Friday, October 30, 2009

October 30 2009: An interview with Stoneleigh - The case for deflation

Dorothea Lange Family Travel June 1938
Family walking on highway, five children. Started from Idabel, bound for Krebs. In 1936 the father farmed on thirds and fourths at Eagleton, McCurtain County. Was taken sick with pneumonia and lost farm. Was refused relief in county of 15 years' residence because of temporary residence elsewhere. Pittsburg County, Oklahoma

Ilargi: The following is a conversation between Stoneleigh and Euan Mearns of TOD Europe.


Euan Mearns: At the ASPO conference in Denver, October 2009, I had the good fortune to meet Stoneleigh, former editor of The Oil Drum Canada, who left the TOD crew with colleague Ilargi to set up The Automatic Earth where they publish stories, news and analysis of the unfolding financial crisis.

I spent a couple of days chatting with Stoneleigh where she recounted her rather gloomy prospects for the immediate future of the global economy. The following interview is a summary of her analysis of the unfolding situation. Note that in a departure from convention my questions are set in "blockquotes" to distinguish these from Stoneleigh's responses.

Euan Mearns: Stoneleigh, the world economy seems to be suffering from two great structural woes at present, namely stubbornly high energy prices that are linked to demand that is persistently ahead of the supply curve, and a level of debt that has destabilized the global finance and banking systems.

Can you explain for us the scale and structure of this debt and to what extent write-downs and quantitative easing (QE) have solved this problem?

Stoneleigh: Firstly, I would say that the energy prices that currently seem stubbornly high should fall substantially as the speculative premium evaporates and demand falls on a resumption of the credit crunch. The sucker rally that has spawned all the talk of green shoots is essentially over in my opinion.

The result should be a reversal of a number of trends that depend on the ebb and flow of liquidity - we should see stock markets and commodity prices fall, a significant resurgence in the US dollar and a large contraction of credit. The scale of the reversal should be substantial, as should its effects on energy demand. Demand is not what one wants, but what one is ready, willing and able to pay for, and in a severe credit crunch the capacity to pay for supplies of most things will be severely reduced.

As demand falls, and with it prices, investment in the energy sector is likely to dry up. Many projects will be uneconomic at much lower prices, meaning that the projects which might have cushioned the downslope of Hubbert’s curve (and the much steeper net energy curve), are unlikely to be developed. In this way a demand collapse sets the stage for a supply collapse that could place a hard ceiling on any prospect of economic recovery. That is a recipe for extremely high energy prices in the future.

Secondly, our vulnerability to the consequences of debt is extremely high at the moment. The scale of that debt is staggeringly large. The global credit hyper-expansion has been decades in the making and is now significantly larger than notable events of the past such as the South Sea Bubble of the 1720s and the Tulip Bubble of the 1630s. It dwarfs the excesses that led to the Great Depression.

Credit bubbles are inherently self-limiting, proceeding until the debt they generate can no longer be supported. We have already passed that point and we are now two years into a contraction phase that is about to accelerate. As the aftermath of a credit bubble is typically proportional to the scale of the excesses that preceded it, we should be in for the largest economic contraction for at least several hundred years, and it will be global.

Real estate, which is a major focus of the mania, should do particularly badly in the coming years (in fact the coming decades or longer). There is still so much deleveraging ahead, and so many danger signals, such as the scale of the coming interest resets on US mortgages between now and 2012 (below). While the subprime resets are ending, Alt A and Option ARMs are just beginning.

There will be a very significant undershoot of historically average values, as there always is following a mania (much more than the Case-Shiller projection below suggests). In my opinion, housing prices are likely to fall at least 90% on average. For those who own property on margin, this will be a disaster.

For evidence that this crisis is indeed global, look, for instance, at European housing bubbles, which were worse than in the US.

Unlike inflation, which divides the underlying real wealth pie into smaller and smaller pieces, credit expansion creates multiple and mutually exclusive claims to the same pieces of pie. Once a credit expansion reaches its maximum extent, and contraction begins, these excess claims begin to be extinguished.

Unfortunately, the leverage is such that there are probably over a hundred claims to each piece of pie. While contraction begins slowly, as is the nature of positive feedback loops, it picks up momentum until a cascade point is reached, whereupon one can expect the excess claims to be extinguished in a rapid and chaotic process. This amounts to a rapid collapse in the supply of money and credit relative to available goods and services, which is the definition of deflation.

The scale of the problem has been temporarily concealed by a market rally and the shovelling of tens of trillions of dollars of taxpayer’s money into a giant black hole of credit destruction. This has done nothing to reignite lending, but the temporary (and entirely irrational) resurgence of confidence has restored a measure of liquidity. As that confidence evaporates with the end of the rally, that liquidity will also disappear

Banks hold extremely large amounts of illiquid ‘assets’ which are currently marked-to-make-believe. So long as large-scale price discovery events can be avoided, this fiction can continue. Unfortunately, a large-scale loss of confidence is exactly the kind of circumstance that is likely to result in a fire-sale of distressed assets. The structure of the credit default swap component of the derivatives market makes this very much more likely.

The CDS market allowed large bets to be placed on certain prices falling, and by entities which did not have to own those assets. This creates a perverse incentive for some parties to cause others to fail for profit (akin to me being able to take out fire insurance on your house and thereby give me an incentive to burn it down).

An added complication is the extreme degree of counterparty risk that resulted from a complete lack of capital adequacy regulation. Many parties with winning bets will not be able to collect, so they may cause financial mayhem for nothing. The CDS market is worth some $62 trillion, and a meltdown is very likely in my opinion.

A large-scale mark-to-market event of banks illiquid ‘assets’ would reprice entire asset classes across the board, probably at pennies on the dollar. This would amount to a very rapid destruction of staggering amounts of putative value. This is the essence of deflation.

Euan Mearns: I have for a long time argued and believed that there are so many interests vested in protecting our current system that national governments, the IMF and institutions working together would keep the market flooded with liquidity in order to ward off the threat of deflation.

In fact, it seems that a prolonged period of inflation is the only way to diminish our debts. I sensed at ASPO International in Denver that this was the majority view. Do you agree that inflation is the most likely near term outcome of current monetary policy?

Stoneleigh: Absolutely not. I agree that this is the consensus opinion, but I see it as fundamentally mistaken. The debt monetization that is going on has done nothing to increase the supply of money and credit relative to available goods and services, which is the definition of inflation.

Credit contraction dwarfs debt monetization, leaving us in a state of net contraction, even though we have just experienced a large rally lasting months, which should have been the most favourable condition for reigniting lending if such a thing were in fact possible. I would argue that it is simply not possible and that deflation is inevitable.

Credit bubbles always end this way, with the mass extinguishing of the excess claims debt represents. They are essentially Ponzi schemes, crucially dependent on the continued buy-in of new entrants. Globalized finance brought a flood of new entrants following the liberalization of the early 1980s, but there are now no more new sources of wealth to tap.

Deregulation allowed the reckless to gamble away virtually everything, including bank deposits and pension funds. Globalized finance has created a giant Enron, which while appearing robust is actually almost completely hollowed out. Such structures implode, often without much notice.

In my opinion, deflationary deleveraging will continue until the (small amount of) remaining debt is acceptably collateralized to the (few) remaining creditors. Until that point, there can be no lasting return of the confidence required to rebuild shattered credit markets.

Deflation is ultimately psychological. Without trust we will see hoarding of the cash which will be very scarce in the absence of the credit that currently comprises the vast majority of the effective money supply. The combination of scarce cash and a very low velocity of money will be toxic.

Money is the lubricant in the economic engine and without enough of it that engine will seize up as it did in the 1930s, when farmers dumped milk they couldn’t sell into ditches while others were starving for want of the money to buy food. There was plenty of everything except money, and without money, one cannot connect buyers and sellers.

Potential buyers will have no purchasing power as they will have lost access to credit and their ability to earn an income will be hit by spiking unemployment. Those who still have jobs will find that they have no bargaining power and there is therefore no wage support.

Sellers and producers will have no market and will themselves lose the means to purchase supplies or raw materials for the things they would like to produce.

If conditions remain frozen for any length of time, they will go out of business. The deeper the collapse, the more protracted the trough and the more difficult the eventual recovery.

I would argue that we have no need to fear inflation until we have reached a trough - until the deleveraging impulse is spent. We can expect to spend a long time in the liquidity trap, where real interest rates will be much higher than nominal rates, leaving central bankers “pushing on a string”.

Euan Mearns: Some would argue that faced with the unimaginable specter of deflation that governments will seize control of interest rates from the bond market. Why do you think this may not happen?

Stoneleigh: The bond market is far more powerful than governments at this point. While the international debt financing model remains, the bond market will retain its power to prevent money printing. Even though governments are not succeeding in increasing the effective money supply for reasons already discussed, they are nevertheless increasing systemic risk with their activities.

This is a recipe for very much higher interest rates as a risk premium. Governments do not set interest rates, they decide what rate to defend, but if that rate is substantially different from what the bond market requires, then defending it would be ruinous.

I think we are headed (not imminently but eventually) for a bond market dislocation, with nominal interest rates on government debt spiking into the double digits. This will amount to hitting the emergency stop button on the economy, especially since real interest rates will be substantially higher (the nominal rate minus negative inflation).

I am in fact expecting interest rates on private debt to rise before we see problems in the market for government debt, as the latter should benefit substantially in the shorter term from a flight to safety. The risk premium on private debt is already rising, which is a serious danger signal for such thoroughly indebted societies as we see in the developed world.

Euan Mearns: But stock markets are booming again, several OECD economies are emerging from recession, unemployment has stabilized, there are green shoots everywhere. Surely the current QE strategy is working?

Stoneleigh: The green shoots are gangrenous. Some of the largest market rallies on record happened during the course of the Great Depression, as depressions are associated with very high volatility. Look for instance at the great sucker rally of 1930. There are always rallies of all different sizes in any bear market, just as there are pullbacks of all sizes in bull markets. No market ever moves in only one direction.

People tend to extrapolate recent trends forward, but this amounts to stepping on the gas while looking only in the rearview mirror. This is one reason why major trend changes are so rarely anticipated. Another is that the prevailing view of markets is fundamentally wrong. There is no perfect information, perfect competition, stabilizing negative feedback, rational utility maximization or efficient markets.

Markets are irrational, driven by swings of optimism and pessimism, or greed and fear, in an endless tug of war, and largely in an information vacuum. Investors chase momentum by jumping on passing bandwagons, hence demand for financial assets increases when prices are rising and falls when prices are falling, in classic positive feedback loops.

We have just lived through a period of several months when greed and complacency were in the ascendancy, but that trend is about to reverse in my opinion. Looking at markets as constructs of human herding behaviour allows them to be probabilistically predictable, permitting the forecasting of trend changes. For anyone who is interested in pursuing this idea further, I suggest looking into Bob Prechter’s socionomics - a fascinating subject which delves into the many effects of changes in collective mood.

