Foolproof Recession Indicators

Economist Paul Kasriel at the Northern Trust has come up with a recession indicator that has called six consecutive recessions with no misses and no false positives dating back to 1962. It does however, have a single miss in 1960. The condition is an inverted yield curve as measured by the 10-yr treasury yield minus the Fed funds rate, in conjunction with an annual rate of change falling below zero on the CPI adjusted monetary base. With a small tweak in methodology as described below we can pick up that isolated miss in 1960.

Paul discussed his idea with me in an Interview with Paul Kasriel and I mentioned it in January in Leading Economic Indicators.

Comments from Paul Kasriel

• The "real" unadjusted monetary base (bank reserves plus currency) seems to provide fewer false recession signals than does real M2 growth. That does not necessarily mean that the real base does a better overall job of forecasting real GDP, just that it does a better job of forecasting official recessions. Mish notes: "Real" in this case means inflation adjusted via the PCE price deflator, and "unadjusted monetary base" means a non-seasonally adjusted monetary base.
• I have used the PCE price deflator to get "real" rather than the CPI for purely arbitrary reasons here, not theoretical -- I don't have time to explain now, but it is not a big issue. Mish note: There is a potentially confusing mix of terminology here but none of the charts in this post were seasonally adjusted (except perhaps for consumer sentiment and on that I am unsure). Our inflation adjustments used the CPI, and any references to "real" in what I wrote (as opposed to what Kasriel wrote) means CPI adjusted. As Kasriel suggests there is little difference between the two. We tried both and settled on using the CPI because that that is what Shostak did as explained in Money Supply and Recessions.
• Starting with the recession of 1970, a negative spread on the 10-yr Treasury minus the fed funds rate in conjunction with a contracting year-over-year change in monetary base/CPI has predicted recessions with no false signals. In Q3 and Q4 of 2005, the real monetary base contracted but the interest rate spread still was positive. Now, the interest rate spread has turned negative, but the real monetary base is no longer contracting -- just barely.
  

Kasriel fully explains his theory in the March 22 article Recession Imminent? Both the LEI and the KRWI are Flashing Warning.

I have found that every recession starting with the 1970 recession has been immediately preceded by the following combination - a negative spread between the yield on the Treasury 10-year security and the federal funds rate (hereafter referred to as "the spread) on a four-quarter moving average basis and a year-over-year contraction in the quarterly average of the CPI-adjusted monetary base.

The monetary base is the sum of bank reserves and coin/currency, both of which have been created out of thin air, as it were, by the Fed.

The following chart shows the historical behavior of the "Kasriel Recession-Warning Indicator" (KRWI).



The KRWI has given no false signals in that when it has warned of a recession, there has been one. Unlike the LEI, which signaled a recession for 1967, the KRWI did not. However the 1960 recession was not signaled by the KRWI because the spread remained positive, although it did narrow. As of the fourth quarter of last year, the spread moved into negative territory, but the year-over-year change in the real monetary base remained positive. So, like the LEI, as of the fourth quarter of last year, the KRWI had not signaled that a recession was imminent.

Barring upward revisions in the LEI and KRWI and sharp increases in the immediate months ahead, both of these indicators will be sending a signal that a recession is on the horizon. Perhaps this will be the first time in over 45 years that the KRWI will emit a false signal and only the second time that the LEI emits a false signal. Perhaps.

10 Yr Treasury Minus 3 Mo Treasury

For comparison purposes I asked Bart at NowAndFutures put together a chart showing the 10 year treasury yield minus the 3 month treasury yield (as opposed to the FF rate) just to see what we could find.



Bingo! A perfect seven of seven with no misses and no false positives. The two blue-grey ovals are conditions where only one of two conditions were met.

Note: The above chart was formulated by subtracting $IRX (the 3 month treasury discount) from $TNX (the 10 year treasury yield). The former is a discount not a yield so the chart is slightly off the stated intent but it is extremely close. I had Bart look at the actual data and the numbers did go negative intra-month even if it does not show it on the chart. Using a true yield instead of a discount would make the spread more negative, so the signal was definitely given (even if ever so slightly).

Interestingly enough the 10 year minus the 3 month spread by itself has no misses since 1960 (seven for seven) but it did have a single false positive in 1967. The CPI adjusted monetary base was also seven for seven but with a false positive in 2005. False positives in isolation are shown in blue-grey ovals. Together they are perfect.

Thus by using Kasriel's idea of a paired set of indicators but substituting the 3 month yield for the Fed Funds rate we achieve a perfect seven of seven dating back to 1960, picking up the single miss of the Kasriel's KRWI in 1960.

M Prime Update

M' is an Austrian money supply indicator that I have been following for some time and started charting (with help from Bart) back in January. See Money Supply and Recessions for the theoretical justification of M'.

M Prime and Recessions



An annual rate of change in M' dipping below the 0% line is a pretty rate event but does not necessarily lead to a recession. On the other hand in each of the last six recessions M' did have a significant dip (though not as severe as the one we see now).

Notes:

• The sweeps data is notoriously late. I am not sure why. The latest data we have is for January. We extrapolated that data forward for two months. That is the best we can come up with at this time.
• The biggest difference between M' and M1 is in sweeps data. M' properly picks up sweeps data while M1 has been distorted since 1995 by the lack of it.
  
• Kasriel mentioned to me in the interview that he felt the Fed includes sweeps data in their M1 analysis. We get the data from an obscure Fed publication that is not updated very frequently. Why isn't sweeps data part of the mainstream data and more up to date?
• We took this series back as far as we could find data. Unfortunately that is no further than 1968.
  

Real M Prime (CPI adjusted) and Recessions



As far as predicting recessions goes, M' CPI adjusted is clearly an improvement over M' straight up. The CPI adjusted M' gives off very strong but not perfect recession warning on a cross of the 0% line on an annual rate of change basis. In conjunction with an inverted yield curve M' is a perfect six of six with no false positives.

Unless it's different this time, another recession is headed our way. Depending on whether one uses M' or the monetary base as a starting point (either will do in conjunction with the 10yr-3mo treasury spread), we are headed for a perfect seven of seven or eight of eight in recession predictive ability (with the difference being how far back the data series goes). Both sets have no misses and no false positives. None of this even takes into consideration the mess in housing which is a pretty good leading indicator in and of itself.

Those looking at M2 or M3 alone as proof of economic expansion or as some sort of inflation picture are missing the big picture. The economy is slowing far faster than most think by the three best leading indicators once can find (the yield curve, rates of change in M' or Monetary Base, and housing). Financial speculation as evidenced by growth in M3 and the final buildout of retail stores already under construction are all that is keeping the good ship Credit Bubble afloat.

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

Is the Fed really "pumping money"?

I had a very interesting email exchange with three Minyanville professors about whether or not the Fed is "pumping money". The three professors are Fil Zucchi, John Succo, and Scott Reamer.

The discussion started off with an email to Fil Zucchi so let's start there.

Mish to Professor Zucchi

Fil, I would like to discuss a comment you made about the “Fed pumping money”. I am not trying to nitpick but "pumping money" doesn't seem to be the best description of what is really happening. Here is how I look at things:

This Fed has chosen to defend an interest rate target. The Fed must supply all demand for credit at that target. If the Fed failed to do so the interest rate target would not be hit and interest rates would either rise or drop accordingly.

Now I am a big fan of abolishing the Fed and letting the market set rates, but as long as the Fed has an interest rate target (as opposed to a money supply target) the Fed is not pumping money per se, the Fed is defending an arbitrary target that it has established, no more no less. Thus it is not the Fed initiating anything, the Fed is merely meeting demand for money at the arbitrary target they set.

Now if the Fed instead set money supply targets instead of interest rate targets then interest rates would float day to day and money supply policy would be known. Yet every day I hear the same comments every day “The Fed is pumping to save housing” or “The Fed is pumping to save the stock market” or “The Fed is pumping the PPT”. All of this kind of talk seems ass backwards to me. The Fed is meeting money supply demands at its target. Period. Typically the Fed has been meeting demand for money with repos. Repos are short term loans, not part of permanent money supply.

But people take these ideas about “pumping” as well as conspiracy theories about M3 and draw still more inaccurate conclusions as to what is going on. I can and will make a case that looking at M3 in isolation is missing the big picture (at least from an Austrian perspective) as to what is really going on with money supply. But that is another issue for Friday or early next week in my blog.

Right now, it’s time to clear up this “pumping money” issue. Claims that the “Fed is pumping money” is putting the cart before the horse because by defending an interest rate target instead of a money supply target the Fed does NOT have a choice as to what the demand for money will be at its designated (and arbitrary) target currently set at 5.25%.

In essence I feel that "pumping money" statements only serve to reinforce various conspiracy theories that are now running rampant. If I am mistaken then perhaps you or John Succo or Scott Reamer can clear up my misconceptions and I welcome the opportunity to learn.

Response from Professor Zucchi

HI Mish – great points and I understand what your saying, but I am not sure I agree entirely with it. A response will require me to wear my thinking cap for a while, but I’ll certainly post one. Meanwhile I’m gonna send this on to Succo, Reamer and Sedacca as I imagine they may wanna give a crack at it as well. Hear u soon, Fil

Response from Professor Succo

Both are right…we are picking over semantics.

