Friday, October 31, 2008

18% of Mortgages are Underwater - HAPPY HALLOWEEN (in case you don't think this scary)

The problem with mortgages that are underwater is that people have the propensity to walk if things get tough. Regardless of what the stock market does (or does not do) the economy and the houinsg market still have some real problems to negotiate. Text in bold is my emphasis. From Yahoo News:

Nearly one in five U.S. mortgage borrowers owe more to lenders than their homes are worth, and the rate may soon approach one in four as housing prices fall and the economy weakens, a report on Friday shows.

About 7.63 million properties, or 18 percent, had negative equity in September, and another 2.1 million will follow if home prices fall another 5 percent, according to a report by First American CoreLogic.

The data, covering 43 states and Washington, D.C., includes borrowers nationwide, even those who took out mortgages before housing prices began to soar early this decade.

Seven hard-hit states -- Arizona, California, Florida, Georgia, Michigan, Nevada and Ohio -- had 64 percent of all "underwater" borrowers, but just 41 percent of U.S. mortgages.

"This is very much a regional problem, and people tend to forget that," said David Wyss, chief economist at Standard & Poor's, who expects home prices nationwide to fall another 10 percent before bottoming late next year.

"Most of the country is not in bad shape," he continued. "Things seem to be stabilizing in Michigan, but the big bubble states -- Florida, California, Arizona and Nevada -- are still very overpriced."

About 68 percent of U.S. adults own their own homes, and about two-thirds of them have mortgages.

JPMorgan Chase & Co, one of the biggest mortgage lenders, on Friday offered to modify $70 billion of mortgages to keep a potential 400,000 homeowners out of foreclosure. Bank of America Corp, which bought Countrywide Financial Corp in July, also has a large loan modification program.

U.S. home prices fell a record 16.6 percent in August from a year earlier, with declines in all 20 major metropolitan areas measured by the S&P/Case-Shiller Home Price Indices.

Foreclosure filings rose 71 percent in the third quarter to a record 765,558, according to RealtyTrac.

Meanwhile, the Commerce Department said gross domestic product fell at a 0.3 percent rate in the third quarter. Some experts expect the worst U.S. recession since the early 1980s.

Yet despite a series of expensive government programs to spur lending, mortgage rates are rising, making it tougher to borrow or refinance. The rate on a 30-year fixed-rate mortgage jumped this week to 6.46 percent from 6.04 percent a week earlier, Freddie Mac said.
Meanwhile, borrowing costs on hundreds of thousands of adjustable-rate mortgages are expected to reset higher in the coming months. The problem may be particularly serious for borrowers with rates tied to the London Interbank Offered Rate, or Libor, which is abnormally high relative to benchmark U.S. rates.

Last week, Wachovia Corp said borrowers with its "Pick-a-Pay" ARMs and living in or near Stockton and Merced, California, owed at least 55 percent more on their mortgages, on average, than their homes were worth. Wells Fargo & Co is buying Wachovia.

First American CoreLogic, an affiliate of title insurance and real estate services company First American Corp, said states with large numbers of homes with negative equity either had rapid price appreciation, many homes bought with subprime mortgages or as speculative investments, steep manufacturing declines, or a combination.

Nevada was hardest hit, where mortgage borrowers on average owed 89 percent of what their homes were worth, and 48 percent had negative equity. Michigan was second, with an 85 percent loan-to-value ratio and 39 percent of borrowers underwater.

New York fared best, with an average 48 percent loan-to-value ratio and just 4.4 percent of mortgage borrowers with negative equity.

But Wyss said this could change as financial market upheaval transforms Wall Street. This month, New York City Comptroller William Thompson estimated that the city alone might lose 165,000 jobs over two years.

"We're going to see home prices coming down pretty significantly in New York," Wyss said. "A lot of people are losing jobs, and won't be getting their usual bonuses, and that leaves less money for housing."

Tuesday, October 28, 2008

Worldwide Losses Due to the Credit Crisis Could Be About $2.8T

The Bank of England estimates worldwide losses due to the credit crisis to be about $2.8T. The following gives a summary of views from other countries about the status of the financial system. Also the aritcle indicates that the Fed, US Treasury, US Governement, etc. is the lend of last resort to much of the world. Text in bold is my emphasis. From Yahoo News:

The global financial system could lose $2.8 trillion to the credit crisis, the Bank of England said on Tuesday, before an expected interest rate cut in the United States that others are poised to match.

Governments have agreed to inject around $4 trillion into banks and markets to contain the worst financial crisis in 80 years, which has forced stock markets to tumble and banks out of business, hastening a recession in much of the world.

Japan restricted investor bets on falling share prices with immediate effect to try to end a stock market slide, which has particularly hit its banking sector, and tried to talk down a rallying yen that threatens to deepen its economic downturn. . . . .

. . . . Prime Minister Taro Aso delayed a parliamentary election to take steps to concentrate on protecting Japan, the world's second biggest economy, from global recession.

The Bank of England (BoE) said the work so far in containing the crisis should calm the banking system but was cautious about the impact on the wider economy. It projected losses globally at $2.8 trillion.

"The instability of the global financial system in recent weeks has been the most severe in living memory," said Deputy Governor John Gieve. "And with a global economic downturn under way, the financial system remains under strain."

The BoE is expected to cut interest rates next week, a move the European Central Bank and the Federal Reserve are also expected to take to try to encourage more spending in economies increasingly fearful of a long, deep recession.

The consensus among Fed watchers is for a half-point cut in overnight rates to 1 percent, the lowest level since June 2004. It has already cut the benchmark federal funds rate to 1.5 percent from 5.25 percent over the past 13 months.

It will announce its decision on Wednesday. The ECB and Bank of England are expected to cut rates on Thursday next week.

Faced with a funding squeeze and a sharp economic downturn across much of the industrialized world, major companies joined banks in the queue for government aid.

U.S. automakers General Motors and Chrysler sought government cash for a merger, South Korean banks tapped a Federal Reserve funding window, Russia was in talks with China for export-backed loans for its companies and Kazakhstan pumped $5 billion into its banks.

The Japanese banking system, which largely escaped the fallout from U.S. mortgage defaults last year, had invested in the stock market and the three largest lenders are looking to replenish capital lost on the bourse.

Tokyo banned naked short selling, bringing the move forward by one week. Naked short selling allows traders to effectively sell stocks they do not own and without borrowing them first in the hope they will profit by buying stocks back at a lower price.

"Similar restrictions have already been put in place in the United States and Europe but Japan has lagged behind," Finance Minister Shoichi Nakagawa said. "I found a lag of a few days is critical for the Tokyo stock market."

The yen pulled away from a 13-year high against the dollar due to growing caution about the possibility of official intervention.

The yen has leapt about 20 percent on a trade-weighted basis this month alone and has compounded fears among Japan's exporters as their key markets lurch toward recession.

"The yen's rise in the past week is astonishing, but it does not reflect Japan's economic fundamentals," Japanese Economics Minister Kaoru Yosano told a news conference.

The Group of Seven finance ministers and central bank governors singled out the yen on Monday in a rare statement that said its rally threatened stability.

With the yen trading at around 94 per dollar, Carlos Ghosn, chief executive of Nissan Motor Co and Renault, said it would be difficult for Nissan to compete, especially with U.S. car sales plunging 26 percent in September from a year earlier.

"Nobody reasonable is going to tell you that next year we're going to be out (of this crisis)," he said.

U.S. automakers are faring much worse than their Japanese rivals and two of America's "Big Three" are planning a merger to survive the crisis.

General Motors Corp and Chrysler LLC's owner, Cerberus Capital Management, asked the U.S. government for a $10 billion rescue package to support the merger, sources familiar with the talks said on Monday.

The U.S. government cobbled together a $700 billion plan to bailout Wall Street last month, after mortgage defaults and credit writedowns wrecked lenders and insurers. recapitalization program launched this month. program launched this month.

Two South Korea banks joined the queue for U.S. government dollars on Tuesday as the country grappled with an acute dollar funding squeeze and a crisis of investor confidence.

