Forecasts & Trends : Subprime

It's Official - 2008 Was A Very Bad Year

Gary D. Halbert — Wed, 31 Dec 2008 15:16:33 GMT

IN THIS ISSUE:

"The 2008 market will go down in history"
"2008: We Learned What We Don't Know"
Happy New Year!!

Introduction

Happy Holidays! I hope that everyone who celebrated Christmas had a very merry one. We certainly did at the Halbert house. I am taking this week off to spend time with my son who is home from college. I will be back to my usual writing schedule next week.

As we close out 2008 tomorrow, I thought it might be good to look back at some of the unusual and unprecedented events that occurred this year. Accordingly, I have reprinted a very good article from MarketWatch that chronicles what happened in the investment markets and the economy this year.

Whenever unprecedented events occur, and we have seen many this year, there is always the question of whether we have learned from those experiences. On that note, I have also reprinted a very good article from economics and business writer Robert J. Samuelson on that very subject. I think you will find it very interesting.

QUOTE:
The 2008 market will go down in history
By Nick Godt

NEW YORK (MarketWatch) -- Investors lost trillions of dollars and U.S. stocks prices plunged to 11-year lows. Overseas markets suffered even worse declines.

Yet, to say that the 2008 market will go down in the history books might almost sound like whistling past the graveyard. As the U.S. and the global economies continue to worsen, investors are still licking their wounds and worrying about 2009.

Looking back to expectations at the start of the year, "the surprise was not that we had a bear market and a recession," said Hugh Johnson, chairman of Johnson Illington Advisors.

"The surprise was that events were as severe as they turned out," said the veteran adviser, who has over 40 years experience in the investment world. "I have been at this for a while and I've never experienced anything like this. It defies words to describe it."

What can be said is that many things that sounded impossible at the start of the year now have to be accepted as facts.

After its astonishing surge to nearly $150 a barrel this summer, oil now trades near $40. The market capitalization of General Motors is now lower than it was in 1927. Bear Stearns and Lehman Brothers are no more. In October, a 900-point swing in the Dow industrials became almost commonplace.

"I'd like to use the old roller-coaster ride comparison," said Paul Nolte, director of investments at Hinsdale Associates. "But it's been more like a one-way trip down the haunted house."

Trillions lost

In a way, it didn't matter that many market strategists and commentators often struggled for the right metaphor to describe the market. The numbers flashing on TV and computer screens across the globe often spoke, and continue to speak, for themselves.

As of Dec. 12, the Standard & Poor's 500 index had lost $6.17 trillion since hitting record highs in Oct. 2007.

That reduction in global stock wealth has outstripped the losses in the last bear market - the S&P 500 lost $5.76 trillion during the entire bear market of 2000-2002. Making matters worse, this one still has room to run.

By Thanksgiving, many individual investors discovered they would have been better off sticking their savings under their mattress rather than the stock market for the past decade.

On Nov. 20, the S&P crashed through the previous bear-market low of 776, made in October of 2002, to end its lowest close since April 1997.

The U.S. showed it hadn't lost its superpower qualities, as a home-grown housing bust and mortgage crisis spiraled into a global market collapse.

The S&P Broad-Market index, which blends more than 11,000 stocks from developed and emerging markets, has lost $17.7 trillion year to date. Most of the losses, or $16.1 trillion, were logged between May and December.

"Until May, global markets were still expected to grow faster than the U.S., as China was seen growing more than 10%," said Howard Silverblatt, index analyst at S&P.

That optimism evaporated as the credit crisis spread around the globe and the U.S. recession clipped the outlook for global growth.

In November, the World Bank said China's economy is likely to expand at a 7.5% rate in 2009, its slowest pace since 1990.

Once leaders in emerging markets, stocks in Russia have now plunged 72%, those in Turkey are off 68%, and those in India have fallen 67%.

In October, Japan's Nikkei 225 hit a 26-year closing low; Iceland's exchange tumbled 81%, while Brazil's Bovespa index slumped 25%, its biggest one-month percentage loss in 10 years.

Dow swings

At times earlier in the year, it looked like investors were going to get a break. After the near-collapse and subsequent bailout of 58-year old investment firm Bear Stearns in March, markets found some degree of stability and even gained back some ground until May.

But as more Wall Street institutions crumbled, all beset by investments linked to bad home loans, fresh selling bruised stocks. After Lehman Brothers went bankrupt late in September, one of a string of large financial failures and government bail-outs that month, stock markets set multidecade records for lows reached and big swings registered.

In October, the S&P 500 had its most volatile month since 1929, right after the stock market crash that preceded the onset of the Great Depression.

The Dow plunged to its worst point drop on record, down 777 points, on Sept.29. By Oct. 15, the index had registered 508- to 733-point drops in three separate session.

The index also proceeded to surge to its biggest point gain on record, up 936 points, on Oct. 13. According to S&P, over the past 60 trading sessions alone, there were 17 days where stocks moved up or down by at least 5%. To put this in perspective, there had only been 17 days of 5% or more swings over an entire 53-year period, between 1955 and 2008.

Between Oct. 27 and Nov. 4, the day of U.S. Presidential election, stocks on the S&P surged more than 18%. But between Nov.4 and Nov. 20, they proceeded to slide 25%, before gaining more than 16% through Dec. 11.

"Playing those swings correctly, an investor could have made a 72% return," said S&P's Silverblatt.

Safe havens or 'money for nothing'

But most investors are unlikely to have tried playing the swings. Safety and preservation of capital became the name of the game for many.

The need to protect one's savings became so pressing that on Dec. 9, the government sold 4-week Treasury bills at a yield of 0%, meaning that bond investors were happy to just have the principal they'd lent back to them without a loss.

The yields on other government bonds, considered the safest among all investment classes, also reached lows unseen since the government began keeping records in the 1950s.

While investors opened their wallets to the U.S. government, they lent very little to anyone else. Commercial paper markets froze after the Lehman collapse, threatening to put out of business anything from big banks to small firms dependent on short-term loans. Borrowing costs for companies surged.

Even banks became increasingly unwilling to lend to each other, as more took huge write-downs from bad assets. The London interbank offered rate, or Libor, soared to record highs near 7% after Congress first rejected a $700 billion bailout for financial firms.

Oil's wild ride

Until July, the one sure bet for the nervous investor had been commodities. Hopes for global growth, along with a combination of natural disasters, geopolitical tensions, a sliding dollar and market speculation, had led energy and food prices to rocket, causing severe food shortages in poorer countries.

It was a shock when oil surpassed $100 a barrel in January. But those prices looked cheap as the futures contracts skyrocketed to $147 a barrel by July.

That level turned out to be commodity's swan song. It has plunged to trade around $40 a barrel in December, a swift descent echoed by other commodities.

"The rise in oil to $147 per barrel and its subsequent decline to $40 was vicious volatility," said Hugh Johnson. "It defies words to describe it. It certainly made life tough for the year."

Goldman Sachs analysts, who were laughed at back in 2005 when they first suggested oil might reach $100 in a "super spike," now predict oil could fall back to $30 a barrel in the coming months.

Gold also hit a record high above $1,000 an ounce in March, before slumping back below $700. The precious metal, however, has managed to crawl back to trade above $800 an ounce as investors seek safe-haven assets.

Besides oil, food stuffs such as corn also first reached record highs above $6.5 a bushel in June, before sliding back under $4 a bushel amid fears of a global recession.

A surge in the dollar helped precipitate the collapse of commodities. The dollar halted its four-year slide around May and proceeded to rally against most of its counterparts as financial and economic concerns spread globally, turning the U.S. currency into a safe-haven play, along with the Japanese yen.

The U.S. currency jumped 13% against a basket of six major counterparts over the course of the year so far.

Dramatic and record-setting swings in nearly every sector of security have sent professional investors thumbing through the record books.

"Nothing compares with the crisis that we have faced," said Johnson of Johnson Illington Advisors. The U.S. stock rout already registers as the fourth-worst bear market since 1898, he said. "It's clearly historic."

Here's another anecdote of how market perceptions and reactions may have changed: With the Dow swinging within an 800 point range on Oct.24, there was little immediate market reaction when Alan Greenspan, the once-venerated former chairman of the Federal Reserve, admitted to making a mistake when he testified to Congress.

While every one of his utterances used to be parsed by analysts, few now reacted when Greenspan said his view of the world might not be right after all.

"Absolutely, precisely," Greenspan said. "You know, that's precisely the reason I was shocked, because I have been going for 40 years or more with very considerable evidence that it was working exceptionally well."
END QUOTE

The following article was published yesterday in the Washington Post, RealClearPolitics.com and elsewhere. Robert Samuelson eloquently points out how many longstanding assumptions were dashed in 2008, as his title suggests below.

QUOTE:
2008: We Learned What We Don't Know
By Robert J. Samuelson

It's the end of an era. We know that 2008, much like 1932 or 1980, marks a dividing line for the American economy and society. But what lies on the other side is hazy at best. The great lesson of the past year is how little we understand and can control the economy. This ignorance has bred today's insecurity, which in turn is now a governing reality of the crisis.

Go back to the onset of the crisis in mid-2007. Who then thought that the federal government would rescue Citigroup or the insurance giant AIG; or that the Federal Reserve, striving to prevent a financial collapse, would pump out more than $1 trillion in new credit; or that Congress would allocate $700 billion to the Treasury for the same purpose; or that General Motors would flirt with bankruptcy?

In 2008, much conventional wisdom crashed.

It was once believed that the crisis of "subprime" mortgages -- loans to weaker borrowers -- would be limited, because these loans represent only 12 percent of all home mortgages. Even better, they were widely held, diluting losses to individual banks and investors.

Wrong. Subprime mortgage losses (20 percent are delinquent) triggered a full-blown financial crisis. Confidence evaporated, because subprime loans were embedded in complex securities whose values and ownership were hard to determine. Similar doubts afflicted other bonds. Demand for all these securities shriveled. Lenders hoarded cash and favored safe U.S. Treasuries. Because investment banks and others relied on short-term debt (a.k.a. "leverage"), a loss of confidence and credit threatened failure. Lehman Brothers failed. The financial system had overborrowed and underestimated risk.

It was once believed that American consumers could borrow and spend more, because higher home values and stock prices substituted for annual savings. Consider: From 1985 to 2005, the personal savings rate dropped from 9 percent of disposable income to almost zero. But over the same years, households' net worth (assets minus liabilities) quadrupled, from $14 trillion to $57 trillion.

Wrong. In recent years, consumers increasingly overborrowed, especially against inflated home values. With the housing "bubble" now collapsed, net worth is falling. Homeowners' equity in their homes -- the share not borrowed -- is at a record low of 45 percent, down from 59 percent in 2005. Consumers have responded by retrenching big-time. Retail sales have dropped for five straight months; vehicle sales are a third below 2006 levels.

It was once believed that the rest of the world would "decouple" from the United States. As Europe, Asia and Latin America expanded, their buying would cushion our recession. A better-balanced world would emerge, with smaller U.S. trade deficits and lower surpluses elsewhere.

Wrong.The crisis has gone global; economic growth in 2009 will be the lowest since at least 1980. Even China has slowed; steel output was down 12 percent in November from a year earlier. The crisis has spread through two channels: reduced money flows and reduced trade. Global financial markets are interconnected. Customer redemptions forced U.S. mutual funds and hedge funds to sell in emerging markets (such as Brazil or Korea), whose stocks have dropped about 60 percent from their peak. Credit has tightened, as money flowing into developing countries is expected to shrink 50 percent in 2009 from 2007 levels, estimates the World Bank. The bank expects trade, up 7.5 percent in 2007, to fall in 2009 for the first time since 1982.

So much that has happened was unexpected that the boom and bust's origins are obscured. These lie in the side effects of declining inflation that started in the 1980s and, in the process of reducing interest rates, boosted stock prices and housing values. Recall that in 1981, when inflation was 9 percent, 30-year mortgages averaged 15 percent. As rates fell (mortgages were 10 percent by 1990, 7 percent by 2001), home prices rose. People could afford more. With lower interest rates, stocks became more valuable.

All the bad habits of recent years -- excessive borrowing by consumers and money managers, careless and reckless lending -- grew in a climate when gains seemed ordained. Even after the "tech bubble" burst in 2000, stock prices at year-end 2002 were seven times their year-end 1981 level. Home prices increased steadily; in the 1990s, they rose 45 percent.

Prosperity, apparently forgiving of mistakes, bred the complacency that undid prosperity. On bad mortgages, losses could be recovered by selling the homes at higher values. Thus rationalized, bad loans were made. Some stocks might decline, but over time, most would rise. Risk seemed to recede, so investors and money managers undertook riskier strategies.

What will emerge from these shattered illusions? Will the crash stir social unrest, abroad if not here? Will Americans become so thrifty that they hamper recovery? Will economic nationalism surge? How will capitalism be reshaped? Much depends on whether the frantic policies to combat the recession succeed. Probably they will, but there are no guarantees. Our ignorance is humbling.
END QUOTE

Happy New Year!!

2008 brought us some tough times, both in the markets and the economy. The credit crisis is still very serious, and the housing slump gets worse by the month. It is clear we are in a recession and we still don't have a good idea how long it will last or if it will get even worse. So, the outlook for 2009 is very uncertain.

Most of the trusted sources I read forecast that the recession will continue through at least the first half of 2009 and maybe longer. None of my best sources has a resolute opinion on whether we've seen the worst of the credit crisis or not. Ditto for the stock market outlook. So it remains to be seen what lies ahead. I don't remember a time of such economic and financial uncertainty in my lifetime.

Fortunately, America has survived serious recessions and financial crises in the past, and I have no doubt that we'll weather this one as well. How long it will take, unfortunately, is anyone's guess at this point. Of course, it never hurts to pray for our leaders, including our new president.

Wishing you a Happy & Profitable New Year,

Gary D. Halbert

SPECIAL ARTICLES

Chronology of Major World Events in 2008 – Part One
http://www.monstersandcritics.com/news/usa/features/article_1448683.php/CHRONOLOGY_Major_world_events_in_2008_Part_I

Chronology of Major World Events in 2008 – Part Two
http://www.monstersandcritics.com/news/usa/features/article_1448684.php/CHRONOLOGY_Major_world_events_in_2008_Part_II

The Recession & More Government Bailouts

Gary D. Halbert — Tue, 09 Dec 2008 21:21:18 GMT

IN THIS ISSUE:

Latest Grim Numbers On The US Economy
The Latest On The Government Bailouts
Fed Announces The Mother Of All Bailouts
Troubling Aspects Of The Fed's Latest Bailout
Fighting A "Debt-Deflation" At Any Cost

Introduction

The economy, the financial crisis and government bailouts were certainly hot topics for discussion among the large group of family and friends that we entertained over the Thanksgiving holiday and the weekend following. These sorts of issues would not normally come up at this annual gathering, but it is just more evidence that the current sinking state of the economy and the credit crisis is on the minds of virtually all adult Americans, no matter their financial strata.

Most of my Thanksgiving guests have been dizzied by all the different government bailouts that have been announced recently (haven't we all!), and most were very much against them, as is a majority of Americans according to several surveys. What most people don't understand is that the government and the Fed will do anything they possibly can to prevent the economy from falling into a full-fledged debt deflation.

Debt deflation is a cycle in which prices fall broadly, in some cases across the spectrum of assets. Most historians attribute the Great Depression to a debt deflation between 1930 and 1934. Likewise, Japan's decade of deflation and severe recession in the 1990s is the model everyone wants to avoid. For obvious reasons our monetary authorities do not want to see either happen again. I will be writing about deflation more in upcoming issues.

This week we will discuss the recent government and Fed bailouts as we go along, including some recent analysis by Stratfor.com and a nice chronicle of how the financial crisis has unfolded thus far. But first we want to take a look at the latest economic data, most all of which are bleak. While 3Q GDP was down only 0.5% according to the latest report, most analysts expect that the economy will plunge by at least 2-3% in the 4Q.

That's a lot to cover, so let's get started.

Latest Grim Numbers On The US Economy

I trust that everyone reading this is well aware that we are in a serious recession brought on almost entirely by the housing slump and the credit crisis which followed. The government and the Fed have proposed massive bailouts in an effort to get the credit markets moving, banks lending, and consumers spending once again. But is it working? The answer is, not yet.

Here are the latest economic reports. Last Tuesday, the Commerce Department revised its estimate of 3Q Gross Domestic Product from -0.3% to -0.5%, annual rate. In the 2Q, real GDP increased 2.8%. The decrease in real GDP in the 3Q primarily reflected negative contributions from personal consumption expenditures, residential fixed investment (housing), and equipment and software that were partly offset by positive contributions from federal, state and local government spending, private inventory investment and exports.

Most economists and analysts are expecting a much greater decrease in GDP for the 4Q. While we won't get the first estimate of 4Q GDP from the Commerce Department until late January, a recent survey conducted by the Philadelphia Fed suggests that real GDP will decline at a 2.9% annual rate in the 4Q. Likewise, the consensus now is that at least the first two quarters of 2009 will see similar decreases in GDP if not worse. There are plenty of analysts that now expect all of 2009 to hold negative growth for the economy. At this point, I cannot disagree. Things are indeed quite bleak.

The Index of Leading Economic Indicators (LEI) fell sharply in October, down -0.8%, marking the fourth decline in the last five months. The LEI declined sharply in October as stock prices, building permits, consumer expectations and the index of supplier deliveries made large negative contributions to the index. Without the very large positive contributions from inflation-adjusted money supply (the largest in seven years), the leading index would have been substantially weaker. Between April and October 2008, the LEI declined 2.4% (a -4.7% annual rate), falling considerably faster than the 1.2% decrease (a -2.3% annual rate) over the previous six months.

Durable goods orders (large ticket items) plunged 6.2% in October, more than double the 3% decline economists expected. The report showed widespread declines throughout manufacturing led by decreases in autos and airplanes. Factory orders plunged 5.1% in October. The manufacturing sector is being hit by the slowdown that is occurring in the rest of the economy. The prospect that the US, the world's largest economy, has entered what could be a severe recession is dragging down growth in other areas and dampening demand for US exports, which had been the one bright spot for the economy this year.

The unemployment rate surged to 6.7% in November as more than 500,000 jobs were lost in that one month alone. Most forecasters now expect the US unemployment rate to soar to 7% or above by the middle of next year. It will not surprise me if unemployment reaches 7% in the 1Q of next year.

As we all know, consumer spending accounts for apprx. 70% of GDP. In October, retail sales dropped 2.8% following a decline of 1.3% in September. It is unusual to see large drops in consumer spending in October with the holiday season approaching, but this is no usual year. Most retailers expect 4Q sales to fall below yearago levels this year.

It is encouraging to note, however, the latest media reports which indicate that on Black Friday (the day after Thanksgiving) retail sales were up 3% over last year. That increase was largely attributed to the fact that retailers had already discounted merchandise to levels not normally seen until later in the season.

The Conference Board's Consumer Confidence Index, which fell to an all-time low of 39.5 in October, rebounded modestly in November to 44.9 largely due to the sharp drop in oil and gasoline prices. However, the University of Michigan's Consumer Sentiment Index, which asks different questions, was basically unchanged in November at 57.9 versus 57.6 in September. Both measures of consumer confidence remain at very discouraging levels.

On the housing front, the numbers continue to worsen with no end in sight. New home sales in October fell to their lowest level in 17 years, according to data released last Wednesday. The US Census Bureau said the sale of new houses tumbled 5.3% in October to an annualized rate of 433,000. That compared to 457,000 one month earlier and was the weakest showing since 1991.

The number of existing homes in the US that were sold in October fell 3.1% compared to September and was 1.6% below the annualized rate in October 2007. Housing starts also fell sharply once again in October to a 17-year low. Building permits also continued to decline significantly in October.

Even though home sales are now down 69% from the July 2005 bubble peak of 1.39 million units, builders have not been aggressive enough in curbing production because the most critical variable of all, the unsold inventory backlog, rose to an 11.1 month supply in October from 10.9 in September. Thus, we may not have seen the worst of the housing slump yet.

The National Bureau of Economic Research (NBER) recently announced that the US economy is officially in a recession that began in December of 2007. This marks one of only a very few times that NBER has made such a determination without two consecutive quarters of decline in real GDP, which is the traditional definition of a recession.

To round out the latest economic reports, the Consumer Price Index fell 1.0% in October, the largest monthly decline in the index since its creation in 1947. The Producer Price Index (wholesale prices) plunged 2.8% in October. These drops in prices reflect the fact that we are in a severe recession, consumer demand is plunging, and producers are dropping prices in reaction.

The data above paint a troubling picture for the US economy and thus those around the world. The trouble is that the US economy is the world's engine of growth, and US consumers are the fuel of that engine of growth. Now, US consumers are being forced to cut back and save more.

