Forecasts & Trends : The Fed

Is The Recession Over? Don't Bet On It

Gary D. Halbert — Tue, 18 Aug 2009 22:12:00 GMT

IN THIS ISSUE:

Economic Signs of Improvement
Fed Vows to Keep Rates Low
Market Comments from John P. Hussman, Ph.D.
Conclusions

Introduction

We have seen some encouraging economic news in recent weeks, and President Obama and his cronies in the mainstream media have declared that the worst recession in post-war history is all but over. The advance estimate of 2Q GDP was down considerably less than expected (-1.0%); the unemployment rate actually fell slightly in July to 9.4%; and the ISM manufacturing index posted a nice improvement last month.

While these reports were better than expected, and continue to suggest that the worst of the recession is behind us (as I have suggested often in recent weeks), this economy is far from out of the woods yet. Growth prospects continue to look muted, although a growing number of forecasters are suggesting that GDP will register a positive number in the 3Q due largely to the rebuilding of inventories, as I discussed in my August 4 E-Letter.

This week, we will look at the latest economic reports, as well as the Federal Reserve's latest decision on interest rates and purchases of Treasury securities. Also, the Fed says it will end its record large purchases of government agency debt in October. If indeed this happens, it will be the first step in ending the Fed's massive stimulus spending.

Next, so that we don't all get caught up in the latest hype that the recession is over, I will reprint excerpts from a recent Weekly Market Comment written by John P. Hussman, Ph.D. Dr. Hussman is best known as the president of Hussman Investment Trust, and he manages the Hussman Strategic Growth and Hussman Strategic Total Return Funds, which are actively managed and can go to cash in bear markets.

Dr. Hussman's latest analysis is consistent with the view many of us have that the recession, while improving in some areas, is not over yet, and that the ensuing economic recovery over the next year or longer will be disappointing -- even if there is a bump up in the 3Q. All of this should make for interesting reading, so let's get started.

Economic Signs of Improvement

Over the last several weeks, we've seen some encouraging economic reports. In some cases, "encouraging" simply means that the reports weren't as negative as expected. That was certainly the case with the advance 2Q GDP estimate at the end of June, which showed a decline of only 1% (annual rate) versus pre-report estimates which were considerably worse. Some analysts expect that number to be revised downward somewhat when the second estimate is released later this month.

On the manufacturing front, the ISM Index rose more than expected in July to 48.9, up from 44.8 a month earlier. Industrial production rose 0.5% in July, and construction spending and the factory operating rate both rose modestly last month as well. These are all signs that the recession may be leveling out.

On Thursday of this week, we get the latest Index of Leading Economic Indicators (LEI) for July, and the pre-report consensus is for a rise of 0.6%, following +0.7% in June. If the LEI is up for July, that will mean the fourth consecutive monthly increase. That would be very encouraging and a sign that we will likely be out of this recession by the end of the year.

The US unemployment rate unexpectedly dropped from 9.5% in June to 9.4% in July, as employers slashed 247,000 jobs, the slowest rate of decline in nearly a year. This news temporarily sent stocks to their highest level of the year since the pre-report consensus was for a rise to 9.6%

However, the July decline in the jobless rate came about not because more people had jobs, but because almost 800,000 "discouraged workers" - people who have essentially given up on looking for a job - were not counted as unemployed, thereby allowing the official unemployment rate to fall modestly in the latest jobs report. The number of long-term unemployed people - those who have been out of a job but looking for more than 26 weeks - rose by another 584,000. Thus, it appears we are still headed for 10% employment before this cycle reverses.

Despite the still troubled employment situation, investors welcomed the reports above, and more and more forecasters have apparently decided that the recession is over. I continue to believe that we are still at least a few months from concluding that the recession has ended. The Consumer Confidence Index fell for the second month in a row in July, and retails sales were down slightly last month. Therefore, it is premature to declare that the recession is over.

Fed Vows to Keep Rates Low

To no one's surprise, the Federal Open Market Committee (FOMC) announced last Wednesday that it will continue its policy of keeping interest rates at their historically low levels. The FOMC also maintained its position that interest rates could remain historically low for an "extended period of time." In other words, the floodgates of liquidity are still wide open.

About the only new revelation was that the Fed announced that it will stop buying long-term Treasuries in October of this year. This could be the ultimate case of good news/bad news, in that it's good that the Fed may no longer be printing money to buy Treasuries, but bad in that these securities will soon have to compete in the open market, and this could lead to higher interest rates. Remember that this is why the Fed committed to start buying Treasuries in the first place.

However, the Fed's printing press will not be idle as it said it will continue to purchase up to $1.25 trillion in agency mortgage-backed securities and other agency debt from Fannie Mae and Freddie Mac. The Fed's hope here is to keep a lid on mortgage rates in an effort to stimulate the housing market.

From an economic standpoint, the latest FOMC statement notes that US economic activity is "leveling out," meaning that the rate of descent has slowed. However, this simply means that the recession may not get deeper. The Fed's prospects for recovery, however, were modest, at best. The Fed expects economic activity to remain weak "for a time" (whatever that means) and a return to sustainable economic growth is likely to be gradual.

Gary D. Halbert, ProFutures, Inc. and Halbert Wealth Management, Inc.
are not affiliated with nor do they endorse, sponsor or recommend the following product or service.

Market Comments from John P. Hussman, Ph.D.

Dr. John Hussmanis best known as the president of Hussman Investment Trust (a mutual fund family), and he manages the Hussman Strategic Growth and Hussman Strategic Total Return Funds. Dr. Hussman is also the chairman, president and controlling shareholder of Hussman Econometrics Advisors, Inc. which has published his Weekly Market Comment letters for years, and they always have some interesting points about the economy, the markets, etc.

As a mutual fund manager, Dr. Hussman is somewhat unique in that he not only actively seeks the best opportunities in the stock market, but will also move to neutral positions in his funds during market downturns. In other words, the investment strategies he employs are similar to those used by the active money managers my firm recommends.

The following excerpts are from Dr. Hussman's August 10, 2009 Weekly Market Comment. [Note that we have removed discussions about specific funds where possible.] Pay particular attention to Dr. Hussman's outlook for the economy.

QUOTE:

The U.S. economy lost a quarter of a million jobs in July. Meanwhile, over 400,000 workers abandoned the labor force (and are therefore no longer counted among the unemployed), which prompted a slight decline in the unemployment rate despite the job losses. In the context of an economy still strained by high levels of consumer debt and still record delinquency and foreclosure rates, labor market conditions are still troublesome. Still, the pace of job losses and new unemployment claims has clearly softened from the pace we observed early in the year.

If we knew that this was a standard economic downturn, we might conclude that the recent improvements are durable. However, nothing convinces us that this is a standard economic downturn. As for market action, the major indices have generally been strong, as has breadth (as measured by advances versus declines), but the "investor sponsorship" evident from trading volume has been uncharacteristically dismal compared with initial advances of past bull markets. So here too, we have very strong concerns that the recent advance may not be as durable as investors appear to believe.

All of that said, we aren't inclined to fight even what we view as errant analysis, and the Strategic Growth Fund has about 1% of assets allocated to near-the-money index call options -- about enough to gradually close down about 40% of our hedge in the event that the market advances markedly higher from here, but without putting us at risk of much loss in the event of failure. With investors now anticipating and pricing in a sustained economic recovery, as well as a spectacular earnings rebound, a lot of things will have to go right from here in order to sustain higher prices than we currently observe.

Frankly, our call option allocation here is something of a paean to a notion -- a sustained economic recovery and new bull market -- that I have no belief in whatsoever. But at this point, the broad strength in the major indices, even lacking volume sponsorship or favorable valuation, requires that we allow for the possibility of additional investor speculation. Even if we do observe such an outcome, it's difficult to envision that the S&P 500 will clear the 1000 level for all time, without revisiting it again in the months (not to mention years) ahead. To the extent that we don't clear 1000 permanently, establishing investment exposure here with anything but call options amounts to a game of trying to "ride" the market higher and to get out before it returns to or below current levels. With the market strenuously overbought already, that game strikes me as exquisitely difficult to get right. Hence the use of a modest allocation to call options only, without closing our downside hedges.

Call me skeptical. But if you look carefully at the economic data that shows improvement, and correct for the impact of government outlays, it is difficult to find anything but continued deterioration in private demand and investment. What we do see is a government that has run what is now a trillion dollar deficit year-to-date, representing some 7% of GDP. That sort of tab will undoubtedly buy some amount of Cool-Aid, but it has been something of a disappointment to watch how eagerly investors have guzzled it down. It is not at all clear that short-term, deficit-financed improvement necessarily implies sustained growth in the context of a deleveraging cycle. This is like somebody borrowing money from their Uncle and then celebrating that their income has gone up.