Comments from The Author of the Laffer Curve - The End of Prosperity

The following editorial appeared in yesterday's WSJ and is worth a read. I am not a fan of the Laffer Curve and its part in Supply Side Economics or even in parts of this editorial, but it brings up some interesting issues that need to be addressed. How are we going to pay for this "bail-out" program? What effect will the inevitable increase in taxes have on the economy at large?

I also agree with the author that President Bush and the Congress will not be well treated by history. Text in bold is my emphasis.

About a year ago Stephen Moore, Peter Tanous and I set about writing a book about our vision for the future entitled "The End of Prosperity." Little did we know then how appropriate its release would be earlier this month.

Financial panics, if left alone, rarely cause much damage to the real economy, output, employment or production. Asset values fall sharply and wipe out those who borrowed and lent too much, thereby redistributing wealth from the foolish to the prudent. This process is the topic of Nassim Nicholas Taleb's book "Fooled by Randomness."

When markets are free, asset values are supposed to go up and down, and competition opens up opportunities for profits and losses. Profits and stock appreciation are not rights, but rewards for insight mixed with a willingness to take risk. People who buy homes and the banks who give them mortgages are no different, in principle, than investors in the stock market, commodity speculators or shop owners. Good decisions should be rewarded and bad decisions should be punished. The market does just that with its profits and losses.

No one likes to see people lose their homes when housing prices fall and they can't afford to pay their mortgages; nor does any one of us enjoy watching banks go belly-up for making subprime loans without enough equity. But the taxpayers had nothing to do with either side of the mortgage transaction. If the house's value had appreciated, believe you me the overleveraged homeowner and the overly aggressive bank would never have shared their gain with taxpayers. Housing price declines and their consequences are signals to the market to stop building so many houses, pure and simple.

But here's the rub. Now enter the government and the prospects of a kinder and gentler economy. To alleviate the obvious hardships to both homeowners and banks, the government commits to buy mortgages and inject capital into banks, which on the face of it seems like a very nice thing to do. But unfortunately in this world there is no tooth fairy. And the government doesn't create anything; it just redistributes. Whenever the government bails someone out of trouble, they always put someone into trouble, plus of course a toll for the troll. Every $100 billion in bailout requires at least $130 billion in taxes, where the $30 billion extra is the cost of getting government involved.

If you don't believe me, just watch how Congress and Barney Frank run the banks. If you thought they did a bad job running the post office, Amtrak, Fannie Mae, Freddie Mac and the military, just wait till you see what they'll do with Wall Street.

Some 14 months ago, the projected deficit for the 2008 fiscal year was about 0.6% of GDP. With the $170 billion stimulus package last March, the add-ons to housing and agriculture bills, and the slowdown in tax receipts, the deficit for 2008 actually came in at 3.2% of GDP, with the 2009 deficit projected at 3.8% of GDP. And this is just the beginning.

The net national debt in 2001 was at a 20-year low of about 35% of GDP, and today it stands at 50% of GDP. But this 50% number makes no allowance for anything resulting from the over $5.2 trillion guarantee of Fannie Mae and Freddie Mac assets, or the $700 billion Troubled Assets Relief Program (TARP). Nor does the 50% number include any of the asset swaps done by the Federal Reserve when they bailed out Bear Stearns, AIG and others.

But the government isn't finished. House Speaker Nancy Pelosi and Senate Majority Leader Harry Reid -- and yes, even Fed Chairman Ben Bernanke -- are preparing for a new $300 billion stimulus package in the next Congress. Each of these actions separately increases the tax burden on the economy and does nothing to encourage economic growth. Giving more money to people when they fail and taking more money away from people when they work doesn't increase work. And the stock market knows it.

The stock market is forward looking, reflecting the current value of future expected after-tax profits. An improving economy carries with it the prospects of enhanced profitability as well as higher employment, higher wages, more productivity and more output. Just look at the era beginning with President Reagan's tax cuts, Paul Volcker's sound money, and all the other pro-growth, supply-side policies.

Bill Clinton and Alan Greenspan added their efforts to strengthen what had begun under President Reagan. President Clinton signed into law welfare reform, so people actually have to look for a job before being eligible for welfare. He ended the "retirement test" for Social Security benefits (a huge tax cut for elderly workers), pushed the North American Free Trade Agreement through Congress against his union supporters and many of his own party members, signed the largest capital gains tax cut ever (which exempted owner-occupied homes from capital gains taxes), and finally reduced government spending as a share of GDP by an amazing three percentage points (more than the next four best presidents combined). The stock market loved Mr. Clinton as it had loved Reagan, and for good reasons.

The stock market is obviously no fan of second-term George W. Bush, Nancy Pelosi, Harry Reid, Ben Bernanke, Barack Obama or John McCain, and again for good reasons.
These issues aren't Republican or Democrat, left or right, liberal or conservative. They are simply economics, and wish as you might, bad economics will sink any economy no matter how much they believe this time things are different. They aren't.

I was on the White House staff as George Shultz's economist in the Office of Management and Budget when Richard Nixon imposed wage and price controls, the dollar was taken off gold, import surcharges were implemented, and other similar measures were enacted from a panicked decision made in August of 1971 at Camp David.

I witnessed, like everyone else, the consequences of another panicked decision to cover up the Watergate break-in. I saw up close and personal Presidents Gerald Ford and George H.W. Bush succumb to panicked decisions to raise taxes, as well as Jimmy Carter's emergency energy plan, which included wellhead price controls, excess profits taxes on oil companies, and gasoline price controls at the pump.

The consequences of these actions were disastrous. Just look at the stock market from the post-Kennedy high in early 1966 to the pre-Reagan low in August of 1982. The average annual real return for U.S. assets compounded annually was -6% per year for 16 years. That, ladies and gentlemen, is a bear market. And it is something that you may well experience again. Yikes!
Then we have this administration's panicked Sarbanes-Oxley legislation, and of course the deer-in-the-headlights Mr. Bernanke in his bungling of monetary policy.

There are many more examples, but none hold a candle to what's happening right now. Twenty-five years down the line, what this administration and Congress have done will be viewed in much the same light as what Herbert Hoover did in the years 1929 through 1932. Whenever people make decisions when they are panicked, the consequences are rarely pretty. We are now witnessing the end of prosperity.

Sunday, October 26, 2008

This Weekend’s Contemplation – The Changing Face of the Banking Business

It should be clear at this point that the Bail-Out Plan, which was originally thought to buy the “toxic” mortgages of the financial industry is now largely being used to selectively re-capitalize the banks. There was the capital injections into 9 financial institutions a couple of weeks ago, which is being followed by injections into about 20 regional banks. This will begin to indicate the clear winners and losers in the credit crisis. The most recent loser is National City, which is being purchased by PNC. Text in bold is my emphasis. From Yahoo News:

The U.S. government took further steps to prop up the U.S. banking system on Friday, starting to inject capital into a new group of banks, and helping to finance a $5.2 billion takeover of National City Corp by PNC Financial Services Group Inc.

The Treasury Department plans to provide funds for 20 to 22 additional lenders as part of its next round of a $250 billion bank recapitalization program. It has already committed half that amount to nine of the nation's largest banks in exchange for preferred shares.

Treasury plans to let banks announce the infusions on their own, rather than release a list of recipients all at once and risk scaring investors who might think banks left off failed to qualify for help, a person familiar with Treasury thinking said.

PNC, First Horizon National Corp, Regions Financial Corp, and Valley National Bancorp said on Friday they will obtain infusions. Capital One Financial Corp and SunTrust Banks Inc were also among banks on the Treasury list, the Wall Street Journal said, citing people familiar with the matter.

Treasury also is examining how to give help to insurers under its $700 billion Troubled Asset Relief Program, two people familiar with the deliberations said. . . . .

. . . . . "Credit quality will continue to deteriorate -- mortgage loans, credit card loans, auto loans, student loans, across the board," said Keith Davis, an analyst at Farr, Miller & Washington in Washington, D.C. "Many of these banks are going to be reporting losses for several quarters."

Banks worldwide are trying to reduce their balance sheet risk after taking on too many mortgages and complex debt, which no longer have buyers.

Credit losses at most major U.S. lenders are soaring, often to three times or more than year-ago levels. The losses are likely to rise if housing prices fall further, unemployment rises, and the economy deteriorates, causing more retail and business customers to have trouble paying their bills.