The Latest On The Government Bailouts

As noted above, the government's efforts to head-off the US financial crisis have already gone beyond what many of us could have imagined just a year ago. This financial crisis has resulted in so many different rescue operations, involving trillions of dollars. The initial $700 billion rescue package that was finally approved by Congress in October boggled our collective minds. This financial crisis has evolved so fast that it is hard for most Americans to keep track of what has happened, much less understand it. Here is a good, concise chronology published by the Houston Chronicle (Chron.com) on November 25th:

QUOTE: Gov't Announces Another $800B in Bailout Plans

The government's commitments to contain the financial crisis now approach $7 trillion. That figure includes funds to guarantee certain corporate assets and debts, although those funds may never actually be spent. Still, the overall figure reflects the huge liabilities the government is taking on to battle the meltdown.

Among the government efforts announced Tuesday are plans to buy up to $600 billion in mortgage-related assets and up to $200 billion in loans for holders of securities backed by various types of consumer debt.

The new plans are the latest in a long list of government moves:

-- March 11: The Federal Reserve announces a rescue package to provide up to $200 billion in loans to banks and investment houses and let them put up risky mortgage-backed securities as collateral.
-- March 16: The Fed provides a $29 billion loan to JPMorgan Chase & Co. as part of its purchase of investment bank Bear Stearns.
-- May 2: The Fed increases the size of its loans to banks and lets them put up less-secure collateral.
-- July 11: Federal regulators seize Pasadena, Calif.-based IndyMac, costing the Federal Deposit Insurance Corp. billions to compensate deposit-holders.
-- July 30: President Bush signs a housing bill including $300 billion in new loan authority for the government to back cheaper mortgages for troubled homeowners.
-- Sept. 7: The Treasury takes over mortgage giants Fannie Mae and Freddie Mac, putting them into a conservatorship and pledging up to $200 billion to back their assets.
-- Sept. 16: The Fed injects $85 billion into the failing American International Group, one of the world's largest insurance companies.
-- Sept. 16: The Fed pumps $70 billion more into the nation's financial system to help ease credit stresses.
-- Sept. 19: The Treasury temporarily guarantees money market funds against losses up to $50 billion.
-- Sept. 29: The Fed makes an extra $330 billion available to other central banks, boosting to $620 billion the amount available to the Fed through currency "swap" arrangements, where dollars are traded for foreign currencies. It also triples to $225 billion the amount available for short-term loans to U.S. financial institutions.
-- Oct. 3: President Bush signs the $700 billion economic bailout package. Treasury Secretary Henry Paulson says the money will be used to buy distressed mortgage-related securities from banks.
-- Oct. 6: The Fed increases a short-term loan program, saying it is boosting short-term lending to banks to $150 billion. It says that by year's end, $900 billion in potential overall credit will be outstanding. It also says it will begin paying interest on reserves that banks keep with the Fed in hopes of coaxing banks into keeping more money on deposit at the central bank.
-- Oct. 7: The Fed says it will start buying unsecured short-term debt, so-called "commercial paper," from companies, and says that up to $1.3 trillion of the debt may qualify for the program.
-- Oct.. 8: The Fed cuts its benchmark interest rate a half percentage point, to 1.5 percent. It follows a one-quarter point cut on April 30 and a three-quarter-point reduction on March 18.
-- Oct. 8: The Fed agrees to lend AIG $37.8 billion more, bringing total to about $123 billion.
-- Oct. 14: The Treasury says it will use $250 billion of the $700 billion bailout to inject capital into the banks, with $125 billion provided to nine of the largest: Bank of America Corp., which received $15 billion; Bank of New York Mellon Corp., $3 billion; Citigroup Inc., $25 billion; Goldman Sachs Group Inc., $10 billion; JPMorgan Chase & Co., $25 billion; Merrill Lynch & Co. Inc., $10 billion; Morgan Stanley, $10 billion; State Street Corp., $2 billion; and Wells Fargo & Co., $25 billion. The $10 billion for Merrill has been deferred until its purchase by Bank of America closes.
-- Oct. 14: The FDIC says it will temporarily guarantee up to a total of $1.4 trillion in loans between banks.
-- Oct. 21: The Fed says it will provide up to $540 billion in financing to provide liquidity for money market mutual funds.
-- Oct. 29: The Fed cuts its benchmark interest rate to 1 percent, matching the low point reached in 2003. The rate hasn't been lower since 1958.
-- Nov. 10: The Treasury and Fed replace the two previous loans provided to AIG with a new $150 billion aid package that includes an infusion of $40 billion from the government's bailout fund.
-- Nov. 12: Paulson says the government will no longer buy distressed mortgage-related assets, formerly the centerpiece of the bailout, and instead will concentrate on injecting capital into banks.
-- Nov. 17: Treasury says it has provided $33.6 billion in capital to another 21 banks, with the largest stake being $6.6 billion to Minneapolis, Minn.-based U.S. Bancorp. So far, the government has invested $158.6 billion in 30 banks.
-- Nov. 23: The Treasury says it will invest another $20 billion in Citigroup Inc., on top of $25 billion provided Oct. 14. The Treasury, Fed and FDIC also pledge to backstop large losses Citigroup might absorb on $306 billion in real estate-related assets.

Citigroup will assume the first $29 billion in losses, and after that the government will absorb 90 percent of losses and the company 10 percent. In return, the government will receive $7 billion in preferred shares and warrants for more than 250 million additional shares.

-- Nov. 25: The Fed says it will purchase up to $600 billion more in mortgage-related assets and will lend up to $200 billion to the holders of securities backed by various types of consumer loans.

The Fed will buy up to $100 billion in direct obligations from mortgage giants Fannie Mae and Freddie Mac as well as the Federal Home Loan Banks. The central bank also will buy $500 billion in mortgage-backed securities, pools of mortgages that are bundled together and sold to investors.

The program on consumer debt will be supported by $20 billion of credit protection from the $700 billion bailout package enacted last month. END QUOTE

Fed Announces The Mother Of All Bailouts

As noted above, on November 25th, the Federal Reserve announced yet another huge bailout - up to $800 billion - aimed at freeing up seized credit markets. You would expect that this new, unprecedented bailout would be still making news and have been completely and utterly analyzed. I don't find that to be the case.

Actually, it's somewhat troubling that the Fed, acting under its own initiative and without any congressional approval, can uncork a bailout $100 billion bigger than the $700 billion TARP rescue package Treasury Secretary Paulson had to peddle on Capitol Hill. Even more surprising is that this newest bill aims to do the very things that Secretary Paulson initially planned for the $700 billion - buy up troubled mortgage securities - before he changed his mind on how best to use the TARP money.

I'll provide some analysis below, but first let's see exactly what the new Fed bailout has been designed to do. Much of the buzz on the street about this new Fed program has been that this is "Main Street's Bailout," meaning that the relief from this $800 billion of pocket change is designed to get to the ultimate consumer rather than going into bank stocks. Is Bernanke playing a little political football here? Maybe.

Stratfor.com had one of the better descriptions of the Fed's new plan to restore liquidity to the housing and consumer credit markets. I have reprinted an excerpt of Stratfor's November 25 article below, and will follow up with my own analysis:

QUOTE: In the past 24 hours, there have been two more major developments, enacted not by the Treasury but by the U.S. Federal Reserve, which, unlike the Treasury, enjoys both policy independence and control of the money supply.

First, the Federal Reserve is using its resources to take over the original idea contained in the TARP I program, launching a $600 billion package to purchase mortgages and mortgage-backed securities that started the problems in the first place. All of this funding will be applied to Freddie Mac, Fannie Mae and their immediate satellites. Because the Fed will be negotiating the terms of the debt purchase with the Treasury (the twins are currently under government conservatorship), price points will be determined very quickly.

And because the Fed enjoys policy independence and control of the money supply, it will not have to go back to Congress for approval or funding. If it deems necessary, it can simply print currency to "pay" for the effort. In essence, the sticky parts of the bailout program have now been handed to the institution with the most capability for unfettered action: the Federal Reserve.

Second, the Fed is using a new $200 billion credit facility to purchase AAA-rated debt -- credit card debt, car loans, student loans and the like -- that is currently foundering because of the dual impacts of the recession and bank skittishness. This program is less of a bailout and more of a reward for good behavior. The Fed will purchase only debt that is new; banks can swap their new loans for cash and then immediately turn around and lend again. Simply put, the Fed is offering the buy-up program as a sort of bait to draw skittish banks out of their holes. (The Treasury tossed in $20 billion for this as a sort of insurance policy.) [Emphasis added, GDH.]

What the government essentially has done in this admittedly confusing shell game is split the rescue program into two categories: a "good debt" management scheme and a "bad debt" management scheme.

With the exception of the $200 billion AAA facility, the Fed is in charge of the bad debt -- primarily the questionable mortgage-backed securities that touched off the problems to begin with. Because the Fed operates largely free of congressional and even presidential oversight, and because it controls the printing presses, it has the authority and ability to turn on a dime and make the serious decisions about how to reform or even (probably) liquidate Fannie Mae and Freddie Mac. If there is a financial loss, and there certainly will be, the Fed can handle it "off the books," so to speak. After all, it can print currency if need be. There would obviously be negative (inflationary) side effects to this, but the impact on the government's bottom line and the taxpayer's pocketbook would be less direct.

In turn, the good debt will go to the Treasury. Assuming Western civilization as we know it does not collapse, the government will be able to sell back the shares the Treasury purchased in the banks. In fact, profit levels for the government are actually written into the agreements with the banks. Not only will the government get the $350 billion allocated in TARP II back, it will make a healthy profit to boot -- if all goes according to plan. END QUOTE

The key is the last sentence and the last phrase - "if all goes according to plan." So far, I would say, not much has gone according to plan, assuming there ever was one. A year ago, most analysts believed that the subprime problems would be contained in the US mortgage/banking sectors and would not affect the overall investment markets. Now we know that these endemic problems have spread to all credit markets, virtually around the world.

Troubling Aspects Of The Fed's Latest Bailout

Reading through Stratfor's excellent analysis of the Fed's recent announcement, you may have picked up on some potentially troubling words. First, Stratfor talks about how the Fed can simply "print currency" necessary to pay for this bailout. Remember the controversy surrounding a 2002 speech by Ben Bernanke that alluded to printing money and distributing it from helicopters? Well, the printing press has evidently been placed on board the chopper at Gate One.

As a general rule, printing money is de-facto inflationary. History is filled with examples of countries that experienced hyper-inflation due to cranking up the printing presses. However, not as evident in Bernanke's "helicopter" speech was a footnote that addressed the fact that some inflation is actually a good thing, since it erodes the real value of outstanding government debt.

As I will discuss below, it can be argued that the Fed had to print money to fund bailouts or risk a severe economic depression. However, we need to be aware that the side effects from this "cure" may include increased inflation in the future. Even Fed Chairman Bernanke acknowledges the risk. In a speech last week here in Austin, he said that the Fed's balance sheet "…will eventually have to be brought back to a more sustainable level. However, that is an issue for the future; for now, the goal of policy must be to support financial markets and the economy."

Next, the Stratfor analysis discusses how the "sticky" parts of the process have now been handled. It is generally believed that Paulson backpedaled on buying up subprime debt from banks because the negotiations would have taken too much time to do the banks any good. Now, however, the Treasury and Fed will be able to negotiate directly on the price of any debt purchased, making these purchase transactions potentially much faster.

However, at what cost do we gain this additional transactional efficiency? We have an admittedly "unfettered" Fed dealing directly with the Treasury Dept. regarding the purchase and sale of hard-to-value debt. Does this bother anyone else out there, or have we come to the point where we have to believe the old line, "I'm from the government and I'm here to help you?"

Finally, Stratfor notes that the Fed's dealing with the bad subprime debt will produce almost certain losses, but that these can be handled "off the books," again by printing money if necessary. The resulting inflation would be a consequence, but would be a less direct way of spreading the cost around to the public. Note that Stratfor doesn't say that it won't impact taxpayers, just that inflation will be a less direct way of paying the piper than other possible methods.

Fighting "Debt-Deflation" At Any Cost

As noted in the Introduction above, discussions about the recent massive government bailouts, and especially the latest from the Fed, are going on everywhere in America. Surveys consistently show that most Americans do not agree with the huge government bailouts. Choruses such as "Just let 'em fail!" and "Where's my bailout?" are common.

What most people don't understand is that the government and the Fed will do anything they possibly can to prevent the economy from falling into a full-fledged debt deflation. Whether we agree or disagree with the bailouts, it is clear that our monetary authorities, namely Treasury Secretary Hank Paulson and Fed Chairman Ben Bernanke, believe that if large financial institutions are allowed to fail on a large scale, it would send the economy into a depression.

It appears quite clear to me that Paulson, Bernanke and company now believe that it was a serious bad decision to let Lehman Brothers go bankrupt. Now, they are doing everything in their power to make sure that no other large financial institution goes under, apparently no matter how much taxpayer money they have to commit, even to the point of firing up the Fed's printing presses as a last resort.

Deflation is typically defined as a persistent decline in the general prices of goods and services, or put differently, a negative inflation rate. A debt deflation is generally regarded as a persistent decline in the prices of goods and services, along with widespread loan defaults and bank failures. The last time the US experienced a serious debt deflation was in 1930-1934, the so-called Great Depression.

In the Great Depression, America saw Gross Domestic Product plunge by 10% annually on average, and the unemployment rate skyrocketed to 25%. Clearly, no one wants to see that happen again, especially Paulson and Bernanke, not to mention President Bush and President-elect Obama.

While most Americans seem to oppose the government bailouts, most of the financial/analytical/forecasting groups that I have followed for years believe that the bailouts were/are absolutely necessary. In fact, some of my most trusted sources believe that the government was slow to react to the credit crisis and has not done enough to make bailout money available.

Certainly, there is also agreement among my sources that the government has made some mistakes and did not have a clearly orchestrated plan for how and when the bailouts would happen or where the bailout money would be directed. Such evidence is clear in simply how many times the plans for the original $700 billion TARP bailout have changed.

At the end of the day the question is: What would have happened if the government and the Fed had done nothing in reaction to the credit crisis? Let's start with the easy ones. AIG would have clearly gone bankrupt sending shock waves through the banking and insurance markets worldwide. Merrill Lynch would have almost certainly gone under, perhaps taking Goldman Sachs, Morgan Stanley and several other large investment banks with it, along with Lehman Brothers.

It is impossible to know what would have happened if these giant financial players had been allowed to fail. Yet most Americans don't seem to care. Just let the chips fall. Would the failure of these instititions have triggered a financial collapse? I think the answer is yes.

But would these financial failures have sent the US economy into a serious depression if the government did nothing? There is no definitive answer. Clearly, Paulson and Bernanke feared that without the bailouts, we would have been looking at a global financial crisis and a worldwide depression of epic proportions.

Most Americans who oppose the bailouts have not, in my opinion, thought through the possible implications had the government done nothing to rescue the credit markets. While we can't be certain that a global depression would have unfolded had nothing been done, we also cannot know that it wouldn't. Think about that.

Finally, I would be remiss not to add the obvious: there is no guarantee that the bailouts will work. Only time will tell. But it is clear that the bailouts are not over. I expect the government to give bailouts to the automakers, one way or the other; if not this year, then President Obama will do it as soon as he gets in office. Likewise, Obama is planning another giant stimulus package - reportedly in the $700 billion range - for early next year.

The point is, the bailouts are not over. More are coming in the Obama administration, if needed. How much more we don't know. What we do know is that we will have a new president that comes from a political persuation that has no problem with the government owning parts of the private sector, which is a little scary now that the government already owns equity stakes in our nation's largest banks and AIG.

But that is another discussion for another time. Time to close and hit the "send" button. Hope this has been helpful.

Very best regards,

Gary D. Halbert

SPECIAL ARTICLES:

Graphic NYT: Tracking The Bailout
http://www.nytimes.com/imagepages/2008/11/26/business/20081126_FED_graph1.html

Bernanke's Daring Experiment
http://www.realclearpolitics.com/articles/2008/12/bens_daring_experiment.html

Getting Out of the Credit Mess
http://online.wsj.com/article/SB122878188688689783.html

Instead of Spending, Cut Taxes
http://www.forbes.com/opinions/2008/12/08/friedman-cut-taxes-oped-cx_bw_rs_1209wesburystein.html

Credit Crisis: Do Bush & Paulson Have A Clue?

Gary D. Halbert — Tue, 18 Nov 2008 21:19:08 GMT

IN THIS ISSUE:

Stratfor's Take On The Subprime/Credit Crisis
Treasury Secretary Paulson Changes The Plan
Do They Even Have A Clue What To Do?
Bailout's Next Phase: Consumer Loans (Maybe)
More From Stratfor On The Credit Crisis & The Economy
Gauging The Recession & The Economy - Not Good
Stock Markets Detest Uncertainty & Economic Woes
Conclusions - They Are Few

Introduction

We begin this week with some interesting analysis from our good friends at Stratfor.com regarding the subprime/credit crisis - how it unfolded and how it may play out from here. Following that, we'll look at the latest curve ball from Treasury Secretary Paulson who last week announced that the government will not buy up troubled mortgage securities from banks, but instead will proceed with more equity infusions for financial institutions that are in trouble.

In addition, Secretary Paulson announced that a significant part of the $700 billion rescue package - most all of which was originally intended to buy up troubled assets - will now be redirected toward consumer debt, including such things as student loans, auto loans and credit card debt. One wonders if the government really has a clue about how to resolve the financial crisis and unfreeze the credit markets.

And finally, we take a look at the current state of the economy and the recession. News continues to worsen, especially forecasts for 4Q GDP, which many economists and analysts now believe could be negative 4-5%. All of this continues to weigh on the stock markets, which as this is written, are threatening to make new lows. It's a lot of ground to cover in one E-Letter, so let's get started.

Stratfor's Take On The Subprime/Credit Crisis

QUOTE:
The root of the American credit crisis is similar to that of previous recessions. As profits pile up during economic expansions, investors eventually find it difficult to find investments that generate large returns, so they send their money after riskier prospects. In the [economic] expansion that just ended, the most important of those questionable investments was subprime mortgages, culminating in mortgage loans that required minimal to nonexistent credit checks, down payments or even proof of income. In total, some $550 billion of subprime loans (and a separate $725 billion of Alt-A loans -- the next quality step up from subprime) are currently outstanding.

The worst of these mortgages granted very low teaser interest rates that adjusted to normal rates after a period of two to five years; there were some $350 billion of these in subprime, and an additional $385 billion in Alt-A. While virtually none of these questionable-quality mortgages have been granted since the credit crunch began roughly a year ago, those resets are now weighing heavily on the housing market. As the rates reset, borrowers with questionable income and credit are often unable to meet the new, grossly enlarged payments based on the new rates. The result is a cascade of foreclosures that gluts the housing market, pushing prices down. So far $55 billion of subprime mortgages are in foreclosure, and just over another $80 billion are in severe delinquency. The numbers for Alt-A are $40 billion and $45 billion, respectively.

Under normal circumstances, this is more or less where things would have ended: A glut in regional housing stocks where subprime mortgages were most overused -- especially in the Southern California, Las Vegas and Miami regions -- would lead to a recession in those housing markets and perhaps some leakage into the broader national housing market.

But there is another step in the process that made the problem bigger. Mortgages are only rarely kept by their issuers -- instead they are bundled into packages and sold to interested investors. This serves three purposes. First, since the mortgage maker can sell his loan for a profit, he can then turn around and make another mortgage. Second, this secondary tier of investors brings an entirely new source of capital into the market. Third, these packaged mortgages can be sold to yet more investors, creating a new series of mortgage-backed assets (and securities) that can be traded abroad. Taken together, this widens and deepens the capital pool and reduces mortgage rates for everyone.

The problem is that as market players chased after ever-shrinking returns, no one treated the dubious mortgages as anything different from normal mortgages -- and that includes the ratings agencies whose job it is to evaluate products. All banks and investment houses are required to hold back a percentage of their assets in cold hard cash to keep from becoming overleveraged. This reserve percentage is based upon myriad factors, but the most important one is the risk level of the investments. Mortgage investments are -- or were, until recently -- widely considered to be among the safest investments available because homeowners will do everything they can to avoid missing payments and losing their homes.

Subprime mortgages are more likely to fall into default. But add in the impact of teaser rates -- and the fact that many of these mortgages were granted without requiring down payments so no equity was ever earned -- and essentially the effect is that time bombs were hardwired into these packages of tradable mortgages.

