How Long Will the Recession Be?

Martin Feldstein is professor of economics at Harvard University, and is the current chairman of the National Bureau of Economic Research which makes the formal declaration on economic recessions in the US. He was the leading contender for the Federal Reserve Chairman along with Ben Bernanke of Princeton.

U.S. May Be in `Very Long' Recession, Harvard's Feldstein Says
By Kathleen Hays and Timothy R. Homan
Bloomberg News

July 31 (Bloomberg) -- The U.S. may now be in a ``very long'' recession that will drive the unemployment rate higher, with little that the Federal Reserve can do to help, said Harvard University Professor Martin Feldstein.

``I don't see recovery'' on the horizon, Feldstein, who headed the National Bureau of Economic Research until June and serves on the group's recession-dating panel, said in an interview with Bloomberg Radio.

Feldstein said the Fed has already lowered interest rates as much as it can to help growth, and that exports offer the only bright spot, while they aren't strong enough to fuel a recovery. A former adviser to President Ronald Reagan, he also warned that policies proposed by Senator Barack Obama, the presumptive Democratic presidential candidate, would prolong the downturn.

The next president ``should not be raising taxes,'' Feldstein said. He said he was ``really surprised'' that Obama ``hasn't backed off his proposals for a major tax increase.''

Feldstein said today's gross domestic product figures reinforced his view that the economy entered a recession in December or January. GDP shrank at the end of 2007 and grew less than forecast in this year's second quarter, the Commerce Department reported today.

Fed officials have lowered their benchmark rate to 2 percent from 5.25 percent since September, bringing the reductions to a halt in June amid rising concern that inflation will accelerate. Feldstein indicated the central bank should refrain from lowering borrowing costs further.

Fed Role

``I don't think that there's much the Fed can do one way or the other at this point,'' he said.

While Treasury Secretary Henry Paulson today said that the fiscal stimulus package enacted in February will keep helping the economy in the second half, Feldstein wasn't so optimistic.

``The little boost that we got from the tax rebates we will give up in the third and fourth quarters,'' Feldstein said. ``We're in for higher levels of unemployment and job losses.''

A ``typical'' U.S. recession lasts about 12 months, while the past two were about eight months, Feldstein said. This time, the slump may be longer, he indicated.

``If we do end up dating the recession as beginning at the end of last year, it could be a very long recession,'' he said.

Both Feldstein and Robert Hall, the Stanford University economist who leads the NBER's Business Cycle Dating Committee that determines U.S. recessions, said it was too early to gather for a formal declaration....

How Much Farther Will the US Dollar Decline?

The short answer is that the dollar will continue to decline in relation to the currencies of its trading partners until it starts generating a trade surplus. As the dollar loses its status as the reserve currency of the world this process will accelerate.

This decline will not be uniform. The Euro may have already achieved much of its appreciation, with the Asian currencies and those of resource exporting countries lagging significantly.

The process will be slower to the extent that the world is willing to subsidize US consumption by treating the dollar as a reserve currency with inherent value greater than their own currencies. This is how the trade surplus was allowed to remain negative for so many years.

The price of imported natural resources such as oil will provide a significant lever in the dollar's decline.

Note that there is no discussion of domestic money supply growth or contraction per se, only the flow of currencies between and among countries. The issue of money supply becomes relevant through its effect on the interest rates, and the interest rate differentials.

This is not a metaphysical debate; this is math. Unless the rest of the world wishes to allow the US to be its sovereign lord and master, the dollar has a significant distance to travel on its long day's journey into night.


What is the Dollar’s Sustainable Value?
By Martin Feldstein
July 31, 2008

How much further will the dollar fall? Or has it already fallen so far that it will now start to move back to a higher level?

For travelers to the United States from Europe or Asia, US prices are dramatically lower than at home. A hotel room or dinner in New York seems a bargain when compared to prices in London, Paris, or Tokyo. And shoppers from abroad are loading up on a wide range of products before heading home.

But, despite this very tangible evidence, it would be wrong to conclude that US goods are now so cheap at the existing exchange rate that the dollar must rise from its current level. Although the goods and services that travelers buy may cost less in the US than abroad, the overall price of American products is still too high to erase the enormous trade imbalance between the US and the rest of the world.

To be sure, the falling dollar over the past few years has made American products more competitive and has caused the real value of US exports to rise sharply – by more than 25% over the past three years. But the trade deficit in 2007 nevertheless remained at more than $700 billion, or 5% of GDP.

The large trade deficit and equally large current account deficit (which includes net investment income) implies that foreign investors must add $700 billion of US securities to their portfolios. It is their unwillingness to do so at the existing exchange rate that causes the dollar to fall relative to other currencies. In falling, the dollar lowers the value of the dollar securities in foreign portfolios when valued in euros or other home currencies, shrinking the share of dollars in investors’ portfolios. The weaker dollar also reduces the risk of future dollar decline, because it means that the dollar has to fall less in the future to shift the trade balance to a sustainable level.

But what is that sustainable level of the trade balance and of the dollar? While experts try to work this out in terms of portfolio balances, a more fundamental starting point is the fact that a US trade deficit means that Americans receive more goods and services from the rest of the world than they send back – $700 billion more last year. The difference was financed by transferring stocks and bonds worth $700 billion. The interest and dividends on those securities will be paid by sending more “pieces of paper”. And when those securities mature, they will be refinanced with new stocks and bonds.

It is unthinkable that the global economic system will continue indefinitely to allow the US to import more goods and services than it exports. At some point, the US will need to start repaying the enormous amount that it has received from the rest of the world. To do so, the US will need a trade surplus.

So the key determinant of the dollar’s long-term value is that it must decline enough to shift the US trade balance from today’s deficit to a surplus. That won’t happen anytime soon, but it is the direction in which the trade balance must continue to move. And that means further depreciation of the dollar.

An important factor in this process will be the future price of oil and the extent of US dependence on oil imports. In each of the past four years, the US imported 3.6 billion barrels of oil. At the current price of more than $140 a barrel, that implies an import cost of more than $500 billion. The higher the cost of oil, the lower the dollar has to be to achieve any given reduction in the size of the trade deficit. So a rising oil price as measured in euros or yen implies a greater dollar fall, and therefore an even higher oil price when stated in dollars.

There is one further important consideration in thinking about the future value of the dollar: relative inflation rates in the US and abroad. The US trade deficit depends on the real value of the dollar – that is, the value of the dollar adjusted for differences in price levels in the US and abroad. If the US experiences higher inflation than our trading partners, the dollar’s nominal value must fall even further just to maintain the same real value.

The inflation differential between the dollar and the euro is now relatively small – only about one percentage point a year – but is greater relative to the yen and lower relative to the renminbi and other high-inflation currencies. Over the longer run, however, inflation differentials could be a more significant force in determining the dollar’s path.

Martin Feldstein, a professor of economics at Harvard, was formerly Chairman of President Ronald Reagan’s Council of Economic Advisors and President of the National Bureau for Economic Research.

Have Fed Policy Errors Pushed Us Into a Stagflationary Depression?

As we noted at the end of 2007, there is little doubt we entered a recession in 2007. The only question was how long and how well the Fed might conceal it, and mask its effects on the financial markets and banking system which is their first priority no matter what else they might say, for a variety of reasons.

Depending on how one wishes to define it, and how one wishes to measure our monetary inflation, we have probably been in a technical recession starting early in 2007 and perhaps late 2006.

The recession is growing stronger and deeper because of the Fed and Treasury policy errors, squandering valuable national capital on a financial sector that requires reform, not welfare support.

Their errors are so large and so misguided that they may have condemned the US to a stagflationary depression. The equally misguided efforts of several national central banks may drag a good part of the developed world down with us for several years.

This study is a significant focus of our inquiries at this time, our intellectual raison d'être now that the question of recession is settled. Its no longer a question of 'how long and how deep' but the evlving nature of this downturn, the actions of the Fed and Treasury in reaction and the manner in which they prolong and mutate it. We may be watching something truly exceptional, and are seeking to understand it.

It will probably be the employment numbers that eventually make the difference in definition, although as we have previously shown that the government is actively revising those numbers many years back on a regular basis.

The major stock markets deflated by an appropriate contra-dollar measure also are consistent with the view that we are entering the recessionary aftermath of a market crash that occurred in 2000-3. We have never legitimately recovered. The Fed has been engaged in a protracted monetary experiment. We await the outcome of their gamble with keen interest, as the stakes of the wage are severe.

A significant challenge is the lack of transparency and reliable government and private statistics, and the willing complacency of most economists.

This may be an historic event. It is entirely consistent with what occurred in 1929-31 that it is happening largely unnoticed by a complacent public until they are swept away by it, with revelation after revelation that they have been deceived and misled.

What about the theory that if we pretend there is no recession or inflation then we won't have one? If we pretend that reality doesn't matter we will simply and slowly go collectively insane. There is some precedent for countries that do this.