The Fed has set an artificially low interest rate. The market wants higher rates because it sees the problems these low rates are causing: that money is getting into speculation and very low grade credit. The Fed must supply enough new credit (repo) in order to keep rates from rising. The recent steepening of the yield curve is telling us that this is hard to do: they are doing too many repos trying to keep rates low.

If the Fed wants to stop pumping money they would admit that rates are too low and would raise them.

In fact the recent steepening is very alarming. It is due to defaults/foreclosures/ where lenders are saying they cannot continue to pass on to speculators/low quality borrowers all that new credit the fed is trying to force into the market.

An inverted yield curve normally predicts a recession. That recession comes home to roost when the yield curve suddenly steepens our of that inversion: the market is tightening out of necessity just as the fed is trying to make it not to.

Response from Professor Reamer

There is another operational element here that very few folks appreciate and it is this: In setting the fed funds target rate and defending it, the Fed’s open market operations take the form of either pumping liquidity into or out of the banking system (via Fed Funds) in an effort to keep the target rate at (for now) 5.25%.

Let’s say that economic activity is heating up; there is more manufacturing activity, more employment, more lending by banks and as a result of all of those, more demand for short term monies by commercial banks. Bank lending activity goes up and their demand for short term money (the cost of which is set by the Fed) increases commensurate with their need to keep capital/coverage ratios at whatever bare minimum regulations demand they be. So, net/net greater economic activity implies more money demand by commercial banks. If money demand by commercial banks increased, in the absence of the Fed, we would see the ‘cost’ of the money (the interest rate) do what?

Like all goods, when the demand for something goes up, the price increases in the short run. So in the case of short term (Fed) funds, increased economic activity generates greater demand for short term funds by commercial banks and that increases the cost of those monies – increases the interest rate of these monies. But the rate – cost – of Fed Funds is 5.25% and the good boys at the NY Fed have pledged that it will defend the FOMC’s Fed Funds target – neither letting it rise nor fall. But if increased economic activity is driving up the Fed Funds rate, then the Fed must increase the supply of credit in an attempt to keep the rate at 5.25%. This is of course a basic law of economics: in the face of increased demand, prices rise. The only thing that can keep prices the SAME would be an immediate increase in supply. And that is what the NY Fed does when economic activity increases – they increase the supply of monies in the system (via repos and other means) in order to defend that Fed Funds target.

More interesting than that is what happens when economic decreases. The opposite situation arrives: when economic activity decreases the demand from commercial banks for short term funds decreases and thus the price (rate) falls. In order to maintain and defend that fed funds target in a scenario where economic activity is decreasing and lending activity is slowing, the Fed has to decrease the supply of monies available to the system. Thus, the Fed will be taking money from the system once economic activity decreases unless and until they change the Fed Funds rate target.

That period of time between a slowdown in economic activity and an eventual decrease in the Fed Funds rate can take months or quarters. If the size and severity of the misallocation of investments in the economy are significant, that period where the NY Fed open market desk is defending the FOMC’s rate by decreasing monies in the system, need not be lengthy at all to create the kind of tightening of monies that is so anathema to a credit-driven, asset-based economy. A few months of taking money out of the system in order to defend a Fed funds target is all that is theoretically needed to create the type of tail event that we believe it highly probable in the credit and stock markets, not to mention the real economy.

The conditions of decreasing economic activity are present; the malinvestments are both huge and pervasive; the Fed could easily start to take money out of the system to keep the Fed Funds rate at 5.25%; and commercial bank lending declined last week more than it has at any time since February 1960. Those are the conditions – sufficient but perhaps necessary – for a credit-based contagion event. And few times in history have markets been implying the odds of this are so low.

I took the liberty of passing on Professor Succo's comments to my Austrian minded friend who goes by the name of Trotsky.

Trotsky Chimes In

• You are right - Since the Fed has abandoned 'money supply targeting' it merely supplies WHATEVER the market demands at the prevailing set target. Note however, that lately, the Fed has supplied funds quite often well BELOW target, so the idea that it is busy 'pumping' right here and now is not totally off the wall. Nonetheless I agree with the general thrust of your argument.
• Succo is also right - When the curve begins to steepen out of an inversion, the recession alarm bells go off. This is due to the nature of the whole thing - Why is the curve inverted? It is not because the Fed has deliberately inverted it - After all, in setting the FF rate, the Fed actually tends to follow rather than lead the short term market interest rate. In other words there is a feedback loop - when the market expects them to tighten, it will raise t-bill yields before they actually tighten, and vice-versa. So what creates inversions? It is mostly enormous demand for short term speculative credit.
  
• The previous episode of money pumping (examine money supply growth charts for 2001-2002 when they dropped rates to 1%, and you will see they went off the charts) begins to percolate through the markets setting off asset bubbles (stocks, housing, commodities - what have you), that produce returns that far exceed the rate charged by the Fed. Consequently, demand for credit based speculation heats up, as the bulk of traders, hedge funds, etc. are simply trend followers. This eventually inverts the curve. Thus, when the curve begins to steepen out of an inversion, it signals a growing loss of liquidity, as speculative demand for credit wanes (for whatever reason - it could well be that lenders become reluctant to supply more credit, such as is the case in housing now).
• The 'market is tightening out of necessity' just as Succo has put it. Since the boom was entirely artificial and credit driven, the sudden loss of credit intermediation support shows up as a steepening curve and morphs into a recession/bear market.
• The Fed IS or HAS BEEN pumping in the sense that the rate it has set is still lower than the one the market would have set if rates were completely free in the face of such overwhelming demand for credit. In short, the housing bubble would have been stopped in its tracks much sooner in a truly free market, as the demand for mortgage credit would have pressured rates higher much earlier. Of course, in a truly free market, the entire rate term structure would look different - there would be scant difference between short and long rates most of the time, and rates overall would be far lower in an honest money system.

Discussion Points

• As Professor Reamer points out the big risk is for a "credit-based contagion event" especially if the Fed artificially tries to hold the Fed Funds Rate higher than where the market thinks rates should on the way back down. Such actions would require various monetary draining operations by the Fed that perhaps the market is not prepared for.
• If the Fed has indeed been supplying money at rates below the Fed Funds Rate as Trotsky pointed out, then the word "pumping" in and of itself seems appropriate.
• If the Fed was targeting money supply instead of defending an arbitrary interest rate target it would be easier to defend claims one way or another whether or not the Fed was "pumping money".
  
• In a free market economy where the market set interest rates instead of the Fed, the housing bubble never would have gotten as big as it did because interest rates would have been driven higher faster and may not have gotten as low as they did in the first place.
  

Outside of the Fed supplying money below their targeted rate, this may be a debate over semantics as Professor Succo suggests. Nonetheless I am sticking with my cart/horse scenario simply because defending an interest rate target while claiming to be fighting inflation (as the Fed is doing now) is putting the cart before the horse.

When it comes to inflation fighting discussions, talk about the CPI, PPI, capacity utilization, as well as the price of oil, copper and cotton is in reality nothing but a sideshow. Inflation starts with an expansion of money and credit. It is striking (as well as absurd) that we have a monetary policy where the Fed discusses everything but money.

By arbitrarily defending interest rates targets that the market never would have set, the Fed put itself in a box and started chasing its own tail inside that box. The Fed is now wondering what to do next when there simply is no right solution at this point other than to abolish the Fed and let the market fix the problem over time. Since that is not about to happen any time soon, the best we can do is watch for conditions that might signal the beginning of a "credit-based contagion event".

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

The Disposable Workforce

The myth is that jobs are plentiful, the economy is geared for growth, and capital spending will pick up where real estate left off. The reality is something else on all accounts.

In Detroit 26,000 apply for 1,000 casino jobs.

About 300 lined up outside MGM's new staffing center on Tuesday in Detroit to apply for 1,000 positions. Those without computer access can use one of the center's 25 workstations to apply for one of the jobs at the permanent gaming complex, which will open this year.



More than 26,000 people have applied online for the 1,000 jobs MGM Grand Detroit intends to fill with the opening of its permanent $765 million hotel and casino complex later this year.

The deluge of applicants -- a reflection of the region's sagging economy -- has come in the nearly three weeks since MGM Grand announced its hiring goals for the new entertainment complex at Third and Bagley streets.

MGM's hiring has been a bright spot in an otherwise dour job market. Michigan has the nation's highest unemployment rate, with the region reeling from the loss of thousands of manufacturing jobs in the automotive industry. The region, too, has been stung by drug giant Pfizer Inc.'s plans to close its Ann Arbor compound and pull more than 2,000 jobs out of the area, and by Comerica Inc.'s decision to relocate its headquarters and 200 workers from Detroit to Dallas.

Many in line at MGM on Tuesday weren't concerned about the per-hour wage. They just want work and a paycheck.

"I'll take anything that is available," said Sharika Haywood, 21, of Detroit, one of the job-seekers in line Tuesday. "I've looked for a job every day. I've filled out applications but never get a call back. I'm hoping that something comes through here."

'I need a job'

MGM's hiring efforts couldn't come at a better time for Terry Pardon, a 45-year-old father of three who lives in Harrison Township and was laid off from a construction job a week ago. "I need a job that pays and has benefits," he said. "I'm going to apply for a maintenance job. It's tough finding a job anywhere in Michigan."

