Inflation Targeting is Flawed

Bloomberg is reporting Bank of England's Inflation-Targeting Loses Luster.

The Bank of England, confronting a record-breaking real-estate boom, is finding there's more to monetary policy than just keeping consumer prices in check.

surging U.K. property values are throwing into question the inflation-targeting approach of Governor Mervyn King and his colleagues, which focuses on consumer prices as the lodestar of policy and gives lower priority to asset values, money supply and credit growth.

The bank's approach isn't broad enough to tackle asset bubbles that can burst and lead to recessions, says Tim Drayson, an economist at ABN Amro Holding NV in London who formerly worked at the U.K. Treasury.

"In a few years' time, people will find that inflation- targeting is flawed,'' he says."

Inflation Goal

The bank's goal is inflation of 2 percent, and it has kept average gains in consumer prices at 1.5 percent since 1997, compared with 4.2 percent in the previous eight years.

While that allowed King, 59, to slash interest rates to the lowest levels since the 1950s, he now faces what Claudio Borio, head of policy analysis at the Bank for International Settlements in Basel, Switzerland, calls a ``paradox of credibility'': The more a central bank succeeds in keeping prices stable, the more likely that signs of an overheating economy will show up first in asset bubbles.

As in the U.S., a combination of stable inflation and low interest rates triggered a real-estate boom in the U.K., where house prices have tripled in the past decade. In the last year alone, London values jumped 16 percent, reports HBOS Plc, the U.K.'s biggest mortgage lender.

King argues that asset values are inflated by many factors outside the bank's control, and it's better off focusing on a single gauge of consumer prices.

World Capital Markets

"What determines asset prices in the U.K. is very much a function of what's going on in the world capital markets," he told a parliamentary committee on April 24. "The impact of higher asset prices can't just be linked solely and exclusively to U.K. monetary policy and credit growth." Immigration and a property shortage caused by planning restrictions are also driving U.K. real-estate prices higher, policy makers say.

Still, King acknowledges that ignoring money supply and credit growth may lead policy makers into "tricky territory."

In 2005, he became the first Bank of England governor to be outvoted by his committee when it decided to ignore the fastest money-supply expansion in eight years and cut rates to shore up economic growth.

"In retrospect, it was a mistake," says Thomas Mayer, chief European economist at Deutsche Bank AG in London. The move reignited the housing market, sending the price of an average London home surging by a quarter. House-price inflation stood at 9.1 percent at the end of 2006, the London-based National Institute of Economic and Social Research said in a report today.

There is no question that inflation targeting is a mistake. For starters the Fed can not possibly know what neutral is if it were to bite them in the ass. After all, it is virtually impossible to define a representative basket of goods and services to measure prices.

For example: Gasoline is far more important to cab drivers than to someone living in a nursing home. Education is far more important to those with school aged children than those who are retired with no kids. Are home prices or rent more important and for who?

The measurement problem is made all the more difficult because new products and services come out all the time. Also compounding the problem (perhaps intentionally so) are hedonics and substitutions. No this does not all average out regardless of what anyone says (or if it does it is only by fleeting happenstance). Finally it should be noted that government has every reason to lie about prices to keep cost of living (COLAs) down for social security recipients.

But even if by some miracle the government was not distorting the data, measurements were accurate, etc etc, inflation targeting misses the boat because it excludes asset prices. Nonetheless, Bernanke is on the inflation targeting bandwagon.

Bernanke & Inflation Targeting

Back on October 17, 2003 Bernanke spoke about Inflation Targeting: Prospects and Problems.

Should the Federal Reserve announce a quantitative inflation objective? Those opposed to the idea have noted, correctly, that the Fed has built strong credibility as an inflation-fighter without taking that step, and that that credibility has allowed the Fed to be relatively flexible in responding to short-run disturbances to output and employment without destabilizing inflation expectations. So, the opponents argue, why reduce that flexibility unnecessarily by announcing an explicit target for inflation?

It would be foolish to deny that the Fed has been quite successful on the whole over the past two decades. Whether the U.S. central bank would have been even more successful, had it announced an explicit objective for inflation at some point, is impossible to say. We just don’t know. We can’t re-run history; and although empirical cross-country comparisons can be useful, they are far from being controlled experiments.

On the premise that effective communication is even more crucial near price stability, I will focus today on how an incremental move toward inflation targeting, in the form of the announcement of a long-run inflation objective, might help the Fed communicate better and perhaps improve policy decisions as well, without the costs feared by those concerned about potential loss of flexibility.

Given the bubbles in the stock market and housing, the implosion of subprime lending, consumer debt bubbles and an economy totally dependent on rising asset prices, Bernanke is showing more than a bit of misguided hubris when he states "It would be foolish to deny that the Fed has been quite successful on the whole over the past two decades". Then again perhaps we need to understand where Bernanke is coming from.

Consider Roger Garrison's article What Does Inflation Targeting Mean?

Although Ben Bernanke has pledged to ensure a continuity between the Greenspan policies and his own, he differs in several important respects, including his endorsement of "inflation targeting." Greenspan has always been against it.

But Bernanke's idea of "inflation targeting" is in need of some deconstruction.

First and foremost, it means that he actually wants some positive rate of inflation, a rate that is expected to persist and therefore gets factored into nominal interest rates. He wants nominal rates kept high enough to give the Fed some elbow room. That is, if the nominal fed-funds rate is, say, 5%, then the Fed has some scope for lowering that rate — in the event that it believes the economy is due for a monetary infusion.

Bernanke was most vocal about this view a year or so ago, when the fed-funds rate was 1% and Fed watchers began to worry about Greenspan "having no more arrows in his quiver."

But can Bernanke actually pursue a policy of inflation targeting in the literal sense? In other words, can he increase the money supply whenever, say, the CPI begins to indicate an inflation rate below the target rate and decrease the money supply whenever the CPI begins to indicate an inflation rate above the target rate? I don't think so.

The lag between changes in the money supply and corresponding changes in the CPI is somewhere between 18 and 30 months. This is the "long and variable lag" identified long ago by the monetarists. One of the lessons in Monetary Economics 101 is that a viable target must be one that yields timely feedback to the targeter.

Bernanke is an advocate of inflation targeting. We should understand this to mean that Bernanke is a deflation-scared inflationist.

For all his studies of the great depression, Bernanke still does not get it it. The fundamental cause of the great depression was the credit boom that preceded it. Inflation targeting that ignores asset prices is not targeting inflation at all. Inflation targeting must start with a proper definition of inflation: expansion of money and credit.

The current boom is a direct result of the greatest liquidity experiment the world has ever seen. Asset prices have been rising nearly everywhere as all central bankers have been in on it. It is now simply too late to do anything about it. All we can do sit sit back and wonder just how more insane things can get before they implode.

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

Capital Spending Suggests Hard Landing

Lost in the headline Capital spending bounces back in March is the fact that first quarter capital spending was down 15.3% annualized.

Demand for U.S.-made durable goods increased 3.4% in March, led by orders for aircraft and capital equipment, the Commerce Department reported Wednesday. "Capital spending is not in free fall," as some had feared, wrote Jan Hatzius, chief economist for Goldman Sachs, in a research note.

Economists were divided about whether the report was merely a one-month reprieve or a more fundamental turnaround in capital spending.

"With capital spending having fallen in the final three quarters of 2006 and quite possibly again in the first quarter of this year, the bear camp will rationally assert that the trend is down," wrote Tony Crescenzi, chief bond market strategist for Miller Tabak & Co., in an email. "Armed with today's today, the bull camp will disagree and assert that a rebound is underway."

Treasuries sold off on the robust data. The market got it wrong, wrote Charles Dumas, an economist for Lombard Street Research. "The durable goods orders data confirm that business cap-ex [capital spending] is front-running a U.S. hard landing."

Demand for core capital equipment increased a robust 4.7% after a cumulative 8.5% decline in January and February. It was the biggest gain in this key gauge of business investment since September 2004. Still, the first quarter was the weakest for core capital equipment orders since the 2001 recession, falling at a 15.3% annual rate.

Durable goods have really been carried by civilian aircraft orders as Boeing booked orders for 119 planes in March compared with 57 in February. Outside of that, there has not been much to cheer about.

It is clear this economy is faltering.