So what ought one to do? Get in there and short the financial markets? That is like running down on the beach to sell flotation devices for an incoming tsunami.

When the tsunami is coming, get off the beach. The 'beaches' in this case are dollar denominated financial assets and financial assets dependent on the US economy.

We hope that the vectors of our data analysis are not correct. May God have mercy if they are.


U.S. Recession May Have Begun in Last Quarter of 2007
By Timothy R. Homan

July 31 (Bloomberg) -- The U.S. economy may have slipped into a recession in the last three months of 2007 as consumer spending slowed more than previously estimated and the housing slump worsened, revised government figures indicated.

The world's largest economy contracted at a 0.2 percent annual pace in the fourth quarter of last year compared with a previously reported 0.6 percent gain, the Commerce Department said today in Washington. Growth for the period from 2005 through 2007 was also trimmed.

The revisions now reinforce measures such as employment and production that already signaled the economy was shrinking. The National Bureau of Economic Research, the Cambridge, Massachusetts-based arbiter of economic cycles, defines a recession as a ``significant'' decrease in activity over a sustained period of time. The declines would be visible in GDP, payrolls, production, sales and incomes.

``We're in a recession,'' Allen Sinai, chief economist at Decision Economics Inc. in New York, said in a Bloomberg Television interview. ``It's going to widen, it's going to deepen.''

The government also said incomes grew less than previously thought, raising the risk that consumer spending will again stumble after getting a temporary boost from the tax rebates last quarter....


Today's GDP Number Will Be Revised Lower - April 28

Why the US Has Really Gone Broke - April 28

Jobs Numbers Revised Back to 2003: Confirm Recession - April 4

The Potemkin Economy Just Fell Over - March 7

SP 500 Tops in Recessions

ISM Numbers As Indicators of Recession - February 6

Are We In A Recession? - February 4

Fed Policy Actions in Anticipation of a Recession - January 7

Recession, Straight Up with a Twist - December 8

Dow Jones Industrial Average Since 1999



Dow Jones Industrial Average Since 1999 Deflated by Gold



Shadow Government Statistics Estimates of Real GDP



Shadow Government Statistics Estimates of Consumer Inflation

Of Government Intervention and Why I Write This Blog

A brief treatise in which Jesse questions the reason for this blog among other things

Most people will read only the subject title of this essay and then immediately begin composing their own off-the-cuff thoughts which they will rush to either email to us or slap on some chatboard or blog somewhere. Or they might even scan it for a daytrade and then discard it. But one or two will read it and think about it, and become links in a chain, and the spirit of knowledge will grow, little by little.

The government is intervening in the various markets. There is little or no question about it, if you allow that actively changing, with intent, the rules, money supply, short term liquidity, interest rates, methods by which key statistics are tallied, spin and other information that might impolitely be called 'propaganda' is manipulating the markets. And it often is.

They admit it. The evidence is there. If you don't know about it you have not been keeping up with current events. So it becomes a question of when, where, and why.

On the other hand, there are those who think every market move is active government intervention. This just is not the case. In the short term markets are more like rugby scrums than chess or even a well-managed game of limit poker, and the bigger players spend a great deal of time putting up bluffs and bullying the smaller player using their better access to information and bigger stacks of chips, especially when government regulation is lax and inefficient, with society ruled by narcissism and greed, as it is today.

The action of the past two days in the US stock markets is a almost classic end-of-month paint job by the fund managers and other-people's-money crowd, who are able to influence the grade on their own reports cards by buying the market and driving certain prices up after selling their losers three days before the end of the month. Their motive is their bonus, and the lax regulation with light penalties, and their general lack of compunction against cheating which they have likely done in school, in sports, in relationships, in most of their lives.

It is very hard to look at a specific market at a specific time and say with certainty "Aha, this is explicit government intervention" as opposed to something else. Governments work through third parties and hide their tracks, except when it suits them to be blatant. Often big third parties are just flush with hot money from the Feds and looking to shove some market for the short term trade.

But they do it, both directly and indirectly. If you are a momentum player it doesn't really matter, and if you are an investor you will see it only in sustained efforts that last some time, and usually involve a multi-faceted approach. We call these 'reflations' and try to point them out as we think they are occurring.

Speculating about when, specific markets on specific days, and the why, their long term motivations, is fun because its like gossip. It also can have some value if it causes us to look at things more deeply and examine the evidence, which may be easily dismissed by the public. Spotting effort to suppress or inflate markets can be exceptionally rewarding, since they often fail and sometimes spectacularly so. And motive is a key companion to opportunity, means, and any other circumstantial evidence.

But more often in questioning long term motivations we are asking a question that cannot be answered objectively except after a very very long time, even if then. Its like arguing about whether or not God exists, or aliens are visiting us, or what is the best beer, or who all shot Kennedy, or which is the greatest football team. Sometimes these discussions are fruitful and scandals are uncovered. They do exist. But often they degenerate into recreational discussion and faux expertise.

What makes it fun is that you can just yell about it endlessly, and believe what you want, because what cannot be proved cannot be disproved.

It is a way to pass the time relatively effortlessly, like griping and bitching at work. It can be a trap because anytime you are wrong you can retreat into the rationale of external forces. How can you be responsible for your actions if 'they' are doing it to you. Sometimes it can be a crutch. But so many things are.

As a general rule an objective person doesn't take credit for being right unless they know why they were right and can explain it. Otherwise they might just have been lucky, and it not only does not add to our knowledge but may reduce it.

If the Fed is indeed making policy errors, then we will take one path versus another. Then one should do one thing versus another. Those things can be examined, can be dissected, can be studied, but they take work and effort, and one can be right or wrong. But they add to a body of knowledge. And often this work is dismissed by those doing the behind the scenes work as recreational gossip. They seek to raise the bar so high that no possible proof can be provided without subpoenas and wiretaps.

Speculation based on evidence is the heart on the scientific method. Yesterday's radical theory scoffed at and discouraged by the established view is tomorrow's generally accepted truth. The difference is free discussion and evidence, above all, strong comprehensible evidence.

The value we get from even pointless disagreements is that it causes us to think and define thoughts which otherwise are all too easily just parked in our minds, and never really given any vigor or life.

Besides the relentless impulse of humanism, this is a major reason for this blog. We used to look for valuable feedback and discussion on the specifics, but that's beyond hope.

Those who are in-the-know are in denial and hiding, trying to line their pockets and curry favor with whomever they think will be in power next.

Those who don't know are running around waving their hands, shouting slogans and hearing only their own voices, or just ignoring it all getting loaded on whatever happens to be handy.

All in all, a nice microcosm. Life imitates high school so often in our experience, and one's best recourse is essere umano, to be human throughout it, and perhaps give the bastards a swift kick just to let them know you're still out there.

In the meanwhile there are important and interesting questions to investigate as best one can. Its not clear yet exactly which way this thing goes, and the variables interact with one another, and are many more than can listed here:

A. Will our government become a better democratic Republic, Fascist, or Socialist, and the related broader question of the Individual vs. the State which tends to modify all the general types.

B. When and how the dollar will be further devalued and how fiat currencies can be sustained without being destroyed by inflation? (By the way in all history none have succeeded}.

C. How will the world's reserve currency evolve? Can a greater centralization of power and control be avoided gracefully? Can freedoms be maintained if it cannot?

D. How deep and protracted will the recession be and will it cross a threshold into a depression through Fed policy errors and how and when will we know it?

E. Will there be a 'moment of clarity' when the failure becomes evident and things move with alarming speed, or will this be a damp fizzling decline into an ignoble whimper.

We will continue to explore all these areas with what we hope is a bias to objective analysis and pertinent data, laced heavily with humour, satire, charts, and pictures.

Little by little, there is progress, and the body of knowledge grows, and life is renewed, and creation is made more orderly, and liberty and the spirit is restored.

The Future of Financials

Here is a video well worth watching.

The Future of Financials - Meredith Whitney

Meredith, in a polite and somewhat understated way, makes some excellent points as an independent analyst, but probably of necessity treads lightly around some serious issues and deeper economic problems.

The real economy must pay a significant 'tax' to support the financial sector as it is now, and an incredibly large tax to restore it to its former excesses. Don't forget this, especially when the government tries to argue that there is no money for human services, and health, and basic infrastructure.

It is a matter of our priorities. We can choose to pay that tax, and let our children pay it, or we can try to restrain the banks again and bring the economy back into balance. A healthy economy requires a finacial sector that functions as a capital accumulation and allocation system with price discovery in an open, honest and transparent system of transactions, with the minimum 'friction' of overhead and corruption.

We will have no sustained recovery overall until we move much further towards a balanced system as set forth in our Constitution, and establish rational, peaceful, and equitable policies for our nation.

So we must roll up our sleeves, let go of our fears, gather ourselves together, and move forward.

Just How Accurate is the ADP Payroll Report?