Moreover, it might be enticing to look at a chart of the S&P 500 and envision a quick return to 2007 highs and beyond, but it is important to recognize that those highs were based on profit margins about 50% above historical norms, combined with an elevated P/E multiple of about 19 against those earnings. Even if the economy is poised for a sustained recovery here, the belief that those joint outliers will be quickly re-established goes against historical precedent.

In any event, we've got some call option coverage to gradually allow participation if this run continues.

Post-Crash Dynamics

When markets crashes are coupled with changes in the fundamentals that supported the preceding bubble -- as we observed in the post-1929 market, the gold market of the 1980's, and the post-1990 Japanese market, and currently observe in the deflation of the recent debt bubble -- they typically do not recover quickly. Indeed, the hallmark of these post-crash markets is the very extended sideways adjustment that they experience, generally for many years.

The chart below updates the position of the S&P 500 (red line) in the context of other post-crash bubbles. The horizontal axis is measured in months. Note that very strong and extended interim advances have been part and parcel of similar experiences.

The intent here is not to argue that the U.S. stock market must by necessity follow the same extended adjustment that followed prior burst bubbles. Rather, the intent is to underscore that it is dangerous to infer that structural difficulties have vanished simply because a market enjoys a strong post-crash advance.

My friend James Montier at SocGen draws a similar pattern from a larger historical collection of post-crash bubbles - including the above instances, as well as others such as the South Sea Bubble and the Railroad Bubble of the 1840's. The underlying theme is that the adjustment period following the bursting of a bubble tends to be very extended.

I understand the eagerness of investors to put the entire credit crisis behind them and look ahead to a recovery of the prior highs, but these hopes are based on the assumption that a positive boost to GDP, once achieved, will propagate into a full-fledged recovery. Again, however, no economic improvement is evident in the behavior of consumer demand and capital spending, once you adjust for the impact of government spending (particularly transfer payments).

Yes, we have observed a massive reallocation of global resources from savers (who have bought newly issued Treasury debt) toward mismanaged financial institutions that made bad loans. Yes, there are certainly favorable short-run economic numbers that can be achieved by running a year-to-date federal deficit equal to seven percent of the U.S. economy. The problem is that this money does not come from nowhere. We have effectively sold an identical ownership claim on our future production to those individuals and foreign governments who bought the Treasuries. Government "stimulus" is not free money. The continued attempt to bail out bad loans with good resources (largely foreign savings) will end up costing our nation some of our most productive assets, which will be acquired by foreign countries and investors for years to come.

From my perspective, investors have gotten entirely too far ahead of themselves with the assumption of a sustained recovery. Nevertheless, we again have about 1% of assets in index call options to allow for further market strength if it emerges. I expect that if they move "in the money," we will leave their strike prices unchanged unless market internals deteriorate measurably. Leaving our call option strikes fixed would open us up to losing on any subsequent downturn whatever we make on a further advance, but again, our opening exposure is fairly limited. We'll let the market put us into a more constructive position if investors are inclined to continue their exuberance here. [Emphasis added, GDH.]

Market Climate

As of last week, the Market Climate for stocks was characterized by unfavorable valuation and mixed market action, but enough evidence of speculation (reasonable or not) to own about 1% of assets in index call options. We are otherwise hedged.

During earnings season, there are often days where most of the performance of the Fund is driven by significant movement in a small handful of Fund holdings. These movements can be positive or negative, and may cause the Fund to move differently than one would expect that the Fund "should" move based on our investment position, and on what the market did on a particular day. As I've frequently noted, short-term movements, particularly day-to-day, are not effective indicators of the Fund's investment position, or predictors of Fund performance. Performance is always best measured from the peak of one market cycle to the peak of the next, or over an extended period of years representing neither a peak-to-trough nor trough-to-peak movement in the market.

Based on our standard methodology, which considers normalized earnings (not the far more depressed level of current earnings) the S&P 500 is now priced to deliver 10-year total returns in the area of 6.9% annually. This is a figure that has historically been associated with bull market peaks, including 1969 and 1987. In most instances, such valuations turned out badly in reasonably short order. It is, however, true that prospective returns were even worse prior to the 1929 crash, and during the bulk of the period since 1996, so there have been some historical periods where speculators have driven valuations to higher levels, and during these times, it has not been particularly effective to stand in front of speculators saying ‘no, stop, don't.' [Emphasis added, GDH.]

Ultimately, all of those periods where valuations were driven to higher levels were followed by poor long-term returns, with stocks generally trading at lower levels at some point one or more years later. So we can say with a reasonable degree of confidence that even if the present advance continues, investors will most likely observe current levels again either within the current market cycle or (worse) several years out. Overvalued markets simply do not "run away" for good. Still, it can be painful or at least unenjoyable to remain defensive during a speculative advance.

In bonds, the Market Climate last week was characterized by relatively neutral yield levels and moderately unfavorable yield pressures. As usual, we will tend to increase our bond durations on spikes in yield (weakness in bond prices), and these are becoming more interesting -- though not strongly attractive. Our most recent extension of durations was in the 3.9%-4% area for 10-year Treasuries, and a push materially above that level would represent enough of a yield pickup to move a modest amount of short-maturity Treasury allocations into mid-maturities. As I've noted in recent weeks, we don't anticipate much in the way of extended directional movement in the bond market, so most of our portfolio activity will probably tend to be modest reallocations in response to yield fluctuations. At the point where we observe either fresh inflation pressure or general declines in Treasury yields (i.e. general downward pressure on real interest rates), I expect that we'll observe fresh pressure on the U.S. dollar and upward pressure on precious metals shares. For now, those markets are likely to be somewhat range-bound as well.

We've got an extended economic adjustment ahead. Most probably far longer than most investors presently expect. As always, we'll take our opportunities as the evidence emerges, with the objective of outperforming our respective benchmarks over the complete market cycle, and an additional emphasis on defending capital over the course of that cycle. [Emphasis added, GDH.]

END QUOTE

Gary D. Halbert, ProFutures, Inc. and Halbert Wealth Management, Inc.
are not affiliated with nor do they endorse, sponsor or recommend the following product or service.

Conclusions

While we have seen some encouraging economic reports over the last few weeks, it is premature to declare that the recession has ended. As discussed above, the unemployment rate is very likely to rise even higher before this cycle is over. Remember that consumer spending is still the main driver of this economy, and retail sales fell slightly in July well below the pre-report consensus. The Consumer Confidence Index fell a second month in a row in July.

On the positive side, the Fed remains committed to keeping interest rates very low for an extended period, and liquidity is plentiful for now. If this Thursday's Leading Economic Indicators report is positive, that will market the fourth consecutive monthly increase, which will be a very good sign that the recession will end by the end of the year.

I agree with Dr. Hussman that stocks are overbought at this point, as many investors who bailed out in February and March are now jumping back in. The stock market has felt like a mini-bubble since the March lows and especially in July. Thus, I would not be surprised to see the downward correction that began last week to continue in the weeks ahead.

Finally, I recently told you about our online webinar featuring the Potomac Guardian Program on August 6th. We had hundreds of investors register for the webinar and it was well-received. If you were unable to attend this webinar but would still like to learn more about the Potomac Guardian Program and its investment strategy, you can now find a recorded version on our Internet website at www.halbertwealth.com.

Wishing you profits in a difficult market,

Gary D. Halbert

SPECIAL ARTICLES

Stocks: Five Key Signals for Investors
http://www.businessweek.com/investor/content/aug2009/pi20090817_099111_page_2.htm

Why Obama's Ratings Are Sinking
http://online.wsj.com/article/SB10001424052970204683204574354383543314054.html

Public Spending's Day Of Reckoning
http://www.forbes.com/2009/08/12/public-spending-finances-economy-debt-opinions-contributors-desmond-lachman.html

Have We Turned The Corner On The Recession?

Gary D. Halbert — Tue, 31 Mar 2009 20:31:08 GMT

IN THIS ISSUE:

Finally a Little Good News for the Economy
Geithner's Latest Toxic Asset Bank Bailout
Does the PPIP Have Any Chance of Working?
Fed to Buy $300 Billion in Treasuries & a Lot More
CBO Assessment of Obama's Record 2010 Budget
Conclusions, Market Implications & What to Do Now

Introduction

Some weeks, it's tough to find a good topic to write about. Then other weeks, I'm overwhelmed with all there is to write about, as is the case this week. So, we'll touch several bases in this week's E-Letter. We'll begin with the latest economic news, some of which was surprisingly positive (especially housing). Unfortunately, the latest good news does not necessarily mean we've seen the bottom of the recession or the bear market.

On Monday of last week, Treasury Secretary Geithner announced the much-awaited new plan to take toxic assets off the books of troubled banks. The plan is called the Public-Private Investment Program. Under this new program, the government along with private investors would buy up toxic assets by way of auctions to get these loans off the banks' books. But will the plan work? I'm not optimistic. We'll discuss this in some detail as we go along.

As if the Obama administration is not spending enough already, the Fed recently announced that it will print and spend over $1 trillion in the months ahead to buy at least $300 billion in direct purchases of Treasury securities and at least another $750 billion for purchasing more toxic assets from banks and other sources. Where will it end? No one knows.