For instance, as pessimism deepens, driving economic contraction, one would expect to see many manifestations of collective anger and mistrust. As this progresses it is likely to lead to xenophobia and a blame-game, with skillful manipulators (such as the fascist BNP leader Nick Griffin in the UK) poised to direct the anger of the herd towards their own chosen targets.

The potential for serious social fragmentation is very high when expectations have been dashed and there is not enough to go around. Having lived through a very long period of manic optimism and increasing inclusion, we in the developed world are not used to expressions of the dark side of human nature, except for entertainment purposes in popular television programmes. It will come as a considerable shock.

Euan Mearns: Would you care to give your opinion on where the Dow Jones Industrial Average is headed in the near (1 year) and medium terms (2 to 5 years)?

Stoneleigh: I think the market will fall hard (intervening short rallies notwithstanding) for perhaps 18 months. This was the length of the first leg down (October 2007-March 2009) and so represents a reasonable first guess at how long the next leg at the same degree of trend might last.

I think we will see falls of thousands of points in a series of cascades. I don’t see the markets reaching a lasting bottom until probably the middle of the next decade, and even then I don’t expect it to be a final bottom. This has been the largest credit bubble in history, and the aftermath of a major bubble always undershoots where it began before any kind of recovery begins.

The aftermath of the last major mania - the South Sea Bubble in the 1720s - lasted decades and culminated in a series of revolutions. We are still relatively near the beginning of our own crisis, but already it compares with the Great Depression.

Euan Mearns: How do you see the US$, gold and oil trading in the same time frame?

Stoneleigh: I think almost all assets will fall as price support is knocked out from underneath them, but the dollar should rise initially on a flight to safety. Scarce cash will be king for a long time, and the value of one’s currency relative to available goods and services domestically will matter much more for most people than its value relative to other currencies internationally.

In a deflationary scenario, prices fall, but purchasing power typically falls even faster, meaning that everything becomes less affordable despite the lower nominal prices. Prices in real terms, adjusted for changes in the supply of money and credit, are what matter.

In a world where almost everything is becoming rapidly less affordable, the essentials will be the least affordable of all, as a much larger percentage of a much smaller money supply will be chasing them. This will confer relative price support.

Although we could initially see a large glut in energy supply as demand falls off a cliff, this is likely to lead to supply collapse as investment dries up, hence I expect energy prices to bottom early in this depression.

Both financial and physical risks to energy exploration are likely to increase substantially in a destabilized and capital constrained world, and even maintaining existing assets could become very difficult. This is a recipe for much greater state involvement in ownership and exploitation of (probably deteriorating) energy assets, with increasing conflict over those assets as supply gets dramatically tighter with lack of investment.

As for gold, I expect it to fall initially as people sell not what they would like to, but what they can, in order to raise the cash they need for living expenses and debt servicing. Owning gold is likely to become illegal again (as it did in the Great Depression) in my opinion.

This wouldn’t necessarily stop you owning it, but would stop you trading it (at least without taking major risks) for other things you might need. Owning gold now therefore only makes sense if one is confident of being able to sit on it for a very long time, as it will hold its value over the long term as it has for thousands of years.

Euan Mearns: What will be the consequences for unemployment levels and services provided by government?

Stoneleigh: Unemployment will go through the roof as the prospects for selling most goods and services decline dramatically. In the developed world we are nations of middle men - generally service economies where we make a living figuratively taking in each other’s laundry.

Most of us produce relatively little. Even those who do will find almost no market for their exports, and those who could find buyers may not be able to send shipments as credit contraction prevents shippers from getting the letters of credit they need to ship goods. A glance at what has happened to the Baltic Dry Index (below) indicates the difficulties already facing shipping companies.

Unfortunately middlemen are almost completely expendable, and the services of others are likely to become unaffordable for the majority very quickly. While there will be a huge surplus of labour, and the few who retain purchasing power will be able to hire anyone they want for very little, most people will have to do everything for themselves, as poor people have done throughout history and as most of the population of the world does now.

Not only will we lose access to the paid labour of others, but we will lose our virtual energy slaves as well. This will represent an enormous fall in the standard of living for the vast majority.

Whereas inflation can conceal a fall in purchasing power, so that people may not even realize it is happening, deflation brutally exposes it. Wages would have to fall just to keep purchasing power the same, but keeping it the same will not be an option for cash-strapped employers. In addition, with a large surplus of labour, workers will have no bargaining power.

This is a recipe for exploitation the like of which we have not seen for a very long time, but in the intervening adjustment period it is likely to lead first to war in the labour markets.

I would expect general strikes and a breakdown in the reliability of centralized services such as healthcare, education, power systems, water treatment, garbage (and snow) removal etc. This will be exacerbated by plunging tax revenues for all levels of government, which governments will try to compensate for by raising taxes, on anyone still capable of paying, to punitive levels. We would thus expect rapidly deteriorating services at much higher cost.

Many people are at risk of being eventually priced out of the market for goods and services, and particularly the essential ones, entirely.

In my opinion, we stand on the brink of truly tragic circumstances.

Euan Mearns: End note:

The day before the ASPO conference began in Denver, Stoneleigh, Rembrandt Koppelaar and myself took a drive into the Rocky Mountains National Park providing the opportunity to discuss and reflect upon the current global situation. As the week unfolded I realised that I was in denial about the gravity of the global financial situation. In what has become a situation of complexity that is beyond the ken of most folks, I find it simpler to break this down into smaller components that I can relate to.

In the UK, we have an escalating burden of government debt that we can unlikely ever repay. Unemployment is rising, tax receipts are plunging whilst expenditure on social security, health and the elderly go through the roof. We have been living way beyond our means, which with the peaking of UK oil and gas have suddenly become more meagre.

We have an election in May 2010. The new government will want to raise taxes and cut public spending. The current reversal in global growth is sending energy prices higher. Higher unemployment, higher taxes, higher energy prices and reduced public services are a toxic mixture for an ailing economy. If the bond market decides to price in the risk premium for escalating debt it will be game over. The questions are if and when? Figure 12 (Fed Follows the Market) is one of the more interesting for me.

That's me (Euan) on the left and Rembrandt Koppelaar on the right, contemplating our future after a most enlightening, if not very cold day in the Rocky Mountains. Photographer - Stoneleigh.

Ilargi: The Automatic Earth’s Fall Fund Drive (see the left hand column) is going well, and we owe heartfelt thanks to all of you who have donated. That said, in order to execute what we think would be the appropriate and logical next steps for us, more is needed, and quite a bit of it actually.

There are many thousands of people who read us every single day, and if everyone of them would donate just a dime for every time they read us we'd be doing just fine. But obviously, most never will.

We would love to be able to expand on what we do, to involve more people, more opinions, a more diverse view from more places in the world. And that is unfortunately not possible right now. Along the same lines, we would like for Stoneleigh to be much more involved at TAE. Not happening. On a happy note, our brand-new Twitter and Facebook presences are directed by our good friend VK, all the way from Nairobi, Kenya, the first time we’ve been able -and willing- to expand and relinquish control at least a little.

The Automatic Earth will be busier than ever as the real economy deteriorates in the months to come and things come to a head. Inevitably that will take more from us, and we hope you will do more as well.

Again for those among you who have donated to us -and many have in the past 3 weeks-, and those who will do so in the days and weeks and months to come, please know we are deeply grateful for, and humbled by, the confidence you have in us.

Thursday, October 29, 2009

October 29 2009: A Halloween beyond your nightmares

Unknown Fodder April 1865
Petersburg, Virginia. Federal soldiers removing artillery from Confederate fortifications

Ilargi: Why does Goldman Sachs make a last minute less-than-rosy prediction about Thursday's GDP numbers? Could it be that they are acting as the voice of the government they own? A voice to counter the 3.2% growth prediction doing the rounds among "experts" [duh!] with a lower 2.7%, so at least the people that count can't say they weren't warned?

Also warned are all the banks missing from Tim Geithner's Christmas card list, who will soon, under proposed new regulation, be at Timmy and Larry Summers' every beck and call. Watch out guys and dolls, they have their eyes on your valuables. They came prepared.

It's not entirely clear to me why the Brits are suddenly so determined to break their too-big-to-fail banks into pieces - the little man inside says it's the EU that makes them do it, and the EU only- but it's certainly a wise move, even if it's too late to stave off all out economic disaster. If you go down anyway, why do it telling blatant lies till the bitter end and cheating every grandma you can put your sweaty palms on, including your own, out of every penny they own? Have these folks no pride?

In Washington, they certainly don't. The Financial Services Oversight Council, which in the future is set to prevent financial firms from becoming too big to fail, will be made up of the same regulators who in the past decade have made sure that those financials DID become too big to fail. Why not put Goldman directly in charge and do away with the tiresome pretense? The direction is obvious: more and more centralized rule. Eat your heart out, Benito.

So tell me, how ridiculous does it have to get? The mortgage and building lobby manages to get its homebuyer tax credit extension through, despite fierce resistance, by having a bunch off their Capitol Hill lackeys bundle it with that other extension, the one for unemployment benefits for people who’ve been out of a job for over year, and are by now deeply miserable. They're really a group of fellow citizens over whose backs you want to get your pet projects financed, ain't they? That's the sort of deal that makes one sleep well at night.

Tell me, did you guys actually vote for these talking lobotomies? They’re selling you out every chance they get when you're not looking. They've voted to burden you with $23.7 trillion in debt, and yes, you will have to pay that back, and that's just in the past year and a half. Before that, they established the too big to fail banks, a bunch of "wars" that kill scores of your kids, and land, water and air that will do in many of those the wars do not.

They’ve made sure tens of millions among you live in homes you're either already not able to afford or won’t be in the near future. They’ve watched over the demise of the manufacturing base your own parents and grandparents fought hard to establish, they’ve made health care unaffordable for a fast growing number among you, and did the same with the education system your children's futures should have been built on.

And you voted for these tricksters? Look at yourself, and then look at them, look at what they’re doing to you. Don't listen to them, look at them.

When are you thinking of starting to think straight? When you’re too sick and cold and hungry to think straight anymore? To even care? Do you still care at all right now? If not for yourselves, maybe for your children? If you ask me, you deserve a Halloween way beyond your wildest nightmares.

Ilargi: The Automatic Earth’s Fall Fund Drive (see the left hand column) is going well, and we owe heartfelt thanks to all of you who have donated. That said, in order to execute what we think would be the appropriate and logical next steps for us, more is needed, and quite a bit of it actually.

There are many thousands of people who read us every single day, and if everyone of them would donate just a dime for every time they read us we'd be doing just fine. But obviously, most never will.

