fall in prices reflected sharply lower energy costs but also the effects of the worst post-war economic downturn. The US had already reported year-on-year falls in consumer prices.

News that inflation had turned negative – and was massively undershooting the ECB’s target of an annual rate "below but close" to 2 per cent - came as the ECB prepares for Thursday’s interest rate setting meeting in Luxembourg. Since last October, the ECB has slashed its main policy rate by 325 basis points to 1 per cent, and pledged to meet in full banks’ demands for liquidity – which resulted in it last week pumping €442bn in one-year loans in the banking system.

But the ECB’s governing council is not expected to cut official borrowing costs further at this week’s meeting and analysts expect the main policy rate to remain at 1 per cent for many months – possibly well into next year or even beyond. The ECB believes the impact of its measures have still to feed through into the economy. But it faces a difficult balancing act. Even though the inflation outlook justified further action, the central bank feared "that more aggressive easing now could risk financial stability and or a too sharp acceleration of inflation over the longer-term," said Nick Kounis, European Economist at Fortis Bank.

Jean-Claude Trichet, ECB president, is likely to stress on Thursday that negative inflation will be only a temporary with a return to positive annual rates expected later this year. But ECB forecasts show inflation remaining well below 2 per cent in 2010 and the worry for ECB policymakers is that months of below-zero inflation rates will stoke fears of full-blown deflation – generalised and persistent falls in prices that wreak significant economic damage. Meanwhile, credit figures released by the ECB just ahead of the inflation news highlighted how the liquidity it has pumped into the banking system have not yet stopped credit flows to the economy from being thrown into reverse.

Businesses repaid a net €5bn in loans in May, slowing the annual rate of growth in such loans to just 4.4 per cent. Even more dramatically, the annual rate of growth of borrowing by households turned negative, with loans down 0.2 per cent on the year. The ECB has been stepping up its appeals recently for banks to pass on the extra liquidity they have been lent, but it could be some months before any extra lending to businesses and households shows up in official data.

German unemployment declines in June
Germany's jobless rate edged down to 8.1 percent in June, official figures showed Thursday, posting a weak seasonal improvement as programs to put workers on shorter hours helped stabilize employment amid a serious recession. The Federal Labor Agency said the unadjusted jobless rate was down from 8.2 percent in May, with the total number of people registered as unemployed dropping by 48,000 to 3.41 million.

However, Germany had a quarter of a million more people unemployed than in June 2008. The labor agency said German companies' use of shorter working hours to protect jobs during the downturn had kept unemployment numbers from rising even more. "Despite the massive downturn in production, the current changes are still comparatively moderate; in particular, the strong participation in short-time programs stabilized the job market," the agency said in a statement.

However, the labor market typically lags behind the economy, and the agency said it was expecting more pressure on jobs as the crisis continues to cut into demand for products from Germany, the world's top exporter. The German economy -- Europe's biggest -- is expected to shrink by 6 percent or more this year and post at best minimal growth in 2010. In seasonally adjusted terms, the unemployment rate edged up to 8.3 percent in June from 8.2 percent in May and the number of people out of work increased by 31,000 -- up from an increase of 7,000 the previous month.

That "contrasts with a much more rapid pace of monthly increases of 54,000 during December-April," Timo Klein, an analyst at IHS Global Insight, said in a research note. However, he said he "expects seasonally adjusted unemployment to rise throughout 2009 and 2010, with monthly increments most likely to pick up during the second half of 2009." German companies that are using or have used short-time working arrangements to preserve jobs include chemical maker BASF SE, steel producer ThyssenKrupp AG and car makers Daimler AG and BMW AG.

The labor agency said the number of companies registering workers for shorter hours declined in June, with an estimated 12,000 firms registering up to 220,000 workers. In May, 14,000 companies signed up some 290,000 for the arrangement. The agency said that since October 2008 about 110,000 German companies have announced plans for more than 3 million people to work shorter hours. However, it noted that such plans are not necessarily implemented, and estimated that between 1.3 million to 1.4 million people are currently working an average of about two-thirds their normal hours.

German June Unemployment Rises to Most Since 2007
German unemployment rose to the highest since 2007 in June as falling demand and rising bankruptcies forced companies to cut jobs. The number of people out of work increased a seasonally adjusted 31,000 to 3.5 million, the Nuremberg-based Federal Labor Agency said today. Economists forecast an increase of 45,000, according to the median of 28 estimates in a Bloomberg News survey. The adjusted jobless rate rose to 8.3 percent from 8.2 percent.

Germany’s deepest recession since World War II led to a 14 percent increase in insolvencies in the first half of the year, according to Creditreform e.V. While Chancellor Angela Merkel’s government is paying companies to hold on to workers as part of its 85 billion-euro ($120 billion) economic package, layoffs are mounting the longer the slump lasts. "The unemployment time bomb’s ticking away," Holger Schaefer, a Berlin-based labor-market analyst at the IW economic institute, said in a phone interview.

"Unemployment, protected so far by government relief to companies and stimulus programs, will rise sharply in the second half, it’s a dead certainty." The German economy, Europe’s largest, will shrink 6.1 percent this year, the Organization for Economic Cooperation and Development said June 24. The unemployment rate will rise from 7.3 percent in 2008 to 8.7 percent this year and 11.6 percent in 2010, it said.