In my March 10 E-Letter, I predicted that President Obama's $3.55 trillion federal budget for fiscal 2010 would result in a deficit of more than $2 trillion, as opposed to the administration's estimate of $1.75 trillion. Turns out I was wrong – the Congressional Budget Office predicted last week that Obama's 2010 budget deficit will hit $2.3 trillion. Wow, this will be bad! The CBO agrees with me that Obama's economic assumptions are too optimistic.

Following those discussions, I will give you my latest thoughts on where we stand in the big picture. With the latest smattering of good news on the economy and the nice rebound in the stock markets, some analysts are concluding that we've turned the corner on the recession and the financial crisis. I think it's premature to make that call, and I will not be surprised if we see another downward leg before long. In fact, it may have already begun. Let's get started.

Gary D. Halbert, ProFutures, Inc. and Halbert Wealth Management, Inc.
are not affiliated with nor do they endorse, sponsor or recommend the following product or service.

Finally a Little Good News for the Economy

As everyone reading this is all too aware, the economic news so far this year has been horrible. Rarely has any good news been seen in recent months. But there was some good news last week, and it came in a very good spot – housing. Existing home sales in February unexpectedly rose by 5.3% above January levels to an annual rate of 4.72 million units. It was the largest monthly jump since 2003; still, sales were down almost 5% below yearago levels.

The increase in sales of existing homes was strongest in the West and in Florida, one of the worst hit markets. February sales of existing homes in Florida rose 20%. Florida Realtors also reported a 15% gain in statewide sales of existing condominiums in February, continuing a trend in recent months for higher statewide sales of both the existing home and existing condo markets compared to yearago levels.

The median sales price for existing homes nationwide rose to $165,400 in February, the first monthly increase in over a year, but it remains 15.5% below yearago levels. Unfortunately, the inventory of unsold existing homes rose again in February, despite the improved sales figures, thus putting the backlog at an estimated 9.7 months supply at the current sales pace.

New homes sales also increased by 4.7% in February to an annual rate of 337,000 units. Economists had expected new home sales to decline to a rate of 300,000 annualized units, so this was welcome news. While the unexpected rise in new home sales might be seen as a positive movement for the beleaguered housing market, the February rate for new home construction is still the second-lowest reading since the last recession in 2002. The median price of a purchased new home fell to $200,900 in February, down over 18% from a year ago.

Housing starts jumped well above expectations in February, rising 22% over January levels. Rising housing starts might not sound like a good thing, as that could mean even more homes on the market, but reportedly over 80% of the February construction starts were for apartment complexes, not new single family homes. Also, building permits climbed in February for the first time in over a year.

On another front, durable goods orders rose a surprising 3.4% in February following six consecutive monthly declines. This news was bittersweet because the Commerce Department revised January durable goods orders further downward from -5.2% to -7.3%.

Elsewhere, the economic news continued to disappoint. Last Thursday, the government reported that 4Q GDP fell at an annual rate of -6.3%, down from -6.2% as reported last month. Consumer confidence continued to plunge in February to only 25.0, a new record low, down from 37.4 in January. However, the latest Rasmussen tracking poll shows that consumer confidence has rebounded a bit in March.

The Index of Leading Economic Indicators fell 0.4% in February. The LEI has fallen very sharply since the last peak in July 2007. The unemployment rate jumped to 8.1% in February from 7.6% in January. The consensus is for a rise to 8.5% in March and at least 9% by yearend. These are just a few of the negative reports we've seen over the last month.

In summary, while we've seen a few positive reports on the economy and the housing sector in particular over the last month, we are far from out of the woods on the recession and the financial crisis. Now, let's move on to the latest bank bailout proposed by Treasury Secretary Timothy Geithner.

Geithner's Latest Toxic Asset Bank Bailout

After Treasury Secretary Geithner announced his new Public-Private Investment Program (“PPIP”) on Monday of last week, the Dow Jones promptly rallied over 500 points. That followed a rally of almost 1,000 points since the low in early March. The Dow and the S&P 500 bounced just over 20% from their recent lows – that is until the latest near 5% downward reversal over the last two trading sessions (Friday and Monday). While the equity markets clearly liked the government's latest bank bailout plan, serious questions remain – such as, will it work, and will private investor groups want to get in bed with the government, which threatened to impose a 90% tax on AIG executive bonuses?

We'll get to those questions and others as we go along, but first let's examine how the Public-Private Investment Program is supposedly designed to work. In an online article in FORTUNE, CNNMoney.com's Jon Birger provided the following summary on how the PPIP is expected to work as follows:

“The [PPIP] plan tries to fix the banking crisis by encouraging the very behavior that got us into this mess in the first place -- using buckets full of leverage to buy mortgages, asset-backed securities and other so-called toxic assets. Moreover, it requires the participation of the very folks -- Wall Street bankers and investors -- whom officials in Washington have spent the last two months threatening and vilifying.

At its core, the Public-Private Investment Program (PPIP) harkens back to what the original bank bailout bill was supposed to do when it was first passed by Congress last fall: remove toxic assets from bank balance sheets, thereby freeing up more money for lending. The mechanics of the program would operate somewhat differently for stand-alone loans than for debt securities (basically bundles of loans packaged as asset-backed or mortgage-backed securities), but the general approach is the same. The government will match, dollar for dollar, any private-sector funds put towards buying these toxic assets.

And if that weren't incentive enough, the government will also facilitate cheap loans -- think of them as FDIC-guaranteed margin loans -- to private investors who will be able to leverage their distressed-debt purchases six to one.

Here's how it might work: Say a bank has a pool of residential mortgages with a $100,000 face value that are deemed good risks by the FDIC. The pool is then auctioned off, and in this example, the winning bid is $84,000. Of that, the government puts up $6,000, the private investor another $6,000, and the remaining $72,000 is financed via a FDIC-guaranteed margin loan.

The goal is to jump start the market for toxic debt and put the prices of these loans more in line with the underlying interest payments (which in some cases have declined far less than the market valuation of the loans or debt securities). Theoretically, once the PPIPs start buying and selling this stuff, the valuations will become clearer, opening the door to other private investors who may see opportunity but have shied away up until now due to the lack of price transparency.

That's the upside. The potential downside is what happens if prices continue to fall. And if you think taxpayers are mad now, just wait till they find out that, on account of government-sponsored leverage, a further 15% decline in the debt markets caused them to lose 100% of their investment in PPIPs. Says Tom Atteberry, co-manager of the FPA New Income bond fund: ‘I do see some irony in the fact that the proposed government solution to the problem looks a lot like a hedge fund and a primary broker -- with the primary broker being the federal government.'

There's also a question of whether Wall Street money managers will play ball with a government that has been bad-mouthing them and threatening them with confiscatory taxes. ‘If they go ahead with the 90% tax, nobody is going to want to work with the government,' says a top mortgage-fund manager, referring to the bill passed by the U.S. House of Representatives that would slap a 90% tax on bonuses paid to employees of bailed-out financial companies. ‘It's a deal killer,' says Rick Hughes, co-president of Portfolio Management Consultants, which directs $70 billion in institutional and retail accounts.

Even if the bonus tax isn't implemented, the mortgage-fund manager worries what might happen if PPIP works too well. He envisions a scenario in which money managers are hauled before Congress and accused of making millions on the backs of taxpayers. ‘I'd rather be attacked by a pack of wild dogs,' he says. There are other, more conventional ways that government involvement could discourage money managers from participating.

FPA's Atteberry notes that under the Treasury Department proposal, the FDIC would provide oversight to the PPIP funds. Atteberry says that if he were putting his firm's capital at risk, he'd want to know more about what ‘oversight' entails. For instance, will political considerations prevent investors from foreclosing on certain homeowners or force them to offer generous loan modifications? Says Atteberry, ‘Those are details you need to flesh out if you want to get private investors to come on board.'

Of course, it could be that some on Wall Street -- hedge fund managers in particular -- are so desperate for any source of income, they'll gladly accept these risks.

Prime brokers are extending less credit to hedge funds and investors are pulling out their money. So if the government now wants to become hedge funds' new BFF -- their new prime broker as well as their biggest investor -- why quibble about the details? ‘The reality is that a lot of hedge funds really don't have a business model any more,' says veteran Wall Street strategist Ed Yardeni. ‘The government is basically putting Wall Street back in business with a whole new business model, which is to take all the toxic assets, repackage them and re-sell them at a discount.'

‘Wall Street is getting paid to re-arrange the deck chairs on the Titanic -- but hopefully with a better outcome.'”

Many thanks to Jon Birger of CNNMoney.com for that summary. Obviously, there are still many unanswered questions about the Public-Private Investment Program. Geithner's roll out of the program last week was very short on details, and many private investors are going to be very wary of getting in bed with the government to buy up these toxic assets, even if the discounts are very attractive.