• Core capital spending for the quarter is negative
• First Quarter Advance GDP came it at 1.3%
• Companies are downsizing managers.
• Existing home sales had biggest monthly slump in nearly two decades
• US auto sales were terrible.
• The Philly Fed manufacturing outlook was near zero

Barring some sort of miracle recovery, the next move by the Fed will be a cut. It will not save housing and in fact mortgage rates may not even decline due to increased default risk

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

Ford Warns on Sales - GM Offers Rebates

Reuters is reporting Ford warns on U.S. industry sales, GM offers rebate.

U.S. auto industry sales have dropped far below expectations for April, a Ford Motor Co. executive said on Friday as rival General Motors Corp. rolled out an incentive program intended to boost crucial month-end sales.

"This month is terrible," Ford chief sales analyst George Pipas said in an interview. "We are not even close to where we expected to be in April."Pipas said the spillover from weaker housing to other areas of the economy and rising gas prices appear to be affecting consumers but added that many of these same factors were also present in March. "I have a hard time explaining why April is so weak," he said.

Ford and other automakers will report April U.S. sales on May 1. For the first three months of the year, U.S. industry-wide auto sales were down 1.2 percent. Earlier this week, General Motors Corp. Vice Chairman Bob Lutz said the crisis in the U.S. mortgage market has hurt U.S. auto sales this month.

Lutz said he did not know how GM's sales performed in April, but he expected the whole automotive sector would feel the impact of the stress on the mortgage market.

GM is offering lower-interest financing to customers with weaker credit ratings through this weekend in an effort to boost sales for April, sources familiar with the sales plan said on Friday. GM will offer reduced interest rates to customers whose credit is assessed at two of its lower rating levels on all brands except Saab, the sources said.

Detroit automakers had forecast a flat to slightly weaker vehicle market going into 2007 before the pressure intensified on subprime lenders, who have poor credit histories.

Pipas's comments followed cautionary remarks from auto dealers on the expected impact from the slowing housing market.

Weak housing starts have also weighed on sales of high-margin pickup trucks, often bought by construction workers. Ford is in the middle of a sweeping restructuring that involves closing 16 plants and cutting about 45,000 jobs.

Ford's U.S. sales were down 13 percent in the first quarter and GM's sales were down 5.5 percent, while Toyota sales rose 11 percent.

Pippas may have a hard time explaining weak sales but the better question is how did they hold up as long as they did? The answer can likely be found in the negative savings rate, and Mortgage Equity Withdrawal. The latter is drying up quickly as a source of consumer funds.

The striking point in the article is that smack in the face of a subprime lending fiasco, GM is desperate enough to boost sales by lowering finance charges to customers with weak credit ratings. This is as foolish as it is desperate.

In a pinch, big ticket items like cars are easier to cut back on than necessities like gasoline. But pressure is mounting in other places, even insurance.

Thousands of drivers scrimp on insurance

The Detroit News is reporting More drop collision and theft coverage as economy takes toll.

Hundreds of thousands of motorists in financially beleaguered Michigan have downgraded their auto insurance -- a money-saving gamble that could leave them without a ride if their vehicle is stolen or smacked by another car.

The latest available data shows that nearly 300,000 comprehensive policies were dropped from 2000 to 2004 -- a trend that has continued, some large insurers say. Comprehensive covers vehicle theft -- Detroit has nearly 100 reports a day -- and deer-vehicle accidents, a growing suburban problem.

Another 28,500 got rid of their collision policy, which covers damage from another vehicle, while many more are reducing coverage or raising deductibles to save money, agents say.

People face tough choices

In a state with the nation's second-highest unemployment rate -- 6.5 percent -- and sky-high auto insurance costs, some people are left choosing between keeping the electricity on and paying for full coverage, said St. Clair Lake, an Allstate agent in Detroit.

One reason for the soaring prices is the high rate of vehicle thefts in Detroit -- the city ranked 16th nationally in 2006 with 35,106, according to the National Insurance Crime Bureau. But the main factor is the cost of the state's "no-fault" insurance structure, officials said.

GM loses lead to Toyota

The Detroit News is reporting GM boss vows fight for sales

General Motors Chairman and CEO Rick Wagoner told senior executives the company hasn't given up the fight despite being outpaced by Toyota in global sales in the first quarter of the year.

"We still have the majority of the year in front of us, and we will fight hard for every sale -- all the while staying focused on our long-term goals as a global, growing company," he told high-level company officials in an e-mail Tuesday shortly after Toyota's sales numbers were released.

Wagoner said GM was surpassed by Toyota largely because of its move to reduce unprofitable sales to fleet customers and the fact that Toyota crushes GM in sales in Japan.

GM Vice Chairman Bob Lutz offered a curt response to Toyota's outpacing GM in the first three months of the year: "My reaction is 'So what?' "

He also noted that GM is "staying focused on further reducing our still huge health care cost disadvantage versus Toyota and other non-U.S. based manufacturers."

At the same time, an issue domestic automakers have been complaining loudly about is the value of the Japanese yen.

Automakers argue Japanese currency "manipulation" unfairly gives Toyota, Honda and Nissan up to a $4,000 per vehicle subsidy, by making American cars more expensive in Japan and Japanese imports less expensive here. Japan and Japanese automakers reject the charge.

Two-thirds of the U.S. $88 billion trade deficit with Japan is auto-related.

Japan subsidy edge touted

Last month, U.S. Sen. Debbie Stabenow, D-Lansing, introduced a bill dubbed the Japanese Currency Manipulation Act, which would force Japan's government "to take action to stop subsidizing millions of auto exports to the U.S. by bringing its currency into proper alignment with the U.S. dollar," said a statement from the Automotive Trade Policy Council, a group representing GM, Ford and DaimlerChrysler AG.

I am puzzled by the huge difference in reactions between Wagoner's vowing "to fight for every sale" while Lutz is saying "So What?" OK guys, which is it and why the interest rate rebates to subprime borrowers? Something tells me this is not just an April thing.

As for currency manipulation, if the US is allowed to debase it's currency the way we do, do we have a legitimate beef about what any other country is doing with their currency or why? It will be interesting to see if any of the misguided tariff efforts against Japan or China gather any steam.

Ford feels heat to refresh lineup

Analysts ask: Can Ford can roll out new models fast enough to keep its comeback going?

To survive in today's auto industry, you need a steady parade of fresh designs to keep consumers interested.

Ford Motor Co. learned that the hard way by allowing initially successful models like the Taurus and Ranger to languish too long without a significant refresh.

Today, it has the oldest lineup of any major automaker.

Ford is trying to change that. By 2010, it expects to have one of the freshest vehicle lineups. But after losing $12.7 billion last year and borrowing against nearly all of its assets to finance the turnaround plan, the question is whether Ford can survive long enough to see the product renaissance.

New models like the Fusion sedan and Edge crossover are not only selling well, but also bringing in new buyers to Ford.

But its aging vehicles like the Explorer SUV and the Focus sedan are losing sales and driving consumers to competing brands in alarming numbers.

According to J.D. Power, 58.5 percent of those who bought a Ford already owned a Ford, while only 42 percent of those who traded in a Ford bought another Ford.

That means most people buying Fords are already Ford customers, but nearly half of those trading in Fords are defecting to other brands.

The problem is shared by Ford's Detroit-based rivals, but the gap is greatest at Ford.

The reverse, however, is true for Toyota Motor Corp. Only 35.8 percent of Toyota buyers in the first quarter were return Toyota customers, yet 58.5 percent of those who traded in Toyotas bought another one.

Union Strife at GM

Reuters is reporting GM cuts work at 2 plants after talks fail.

Friday April 27, 2:48 am ET
General Motors suspended development work at two U.S. plants after talks between the union and management on cost cutting ended, the Wall Street Journal reported on its Web site on Friday.

United Auto Workers leaders ended talks at facilities in Fairfax, Kansas and Lordstown, Ohio after disagreements with the company, the Journal reported, citing unnamed sources.

The paper cited sources as saying GM told UAW that it was suspending work related to two new-vehicle programs.

UAW and GM could not immediately be reached for comment.

US Outlook is Poor

• The economy is dramatically slowing (GDP came in at 1.3%)
  
• Auto sales are falling
• Ford's lineup is aging
• GM is arguing with the union over cost cutting
• MEW is falling along with falling home prices
• GM is showing signs of desperation by appealing to subprime borrowers
  

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

Managers are Passé

Circuit City started the ball rolling by Cutting More Than 3,500 Jobs.