We would love to be able to expand on what we do, to involve more people, more opinions, a more diverse view from more places in the world. And that is unfortunately not possible right now. Along the same lines, we would like for Stoneleigh to be much more involved at TAE. Not happening. On a happy note, our brand-new Twitter and Facebook presences are directed by our good friend VK, all the way from Nairobi, Kenya, the first time we’ve been able -and willing- to expand and relinquish control at least a little.

The Automatic Earth will be busier than ever as the real economy deteriorates in the months to come and things come to a head. Inevitably that will take more from us, and we hope you will do more as well.

Again for those among you who have donated to us -and many have in the past 3 weeks-, and those who will do so in the days and weeks and months to come, please know we are deeply grateful for, and humbled by, the confidence you have shown in us.

Ahead Of Thursday's Report, Goldman Sachs Cuts GDP Estimate
Ahead of Thursday's U.S. gross domestic product numbers, Goldman Sachs cut its third-quarter GDP estimate to 2.7%, following lower-than-expected durable-goods shipments Wednesday morning. The estimate, calculated on an annual basis, is down from the 3% Goldman previously expected.

Despite the reduced estimate for GDP growth, Goldman noted that orders for long-lasting goods were less dependent on volatile components than some, including Goldman, had expected. The firm called the durable-good numbers "actually quite encouraging," because the gains were "not heavily concentrated in the volatile defense and transportation categories." However, shipments were "somewhat weaker, especially for nondefense capital goods," Goldman said in the Wednesday report.

Stocks slammed
Stocks tumbled Wednesday, led by the tech-fueled Nasdaq, as a weaker-than-expected new home sales report added to questions about the strength of the economic recovery. The Dow Jones industrial average lost 119 points, or 1.9%, to close at 9,762.69, according to early tallies. The S&P 500 index dropped 21 points, or 2% to close at 1,042.63. The Nasdaq composite tumbled 56 points, or 2.7% to close at 2,059.61.

The Dow and S&P have fallen for three of the last four sessions, and the Nasdaq for all three, as investors have turned cautious following a 7 1/2-month stock rally. Since bottoming at a 12-year low in March, the S&P 500 gained 62% through its peak last week. But since then, it's lost 3.5%, as of Tuesday's close. Enthusiasm about the largely better-than-expected quarterly earnings reports has been tempered recently by concerns about the still-burgeoning economic recovery.

"There's been some nervousness over the last week, and today the worry is that the weaker new home sales report means the consumer is still flat on its back," said Alan Gayle, senior investment strategist at RidgeWorth Investments. Gayle said Wednesday's action shows investors are feeling less willing to take on risk at the moment, a factor made clear by the sector movement. In particular, the weakness in areas such as retail, financial and technology - and strength in defensive sectors like consumer staples and healthcare.

Housing: New home sales fell to a 402,000 unit annualized rate in September from a revised 417,000 unit annualized rate in August, the Commerce Department reported. Sales were expected to rise to a 440,000 unit annualized rate, according to a consensus of analysts surveyed by

Durable goods: Orders for manufactured goods meant to last three years or more rose 1% in September, after falling 2.6% in the previous month. The rise was in line with estimates. Goods excluding transportation rose 0.9% after falling 0.4% in August. Economists thought they would rise 0.7%. Another report showed that fewer metro areas reported jobless rates above 10% in September than in the previous month.

GDP: Thursday's reading on gross domestic product (GDP) growth is the key economic event of the week. GDP is expected to have grown at a 3.2% annualized rate in the third quarter after shrinking at an 0.7% annualized rate in the second quarter. GDP has declined steadily for four straight quarters, as Americans have contended with the worst recession since the Great Depression.

But the end of the recession doesn't necessarily mean a return to a period of robust growth, particularly amid rising joblessness and still-sluggish consumer spending. Government stimulus programs have played a big role in the recovery, and there are concerns about the strength of the system once that support winds down.

$8,000 Home Tax Break Update
Looks like Congress held off on extending UE benefits so they could bundle it with the tax credit and that ensures there is ZERO chance Obama will veto them packaged together.
In an effort to make the new credit more confusing and less economically beneficial, the credit amount will be reduced to $7,290 (no idea who came up with that number), but it will allow for "move-up" buyers to qualify for the credit so long as they either live in their existing house for 5 years or are willing to "state" that they have (This constitutes a fairly large number of recent home purchasers who procured the loan via "stated" income).
This newly extended / modestly reduced credit will only extend to April 30th, 2010 (plus 60 days for closing), though I would expect if the USA has not completely run out of ink in the printers that the credit will be extended one more time (perhaps to $6,480), as I doubt any politicians will want to stop giving away "free money" before the 2010 elections. The next non-sense housing agenda that I have not heard any movement on is extending the limits on FHA conforming loans. That is currently set to expire at year-end and will keep FHA out of loans over $417,000.
I’m not holding out hope, but I will still wish for a Friday miracle that gets rid of this wasteful, ineffective credit. As far as the impact to the housing market, by the way, I expect this has little to no impact. This credit getting extended was more or less fully priced in. I maintain my central belief that despite the past few months of rises, national housing prices median will not bottom until at least one year from now.

Outrage Of The Day: Tim Geithner's Latest Bailout
When the historians finally finish sorting through the appalling decisions that have been made in the past two years, some of Tim Geithner's will be at the top of the heap. It is probably safe to say that no man in history has given more to Wall Street at the expense of the taxpayer. Tim Geithner's latest outrage, yet another bailout of GMAC, makes him the Outrage of the Day.

The Debt Crisis Is Not a Conspiracy
by Kevin Depew 

1. The Debt Crisis is Simple

Awash as we are in a sea of Federal Reserve- and Treasury Department-sponsored financial acronyms, it would be easy to assume the complexity of the debt crisis is beyond the comprehension of the average person. After all, who, apart from a wonkish cadre of financial engineering geeks, can be bothered with trying to sift through the details of things like the Primary Dealer Credit Facility or an array of seemingly sketchy repurchase agreements? Yes, it would be easy to assume the complexity is beyond comprehension; easy, but wrong.

Recently, I ran across a long-winded, chart-filled screed haranguing the Federal Reserve for single-handedly taking over the entire capital market. The claim actually made a certain kind of hysterical sense, perhaps because it appeared in bold typeface, even if it missed the point; outrage over the Fed intervening in equity markets is akin to expressing outrage over what color sack the robbers are using to haul away their loot. At what point did we all become armchair central bankers?

The reality is that the Federal Reserve is simply following the Irving Fisher debt-deflation game plan and doing exactly what the vast majority of US central bankers have always insisted they would be doing if trying to prevent a full collapse into a deflationary depression; that is, try and reflate.

2. When Did We All Become Armchair Central Bankers?

The various mechanics of this reflation attempt are only worth arguing about among armchair central bankers and the various banking system participants concerned with how big of a slice they're getting of the great reflation pie. For everyone else, things are far less complicated and, sorry to spoil a good conspiracy theory, far more bureaucratic and mundane. In order to understand it, let's go to the source.

Toward the end of the Great Depression, economist Irving Fisher outlined a nine-step sequence of events that followed a debt bubble, which became known as his Debt-Deflation Theory of Great Depressions. Believe it or not, the St. Louis Federal Reserve actually has available for download a very easy-to-read 21-page paper by Fisher outlining this theory. The paper consists of what Fisher called his "creed," consisting of 49 "articles." Among the most important for our purposes is number 20, covering "over-indebtedness":
Over-investment and over-speculation are often important; but they would have far less serious results were they not conducted with borrowed money. That is, over-indebtedness may lend importance to over-investment or to over-speculation. The same is true as to over-confidence. I fancy that over-confidence seldom does any great harm except when, as, and if, it beguiles its victims into debt.

3. The Debt Bubble Sequence

In that brief article, Fisher handily summarizes why this is no ordinary recession. This debt bubble, over-indebtedness, was fueled by borrowed money, which was made too cheap for too long, and which resulted in massive over-investment, over-speculation, and over-confidence.

But everyone knows that. After all, it's how Alan Greenspan became a household name, appeared on the cover of Time magazine, and became known as The Maestro in the first place, and it's why all those accolades will ultimately be for nought as we continue to try and transfer the excessive corporate and public debt incurred during Greenspan's tenure, and which accelerated under Ben Bernanke, to government debt. More on that in a moment.

The debt bubble sequence Fisher described is very intuitive, which is why you don't need to know much about structured finance or the precise mechanics of Federal Reserve operations to see it play out. According to Fisher, assuming over-indebtedness exists, the following chain of consequences will result in nine steps that are easy to understand, if a bit more complicated in their inter-relations:
Step One: Debt liquidation leading to distress selling.

Step Two: A contraction of deposit currency as bank loans are paid off, and a slowing down of the velocity of circulation.

Step Three: A fall in the level of prices, or a swelling of the dollar (assuming this fall in prices is not interfered with).

Step Four: A still greater fall in the net worth of businesses, leading to bankruptcies.

Step Five: A decline in profits, which leads to...

Step Six: A reduction in output, trade, and employment, which lead to...

Step Seven: Pessimism and loss of confidence.

Step Eight: Hoarding of money, slowing down still more the velocity of circulation, which conspires to cause...

Step Nine: Complicated disturbances in the rates of interest, in particular, a fall in the nominal, or money, rates and a rise in real, or commodity, rates of interest.

4. So, What to Do?

It's obvious, isn't it? Let's go back to Step Three in the sequence for a moment, "A fall in the level of prices, or a swelling of the dollar (assuming this fall in prices is not interfered with)." Fisher writes, "assuming this fall in prices is not interfered with," an important observation. Later, he explains, "when over-indebtedness stands alone, that is, does not lead to a fall of prices, in other words, when its tendency to do so is counteracted by inflationary forces (whether by accident or design), the resulting 'cycle' will be far milder and far more regular."

And so there you have all you need to know about the Federal Reserve's game plan for ending the unwinding of the debt bubble. The answer is simple: reflate, reflate, reflate, by all means necessary reflate.

5. Will it Work?

Federal Reserve Chairman Ben Bernanke has been even more explicit than Fisher, who was writing more than 70 years ago, in the types of policies he believes the Federal Reserve should pursue in attempting to reflate and, it is hoped, avoid a deflationary depression.

Unless we're intent on debating specific monetary transmission mechanisms and the intricacies of trying to force feed more credit into the system, we can leave the actual mechanics to the armchair central bankers. What's important from our standpoint is one thing: Will it work?

Looking at the market through the lens of complex systems theory, the problem is actually one of time. On short-term time scales, the Fed and Treasury think they are rock stars, "The Committee to Save the World"... indeed. But on longer-term time scales we know they have simply made the problem worse. The question, then, becomes: How much longer?

Going back to Fisher's Debt-Deflation Theory, the dollar is the real canary in the coalmine because during aggressive debt deflation the value of the dollar "swells," to use Fisher's term. And I suppose that's what keeps me up at night. When I look at the dollar with  long-term DeMark indicator studies applied, they're pointing to a high probability of multi-scale alignment by the first quarter of 2010 and a major bottom for the US dollar. Currently, there's a weekly TD Buy Setup that has been perfected, so the next four weeks for the US dollar look higher, after which we need one more move lower, preferably below 72.509, for a major bottom.