German unemployment began to increase in November after falling steadily for more than three years and the Bundesbank estimates that the number of people out of work will rise to 4.4 million next year. The country’s engineering and electrical sector has shed 124,000 jobs since December, half the number of positions it created between 2006 and 2008, the Gesamtmetall employers group said on June 20. Hypo Real Estate Holding AG, the German lender that almost collapsed last year, said on June 22 it will cut 1,000 jobs by 2013. Around 40,000 jobs have been put in jeopardy after retailer Arcandor AG filed for insolvency last month.

Insolvencies cost the German economy 20.8 billion euros in the first half and eliminated 254,000 jobs, Creditreform said on June 22. For the full year, the number may rise to 540,000, it said. Lengthening jobless lines may undermine Merkel’s chances of forming a coalition government with the pro-business Free Democratic Party in September elections. Her government is trying to limit the unemployment increase by subsidizing the cost of retaining workers. Labor Agency aid under the plan was extended from six months before the crisis to 24 months.

Combined support for Merkel’s Christian Democratic Union, its Christian Social Union Bavarian sister party and the FDP rose to 51 percent, a Forsa poll for Stern magazine and RTL television showed June 24. Support for the Social Democratic Party, Merkel’s current coalition partner, rose 1 percentage point to 22 percent. Even as unemployment rises, confidence is starting to improve, with GfK AG’s consumer sentiment index rising for a second month in July. Still, the market research company said it is "unclear" whether the improvement marks the beginning of a "sustained recovery."

"With regards to the downward dynamics, I think we’ve left the worst behind and currently are in a stabilization phase," Bundesbank President Axel Weber said on June 16. "However, we’re far away from a significant pick-up of the economy." The economic slump has prompted the ECB to cut its benchmark interest rate to a record low 1 percent and lend banks as much money as they want for 12 months to get credit flowing. Business confidence in Germany rose for a third month in June, the Ifo institute in Munich said June 22.

According to the latest comparable OECD data, Germany’s jobless rate rose to 7.7 percent in April from 7.6 percent a month earlier. Unemployment in the U.S. and France was 8.9 percent that month. In western Germany, the number of people out of work rose by a seasonally adjusted 27,000 in June, while the number in eastern Germany grew by 4,000, today’s report showed.

Bundesbank Colossus Loses Ability to Dictate ECB Rate
Germany’s Bundesbank, which once dictated interest rates for a continent, is losing influence to smaller nations as the European Central Bank tries to reverse the worst recession since World War II. President Axel Weber’s focus on fighting inflation at any cost, rooted in German hyperinflation during the 1920s, is under attack on the ECB’s 22-member Governing Council by policy makers from Slovenia to Cyprus who want to promote growth.

Weber was defeated last month after trying to stop the central bank from buying assets to ease credit. His December warning against allowing the benchmark interest rate to fall below 2 percent went unheeded as the ECB cut it to half that level by early May. The Bundesbank’s diminished clout may mean the council, which convenes on July 2 in Luxembourg, will keep interest rates lower for longer than it would have tolerated in the past. Barclays Capital predicted last week that Europe’s central bank won’t increase them for at least two years.

While Weber, 52, has already called for rates to be raised before inflation risks materialize, "the Bundesbank colossus is losing its influence," said Stuart Thomson, who helps oversee the equivalent of about $107 billion at Ignis Asset Management in Glasgow. "In a Bundesbank-driven ECB, rates wouldn’t have been cut this low, and it would have been the first central bank to signal an exit," said Thomson, who’s shunning the euro and buying British pounds on speculation the Bank of England will be faster to scale back its purchases of bonds and raise borrowing costs.

The shift in the balance of power away from the Bundesbank is forcing investors to look beyond Weber for clues about the strategy of the Frankfurt-based ECB, which is headed by President Jean-Claude Trichet, a 66-year-old Frenchman. That’s pushing officials such as Slovenia’s Marko Kranjec and former Federal Reserve senior adviser Athanasios Orphanides of Cyprus onto their radar screens. "Other countries’ collective voices are now becoming much more important, and the ECB is more likely to strike a compromise," said Andrew Bosomworth, a former economist at the central bank and now a fund manager in Munich for Newport Beach, California-based Pacific Investment Management Co.

The economy will undercut any argument Weber makes for higher rates anytime soon, according to Richard Batty at Standard Life Investments Ltd. in Edinburgh. "I don’t see any entrenched inflation tendencies coming through in Europe," said Batty, a global-investment strategist who helps oversee $194 billion and is positive about the outlook for German government bonds. "I’d be very surprised if the ECB needs to preemptively raise interest rates."

On June 24, the Organization for Economic Cooperation and Development predicted that consumer prices in the euro area will rise 0.5 percent this year and 0.7 percent in 2010, less than half the ECB’s 2 percent limit. Prices increased 3.3 percent last year, the most since the single currency began trading a decade ago. In its global outlook, the Paris-based group said the ECB should quickly cut interest rates more to revive the economy, which the OECD said would contract 4.8 percent this year and stagnate in 2010. The economy grew 0.7 percent in 2008. Economists at Barclays in London have forecast that Europe’s policy makers won’t begin raising rates until late 2011.