Veneisha Boyce, 23, of Detroit was looking for a housekeeping or security position.
"But I'm looking for anything," said the single mother of a 3-year-old daughter. "It's tough finding a job. I need a job with benefits."

Guy Janicki, 64, of Grosse Pointe Woods said he can't afford to retire and would like a job as a dealer or cashier. For the past 10 years, he has been a cashier at a downtown parking structure.

"I've been looking for work, but I just can't find any," he said. "It's pretty rough in the job world."

Detroit Summary

1. I've been looking for work but can't find any.
2. I need a job with benefits.
3. I'm looking for anything.
4. I can't afford to retire.

Unfortunately this is not just Detroit I am talking about. Nor is this is a manufacturing thing. Areas where housing has been booming and jobs were more plentiful are going to get hit hard as well. Retail stores followed the home expansion and that provided additional sources for jobs. But few are looking ahead to see what happens when that retail expansion stops. Fewer still see the actual jobs contraction that is coming.

Pay close attention to point number 4 as well. We are going to hear more and more about it. Too many baby boomers are simply not prepared for retirement. Any number of things can happen even to those who think they are prepared: rising property taxes, insurance or medical costs may force some back out of retirement. Others may be hit hard in the next stock market decline. Penson plans that are under funded may renig on benefits. And far too many are dependent on their houses for a source of income.

Grim Reality

With that backdrop it is fitting that Bill Gross at Pimco is talking about the Grim Reality.

It will not be loan losses that threaten future economic growth, however, but the tightening of credit conditions that are in part a result of those losses. To a certain extent this reluctance to extend credit is a typical response to end-of-cycle exuberance run amok. And if one had to measure this cycle’s exuberance on a scale of 1-10, double-digits would be the overwhelming vote.

Anyone could get a loan because shabby credits were ultimately being camouflaged within CDOs that in turn were being sold to unsophisticated foreign lenders in need of yield as opposed to ¼% bank deposits (read Japan/Yen carry trade). But there is something else in play now that resembles in part the Carter Administration’s Depository Institutions and Monetary Control Act of 1980. Lender fears of potential new regulations can do nothing but begin to restrict additional lending at the margin, as will headlines heralding alleged predatory lending practices in recent years. After doubling over 18 months between 2005 and the first half of 2006, non-traditional loan growth has recently turned negative, and lenders’ attitudes are turning decidedly conservative as shown in Chart 1. [Annotations by Mish]



Bulls and bears argue over websites as to the percentage of all lending that subprime and alternative mortgage loans provide but while important, the argument obscures the critical conclusion that tighter lending standards and increased regulation will change the housing outlook for some years to come. As past marginal buyers are forced to sell their home to prevent foreclosures, so too will future marginal buyers be restricted from buying them.

Looking forward I see little chance that housing has bottomed. Not only are credit standards tightening significantly but the process has barely started timewise. Between 1991 and 1994 we saw a 45 point drop in roughly 3.5 years. We are only half a year in the credit tightening process and we still have not see the effects of mortgage ARMs resets. This was the biggest housing bubble in history. Can credit standards tighten or stay high for another 3 years? 6 years? Why not? Better yet, why shouldn't they?

There has never been a national housing (credit/debt) bubble as big as this one. Indeed, because of the carry trade and loose economic policy everywhere, this is an international fiasco. We are in uncharted territory and the good ship "Credit Bubble" is taking on water fast. It can capsize at any time.

Capital Spending

The ongoing myth is that capital spending will pick up where housing left off. The theory is truly inane as I have stated many times. Why should businesses expand when consumers are pulling back. It makes no sense.

Two years ago there was nothing but denial culminating with Time Magazine's cover "Why we are gaga over real estate". Is anyone of merit denying the housing bubble anymore? The capital spending myth will likely perpetuate as well until it shatters just as various housing myths were shattered one by one.

The Disposable Workforce

There was an interesting article in Bloomberg today Circuit City to Fire 3,400, Hire Less Costly Workers.

Circuit City Stores Inc., the second-largest U.S. electronics retailer after Best Buy Co., fired 3,400 of its highest-paid hourly workers and will hire replacements willing to work for less.

The company said its eliminating jobs that paid "well above" market rates. Those who were fired can apply for the lower pay, company spokesman Bill Cimino said today. He declined to give the wages of the fired workers or the new hires.

"Firing 3,400 of arguably the most successful sales people in the company could prove terrible for morale," Colin McGranahan, an analyst with Sanford Bernstein & Co., wrote in a note today. "The question remains as to whether Circuit City can rebuild in time for the all-important holiday season."

The fired employees will get severance pay. Today's job cuts, as well as plans announced last month to close 600 stores and cut 400 jobs, will result in a $145 million pretax charge in the fiscal 2007's fourth quarter.

Circuit City pays about $10 to $11 an hour, on average, said Rick Weinhart, an analyst with BMO Capital Markets Corp. in New York. Entry level pay probably is close to $8 for inexperienced workers, he said.

Chief Executive Officer Philip Schoonover was paid $8.52 million in fiscal 2006, including a salary of $975,000. Best Buy CEO Brad Anderson received $3.85 million, including a $1.17 million salary.

Circuit City, along with Best Buy, was forced to slash TV prices during the 2006 holiday season after Wal-Mart Stores Inc., Home Depot Inc. and CostCo Wholesale Corp. began selling flat panels for less.

The job cuts are "one of the most brazen examples of corporate America run amuck," said Greg Tarpinian, executive director of Change to Win, which represents seven unions and about 6 million workers. "It's workers as disposable commodities, put in and put out based on whatever happens to the stock price."

Key Points

• Workers are being fired simply because they make too much money not because they are no longer needed. While this has happened before, typically under the guise of some sort of "rightsizing" effort, this is the first explicit massive public disclosure of this nature on this scale that I can think of.
• There are price wars on retail goods involving Walmart, Circuit City, Costco, Home Depot and Best Buy. So much for the idea that input costs are rising so prices on stuff will follow suit.
• There is unrelenting pressure on wages. That pressure has now expanded outside the automotive/manufacturing sectors to jobs paying as little as $11 an hour. Think raising the minimum wage will do any good? If so, think again. An increase in the minimum wage is going to cost jobs, 100% guaranteed.
  
• The second largest electronics retailer is closing 600 stores. Can anyone say "overexpansion"?
• Kiss those capital spending savior thoughts goodbye.

Unemployment is going to skyrocket and the fuse is already lit. I have been asking for months what exactly we need more of that is going to cause corporations to expand capital spending. That's now the wrong question. The right question is "How big are the cutbacks going to be?"

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

Three Clowns

In one of the most blatant cheerleading fluff interviews in history, Bloomberg touted a "Housing Panel Discussion Like No Other". Indeed it was. Click on the link for an audio of what can best be described as a three ring circus act.

Meet The Clowns

1. Chris Kelly (CGK Construction)
2. John Sauro (North Atlantic Mortgage Corp.)
3. Conrad DeQuadros (Bear Stearns)

Clown Excepts

Chris Kelly (CGK Construction)

• Lower home prices are because builders are building smaller homes not because of price cuts.
• On existing home sales, if people drop their prices they are still going to come out ahead.
• It's not like you are going to get a 3000 square foot house for cheaper price. You will get a 2000 square foot house for cheaper price than a 3000 square foot house.
• Land still costs and materials have not dropped in price.
• The only savings is in the size of the house.
• Looking forward to a strong season.
• The FHA was not giving out enough money to buy a house.
• FHA raising limits would help things out a lot.
• If someone can get $425,000 from the FHA they can buy a home from me.

John Sauro (North Atlantic Mortgage Corp.)

• Chris Kelly is right about home prices.
• People selling existing homes are still making money.
• The market was "very healthy" over the last 3-5 years.
• People pricing their home to sell will still make money.
• Delinquencies will peak in 2007 well below past peaks.
• A lot of subprime lending concerns are very overblown.
• We do not want to see subprime programs go by the wayside.
• Now is an excellent time to buy as home.
• The subprime market helped the first time homebuyer to get a home.
• Rate hikes have gotten the Fed into trouble.

Conrad DeQuadros – Senior Economist - Bear Stearns

• Unusual weather patterns created volatility in housing.
• We are probably near the bottom here.
• Homebuilder sentiment index shows increases in sales are expected this year.
• OTHEO has it right and saw a 6% increase in prices by Q4.
• The economy is on a firm footing.
• The labor market is strong and that will support the consumer.
• We may see a modest moves up in interest rates second half of 2007.

Totally Lame Excuses

• Blaming the FHA for not making enough loans.
• The weather.
• Rate hikes got the Fed in trouble.
  

Totally Lame Statements

• Home prices are not dropping, rather homes are getting smaller.
• The economy is on a firm footing.
• Subprime concerns are overblown.
• The labor market is strong.

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

Tales of the Unexpected

The unexpected happened again. New-home sales fell to a seven-year low and February's inventories of unsold houses at sitting at a 16-year high. Both were unexpected.

Sales of new homes unexpectedly dropped in February to the lowest level seen in nearly seven years, while inventories of unsold homes rose to a 16-year high, suggesting that the nation's housing market was softening heading into the vital spring buying season.