If the dollar does bottom, then it will become quite clear that reflation attempts have failed, and then we face the heart of the debt deflation where the swelling of the dollar competes simultaneously with debt destruction and where debt levels increase in dollar terms faster than they can be paid down.

Make no mistake, debt-deflation will conclude with an inevitable sharp rise in inflation as monetary policies designed to battle deflation remain in place even as excessive debt is eventually destroyed, but the outlook for the dollar says that isn't today's business. Be careful which scenario you're preparing for because those who anticipate inflation before the debt-deflation has fully run its course will find themselves digging out of a deep and painful hole.

Deflation fears as Eurozone and US credit contracts
Bank lending to firms and households in the eurozone has fallen for the first time, raising fears of an economic relapse and a slide into deflation next year. Data from the European Central Bank shows that the M3 broad money supply has contracted over the last six months, confounding expectations that ultra-low interest rates would soon boost monetary growth. Loans to the private sector fell 0.3pc from a year earlier, the first such decline since the data started in 1983. The M3 figures include a wide range of bank accounts. They are watched closely by experts for early warnings about the economy a year or so ahead.

The picture is even starker in America where M3 has shrunk at an annual rate of 6.5pc over the last three months, a pace of contraction not seen since the 1930s. US bank loans have plummeted since May. Michael Taylor from Lombard Street Research said the eurozone was "blundering towards deflation". Inflation was minus 0.3pc in September, but unevenly distributed. Prices fell 3pc in Ireland, 1.8pc in Portugal, and 1pc in Spain. "All the ingredients are there for deflation next year. At some stage this may start alarm bells ringing at the ECB," he said. The credit data on both sides of the Atlantic are hard to square with market expectations of a "V-shaped" recovery. Experts at the ECB and the Federal Reserve view the loan contraction as a short-term anomaly caused by the distortions of the crisis, and some have begun to hint that emergency stimuli will be withdrawn soon.

However, an ominous pattern is emerging where excess liquidity from low rates and quantitative easing is flooding into the equity (QE) and bond markets without gaining full traction on the underlying economy. This threatens to become a central banker's nightmare. Otmar Issing, the ECB's former chief economist, told an Open Europe forum in London that policymakers are entering treacherous waters. "Nobody can be sure that we have a self-sustaining recovery. The challenges facing the ECB are tremendous," he said. "Money multipliers have collapsed everywhere. What M3 is telling us is that confidence is missing. I don't see any way to stabilise M3 in such circumstances," he said. Professor Tim Congdon from International Monetary Research called on the ECB to buy state bonds in a blitz of QE to insure against a double-dip recession. He said: "2010 is going to be very difficult."

However, any move to purchase EMU state debt would erode ECB independence and be viewed in Berlin as a monetary bail-out of Club Med countries. "They would enter a political minefield," said Dr Issing. So far the ECB has confined itself to purchasing €60bn (£54bn) of covered bonds, a pittance compared to the Fed's actions. The assumption is that aggressive QE is not needed because the credit bubble in core Europe was less extreme. However, there is a heated debate over credit conditions in Germany. Mittelstand family firms complain that the window for fresh loans has slammed shut. Savings banks are tightening credit to meet capital rules agreed at the G20 summit.

A report by Germany's five institutes said it was a error to push banks into raising capital ratios before the recovery is secure. "Financial conditions are likely to worsen further. Banks are facing large write-offs on toxic debt and a rising toll of company insolvencies. There is a major danger that already tight financing conditions could lead to a credit crunch next year," they said. JP Morgan says European banks may have to raise $78bn (£48bn) in fresh equity over the next six months.

BNP Paribas, Unicredit and others have already tapped the market, but some have dragged their feet – even clinging on to Icelandic bank debt at face value. Jürgen Fitschen of Deutsche Bank said lenders would face "major challenges" in the first half of 2010. "We are going to see some pain," he said. Germany is competitive and will recover. The bigger danger lies in the South. Italy's public debt will reach 125pc of GDP next year. The country risks a compound interest trap. Nations can endure high debt, or deflation: both together are toxic.

UK government to break up the banks
Lloyds, RBS and Northern Rock will be split up in state sell-off

Lloyds, Royal Bank of Scotland and Northern Rock will be broken up and parts of their businesses sold off to create three new banks, it emerged last night. Government sources said ministers were "determined" to see more competition in the market, following the £1.2 trillion bailout of the sector which resulted in the loss of three independent banks and several building societies.

The European Union will today approve the split of Northern Rock into two sections, a "good", profitable, bank with no bad debt, and a "bad" bank. Ministers will begin exploring sale options at the start of next year when the split happens and a deal could be finalised before the general election. The remaining "bad" bank will remain in state hands for the time being although sales of "tranches" of the more risky mortgages it holds will be explored in the longer term.

The Lloyds and RBS sell-offs will follow over the next three to five years and will be supervised by UK Financial Investments, the government body set up to oversee taxpayers' investment in the banks. The Government is understood to have made clear that existing larger operators will be banned from participating in the sales. Ministers want to drive competition in a sector they believe is too concentrated in the hands of the "Big Four" of Barclays, HSBC, Lloyds and RBS. Virgin Money is known to be watching the situation closely and is in talks to add former Northern Rock chairman Bryan Sanderson to its board ahead of a possible bid for Northern Rock.

Tesco is another company that could be enticed into an auction as it seeks to grow its financial services business. Spain's Banco Santander, which owns Abbey, Alliance & Leicester and part of Bradford & Bingley, may be allowed to get involved because it is significantly smaller than the big banking groups in Britain. But it could still be frustrated by the Government's determination to attract new entrants. "We are keen to see greater competition in the banking sector as soon as possible," said a government source.

A deal to buy "good" Northern Rock would bring a new entrant around £20bn of deposits together with a portfolio of low-risk mortgages and a platform to expand operations that remain concentrated in the North-east nationwide. Lloyds is expected to face a forced reduction in its share of the retail banking market from 30 per cent to 25 per cent, with the disposal of more than a seventh of its 3,000 branches expected.

It has been desperately seeking support in the City for a share issue of up to £15bn to keep it out of the Government's asset protection scheme that will cover it against losses from up to £260bn of risky loans. But even if Lloyds can achieve this, it will be forced to sell parts of itself as a consequence of the Government's injection of nearly £15bn to recapitalise the bank at the height of the financial crisis. That will be seen as a blow to Eric Daniels, chief executive, who indicated at the bank's recent results that he did not expect to make significant disposals. A spokesman said: "We continue to work with European regulators."

Royal Bank of Scotland, meanwhile, is working on plans to sell off a "couple of hundred" branches, including RBS branded outlets in the UK and NatWest's Scottish branches. It is certain to join the government scheme although how much will be protected is not yet certain. Final details on the Lloyds and RBS disposals are set to be announced alongside details of the asset protection scheme.

But an indication of the EU's "get tough" approach came on Monday when ING, which owns the ING Direct savings bank in Britain, said it would split itself in two to satisfy watchdogs unhappy at its bailout by the Dutch government. Britain's banking sector was further consolidated on Monday with the announcement by Barclays of a deal to buy Standard Life Bank.

Government sources said that while the new banks would be relatively small compared with the big four, they hoped they would prove fast moving and innovative. The effect Standard Life Bank had on the market when it was launched has been noted, although its activities were constrained by the credit crunch. The Government currently has a stake of 70.34 per cent in Royal Bank of Scotland and 43.44 per cent in Lloyds. That gives ministers the whip hand over both banks. They are expected to take up the taxpayers' "rights" when Lloyds launches its share issue to maintain the size of its investment.

Familiar Flavor To US Financial Reform Bill
Proposed system to regulate firms too big to fail features council that looks remarkably similar to existing advisory group.

More than a year after the U.S. government began bailing out the nation's biggest financial firms, a key congressional committee has unveiled a bill to prevent companies from becoming too big to fail.
The draft of the bill, released by the House Financial Services Committee on Tuesday, is designed to minimize the threats from firms that are so big or interconnected that they pose a "systemic risk" to the overall economy. It also sets forth a plan to wind down troubled non-financial firms, blunting the impact that the failure of those companies can have on the economy.

In many ways, the bill's aims mirror proposals put forth by the Obama administration earlier this year. As proposed, at the pinnacle of the new system would be a panel of top regulators dubbed the Financial Services Oversight Council.

The membership would be a who's who of Washington's regulators (take a deep breath before reading the list out loud): The Treasury secretary, the chairman of the Federal Reserve and the head of the Securities and Exchange Commission, as well as the heads of the Commodity Futures Trading Commission, the Federal Deposit Insurance Corporation, the Office of the Comptroller of the Currency, the Federal Housing Finance Agency and the National Credit Union Administration. Only one regulator, the Office of Thrift Supervision, is getting the ax in this proposal. The Treasury Secretary would chair the council. One state insurance regulator and one state bank regulator will also get non-voting seats.

The council's task will be "to monitor the financial services marketplace to identify potential threats to the stability of the United States financial system"--in other words, to watch out for financial crises and stop them before they begin. A key part of this task is identifying firms that "could pose a threat to financial stability," firms that are considered "too big to fail." The council will identify these firms and ask their respective regulators to tighten oversight. This tighter oversight would mostly mean requiring banks to keep more liquid capital on hand. It could also take the form of limiting how much exposure a bank has to another institution, or requiring an institution to change its risk management practices.

In an apparent attempt to avoid moral hazard, no public list will be kept of these too big to fail companies. The authority is somewhat toothless as regulators are allowed to ignore the council as long as they provide a written justification for doing so. The council will also have binding authority to resolve turf battles between different regulators. The council of regulators is remarkably similar to an advisory council that already exists: the President's Working Group on Financial Markets, which includes the Treasury secretary, Fed chair, and the heads of the SEC and CFTC.

Putting all these regulators in a room didn't provide much early warning about the crisis in 2008. In the 1990s, Brooksley Born, then the chair of the CFTC, sounded an alarm about the unregulated derivatives market, but the other regulators in the working group disagreed with her and so her efforts went nowhere--the sort of mistake a new council could easily repeat. One of the key dilemmas the bill aims to solve is how to unwind troubled non-financial firms that pose a threat to the economy. Traditional bankruptcy procedures can be drawn out, which could endanger the overall financial system. In addition, banking regulators don't have the legal authority to "resolve" a non-financial firm.

Under the proposal put forth by House Democrats, the FDIC would take over a failing firm so that taxpayers won't have to foot the bill for a bailout, as has happened with insurance giant American International Group during the past year. A troubled firm's shareholders and creditors would be responsible for bearing the costs of its resolution, but the government would also establish a Systemic Resolution Fund within the Treasury Department to help cover any additional costs. Financial firms with assets of $10 billion or more would be required to kick in money to help cover the cost of a firm's unwinding.

