Banks Put Stranglehold On Credit

Bloomberg is reporting Company Default Risk Rises as Recession, Lending Concerns Mount.

The risk of companies defaulting rose after reports showing contraction in the U.S. service industry and a tightening of lending standards by banks.

Benchmark credit-default swap indexes in the U.S. and Europe reached the highest in two weeks, a sign of eroding investor confidence in corporate creditworthiness. Contracts tied to the bonds of student lender SLM Corp. rose the most in two weeks after Standard & Poor's cut its credit rating two levels. Real- estate broker Realogy Corp. moved further into distressed levels on concern it won't be able to weather the housing-market slump.

Financial companies are reluctant to lend because they may face losses exceeding $265 billion on securities linked to subprime mortgages, Standard & Poor's said last week. Banks also are saddled with about $220 billion of high-yield, high-risk loans and bonds, according to Barclays analysts. Most of the debt was committed to fund leveraged buyouts.

"If lending standards do not loosen then this is very bad news for the rest of the economy," said Jim Reid, head of fundamental credit research at Deutsche Bank AG in London.

My take: If lending standards loosen headed into a hurricane force consumer led recession, banks are fools. How much more capital impairment does Reid want? It's no wonder banks are in the trouble they are in if that is the type of thinking coming out of bank credit departments.

Banks are putting a stranglehold on credit

The Fed says Banks are getting much stricter on loans.

Banks are raising their credit standards for mortgages, consumer loans and commercial real estate loans at a pace never seen in the 17-year history of the Fed's quarterly survey of senior bank loan officers, the Fed said.

Plain-vanilla business loans were also much harder to obtain, the Fed said.
Banks expect more delinquencies and charge offs for most types of loans to consumers and businesses, the survey said. Banks said they were tightening their lending standards in response to weaker economy, reduced tolerance of risk, and decreased liquidity in secondary markets.

Banks are requiring more disclosures, more collateral and a higher interest rate before approving loans, the survey said. Demand is plunging for many types of loans, especially for residential mortgages and commercial real estate loans.

For consumers, banks are tightening up on all types of mortgages, not just subprime loans. And banks are less willing to approve consumer installment loans.

Tightening By The Numbers

• More than 80% of banks, the largest percentage ever, said they had tightened lending standards for commercial real estate loans.
• About a 33% of banks were tightening their standards for commercial and industrial loans, the highest rate in more than five years.
• Over 50% of banks tightened standards for prime mortgages, by far the highest percentage in the 17-year history of the survey.
• More than 80% of the banks tightened their standards for nontraditional loans, including jumbo loans and other loans that do not conform to standards set by Fannie Mae and Freddie Mac.
• About 70% of banks that offer subprime mortgages tightened their lending standards
  
• More than 90% of the banks responding to the survey said they do not offer subprime loans at all.
• About 60% of banks tightened their standards for home equity lines of credit

Charts From Fed Survey

Inquiring minds may wish to look at charts of actual results from the Fed survey on credit lending.

Silver State Helicopters Sinks Into Oblivion

Silver State Helicopters Files For Chapter 7

Silver State Helicopters filed for Chapter 7 bankruptcy Monday, about 24 hours after suddenly closing its doors at more than 30 locations nationwide. The move left about 750 employees out of work and roughly 2,700 flight students on the hook for thousands of dollars in student loans.

According to a former employee who requested anonymity, the shutdown was triggered after student loan lender Citibank told the company on Thursday that it would no longer make loans to its students.

Pete Lown, a Georgia lawyer representing 40 former Silver State Helicopter students from Arizona who sued the company, said it was just a matter of time until it collapsed. He called the business a Ponzi scheme that relied on an influx of new students to support the existing students.

Now the company's 200 helicopter pilots are flooding a job market that doesn't have enough spots for them, he said.

Look for more horror stories like this as the recession strengthens. Loose credit and bull market fraud go hand in hand. No one cares as long as share prices are going up. The fraud shows up when the supply of greater fools dries up. Unfortunately many innocent lives get wrecked in the process.

MBIA Back In Spotlight

Bloomberg is reporting MBIA's AAA Rating Placed Back Under Review by Fitch.

MBIA (MBI) Inc.'s AAA bond insurance ranking was placed back under review for a downgrade by Fitch Ratings less than a month after being affirmed with a stable outlook.

Fitch will likely raise the amount of capital it requires, a move that would put "further downward pressure on the ratings" of Ambac Assurance Corp. (ABK), CIFG, Financial Guaranty Insurance Co., MBIA and Security Capital Assurance Ltd., according to the statement. Ratings on $2.4 trillion of debt the industry guarantees would be thrown into doubt if the downgrades expand.

"Right now the AAA ratings for MBIA, Ambac and FGIC simply aren't justified," said Janet Tavakoli, president of Chicago- based Tavakoli Structured Finance, said in an interview with Bloomberg Television. "They simply don't have the capital."

