Payroll Playbook: Is Bernanke in Control?

The key to what happens at the October FOMC meeting is likely to depend on jobs. Before we take a look at what might transpire later this month, here is a quick recap of recent Fed actions:

In August the Fed surprised the market with a 50 basis point cut in the discount rate on options expirations Friday. The Fed then followed up with a surprise 50 basis point cut in the Fed Funds rate at the September meeting. The market was only expecting a quarter point cut. A tremendous rally in equities worldwide ensued.

Nothing Fundamentally Has Changed.

• Housing is still horrendous.
• The last jobs report was a disaster. See Moonbats Active Again in Massive Jobs Disaster.
  
• Mortgage interest rates are above where they were both a year ago.
  
• Interest rates are also higher than they were right before the September rate cut decision.
• Huge numbers of ARMs reset in 2008.

So what does the future portend?

The Federal Reserve Bank of Cleveland has a Web site that shows Fed funds rate predictions. Following is a chart of October probabilities.



The above chart shows the market is expecting ...

• a 40 percent chance of a quarter point cut
• a 40 percent chance of no move
• a 20 percent chance of a half point cut

Looking ahead to December (click on the above link to see), multiple cuts are priced in.

Is it all so simple?

Bernanke has surprised the markets twice now. Could he surprise the markets again for the third time? The answer depends on jobs.

1. If jobs are horrid, the market may force his hand.
2. If jobs are just slightly weak to neutral, Bernanke just might want to send a message.
3. If jobs are strong, there is little doubt. The Fed will go into a holding pattern and will not cut rates in October.

Now that the markets have stabilized (on the surface anyway), Bernanke is likely to find any excuse to show who is in control (using the word control loosely). Shock and Awe just might be a shock of no cut. Yes, that's likely to upset the market, but Bernanke is going to want to steer the ship somewhere between hyperinflationary bubbles and a complete economic collapse.

With sentiment against the U.S. dollar at an extreme, an expected cut that does not happen could send the dollar soaring while sinking various anti-dollar plays such as commodities and gold. The reverse happened twice when the Fed unexpectedly cut the discount rate then the Fed Funds Rate by 50 basis points.

Bernanke has already proven the U.S. dollar is not his top concern, but it still is a concern.

The only way we learn anything about Bernanke is if jobs are slightly weak to neutral (or horrid) and Bernanke does not cut or if jobs are robust and Bernanke cuts anyway. A strong jobs report where he goes on hold, or a weak jobs report where he cuts a quarter does not tell us much. Given the bounce in the stock market, I suspect no matter how bad things are Bernanke will be reluctant to cut more than 25 basis points.

October is a weak month as far as birth/death revisions go. With that in mind, and taking into account ongoing retail weakness, mass layoffs in financials, and a continuing disaster in housing, I expect a weak to poor jobs report on Friday.

However, in light of universal extreme pessimism towards the dollar, and given Bernanke's penchant for throwing surprise parties, those heavily short the dollar may wish to consider taking some chips off the table. Given the extreme sentiment, it's possible the dollar rallies for a while no matter what the jobs report says or what the Fed does later on in response.

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

Drowning in Debt: How do we protect ourselves?

In response to Is the Fed Deflating? I received several reader question similar to this one from Mike:

Thank you for your analysis. Could you please tell me, and others, what we should do to protect ourselves per your warning below?

"Those who ignore the warnings are likely to drown."

Sincerely,
Mike

Thanks for the question Mike. It's a good question and not often discussed enough. Let's add two more words to the very end of the above warning then see if we can answer your question: "Those who ignore the warnings are likely to drown in debt."

The best way to avoid drowning in debt is to not get into debt in the first place. Those who are in debt should attempt to get out of it as quick as they can. The way to do this is simple: Live within your means or better yet live below your means.

Those who carry credit card balances from month to month are not living within their means. Far too many people treated their house as an ATM, taking out cash to pay off credit cards, only to run up credit card or auto loan debt time after time. The housing ATM is now shutoff but consumers keep buying more than they can afford. The result is that credit card debt is soaring once again.

The number one rule in all of this is:

Don't Buy Stuff You Cannot Afford



Click here to see one of the funniest Saturday Night Live skits ever.