Sales of newly constructed single-family houses unexpectedly slowed again in February, falling 3.9% to a seasonally adjusted annual rate of 848,000, the lowest level since June 2000, the Commerce Department reported Monday. Sales were down 18.3% compared with February 2006.

Economists surveyed by MarketWatch had been expecting an increase in February to about 1 million units.

I am wondering if bad news is ever expected. I am also wondering exactly what economists MarketWatch is surveying. Perhaps they need a new set of economists because this was simply not all that surprising.

Census Bureau Report

Those wanting to see the official data can find it in the Census Bureau report New Residential Sales For February 2007.

Sales of new one-family houses in February 2007 were at a seasonally adjusted annual rate of 848,000, according to estimates released jointly today by the U.S. Census Bureau and the Department of Housing and Urban Development. This is 3.9 percent below the revised January rate of 882,000 and is 18.3 percent below the February 2006 estimate of 1,038,000.

Home Sales Revisions

RodgerRafter on the Economic Rebalancing blog posted an interesting chart about the unexpected revisions.



The Housing Doom Blog had this graphic representation of the unexpected.




I am struggling to understand why month in and month out no one expects a decline in home sales to happen when I expect things to get much worse.

We are not even in a recession yet (or so is claimed) but inventories of unsold housing are at 16 years highs dating back to 1991. This is simple economics: To sell that inventory prices have to drop or demand has to pick up.

Understanding Demand - 3 Questions

1. Who wants a house that does not have one?
2. Who wants a house that can afford one?
3. Who does not have a house and is willing to pay substantially more than rental prices for one?

Understanding Supply - 2 Questions

1. How many have a house they can not afford?
2. How many have a house they soon will not be able to afford?

Forget demographics, forget wants and desires, forget the fact that people have to live somewhere. Forget all of the nonsense from the NAR. Especially forget the NAR's perpetual chant "There is no better time to buy than now". According to the NAR there is never a better time to buy than now. Furthermore there will never ever be a better time to buy than now.

Two Key Facts

1. Demand is weak and is going to get weaker.
2. Supply is high and is going to get higher.

The following graphic thanks to JMF at Immobilienblasen.

Heading into a recession demand will weaken due to loss of jobs and rising subprime rates.

Supply is high but the bulk of ARMs resets has not occurred yet. Layoffs in the upcoming recession have not occurred yet. Substantial foreclosed properties are not even on the market yet.

So.... With demand getting weaker and supply getting higher exactly why was this report unexpected?

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

Hot Lines for Hard Times

Jobs are supposedly plentiful yet 2.1 million Americans with a home loan missed at least one payment at the end of 2006. That seems pretty hard to me. And it's going to get a lot harder paying that mortgage when ARM interest rates reset and unemployment starts to rise. Both are going to happen.

Kiss the easy button goodbye.
Here is the new button.



Things Hard

• 100% financing
• Subprime loans
• No doc loans
• Stated income loans
  
• Cash out refis
• Selling real estate, especially condos
• Living on no commissions
  

Some of the things in the above list are not only hard, but next to impossible.

Hotlines for Hard Times

There are a number of foreclosure prevention hotlines serving various states and cities as well as a national hotline to which people can turn for help. A quick search turned up the following list.

• The Colorado Foreclosure Prevention Hotline is 877-601-HOPE (4673).
• The homeownership preservation foundation has a national homeownership hotline at 1-888-995-HOPE (4673).
• The Florida Foreclosure Prevention Hotline is 1-877-532-HELP (4357).
• The New York City Foreclosure Prevention Hotline is 718-246-3279.
• The Boston Foreclosure Prevention Initiative phone number is 617-635-HOME (4663).

Don't Borrow Trouble

Boston started a "Don't Borrow Trouble" campaign to warn borrowers about predatory lenders. Minnesota and Virginia have similar campaigns.

• Boston "Don't Borrow Trouble"
• Minnesota "Don't Borrow Trouble"
• Virginia "Don't Borrow Trouble"

Eleven Tips from Freddie Mac

1. Say NO to "easy money." Borrowers should beware if someone claims "credit problems won't affect the interest rate." Avoid solicitations for loans that sound too good to be true. If it sounds too good to be true, it probably is. If a solicitation is really interesting, get it in writing!
2. Shop around. Borrowers should talk to several lenders to find the best loan for which they qualify. A loan product or lending practice may not seem predatory until compared with a similar loan product offered by other lenders.
3. Understand the loan terms. Borrowers should compare loan terms from different lenders. Understand the best loan terms available in the marketplace and compare the APR (annual percentage rate) of loans from different lenders. The APR takes into account both the interest rate and the points and fees of the loan. A nonprofit housing counselor or a lawyer can review the information with a borrower.
4. Find out about prepayment penalties. Borrowers should know if the loan offered to them has a prepayment penalty. Prepayment penalty should be a choice, not a requirement.
5. Make sure documents are correct. Be cautious of someone who offers to falsify a borrower's income information to qualify for a loan. Borrowers should never falsify information or sign documents that they know to be false.
6. Make sure documents are complete. A borrower should not sign documents that have incorrect dates or blank fields. Be wary of promises that a lender will "fix it later" or "fill it in later."
7. Ask about additional fees. Borrowers should question any items they didn't ask for. Borrowers should also beware if they are told that single premium credit insurance is required get a loan, or that purchasing it will help loan approval. Review every fee and compare different lenders' fees to ensure the most competitive loan terms.
8. Understand the total package. Ask for written estimates that include all points and fees. The situation may not seem abusive until everyone gets to the closing table. If any fees or charges differ from what was previously disclosed, delay the closing until all terms of the loan are clearly understood.
9. Work with credit counselors. A borrower should get all the facts before deciding to combine credit card or other debts into a home loan. Beware of scam credit counseling/ credit consolidation agencies – unfortunately, not all credit counseling agencies are acting in your best interests. Talk to a community-based consumer credit counseling agency or housing counselor before signing the loan documents.
10. Protect home equity. If borrowers are taking equity out of their property, they should take out the minimum amount needed. The equity in a home is a source of wealth, which builds up slowly over time.
11. Get advice first! Talk to a community-based consumer credit counseling agency or housing counselor.

Hot Water

Not only is Beazer struggling to sell homes but things are starting to get a little hot for Beazer as well. The Charlotte Observer is reporting Beazer arranged loans are under federal review.

Federal housing officials will review whether Beazer Homes USA complied with federal rules in arranging government-insured loans for buyers in its subdivisions.

The Department of Housing and Urban Development, responding to an Observer investigation, will look at lending records from Charlotte and other cities where a large share of Beazer loans ended in foreclosure, officials said Friday.

Beazer's case is different. The company worked as a mortgage broker, matching lenders with borrowers. And almost all its loans were insured by the Federal Housing Administration, which promised to pay the lender if the borrower did not.

An Observer investigation published last week charted Beazer's actions in Southern Chase, a Beazer development in Cabarrus County where 77 buyers have lost homes to foreclosure in a neighborhood of 406 homes.

The Observer found Beazer acted in ways that made a high rate of foreclosures inevitable. It arranged larger loans than some buyers could afford. That allowed it to include the cost of financial incentives in the price of homes.

Some of the company's actions violated federal lending rules, the Observer found.
In Mecklenburg, a record 2,500 owners lost homes last year. Foreclosures this year are up 8 percent over the same time last year.

The problems are concentrating in starter-home developments of low-priced homes built in the last decade. The Observer found at least 35 such developments in Mecklenburg with a foreclosure rate above 20 percent.

Beazer built nine of those starter-home developments, with average property values below $150,000, and one more with slightly higher values. No other single company has built so many Mecklenburg developments with such high foreclosure rates, the Observer reported last week.

Ohio officials said last week that the state will refinance about 1,000 owners facing foreclosure into loans with lower interest rates, using a $100 million issue of municipal bonds. Ohio has the nation's highest foreclosure rate.

It will be interesting to see what happens to Beazer. If they have to buy back those homes because they violated federal lending rules then perhaps we will be able to kiss Beazer goodbye. Lennar is arguably in a similar situation over defects.

Things are hard and about to get harder for those trapped in a shoddy home a builder refuses to fix, for those trapped in a mortgage they can not afford, and for those trapped in a house or condo they can not sell.

The best advice for anyone struggling to pay the bills is to avoid borrowing more trouble at terms that are difficult to understand. For those already in trouble the best advice is to talk to the lender before things get worse. The last thing a bank wants to be forced to do is sell a bunch of foreclosed properties at a loss in a declining market.

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

Slowdown in shipping, phones, Alt-A mortgages

BusinessWeek is reporting a slowdown at FedEx.

Package delivery company FedEx said Mar. 21 that it's been struggling to grow profits during recent months. Fuel costs cut into profits, while snowstorms made it tougher for trucks to deliver packages. And as the U.S. economy slowed, customers who might have insisted on shipping everything overnight express during easier years downgraded to less expensive services.

Buffeted by such factors, the Memphis (Tenn.) company's net income during the third quarter ended Feb. 28 fell 2% from a year ago to $420 million. "The U.S. economy grew at a lower rate than we expected in the third quarter, and we saw continued adjustments in the automotive and housing markets," said CEO Frederick W. Smith in a press release March 21.