Gary D. Halbert, ProFutures, Inc. and Halbert Wealth Management, Inc.
are not affiliated with nor do they endorse, sponsor or recommend the following product or service.

Does the PPIP Have Any Chance of Working?

If President Obama wants this plan to have any chance of working, he needs to make sure the Senate does not go along with the House in passing the 90% retroactive income tax on the AIG executives that received big bonuses. Hedge funds, private equity funds and the like will not want to pony up money to buy toxic assets if they fear that the government will change the rules on profit sharing in these PPIP transactions.

I have read several articles recently that indicated the Treasury was already planning to recoup the AIG bonuses by subtracting that amount from the next round of bailout money AIG will need. That would have been an easy way to get the money back and put the onus on top AIG management to claw back the bonuses. But the Democrats in the House couldn't resist the opportunity to grandstand in front of the American people with an illegal, retroactive 90% income tax on the AIG bonus money.

Political commentator Dick Morris has an interesting take on the PPIP. Morris believes strongly that President Obama wants the PPIP to fail. Morris is convinced that, while Obama says publicly that he does not want to nationalize the big banks, privately Obama and Rahm Emanuel would very much like to see the government take over these large money center banks that have taken bailout money.

Morris argues that this is precisely why the president has been lambasting Wall Street and the big banks for weeks now, in the hope that private investors will not jump into the PPIP with both feet. Morris also believes that this is why Obama packaged the PPIP as Geithner's plan, not his own, so that if it fails he won't get the blame. If it does fail, Morris predicts that Obama will then nationalize the troubled banks. I sincerely hope this assessment is wrong!

As noted earlier, the stock markets reacted extremely strongly following Geithner's announcement of the Public-Private Investment Program. If it is to have any chance of working, he needs to get the details out fast, including assurances that the government won't change the rules in the middle of the game. We'll see.

Fed To Buy $300 Billion in Treasuries & a Lot More

The Fed Open Market Committee met on March 17-18, and the policymakers approved some bold new (yet troublesome) actions. Citing that the economy continues to worsen and the credit markets are still dysfunctional, the FOMC voted unanimously to authorize the Fed to make direct Treasury security purchases of $300 billion over the next six months, with a suggestion that much more could be authorized later on if needed.

This move is controversial because the Fed will have to print the $300 billion to pay for the purchases of Treasury securities. Many fear that this action (and likely more to come) will further sew the seeds of significantly higher inflation when we emerge from this recession. But as I have written often in recent letters, the Fed is scared to death of deflation and will do whatever they feel is required to avert a debt deflation in the economy.

At the same FOMC meeting, Bernanke & Company also voted to double the Fed's purchases of mortgage-backed securities and take on more agency debt. That means the Fed will purchase another $750 billion in toxic mortgage-related securities this year. Between the Treasury purchases and the additional mortgage-related securities – all of which they will have to print money for - the Fed's balance sheet liabilities will skyrocket to well above $3 trillion this year.

Here are excerpts from the March 17-18 FOMC official statement:

“In these [bad economic] circumstances, the Federal Reserve will employ all available tools to promote economic recovery and to preserve price stability. The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and anticipates that economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period. To provide greater support to mortgage lending and housing markets, the Committee decided today to increase the size of the Federal Reserve's balance sheet further by purchasing up to an additional $750 billion of agency mortgage-backed securities… and to increase its purchases of agency debt this year by up to $100 billion to a total of up to $200 billion. Moreover, to help improve conditions in private credit markets, the Committee decided to purchase up to $300 billion of longer-term Treasury securities over the next six months. The Federal Reserve has launched the Term Asset-Backed Securities Loan Facility to facilitate the extension of credit to households and small businesses and anticipates that the range of eligible collateral for this facility is likely to be expanded to include other financial assets.”

Following this announcement, yields on 10-year Treasury notes plummeted in the largest one-day decline on record to near 2.5%, down from above 3% just two days before. Stocks also rallied on March 18 and since then (at least until the last two days), a clear indication that many investors approve of the Fed's unprecedented actions in buying Treasury debt directly and doubling its purchases of toxic assets.

But it should also be noted that the US dollar plunged on the news that the Fed would be buying $300 billion in Treasuries and another $750 billion in toxic assets, and the implication that those numbers may well go even higher later this year. Keep in mind that these numbers are in addition to the $2+ trillion budget deficit we will have in fiscal 2010 (more on that below) and well over $1 trillion in each of the next several years.

Given the staggering size of these numbers, I don't see the US dollar going anywhere but down over the next several years. Maybe that's why China is threatening to stop buying US Treasuries and calling for a serious discussion of a new world currency at the upcoming G-20 Summit on April 2. I will discuss this issue more in coming weeks.

CBO Assessment of Obama's Record 2010 Budget

In my March 10 E-Letter, I discussed President Obama's record $3.55 trillion budget for fiscal 2010, with its projected budget deficit of a record $1.75 trillion. I also discussed why I believe the deficit next year will be well north of $2 trillion. Last week, the supposedly non-partisan (but Democrat controlled) Congressional Budget Office (CBO) released its own analysis of President Obama's proposed budget for 2010 and the next 10 years.

The CBO estimates the 2010 budget deficit at $2.3 trillion; the budget deficits for 2009-2011 at almost $5 trillion; with deficits of $1 trillion or more each year thereafter to 2019, and concludes that Obama's budgets would add $9 trillion to the national debt over that 10-year period, if enacted.

If you recall, I noted in my March 10 letter that I believe the Obama administration used economic assumptions that were too optimistic. I pointed out that Obama's projections for GDP growth were too rosy. Likewise, I noted that his assumptions for unemployment were considerably too low. I concluded that discussion by saying: But it will not surprise me if the deficit is $2 trillion or more in 2010. Now the Democrat controlled CBO agrees with me!

Interestingly, Obama has routinely criticized George W. Bush for out-of-control spending, which is a well-deserved criticism. In Bush's eight years, he – with the help of Congress – added almost $5 trillion to the national debt. Obama's budgets would add almost twice that amount - $9 trillion - according to the CBO.

I think most people reading this would agree that a 2010 budget deficit of $2.3 trillion is simply way too much, even in this economic and financial crisis. While Obama says his budget is necessary to get the economy out of the ditch, it could make things worse by ruining America's credit standing in the world. Unfortunately, it looks like he has the votes to get most of his budget passed.

Gary D. Halbert, ProFutures, Inc. and Halbert Wealth Management, Inc.
are not affiliated with nor do they endorse, sponsor or recommend the following product or service.

Conclusions, Market Implications & What To Do Now

The 20% bounce in the stock markets and the latest smattering of good news on the economy have led some analysts to conclude that the worst of the recession and the credit crisis are behind us. That could be, but the forecasters I respect believe we will see at least another 1-2 quarters when GDP will fall 6-7% or possibly more. So, I am not convinced we've seen the worst of the recession or the credit crisis. I hope I am wrong.

The good news (if we can call it that) is that the US was the first major economy to go into recession; it has suffered a more severe contraction than most other sizable economies, with the notable exception of Japan; and it would therefore be reasonable to assume the US will be one of the first major economies to turn the corner.

Yet in many ways, calling the bottom in the recession misses the point. Unlike past recessions that were followed by a strong recovery, I believe (and my best sources agree) that we face at least a couple of years of very slow growth when this recession ends. Yes, the government and the Fed are spending trillions like drunken sailors, but this economic and financial crisis is likely to put a damper on growth for at least several more years.

With that backdrop, investors have to consider the likelihood (or unlikelihood) that the US equity markets bottomed in early March. With the major market indexes having plunged over 50% from their peak in late 2007 to early March, it is easy to assume that we've seen the bottom. I, on the other hand, am not so convinced.

But that, too, misses the point in my opinion. Whether the bottom is in or not, I fully expect the equity markets to at least retest the lows seen early this month when the Dow fell to 6,500 and the S&P 500 fell to 675. And there is no guarantee that those lows will hold. Therefore, if you are looking to exit failed buy-and-hold positions in stocks, and move to more defensive strategies, I would suggest doing so now.

My greatest concern at this point is that the new Public-Private Investment Program may not work. As I have written in several recent letters, it is clear that relatively little of Obama's $787 billion stimulus plan will be spent this year when it is needed most. Thus, that means that it is even more critical that the PPIP get started quickly and that it succeeds. As noted earlier, there is no assurance that it will get up and running quickly, or that it will succeed (or if President Obama is fully behind it).

If the PPIP does not succeed, I would expect the US equity markets to plunge once again, and if so, buy-and-hold strategies will get hammered again.

If you have been considering alternatives to the buy-and-hold strategy for a portion of your equity portfolio, such as the active management programs I recommend – which can move to cash and/or hedge long positions - now may the time to get such strategies in place.

Remember, it does not matter where you live; we have hundreds of clients all across America.