A new plan for layoffs at Circuit City is openly targeting better-paid workers, risking a public backlash by implying that its wages are as subject to discounts as its flat-screen TVs.

The electronics retailer, facing larger competitors and falling sales, said Wednesday that it would lay off about 3,400 store workers -- immediately -- and replace them with lower-paid new hires as soon as possible.

The laid-off workers, about 8 percent of the company's total work force, would get a severance package and a chance to reapply for their former jobs, at lower pay, after a 10-week delay, the company said.

Citigroup stepped up to the plate big time with a massive Massive Restructuring Plan.

Citigroup Inc. said it will eliminate 17,000 jobs, or 5 percent of its workforce, as part of a broad restructuring plan designed to cut costs and bolster its long underperforming stock price.

Citigroup plans to move more than 9,500 jobs to lower-cost locations worldwide, with about two-thirds through attrition. It will also eliminate layers of management, often increasing the number of workers reporting to each manager.

Wal-Mart decided to follow suit by cutting manager jobs at Sam's Club.

The world's largest retailer, is cutting about 1,000 management positions at its Sam's Club stores, a spokeswoman for the company's warehouse chain said on Thursday.

Wal-Mart is consolidating about 2,800 salaried-manager positions at some 580 U.S. Sam's Club stores, spokeswoman Susan Koehler said.

The restructuring, which began in early March and is expected to be completed within the next couple of weeks, was done to improve customer service and gain more flexibility in managing the stores rather than to cut costs, Koehler said.

The company has created three higher-paying positions to replace about 1,800 of those jobs and is also offering affected employees other positions in the company, Koehler said.

So....

• Wal-Mart is "consolidating" 1,800 jobs down to 3
• Offering (presumably lower paying jobs) to those who were downsized. Most took it even though jobs are said to be plentiful.
• This was not done to cut costs but to improve service

Managers? Bah humbug. Who needs em? Get rid of them all and customer service will soar. They are after all, so Passé. What company will be next to realize that?

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

The Knowledge Based Economy (Part 2)

I had no plans to do a part two when I wrote The Knowledge Based Economy nor did I know how well part one would be received. The number of comments to the above link was extremely high and many of them were excellent.

One of the ideas I proposed yesterday was that China and India were not standing still when it comes to education. Some responded with negative comments about what constitutes an engineer in China vs. the US. What I sense however, is enormous strides being made by China relative to the US at a time when US education costs are unjustifiably soaring in the US.

In a totally random event, there were two articles out today in the BBC supportive of my position (taking the liberty of using education in the UK as a Western proxy). The first was about college entrance exams in China vs. first year exams in the UK.

Maths enthusiasts are being challenged to answer a sample question from Chinese university entrance tests. The tests are set for prospective science undergraduates.

The UK's Royal Society of Chemistry is offering a £500 prize to one lucky but bright person who answers the question below correctly.

It has also published a test used in a "well known and respected" English university - the society is not naming it - to assess the strength of incoming science undergraduates' maths skills.





A glance at the two questions reveals how much more advanced is the maths teaching in China, where children learn the subject up to the age of 18, the society says.

It has sounded a warning about Britain's future economic prospects which it claims are threatened by competition from scientists in China. RSC chief executive Richard Pike says mathematics is seen as integral to the sciences in China and its economy.

Math is a Difficult Subject

The BBC is reporting Pupils 'are urged to drop math classes'.

The Royal Society of Chemistry said that as maths was a difficult subject, schools feared examination failures which would threaten their standings. Chief executive Richard Pike also said universities were increasingly having to run remedial classes in maths.

Dr Pike said: "Schools and students are reluctant to consider A-level mathematics to age 18, because the subject is regarded as difficult, and with league tables and university entrance governed by A-level points, easier subjects are taken."

In a paper entitled Why League Tables Have to Go, he said it was not unusual for students taking chemistry and biology to take another non-mathematical "quite unconnected" subject.

He went on: "Increasingly, universities are having to mount remedial sessions for incoming science undergraduates because their maths skills are so limited, with many having stopped formal lessons in mathematics two years earlier at the GCSE level."

This contrasted strongly with countries like China where maths was taught to all up the age of 18, he said.

William Shaw, professor of financial mathematics at King's College, London,[responded by calling it] a "cheap and uninformed" attack on UK teaching.

"We are changing the curriculum, creating a new entitlement to give more pupils the chance to study separate physics, chemistry and biology GCSEs and piloting 250 science clubs for 11 to 14-year-olds."

In the United States, many good students might not learn calculus until they got to college.

"So I could set a test for university entrants in China (or the US) which many British sixth form maths students could do, based on some calculus, which could make a similarly unbalanced media story in the Chinese papers," he said.

Choose a Door

1. This is just a "curriculum change".
2. It's the UK that's lagging, not the US.
3. China is making huge inroads vs. the UK and US in math, science, and medicine.

I select door number 3.

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

The Knowledge Based Economy

I received an interesting question today on The Market Traders about the Knowledge Based Economy.

Dear Mish,

Considering the dismal manufacturing news today - three million jobs lost since 2000 - I am wondering what people think about our move into the 'knowledge economy.' Is it just a hoax, or is there really a shift going on, in the same way that America shifted from being an agricultural economy to a manufacturing economy in the last century. I lived and worked in Taiwan for two years, and they are big believers in the knowledge economy. Because they are such a small country - 23 million people - they have a somewhat different model of economic organization than ours here in the US. Below is a draft of an article that I'm working on, and I'm looking for any and all input. The draft originally appeared here: Value Creation in the Knowledge Economy: The Stan Shih Smile Curve. I posted it to Free Republic and got some feedback, but nothing too helpful.

Much appreciated.
Michael Nystrom

Thanks for that question Michael. It is much appreciated. Before answering let's take a look at the key ideas in the above link.

Until very recently, the United States was both the world’s wealthiest nation, and world’s manufacturing powerhouse, leading economists to believe that there was a correlation between the two. This is why the “hollowing out” of American manufacturing was viewed with such alarm throughout the 1980’s and 90’s. Remember Ross Perot sounding the alarm bell during the 1992 election over NAFTA and the loss of American jobs?

Perhaps this was just an overreaction, a misunderstanding. If it is indeed true that we are moving into an “information age” or a “knowledge economy,” as the experts tell us, the new source of wealth becomes something intangible: Knowledge. This is demonstrated by Stan Shih’s smile curve:



Perhaps you’ve never heard of Stan Shih, but in Asia, he is a rock star capitalist –the founder of Acer Computer, a genius business theorist and now a hotshot VC.

Shih’s “Smile Curve” comes from his observations as a contract manufacturer of PCs for US brand name manufacturers. Remember back in the mid-80’s when PC clones first caught fire? There were hundreds of PC clone brands, but most of them were made by OEMs (original equipment manufacturers) – like Stan Shih’s Acer - in Taiwan.

What Shih noticed was that while companies like his did all the hard manufacturing work, it was the name brands – the IBM’s, the Compaq’s and the Digital’s – that got all the glory -- and the profits. The big American firms with the concept, the R&D, the brands and the distribution channels could outsource the 'lowly' manufacturing work to the lowest bidder. This resulted in a bidding war to the bottom in Taiwan, driving down the cost of production not only in the realm of PCs, but chips and components as well.

To explain this using a more modern example and in concrete terms, let's take the example of the Apple iPod. Apple recently announced that has sold 100 million iPods, and the product has been a cash cow for Apple. Everyone seems to have an iPod. But where was the value in this product created? Not in the manufacturing. Apple doesn’t make the iPods, they contract the manufacturing out to a Taiwanese manufacturing giant you’ve probably never heard of: Inventec.

In fact, “manufacturing” is rather a misnomer. Assembly is more like it. An iPod’s chips come from a variety of high-value suppliers (Texas Instruments among them), the hard drives from others (Hitachi), and the hundreds of other electronics components from hundreds of other suppliers. Inventec is really just a very organized assembler of parts from different companies all over the world. And the assembler’s margins are woefully slim. Inventec doesn’t just make iPods, it also makes notebook computers, phones, personal digital assistants, calculators and whatever else it can for companies much more famous than Inventec is or likely will ever be.

The real “value creation” in the iPod came in the knowledge required to conceptualize, create, market, brand and position the player, as well as the ability to leverage that knowledge into a hefty profit. The iPod certainly wasn’t the first mp3 player, but it is by far the most popular, thanks to the unique conceptualization, sleek branding, and superior design and engineering. In short, the value came from knowledge and through leveraging that knowledge.