In this tenuous jobs market (see Moonbats Active Again in Massive Jobs Disaster), one needs to be prepared for the loss of a job. It can happen at anytime in any industry. The housing spillover has just started. It is highly likely the financial sector will continue to get hit. A downturn in commercial real estate and retail appears to be starting.

The Wall Street Journal reported Durable goods orders declined 4.9%. Target and Lowe's both warned. See Target Warns and Blames Florida - Lowes Blames Dry Weather.

Just as the housing problem spread from subprime to Alt-A to prime, job losses are highly likely to spread from housing, to commercial real estate, to retail. To protect oneself from a loss of income, it is imperative to have actual cash savings in a money market, short term treasuries, or short term CDs. Those barely able to make home payments now and who have no cash savings, will be in serious jeopardy if they lose a job. Don't be one of them.

Have a Years' Worth of Living Expenses in Cash

Before thinking about vacations, new cars, or even investing, I would recommend for people to have 12 months of living expenses in cash, short term CDs, or short term treasuries. Those who say "cash is trash" have never lost a job for an extended period of time.

I have and I know what it's like.

Consider a decision to have "emergency cash on hand" as sound financial planning and as an additional means test on purchases as well. Can you really afford an expensive vacation, a boat, or a new car if such purchases would deplete your savings leaving nothing for emergencies like the loss of a job?

Buy Food On Sale

Food prices seem to be soaring. Get an electrically efficient freezer and buy what's on sale. Food can easily last three to six months or longer, if properly wrapped in plastic and/or freezer paper. My parents did this. Mom would buy what was on sale, dad would wrap it in freezer wrap and label and date the package. It seems to be a lost art.

Even as non-sale prices seem to be rising, sale prices on meat (the largest part of our food budget by far), have hardly budged for six years. I routinely get center cut pork chops for $2.49 or so but the regular price is now often $4.49 or higher. Whole chickens, vacuum sealed so they don't even have to be wrapped can be purchased on sale for .49 lb. or so. I wonder how they can raise them for that price.

Last week I bought round steak for $1.49 lb. Round steak was a loss leader at .99 lb when I worked in a grocery store in 1971. That's hardly any inflation in over 30 years! Many stores will grind meat for free. Why pay $3.98 lb for ground round when you can pick up a round steak for $1.49 and have the butcher grind it for free? It's the same thing with ground chuck. Besides, you also know exactly what you are getting that way as opposed to buying a package of ground beef wondering "what the heck is in this and how fresh is it?"

Prime rib on sale is $4.99 lb not on sale is $10 lb. A 20 oz bottle of White Rain shampoo is .99. If you buy the advertised name brand shampoo it will cost over 5 times a much and it won't clean your hair any better.

If you can't afford to eat out, then don't. Even if you can afford to eat out there is nothing wrong with cutting back on the frequency and saving for a rainy day.

Consider Wants vs. Needs vs. Affordability

Do you really need an SUV? Can you afford one? What about the cost of filling it up? Auto sales persons, real estate agents, and in fact nearly every sales person's job is to convince you that what you are looking at is affordable. If one has to stretch a car payment out to 5 years to be able to "afford" it, the car is simply not affordable in my book. But even if the car is affordable what about the increase in auto insurance? The salesperson is 100% guaranteed not to mention it.

Cars, trucks, and boats are depreciating assets. If they are depreciating faster than you are able to paying off the loan, then they are not really affordable. It's best to pay cash for such items. But if you can't do that, at least make sure you are not upside down in the loan a few years down the road.

Interest only loans and teaser rates on houses do not make houses affordable either. Many are finding that out the hard way right now. Perhaps the sales agent forgot to point out escalating association dues, hurricane insurance costs, property tax, and heating bills when considering "affordability".

Reduce Leverage

Paying down mortgage debt is a reduction in leverage. It's a good idea. In contrast, some financial advisors are recommending that people take out home equity loans and buy stocks. This advice is based on the premise that the stock market always goes up over time. The current advice is to Aim High. I disagree.

Didn't we just hear the same thing about home prices?

At 20% down homes are already highly leveraged. Increasing leverage for the purpose of investing stands a good chance of losing twice. All it takes is a continued decline in home prices and another bear market in equities. Both are likely. Risk is a two way street. It is not always rewarded. Leveraging up and throwing the rest into stocks is simply poor financial advice no matter how it turns out.