Beginning in late 2006, these teaser rates began to adjust to normal rates and the bombs started going off. That decreased the value of the mortgage-backed assets directly by their affiliation with subprime in specific, and indirectly via their affiliation with property in general. Suddenly, anyone holding the weakening mortgage-backed securities found themselves needing to use those cash reserves to rebalance their asset sheets. As the price drops intensified, anyone who might have been willing to purchase or trade these mortgage-backed securities suddenly lost interest. The holder then held an asset of questionable value that he could not unload.

As the cash crunch of individual firms increased, two things happened. First, investment houses started snapping like twigs because they are uniquely vulnerable to credit crunches. Banks, unlike investment houses, are required to hold a certain percentage of their deposits back to cover their losses should disasters strike; right now that percentage is 10 percent. The major investment houses, however -- which are regulated by the Securities and Exchange Commission instead of the Treasury -- are only required to set aside a minuscule amount of cash, which comes out to less than 1 percent of their total asset list and therefore provides them with a smaller cushion than banks.

By the end of September, the major Wall Street investment houses had been broken (Bear Stearns), gone bankrupt (Lehman Brothers) or were forced to recategorize themselves as banks, thus submitting themselves to the regulatory authority of the Fed (Goldman Sachs). In a few short months, everything on Wall Street changed.

Second, banks also needed to rationalize their balance sheets by dipping into their reserves. Luckily, since banks have a 10 percent reserve ratio, they have much more room to maneuver than investment houses (although some, such as Washington Mutual, still cracked under the pressure).

It is at this point that Stratfor gets interested in the economics of the issue, because it is at this point the problem transforms from angst for Wall Street into a danger for the broader system.

When an investment house faces a credit crunch (or goes under) the impact is rather limited -- the only entities that are truly hurt are those that purchased shares in the house itself -- but when a bank faces a crunch, the impact is much greater. The best means that banks have of rebuilding their emergency reserves after a write-down is to reduce lending and hoard their income until their reserves are built up again. Such actions immediately reduce the availability of credit for everyone across the entire economy -- homebuyers cannot get mortgages, companies cannot borrow to fund expansions, credit card rates go through the roof. Voila, a Wall Street crisis becomes a national economic crisis.

U.S. Treasury Secretary Hank Paulson's $700 billion bailout plan is an attempt to address the problem at its source: the nonliquidity of the mortgage-backed securities. The government will offer to exchange these securities for cold, hard cash. In one fell swoop, banks can rid themselves of untradable assets of questionable value while recapitalizing their reserves. Flush with cash and sporting newly healthy asset sheets, this should unfreeze the credit picture and allow banks to get back into the business of banking -- most notably lending. END QUOTE

Treasury Secretary Paulson Changes The Plan

I am forced to depart from Stratfor's analysis of the credit crisis at this point for one important reason (we will revisit Stratfor below). On Wednesday of last week, Treasury Secretary Hank Paulson made it official that the government is abandoning the original plan to spend $700 billion to buy up troubled mortgage assets from financial institutions.

The next phase of the Treasury's $700 billion "Troubled Asset Relief Program" (TARP), according to Paulson, would have the government continue to take equity stakes in banks and financial institutions vis-à-vis more cash infusions in exchange for stock, rather than buying up their bad mortgage-related assets and taking them off their books.

This seems like an odd turn of events given that the credit markets are still more or less frozen and we are in a recession that is looking more and more severe. Yet Paulson defended the latest swerve in the TARP mission by noting that some of the $700 billion needs to be redirected at increasing the availability of student loans, auto loans and credit cards.

Some analysts viewed the Treasury's latest redirection of TARP funds as merely the recognition that the Bush Administration has finally realized that some of the TARP billions needs to be spent directly on consumers. Clearly, the public perception is that the TARP is simply a bailout of banks and Wall Street financial institutions. Some analysts welcomed the latest announcement.

Do They Even Have A Clue What To Do?

Your editor has a different take on the latest announcement by Treasury Secretary Paulson. First, I have to question whether the Bush Administration and the Treasury Secretary know what they are doing. The original $700 billion rescue plan, which was hastily passed by Congress, was intended specifically to: 1) buy up troubled mortgage-related assets from banks and others; 2) hold those assets on the Treasury's books until the housing slump subsided; and 3) eventually sell those assets back into the market when it was expedient to do so.

Supposedly, the Treasury was busy constructing the TARP infrastructure and hiring lots of people to implement the massive buying of troubled mortgage-related debt. However, in October, the Treasury shifted its focus and allocated some $250 billion for direct equity infusion to the major banks in return for stock (warrants).

The banks that agreed to receive equity investments from the Treasury included Goldman Sachs Group Inc., Morgan Stanley, J.P. Morgan Chase & Co., Bank of America Corp. (including Merrill Lynch), Citigroup Inc., Wells Fargo & Co., Bank of New York Mellon and State Street Corp. Interestingly, some of these large banks resisted the effort and opposed the cash infusion in return for equity. However, it was widely reported that Secretary Paulson made it clear that the cash infusion was not optional.

The next twist, as noted above, came last Wednesday when Paulson announced that the TARP will not purchase troubled assets from financial institutions, but instead will continue with equity infusions for banks (and non-banks) and somehow provide other TARP money for student loans, auto loans and credit card loans. This all suggests to me that the Bush Administration and the Treasury Secretary don't know what they're doing!

Obviously, the move to make TARP money available for student loans, auto loans and credit card loans is in reaction to growing pressure in Congress to make some of the money available for consumers, rather than just financial institutions. President Bush and Secretary Paulson know that they must go back to Congress for authorization of the second $350 billion installment of the TARP. But does Congress have any better idea how to spend the money than Paulson?

To me, it makes much more sense for the government to buy up the troubled assets and hold them until the housing market recovers than to buy increasing equity stakes in banks. However, in his press conference last week, Secretary Paulson said that he decided to drop the plan to buy troubled assets because it is no longer the best way to restart the credit markets. What I read that to mean is that it will take too long to buy up the troubled assets, and the banks could fail in the meantime. Thus, the decision to inject $250 billion now in return for stock was made.

Bailout's Next Phase: Consumer Loans (Maybe)

Congress is quite unhappy with Secretary Paulson for not forcing banks to make new loans with the funds they have received from the TARP. Many in Congress are also unhappy that some of the TARP money has not been earmarked to help homeowners avoid foreclosure. Paulson responded last Wednesday stating that, as a part of the new direction, the Treasury is looking into ways to use some of the TARP money to prevent home foreclosures. Specifically, he said they are considering a plan that has been floated recently by the FDIC, although he noted that the plan has some problems in his view.

Paulson stated in his news conference on Wednesday that the market in consumer finance "is currently in distress, costs of funding have skyrocketed and new issue activity [loans] has come to a halt." As a result, Paulson also announced that the Treasury is considering setting up a new lending facility to focus on consumer loans. Paulson said he was more interested in helping the currently stalled market for financing of credit card and auto loans, among other things.

The Treasury Department says nothing has been finalized, but reportedly Paulson and his advisers are looking into using TARP funds, along with some money from outside investors, to buy up credit card debt, auto loans and other, non-mortgage consumer debt. The financing mechanism for that type of debt, often called "securitization," has stalled like much of the rest of the banking sector. Paulson is hoping that buying up debts directly will be a better way of stimulating lending than just purchasing banks' shares and trying to force the firms to extend loans.

Interestingly, this new lending mechanism sounds a whole lot like another "Collateralized Debt Obligation" (CDO). Accordingly, one wonders why buying up credit card and auto loan debt is any better or easier to do than buying up mortgage bonds. In fact, when it comes to credit card debt, it could be an even riskier way to use taxpayer money. That's because credit card debt, unlike home mortgages, is unsecured. If a borrower defaults, there's no house to repossess. What's more, credit card debt, unlike a mortgage, can be wiped away in bankruptcy.

Pardon me, but this raises another obvious question. Would a huge new round of CDO-like securities be good for investors? I think not. We are in the midst of a massive deleveraging in the credit and investment markets. You would think that Bush advisors and Secretary Paulson would realize this.

Given these potential problems, it occurs to me that Secretary Paulson may simply be talking about such consumer oriented programs to satisfy Congress, when in reality he may have no plans to actually implement these proposed new plans. These ideas may simply be lip service for the time when the Treasury has to ask Congress for the second $350 billion to fund the TARP. The TARP reportedly has only apprx. $60 billion left from the initial $350 billion allocation.

Finally, it appears to me that President Bush and Secretary Paulson have decided to simply ‘run out the clock' on the bailout and hand it over to the Obama administration (note: Paulson will not be staying on at Treasury). On Wednesday, Paulson stated that he had set no date for going back to Congress for the additional $350 billion, possibly a hint that he won't.

Paulson also said he has no plans to establish major new programs ahead of President-elect Obama's inauguration. He said, "I'm not looking to make anything more difficult by implementing programs that don't need to be implemented before they're here." Paulson also said the Treasury will likely keep the remaining $60 billion on the sidelines in case of emergencies.

So, it increasingly looks like Bush and Paulson are content to run out the clock and hand this enormous credit crisis over to the Obama team.

More From Stratfor On The Credit Crisis & The Economy

I will tell you that Stratfor is less pessimistic about the credit crisis and what lies ahead for the economy than numerous other sources I read. Dr. George Friedman and his staff believe that the Treasury will be successful in largely turning around the credit crisis next year. Likewise, barring any major surprises, they do not believe that the recession will be long and overly severe. I hope they are right.

QUOTE
In our analysis of the current financial crisis in the United States -- and the world as a whole -- we have sought the center of gravity of the problem. We approached that simply by asking one question: is what is going on simply another inflection point in the business cycles that have occurred since World War II, or does it represent a systemic failure such as that which happened during the Great Depression? This struck us as the urgent issue.

We noted that in the Great Depression, the U.S. gross domestic product (GDP) contracted by nearly 50 percent over three years. It was an unprecedented calamity. Bearing this in mind, we compared the current situation to other events since World War II to see if there was a framework for measuring it. We found that framework in the Savings and Loan crisis of 1989, when an entire sector of the U.S. financial system collapsed and the federal government intervened -- essentially guaranteeing or purchasing commercial real estate, whose price decline had triggered the crisis.

We noted that the total amount allocated by the federal government in that crisis was about 6.5 percent of the GDP (and the amount actually spent, before recouping of costs via sales, was less than 3 percent). We noted also that in the current crisis another sector of the financial system -- the investment banks -- were devastated, and that the federal government intervened, this time at about 5 percent of GDP.

Meanwhile, the equity markets had not declined as much as they did in 2000-2001, and as of the second quarter of this year the economy was still growing by more than 2 percent. From this we concluded that the U.S. economy was moving into a recession but that the recession would not break the framework of the postwar economy, although clearly the degree of government intervention will reshape the financial markets.

The United States is a $14 trillion economy with a potential problem amounting to $1-2 trillion (and probably far less than that). If the government intervenes, it will create inequities and imbalances in the system. But between the size of the economy and the government printing press, the problem will be managed -- particularly because there are underlying assets -- houses -- that can be monetized in the long run. The gridlock in the financial system will undoubtedly create a recession, but there hasn't been one for seven years and it's high time. END QUOTE

Stratfor seems to believe that the worst of the credit crisis is now behind us, barring any major surprises. They note that bank lending has increased somewhat since the $250 billion injection in October. Likewise, they believe the recession will likely end in the first half of next year.

As always, I appreciate Stratfor's insights and the ability to share them with you. I encourage you to visit their website at www.Stratfor.com and consider subscribing to their always insightful analysis. Click HERE to get a free 7-day trial subscription to Stratfor .

Gauging The Recession & The Economy - Not Good

When Stratfor suggests above that "...the recession would not break the framework of the postwar economy...," I take that to mean that they do not believe the current recession will be worse than the recessions of 1973-74 or 1981-82, both of which lasted well over a year. Most economists seem to agree that the current recession probably began in July of this year.

In late October, the Commerce Department reported that 3Q GDP had contracted by an annual rate of -0.3%. On November 25, we will get the second estimate of 3Q GDP, and the consensus now is for a revision to -0.6%. That will not come as a surprise.

What is much more worrisome is the outlook for the 4Q. Economists and analysts are downgrading their estimates for 4Q GDP. I am hearing increasing forecasts of a 4-5% drop in GDP for the 4Q! We won't get the first estimate of 4Q GDP until late January, so it will be interesting to see what the consensus is after the first of the year. Suffice it to say, it will be ugly.

Retail sales fell a record 2.8% in October, and retail chains are bracing for the worst holiday shopping season in years. Best Buy now expects its sales to fall 8% for the year. What a shift - in early September, Best Buy was forecasting a sales increase of 3% for the year. Best Buy CEO Brad Anderson said, "Since mid-September, rapid, seismic changes in consumer behavior have created the most difficult climate we've ever seen." Best Buy rival CircuitCity filed for bankruptcy last week.

Economists and analysts are increasingly forecasting that the recession will last at least until late next year. If that is true, the current recession would be on par with the recessions of 1973-74 or 1981-82. And it could be worse.

Most forecasters now expect the US unemployment rate to climb to at least 8% sometime next year, with many expecting that to occur in the first half of next year. Over a half a million jobs have been lost in the US in the last two months alone, driving the unemployment rate to 6.5%, a 14-year high. 8% unemployment would be the highest in 25 years.

Stock Markets Detest Uncertainty & Economic Woes

Everywhere I go, people ask me the same question: What's it gonna take for this crazy stock market to find a bottom? I don't tend to talk about my business or investments to people in my personal life, but people who have never inquired before are asking me for advice now - family, friends and even people who don't know me well but know I work in the investment industry.

The fact is, no one knows when this bear market will end. If someone tells you they know when the bear market will end, keep one hand on your wallet!

One thing is clear, however. The stock markets have consistently reacted negatively to the government's massive $700 billion bailout plan. Let's take a look at recent market action. Treasury Secretary Paulson submitted the huge bailout plan - which was intended to fix the credit crunch and stabilize the market - to Congress on Saturday, September 20. Take a look at what happened thereafter. The stock market tanked.

The Dow Jones Industrial Average plunged from above 11,000 on September 22 to below 8,000 on October 11 at the low. Certainly not the reaction that Bush, Paulson & Company had expected. The equity markets do not like uncertainty and were shocked at the massive size of the requested bailout - we all were.

The stock market tried to bounce back from the low, but on October 14 Secretary Paulson announced that on the prior day he had met with the nation's largest banks and had informed them of the government's plan to take equity stakes totalling $250 billion in their companies. You can see in the chart above that the stock markets declined sharply once again to near the October 11 low.

The markets once again tried to recover, climbing back above 9,500 in the Dow. Then last Wednesday, November 12, Secretary Paulson announced that the Treasury would not buy any of the banks' troubled assets and would only take equity positions in their stock. Now, we find the equity markets back near their October lows and threatening to make new lows as this is written.

It remains to be seen if the stock markets are in the process of forming a bottom. From a technical perspective, if the Dow can hold above the October lows once again in the next few days, that would be very encouraging (triple bottom), and we could see a much overdue strong rally in this bear market. If not, and we make new lows, expect another round of aggressive selling to follow.

Conclusions - They Are Few

I know that many of my readers are opposed to the government bailout of financial institutions. I assume that many of you will also be opposed to the latest plan to spread some of the bailout money to consumer loans. In normal times, I would agree - just let the chips fall.

However, the current credit crisis is unprecedented and the consequences of letting America's largest banks and financial institutions fail would virtually ensure a depression and a Japan-style debt deflation that could last for a decade or longer.

Of course, it remains to be seen if the government bailout plan will work. But most of my trusted sources agree that some kind of large government rescue plan was required, since letting the credit system go down the tubes would have resulted in financial Armageddon.

Personally, I believe the government will have to resort to buying up many of the toxic mortgage-related securities and taking them off the market before this crisis abates. But based on the hints and inuendo from Secretary Paulson, it seems that President Bush has decided to leave that decision to his successor, Barack Obama. I would not want to be in his shoes.

Finally, I know that many of you who read this E-Letter are facing tough decisions about what to do with your investments, your 401(k) and other retirement accounts at this point. Keep in mind that my staff of Investment Consultants and I stand ready to assist you in making those decisions if you would like to talk about it - free of charge and with absolutely no pressure to invest in the programs we recommend.

You can call us at 800-348-3601 or e-mail us at info@halbertwealth.com. We don't claim to have all the answers, but we've been through bear markets before, and we are happy to consult with you on the issue of what to do now.

Wishing you a market bottom,

Gary D. Halbert

SPECIAL ARTICLES:

Paulson - Fighting the Financial Crisis
http://www.nytimes.com/2008/11/18/opinion/18paulson.html?_r=1&ref=opinion&oref=slogin

To Prevent Bubbles, Restrain the Fed
http://online.wsj.com/article/SB122688652214032407.html

Fred Barnes on how Obama could help Republicans
http://www.weeklystandard.com/Content/Public/Articles/000/000/015/819jyryw.asp?pg=1

"Buy-And-Hold" Bites The Dust - Now What?

Gary D. Halbert — Tue, 11 Nov 2008 20:54:52 GMT

IN THIS ISSUE:

Economic Overview
The Conventional Wisdom Was Wrong
The Shortcomings Of Index Investing
Are Low Fees The Key To Investment Success?
Risk Management Is Crucial

Introduction

In the newsletter business, it's rewarding to see market action reinforce the advice you have been giving in your publication. Ever since I started writing this E-Letter, I have warned of the perils of passive "buy-and-hold" investing in general, and "index investing" in particular. While adherents to these strategies like to trot out long-term charts and graphs supporting their case, I have always warned that passive investing can result in major losses at just the wrong time from the investor's perspective.

However, I have to admit that being right rings hollow in the aftermath of the carnage we have seen in the US stock market since its peak in October of 2007, and especially over the last month or so. It is estimated that over $8 trillion of investor value has been lost in the US equity markets since then, and no one knows how long the bear market may continue. Many Baby Boomers are now realizing that their passive investments have incurred huge losses at a time when capital preservation is far more important to them.

How did we ever get to the point where buy-and-hold became investment gospel? It's as if investors were convinced that it's OK to stay on the track and get hit by an oncoming bear-market train, since a bull-market train going the other direction would soon bring them back to where they were before, and eventually higher over the long term. Yet it has always made sense to me to step off the tracks (go to cash or hedge) to avoid oncoming trains altogether.

Many investors are now feeling as if their portfolios have been hit by a train and it's uncertain if and when one going the other direction (bull market) may come along. Since many of the highest investment balances were held by Baby Boomers nearing retirement, it's an even worse train wreck because they lack the lengthy time horizon that may be necessary for the market to regain recent large losses.

This week, I'm going to revisit the issue of passive investing, and especially index investing. I'll discuss why I think they became so popular, and why I continue to recommend actively managed programs that have the potential to reduce risk during market meltdowns. First, however, I'm going to give you an overview of the latest economic forecasts I am seeing. Let me warn you, the news is not good.

Economic Picture Getting Darker

Every economic forecasting group that I read has downgraded its predictions over the last few weeks in light of the plunge in the global equity markets in October. As noted last week, 3Q GDP was estimated at -0.3% (annual rate), and that estimate is likely to be downgraded later this month. Most forecasters are now predicting that 4Q GDP will be down at least 1-2%.

While forecasts earlier in the year suggested that the economy would rebound to positive growth in the second half of next year, such forecasts have all but disappeared. Now, there is a general consensus that the US economy will be negative for at least several more quarters to come. Specifically, that this will be the worst recession since the Great Depression. All of the sources I trust believe that it will take several years to work out of this financial crisis.

It remains to be seen if the stock markets have seen the bottom. In any event, most forecasters I respect believe that once the stock markets have bottomed, they will move into a broad, multi-year trading range. No one I respect is predicting a "V" bottom or a quick return to a bull market.

This is precisely why we need to revisit the problems associated with passive, buy-and-hold investment strategies. These strategies got killed over the last year, especially the last month or so, and are not designed to do well in a broad trading range, which could persist for the next several years. Fortunately, there are alternatives.

The Conventional Wisdom Was Wrong

The basics of passive investing are relatively simple. You put your money into a diversified portfolio, usually based on "asset allocation" strategies, and leave it there during good and bad market cycles. Armed with reams of historical data, the conventional wisdom was that including multiple asset classes in a portfolio would protect investors during all types of market conditions. While changes are made periodically to rebalance allocations or adjust for advancing age, the portfolio is largely a "set it and forget it" instrument, so the theory goes.

