Multiple Disasters at WCI

There are disasters in the making at WCI. Let's takes a look.
On February 27th WCI reported wider-than-expected quarterly loss.

WCI Communities Inc. a Florida upscale home and condominium builder that may put itself up for sale, on Tuesday reported a wider-than-expected quarterly net loss, amid the weak U.S. housing market.

The company posted a quarterly net loss of $64.6 million, or $1.52 per share, versus a profit of $54.6 million, or $1.20 per share, in the year-earlier quarter.

Analysts had expected a net loss of $1.37 per share, according to Reuters Estimates.

Excluding the impact of $118.3 million for the write-off for deteriorating values of its land holdings and residential towers, WCI's income was $6.6 million or 18 cents per share.

Fourth-quarter revenue fell 37.6 percent to $526.3 million, the result of lower sales, higher cancellations of both homes and condominiums, the Bonita Springs, Florida company said.

Gross margins as a percentage of revenue were negative during the quarter, WCI said, a result of write-offs and greater sales cuts.

Earlier this month, WCI said it hired Goldman Sachs & Co. to explore strategic options, which included a possible sale, selling some assets or repurchasing stock. The move was viewed as a response to pressure from investors such as Carl Icahn, Hotchkiss & Wiley Capital Management and SAC Capital Advisors.

WCI last month adopted a shareholder rights plan, commonly known as a "poison pill" after investor Carl Icahn said he had boosted his stake in the company to 14.6 percent.

Meanwhile, billionaire investor Icahn said he and nine others will seek seats on the WCI board. WCI said Icahn's hand-picked slate would further his personal objectives and would be highly disruptive to the company.

A Realistic Look

1. No one in their right mind would want to but this company. Of course that does not exclude it from happening as insane leveraged buyouts of all sorts have been happening recently. However, I suspect the widening of credit spreads and recent global stock market action will put an end to such absurdities sooner rather than later.
2. Poison pills are an act of desperation.
3. The threat of repurchasing stock is a bluff. WCI has a serious cash flow problem and wasting money repurchasing stock would compound it.

Forecast Withdrawn

Later in the day WCI withdrew its 2007 earnings forecast.

Feb 27 WCI Communities Inc. a builder of upscale homes and high-rise apartment buildings, chiefly in Florida, withdrew its 2007 earnings forecast on Tuesday, citing difficulty in forecasting regional housing demand.

In November the company forecast 2007 earnings of $1 to $2 per share.

"Because of the lack of visibility on demand, cancellations that we've experienced ... we're withdrawing the guidance that we provided previously and believe that the most important metrics for WCI to focus on during 2007 is cash flow and debt reduction," Jerry Starkey, president and chief executive, said during a conference call with analysts.

Reasons for withdrawing forecast

• No visibility
• Cancellations exceeding closings
• Difficulty in forecasting regional demand
• Wants to focus on cash flow and debt reduction

Liquidity Crunch

Is there a liquidity crunch at WCI? Rodger Rafter on The Market Traders offered these thoughts:

WCI wants to generate $1 billion in cash flow from operations this year. Last year they burned $490 million, and they burned smaller amounts in 2004 and 2005, so that would be quite a turn around. Indeed, for many years builders were content to pile up inventory of land and homes for sale, along with mountatins of debt. They didn't care about cash from operations when there was plenty of cash from financing to be had.

Why the sudden need to generate cash?

My take is that the financing is drying up. If builders can't raise cash from operations while the losses are mounting, then they'll have an especially hard time getting lenders to extend their credit agreements. With today's write-offs, WCI is already in violation of their credit covenants. DHOM violated theirs last year and had to renegotiate at significantly higher interest rates. OHB is also on a mission to generate cash from operations.

WCI Releases Fourth Quarter and Full Year 2006 Earnings

Financial Highlights

• Full year 2006 net income: $9.0 million
• Full year 2006 diluted EPS: $0.21
• Full year 2006 figures include $139.5 million of pre-tax asset impairments & write-offs
• Full-year 2006 diluted EPS before impairments and write-downs: $2.16
• Fourth quarter net income: loss of $64.6 million
• Fourth quarter diluted EPS: loss of $1.52
• Fourth quarter figures include $118.3 million of pre-tax asset impairments & write-offs
• Fourth quarter diluted EPS before impairments and write-offs: $0.18
• 2006 year-end backlog: $911.2 million vs. $2.05 billion in 2005
• Projected 2007 cash flow from operations of approximately $1 billion
• Projected year-end 2007 net debt to capital ratio of approximately 50%

click on chart for a better view


"Our principle business focus in 2007 is on maximizing cash flow, reducing debt, and improving our financial flexibility. We expect to generate approximately $1 billion of cash flow from operations during 2007. While all aspects of our business will contribute to this cash flow objective, completing and closing nine towers during the year is the primary driver. We expect around $1 billion in collections from the closing of those nine towers and from the closing of the remaining sold units from three towers that were completed in December 2006."

WCI has not made its numbers for a year, the economy is headed into a recession, they have negative new orders for their latest quarter, and demand for condos is in the gutter. In addition they have "lack of visibility on demand" and are "withdrawing the guidance provided previously" yet somehow we are supposed to believe they are going to "complete and close nine towers" and that will be the "primary driver" enabling them to "generate approximately $1 billion of cash flow from operations during 2007." As ridiculous as it sounds, someone must believe that story or their stock would be trading closer to $2 than $20.

Mike Shedlock / Mish
http://globaleconomicanalysis.blogspot.com/

Fed Is Ready and Willing To Act

Market Watch is reporting Fed ready to act in a financial crisis.

The Federal Reserve stands ready to lower interest rates if a financial crisis erupts, said Tim Geithner, the president of the New York Fed, on Wednesday. "As always, central banks need to stand prepared to make appropriate monetary policy adjustments if changes in financial conditions would otherwise threaten the achievement of the goals of price stability and sustainable economic growth," Geithner said in a speech about liquidity in financial markets to a business group.

Geithner said his remarks were general in nature and not related to "the specific conditions of the moment" where the stock prices plunged around the world. Geithner said liquidity, like market confidence, is very difficult to measure and a reversal of both liquidity and confidence play a critical role in leading to financial shocks. Geithner said financial regulators have a difficult time in predicting when liquidity may reverse.

The best way to limit the risk of crisis is shock absorbers in the financial system. "These shock absorbers are substantially stronger today that they have been even in the relatively recent past," Geithner said.

Exactly who does Geithner think he is fooling when he said his comments were general in nature and not related to the "specific conditions of the moment". Even if by some miracle those were planned comments that just happened to come when they did, Geithner without a doubt proved he is just another Fed charlatan.

One of the reasons bubbles keep getting bigger and bigger is because the Fed has a history of being ready and willing to act. Market participants know the fed is ready and willing and plan on the Fed bailing them out when risk gets blown out of the water.

Geithner is now openly bragging "These shock absorbers are substantially stronger today that they have been even in the relatively recent past". There is a curious thing about those shock absorbers, though: It seems they have get stronger and stronger to work. The last "shock absorber" took interest rates down to 1% while creating the mother of all bubbles in credit lending and housing. What's next ye great wizards?

The best way to limit risk is to not let asset bubbles and risky conditions foment in the first place. Instead, the charlatans at the Fed are depending on shock absorbers to cover up their own mistakes. Eventually (perhaps it has started already, perhaps not), one of those shock absorbers will fail. That is when the charlatans at the Fed will be exposed for what they are.

Mike Shedlock / Mish
http://globaleconomicanalysis.blogspot.com/

Advance / Decline & Volatility Charts 2007-02-27

Following are a few charts of interest for February 27, 2007.
Click on any chart for a better view.

NYSE Declining Volume



NYSE Advancing Volume



NYSE Declining Issues



NYSE Advancing Issues



$Nasdaq Declining Volume



$Nasdaq Advancing Volume



Nasdaq Declining Issues



Nasdaq Advancing Issues



VIX



VXN

Quick Observations

Following are a few quick observations by 3 astute observers of today's stock and commodity market action.

Trotsky on The Market Traders:

I've seen something very unusual today - market-on-close bidding for index puts. I have a feeling this doesn't bode well for tomorrow.

There must be a load of open derivatives positions that have suddenly turned sour. e.g. I noticed a big put seller getting active just before the plunge accelerated, apparently on a 'this is business as usual' assumption. Maybe it is, but the odds chart-wise are that it isn't. Also, this has the typical feel of a sudden turn in sentiment from totally complacent to full of fear - and the fear has not found full expression just yet.

Please note, market 'liquidity' is largely a psychological phenomenon. It is those sudden turns when liquidity evaporates the fastest.

Professor John Succo on Minyanville:

Interestingly, I've only seen option sellers. Vega is up a little but not much. There's no panic put buying--the VXO is up only because correlation between stocks is up.