"Any prospective ECB tightening is not likely to materialize until well after the Fed has embarked upon a tightening cycle," Julian Callow, the firm’s chief European economist, said in a June 25 report. The Bundesbank’s dedication to stable prices is rooted in German memories of the rampant inflation that followed World War I and fueled the social unrest that helped elevate Adolf Hitler to power. The government printed money to fund the war and pay reparations to the Allies. By the end of 1923, prices were surging 2,400 percent every month, according to Bundesbank data.

"Fear of inflation is in the German DNA," said Andreas Scheuerle, an economist at Dekabank in Frankfurt. Those genes shaped the euro. To ensure German support for the new currency before its 1999 birth, European politicians agreed to transfer the Bundesbank’s price-stability mandate to the ECB’s statutes. That differs from the dual mandate of the Fed to fight inflation and foster job creation.

Weber, who has headed the Bundesbank since April 2004 after serving as an economic adviser to the German government, isn’t pushing for higher interest rates now. Euro-area consumer prices fell 0.1 percent this month from a year ago, their first annual decline since records began in 1996. What Weber has begun to do is use speeches to outline how he thinks the ECB should remove its emergency-stimulus measures when the economy recovers.

Among his proposals: eventually raising interest rates as a "precaution" to temper inflation before it emerges and pursuing a "timely withdrawal" of the unlimited loans the ECB has been making to banks. Last week it provided a record 442 billion euros ($623 billion) for 12 months. It will hold two further 12-month tenders this year. Removing the extra liquidity "as fast as possible once the economic environment improves" is necessary to ensure price stability, Weber said in a May 25 speech. On June 23 he said the ECB has no more room to cut rates and no need to introduce new stimulus initiatives.

A former marathon runner and professor of international economics at the University of Cologne, Weber is building his case as data show the recession is easing. The contraction in Europe’s services and manufacturing industries is weakening, according to an index based on a survey of purchasing managers by research company Markit Economics. The index increased to 44.4 this month, the highest since September. The European Commission reported yesterday that its gauge of executive and consumer sentiment rose in June to 73.3 from a revised 70.2 in May.

Weber has been calling for restraint since the end of last year, expressing concern that low interest rates and asset purchases could sow the seeds of future asset bubbles and inflation. His arguments failed to carry the day. On May 7, the ECB cut its key rate by a quarter point to 1 percent and announced its intention to buy, for the first time, 60 billion euros of covered bonds: securities backed by mortgages or public-sector loans. The decisions marked a victory for Cyprus, Greece and Austria, which had pushed for more-aggressive action. Orphanides spearheaded the argument, saying as early as Jan. 28 it was "dangerous" and a "fallacy" to argue that rates become ineffective as a central-bank tool the lower they fall.

When Orphanides signaled in an April 11 interview that the ECB may have to take more steps to quell deflation risks, government bonds extended gains, pushing the yield on the two- year German note down four basis points to 1.35 percent, the lowest since April 1. Weber’s comments can still move markets, too. The euro and yields on two-year German notes both rose when he declared last week there was no more scope to cut rates. Had it not been for him, policy makers might have acted even more aggressively, said Marie Diron, a former economist at the central bank and now senior economist at Oxford Economics Ltd. in London.

The ECB’s 60-billion euro asset-purchase plan amounts to just 0.6 percent of gross domestic product compared with 12 percent for the Fed’s program, and the ECB’s benchmark rate is the highest among the Group of Seven nations. "Weber has won arguments," Diron said. Even so, in a financial crisis with no parallels, the Bundesbank’s road map is little comfort to some members of the ECB council. "The primary goal should be to restore economic growth as fast as possible," Austria’s Ewald Nowotny said at a conference in Vienna on June 15.

Slovenia’s Kranjec said in a May 13 interview in Ljubljana that it’s "very likely" the ECB will expand and broaden its plan to buy covered bonds. Paul De Grauwe, a professor at Belgium’s Catholic University of Leuven, said inflation is the least of the central bank’s worries, and Weber is on the wrong side of the debate. "At the moment, other problems prevail," De Grauwe said. "He looks a bit like he’s fighting yesterday’s war."

Spain’s 'Mythical Land' Shows Savings Bank Links to Politicians
Terra Mitica, a theme park in the Spanish resort of Benidorm, features Roman gladiators and a replica of an Egyptian pyramid. Unfortunately for the regional government and two savings banks that own "Mythical Land," the profits have proven no more real. The park is a monument to the way Spain’s savings banks, known as cajas, helped finance the ambitions of politicians, fueling the country’s decade-long boom and setting up the lenders for losses when the bubble burst, said Jordi Palafox, 57, a University of Valencia economic history professor.

The government announced on June 26 a $9 billion-euro ($12.6 billion) rescue fund to support ailing lenders and finance mergers. The move may speed consolidation among the cajas, which account for about half of Spain’s bank lending, said Daragh Quinn, an analyst at Nomura International in Madrid. "Terra Mitica was a political caprice that lost a lot of money," said Palafox, 57, a former board member of Bancaja, the Valencia-based bank that owns about 22 percent of the park. "It’s part of a wider story whereby savings banks were used to finance massive speculation in property and construction."