Not as accurate as we had thought it appears. Most assume that the monthly ADP employment report is based on actual data from the business sector on jobs additions, merely excluding the government sector, but a good "hard data" source indicative of the Non-Farm Payrolls Report.

We have this piece of information in an email from a capital asset fund manager:

"I just called an economist at MacroEconomic Advisors, the local St. Louis firm that compiles the monthly ADP (private) employment data which was reported today for the month of July. Please keep in mind that this firm has ties to former St. Louis Fed Governor Laurence Meyer. The statistic was a "shocking" +9000 JOB GAIN!!! This promptly pushed the equity futures market (and U.S. dollar) sharply higher at 8:15EDT. The DJIA after a half hour of trading is up 122 pts.

Now, are you sitting down? A component of this very suspicious report showed that Financial firms INCREASED employment by +4000 jobs. I promptly told this "economist" that there was no way in God's Green Earth that banks, brokerages, mortgage companies, and any other financial institutions had increased employment by 4000 jobs in July. He candidly told me that the firm had probably overestimated that sector for many months. Upon hearing that, I asked him why they don't change their methodology in compiling their data? He indicated that they were doing that but that it was a "monumental task!"

So, we have a sharp rally this morning in the equity market and U.S. dollar, based on data that even the reporting firm questions. I think we've seen it all!"

No we haven't seen it all yet. But we're on our way.

ADP Payroll Report or not, this stocks rally is frivolous.

The market was predisposed to rally however, otherwise it would not have. It was looking for an excuse, since the fund managers must have their fatter bonuses, and hot money must be consumed by mispriced beta.

To give the rally a little credit we'd allow that optimists are grasping at straws looking for a turn, a bottom. Some may be sincere in their hopes, like some of the financial media may be. Who wouldn't?

But we are watching people who are most likely about to lose real money, with real consequences, based on a system with too little in the way of transparency and integrity.

Until the banks are restrained and the proper regulation is restored there can be no recovery, no restoration of a sound economy based on sustainable values. We have no objective price discovery mechanism to determine the wheat from the chaff, the flawed from the viable, the foundation from the sand.

The Difference Between a Panic and a Crash

The definitions of terms in financial markets are evolving, to say the least.

The difference between a panic and a crash in the financial markets is an interesting study, and not particularly well defined. Here is our most recent effort.

As a rule of thumb, a correction is a decline in prices of less than 20 per cent. After the declines exceed 20 per cent for at least a two weekly prints on the charts we seem to be in the realm of the panic or a crash.

A panic might best be defined as a sharp decline in prices over a short period of time, usually less than a year, as assumptions and valuations are cast in doubt and corrected, often severly. A panic comes and goes, distorting perhaps the progress of the markets, adding certain safeguards to the regulatory process, but having otherwise relatively small lasting effects to the national economy.

A crash is a watershed event, generational in its scope, always accompanied by an economic slump of greater than a year, often called a depression rather than a recession. Its effects are measured in years. It is a furnace in which the national character is tested and tempered, hammered into something different from what had gone before.

From The Great Crash of 1929 by John Kenneth Galbraith:

"A common feature of all these earlier troubles [panics such as 1907 and 1914] was that having happened they were over. The worst was reasonably recognizable as such.

The singular feature of the great crash of 1929 was that the worst continued to worsen. What looked one day like the end proved on the next day to have been only the beginning.

Nothing could have been more ingeniously designed to maximize the suffering, and also to insure that as few as possible escaped the common misfortune. The fortunate speculator who had funds to answer the first margin call presently got another and equally urgent one, and if he met that there would still be another. In the end all the money he had was extracted from him and lost.

The man with the smart money, who was safely out of the market when the first crash came, naturally went back in to pick up bargains. (Not only were a recorded 12,894,650 shares sold on 24 October; precisely the same number were bought.) The bargains then suffered a ruinous fall.

Even the man who waited out all of October and all of November, who saw the volume of trading return to normal and saw Wall Street become as placid as a produce market, and who then bought common stocks would see their value drop to a third or a fourth of the purchase price in the next twenty-four months.

The Coolidge bull market was a remarkable phenomenon. The ruthlessness of its liquidation was, in its own way, equally remarkable."

If the Great Depression had never happened, would the Great Crash of 1929 be remembered as vividly as "the great crash" or as a panic such of that of 1907 and 1987? (Give 1987 a little more historic distance, and it will be just a blip in the generational memory, if it is not one already).

The economic progressive believe that the Great Depression was a policy error by the new Central Bank, and are quite confident that it can never happen again, as we are now smarter and better. With the ascendancy of pure fiat currency and sophisticated financial engineering, are all Crashes extinct, merely the dinosaurs of an age of monetary barbarism?

Are financial markets now a science, freed of the emotions and bondage of human nature? Are we now Icarus, released from the bonds of the earth? There are those who believe that this is the case, and their wills and knowledge are being tested as we speak, if only the public can be kept malleable and docile and deluded enough to allow them time and latitude to work their financial alchemy. What if the Fed makes a different sort of policy error this time? Oops?

"There is no worse mistake in public leadership than to hold out false hopes soon to be swept away. The British people can face peril or misfortune with fortitude and buoyancy, but they bitterly resent being deceived or finding that those responsible for their affairs are themselves dwelling in a fool's paradise." Winston Churchill

Plus ça change, plus c'est la même chose

Fed Adds 84 Day TAF Loan and Extends Emergency Status until 30 January 2009

While the good times are rolling in the equity markets and the insiders are racking up those end of month bonuses, the Fed is quietly breaking out the emergency equipment and getting ready for more bail outs.

If there is nothing else we learn from this, it is that the banks must be restrained from speculation and regulated by incorruptible rules, for the good of the country.

Unless we put strong reforms in place we have done nothing to correct our problem.

Fed to Conduct Liquidity Operations Through January 2009, Introduces 84-Day TAF
07/30/08 08:58 am (EST)
By Erik Kevin Franco

(CEP News) - In addition to the $75 billion 28-day Term Auction Facility (TAF), the Fed will also be conducting a $25 billion 84-day TAF to address the ongoing "fragility" of the financial system.

The Fed also said it would be extending its extraordinary lending to late January 2009.

"In light of continued fragile circumstances in financial markets, the Board has extended the PDCF through January 30, 2009, and the Board and the Federal Open Market Committee (FOMC) have extended the TSLF through that same date," according to a statement from the Fed on Wednesday. "These facilities would be withdrawn should the Board determine that conditions in financial markets are no longer unusual and exigent."

Starting Aug. 11, the Fed will conduct bi-weekly TAF auctions alternating between 28-day and 84-day loans. The Fed currently holds a 28-day TAF every two weeks.

Dealers will also be allowed to access up to $50 billion in treasuries at the Term Securities Lending Facility (TSLF).

The Fed also announced that it was stepping up its international co-operation with the European Central Bank and Swiss National Bank. It will increase its swap line with the ECB to $55 billion from $50 billion while the SNB's line remains at $12 billion.

Both central banks will follow the Fed's TAF auction and offer U.S. dollar loans on their end.

The ECB said the move "is intended to continue the provision of USD liquidity for as long as the Governing Council considers it to be needed in view of the prevailing market conditions."

Corporate Bond Market Says A Tsunami of Debt Default is Coming

Wall Street is throwing an equity party and painting the tape for the end of month bonus calculations.

But the corporate bond markets are signalling serious economic trouble dead ahead, NOT behind us.

Brace for disillusion.


Crumbling bond market sounds distress alarm
Tue Jul 29, 2008 7:25am EDT
By Walden Siew and Dena Aubin

NEW YORK (Reuters) - Corporate bond investors are bracing for growing defaults and record company bankruptcies starting in 2009 as the volume of distressed debt climbs past $184 billion, an all-time high.

More corporate debt is now trading at distressed levels than in 2002, when there was $165 billion of distressed corporate debt following the last bankruptcy boom, according to Moody's Investors Service data.

Nearly one in three junk bonds trade at levels known as "distressed," suggesting a serious risk of default. Even higher-rated corporate bonds have sunk to distressed levels in near-record volumes.

Automakers General Motors Corp and Ford Motor Co lost their investment grade status in 2005 and their bonds have since plummeted to distressed credit levels.

Now bonds of financial firms such as CIT Group Inc, National City Corp, and bond insurers like MBIA Inc are trading as though investors expect them to follow that ignominious path.

"It's the fast deterioration of some of the higher-rated credits that is most alarming," said Jason Brady, a managing director at Thornburg Investment Management. "From a dollar standpoint, we're going to see a record wave of defaults and bankruptcies."

Spokespersons at CIT and National City didn't immediately return phone calls seeking comment about how their debt is trading. MBIA's spokeswoman cited the company's policy of not commenting on its bond market performance.

The total amount of high-yield debt trading at distressed levels is now $147 billion, while investment-grade distressed debt is about $37 billion, according to Moody's credit strategy group.