Professor Kevin Depew on Minyanville

Tomorrow has the potential to be an even more severe day. For one thing, unlike May when a partial carry trade unwind began mid-month, this "event" has occurred at the end of the month, beginning in Asia and spreading across the globe.

There are many risk models that will need to be de-leveraged tomorrow - portfolios that most likely were not even considered at risk going into today. With the VIX up more than 62% today models that adjust on month's end will require some fine-tuning tonight... to say the least.

What is most interesting as a tell is weakness today in gold and gold shares. Leverage is everywhere.

Leverage is indeed everywhere and today is just a down payment on the unwinding of that leverage. Whether or not tomorrow is "business as usual" remains to be seen but the risk of a "sustained event" is certainly not going away.

Mike Shedlock / Mish
http://globaleconomicanalysis.blogspot.com/

Understatement of the Month Award

The understatement of the month award goes to Garry Evans at HSBC for his comment on the Shanghai Composite Index "I think the market had gotten a little too expensive".

China's leading stock index tumbled nearly 9% Tuesday, marking its biggest plunge in a decade, on concerns of more economic tightening measures as China's parliament prepares for its annual session next week.

The Shanghai Composite Index, which tracks shares listed on the larger of China's two stock exchanges, tumbled 8.8% to 2,771.79. The declines rank as its biggest single-day drop since the benchmark plunged 9.4% on Feb. 18, 1997, which reportedly came after the death of reformist Communist Party elder Deng Xiaoping.
The Shenzhen Composite, a gauge of shares on China's smaller exchange, shed 8.5% to 709.81.

Analysts said the declines, which came a day after the Shanghai Composite ended at an all-time high, were sparked by concerns the government may implement new measures to cool speculative behavior.

Market watchers said investors in China were spooked by rumors the government may impose a 20% capital gains tax, while comments by People's Bank of China Governor Zhou Xiaochuan, published in a Chinese-language publication Tuesday, also stirred unease about the prospect for further rate hikes.

"If inflationary pressure increases the central bank should consider monetary policy action, including interest rate policy," the Xinhua Finance news service reported Zhou as saying in the interview, which was published in the Hong Kong Commercial Daily.

Investors were also wary that additional macro-tightening policies could be in the works after the annual session of the China's National People's Congress, which gets underway March 5. China's central bank lifted the reserve requirement on domestic banks by 50 basis points from Sunday.

"I think the market had gotten a little too expensive and had reached about 26 times forward price earnings, at the top of what we see as a fair value range," Evans said. Prior to Tuesday's decline the Shanghai Composite had risen 14% year to date, following on from a 130% gain in 2006.

Chart Defining "A Little Too Expensive"



How did this happen?

Inquiring minds might be wondering just how the market got "A Little Too Expensive". That's a good question. For the answer we turn to Eager Chinese grab bull market by the horns.

February 16, 2007

SHANGHAI — After emptying his savings account, Lu Gang borrowed funds from his mother, relatives and friends. Now he's planning to mortgage his home.

Where's all the money going? Into China's booming stock market.

"Both of my parents think it's crazy, but I think it is OK," said the 26-year-old investment company manager, who's already sunk about $15,000 into stocks since getting in on the action last summer. "If there is opportunity, you have to grasp it."

Millions of Chinese have entered the trading frenzy in the last year amid the strongest bull market in the nation's young capitalist history. The Shanghai composite stock index has doubled since August after four years of dismal performance. On Thursday, the Shanghai index set a fresh record, gaining 3% to finish at a whisker below 3,000.

Many individual investors have reaped handsome profits, but a growing number of them are tapping their credit cards and using their homes as collateral for cash to buy more stock, say bankers and analysts. That has stoked government concerns about excessive speculation.

China prohibits banks from giving consumers home-equity loans to play the stock market. So many people are hocking their homes with pawn shop dealers, who typically front borrowers as much as 60% of the value of their homes — but charge an annual interest rate of 36%.

China's Pawn Assn. recently warned its members about the risks of making such loans, saying that although it is quick and easy to advance cash to clients, collecting on loans in default is another matter. "It's quite complicated and troublesome to transfer ownership," said Wu Xianda, director of the association, which has about 100 members.

At Jinbao Pawn Shop in Beijing, manager Hu Bo usually sees a surge in business this time of year. Before the lunar New Year, which falls on Sunday, bosses seek extra cash to settle debts and pay bonuses to employees. But Hu estimates that the stock mania has helped push up Jinbao's mortgage loans by at least 30% this year.

He recalled one client in particular, a man in his 40s who mortgaged his 800-square-foot apartment in Beijing for $40,000. "I told him that he might suffer losses, but he insisted anyway. He was very confident. He said, 'I have targeted one good stock and I just need the money for one month.' "

"I just need the money for a month". Oops. It seems the market gave you less than two weeks. The unanswered questions of the month are as follows: "How many homes is Jinbao's Pawn Shop going to own at the end of the month, and what will manager Hu Bo do with them?"

Durable Goods

Meanwhile back in the states Core capital-equipment orders post biggest drop since January 2004.

New orders for U.S.-made durable goods plunged 7.8% in January as nearly every category of manufactured goods declined, the Commerce Department reported Tuesday. Transportation orders fell 18% in January after rising 3.1% in December. Aircraft orders fell 60.3% in January. But the weakness in January's durable-goods orders extended well beyond the aircraft sector. Orders excluding transportation fell 3.1% in January. This is the third drop in the past four months and the sharpest decline since July 2005.

Orders for core capital equipment, the kind of goods producers invest in to build their productive capacity, fell 6.0% in January, the biggest drop since January 2004. Core capital equipment orders (which exclude aircraft and non-defense goods) are the best monthly indicator of capital expenditures.
Economists said the drop raised questions about how strong business spending will be this year.

"With capital spending having been down in the fourth quarter, this trend is not something that makes one comfortable about the strength of the economy," said Joel Naroff, president of Naroff Economic Advisors. Ian Shepherdson, chief U.S. economist at High Frequency Economics, went so far as to say the factory rector was in a "recession."

The Yen

The weak capital goods report and the implosion in Asia seems to have gotten the carry trade players a bit nervous. Here is a chart of the Yen.


The Euro



The combination of the Euro, Yen, and Pound all being up means the US$ is sinking. But guess what? Treasuries are continuing their rally and the yield curve is further inverting.



Thanks to Bloomberg for the above chart. Click to refresh.

Yesterday, in Does anything mean what it used to? I noted that Bernanke thinks that the data suggests a "somewhat firmer economy" and Greenspan thinks housing has bottomed, and neither thinks the inverted yield curve means what it used to. Meanwhile fresh off the presses today The Boston Globe is reporting Massachusetts foreclosure filings smash record.

January had the highest number of monthly Massachusetts foreclosure filings in at least two decades as local consumers struggled to hang onto their homes, according to a new report.

Last month, 2,207 foreclosure filings - or 110 every business day - were submitted in Massachusetts, more than double the number of a year ago; filings in January 2007 were up 105 percent from 1,076 filings in January 2006, according to ForeclosuresMass.com, a Framingham firm that provides online Massachusetts foreclosure data to investors, real estate agents, and lenders.

"The flood of foreclosures in Massachusetts is not only continuing; it has reached a new high," company president Jeremy Shapiro said in a statement. "The fact we are starting the year with the highest number of foreclosures we've ever recorded for a single month is more than significant - it's ominous."

Message to Ben Bernanke: It's high time for you and Greenspan to leave Wonderland and face the real economy.

Mike Shedlock / Mish
http://globaleconomicanalysis.blogspot.com/

Does anything mean what it used to?

Flashback May 24, 2006 CNN Money reported Yields throw the Fed a curve.

Fed Chairman Ben Bernanke repeated the view expressed by his predecessor Alan Greenspan that an inverted yield curve is no longer a good indicator of a recession ahead.

"In previous episodes when an inverted yield curve was followed by recession, the level of interest rates was quite high, consistent with considerable financial restraint. This time, both short- and long-term interest rates -- in nominal and real terms -- are relatively low by historical standards."

Apparently Greenspan and Bernanke are in agreement that the yield curve does not mean what it used to.

The Yield Curve 2000-2007



A snapshot as of February 26, 2007.


The above chart thanks to Bloomberg. Click to refresh.

Flash Forward February 26, 2007
Greenspan says Recession 'possible' by end of year

Former Federal Reserve Chairman Alan Greenspan said Monday it is "possible" the U.S. economy might fall into recession by the end of the year. He said the U.S. economy has been expanding since 2001 and that there are signs the current economic cycle is coming to an end.

"When you get this far away from a recession, invariably forces build up for the next recession, and indeed we are beginning to see that sign," Greenspan said via satellite link to a business conference in Hong Kong. "For example in the U.S., profit margins ... have begun to stabilize, which is an early sign we are in the later stages of a cycle."