Still, FedEx's Smith promised better times ahead. He called the U.S. economy's recent performance "a healthy transition" as it "phases into a more sustainable growth rate."

FedEx Summary

• Shipping volume down
• Customers seeking cheaper alternatives (cutting back on overnight)
• Economy slowing and FedEx did not see it
• Denial about the future

Bloomberg is reporting Motorola 'Running Out of Scapegoats' as Profit Fades.

Motorola Inc. Chief Executive Officer Ed Zander, once heralded as a turnaround artist for reviving the mobile-phone maker, may be falling out of favor.

Zander yesterday forecast a loss for this quarter and the first sales decline in four years. The stock slid to its lowest level in almost two years.

"He's running out of scapegoats," said John Krause, an analyst at Thrivent Financial for Lutherans in Minneapolis, which owns 1 million Motorola shares. "The buck's got to stop at the top. People are losing patience."

Earnings and revenue this year will be "substantially" below its forecasts because of plunging mobile-phone prices, Schaumburg, Illinois-based Motorola said yesterday. Zander, who already is cutting 3,500 jobs, said the company will overhaul marketing and product design to make its prices competitive without sacrificing earnings.

Zander, a 60-year-old former Sun Microsystems Inc. executive with a fondness for Armani suits, said he plans to introduce "feature-rich" phones and refocus the company's marketing message away from sleek design to the tasks users can do with the device.

"We need to get back to the things we do best around innovation, operational discipline and execution," Zander said in an interview. "And we've got to get it right in all three areas."

Zander said he plans to reduce spending on chips and trim the cost of designing products after Motorola said it would miss sales forecasts for a third straight quarter amid price cuts in emerging markets such as India.

"We didn't react fast enough," Zander said.

Motorola expects a loss of 7 cents to 9 cents a share, its first loss since 2004, on revenue of $9.2 billion to $9.3 billion this quarter. Motorola didn't provide new full-year figures.

"I never would have thought that they would go into a money-losing situation," [said Albert Lin, an analyst at American Technology Research in San Francisco].

Zander's [previous] answer was the Razr, a slim, all-metal design that was an epitome of cool and sold for $499 when it came out two years ago, at least twice as much as many phones Motorola made. The Razr, overshadowed by sleeker, cheaper models from Nokia and Samsung Electronics Co., now sells for as little as $29.99.

Questions for Motorola

• So the "epitome of cool" has dropped in price from $499 to $29.99. How cool is that?
  
• Did the price of plastic, chips, copper, or any other ingredients in a phone drop in price that much over the last two years? Did it matter?
• Zander claims Motorola "needs to get back to the things we do best around innovation, operational discipline and execution. Exactly when was that?
• "We didn't react fast enough" Zander said. Hmm. When did Motorola last react fast enough?

Motorola is reporting is a whopping 94% drop in the price of cool. Welcome to global phone technology glut revisited. How many more features can be packed into a phone anyway?

CFC Begging for more Subprime Pain

Reuters is reporting Countrywide 2006 failed subprime loans could be new worst.

Countrywide's subprime mortgage defaults for 2006 loans may exceed the company's highest on record, a company executive told a government panel examining mortgage lending.

Countrywide's "worst single origination year was 2000, for which the cumulative foreclosure rate was 9.89 percent," Sandor Samuels, the company's executive managing director, said in prepared remarks.

"We believe that declining home prices and other factors ... may produce foreclosures numbers on 2006 originations approaching or exceeding those on loans originated in 2000," Samuels said in remarks.

The company believes that there was overcapacity in the mortgage market in 2004, the company said, and does not agree with federal regulators that borrowers should be approved at the "fully indexed rate" that considers the long-term costs of the loan.

Countrywide is not close to the reality phase yet. I base that statement on the comment CFC "does not agree with federal regulators that borrowers should be approved at the 'fully indexed rate' that considers the long-term costs of the loan."

Not looking at borrowers' ability to repay loans is just what got CFC and every other subprime lender into hot water in the first place. That they see no need to take fully indexed rates into consideration says that they are begging for more pain down the road.

Kiss No Down Payments Goodbye

Bloomberg is reporting Subprime Meltdown Snares Borrowers With Better Credit.

The subprime credit crunch is beginning to ensnare even borrowers with better credit. Lenders are increasingly refusing to lend to homebuyers who can't make a down payment of more than 5 percent, especially if they won't document their income.

"It's going to be very difficult, if not impossible, to do a no-money-down loan at any credit score," said Alex Gemici, president of Parsippany, New Jersey-based mortgage bank Montgomery Mortgage Capital Corp. Companies that buy the loans "are all saying if they haven't eliminated them yet, they'll eliminate them shortly."

Bear Stearns Cos., General Electric Co.'s WMC Mortgage, Countrywide Financial Corp., IndyMac Bancorp Inc., Goldman Sachs Group Inc., Lehman Brothers Holdings Inc. and Credit Suisse have all said in the last two weeks they're pulling back from buying Alt A mortgages sold with no down payment or in a refinancing of the house's entire value.

So another chunk of marginal buyers just went out the window. Who was it that said this mess would be contained?

Choppy Growth?

MarketWatch is reporting Leading economic indicators declined 0.5% signaling choppy growth.

The economy is likely to grow at a moderate but "choppy" pace in the coming months, the Conference Board said Thursday upon the release of the index of leading economic indicators. The index fell 0.5% in February, close to the 0.4% drop expected by economists surveyed by MarketWatch. Four of the 10 indicators increased in February. The index is up 0.2% in the past six months. "The housing and manufacturing sectors are clearly going through a correction, but the consumer sector appears to be holding up," said Ken Goldstein, labor economist for the private research organization, in a press release. "That mix should generate moderate but choppy growth ahead."

Another chunk of potential home buyers went out the window, better late than never, and with that, things (already choppy) will get choppier and choppier as the year rolls on.

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

Near panic at the Fed

There is near panic at the Fed. You can see it in their statements even if you can't hear in their voices. It would have been fun to be in that FOMC room today with a recorder so we could hear the sound effects but instead we have to "hear between the lines".

RogerRafter on The Market Traders took a look at wording changes in the last two FOMC statements.

Here is the statement from the January 31, 2007 FOMC Meeting.
Here is the statement from the March 21, 2007 FOMC Meeting.

Old wording: "Recent indicators have suggested somewhat firmer economic growth, and some tentative signs of stabilization have appeared in the housing market. Overall, the economy seems likely to expand at a moderate pace over coming quarters."

New wording: "Recent indicators have been mixed and the adjustment in the housing sector is ongoing. Nevertheless, the economy seems likely to continue to expand at a moderate pace over coming quarters.


Old wording: "Readings on core inflation have improved modestly in recent months, and inflation pressures seem likely to moderate over time. However, the high level of resource utilization has the potential to sustain inflation pressures."

New wording: "Recent readings on core inflation have been somewhat elevated. Although inflation pressures seem likely to moderate over time, the high level of resource utilization has the potential to sustain those pressures."


Old wording: "The Committee judges that some inflation risks remain. The extent and timing of any additional firming that may be needed to address these risks will depend on the evolution of the outlook for both inflation and economic growth, as implied by incoming information."

New wording: "In these circumstances, the Committee's predominant policy concern remains the risk that inflation will fail to moderate as expected. Future policy adjustments will depend on the evolution of the outlook for both inflation and economic growth, as implied by incoming information."

Thanks Rodger.
The new statements show that Fed is supposedly more concerned about inflation and supposedly more concerned about high capacity utilization than in January. Previously they stated "some inflation risks remain", but their "predominant policy concern" now is that "inflation will fail to moderate".

With those concerns the Fed ought to be tightening, at least in theory. Instead the Fed completely dropped the phrase "The extent and timing of any additional firming that may be needed to address these risks will depend on the evolution of the outlook for both inflation and economic growth".

Dropping that phrase shows the Fed is far more concerned over a recession and an implosion in housing than any inflation they are harping about. A more honest wording would have been something like this.

FOMC Announcement Translation

We are unanimously scared half to death by the implosion in housing, defaults and foreclosures. Our biggest fear is a recession. A jobs slowdown would worsen that situation dramatically.

We are also somewhat concerned by rising food prices but those prices are soaring primarily because of Bush administration policy handouts to farmers and the ethanol industry. Economic policy can not really cure problems caused by poor administrative decisions. It would be a mistake to try.

Because of blatantly bad policy decisions by us, notably Greenspan's praise of subprime lenders, promotion of ARMs at the exact worst time for the consumer, support of toxic loans, and most importantly our previous decision to slash interest rates to 1%, we created the current property bubble. We now admit we did that on purpose. We just never expected the bubble to get this out of hand. We created the housing bubble on purpose to bail out banks that were at risk due to poor loans made to the dotcom industry. Now to bail out the housing industry we feel compelled move to a more neutral stance.

With consumer debt levels where they are, we are going to do everything in our power to keep asset prices high. If we could, we would even reinflate the housing bubble. But that gig is up unfortunately and with it any real hope for jobs expansion.

Now is not the time for a recession. We are in this fix because there is never a time for a recession. We hope to forestall recessions forever because if we can't all hell will break loose on the downside.

That Mish readers is what the Fed really said today. Nonetheless the market seemed to love it. But what's not to love? The simple written translation of the above text is "Party On Dudes".