"The market is pricing in pretty ugly bankruptcy scenarios," said Brady from his Santa Fe, New Mexico, office, where the firm oversees $4 billion in fixed-income assets. "The dramatic bank deterioration is coinciding with the overall level of distress."

A slumping economy, high oil prices and tighter credit conditions are putting a greater squeeze on corporations and impacting their ability to manage and pay off their debt.

Credit crisis fears, especially in the financial sector, have pushed yields on several companies into distressed territory recently, though rating agencies still assign them low default risk.

High-grade companies trading at distressed levels in recent days include Washington Mutual Inc, CIT and Ambac Financial Group, according to MarketAxess.

Ambac's spokeswoman declined to comment, while Washington Mutual didn't immediately return a call.

In all, about 7.5 percent of high-yield and investment-grade debt combined is distressed, the same level seen during the credit downturn of 2000 to 2002, when bankruptcies soared, according to data from research firm Leverage World.

Public company bankruptcy filings climbed to 179 in 2000 and rose to a record 263 in 2001, according to bankruptcy court records.

"Investment-grade bond distress is a new feature of this cycle," according to analyst Christopher Garman, adding, "The largest corporate bankruptcies on record often follow this level of distress."

Some 27.2 percent of high-yield bonds by par value are distressed, or trade at yields of at least 1,000 basis points more than U.S. Treasuries, Garman wrote for Leverage World in a report titled "MegaDefault."

The 7.5 percent distress level points to nearly $97 billion of defaults through 2009, said Garman, a former head of high-yield strategy at Merrill Lynch.

For investment-grade bonds, the distressed level has climbed to 1.8 percent, shy of an all-time high of 2.4 percent. If all the high-grade distressed debt were downgraded, it would increase the volume of high-yield debt by 6 percent.

Both Standard & Poor's and Moody's Investors Service have noticed a sharp increase in junk bonds and credit default swap contracts trading at distressed levels as well.

The overall number of U.S. high-yield bonds trading at distressed levels has soared to about 27 percent, versus 17 percent in April and just 2 percent last year, according to Moody's research group.

More than 20 junk-rated borrowers have credit default swaps trading wider than 1,000 basis points, which implies a 58 percent chance of default over the next five years, according to Credit Derivatives Research.

Much of the distressed debt is in the auto sector, but high-yield opportunities may be growing in the financial sector, said Joe Robison, director of credit research at Allegiant Asset Management.

"As autos go, so does the high-yield market these days," Robison said. "Our area of emphasis is watching the financial companies. We're definitely going to see some financial names go from investment-grade to junk over the next years, and that's where we see opportunities."

There is No Doubt the US is in a Recession - SP 500 Operating Earnings

With the end of month rally in stocks, to provide fatter bonuses for fund managers, the happy-talk is flowing hot and heavy on the financial networks and the internet chatboards.

However, based on the facts there should be little doubt that the US is in an economic recession.

The only question is 'depth and duration?'

Expect the next phase to be the 'bottom-callers' predicting that stocks are starting to rally in expectation that the economy will recover in January 2009, roughly about six months out.

US Lawmakers Pressure FASB to Slow Down Disclosure Reforms

Yet another good reason to sweep the Congress clean in the fall elections.

FASB may delay off-balance sheet accounting change
By Emily Chasan

NEW YORK, July 28 (Reuters) - The Financial Accounting Standards Board, under pressure from lawmakers, will reconsider its timeline for a controversial rule change that may force banks to bring trillions of dollars in off-balance sheet assets onto their books at its Wednesday meeting.

FASB, which sets U.S. accounting rules, will reconsider the rule's effective date and transition provisions, according to a schedule posted on its website.

"Additionally, the Board will consider transitional disclosures and the timing of both projects," FASB said on its website.

FASB voted in April to revamp two accounting standards known as FAS 140 and FIN 46R, to eliminate a concept known as the "qualifying special-purpose entity," or QSPE, that banks use to keep assets like mortgage-backed securities and special investment vehicles off their balance sheets.

The board is expected to release its proposal by the end of August and leave it open for public comment for 60 days. It has suggested parts of the new rule could be applied as soon as next year for companies with fiscal years beginning after Nov. 15.

Troubles in those off-balance sheet assets have been blamed for helping trigger the credit crisis. FASB members have said they believe the current rules prevented investors from understanding the true risks banks faced. Analysts have estimated the rule change could force banks to bring $5 trillion in assets onto their books.

But concerns about the rule's effect on the capital requirements at financial institutions have triggered a firestorm on Wall Street and been partially blamed for the sharp decline in shares of mortgage lenders Fannie Mae and Freddie Mac over the past month.

Some have urged FASB to slow down the rule.

"Changes to securitization accounting could have a dramatic impact on the economy, the capital markets and consumers seeking credit," Republican Rep. Spencer Bachus of Alabama said in a letter to the chairmen of FASB and the U.S. Securities and Exchange Commission last week.

Industry groups such as the American Securitization Forum and the Securities Industry and Financial Markets Association have also written FASB to say "the risks of too much haste are high."

FASB spokesman Neal McGarity has said that other regulators, not FASB, are responsible for setting capital ratios for financial institutions. He was not immediately available for comment on the board's plans. (Editing by Leslie Gevirtz)

Traders Walking Like Egyptians Down "De Nile" on the Merrill Writedowns

First, and we cannot say this often enough, in light volume markets the short term action is more like a rugby scrum than a game of chess.

The funds are trying to 'paint the tape' into the end of month, and perhaps squeeze a few shorts along the way. Why? Because its fees and bonuses that drive Wall Street, the customers be damned, and don't ever forget it.

We are also in a period in which the cynicism and short term focus of professional traders is near all time highs thanks in large part to our government and regulatory environment. (See dollar chart below) This is the classic setup for a conflagration.

But in the short term, the market is what it is.

What Merrill shows is that the estimates of losses in the financials are substantially low, placing companies like Citigroup and Lehman and the other investment banks on the cliff edge of insolvency. Technical insolvency doesn't count, they are still a game until someone calls their hand, and Benny is trying to slip them a couple cards and some cash to help keep the game going.

Citigroup Markdowns May Rise $8 Billion, Analyst Says
By Adam Haigh

July 29 (Bloomberg) -- Citigroup Inc. will probably write down the value of collateralized debt obligations by $8 billion in the third quarter, Deutsche Bank AG analyst Mike Mayo said, after Merrill Lynch & Co. said it will sell the firm's CDO holdings for 22 cents on the dollar.

Citigroup values the securities, mortgage-related bonds at the heart of the credit crisis, at 53 cents, Mayo wrote in a report to clients today. Citigroup has $22.5 billion of CDOs and it may have another $7 billion in writedowns to come, Mayo said. That could force it to raise more money, as Merrill did today, he said.

''The decision about raising new capital may be closer than we previously thought,'' Mayo said in the report. He also expects the bank to write down an additional $1 billion because of its $2 billion in exposure to so-called monoline insurance companies.

The additional writedowns at Citigroup mean the bank probably will report a third-quarter loss of 59 cents a share and a full-year loss of 80 cents, said Mayo, who has a ''hold'' rating on the stock. He previously estimated the New York-based bank, the biggest in the U.S. by assets, would report a loss of 66 cents in 2008.

Citigroup fell 28 cents, or 1.6 percent, to $17.15 at 10:27 a.m. in New York Stock Exchange composite trading. They dropped 41 percent this year before today.

'Good News'

Merrill is taking a $4.4 billion loss on the sale of $11 billion of CDOs.

''The good news is that that the actual sales can give confidence that Merrill is finally selling assets rather than merely marking them to market,'' Mayo said. (Mayo is no Meredith by a long shot. Check out his revision just below on Merrill's full year losses. - Jesse)

Mayo estimates that Merrill, the third-largest U.S. securities firm, will report a full-year loss of $10.95 a share, compared with his earlier prediction of a $5.80 loss. Oppenheimer & Co. analyst Meredith Whitney estimates the company will report a loss of $10.50 in 2008.

UBS AG analyst Glenn Schorr estimates Merrill will report a full-year loss of $11.36 a share because of ''significant dilution'' from the plan to raise capital by selling about $8.5 billion of stock. Schorr has a ''neutral'' rating on Merrill.

''While we don't think Merrill's announcement necessarily implies a 40 percent writedown ($7.2 billion) for Citi, directionally we think investors should expect further incremental writedowns in coming quarters,'' Schorr wrote in a report to clients today.

Lehman Brothers Holdings Inc., the fourth-biggest U.S. securities firm, may have to sell ''significant assets'' to guard against further losses from its $65 billion of mortgage and real estate holdings, Schorr said.

Merrill Sells $30.6 Billion of "Super Senior" ABS Debt for 22 cents on the dollar and Provides the Financing for 75% of the Purchase Price

Until not too long ago this $30.6 B worth of super senior toxic crap was valued at over $11 B and is now in what can only be called a 'get us the hell out' distress sale with a government entity wealth fund. Said entity is also participating in a share offering, several billions of which is also coming from Merrill in penalties from prior offerings with resets based on share performance. Yikes!