One concern is that the bill does little to streamline the nation's fractured system of financial regulation. And it's not clear how a council of regulators will prevent a few firms from posing a threat to the system. These questions will be addressed in depth by the committee in the days ahead. Many questions will likely be answered Thursday, when Treasury Secretary Timothy Geithner is scheduled to testify before the panel. But the key hurdle for Democrats won't be in getting the bill to the House floor in the coming weeks. (The party has an overwhelming majority in the House.) It'll be minimizing the influence of lobbyists and getting the Senate to produce similar legislation.

The Worst September For Home Sales Since 1981
Even uber-bearish housing analyst Mark Hanson was taken aback by the shortfall in home sales this morning. Even he thought that the remaining homebuyer tax credit, plus all the other stimulus out there, would produce a rise in new home sales.

But no. September was the worst month since 1981.


Builders, of course, will use the number as evidence that the subsidy MUST remain in place, but at this point there's probably no helping them. See, new homes compete for low-end homebuyers with foreclosures, and though we're still limiting the number of foreclosures out there (through moratoria and whatnot) the wave is just enormous.


New-Home Sales Drop as End of Tax Credit Looms
Sales of new U.S. homes unexpectedly fell in September as the end of a tax credit for first-time homebuyers approached, highlighting the importance of government aid to the emerging economic recovery. Purchases dropped 3.6 percent to a 402,000 annual pace that was lower than the most pessimistic economist’s forecast, according to Commerce Department figures issued today in Washington. Other data showed orders for durable goods climbed 1 percent in September, the fourth gain in the last six months.

Stocks fell as the home-sales report reinforced concerns a recovery from the worst recession since the 1930s may cool after programs such as the $8,000 tax credit and Federal Reserve purchases of mortgage-backed securities expire. Economists say a recovery in housing is a key to rebuilding the confidence and finances of American consumers, whose spending makes up 70 percent of the world’s largest economy.

The drop in sales "does raise some questions about where the housing market is going to be in six months, arguably without any more support," said Michael Feroli, an economist at JPMorgan Chase & Co. in New York. "Whatever you think about the economy, it’s not going to be a straight line" toward recovery. The Standard & Poor’s 500 Index declined 1.1 percent to 1,051.86 at 11:57 a.m. in New York, extending a global slump. The S&P Homebuilder Supercomposite Index, which includes companies such as Lennar Corp. and KB Home, dropped 4.2 percent to 243.63.

New-home sales were forecast to rise to a 440,000 annual rate, according to the median forecast of 75 economists in the Bloomberg survey. Estimates ranged from 412,000 to 460,000 after an initially reported 429,000 rate the prior month. Sales of new homes, which make up less than 10 percent of the market, are tabulated when a contract is signed. Purchases of existing homes, which account for the remainder, are counted when transactions close and thus reflect contracts signed a month or two earlier.

Contracts signed last month to buy a new house may not be able to close before the tax credit expires at the end of November. A proposal to extend the credit as part of an unemployment-benefits measure has significant support, Senate Majority Leader Harry Reid said today. Previously owned homes in September sold at a 5.57 million pace, up a record 9.4 percent from the prior month, the National Association of Realtors reported last week. The level of sales was the highest in more than two years.

The median price of a new house fell to $204,800, compared with $225,200 at the same time last year. The value was up 2.5 percent from the prior month, reflecting a plunge in the share of houses selling for less than $150,000, a category that often includes first-time buyers. Sales fell 11 percent in the West and 10 percent in the South. Purchases in the Midwest jumped 34 percent and were unchanged in the Northeast. Builders had 251,000 houses on the market last month, the fewest since November 1982. It would take 7.5 months to sell all homes at the current sales pace, the same as in August.

A report from the Commerce Department tomorrow may show the economy grew at a 3.2 percent annual pace last quarter, according to the median estimate of economists surveyed. It would be the first positive reading in more than a year and the strongest performance since the third quarter of 2007. Growth is forecast to slow to a 2.4 percent pace in the fourth quarter.

"Much of the strength in the economy is due to temporary factors such as fiscal stimulus initiatives like the home- buyers credit," said Dana Saporta, an economist at Stone & McCarthy Research in Skillman, New Jersey. Fed policy makers meeting next week are likely to repeat their commitment to keeping interest rates low for an "extended period." The Fed last month decided to slow purchases of $1.25 trillion in mortgage-backed securities while extending the end-date of the program by three months, to March 31.

The gain in durable goods orders illustrates how manufacturers such as Caterpillar Inc. are benefiting from $2 trillion in global stimulus spending. The 1 percent increase in bookings for goods meant to last several years matched the median estimate of economists surveyed by Bloomberg News and followed a 2.6 percent drop the prior month. Caterpillar, the world’s largest maker of bulldozers and excavators, issued a full-year profit forecast exceeding the highest prediction from analysts. Peoria, Illinois-based Caterpillar is considered a bellwether for its ties to construction and mining and its overseas presence.

"We are seeing encouraging signs that indicate a recovery may be under way," Chief Executive Officer Jim Owens said in a statement on Oct. 20. "We’ve already started planning for an upturn." Shipments for non-defense capital goods excluding aircraft, used in calculating gross domestic product, fell 0.2 percent in September. For the quarter, such shipments dropped at a 1.9 percent annual pace compared with a 14 percent plunge in the prior three months, indicating business investment stabilized after plunging over the past four quarters.

Fears of a New Chill in Home Sales
Even as new figures show house prices have risen for three consecutive months, concerns are growing that the real estate market will be severely tested this winter.

Artificially low interest rates and a government tax credit are luring buyers, but both those inducements are scheduled to end. Defaults and distress sales are rising in the middle and upper price ranges. And millions of people have lost so much equity that they are locked into their homes for years, a modern variation of the Victorian debtor’s prison that is freezing a large swath of the market.

"Plenty of pain yet to come," said Joshua Shapiro, chief United States economist for MFR. He is forecasting an imminent resumption of price declines. This summer, housing seemed at last to be stabilizing. A flood of last-minute buyers trying to conclude a deal before the tax credit expires Nov. 30 helped push up the Standard & Poor’s/Case-Shiller home price index a seasonally adjusted 1 percent in August, it was announced on Tuesday.

That was the first time since early 2006 that the widely watched measure of 20 metropolitan areas put together three consecutive increases. While underlining the importance of that long-awaited rise, Maureen Maitland, the S.& P. vice president for index services, warned, "Everything is up for grabs this winter." Consumers seem acutely aware of the strains ahead. The Conference Board’s consumer confidence index fell unexpectedly in October, after reaching its high for the year in September, the board announced on Tuesday.

The only hot sector of the real estate market has been foreclosures. Investors and first-time buyers have been competing for these, often creating bidding wars. But with the economy still weak, many analysts expect more foreclosures. Another factor likely to weigh on home sales in the coming months is a rise in interest rates. As the Federal Reserve ceases its buying of mortgage-backed securities, rates may well drift up to 6 percent, from 5 percent.

Worries about the fragility of the housing market, fanned by the real estate industry, may prompt an extension of the tax credit. The controversial program has spurred as many as 400,000 buyers, including Brenda Colon, a nurse in Las Vegas. "If you had told me in January that I would be buying a house, I would have laughed," said Ms. Colon, 48, who lives with her two daughters and granddaughter. "But the tax credit was just the kicker to throw me over."

Yet despite the tax credit and other local and federal incentives for homebuyers in Las Vegas, prices there are continuing to fall, shedding 0.8 percent in August. The city’s home prices have declined on average more than 55 percent from their peak, more than in any other metropolis. Whenever the tax credit finally expires, Las Vegas and every other city will have to confront the inevitable question after all such stimulus packages: what will motivate the buyers of tomorrow?

"In my office, people were buying homes left and right because of that tax credit," said Kitty Berberick, who works for an insurance company in Las Vegas. "That credit was a godsend." Ms. Berberick, 62, could not strike a deal in time, and now has signed another lease for her apartment. If the credit is not extended, she said, she is likely to give up the search entirely until the market really crashes.

This, of course, is the sort of fatalistic attitude that relentlessly drove down prices last fall. "Everyone keeps telling me, it’s going to go down before it goes up," Ms. Berberick said. "I hope it does, because then I can buy." The recovery is both modest and tentative when measured against the preceding plunge. Prices have fallen nearly a third from their peak, and are down 11.4 percent over the last year.

In most major cities, it is as if the housing boom never happened. Prices over all are back to where they were in the fall of 2003. Some cities have been pushed down even more: In Cleveland, prices are at 2001 levels; in Detroit they’re at 1995. It is the magnitude of this decline that makes Karl E. Case, the Wellesley professor for whom the Case-Shiller index is partly named, an optimist.

While acknowledging "there are a lot of dangers out there," Mr. Case said "housing is as affordable as it’s been in 20 years. I don’t see a very rapid recovery, but I think we’ve seen the bottom." Sixteen of the 20 cities in the index rose in August, including San Francisco, up 2.6 percent, and Minneapolis, which rose 2.3 percent. Besides Las Vegas, three cities fell: Charlotte, Cleveland and Seattle. New York was up 0.3 percent.

The Case-Shiller numbers on prices lag behind the National Association of Realtors’ report on existing-home sales, which has been issued for September. Sales were up 9.4 percent from August, with the tax credit again getting much of the credit. Critics of the credit argue that the number of those who merely qualify for it — and gladly take it — greatly outnumber those it is precisely intended to assist: people who would not have bought a house otherwise. That means, they argue, that the government is essentially paying more than $40,000 for each purchase that would not have occurred without the credit.

That is an expensive proposition, said Roberton Williams, a senior fellow at the Tax Policy Center who has closely followed the issue. "The bigger threat to the housing market is not the reduction in demand from the end of the credit, but the continuing wave of foreclosures we’re likely to see over the next 18 months," he said. In California, there is strong evidence that foreclosures are beginning to migrate from the subprime inland areas to the more exclusive coastal region.

According to MDA DataQuick, third-quarter notices of default in Santa Barbara were up 25 percent from 2008; in San Luis Obispo, they rose 46 percent; in Marin County, they were up 66 percent. Defaults in hard-hit Sacramento, by contrast, were up only 10 percent. In Merced County in the Central Valley, an epicenter of the bust, they actually fell.

While defaults are only the first stage in foreclosure, Mr. Shapiro, the MFR economist, expects many formerly creditworthy homeowners to go under. He says he thinks the recent improvement in Case-Shiller numbers is an aberration rather than the beginning of a long-term improvement, with consequences for the larger economy. "Another leg down in home prices, even if much more limited than the initial move, would nonetheless weigh on consumer spending," Mr. Shapiro said, adding that he did not expect a second recession.