Bank ratings may be cut on bond insurer woes

It only seems fitting that if the monolines' ratings are cut, that bank ratings would be cut right along with it. Indeed, MarketWatch is reporting Bank ratings may be cut on bond insurer woes.

"Bond insurers are suffering as a result of their roles as guarantors of mortgage-related securities, and downgrading them could affect all markets in which they are active, including the municipal bond, commercial mortgage-backed securities, and other structured finance areas," Tanya Azarchs, a credit analyst for S&P, wrote in a note to investors. "In turn, dislocation in those markets could affect banks."

"We believe that the specific, identifiable effect on banks may be significant and, in a few cases, could lead to downgrades. Large global institutions have direct exposure to the bond insurers in a number of ways," Azarchs said.

If there are big downgrades, banks that have hedged CDO positions with guarantees from bond insurers may suffer more write-downs. The ratings agency pointed to several banks that have recently increased loan loss reserves and could have existing CDO risk, including Merrill Lynch (MER), Citibank (C) and CIBC.

Fellow ratings agency Fitch Ratings said today that it may downgrade the more than $220 billion of CDOs that it currently assesses by as much as five levels. Fitch created new risk-defining protocols after determining it did not accurately assess dangers associated with these types of assets. It lowered ratings in November on more than $67 billion of mortgage-linked CDOs, effectively naming many of them junk.

The formerly hot CDO market has since slowed down to a trickle, with only one created in the U.S. in 2008.

Only one CDO created this year. The annualized pace is 10-12 for the entire year. Clearly Bernanke cannot cajole lending at 3%. Will 2% work? 0%?

Banks are not lending for one of two reasons

1. They are unable (Bank balance sheets are too impaired with non performing loans).
2. They are unwilling (Banks do not see any risks worth taking).

With the US Service Sector in Recession and banks unable or unwilling to lend, inflation fears are simply unfounded. Those who see inflation out of this mess simply do not understand what inflation is. Faith in the Fed's ability (and willingness) to generate inflation will be the last bubble to pop.

Mike "Mish" Shedlock
http://globaleconomicanalysis.blogspot.com
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Housing Bubble What's The Trouble?

New Jersey Business News is talking about Owners having trouble unloading homes.

For James Bednar, the 29-year-old founder of the blog New Jersey Real Estate Report, there's nothing like a game of "Lowball!" to get a sense of how buyers and sellers are behaving these days.

For those new to the game, it works like this: Every time a buyer makes an offer on a home that's at least 20 percent below the original listing and the seller accepts it, Bednar takes note of it. Then, every month or so, he takes the most dramatic lowball deals and posts them on his blog.

"Two years ago ... it was difficult for me to get even a handful of lowballs, maybe a dozen at most," Bednar said. "But when I do the same analysis today, I get back 10 times that number."

Despite the sharp slowdown in sales and the drop in home prices, Sean Maher, a housing analyst with Moody's Economy.com, said it would be a stretch to characterize the housing slump in New Jersey as a "crash."

No Crash Huh?!

Let's take a look at Lowball! January 2008



The above is a partial list.

The Unsold Inventory Index for New Jersey now stands at 15.6 months. With that inventory, I sure am relieved to find out New Jersey home prices haven't crashed yet. Given that 38%-65% off simply isn't crash level, I am now figuring 85% off is the minimum requirement before we can call an "official" crash unless I receive clarification from Sean Maher at Moody's.

More About Lowball Bids

Tonight I received this email from "DD" about lowball bids.

Mish,

Really enjoy your work. I live in Hinsdale, Illinois not far from you. The housing market here is basically frozen, with very few transactions taking place, so it's very hard to gauge what the market is like.

Last week my brother in law bought a house that originally was listed a 3.5 million for 2 million even. Down 40%. The listing price had dropped to 2.25 million and he low balled with a 2 million bid that had his agent all freaked out as being too low. Five minutes later, "sold to you". Now I am sure there were issues, a divorce, etc. It's just one sale but I think it could rock the high end of the market. Things are getting very interesting around here.

Regards,

DD

Five minutes later "sold" makes me think the lowball bid wasn't low enough. In this market, any bid accepted in 5 minutes is likely to be be outrageously high.

The Interest Rate Sucker Trap

The Sacramento Bee is reporting builders are attempting to unload homes with with low rates.

Sacramento home builders have tried practically everything to move product in a slow market: lower prices, auctions, luxurious upgrades and so on. Now they're offering cheap money. Working in tandem with lenders, two home builders are offering mortgage financing for new homes at below-market rates.

JMC Homes of Roseville and Lennar Corp. offered properties with 30-year fixed-rate mortgages of 4.875 percent in newspaper advertisements Friday. The offer by Miami-based Lennar offer is nationwide.