In the UK they are now admitting to the "Party On Dudes" philosophy as noted by the The Independent headline Ex-Governor George says Bank deliberately fuelled consumer boom.

The Bank of England deliberately stoked the consumer boom that has led to record house prices and personal debt in order to avert a recession, the former Bank Governor Eddie George admitted yesterday.

Lord George said he and his colleagues on the Monetary Policy Committee "did not have much of a choice" as they battled to prevent the UK being dragged into a worldwide economic slump by slashing interest rates. And he said his legacy to the current MPC was to "sort out" the problems he had caused.

Lord George, who headed the Bank for a decade from 1993, revealed to MPs on the Treasury Select Committee that he knew the approach was not sustainable. "In the environment of global economic weakness at the beginning of this decade... external demand was declining and related to that, business investment was declining," he said. "We only had two alternative ways of sustaining demand and keeping the economy moving forward - one was public spending and the other was consumption.

"We knew that we were having to stimulate consumer spending. We knew we had pushed it up to levels which couldn't possibly be sustained into the medium and long term. But for the time being, if we had not done that, the UK economy would have gone into recession just as the United States did."

Heaven forbid! "A recession?" The lengths that central banks are going to avoid a recession are staggering. And each attempt to prevent said recession adds more and more and more to consumer debt. The hangover from this long running party is going to be the worst since the great depression. But who cares now? For now, the only discernible message from the Fed was "Party On Dudes". No one could hear the panic in their voices when they said it.

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

Pension Plans & Chasing Yields

In New Jersey, the pension plan for teachers is badly underfunded to the tune of $10 billion.

The state shortfall for teachers' pensions has grown to $10 billion, an actuary reported Thursday. The latest report shows a $1.8 billion, or 22 percent, increase in the funding gap since the previous report a year earlier. It means the state, and taxpayers, should pay $1.5 billion toward the teachers' retirement system this year, but the actual contribution will likely be a fraction of that amount. Gov. Corzine has proposed paying half of the state's pension obligations this year.

As the state continues putting less money into the pension system than required, the funding gap has grown. New Jersey has failed to contribute some $1.9 billion in recent years, said Scott Porter, an actuary with Millman Consultants and Actuaries. The funding shortfall from last year alone has added $30 million to the latest state tab, Porter said.

"The main culprit is the state, for the last six years, underfunding its commitment," said Steve Wollmer, a spokesman for the New Jersey Education Association.

The $35 billion Teachers Pension and Annuity Fund pays for retirements for some 220,000 teachers.

We are coming off the biggest housing boom in history, with property taxes soaring, tax revenues up, and 4 good years in the stock market and the NJ teachers' pension plan is still $10 billion short and to top it off Gov. Corzine only want to fund half of the state's pension obligations this year, which will put the plan further in the hole.

Exactly how do they expect to fund this if we have an 18 month recession and falling stock prices on top of it? Either taxpayers are going to foot the bill or plan promises made to 220,000 teachers will not be met or some combination thereof.

Illinois

As bad as Massachusetts looks, Illinois looks worse. Illinois comptroller Daniel Hynes says "Pensions Continue to Put Pressure on the State Budget"

Illinois’ state pension systems continue to be seriously underfunded with the latest calculations placing the unfunded liability at over $40 billion. As of June 30, 2006, the five pension systems primarily supported by the state had accumulated $103.1 billion in actuarial liabilities for pension, disability, and death benefits. The systems held assets valued at $62.3 billion leaving $40.7 billion in unfunded obligations, or a funded level of only 60.5%.



A key concern for the fiscal year 2008 budget is how to get pension funding back on track. ...
If the [1995] plan is followed, state contributions to the pension systems for fiscal year 2010 will be 2 1/2 times the level of fiscal year 2007 contributions. ...

Conclusion

With ongoing demands for increased funding for education and health care among other state priorities, it will take serious discipline on the part of budget makers to meet the steep funding requirements set by the 1995 pension funding plan based on likely growth of current state General Funds revenues.

Once again I see a state deep in the hole having failed on a 15 year plan established in 1995 to get out of that hole. One of the problems pension plans faced was the stock market decline between 2000-2003. The same problem is about to hit again. Illinois, as well as every other state likely has pension returns and revenue growth assumptions that are way too high headed into a recession. The likelihood of negative returns and falling revenues simply is not being planned for by any one at any level.

Massachusetts

The Boston Globe is reporting Assets of 35 pension systems are targeted.

State's intention is to boost results

The assets of 35 pension systems, including those of Plymouth County, the Essex Regional Retirement Board, Newton, and Andover, would come under the control of a state trust in a proposal by the Patrick administration to boost returns, improve pension management, and provide fiscal relief to cities and towns, according to a new analysis prepared by the state retirement commission.

Several of the worst-performing systems have begun moving into the state fund. On Jan. 1, the city of Fitchburg, for instance, put $44 million of its total retirement assets of $86 million under state control. For the five-year period ending in 2005, Fitchburg posted one of the worst investment performances in the state, 3.35 percent a year. By contrast, the state retirement fund posted average annual returns of 7.04 percent during the same period.

Richard N. Sarasin, chairman of Fitchburg's retirement board, said one goal is to reduce the $6 million a year the city currently must commit to future benefits, a significant part of the city's roughly $90 million annual budget. The greater the returns generated by investment, the smaller the contribution the city must make out of its annual budget.

"If you can't beat them, join them," Sarasin said.

Boston's retirement system would remain under local control if the Patrick administration standards were applied to its performance from 2001 to 2005. Boston had 20,456 active members and 14,034 retirees, according to its most recent figures as of Jan. 1, 2006. Its funded ratio, the money needed to cover future payments to retirees, was 62.4 percent, well below the 80 percent level required to remain independent by Patrick's proposal. It also earned significantly less on its $3.7 billion portfolio -- 4.96 percent a year over the five years -- than the state's return of 7.04 percent. But under Patrick's proposal, only those systems earning 4.79 percent or less over those five years would have be taken over.

Pension attorney Michael Sacco, who represents more than 10 of the boards on the list, including Natick , Plymouth County , and Andover , defended the performance of the boards. He called the administration's method for weaning out poor-performing systems "an overly simplistic approach to a complicated issue."

For one thing, he said, the smaller boards are restricted from certain types of riskier, high-return instruments that the state can invest in such as hedge funds or real estate portfolios.

Officials in Arlington say they are in talks with the state board to take over retirement assets. Citing the state's healthy returns, Town Manager Brian F. Sullivan said, "You have to question why wouldn't it be to the town's advantage to do that."

Chasing Yields

Massachusetts is taking a different approach to the problem: "If you can't beat them, join them." That plan has an alias name of "Chasing Yields".

As we have seen with subprime lending, chasing yields works until it doesn't. And somehow, in just a few short years, the memories of 2000-2002 have faded away. The subprime fisaco isn't scaring anyone either. The current consensus is that housing has bottomed or soon will, subprime woes will not spread, there will be no recession, and any pullback in the stock market will be temporary.

I guess everyone is listening to Mr. Bubble (Greenspan) when he says Subprime Spillover Unlikely.

"I think it's important to recognize that what we're dealing with ... is more an issue of house prices than it is mortgage credit," Greenspan said at a Futures Industry Association conference in Boca Raton, Fla. Greenspan said that as home prices dipped, "subprime borrowers have not been able to build up enough equity."

If home prices drop in a year, he predicted that could cause the problems to "spill over into other areas." "At the moment, we're not seeing this," he said. "The spillover is just not there." ... If home prices "would go up 10 percent, the subprime mortgage problem would disappear."

If home prices would go up 10% the problem would not go away. The problem is people bought houses they can not afford at prices that were ridiculous. If home prices rose 10% there would still be no one able or willing to afford them. It's comments like those from Greenspan that seriously make me wonder if he is senile. Just when I am convinced, he actually says something that makes some sense.

On another matter, Greenspan repeated a warning about the massive strain on the U.S. budget and the economy in the future from the looming retirement of 78 million baby boomers, who will draw benefits from Social Security and Medicare.

He called the pending retirements "one of the seminal events in the first part of the 21st century in the United States." ... "There is a significant probability that under existing law, that we have overpromised what will be available to Medicare recipients," he said.

Yes, we have not only over promised, but we have under budgeted, and pension plans are starting to chase yields in a foolish attempt to catch up. I find it amazing how quickly even recent lessons are forgotten and current lessons (subprime) are dismissed outright.

Advice from Mom

Here is some practical advice from someone who goes by the name of "PolymerMom" posting on my board on TheMarketTraders about the risks of chasing yield. It seems a pension plan change where she works caught her by surprise....

Earlier this year I received a note saying the Core Bond Fund in my 401k was changing to a new bond fund this year. They nicely transferred the old holdings to the new fund without any cause for action on my part.

Both were int. term (2.5-5 yrs duration).

They finally got around to posting the new fund's top 10 holdings and per cent asset categories. The new fund is almost 37% invested in mortgage securities. The old was only a tad over 1%.

Imagine my surprise when the value of the [new] fund had dropped almost 13% from Friday to today! [3/2/2007 -3/5/2007]

The HR analysts were chasing yields without a thought as to risk. I wonder how many will even realize what is happening...