Greenspan also said he has seen no economic spillover effects from the slowdown in the U.S. housing market.

"We are now well into the contraction period and so far we have not had any major, significant spillover effects on the American economy from the contraction in housing," he said.

OK guys, which is it? Does the yield curve mean what it used to or not?

On February 17th Greenspan said Worst of U.S. housing slowdown over.

"I think the worst is behind us," Greenspan, 80, told a Toronto conference Wednesday, during a speech broadcast live via satellite. "We are in the midst of a very significant inventory liquidation of unsold new homes."

Greenspan's comments represent a view similar to those of his successor, Ben S. Bernanke. Bernanke told the Senate Banking Committee this week that the Fed expects economic growth to strengthen "somewhat as the drag from housing diminishes."

Fed policymakers predicted gross domestic product will increase by 2.5 per cent to 3 per cent this year.

In the statement after the Federal Open Market Committee's most recent meeting on Jan. 31, the Fed said recent data suggest "somewhat firmer economic growth," while the housing market is showing "some tentative signs of stabilization."

Housing Inventory

The Chicago Tribune is reporting Canceled contracts masked glut of homes

Housing analyst David Seiders told Chicago-area builders Thursday that the federal estimate of 3.5 million homes for sale at the end of 2006 is "grossly understated."

"There is a big inventory overhang out there, and it's bigger than anybody understands," he said.

In an annual forecast on the local industry in Addison, Seiders, chief economist of the National Association of Home Builders, cited the high level of sales contract cancellations in 2006. It created a snag in the recordkeeping, so many homes marked as sales in government data ended up back on the market too late to be counted as inventory, he said.

"Cancellation rates more than doubled between the end of 2005 and the end of 2006, meaning that net sales for the year nationally may be down 65 percent."

Employment

In addition to the yield curve not meaning what it used to, it seems that employment does not mean what it used to either. The Wall Street Journal is reporting Policy Makers At Fed Rethink Inflation's Roots.

For decades, a simple rule has governed how the Federal Reserve views the nation's economy: When unemployment falls too low, inflation goes up, and vice versa.

But Fed officials have rethought that notion. They believe it takes a far bigger change in unemployment to affect inflation today than it did 25 years ago. Now, when inflation fluctuates, they are far more likely to blame temporary factors, such as changes in oil prices or rents, than a change in the jobless rate.

Summary

• The yield curve seems to be strongly hinting at recession except for the fact that it does not mean what it used to. Besides, data suggests a "somewhat firmer economy".
• Then again, "a recession is possible by the end of the year" so maybe the yield curve really does mean what it used to.
• Of course if a recession does happen, a housing spillover will have nothing to do with it.
• The primary reason we should not worry about a housing spillover is because it hasn't mattered yet.
  
• Besides, housing is stabilizing even though Housing Starts and Permits are Plunging.
• And somehow "We are in the midst of a very significant inventory liquidation of unsold new homes" even though inventory is rapidly rising because of cancellations.
• And finally, after a decade of thinking things through, the best the Fed can come up with regarding the cause of inflation is that it is not related to employment but instead it is caused by "temporary factors".

A careful analysis of the above comments leads me to believe that Greenspan and Bernanke both stepped through the magic looking glass and are now commenting on happenings in wonderland.

Mike Shedlock / Mish
http://globaleconomicanalysis.blogspot.com/

Out of Control

This post attempt to assess what powers the fed has to control inflation, deflation, and economic growth. The key word in that sentence is "control". Let's take a look at where we are today.

The Fed is only in control (using the word loosely as we shall see in a moment) of base money supply, reserve requirements, and short term interest rates. Even then the fed can not target money supply and interest rates at the same time. The Fed can target reserve requirements and either money supply or interest rates (but not both). Yet the myth persists that "the Fed is Pumping M3", that Fed has the power to "drop money out of helicopters" and as one person actually proposed "add zeros to everyone's account" to prevent deflation.

In practice, the Fed would not add money to people's accounts or drop money out of helicopters even IF the Fed could do it. The Fed would not do such things because it would destroy banks and creditors (their own cartel) to bail out consumers. Thus his infamous speech Deflation: Making Sure "It" Doesn't Happen Here can best be described as "Bernanke's Bluff". If deflation was so easy to prevent in practice, Japan would not have endured it for decades.

Yes the Fed will likely slash interest rates but at some point that "magic" will cease to work except perhaps to raise the price of gold. The reason it will not work is simple: there is too much overcapacity and malinvestments already. Slashing rates will not stimulate jobs, home building, capex spending, or anything else productive. This by the way is exactly why Bernanke is wrong about the cause and cure of the great depression. The cause of the great depression was the rampant increase of money supply and credit leading up to it. It is illogical to assume the cure (increasing money supply and lowering interest rates) is same as the cause.

Magic Powers of the Fed

In reality, the Fed has no magic powers. The Fed can not create jobs, drop money out of helicopters, cause wages to rise, set interest rates in Japan, force China to float the RMB, stop various carry trades, or add zeros to everyone's account. It is amazing the powers people attribute to the Fed.

Consider The Real Economy

• Rising bankruptcies and foreclosures
• Implosion of 23 subprime lenders
• A stalled GDP
• Rising inequities between the "haves" and the "have nots"
• ISM under 50
• Inverted yield curve (Yes, Bernanke it still means what it used to)
• Credit standards starting to tighten over default fears
• Rising weekly jobless claims

Consider Financial Speculation

• Junk Yield Spreads vs. Treasuries
• Leveraged Buyout Mania
• Stock buybacks on bowwowed money
• Parabolic charts on emerging markets
• Carry Trade in full force

What Can the Fed Do?

Bernanke 's problem in a nutshell is that interest rates are no longer supportive of the real economy (primarily because there is rampant overcapacity and malinvestments everywhere) even if they are not restrictive enough (for now) to stop wild financial speculation in various carry trades, credit swaps, leveraged buyouts, and stock buybacks.

Can the Fed put an end to that speculation by targeting money supply instead of interest rates? Perhaps, but what would that do to housing and the real economy? Can the Fed target interest rates? Yes, but if they do, then money supply is not in their hands. No matter how one twists and turns the Fed can not control both money supply and interest rates. The Fed gets to pick its poison in that regard.

Can the Fed stimulate jobs? Not really, unless they can reignite the housing bubble. Is that likely? Would they do it even if they could? If they did manage it, would it do anything but postpone the problem? The Fed can (and will eventually have to) raise reserve requirements. Because of sweeps and fractional reserve lending there are essentially no reserve requirements now. There is only an illusion of reserve requirements. This is clearly one of the things the Fed allowed to get out of control and for now there is no good solution.

Eventually this will blow up just as every asset and financial speculative bubble in history has blown up. That is the message conveyed in Central Bankers Cry Wolf.

Weber: European Central Bank council member Axel Weber said investors shouldn't expect central banks to bail them out in the event of an "abrupt" drop in financial markets. "If you misprice risk, don't come looking to us for liquidity assistance," Weber said in an interview in Davos, Switzerland at the annual meeting of the World Economic Forum. "The longer this goes on and the more risky positions are built up over time, the more luck you need."

Trichet: Current conditions in global financial markets look potentially "unstable", suggesting that investors need to prepare themselves for a significant "repricing" of some assets, Jean-Claude Trichet, president of the European Central Bank. "We are currently seeing elements in global financial markets which are not necessarily stable," he said, pointing to the "low level of rates, spreads and risk premiums" as factors that could trigger a repricing.

Poole: "The Fed can provide liquidity support but not capital".

Poole's statement is critical: "The Fed can provide liquidity support but not capital". That is an accurate assessment of the situation, and it is in start contrast to those who think the Fed can drop money out of helicopters or add zeros to peoples accounts. Liquidity support would most likely come from extremely short term borrowing and/or lowering of interest rates.

The most important facet of all of this is that monetary claims very likely exceed the pool of real funding by several orders of magnitude. When push comes to shove, this house of cards will eventually collapse in some way.

Rampant Inflation

Professor John Succo wrote an interesting article on Minyanville last week entitled Rampant Inflation.

Why would the Federal Reserve minutes show concern for inflation? Consumer prices certainly seem under control (although I can argue that the BLS measure of that is flawed). The reason is most people have a misconception of what inflation is. The Fed members must understand the real problem. The problem is dire.

Inflation is the growth in money and credit and it is growing like a weed. The Fed stopped publishing M3, the broadest measure of this money, so most don't even talk about this troublesome statistic. It's clearly growing much faster than nominal GDP and illustrates the devastating nature of the Fed's policies.

If you reconstruct M3 it is currently growing at around 12-13%, a level which has rarely been seen, a level way above average and one that is ultimately deflationary (at some point it will get so large that it must be paid back or defaulted on).