Those rates are considerably below the U.S. average of 5.68 percent, according to mortgage company Freddie Mac. The average rate hasn't fallen below 5.23 percent in Freddie Mac's 37-year history.

Buydown Bingo

That interest rates sounds cheap. It's not. The deal is an expensive sucker trap.

I asked David Donhoff at No Bull Mortgage and Michael Dorff at Trans World Financial how much that buydown is worth. I was told 2.25-2.50 points for a buydown to 5% by Dorff and 2.5-3 points for the buydown to 4.875 by Donhoff. Assuming 3 points and a $400,000 house, that buydown amounts to a maximum of $12,000.

In this market, $12,000 of incentives is clearly peanuts. My advice is to wait until Lennar gets desperate. At that point make a truly lowball bid or better yet wait some more. The longer you wait the better the deals will get. You might have to wait a long time. Click here for an estimate as to when housing may bottom.

Lawsuits Over Commissions

You know builders are desperate for cash when when Developers Sue Realty Firms over previous paid commissions.

With numerous condo buyers walking away from sales contracts, developer Related Group has begun suing real estate brokerages to get back commissions on those busted deals.

Related has filed at least 15 lawsuits in Miami-Dade Circuit Court since last month to recover more than $460,000 in commissions on at least 19 sales contracts in the 389-unit Hallandale Beach Club Tower III property at 1800 Ocean Dr.

In suing, Related risks alienating realty firms that bring prospective buyers to its developments, some brokers said.

“If somebody is suing you, do you do business with them?” asked Edward Roberts, owner of Beachfront Realty in Miami Beach, which is being sued for the return of about $53,000 in commissions. “We’re furious that they are doing this. We have made them billions of dollars in the last five or six years.”

The lawsuits mark the latest legal spats in the fallout from the overheated real estate market. Up until now, most of the litigation has been spawned by dozens of buyers trying to escape contracts with their deposits.

“Buyers put up 20 percent deposits. Where did that money go?” said Roderick Coleman, a Boca Raton lawyer representing three brokerages being sued by Related. The developer “didn’t give it back to the buyer. It shows Related must have some business difficulties if they are trying to get back commissions on deposits they have kept.”

Housing Bubble Trouble



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Mike "Mish" Shedlock
http://globaleconomicanalysis.blogspot.com
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US Service Sector in Recession - Eurozone is Fading Fast

If there was any doubt before, there should be no doubt now, the economy, led by the service sector is now in recession. The US service sector contracted in January.

The Institute for Supply Management reported that its index of service sector business activity declined to 44.6 in January from a revised reading of 54.4 in December. Economists surveyed by Thomson Financial/IFR had expected a slight slowdown but had still forecast growth, with a median estimate for the index of 53.

A reading above 50 indicates expansion, while below 50 indicates contraction. It was the first time the service sector reading has contracted since March 2003.

"This is an absolute collapse of this index," said Nigel Gault, chief U.S. economist at Global Insight.

ISM said only three service industries reported growth, while 14 showed contraction. The three growing segments — utilities, professional services and educational services — include more crucial needs such as doctor visits. Meanwhile, cutbacks in less-essential spending has dragged down such segments as arts and entertainment, fishing and hunting, and lodging and food services.

Two measures that fell were those for new orders and employment, which Nieves said were more forward-looking — so their drops could indicate trouble ahead. New orders fell to 43.5 while employment fell to 43.9.

ISM Table At A Glance



Click on chart for sharper image
Click here for the complete January 2008 Non-Manufacturing ISM Report On Business

EuroZone Fades

Reuters is reporting Services contract in US, fading fast in euro zone.

"An absolutely stunning ISM non-manufacturing number leaves the chart of the index looking like it has fallen off the edge of a cliff, and is heartwarming only for those who think the economy is already in a recession," said Alan Ruskin, strategist at RBS Greenwich.

"It seems clear that the economy has slowed in recent months: however, we will need to see much more in the way of supporting evidence before we believe that growth has slowed as much as this series suggests," said Drew Matus, economist at Lehman Brothers in New York.

My Comment: More supporting evidence is needed? The holiday shopping season was miserable. More importantly, Jobs Contracted in 2007 as Job Growth Revised Away. How much more supporting evidence does one need? Is Matus reporting from Pluto?

The data followed news earlier on Tuesday that euro zone services growth slowed to a near halt in January from an already weak early estimate, with services in three of the bloc's four biggest economies -- Germany, Italy and Spain -- contracting.

Of the big four only France showed growth.

The RBS/NTC Euro zone Services Purchasing Managers Index fell a sharp 1.4 points to 50.6 in January from an earlier flash estimate of 52.0. That index is now dangerously close to the 50 mark that divides growth from contraction.

Those data marked a new four-and-a-half year low for services in the 15-member bloc and also came in well below the 52.0 consensus -- although by nowhere near a big a gap as the U.S. numbers.