The cajas, non-profit lenders without shareholders, increased lending to developers to 243 billion euros by the end of 2008 from 36.2 billion euros at the start of the decade, according to the central bank. Now, as Spain faces its worst recession in 60 years, the 45 savings banks are leading the surge in overdue loans. Bad loans represented 5.05 percent of the cajas’ lending in April, compared with 3.81 percent for commercial banks, Bank of Spain data show. The crash claimed its first victim in March, when the central bank seized Cuenca, Spain-based Caja Castilla La Mancha.

A 1977 royal decree helped pass oversight of the cajas from the central government to an array of groups, including local politicians and customers, said Juan Jose Toribio, who was head of finance policy in the economy ministry at the time. "It was a mistake," said Toribio, now a professor at the University of Navarra’s Barcelona-based IESE business school. "Politicians inevitably tend to ask savings banks to finance projects they think will win them votes."

Many Spaniards admire the cajas because their profits fund health, culture and research programs instead of dividends to shareholders, said Manuel Romera, director of financial industry studies at Madrid’s Instituto de Empresa business school. The cajas spent 2.03 billion euros on social spending in 2008, according to Spain’s savings bank association. That compares with the $2.8 billion (2.00 billion euros) in grants worldwide by the Seattle-based Bill & Melinda Gates Foundation. "In the majority of cases, political influence is very limited indeed," Antonio Claret Garcia, chairman of Granada- based Caja Granada, said in an interview.

Terra Mitica opened in 2000 after a campaign by Eduardo Zaplana, then Valencia’s regional governor, to boost the local economy with projects aimed at the tourists who flock to Spain’s Mediterranean coast. Valencia owns 22.4 percent of the park, and Alicante-based Caja de Ahorros del Mediterraneo owns 22 percent. Avril Hewitt, 56, an unemployed newspaper advertising salesman from Stockport, England, took advantage of two-for-one coupons offered at a McDonald’s restaurant in Benidorm to visit the park with 17 friends and relatives on May 29. "The park is fine, but I wouldn’t pay full price to get in," he said. A one-day adult admission costs 34 euros.

Terra Mitica has lost more than 270 million euros since it opened, estimates Jose Camarasa, a spokesman for the opposition Socialist Party on the Valencia regional assembly, and filed for bankruptcy protection in 2004.
Santiago Lumbreras, a park spokesman, declined to discuss finances except to say the park was profitable in 2006 and 2007 and had losses in 2008. The park has helped spur development in the area, he said. "It’s a mistake to only judge the park’s success by its profit and loss account," Lumbreras said.

Political considerations didn’t influence the decision to build Terra Mitica, Bancaja Chairman Jose Luis Olivas, a former head of the regional government, said in an interview. Olivas said he favored more "depoliticized" cajas.
Bancaja’s profit fell 5.8 percent in the first quarter from a year ago to 107 million euros. Defaults and bad loans as a proportion of total lending jumped to 5.20 percent from 1.13 percent. Terra Mitica is only a small part of the bank’s business, Olivas said. The cajas’s structure makes them susceptible to political control, Palafox said.

Of Bancaja’s 199-strong general assembly, which names the board and executive committee, 99 are appointed by the regional government and town halls. The bank’s customer association picks 66. The cajas’ practice of funding customer associations and other groups linked to management tends to extend political influence, Palafox said. Client associations are "absolutely independent," said Angel Villanueva, chairman of the Valencian savings bank customers’ group.

Because savings banks don’t have shareholders, they are more focused on market share and revenue than profitability and management of risk, said Quinn, the Nomura analyst. "This has been the key driver behind the savings banks’ greater exposure to real estate deals and would arguably have happened with or without politicians," he said.

Czech Industrial Output Plunged 21.7% in May as Economic Recesion Deepened
Czech industrial output dropped for an eighth consecutive month in May as the effects of the global financial crisis deepened. Output declined an annual 21.7 percent, the Czech Statistical Office said in a preliminary estimate posted on its Web site today. The drop followed a 22.1 percent decrease in the previous month and compares with a median estimate of 11 economists for an 18 percent fall in output. The Czech economy contracted at a record pace in the first quarter as recessions across western Europe undermined demand for exports, forcing companies to cut production.

After adjusting for the effect of different number of working days, the May industrial output fell a preliminary 19.8 percent in year, the office said. The final report will be released on July 13. Industrial sales in constant prices dropped 27.6 percent in a year, while the value of new orders declined 27.6 percent, the office said.

Ukraine Economy Shrank 20.3%, Fastest Pace on Record
Ukraine’s economy contracted at the fastest pace on record in the first quarter as the global financial crisis took its toll on the eastern European nation, cutting its production, consumption and investments.
Gross domestic product plummeted 20.3 percent, compared with growth of 6.3 percent in the same period a year ago, the Kiev-based state statistics committee said today in a statement on its Web site. The median forecast of 11 economists in a Bloomberg survey was for a 22 percent decline.