Finally, we hosted our second Webinar with Scotia Partners on March 25. I'm very pleased to report that almost 300 of you registered for this opportunity to learn more about Scotia's very successful investment program. If you missed it, you can watch and listen to the full Webinar discussion (including all charts) at www.halbertwealth.com.

Hoping we can help you in these tough times,

Gary D. Halbert

SPECIAL ARTICLES:

Obama Budget - $9.3 Trillion in Deficits says CBO
http://news.yahoo.com/s/ap/20090320/ap_on_go_pr_wh/obama_budget

Obama Sticker Shock (more CBO budget analysis)
http://online.wsj.com/article/SB123776518094909023.html

Uncle Sam's Hedge Fund (the Geithner bank bailout plan)
http://www.realclearpolitics.com/articles/2009/03/uncle_sams_hedge_fund.html

Who Will Buy America’s Trillions In New Debt?

Gary D. Halbert — Tue, 24 Feb 2009 21:00:08 GMT

IN THIS ISSUE:

Federal Bailouts Surpassing $10 Trillion

Government Finance 101

Who Will Buy All This New Debt?

Bernanke: Crank Up The Printing Presses

Real Storm Clouds On The Horizon

Conclusions – Not Many I Can Find

Introduction

Over the last two weeks, I have discussed at some length President Obama's $787 billion stimulus package and Treasury Secretary Geithner's bank rescue plan that he said would cost $1½-$2 trillion or more. Add to that President Obama's announcement last week of another potentially $275 billion in a new bailout plan aimed at homeowners and mortgage lenders.

But these latest revelations are only the tip of the iceberg.

Bloomberg has recently discovered that with the passage of the $787 billion stimulus package, the federal government is now on the hook for $9.7 trillion in direct bailouts and associated government guarantees. Add to that Geithner's $1½-$2 trillion and another $275 billion to help the housing crisis, and you get pretty close to $12 trillion which is staggering.

Where will the government get that kind of money? In the pages that follow, I will discuss how the government normally finances its deficits, and how those sources are beginning to dry up due to the global recession. Unfortunately, it appears that the Federal Reserve will become the “lender of last resort” to fund the massive credit needs of the US government.

There are many serious implications of the historic bailout spending we have seen in the last year, with much more to come, especially if the Fed moves ahead to directly purchase trillions in Treasury debt. Sadly, there are no guarantees that this massive spending will even work. Even worse, we could be facing unprecedented inflation once we come out of this recession, or even before, as I will discuss below.

Federal Bailouts Surpassing $10 Trillion

Following announcement after announcement over the last year, Americans are growing dizzy from the various federal bailout plans. Who knows what the federal government is on the hook for? After filing a federal lawsuit to get the actual information on the bailouts and various bailout guarantees, Bloomberg reported the following on February 9:

“The stimulus package the U.S. Congress is completing would raise the government's commitment to solving the financial crisis to $9.7 trillion, enough to pay off more than 90 percent of the nation's home mortgages. The Federal Reserve, Treasury Department and Federal Deposit Insurance Corporation have lent or spent almost $3 trillion over the past two years and pledged to provide up to $5.7 trillion more if needed.

The Senate is to vote early this week on a stimulus package totaling at least $780 billion that President Barack Obama says is needed to avert a deeper recession. That measure would need to be reconciled with an $819 billion plan the House approved last month.

Only the stimulus package to be approved this week, and the $700 billion Troubled Asset Relief Program passed four months ago and $168 billion in tax cuts and rebates approved in 2008 have been voted on by lawmakers. The remaining $8 trillion in commitments are lending programs and guarantees, almost all under the authority of the Fed and the FDIC. The recipients' names have not been disclosed.” [Emphasis added, GDH.]

As we all know, Obama's $787 billion stimulus has already been passed. The $9.7 trillion discussed above breaks down as follows. We have not spent it all yet, but it could happen depending on how things go. Bloomberg continues:

“The pledges, amounting to almost two-thirds of the value of everything produced in the U.S. last year, are intended to rescue the financial system after the credit markets seized up about 18 months ago. The promises are composed of about $1 trillion in stimulus packages, around $3 trillion in lending and spending and $5.7 trillion in agreements to provide aid.

The worst financial crisis in two generations has erased $14.5 trillion, or 33 percent, of the value of the world's companies since Sept. 15; brought down Bear Stearns Cos. and Lehman Brothers Holdings Inc.; and led to the takeover of Merrill Lynch & Co. by Bank of America Corp.

The $9.7 trillion in pledges would be enough to send a $1,430 check to every man, woman and child alive in the world. It's 13 times what the U.S. has spent so far on wars in Iraq and Afghanistan, according to Congressional Budget Office data, and is almost enough to pay off every home mortgage loan in the U.S., calculated at $10.5 trillion by the Federal Reserve.” [Emphasis added, GDH.]

Actually, the various bailouts and guarantees are even larger than Bloomberg outlined above. The day after this article was published on February 9, Treasury Secretary Geithner announced a new financial rescue package aimed at not only banks but also consumers, which will total another $1½-$2 trillion. That puts the total up to $11.7 trillion in bailouts and guarantees.

Then on February 19, President Obama announced his “Homeowner Affordability and Stability Plan” that will spend up to $275 billion for “refinancing loans for millions of families in traditional mortgages who are underwater or close to it, by modifying loans for families stuck in subprime mortgages they can't afford as a result of skyrocketing interest rates or personal misfortune, and by taking broader steps to keep mortgage rates low so that families can secure loans with affordable monthly payments.” That puts us close to $12 trillion in bailouts and guarantees, and we're probably not done yet.

I could spend the rest of this E-Letter discussing the implications of spending this unheard of amount of money trying to bail this economy out of recession and unfreeze the credit markets. But a more basic question comes to mind: Where is the US going to get all this money?

Government Finance 101

Now that we know the real numbers, the question then becomes how the federal government intends to pay for all of these programs. Remember, the federal budget deficit is already scheduled to exceed $1 trillion this fiscal year, so where is all of this money going to come from?

That's a very good question. The answer may appear to be very basic, but please bear with me as it leads into more important matters below. The US government essentially has three ways to deal with budgetary issues. First, it can reduce spending on other programs in order to fund the bailouts. Of course, we all know that politicians will never cut spending, so there's no use in even entertaining this option.

Next, the federal government can increase revenues by raising taxes. President Obama has already indicated that he wants to raise taxes on those making over $200,000 to $250,000 a year, but has also lowered taxes (or increased giveaways, as the case may be) to those with lower incomes. To fund the bailouts, however, would require a massive tax increase that may even be more than liberals could bear.

Consider this: the total amount of personal income tax revenue received by the federal government in 2006 (latest data available) was just over $1 trillion. With trillions of dollars of bailouts either enacted or proposed, a tax increase in an amount to cover these expenditures would likely be dead on arrival in Congress, and certainly would make the economy even worse.

Numerous studies have shown that as you tax income at higher and higher rates, there is less of an incentive to take the risks necessary to invest in new businesses. This, in turn, can lead to reduced economic activity. In other words, higher income tax rates could stall the very economic recovery the bailouts seek to bring about. This is just another reason that increasing income taxes to fund the bailouts is not a good idea.

A final way to fund the activities of our federal government is through the issuance of debt securities. Accordingly, the Treasury Department issues a variety of T-bills, notes and bonds to finance budget shortfalls. Currently, the total debt incurred by the federal government (the “national debt”) is just over $10 trillion. That amounts to over $32,000 for every man, woman and child in America based on the Census Bureau's population clock. The annual interest on this debt amounted to over $454 billion in 2008, including interest accrued by bonds held by the government itself.

As you might expect, Treasury Department officials have indicated that money to pay for past and future bailouts and stimulus legislation will be funded by borrowing through the issuance of additional Treasury securities. That being the case, it might be interesting to see who currently purchases these debt instruments, and whether they have appetites for more.

By far, the single largest entity holding Treasury securities is the federal government itself. According to the recent Government Account Office's Schedules of Federal Debt, as of September 30, 2008 over $4.2 trillion of government debt is categorized as “Intragovernmental Debt Holdings.” Of course, the largest among this group is the Social Security Administration, but this category also includes various federal retirement funds, health care funds and agency trust funds.

The remaining $5.8 trillion of government debt held by the public is spread among a variety of holders, including Federal Reserve Banks, state and local governments, foreign governments and central banks, pension plans, trusts and many individual investors. By far, the greatest percentage of publicly held debt is owned by foreign interests, reaching a total of $2.8 trillion as of September 30, 2008. China has recently become the largest foreign holder of US debt, followed by Japan, the United Kingdom and a host of other countries owning smaller amounts.

Who Will Buy All This New Debt?

In light of having to fund additional expenditures related to the bailouts, I did some thinking about who among the various buyers of US debt might be able to expand their appetite for Treasury securities just ahead. While I'm not an economist or an expert in Treasury securities, the future does not look bright in my opinion.

Given that we're in a global economic recession, will the same foreign purchasers of US debt be able to continue to buy Treasuries at their previous pace, much less take on more? Let's take a closer look at just a few of the major sources of debt financing for the federal government.