"Euro zone growth is in trouble and the risk of recession at some stage should not be underplayed. Business confidence is sliding and consumer morale is being hit hard," said David Brown, chief European economist at Bear Stearns, before the U.S. ISM report was released.

Decoupling Theory Dead

The EuroZone Decoupling Theory is now officially dead. The only question now is how big the recession in Europe will be. The US is in recession and it is going to be nasty.

Professor Depew was talking about the ISM in point number 1 of Five Things: Everybody, Back Into the Woods! Back Into the Woods!

There was very little about this morning's release of the Institute for Supply Management's Non-Manufacturing Index that wasn't a fiasco.

First, the report was released about an hour early "due to a possible breach of information." Second, the plunge in the index headline composite index number, from 53.9 to 44.6 stunned even the most grim-faced bears. Third, a recently announced change in the composition of the index mistakenly led a few "We're Out of the Woods" optimists to conclude that perhaps the numbers aren't' as bad as they seem. Well, everyone can run back into the woods, because they are as bad as they seem.

All that was revised was the weighted formula for the overall headline composite index number. The previous weighted formula was scrapped in favor of an equal-weighted formula because, according to the ISM, to more closely predict GDP. What does that gibberish mean?

There are four categories that make up the overall composite index reading. They are:

1) Business Activity Index
2) New Orders Index
3) Employment Index
4) Supplier Deliveries Index

In the old formula these were weighted unequally. Now, they are weighted equally at 25% each. So while the overall composite reading of 44.6 may not compare easily to the January weighted composite of 53.9, the measurements of the components themselves are unchanged, and the component index readings are most important.

Therefore, when one sees the Business Activity Index plunge from 54.4 to 41.9 or the New Orders Index decline from 53.9 to 43.5, the Employment Index slip from 51.8 to 43.9 and the Supplier Deliveries Index fall from 52.5 to 49, the weakness is apparent. remember, any reading below 50 signals contraction.

Bottom Line: Service industries make up more than three-quarters of the economy. This is a very weak report. Some of the internals are at 2001 levels reached during post-9/11 stress and ahead of the 2002 deflationary scare. Everyone out of the woods should now run back into the woods for cover.

Bernanke needs a Crash Course On Economics. The global economy is fading fast.

Mike "Mish" Shedlock
http://globaleconomicanalysis.blogspot.com
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Deflationistas Do It For Less

Professor Depew is talking about the Rise of the Deflationistas in point number 4 of Tuesday's Five Things.

Having recently been labeled a "Deflationista," we want to reiterate something we believe is very important to understand in this economic cycle: inflation does not cause more inflation. This is a consumer-led recession. Consequently, all that "commodities demand" that Inflationistas point to as evidence of still more inflation ahead of us will recede with stunning swiftness once the slowdown in the velocity of money in our economy becomes truly apparent.

Clorox (CLX) yesterday in the company's earnings conference call provided what might seem like ready-made fuel for the Inflationista fire on the surface - they are raising prices an average of 7% on glad trash bags and Gladware disposable containers - but the reality requires seeing through to the other side.

As CLX Chief Operating Officer Lawrence Peiros pointed out, "We are closely attuned to concerns about the U.S. economy and consumer spending. However, we do not believe that our categories will be dramatically impacted, as people tend to buy bleach and household staples even in difficult times."

True enough. In weak versions of the recession we experienced in 2001, consumer spending actually increased. That will not be the case this time around because the single largest factor influencing consumer perceptions of financial safety and wealth - their homes - are deflating.

But what about all that demand for raw materials from China and India? Surely that will pressure prices. And in fact, some central banks, such as the Reserve Bank of Australia, are raising rates. What gives?

There is no question that demand for raw materials in some emerging markets has created the feeling there is a floor under certain commodities markets, but we'll simply out that those countries are still far more dependent on U.S. consumption that the Inflationistas would have us believe.

American consumers spent more than $9.5 trillion last year. China's booming domestic economy accounted for about $1 trillion in consumer spending. India's was $650 billion. Our largest bank by market cap, Bank of America (BAC), may be a close second place to the Industrial & Commercial Bank of China, but our consumers are dominant. They still need us.

At any rate, we'll add the Deflationista label to our growing T-Shirt collection:

Deflationistas do it for less.



Click Here To Order

Don't worry. It's well contained.



Click Here To Order

Deflationista T-Shirts

Yesterday in response to Bubble Economy Endgame Kevin pinged me with this comment:

Great read Mish.
I'm proud to be a deflationista!
Maybe I should have some t-shirts printed up.
Cheers,
Kevin

And there they are. Prices are expected to drop. Delay your order now.

Deflationista Club Membership Is Free

Who can turn an offer down like that? We are proud to report expanding membership every day. We do it the hard way. One member at a time. However, you don't choose the club, the club chooses you.