The global recession is compounding problems in east European economies, which are being battered by a lack of credit, weakening currencies and plunging demand for their products on world markets. In November, Ukraine was forced to turn to the International Monetary Fund along with other emerging-market countries including Hungary and Latvia for funds to support its financial system and avoid default. "It’s a large headline drop in gross domestic product, but in line with market expectations," said Jathan Tucker, head of trading at Kiev brokerage Galt & Taggart Holdings Inc. "The full year number will be impacted more by what goes on with non- performing loans and the banking sector later this year."

Ukraine’s bad loans rate jumped to 4.89 percent of all loans by June, compared with 2.27 percent as of Jan. 1 as households and companies struggle to repay debts, the central bank said June 24. Non-performing loans may reach more than 20 percent of the total by the end of 2009, Moody’s Investors Service said June 22. The first-quarter contraction was led by industrial production, construction and trade, data showed. Output has declined more than 30 percent each month this year, while retail sales slumped 15.3 percent in the first five months of the year, compared with growth of 30.2 percent last year.

Ukraine’s Presidential office of Viktor Yushchenko, which is in a struggle with Prime Minister Yulia Timoshenko’s government, forecast the economy will contract by 10 percent this year, the steepest decline since 1996. The government still officially sees growth of 0.4 percent. Ukraine’s economy, which has been expanding at an average annual pace of almost 7 percent since 2000, shrank 8 percent in the fourth quarter, the first contraction since 1999.

Magna-Opel deal in doubt
Efforts to save two leading European carmakers took a twist on Tuesday that could change the ownership of both crisis-hit General Motors Corp's Opel and German sportscar maker Porsche. As GM readied for bankruptcy, the Financial Times reported Belgium-based holding company RHJ International, a former bidder for Opel, was back in the running and close to a deal that would strand Canadian-Austrian auto parts group Magna International.

Elsewhere, Qatar made an offer to the Porsche and Piech families that control the Porsche SE automotive holding that could help cut its debt mountain. Porsche and Volkswagen have been in talks to create an "integrated" automotive group after Porsche's 9 billion euro ($12.6 billion) debt burden forced it to drop plans for a full takeover of VW. But progress toward creating a combined company stalled after Porsche chief executive Wendelin Wiedeking sought investment from Qatar's sovereign wealth fund.

The FT reported GM was close to a deal with RHJ to sell a stake in Opel, and a memorandum of understanding could be signed within days. Talks on a stake in Opel between its parent, GM, and Magna -- going on since Magna clinched an agreement just before GM's bankruptcy filing in May, pipping Fiat to the post at the time -- have hit snags, the paper said. RHJ was named as a potential Opel buyer in media reports but never confirmed or denied it had made an initial bid let alone a second, improved one. But according to the Financial Times, RHJ has improved an earlier bid and is being taken "very seriously" by GM and a memorandum of understanding could be signed in days.

The FT reported RHJ's new offer was said to be more sensitive to job losses in Germany, which is providing $2.1 billion of bridge financing to keep the carmaker afloat as GM goes through bankruptcy proceedings. Another sticking point in negotiations with Magna is access to the Detroit carmaker's global technology, which Magna wants to secure on behalf of Russian partners, the paper said. Magna has teamed up with GAZ and Sberbank for the bid.

RHJ and Magna declined to comment, as did Fiat whose chief executive Sergio Marchionne has said he wants to focus on Chrysler -- in which it has taken a 20 percent stake -- after the Italian automaker's bid for Opel failed, and that its existing bid for Opel was the best it can do. Back in the United States, GM is due to seek approval from a court on Tuesday to sell its assets to a "New GM" in a plan to reinvigorate the automaker under government ownership. Also on Tuesday, Hyundai Motor Co offered to allow customers to lock in fuel prices for new vehicles in a sales promotion aimed at the economic anxieties of American consumers.

Iraq oil auction fizzles
The first international bidding process in more than 30 years for development rights to some of Iraq's oil fields has finished, with only one field being awarded. Iraq had offered six oil and two gas fields in a landmark auction the government hoped would help boost output to 4 million barrels per day and generate cash it desperately needs for postwar reconstruction. But the bidding round Tuesday faltered quickly as companies demanded terms far greater than what the government was willing to provide. The country, which sits atop 115 billion barrels of crude reserves, currently produces about 2.4 million barrels per day and was hard hit by the collapse of oil prices in the second half of 2008.

A 20-Year Bear Market?
by David Galland, Casey Research

In November of 1997, my partner and co-editor of The Casey Report, Doug Casey, wrote an article titled "Foundations of Crisis," which leaned heavily on the research of Neil Howe and the late William Strauss.

Howe and Strauss have written many books on how generations determine the course of history and how they will shape America's future. Their forecasts on a wide variety of indicators have turned out to be amazingly accurate. They were among the first to predict (back in the late 1980s) the rise of Boomer-driven culture wars and the simultaneous rise of Gen-X-driven free agency and distrust of government. And they were completely alone back then in predicting, for the post-X "Millennial Generation" (a label they coined), a decline in youth crime and risk taking and an increase in youth civic engagement that would first become apparent around the year 2000. Guess what? For the last ten years, everyone has been noticing exactly these trends among teens and 20somethings.