Stock prices and housing prices fell for 18 years in Japan. The same can happen here. I'm not saying they will, I am saying they can. There certainly have been many 10-20 year periods where stocks went down to sideways. It's a huge mistake to judge things from the recent bull market.

Consider Retirement Plans

The closer one is to retirement the more risk avoidance is likely to come into play. The key here is to understand your timeline as well as your risk tolerance. Someone five years from retirement does not have ten years or longer to break even if the market takes another slump. Someone in the S&P and holding from 2000 is just now back to even.

Look at LBOs now being balked at by Citigroup (C), Lehman (LEH), Merrill Lynch (MER), Goldman Sachs (GS), and Bear Stearns (BSC). As long as they could securitize the debt they were fine in pumping it. Buyout Bingo has now stopped. If Citigroup does not want the debt or the deals why should anyone else?

One of the reasons that earnings have been high is underwriters were able to pass the CDO and mortgage trash to pension plans and foreign investors, collecting enormous fees along the way. Another reason was that people continued to buy stuff they could not afford, primarily on the belief that home prices would continue rising.

Investors needs to understand how the credit binge affected earnings as well as the likelihood that the credit binge grinds to a halt. Traders have no such considerations.

No one really knows for sure if stocks are going to drop or not drop, but they certainly are nowhere near as cheap as most make them out to be. Historically stock market returns with this backdrop have been weak to poor. Is this time likely to be any different?

Bear markets have a way of exposing fraud and all sorts of other problems. One look at housing should be proof enough. The stock market is not immune either. Risk has increased and one should factor that risk assessment into investment decisions.

Challenge Traditional Thinking

The past several years have been rather amazing. Nearly every asset class around the globe rose in unison. This is not normal market behavior. What was correlated on the way up can easily be correlated on the way down. In that regard, diversification does not guarantee success nor does traditional thinking.

Traditional thinking still boils down to a recommendation of buying a mix of stocks and bonds (with bonds specifically meaning corporate bonds). Unfortunately there is no magic formula that can properly allocate stocks and bonds in a portfolio by a person's age as some attempt to do. And if the economy is headed into an economic slowdown, default risk will rise and corporate bonds (especially junk bonds) are likely to be punished.

In general, corporate bond spreads are simply too low vs. treasury yields to make them a good buy at this juncture. But that has not stopped advisors from recommending them.

There are ways to hedge stocks but those ways are seldom mentioned by advisors. And there is nothing at all wrong with seeing increased risk and pulling some chips off the table. There are also currencies, commodities, and precious metals to consider.

Advice on all these issues has to be given individually and that advice also needs to consider the goals, risk tolerances, and timelines of the investor as well. That is what we do at Sitka Pacific Capital Management.

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

Time to Aim High?

John Wasik, a Bloomberg columnist is writing about the CPI Lie on Household Inflation.

The U.S. consumer price index continues to be a testament to the art of economic spin. Since wages, Social Security cost-of-living increases and some agency budgets are tied to it, the government has a vested interest in keeping it as low as possible.

Yet your real cost of living -- what you keep after taxes, medical bills, college expenses and other household costs -- is probably much higher than the 2 percent annual rate the government reported in July, showing a slight decline.

Gerald Prante, an economist with the Washington-based Tax Foundation, found that median real-estate taxes on owner- occupied housing went from $1,614 in 2005 to $1,742 last year. "That's an increase of 7.93 percent, more than double the inflation rate in that time period," Prante says.

Medical expenses are given short shrift as well. It wasn't that long ago when employers could cover almost all of an employee's health-care bills. Now workers are shelling out an average of $3,281 from their paychecks for family medical coverage, according to the Kaiser Family Foundation, a non-profit organization based in Menlo Park, California. The average premium for a family policy is more than $12,000 annually.

Since 2001, health premiums have risen 78 percent while wages have only gained 19 percent. The government's inflation measure during that stretch was 17 percent.

When making goals for your portfolio returns, it's wise to avoid using the government's inflation rate as a benchmark. Aim higher. Shoot for outpacing your household's cost-of-living increase. That's the most important number to beat.

The Fed, like Wasik, wants everyone to "aim high"

When making goals for your portfolio returns, it's wise to avoid using the government's inflation rate as a benchmark. Aim higher. Shoot for outpacing your household's cost-of-living increase. That's the most important number to beat.

Right now, the Fed is desperately trying to encourage everyone to "Aim High". It's the only way to stave off a severe consumer led recession. But eventually a severe recession will come whether anyone is ready for it or not.