Attitudes play a key role in the selection process. Surprisingly, Jim Sinclair willingly or unwillingly joined the Deflationista Club on February 4th with this statement.

"All the monetary and fiscal stimulus will not create the circumstances required to heal the underlying problem. The meltdown in credit derivatives and revelation that all derivatives are pieces of cyberspace garbage that will not perform when called upon will become worthless, not simply worth less."

That is an explicit admission that the Fed cannot inflate out of this mess, that a derivatives blowup is coming that will make trillions of dollars in derivatives worthless. A writedown of that much credit/debt would be impossible for the Fed to do anything about. We are particularly fond of the clever distinction between “worth less” and “worthless”.

That's just the kind of attitude the club is looking for. The Deflationista Club Sponsorship Committee could not possibly agree more. Welcome to the club Jim.

Mike "Mish" Shedlock
http://globaleconomicanalysis.blogspot.com
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US Homeowners Confound Predictions

The Financial Times is discussing attitudes in Last year’s model: stricken US homeowners confound predictions.

When Ray McDaniel, president of Moody’s, addressed a debate in Davos last week, the mood was so hostile that some speakers joked that he was brave to appear “without a bodyguard”.

“There has been a failure in some of the key assumptions which supported our analysis and modelling,” Mr McDaniel admits. “The information quality deteriorated in a way that was not appreciated by Moody’s or others.” Mortgage borrowers, in other words, did not behave as expected.

When American households have faced hard times in previous decades, they tended to default on unsecured loans such as credit cards and car loans first – and stopped paying their mortgage only as a last resort. However, in the last couple of years households have become delinquent on their mortgages much faster than trends in the wider economy might suggest.

More­over, consumers have stopped paying mortgages before they halt payments on their credit cards or automotive loans – turning the traditional delinquency pattern on its head. As a result, mortgage lenders have started to face losses at a much earlier stage than in the past.

In particular, it seems that mathematical models used to predict future default rates, based on past patterns of losses, have gone wrong because they did not adjust to reflect shifts in household behaviour. Or, to put it another way, financiers have been tripped up because they ignored one of the most basic rules of investment, which is usually found in product literature: the past is not always a guide to the future.

“There has been a failure in some of the key assumptions which supported our analysis and modelling,” Mr McDaniel admits. “The information quality deteriorated in a way that was not appreciated by Moody’s or others.” Mortgage borrowers, in other words, did not behave as expected.

Nevertheless, one thing is clear: the credit crunch will force many institutions to rethink their reliance on backward-looking models and perhaps put a greater emphasis on behavioural economics. “Simply extrapolating from the past into the future is not good enough,” says one US policymaker. Or as the beleaguered Mr McDaniel at Moody’s adds: “We [in the ratings industry] know we have got to retool our processes.”

Failure at Moody's, Fitch, and S&P

Why did the ratings agencies find this so unexpected? If you give a $500,000 mortgage to someone making $30,000 a year, you have to be dense to think they will pay their house before their car. The only way they could make the house house payment was by borrowing against it to pay the bills. How long could that last?

Another reason to pay the car before the house is that down payments went to zero. Again, it should not have taken a genius to figure out that defaults would soar.

The assumptions made by Moody's, Fitch, and the S&P were so ridiculous that the only way they are still in business is by government support. See Fitch Discloses Its Fatally Flawed Rating Model for more about flawed assumptions.

It's only about those who could afford to pay but chose not to, could there have been any excuse for poor assumptions. Even then, the "big three" made enormous failures to account for relaxed lending standards and home prices 3 standard deviations above rental prices and wage growth.

Attitudes Continue To Evolve

Professor Depew was talking about attitudes in Monday's Five Things. Lets tune in to point number three The Sea Change in Social Mood the Models Failed to Predict.

Over the weekend we ran across an interesting article in the Financial Times discussing how it is the ratings agencies failed to accurately predict the wave of foreclosures and loan defaults now spreading across the credit spectrum.

The problem lies, as do nearly all financial problems, with the models. It turns out the mathematical models used by the ratings agencies to predict future default rates simply failed to account for a profound shift in social attitudes.

As Bank of America (BAC) CEO Kenneth Lewis noted recently, "There's been a change in social attitudes toward default." People are walking away from their homes but keeping their credit cards and auto loans.

This is not what the models predicted. Part of the explanation for this is related to the continuing shift in social mood toward debt repudiation and the relative attractiveness of scaled down living. And some of it is simply a rational response to deflation and negative home equity. Why fight to save something that is going down in value?

This, of course, is how a deflationary credit contraction feeds itself. Financial institutions will be forced to update their models to account for shifting consumer behavior. The net result: less credit available going forward.

Secular Trends In Consumption And Risk Taking Have Peaked

• The ability and willingness of consumers to take on debt has reached a secular peak.
• The ability and willingness of businesses to take on debt has reached a secular peak.
• The ability and willingness for banks to lend has reached a secular peak.