National City, a Cleveland-based bank battered by soured mortgage and construction loans in the U.S. Midwest and Florida, agreed to be acquired by PNC in a transaction valuing it at just $2.23 per share, 19 percent below where it closed on Thursday and 94 percent below where it traded in March 2007.

"This is a difficult environment," James Rohr, chief executive of Pittsburgh-based PNC, said on a conference call. "The economy has been deteriorating quarter by quarter."

National City had lost money in five straight quarters. It joins Bear Stearns Cos, Merrill Lynch & Co, Sovereign Bancorp Inc, Wachovia Corp and Washington Mutual Inc among financial companies that were swallowed up this year by lenders considered healthier.

PNC said the purchase would make it the fifth-largest U.S. bank by deposits. The acquisition roughly doubles PNC's size. . . . .

. . . . . The selling is "part and parcel of the eventual cleanout" of leverage in the financial system, said Marshall Front, chairman of Front Barnett Associates LLC in Chicago.

"We are aware of hedge funds that are being forced to sell, and banks are forcing customers to bring margins up. Mutual funds are getting large redemptions, and exchange traders are under extreme pressure," he added.

Meanwhile, shares of some regional banks that analysts consider relatively healthy, and potential acquirers of weaker rivals, rose. BB&T Corp rose 6.8 percent to $32.25, while U.S. Bancorp gained 2.7 percent to $29.45.

Minneapolis-based U.S. Bancorp had looked into buying National City, people familiar with the matter said on Friday.

One of Friday's biggest decliners was Fifth Third Bancorp, whose shares slid 28.7 percent to $8.07.

The Cincinnati lender also has seen loan losses mount, and been thought to be a takeover target, perhaps for PNC. Goldman Sachs & Co analysts downgraded Fifth Third to "sell" from "neutral," and Fitch Ratings lowered the bank's credit rating.

Friday, October 17, 2008

Banks Bracing for a Tough Recession

As stated before if you weathered the credit crisis you still have to negotiate the economic crisis that will follow. At this point no one knows how long it will last or how deep it will be. But, it is clear to most that the economy is slowing down dramatically and that it is under considerable deflationary pressure. Hence, my comments earlier this week that there is no guarantee that all the bail-out plans are going to work. Next week various investors file insurance claims against AIG for the Lehman Brothers bond losses. We will see if that will make things worse. Text in bold is my emphasis. From the NY Times:

JPMorgan Chase, Wells Fargo, and State Street have weathered these bad times better than most banks. But things are about to get worse.

Skip to next paragraph Sobered by the prospect of a drawn-out erosion in the economy, investors drove down the shares of all three Wednesday even after they reported earnings that beat the low expectations of Wall Street analysts.

“If you made it past the
credit crisis, you are not making it past the economic carnage,” said Meredith A. Whitney, a banking analyst at Oppenheimer & Company. “And there is more to come.”

The banks are among the first to announce their results in what is expected to be yet another dismal quarter for nearly all financial firms.
Bank of America already reported disappointing earnings as it struggled to raise $10 billion in fresh capital. And Citigroup, Merrill Lynch, PNC Financial, and Bank of New York Mellon are expected to release weak results on Thursday, followed by regional and small banks whose fortunes have been changed by the upheaval of the American financial landscape.

Profit at JPMorgan Chase slumped 84 percent, to $527 million, or 11 cents a share, in the third quarter as the bank weathered losses of $3.6 billion on bad investments, leveraged loans and a bevy of unusual charges, including ones tied to its takeover of
Washington Mutual last month. In a sign it is preparing for more fallout from a contracting economy, the bank set aside another $2.2 billion to cover current and future losses on credit card, mortgages and commercial real estate loans.

Wells Fargo & Company said profit fell 25 percent, to $1.64 billion, or 49 cents a share, after absorbing big losses on investments in
Fannie Mae, Freddie Mac and Lehman Brothers. It also bolstered its reserves by $2.5 billion as it braces for higher loan losses, and will soon inherit tens of billions in new losses from its takeover of Wachovia.

State Street Corporation, a custodial bank based in Boston, profit rose 33 percent, to $477 million, or $1.09 a share, as it booked higher trading fees amid volatile markets. But it, too, faced heavy losses on investments, including loan collateral from Lehman Brothers. It also may need to set aside as much as $450 million to prop up some of its battered investors in its fixed-income funds.

The banks were among the nine firms compelled by Treasury Secretary
Henry M. Paulson Jr. on Tuesday to take a big cash infusion from the government. Both JPMorgan Chase and Wells Fargo agreed to received $25 billion investments; State Street, which has a much smaller balance sheet, received about $2 billion. Though all of the firms denied needing the money, federal officials hope they use it to increase lending.

Even if the flow of credit improves soon, executives are planning for a future shaped by thousands of lost jobs in the economy, weaker consumer spending and more market turmoil and uncertainty. “We necessarily need to be prepared for a bad environment,” said
Jamie Dimon, JPMorgan’s chairman and chief executive.

With losses on housing far worse than anticipated, he said the bank was “getting braced” to increase its reserves against losses on loans over the next couple of quarters, and for “very tough” trading results. The finance chief, Michael J. Cavanagh, said the bank believed the economy was already experiencing “recessionary conditions” that would worsen.

On Wednesday,
Ben S. Bernanke, the chairman of the Federal Reserve, warned that the American economy was headed toward an extended period of difficulty in spite of a worldwide effort to stabilize the markets. Investors, fearful that the worst is still to come, sent financial stocks plummeting. The KBW Index, a popular measure of the sector, fell more than 7 percent on Wednesday. It is down more than 45 percent since last year.

A continued contraction may make it even tougher for consumers to pay off loans, especially credit card and auto debt, creating another layer of risk.

And banks are also being hurt by narrower lending margins. Without the volume of new business, banks will find it especially challenging to be profitable. “Profit pressure is picking up at a time when you are trying to build it up as fast as you can to handle these credit problems,” said Gerard Cassidy, an analyst at RBC Capital Markets.

Wells Fargo’s chief financial officer, Howard I. Atkins, warned that the bank faced intense pressure on its huge consumer loan portfolio. He cited weakness in residential real estate, rising unemployment and increases in bankruptcies.

JPMorgan outlined signs of strain already showing up in its big consumer businesses. Its Chase retail banking operations reported $247 million in net income, a 61 percent drop from the period last year. It has pulled back on new lending, tightening standards on mortgages and home equity loans. And Chase’s big credit card division reported $292 million in net income, a 63 percent drop from last year. The unit took a $2.2 billion write-down to buffer against potential losses, as more consumers struggled to pay their credit card balances.

“Credit has deteriorated meaningfully this quarter, and it is going to get worse before it gets better,” Mr. Cassidy said. “That is going to continue to drive the results well into 2009.”

Mr. Dimon, on a conference call with analysts, said he expected lending to return to normal eventually. But now, he added, is the time to be prudent. “We are not going to say, ‘
Yahoo, this is over,’ and go extend credit like we did without fear,” he said. “If you are not fearful, you are crazy.”

Ms. Whitney, one of the most bearish banking analysts on the call, shot back, “I’m fearful, thanks.”

Mr. Dimon deadpanned: “We know you are. We are waiting for you to reverse your position.”

Thursday, October 16, 2008

We Stepped Away from the Edge After Looking Down

David Wessel, one of my favorite WSJ authors, made some comments about what happened last week and then on Monday. I agree with David (and Jim Cramer) that the Great Depression scenario appears to be off the table for the time being. But, we are still looking at a very weak economy and a very difficult stock market for a while. The question now is how long "for a while" is? Text in bold is my emphasis. From the WSJ:

So is it over? Have governments in the U.S. and Europe finally found the cure? Has recession been averted?

No. We're still in for a rough recession, with U.S. unemployment, now at 6.1%, likely to rise above 8%, with all the misery that brings.

But it could be worse. For a few scary moments last week, governments began to take action to protect their own countries that made other countries worse off. It looked like the world economy was lurching uncomfortably close to conditions that precipitated the Great Depression. The newfound trans-Atlantic unity -- particularly the move by the U.K., then the rest of Europe and now the U.S., to give the banking system a taxpayer-funded transfusion -- has significantly reduced the odds of a really bad outcome. That alone is reason to be less panicky today than many were this time last week.