Advice from mom:
Always check a new 401k fund ASAP!

Thanks Mom!
Unfortunately those in state pension plans do not have the luxury of spotting things like that. If someone managing a government plan decides to chase yields, invest in swaps or emerging markets or real estate, or even if the state chooses not to fund the plan at all, there is little one can do about it. This adds up to yet another huge problem that is coming our way as returns over the next few years are unlikely to be anywhere near as good as those plans expect.

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

Who's to blame for the housing mess?

There is one hell of a rant by Nouriel Roubini about who's to blame for the current mess in housing and subprime lending. Roubini's answer is "Unregulated Free Market Fundamentalism Zealotry".

While Roubini makes some points about reasonable policies that may have stopped some of the ongoing carnage, what has actually transpired was anything and everything but free market constructs.

The Unfree Markets

1. We have a government sponsored “ownership society” promoting housing.
2. There is government economic cheerleading.
3. There is additional cheerleading by the Fed
4. There was blatant promotion of ARMs and subprime lending by the Fed and Alan Greenspan.
5. There are ongoing lies by the Fed and the treasury department about the state of the economy.
6. The Bush administration promoted spending as a way to defeat terrorists. Typically there is (or at least there should be) sacrifices made to support a war.
7. The Fed has monetary policy that excludes looking at money to make its decisions. Rampant increases in M3 were allowed to happen by the Fed. That growth fueled the houing bubble.
8. We have a Fed and a government that stands ready and willing to bail out lending institutions when those institutions fail. Lending institutions know it. This encourages speculation.
9. The US has an economic policy designed to kill the US dollar. Congress appropriates hundreds of billions of dollars more than it takes in. This encourages speculation in assets of all sorts, including housing.
10. Japan has a ZIRP economic policy. That policy fueled a massive carry trade that contributed to speculation in all kinds of assets as well.
11. There are some 300-400 government programs designed to make housing affordable that do no such thing. Yes this includes GSEs. And just because GSEs did not matter for years, that does not mean that GSEs will never matter.
12. Proposition 13 laws in California and Florida benefit those who speculate in assets first. This eventually created a panic by some to “get in before it’s too late”.
13. Our immigration policy is a mess, starting off with all kinds of free services like education and health care that illegal aliens have access to. This helped fuel the bubble as well.
    
14. The government guarantees CDs. Many banks offered above market rates as high as 7% or more to attract capital. Much of that capital went into risky real estate projects and condos. The way to fix this problem is to stop guaranteeing CDs or at least those with rates above treasuries.
    
15. Cities and states gave tax breaks and cheap land to developers. This encouraged overdevelopment.

None of those items has anything to do with what a reasonable person would call a “Free Market”. Blaming this mess on lack of regulation on “Liar Loans” or “NINJA Loans” (No Income, No Job and no Assets) and the like misses the big picture. The big picture is we do not have remotely anything close to a free market in housing or for that matter anything else. Taken together those fifteen points all combined to encourage reckless speculation.

Is the solution then, more government regulation or less government interference in the first place? Note that in the current state of affairs there could have and should have been reasonable capital restrictions placed by the Fed on lenders. But would that have worked?

In light of the massive list of non-free market distortions noted above my answer is “perhaps or perhaps not”. I suppose one could also argue that a simple rule such as “you originate a loan and you own it for 10 years” would have prevented much of this problem as well.

Then again perhaps the problem would have been solved if the Fed simply had a monetary policy that actually looked at money supply figures rather than distorted PCE deflators or the CPI.

But perhaps the real solution is to get rid of government sponsored ownership societies designed to make renters look and feel like second class citizens, and let the free markets work as they are supposed to. Blaming the free market for this mess is certainly starting in the wrong place. It was a lack of a free market that both started then escalated this mess. In that regard, the best answer is not more regulation by the Fed, the best answer is to abolish the Fed and stop doing everything else on the above 15 point list as well.

That is my answer. What is yours? Cast your vote in the who's to blame game.

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

Rate Cuts and Stock Prices

William Hester writing for Hussman Funds is addressing the question Must Stocks Rise Following a Cut in the Fed Funds Rate?

Since 1955 there have been 11 periods where the Fed lowered rates at least once after raising them multiple times. Average returns have been strong during these periods. Following the first interest rate cut, the S&P 500 has advanced at annualized rates of 23.9% over the following 6 months, 18.3% over the following 12 months, and 18.7% over the following 18 months.

Segmenting the data by valuation quickly highlights the role that cheap markets play in affecting stock market returns. During periods where the S&P 500 price-to-peak-earnings multiple was less than 15, an initial rate cut was followed by annualized S&P 500 returns of 43.2% over 6 months, 26.1% over 12 months, and 25.4% over 18 months.

Good returns followed nearly every instance that a rate cut took place at low valuations. This is because the Fed often begins cutting rates only in the later portions of bear market declines. The Fed began easing rates in December 1974 when stocks were trading at 7 times earnings. Two more easing cycles began in 1980 and 1981, when stocks were trading at less than 9 times earnings. The 1990 easing cycle began when the S&P was priced at 12.5 times peak earnings.

In contrast, rich valuations have produced far more tepid returns. When the S&P 500 price-to-peak-earnings ratio has been above 17, the market's annualized return following the initial rate cut was –2.3% over the following 6 months, 5.9% over the following 12 months, and 6.2% over the following 18 months. Though there are fewer occurrences of rate cuts at higher valuations, they're also more varied.

The conclusion, stated upfront was "The strongest stock market rallies after an initial interest rate cut have occurred during periods very different than today."

It's hard to argue with solid data and Hussman Funds has a chart to prove it (see above link). Also note that historically the market does not react UNTIL the second cut. Here we are some 6 months in advance of a presumed rate cut that may not even occur. I do think one or more rate cuts later this year are extremely likely but the bulls are trumpeting "the second half rate cut" already and have been for months. Are we looking forward to a massive sell the news event?

I am also wondering if anyone remembers "the second half recovery" chant a few years ago. That chant droned on for close to two years before a recovery finally happened.

More to the point, valuations here are NOT cheap. Valuations only look cheap much the same way that valuations of subprime lenders like NEW and LEND looked cheap. Was New Century Finance cheap at $40? It sure looked that way on a PE basis. Is it cheap now a few months later at $1.65?

Current earnings not cheap, in fact they are an out an out mirage based on cheap credit. Take away the credit and you take away the earnings. An earnings collapse started in subprime lending and it will spread. The interesting thing is that even if the bulls are correct and the subprime disaster is contained, the odds of a huge rally heading into a recession are extremely unlikely given current valuations.

Of course the answer to the question "Must Stocks Rise Following a Cut in the Fed Funds Rate?" is that nothing "must" happen either way, but the probabilities of anything good happening once the Fed is forced to cup in an upcoming slowdown are simply not very good even if one presumes that subprime contagion does not spread. A "double whammy" will occur when the subprime contagion spreads and we see the forward earnings for what they really are: a mirage.

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

No Time for Alarm vs. The Great Unraveling

Defaults are soaring and stocks are tanking but BusinessWeek says it's no time for alarm.

On Mar. 13 the Mortgage Bankers Assn. reported a record percentage of mortgages entering foreclosure in the fourth quarter—news that sent the Standard & Poor's 500-stock index tumbling 2%.

Nonetheless, in the broadest sense, say economists, the economy should be able to withstand the downdraft in the mortgage market. "It's going to have limited impact."

The good news is that, although the subprime business has grown rapidly in recent years, it remains a small part of the overall mortgage market—14% of outstanding mortgage loans. And only some subprime loans are in trouble. About 13% were past due in the fourth quarter, the Mortgage Bankers Assn. said.

So the most serious damage is confined to a fraction of a sliver of the overall mortgage market. Christopher L. Cagan, chief economist at Santa Ana (Calif.)-based First American CoreLogic (FAF), projects mortgage defaults of about $300 billion through 2010, just a flea on the nation's $10 trillion housing elephant. And about two-thirds of the losses will be recovered when lenders repossess homes.

The overall economy is doing reasonably well, creating 97,000 jobs in February, according to the Bureau of Labor Statistics. The unemployment rate is just 4.5%. Subprime's woes aren't an indicator of deeper-seated problems.

David Rosenberg, chief North American economist at Merrill Lynch (MER), who is among the more bearish economists on Wall Street, wrote on Mar. 14 that "it is not inconceivable" that house prices will fall 10% this year, which he estimates would cause economic growth to slump to about 1.75% in 2007 from 3.3% in '06.

Wyss of S&P thinks the weakness in housing, compounded by subprime's problems, will slow economic growth to 2.4%, though he recently raised his estimate of the probability of a recession starting in the next 12 months to 30%, from 25%

Greg Jensen, co-chief investment officer at Bridgewater Associates, a large manager of institutional investments, wrote in a report to clients on Mar. 14: "Our guess is that the current bond rally will do more to fuel global growth than the subprime problems will do to slow it."

Greenspan: Spillover Unlikely

It is difficult to determine what the consensus is, or even if there is one because there certainly are numerous housing bears to be found, but I suspect the above article comes closer to representing a main stream view than not. One can even add Greenspan to the list when he said Subprime Spillover Unlikely.