The historical data also suggested that most hands-on mutual fund managers were not adding value above and beyond what the broad market indexes could provide, so mutual funds tied to various market indexes were developed to offer a low-cost alternative to actively managed mutual funds. However, back in December 2005, I wrote an E-Letter about the potential drawbacks of passive index investing:

"'Index investing' is growing like wildfire among investors today…And it's no wonder why. The allure of a simple, low-cost investment strategy tied to market indices that have been shown to grow over long periods of time sounds irresistible…The main problem is that Wall Street's ad machine is only telling half of the story. They often use historical time periods that are far longer than what most people have to invest, and they also fail to disclose how much an investor might lose in a bear market or major correction."

To illustrate, during the 2000 - 2002 bear market, the S&P 500 Index lost over 44% of its value, and the Nasdaq Composite fared even worse, losing over 75%! Unfortunately, however, neither investors nor Wall Street learned a lesson about how fickle the market can be, and at the worst possible times.

Thus, even with those huge 2000 - 2002 market losses fresh on their minds, investors still flocked to index investing as if there would never be another bear market or correction. I think there were several reasons for this, including:

Having just been through a major bear market caused some of them to think that the worst was over, and that the market would now over-perform in order to get back to historical long-term averages. Unfortunately, they failed to study history, which shows that, since 1952, bear markets have occurred an average of once every five or so years, so we were actually due for a bear market.

The market's action during 2003 through 2006 seemed to confirm index investors' convictions that happy days were, indeed, here again. The S&P 500 Index gained 28.68%, 10.88%, 4.91% and 15.79% in 2003 through 2006, respectively. This annualized return of 14.74% over those four years compared favorably to the 10% to 12% touted as the long-term average stock market return, so "reversion to the mean" became the watchword of the day.
Though 2007 saw the first warnings of the subprime crisis, the Dow and S&P 500 market indexes still managed to hit all-time record highs in October of 2007. Investors were convinced that this, too, shall pass and stayed invested.
The bear market of 2000 - 2002 also claimed another victim, and that was the average mutual fund manager. Unfortunately, all active management strategies seemed to be lumped into the same category by the financial media and Wall Street firms. No difference was made between an active mutual fund manager and specialized strategies such as market timing, sector rotation, long/short or a variety of other active management techniques. Wall Street even promoted flawed statistics to support their point, as I noted in my June 21, 2005 E-Letter.
Investors were subjected to so many different investment opinions and theories that many of them just didn't know which way to turn. They were paralyzed by all of the conflicting information out there. I call it "information overload." Thus, they chose the option that seemed to be the simplest, plus it was supported by Nobel Prize Winning theories. How could they possibly go wrong?
Since most index investing used asset allocation strategies based on the work of Nobel Laureate Dr. Harry Markowitz, many investors felt that using multiple asset classes including bonds and international investments would protect them in a bear market. Another big plus was that the financial services industry found Markowitz's theories relatively easy to incorporate into computerized portfolio modeling programs, resulting in highly effective proposal presentations.

Unfortunately, we have learned that the subprime crisis spared no asset class as it ravaged global stock and bond markets. The traditional correlation among asset classes broke down, which is often the case in severe bear markets.
Finally, fees became one of the major selling points of passive index investing, especially among the financial media (more about this later on). I now find it interesting that some members of this same financial media are now declaring that "buy-and-hold is dead." How convenient to be able to change your story to fit the times.

Over the course of my 30-plus-year career in the investment business, I have found that most investors' goals are very simple. They want to put their money into investments that are: 1) reasonably safe; 2) have the potential to earn a reasonable rate of return; and 3) will not suffer large losses along the way. While these goals are relatively simple, how you invest to achieve them is not a simple process.

However, the investment industry is always willing to create products to fill investor demands, some of which are based on the conventional wisdom of the day. For those wanting a simple solution, the financial services industry created a number of different "one-size-fits-all" investment products, with index investing being one of the most popular.

They even created "target-retirement" and "lifestyle" funds that incorporated asset allocation so that investors need only know the year they wanted to retire in order to select the "right" investment. I guess you could call this the ultimate in conventional wisdom portfolios.

Chinks In The Index Investing Armor

Before I discuss some of the arguments against index investing, let me say that I am a big fan of both index mutual funds and ETFs. I feel that the ability to "buy the index" has changed the investing landscape in a number of positive ways, though I don't always agree with proponents of buying and holding index funds. Several of the Advisors whose programs I recommend use index mutual funds to facilitate their active management strategies, so I am a big fan.

That being said, I have often advised against combining index funds and asset allocation programs as the sole investment strategy in an investor's portfolio. The reason for this is within the passively managed nature of the index fund. Index funds, by their very nature, will not exit positions and move to cash during bear markets or downward corrections. An index fund will follow its underlying index, even if it dives right into the dirt (or gets hit by a train).

Index fund proponents say that this is no problem - just diversify among a variety of index funds covering various stock and bond asset classes, and everything will be OK in the long run. I can best illustrate this strategy using an investment offer I once received from a financial Advisor back in 2005. While the information is somewhat dated, the shortcomings are the same today as they were then.

The Advisor recommended only "index" funds allocated among a variety of selected funds based on traditional asset allocation principles. The Advisor went on to illustrate the performance of a set of index funds over a 25-year period of time from 1979 through 2004. The performance was excellent, especially as compared to fixed rate investments like CDs and fixed annuities.

The Advisor's implication was clear: the market indexes will do well over long periods of time, so all you need to do is invest in his special blend of index funds and you'll be just fine. Since the time period included returns during the bear market of 2000 - 2002, it would seem that his argument would have been fair, right?

Sorry, but I'm still not convinced. Here are just a few of the fallacies of this Advisor's argument, in my opinion:

It assumed the next 25 years will be the same as the last 25 years. Let's see, did 78 million Baby Boomers retire in the last 25 years? Were we afraid of terrorist attacks on our major financial centers prior to 2001? Will Medicare and Social Security costs be the same percentage of government spending in the next 25 years as they were in the last 25 years? And, of course, had we experienced a housing and subprime mortgage crisis resulting in a global credit crunch, massive Wall Street bailouts and a stock market meltdown? (Hint: "NO" is the appropriate answer to all of these questions.)
The 25-year time period cited as an example doesn't necessarily correspond to any individual investor's actual time frame. What if an investor's time frame had them needing their money for retirement in September of 2002 at the bottom of the bear market? I doubt index investing would have met with much praise at that point in time. Fast forwarding to the present, what if a retiree needs money NOW?
It doesn't hurt your argument when you choose a 25-year period that just happens to include the longest bull market in history, along with a stock market bubble in the go-go 90s. Let's roll the clock on back a bit. What if we chose a period of time from 1966 through 1982? Over this 16-year span of time, the stock market went nowhere.

Even Vanguard's John Bogle, the father of index investing, has pointed out that "each and every comparison we see is period-dependent." This means that the time period you choose can greatly affect the outcome of your analysis. I have written about this before, but it is especially important in regard to index investing.
Finally, historical analysis of stock market returns does show that stocks increase in value over long periods of time. Yet, there are many shorter periods in which stocks do poorly, or even lose money. Investors are often confronted with glossy charts and graphs illustrating stock market performance data over 25 years, 50 years and even 75 years. Yet, few people trying to make investment decisions today have a 50 or 75-year time horizon!

Let's look at the timelines. The youngest of the Baby Boomers are now nearing age 45, at which time they will have 20 years until retirement at 65. A 50-year-old has only 15 years, and at 55, you're looking at only a decade to accumulate wealth. Are there lots of 10-year periods during which the major market indexes did poorly? You bet there are, and we're in one of them right now!

So, you have to ask yourself, what historical 10-year period will the next 10 years be like? Don't know? Neither do I, and neither do economists, financial planners, mutual fund managers, or anyone else.

Because of these shortcomings, I continue to believe active management strategies with a historical track record of having provided reasonable returns with reduced risks are more appropriate for many investors than buy-and-hold index investing. Some of the financial media are now agreeing with me, but where were they in 1995 when I first began to recommend these active management strategies to my clients?

Do Low Fees = Good Investments?

One facet of investing where the index proponents have been successful is that of fees. Many investors will automatically reject any investment with expenses greater than those of an index fund. They have bought into the idea that active management doesn't pay, so they are not willing to pay higher fees for the expertise of an active manager. They use fees as a simple way to eliminate alternatives from their investment radar screen.

Unfortunately, this simple criterion can eliminate many qualified alternatives. After all, do you drive the least expensive car? Why not? Don't all cars offer you a mode of transportation? Do you shop for the least expensive doctor, lawyer or dentist? Those who do many times find out exactly why they charge fees below the going rates.

The important thing is not always what fees are being charged, but how the investment program has performed net of all fees and expenses. Many people will pay more for a product or service if they can see, hear, or feel added value, and investments should be no different.

Now, however, the focus on low fees is coming back to haunt many investors. For example, the Vanguard S&P 500 mutual fund has one of the lowest fees around, at only 0.15%, but according to the Vanguard website, this fund had a year-to-date loss of 32.87% as of the end of October.

At the same time, the Niemann Equity Plus Program that I have featured in this E-Letter had a year-to-date loss of only 10.85%, net of Niemann's 2.3% annual fee. Would you pay an additional 2.15% fee to shave over 22 percentage points off of your losses right now? I'll bet you would! (Past performance is not necessarily indicative of future results. Niemann's October 2008 performance is an estimate and may vary. Be sure to see Important Notes at the end of this E-Letter.)

It gets even better - since the inception of the Niemann Equity Plus program in November of 1996, it has produced an annualized return of 12.25%, again net of all fees. Over the same period of time, the Vanguard S&P 500 Index mutual fund has produced an annualized gain of only 4.32%, also net of fees. Again, the lower fee alternative produced an inferior return to the higher-fee actively managed program. Of course, there are no guarantees it will always do so.

Obviously, we have other programs that have higher and lower returns than the Equity Plus Program, but this comparison does show that relying on fees alone can be detrimental to your investment returns, even in comparisons spanning over a decade. Of course, there are no guarantees.

Finally, there are some financial services companies that extol the virtues of low fees to "retail" investors, while at the same time offering hedge funds to their wealthy clients. As you probably already know, hedge funds carry some of the highest fees of any investment vehicle.

So, if high fees are such a bane on the investment industry, then why have wealthy individuals flocked to hedge funds as never before? The answer is that there are some (albeit few) money managers who are able to provide value over and above their fees in the form of consistent risk-managed returns. This is the type of money manager we look for to recommend in our AdvisorLink® Program.

What About Risk Management?

As I noted above, many investors seek investments that are: 1) reasonably safe; 2) have the potential to earn a reasonable rate of growth; and 3) will not suffer large losses along the way. My biggest problem with index investing is that it can fail all three of these tests, and the recent market meltdown is a good case in point.

On the first issue of safety, you could say that index investing passes this test in one sense because there is little likelihood of losing money through embezzlement or fraud. However, safety can mean more than protection from fraud. One example is in regard to a type of mutual fund that has been getting a lot of attention lately. There are some new index funds that allow investors to "short" the market, or participate in a fund that generates double the movement of the underlying market through 2-to-1 leverage.

As the stock market has been hit by loss after loss, these funds are looking very attractive. Investors who have moved to these funds brag of outsized performance, and will continue to do so as the markets continue to go down. However, when the markets do turn around, the leverage and short position will begin to work against the investor. And since much of the gain is concentrated in the early days of a new bull market, losses could be big and quick.

Thus, while the ability to short the market and use leverage offer a lot of flexibility, they can also offer a lot of additional risk. Unless managed by a competent professional using a disciplined strategy, I consider participation in leveraged and short funds little more than gambling. You might win big, but you can lose just as big, and may never be able to recover your losses.

As for the second test of the potential to earn a reasonable rate of growth, index investing proponents would say that index funds pass this test with flying colors, considering the historical long-term return of the stock market. However, as I have shown in this article, stock market returns are very period-dependent. The shorter your investment time horizon, the better the chance that index funds will provide results below their long-term average. In fact, there have been examples in the past where the stock market has gone virtually nowhere for 10, 15 or even 20 years.

On the final qualification that the investment program not suffer large losses along the way, index investing fails miserably. Since there is no active management of the underlying portfolio, the investor is destined to rise and fall with the markets. During the past bear market of 2000 - 2002, the major market indices had some tremendous drawdowns in value, with the S&P 500 losing over 44% of its value, and the Nasdaq Composite Index losing over 75%!

In the current bear market, drawdowns have not yet accumulated to the low points experienced during 2000 - 2002, but they are very close. As this is written, the S&P 500 Index is approximately 40% below its October 2007 peak. The last bear market drawdown bottomed out in September of 2002, so that's two 40% drawdowns in six years. No wonder many retirees are saying they're "done" with the stock market.

My staff and I have personally talked to a number of investors who needed their money for retirement during this time, only to find that a large part of their investments' values had vanished into thin air. Even if I were sold on the value of index investing over the long haul, I would still not recommend it to my clients simply because of this last shortcoming.

Conclusions

I would like to believe that the latest market mayhem will spell the end of one-size-fits-all index investing, but I know better. Wall Street has sunk far too much money into literature and software to let the concept die a peaceful death. Just as we saw index investing take off after the 2000 - 2002 bear market, I expect to see it marketed heavily once the market starts to come back from the current low point.

Oh yes, some of the marketing material will be changed to reflect the subprime debacle, but I will bet that the industry will attempt to explain the current market malaise away by saying it's a "market aberration" that won't happen again because of improved regulatory scrutiny that is almost certain to come. Thus, Wall Street will attempt to skip over this bump in the road and do what they do best - marketing.

One of the primary reasons I agreed to write this weekly E-Letter in the first place was the hope that I might be able to make a difference by countering some of the expensive marketing efforts launched by the major Wall Street firms and large mutual fund families. In this way, I can share some of the insights I have been able to gain from my 30+ years in the investment industry. To that end, I hope that I have provided some information this week that will help you resist the siren song of index investing in the future.

Through the years, many of my readers have sought out some of the investment programs my company offers, but many have not. While I'm the first to admit that some of our programs did a better job of limiting risk than others, almost all have been successful in holding risks to less than those of the S&P 500 Index, which is what they are designed to do. Plus, we have a couple of programs that have actually made money during the down market. Past performance, however, cannot guarantee future results.

If you are among those who have put off checking out our risk-managed investment programs, perhaps the current market meltdown will convince you it's time to take a look. Just give one of our Investment Consultants a call at 800-348-3601 or complete our online information request form. You can also find out more about these programs and the strategies they employ on our website at www.halbertwealth.com.

Wishing you a market bottom,

Gary D. Halbert

SPECIAL ARTICLES:

The Death of Buy and Hold
http://www.cnbc.com/id/27651174

The Specter of Deflation
http://www.realclearpolitics.com/articles/2008/11/the_specter_of_deflation.html

What lower oil prices mean for the world
http://www.ft.com/cms/s/0/5c238848-af5d-11dd-a4bf-000077b07658.html?nclick_check=1

IMPORTANT NOTES: Halbert Wealth Management, Inc. (HWM) and Niemann Capital Management, (NCM) are Investment Advisors registered with the SEC and/or their respective states. Some Advisors are not available in all states, and this report does not constitute a solicitation to residents of such states. Information in this report is taken from sources believed reliable but its accuracy cannot be guaranteed. Any opinions stated are intended as general observations, not specific or personal investment advice. Please consult a competent professional and the appropriate disclosure documents before making any investment decisions. There is no foolproof way of selecting an Investment Advisor. Investments mentioned involve risk, and not all investments mentioned herein are appropriate for all investors. HWM receives compensation from NCM in exchange for introducing client accounts to the Advisors. For more information on HWM or NCM, please consult HWM Form ADV Part II, NCM Form ADV Part II and Niemann's Annual Disclosure Presentation, 2007, available at no charge upon request. Any offer or solicitation can only be made by way of the Form ADV Part II. Officers, employees, and affiliates of HWM may have investments managed by the Advisors discussed herein or others.

As benchmarks for comparison, the Standard & Poor's 500 Stock Index, the Vanguard S&P 500 Index and the NASDAQ Composite Index (which include dividends) represent an unmanaged, passive buy-and-hold approach. The volatility and investment characteristics of the S&P 500, the Vanguard S&P 500 Index and the NASDAQ Composite Index may differ materially (more or less) from that of the Advisor. The performance of the S & P 500 Stock Index, the Vanguard S&P 500 Index and the NASDAQ Composite is not meant to imply that investors should consider an investment in the Niemann trading program as comparable to an investment in the "blue chip" stocks that comprise the S & P 500 Stock Index and the Vanguard S&P 500 Index, or the stocks that comprise the NASDAQ Composite. Historical performance data is provided by the Advisor in compliance with the Global Investment Performance Standards (GIPS), except for the month of October 2008, which is an estimate which has not been verified for GIPS compliance. The actual final performance number for October 2008 could change significantly from the estimate. See the Annual Disclosure Presentation, 2007 for more details on GIPS performance. Statistics for "Worst Drawdown" are calculated as of month-end. Drawdowns within a month may have been greater. PAST RESULTS ARE NOT NECESSARILY INDICATIVE OF FUTURE RESULTS. Any investment in a mutual fund carries the risk of loss. Mutual funds carry their own expenses which are outlined in the fund's prospectus. An account with any Advisor is not a bank account and is not guaranteed by FDIC or any other governmental agency.

When reviewing past performance records, it is important to note that different accounts, even though they are traded pursuant to the same strategy, can have varying results. The reasons for this include: i) the period of time in which the accounts are active; ii) the timing of contributions and withdrawals; iii) the account size; iv) the minimum investment requirements and/or withdrawal restrictions; and v) the rate of brokerage commissions and transaction fees charged to an account. There can be no assurance that an account opened by any person will achieve performance returns similar to those provided herein for accounts traded pursuant to the Niemann Equity Plus trading program.

In addition, you should be aware that (i) the Niemann Equity Plus trading program is speculative and involves risk; (ii) the Niemann Equity Plus trading program's performance may be volatile; (iii) an investor could lose all or a substantial amount of his or her investment in the program; (iv) Niemann will have trading authority over an investor's account and the use of a single advisor could mean lack of diversification and consequently higher risk; and (v) the Niemann Equity Plus trading program's fees and expenses (if any) will reduce an investor's trading profits, or increase any trading losses.

Returns illustrated are net of actual management fees, custodial fees, underlying mutual fund management fees, and other fund expenses such as 12b-1 fees. They do not include the effect of annual IRA fees or mutual fund sales charges, if applicable. All dividends and capital gains have been reinvested. Performance is based on actual fee-paying, fully discretionary accounts in a composite. Individual account performance may differ from the composite. No adjustment has been made for income tax liability. Some Funds also charge short-term redemption fees and excess transaction fees (Special Fees), which are billed to shareholders at the time of the event causing the fee. All of these fees are in addition to Niemann's advisory fees. In selecting Funds in which to invest, Niemann considers the nature and size of the fees charged by the Funds. Niemann will select a Fund only if Niemann believes the Fund's performance, after all fees, will meet Niemann's performance standards. Consequently, Niemann may select Funds, which have higher or lower fees than other similar Funds, and which charge Special Fees. When deciding whether to liquidate a Fund position, Niemann will take into consideration any Special fees which may be charged. Niemann may decide to sell a Fund position even though it will result in the client being required to pay Special Fees. Money market funds are not bank accounts, do not carry deposit insurance, and do involve risk of loss. The results shown are for a limited time period and may not be representative of the results that would be achieved over a full market cycle or in different economic and market environments.

SPECIAL ISSUE: Financial Crisis For Beginners

Gary D. Halbert — Wed, 15 Oct 2008 20:48:25 GMT

Everywhere I go, people ask me how we got into this financial crisis that has seized up credit and driven the stock markets down 40% or more, most of it in just the last few weeks. Obviously, the simple answer is that the housing bubble burst, and as home prices tumbled, mortgage delinquencies and home foreclosures spiked, and banks and other financial institutions got into trouble. In fact, many have failed.

Millions of Americans do not understand many of the financial terms that are used to identify many of the mortgage-related instruments, nor how intertwined all of the major banks and financial institutions are. This lack of understanding and confusion make the fear even worse. This is one big reason for the collapse in the stock markets.

I recently ran across the following very good explanation of the financial/credit crisis at BaselineScenario.com. BaselineScenario.com is a very useful website/webblog that was founded by Peter Boone, an Associate at the Centre for Economic Performance at the London School of Economics, Simon Johnson, former chief economist of the International Monetary Fund and professor at the MIT Sloan School of Management, and James Kwak, a former McKinsey consultant and co-founder of Guidewire Software. These are some smart guys.

On their website, they have a lot of useful information, including the article reprinted below entitled Financial Crisis For Beginners. This article explains in understandable language many of the intricacies of the credit markets, along with some of the technical terms such as CDOs, CDSs and others. If you want to better understand the credit crisis, this is a good place to start.