Capmark's bankruptcy provides a template for the future
Capmark Financial Group Inc.'s weekend bankruptcy filing surprised no one, but it was still a harsh reminder of the hard times ahead in the commercial real estate industry. "It's not a turning point. The problems are only starting," Dennis Yeskey, a senior adviser at AlixPartners L.L.P., a business-advisory firm in New York, said yesterday. Yeskey and other experts warned that as long as the economy keeps shedding jobs, the commercial real estate market will be plagued by declining demand and falling property prices.

In its Chapter 11 bankruptcy filing Sunday, the commercial-property lender listed assets of $20.1 billion and debts of $21 billion. Capmark, which has 585 of its 1,000 employees in Horsham, relied heavily on selling loans it had made into the secondary market. When that froze and property values fell, the company got stuck owing more to its own lenders than its loans were worth. "It's a template that you will see multiply itself many times over over the next three years," said Matthew McManus, chairman of NAI BlueStone Real Estate Capital, a real estate investment bank in Philadelphia.

The problem for the industry is that between now and 2013, more than $2 trillion in commercial mortgages, which typically have a five- to 10-year term, will need to be refinanced, according to a July report by Richard Parkus, head of commercial mortgage-backed securities at Deutsche Bank AG. It is not turmoil in the capital markets that is causing the bottleneck, but rather the fact that properties are not worth enough to retire the old debt in a refinancing, Parkus said.

The value of commercial properties has fallen 40 percent from their peak in October 2007 through August, according the Moodys/REAL Commercial Property Price Index. The sharp decline in property values has contributed to a rapid deterioration of the $7.8 billion loan book at the Capmark Bank unit. Most loans were made at the peak of the lending frenzy in 2006-07.

During the five quarters ended June 30, the percentage of loans on the bank's "watch list" for problems soared to 39 percent from 2 percent, according to a presentation posted on the firm's Web site.
Capmark had $340.3 million in loans outstanding in the Philadelphia market, or 4.3 percent of its total, as of Sept. 30. Of those, $35.6 million, or 10.5 percent, were behind on payments, according to the presentation.

Paul Halpern, a partner at Versa Capital Management Inc., of Philadelphia, said a lack of ready financing for commercial real estate had prevented properties from trading at depressed values. That could help some lenders otherwise facing big write-offs. "By the time financing is available, asset prices will have recovered substantially, though not enough to save everybody," Halpern said.

GMAC Asks for Fresh Lifeline
In a stark reminder of how some battered financial firms remain dependent on government lifelines, GMAC Financial Services Inc. and the Treasury Department are in advanced talks to prop up the lender with its third helping of taxpayer money, people familiar with the matter said. The U.S. government is likely to inject $2.8 billion to $5.6 billion of capital into the Detroit company, on top of the $12.5 billion that GMAC has received since December 2008, these people said. The latest infusion would come in the form of preferred stock. The government's 35.4% stake in the company could increase if existing shares eventually are converted into common equity.

The willingness by Treasury officials to deepen taxpayer exposure to GMAC reflects the troubled company's importance to the revival of the auto industry. Founded in 1919, GMAC has $181 billion in assets and is a major financier for 15 million borrowers and thousands of General Motors and Chrysler car dealerships in the U.S. The new capital would help firm up GMAC's balance sheet and solidify its auto-loan business. GMAC provides the vast majority of wholesale financing for GM dealerships across the country, meaning scores of local distributors would be unable to bring new vehicles onto their lots if GMAC were to collapse.

Federal officials also are moving to shore up GMAC's ability to fund its daily operations, with the Federal Deposit Insurance Corp. telling the company Tuesday the agency will guarantee an additional $2.9 billion in debt, according to people familiar with the discussions. The FDIC guarantee will make it easier for the company to sell debt to investors. The FDIC backed $4.5 billion in GMAC-issued debt earlier this year. The FDIC approval came just four days before the expiration of the regulator's program that guarantees debt issued by certain banks. It ended months of tense negotiations between GMAC and regulators. Without a deal, the company would have been forced to further reduce its lending volume. New-car loans by the company tumbled 55% to $5.6 billion in the second quarter from a year earlier.

While GMAC would be the only U.S. company to get three capital injections from the government since the financial crisis erupted two years ago, thousands of banks and other financial firms remain weakened by exposure to fallen real-estate values and clobbered financial markets.

Paying Back TARP
Among U.S. banks that got a total of $204.64 billion in aid through the Troubled Asset Relief Program, just one-third of the capital has been repaid so far. Government officials are skeptical that some banks now wanting to escape the government's grip are strong enough to do so, with Bank of America Corp.'s attempt to repay bailout funds snagged by a disagreement over how much additional capital the bank must raise to satisfy regulators, people familiar with the situation said.

At GMAC, the likelihood of a third infusion increased when the government's stress-test results were released in May. The tests were conducted to determine whether banks would need more capital to continue lending if the economy deteriorated in 2009 and 2010. The test concluded GMAC needed $11.5 billion in common equity to continue lending in a stressed economy.

GMAC raised some of the money directly from the government, but a significant hole remains. The company hasn't been able to attract much capital from private investors because it isn't listed as a public company, forcing GMAC to begin negotiating with the government to find the remaining funds. GMAC and Treasury officials are now negotiating about exactly how much capital the company needs. "GMAC is the only one of the banks that went through the stress test to need additional government capital," Treasury spokesman Andrew Williams said. "All other institutions were able to raise any necessary capital from investors and several paid back the taxpayer."

Capital Hole
People close to GMAC said the company's outlook is better than it was in May, and that unlike other banks that went through the stress-test process, GMAC won't be forced to fill the entire capital hole even with a third infusion. Bank of America has raised about $40 billion in new equity, higher than the $34 billion required, and regulators are asking it to raise even more if it wants to return $45 billion in U.S. aid. The U.S. government's current 35.4% stake in GMAC is the result of a 2009 restructuring of GM.

People close to GMAC said they don't expect the government to call for changes in management as a result of the likely infusion. The company posted a second-quarter loss of $3.9 billion amid rising loan delinquencies and the continued U.S. auto slump. It expects to release third-quarter earnings next week. For decades, GMAC served as GM's finance arm. In 2006, GM sold a majority stake to private-equity firm Cerberus Capital Management, which eventually installed former Bank of America Chief Financial Officer Alvaro de Molina as CEO. The collapse of the U.S. housing market and declining U.S. auto sales nearly crushed GMAC, forcing Mr. de Molina to curtail lending and seek help to finance its operations.

Bank-Holding Status
Mr. de Molina's search for capital brought him to the government's door. The Fed awarded GMAC status as a bank-holding company and Treasury injected $5 billion in December 2008. It came back with an additional $7.5 billion on May 21. The Fed also waived rules to allow the bank to pass assets down into its bank division, and the FDIC reluctantly agreed to issue "up to" $7.4 billion in government-backed debt. The FDIC approval issued Tuesday brings GMAC to the full amount authorized in May.

In another defining moment, GMAC entered into an agreement with Chrysler in April 2009 to provide auto financing and services to Chrysler dealers and customers. This allowed GMAC to leverage its core strength of auto financing and become part of a solution with the U.S. government to restructure the auto industry.

In May, GMAC also launched a new brand for its online bank, called Ally Bank. Its pursuit of deposits at high rates became a key leg of its strategy, since deposits provide a cheap form of funding, but the taxpayer-assisted approach rankled competitors and the FDIC. The dispute nearly cost GMAC its chance at the final $2.9 billion in FDIC debt guarantees. The two sides were able to hammer out an agreement that requires GMAC to keep its rates at certain amounts in exchange for the support, according to people familiar with the situation.

Jeremy Grantham: Little Has Changed in the Last 18 Months
The latest Grantham quarterly is a real gem. It sounds to me like he has been reading too much TPC (more likely, I have been reading too much Grantham!). He calls out just about everyone involved in the economy in the letter. He claims Bernanke is clueless and is repeating the mistakes of Greenspan. He calls Geithner and Summers the captains of the USS Disaster.

He says the homebuilders are reckless and that the mortgage borrowers and consumers are idiotic. He hammers the big banks and CEO pay. In essence, he argues that very little has changed in the last 18 months and that the market is now well overbought and at risk of a substantial downturn that is based on the weak real economy and realization that stimulus can’t get us out of this mess. The main takeaways:
  • The market is 25% overvalued
  • He hopes for "some modest hopes for a collective sensible resistance to the current Fed plot to have us all borrow and speculate again."
  • "The U.S. market will drop below fair value, which is a 22% decline (from the S&P 500 level of 1098 on October 19)."
  • "All in all we are likely to have learned little, or rather to act, through lack of character, as if we have learned nothing. In doing so we are probably condemning ourselves to another serious financial crisis in the not too-distant future."

I hope investors will take particular note of point two above. This Federal Reserve is destroying the dollars in our pockets as they implement the exact same boom/bust policies that helped create this mess in the first place. We absolutely must do something to help change the system and limit the power of these reckless and destructive bankers. Grantham has some suggestions in his letter, but it’s the investors who need to take power back from the Fed and the bankers.

U.S. foreclosures spike in new regions in 3rd quarter
U.S. mortgage defaults ebbed in some hard-hit cities in the third quarter, but unemployment created new trouble spots as foreclosures set a record in the quarter, real estate data company RealtyTrac said on Wednesday. Foreclosure activity declined in five of the top 10 metro areas from a year earlier, at least temporarily aided by government programs to modify terms of home loans.

Job loss as well and mortgage rate resets, however, are severely curbing the ability of homeowners to make timely payments. Many metro areas with the 50 highest foreclosure rates had sharp increases in filings during the past three months. "Rising unemployment and a new variety of mortgage resets continue to gradually shift the nation's foreclosure epicenters in the third quarter away from the hot spots of the last two years and toward some metro areas that had avoided the brunt of the first foreclosure wave," James J. Saccacio, RealtyTrac's chief executive, said in the company's quarterly Metropolitan Foreclosure Market Report.

U.S. unemployment reached a 26-year high of 9.8 percent in September. Foreclosure filings -- which include notice of default, auctions and bank repossessions -- rose 5 percent in the third quarter from the prior quarter and 23 percent from a year ago, RealtyTrac reported earlier this month. One in every 136 households with a loan got a filing in the quarter, a record since the firm started tracking them in the first quarter of 2005. Filings were reported on more than 937,000 properties in July through September.

All of the cities with the 10 highest foreclosure rates were in California, Florida and Nevada, led by Las Vegas, Nevada; Merced, California; and Cape Coral-Fort Myers, Florida.
Las Vegas had a third-quarter foreclosure activity rate of 5.13 percent, affecting one in 20 households with loans. Five of the top 10 metro areas, including Merced and Cape Coral-Fort Myers, reported a decrease in foreclosure activity in the quarter from a year ago. The other big metro areas that saw a decline in foreclosure activity were all in California: Stockton, Modesto, and Vallejo-Fairfield.