In spite of the above, Bernanke does not give up easily. He wants to deal. His working capital is 300 basis points, down from a recent high of 525 basis points. What will 300 basis points buy?

I have it on great authority that Bernanke is willing to offer 250 of his 300 basis points for the right to select what's behind one of three doors. Bernanke Chose Door Number Two. As soon as he gets around to opening that door, a surprise awaits. That surprise is called deflation.

Mike "Mish" Shedlock
http://globaleconomicanalysis.blogspot.com
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Personal Side of Wickes Furniture Bankruptcy

The Chicago Tribune is reporting Wickes Furniture files Chapter 11 bankruptcy.

Wickes Furniture Co., hit by the downturn that has hit furniture retailers in the wake of the housing industry's big slump, filed Sunday for Chapter 11 bankruptcy protection.

Wickes, based in Wheeling, is owned by Sun Capital Partners Inc., a Boca Raton investment firm that specializes in leveraged buyouts and other transactions.

In its filing with the federal bankruptcy court in Wilmington, Del., Wickes declared that it has assets of between $10 million and $50 million, and estimated its liabilities at between $50 million and $100 million.

The trade magazine Furniture Today reported in mid-January that Wickes Furniture was asking suppliers to sign an agreement that would postpone the company's repayment of overdue debt until mid-2009.

A Personal Side of Wickes

I knew this was coming weeks ago. My wife Joanne works at Wickes as an accountant. When you are not paying bills any bills for 3 weeks straight you know it's over. Today they let the entire buying staff go and a huge percent of the corporate office. Joanne will be on for possibly 2 more weeks.

Wickes was borrowing millions at 12% from a major bank for a long time. I won't name the bank because I do not know if it is public information. The bank receiving their assets (the primary asset being the corporate office) will find it will not come close to covering the debt.

Sun Capital Partners Inc. made a mistake on this one. Their investment may be worth zero. Add this to the Overhang of LBO Debt gone sour.

The Furniture business in the US is dead. I recently talked about the furniture liquidation business in the Fallout From US Slowdown Hits Canada. Now there will be more furniture for someone to liquidate.

The ranks of the unemployed may soon go up by one. This one strikes home.

I simply cannot stress enough how important it is to be prepared for these kinds of events. Fortunately we were prepared.

Mike "Mish" Shedlock
http://globaleconomicanalysis.blogspot.com
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Bubble Economy Endgame

There was an interesting post on iTulip over the weekend about the Bubble Economy Endgame. The post was written by Eric Janszen, and called Door Number Two. Here are some highlights:

Today one of our best and brightest iTulip members posted an excerpt and a link to yesterday's comments by Stephanie Pomboy: Economic Fear Taking Hold. In it she says a US deflationary spiral is a mere 3% away. Our long standing position is that the ongoing asset price deflation, debt deflation, now with rising unemployment, falling demand and recession will lead to further erosion in the purchasing power of the dollar and thus to more inflation.

Pomboy's suggestion sounds like a variation on ideas that Mish and many of the good folks over at Minyanville believe. We call the group Deflationistas. Deflationistas have repeatedly called for a deflation spiral and all-goods prices declines for the past several years, since at least 2005.

Actually we need to stop right there for a moment because Deflationistas, at least this one, have not repeatedly called for "all-goods prices declines for the past several years, since at least 2005". While I cannot speak for others, I am not aware of any Deflationistas on Minyanville making that specific claim either.

The general Minyanville Deflationistas Viewpoint (if indeed there is such a thing) seems to be along the lines of necessities (oil and food) are likely to be somewhat price sticky, while prices of manufactured goods and assets are likely to collapse. I would be in that general group.

Furthermore, the price of oil is irrelevant as to the inflation/deflation argument, at least as far as this deflationista is concerned.

What Definitions Are We Using?

Before one can make a claim as to whether it's inflation, deflation, or hyperinflation lurking behind door number two, we have to agree as to what inflation, deflation, and hyperinflation mean. There can be no debate without agreement to definitions.

I have consistently used an Austrian definition of inflation based on money and credit.

• Inflation is a net expansion of money and credit.
• Deflation is a net contraction of money and credit.
• Hyperinflation is extreme expansion of money and credit leading to complete collapse of faith in the currency.

Prices actually do not enter into the equation. Nor should prices enter into the equation. I have stated the reasons for this many times, but Inflation: What the heck is it? sums things up nicely.

Now if someone chooses to define inflation as rising prices, then we need to start all over. Because of peak oil, I expect the price of oil to go up over the long haul, and I also think the prices of minerals and raw materials will go up over the long haul. Over the short to mid haul, I do expect oil will drop to $65 or lower and prices of things like copper are likely to collapse. This expectation is based on beliefs the recession we are now in is going to be severe.