The U.S. saw a total of $4 trillion in new credit created last year. All that money you see out there has been borrowed.

Normally all that money would go to bid up consumer prices. It is not because of the U.S.' sickness.

All that free money (first fostered by Japan's ridiculously low interest rates, a rate that was just raised yesterday because it is clearly causing malinvestment) combined with globalization has created overcapacity. The latest capacity numbers show it now falling from already below average numbers. The U.S. has too much production in the world so producers can't increase prices. The U.S. has too many houses so the prices are beginning to fall. The U.S. has too much commercial real estate so REIT stocks are showing severe weakness. The U.S. made too many risky loans so the subprime mortgage market is falling apart. The U.S. has too many strip malls so the countryside is getting ugly.

All that borrowed money is now going into speculation because there is nothing left to build. It is going into stock prices, gold, commodities as the last flushes before the market says "we can't take anymore debt." Total U.S. debt is 3.5 times GDP, a level never seen before. The second highest level was 2.9 times in 1929. Total U.S. financial debt (excludes consumer debt) is 2.1 times GDP, the highest ever and up from one time in 1987.

The timing is uncertain, but logic tells us that this must end.

Thank's professor Succo and Minyanville. It is important to keep harping about what inflation is and what it isn't. Eventually it will sink in (I hope). And speaking of hope....

Hope

• The Fed is now hoping that subprime blowups do not filter through into higher grades.
• The Fed is now hoping that jobs do not collapse.
• The Fed is now hoping that the inverted yield curve does not mean what it used to.
• The Fed is now hoping that financial speculation stops before things blow up.
• The Fed is now hoping that it has found the "magic interest rates" for a soft landing.

Any action the Fed might take right now risks imploding the real economy or further inflating financial speculation. The situation, however, is now so far out of Bernanke's control that the Fed's economic policy has now been reduced to misguided hope.

Mike Shedlock / Mish
http://globaleconomicanalysis.blogspot.com/

Caroline Baum on Inflation

Caroline Baum hit the nail smack on the head with her article Fed's Inflation Analysis Ranks With Zimbabwe's. I intended to do a supportive blog on it when it first came out but was delayed by some breaking news on housing. As it turns out I find that I am in a very small minority as reported in her followup piece From Pluto, U.S. Inflation Is Near 10%. Let's take a look at both articles.

Fed's Inflation Analysis Ranks with Zimbabwe's

There's a big difference between an inflation measure and the inflation process. Policy makers -- Bernanke, Alan Greenspan before him, the Fed governors and bank presidents -- talk about the effect oil prices or imputed rental costs have on inflation gauges, such as the consumer price index. That's not the same as the inflation process, which is always and everywhere a monetary phenomenon.

If oil prices rise because cold weather boosts demand, the relative price increase may manifest itself as a rise in the CPI in the short run. But with appropriate growth in the money stock, the demand for, and price of, something else should fall.

Cause and Effect

So when Bernanke talks about temporary "factors" boosting inflation, he is really talking about temporary "effects" of higher oil prices on the CPI. Oil prices don't cause inflation. Nor do wages, even though you'd never know it from discussions on the subject. The Fed causes inflation all by itself, creating too much money relative to the supply of goods and services.

If the inflation-as-effect posture is just a shorthand way of communicating with Congress, that's one thing. If it's the Fed's analytical framework for inflation, then we're in trouble. The tenor of the discussion of inflation in the minutes of the Fed's policy meetings, which are in line with the comments in the testimony, makes me wonder.

Caroline Baum seems to grasp what far too few others do: "the inflation process is always and everywhere a monetary phenomenon". From an Austrian viewpoint, inflation is the expansion of money and credit. Of those two, the Fed is only in control of base money supply. The Fed is not directly in control of credit. (This issue will come up again shortly).

The expansion of credit, however, is so far out of control and has been for so long now that for all practical purposes the Fed is not really in control of anything. This is one of the things that happens when sweeps effectively cut bank reserves to zero and fractional reserve lending allows infinite (in theory) lending of the same money over and over and over again. Rather than being in control, the Fed is in an ever tightening box praying for a miracle soft landing that is not going to happen. This was discussed in Counterfeiting Money - Crime or Good Economics?

Money itself (however one defines it) is a claim on real savings (a placeholder for saved goods). For example, a baker makes bread, so what he actually saves is bread. The baker only transforms his savings into money (typically a monetary commodity that has a prior demand for other uses, such as gold) because that's far more convenient. The baker can not actually save bread, as it would get old.

Therefore money, as such, is a claim on real goods. Credit by contrast, is a claim on money itself, which in turn is a claim on real goods. In our present system, credit claims on money to be paid back in the future masquerade as actual money and can thus be termed "synthetic money". In addition there is a "multiplier" effect. Someone gets a loan and spends it on goods. That money is deposited and is treated as money regardless of whether or not it is backed by real goods. Via sweeps and still more lending (see Money Supply and Recessions), the same money is lent out time and time again (the multiplier effect). This is the failure of the central bank administered fiat system: monetary claims proliferate beyond actual production of goods to back them up. In a honest system, only actual savings would be transferred from savers to borrowers (with banks acting as middlemen).

This "credit inflation" is thus fundamentally different from the "Weimarian printing press inflation". The Weimar situation brings about hyperinflation as the monetary unit itself is inflated in its physical form, as banknotes. By contrast, a credit inflation that creates claims that masquerade as money is prone to deflation because the money needed to pay back the credit is in a shortage (relatively speaking) compared to the outstanding credit claims.

My main quibble with the first article is Baum's statement "The Fed causes inflation all by itself, creating too much money relative to the supply of goods and services". The source of the quibble is that credit is not directly controlled by the Fed, and a second point is the idea that inflation is "too much money relative to the supply of goods and services". The problem with latter idea is that it ignores asset prices and it also ignores productivity improvements. From an Austrian perspective inflation is an expansion of money and credit whether or not prices are held in check by increases in productivity.

Regular readers know what is coming up. Here it is: An Interview with Paul Kasriel.

Mish: Do you have any comments regarding Greenspan?
Kasriel: Greenspan is a fascinating study. Some day I hope to write a book about him. Right now I willing to say he is the luckiest Fed chairman in history.

Mish: Greenspan is the luckiest Fed chair in history? How so?
Kasriel: He was fortunate in two very big ways. First off, he was fortunate to preside over the economy at a time when productivity was soaring and the global supply of goods was expanding rapidly because China had entered the world trading arena. In that environment the Fed could create large amounts of money and credit without causing inflation other than in asset prices.

Mish: Does that mean you believe that inflation is a monetary phenomenon related to increases in money supply and credit as opposed to rising prices?
Kasriel: Yes, and that is exactly why Greenspan was so lucky. Inflation was masked by the factors we just mentioned.

But on the main issue it is clear that Caroline is correct: "If oil prices rise because cold weather boosts demand, the relative price increase may manifest itself as a rise in the CPI in the short run. But with appropriate growth in the money stock, the demand for, and price of, something else should fall." Bingo. In this regard, Caroline hits the nail on the head again by suggesting the Fed's inflation analysis ranks with Zimbabwe's.

This is THE critical point: Peak Oil, hurricanes, weather, and crop shortages do not cause inflation (see Inflation: What the heck is it?). Silly government policies such as subsidies that promote ineffective use of corn for production of ethanol do not cause inflation either. Nor do obscenely bad medical practices such as not allowing importation of drugs from Canada.

For those that disagree, please tell me how jacking up interest rates will fix problems associated with peak oil, hurricanes, global warming, government policies on ethanol, or anything else. A focus on prices (with the cure supposedly being interest rates) simply puts the cart before the horse while ignoring pent up pressures of asset bubbles.

From Pluto With Love

Reader reactions to Caroline's first article can be found in From Pluto, U.S. Inflation Is Near 10%. I will score the debate.

Earlier this week, a column on inflation -- what it is (a monetary phenomenon) versus how the Federal Reserve talks about it (seemingly exogenous price increases) -- prompted the "regulars" to check in.

This select all-male club (women, no doubt, have better things to do with their time) can best be described by the shared belief system of its members: a fixation with all things gold; an ingrained distrust of any statistic published by the government; and a firm belief that the Federal Reserve's discontinuance of weekly publication of the M3 monetary aggregate last year was just another sign the U.S. is headed down the road of Weimar Germany.

My feedback tends to fall into some broad general categories:

The Close-But-No-Cigar Department

"Precisely why did the Fed discontinue reporting M3?" writes one reader, echoing a burning question among conspiracy theorists.

The M3 conspiracy theorists (CTs) seem to ignore the monetary base (currency and bank reserves), which is the only instrument the Fed controls. Annual base growth slowed to 2.7 percent in January from 10 percent four years ago.