As the IMF said today, this credit crisis is just not over yet at all, thereby taking down the US equities market and in particular the financial sector. Our cynical view is that there was knowledge of the coming Merrill announcement during the day in select trading circles as well.

There is no predicting how the Wall Street wiseguys will try to wrap this tomorrow. Is this finally the 'kitchen sink' mother of all writedowns for Merrill? Is this a sign of the bottom? We tend to think this shows what a farce the writedowns have been to date, and what accounting legerdemain underlies the valuations of several US financial companies. This does not bode well for a few of Merrill's Wall Street cousins. There may not be an indedependent investment bank standing by the time this is over, and north of fifty percent fewer hedge funds.

We are not sure about that. But we are reasonably confident that the credit crisis is going to come on with the relentless force and fury of a pyroclastic flow [1] and ignite a new bonfire of the vanities.

Get out of its way. Minimize your exposure to the financial system at your earliest convenience and seek the highest financial ground. The strategy now is the protection of wealth, the conservation of capital.

[1] A pyroclastic flow is a common and devastating result of some volcanic eruptions. The flows are fast-moving currents of hot gas and rock which travel away from the volcano at speeds generally greater than 80 km/h (50mph). The gas can reach temperatures of about 1,000 degrees Celsius (1,800 F). The flows normally hug the ground and travel downhill, destroying everything that they overtake.

Merrill to take $5.7 billion mortgage asset write-down
Mon Jul 28, 2008 6:31pm EDT
By Christian Plumb and Jeffrey Benkoe

NEW YORK (Reuters) - Merrill Lynch & Co Inc said it expects to take a $5.7 billion pretax write-down in the third quarter due to losses on the sale of mortgage assets and plans to raise at least $8.5 billion by selling new common shares.

Merrill said Singapore's Temasek Holdings Pte Ltd TEM.UL would buy $3.4 billion of the offering. Merrill has already taken billions of dollars in write-downs in past quarters and said it sold key holdings including a 20 percent stake in Bloomberg when it announced second-quarter earnings.

Merrill said on Monday it would pay $2.5 billion as required under a previous stock sale to state-run Temasek, along with $2.4 billion in required dividends to preferred shareholders. In previous deals to raise capital, Merrill had agreed that if it sold shares at too low a price in the future, it would reimburse investors.

The No. 3 Wall Street investment bank's shares were down 5 percent in after-hours trading after retreating 12 percent to $24.33 in the main trading session on the New York Stock Exchange.

Merrill also said it agreed to sell collateralized debt obligations with a face value of $30.6 billion for $6.7 billion to an affiliate of private equity fund Lone Star. (These are U.S. "super senior ABS collateralized-debt obligations" that are being sold for a little less than 22 cents on the dollar - Jesse)

Merrill Lynch Announces Substantial Sale of U.S. ABS CDOs, Exposure Reduction of $11.1 Billion
Monday July 28, 5:25 pm ET
Merrill Lynch Announces Initiatives to Further Enhance Capital Position
Original release from Merrill with Two Pro Forma Attachments

NEW YORK--(BUSINESS WIRE)--Merrill Lynch today announced a series of actions to significantly reduce the company’s risk exposures and further strengthen its capital position. These actions include:

-Announced substantial sale of U.S. super senior ABS CDO securities, resulting in an exposure reduction of $11.1 billion from June 27, 2008 (ABS CDOs are defined as collateralized debt obligations comprised of asset-backed securities).

-Agreement to terminate ABS CDO hedges with monoline guarantor XL Capital Assurance Inc. (“XL”) and settlement negotiations with other monoline counterparties

-Plans to issue new common shares with gross proceeds of approximately $8.5 billion through a public offering launched today (excluding a fifteen percent, or approximately $1.3 billion, option granted to the underwriter to purchase additional shares of common stock to cover over-allotments)

-Agreement that Temasek Holdings will purchase $3.4 billion of common stock in the public offering, a portion of which is subject to receipt of regulatory approvals

-Exchange of all of the outstanding mandatory convertible preferred securities for common stock or new preferred securities, which eliminates the reset features in the original securities

-Purchase of approximately 750 thousand shares of common stock in the public offering by executive management

“The sale of the substantial majority of our CDO positions represents a significant milestone in our risk reduction efforts,” said John A. Thain, Chairman and CEO of Merrill Lynch. “Our consistent focus has been to opportunistically reduce risk, and in order to take advantage of this sizeable sale on an accelerated basis, we have decided to further enhance our capital position by issuing common stock. The actions we announced both today and on July 17 will materially enhance the company’s capital position and financial flexibility going forward.”

As a result of the transactions announced today, the company expects to record a pre-tax write-down in the third quarter of 2008 of approximately $5.7 billion. This write-down is comprised of a $4.4 billion loss associated with the sale of CDOs, a $0.5 billion net loss on the termination of hedges with XL Capital Assurance and an approximately $0.8 billion maximum loss related to the potential settlement of other CDO hedges with certain monoline counterparties. In the third quarter, Merrill Lynch also expects to record an expense of $2.5 billion related to its reset payment to Temasek and $2.4 billion of additional dividends as a result of the exchange of certain existing mandatory convertible preferred stock for common stock as described under “Common Stock Offerings and Early Conversion of Mandatory Convertible Preferred.”

Pro forma for the transactions announced today, the sale of our interest in Bloomberg L.P. and the expected FDS transaction, Merrill Lynch’s Tier 1 capital ratio, total capital ratio and adjusted “if-converted” book value per share as of June 27, 2008 would have been 10.5%, 16.6% and $22.21. These figures do not include the impact of any exercise of the approximately $1.3 billion over-allotment option.

CDO Sale:

On July 28, 2008, Merrill Lynch agreed to sell $30.6 billion gross notional amount of U.S. super senior ABS CDOs to an affiliate of Lone Star Funds for a purchase price of $6.7 billion. At the end of the second quarter of 2008, these CDOs were carried at $11.1 billion, and in connection with this sale Merrill Lynch will record a write-down of $4.4 billion pre-tax in the third quarter of 2008.

On a pro forma basis, this sale will reduce Merrill Lynch’s aggregate U.S. super senior ABS CDO long exposures from $19.9 billion at June 27, 2008, to $8.8 billion, the majority of which comprises older vintage collateral – 2005 and earlier. The pro forma $8.8 billion super senior long exposure is hedged with an aggregate of $7.2 billion of short exposure, of which $6.0 billion are with highly-rated non-monoline counterparties, of which virtually all have strong collateral servicing agreements, and $1.1 billion are with MBIA. The remaining net exposure will be $1.6 billion. The sale will reduce Merrill Lynch’s risk-weighted assets by approximately $29 billion.

Merrill Lynch will provide financing to the purchaser for approximately 75% of the purchase price. The recourse on this loan will be limited to the assets of the purchaser. The purchaser will not own any assets other than those sold pursuant to this transaction. The transaction is expected to close within 60 days.

Termination of Monoline Hedges:

In addition to the CDO sale referenced above, Merrill Lynch also agreed to terminate all of its CDO-related hedges with XL and is in the process of negotiating settlements on certain contracts with other monoline counterparties. These short positions were the hedges on long CDO positions that are part of the announced sale.

Merrill Lynch executed an agreement to terminate all of its CDO-related hedges with XL. The transaction is expected to close in early August 2008. When the transaction closes, all of Merrill Lynch’s CDO-related hedges with XL will be terminated in exchange for an upfront cash payment to Merrill Lynch of $500 million. These hedges had a carrying value of approximately $1.0 billion at June 27, 2008. As a result of this transaction, Merrill Lynch will record a pre-tax loss of $528 million during the third quarter of 2008.

Merrill Lynch is also in the process of negotiating settlements on certain contracts relating to CDO hedges with MBIA and other lower-rated monolines. If Merrill Lynch were to receive no payments in connection with the settlement of these hedges, the maximum loss Merrill Lynch expects to record would be their current carrying value, $0.8 billion.

The hedges described above had a net notional value of $8.4 billion. To reflect the XL termination and the other potential settlements with other monolines, Merrill Lynch will reduce its U.S. super senior ABS CDO short exposures, or hedges, from $15.6 billion at June 27, 2008, to $7.2 billion on a pro forma basis.

Common Stock Offering and Early Conversion of Mandatory Convertible Preferred:

Merrill Lynch plans to raise $8.5 billion through the public offering of common stock announced today (excluding a fifteen percent, or approximately $1.3 billion option granted to the underwriter to purchase additional shares of common stock to cover over-allotments). Temasek Holdings, Merrill Lynch’s largest shareholder, has committed to purchase $3.4 billion of common stock in the offering, a portion of which is subject to regulatory approvals that are expected to be obtained after the closing of the offering. In addition, Merrill Lynch’s executive management team intends to purchase approximately 750 thousand shares of common stock in the offering.