Apple is able to capture huge margins on sales of the iPod. Say each iPod costs $5 -10 to make, but Apple sells them anywhere from $150 - $250 because it controls the distribution network and can therefore set the price. Because the iPod is a unique item, there are no bidding wars with other mp3-player makers. Let others sell mp3 players as cheap as they like – few people want them.

From this example, manufacturing does indeed appear to be the lowest value input. This is why, the capitalists say, the world has evolved to the point that it has. “We think, they sweat,” they say. We of course, are the Americans and they are the sweating Asians

Clever, isn’t it? But I have a nagging feeling there is something wrong with the theory, though I’m not exactly sure what. Perhaps I’m too rooted in the old economy, unable yet to adjust to the idea of the “knowledge economy.” But I have a feeling there is something more.

What is wrong, if anything, with the model? Or am I just a dinosaur?

Michael Nystrom

Michael there is nothing wrong with that chart. One can clearly look at China, India, and SE Asia in general and see without a doubt what is happening. And in spite of enormous increases in raw materials, the prices of finished goods have barely risen.

Are cars, boats, pottery, computers, monitors, printers, light fixtures, etc keeping up with the prices of raw materials that make them? Clearly the answer is no. The curve reflects what is happening. In fact, the curve represents additional profit that can be had by shifting manufacturing to low cost providers. That is in essence the very foundation of global wage arbitrage. However, You are missing several key points.

Key Points

1. Global wage arbitrage is not just about manufacturing
2. The US has no intrinsic brainpower advantage
3. The smile curve is flattening
   

Please consider the recent announcement: Citigroup Details Massive Restructuring Plan

Citigroup Inc. said it will eliminate 17,000 jobs, or 5 percent of its workforce, as part of a broad restructuring plan designed to cut costs and bolster its long underperforming stock price.

Citigroup plans to move more than 9,500 jobs to lower-cost locations worldwide, with about two-thirds through attrition. It will also eliminate layers of management, often increasing the number of workers reporting to each manager.

Poof! 17,000 jobs are gone and the details show that we are talking about "layers of management", not just low level clerks. Where are the jobs headed? To "lower-cost locations worldwide" is the answer.

We are seeing the same thing in medical outsourcing, tax preparation, and accounting functions. In regards to medical outsourcing we have X-rays being taken here, shipped to India for diagnosis and only the treatment being performed in the US.

Outsourcing Innovation

Next consider Outsourcing Innovation.

First came manufacturing. Now companies are farming out R&D to cut costs and get new products to market faster.

While the electronics sector is furthest down this road, the search for offshore help with innovation is spreading to nearly every corner of the economy. Underlying this trend is a growing consensus that more innovation is vital -- but that current R&D spending isn't yielding enough bang for the buck. After spending years squeezing costs out of the factory floor, back office, and warehouse, CEOs are asking tough questions about their once-cloistered R&D operations: Why are so few hit products making it out of the labs into the market? The result is a rethinking of the structure of the modern corporation. What, specifically, has to be done in-house anymore?

"You have to draw a line," says Motorola CEO Edward J. Zander. At Motorola, "core intellectual property is above it, and commodity technology is below."

Wherever companies draw the line, there's no question that the demarcation between mission-critical R&D and commodity work is sliding year by year. The implications for the global economy are immense. Countries such as India and China, where wages remain low and new engineering graduates are abundant, likely will continue to be the biggest gainers in tech employment and become increasingly important suppliers of intellectual property.

Some analysts even see a new global division of labor emerging: The rich West will focus on the highest levels of product creation, and all the jobs of turning concepts into actual products or services can be shipped out. Consultant Daniel H. Pink, author of the new book A Whole New Mind, argues that the "left brain" intellectual tasks that "are routine, computer-like, and can be boiled down to a spec sheet are migrating to where it is cheaper, thanks to Asia's rising economies and the miracle of cyberspace. "The U.S. will remain strong in "right brain" work that entails "artistry, creativity, and empathy with the customer that requires being physically close to the market."

The idea that "The U.S. will remain strong in "right brain" work that entails "artistry, creativity, and empathy with the customer that requires being physically close to the market." is pure arrogance.

But let's for a second assume it is true. The question then is: How many "right brained" creative jobs do we need vs. how many "routine, computer-like" jobs we need.

Look at the jobs this service economy is creating: jobs at Walmart, Pizza Hut, Home Depot, Lowes, Nail Salons, Grocery Stores, etc etc. Exactly how many of those jobs are needed vs. the creative, artistic, super wiz-bang design jobs.

Is education the answer?

Some have proposed that education is the answer. That presumes China and India and other countries are standing still. But India and China are not standing still. They are churning out engineers and PHDs faster than the US. I am not trying to dismiss the importance of education, but logic dictates that if everyone had a PHD then PHDs would be greeters at Walmart and serving pizzas at Pizza Hut.

In short, this is not a right brained vs. a left blame phenomena, nor does the US have a monopoly on brainpower. The idea that we no longer need manufacturing jobs and the US can thrive on R&D, branding, marketing, and other value added services assumes the world is standing still. It also assumes those jobs are somehow safe from competition. That's a big mistake.

Global competition for jobs at every level in every capacity is increasingly the norm. China and India are churning out enormous numbers of doctors and engineers. Global wage arbitrage has now shifted from manufacturing to other spots on the curve. Look at medical outsourcing and increased outsourcing of R&D as proof. Expect further pressures on wages at every spot on the "Smile Curve" with intense competition at the ends of the curve and you won't be far wrong. Is the US prepared for a flattening of that curve while the world catches up? I think not, but it will happen anyway.

This post originally appeared in Whiskey & Gunpowder.

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

If it feels good... Buy it.

The question of the day is "What are Americans buying?" The answer was provided by Fed governor Richard Fisher in response to a question on housing:

Q: What are the positives that are helping the economy weather the housing downturn?

A: Americans will buy anything that looks good, feels good, smells good and tastes good. We're great consumers. And consumption is over 70% of GDP.

Gee. What a great nation we could be if we could only manage to consume 200% of GDP.

Still Renting

Unlike Fisher I keep wondering how people are buying stuff. Mark Kiesel at Pimco who is Still Renting seems to feel the same way.

Over the past several years, consumers leveraged rising housing prices and easy credit availability using their home as an ATM. Mortgage equity withdrawal (MEW) soared, allowing consumer spending to grow faster than income growth over the past several years. This process was facilitated by rising home prices and loose lending standards. As long as housing prices were rising, lenders were willing to lend, and consumers were willing to spend, as rising housing prices gave them the confidence to draw down on savings.

Today, mortgage equity withdrawal appears tapped. Consumers have been accessing their homes as bank accounts, but housing prices are now falling in many areas, and credit is becoming more difficult to obtain. The slowdown in MEW has been remarkably swift. Over the past year, consumers tapped over $400 billion less equity out of their homes than the previous year. And, in looking at the four-quarter moving average of MEW divided by nominal GDP, the change in MEW as a percent of nominal GDP is now –1.8% Slower housing price appreciation is causing mortgage equity withdrawal to fall sharply, and is set to detract from U.S. economic growth.



Housing Is Today’s Leading Indicator

Housing is today’s leading economic indicator. To quote our forecast from one year ago in For Sale, “with a softening housing market, we should expect tighter lending standards, a moderation in the willingness to take risk, a slowdown in the pace of asset price appreciation, less liquid markets, and rising volatility in financial markets.” On the economic front, I believe declining housing prices and tighter credit are set to unleash a sharp downturn in housing turnover and job creation. As housing prices fall, corporate profits are expected to be at risk as consumers pull back their spending.

Housing is a momentum market. Turnover rises when real housing prices, as defined as housing price appreciation (HPA) minus mortgage rates, are rising. Turnover slows when real housing prices are falling (Chart 9). Today, the growth in real housing prices is falling. We believe real housing prices will turn further negative in 2007, causing new and existing home sales to decline towards 5 million units per year, down from a peak of over 7.5 million units per year in 2005.

Housing starts and permits tend to be a good leading indicator of job growth. Through February 2007, housing starts are down –28% year-over-year. This type of decline in housing starts typically leads to a sharp slowdown in job growth, within roughly one year. As a result, I believe that job creation is set to slow, possibly materially. The U.S. economy created approximately 200,000 new construction jobs last year. It would not surprise me if we lost 400,000 construction jobs this year, as homebuilders complete their existing projects and then lay off workers. As corporate profit growth deteriorates with a slowdown in housing, business investment and consumer spending, layoff announcements across all sectors of the labor market will likely pick-up.