The Fed always wants to put off the inevitable. In the process, bubbles get bigger and bigger as everyone aiming high is willing to take on excessive risk perhaps counting on the Fed's ability to control the economy and the stock market.

Is the Fed is in Control?

Federal Reserve Governor Frederic Mishkin thinks the Fed is in control. I don't. Nor does Professor Kevin Depew who was talking about the Fed's ability to stabilize prices in point number 3 of last Friday's Five Things.

Last night Federal Reserve Governor Frederic Mishkin gave an interesting speech at the "Domestic Prices in an Integrated world Economy Conference" in Washington on "Globalization, Macroeceonomic Performance, and Monetary Policy."

• According to Mishkin, "The Federal Reserve and other central banks retain the ability to stabilize prices and output."
• And "central banks still retain the ability to control short-term interest rates, which affect the domestic cost of credit and long-term interest rates, and so can continue to do their job of stabilizing inflation and output."
• Perhaps he wrote this speech before August.
• Either way, the quote of the day comes near the end of his speech when he makes this astonishing claim: "Has globalization been an important part of the story of inflation's remarkable decline in recent years? In terms of direct effects, the discussion here provides a clear-cut answer: No. Inflation has come down in the old-fashioned way. Tighter monetary policy and a commitment to price stability by central banks throughout the world have led to lower inflation and an anchoring of inflation expectations."
• What's hilarious - and we mean "hilarious" in the most cynical way possible - is that we read the Mishkin speech not 10 minutes before reading a Bloomberg article from John Wasik (CPI's Lie on Household Inflation Doesn't Wash) that noted the following: "The U.S. consumer price index continues to be a testament to the art of economic spin."
• Wasik notes that "millions are falling behind inflation because wage increases aren't keeping pace with the cost of medical care, lost employment benefits, homeownership expenses, energy and transportation.'
• True enough. The net effect if this cyclical upturn in inflation, however, is NOT MORE INFLATION.
• That is the disconnect.
• The seeds of long-term malinvestment and overproduction - globally - that masquerade today as " benefits of globalization" are now beginning to wilt under central bank policy that is precisely the opposite - demonstrably - that Mishkin describes as "tighter monetary policy and a commitment to price stability." The opposite.
• For inflation to create more inflation, which seems to be what everyone is looking for these days, there must be consumers with both the desire and the ability to push forward purchases to get ahead of rising costs.
• The alternative is inflationary pressures that terminate at the point where appetite for credit diminishes and transitions to risk aversion.
• In other words, these speeches by Federal Reserve speakers congratulating themselves on successfully defeating inflation are in reality unwittingly congratulating themselves on simply being around at the very beginning of the deflationary credit contraction.

If the Fed was in control the dotcom crash would not have happened , we would not be in an even bigger housing/credit bubble that is now bursting, and the dollar would not be at all time lows. Please see Can the Fed control prices? and The Activist Fed and Credit Cycles for more discussion on who is in control.

Is now the time to aim high?

Wasik's advice might be suitable (or not) for someone who is 20 or 30, but the closer a person is to retirement the worse Wasik's advice becomes. Such advice ignores the possibility of a sustained stock market down turn, a severe bear market and/or a consumer led recession with rising unemployment.

It took 7 years for someone in a diversified basket of S&P stocks to recover from the crash of 2000-2001. Treasuries did better without the risk. Nonetheless, I salute Wasik for pointing out the sham that the CPI is. However, it is because of the debasement of the dollar and distortions in the CPI that the Fed has practically forced risk down everyone's throat.

But one must be cognizant of herding behavior that has nearly everyone thinking exactly like he is and the Fed wants. Aim high. Shoot for the moon. Do or die. You are losing money by saving. Buy assets. Only fools save. In the long term, stocks always go up.

The problem is that aiming high is synonymous with increasing risk. Up to now risk taking has been rewarded.

But what happens when everyone does the same thing? More to the point, what happens when everyone does the same thing for 20 years or longer? Eventually risk gets so unappreciated that various asset classes go to the moon. Consider real estate. About a year ago, the mantra was that real estate always goes up. There will never be a national housing decline because all real estate is local.