Despite a 13 percent drop in foreclosure activity from the second quarter and 11 percent drop from a year ago, Merced had the second highest rate. The Cape Coral-Fort Myers metro area ranked third in foreclosure activity, RealtyTrac reported. And some cities that haven't been a focal point of the foreclosure crisis showed steep increases in activity in the third quarter. Boise City-Nampa, Idaho, and Provo-Orem and Salt Lake City in Utah had the biggest year-over-year increases in foreclosure rates among the top 50 areas.

In California, the Chico area posted the biggest year-over-year increase in foreclosure activity, up 98 percent from the third quarter of 2008. Chico, located about 100 miles north of Sacramento, had a 12.8 percent unemployment rate in August, above the state and national averages, RealtyTrac noted. "As unemployment is likely to stay high and maybe even go a little higher for a while, it means we will continue to see people defaulting and their homes ending up in foreclosure," Jed Kolko, associate director of research at Public Policy Institute of California in San Francisco, said on Tuesday.

The two other looming uncertainties are the fallout from the next wave of adjustable-rate mortgage resets and the degree of success of U.S. loan modification programs, he said, noting the possibility that the government program may have only delayed defaults and foreclosures.

U.S. stock market analysts disagree on impact of Fed moves
As U.S. stock investors start factoring in the idea of the Federal Reserve tightening moves, analysts held starkly divergent views on how the market will greet central bank steps to pull its massive stimulus out of the economy. The Fed, which has cut interest rates to near zero in an effort to pull the economy out of its worst recession since the 1930s, will begin to hike rates in mid-2010, said Jeffrey Kleintop, chief market strategist at LPL Financial.

The central bank will also likely abandon use of the phrase "extended period" in statements related to how long it intends to keep rates low, he said. "I think the market weakens as the Fed begins to hike interest rates, and leading up, as the market fears what the Fed may do," said Kleintop. But the Fed would only start hiking interest rates on signs of increased economic activity, sending a bullish signal to the equities market as central bankers try to preserve economic growth coupled with low inflation, said Art Hogan, chief market strategist at Jefferies & Co.

"The Fed has a pretty good picture of the economy, and can usually see around the corner," said Hogan. Bob Baur, chief global economist at Principal Global Investors, also believes a Fed rate hike would be viewed favorably by the equities market. "By the time the Fed does something, enough people will be saying it's about time. Plus, it'll be a pre-emptive strike against future inflation. And, others will like it as an indication the economy is strong enough to handle a rate hike," said Baur.

Kleintop concurs that Fed tightening moves would be a "nice confirmation that the recovery is here." But, he said, "investors would be more concerned that we're finally going to have to pay for all the resources brought to bear to end the recession. It would weigh on stocks and the economic outlook too." Defensive sectors such as utilities, consumer staples and health care would hold up best as the Fed begins to raise rates, he said.

"Everybody likes low interest rates rather than rising rates, so it is going to put some of the U.S. in a little bit of a bind - anyone who has to borrow money - and the dollar would strengthen some," said Baur of the downsides of Fed tightening moves.

One might assume higher interest rates would cast a negative spin on equities, but if one looks at the market's behavior in the 1980s during the three- and six-month spans after tightening cycles begin, "stocks actually work in the other direction," offered Hogan. Calling the risk of inflation "clear and present," Hogan said investors would be wise to consider investments that do well in an inflationary environment.

Hogan points to industries with exposure to commodities, such as basic materials, energy, natural resources and industrials, what he called "hard assets as a storer of value in an inflationary economy." Sectors to be avoided, in Hogan's view, include large financial institutions now able to borrow at near-zero and lend at healthy rates. "When the spreads tighten they will be less profitable." Another reason not to be long traditional financials that have drawn government assistance is they'll soon have to stand on their own and repay TARP funds, which "will be redeployed to the smaller and regional banks that need help," said Hogan.

Hogan advises investors to look at regional banks that haven't been exposed to government assistance. Beyond the interest-rate trade, the technology sector tends to outperform as economic conditions improve, with companies turning to tech to help productivity. The tech sector is also likely to see more activity on the M&A front, since top-tier companies still have "lots of cash," said Hogan.

On Wall Street, financials fronted the losses as the major indexes finished sharply lower. Hit with its third triple-digit fall in four sessions, the Dow Jones Industrial Average finished at 9,762.69, off 119.48 points, or 1.2%. The S&P 500 Index dropped 20.78 points, or 2%, to 1,042.63, with the broad market indicator erasing its gains for October. The Nasdaq Composite Index declined 56.48 points, or 2.8%, to 2,059.61.

Roubini Says Carry Trades Fueling 'Huge' Asset Bubble
Investors worldwide are borrowing dollars to buy assets including equities and commodities, fueling "huge" bubbles that may spark another financial crisis, said New York University professor Nouriel Roubini. "We have the mother of all carry trades," Roubini, who predicted the banking crisis that spurred more than $1.6 trillion of asset writedowns and credit losses at financial companies worldwide since 2007, said via satellite to a conference in Cape Town, South Africa. "Everybody’s playing the same game and this game is becoming dangerous."

The dollar has dropped 12 percent in the past year against a basket of six major currencies as the Federal Reserve, led by Chairman Ben S. Bernanke, cut interest rates to near zero in an effort to lift the U.S. economy out of its worst recession since the 1930s. Roubini said the dollar will eventually "bottom out" as the Fed raises borrowing costs and withdraws stimulus measures including purchases of government debt. That may force investors to reverse carry trades and "rush to the exit," he said.

"The risk is that we are planting the seeds of the next financial crisis," said Roubini, chairman of New York-based research and advisory service Roubini Global Economics. "This asset bubble is totally inconsistent with a weaker recovery of economic and financial fundamentals."

The MSCI World Index of advanced-nation equities has surged 65 percent from this year’s low on March 9, while the MSCI Emerging Markets Index has jumped 96 percent. The Reuters/Jefferies CRB Index of 19 commodities has added 33 percent. Roubini said he sees a bubble in emerging-market equities and that gains in some developing-nation currencies are becoming "excessive." The rally in oil "is not justified by the fundamentals," he said.

An asset "bust" may not occur for another year or two as a "wall of liquidity" pushes prices higher, Roubini said. In a carry trade, investors borrow in countries with low interest rates to invest in higher-yielding assets. Roubini said the U.S. recession seems to be over, though the economic recovery in advanced nations will be "anemic." He’s "more optimistic" on the outlook for emerging-nation growth. The U.S. economy probably expanded at a 3.2 percent pace from July through September after shrinking the previous four quarters, according to the median estimate of 65 economists surveyed by Bloomberg News before the Commerce Department’s report on gross domestic product due Oct. 29.

The economy shrank 3.8 percent in the 12 months to June, the worst performance in seven decades. Roubini’s July 2006 warning about the financial crisis protected investors from losses in the Standard & Poor’s 500 Index’s worst annual tumble in seven decades. The U.S. equity benchmark has surged 58 percent from a 12-year low in March even as Roubini said that month the advance was a "dead-cat bounce," that it may "fizzle" in May and warned in July that the economy is "not out of the woods."

The S&P 500 gained was little changed at 1,067.30 as of 12:44 p.m. in New York, while the MSCI emerging markets index lost 1.8 percent. South Africa’s rand dropped 0.9 percent against the dollar as developing-nation currencies weakened. Crude oil for December delivery added 1.2 percent to $79.60 a barrel.

How mistaken ideas helped to bring the economy down
How did the world economy fall into such a deep hole? It is recovering, but painfully, and after a deep recession, despite unprecedented monetary and fiscal easing. Moreover, how likely is it that a balanced world economy will emerge from this force-feeding? The very fact that such drastic action has been necessary is terrifying. The fact that there is little room for a policy encore is yet more terrifying. Most terrifying of all is that this is not the first time in recent decades the world economy has had to be guided through a post-bubble collapse.

In his latest book – a successor to Valuing Wall Street, which appeared in time to help alert readers avoid the 2000 meltdown – Andrew Smithers of London-based Smithers & Co, provides an invaluable guide to past errors of analysis and policy.* He is a rare guide – a man with a deep understanding of economics and a lifetime’s experience of financial markets. His work helps to explain the stock-market bubble of the 1990s, the fiscal errors of Gordon Brown and the recent credit excess.

The big points of the book are four: first, asset markets are only “imperfectly efficient”; second, it is possible to value markets; third, huge positive deviations from fair value – bubbles – are economically devastating, particularly if associated with credit surges and underpricing of liquidity; and, finally, central banks should try to prick such bubbles. “We must be prepared to consider the possibility that periodic mild recessions are a necessary price for avoiding major ones.” I have been unwilling to accept this view. That is no longer true.

The efficient market hypothesis, which has had a dominant role in financial economics, proposes that all relevant information is in the price. Prices will then move only in response to news. The movement of the market will be a “random walk”. Mr Smithers shows that this conclusion is empirically false: stock markets exhibit “negative serial correlation”. More simply, real returns from stock markets are likely to be lower, if they have recently been high, and vice versa. The right time to buy is not when markets have done well, but when they have done badly. “Markets rotate around fair value.” There is, Mr Smithers also shows, reason to believe this is true of other markets in real assets – including housing.

A standard objection is that if markets deviate from fair value, they must present chances for arbitrage. Mr Smithers demonstrates that the length of time over which markets deviate is so long (decades) and their movement so unpredictable that this opportunity cannot be exploited. A short seller will go broke long before the value ship comes in. Similarly, someone who borrows to buy shares when they are cheap has an excellent chance of losing everything before the gamble pays off. The difficulty of exploiting such opportunities is large for professional managers, who will lose clients. The graveyard of finance contains those who were right too soon.

Mr Smithers proposes two fundamental measures of value – “Q” or the valuation ratio, which relates the market value of stocks to the net worth of companies and the cyclically adjusted price-earnings ratio, which relates current market value to a 10-year moving average of past real earnings. The two measures give similar results (see chart). Professional managers use many other valuation methods, all of them false. As Mr Smithers remarks sardonically: “Invalid approaches to value typically belong to the world of stockbrokers and investment bankers whose aim is the pursuit of commission rather than the pursuit of truth.”

Imperfectly efficient markets rotate around fair value. Bandwagon effects may push them a long way away from fair value. But, in the end, powerful forces will bring them back. Trees do not grow to the sky and markets do not attain infinite value. When stocks reach absurd valuations, investors will stop buying and start to sell. In the end, the value of stocks will move back into line with (or below) the value – and underlying earnings – of companies. House prices will, in the long term, also relate to incomes. Anybody interested in investing would gain from reading this book. They would then understand, for example, why the “buy and hold” strategy advocated by many pension advisers, even at the peak of the stock market bubble, was such a catastrophe. Value matters, as Warren Buffett has said so often.