Housing is today’s leading indicator of economic growth and risk appetite. An extended downturn in housing will likely lead to slower job creation, softer corporate profit growth, tighter lending standards and weaker consumer and business confidence. The Fed should lower the Fed Funds rate as soon as we have confirmation that the employment situation is deteriorating. By that time, credit spreads will have already anticipated the fact that risk appetite is set to turn for the worse.

For renters and potential homebuyers, my advice is to still rent. The housing market has turned for the worse but the unwinding of this bubble will take more time. Unfortunately, this is not good news for the U.S. economy, job creation or corporate profits. Nevertheless, investors who are patient and adopt a conservative investment strategy should prosper over the next few years.

I happen to agree with Mark Kiesel about housing, jobs, weaker consumer spending, and credit spreads. I also think emerging markets are likely to get hit hard if the US goes into a recession. But right now the markets seem to have a mind of their own especially in regards to yields.

Things with the same yield

1. 30 year Treasuries
2. 2-year Fannie Mae Benchmark Notes
3. 2-year Freddie Mac reference Notes
4. World Bank 2-year notes
5. Mexican Global 2-year notes
6. Brazilian 2-year notes
7. Colombian Global 2-year notes
8. Chilean 2-year notes
9. Peruvian 2-year notes
10. 2-year Citigroup notes

Thanks to Bennet Sedacca on Minyanville for the above list.

I find the above comparison quite amazing and so did Bennet. Nonetheless, that's how correlated risk is right now. The "Feels Good" society has now gone global.

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

Mod Squad Containment

I recently talked about some of the bailout plans in The Fatal Flaw in Housing Bailout Plans. But somehow I missed the "Bear Stearns/EMC Mod Squad" to Help Keep Customers in Their Homes.

Mortgage Corporation, a leading mortgage servicer that has specialized in subprime and Alt-A loans for 15 years, announced the formation of the "EMC Mod Squad" - a loan modification team dedicated to helping delinquent borrowers avoid foreclosure on their homes. Teaming up with local community groups, the EMC Mod Squad will meet with targeted groups of EMC Mortgage customers across the country. Concentrating on cities with higher numbers of at-risk EMC Mortgage customers, the team will conduct educational workshops and explore possible financial restructuring for these homeowners.

The EMC Mod Squad is comprised of 50 designated loan workout specialists and EMC Mortgage is committed to growing the team to meet borrower demand. The team will partner with local community groups such as the Consumer Credit Counseling Service to reach out to EMC Mortgage customers who are either delinquent or already in the foreclosure process to offer counseling and alternatives. In addition to one-on-one meetings with customers, the EMC Mod Squad will hold workshops across the country and its phone team will conduct outreach efforts to try to reach every delinquent EMC Mortgage customer. EMC Mortgage has set up a toll-free telephone hotline for customers to reach the EMC Mod Squad at 877-EMC-MOD1 (877-362-6631), staffed Monday-Friday 7 am to 9pm CST and Saturdays 7am-12pm CST.

The EMC Mod Squad will begin their six-city national road show in Dallas tentatively scheduled for May 4th and 5th, partnering with the local Consumer Credit Counseling Service. The team will also meet consumers in Atlanta, Chicago, Detroit, Minneapolis/St. Paul and Cleveland.

Observation: There is an amazing amount of effort being put forth to contain something that is supposedly already contained.

Containment Plans

• Neighborhood Assistance Corp. has a $1 billion rescue of subprime loans.
• Ohio mortgage bailout plan gets off to slow start.
• Washington Mutual has a $2B program to help subprime borrowers.
• Freddie Mac promise to buy $20 billion in subprime mortgages.
• "Bear Stearns/EMC Mod Squad" to Help Keep Customers in Their Homes.
• Fannie Mae has a "HomeStay" program to offer "a range of workout" solutions.
• The Federal Reserve, Federal Deposit Insurance Corporation, National Credit Union Administration, the Office of the Comptroller of the Currency and Office of Thrift Supervision all want 'prudent workout plan' for borrowers.
  

It seems to me that we have a Mod Squad of Mod Squads with at least a dozen major programs and/or sponsors. I am sure there are more. But lost in the effort to contain what 5 Fed governors and Greenspan have said is already contained is any quantifiable reason to do so. Perhaps because there isn't one.

Should we bailout anyone?

The San Francisco Chronicle headline reads Why we shouldn't be bailing out subprime lenders or borrowers.

Dumb: Buying a house you can't afford with no down payment and a loan whose monthly payments will explode in a few years.

Dumber: Lending money to people who can't afford a traditional mortgage, especially when they have lousy credit ratings and don't substantiate their income.

Dumbest: Bailing out dumb and dumber, especially with taxpayer money.

State and federal lawmakers, community groups and housing advocates are proposing schemes to prevent the victims of the subprime loan crisis from losing their homes. I hate to sound callous, but it's hard for me to know who the victims are in this mess.

If mortgage brokers or lenders used inflated appraisals or made false or misleading statements, they should be prosecuted or at least forced to restructure the loans. If borrowers lied about their income or assets to get a bigger loan, they too should be prosecuted.

But many people got into the subprime mess because they were willing to believe a fast-talking broker who told them they could buy a home, or a bigger home, or take more cash out of their home than they could with a conventional mortgage.

Keeping people in homes they had no business buying is wrong in many ways.

For starters, there's no easy way to bail out homeowners without bailing out the lenders and investors who were largely responsible for the subprime mess.

Many experts say we are in the early innings of the foreclosure cycle. If we bail out people today, will we be willing and able to help people who fail later in the game?

Propping up borrowers who took a gamble on a house and lost reinforces gambling.

"If people think they can take out a bad mortgage and they get bailed out, that's called moral hazard in social insurance and it's a very bad thing," says Thomas Davidoff, an assistant professor in the Haas Real Estate Group at UC Berkeley.

Bailout advocates say they want to help people who were duped, not gamblers. But even if you could separate the swindled from the speculators, there's no guarantee that people who get a bailout will keep their homes. It could be an expensive form of life support.

Nobody offered to bail out investors who bought tech stocks in 1999. Nobody bailed out Enron employees who lost their jobs and chunks of their 401(k) plans because the company was a fraud. Nobody offers to bail out credit card abusers.
...

Kathleen Pender, your logic is impeccable. Also hitting the nail on the head is Laura Rowley talking about Footing the Bill for the Subprime Fiasco.

"It makes good sense to make sure families and neighborhoods are protected from rogue lenders and lax government oversight," Schumer said in a speech last week, adding that he's working on the legislation. "It'll save homeowners from losing their equity, save cities and local governments from losing their tax revenues, and save neighborhoods from taking a big hit."

Good sense? If a bailout is good sense, Schumer should also sponsor a bill funding free cardiac bypass surgery and liposuction for anyone the government failed to protect from eating repeatedly at McDonald's.

"The real tragedy here is that 2.2 million homeowners face the real possibility of losing their homes because they were misled, or just plain swindled by modern-day bandits," Schumer said in a hearing in March.

On the other hand, as far as I can tell, none of these modern-day bandits held a gun to anyone's head and forced them to take out a loan.

Lenders Take Their Medicine

Some lenders were clearly predatory, and should be prosecuted for swindling consumers. But most were businesspeople looking to profit on vulnerable borrowers. We all know profit has a twin -- it's called risk. These financial institutions, and the investors who bought their bonds, knew what they were doing. Now let them pay for it.

Schumer said families were "teased into unsuitable subprime loans."

"Teased into"? What kind of language is this? When did we transform from being a culture of opportunity to a culture of victimization? Taking out a mortgage is a choice, and choices have consequences. If we want to own our financial successes, we also have to own our financial mistakes.

And what kind of message does a government bailout send to Americans who did things the right way? People who had a job, paid their bills on time, built solid credit scores, saved for a down payment, read their loan terms, and scrutinized their budgets to make sure they could afford not only the mortgage payments, but the taxes, insurance and maintenance on their homes?