[Mish scoring: Baum 1 - CTs 0 - The subject of M3, however, brings us back to a sentence from the first article .... "The Fed causes inflation all by itself". If the Fed is not in control of M3 (and I agree with Caroline that the Fed is not) then how did the Fed cause inflation "all by itself"? Yes, on one hand I am suggesting the Fed is not in control and on the other hand I am blaming the Fed just as Caroline is doing. The answer is that the system is now so totally messed up and credit lending is so out of hand caused by imbalances stemming from Bretton Woods II, fractional reserve lending, and Fed bubble blowing policies over decades, that the current mess is simply not repairable until there is a complete collapse in credit that forces another look at said policies. The real question at this point is not whether or not the Fed is in control of money supply but rather: Is the Fed really in control of anything at this point? In the meantime, from a technical point of view, I am tired of all the statements I hear day in and day out that "The Fed is pumping M3" or other such nonsense. The Fed is simply not pumping M3. The Fed is defending an interest rate target as if they knew what that rate should be. The problem is the Fed and other central bankers have no idea what interest rates should be and that is a huge part of the problem. In addition, even IF the Fed knew what Japan's rate should be, the Fed is powerless to set it. Thus the Fed is not in any position to stop the carry trade in Yen. The whole system is a mess and will eventually have to be replaced.]

The Finger-to-the-Wind Department

"Dear Ms. Baum," another reader writes. (They start out politely to get my attention.) "Do you really believe that nonsense about the 'core inflation rate?' Inflation is actually running 8-10 percent per annum and getting worse."

This is the consensus forecast among CTs, who rely for their stats on John Williams's Shadow Government Statistics Web site.

For the record, I don't believe in excluding all the prices that rise in any given month to portray inflation in the best possible light. And I agree that some series in the consumer price index, such as imputed rents, are fundamentally flawed.

But the numbers aren't cooked up in the BLS basement, as the CTs think.

"All the wonks in the federal government spin the numbers for the best possible outcome," he writes. "Of course, they can't give us glowing reports every month, so they have to `spice' them with a little `bad news' now and then. Otherwise they'd lose total credibility."

Ah, good to know. The numbers are all rigged, but they're rigged in both directions.

"I think my estimate (of 10 percent inflation) is a LOT closer than what the fed wants us all to believe," writes a reader whose handle is "PlutoDave."

Pluto may no longer be a planet, but it's still far out.

[Mish scoring: Baum 3 - Fingers in the Wind 0 - Baum's use of sarcasm was impressive. However she missed a good chance to point out how understated housing was in the CPI when housing prices were soaring and how overstated housing now is on the way down. Also any sane person knows that medical expense have risen far more than the CPI suggests. But with falling energy prices since last summer and falling housing prices for 18 months, inflation (as measured by prices) is probably a lot closer to the 2.5% to 3.5% range this year, by my "Finger to the Wind Measurement" than any measurements pegging price inflation at 10%. Inflation as measured by growth in M3, however, is a huge problem.]

The Tin-Foil-Hats Department

"The truth, Caroyn (sic), again?" a Plunge Protection Team alumni writes. "What's gotten into you? Next thing you'll be calling for an investigation into market manipulation by the government. Especially the gold market."

Where was the PPT during the precipitous plunge in the stock market from 2000 through 2002? Never mind. I can't prove the markets aren't rigged, and they can't prove they are. Ergo, I'm the one who's naive.

[Mish scoring: Baum 1 - Tin Hats 0 - Baum's reply was infallible.]

The Out-of-Nowhere Department

Many of the e-mails I receive have only the slenderest connection to what I wrote -- and to reality.

"There is no rebalancing or inflationary outlet. If there was, it would have happened by now and people would no longer be debating the issue of imbalances. The only person I've seen touch on this issue is Mr Stephen Roach at JP Morgan in his weekly commentary."

Who's on first? What's on second? I don't know who's at JPMorgan, but Roach is at Morgan Stanley and has a solid following among Armageddon types.

[Mish scoring: Baum 1/2 - Rebalancers 0 - The rebalancing comment can best be described as totally bizarre. But the response certainly could have been better. An answer like "What the H are you talking about?" would have gotten a full point]

The Kill-'Em-With-Sarcasm Department

"Caroline, if fixing inflation according to you is such a simple exercise then, perhaps, you should get in touch with the Zimbabwe government and give them a quick lecture to pull them out of the misery."

Zimbabwe has lots of other problems, but as my late friend Bob Laurent used to say, inflation isn't the toughest one for a central bank. A Chicago-schooled monetarist, Bob meant that the central bank was up to the task of controlling the growth in the money stock.

Yes, there will be short-term pain (back-to-back recessions in the early 1980s in the U.S.), but hyperinflation has only one cause and one cure.

[Mish scoring: Baum 1/2 - Sarcasm Depratment 0 - Yes, hyperinflation has one cause and one cure. But I disagree with the implied idea that "deflation is the toughest problem for a central bank". Deflation is only a problem because banks try to defeat it by throwing money at it when in fact deflations and recessions are a very necessary force needed to cure excesses in monetary expansion. This is what Bernanke fails to understand. Deflations occur because there was an excess expansion of credit and asset speculation. The cure is NOT as Bernanke thinks: throwing more money at it out of helicopters. Such actions only prolong the agony and create bigger imbalances like the housing bubble we are now in.]

The Pseudo-Philosopher Department

"I'm no theoretical economist," writes a reader, "but I do believe that empirically consistent descriptions of reality are attractive, in that regard monetarism doesn't bode too well as a variable which drives inflation."

Got it?
[Mish scoring: Baum 1 - Philosopher 0 - A layup]

The grand total was Baum 7 - Everyone else 0

Note to Caroline:
All we need now is to get you firmly in the Austrian camp.
Lunch with Paul Kasriel just may cure those lingering "monetarist blues" that you seem to have. Can I try and set that up for you?
Cheers!

Mike Shedlock / Mish
http://globaleconomicanalysis.blogspot.com/

Is Morgan's 'gripe site' on Lennar protected free speech?

Here is the question of the day: Is Morgan's 'gripe site' on Lennar protected free speech?

STUART — A consumer watchdog group founded by Ralph Nader has come to the defense of a Stuart real estate broker who is being sued by Lennar Corp.

The suit stems from the use of the home builder's name in a Web site that criticizes the quality of several of Lennar's houses.

Public Citizen, based in Washington, is filing a friend of the court brief asking Judge Larry Shack to throw out Lennar's trademark infringement claims against Mike Morgan because his "gripe site" is protected by the Constitutional right to free speech.

"The notion that you can't identify the subject of your criticism by using the name of the company you're criticizing is absurd," said Paul Levy, a lawyer with Public Citizen. "We think it's a matter of simple free speech."

The brief was sent overnight Tuesday for delivery to the Circuit Court on Wednesday, Levy said. A hearing on a request to dismiss Lennar's suit against Morgan is set for March 21.

Mark Sustana, the general counsel of Miami-based Lennar, declined to comment on Public Citizen's brief or the company's suit against Morgan.

Lennar filed suit against Morgan in June 2006 charging his Web sites Defective Homes and Lennar Homes Info violated the company's trademark and defamed Lennar with false claims that several homes built by the company were defective.

Morgan has alleged Lennar built several defective homes in the Martin's Crossings subdivision in Stuart, the Newport Isles subdivision in Port St. Lucie and the Diamond Lake subdivision in Vero Beach. Morgan also is suing Lennar for sales commissions he believes he is owed.

While Public Citizen took no position on the defamation claim against Morgan, Levy said Lennar's trademark claims have national importance because they involve a person's right to buy key word advertisements on Internet search engines.

"This is the first case I know of that has tried to apply that theory of trademark infringement to the 'gripe site' context," Levy said. "We'd hate to see that trend continue."

Lennar's Lawsuit Against Morgan

• June 6: Speaking during a Martin County Commission meeting, Morgan accuses Lennar Corp. of shoddy workmanship at three homes in the Martin's Crossings subdivision.
• June 9: Lennar Corp. files a lawsuit against Morgan alleging trademark infringements.
• June 21: Lennar Corp. amends lawsuit adding defamation and unfair competition claims.
• Tuesday: Public Citizen overnights a friend of court brief supporting Morgan's request to dismiss Lennar's trademark claims.
• March 21: Hearing schedule on Morgan's request to dismiss Lennar's lawsuit.

Email Comments From Mike Morgan

Attached is a brief that Ralph Nader’s Public Citizen Group filed in support of our position in our legal battle with Lennar. On March 21 there is a Motion for Summary Judgment (MSJ) on some of the issues. We expect to slam dunk the MSJ, and we are preparing to file a second MSJ within the next week regarding other issues.