Howe and Strauss also made extensive predictions, based on generational aging, on how America's entire social mood would likely change, in dramatic fashion, during our current 2000-2010 decade. To quote Doug's prescient 1997 article, which was reprinted in Outside the Box late last year...

"... an excellent case can be made the U.S. is approaching another time of secular crisis, a Fourth Turning, with an expected due date of 2005 – seven years from now – plus or minus a few years in either direction.

The Stamp Acts catalyzed the American Revolution, the election of Lincoln catalyzed the Civil War, the Crash of '29 catalyzed the Depression/WW II era. What might precipitate the elements now floating in solution? The answer is practically any random event that's sufficiently traumatic. Any of the theses of current disaster/action novels and movies will do nicely. Perhaps the accidental or intentional release of a super plague vector. The crashing of an airliner into the Capitol during a joint session. An all-out assault on the IRS computers by an armed group – or perhaps the computers just melting down due to the Year 2000 Problem. Perhaps a financial disaster that cascades into the Greater Depression. In any of these, or a hundred other scenarios, the federal government would almost certainly act precipitously and with a heavy hand, which would bring on a whole other set of consequences.

There's no way of telling where the Crisis will lead, or how it will end. That's going to depend not only on exactly who's in control, but what they do, who they're up against, and a hundred other variables we can't even anticipate.

One thing that seems certain is that real crisis brings out strong leadership. Because of its age and size, it will come from the Boomer generation, and it will be in the mold of Roosevelt or Lincoln – both very dangerous precedents. The boomers in elderhood will be dogmatic, harsh, puritanical, and quite willing to burn down the barn in order to destroy whatever rats they see. Admix that attitude to a time resembling the Revolution, the Civil War, or WW II, overlain with today's ethnic strife, urbanization, financial overextension, and powerful, compact new weaponry in the hands of foreign fanatics out to teach the Great Satan a lesson and it's a real witch's brew.

As eye-opening as Doug's predictions were, they brought us only to the onset of the current crisis. Consequently, we thought it both timely and important to check back with the source of much of the research he relied on. And so it was that I spent several hours talking with Neil Howe, co-author of the seminal work on generational cycles, The Fourth Turning, and, just recently, the subject of the DVD "The Winter of History." Howe is not just an historian, but also a Washington DC-based economist and demographer. While our conversation covered a great many topics, the overriding focus was on how things are likely to unfold from here.

Many bullish readers won't be thrilled to hear Howe's latest findings about the future, but given his predictive track record, dismissing them out of hand could be a costly mistake.

The summary outlook, according to Howe, is that we are in the very early stages of a 20-year period of economic and institutional upheaval – an era denominated by a crisis during which we'll likely witness the tearing down and reconstruction of many aspects of society as we know it.

As individuals, understanding Howe's views and taking some reasonable precautions makes a lot of sense. As investors, those views also have the potential to make us a lot of money.

Following is my high-level recap of my long conversation with Neil Howe, along with some general thoughts on the investment implications of a 20-year bear market.

Remember the Sixties?

If you're old enough -- or possess even a rudimentary sense of history -- think back to the 1950s, with roller-skating waitresses, crew cuts, and nuclear families of the sort represented by the iconic Leave it to Beaver. Fathers worked, while many mothers stayed home. Life had a certain predictable quality and, as far as anyone knew, would continue along the same lines for time immemorial.

But then something happened... the 1960s. Literally no one saw it coming. It was as if someone had flipped a switch that electrified America and, quickly, the world. Most everything changed, and a society accustomed to conformity was blown away with a fierce individualism expressed with long hair, sex, drugs, and rock and roll, topped off with civil disobedience and bloody riots in the streets.

What happened?

According to Neil Howe, in the mid-1960s, generational change pushed society around a dramatic corner as idealistic, individualistic young Baby Boomers (born 1943 to 1960) rebelled against the midlife leadership of their G.I. Generation parents (born 1901 to 1924).

These periods of transitions are part of a larger cyclical pattern made up of four distinct eras, or "Turnings," each lasting approximately 20 years. It can be helpful to think of the four turnings as you might think of the four seasons, repeating predictably in their own natural rhythm. A full cycle of turnings takes place over a period of about 80 to 90 years -- roughly the span of a long human life. A new turning begins as a new youth generation comes of age, bringing a new social ethic that compensates for the excesses of the midlife generation then in power.

While we don't have the space here to go into the full details of Howe's research, it's important to the topic at hand that we quickly recap the Four Turnings.

The First Turning is referred to by Howe as a High. As this follows a period of crisis, one of the hallmarks of a First Turning is a heightened sense of community and collective optimism, driven in part by the fact that the society has just come through a difficult and challenging time. Consequently, during First Turnings, societal institutions tend to be strong while individualism is weak. The post-World War II "High" of the mid-1940s through early '60s is the most recent example of a First Turning.

The Second Turning, called an Awakening, typically starts out feeling like the high tide of a High, with signs of progress and prosperity everywhere. But just as everything seems to be going along swimmingly, large swaths of society begin to chaff under the social conformity of the High, beginning to gravitate to more individualistic pursuits and demanding that their personal interests come first. You may recognize the "Consciousness Revolution" of the mid-1960s through early 1980s, correctly, as the Second Turning.