Government and the Fed created this Mess

Government intervention helped create this mess. It started with GSEs to designed to promote affordable housing. That was followed by 300 or so additional programs to create affordable housing (all of which had the opposite effect). The Greenspan Fed certainly threw fat on the fire panic to cut rates to one percent. Greenspan himself also endorsed ARMs right at the bottom in interest rates. Bush piled on with his "Ownership Society". Of course there are huge mortgage interest rate deductions for home owners. In Illinois, Governor Rod Blagojevich went off the deep end with an Opportunity I-Loan mortgage loan program for illegal aliens. Right near the height of insanity (in May of 2005) the Housing and Urban Development Secretary Alphonso Jackson stated: "I am absolutely emphatic about winning back our share of the market" that has slipped away to subprime lenders. Somewhere along the line, lenders and borrowers both lost all sense of risk, especially when huge fees could be obtained by passing the trash to Fannie Mae or securitizing the loans in investor pools.

In light of the above, who is it we want to bailout and why? Close observation will reveal two facts.

1. This is political vote buying by Schumer because he thinks he can get away with it. It is akin to senseless programs designed to "save the family farm" or to promote ethanol that do nothing but jack up the prices paid by consumers while padding the pockets of rich and powerful constituents.
2. The little guy will not be bailed out by these programs. These programs all have their roots in attempting keep people underwater and in trouble from declaring bankruptcy. The idea is to make people debt slaves forever. The last thing any lender wants is to be stuck with an overpriced home with no one to sell it to.

It will be interesting to watch going forward how many more programs will be brought forth to contain that which is already said to be contained. But that won't stop the reality of the situation: These plans are nothing but political pandering by Congress, and/or acts of desperation by lenders fearing they will lose debt slaves to bankruptcy.

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

The Activist Fed and Credit Cycles

There was an interesting exchange on Minyanville today about the Activist Fed. The origin was a set of reader questions about subprime bailouts, the Fed's role in the process, and thoughts from Pimco about the real estate (credit) lending excesses that will bear on the economy for years to come.

Questions to John Succo and Scott Reamer

1. What do you think the probability is that an activist Fed will seek to spread the consequences over a significantly longer time period?
2. Do we really have a much more "activist" Fed, or am I reading too much between the lines?
3. If some of what I've hypothesized is really possible, what are some not broadly considered potential ramifications that I should be thinking about for the markets and the economy?

The answers to those interesting questions can be found in Minyan Mailbag: The "Activist" Fed. Here is a synopsis:

If the Fed had the ability, they would of course insulate the banking system and markets from the pain of this credit write down for as long as they could – by spreading it out over time. On that there is no debate.

The real debate is whether or not the Fed can do that. After all, the Fed itself can monetize anything and keep rates low (at the expense of the currency), but the only thing that matters really is will the market want the credit? The more debt there is, the more income is needed to service that credit, the less effective the Fed is in cajoling the market into taking it. That is, the bankers become less inclined to lend and borrowers become less able to borrow.

In Japan from 1990 to 2003, the BOJ kept rates at virtually zero but during that entire time the Japanese consumer and corporation did not want to borrow (having suffered asset price write downs and thus hits to their capital bases) and the Japanese banks themselves did not want to lend (having themselves suffered the same capital write-downs from their holdings (direct on their balance sheets and indirect via loans to consumers/corporations). Thus what the BOJ wanted was moot - they wanted to shield the Japanese banking system from the negative effects of the property and stock busts but were unable to at all. Huge debt levels create the circumstances above: where consumers and corporations cannot suffer even small capital declines (stock or property) before their appetite for credit diminishes massively.

The fact that total US bank lending y/y is now about 8% y/y vs. 13.5% or so as early as last summer (growth rate is coming down pretty rapidly) speaks to this idea: the US is already seeing declines in total bank lending that have in 1990, 1996, and 2000 led to credit cycle ‘busts’ of some degree. And obviously the amount of debt outstanding now dwarfs all of those periods; so a decline in the willingness of bankers to lend (and thus support the ability of debtors to service their debts and simultaneously support debtor’s capital bases) bodes ill indeed for the US' debt laden consumer economy.

Most of the LBO deals we have seen will eventually suffer greatly because of leverage: one little problem in margins will cause a catastrophe to earnings. This is what leverage does. The more levered a company is the more stable its margins must be.

Given the massive amounts of credit that are now being created outside of the traditionally controlled “Fed channels” (Stephanie Pomboy puts the number at 75% of total credit creation), one must ask the additional question of if the Fed can impact marginal credit demand (by lowering its price or monetizing it outright). Recall that while the Fed was increasing rates 17 times in 2004/05, the housing bubble – and the ‘creative’ financing that fed it - was reaching manic proportions. Thus, from that experience, you could conclude that the Fed is less in control of credit supply (and as well credit demand) as they would like to admit.

Who is in control? The People’s Bank of China, the Bank of Japan, pension and hedge funds, and the broader capital markets: all have a stake in keeping the liquidity cycle going (and thus the credit creation cycle cycling). But those are fickle friends: the Olympics, the carry trade, the aging of the G7 populations, and the 2%/20% model of hedge funds are feeding the frenzy now but any one of those factors could change and cause any of those factors to turn tail and end the game of musical chairs, causing the deflationary credit bust we think is an inevitability with a system as heavily indebted as the US'.

From the Fed’s own flow of funds we see just how ineffective the Fed has become: in 1980 it took $1 of new debt to create $1 of GDP (debt levels were much lower and capital usage was much tighter so new credit found its way into production), whereas today it takes $7 to $8 of new debt to create $1 of GDP.

No matter what the Fed ‘wants,’ no matter what they are able to get FNM, FRE, BAC, WM, C and the gang to do, and no matter who (PBOC, BOJ, TIAA-CREF, or PIMCO) gets the last chair, there is one verity in macroeconomics:

All credit cycles cycle.

John Succo and Scott Reamer

Minyan Mailbag Key Ideas

• The Fed's wants and the Fed's ability are two different things
• 75% of credit creation is now outside the Fed's control
• Inability to service debt is the limiting factor
• With leverage small problems in margins can be catastrophic to earnings
• 1980 it took $1 of new debt to create $1 of GDP. Today it takes $7 to $8 of new debt to create $1 of GDP.
• All credit cycles cycle

Following are a few thoughts of my own on the progression of the Credit Cycle

Progression of Debt Problems

1. Rising delinquencies
2. Rising foreclosures
3. Rising bankruptcies

Today's delinquencies become tomorrow's foreclosures and bankruptcies. All three are soaring now. 2.1 million people missed a mortgage payment in 2006. But unemployment rates are at historic lows with only one way to go. Rising unemployment will compound the already huge problems by orders of magnitude. Rising unemployment is likely to be the key factor that pushes the mess from subprime to prime.

Yes, the Fed is trying to stop this progression. So is Wa-Mu and so is Freddie Mac. But the intervention is doomed to failure as I pointed out in The Fatal Flaw in Housing Bailout Plans.

The flaw is these programs are all designed to keep people in their homes regardless of the value of those homes. Who wants to be "bailed out" if it means owing $350,000 on a mortgage when their house is only worth $175,000?

I started to write "The longer the Fed and global central bankers try and prevent the cycle from cycling, the bigger the disaster when they finally lose control" but that's not quite correct.

Professors Succo and Stephanie Pomboy have already shown the Fed is no longer in control. I have talked about that idea before as well and so have others like John Hussman (See Independent Thought and Superstition and the Fed). The only question then is not about what will happen but rather how feverish the speculation gets before the whole mess implodes and of course the timing of that implosion.

Timing is the real problem. For a technical perspective on the issues at hand, Jeffrey Cooper has his second Minyanville article called Bear Hunting Season.

Check it out. It's another good one.

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

The Fatal Flaw in Housing Bailout Plans

The CNN Money headline states Feds want 'prudent workout plan' for borrowers.

U.S. banking regulators urged lenders Tuesday to help distressed borrowers unable to make mortgage payments and to offer possible incentives to move homeowners to lower-cost loans.

The Federal Reserve and other agencies said they may relax some regulatory penalties for financial institutions that pursue reasonable workout plans with borrowers. Lenders may also receive favorable consideration under the Community Reinvestment Act, the regulators said in a statement.

"The agencies want to remind their institutions that existing regulatory guidance and accounting standards do not require immediate foreclosure on homes when borrowers fall behind on payments," they said.

U.S. banking regulators and lawmakers are exploring ways to help millions of borrowers with poor credit history who took out adjustable rate mortgages that start with low introductory monthly payments and then dramatically increase after the first two or three years.