In satisfaction of Merrill Lynch’s obligations under the reset provisions contained in the investment agreement with Temasek Holdings, Merrill Lynch has agreed to pay Temasek $2.5 billion, 100% of which Temasek has contractually agreed to invest in the offering at the public offering price without any future reset protection.(This reminds one of a company going to the vulture capitalists for last gasp financing. They are rolling penalties Merrill owes them from prior fundraising into this latest tranche. - Jesse)

In addition, $5.4 billion of the $6.6 billion of outstanding mandatory convertible preferred holders have agreed to exchange their outstanding preferred stock for approximately 195 million shares of common stock, plus accrued dividends payable in cash or stock at the option of the holder. A holder of $1.2 billion of outstanding mandatory convertible preferred has agreed to exchange their securities for new mandatory convertible preferred securities with a reference price of $33.00. The reset feature for all securities exchanged has been eliminated.

Toyota Suffers First Sales Declines in Seven Years

Toyota sees first output fall in 7 years, cuts '08 forecast
29 Jul, 2008, 0141 hrs IST,
The Economic Times

TOKYO: (Reuters) Toyota Motor on Monday cut its 2008 groupwide global sales forecast by 3,50,000 units to 9.5 million vehicles due to a pronounced downturn in the US market, in a rare setback for the world’s biggest automaker. The weaker sales outlook also means global production at the parent company would fall 1% from 2007 to 8.43 million vehicles, marking the first decline in seven years.

Toyota’s revision underscores an ever-toughening environment for global automakers faced with falling demand for cars, especially higher-margin, bigger vehicles amid rising gasoline pump prices. Profits are already under severe pressure as prices of steel and other raw materials continue to climb, while tightening environmental regulations raise the cost of research and development.

Analysts said the sales revision was expected after a weak performance in the year to date, particularly in the US, but one raised concerns about a possible profit warning when Toyota announces its April-June results on August 7.

“Toyota typically doesn’t alter its forecasts at the first quarter, but after a revision of this scope there’s always an off chance that they’ll lower their earnings outlook,” said Credit Suisse auto analyst Koji Endo.

Hit by a demand meltdown for pickup trucks and large sport utility vehicles in the United States, Toyota cut its parent-only sales forecast there to 2.44 million vehicles from the 2.64 million it announced in December. The new projection would represent a 7% fall from 2007. — Reuters

Toyota’s initial global sales plan called for sales at the group, which includes truck unit Hino Motors and minivehicle maker Daihatsu Motor, to grow 5% to 9.85 million vehicles this year. Overall sales forecasts did not change at Hino and fell only 10,000 units at Daihatsu. Toyota was responsible for the rest of the undershoot. Global sales are now expected to rise just 1%, likely keeping Toyota ahead of General Motors as the world’s biggest carmaker.

Industrywide US vehicle demand has taken a sharp turn for the worse in the second quarter of this year, prompting many automakers and forecasters to revise their 2008 sales outlook by around 1 million vehicles compared with even some of the more sober views at the beginning of the year....

US Stock Markets are in Important Support Areas Ahead of the End of July and the Jobs Report

We are heading into the end of July, and with settlements today was the last day for the funds to trade in this month.

We are on important support, and the stock bulls must rally tomorrow or risk some serious slipping all the way into the end of summer.

Volumes continue to be lackluster, but fear of financials are curbing the animal spirits. The big Jobs Report is coming out at the end of the week, so we may see a few more rally attempts until then and one might stick. But if they do not, the market can turn ugly, quickly.

Keep an eye on the financials. The market cannot sustain a rally without them. The low volume may be the bull's best friend, vis a vis a short squeeze attempt. But if serious selling starts, look out below.

Russian Central Bank Slashes Its Exposure to Fannie and Freddie

The opening move in The Prisoner's Dilemma tends to be the winning move.

Russia cuts exposure to US mortgage lenders
Mon Jul 28, 2008 9:19am EDT
Reuters

MOSCOW, July 28 (Reuters) - Russia has approximately halved to less than $50 billion its exposure to U.S. mortgage lenders Fannie Mae and Freddie Mac a senior central bank official told Reuters on Monday.

"It's now less than $50 billion," central bank first deputy chairman Alexei Ulyukayev said, when asked about Russia's investments in the agencies.

Russia held about $100 billion at the start of 2008.

Reporting by Yelena Fabrichnaya, writing by Robin Paxton

IMF Sees No End to the Credit Crisis - the possibility of hyperinflation

The outsized financial sector in the US has been slowly strangling the real economy for the past twenty years. The most telling symptom of this has been the stagnancy in the growth of median real wages, and the growing inequality in income and wealth distribution. This is not the hallmark of a healthy, growing economy.

As an aside, globalization is a policy that favors the large financial interests in the US as the primary wielders of the global reserve currency. If there is a price to pay for this by a large segment of the domestic population, then so be it. We will speak more about this some future day.

There will be no sustained, legitimate recovery in the US economy until this imbalance is corrected. If this is true all the Fed's and Treasury's efforts to support the status quo of the current financial sector are not only going to be futile, but are exactly the wrong thing to do. They are painting over rot.

Short of serious reform or an exogenous stimulus shock to demand (such as war or natural disasters) we see a deepening stagflation. But with the bailout of Freddie and Fannie and the blank check handed to the Treasury by the Congress we are now seeing the glimmers of a more serious inflation, and a potential hyperinflation in the dollar.

The conventional wisdom of the street is that hyperinflation is not possible, because there will be no one to "borrow the funds into existence." Technically a hyperinflation implies the destruction and reissuance under duress of the currency, as opposed to a devaluation by even some large number, such as fifty or even sixty to seventy percent. We do expect the dollar's fall to be about that, considering its downfall started when the DX was 120. (The DX index by the way is far from an optimal index with which to gauge the true downfall of the dollar from here).

There are no rules or magic formula per se in the creation of fiat currency. No one HAS to borrow anything. The Treasury and Fed are the printing machine. The rules regarding the creation of fiat are part of the illusion of substance that surrounds a currency that is backed by nothing.

Yes there are some niceties about the Fed not buying the Treasury debt directly, but these are not hard wired, and are likely to fall rather quickly when circumstances dictate. When you see this happen, you will know that the US is on the path to a hyperinflation.

People like to create these rules in their own minds because otherwise the current financial system would appear to be insane. Who was there to 'borrow' the money into existence in the Weimar Republic? There was no need for borrowing because the Republic owed a substantial debt in real assets to exogenous forces (the Allies). Does this sound familiar? Does the US owe significant debt IOUs in the form of Treasuries to foreign holders?

We still view hyperinflation and deflation as outliers to the strongest probability of a stagflationary recession that is likely to be deep and protracted.

But the possibilities of other outcomes are there, and it is important to know what to look for as the situation develops.

IMF sees no end in sight to credit crisis
By Krishna Guha in Washington
July 28 2008 15:45
The Financial Times

Global financial markets are “fragile” and indicators of systemic risk remain “elevated” almost a year into the credit crisis, the International Monetary Fund said on Monday.

The fund warned credit growth in the US could fall further as a result of ongoing financial system stress and warned that emerging markets would be tested as global financing conditions tighten and policymakers grapple with rising inflation.

The IMF also noted that house prices had softened in a number of European economies including the UK, raising the possibility of further problems in those markets.

The assessment came in the July update to the Global Financial Stability Report, led by former Bank of Spain governor Jaime Caruana.

The IMF said that while likely losses on US subprime mortgages have “largely been acknowledged” in the form of writedowns, financial institutions faced a second wave of losses on other loans.

Credit quality “across many loan classes has begun to deteriorate with declining house prices and slowing economic growth.”

The Fund said bank balance sheets were under “renewed stress” and that the decline in bank share prices had made it more difficult for them to raise new capital.

This “increased the likelihood of a negative interaction between banking system adjustment and the real economy.”

With mounting inflationary pressure, the Fund added: “Policy trade-offs between inflation, growth and financial stability are becoming increasingly important.”

The IMF reaffirmed its controversial earlier estimate that total losses in this cycle could total $945bn – a number that combines mark-to-market losses on subprime-related securities and estimates of likely losses on loans. (Its probably light by about a half a trillion or more - Jesse)

Relative to April, when the Fund published its last GFSR, it said “systemic strains in funding markets continue” and the “low level of risk appetite remains unchanged.”

Interbank lending rates “remain elevated” while “long term funding costs have risen” for financial institutions.

The IMF said financial institutions globally have written off about $400bn since the crisis began last August, and that while they had raised substantial amounts of capital, the losses “exceeded capital raised.”

Banks also faced problems maintaining their earnings, weakening stock prices, and making it more difficult to raise further capital.

The Fund said that policy interventions – mostly by the US Treasury and the Federal Reserve – had so far succeeded in containing systemic risk.

But it said the “nature of resolution strategies and the extent of support have come into sharper focus” in recent months – a polite way of saying that the authorities in the US in particular have had to intervene further to preserve financial stability.