Federal Government – As noted above, the single largest holder of Treasury securities is the US government itself, most of which is held in the trust funds for entitlement programs such as Social Security and Medicare. However, it is not likely that these trust funds can be counted upon to increase their purchases since the amounts they buy are determined by the excess of tax revenues over expenditures. Here are some things we know about these trust funds:

In 2004, the Medicare Hospital Insurance expenditures began to exceed tax revenues. This means that the Medicare Trust Fund is now in the process of cashing in bonds, not buying new ones.
The Social Security Trust Fund will actually be purchasing less and less government debt as the Baby Boom generation begins to retire and claim benefits. As more workers retire, tax revenues go down and expenditures go up. It is generally agreed that the Social Security benefit expenditures will outpace tax revenues in the year 2018 (if not sooner). This is hardly a scenario for a source of increased Treasury purchases.
Let's take this one step further. As the expenditures outpace tax revenues, trustees of these funds will have to start transferring money back into these programs to cover the shortfall. Where do you think they will get the money? That's right, they'll cash in some of their Treasury bonds. But wait, where will the government get the money to redeem the bonds? Well, they'll either have to borrow from another source or print the money, much as they plan to do to finance the bailout. So, in reality, the $787 billion “stimulus” and the $1½-$2 trillion bank rescue package Geithner announced two weeks ago may be just a dress rehearsal for an even greater expansion of the money supply starting in 2018 (or sooner).

Of course, the Federal Reserve can also purchase Treasury Securities, but must generally print the money to do so. I'll discuss this option and its possible negative consequences in more detail later on.

State and Local Governments – These sources of debt financing are now on the receiving end of the recent stimulus bill, and are not likely to be making new investments to the same extent they have in the past, and may actually have a net reduction in their Treasury securities holdings as states and cities seek cash to maintain their services.

Individual Investors – Treasury securities got a boost late last year as investors joined in a flight to safety. However, some observers see this as a one-time event as investors moved to the sidelines and out of equities. Future purchases by investors may be hampered by low rates on these securities.

Americans have been spending less and saving more over the last year or so. Most economists expect this trend to continue for some time yet. That may well be, but one estimate I ran across said that even if Americans got back to their historical average savings rate of 8%, this would mean only about $830 billion of new Treasury purchases - and that's IF the public chooses to invest its increased savings in Treasuries. Personally, I expect some new money from individual investors to continue to flow into Treasury securities as they seek a safe harbor in uncertain times, but this is almost certainly a temporary phenomenon. Who knows, to encourage private investment to help finance the bailouts, the government may even dust off some of the old bond promotions that they used back in World War II to encourage the public to buy war bonds.

Pension Plans, Endowments, Etc. – Many institutional investors got creamed in the recent bear market, with some losing half or more of their asset values. To the extent new contributions are made to these entities, they may continue to be a source of funding for the government. Plan trustees and investment managers have been burned, and may choose to buy safe Treasury securities until they feel better about the equity and bond markets, as well as the economy as a whole. But here, too, this is likely a temporary phenomenon.

Foreign Governments – Many foreign governments have bought Treasuries because they have been flush with US dollars from exporting goods to us. As the recession deepens and Americans cut down more on spending, fewer dollars will be flowing offshore, and this could affect the ability of foreign entities to purchase even the same amount of Treasuries, much less increase their buying activities. Plus, if we factor in the latest protectionist legislation like the “Buy American First” piece of the $787 billion stimulus bill, it might be hard to make a case to foreign nations for investing more in US Treasury securities.

The problem with all of the above sources of debt financing is that they may require concessions on the part of the Treasury to continue to buy its debt securities. Should the US be seen as unable to perform on these notes, investors may require a higher rate of interest to compensate for the added risk.

Foreign purchasers who have so reliably gobbled up our Treasury securities in the past are already balking. China recently demanded guarantees on the $690-plus-billion of Treasury securities it owns, which is not likely to happen soon but it is nonetheless a troubling development. Plus, in light of the global recession (or worse), our trading partners will likely have fewer dollars with which to buy our debt.

Bernanke: Crank Up The Printing Presses

In light of the above difficulties, there is little surprise that Chairman Bernanke recently announced that the Fed would be the purchaser of last resort of the potentially trillions of dollars of Treasury securities being issued to pay for the bailouts. I first brought this to your attention in my December 9, 2008 E-Letter. In a speech delivered in Austin on December 1, Bernanke first announced that the Fed was considering very large direct purchases of Treasury securities.

Speaking to the Austin Chamber of Commerce, Bernanke said, “Although further reductions from the current federal funds rate target of 1 percent are certainly feasible, at this point the scope for using conventional interest-rate policies to support the economy is obviously limited.”

Another option he offered was: “The Fed could purchase longer-term Treasury or agency securities on the open market in substantial quantities. This approach might influence the yields on these securities, thus helping to spur aggregate demand.” Bond prices soared on this news and yields fell to record lows.

This should not have come as a surprise. As the discussion above points out, the government has only limited ways to finance its deficits, and the global recession is serving to reduce some of those sources. Moreover, the Fed had already expanded its balance sheet by close to $2 trillion over the last year by buying up troubled assets. Even before Obama's $787 billion “stimulus” package became law, the Fed announced it would make up to $1 trillion available for consumer loans.

The problem with the Fed buying trillions of dollars worth of Treasury and other debt is that it has to print the money to pay for them. Most experts agree that we could be facing significantly higher inflation whenever the economy comes out of this recession, if the Fed monetizes trillions in federal debt by buying Treasuries.

Even when the economy and the securities markets are weak, the Fed's financing of big federal deficits can be inflationary. We learned that in the late 1970s when the Fed's deficit financing sent the CPI up to an annual rate of almost 15%. That confounded the Keynesian theorists who believed then, as now, that federal spending “stimulus” would restore economic health.

Inflation is the product of the demand for money as well as of the supply. And if the Fed finances trillions in federal deficits and more bailouts in this recession, it could create more money than the economy can use. The result could be the return of “stagflation,” a term coined to describe the 1970s experience when the economy slowed but prices rose anyway. As the global economy slows and Congress relies more on the Fed to finance a huge deficit, there is a very real danger of a return of stagflation.

These concerns, however, are not at the top of Bernanke's worry list (or Obama's or Geithner's). Remember that Bernanke is a student of the Great Depression, and he believes that the government waited too long and did too little to head off the economic and financial crisis of that period. As I have noted frequently of late, Bernanke is worried about deflation, not inflation. Here are some excerpts from the Fed's last policy meeting on January 28:

“In light of the declines in the prices of energy and other commodities in recent months and the prospects for considerable economic slack, the Committee expects that inflation pressures will remain subdued in coming quarters. Moreover, the Committee sees some risk that inflation could persist for a time below rates that best foster economic growth and price stability in the longer term [read: deflation].

The Federal Reserve will employ all available tools to promote the resumption of sustainable economic growth and to preserve price stability. The focus of the Committee's policy is to support the functioning of financial markets and stimulate the economy through open market operations and other measures that are likely to keep the size of the Federal Reserve's balance sheet at a high level.

The Federal Reserve continues to purchase large quantities of agency debt and mortgage-backed securities to provide support to the mortgage and housing markets, and it stands ready to expand the quantity of such purchases and the duration of the purchase program as conditions warrant. The Committee also is prepared to purchase longer-term Treasury securities if evolving circumstances indicate that such transactions would be particularly effective in improving conditions in private credit markets.

The Federal Reserve will be implementing the Term Asset-Backed Securities Loan Facility [up to $1 trillion] to facilitate the extension of credit to households and small businesses.”

So it is clear that the Federal Reserve is prepared to purchase however many trillions of Treasury paper that are required to fund the massive bailouts President Obama is asking for. The implications of this massive monetization of government debt are far from clear, especially as they relate to possible inflation down the road. Ironically, there are no guarantees that any of this will work.

Real Storm Clouds On The Horizon

Ever since the end of the 1980-82 recession, I have been a consistent optimist regarding the US economy. For the last 25+ years, I have believed that the technology and productivity-led US economy would surprise on the upside, not without a brief recession or two along the way. I was correct. As long-time readers will attest, I have condemned the “gloom-and-doom” crowd countless times in my newsletter and in recent years in this weekly E-Letter.

Likewise, over those same 25+ years, I have predicted that the US stock markets would also surprise on the upside, and they did with the greatest bull market in history, which the gloom-and-doom crowd totally missed. I encouraged clients and readers to remain fully invested in US stocks, but with a significant allocation to strategies that had the flexibility to move to cash (or more recently hedge long positions) during periodic stock market downturns.

I also predicted since 1982 that inflation, which had reached 15% in the late 1970s, would be brought under control, thanks in large part to former Fed chairman Paul Volcker. Inflation has not been a major threat since then, despite non-stop warnings from the gloom-and-doom crowd and the gold bugs to the contrary.