Next up, the Third Turning, which Howe calls an Unraveling, is much the opposite of a High. To wit, individualism dominates, while institutions are increasingly weak and discredited. Quoting Howe on the Unraveling...

"This is a time when social authority feels inconsequential, the culture feels exhausted, and people feel bewildered by the number of options available to them. It is a time of celebrity circuses and a tremendous amount of freedom and creativity in our personal lives, but very little sense of public purpose.

The most recent Third Turning began in the mid-'80s with Morning in America, and continued through the '90s. Previous periods of Unraveling in American history were also decades of cynicism and bad manners. Think of the 1920s, the 1850s, the 1760s. And history teaches us that the Third Turnings inevitably end in Fourth Turnings.

Finally, there is the Fourth Turning, called a Crisis. The recent Third Turning appears to be winding down, and we are currently on the cusp of a Fourth Turning. This is a time of great turmoil, when society's basic institutions are torn down and rebuilt, and seemingly insurmountable problems are addressed. During Fourth Turnings, America engages in a struggle for its very survival and redefines its identity as a nation. Large wars are often a part of this process. The American Revolution, Civil War, Great Depression, and World War II were all features of past Fourth Turnings.

In sum, Howe's research has shown that, with remarkable predictability, history is not a straight line extending toward a better and brighter (or increasingly awful) future, but rather a repeating cycle of the four distinct social eras. These four turnings have recurred with remarkable consistency throughout Anglo-American history, as Neil Howe outlines at length in Generations and The Fourth Turning. It is therefore no accident that America has experienced great cataclysms or "Crises" about every 80 years. Travel back eighty years from Pearl Harbor Day, and you land in the middle of the Civil War. Eighty years before that takes you to the Revolutionary War. If the rhythms of history hold, America is now poised to enter another Fourth Turning.

Bad News, Potentially Good News

You don't need me to tell you that the United States and in fact the world are now facing a plethora of intractable problems. The world's former powerhouse economy, the U.S., is now the world's largest debtor nation – and by a wide margin. The nation has trillions in unpayable liabilities coming due on Social Security and Medicare, to name just two of many broken government programs weighing on the country. And our much vaunted democracy is increasingly dysfunctional – rotten to the core, truth be known – thanks largely to entrenched special interests and a voting public clamoring for their own piece of the pie, while trying to hand the bill off to somebody else.

Meanwhile, the economy – despite rigorous jawboning by the government and its many friends in the large banking institutions -- is in serious trouble, with the housing market buffeted by tsunami-like waves of defaults, foreclosures, overvaluations, historic levels of personal debt, and tight credit that has left the U.S. government as the sole lender in many markets.

Bernanke and his ilk may see green shoots, but what they're really seeing is the deep, green sea rising up once again to bury the economy.

That's the bad news.

The potentially good news, if you credit Howe's research, is that the Crisis we're now entering will change pretty much everything. While this change will entail a great deal of pain and a reduced standard of living for a large number of people, by the time the Crisis subsides, society will have pretty much remade itself in ways that no one can predict at this point.

Put another way, today's intractable problems will be solved... one way or another.

What's Next

When discussing what's likely to follow next, Neil Howe turns to his generational profiles and points out that the rising societal power today belongs to the generation he calls the Millennials, individuals born between 1982 and 2004. They are a "Hero" generation, just like the G.I. Generation that coped so well with the turmoil of the Great Depression and World War II -- the last Fourth Turning. Coddled as children, the G.I.s were ultimately called upon to help society through a dark and dangerous period and rose to the occasion. Again, quoting Howe on the Millennials...

"These are today's young people, who are just beginning to be well known to most Americans. They fill K-12 schools, colleges, graduate schools, and have recently begun entering the workplace. We associate them with dramatic improvements in youth behaviors, which are often underreported by the media. Since Millennials have come along, we've seen huge declines in violent crime, teen pregnancy, and the most damaging forms of drug abuse, as well as higher rates of community service and volunteering. This is a generation that reminds us in many respects of the young G.I.s nearly a century ago, back when they were the first boy scouts and girl scouts between 1910 and 1920.

Unlike the Baby Boomers, who are largely individualistic and anti-establishment, the Millennials are good team players. We hear a lot these days about working together for a common cause, volunteerism, and the need for stronger government institutions, largely because these are the new priorities of the Millennial Generation.

As you may recall, out of the devastation of World War II, a spate of transnational political and economic institutions were born, including the United Nations, the World Bank, the World Health Organization, and the International Monetary Fund. By the time the current Fourth Turning is over, expect more of the same -- but probably even bigger and more ambitious.

What Does This Mean to You?

Most importantly, if Howe is right, this crisis is far from over. In fact, when I asked him where we are today on a scale from 1 to 10 -- with 10 representing as bad as the crisis will get -- he replied that we are at either 2 or 3. In other words, the worst is very much yet to come. And, per above, he expects this period of turmoil to take 20 years to play out. Thus, if nothing else, you may want to continue approaching matters of personal finance cautiously.