Paul Krugman, the newest Nobel laureate in economics, described in a CNBC interview Tuesday the latest government action as "emergency battlefield medicine to keep the guy from bleeding to death." That's no small accomplishment given how bad the wounds were. If the treatments work as intended, banks should resume lending at least to each other, a necessary step toward recovery.

The new U.S. plan "is going to boost confidence that the most extreme downside risks have been diminished, but the damage has been done, and this isn't going to prevent the economy from being in recession and remaining weak for a while," Laurence Meyer, an economic forecaster and former Federal Reserve governor, said Tuesday. Exactly.

The U.S. economy had slowed substantially before the chaos of the past couple of weeks. Unemployment was rising. Consumers were spending less readily. Businesses were growing more cautious about expansion and investment. Housing prices were falling. The credit crunch was spreading as lenders from banks to money-market funds hoarded cash in response to unfathomable uncertainty. A steady stream of banks were failing. The rest of the world was showing symptoms of the American ailment, which meant the U.S. couldn't count on export growth to offset domestic weakness. Any lingering hope that the U.S. would avoid recession evaporated. Forecasters began talking about two, three, maybe even four quarters of a contracting economy.

Then things got worse. The plunge in stock markets made everyone with a 401(k) or mutual fund poorer and wiped out whatever lingering confidence remained. Banking problems surfaced in Europe. The global economy's circulatory system -- the flow of credit from savers to investors, from lenders to borrowers, from one bank to another -- got clogged. All the money that the Fed and other central banks were injecting into the banks was staying in the banks, and not being loaned. Financial markets were moving on panic, not reason. Even the coordinated interest-rate cuts by the Fed and European central banks didn't help.

Last week it became clear to the remaining advocates that buying bad assets from banks, as the original plan outlined by Treasury Secretary Henry Paulson involved, wouldn't suffice. It might help eventually, but it would take too long and was too indirect -- hence the radical remedy of investing taxpayer money directly into those banks that have a reasonable chance of survival. (Officials know, but haven't advertised, the corollary: Regulators must quickly close banks so weak that their only plausible strategy is to gamble for resurrection or use taxpayer money to take foolishly risky bets.)

The latest steps reduce the risk of the worst-case scenario and may mark a turning point in the 14-month-old crisis, though it's too soon to know. But they don't reverse the forces that were crushing the economy before Lehman Brothers Holdings Inc. went under on Sept. 14. Stock prices are well below Oct. 1 levels, so investors are poorer. House prices are still falling. Consumers, companies and bankers still have good reason to be extremely cautious, and they will be.

When in doubt, wait -- wait to buy a new car, wait to plan a Christmas vacation, wait to sign off on a loan, wait to approve a new hire. When everyone waits, the economy contracts. That realization restrained the stock market Tuesday after Monday's exuberance. And that realization is prompting Democrats and the economists they consult to contemplate another dose of fiscal stimulus, perhaps to be approved soon after the Nov. 4 election.

A lot still could go wrong. Banks could take the taxpayer capital, but not expand lending. Housing prices could fail to stabilize in the middle of next year, as has been widely predicted. Fear and pessimism could continue to depress the stock market. A big U.S. auto maker could stumble into bankruptcy court, or some other company believed today to be strong could disclose unanticipated vulnerability. Controversy or mini-scandal in the government rescue -- almost inevitable given its size and the speed with which it is moving -- could undermine government credibility. The transition from George W. Bush to the next president could create uncertainty about the direction of policy at a delicate moment.

The global economy is far from healthy. It almost surely will get worse before it gets better. The U.S. economy's legendary resilience will be tested. The market will have some bad days. But for the first time in weeks, governments -- with the grudging acquiescence of big banks -- are moving in ways that bolster, rather than undermine, confidence, and that's a very welcome development.

Wednesday, October 15, 2008

The Economic Crisis - Retail Sales are Down

As you might expect retail sales are down significantly in September. Sales are down in 11 of the 13 retail sectors. We may have averted a banking crisis, but the economic problems are just getting started. The GDP numbers for Q3 are out at the end of the month. We will see at that time how things are going. Text in bold is my emphasis. From Bloomberg:

The eroding U.S. economy drove retail sales into their longest slump in at least 16 years, even before this month's market collapse signaled a deepening recession.

Consumer purchases fell 1.2 percent in September, extending the decline to three straight months, the first time that's happened since comparable records began in 1992, Commerce Department figures showed today. In another sign of weakening demand, prices paid to U.S. producers fell last month on lower fuel costs.

Sales are slowing just as merchants prepare for the holiday selling season, on which they depend for the largest share of their revenue. San Francisco Federal Reserve President Janet Yellen said yesterday the U.S. may already be in a recession, and stocks dropped amid concern that the government's plans to inject capital into banks won't halt the economy's decline.

``I don't think things can get much worse,'' said Brian Bethune, chief financial economist at Global Insight Inc. in Lexington, Massachusetts. ``September was a terrible month in terms of the overall situation, in both sales and production. The fourth quarter is guaranteed to be a terrible quarter.''

An early regional gauge of manufacturing for this month showed production weakening in New York state as the freeze in global credit markets prompted businesses to pull back. The Federal Reserve Bank of New York's general economic index sank to the lowest level since it was first compiled in 2001.

The Labor Department reported that prices paid to U.S. producers fell 0.4 percent in September, while so-called core producer prices that exclude fuel and food increased 0.4 percent.

Falling oil prices and weaker consumer spending are making it harder for American companies to raise prices, giving the Fed scope to cut interest rates. Still, the costs for food and other household goods are higher than a year ago.

September's drop in retail sales was the largest since August 2005 and followed a 0.4 percent decline the prior month. Excluding autos, sales fell 0.6 percent. Both declines were more than economists had forecast. . . .

. . . . Eleven of the 13 main categories tracked by Commerce showed a drop in demand last month, led by a 3.8 percent slump at auto dealers. Carmakers see little relief in sight.

``We continue to see the trend of the past couple of months,'' Ford Motor Co. North American chief Mark Fields said in the Ford plant in Dearborn, Michigan.

GMAC LLC, the lender once owned by General Motors Corp., said this week it will grant financing only to buyers with credit scores of at least 700, who represent about 58 percent of U.S. consumers.

Industry figures earlier this month, which are the ones used to calculate gross domestic product, showed cars and light trucks sold at a 12.5 million annual pace in September, the fewest since 1993. October sales may drop to an 11 million pace, the first time the rate has dropped below 12 million since April 1983, according to an estimate by an analyst at Deutsche Bank AG.

Sales at furniture stores dropped 2.3 percent, the most since February 2003, and purchases at clothing outlets decreased by the same amount, the most this year. Americans cut back on visits to restaurants and bars, where sales dropped 0.5 percent, the most since January 2007.

Weakening demand at merchants such as Gap Inc., J.C. Penney Co. and Macy's Inc. also hurt total purchases, signaling retailers may be heading for the worst holiday shopping season in six years.

Terry Lundgren, chief executive officer at Macy's, the second-biggest U.S. department-store chain, forecast a recovery in sales won't begin until the second half of next year.

``The most important issue for us is jobs,'' Lundgren said in an Oct. 10 telephone interview. ``That's what has to stabilize. If you lose your job, that affects everything.''

Excluding autos, gasoline and building materials, the retail group the government uses to calculate GDP figures for consumer spending, sales dropped 0.7 percent, after a 0.4 percent decrease in August. The government uses data from other sources to calculate the contribution from the three categories excluded.

The only categories registering gains last month were service stations, with a 0.1 percent increase, and health and personal care stores, where sale rose 0.4 percent.

Consumer spending fell at an annual rate of 2 percent in the third quarter, bringing to a halt a record expansion that began in 1992, according to the median estimate of economists surveyed in the first week of October. Purchases will probably drop at a 0.9 percent pace in this quarter and be unchanged in the first three months of 2009, the projections also showed.

The U.S. has lost 760,000 jobs in the first nine months of the year and the jobless rate was unchanged at a five-year high of 6.1 percent in September, the Labor Department reported earlier this month. . . . .