Public Citizen Group Brief

Click here to see Nader's Defense of Mike Morgan vs. Lennar.
Responses are welcome and Mike Morgan has agreed to respond as time permits. The forums are free and they will stay that way. We are very pleased to have Mike Morgan on our Housing Discussion Group at The Market Traders.

Mike Shedlock / Mish
http://globaleconomicanalysis.blogspot.com/

New Wave Thinking

The latest in "It's different this time" thinking comes from Tobin Smith at Change Wave in an article called Doom And Gloom Rehab.

Remember The Super Spenders

Here's one more thing people don't understand about this economy. We have what I would call the super spenders -- the top 10%-20% earners in the United States. This group accounts for almost 90% of our economic activity when you talk about anything related to discretionary spending.

We're talking about spending on a second home, new TVs, putting the kids through college, etc. If you study that group -- people over the age of 30 with some college -- the unemployment rate is about 1%.

And the fact of the matter is that at the low end of economic spectrum, if they're having financial difficulty because their mortgage rates have gone up to the point where they can't make them, I mean, you know, as dreadful and heartbreaking a story as that is, from a pure economic standpoint, it really doesn't matter as much to the overall economy.

So what you really want to worry about in 2007 is how the super spenders are doing in the American economy. And if you look at those numbers, you'll see they're doing great, and that's why this economy continues to grow and continues to have this soft lading -- and is getting ready to rebound again.

But I really think there's a group of doom and gloomers out there that need to come to my rehab center and get adjusted to current reality in the global economy, and not keep overlaying what happened in 1985 and making that comparison.

From an economic standpoint, that argument really doesn't hold water. Remember, we also have about 2 billion more consumers in the world than we had at that time. Thank you, China. Thank you, Russia. Thank you, India.

We have a huge amount of capital -- I mean the world is literally twice, almost three times as wealthy as it was then.

And we are just so much bigger, so much more powerful, so much more insulated from these specific shocks, that we just don't have that down risk. And that reality has really not been priced into stocks because I think when people understand how much safer from an economic standpoint this overall global economy is, they'll probably do one thing -- and that's price stocks even higher.

So, doom and gloomers, there's plenty of room in my rehab program. You guys are out of touch with reality, and you can use my help.

New Wave Thinking

• Only the top 10% of the country matters anymore.
• If the super spenders are doing OK everything will be fine.
• Bankruptcies and foreclosures at the bottom 90% of the population are "heartbreaking" but otherwise meaningless "from a pure economic standpoint".
• The world is "almost three times as wealthy" as before because there is "a huge amount of capital".
• We are insulated from risk because we are bigger and more powerful.
• "When people understand how much safer from an economic standpoint this overall global economy is, they'll probably do one thing -- and that's price stocks even higher".

Anyone who readily dismisses what 90% of the US population is doing doesn't know much about economics. In addition, these new wave thinkers in general (and they seem to be everywhere) are clearly confusing money with wealth. It is equally clear they do not have a firm grasp on reality when it comes to either risk management or the valuation of stocks.

Thanks Tobin for the laugh of the day.

Mike Shedlock / Mish
http://globaleconomicanalysis.blogspot.com/

Pricing Risk

The USA Today is reporting Sacramento: The pressure's on sellers to lower their prices.

Here's an alarming fact about Sacramento's housing market: About one of every five existing homes on the market is a "short sale." That means the home is worth less than the value of the mortgage, and the lender is willing to accept less than full repayment of the loan to avoid foreclosure, says Tracey Saizan, president of the Sacramento Association of Realtors.

That, in turn, puts pressure on the remaining 80% of sellers, who have equity in their homes, to cut prices. The median price in the state capital, one of the most overheated metro areas during the real estate boom, fell 4.3% in December compared with December 2005.

"Sellers are having to give concessions and cut prices," Saizan says. "It's all about making the house show the best it can and aggressive pricing."

One in five sales is a short sale. That is pretty staggering. It will be interesting to watch this trend develop. What is clear is that lenders do not want those homes back. Equally clear is there are likely to be some huge tax consequences for forgiveness of debt some time down the road.

It seems to me that borrowers did not correctly price the risk of buying those homes. Many homes were purchased on a wing and a prayer without the income to support the purchase. Homes were bought for the sole reason that prices were rising and multitudes piled on in the belief that prices would rise forever. The fallout is just starting.

Subprime Lenders

It was not just buyers that mispriced risks. What were lenders thinking? It seems they weren't thinking much either. The Mortgage Lender Implode-O-Meter is now up to 23 US Mortgage lenders that have stopped subprime lending and/or gone bankrupt since Dec 2006.

The performance of subprime adjustable-rate securities issued in 2006 continues to deteriorate rapidly, and the default rate hit 4.62% in January, up 21% in just one month, according to a report by Friedman Billings Ramsey. The default rate of the 2006 origination year exceeds that of 2005 by 51.6% and that of 2004 by a "whopping" 137% at the same age, the FBR report says. The early defaults on 2006 originations have sparked massive loan buybacks and forced a dozen subprime firms into bankruptcy. In a previous report, FBR researchers warned that this book of business is rapidly deteriorating and that "higher default and loss rates may ensue."

Investor Risk

What happens when a high yielding dividend play suddenly declares it has no taxable income?
NFI provided that answer today.



NovaStar sinks 41%, leads subprime lender stocks down

NovaStar Financial (NFI) shares sank as much as 40% Wednesday, leading declines in shares of many subprime lenders as defaults mount among homeowners with poor credit histories. The decline came after NovaStar said late Tuesday that it may realize no taxable income from 2007 to 2011 and may drop its tax-friendly real estate investment trust status in 2008.

It also posted a fourth-quarter loss of $14.4 million, or 39 cents a share, compared with a year-earlier profit of $28.1 million, or 84 cents a share. "Earnings were indicative of the challenging non-prime environment and proved that no company will likely go unscathed," wrote Scott Valentin, an analyst at Friedman, Billings, Ramsey.

Valentin downgraded NovaStar to "underperform" from "market perform." Deutsche Bank Securities analyst Stephen Laws lowered his rating to "hold" from "buy."

The problems at NovaStar, based in Kansas City, Mo., are the latest in the subprime sector, where rising delinquencies and defaults and lower loan volumes are battering lenders. Many are losing money as investors such as Merrill Lynch demand that they buy back soured loans.

Wells Fargo (WFC), the largest subprime lender, said Wednesday that it is cutting 320 subprime jobs in Fort Mill, S.C. and Concord, Calif., saying loan volume may decline following a Feb. 16 tightening of its lending policies.

Supposedly this would "never" happen because home prices would just keep rising forever.

Leveraged Buyout Mania

Not having learned a thing about risk management from a multitude of subprime blowups, LBO Loan Rates are at Record Lows.

Henry Kravis and Stephen Schwarzman never had an easier time getting the lowest interest rates on loans from their bankers.

Just three months after borrowing $12.8 billion to pay for hospital operator HCA Inc. in November, Kohlberg Kravis Roberts & Co. and its partners negotiated a new loan with lower rates. Schwarzman, chief executive officer of Blackstone Group LP, is doing the same for a $3.5 billion loan that financed the takeover of Freescale Semiconductor Inc., the mobile-phone-chip maker.

Leveraged buyout firms are leading borrowers refinancing $64 billion of loans so far this year, more than in all of 2006, according to ratings company Standard & Poor's. Banks are giving in and reducing rates because corporate defaults are near all- time lows.

"This is the best loan market for borrowers I have ever seen,'' said Kenneth Moore, a managing director at First Reserve Corp., a private equity firm in Greenwich, Connecticut, that manages more than $12.5 billion and specializes in buying energy companies.

Loans for companies rated four or five levels below investment grade yielded an average 2.26 percentage points more than the three-month London interbank offered rate in the week ending Feb. 15, S&P says. That gap over Libor, a lending benchmark, was the smallest ever and compared with more than 4 percentage points in 2003.

Loans helped fuel a record $1.55 trillion in mergers and acquisitions in the U.S. last year, New York-based S&P said. So-called leveraged loans financed 57 percent of those transactions, the highest in seven years, it said. Leveraged loans are considered below investment grade and are rated below BBB- at S&P and Baa3 by Moody's Investors Service.

"There is clearly room to exceed the biggest loan deal ever done," Moore said. HCA's financing was the largest sold to investors.

Investor `Influx'

More than 250 institutions purchased high-yield loans last year, compared with fewer than 100 in 2002, S&P says. Many of the investors are new to the market, including Boston-based State Street Global Advisors, which said in November it would start buying loans.

Little Risk

Lenders see little risk in giving borrowers what they want. An expanding economy is making it easier than ever for companies to meet their debt payments. The default rate on leveraged loans was 0.45 percent in January, the lowest ever, according to S&P. That compares with an average of 3.05 percent over the past 10 years, according to data compiled by Credit Suisse Group.