Yet, for those interested in economic policy, Mr Smithers’ arguments have wider significance. If markets can be valued, it is possible to tell whether they are entering bubble territory. Moreover, we also know that the bursting of a huge bubble can be economically devastating. This is particularly true if there was an associated surge in credit. This is also the conclusion of a significant chapter in the latest World Economic Outlook. In extreme circumstances, monetary policy loses its impact, as the financial system is decapitalised and borrowers become bankrupt. What we see then is what Keynes called “pushing on a string”.

So what are the policy lessons? The International Monetary Fund concludes, ponderously: “Simulations suggest that using a macroprudential instrument designed specifically to dampen credit market cycles would help to counter accelerator mechanisms that inflate credit growth and asset prices. In addition, a stronger monetary reaction to signs of overheating or of a credit or asset price bubble could also be useful.” Mr Smithers suggests that policymakers should monitor the price of stocks, houses and liquidity. If one of these, and especially if all three, are flashing red central bankers should respond. He recommends measures that raise capital requirements of banks in the boom. I would also support measures that directly limit the leverage among borrowers, as asset prices soar, particularly house prices.

The era when central banks could target inflation and assume that what was happening in asset and credit markets was no concern of theirs is over. Not only can asset prices be valued; they have to be. “Leaning against the wind” requires judgment and will always prove controversial. Monetary and credit policies will also lose their simplicity. But it is better to be roughly right than precisely wrong. Pure inflation targeting and a belief in efficient markets proved wrong. These beliefs must be abandoned.

More than you probably ever wanted to know about the Hamp
by Tracy Calloway

The Federal Reserve Board had just released a working paper on the Home Affordable Modification Plan — the Hamp.

The paper is fantastic for details on just how the programme — which is aimed at making mortgages more affordable by reducing interest payments — came about and feeds into the wider financial system. When it comes to the programme’s potential success, authors Larry Cordell, Karen Dynan, Andreas Lehnert, Nellie Liang and Eileen Mauskopf think the Hamp will help a lot of homeowners — but they do see limitations.

Of particular note is the idea that the Hamp might not be helping those who need it most:
Nonetheless, millions of foreclosures are likely to occur over the next couple of years. House price declines have led to a sharp deterioration in the financial situation of many homeowners, leaving them less willing or able to afford even reduced mortgage payments. Further, HAMP modifications are not well-suited to address many cases where homeowners have suffered a large temporary decline in income, as might be the result of job loss. In particular, because the modification calls for a reduction in the ratio of payments to income based on the current level of income, a reduction that would not be reversed if income were to return to its previous level, the required modification in such cases will often be too costly to qualify the program.

Which means that because the size of the reduction in payments permanently depends on current income (virtually none in the case of the unemployed) — the loan modification could turn out to be overly generous. Once the jobless homeowner resumes work he will still be making Hamp payments based on his unemployed income — and those bearing the cost of the Hamp exercise will be left to pick up the tab. Furthermore:
In addition, the program may not be very effective when the value of the mortgage greatly exceeds the value of the home. Some borrowers who believe that there is little prospect for house prices to recover enough to put the mortgage “above water” within some reasonable period of time will not participate in the program and instead walk away from their mortgages. Worse yet, other borrowers may shift beliefs only after entering the program; these borrowers are likely to default after many of the costs associated with the modification have already been borne.

Which is a problem that’s been mentioned before. If you are say, a homeowner offered a Hamp trial modification plan where your monthly payments are reduced, you could easily walk away after making a few cheap payments. We’ve noted one instance where a Hamp modification plan entailed monthly payment of $1170 a month, when comparable houses were renting for close to $1,500 a month. That’s a bargain for the (underwater) homeowner.

But it’s not so great for the people and institutions assuming the cost of the modifications:
The HAMP protocol requires servicers to lower monthly mortgage payments, which include principal, interest, taxes and insurance (PITI), to 38 percent of the borrower’s gross income, through any method they choose, with investors bearing the losses implied by the reduced payments. Servicers are then required to reduce the DTI [payment to current income ratio] from 38 percent to 31 percent by using the waterfall provided by the plan; the losses associated with the additional reductions in the DTI are shared equally by the government and the investors

Now a typical mortgage investor is someone like Greenwich Financial Services. But they also include Fannie and Freddie — the government-sponsored enterprises. Banks tend to be on the mortgage lending and servicing side of things — which presumably is why you sometimes see them lobbying for more aggressive Hamp action. Servicers and lenders get payments for Hamp participation — the trade-off is they have to commit a lot of time and resources to the actual modification process.
Anyway, back to the GSEs:
For loans owned or guaranteed by the government-sponsored entities, the modification may proceed even if the present value of the modified revenue stream is less than that expected to be obtained under foreclosure. In all cases, the GSE buys the loan out of the pool, the investor is made whole with respect to the remaining balance on the loan. Under the Treasury’s commitment to maintain a positive net worth for the GSEs, the cost of the modification may ultimately be borne by the taxpayer. (23)

23 These modification costs are over and above the Treasury incentive payments under HAMP. Given the Treasury’s commitment to the GSEs, a modification that lowers the borrower’s payments means that the taxpayer receives a lower return than he would under the terms of the original loan when the loan is owned or guaranteed by the GSEs.

Got it? Mortgage investors get lower payments. Mortgage lenders and servicers get Hamp bonus incentives and Fannie and Freddie get Treasurized.

The argument of course, is that a loan modification will ultimately be cheaper than foreclosure — though some of that loses weight if you consider that a Hamp homeowner dragging out proceedings in an environment of declining houseprices, will mean losses from delaying foreclosure could be larger than losses if foreclosure had been initiated immediately. The authors say incentive payments — linked to the rate of recent home price decline — should mitigate this.

But the historic evidence presented from the paper is not encouraging.

The authors, for instance, looked at 5.5m active loans in the First American CoreLogic Loan Performance ABS database as at March 2009. Of note:
. . . the performance of loans modified as of March 2009 was poor, as only 40 percent of modified loans were current at 6 months after modification, and 29 percent were seriously delinquent. Given that loans are marked as seriously delinquent if they have missed three or more payments or are in foreclosure, such borrowers likely made only one or two payments on their modified loan.

BMW Links Executive Pay to That of its Line Workers
BMW has become the first major company in Germany to change its compensation practices amid growing concern over excessive banker bonuses. The company cited a fairer work environment as its reason. Other firms are sure to take notice, given BMW's size and weight in the global business market. BMW became the first major blue chip German company to link the bonuses of its top managers to those of its assembly line workers, amid growing global criticism of executive compensation. The move sends a strong message to other firms also examining their compensation practices, as the world's largest banks in particular have come under fire from politicians, shareholders and the public over excessive bonuses during one of the worst economic crises the world has seen.

BMW plans to tie executive bonuses to those of its blue-collar workers, in a bid to create a fairer and sustainable compensation environment within the company. Starting in 2010, the company will use a common formula to ascertain and award bonuses to its upper and lower level employees, based on the company's performance as measured by profit, sales and other factors. That means that upper level management could potentially lose more money than their lower level counterparts for bad performance, BMW said.

A spokesman for BMW said the company's goal was to create fair and transparent compensation practices and to prevent a gap between management and the workers, as the under class, from developing. "We don't just want to build sustainable cars. We also want to have sustainable personnel politics. We think this is good for the company culture," the spokesman told SPIEGEL ONLINE. He declined to be more specific on how the formula will work.

Other companies may follow BMW's example as pressure grows on firms to curb excessive bonuses in the wake of the financial crisis. German Chancellor Angela Merkel has been outspoken about her dislike for excessive bonuses, calling them "inappropriate." In September, she penned a letter with French President Nicolas Sarkozy and Prime Minister Gordon Brown of the United Kingdom ahead of the G20 summit in Pittsburgh that proposed a cap on the the total amount of bonus money a bank could pay out. They didn't stipulate how much banks could reward a single individual. "Our citizens are deeply shocked at the revival of reprehensible practices, despite taxpayers' money having been mobilized to support the financial sector at the height of the crisis," the letter stated.

US President Barack Obama has also been outspoken about excessive compensation. In June, he appointed attorney Kenneth Feinberg to oversee compensation practices at seven companies that received bail-out funds from the government. To that end, Feinberg has devised a plan to cut the total compensation for these companies in half. This month, Feinberg pushed Kenneth D. Lewis, outgoing chief executive of Bank of America Corp., to give back $1 million in compensation and forgo any additional salary this year, arguing his retirement benefits and stock, worth millions, was enough.

Joseph Sorrentino, managing director with Steven Hall & Partners, a US-based executive compensation consulting firm, said a combination of factors including political pressure, government bailouts, public pressure and the declining stock market has led to many companies re-examining their compensation practices to make sure they are effectively paying for performance and not encouraging excessive risk-taking. "Companies are trying to make sure they balance the public outcry with what they need to make sure they are able to attract and retain their employees," Sorrentino told SPIEGEL ONLINE. He added that often when big companies such as BMW change their compensation practices, other companies take notice.

To be sure, the BMW spokesman said the company has been discussing its compensation practices for months, and that its announcement has nothing to do with the larger debate over executive compensation circulating through governments currently. However, Harald Krüger, BMW's human resources director, was critical of the bonus structure of banks and other businesses. "If employees need the money or bonuses for motivation, it encourages harmful developments inside a company," the executive told Frankfurter Allgemeine Sonntagszeitung newspaper on Sunday.

Norway raises interest rate
Norway’s central bank increased its key interest rate by a quarter point to 1.5 per cent on Wednesday – Europe’s first monetary policy tightening since the global economic crisis bit hard last year. Norges Bank said it would gradually continue with more rises, holding its main rate at between 1.25 and 2.25 per cent until the next monetary policy report in late March. Analysts think the central bank is seeking to keep rates around the mid-point of the range, signalling another 25 basis point rise.

The krone initially rose, pushing the euro down to about NKr8.3680 from NKr 8.4071 before the announcement. It then pulled back to NKr8.40. Norges Bank said inflation had been slightly higher than expected, while unemployment was "considerably lower than previously projected". "Activity in the Norwegian economy has picked up more rapidly than expected ... developments indicate that it is appropriate to raise the key policy rate now," said Svein Gjedrem, the central bank governor, in a statement. He added that projections indicated that the key policy rate should be "raised gradually".

Erik Bruce, chief analyst at Nordea Markets, said the rate rise was expected, and he was expecting further rises early next year. "There will be no rate rise at the next meeting [in December], which was priced in. Norges Bank is signalling that they will wait until February with the next rate rise," he said. "It looks like the crown strengthened on the rate rise, but this could be short-lived." All 10 economists polled by Reuters last week expected a 25bp increase to help the already recovering Norwegian economy neutralise a hefty fiscal stimulus unleashed by the government during the worst of the crisis. Norges Bank had cut borrowing costs seven times during the past 12 months to a record low of 1.25 per cent.