Tuesday, October 14, 2008

As the Banking Crisis Ends the Economic Crisis Begins

The latest from Ambrose Evans-Pritchard indicates that the banking crisis has been averted but now the economic crisis will begin. Unemployment will increase as consumer spending and international trade continues to decrease. It looks like a weak housing sector may still have a few years to go. The article indicates that the economic recession will last 18 - 24 months. Don't be surprised if this lasts longer. The de-leveraging process that the economy must go through still has a lot of pain left in it.

The issue that historians and the rest of us will discuss for some time to come is how bad could it have been if some of the unprecedented actions were not taken by the European and US governments and central banks. From the UK Telegraph:

Tuesday's sweeping move by US Treasury Secretary Hank Paulson to guarantee financial debt and inject state capital into America's biggest banks brings the US into line with Britain and Europe, where almost $3,000bn (£1.7 trillion) has been vouched in the biggest bail-out of all time.

If the history of financial crises is any guide, the violent credit shock of 2007-2008 has largely run its course. The sovereign states of the US, Britain, France, Germany, Italy, Spain, and Holland have broad enough shoulders to carry their load of fresh liabilities – even if Iceland does not.
We are now moving to the next phase, a grinding slump across the G7 bloc of leading industrial economies as years of excess debt are slowly purged from the system. This is when people start to lose their jobs in earnest.

Professor Nouriel Roubini from New York University, the vindicated prophet of the crisis, says he can at last glimpse light at the end of the tunnel.

"Policy makers peered into the abyss of systemic collapse a few steps in front of them and finally got religion. While the economic damage is already done, and the global economy will not avoid a painful recession, rapid action will prevent a decade-long stagnation like the one in Japan after the bursting of its real estate and equity bubble," he said, predicting a 'U-shaped' slump lasting 18 to 24 months.

World trade has already stalled. The Baltic Dry Index measuring freight rates for shipping has crashed by 82pc since May, touching a five-year low yesterday. Container vessels are leaving Asian ports with 20pc spare capacity. "We're heading into a global recession," said Simon Johnson, the IMF's former chief economist.

The whole OECD bloc of rich economies is crumbling in unison – a rare event. Such is the dark side of globalisation. Asia is deeply linked into the debt bubble through trade effects, which is why Japan and Singapore are contracting as sharply as the West.

Oil-rich Russia had to step in yesterday with a $56bn package to recapitalise banks and cover foreign loans. Brazil has seen a triple rout in its stocks, bonds, and currency. The Gulf states of Qatar and the Emirates have had to support their financial systems. Even Norway needed a $55bn bank rescue over the weekend.

The French economy is officialy shrinking. Germany's exports fell 2.5pc in August, led by the car industry. BMW has begun to idle three plants; Opel has shut a factory in Eisenach for three weeks.

"The eurozone is in recession already," said David Owen from Dresdner Kleinwort. "The consumer downturn has begun, but the cuts in business spending that you see late in the cycle have yet to come. This is going to get a lot worse," he said.

Brussels invoked its "exceptional circumstances" clause yesterday, allowing EU states to breach the budget deficit limit of 3pc of GDP. But leeway for fiscal stimulus is already constrained. Ireland had to raise taxes yesterday to stop borrowing spiralling out of control. Its deficit will reach 6.5pc.

Former Federal Reserve chief Paul Volcker, a harsh critic of the debt bubble, says there is no alternative to the Paulson bail-out measures at this late stage, however "distasteful" they may be. "They will turn an inevitable recession into something more manageable," he said.

Be thankful for small mercies.

The Government to Take Equity Positions in 9 Financial Institutions

Unlike my "totally free market" brethren, I totally agree with the US government taking a preferred stock position in the the banks. Now is not the time to cling to some ideology. It is time to move to save and restore the banking system. The question I have is that US Bank is conspicuous by its absence from the list. Maybe they get an equity injection when they have to pick up one of the large regionals that is in bad shape. This is just round 1 of a 100 round fight. In 5 - 10 years the banking system will look completely different from what it looks like today. Text in bold or para thesis is my emphasis. From the WSJ:

U.S. government officials released a plan to take stakes in nine large financial institutions in an effort to help revive the banking sector and fight the global credit crunch.

In one of the most dramatic actions taken by regulators to address the financial crisis, officials plan to funnel up to $250 billion from the $700 billion financial rescue package into potentially thousands of banks through the new, voluntary program.

The government is set to buy preferred equity stakes in
Goldman Sachs Group Inc., Morgan Stanley, J.P. Morgan Chase & Co., Bank of America Corp. -- including the soon-to-be acquired Merrill Lynch -- Citigroup Inc., Wells Fargo & Co., Bank of New York Mellon and State Street Corp.

Banks have a month to join Treasury's capital purchase program. They must elect to participate before 5 p.m. on Nov. 14.

"The efforts are designed to directly benefit the American people by stabilizing the financial system and helping the economy recover,'' President George W. Bush said in a morning announcement.

Additionally, federal regulators announced that they'd guarantee new bank debt and expand insurance for non-interest-bearing accounts. They also issued new details on a plan to backstop the commercial paper market, where major corporations go for critical loans to fund their daily operations.

"They've exposed the whole toolkit," said Vincent Reinhart, former head of the Fed's monetary affairs division. "What do you do if this doesn't work? You do more of it."

Under the last step announced by Mr. Bush, the Federal Reserve will finalize a program to serve as a buyer of last resort for commercial paper, an important source of short-term financing for businesses banks.

Treasury Secretary Henry M. Paulson, Federal Reserve Chairman Ben Bernanke, and FDIC Chairman Sheila Bair also made comments Tuesday.

Mr. Bernanke said the U.S. will not "stand down" until financial system and prosperity restored. Mr. Paulson, in his own remarks, said financial institutions in the new program will limit executive compensation. He said that "government owning a stake in any private U.S. company is objectionable to most Americans," but said the alternative "of leaving businesses and consumers without access to financing is totally unacceptable."

Some of the big banks were unhappy about the government taking equity stakes, but acquiesced under pressure from Mr. Paulson in a meeting Monday. During the financial crisis, the government has steadily increased its involvement in financial markets, culminating with a move that rivals the breadth of the government's response to the Great Depression. It intertwines the banking sector with the federal government for years to come and gives taxpayers a direct stake in the future of American finance, including any possible losses.

Formulated jointly by the Treasury, the Fed and the FDIC, these moves announced Tuesday are designed to keep money flowing through the financial system, ensuring that banks continue lending to companies, consumers and each other. A freeze in these markets rippled through the economy and helped cause stocks to crater last week.

"Government owning a stake in any private U.S. company is objectionable to most Americans -- me included," Mr. Paulson said in a statement Tuesday. "Yet the alternative of leaving businesses and consumers without access to financing is totally unacceptable."

Along with the government's involvement come certain restrictions, such as caps on executive pay. For example, firms can't write new employment contracts containing golden parachutes and their ability to use certain executive salaries as a tax deduction is capped. These restrictions are relatively weak compared with what congressional Democrats had wanted when they approved this spending, a potential flash point.

Some critics also say Treasury should have formulated a comprehensive plan earlier in the crisis. Even if this move helps mend credit markets, the economy is likely to suffer in the months ahead from the aftershocks of the recent turmoil. (It is easy to Monday morning quarterback in a crisis. It is much more difficult to join them shoulder to shoulder on the firing step.)

A central plank of these new efforts is a plan for the Treasury to take about $250 billion in equity stakes in potentially thousands of banks, using funds approved by Congress through the recently approved $700 billion bailout plan.

Treasury will buy $25 billion in preferred stock in Bank of America -- including Merrill Lynch -- as well as J.P. Morgan and Citigroup; between $20 billion and $25 billion in Wells Fargo; $10 billion in Goldman and Morgan Stanley; $3 billion in Bank of New York Mellon; and about $2 billion in State Street.

The government will purchase preferred stock, an equity investment designed to avoid hurting existing shareholders and deterring new ones. Such shares typically don't come with voting rights. They will carry a 5% annual dividend that rises to 9% after five years, according to a person familiar with the matter. By investing in several big firms at once, the government hopes to avoid placing a stigma on any one firm for getting government help.