Secondly, if you're the type of individual that tends to get steamed up by larger and more intrusive government programs, you may want to take a few deep breaths and resolve yourself to the fact that this phenomenon is likely to get far worse before we see a return to celebration of individual rights. (And the cycle shows that we will see such a return -- about 40 to 50 years from now, when the next Second Turning comes around.)

If it is any consolation, the Millennial Generation places a great deal of weight on teamwork and the notion of doing things "smart." That doesn't mean, of course, that the various programs that are kicked off in an attempt to fix the many problems now confronting society will in fact turn out to be technically smart. But they will almost certainly be better thought out than some of the numbskull initiatives we've seen over the last 20 years.

You can also take some comfort in the fact that Millennials are builders, not destroyers. By contrast, the individualistic Boomers that dominate today's aging political class are world-class dissenters, radio talk show aficionados always ready to scrap it out for their beliefs. Millennials want to skip the philosophical debate and get straight to fixing things.

Other insights about Fourth Turning periods gained from my conversation with Neil Howe...

  • Government grows powerful, and sweeping new legislation is enacted. The old 1990s rule was: just compete and stay off the state's radar screen. The new 2010s rule will be: better have a presence in Washington so you're not dealt out of the "new" new deal. One political party tends to dominate. The Democrats under FDR during the last Fourth Turning offer a good example. While Neil Howe doesn't think it will necessarily be the Democrats this time around, they are certainly in the pole position at this point.

  • While public history speeds up, personal life slows down. Families will spend more time together, like in the old Frank Capra movies. Ever more households will be multi-generational, a trend now spurred by Boomers with large, empty McMansions and Millennials without jobs. There will be a blanding of the pop culture, with the entertainment of the young (put Miley Cyrus or "High School Musical" on fast forward) increasingly regarded as tamer than the entertainment of the old.
  • Innovation tends to stagnate, while a few new technologies will be chosen to be adopted on a large scale. We will see the equivalent of canals or railroads or interstates being built across America. To borrow from Carlotta Perez' four-stage description of technological revolutions, we are moving from the "innovation" to the "implementation" stage.

  • New laws and regulations will do less to referee a free market and more to pursue one or another national priority. They will increasingly favor the large producer over the retail buyer, investment over consumption, planning over risk, debt over equity. Businesses will hustle to reposition themselves. Anti-trust legislation will weaken.

  • The authority and obligations of community will strengthen at all levels, from local to national and possibly beyond (if our alliances prove durable). Personal reputation and membership will matter more. A "new localism" will reshape town and urban planning. A global slide toward national or regional protectionism will loom as a real danger.

  • It is too early to tell whether the crisis will ultimately be inflationary or deflationary, though we at Casey Research come down on the side of inflation for the simple reason that the government possesses the means to inflate. Due to the gold standard, that was not the case early in the Great Depression.

  • In the past, Fourth Turning periods have always resulted in the nation redefining who we are in some essential way. That was certainly the case during the American Revolution, when we transitioned from a British colony into a collection of independent states -- and the Civil War, when those states were hammered into a single nation. And, again, after World War II, when the U.S. went from being a relatively isolated nation to a global empire. A wild card, for instance a terrorist nuke going off in a city anywhere on the planet, could similarly take the country, and the world, into unforeseeable new directions.

    li>Baby Boomers will continue to be respected for their cultural achievements (it's not a fluke of history that Boomer music and other entertainments are still wildly popular among the young), but will be increasingly ignored in the political debate. The term "senior citizen," already in decline, will disappear entirely. And if push comes to shove, Boomer's financial interests – including Social Security – will be subjugated "for the greater good."

  • There will be a growing push to rebuild the middle class. The wealthy and the impoverished alike will both come under pressure thanks to new pro-middle class initiatives. If you are a high-income earner, it's a certainty your taxes are going up, and likely by a lot. If you want to make a fortune, don't pursue the niche or the "long tail." Invent the next big brand that will appeal to Everyman.

Don't Worry, Be Happy

That is, at best, a sketch of my long conversation with Neil Howe and doesn't do justice to his research. If nothing else, however, I hope I've succeeded in giving you at least some sense of the man and his unique research and encouraged you to think outside the box about the nature of today's crisis.

A couple of final observations.

First, Neil Howe is not a negative person, nor a professional doomsayer. Rather, he is a social scientist and historian with decades of experience in the social sciences. As you speak to him, you get the sense that he doesn't view the world through any particular philosophical bias, but rather is simply reporting what his research is telling him about the current players on the global stage, and which act we are currently in.

Secondly, speaking as a Baby Boomer and someone with a lifelong distrust of government and its meddling institutions, talking to Neil left me feeling oddly relaxed -- letting go, if you will, of some of the frustration that has been building within me as I watch the nanny state grow more and more bloated.

That is not to say we won't continue to speak out against government waste and prolificacy. We will. But it seems increasingly clear that we're now caught up in a powerful trend toward bigger, not smaller, societal institutions -- and that these institutions will, over the period ahead, change the world as we know it.

Of course, being active investors, at the same time we raise our voices in protest, we'll deal with the reality of the situation by strategically positioning our portfolios to profit from the coming changes.

And so, like the Rockefellers and J.P. Morgan during the Great Depression, we'll make the trend -- to matter how negative -- our friend. You may want to consider doing so yourself.