The regulatory agencies said a prudent workout plan is in the long-term interest of both the financial institutions and borrowers and urged lenders to work with consumer groups to help borrowers avoid predatory foreclosure rescue scams.

Let's be realistic here. This has nothing to do with helping out distressed borrowers. This has everything to do with helping out lenders who are stuck in loans with increasing chances of default.

The prudent thing to do would be to stop risky lending practices cold. The way to do that would be to punish irresponsible lenders and borrowers both. Instead the Fed is attempting to prop up asset prices by the carrot and stick method of relaxing regulatory penalties for misbehavin'.

$1 billion rescue of subprime loans set

Neighborhood Assistance Corp. is announcing a $1 billion rescue of subprime loans.

A Boston-based national community advocacy group on Wednesday announced a $1 billion campaign to rescue predatory loan victims by refinancing their mortgages, as a new U.S. Senate report said such foreclosure prevention efforts are beneficial to communities.

Using its capacity as a nonprofit mortgage broker, Neighborhood Assistance Corp. of America will act as an agent for Citigroup and Bank of America Corp., the two biggest U.S. banks. The group will approve new loans for “subprime” borrowers — those with spotty credit — who are in danger of losing homes to foreclosure.

NACA will counsel the struggling borrowers, process loan applications and underwrite the loans, which the banks will fund before likely selling them to Wall Street investors in the form of securities and bonds. The 30- year loans will carry a fixed interest rate one point below the prime rate, putting it currently at 5.5 percent. There are no fees, and the banks pay all the closing costs.

“We have created a new program that is going to be out there to really save the thousands of people who are at risk of losing their home, just in the Buffalo area not to mention nationwide,” said NACA CEO Bruce Marks in an interview.

Using data from First American LoanPerformance, the report also looked at the percentage of subprime loans that were at least 60 days late in payments. Buffalo’s rate of 13 percent was the highest among New York’s large cities, though well below Cleveland at 24.1 percent. The national average is 12.4 percent.

“We need to redouble efforts to protect American families and communities who are at the losing end of this mess,” Schumer said in a press release. “The subprime mortgage meltdown has economic consequences that will ripple through our communities unless we act.

“It’s always the best deal out there,” Marks said. “Everybody would love to have a NACA loan, but we are prioritizing. The people who have a predatory loan, those are the people that we are going to assist.”

Ah yes, Priorities

"We are prioritizing. The people who have a predatory loan, those are the people that we are going to assist."

It's a brilliant plan. Let's reward the totally inept with 5.5% loans. Let's make everyone wish they got trapped in loans they could not afford. But what happens when this escalates from subprime to Alt-A to prime? Are we going to bail out everyone? Who is it we are bailing out anyway: the homeowner or the predatory lender? A better question is: Are we bailing out anyone at all or just padding the pockets of a new set of lenders? Questions, questions, questions.

By the way, who exactly are those 5.5% subprime loans going to be sold to? I suppose when push comes to shove the government could always pad another pocket and guarantee them.

"The report said foreclosure prevention efforts pay off, since every new foreclosure can cost up to $80,000 including the impact on homeowners, lenders, neighbors and local governments. By contrast, foreclosure prevention programs cost only about $3,300 per household".

Hells bells, why not just give everyone $3,300 and be done with it? To think we could have prevented this subprime blowup for a measly $3,300 per and we did not do it. Shame on us.

The Ohio Rescue Plan

On April 5th Reuters reported Ohio mortgage bailout plan gets off to slow start.

Struggling with one of the highest foreclosure rates in America, Ohio rolled out a rescue program for struggling home owners this week. Lenders have been lined up, a Web site developed and phone lines opened.

Trouble is, no one can quite figure out how to tell desperate homeowners about it -- and lenders say the ones who have heard about it may be too far gone to help.

"Even though it has been in the newspapers, it's really one of those referral type of things that gets around by word of mouth," said Patricia Kuether, a loan officer at Sibcy Cline Mortgage Services in Cincinnati. "We haven't experienced any phone calls asking about it yet."

The state-sponsored program, run by the Ohio Housing Finance Agency, is designed to refinance borrowers facing rising payments and looming foreclosure into a 30-year fixed-rate loan with a 6.75 percent interest rate. That's a huge discount for subprime borrowers who have seen rates rise to as much as 10 percent to 12 percent in recent months.

Housing experts estimate some 1.5 million U.S. homes will be foreclosed in 2007 as interest rates rise and borrowers fall behind on their payments.

Ohio hopes the program will help about 1,000 home owners struggling to keep up with rising interest rates -- if only they can get the word out.

"When we opened our phone lines on Monday morning, we received a lot of phone calls," said Rita Parise, director of programs at OHFA.

"But unfortunately we found that a lot of those people don't have Internet access, so it's a matter of walking them through the process to find lenders and nonprofit counselors in their community who can help."

Ohio had the highest rate of foreclosure in 2006. Nearly 7,500 households -- or one out of every 640 -- registered a foreclosure filing in February, nearly 30 percent above the national average, according to foreclosure tracking service RealtyTrac.

Lenders said the most desperate of borrowers also may not qualify for the program. There are minimum credit requirements, and applicants must have enough income and only a certain amount of debt to be accepted. All will have to undergo four hours of face-to-face financial counseling.

"Unfortunately, I think some of the people who are going to be interested in it, they are so close to foreclosure it's not going to work for them," said Beverly Pineault, a loan officer at Humphries Mortgage in Cincinnati.

"We've had a couple of phone calls, maybe three phone calls about it," she said. None look like they can yet qualify for the loan. "Once someone starts spiraling down financially, they get behind on their house payments, their credit scores drop, so it may be too late."

Note that the program can't reach the people they want to help because many of them do not have internet access. Is that funny or is that sad? Whatever it is, let's do the math. Ohio hopes to help 1,000 homeowners through this program. Now assume that every state came up with a similar program and lets assume each state saves 1,000 foreclosures. That's 50,000 total out of an expected 1.5 million foreclosures.

Washington Mutual announces $2B program to help subprime borrowers

In contrast to the piddly $100 million Ohio bailout program, Washington Mutual announced a $2B program to help subprime borrowers.

In the $2 billion program, the Seattle-based bank said subprime borrowers who are current with their existing loans but face payment increases may apply for "new discounted fixed-rate loans or other mortgage products," such as a 30-year fixed-rate subprime loan with the interest rate discounted by 50 basis points.

Washington Mutual also said it will offer "prime mortgage product options for borrowers who qualify."

The reason Wa-Mu is doing this is simple: Steve Rotella, Washington Mutual's president and chief operating officer, said there was "turmoil in the subprime sector," and told shareholders that Washington Mutual's subprime segment lost $164 million in the first quarter.

In other words this is an act of desperation by Wa-Mu hoping to cut further losses.

Freddie Mac ups the ante to $20 billion

Upping the ante even further is a Freddie Mac promise to buy $20 billion in subprime mortgages.

Freddie Mac says it will buy $20 billion in mortgages in a bid to clean up the looming mess in the so-called subprime lending business. The big government-sponsored mortgage company says that starting this summer, it will buy "fixed-rate and hybrid ARM products that will provide lenders with more choices to offer subprime borrowers."

Freddie, which made the announcement on a day when it appeared before Congress to explain its role in the controversy, says its new products "will limit payment shock by offering reduced adjustable rate margins; longer fixed-rate terms; and longer reset periods."

This will be interesting. The Fed wants to rein in Fannie and Freddie but they are bound and determined to expand business. This is another disaster in the works. Fannie and Freddie bonds trade as if there is a government guarantee even though there is none.

The Washington Post is also talking about Freddie Mac and Refinancing Loans.

Freddie Mac, one of the nation's largest mortgage investors, plans to buy about $20 billion worth of mortgages that would primarily refinance the loans of people in danger of losing their homes.

The McLean company is targeting the loans of subprime borrowers, who typically have blemished credit records or other factors that make them risky to lenders. Since the housing market softened, many such borrowers have missed payments and defaulted at record rates in parts of the country.

Richard F. Syron, Freddie Mac's chief executive, announced his company's plan at a Capitol Hill briefing yesterday. The goal is to buy fixed and adjustable-rate mortgages with more affordable terms, starting midsummer, he said.

The idea is that if more troubled borrowers could refinance their homes, they would not lose them, and if investors such as Freddie Mac are willing to buy these loans, lenders would be willing to make them.