The plan will be structured to encourage firms to bring in private capital. For instance, firms returning capital to the government by 2009 may get better terms for the government's stake, a person familiar with the discussions said.

Among the other key components of the plan is the FDIC temporarily guarantee, for a fee, certain types of new debt called senior unsecured debt issued by banks and thrifts. This would apply to debt issued by June 30 with maturities up to three years. One problem plaguing credit markets has been a fear among financial institutions that it is unsafe to lend to each other even for periods of a few days. U.S. officials hope this guarantee removes that fear, which could bring down short-term lending rates, such as the London interbank offered rate, or Libor, a benchmark for consumer and business loans.

The FDIC is also temporarily offering banks unlimited deposit insurance for non-interest bearing bank accounts typically used by small businesses, through 2009. This would be voluntary for banks, and would extend the $250,000 per depositor limit lawmakers agreed on two weeks ago. To use these new powers, the FDIC is invoking a "systemic risk" clause in federal banking law that allows it to take extreme steps to prevent shocks to the economy.

The FDIC's central role in the plan is consistent with its presence during past banking crises, the Great Depression and the savings and loan crisis. Each crisis sparked a major boost in the agency's power.

The shift brings U.S. policy more in line with that of other countries. Monday, the U.K., Germany, France, Spain and Italy provided further details of measures to buy stakes in struggling banks and offer lending guarantees. The U.K., which first formulated such a plan, is planning to issue some £37 billion ($63.1 billion) in new government debt to pay for purchases of the common and preferred shares of three big banks.

The U.S. plan to inject capital into banks is expected to be open to almost all such institutions, with a focus on getting the participation of the firms most important to the financial system, according to people familiar with the matter. Treasury's main goal is to attract private capital. To make sure private investors aren't scared away, it is expected to structure its investment on terms favorable to the banks and will inject capital in exchange for preferred shares or warrants, these people said.

The government's new focus is raising questions about why it didn't adopt such an approach sooner. Mr. Paulson actively opposed the idea of investing in banks because he worried about picking winners and losers, though Fed Chairman Ben Bernanke was an early advocate. Mr. Paulson was also concerned banks wouldn't participate because of the perceived stigma and the potential for the government to meddle in their affairs, according to people familiar with the matter.

Senior executives and advisers to some of the nation's leading banks pitched such a plan at various points earlier this summer but were rebuffed by officials at Treasury and the Fed, according to people familiar with the matter. Instead, Treasury initially marched ahead with a plan to buy distressed assets directly from banks.

House Democratic leaders, including Speaker Nancy Pelosi and House Financial Services Committee Chairman Barney Frank, held a closed-door session Monday with 11 economists and other advisers. The group threw its weight behind Treasury's decision to inject capital into the banking system.

"The consensus was so strong towards direct equity injections that there was literally no dissension on the point," said one of the invited economists, Jared Bernstein of the liberal Economic Policy Institute. "The only head-scratching is why did it take us so long to get here?"

Officials at the Treasury and Federal Reserve have been looking for a comprehensive approach to the credit crisis after a series of ad hoc interventions and say they didn't have the authority to make such a comprehensive move until Congress passed the bailout bill. The government's various moves, from saving mortgage giants Fannie Mae and Freddie Mac to letting Lehman Brothers Holdings Inc. fail, have confused investors and frozen many in place at a time when the banking system was desperate for fresh capital. That contributed to what in essence was a high-level run on Wall Street banks, with funding drying up overnight.

The government's hope is that the new plan will more thoroughly address the problems of ailing financial institutions and persuade private investors that government involvement won't come at their expense.

For troubled assets there is the Troubled Asset Relief Program, created by the $700 billion bailout bill, which gives the Treasury Department authority to acquire bad assets from banks and other financial institutions. TARP will also be used by Treasury when it puts new equity into banks.

The other steps, including the FDIC's role in guaranteeing new funds raised by banks and thrifts, are designed to address the way banks fund themselves, freeing them to start lending again.
Meanwhile, the Federal Reserve announced that beginning Oct. 27, a new program will be open to fund purchases of commercial paper of three-month maturity from high-quality issuers. It will cease purchasing commercial paper on April 30, unless the program is extended.

Unsecured commercial paper will be priced at the three-month overnight index swap rate plus 100 basis points with an additional 100-basis-point surcharge. Asset-backed commercial paper will be priced at the OIS rate plus 300 basis points.

Libor rates, which are set daily in London, fell in anticipation of Tuesday's announcement. The largest decline was in overnight Libor rates, though one- and three-month rates also fell. Prices of U.S. Treasury bills, which usually benefit from flight-to-quality buying, fell Tuesday -- a sign that investors are willing to take on more risk. (The spread between short term Treasury and LIBOR rates are probably still too high.)

Mr. Ben Bernanke on Tuesday made clear that regulators will keep taking actions until the turmoil in financial markets eases. "We will not stand down until we have achieved our goals of repairing and reforming our financial system and thereby restoring prosperity to our economy," he said.
William Poole, former president of the Federal Reserve Bank of St. Louis, was a fierce critic of Treasury's initial plan to buy up distressed mortgage-backed securities. Such a scheme, he said, would lead banks to dump their worst assets on the taxpayers.

But Treasury's new tack may well do the trick, said Mr. Poole, now a senior fellow at the free-market-oriented Cato Institute.

"Investors need to be confident that the banks they're dealing with are unquestionably solvent, and it's in the interest of banks to assure investors that that's the case," he said. "One way banks can provide that assurance is to raise additional capital, in some combination of private and government capital."

Dean Baker, co-director of the left-of-center Center for Economic and Policy Research, argues the country may have turned a corner on the financial panic -- the fear that has kept banks and investors from making even the most prudent loans. "I think we're through the worst on that," he said. "Maybe I'll be proven wrong, but it really was at an extreme last week."

Blanket guarantees, however, might inspire banks to take unnecessary risks, warned Frederic Mishkin, a Columbia University economist who stepped down as Fed governor in August. "You don't want to give a guarantee to banks that are in trouble" that might try to gamble their way out of problems, he said. He says offering broad guarantees will require that U.S. officials more aggressively act to sort out good banks from bad banks.

One sticking point could come from Congress, which wrote into the original bailout bill requirements that Treasury tamp down executive pay. Rep. Frank said Monday he wants the government to set tough conditions for any company that receives a capital injection. If Mr. Paulson didn't enforce such rules, Mr. Frank said the Treasury secretary could be "making a big mistake." (Maybe they should roll AIG executives into this as well.)

Monday, October 13, 2008

Some Historical Perspective on the Stock Market

Below is an article in the WSJ that I found interesting, because it gives you some perspective on the market. By the way, if you want to believe that today's gain in the DJIA means the market is back, that is up to you. This is a dance I plan to sit out. Text in bold is my emphasis.

July 9, 1932 was a day Wall Street would never wish to relive. The Dow Jones Industrial Average closed at 41.63, down 91% from its level exactly three years earlier. Total trading volume that day was a meager 235,000 shares. "Brother, Can You Spare a Dime," was one of the top songs of the year. Investors everywhere winced with the pain of recognition at the patter of comedian Eddie Cantor, who sneered that his broker had told him "to buy this stock for my old age. It worked wonderfully. Within a week I was an old man!"

The nation was in the grip of what U.S. Treasury Secretary Ogden Mills called "the psychology of fear." Industrial production was down 52% in three years; corporate profits had fallen 49%. "Many businesses are better off than ever," Mr. Cantor wisecracked. "Take red ink, for instance: Who doesn't use it?"

Banks had become so illiquid, and depositors so terrified of losing their money, that check-writing ground to a halt. Most transactions that did occur were carried out in cash. Alexander Dana Noyes, financial columnist at the New York Times, had invested in a pool of residential mortgages. He was repeatedly accosted by the ringing of his doorbell; those homeowners who could still keep their mortgages current came to Mr. Noyes to service their debts with payments of cold hard cash.

Just eight days before the Dow hit rock-bottom, the brilliant investor Benjamin Graham -- who many years later would become Warren Buffett's personal mentor -- published "Should Rich but Losing Corporations Be Liquidated?" It was the last of a series of three incendiary articles in Forbes magazine in which Graham documented in stark detail the fact that many of America's great corporations were now worth more dead than alive.