Here is the big question: Is this more like 1994 or more like 1929? In other words is this a mid cycle correction or the cusp of collapse? Everyone ignores the latter possibility. Japan underwent deflation where land prices and the stock market fell for 18 years. There was no depression. Life still went on. The same scenario can happen here too, regardless of what anyone thinks.

There is an amazing belief in the Fed's ability right now to control the business cycle as well as control price stability. It's not warranted. Worse yet, the same failed advice recently given for real estate (you cannot buy too much home, home prices always go up, etc.) is now being touted for stocks in the form of a recommendation to “aim high”. At this stage of the cycle in a slowing economy, with rampant overcapacity, a tenuous job climate, no real reason for businesses to expand, and increasing bullishness in the face of deteriorating fundamentals, the odds are that aiming high is precisely the wrong thing to do.

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

New Twists Already in Mortgage Forgiveness Act

On Monday I talked about the Seen and Unseen in the Mortgage Forgiveness Act.

New twists have arisen already. For example, the IRS is going to penalize those who rent their homes out before they are foreclosed on.

An IRS website aimed at assisting those facing foreclosure shows the details.

The IRS urges struggling homeowners to consider their options carefully before giving up their homes through foreclosure.

Under the tax law, if the debt wiped out through foreclosure exceeds the value of the property, the difference is normally taxable income. But a special rule allows insolvent borrowers to offset that income to the extent their liabilities exceed their assets.

The IRS cautions that under the law, relief may be limited or unavailable in some situations where, for example, part or all of a home was ever used for business or rented out.

The fact that IRS has a special website aimed at helping those in foreclosure should be enough to tell anyone what the trend in foreclosures is. That said, I have to laugh at this new twist.

The IRS is essentially warning people not to attempt to get out of problems by renting their houses. Someone with debt problems that was thinking about renting out their house or even a room in their house now has a solid reason not to do so: fear of tax consequences. At the margin, this tax interpretation is going to encourage people to walk away via foreclosure vs. taking a chance on rental options.

In addition, several people have Emailed me about possible fraud implications of the new bill. One of them has to do with cash back at closing. The question to ponder is: "If cash back at closing can also be forgiven, won't this encourage fraud?"

Indeed it will, but cash back at closing, highball appraisals, and revised subprime lending are now being closely monitored. I am sure some things will slip through the cracks however, especially fraud by persons seriously in trouble but not yet perceived as being credit risks.

Oh what a tangled web we weave when tax laws are piled on tax laws on top of tax laws.

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

Don't Ask Don't Tell Price Stability

The Telegraph is reporting British banks gorge on ECB's cheap credit.

British lenders are shunning the Bank of England and turning instead to the European Central Bank on a massive scale, taking advantage of much lower interest rates and guaranteed anonymity to weather the credit crunch.

EU sources say Britain's banks have been clamouring for money in Frankfurt, accounting for a substantial chunk of the €190bn (£132bn) lent last week in the ECB's variable tender operation. "It is fair to say they have been borrowing from the ECB on a very large scale. It's cheap, so why not," said one official.

Hans Redeker, currency chief at BNP Paribas, said British reliance on ECB funds has become to big that it is leaving a clear footprint in the currency markets, forcing up sterling on the days following ECB tenders as the banks switch euros into pounds – typically Thursdays, Fridays, and Mondays.

"There's been a huge amount of borrowing. It is causing movements in the euro-sterling exchange rate that do not make any sense otherwise. It is why the pound shot up in early September when the liquidity crisis was in full swing and there was nothing to justify this," he said.

"The money markets may look as if they are functioning again in Britain, but in reality they are not," he said. Mr Redeker believes the key motive in going to Frankfurt is the certainty of secrecy, rather than the lower interest rate.

"Nobody wants to take up the Bank of England's three-month tender because of the stigma. They will be punished immediately by the markets," he said.

While the Bank of England says it will not publish names, there are concerns that the British press will unearth the story somehow. It is safer to stick to Frankfurt, where the ECB does not even reveal the nationality of banks coming to the window -- masking the picture.

Don't Ask Don't Tell Price Stability

Flashback September 20, 2007: Price Stability & Top Secret Missions

Occasionally, like now, Central Bankers need Covert Actions to "ensure price stability".

Bank of England Governor Mervyn King said today that British and European Union laws complicated plans to rescue Northern Rock Plc and prevented the Bank from acting covertly to prevent a panic. "The interaction between different pieces of unconnected legislation made it almost impossible for us to act as a lender of last resort in the way that I would prefer."