It in effect endorsed the need for the US to shore up Fannie Mae and Freddie Mac in the short term – saying their failure would have systemic consequences – but said “the policy challenge now is to find a clear and permanent solution” for the troubled government-sponsored mortgage groups.

The US Treasury has tried to deal with the immediate threat to Fannie and Freddie, while postponing discussion of their long term futures to a later date.

Charts in the Babson Style for the Week Ending 25 July 2008

US Dollar Weekly Chart with Commitments of Traders as of 22 July 2008

US Dollar Weekly Chart with Moving Averages

Stiglitz on Fannie and Freddie, Free Lunches and Moral Hazard

Fannie’s and Freddie’s free lunch
By Joseph Stiglitz
July 24 2008 18:25
The Financial Times

Much has been made in recent years of private/public partnerships. The US government is about to embark on another example of such a partnership, in which the private sector takes the profits and the public sector bears the risk. The proposed bail-out of Fannie Mae and Freddie Mac entails the socialisation of risk – with all the long-term adverse implications for moral hazard – from an administration supposedly committed to free-market principles.

Defenders of the bail-out argue that these institutions are too big to be allowed to fail. If that is the case, the government had a responsibility to regulate them so that they would not fail. No insurance company would provide fire insurance without demanding adequate sprinklers; none would leave it to “self-regulation”. But that is what we have done with the financial system.

Even if they are too big to fail, they are not too big to be reorganised. In effect, the administration is indeed proposing a form of financial reorganisation, but one that does not meet the basic tenets of what should constitute such a publicly sponsored scheme.

First, it should be fully transparent, with taxpayers knowing the risks they have assumed and how much has been given to the shareholders and bondholders being bailed out.

Second, there should be full accountability. Those who are responsible for the mistakes – management, shareholders and bondholders – should all bear the consequences. Taxpayers should not be asked to pony up a penny while shareholders are being protected.

Finally, taxpayers should be com­pensated for the risks they face. The greater the risks, the greater the compensation.

All of these principles were violated in the Bear Stearns bail-out. Shareholders walked away with more than $1bn (€635m, £500m), while taxpayers still do not know the size of the risks they bear. From what can be seen, taxpayers are not receiving a cent for all this risk-bearing. Hidden in the Federal Reserve-collateralised loans to ­JPMorgan that enabled it to take over Bear Stearns were almost surely interest rate and credit options worth billions of dollars. It would have been easy to design a restructuring that was more transparent and protected taxpayers’ interests better, giving some compensation for their risk-bearing.

But the proposed bail-out of Fannie Mae and Freddie Mac makes that of Bear Stearns look like a model of good governance. It sets an example for other countries of what not to do. The same administration that failed to regulate, then seemed enthusiastic about the Bear Stearns bail-out, is now asking the American people to write a blank cheque. They say: “Trust us.” Yes, we can trust the administration – to give the taxpayers another raw deal.

Something has to be done; on that everyone is agreed. We should begin with the core of the problem, the fact that millions of Americans were made loans beyond their ability to pay. We need to help them stay in their homes, including by converting the home mortgage deduction into a cashable tax credit and creating a homeowners’ Chapter 11, an expedited way to restructure their liabilities. This will bring clarity to the capital markets – reducing uncertainty about the size of the hole in Fannie Mae’s and Freddie Mac’s balance sheets.

The government should set a limit to the size of the bail-out, at the same time making it clear that, while it will not allow Fannie Mae and Freddie Mac to fail, neither will it be extending a blank cheque. There may need to be a drastic reorganisation. There should be a charge for the “credit line” (any private firm would do as much) and, given the risk, it should be at a higher than normal rate.

The private sector knows how to protect its interests; the government should do no less. As long as the credit line is extended, no dividends should be paid. To ensure that the government is not simply bailing out creditors who failed in due diligence, at least, say, 25 per cent of any notes, loans or bonds coming due that are not lent again should be set aside in an escrow account, to be paid only after it is established that taxpayers are not at risk. Any government loans should be cumulative preferred debt: the taxpayers get paid before any other creditors receive a dime. To discourage moral hazard the interest rate should be at a penalty rate and, reflecting the rising risk, increase with the amount borrowed. Finally, the government should participate in the upside potential as well as the downside risk: for instance, by taking shares (which it might later sell) or, as it did in the Chrysler bail-out, warrants.

We should not be worried about shareholders losing their investments. In earlier years, they were amply rewarded. The management remuneration packages that they approved were designed to encourage excessive risk-taking. They got what they asked for. Nor should we be worried about creditors losing their money. Their lack of supervision fuelled the housing bubble and we are now all paying the price. We should worry about whether there is a supply of liquidity to the housing market, so that those who wish to buy a home can get a loan. This proposal provides the necessary liquidity.

A basic law of economics holds that there is no such thing as a free lunch. Those in the financial market have had a sumptuous feast and the administration is now asking the taxpayer to pick up a part of the tab. We should simply say No.

The writer, 2001 recipient of the Nobel Prize for economics, is university professor at Columbia University. He is co-author with Linda Bilmes of The Three Trillion ­Dollar War: the True Cost of the Iraq Conflict

Fitch Projects A Further 25% Decline in US Home Prices

Fitch Updates Ratings Model; Projects Steep Housing Price Declines
By: PAUL JACKSON
July 24, 2008
HousingWire.com

Fitch Updates US RMBS Model, Warns on More Downgrades

Fitch Ratings said Thursday that it had enhanced its U.S. residential mortgage loss model, called ResiLogic, a key component of the agency’s overall approach to assessing U.S. RMBS new-issue ratings. While the new-issue market has been essentially dead for all of 2008, Fitch’s revisions suggest that the agency is preparing for where the market might be headed next: seasoned mortgage issuance.

They also suggest a very bearish take on housing prices over the next five years: Fitch said in its report that it is expecting home prices to decline by an average of 25 percent in real terms at the national level over the next five years, starting from the second quarter of 2008. (If we get enough monetary inflation people may keep the illusion of price appreciation. Twenty-five percent inflation over five years is probably a lowball estimate. - Jesse)

And that’s the base case scenario....

For more information, visit http://www.fitchratings.com.

We interrupt regular programming to announce that America has defaulted …

As regular readers know, we have been fans of Satyajit Das for some years now. His knowledge of the derivatives market is outstanding, given his first-hand experience. He is the author of Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives. We have read it, and are trying to find the time to read it again in the light of what we have learned since it first appeared on the bookshelves.

The scenario he puts forward in this essay is feasible, although we expect the announcement to be less intrusive, more evolutionary, and accompanied by currency controls, selective default plans, and perhaps some geopolitical events. Domestically we will likely see the introduction of digital scrip to be used rather than dollars, as a form of rationing. Barter and black markets will flourish.

It also perhaps helps the reader to understand why the notion of a stronger dollar through debt default is a mistaken application of inappropriate examples at best, and a delusionary fantasy unto personal financial oblivion at worst.

A default on the dollar debt at this point seems inevitable. It is merely a matter of how they wrap and deliver it, and how far and wide the pain is spread.


EuroIntelligence
"We interrupt regular programming to announce that the United States of America has defaulted …"
by Satyajit Das

High levels of debt are sustainable provided the borrower can continue to service and finance it. The US has had no trouble attracting investors to date. Warren Buffett (in his 2006 annual letter to shareholders) noted that the US can fund its budget and trade deficits as it is still a wealthy country with lots of stock, bonds, real estate and companies to sell.

In recent years, the United States has absorbed around 85% of total global capital flows(about US$500 billion each year) from Asia, Europe, Russia and the Middle East. Risk adverse foreign investors preferred high quality debt – US Treasury and AAA rated bonds (including asset-backed securities ("ABS"), including mortgage-backed securities ("MBS")). A significant portion of the money flowing into the US was used to finance government spending and (sometimes speculative) property rather than more productive investments. (Allow us to print the world's reserve currency and we care not who makes the laws - Jesse)

The real reason that the US actually has not experienced a sovereign debt crisis is that it finances itself in it own currency. This means that the US can literally print dollars to service and repay it obligations.

The special status of the US derives, in part, from the fact that the dollar is the world’s major reserve and trade currency. The dollar’s status derives, in part, from the gold standard that once pegged the dollar to the value of gold. The peg and full exchangeability is long gone. The aura of stability and a safe store of value based on the strength of US economy and military power has continued to support the dollar. In 2003, Saddam Hussein, when captured, had US$750,000 with him – all in US$100 bills. The dollar's favoured position in trade and as a reserve currency is based on complex network effects.