Should oil sink to $65 it will not be proof of deflation any more than oil rising to $200 if Bush attacked Iran would be proof of inflation. Prices in isolation are meaningless.

Can Deflation Happen In A Fiat Regime?

Some claim deflation in the US cannot happen because we are no longer on the gold standard. I disagree and Japan is proof. Of course others claim Japan never went into deflation at all. Let's pick this line of thinking up with Not Your Father's Deflation: Rebuttal.

Some argue that Japan never went through deflation. One basis for that argument is that "money supply" as measured by M1 never contracted over a sustained period. The other argument is that prices as measured by the CPI never fell much. Once again we have a flawed argument about consumer prices and a flawed argument that only looks at money and not credit.

Although Japan was rapidly printing money, a destruction of credit was happening at a far greater pace. There was an overall contraction of credit in Japan for close to 5 consecutive years. Property values plunged for 18 consecutive years. The stock market plunged from 40,000 to 7,000. Cash was hoarded and the velocity of money collapsed. Those are classic symptoms of deflation that a proper definition incorporating both money supply and credit would readily catch. Those looking at consumer prices or monetary injections by the bank of Japan were far off the mark.

In the end, one factor alone is going to seal the fate. That factor is called the psychology of deflation. Simply put, the Fed cannot force consumers or businesses to borrow or banks to lend.

Paul Kasriel On The Possibility Of Deflation

Here are some excerpts from an Interview With Kasriel to consider.

U.S. banks currently hold record amounts of mortgage-related assets on their books. If the housing market were to go into a deep recession resulting in massive mortgage defaults, the U.S. banking system could sustain huge losses similar to what the Japanese banks experienced in the 1990s. If this were to occur, the Fed could cut interest rates to zero but it would have little positive effect on economic activity or inflation.

Short of the Fed depositing newly-created money directly into private sector accounts, I suspect that a deflation would occur under these circumstances. Again, crippled banking systems tend to bring on deflations. And crippled banking systems seem to result from the bursting of asset bubbles because of the sharp decline in the value of the collateral backing bank loans.

Paul L. Kasriel
Sr. V.P. and Director of Economic Research
The Northern Trust Company

The above are excerpts from an Email exchange. In a followup phone interview I asked about the endgame.

Mish: How does inflation start and end?
Kasriel: Inflation starts with expansion of money and credit.
Inflation ends when the central bank is no longer able or willing to extend credit and/or when consumers and businesses are no longer willing to borrow because further expansion and /or speculation no longer makes any economic sense.

More From Door Number

Eric Janszen continues with a discussion of a May 2005 article I wrote called Deflation is in the Cards. The correct/incorrect determinations of my scenario were made by Janszen (In Red).

• Wages continue to fall due to outsourcing, mergers, and global wage arbitrage (no, they are starting to rise due to inflation)
• Home prices level off then fall sharply (correct)
• Home equity loans stagnate as result of stagnating home prices (correct)
• Home building stalls because affordability finally starts to matter (correct)
• Trade jobs fall with falling home starts (correct)
• Expansion of Walmarts, Home Depots, etc. stops with the slowdown of new home subdivisions (correct)
• Retail expansion peaks and stalls (correct)
• Consumer sales slow with the slowing economy (correct)
• Bankruptcies increase (correct)
• Consumer lending based on rising home prices falls flat (correct)
• Credit growth declines (correct)
• The US goes into a recession (correct)
• Layoffs in the financial sector increase (correct)
• Layoffs in the real estate sector increase (correct)
• Credit is destroyed in more bankruptcies (correct)
• Deflation is finally recognized in hindsight (No. The dollar weakens further as these events occur, leading to further inflation.)
• Hyper-inflationists throw in the towel (No, this is a straw man argument. The choice is not between a US 1930s style deflation spiral and a hyperinflationary spiral that ends with a complete repudation of the currency. The rate of decline of the dollar is buffered by foreign central bank holdings.)

Actually, that looks like a pretty good success rate. I might also point out that with the sole exception of home prices, prices were not mentioned.

What About Wages and Towel Throwing?

One reason wages have recently risen because of new minimum wage increases. That is not inflation, that is misguided government policy that will put more people out of work. In addition, what real wage growth we have seen has primarily been at the top end of the salary scale.

With the increased outsourcing or manufacturing and now white collar jobs, we have been removing high paying jobs (for the masses), and replacing them with minimum wage jobs with no benefits at Wal-Mart. And speaking of benefits, companies in general have been cutting back. Benefits needs to be factored into the "wages are increasing" fallacy.

As for the "Deflation is finally recognized in hindsight", I maintain the door number two has not been opened yet. It is premature to place a (no) on that line item.

The same applies to my statement that "Hyper-inflationists throw in the towel". That statement never limited the debate between hyperinflation and deflation. I merely stated that hyperinflationists would throw in the towel. Those looking for a strawman can find it in the rebuttal to that simple sentence.