Finally, since their website is also a blog, I would suggest that you visit there at least occasionally to keep up with their latest thinking on the global credit crisis.

QUOTE:
Financial Crisis For Beginners

We believe that everyone should be able to understand how the financial crisis came about, what it means for all of us, and what our options are for getting out of it. Unfortunately, the vast majority of all writing about the crisis - including this blog - assumes some familiarity with the world of mortgage-backed securities, collateralized debt obligations, credit default swaps, and so on. You've probably heard dozens of journalists use these terms without explaining what they mean. If you're confused, this page is for you… (Some of the explanations on this page are simplified and not 100% accurate; their goal is to explain the key concepts to a general audience.)

Historically local banks took deposits from savings account customers and lent money to homebuyers. They paid 1% for the savings accounts and collected 6% on the mortgages, and the spread (5 percentage points in this case) was more than enough to compensate for any homebuyers who couldn't pay their mortgages. (The numbers are illustrative only.)

Then, as any explanation of the subprime crisis says, banks started reselling and securitizing mortgages. But what does it mean to resell (let alone securitize) a mortgage?

To understand this, you have to look at it from the bank's point of view. To them, a mortgage is a product. This product gives them a monthly stream of payments - about $1,000 per month for a 30-year, fixed-rate mortgage on a loan amount of $150,000 (numbers are very approximate), but that stream is not guaranteed; the homebuyer might not be able to pay (in which case they might have to renegotiate or foreclose, both of which are costly), or might pay the whole thing [off] early. The price they pay for this product (this stream of payments) is just the loan amount; from their perspective, they are "buying" the stream of payments by paying you the loan amount. The lower the interest rate you get, the higher the price they are paying for your payments.

If Bank A resells your mortgage to Bank B, Bank B buys your payment stream from Bank A in exchange for a lump sum of money. Under stable market conditions, the lump sum that B gives A will be about the same as the lump sum you received from A (in which case A only makes money from various fees). You can also think of this as Bank B loaning you the money for your house, with Bank A acting as an intermediary.

Now, in practice, Bank B (or C, or D, …) is often an investment bank. And Bank B often securitizes your mortgage. This means they take your mortgage and combine it with many (thousands of) similar mortgages. If the mortgages are similar according to certain objective criteria - creditworthiness of borrowers, loan-to-value ratios, etc. - they can be treated as homogeneous. (Something similar happened with corn in the 19th century; certain standards were established for different grades of corn, and from that point bushels of corn from different farms didn't have to be separately shipped and inspected by buyers, but could be poured together into huge vats.)

Now you have a pool of, say, 10,000 mortgages, with about $10 million in payments coming in from borrowers every month. That pool as a whole has a price - the amount someone would pay to get all of those payment streams of that riskiness. In a securitization, the investment bank divides the pool up into many small slices [also referred to as tranches] - say 1,000 in this case. Each slice can be bought and sold separately, and each slice entitles the buyer to 1/1,000th of the payments streaming into that pool.

The price of these slices is based on current assumptions about the riskiness of those payments - the riskier those payments are perceived to be, the lower the price anyone will pay for a slice of them. The problem is that at the time those mortgages were securitized, the buyers assumed that housing prices could only go up, and therefore the payments were not very risky; when housing prices began to fall, many more borrowers became delinquent than had been expected. As a result, if you own a slice of that pool, you still own 1/1,000th of the payments coming in, but your expectations of how many payments will come in are much lower than they were when you bought the slice.

(A collateralized debt obligation [CDO] is a securitization where the slices are not created equal. Some slices are entitled to the first payments that come in each month, and hence are the safest; some slices only get the last payments that come in each month, so when people start defaulting, those are the slices that lose money first.)

This brings us to writedowns and, eventually, to the subject of banking capital. Let's say you are an investment bank and you paid $1 million for a slice of a securities offering (a pool). You put that on your books as an asset (in the world of finance, a stream of payments coming to you is an asset) valued at $1 million. However, a year later, that slice is only worth $200,000 (you know this because other people selling similar slices of similar pools are only getting 20 cents on the dollar). You generally have to mark your holding to market (account for its current market value), which means now that asset is valued at $200,000 on your balance sheet. This is an $800,000 writedown, and it counts as a loss on your income (profit and loss) statement. And that is what has been going on over the last year, to the tune of over $100 billion at publicly traded banks alone.

The next problem is that, over the last two decades, most of our banks have become giant proprietary trading rooms, meaning that they buy and sell securities for profit. Let's say you start a bank with $10 million of your own money. That's your "capital." You go out and borrow $90 million from other people, typically by selling bonds, which are promises to pay back the money at some interest rate. Then you take the $100 million and buy some stuff (like slices of mortgage pools), which pays you a higher interest rate than you are paying on your bonds. Suddenly you are making money hand over fist. But then let's say that housing prices start falling, securitized subprime mortgages start plummeting in value, and your $100 million in assets are now only worth $80 million. Since the value of your debt ($90 million) hasn't changed, you are technically insolvent at this point, because your losses exceed your capital; put another way, the money coming in from your slices of mortgage pools isn't enough to pay your bondholders.

According to some observers, this is where Fannie and Freddie were until they were bailed out by the U.S. government; by certain accounting rules, they had negative capital.

Crises of confidence and bank runs

The discussion above describes how a bank can become technically insolvent - that is, their assets become worth less than their liabilities. However, since the Lehman bankruptcy on September 15, the crisis has moved into a new phase. In this phase, financial institutions are facing liquidity runs, or bank runs, whether or not they are solvent. How can this happen?

To understand this, first you have to understand the time dimension of assets and liabilities. A 30-year mortgage, for a bank, is a long-term asset. They will get a mortgage payment every month for 30 years and, most importantly, they can't call in the loan before then; that is, they can't demand that the homeowner pay it back [early]. Bank assets have different maturities, or durations, but a lot of them are medium and long term. On the other side, banks have liabilities with different maturities. For example, deposits (savings accounts) can be withdrawn at any time, so their maturity is essentially instant. Banks also issue bonds: in exchange for some money up front, the bank typically has to pay the bondholder (lender) a fixed monthly payment for some period of time, and then pay back the face value at the end of that period. Banks also engage in many more exotic forms of financing, such as repo agreements, where the bank sells a security to a counterparty for $99 and promises to buy it back for $100 some time later.

The general point, though, is that banks tend to borrow short and lend long. In the classic case, the bank takes money from depositors and loans it out as mortgages. The bank may have $100 in deposits and may lend $80 of it out as mortgages, which means it has $20 in capital and a leverage ratio (assets to capital) of just 5, which is pretty low, and it is very solvent on paper. But do you see the problem? If every depositor tries to withdraw his money at the same time, the bank can't call in its mortgages, and there won't be enough cash for everyone. Now why would this happen, since it is unlikely that everyone will need his cash at the same time? It happens if each depositor starts worrying that his or [her] money might not be safe, and that every other depositor will try to withdraw money, then everyone tries to withdraw his money at the same time.

In ordinary times, bank runs don't happen. First, the FDIC insures all deposit accounts up to $100,000 [now $250,000] per account holder, precisely to prevent this kind of panic. However, in a real bank many of the liabilities are not deposit accounts and hence are not insured. Second, banks can ordinarily borrow money "against" their assets; that is, a bank with $100 in good mortgages can borrow almost $100 from another bank - or, under certain conditions, from the Federal Reserve - by pledging those mortgages as collateral. If the bank's assets are securities - mortgage-backed securities or CDOs, for example - they can also be used to raise short-term money.

These are no ordinary times, however. The fundamental problem is that all players in the financial system have realized that a bank that is solvent (assets > liabilities) can still be subject to a bank run. Once that happens, Bank A doesn't want to lend money to Bank B for two reasons: first, Bank A wants to hold onto its cash in case it becomes the target of a bank run; and second, Bank A is afraid that Bank B could be the target of a bank run, and hence is afraid that if it lends to Bank B it won't get its money back. Like all such panics, of course, this becomes self-fulfilling: because banks don't want to lend, banks can't get short-term credit, which makes them vulnerable.

This hits home when a bank has to "roll over" its short-term liabilities. Remember, banks borrow short and lend long. So periodically - almost continuously, in fact - banks have to pay off and replace their short-term liabilities (or just agree with the lender to extend the loan another 30 or 90 days). And even though depositors are insured, all the other liabilities are not insured. The bank run happens when none of the short-term lenders want to extend their loans, and no one else is willing to offer a short-term loan.

In short, this is what has been going on during the last few weeks. The key characteristic of such a crisis is that banks can be hit by bank runs - and go bankrupt - even if their assets are worth more than their liabilities. The Fed has vastly expanded the amount of money it is willing to lend to banks and the range of collateral it is willing to take in an effort to provide the short-term funding banks need to fend off bank runs. In the longer term, though, the Fed is a relatively small player combined to the entire market for short-term credit, and the problem will not go away completely until that market is working properly again.

Credit default swaps

A credit default swap (CDS) is a form of insurance on a bond or a bond-like security. A bond is an instrument by which companies raise money. A company, say GE, issues a bond with a face value of $100 and a coupon of, say, 6%. This means that if you hold the bond, they will send you $6 per year (6% of $100) until the bond matures (say in 10 years); at that point, they will pay you $100 (the face value). To buy that bond, you pay them about $100. If you pay exactly $100, the yield is 6% ($6 divided by $100). If you pay less, the yield is more than 6%. How much the bond actually sells for depends on how risky you think GE is (the chances that they will go bankrupt and won't pay you) and on what interest rates you can get for other, similarly-risky bonds in the market. Bond-like securities, like CDOs, are similar in these basic respects.

When you buy a bond, you are taking on two types of risk: (a) interest rate risk and (b) default risk. Interest rate risk is the risk that interest rates in general will go up. If interest rates go up, the value of your bond goes down (bonds are traded in the secondary market), because you are still only getting $6 per year. Default risk is the risk that the bond issuer goes bankrupt and doesn't pay you back. A CDS is called a "swap" because you are swapping the default risk - but not the interest rate risk - to another party, the insurer. The bond holder pays an insurance premium - typically quoted in basis points, or one-hundredths of a percentage point, per year - to the insurer. In exchange, the insurer promises to pay off the bond if the issuer goes bankrupt and fails to pay it off. At the time the CDS goes into effect, the expected value of the premium payments (a small amount every year) should exactly equal the expected value of the insurance payments (a large amount, but only if the issuer defaults).

This sounds pretty simple, right? So how did CDS become a dirty word? There are two main wrinkles to be aware of.

First, in order to buy a CDS (I call the bondholder in the above example the "buyer," and the insurer the "seller"), you don't actually have to own the bond in question. These are over-the-counter derivative contracts, which means they are individually negotiated between buyers and sellers. As a result, CDS became the tool of choice for betting on the likelihood of a company going bankrupt. If you thought the chances of company A going bankrupt were higher than everyone else thought they were, you would buy a CDS on company A. Three months later, when everyone else realized company A was in trouble, the market prices for CDS would have gone up, and you could either sell your CDS to someone else at the higher price, or you could sell a new CDS at the higher price. (In the latter case, you still have your original contract, and you [write] a new contract with a new buyer.) As a result, there are a lot of CDS out there; estimates are generally around $60 trillion, which means the total face value of the bonds insured is $60 trillion.

Second, CDS are not regulated, and in fact there was a measure inserted into an appropriations bill in December 2000 that blocked any agency from regulating them. Traditional insurance, by contrast, is highly regulated. Insurers have to maintain specific capital levels based on the amount of insurance they have sold; certain percentages of their assets have to be investments of specified quality levels; and, for personal insurance and workers' compensation at least, private insurance companies are generally backed up by state guarantee funds, which charge a percentage of all insurance premiums and, in exchange, pay off claims for bankrupt insurers. The CDS market had none of that, so a bank could sell as many CDS as it wanted and invest the money in anything it wanted.

So, 2008 rolled around, and bonds started going bad. There were CDS not just for traditional corporate debt, but also for mortgage-backed securities, CDOs, and secondary CDOs. During the boom, when everyone was optimistic, CDS for these exotic products were cheap; when they started failing, the price of CDS shot up, and anyone who had sold these swaps was looking at losses on them. So CDS were one way that losses on subprime mortgages triggered writedowns at other financial institutions. This only got worse as banks, such as Bear Stearns and Lehman, started failing, and people who had sold CDS on their debt faced even larger losses. So the most basic problem with CDS is that the insurers selling them (and many of the companies selling them were not insurance companies) sold them at excessively low prices, and now they are facing major losses.

Second, you have the risk that the insurance companies won't be able to pay. If a financial institution - say, AIG - sold a lot of CDS based on the debt of a particular company - say, Lehman - there is a risk that it won't be able to honor all of those swap contracts. In that case, their counterparties - other banks - may be looking at losses they thought they were insured against. If Bank B bought a CDS from Bank C on the debt of Company X, and Company X defaults, Bank B thinks it has a payment coming to it from Bank C; but if Bank C doesn't have the cash, Bank B won't get its payment. Even worse, let's say Bank B bought a CDS from Bank C, and then sold a different one to Bank A. Bank B thinks it is perfectly hedged, and Bank A thinks it has a payment coming. But if Bank C can't pay out, Bank B may not be able to pay Bank A - and these chains can go on and on and on. So CDS are one of the things that create uncertainty in the banking sector; a bank may look healthy, but it may be counting on CDS payouts from other banks that you can't see, so you can't be sure it's healthy, so you won't lend to it.

The cumulative effect of CDS is to spread risk, which sounds good, but to spread risk in unpredictable and invisible ways. One of the major reasons why the government refused to let AIG fail - one day after letting Lehman fail - was that AIG was a large net seller of CDS, and if it had defaulted on those swaps no one could predict what the implications would be for the rest of the financial sector. At this point in the financial crisis, it would be a mistake to blame the whole thing on CDS, but they have had the effect of amplifying and spreading uncertainty in ways that have reduced confidence in the financial sector.

Stock market vs. credit market

Fears of a global economic slowdown are reflected in the stock market. Stocks are claims on the future cash flow of companies, and companies do better during economic growth periods than during recessions. When sentiment shifts from the belief that we will see a short, mild recession to the belief that we will see a long, harsh recession, the stock market goes down. By contrast, the acute credit crunch is reflected in the credit market in the record-high prices that banks are charging to lend to each other and to ordinary companies.

Although you and I and most people with investments have more money in the stock market than in the credit market, the stock market is more a gauge of sentiment than an independent force in the economy. Lower stock prices make it more expensive for companies to raise equity capital, but most companies raise more money by issuing debt than by issuing stock. And when people's investments go down, they tend to spend less, but only a little; if their 401(k) goes down by $10,000, they don't cut back on spending by $10,000. The credit markets, by contrast, have direct and immediate effects on how companies behave; in an extreme case, no credit can mean no cash with which to make payroll.

Now the credit and stock markets are related, because when the credit market freezes up, people's expectations about the future turn downward, and hence stock prices fall. Ironically, all the attention the credit crisis has gotten over the last three weeks has undoubtedly hurt stock prices because of all the talk about potential dire consequences. So in this context, what does the fall in the stock market mean? Probably two things. First, people are only beginning to realize that Europe is in big trouble - given its difficulty in coming up with coordinated economic policy, perhaps bigger trouble than the U.S. Because U.S. companies operate in a global economy, that will hurt all companies. Second, it means that more people are realizing that the Paulson plan is only a partial solution, which is something we (along with many other people) have been saying for a while.

As long as the credit market remains tight, fears of recession will remain high, and stock prices will suffer. The important question is when the credit market will loosen up. Right now it looks like there are still enough open issues with the Paulson plan (what price, which securities, how fast) that lenders are still waiting and seeing. In the long term, though, the stock market will only turn up when people believe there is a credible plan for fighting the recession in the real economy. END QUOTE

I hope the information in this SPECIAL ISSUE of Forecasts & Trends E-Letter has been helpful to you in better understanding the global credit crisis we are in. Feel free to forward and share with others as you see fit.

My thanks to the folks at BaselineScenario.com. As noted at the beginning, since their website is also a blog, I would suggest that you visit there at least occasionally to keep up with their latest thinking on the global credit crisis.

Wishing you better times,

Gary D. Halbert

Might Uncle Sam Make Money On The Bailout?

Gary D. Halbert — Tue, 30 Sep 2008 19:36:00 GMT

IN THIS ISSUE:

The Latest $700 Billion Bailout Package
What Could Go Wrong? Potentially A Lot
What Could Go Right, If We're Lucky?
What Would Happen To The Profits, If Any?
A "Main Street" Backlash To Come?

Introduction

Like it or not, members of the House and Senate, with the approval of President Bush and both Senators McCain and Obama, reached a final agreement on the massive $700 billion mortgage bailout package over the weekend, with the much-awaited announcement on Sunday afternoon. Yet on Monday, the bailout bill failed to pass in the House of Representatives. As this is written, is not certain what will happen next. The next action probably doesn't happen until Thursday.

Assuming the latest rescue package (or some version of it) passes both houses of Congress, which is a real stretch at this point, it will give President Bush, Treasury Secretary Paulson and Fed Chairman Bernanke most of what they asked for. I'll discuss the details below.

Most Americans do NOT like the latest huge government bailout of Wall Street banks, brokers, etc. Some polls late last week and over the weekend suggested that 65-75% of Americans opposed the bailout. I can understand why, especially with millions of American families struggling to make their monthly mortgage payments.

One reason for this anger over the bailout is the widespread perception that the $700 billion (or whatever the number turns out to be) is money down a rat hole that the government and taxpayers will never see again. While there are numerous risks in the bailout, the odds seem low that the government will lose all or even most of the bailout money. I will discuss some of the main risks to the bailout as we go along.

Interestingly, there is a growing number of intelligent folks in the financial world that believe the government could actually make a lot of money on this huge bailout effort, especially if they play their cards correctly. As I will discuss below, some respected analysts believe the government could net $1 trillion or more off of its investment of $700 billion.

Don't count me among this group, however. While I would concede that there may be some potential upside in this massive bailout program, we have to keep in mind that it's the government, after all, that will be running the enormous and complicated operation. The government is not known for making money, especially in complex financial dealings.

In any event, I do believe that if more Americans understood there is the potential to get most or maybe even all of the bailout money back, they might not be quite so angry about the deal. We'll talk about all of this as we go along this week.

The Latest $700 Billion Bailout Package

As discussed at length in last week's E-Letter, the massive rescue package floated by President Bush, Treasury Secretary Paulson and Fed Chairman Bernanke on September 19 was fraught with problems. That plan would have us turn over $700 billion to the Treasury Secretary with no oversight, no transparency, no accountability and no legal challenge in the courts.

There was no chance that package was going to pass, as I pointed out last week. Yet over the ensuing week, all parties rolled up their sleeves, put in very long hours, made compromises on both sides of the aisle and came up with a much better rescue plan by last Sunday. Whether we like it or not, here is an overview of the latest massive bailout plan as we now understand it.

Doling the money out: The $700 billion would be disbursed in stages, with $250 billion made available immediately for the Treasury's use. More would be made available as needed. Authority to use the money would expire on Dec. 31, 2009, unless Congress certifies a one-year extension.

Overseeing the program:The bill would establish two oversight boards. A new Financial Stability Oversight Board would be charged with ensuring that the policies implemented protect taxpayers and are in the economic interests of the United States. The oversight board would include the Federal Reserve Chairman, the Securities and Exchange Commission Chairman, the Federal Home Finance Agency Director, the Housing and Urban Development Secretary and the Treasury Secretary.

Second, a congressional oversight panel would be charged with reviewing the state of financial markets, the regulatory system and the Treasury's use of its authority under the rescue plan. Sitting on the panel would be five outside experts appointed by House and Senate leaders.

Insuring against losses:The Treasury would establish an insurance program - with risk-based premiums paid by the industry - to guarantee certain of the companies' troubled assets, including mortgage-backed securities purchased before March 14, 2008. The amount the Treasury would spend to cover losses minus company-paid premiums would come out of the $700 billion the Treasury is allowed to use for the rescue plan.

Protecting taxpayers: One provision requires the President to propose legislation to recoup losses from the financial industry if the rescue plan results in net losses to taxpayers five years after the plan is enacted. In addition, Treasury would be allowed to take ownership stakes in participating companies.

Limiting executive pay: Curbs would be placed on the compensation of executives at companies that sell mortgage assets to the Treasury. Among them, companies that participate will not be able to deduct the salary they pay to executives above $500,000. They also will not be allowed to write new contracts that allow for "golden parachutes" for their top five executives if they are fired or the company goes under. However, the executives' current contracts, which may include golden parachutes, would still stand.