Many global currencies are pegged to the dollar. The link is sometimes at an artificially low rate, like the Chinese renminbi, to maintain export competitiveness. This creates an outflow of dollars (via the trade deficit that in turn is driven by excess US demand for imports based on an overvalued dollar). Foreign central bankers are forced to purchase US debt with dollars to mitigate upward pressure on their domestic currency. The recycled dollars flow back to the US to finance the spending. This merry-go-round is the single most significant source of liquidity creation in financial markets. Large, liquid markets in dollars and dollar investments are both a result and facilitator of the process and assist in maintaining the dollar’s status as a reserve currency. (Foreign countries must ironically liberalize their own internal policies to encourage consumption and write down their US dollar holdings significantly to break this cycle and maintain their sovereign freedom from the US financial interests. It will take the "too big to fail" debate to a new level. This is a classic prisoner's dilemma. The first country to do it will find it the easiest in the long term but potentially risky in the short term. - Jesse)

The dominance may be coming to an end. There is increasing discussion of re-denominating trade flows in currencies other than US$. Exporters are beginning to invoice in Euro or Yen. There are proposals to price commodities, such as oil and agricultural goods, in currencies other dollars. Some countries have abandoned or loosened the linkage of their domestic currency to the dollar. Others are considering such a move.

Foreign investors, including central banks, have reduced investment allocations to the dollar. The dollar’s share of reserves has fallen from a high of 72% to around 61%. Foreign investor demand for US Treasury bonds has weakened in recent times. Low nominal (negative real) rates on interest and dollar weakness are key factors.

Foreign investors may not continue to finance the US. At a minimum, the US will at some stage have to pay higher rates to finance its borrowing requirements. Ultimately, the US may be forced to finance itself in foreign currency. This would expose the US to currency risk but most importantly it would not be able to service its debt by printing money. The US, like all borrowers, would become subject to the discipline of creditors.

For the moment, the US$ is hanging on – just. This reflects structural weakness in the Euro and Yen based on deep-seated problems in the respective economies. The artificial nature of the Euro is also problematic. (Gold, perhaps along with silver, is the obvious alternative currency but the banking interests will fight it to the end - Jesse)

The dollar is also a beneficiary of the "too big to fail" syndrome. Foreign investors, especially central banks and sovereign investors in East and South Asia, Russia and the Gulf, have substantial dollar investments that would show catastrophic losses if the US were to default. The International Monetary Fund ("IMF") estimated that Gulf Cooperation Council (Saudi Arabia, the United Arab Emirates, Qatar and other Gulf States) may lose US$400 billion if they decide to stop pegging their currencies to the dollar.

Every lender knows Keynes’ famous observation: "If I owe you a pound, I have a problem; but if I owe you a million, the problem is yours." In history’s largest Ponzi scheme, foreign creditors must keep supporting the US. As the old observation goes: "The only man who sticks closer to you in adversity than a friend is a creditor." (Don't quickly dismiss the scenario that the elites try to present the world with an offer they cannot refuse involving global governance and a New World Order - Jesse)

Does any of this matter? Walter Wriston, then chairman of Citigroup, opined that: "Countries don't go broke". In 1982, shortly after this statement, Mexico, Brazil and Argentina defaulted inflicting near mortal losses on Citibank.

Sovereign debt crisis, especially in emerging markets, are characterised by high levels of debt, especially foreign borrowings, poor fiscal policies, persistent trade deficits, a fragile financial system, over-investment in unproductive assets and a sclerotic political system. Arturo Porzecanski (in Sovereign Debt at the Crossroads (2006)) noted that: "Governments tend to default specifically when they must increase spending quickly (for instance, to prosecute a war), experience a sudden shortfall in revenues (because of a severe economic contraction), or face an abrupt curtailment of access to bond and loan financing (e.g. because of political instability). He further observed that: "governments with large exposures to currency mismatches and interest rate or maturity risks are, of course, particularly vulnerable."

Can the status quo continue? The US must ultimately pay the piper. So what must the US do to remedy the problem? In 1989, John Williamson described certain economic prescriptions - the Washington Consensus – that became a "standard" reform package promoted for crisis-wracked countries by the IMF. The controversial, much criticised package includes: fiscal policy discipline; redirection of public spending from subsidies; tax reform; market determined and positive real interest rates; competitive exchange rates; trade liberalization; liberalization of inward foreign direct investment; privatization of state enterprises; and deregulation. Resolution of the problems facing the US requires adopting many elements of the standard IMF economic reform package for emerging markets.

Some elements, such as fiscal and monetary discipline, are politically difficult if inevitable. Reform of farm subsidies must overcome deep-seated resistance.

Markets are restless for action and do not wait. The US dollar has weakened and is likely to fall further.. This helps exporters, tourism and will ultimately attract inwards foreign investment.

Foreign investment has been slow. Weak economic growth and concerns about the US financial system have offset the effects of a lower dollar. Despite this the "closing down sale" of US assets - real estate, companies and infrastructure assets - has begun. InBev, a Belgian based brewer has launched an unsolicited bid of US$46 billion for Anheuser-Busch, the brewer of Budweiser, the quintessential American beer. Abertis Infraestructuras, a Spanish infrastructure company teamed with Citigroup, submitted US$12.8 billion, the largest bid, for the right to lease the Pennsylvania Turnpike for the next 75 years.

Increasing foreign investment is politically sensitive in America. Surveys show that most American would prefer key businesses to remain in American hands. Public concern about investment by Sovereign Wealth Funds ("SWF") reflects this financial xenophobia.

The "adjustment" may be under way. The dry measured economic prose of the Washington Consensus does not capture its human elements. It will require reductions in US real wages and living standards on a scale that those who have not experienced it first hand cannot understand. Just ask the average citizen of many Asian countries (post the 1997/ 1998 monetary crisis), Argentina and any other country that has taken the IMF’s "cure". (We like the example of Russia in the 1990's since we were doing business there and saw it first hand. - Jesse)

In the twentieth century, the US and the dollar overtook Great Britain and the Pound Sterling as the pre-eminent global economic power and currency. A similar epochal tectonic shift in global economic order may be commencing.

The shift is not inevitable. There is much to admire about the US. It remains wealthier than other nations including the new titans - China and India. America remains a science and technology powerhouse. It accounts for 40% of total world spending on research and development, and outperforms Europe and Japan. For example, between 1993-2003 America’s growth rate in patents averaged 6.6% a year compared with 5.1% for the European Union and 4.1% for Japan. America's relatively fast-growing population, secure property rights and well-developed financial markets have been attractive to investors.

However as Warren Buffett in his 2006 annual letter to shareholders observed: "Foreigners now earn more on their U.S. investments than we do on our investments abroad … In effect, we’ve used up our bank account and turned to our credit card. And, like everyone who gets in hock, the U.S. will now experience ‘reverse compounding’ as we pay ever-increasing amounts of interest on interest. …. no matter how rich you are, borrowing on top of borrowing is not a great long-term financial plan. I believe that at some point in the future, U.S. workers and voters will find this annual 'tribute' (of interest payment on the debt) so onerous that there will be a severe political backlash … How that will play out in markets is impossible to predict – but to expect a 'soft landing' seems like wishful thinking."

The US faces a challenge to reestablish its economic credentials. Without drastic and radical action, America’s ability to continue to borrow from foreign investors to meet its financing requirement is likely to become increasingly difficult. (Meaning increasingly higher interest rates, asset sales, and then le deluge - Jesse)

The mass hysteria and panic that followed the broadcast of Orson Welles The War of the World played on fears about an attack by Germans. It is interesting to speculate whether a broadcast on a default by the US on its sovereign debt would play on the secret fears of global markets triggering a similar panic. "We interrupt regular programming to announce that the United States of America has defaulted on its debt!"

A good friend just sent us this excerpt of an essay from a long time favorite author of ours that seems pertinent to the above, and our current state of affairs.

National Madness
Gilbert Keith Chesterton

"This slow and awful self-hypnotism of error is a process that can occur not only with individuals, but also with whole societies. It is hard to pick out and prove; that is why it is hard to cure. But this mental degeneration may be brought to one test, which I truly believe to be a real test.

A nation is not going mad when it does extravagant things, so long as it does them in an extravagant spirit. But whenever we see things done wildly, but taken tamely, then the State is growing insane...

I should, in other words, think the world a little mad if the [wild] incident, were received in silence. Now things every bit as wild as this are being received in silence every day.... For madness is a passive as well as an active state: it is a paralysis, a refusal of the nerves to respond to the normal stimuli, as well as an unnatural stimulation. There are commonwealths, plainly to be distinguished here and there in history, which pass from prosperity to squalor or from glory to insignificance, or from freedom to slavery, not only in silence, but with serenity.

The face still smiles while the limbs, literally and loathsomely are dropping from the body. These are peoples that have lost the power of astonishment at their own actions. When they give birth to a fantastic fashion or a foolish law, they do not start or stare at the monster they have brought forth. They have grown used to their own unreason; chaos is their cosmos; and the whirlwind is the breath of their nostrils.

These nations are really in danger of going off their heads en masse; of becoming one vast vision of imbecility, with toppling cities and crazy country-sides, all dotted with industrious lunatics.... "