What way does Mervyn King prefer? Covertly of course. The Bank Of England does not want anyone to know what it's doing. (For that matter neither does the Fed). This is interesting because just a week ago Governor King said it was a moral Hazard to bail out Northern Rock. I guess there is no moral hazard as long as it can be done on a top secret mission and no one knows.

The ECB credit gorge is just the beginning of what can be accomplished by a broad policy of Don't Ask Don't Tell.

For example, I see that on September 28, 2007 the Bank of Canada injected $1-billion to defend rate.

The Bank of Canada injected almost $1-billion into money markets yesterday, a stark reminder that all is not right in Canada's credit market.

Just two days after Bank of Canada Governor David Dodge declared that "the overnight market is now well on its way back to normal operations in Canada," the bank found itself having to defend its key interest rate with one of its largest cash injections to date.

The central bank also increased the amount that it leaves in its settlement system to allow for easy money transfers between banks. It has set aside $300-million, instead of the $150-million target of the past few weeks, and the $25-million during normal market conditions.

"It drums home the point that it ain't over," said Douglas Porter, deputy chief economist at BMO Nesbitt Burns.

Credit crises are exactly the kind of things that people will talk about under clearly failed policies of ask and tell. In the interest of price stability, central bank actions and in fact all bank lending should be kept in the dark.

Don't Ask Don't Tell Applications

• How much mortgage collateral is the Fed holding? DADT.
• Coupon Passes? Repos? It's best if you don't know. DADT.
• What's the total amount of government debt? DADT.
• How much off the book assets are held by banks? DADT.
• Are those assets marked to market? DADT.
• Are corporations smoothing earnings? DADT.
• What's that land worth? DADT. They don't make land anymore. Land prices always recover.

For the sake of price stability we are just scratching the surface of things no one should ask about and no one should disclose if asked.

In case a few new readers missed the sarcasm, I am not serious about recommending more Don't Ask Don't Tell Applications. Interest rate micromanagement by the Fed in conjunction with other government distortions, all topped with increasing secrecy is a huge part of the problem set. Don't expect central bankers to see it that way.

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

Mortgage Forgiveness Act - The Seen and Unseen

Inquiring minds have been asking me about H.R. 3648, the Mortgage Forgiveness Debt Relief Act of 2007.

Families dealing with the pain of a foreclosure should not have the double whammy of a large tax bill for terminating their mortgage through no fault of their own," said Ways and Means Committee Chairman Charles B. Rangel. I am pleased the Committee joined together to unanimously pass this critical legislation and I look forward to bringing this measure before the full House."

Details of the Bill

Here is the H.R. 3648 Summary of Legislation.
My notes on the legislation follow:

1) The legislation would provide relief to those families by permanently excluding debt forgiven under these circumstances from tax liability. Prior to this legislation, forgiven debts were added to a person's tax liabilities as ordinary income. For example, if a person walked away from a home owing $100,000 more on a house than the foreclosure sale proceeds and that debt was forgiven by the lender, the IRS considered that $100,000 as ordinary income and expected taxes to be paid on the amount of forgiveness. This proposal is estimated to cost $1.379 billion over 10 years.

2) The bill extends the deduction for private mortgage insurance for seven years. This proposal is estimated to cost $570 million over the next 10 years.

3) Two alternatives will make it easier to qualify as a cooperative housing corporation. This proposal is estimated to cost $22 million over 10 years.

4) The bill amends the current law exclusion of up to $250,000 ($500,000 if married filing a joint return) of gain realized on the sale or exchange of a principal residence. Under current law, the sale of a home will qualify for this exclusion if the home is a taxpayer’s principal residence for at least two of the five years ending on the sale or exchange. This exclusion applies even if the home was initially purchased as a second home. Under the bill, if a taxpayer moves their principal residence to a second home, the taxpayer will only be able to utilize this exclusion to the extent that it relates to the period of time when the home was first used as a principal residence. The bill grandfathers use before 2008. This proposal is estimated to raise $2.005 billion over 10 years.

Support For The Bill

Letters of support for H.R. 3648

The National Association of Homebuilders (NAHB) chief lobbyist Joseph M. Stanton sent a letter of support on behalf of the more than 235,000 members of the NAHB to the Chairman and Ranking Member of the Committee on Ways and Means. The Mortgage Bankers Association and the National Association of Realtors (NAR) did the same. See the above link for the respective letters.