"I think it's important to recognize that what we're dealing with ... is more an issue of house prices than it is mortgage credit. .... If home prices would go up 10 percent, the subprime mortgage problem would disappear."

It's hard to know where to even start rebutting nonsense of this sort. Let's just say that rot starts at the bottom. That rot exceeds far more than a "fraction of a sliver of the overall mortgage market". The USA Today is reporting Record foreclosures hit mortgage lenders.

The reason many mortgage lenders are in trouble became alarmingly clear Tuesday. The Mortgage Bankers Association said more than 2.1 million Americans with a home loan missed at least one payment at the end of last year — and the rate of new foreclosures hit a record.

The problem is most severe for borrowers with scuffed credit and adjustable-rate mortgages. More than 14% of them were behind on their payments. And the worst is yet to come, the MBA said.

2.1 million Americans are in jeopardy of losing their homes. That sounds more like a significant piece of the pie than a sliver of a slice. Ten states have delinquency rates that exceed 7%. Note that the big bubble states of Florida and California are not even in that list yet. (Click on the above link to see the full table).

And the big wave of ARMs resets has not even occurred yet. That will happen later this year. Most interesting is the viewpoint that anyone would stake a claim that "The overall economy is doing reasonably well" on the basis of an anemic 97,000 jobs in February, when 39,000 of those jobs were government jobs.

Hardly anyone is looking at the slowdown in consumer spending that is going to occur once cash out refis completely dry up in the face of tougher appraisals and tougher lending standards. A reduction in MEW (mortgage equity withdrawal) will impact spending and reduced spending will further impact jobs.

The downward spiral has barely begun and optimists think the "current bond rally will do more to fuel global growth than the subprime problems will do to slow it." No, the Fed is not going to be able to get this trainwreck back on track. After all, long term fixed rates have barely budged in the last few years. Teaser rates have however, in the face of 17 consecutive rate hikes. One or two rate cuts is not going to help the average borrower that much and meanwhile the rot is already spreading into Alt-A loans. That rot will eventually spread to prime loans. A prime loan is only going to remain a prime loan as long as the borrower has a job.

Manufacturing Indices

With little fanfare last week came the announcement Two factory gauges show little growth.

Empire State index plunges to 1.9, Philly Fed inches down to 0.2
The New York Fed's Empire State index fell sharply to 1.9 in March from 24.4 in February, putting the index at its lowest level since May 2005.

The size of the decline in the Empire State index surprised economists, who were expecting the index to slip to 19.0. Economists had expected the Philly Fed index to rebound to 4.2.

In both indexes, readings over zero indicate growth. The two gauges are of interest primarily because they are seen as clues to the Institute for Supply Management's national survey for March due out in two weeks. The ISM has been trending lower, but has averaged 50.7% over the past four months. Readings under 50% would indicate a contraction in the sector.

Philly Fed Index



Notes: The above chart was constructed by subtracting the percentage of respondents reporting a decrease from those reporting an increase. Constructed this way, numbers below 0 indicate contraction while the ISM goes negative at 50 (the percentage of respondents reporting an increase in activity drops below 50%). The Fed has never hiked with an ISM reading under 50 and I expect we are soon going to see a crossover in the ISM that gains no traction for quite some time.

Interestingly enough the Business Outlook Survey by the Philly Fed shows optimism looking six months ahead.

Overall activity in the region’s manufacturing sector was steady this month, and indicators for new orders, shipments, and employment improved only slightly from February. Firms continue to report higher prices for inputs and for their own manufactured goods, and the survey's price indexes edged higher this month. The manufacturers’ outlook remains generally optimistic: They expect a pickup in growth during the second quarter and improved conditions over the next six months.

In special questions this month, firms were asked about expected growth in production during the second quarter. Fifty-nine percent of the firms indicated that production would increase in the second quarter; only about one-third of these firms said the increase was due to seasonal factors. Twenty-three percent indicated that production would decrease, and a small percentage of these firms attributed the expected decrease to seasonal factors. The largest share of firms (43 percent) indicated that the growth expected represented “some acceleration” from the first quarter; 10 percent indicated that it represented a “significant acceleration.”

I am not sure where this optimism stems from but I am willing to take the other side of the bet. In fact, if you look at the above chart there has been an overabundance of optimism for nearly seven straight years.

Economists were surprised by the plunge from 24.4 to 1.9 in the New York region (chart not shown) and they are going to be surprised again at the rate of contraction in the second or third quarter. If for some reason there is not a contraction, then I look for inventories to skyrocket in the face of declining sales.

The Great Unraveling

Even as others are predicting containment, Stephen Roach is pondering The Great Unraveling.

From bubble to bubble – it’s a painfully familiar saga. First equities, now housing. First denial, then grudging acceptance. It’s the pattern and its repetitive character that is so striking. For the second time in seven years, asset-dependent America has gone to excess. And once again, twin bubbles in a particular asset class and the real economy are in the process of bursting – most likely with greater-than-expected consequences for the US economy, a US-centric global economy, and world financial markets.

Too much attention is being focused on the narrow story – the extent of any damage to housing and mortgage finance markets. There’s a much bigger story. Yes, the US housing market is currently in a serious recession – even the optimists concede that point. To me, the real debate is about “spillovers” – whether the housing downturn will spread to the rest of the economy.

The spillover mechanism is hardly complex. Asset-dependent economies go to excess because they generate a burst of domestic demand that outstrips the underlying support of income generation. In the absence of rapid asset appreciation and the wealth effects they spawn, the demand overhang needs to be marked to market. The spillover is a principal characteristic of such a post-bubble shakeout. Interestingly enough, in the current situation, spillovers have first become evident in business capital spending, as underscored by outright declines in shipments of nondefense capital goods in four of the past five months. The combination of the housing recession and a sharp slowdown in capex has pushed overall GDP growth down to a 2% annual rate over the past three quarters ending 1Q07 – well below the 3.7% average gains over the previous three years. Yet this slowdown has occurred in the face of ongoing resilience in consumer demand; real personal consumption growth is still averaging 3.2% over the three quarters ending 1Q07 – only a modest downshift from the astonishing 3.7% growth trend of the past decade.

Therein lies the risk. To the extent the US economy is now flirting with “growth recession” territory – a sub-2% GDP trajectory – while consumer demand remains brisk, a pullback in personal consumption could well be the proverbial straw that breaks this camel’s back. The case for a consumer spillover is compelling, in my view. A chronic shortfall of labor income generation sets the stage – real private compensation remains over $400 billion below the trajectory of the typical business cycle expansion.

Former Fed Chairman Alan Greenspan crossed the line, in my view, by encouraging reckless behavior in the midst of each of the last two asset bubbles. In early 2000, while NASDAQ was cresting toward 5000, he was unabashed in his enthusiastic endorsement of a once-in-a-generation increase in productivity growth that he argued justified seemingly lofty valuations of equity markets. This was tantamount to a green light for market speculators and legions of individual investors at just the point when the equity bubble was nearing its end. And then only four years later, he did it again – this time directing his counsel at the players of the property bubble. In early 2004, he urged homeowners to shift from fixed to floating rate mortgages, and in early 2005, he extolled the virtues of sub-prime borrowing – the extension of credit to unworthy borrowers. Far from the heartless central banker that is supposed to “take the punchbowl away just when the party is getting good,” Alan Greenspan turned into an unabashed cheerleader for the excesses of an increasingly asset-dependent US economy. I fear history will not judge the Maestro’s legacy kindly. And now he’s reinventing himself as a forecaster. Figure that!

Is the Great Unraveling finally at hand? It’s hard to tell. As bubble begets bubble, the asset-dependent character of the US economy has become more deeply entrenched. A similar self-reinforcing mechanism is at work in driving a still US-centric global economy. Lacking in autonomous support from private consumption, the rest of the world would be lost without the asset-dependent American consumer. All this takes us to a rather disturbing bi-modal endgame – the bursting of the proverbial Big Bubble that brings the whole house of cards down or the inflation of yet another bubble to buy more time.

Roach may be wondering whether or not the Great Unraveling is at hand, but not me. In quick order the spillover is going to hit both jobs and consumer spending. The Wall Street Journal is reporting Out of Space, Retailers Trim Growth Plans.

For years, investors rewarded those retailers with fast expansion rates. Now that some retailers have nearly tapped out their potential in the U.S., investors are punishing them for failing to slow down.

The result is that a number of major retailers are ratcheting back on the number of new stores they open each year and are diverting more of their spending to repurchasing shares and increasing dividends. Among those adopting this strategy are Sears Holdings Corp., Home Depot Inc. and AutoZone Inc.

The full article is subscription only.

I have talked about this before but corporate expansion is not going to be the savior where homebuilding left off. The goldilocks theorists simply refuse to believe that even as the WSJ is reporting that it is happening.

Corporate construction follows residential with a lag. We are saturated with stores. There will be a diminishing job hiring effect heading forward just as homebuilding is set for another wave down caused by foreclosures. Simply put, there is nothing that can remotely come close to filling the jobs needs of the US with a pullback in housing construction, commercial construction, manufacturing, and a consumer spending revolt against all kinds of discretionary things like eating out at restaurants. That is the downward spiral that has already started, and the only debate should be about the speed at which it continues as opposed to whether or not it is about to happen.

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