My optimism over the last 25+ years was well placed, and hopefully allowed my clients and readers to take advantage of the greatest bull market in stocks and bonds ever. But I must admit that my optimism is fading fast. While I am not remotely in the gloom-and-doom camp today, I am not optimistic about America's future, especially in light of the discussion above.

Our nation is in the process of borrowing nearly $12 trillion in an effort to bail us out of the current financial crisis. As noted above, there is no assurance that this plan will work. And most importantly, there is no plan for how this money will be paid back.

So the government will be incurring the most massive federal debt ever at arguably the worst possible time in our nation's history. This fact is highlighted by the reality that tens of millions of Baby Boomers will be entering retirement (if they are lucky) over the next 10-15 years.

We have all seen reports of the strains this will put on Social Security over the next 10-20 years, which will mean even more government borrowing to shore up our nation's entitlement programs. If you believe the numbers, Social Security outlays will begin to outstrip inflows by 2018. I will not be surprised if it happens even sooner.

My confidence in the massive bailouts discussed above was never much, and is fading rapidly. Frankly, I am not sure what the best course of action is at this point. But I do not believe that putting the government into the largest net debtor position in our nation's history is where we should go. Likewise, I do not believe that the government should nationalize our largest banks, but it may very well do so in the months ahead.

Not to end on a political note, but I have warned repeatedly that President Obama comes from a political persuasion which believes that government ownership of the private sector is just fine. I hope not, but we are seeing this evolve after only just over a month of his presidency. It remains to be seen what we should expect next.

Conclusions – Not Many I Can Find

The financial crisis is far from over, and the government is planning to borrow and spend several trillions more over the next couple of years or longer. The Federal Reserve is pledged to be the “lender of last resort,” which could lead to a big rise in inflation in the coming years, or stagflation depending on how the economy does going forward.

The stock markets are devastated, with many people's retirement accounts down by half or more. There is little sentiment that a recovery to new highs will occur anytime soon, for good reason. Millions of Baby Boomers have nowhere near enough to retire into the lifestyles they previously envisioned. As the latest massive bailouts have been announced, stock market prices have consistently tumbled over the last few months to new lows. Does the Obama administration get the point? Obviously not.

At the end of the day, the question is: Will all of these bailouts work? Or are we just delaying the inevitable (as suggested last week in the article by Nouriel Roubini). The main point is that we could have just let banks, brokerage firms and other businesses fail, but this possibly would have created a global depression. However, are we still headed for that fate, only $10 to $20 trillion deeper in debt? Only time will tell.

President Obama is scheduled to speak before Congress tonight (Tuesday), at which time he is expected to present “a road map for how we get to a better day,” a senior adviser said on Monday. Then later this week, Treasury Secretary Geithner is expected to unveil more details on the massive bank rescue plan. It should be another very interesting week.

Best regards in troubling times,

Gary D. Halbert

SPECIAL ARTICLES:

Obama's Stimulus: A Colossal Waste (Read this!)
http://www.realclearpolitics.com/articles/2009/02/obamas_stunted_economic_stimul.html

Obama's Failing Leadership
http://www.humanevents.com/article.php?id=30804

How the GOP Should Approach TARP 2.0
http://online.wsj.com/article/SB123534958659044761.html

Obama should rebuke Attorney General Eric Holder
http://www.forbes.com/2009/02/22/obama-eric-holder-racism-america-cowards-opinions-columnists_attorney_general.html

Throwing Trillions Around Like Crazy

Gary D. Halbert — Tue, 17 Feb 2009 23:06:38 GMT

IN THIS ISSUE:

President Obama Gets His “Spendulus” Bill
Geithner’s Bank Rescue Plan Short On Details
Should The Government Nationalize The Banks?
Conclusions - Trillions of Dollars Being Thrown Around

Introduction

Today, President Obama will sign into law the enormous American Recovery and Reinvestment Act of 2009 - $787 billion – which was passed entirely by Democrats in the House and with the help of only three moderate Republicans in the Senate. Unfortunately, the final bill directs only about one-third of the money to tax incentives and apprx. two-thirds to spending projects. We will look at the highlights as we go along.

Treasury Secretary Timothy Geithner gave his much-anticipated speech on how the government intends to rescue the banking system and unfreeze the credit markets on Tuesday of last week. President Obama had led people to believe that Geithner’s speech would be long on details and substance. It wasn’t. In fact, Geithner has since been roundly criticized by the media.

There are those who now believe that it would have been better for the Obama administration not to have put out any information at all until they had the details. Certainly, the stock markets didn’t like Geithner’s speech; the Dow plunged over 400 points at one point just after the speech. In the pages that follow, I will summarize what little Mr. Geithner outlined last week.

While the latest Treasury rescue plan includes spending $2 trillion or more to rescue banks and get credit moving, there are some knowledgeable analysts that do not believe that will be enough to save the banks and financial institutions. As a result, we are hearing more and more about nationalizing the banks.

While I am NOT in favor of nationalizing the banks, I think we all should understand how and why it might happen. In the pages that follow, I will reprint a very informative analysis written by Dr. Nouriel Roubini. In it, he discusses why he believes that the latest bank rescue plan won’t work, and why he thinks the government will ultimately have no choice but to nationalize many of our largest banks. I think you should read it carefully, if for no other reason than to be informed.

President Obama Gets His “Spendulus” Bill

As you are no doubt aware, Congress passed the $787 billion mostly spending bill last Friday, and the president is expected to sign it into law later today. Unfortunately, the compromise bill includes only $281 billion (36%) for tax incentives and $506 billion (64%) in new government spending programs. Of the $506 billion, $198 billion is spending for programs such as unemployment assistance, Social Security benefits and added money for states to help with Medicaid for low-income and disabled Americans. The bill is loaded with pork.

In addition to the size of the spending in the bill was the concern that most of the money would not be spent until 2011-2012. We are told, however, that the compromise bill envisions spending at least half the money by the end of next year. But that remains to be seen.

The tax incentives in the final bill were further watered down to the point that most workers will see only an extra $8-$13 more in their weekly paychecks. Most of the other tax incentives were in the form of tax credits which won’t be received until they file their tax returns. All in all, I think it was a terrible piece of legislation, and there is no guarantee it will work.

Geithner’s Bank Rescue Plan Short On Details

Last Tuesday, new Treasury Secretary Tim Geithner unveiled the Obama administration’s latest “Financial Stability Plan.” For a week leading up to last Tuesday, President Obama had heralded the plan Geithner was to announce. Unfortunately, the plan outlined by Geithner last Tuesday was very short on substance and there were virtually no details. As the world watched and listened, the US stock markets plunged during and after the speech, with the S&P 500 Index down almost 5% for the week.

Here are some excerpts from Secretary Geithner’s speech. He began as follows:

Today, as Congress moves to pass an economic recovery plan that will help create jobs and lay a foundation for a stronger economic future, we are outlining a new Financial Stability Plan. Our plan will help restart the flow of credit, clean up and strengthen our banks, and provide critical aid for homeowners and for small businesses.

After these opening remarks, Geithner went on to describe the current financial crisis and how we have gotten to where we are. Thereafter, he began to describe the plan the Treasury has come up with. For starters, he said that US banking institutions would undergo a “comprehensive stress test,” essentially to determine which banks should go forward and which banks should be closed or merged with other stronger banks. Those banks that continue to operate would have access to funding from the Treasury.

Those institutions that need additional capital will be able to access a new funding mechanism that uses funds from the Treasury as a bridge to private capital. The capital will come with conditions to help ensure that every dollar of assistance is used to generate a level of lending greater than what would have been possible in the absence of government support. And this assistance will come with terms that should encourage the institutions to replace public assistance with private capital as soon as that is possible.

Geithner did not say how much money the Treasury is willing to make available to banks under this Financial Stability Plan, nor what terms and conditions would be placed on banks that take government money. There was nothing on whether the government would require equity from the banks. Some analysts expect Geithner will need at least $500 billion for this program.

Next, Geithner talked of a new “Public-Private Investment Fund” for purposes of making a market in toxic assets and removing troubled assets from the banks’ books. He said:

Second, alongside this new Financial Stability Trust, together with the Fed, the FDIC, and the private sector, we will establish a Public-Private Investment Fund. This program will provide government capital and government financing to help leverage private capital to help get private markets working again. This fund will be targeted to the legacy loans and assets that are now burdening many financial institutions.

By providing the financing the private markets cannot now provide, this will help start a market for the real estate related assets that are at the center of this crisis. Our objective is to use private capital and private asset managers to help provide a market mechanism for valuing the assets.

We are exploring a range of different structures for this program, and will seek input from market participants and the public as we design it. We believe this program should ultimately provide up to one trillion in financing capacity, but we plan to start it on a scale of $500 billion, and expand it based on what works. [Emphasis added, GDH.]