The U.S. economy will expand 2.7 percent this year, according to a survey of 69 analysts by Bloomberg News from Feb. 1 to Feb. 8. The anticipated rate of growth is 0.2 percentage point faster than a survey the previous month.

Too Complacent

Banks may be too complacent, according to CreditSights Inc., a New York-based debt research firm.

"The worst of loans are written in the best of times and that could well apply to the current lending boom,'' said Louise Purtle, an analyst at CreditSights. "Loan sizes are increasing, borrowers are becoming more levered, and the number and stringency of covenants is being reduced.''

Borrowers in the U.S. this year have received or are seeking $16.3 billion of loans without so-called maintenance covenants, or restrictions such as quarterly limits on the amount of debt a borrower can have relative to earnings before items such as depreciation, interest and taxes. The amount compares with the record $24 billion for all of 2006, according to S&P.

`All About Control'

"Covenants are all about control," said GSC's Katzenstein. "With covenants, you can get concessions from the borrower such as an increased interest rate or fees" if they violate the terms of their loans, he said.

"The worst of loans are written in the best of times. Loan sizes are increasing, borrowers are becoming more levered, and the number and stringency of covenants is being reduced.'' I would say that about sums it up. But no one sees the risk because defaults are at record lows. Excuse me but weren't subprime defaults and foreclosures at record lows too before things starting blowing up just a few months ago?

I find this interesting too: More than 250 institutions purchased high-yield loans last year, compared with fewer than 100 in 2002, S&P says. Many of the investors are new to the market, including Boston-based State Street Global Advisors, which said in November it would start buying loans.

250 institutions are now plowing into junk right now when risk spreads are amazingly low. Of course that is not the proper way to look at it. The proper way to look at it is that risk spreads are amazingly low because so many institutional investors, some of them new to the market, have all decided they have to get in now. Is this the final panic attempt to get in before "It's too late"?

Whatever those institutions are thinking (if they are thinking at all) it's simply too late to go plowing into junk now, just as it was too late for flippers to be buying houses in December of 2005. But that's not stopping this train of thought: "There is clearly room to exceed the biggest loan deal ever done". Is that the idea .... to see just how insane things can get? If not, then what is the idea? Whatever it is, risk management sure is not part of it.

Mike Shedlock / Mish
http://globaleconomicanalysis.blogspot.com/

State Tax Revenues

Let's take a look at state tax revenues for a few states to see if we can spot potential problems down the road. This is not an all inclusive list of states but a representative sample of what potentially lurks ahead.

State Samples

• California
• Georgia
  
• Florida
• Michigan
• Massachusetts
  
• Illinois

California

Boston.com is reporting Google stock boom boosts California coffers

Someday, this era may simply be known as The Google Years. California, whose budget revenue slides up and down like a yo-yo with changes in capital gains and stock options, is once again counting on outsized income tax filings from a handful of tech executives to help balance its budget.

For this wave, California can largely thank Google Inc.

After cashing in more than 9 million shares valued at $3.7 billion last year, 16 Google insiders will owe the Golden State as much as $380 million in taxes -- enough to cover the salaries of more than 3,000 state workers.

Taxes paid by Google founders Sergey Brin and Larry Page account for nearly half the amount. There is virtually no way for them or other California billionaires to escape a 9.3 percent state capital gains tax or a recent voter-approved 1 percent tax on the wealthy to underwrite the state's mental health programs.

"On behalf of a grateful state, I'll be happy to wash their windows or mow their lawn," said H.D. Palmer, spokesman for California's Department of Finance.

Mega-sized tax filings from Google executives began flowing into state coffers in earnest in 2006, two years after the company went public. The receipts helped fuel a multibillion dollar tax windfall last spring that allowed Gov. Arnold Schwarzenegger to pour money into roads, classrooms and other popular programs, pleasing political enemies and helping smooth his path to re-election.

Schwarzenegger's good fortune, it turns out, did not end there.

As Google's stock topped $500 in 2006, company executives continued to sell hundreds of thousands of shares each month, according to an analysis of insider transaction data provided to The Associated Press by research firm Thomson Financial.

Although the company is helping push capital gains revenue above historical averages, state finance experts say they are not overly concerned that the latest tech boost is another bubble ready to burst and wreak havoc with the state budget.

According to the state's latest figures, capital gains and stock options accounted for nearly 14 cents of every tax dollar collected in California in the fiscal year that ended last summer. Similar numbers are expected this year. That's nearly double the percentage two years ago, following the dot-com bust.

"I admit, I've been looking at those insider trading sheets almost daily. It's amazing; day after day, millions and millions of shares," said Brad Williams, senior fiscal forecaster for the state's nonpartisan Legislative Analyst's Office. "It's not all attributable to one company, but Google is a big sign that we're going to see capital gains again this year and that the budget won't be as bad as it could be."

Two Questions

Ah yes, the Google Years. Not to spoil the party but I have two questions.

1. Is this sustainable?
2. So, California is in great shape, right?

Let's leave the first question for the optimists. But with all of this money pouring in, California must be in great shape, right?

In an attempt to answer the second question please consider the San Francisco Gate article California short $1 billion in tax revenue.

Personal income tax receipts coming into the state in January fell $1.3 billion below Gov. Arnold Schwarzenegger's revenue estimates in the spending plan he released last month, the state controller said Tuesday.

The lower-than-expected revenue raises questions about whether Schwarzenegger will reach his stated goal of eliminating the state's net operating deficit in the budget year beginning in July.

The governor's proposed 2007-2008 budget assumes tax revenue in the current budget year would grow by $1.1 billion, or 1 percent. In the coming fiscal year, Schwarzenegger also assumed a $6.8 billion boost, or 7 percent increase.

"Tax payments are down about $1 billion, and we don't yet have the source of that decrease," said Controller John Chiang, holding a news conference at the state's tax-collection center, where 2006 tax returns have begun to trickle in.

Chiang speculated that the state's slumping housing market might be a cause of the revenue decline. He also said revenue other than personal income tax rose in January, leaving the state short about $710 million for the month.

During a press conference touting his plan to overhaul health care in California, Schwarzenegger on Tuesday dismissed news of January's lower tax receipts. He said it would not affect his policy ambitions on health care reform.

"Revenues go up and down," he said. "I am very optimistic. Our economy is doing well and businesses are doing well, so I am very optimistic." In addition to the uncertain tax revenue, Schwarzenegger's $143.2 billion budget relies on other risky revenue assumptions, analysts say. The governor's budget assumes increases in property tax revenue and higher income from a rebounding housing market in the second half of 2007.

It bets that the Legislature will immediately approve gambling compacts that it refused to pass last year, bringing more than $500 million in projected revenue to the state. Schwarzenegger also assumed the state will win appeals in two court cases that it already has lost at the superior court level. Those two cases could take another $1.1 billion out of the governor's balanced-budget equation if the state does not prevail.

Schwarzenegger Rolls The Dice On

• Improved gambling revenue
• Rising property taxes
• Continuation of Google income
• Winning 2 appeals cases it has lost twice
• Increasing payroll tax revenue
• Higher income from rebounding real estate market
  

Bear in mind that Schwarzenegger needs that lotto parlay just to break even with projections. Like all gamblers betting with someone else's money Schwarzenegger had this to say: "I am very optimistic. Our economy is doing well and businesses are doing well, so I am very optimistic."

Georgia

The Atlanta Journal Constitution is reporting Revenue drop may hit budget.

Georgia's disappointing tax collections over the past six months have some lawmakers worried that the state may not raise enough money to pay for Gov. Sonny Perdue's proposed $20.2 billion budget.

Perdue is requesting a more than 8 percent increase in spending, from $18.6 billion this year to $20.2 billion for fiscal 2008, which begins July 1. Part of that increase will be funded with surplus money raised last year. And administration budget officials say the state should take in enough to meet the governor's spending plan. However, most members of the General Assembly recall 2003 and 2004 when they had to slash spending, raise cigarette taxes and gut the state's rainy day fund to make ends meet.

They worry an economic slowdown will force them to cut spending again if tax collections don't improve. You've always got a concern in the back of your mind — this year more than others — about whether we are basing this [budget] on good numbers," said House Appropriations Chairman Ben Harbin (R-Evans).

Sen. George Hooks (D-Americus), longtime former Senate Appropriations chairman, said, "Obviously the governor and his economist are banking on a tremendously aggressive, strong economy. Indicators now are that the economy is not growing that strong."

Lawmakers who run the Legislature's appropriations committees closely watch revenue collection reports. And they have noticed the slower growth — particularly in the net sales tax take.

Most of the state's revenue comes from income and sales taxes, both of which are an indicator of the strength, or weakness, of the economy. "It's just strange we haven't had a good month [of collections] since July," said Senate Appropriations Chairman Jack Hill (R-Reidsville).