Like it or not, these are the highlights of the latest proposed massive government bailout of troubled financial institutions which may yet be signed into law this week. While leaders of Congress praised themselves for acting quickly, it is indeed a very sad time for America.

What Could Go Wrong - Potentially A Lot

Let's be clear from the outset: this is the largest and most complex financial rescue plan in history. Given that fact, some argue that Treasury Secretary Hank Paulson is the right man for the job. Paulson was Chairman and CEO of investment banking giant Goldman Sachs from 1999 to June 2006 when be became Treasury Secretary. While Paulson may be very qualified to head-up this massive financial operation, we must keep in mind that the rescue plan will hardly be off the ground by January 20 when the new administration takes over.

Perhaps the new president will keep him on, but there's no guarantee. So, leadership of this massive, complex operation is a big, big question mark as we begin our summary of the possible risks and problems.

The next fundamental risk is this: the banks, brokerages and others will be trying to unload the worst of the worst of their mortgage-backed securities on the government for the best possible price. The question is, will the government pay too much?

The mortgage-backed securities (MBSs) that the Treasury will buy from the various financial institutions that hold them are in many cases very complicated instruments. Space does not permit a discussion of all the intricacies and the various combinations and mutations of these complex packages of MBSs (not to mention that I don't fully understand them all myself).

Suffice it to say that even the supposedly brilliant minds of Wall Street cannot determine how to value many of these securities today, so why should we think that government bureaucrats will know how to value them correctly? Why would we not assume that the Wall Street banks and brokers will convince Treasury to pay more than the securities are really worth?

And as I discussed briefly last week, the government has some incentive to pay more than these assets are really worth. After all, the supposed purpose of this massive bailout is to allow the banks and other financial institutions to recapitalize and resume lending and unfreeze the credit markets. If the government buys these MBSs at even further discounted prices, the banks would have to book even more losses, and more banks would fail.

The thinking is that since Uncle Sam has the deep pockets and the ability to hold these securities for a long time, it can pay the banks somewhat more than today's crisis values, thus allowing them to recapitalize. Presumably, the government can hold the mortgage securities long enough for them to recover and make at least a decent profit on some of them. That remains to be seen, of course.

I think we can all agree that the government has the deep pockets, at least as long as the world is willing to buy our Treasury bills, notes and bonds. But my question is whether the Treasury, the Congress (and the public for that matter) will have the patience to hold these distressed securities, potentially for years for them to recover. Or will there be pressure on the Treasury to dump these securities prematurely?

Patience is not a commodity that is in heavy supply in today's debt-laden, entitlement-oriented society in America. Baby Boomers need a renewed bull market in stocks to fund their retirement, which may be postponed due to this massive pool of MBSs hanging over the market.

Bottom line: if the Treasury is pressured into unloading these mortgage-backed securities before the economy and the debt markets have recovered, then we should expect to incur potentially huge losses and possibly yet another credit crisis.

Next, there is the question of how will the Treasury determine which banks and other financial firms get to participate in the bailout, especially in the first $250 billion tranche (assuming that is the final deal). One possible mechanism that has been discussed by Paulson and others is a "reverse auction." However, a traditional reverse auction may not be effective in this situation where the government is not necessarily looking to purchase the MBSs at the lowest possible price. The objective of the enormous bailout is not to drive more financial firms out of business, but to help them recapitalize, stay in business and resume normal lending.

Another tricky part of determining which banks and financial firms get to unload their bad debt is as follows. As noted earlier, everyone will likely try to unload the worst of the worst MBSs on the government. Some firms that are in better shape and have limited MBSs may be in a position to take less for them just to get them off their books, whereas firms that have much higher exposure to MBSs could yet go out of business were they to unload their toxic positions at further discounted prices.

The bottom line is, the process for determining which firms get to unload these securities, and at what prices, will be extremely complicated and risky. A lot could go very wrong.

The discussion just above is by no means a comprehensive summary of the possible risks to this massive mortgage bailout. In fact, it is overly general, but I think you get the idea that we are far from out of the financial crisis, even if the massive bailout becomes law later this week.

What Could Go Right, If We Are Lucky

As noted in the Introduction, there are some very smart people that believe the government could actually make a profit on the bailout, perhaps a lot of money if managed effectively. Bill Gross is one of the most highly respected money managers and financial writers around. He is the portfolio manager for the largest bond mutual fund in the world, PIMCO's Total Return Fund. He is also the author of two very popular books on investing.

Last Wednesday, Bill penned an editorial in the Washington Post in which he made it known that he was in favor of some form of the government rescue plan that was being debated in Congress last week. Furthermore, he made it clear that he believes the government could make a lot of money on the mortgage-related assets the Treasury intends to buy. He said of the bailout plan:

"The extreme measures [needed] are extended government guarantees and the formation of an RTC-like holding company housed within the Treasury. Critics call this a bailout of Wall Street; in fact, it is anything but. I estimate the average price of distressed mortgages that pass from ‘troubled financial institutions' to the Treasury at auction will be 65 cents on the dollar, representing a loss of one-third of the original purchase price to the seller, and a prospective yield of 10 to 15 percent to the Treasury. Financed at 3 to 4 percent via the sale of Treasury bonds, the Treasury will therefore be in a position to earn a positive carry or yield spread of at least 7 to 8 percent.

Calls for appropriate oversight of this auction process are more than justified. There are disinterested firms, some not even based on Wall Street, with the expertise to evaluate these complicated pools of mortgages and other assets to assure taxpayers that their money is being wisely invested. My estimate of double-digit returns assumes lengthy ownership of the assets and is in turn dependent on the level of home foreclosures, but this program is, in fact, directed to prevent just that…

Today, the purchase of junk mortgages, securitized credit card receivables and even student loans will be bought at prices significantly below ‘par' or cost, and prospectively at levels allowing for capital gains. This is a Wall Street-friendly package only to the extent that it frees up funds for future loans and economic growth… The Treasury proposal will not be a bailout of Wall Street but a rescue of Main Street, as lending capacity and confidence is restored to our banks and the delicate balance between production and finance is given a chance to work its magic."

So, Bill believes the government should be able to make 10-15% on average on the distressed mortgage and related securities it purchases – IF the massive operation is managed well. Interestingly, it was reported in the media late last week that Bill offered to manage the government-owned mortgage/securities portfolio himself for free. Who knows if this offer is for real, but PIMCO manages over $825 billion in assets now, an amount similar to the size of the proposed bailout, so…. Hank, are you listening?

The next example of a savvy market maven who thinks the government could make some serious dough on the bailout package is Andy Kessler. Andy is a former hedge fund manager who made his claim to fame by reportedly taking $100 million in his fund's assets in 1996 to $1 billion by 2001. He has since written several popular books on investing and business.

Andy believes the government could make far more money on this mortgage rescue package than Bill Gross envisions. Here are excerpts of what Andy offered up last Thursday in his latest Wall Street Journal editorial (emphasis added):

"There is a saying on Wall Street that goes, ‘The market can stay irrational longer than you can stay solvent.' Long Term Capital Management learned this lesson 10 years ago when it got its portfolio picked off by Wall Street as its short-term financing dried up. I had thought the opposite -- hedge funds picking off Wall Street -- would happen today. But in a weird twist, it's the government that is set up to win the prize.

Here's how: As short-term financing dried up, Fannie Mae and Freddie Mac's deteriorating financials threatened to trigger some $1.4 trillion in credit default swap payments that no one, including giant insurer AIG, had the capital to make good on. So Treasury Secretary Henry Paulson put Fannie and Freddie into conservatorship. This removed any short-term financing hassle. He also put up $85 billion in loan guarantees to AIG in exchange for 80% of the company.

Taxpayers will get their money back on AIG. My models suggest that Fannie and Freddie, on the other hand, are a gold mine. For $2 billion in cash up front and some $200 billion in loan guarantees so far, the U.S. government now controls $5.4 trillion in mortgages and mortgage guarantees.

Fannie and Freddie each own around $800 million in mortgage loans, some of them already at discounted values. They also guarantee the credit-worthiness of another $2.2 trillion and $1.6 trillion in mortgage-backed securities. Held to maturity, they may be worth a lot more than Mr. Paulson paid for them. They're called distressed securities for a reason.

Now Mr. Paulson is pitching Congress for $700 billion or more to buy distressed loans and CDOs [Collateralized Debt Obligations] from the rest of Wall Street, injecting needed cash onto balance sheets so that normal loans for economic activity can be restored. The trick is what price he will pay. Better mortgages and CDOs are selling for 70 cents on the dollar. But many are seriously distressed (15-25 cents on the dollar) because they are the last to be paid in foreclosures. These are what Wall Street wants to unload the quickest.

Firms will haggle, but eventually cave -- they need the cash. I am figuring Mr. Paulson could wind up buying more than$2 trillion in notional value loans and home equity and CDOs for his $700 billion...

It's not without risk, but the Feds, with lots of levers, can and will pump capital into the U.S. economy to get it moving again. Future heads of Treasury and the Federal Reserve will be growth advocates… This is a huge change. Plus, a stronger U.S. economy, with its financial players having clean balance sheets,[the U.S.] will become a safe haven for capital...

You can slice the numbers a lot of different ways. My calculations, which assume 50% impairment on subprime loans, suggest it is possible, all in, for this portfolio to generate between $1 trillion and $2.2 trillion -- the greatest trade ever. Every hedge-fund manager will be jealous. Mr. Buffett is buying a small piece of the trade via his Goldman Sachs investment.

Over 10 years this could change the budget scenario in D.C., which can also strengthen the dollar. The next president gets a heck of a windfall. In the spirit of Secretary of State William Seward's purchase of Alaska for $7 million in 1867, this week may be remembered as Paulson's Folly."

What exactly does this mean? Kessler believes that the Treasury will recover at least $1 trillion off of the investment of $700 billion – even with some of the mortgage securities fetching zero – and quite possibly as much as $2.2 trillion. Only if the operation is bungled should the government lose a dime, so Kessler believes.

Finally, I'm seeing more and more analysts come to increasingly positive conclusions about how the government ought to be able to make money – and not lose money – on this massive mortgage rescue package.

As for me, I'm not drinking the kool-aid just yet, but then again, I'm willing to admit that there's potential if a lot of things happen right. But a lot could go wrong as well. We are talking about the government after all, and one that may well be controlled by a liberal Congress and a liberal president for the next four-to-eight years. So I would not bet a dime that this massive bailout will end up being profitable. On the other hand, I do hope that it will.

What Would Happen To The Profits, If Any?

No doubt we will all rejoice if the $700 billion bailout reaps some big profits in the next 5-10 years (not that I am convinced, of course). As thoughts of some sizeable profits have become the talk of the town in recent days, questions have arisen as to what the government would do with the windfall should it happen.

Would Uncle Sam issue checks directly to the taxpayers? Not hardly! That would be seen as a tax cut, when in fact the taxpayers never had to loan the government any money directly to fund this massive $700 billion bailout.

Some intelligent observers have suggested that the government could use the potential profits from the giant bailout to pay down the national debt. This is precisely what Andy Kessler refers to above when he writes: "Over 10 years this could change the budget scenario in D.C." He is suggesting that the government could use the profit he projects (up to $1.5 trillion) to pay down the national debt.

Others have suggested that the potential bailout windfall could be used to help shore-up Social Security and/or Medicare. A trillion dollars, they suggest, could go a long way toward keeping these giant entitlement programs solvent in the years ahead.

That's a nice idea, assuming such a windfall profit actually occurs. But even if you assume that there will be some large profits some years down the road on this huge bailout, which I don't, what do you think Congress and the Administration in power at the time will do with the money? Three guesses, and the first two don't count.

They will spend it and delight in doing so. They will not send us a check or even cut taxes. They will not pay down the national debt. They will see it as a green light to increase the budget and thus the size of government. Just keep this in mind in a few years – if there are any profits to be dealt with.

Thus, I would insist that there should be clear language in the bailout bill, assuming one passes, that specifies exactly what would be done with any profits that might result from it. Yet that is not likely to happen.

A "Main Street" Backlash To Come?

As noted earlier, some polls over the last two weeks suggested that two-thirds to three-fourths of Americans were opposed to the Wall Street bailout. Clearly, millions of Americans are downright angry about it. A few polls indicated that the numbers were not as negative as 65-75% opposed, but clearly there are far more Americans who oppose the bailout than are remotely in favor.

This indeed raises the question of whether there will be a Main Street backlash if the $700 billion bailout is voted into law. Clearly, millions of Americans see this massive bailout as nothing more than the government's willingness to spend historic amounts of taxpayer money to bail out the Fat Cats on Wall Street.

Along this line, let me remind you of something I wrote last week: "the current financial crisis and the enormous $700+ billion government bailout virtually assure that, if elected: 1) Obama will not be able to push through his aggressive spending plans; and 2) McCain will not be able to push through any tax cuts. Realistically, the money for either of these proposals is no longer there."

Let there be no mistake, millions of Americans have been counting on the promises made by these two candidates. Most of Obama's supporters have bought into his promises of wide sweeping social reform, including nationalized health care, lower taxes on the middle class, and higher taxes on those making $250,000 or more a year. Likewise, many McCain supporters are banking on him extending the Bush tax cuts and other tax cuts he has promised.

If sound fiscal minds prevail, in light of the latest $700 billion spending bailout, neither candidate will be able to pursue these campaign promises. If people are angry today, they are likely to get even angrier in the months and years ahead. Why?

Despite the dire warnings of financial calamity from the White House, the Treasury Secretary, the Fed Chairman and some high-profile business leaders, much of Middle America wasn't buying the story that their own livelihoods were linked to the fate of the rescue package. Instead, average workers read the plan as the big guys in Congress bailing out their friends on Wall Street.

A majority of Americans didn't want Congress to use taxpayer dollars to bail out financial institutions, even if their collapse meant a rocky ride for investors in the stock market. A few congressmen and women admitted publicly that their calls from constituents were running as high as 100-to-one against the bailout plan.

Never mind that the collapse of Wall Street will almost certainly result in a recession, or worse, that will affect virtually all Americans. Never mind that the credit markets have seized up, and that lending for such things as home mortgages had ground to a virtual halt. Never mind that credit card spending may actually be at risk next.

I am reminded of the 1970s the movie "Network" which featured a news anchor who lost control and exclaimed, "I'm mad as hell and I'm not going to take it any more." I think that many in our country today have similar feelings, and no one knows at this point exactly what the eventual consequences will be.

Will there be a major backlash against the big Wall Street banks, brokers and others? Will Americans opt to move their money and their business to local banks that never participated in subprime mortgages, CDOs and other complicated mortgage backed securities? Will they move their investments from the Merrill Lynches of the world to local investment firms?

In my opinion, this suggests that big banks, big brokerage firms and multi-million dollar executive big bonuses may be in big trouble. We may well see a return to local community banks, many of which are in fine shape and have no subprime/MBS exposure at all. Local investment firms, financial planners and the like may benefit from a migration from "big box" brokerage/investment firms that were big players in toxic mortgage securities and still paid their CEOs and top execs multi-million dollar bonuses.

Unfortunately, we'll also likely see a move toward populist political candidates, who are far less friendly to big business – that being the Democrats. For example, Senator Obama has seen a big bounce in the polls over the last two weeks as the credit crisis worsened and the massive bailout was concocted.

If there is a further trend toward populist politicians, that will mean more spending and higher taxes, which will be bad for our economy over the long-term. But then, that's a subject for another E-Letter.

Very best regards,

Gary D. Halbert

SPECIAL ARTICLES

The Bailout Defeat: A Political Credibility Crisis
http://www.time.com/time/nation/article/0,8599,1845655,00.html

ACORN, Obama and the Mortgage Mess (what, you didn't hear about this?)
http://www.realclearpolitics.com/articles/2008/09/acorn_obama_and_the_mortgage_m.html

Congress lives up to its abysmal approval rating.
http://online.wsj.com/article/SB122273257698488295.html

What Goes Before a Fall? On Wall Street, Reassurance
http://www.nytimes.com/2008/09/30/business/30sorkin.html?_r=3&ref=business&oref=slogin&oref=slogin&oref=slogin

Uncle Sam's $700+ Billion Toxic Securities Fund

Gary D. Halbert — Tue, 23 Sep 2008 20:03:55 GMT

IN THIS ISSUE:

Details Of The Massive $700 Billion Bailout
Government Guarantees Money Market Funds
Will Congress Pass The Bailout Plan?
Should The Government Bail Out Homeowners?
Will Uncle Sam Overpay For The Assets?
Credit Crisis May Tip The Election To Obama
Time To Prepare For A Recession Just Ahead

Introduction

By now, everyone reading this is well aware that the Bush Administration, the Treasury Department and the Federal Reserve Bank are pushing Congress to quickly approve a gargantuan $700+ billion bailout plan, with the hope of saving large banks, investment firms and other financial institutions that are overloaded with troubled mortgage-related securities.

This is by far the largest financial rescue plan ever envisioned on the part of the government, and I would argue, by far the most risky – both in terms of the potential losses for American taxpayers, and in terms of the sweeping, unchallengeable powers it would grant to the government. I will have more to say about the latter in the pages that follow.

Three questions emerge: 1) Is this massive bailout necessary?; 2) Is it the best way to solve the credit crisis?; and 3) Will it work? Unfortunately, the answer to all three is, we just don't know.

I believe that Treasury Secretary Paulson and Fed Chairman Bernanke were correct last week to fear that we were headed for a potentially serious run on banks and money market funds, starting possibly as early as this week, had the carnage in the markets continued. Whether you agree or disagree with the bailout, I think Paulson and Bernanke believed they had no other choice.

Of course, it remains to be seen if Congress will pass the colossal $700+ billion bailout this week as Bush, Paulson and Bernanke are urging. The stock markets that plunged lower early last week reversed their losses late in the week as rumors of the huge bailout package surfaced, culminating with the official announcement on Friday.

Yet on Monday of this week, the stock markets plunged again amid fears that Congress may not go along with the government's massive bailout plan. As this is written, it is impossible to know what will happen. But what is clear is that the US financial markets have frozen up, and if something significant isn't done soon, I believe we will be headed for a stock market crash and a serious recession or worse.

Finally, there will be millions of Americans who do not understand the dire implications of this financial meltdown, and will assume that this is just another massive bailout of the Wall Street rich by the Bush Administration and the Republicans (McCain included). Therefore, I expect this latest crisis and enormous bailout will likely hand the election to Barack Obama.

There are so many ramifications of this massive bailout that I don't even know where to start. But start we must, so here we go.

Details Of The Massive $700 Billion Bailout

We are told that the government's proposed $700 billion bailout may be structured along the lines of the Resolution Trust Corporation ("RTC") established in 1989 to liquidate the assets of failed Savings & Loans. But there is one distinct difference this time around. In 1989, the RTC was formed to take over assets of S&Ls that had already gone into bankruptcy.

This time, should the massive Treasury bailout (or something like it) be passed, the government will be taking over toxic assets of financial institutions that still survive, but are at risk of failure due to the mortgage related securities they hold. Here are the details of the massive government bailout plan, at least as we know at this point.

Under the proposal (the "Act") submitted to Congress on Saturday, the Treasury Secretary would be authorized to purchase mortgage-related assets from any financial institution having its headquarters in the United States, totaling up to $700 billion at any given time. On Monday, the government expanded the bailout to include foreign corporations with "significant operations" in the US that bought mortgage related securities.

The term "mortgage-related assets" is defined in the Act as: "residential or commercial mortgages and any securities, obligations, or other instruments that are based on or related to such mortgages, that in each case was originated or issued on or before September 17, 2008."

If the bailout passes in its proposed form, the Treasury Secretary would be authorized to take wide-sweeping actions at his sole discretion.

Such actions include: 1) designating financial institutions as "financial agents" of the government, and requiring them to perform duties related to the Act as the government may require of them; 2) creating agencies to carry out the bailout and appointing such employees as may be required to carry out the authorities in the Act and defining their duties; and 3) issuing such regulations and other guidance that may be necessary to carry out the authorities of the Act.

Such actions also include: The Secretary shall have authority to manage mortgage-related assets purchased under the Act, including revenues and portfolio risks. The Secretary may, at any time at his discretion, sell or enter into securities loans, repurchase transactions or other financial transactions in regard to any mortgage-related asset purchased under the Act.

In short, the Treasury Secretary would have complete control of how the massive bailout effort is undertaken. The Act states: "The Secretary may, at any time, exercise any rights received in connection with mortgage-related assets purchased under this Act."

The only requirement under the proposal sent to lawmakers on Saturday is that the Treasury Secretary must report to Congress within three months of the first exercise of the authority granted in the Act and only semi-annually thereafter. Wow! $700 billion, and you only have to report to Congress twice a year!! But that is not likely to stand.