Winners and Losers - Seen And Unseen Analysis

The bill is almost revenue neutral, adding $34 million to government revenues (assuming one believes the cost estimates) . Let's take a look at the winners and losers of this bill as well as the unseen consequences of the legislation.

1A) The winner in the debt forgiveness provision (if there is a winner) is the struggling homeowner. The unseen loser is the mortgage holder, the NAR and the NAHB. Prior to this legislation a homeowner had to worry about tax liabilities of just handing over the keys and walking away. If debt was forgiven prior to bankruptcy, there was also a tax liability. Such considerations have been removed. At the margin, more people will be tempted than before to hand over the keys and walk away.

If instead, banks start forgiving bad debt in advance just to stave off foreclosures, margins will suffer and it will encourage more people to actively seek debt relief, up to and including purposely not paying bills. Certainly anyone with a grudge against either a builder or a lender may just decide to "make things fair" (in their eyes of course).

The seen supposedly keeps people in their homes. The unseen questions the merit of keeping people in their homes at any cost, as well as the likelihood that the measure actually works as intended in the first place. Besides, many of those in trouble have had their loans securitized, packaged, and further sliced and diced. It may be hard to get the right parties to the table to forgive the debt. Handing over the keys forces that issue.

If more people do walk away, inventories will rise and home prices will fall in response. Looking still further ahead, if debt is not forgiven after people walk away and lenders start hounding the prior homeowner for payment, the prior homeowner will seek relief via bankruptcy. Given that there is a means test on bankruptcies because of the Bankruptcy reform act of 2005, those seeking bankruptcy will be encouraged to find a way to meet the means test.

The debt forgiveness provision of this bill has the ability to cascade into all sorts of things mortgage holders would not want to see. Specifically, any housing relief measure that rewards bad behavior (not paying the mortgage or handing over the keys) is likely to fail miserably. For more on this topic, please see Mr. Practical's take on the Countrywide Mortgage Restructure Free-For-All.

2A) The homeowner and the various sponsors of the PMI deduction are winners of this provision at the expense of non home owners and other taxpayers of course. Such unfair tax promotion of housing is one of the problems that helped create the mess we are in.

3A) I do not know enough to comment on cooperative housing, but the perceived benefit seems to be very small, at least at the moment. Nonetheless, the provision is there for a reason. Someone thinks they will gain by it.

4A) The principle residence exclusion is the most interesting provision in the bill. Previously, homeowners could play the "moving game" and reap huge tax gains on multiple properties. The retroactive closing of this loophole discourages moving for tax purposes and it discourages buying second homes as a tax shelter in the first place. The most important point is the retroactive nature of the provision regarding the first use of the home as a primary residence.

From the point of view of the NAHB the negatives should be obvious. There will be reduced desire to build new homes attempting to take advantage of tax shelters.

From the point of view of the NAR, there will be fewer tax avoidance transactions in future years. Fewer transactions means less commissions. A small positive is that it might on balance (in future years) reduce inventory. But there also could be a mad dash by motivated sellers right now, all attempting to take advantage of the tax loophole before this bill is signed into law. If so, additional inventory could be coming on to the market right now as I type, when home inventories are already soaring.

What's Fair?

The bill is arguably far more fair than before. That's actually surprising. But what really needs to happen is that Congress should scrap virtually every existing tax law in entirety, eliminate the IRS, reign in government spending, reduce the role of government in our lives, and start all over with a simple flat tax, consumption tax, or combination thereof.

Instead of doing what right, more and more legislation is piled on top of existing legislation. And as you can see from the tangled web of unseen consequences above, Congress will no doubt be back amending and re-amending this very bill in years to come on behalf of lobbyists who did not foresee the consequences of the bill as it was written today.

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

Perpetual Motion Theory of Inflation

Let's take a look at a point counterpoint discussion of inflation. The October 8 2007 issues of Newsweek provides the point: There's No Inflation (If You Ignore Facts).

In the first eight months of 2007, the consumer price index—the main gauge of inflation—rose at a 3.7 percent annual rate. That's more than 50 percent higher than the mild 2.3 percent core rate. The prices of energy and food are soaring, at 12.7 percent and 5.6 percent annual rates, respectively, and have been doing so for years. As a result, the CPI—including food and energy—has risen 12.6 percent since July 2003, for a compound rate of about 3 percent.