Shelley Nickel, director of the Office of Planning and Budget, said she thinks Perdue's estimate of how much money the state will collect during the upcoming year is "still fairly conservative."

However, Alan Essig, executive director of the Atlanta-based Georgia Budget and Policy Institute and a former state budget analyst, isn't so sure. "It seems to me they [Perdue officials] are forecasting a better economy than what we have today," Essig said. "It seems very optimistic to me."

"It's just strange we haven't had a good month [of collections] since July" said Senate Appropriations Chairman Jack Hill (R-Reidsville).

No, That's not what is strange. What is strange is that few see the recession that is staring them smack in the face. On the other hand Alan Essig, unlike Schwarzenegger is not clueless: "It seems to me they are forecasting a better economy than what we have today. It seems very optimistic to me."

Illinois

The News Gazette is asking With healthy revenue, why is Illinois looking at tax increases?

There are some interesting numbers in the latest report from the Illinois Commission on Government Forecasting and Accountability. The bottom line is that the state's revenue numbers are very healthy, and that Illinois doesn't look like a state with financial troubles.

But government receipts unfortunately tell only part of the story. The other side of the ledger apparently is so bad that all sorts of fundraising schemes – an income tax increase, expanding the sales tax to include services, a gross receipts tax, selling the state lottery, selling the Illinois Tollway and expanding legalized gambling – are being discussed by state lawmakers. Illinois' biggest financial problem, as it has been for years, isn't the result of meager revenue but aggressive spending.

Personal income tax collections are up 8.2 percent, corporate income tax revenue has grown 18.3 percent, sales taxes are up 4.2 percent and public utility tax revenue is up 6.6 percent. Overall state revenue, even including a steep 12 percent drop in state lottery sales, is up 7.1 percent. In other states, governors would rejoice at economic growth like that. But in Illinois, that isn't enough to overcome discussion of more tax increases or asset sales.

Before lawmakers get ahead of themselves this spring with heated debate about revenue enhancements, they should stop to consider the effect that their overspending and their indifference to responsible fiscal management has had on the state's financial condition. The reason Illinois' budget is billions of dollars in the red can't be blamed on weak revenue. Instead it's the fault of weak-willed political leaders who haven't been able to spend within the state's means.

Illinois seems to be firing on all four cylinders yet it still does not have its financial act together.

Illinois Proposals

• Raise income taxes
• Sell the state lottery
• Sell the Illinois Tollway
• Expanding legalized gambling

Is Illinois in any shape for a downturn if it needs to do those things when personal income tax collections are up 8.2 percent, corporate income tax revenue up 18.3 percent, sales taxes up 4.2 percent and public utility tax revenue is up 6.6 percent? Let's face it, Illinois is a basket case, just as is California if it can not make ends meet with those windfalls.

Michigan

The South Bend Tribune is reporting Michigan taxpayers have seen state tax bills drop. That seems like great news, but let's look at the fine print.

Shrinking tax revenue has made it more difficult to balance the state budget. A shortfall of around $800 million exists this year, and the deficit in next year's budget could be $1 billion or more.

In the previous four years, the state wrestled with more than $4 billion in shortfalls. Tax cuts passed beginning in 2000 -- including cuts in the Single Business Tax, which expires at the end of the year -- have chopped state revenue by $1.4 billion a year, according to state Treasurer Robert Kleine.

Michigan is losing jobs, home prices are sinking, foreclosures are rising and the state has a huge budget deficit. This is not exactly a pretty picture.

Florida

The St. Petersburg Times is reporting "People are screaming for relief".

TALLAHASSEE - Gov. Charlie Crist on Tuesday called for sweeping property tax reductions, seeking to deliver quickly on a second campaign promise and setting the stage for a fight with cities, counties and school districts.

At city and county halls across Florida, Crist's call for widespread property tax cuts got an icy reception. "Maybe he hasn't thought this through," said Tampa City Council member Linda Saul-Sena. She said Crist's proposal essentially caps local government revenue growth at 3 percent a year at a time when cities and counties are facing increasing pressures to provide services while grappling themselves with rising costs of insurance, health care, gasoline and other essentials.

"I don't see how we're going to provide the basic services that our citizens expect," Saul-Sena said.

Clearwater Mayor Frank Hibbard said he wanted to fully realize the long-term ramifications of major property tax law changes. He said the inequities that now exist in the Save Our Homes law were not evident when it was enacted 15 years ago. Hillsborough County Property Appraiser Rob Turner said he feared that cities and counties would simply raise their tax rates to offset the lost revenue.

People are screaming for relief huh? So the proposal is to just keep spending while cutting taxes. Sorry, only the Federal government has the right to magic tricks like that. Florida, you have to decide to cut spending or raise taxes. Which is it? Then again you can do what Schwarzenegger has done and mortgage the next umpteen years worth of revenue into state bonds while rolling the dice on an improving economy.

What I find most interesting is the "Save Our Homes Law" seems to be backfiring. This of course is more proof that government programs over the long haul do exactly the opposite as intended.

Save Our Homes

Please consider this Special Report on "Save Our Homes".

• The Save Our Homes constitutional amendment doles out its benefits unevenly. Even among neighbors, the difference in annual taxes can be thousands of dollars.
• The program that was supposed to save little old ladies from being forced from their homes has turned into a cash cow largely for the rich.
• New owners in modest neighborhoods often pay the same tax bill as millionaire homeowners near the beach.
• Some Florida property appraisers say illegitimate and fraudulent homesteading are among the largest problems they face, resulting in tens of millions of lost tax dollars every year.

Massachusetts

The Boston Globe is reporting Lottery revenue drop worries officials.

The Massachusetts State Lottery, after years of increasing sales of scratch tickets and other games, is experiencing a substantial decline in revenue , setting off deep concern on Beacon Hill. According to figures filed with the governor's office, revenues fell $71 million, or 3.8 percent, during the first five months of the fiscal year.

State Treasurer Timothy P. Cahill is expected to brief legislative leaders today on the most recent sales figures. But some lawmakers already worry that Massachusetts residents are too tapped out by fluctuating gas prices to continue their regular lottery habit. The state lottery has been one of the most successful in the nation and has generated billions of dollars for cities and towns. Municipal officials are especially alarmed by the revenue decline.

"This is critical funding," said Senator Karen E. Spilka, a Democrat who represents Framingham, Natick, and five other towns. "My communities are hurting. . . . I don't want there to be a deficit and then for us to have to tell our cities and towns the funding isn't there."

Through November, sales were down for all lottery games except Keno, which was up 3.5 percent from the same time last year. The sharpest decline was in MegaMillions sales, which were off 47.7 percent. A former official attributed the decline to smaller jackpots; last year there were three $100 million prizes.

If lottery revenues don't rebound, it will make it even more difficult for Governor Deval Patrick to close an estimated $1 billion deficit in the next fiscal year's budget. Yesterday, Patrick asked each of his agencies to identify 5 to 10 percent in savings within their budgets.

Communities are already counting on this year's lottery aid; it's unclear whether the state would have to make up any shortfall.

"The lottery right now is extraordinarily important to cities and towns," said Geoffrey Beckwith, executive director of the Massachusetts Municipal Association, which represents communities across the state. "We're hoping that the lottery sales rebound. It's something we're watching very closely.

But he said communities shouldn't assume the lottery will continue to grow indefinitely. Michael Widmer, president of the Massachusetts Taxpayers Foundation, called declining lottery sales "a serious short- and long-term problem facing the state and cities and towns."

"To have this major source decline after years and years of growth adds further to the dilemma facing the state's political leaders," he said. "I've looked at the numbers, and the shortfall has been steady month to month. Every month I've seen a shortfall."

Lottery Summation

• Massachusetts residents are too tapped out by fluctuating gas prices to continue their regular lottery habit.
• If lottery revenues don't rebound, it will make it even more difficult for Massachusetts to close an estimated $1 billion deficit in the next fiscal year's budget.
• The lottery right now is extraordinarily important to Massachusetts cities and towns.
• Illinois is considering selling the state lottery.

Lottery playing is perhaps another significant shift in psychology. The masses simply can no longer afford to waste even a few bucks a week on dreams of a big payoff. This is coming at a time when cash strapped cities and states are struggling to meet budgets and dependent on that revenue.

Meanwhile rising property taxes have people screaming for relief in Florida, a state whose property values ironically enough are crashing. And California is banking on an entire series of unlikely events including rising property taxes, gambling revenue, and a recovering real estate market.

Are there any states in the country remotely prepared for a recession hitting this year? If so, which one(s)? When the recession does hit, states are going to have to choose between two very painful options: raise taxes or cut services. The first will have people screaming and the latter will throw more people out of work. Either way is going to be painful. We are in for some very rocky times ahead.

Mike Shedlock / Mish
http://globaleconomicanalysis.blogspot.com/