More than one out of every 12 companies on the New York Stock Exchange, Graham calculated, were selling for less than the value of the cash and marketable securities on their balance sheets. "Banks no longer lend directly to big corporations," he reported, but operating companies were still flush with cash -- many of them so flush that a wealthy investor could theoretically take over, empty out the cash registers and the bank accounts, and own the remaining business for free.

Graham summarized it this way: "...stocks always sell at unduly low prices after a boom collapses. As the president of the New York Stock Exchange testified, 'in times like these frightened people give the United States of ours away.' Or stated differently, it happens because those with enterprise haven't the money, and those with money haven't the enterprise, to buy stocks when they are cheap."

After the epic bashing that stocks have taken in the past few weeks, investors can be forgiven for wondering whether they fell asleep only to emerge in the waking nightmare of July 1932 all over again. The only question worth asking seems to be: How low can it go?

Make no mistake about it; the worst-case scenario could indeed take us back to 1932 territory. But the likelihood of that scenario is very much in doubt.

Robert Shiller, professor of finance at Yale University and chief economist for MacroMarkets LLC, tracks what he calls the "Graham P/E," a measure of market valuation he adapted from an observation Graham made many years ago. The Graham P/E divides the price of major U.S. stocks by their net earnings averaged over the past 10 years, adjusted for inflation. After this week's bloodbath, the Standard & Poor's 500-stock index is priced at 15 times earnings by the Graham-Shiller measure. That is a 25% decline since Sept. 30 alone.

The Graham P/E has not been this low since January 1989; the long-term average in Prof. Shiller's database, which goes back to 1881, is 16.3 times earnings.

But when the stock market moves away from historical norms, it tends to overshoot. The modern low on the Graham P/E was 6.6 in July and August of 1982, and it has sunk below 10 for several long stretches since World War II -- most recently, from 1977 through 1984. It would take a bottom of about 600 on the S&P 500 to take the current Graham P/E down to 10. That's roughly a 30% drop from last week's levels; an equivalent drop would take the Dow below 6000.

Could the market really overshoot that far on the downside? "That's a serious possibility, because it's done it before," says Prof. Shiller. "It strikes me that it might go down a lot more" from current levels.

In order to trade at a Graham P/E as bad as the 1982 low, the S&P 500 would have to fall to roughly 400, more than a 50% slide from where it is today. A similar drop in the Dow would hit bottom somewhere around 4000.

Prof. Shiller is not actually predicting any such thing, of course. "We're dealing with fundamental and profound uncertainties," he says. "We can't quantify anything. I really don't want to make predictions, so this is nothing but an intuition." But Prof. Shiller is hardly a crank. In his book "Irrational Exuberance," published at the very crest of the Internet bubble in early 2000, he forecast the crash of Nasdaq. The second edition of the book, in 2005, insisted (at a time when few other pundits took such a view) that residential real estate was wildly overvalued.

The professor's reluctance to make a formal forecast should steer us all away from what we cannot possibly know for certain -- the future -- and toward the few things investors can be confident about at this very moment.

Strikingly, today's conditions bear quite a close resemblance to what Graham described in the abyss of the Great Depression. Regardless of how much further it might (or might not) drop, the stock market now abounds with so many bargains it's hard to avoid stepping on them. Out of 9,194 stocks tracked by Standard & Poor's Compustat research service, 3,518 are now trading at less than eight times their earnings over the past year -- or at levels less than half the long-term average valuation of the stock market as a whole. Nearly one in 10, or 876 stocks, trade below the value of their per-share holdings of cash -- an even greater proportion than Graham found in 1932. Charles Schwab Corp., to name one example, holds $27.8 billion in cash and has a total stock-market value of $21 billion.

Those numbers testify to the wholesale destruction of the stock market's faith in the future. And, as Graham wrote in 1932, "In all probability [the stock market] is wrong, as it always has been wrong in its major judgments of the future."

In fact, the market is probably wrong again in its obsession over whether this decline will turn into a cataclysmic collapse. Eugene White, an economics professor at Rutgers University who is an expert on the crash of 1929 and its aftermath, thinks that the only real similarity between today's climate and the Great Depression is that, once again, "the market is moving on fear, not facts." As bumbling as its response so far may seem, the government's actions in 2008 are "way different" from the hands-off mentality of the Hoover administration and the rigid detachment of the Federal Reserve in 1929 through 1932. "Policymakers are making much wiser decisions," says Prof. White, "and we are moving in the right direction."

Investors seem, above all, to be in a state of shock, bludgeoned into paralysis by the market's astonishing volatility. How is Theodore Aronson, partner at Aronson + Johnson + Ortiz LP, a Philadelphia money manager overseeing some $15 billion, holding up in the bear market? "We have 101 clients and almost as many consultants representing them," he says, "and we've had virtually no calls, only a handful." Most of the financial planners I have spoken with around the country have told me much the same thing: Their phones are not ringing, and very few of their clients have even asked for reassurance. The entire nation, it seems, is in the grip of what psychologists call "the disposition effect," or an inability to confront financial losses. The natural way to palliate the pain of losing money is by refusing to recognize exactly how badly your portfolio has been damaged. A few weeks ago, investors were gasping; now, en masse, they seem to have gone numb.

This collective stupor may very likely be the last stage before many investors finally let go -- the phase of market psychology that veteran traders call "capitulation." Stupor prevents rash action, keeping many long-term investors from bailing out near the bottom. When, however, it breaks and many investors finally do let go, the market will finally be ready to rise again. No one can spot capitulation before it sets in. But it may not be far off now. Investors who have, as Graham put it, either the enterprise or the money to invest now, somewhere near the bottom, are likely to prevail over those who wait for the bottom and miss it.

Models for What the US is Trying to Accomplish are Already Out There - Use Them

The are models out there for what the US is trying to accomplish with the bail-out program. We should use them. Text in bold is my emphasis. From the WSJ:

Talk about your role reversals. In the past few weeks, officials at the Federal Reserve have discussed the unfolding crisis with at least one central banker from a developing nation who witnessed his own country's financial system implode: Mexico's Guillermo Ortiz.

The Stanford graduate was Mexico's finance minister during the country's 1994-95 peso collapse, which led to a massive government bank bailout and Mexico's biggest economic slump since the Great Depression.

The so-called Tequila Crisis, named after Mexico's national drink, is today seen as the first financial crisis of the globalized economy. The U.S. put together a massive credit line that helped Mexico emerge from the crisis and grow prosperous in its wake.

Last week, before the start of the International Monetary Fund's annual meeting, the Mexican central banker, who steered his nation to recovery in those dark days, met with Fed Chairman Ben Bernanke. Mr. Ortiz had previously met with some Fed officials in mid-September.

Mr. Ortiz declined to discuss details of the discussions, but the fact that officials in Washington are talking to foreign officials such as Mr. Ortiz suggests they are open to learning from other countries' experiences -- even as the current crisis roils those very nations. Mexico, for its part, has had to spend about a tenth of its foreign exchange reserves defending the peso, and the cost of credit is soaring for Mexican companies, as it is for so many others.

Nonetheless, many of the lessons of the Tequila Crisis and others like it apply to the U.S. Among the most important: Don't be ruled by ideology -- stay flexible and act decisively. Help those with mortgages they can't pay. Take stakes in troubled banks. Don't expect to turn a profit on government investment.

"Do whatever it takes to restore confidence," Mr. Ortiz said in an interview. "Once you lose it, it's very difficult to get it back."

In today's globalized financial markets, once trust is blown, the markets will often overreact and the crisis will spin out of control. As a result, policy makers may need to take steps they never imagined taking. The longer they wait, the worse the pain. We are already learning this lesson the hard way.

In nearly all financial crises, the government usually reacts too slowly at first. In the case of the U.S., the Federal Reserve and Treasury tried to put out each fire as it flared, first bailing out Bear Stearns, then insurance giant AIG, then lender Washington Mutual.