Signs of inflation are evident throughout the economy. When investors fear a rising inflationary tide, they latch onto the driftwood of gold. The day Bernanke cut rates, the price of the precious metal soared to heights not seen since 1980, when inflation ran at nearly 12 percent!

China's government is trying to deal with its inflation in predictably Orwellian fashion. "Beijing has instructed local provincial and urban statistical bureaus in a subtle form of denial—they are not to use the word 'inflation' to describe what is happening," notes Keidel. It's easy to mock Beijing's clumsy bureaucrats. But by focusing on core inflation, the Federal Reserve—along with the legions of investors who reacted ecstatically to the interest-rate cut—is practicing its own subtle form of denial.

Meme of the Moment: Counterpoint

Professor Kevin Depew provides the counterpoint in Point #2 of today's Five Things - Meme of the Moment: Inflation.

Inflation - the meme of the moment. It's even made the pages of Newsweek, the magazine where investment themes go to die, which is not a critique of Newsweek because popular news magazines, by definition, purpose and mission only cover news stories at moments of maximum saturation.

• We write mostly about deflation here and sometimes about stagflation, which is the transition from cyclical inflation to deflation, but mostly about deflation.
• Most of the emails we receive read like this:
  - "C'mon man, take your head out of the sand and look around! Inflation is everywhere."
  - "Where do your kids go to college? Because tuition for my kids is going through the roof."
  - "Do you get free gas or something?"
  - "Wake up! The government is purposefully disguising inflation through their bogus numbers."
• We're sympathetic to these views because, believe it or not, because we too have found ourselves paying more for things such as education, healthcare, energy and food.
• But the hysteria over inflation is beginning to tautologize itself.
• The argument is basically becoming this: Inflation is being ignored by the Fed and is making inflation worse, which threatens to make inflation even worse as inflation gets worse.
• To be clear, the cyclical inflation we have been experiencing does not itself sow the seeds for... still more inflation.
• In a weird, geeky way, we kinda wish it did because then we would be on the verge of discovering something akin to perpetual motion.
• Instead, this cyclical inflation is simply sowing the seeds of deflation.
• How does that work?
• Well, take a look at housing - a macro event that we like to remind is a symptom, not a cause - in today's Number Three... Too Broke to Sell...
  

The Emails Kevin received are certainly tame compared to the comments on some of my blogs and the Emails I receive. But Like Kevin, I do not believe there is a magic perpetual motion machine. If financial perpetual motion worked in practice, Zimbabwe would be the richest nation on the globe.

All we can say is that for now, the Fed has managed to fan the fires of speculation once again. And speculation is all that's left. It was mammoth speculation that drove up the prices of homes to absurd heights in the summer of 2005. Time Magazine's cover at the time was "Why We Are Gaga Over Real Estate".

Speculation is now driving up the price of stocks. Some know it and are playing the Greater Fool's Game, but most believe in perpetual motion.

Today Citigroup Says Profit Dropped 60% on Credit Losses.

Citigroup Inc., the biggest U.S. bank, said third-quarter profit fell 60 percent after $5.9 billion of credit and trading losses on loans and mortgage-backed securities.

Earnings may drop to the lowest since the second quarter of 2004 because Citigroup will write down loans for leveraged buyouts by $1.4 billion before taxes, the New York-based company said in a statement today. It lost $1.3 billion on subprime assets and about $600 million in fixed-income trading, while higher loan-loss reserves contributed to $2.6 billion in credit costs in the consumer-banking business.

Citigroup shares rose as much as 1.9 percent after Chief Executive Officer Charles Prince said earnings will return to "normal" in the fourth quarter.

It's highly likely that Citigroup threw everything but the kitchen sink into third quarter writeoffs. That means earnings may indeed return to "normal" in the 4th quarter. But it's not really bank earnings that everyone should be watching. Please see Bank Balance Sheets and Earnings for what's really important. 4th quarter earnings will come soon enough.

In the meantime, the market shrugged off a horrid quarter at Citigroup as if it was a onetime affair. Oddly enough, the focus is on rate cuts as being the economic savior when rates cuts created the credit bubble in the first place. Belief in the Fed's perpetual motion machine to smooth things out is obviously running strong.

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