Over the weekend, Democratic leaders discussed enhancing oversight by carving out a special monitoring role for the Government Accountability Office (GAO), the investigative arm of Congress. The Republican leadership echoed similar wishes for tougher scrutiny, suggesting the creation of a congressional oversight panel, headed by top leaders in both parties.

Oversight, or lack thereof not withstanding, there was another bombshell in the rescue package. The bailout proposal sent to Congress on Saturday states the following: "Decisions by the [Treasury] Secretary pursuant to the authority of this Act are non-reviewable and committed to agency discretion, and may not be reviewed by any court of law or any administrative agency."

This provision, if it stands, would mean that the Treasury bailout would be beyond the rule of law, both as it relates to the current Treasury Secretary and the next one appointed by McCain or Obama. Obviously, this provision was included to protect against potentially unlimited challenges in the courts which could stall or prohibit the rescue efforts. This is very troubling.

While the brief summary above is not comprehensive, it should give you an idea of the enormity of the latest massive plan to rescue financial institutions to the tune of at least $700 billion – actually much more as I will discuss later on.

We will continue our discussion of the bailout plan below, but first here's the latest on the money market fund developments.

Government Guarantees Money Market Funds

I trust that virtually everyone reading this E-Letter has some assets in money market funds. As you probably know, the turmoil in the financial markets spilled over into the supposedly safe money market mutual funds last week. Last Tuesday, one of the oldest and largest institutional money market funds, the Reserve Primary Fund, announced that its share price had fallen below the $1.00 level to 97 cents. In financial terms, it "broke the buck."

The Reserve Primary Fund dipped below $1.00 as a result of the bankruptcy of Lehman Brothers. The Reserve Primary Fund, with over $62 billion in assets, announced last week that it owned $785 million in Lehman bonds, and that it was writing those bonds down to zero, which effectively caused its share price to break the buck. Redemptions were halted.

Also, last week Putnam Investments closed an institutional money market fund and said it will return money to clients, after investors pulled out cash despite the fund's lack of exposure to troubled financial firms such as Lehman.

To shore up investor confidence, the Treasury Department announced plans Friday to insure and guarantee US money market funds.

President Bush authorized the Treasury to tap up to $50 billion from a Depression-era fund to insure the holdings of eligible money market mutual funds. And the Federal Reserve announced it will expand its emergency lending program to help support the apprx. $3.5 trillion in assets in US money market funds.

The government guarantee will be in place for at least one year. Money market funds will pay a fee to be in the insurance program. So for now, at least, your money in money market funds is as safe as if it were in a FDIC insured bank. Note, however, that the Treasury pronouncement on the money market funds guarantee stated that the insurance only applies to money that was on deposit with such funds on or before September 19. Money deposited after September 19 is apparently not covered by the guarantee.

Now back to the $700 billion mortgage bailout.

Will Congress Pass The Bailout Plan?

As noted in the Introduction, the stock markets surged higher late last week as news of the massive bailout plan surfaced, reversing all or most of the huge losses incurred early last week. But then the nation had the weekend to think about the enormous bailout plan, and whether or not the Congress would go along with the gigantic intervention.

The House of Representatives and the Senate are both controlled by the Democrats. While I believe there is a sufficient sense of urgency regarding the passage of some kind of large bailout plan, I will not be surprised if the Democrats, along with some Republicans as well, will not approve the rescue package. I believe that is precisely why the stock markets tanked again on Monday.

As this is written, several prominent Democrats are insisting that such a bailout must be accompanied by increased regulation and oversight. Certainly everyone would agree that the regulation of our financial markets is sorely overdue for an overhaul. But as Treasury Secretary Paulson made clear over the weekend, he believes the funding of the huge bailout package needs to happen NOW, whereas the regulatory changes will take time to implement.

Over the weekend, Democrats and some Republicans also complained that the proposed $700 billion bailout does little to help homeowners that are struggling to make their mortgage payments. It is very possible that lawmakers will tack on additional hundreds of billions of dollars to the already enormous rescue package that would go directly to homeowners who may be facing foreclosure.

Some Democrats, including Barack Obama, are arguing that the rescue package must include restrictions on the compensation of corporate executives of companies that make use of the rescue program to unload toxic mortgage securities on the government. On Monday, even John McCain suggested that the top executives of companies seeking to participate in the bailout should not make more than $400,000 a year (no more than President Bush's salary).

Some Democrats, including Senators Chris Dodd (D-CN) and Chuck Schumer (D-NY), are pushing for more egregious changes in US bankruptcy laws regarding home foreclosures. The proposal that Dodd has sent to Treasury Secretary Paulson would let bankruptcy judges modify the mortgages of homeowners facing foreclosure to allow them to keep their homes. Judges rewriting existing mortgages so people can stay in their homes? This is scary!

Some Democrats, including Barack Obama, are arguing that the rescue package must include a second economic stimulus package of up to $100 billion, following the $160 billion sent out earlier this year.

Then there is always the risk that Congress will load the already huge bailout legislation with billions more in "earmarks." It would not surprise me if the final bill easily surpasses $1 trillion if it is actually passed, which is looking increasingly uncertain. In that case, one can only wonder if President Bush will sign it.

So, it remains to be seen if the massive bailout Act, or something like it, is passed or not. Based on the stock market plunge on Monday, and the rhetoric coming out of the Senate banking hearings this morning, I would say the odds are no better than 50/50 for passage. If that is the case, look for the stock markets to continue to tank. Something serious needs to happen soon.

Should The Government Bail Out Homeowners?

As discussed above, many Democrats and some Republicans are arguing that, as a part of the government bailout, something should be done to help homeowners who are struggling to make their mortgage payments. In particular, many in Congress want to minimize the effect on homeowners who financed their homes with subprime and other non-traditional mortgages.

Never mind that many of these families should never have been given a mortgage due to their credit history or employment (or unemployment) situation in the first place. Most of us have heard the term NINJA loans: No Income, No Job or Assets. We also heard about the so-called LIAR loans where mortgage applicants purposely lied about their financial condition to buy a house.

Of course, in the spirit of political correctness, the government has now identified families who lied on their applications to get a mortgage as "victims." Thus, while many moan and groan about the lack of moral hazard in relation to the Wall Street bigwigs who wanted to make money, no one seems to want to hold individuals responsible for lying on their applications.

Instead, as John McCain ridiculously claimed last week, they were "forced" to take these mortgages. Give me a break! While many mortgage lenders were clearly too aggressive in offering home loans, no one forced borrowers to take out these loans. Let's get real.

It is clear now that the Democrats who run Congress are going to insist that additional billions be added to the bailout plan that will help out homeowners who are having a hard time making their mortgage payments, with little regard to whether they lied about their financial condition when they applied. If so, the bailout plan could be substantially higher than the $700 billion the Treasury asked for – if it is passed at all.

In fact, if we consider what has already been spent on the mortgage crisis, the total may be well above $1 trillion already, assuming that Congress passes the $700 billion rescue package this week, plus whatever amounts they add to it.

Will Uncle Sam Overpay For The Assets?

Treasury Secretary Paulson made the rounds on the Sunday talk shows, pushing the $700 billion bailout plan, and urging lawmakers to pass it this week before they adjourn. One thing Secretary Paulson did not make clear was how the government would value the mortgage-related assets that it would purchase from those wishing to participate in the program.

A Treasury pronouncement released on Saturday made the following statements about pricing: "Treasury will have authority to issue up to $700 billion of Treasury securities to finance the purchase of troubled assets… The timing and scale of any purchases will be at the discretion of Treasury and its agents, subject to this total cap. The price of assets purchases will be established through market mechanisms where possible, such as reverse auctions."

The problem is, there's no liquid market for subprime mortgages and other mortgage-backed securities that have dragged down banks and investment firms. With no trading in the assets, no one knows what they are worth now or might be worth in the future. They are being carried on institutions' books with values based on various indexes that are in some cases little more than guesses. And as those indexes have gone down, the institutions have recorded huge losses.

Furthermore, some of the instruments are complex, opaque derivatives tied to slices of other derivatives and financed by the sale of credit-default swaps to hedge funds and a variety of buyers. How do you price something like that? 80 cents on the dollar, 20 cents on the dollar, or somewhere in between? Who knows?

The government is, in some respects, constrained in driving a hard bargain because the whole point of the rescue program is to help banks get back on solid footing - not to force them into much deeper write-downs, potentially exacerbating their problems staying afloat. At the same time, the market turmoil has complicated efforts to determine the "real" value of the assets.

Obviously, it is too early for the Treasury to have all these details worked out. Suffice it to say that it will be a complicated process that will have serious implications, not only for the government and the holders of toxic debt, but also for the financial markets themselves.

Credit Crisis May Tip The Election To Obama

Americans have grown increasingly nervous as the mortgage/credit crisis has unfolded this year. The failure of Wall Street financial giants like Bear Stearns, Lehman Brothers, Merrill Lynch, AIG and others has only heightened concerns among the public.

Add to that the significant stock market downturn over the last year, which has affected tens of millions of Americans' investment and retirement accounts. Until now, most people thought this credit problem was at least reasonably under control.

Yet, last Friday's announcement of a $700+ billion government bailout of the banks and financial institutions sent a shockwave not only to Americans but investors around the world. Few, if any, had an inkling that the number would be remotely that large, and now we know that the ultimate number could be much higher, well over $1 trillion. It was a startling revelation!

But here's the reason I now believe the massive bailout may gift the election to Obama. Millions of American voters will see the bailout as nothing more than another George Bush giveaway to his rich friends and cronies on Wall Street – at the taxpayers' expense. Many may believe that John McCain would do the same thing if he were president.

Many Americans will not understand the gravity of the current financial crisis which has the potential to trigger a global recession or worse. Many will not understand Secretary Paulson's plea to enact the bailout now and reform the system and pursue and prosecute the bad guys later.

John McCain and Barack Obama have been in a statistical dead-heat for the last several months, although Obama has been marginally ahead most of the time. McCain got a bump up following his selection of Sarah Palin and the GOP convention, but over the last week or so, Obama pulled back into the lead, marginally, in the national polls.

Because of the latest escalation in the credit crisis, and the gigantic $700+ billion bailout request, I expect that potentially millions of undecided voters will now opt to go for Barack Obama. Even some who had never before considered voting for Obama may be rethinking that decision in light of the latest developments.

A lot can change in the next 43 days to the election. Who knows what other financial surprises may await us between now and November 4? But if I were to have to bet today, I would sadly put my money on Obama to win by a comfortable margin.

I have made no secret that John McCain was not my first choice for the GOP presidential nominee. But I have also made it known that I would certainly prefer Senator McCain over Senator Obama by a long-shot. So, it is not easy for me to predict now that Obama will likely be our next president.

One last political point: the current financial crisis and the enormous $700+ billion government bailout virtually assure that, if elected: 1) Obama will not be able to push through his aggressive spending plans; and 2) McCain will not be able to push through any tax cuts. Realistically, the money for either of these proposals is no longer there.

In light of the credit crisis and the massive bailout plan, McCain is now hedging on his promise of tax cuts, realistically so. Obama on the other hand says his social spending programs, including nationalized health care, are "already paid for." How is that? By allowing the Bush tax cuts to expire (a tax increase) and raising taxes on those making over $250,000 a year. Yet Obama claims shamelessly that he will cut taxes for 95% of Americans. Never mind it's a lie.

Time To Prepare For A Recession Just Ahead

On Friday, the Commerce Department will release its final report on 2Q Gross Domestic Product. In its previous estimate, 2Q GDP was 3.3%, well above most expectations. The pre-report estimate is that the government will raise that number to 3.4-3.5% on Friday. But in light of the deepening financial crisis, this week's final 2Q GDP report will be ignored.

While I have tended to be on the more optimistic side for the last several years as it pertains to the US economy, I am now turning bearish. I believe the events we have seen over the last two weeks will crush consumer confidence in the weeks and months ahead.

It seems clear that most consumers are angered and alarmed by the proposed massive $700+ billion bailout of financial institutions. They certainly are not comforted by it. Many are scared by the magnitude of the crisis. Virtually everyone knows who Merrill Lynch is - or was. Now it is gone as an independent American financial icon. People are realizing that we are in dangerous territory.

I predict we will see a significant slowdown in consumer spending for the balance of this year unless the financial markets stabilize quickly. Consumer spending accounts for over 70% of GDP. If I am correct, then we are headed for a recession.

The Index of Leading Economic Indicators fell 0.7% in July and 0.5% in August (latest data available). The Index has been down in three of the last four months. This suggests that economic growth slowed significantly in the 3Q. I will be surprised if economic growth doesn't fall into negative territory in the 4Q.

Much will depend on whether or not the mortgage bailout works.

Conclusions

Given the scope and magnitude of the recent mortgage-backed securities bailout proposed by the government, I think there are a number of conclusions that we can draw:

1. The massive mortgage bailout is unprecedented and extremely risky, but some kind of government intervention is most likely necessary in order to avert a global financial meltdown;

2. While the government is asking for $700 billion, we already know that the Fannie Mae, Freddie Mac and AIG bailouts transactions will push the combined cost to well over $1 trillion, plus whatever the Congress adds on, and you can bet there will be a major addition that will directed, rightly or wrongly, to struggling homeowners;

3. We are now past the issue of "moral hazard," in my opinion. We are now truly in a financial crisis that could easily spiral out of control very quickly. Something major needs to be done quickly, and there is no time for political games. People are on the verge of panic, and the stock markets may continue to plunge. Expect volatility to remain sky-high for a while longer.

4. I now believe this financial crisis will send us into a recession just ahead. While I have correctly been more optimistic than most of my peers in newsletter-land for the last several years, I am now turning bearish on the US economy. It now appears just a question of how deep it will be and how long it will last;

5. It remains to be seen just how deeply this financial crisis will affect the campaign rhetoric coming out of the two presidential contenders. Any thinking person can see that a $700 billion to $1 trillion bailout will severely restrict any politician's ability to cut taxes or increase social spending, but let's see if we hear any scaling back of such campaign promises; and

6. Finally, I now believe that the housing/financial crisis and the massive government bailout may hand the presidential election to Barack Obama in November. The general public does not fully understand the seriousness of the credit crisis, and will deem the massive bailout as just one more example of President Bush bailing out his rich cronies on Wall Street

The race between McCain and Obama has been neck-and-neck for several months, but Obama has pulled back into the lead following McCain's convention bounce. Barring something unusual, I expect the credit crisis and the bailout to send Obama increasingly ahead in the polls, with a win likely in November.

In fact, the latest polling data out this morning show Obama pulling decisively ahead in Colorado, ahead in Virginia and up to even in Ohio and North Carolina. McCain has to carry every one of these battleground states to win, yet they are now trending to Obama.

If this trend continues, it will be Obama, a Senator for less than three years, who will be in charge of solving the worst financial crisis in most of our lifetimes.

Sorry for a depressing E-Letter, but things are what they are.

Very best regards,

Gary D. Halbert

SPECIAL ARTICLES

How Fannie & Freddie Failed (prepare to be angry)
http://www.ibdeditorials.com/IBDArticles.aspx?id=306978378974502

Treasury agrees to some changes in mortgage bailout proposal.
http://online.wsj.com/article/SB122209290438362805.html

Obama's spending & McCain's tax cuts are out the window now.
http://www.washingtonpost.com/wp-dyn/content/article/2008/09/19/AR2008091903185.html

‘Wall Street' No Longer Exists
http://online.wsj.com/article/SB122212959612065505.html

Category 2 Hits Texas, Cat 4 Hits Wall Street

Gary D. Halbert — Tue, 16 Sep 2008 21:57:22 GMT

IN THIS ISSUE:

Lehman Brothers Files For Bankruptcy
Bank of America Buys Merrill Lynch
Largest Bank/Brokerage In The World
Will AIG Be The Next Giant To Fall?
Emergency Sunday Wall Street Trading Session
Where Our Clients’ Assets Are Held
Conclusions – History In The Making, Perhaps

Introduction

Hurricane Ike, a massive Category 2 storm, ravaged the coastal areas of southeastern Texas and western Louisiana on Saturday as it moved inland. Galveston and Houston were severely damaged, both by the winds and the massive storm surge. Damages are preliminarily estimated to be in the $25 billion area. As this is written, the death toll is estimated at 33 for those in the storm’s path.

While the nation’s attention was focused on Hurricane Ike over the weekend, there was another storm brewing on Wall Street. We awoke on Monday to learn that Lehman Brothers, America’s fourth largest investment bank, was declaring bankruptcy. We also learned that brokerage giant Merrill Lynch had been acquired by Bank of America, reportedly for $45-$50 billion in stock.

If those two landmark events weren’t enough, we also learned on Monday that American International Group (AIG), the 18th largest company in the world, was entering a major restructuring plan, which would include a major sale of assets in order to raise a huge amount of cash – estimated to be $70-$75 billion - to avoid a fate similar to Lehman Brothers.

It was also revealed that AIG is seeking up to $40 billion in loan guarantees from the Fed. It was reported on Monday that the Fed said NO over the weekend. AIG’s share price plunged over 60% early Monday and closed down over 50% at the end of the day, and is sharply lower again today. Not surprisingly, there is widespread speculation that AIG may be the next US financial giant to fail.

These latest dire financial events last weekend came on the heels of the announcement just over a week ago that mortgage giants Fannie Mae and Freddie Mac had been nationalized by the federal government due to the mortgage/credit crisis. Likewise, the Lehman, Merrill and AIG developments are also largely due to the housing slump and the subprime mortgage/credit crisis.

Stocks immediately plunged on the opening yesterday morning as investors around the world worried about the safety of their money. Unlike the Bear Stearns bailout by the government in March, the Fed allowed Lehman Brothers to go bankrupt. Likewise, the takeover of Merrill Lynch, the world’s largest brokerage/investment banking firm, sparked concerns among investors worldwide. The Dow plunged more than 500 points on Monday.

This week, we take a look at the latest developments on Wall Street and what they may mean for the investment markets. I will also summarize where our clients’ money is invested. For the record, we do not hold any client accounts at Lehman Brothers or Merrill Lynch.

Let’s get started, as there is a lot to cover.

Lehman Brothers Files For Bankruptcy

Founded in 1850, Lehman Brothers Holdings Inc. had grown to become the fourth largest investment bank in the US, with operations around the globe. The firm was a major player in investment banking, equity and fixed-income sales, research and trading, investment management, private equity and private banking. It has also been a primary dealer in the US Treasury securities market.

During the housing boom of the last decade, Lehman became increasingly active in the home mortgage market and the packaging and selling of mortgage-backed securities. A Lehman subsidiary, BNC Mortgage, was a large player in the subprime mortgage market. In August of 2007, Lehman shut down BNC, but this was not the end of the firm’s subprime troubles. According to published reports, here’s how Lehman imploded.

In 2008, Lehman faced an unprecedented loss due to the continuing subprime mortgage crisis. Lehman’s loss was apparently a result of having held on to large positions in subprime and other lower-rated mortgage tranches. Whether Lehman was unable to sell the lower-rated bonds, or made a conscious decision to hold them, is unclear. In any event, huge losses accrued in lower-rated mortgage-backed securities throughout this year.

In the second fiscal quarter, Lehman reported losses of $2.8 billion and was forced to sell off $6 billion in assets. In the first half of 2008 alone, Lehman stock lost 73% of its value as the credit markets continued to tighten. In August 2008, Lehman reported that it intended to release 6% of its work force, some 1,500 people, just ahead of its third-quarter-reporting deadline in September.

On September 10, Lehman announced a third quarter loss of $3.9 billion and their intent to sell off a majority stake in their investment-management business, which included Neuberger Berman and other subsidiaries. Lehman’s stock plunged another 40% on September 11. According to reports, the company was desperately seeking a merger partner at that point and well into last weekend.

It is still uncertain whether Lehman formally requested a Fed bailout, but the government reportedly let Lehman know that it would not come to the rescue with loan guarantees as it did with the Bear Stearns bailout. According to the Wall Street Journal and other sources, Lehman entered into negotiations with Bank of America (BofA), Merrill Lynch and Barclays Bank late last week and over the weekend.

According to the WSJ, BofA pulled out of the Lehman talks as it considered Merrill Lynch to be a better fit. Barclays Bank also reportedly declined to make an offer to purchase the firm. On Sunday, The New York Times reported that Lehman would file for bankruptcy protection for its parent company, Lehman Brothers Holdings, on Monday while planning to keep its subsidiaries solvent during the bankruptcy proceedings.

In negotiations over the weekend, a group of Wall Street firms agreed to provide capital and financial assistance for Lehman’s liquidation in an effort to avoid chaos in the markets. The Federal Reserve, in turn, agreed to a swap of lower-quality assets in exchange for loans and other assistance from the government.