Janszen Continues...

Clearly we are seeing price deflation in asset prices–stocks, housing and soon commercial real estate–and marked-down consumer goods as the Monthly Payment Consumer buckles under the combined pressures of rising inflation and unemployment. Platinum and other industrial metals are starting to fall in price as markets anticipate falling demand. Gold is rising in anticipation of what the government must continue to do to keep real interest rates negative: inflate, inflate, inflate.

Not exactly. The consumer buckles under a massive heap of debt because rising asset prices no longer bail him out. That is deflationary. Industrial metals will drop under decreasing demand. And gold is rising for two reasons: Gold is the safest money in times of economic stress. The Fed is "trying" to inflate, and that is a good environment for gold.

Janszen Continues...

The critical flaw in the US deflation spiral analysis is that the Deflationistas forgot to ask: In what currency is a US treasury bond denominated? Of course the dollar is deflating with respect to itself! But imports determine a nation's inflation rate. As the dollar deflates that can only mean one thing: rising imports prices and all-goods price inflation.

Rising prices of imports? On what other than oil? Prices are not central to my arguments but for those who think price is everything, I would like to point out Wal-Mart Reduces Prices & Offers 0% Interest. There is virtually no pricing power now except on necessities. Once again, general Minyanville Deflationista Viewpoint seems to have gotten this correct.

Janszen Concludes ...

Behind Door Number One are guys who have been wrong for years on end and will stay that way unless the US enacts the kind of austerity measures the IMF once imposed on debtors: raise taxes, cut spending, send 20 million people into the unemployment lines.

Behind Door Number Three are guys who may eventually be right but three new conditions have to be met first: The US must become as politically and economically isolated and unimportant on a global scale as Argentina was in the 1980s, external demand for the dollar has to fall to the level of the Iraqi Dinar, and there have to be tanks rolling down the street. The probability of all three of those occurring? Zero.

Behind Door Number Two are guys who have turned a few million dollars into more than a hundred million after reaching the same conclusion in 2002 that I did in 2001, that the dollar will decline but will not crash, and the decline will exert an inflationary bias on the economy.

Behind Door number one is someone who was correct about 14 out of 17 items with 3 in dispute. In addition, at least one deflationista has been bullish on gold for the last 5 years while also being bullish on treasuries for the same period. That’s two more correct opinions.

Debate on the purchasing power of the US dollar overseas is a sideshow. The price of oil is a sideshow. Those focused on sideshows simply cannot understand treasury yields at 2% because they do not understand what inflation is.

There are many deflationistas bullish on gold. There is one prominent one who is not. It is a mistake to lump all deflationistas with one lighting rod. That person has been wrong about gold for seven years and may be wrong for another 15. But inflationistas have been wrong about treasuries for the same period.

Two Viewpoints

• Gold is money.
• Money is going to do well in deflation.

That is my simple Austrian economist based belief. Having said that, I do expect a significant correction in the price of gold as deflation forces a reduction in leverage of all kinds (including leverage in gold and leverage in the carry trade). I simply do not know if that starts now or at a much higher level.

The K-Wave

The Kondratieff Cycle is a long one. Briefly it looks like this.

• Spring - Reflation - Characterized by rising equity prices and rising interest rates
• Summer - Inflation - Characterized by rising commodity prices and falling equity prices
• Autumn - Disinflation - Characterized by rising asset prices and falling interest rates
• Winter - Deflation - Characterized by falling asset prices and falling interest rates

During Autumn, with falling interest rates, everyone loads up on debt and asset prices go to the moon. Eventually a point is reached where consumers are unable or unwilling to take on more debt, and banks are unable or unwilling to extend credit. This attitude shift is happening now.

See Changing Social Attitudes About Debt, a Crash Course For Bernanke, and The Business of Walking Away for more about attitudes. Attitudes are crucial to the deflationista debate.

Boomers counting on their home as their retirement now have to worry about saving rather than spending. Social attitudes towards consumption are changing slowly but surely. Those changing attitudes are exactly why Things That "Can't" Happen, will happen.

Because each season is long, up to 25 years, by the time Winter is about to hit, it's been 75 years since there has been deflation. That length of times causes people to think deflation will never happen again. The biggest manifestation this time was the widespread belief "Home Prices Always Go Up". That belief has now been shattered. Somehow, people still believe in the Fed.

Faith In The Fed Is The Last Bubble

The last remaining bubble is faith in the Fed's ability to inflate.

"Door Number Two" was a very well written rebuttal. Unfortunately, the rebuttal was based on a strawman that does not exist. The initial flaw was that no agreement was reached on critical definitions. A major subsequent flaw is the assumption that deflationistas in general have been wrong about gold. Finally, the "Door Number Two" post shows that even after all this time the inflationistas somehow do not understand what the deflationistas have been saying, even when it is spelled out point by point.

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