At some point, an event happens that causes the market to lose confidence. In Mexico, it was a failed attempt by the central bank to gradually devalue the peso, a move that destroyed the bank's credibility. In the U.S., it may have been letting Lehman Brothers Holdings Inc. fail, a move that created uncertainty among investors as to which financial institutions would be saved and which wouldn't.

Since then, authorities in both the U.S. and Europe have been scrambling to catch up to the crisis. "Despite all of the measures that have been taken, the authorities are now behind the curve ," Mr. Ortiz said in remarks Sunday to the Institute of International Finance in Washington. "It's better to err on the side of doing too much rather than doing too little."

In the end, Mexico acted directly to tackle the underlying problem of bad debt by launching a program to restructure mortgages, with banks, borrowers and the government all sharing loses.

The key to a mortgage restructuring: "Keep it simple," says Vicente Corta, who led Mexico's bank bailout program for several years. "We tried fancy schemes that didn't work. We ended up saying, 'OK, you pay half your mortgage, and we'll pick up the other half.' "

Mexico's bank bailout itself didn't ward off a major economic recession, although the country was also dealing with a currency crash. But within a few years, Mexican banks were healthy and the economy was growing again.

What lasted longer was political bitterness linked to the bailout, which was seen as having helped rich bankers at taxpayers' expense.

The Mexican and U.S. bank rescue plans have both involved the government taking bad loans from bank books in order to get credit flowing again. Much like Washington, the Mexican government expected to break even and possibly make some money on the bad loans that it purchased.

The reality: The government lost money -- lots of it. The bailout's final price tag of about $75 billion was three times what the Mexican government expected. In other words, the $700 billion U.S. rescue plan could be just the beginning of the final cost.

In Mexico's bailout, banks were required to recapitalize as a condition of selling bad loans to the government. In some cases, bank owners put up new money. Banks that couldn't were forced to merge or sell to a foreign bank, or were taken over by the government.

In recent days, the U.S. government has appeared to be moving toward a major recapitalization program, opening the door to the possibility that the U.S. government might take direct stakes in the banks.

A government stake in banks might help ease the inevitable political fallout. Mexico learned -- again, the hard way -- the importance of designing a bailout that gives the government, and by extension the taxpayers, some upside in an eventual recovery. Consider the case of Banamex, Mexico's biggest bank.

Banamex's owners recapitalized the bank and sold billions of dollars in bad loans to the government -- which didn't take a stake in the bank. Once healthy, the bank was later sold to Citigroup for $12 billion, in a transaction in which Banamex's owners didn't pay a dime in taxes.

In Mexico, many voters felt betrayed by the bailout, which poisoned the political atmosphere for years. It was one reason why a left-wing populist candidate, Andrés Manuel Lopez Obrador, nearly won the presidency in 2006. Every year at budget time, there are still debates about spending so much money on rescuing banks, versus public schools.

Whoever wins the U.S. presidential election is bound to deal with other political fallout as well. The auto industry is already using the financial bailout to win a big loan program in Congress; expect other troubled industries to line up for rescues, too. And every time an industry gets bailed out, ordinary workers and powerful unions will expect help as well.

Today’s Contemplation – Things Are Not Getting Better for Awhile!

Other than limited comments about articles in the media I seldom give my opinion about what the future holds. Considering the condition of the various markets adding my voice to the of voices already out there certainly will not make the situation anymore confusing. To demonstrate that I have some knowledge of the financial/economic system, here are a few comments about who I am and what I do:

1. I have been in the banking/finance business for almost 3 decades
2. Most of my time was spent on the consumer side business in Risk Management
3. I talk regularly with my friends in the business, that are now in other major banks, financial institutions, and regulatory agencies.
4. In my current position I complete a monthly update of current economic conditions and forecast losses for the mortgage and home equity portfolios.

Where we are today:

1. We are currently in the midst of the worst decline in housing prices since the Great Depression. The decline results from over-leveraging asset purchases coupled with weak underwriting practices at a number of banks. Basically, the banks and other creditors (those who bought the debt securities) took on too much risk.

2. This decline in housing prices and the associated defaults on mortgages and home equity lines and loans are causing a dramatic increase in non-performing assets and losses at banks (includes S&Ls), that will take some time to work-off.

3. The mortgage losses have put the banks and mortgage insurance industry at considerable risk.

4. Although little is said about the commercial real estate market, the significant weakness in this sector will have profound effects on many local and regional banks.

5. The continued problems at the banks, has led to a number of failures and mergers in the industry (Indy Mac, Wachovia, Countrywide, Washington Mutual, etc.).

6. Due to the losses and uncertainty surrounding the value of homes, banks have largely stopped lending in this sector or made qualifying for a loan very onerous. This is “choking-off” the demand for houses, because the demand for houses is ultimately a function of one’s ability to borrow. In turn this is further depressing the price of homes.

7. The fear of continuing losses at the banks, uncertainty about the value of collateral, etc. is causing severe tightening in the credit markets, including bank to bank, bank to business (commercial lending), and bank to consumer (retail lending).

8. Losses in real estate are spilling over into other loan portfolios such as auto and credit cards as the economy weakens. Other smaller consumer portfolios such as RV and boat are extremely weak.

9. The severe tightening in the credit markets has caused portions of the credit markets to “seize-up” and no longer function.

10. The significant drop in real estate prices, severe tightening in the credit markets, and the associated decline in economic conditions is causing widespread panic among investors. One way this is manifesting itself is in widespread redemptions at mutual funds and hedge funds causing a significant “crash-like” drop in stock prices over the past two weeks.

11. The purpose of the Bail-Out Bill (TARP) is to keep the banking system in functioning. By definition it does not and will not address deteriorating conditions in the housing market.

12. The success of the Bail-Out Bill is not guarantied. In addition it is changing in its scope and execution as cooperation is sought with banks in Europe.

13. The various world governments and central banks are working extremely hard to avoid the mistakes made in the 1930s, namely tight money and a lack of international cooperation. However, with that said success is not guarantied. The mistakes of the past are understood, but no one knows if the current actions are sufficient to avoid an economic catastrophe.

14. By the time this is all over, the bill for this “bail-out” of the financial industry will cost over $1T (that is T as in trillion, $750 B for TARP, $122 B for AIG, and we haven’t started adding up the FDIC losses or additional bail-outs yet). Admittedly, much of this will be repaid over time, but the money still has to go out the door now.

15. By the way, in terms of being repaid on the $1T mentioned in point #14, " I'll believe it when I see it."

Where we are headed:

1. Due to the panic selling and concerns about the preservation of capital expect the stock market to continue to fall. How far will it go? Not sure, but a DJIA in the 6000 range would not be surprising.

2. Will the recovery be V-shaped like 1987? Probably not, the economy in 1987 was in much better shape than the economy now. The market will probably decline and then bounce along the bottom for some time. Don’t be surprised if this bouncing along the bottom lasts for 2 – 4 years.

3. There is a good chance there will be a stock market rally between now and first of the year, but after the first of the year the market will reach new lows as economic conditions deteriorate further and earnings are weak.

4. We are probably in the midst of a long-term bear market that started in January 2000 will probably continue until 2011 – 2015.

5. Banks and other financial institutions will continue to suffer from on-going loan losses. Losses in 2009 will probably be worse then 2008.

6. The banks will probably take until 2011 or 2012 to work-off their inventory of bad loans, non-performing assets, and OREOs (real estate owned largely resulting from foreclosure).

7. The housing market will not recover for some time (2 – 4 years). The housing market needs to work through its inventory of existing homes and the shadow supply of homes (people that want to sell but will not due to poor market conditions). This will be difficult because conditions in the credit markets and declining economic conditions will make it difficult to borrow.

8. The de-levering of the economy will continue. How fast or slow this proceeds depends on how well the stabilization efforts of the world’s governments and central banks works.

9. The financial crisis playing-out in the media everyday is only half the problem. The difficulties in that sector are only beginning to be felt in the consumer economy. Expect a difficult holiday season in 2008, which will continue into 2009 as the consumer finds little to be optimistic about.

10. The banking/finance industry in the US and many other countries will undergo significant changes, mostly in the form of new regulations.

11. Two businesses in the US that will shrink significantly and will be slow to return to their former prominence (a generation) are investment banking and consumer mortgage/loan brokers.