Interestingly, the International Swaps and Derivatives Association (ISDA) orchestrated an emergency special trading session on Sunday to allow market participants an opportunity to potentially offset positions in various derivatives on the condition of Lehman’s impending bankruptcy. More details on this emergency Sunday trading session will follow below.

Shortly before 1 a.m. on Monday morning, Lehman Brothers Holdings announced it would file for Chapter 11 bankruptcy protection. Lehman’s bankruptcy will be the largest failure of an investment bank since Drexel Burnham Lambert collapsed amid fraud allegations 18 years ago.

Bank of America Buys Merrill Lynch

As everyone reading this knows, Merrill Lynch (ML) is one of the world’s largest brokerage firms with offices in 40 countries and territories, with apprx. 60,000 employees worldwide and total client assets of approximately $1.6 trillion. ML is also a global provider of wealth management, underwriting and various advisory services. The company was founded in New York in 1914 by Charles E. Merrill.

Obviously, Merrill Lynch is a global powerhouse in the financial industry. Yet along with Lehman Brothers and many others, ML became a large player in the mortgage markets in the 1990s, including a significant presence in the subprime mortgage market. By late 2007, ML announced that it was writing down $8.4 billion in losses related to the “national housing crisis” (read: subprime), and that its CEO, Stanley O’Neal, had resigned.

During the 12 months from July 2007 to June 2008, Merrill reported losses of $19.2 billion. Over the last year, ML’s share price tumbled from above $75 to below $20 as this is written.

In August of this year, New York Attorney General Andrew Cuomo threatened to sue Merrill Lynch over its alleged misrepresentation of the risk on mortgage-backed securities. A week earlier, ML reportedly offered to buy back $12 billion in mortgage-backed debt and later said they were surprised by the lawsuit. Three days later, the company reported a hiring freeze and revealed that they had charged almost $30 billion in losses to their subsidiary in the United Kingdom.

On August 22, Merrill’s CEO John Thain announced an agreement with the Massachusetts Secretary of State to buy back all auction-rate securities from customers with less than $100 million on deposit with the firm, beginning in October 2008 and expanding in January 2009. Bloomberg reported earlier this month that ML had lost $51.8 billion in mortgage-backed securities as a result of the subprime mortgage crisis. In short, Merrill Lynch was in trouble.

Enter Bank of America (BofA). Charlotte, NC-based Bank of America is the second largest bank in the US based on assets, behind Citicorp. But BofA has more branches (5,700 and counting) than either Citicorp or JP Morgan Chase.

Ken Lewis, BofA’s CEO since 2001, side-stepped the subprime mortgage crisis. Lewis reportedly shunned subprime mortgages as he believed these risky loans could backfire – as they did. He focused instead in building more branches, including international operations, acquiring other financial firms and expanding its asset base.

In late 2006, BofA acquired US Trust Company ($100 billion in assets) from Charles Schwab for $3.3 billion. In late 2007, BofA acquired the US assets of ABN AMRO, the large Dutch bank, for a reported $21 billion. These are just two examples of BofA’s numerous acquisitions.

On August 23, 2007 Ken Lewis decided it was time to test the waters in the subprime mortgage business, as BofA announced a $2 billion repurchase agreement for Countrywide Financial. Countrywide provides mortgage servicing for nine million mortgages valued at $1.4 trillion as of the end of last year, and was a big player in subprime mortgages.

Following that initial investment, on January 11, 2008, Bank of America announced that they would buy Countrywide Financial outright for $4.1 billion. This acquisition, which closed on July 1, 2008, gave the BofA a substantial market share of the mortgage business, and access to Countrywide’s expertise, technology, and employees for servicing mortgages. The acquisition was seen as preventing the potential of bankruptcy for Countrywide.

The point is, Bank of America avoided the subprime debacle and has a long history of aggressive acquisitions.

Largest Bank/Brokerage In The World

On Sunday, Bank of America announced it would purchase Merrill Lynch for $38.25 billion in stock. The Wall Street Journal reported later that day that Merrill Lynch was sold to BofA for about $44 billion or about $29 per share. Other reports on Monday indicated the purchase price was near $50 billion.

BofA gets Merrill’s investment-banking expertise and sprawling, powerful brokerage force, which is a natural fit for BofA’s own increasing focus on domestic banking and brokerage. Over 90% of Merrill’s “Thundering Herd” of brokers is focused on the US, which is BofA’s strength as well. ML’s wealth management is a stable business and its recurring revenue makes up 70% of the unit’s overall revenue, up from 59% in 2003 according to a ML executive.

In return, Merrill gets BofA’s financial stability. Still, Merrill comes with plenty of exposure to toxic assets, including $8.8 billion of gross exposure to collateralized debt obligations (CDOs).

The combined company would have leadership positions in retail brokerage and wealth management. By adding Merrill Lynch’s more than 16,000 financial advisers/brokers, BofA would become the largest brokerage in the world, with more than 20,000 advisers and $2.5 trillion in client assets.

The combination brings BofA global scale in investment management, including an apprx. 50% ownership in Black Rock, Inc., the largest publicly traded US investment management firm, which has $1.4 trillion in assets under management. BofA reportedly had $589 billion in assets under management prior to the ML acquisition.

Merrill Lynch’s stock closed at $17.05 per share last Friday, and some are questioning why BofA agreed to pay $29 per share for the giant brokerage. Numerous analysts speculated as to why BofA offered such a price when ML’s stock was probably headed lower, perhaps significantly lower. Nevertheless, BofA CEO Ken Lewis offered the following upon announcing the deal:

“Acquiring one of the premier wealth-management, capital-markets and advisory companies is a great opportunity for our shareholders… Together, our companies are more valuable because of the synergies in our businesses.”

Interestingly, Bank of America has apparently had its eyes on Merrill Lynch for many years. According to several reports, BofA chairman Ken Lewis, and his predecessor Hugh McColl, had more than a passing interest in acquiring the nation’s largest brokerage firm. Thanks to the subprime mortgage/credit crisis, BofA got ML on the cheap.

Will AIG Be The Next Giant To Fall?

Rumors are flying that American International Group (AIG) is also in serious financial trouble. AIG is one of the largest insurance company in the world. The company describes itself as follows on its home page on the Web:

“American International Group, Inc. (AIG), a world leader in insurance and financial services, is the leading international insurance organization with operations in more than 130 countries and jurisdictions. AIG companies serve commercial, institutional and individual customers through the most extensive worldwide property-casualty and life insurance networks of any insurer. In addition, AIG companies are leading providers of retirement services, financial services and asset management around the world. AIG’s common stock is listed on the New York Stock Exchange, as well as the stock exchanges in Ireland and Tokyo.”

Unfortunately, AIG has been one of the largest underwriters of complex debt securities known as “credit default swaps” that are used as insurance for a wide range of products, as well as a large portfolio of mortgages including subprime loans.

On Monday, New York Governor David Patterson approved a transaction in which various AIG subsidiaries would loan the parent company apprx. $20 billion to bolster its capital as it faces potentially disastrous credit downgrades. Actually, there are questions regarding whether the governor of New York has such authority, and if such loans are legal.

Specifically, many of AIG’s subsidiaries are not domiciled in New York. Such is the case in Texas where AIG is domiciled here. It is my understanding that Texas insurance regulators would have to approve a large loan (potentially several billion dollars) from AIG Texas to AIG’s parent which is domiciled in New York state. The same may be true in numerous other states (and foreign countries) where AIG subsidiaries are domiciled. Thus, we may be hearing more about this $20 billion loan in the days and weeks ahead.

AIG has also sought a $40 billion bridge loan from the Federal Reserve as a lifeline, as the three-part rescue plan it had devised appeared to be crumbling. Once again, it does not appear that the Fed will come to the rescue, at least not directly – yet.

While AIG reportedly has over $1 trillion in assets, the insurance giant is seeking $70-$75 billion in emergency lending, according to several sources. The Fed has apparently tapped Goldman Sachs and JP Morgan Chase to attempt to form a Wall Street lending consortium to come up with the money. It remains to be seen what will happen. My question is, what’s in it for Goldman, JP Morgan and other banks that will be asked to join this lending consortium?

It is interesting to note that the current US Treasury Secretary, Hank Paulson, is the former chairman and CEO of Goldman Sachs. I’m just speculating, but it would not surprise me if some kind of deal between the large banks and the government is struck to save AIG from failure.

Shares in AIG tumbled more than 60% on Monday morning as investors grew concerned that the firm lacked capital to withstand cuts to its debt rating. Ratings agencies had threatened to downgrade the insurance giant’s credit rating by Monday morning, allowing counterparties to withdraw capital from their contracts with the company. S&P, Moody’s and Fitch credit rating services actually lowered AIG debt rating this morning (Tuesday), and AIG’s stock plunged another 35-40% in early trading this morning after the credit ratings announcements.

AIG’s problems are not new. The company reportedly lost $13.2 billion in the first six months of 2008, largely owing to declining values in mortgage-related securities held in its investment portfolio and collateralized debt obligations it owns. As of the most recent quarter, for example, AIG reportedly had $20 billion of subprime mortgages marked at 69 cents on the dollar and $24 billion in so-called “Alt-A” mortgage related securities valued at 67 cents on the dollar.

Thus, there are widespread fears that AIG will be the next giant financial institution to fail. If AIG fails in all of its guarantees, there will be huge (hundreds of billions) exposure for banks worldwide. In addition, millions of Americans own products (insurance policies, annuities, etc.) directly from AIG and/or its affiliates. The Lehman bankruptcy would pale in comparison to the failure of AIG. Therefore, I will not be surprised if the Fed ultimately steps in to rescue AIG if that becomes necessary.

There are also concerns that Washington Mutual, another huge financial services firm, and others, may also be in trouble. AIG is not likely to be the last of the bad news.

Emergency Sunday Wall Street Trading Session

Fading hopes for a Lehman rescue deal last Saturday raised the risk the firm would have to file for bankruptcy on Sunday or early Monday morning. In fact, Lehman hired law firm Weil Gotshal & Manges to prepare a potential bankruptcy filing, the Wall Street Journal reported on Saturday in its online edition.

Bill Gross, chief investment officer of PIMCO, said a Lehman bankruptcy risked an “immediate tsunami” because of the unwinding of derivative and credit swap-related positions worldwide in the dealer, hedge fund and buy-side universe (mutual funds, pension funds, etc.). The implications for the financial markets were huge.

As a result, the International Swaps and Derivatives Association (ISDA) announced late Saturday, with the apparent blessing of US securities regulators, that there would be a special trading session on Sunday afternoon for the purpose of allowing derivatives market participants an opportunity to unwind Lehman-related market positions. ISDA indicated that the special session was actually suggested by the Federal Reserve.

Major players in the $455 trillion global derivatives market rushed Sunday to scale back exposure to a potential bankruptcy filing by Lehman Brothers in the rare emergency trading session. The session opened at 2 p.m. New York time and was due to run until 4 p.m. However, the ISDA later extended the emergency session for another two hours, and reportedly some banks continued to offset their Lehman exposure even after the official session ended.

Trading involved credit, equity, rates, foreign exchange and commodity derivatives. Trades were contingent on a bankruptcy filing by Lehman before the markets opened on Monday. If there was no bankruptcy filing by Lehman, the Sunday trades would have been reversed.

Implications For The Investment Markets

On Monday, the Dow Jones plunged 504 points, or 4.42%, to 10,917.51, moving below the 11,000 mark for the first time since mid-July. It was the worst point drop for the Dow since it lost 684.81 on Sept. 17, 2001, the first day of trading after the 9/11 terror attacks.

In percentage terms, the drop was the steepest since July 19, 2002. It was also the sixth-largest point drop in the Dow, just behind the 508.00 it suffered in the October 1987 crash. The Dow is now down apprx. 23% from its record high of 14,198.09 last October.

Broader stock indicators also fell. The S&P 500 index declined 59.00, or 4.71%, to 1,192.70 — also its biggest drop since just after 9/11 and the first time it closed below 1,200 in three years. The decline on Monday violated the previous S&P low in July, which many had hoped was the bottom in this bear market.

Clearly, the trend is down in the equity markets, and investors worldwide are wondering how bad things may get. Obviously, a lot depends on what happens with AIG, as discussed earlier. If AIG goes down, the negative implications are much larger indeed than the failure of Lehman Brothers.

On the other hand, if some kind of a deal is struck to rescue AIG, even temporarily, stocks would likely get a bounce. In today’s trading session, the Dow Jones Industrial Average tested its July 19 low of 10,732, but did not penetrate it, and then reversed to close up 141 points on the day. I expect there will be technicians who will argue that we’ve seen a double bottom. We’ll see.

Bottom line: If AIG goes down, I would expect the stock markets to plunge yet again, even harder. As a result, I will be surprised if the Fed ultimately let’s AIG go down. The financial implications are just too great, in my opinion.

Even if AIG manages to stay afloat, investors are worried that there may be other large financial institutions that are in trouble. Investors hate uncertainties, and we are far from the point where the financial industry is out of trouble. This argues that the bear market in stocks continues for at least a while longer.

Finally & Most Importantly:
Where Our Clients’ Accounts Are Held

As noted in the Introduction, we do not hold any client accounts at Lehman Brothers or Merrill Lynch. As most of you know, my companies specialize in investment programs that are professionally managed by third party Advisors that we carefully select. Our business is concentrated in three particular areas: 1) our AdvisorLink program which is mutual fund-based; 2) our Absolute Return Portfolios which are also mutual fund-based; and 3) our futures funds.

Client accounts in our AdvisorLink program are held at one of the following mutual fund families and/or trading platforms – Fidelity Institutional Brokerage, Rydex Mutual Funds, TD Ameritrade or Trust Company of America. These are not investment banks.

Client accounts in our Absolute Return Portfolios, which are carefully selected groups of mutual funds, are held at TD Ameritrade.

Assets in our four futures funds are custodied in segregated accounts at MF Global, which is considered one of the leading international brokers for exchange-traded futures and options and a leading intermediary in the markets for other major financial instruments around the world. MF Global provides access to the world’s largest and fastest growing financial markets through offices on five continents and affiliations with more than 70 financial exchanges.

Established in 1783 by James Man as a commodities brokerage firm in London, MF Global is probably better known to many in the investment world as E D & F Man. MF Global spun off from the Man group in 2007 with a public offering and is listed on the New York Stock Exchange as NYSE: MF.

Conclusions – History In The Making, Perhaps

While the US economy is holding up at least reasonably well, the subprime and mortgage related financial crisis is taking its toll on Wall Street financial institutions, one by one. The worsening confidence among lenders and borrowers continues to complicate matters in the financial markets. The question is, have we seen the worst with the bankruptcy of Lehman Brothers and the fire sale of Merrill Lynch, or is there much more to come? That remains to be seen.

Stock markets worldwide don’t like this kind of uncertainty, and they have reacted accordingly. How much more the bear market in US stocks has to go remains an uncertainty. A great deal depends on how much more bad news is to come over the next few weeks. Questions remain about AIG and how many other large financial firms may be waiting to announce similar problems.

I sincerely hope that we are not witnessing history in the making, and that the worst of our financial problems have already been revealed. But the fact is, we just don’t know yet. The housing/subprime repercussions continue to unfold.

Normally, I would take this opportunity to promote the active management strategies I recommend – that have the flexibility to go to cash or hedge long positions during downward trends in the stock markets – but given the latest serious developments in the financial markets, on the heels of the devastation on the GulfCoast, I will forego any advertisement.

I will say that we have recently seen a marked increase in calls from E-Letter readers that have grown increasingly uncomfortable with performance results from their traditional investment advice providers. This is what usually happens in bear markets.

As always, feel free to call us for an independent second opinion and review of your investment portfolio.

Very best regards,

Gary D. Halbert

SPECIAL ARTICLES

The Resilience of American Finance
http://online.wsj.com/article/SB122152085270539225.html

This Too Will Pass
http://www.ibdeditorials.com/IBDArticles.aspx?id=306370630265658

Do Wall Street’s Woes Help McCain or Obama?
http://www.usnews.com/blogs/capital-commerce/2008/9/15/do-wall-streets-woes-help-mccain-or-obama.html

Market Mayhem & Credit Fears - What's Next?

Gary D. Halbert — Tue, 11 Sep 2007 09:20:00 GMT

Market Mayhem & Credit Fears - What's Next? IN THIS ISSUE: 1. The Economy - The News Is Not All Bad 2. Consumer Spending Remains Firm For Now 3. Housing & Subprime - More Bad News 4. Should The Government Come To The Rescue? 5. The Fed Needs...(read more)

Is A Subprime Recession Inevitable?

Gary D. Halbert — Tue, 28 Aug 2007 09:21:00 GMT

Is A Subprime Recession Inevitable? IN THIS ISSUE: 1. Stocks - Correction Or New Bear Market? 2. Consumer Confidence & Spending Remain Key 3. A Look At Previous Credit Crunches 4. How Bad Is The Subprime Mortgage Problem? 5. Crisis In Confidence 6...(read more)

Stock Prices Plunge In The Perfect Storm

Gary D. Halbert — Tue, 14 Aug 2007 09:23:00 GMT

Stock Prices Plunge In The Perfect Storm IN THIS ISSUE: 1. Stocks Make New Record Highs, Then Plummet 2. Forget The Cheese, Just Let Me Out Of The Trap! 3. Unwinding The "Yen Carry Trade" 4. Fed & Central Banks To The Rescue 5. So What Next...(read more)

The Economy Surges, Stocks Plunge - What's Up?

Gary D. Halbert — Tue, 31 Jul 2007 09:32:00 GMT

The Economy Surges, Stocks Plunge - What's Up? IN THIS ISSUE: 1. Economy Surges Ahead In The 2Q? 2. Inflation - Some Good News For The Fed 3. Other Economic Reports Of Late 4. Stocks - A Correction, Or Something Worse? 5. Ignore The Shocking Financial...(read more)

Forecasts & Trends : Subprime

It's Official - 2008 Was A Very Bad Year

Introduction

Happy New Year!!

The Recession & More Government Bailouts

Introduction

Latest Grim Numbers On The US Economy

The Latest On The Government Bailouts

Fed Announces The Mother Of All Bailouts

Troubling Aspects Of The Fed's Latest Bailout

Fighting "Debt-Deflation" At Any Cost

Credit Crisis: Do Bush & Paulson Have A Clue?

Introduction

Stratfor's Take On The Subprime/Credit Crisis

Treasury Secretary Paulson Changes The Plan

Do They Even Have A Clue What To Do?

Bailout's Next Phase: Consumer Loans (Maybe)

More From Stratfor On The Credit Crisis & The Economy

Gauging The Recession & The Economy - Not Good

Stock Markets Detest Uncertainty & Economic Woes

Conclusions - They Are Few

"Buy-And-Hold" Bites The Dust - Now What?

Introduction

Economic Picture Getting Darker

The Conventional Wisdom Was Wrong

Chinks In The Index Investing Armor

Do Low Fees = Good Investments?

What About Risk Management?

Conclusions

SPECIAL ISSUE: Financial Crisis For Beginners

QUOTE:Financial Crisis For Beginners

Crises of confidence and bank runs

Credit default swaps

Stock market vs. credit market

Might Uncle Sam Make Money On The Bailout?

Introduction

The Latest $700 Billion Bailout Package

What Could Go Wrong - Potentially A Lot

What Could Go Right, If We Are Lucky

What Would Happen To The Profits, If Any?

A "Main Street" Backlash To Come?

Uncle Sam's $700+ Billion Toxic Securities Fund

Introduction

Details Of The Massive $700 Billion Bailout

Government Guarantees Money Market Funds

Will Congress Pass The Bailout Plan?

Should The Government Bail Out Homeowners?

Will Uncle Sam Overpay For The Assets?

Credit Crisis May Tip The Election To Obama

Time To Prepare For A Recession Just Ahead

Conclusions

Category 2 Hits Texas, Cat 4 Hits Wall Street

Introduction

Lehman Brothers Files For Bankruptcy

Bank of America Buys Merrill Lynch

Largest Bank/Brokerage In The World

Will AIG Be The Next Giant To Fall?

Emergency Sunday Wall Street Trading Session

Implications For The Investment Markets

Finally & Most Importantly:Where Our Clients’ Accounts Are Held

Conclusions – History In The Making, Perhaps

Market Mayhem & Credit Fears - What's Next?

Is A Subprime Recession Inevitable?

Stock Prices Plunge In The Perfect Storm

The Economy Surges, Stocks Plunge - What's Up?

QUOTE:
Financial Crisis For Beginners

Finally & Most Importantly:
Where Our Clients’ Accounts Are Held