Freddie Mac is allocating money to this troubled sector "because it's needed and because, quite honestly, it's a good business opportunity," Syron said in an interview. Considering that the average mortgage is $150,000, the $20 billion Freddie Mac has allocated would cover about 130,000 mortgages, he said.

Freddie Mac has not decided exactly what terms it will set for the loans it will buy. Fannie Mae's program, HomeStay, would allow lenders to refinance without having to wait until the borrowers clear unpaid bills on their credit reports. It also would stretch the loan term to a maximum of 40 years from the current 30-year limit. Fannie Mae has not placed a dollar amount on how many such loans it would buy.

Freddie Mac plans to keep the loans affected by yesterday's announcement in its portfolio, Syron said. That way, it can launch the program quickly and alter loan terms if necessary, which is difficult to do if the loans are sold to investors.

The loans Freddie Mac buys under this program would not be limited to refinancing, though refinancing is the initial focus now that millions of people have adjustable-rate mortgages with low teaser rates that will soon spike.

The loans under the program would not be limited to refinancing. Why not? After all isn't that what the program is for?

Wendy on The Market Traders is skeptical.

Quite honestly, if it was a good business opportunity, real banks, not government-sponsored organizations, would be offering it.

Many subprime mortgages have prepayment penalties of up to 6 months. With home prices stable or dropping, how will the new Freddy mortgages cover the transaction costs of refinancing?

If Freddy "cherry picks" only those mortgages that actually make sense to refinance, it will only be a fraction of the market. Will the government mandate a non-discrimination policy, and force them to take even bad mortgages (after all, if the people could pay, they wouldn't be in default)?

Taxpayer funded bailouts always distort the market.

Wendy

I'm right with you on this Wendy. This is a slippery slope we are on and it has nothing really to do with bailing out homeowners. For Fannie and Freddie it is a way to get Congress off their backs and start expanding again regardless of risk. For Wa-Mu it is an act of desperation. And it certainly is not a "good business opportunity" for anyone except perhaps someone with a government guarantee or government funds. Regardless, every one of these plans will fail because they all have a fatal flaw.

The Fatal Flaw in Bailout Plans

The flaw is these programs are all designed to keep people in their homes regardless of the value of those homes.

Who wants to be "bailed out" if it means owing $350,000 on a mortgage when their house is only worth $175,000? The last thing a rational borrower needs or wants is that kind of bailout. Essentially what is being offered is a sucker play to stop people from handing over the keys and walking away. It won't work.

Some might argue that it was irrationality that led to absurd prices in the first place so "why expect rationality now?" The answer is expectations are lower and few expect a return to madness any time soon. In short: Housing psychology has changed. The bottom will be formed when no one expects prices to rise again. Look at Japan. This can be many years from now.

A second reason is the slowing economy itself. Eventually the slowing economy will take a toll. The problems are already spreading beyond subprime into Alt-A. Eventually it will spread into prime. Finally, capital spending is slowing dramatically and with that will come rising unemployment. More people will have a harder time making payments, and not just on subprime loans either.

The refusal to let this play out, first by Greenspan in slashing rates to 1%, now by Congress, and soon again by the Fed, all attempting to contain the uncontainable has a recent parallel. But no one sees it. Hidden in the shadows of rising commodity prices, the refusal to write off bad loans is following in the exact same footsteps as Japan.

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

Manufacturing Stalls

The Philly Fed Business outlook Survey April 2007 has been released.

The index for general activity was near zero, and indicators for new orders, shipments, and employment were only slightly positive, suggesting little change from March. Regarding future activity, the region’s manufacturing executives were somewhat more optimistic this month than they were in March.

Growth in Manufacturing Stalled

The survey’s broadest measure of manufacturing conditions, the diffusion index of current activity, was unchanged at 0.2 this month.



Demand for manufactured goods, as represented by the survey’s new orders index, reflects virtually no growth again this month. The new orders index, at 2.8, was only one point higher than in March, and the shipments index fell almost three points, to 4.3, suggesting little change from last month. Indexes for delivery times and unfilled orders remained negative, indicating shorter delivery times and a decline in unfilled orders.

Cost Pressures Remain

Area manufacturers reported higher costs for inputs again this month. The prices paid index edged three points higher and has now increased for three consecutive months. Thirty-seven percent of the firms reported higher input prices, up seven points from March; 13 percent reported lower input prices in April.

Despite increased costs, fewer firms reported higher prices for their own goods this month: 17 percent reported higher prices, down nine points from March. The prices received index fell 11 points, to 5.2, its lowest reading since August 2005.

Six-Month Forecasts Improve

The outlook for manufacturing growth over the next six months showed some improvement this month. The future general activity index increased from 17.4 to 25.8, the highest reading since April 2006.

The indexes for future new orders and shipments remained near their readings in March. Forty-one percent of the firms expect increases in new orders over the next six months; 42 percent expect increases in shipments.

The most significant factor in the report is cost pressures. Commodity prices have been rising but there has been no passthru of those costs. I keep hearing that rising input costs must be passed on. I keep seeing otherwise. This indicates falling demand or at least overcapacity relative to demand. This will also effect earnings unless productivity improvements take up the slack, which is an idea I find doubtful this late in the cycle.

The big puzzle in the report is the future optimism. The housing subprime contagion is spreading from subrime to Alt-A, and a slowdown in MEW (mortgage equity withdrawal) are all guaranteed to impact consumer spending at some point. Capital spending is dramatically slowing and the effects of that slowdown have not yet rippled through the economy. Finally, unemployment is a lagging indicator and is poised to head higher (I believe sharply higher).

Note the period lasting nearly two years starting in 2000 where the future index shot up far in advance as current activity was in contraction. It took another year after that for the future and current activity indexes to get in sync.

Judging from what we know about capital spending, spreading contagion in housing, and recent upticks in initial unemployment claims, manufacturing optimism is simply unwarranted at this time.

Notes:
This article originally appeared on Minyanville.
Joining Minyanville today is Jeffrey Cooper who wrote a classic debut on market psychology entitled Perception Trumps Reality. It's well worth a read.

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

Wa-Mu Accounting Playbook

Check out the first quarter 2007 Washington Mutual Financial Statement. Some of the accounting appears to be from the March 2000 dotcom playbook as we shall soon see.

Washington Mutual, Inc. reported first quarter 2007 net income of $784 million, or $0.86 per diluted share, compared with net income of $985 million, or $0.98 per diluted share, in the first quarter of 2006, a period that included an $85 million after tax partial settlement related to Home Savings goodwill litigation.

Financial Summary



Nonperforming Assets Soar

Nonperforming assets went from .59% in the quarter ending March 2006 to .80% in December 2006 to 1.02% in March 2007. Meanwhile the provision for loan losses decreased from $344 million in December 2006 to $234 million in March 2007.



The above chart looks smoother than it really is because 2001-2005 is in years while 2006 on is in quarters. Let's see if we can fix that.


Asset Growth Shrinks



Card Services Credit Losses Rise



Net credit losses on card services jumped from 5.84% in the 4th Quarter of 2006 to 6.31% in the 1st quarter of of 2007 while the provision for loan losses dropped by $100 million.

Negative Amortization Earnings Soar



Wa-Mu Statement Summary

• Nonperforming assets as a percentage of total assets was 1.02 percent at the end of the first quarter up from 80 basis points at year end
• Net charge-offs for the quarter of $183 million were up $47 million from the fourth quarter
• Non-card provision for loan losses was $128 million up from $69 million in the prior quarter
• The further softening of the housing market and rising NPAs in the first quarter caused Wa-Mu to conclude that guidance for credit provisioning should be increased
• Net credit losses on card services jumped to 6.31% in the 1st quarter of 2007 from 5.84% in the 4th Quarter of 2006
• Capitalized interest recognized in earnings that resulted from negative amortization within the Option ARM portfolio totaled $361 million, $333 million and $194 million for the three months ended March 31, 2007, December 31, 2006 and March 31, 2006.
  

So...... Wa-Mu "expects both NPAs and charge-offs to increase" and right in the face of rising credit card losses boosted earnings by lowering loan loss provisions by $110 million. In addition, a rise in negative amortizations added $361 million in questionable profit to their earnings. The former amounts to approximately 12 cents per share and the latter approximately 40 cents per share. In other words, 52 cents out of the reported 86 cents is quite suspect.

Managed Earnings

Q: Why might Wa-Mu have wanted to pull this stunt?
A: They needed every bit of it to beat analysts' expectations by 2 cents.

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