So there’s another potential trillion of new government spending. Geithner then went on to talk about the next part of the rescue program:

Third, working jointly with the Federal Reserve, we are prepared to commit up to a trillion dollars to support a Consumer and Business Lending Initiative. This initiative will kickstart the secondary lending markets, to bring down borrowing costs, and to help get credit flowing again. [Emphasis added, GDH.]

In our financial system, 40 percent of consumer lending has historically been available because people buy loans, put them together and sell them. Because this vital source of lending has frozen up, no financial recovery plan will be successful unless it helps restart securitization markets for sound loans made to consumers and businesses - large and small.

This lending program will be built on the Federal Reserve's Term Asset Backed Securities Loan Facility, announced last November, with capital from the Treasury and financing from the Federal Reserve. We have agreed to expand this program to target the markets for small business lending, student loans, consumer and auto finance, and commercial mortgages.

Assuming the Financial Stability Trust costs only $500 billion (doubtful), we’re up to $2.5 trillion for this giant rescue package. But that’s not all. Geithner continues:

Finally, we will launch a comprehensive housing program. Millions of Americans have lost their homes, and millions more live with the risk that they will be unable to meet their payments or refinance their mortgages. Many of these families borrowed beyond their means. But many others fell victim to terrible lending practices that left them exposed, overextended, and with no way to refinance.

…The President has asked his economic team to come together with a comprehensive plan to address the housing crisis. We will announce the details of this plan in the next few weeks. Our focus will be on using the full resources of the government to help bring down mortgage payments and to reduce mortgage interest rates. We will do this with a substantial commitment of resources already authorized by the Congress under the Emergency Economic Stabilization Act. [Emphasis added, GDH.]

Note that Mr. Geithner did not put a number on the amount of money the government may be willing to provide to help Americans stay in their homes, preferring to use the term “full resources,” and there were no details as to how this money will be made available. Apparently, President Obama will speak tomorrow (Wednesday) with more information on the housing part of this giant rescue plan.

There was considerable disappointment over Secretary Geithner’s speech last Tuesday. As noted above, the stock markets started to plunge before the speech was over and the Dow fell over 400 points at one point and closed down 381 on the day. The markets were not happy!

It remains to be seen what the markets will do this week as we (hopefully) get more details. We are dangerously close to hitting new lows in the major equity markets, and that could bring yet another large wave of selling. Let’s hope not.

Should The Government Nationalize The Banks?

With the economy worsening by the month, and the credit markets still frozen for the most part, we are hearing more and more calls to nationalize the banks. Personally, I am NOT for nationalizing the banks. But if the latest credit market rescue plan outlined in very broad terms above does not work, it would not surprise me to see President Obama opt for nationalization.

With more and more talk of nationalizing the banks, I have chosen to reprint a recent article written by Nouriel Roubini, PhD. Dr. Roubini is a professor of economics at the Stern School of Business at New YorkUniversity and is chairman of RGE Monitor, a well-known economic consultancy firm. Roubini is best known for having warned about the subprime crisis and an impending economic and financial crisis way back in late 2005.

Roubini does not believe that the government’s rescue plans announced by Secretary Geithner last week will save the banking system, and he believes the system will have to be nationalized at some point, at least those banks that are insolvent. Whether you agree or not, I suggest you read the following closely, if for no other reason than to be informed.

QUOTE:
“Nationalize Insolvent Banks
by Nouriel Roubini

A year ago I predicted that losses by U.S. financial institutions would be at least $1 trillion and possibly as high as $2 trillion. At that time, the consensus was that such estimates were gross exaggerations--the naïve optimists had in mind about $200 billion of expected subprime mortgage losses. But, as I pointed out, losses would rapidly mount well beyond subprime mortgages as the U.S. and global economy spun into a severe financial crisis and ugly recession.

I argued that we would see rising losses on subprime, near-prime and prime mortgages; commercial real estate; credit cards, auto loans and student loans; industrial and commercial loans; corporate bonds, sovereign bonds and state and local government bonds; and massive losses on all of the assets--collateralized debt obligations (CDOs), collateralized loan obligations, asset-backed securities and the entire alphabet of credit derivatives--that had securitized such loans.

By now, write-downs by U.S. banks have already passed the $1 trillion mark (my floor estimate of losses), and institutions such as the International Monetary Fund and Goldman Sachs predict losses over $2 trillion (close to my original expected ceiling for such losses).

But if you think $2 trillion is already huge, our latest estimates at RGE Monitor suggest that total losses on loans made by U.S. financial firms and the fall in the market value of the assets they are holding will be, at their peak, about $3.6 trillion. The U.S. banks and broker-dealers are exposed to half of this much, or $1.8 trillion; the rest is borne by other financial institutions in the U.S. and abroad.

The capital backing the banks' assets was just $1.4 trillion (last fall), leaving the U.S. banking system some $400 billion in the hole, or close to zero even after the government and private-sector recapitalization of such banks. Thus, another $1.4 trillion will be needed to bring back the capital of banks to the level it had before the crisis, and such massive additional recapitalization is needed to resolve the credit crunch and restore lending to the private sector.

These figures suggests the U.S. banking system is effectively insolvent in the aggregate; most of the U.K. banking system looks insolvent, too, and many other banks in continental Europe are also insolvent.

There are four basic approaches to a clean-up of a banking system that is facing a systemic crisis:

No. 1: Recapitalization together with the purchase by a government "bad bank" of the toxic assets;

No. 2: Recapitalization together with government guarantees--after a first loss by the banks--of the toxic assets;

No. 3: Private purchase of toxic assets with a government guarantee and/or--semi-equivalently (a provision of public capital to set up a public-private bad bank where private investors participate in the purchase of such assets--something similar to the U.S. government plan presented by Treasury Secretary Timothy Geithner for a public-private investment fund);

No. 4: Outright government takeover (call it nationalization--or “receivership” if you don't like the N-word) of insolvent banks, to be cleaned after takeover and then resold to the private sector.

Of the four options, the first three have serious flaws. In the bad-bank model (the first, above) the government may overpay for the bad assets, at a high cost for the taxpayer, as their true value is uncertain; if it does not overpay for the assets, many banks are bust, as the mark-to-market haircut they need to recognize is too large for them to bear.

Even in the guarantee-after-first-loss model (No. 2 above), there are massive valuation problems, and there can be very expensive risk for the taxpayer, as the true value of the assets is as uncertain (as in the purchase of bad assets model).

The shady guarantee deals recently done with Citigroup and Bank of America were even less transparent than an outright government purchase of bad assets, as the bad-asset-purchase model at least has the advantage of transparency of the price paid for toxic assets.

In the bad-bank model, the government has the additional problem of having to manage all the bad assets it purchased, something that it does not have much expertise in. At least in the guarantee model, the assets stay with the banks. The banks know better how to manage--and also have a greater incentive than the government to eventually work out such bad assets.

The very cumbersome U.S. Treasury proposal to dispose of toxic assets, presented by Geithner, taking the toxic asset off the banks' balance sheets as well as providing government guarantees to the private investors that will purchase them (and/or public capital provision to fund a public-private bad bank that would purchase such assets). But this plan is so non-transparent and complicated it got a thumbs-down from the markets as soon as it was announced. All major U.S. equity indexes dropped sharply.

The main problem with the Treasury plan--that in some ways may resemble the deal between Merrill Lynch and Lone Star--is the following: Merrill sold its CDOs to Lone Star for 22 cents on the dollar. Even in that case, Merrill remained on the hook in case the value of the assets were to fall below 22 cents, as Lone Star paid initially only 11 cents (i.e., Merrill guaranteed the Lone Star downside risk). But today, a bank like Citi has similar CDOs that, until recently, were still sitting on its books at a deluded value of 60 cents.

Since the government knows no one in the private sector would buy those most toxic assets at 60 cents, it may have to make a guarantee (formally or informally) to limit the downside risk to private investors from purchasing such assets. But that guarantee would be hugely expensive if you needed to convince private folks to buy at 60 cents assets that are worth only 20--or even 11--cents.

So the new Treasury plan would end up being again a royal rip-off of the taxpayer if the guarantee is excessive in relation to the true value of the underlying assets. And if, instead, the guarantee is not excessive, the banks need to sell the toxic assets at their true underlying value, implying that the emperor has no clothes [i.e. – large bank failures].

A true valuation of the bad assets--without a huge taxpayer bailout of the shareholders and unsecured creditors of banks--implies that banks are bankrupt and should be taken over by the government.

Thus, all the schemes that have so far been proposed to deal with the toxic assets of the banks may be a big fudge--one that either does not work or works only if the government bails out shareholders and unsecured creditors of the banks.

So, paradoxically, nationalization may be a more market-friendly solution to a banking crisis. It creates the biggest hit for common and preferred shareholders of clearly insolvent institutions and, most certainly, even the unsecured creditors, in case the bank insolvency hole is too large; it also provides a fair upside to the taxpayer.

Nationalization can also resolve the problem of the government managing the bad assets: If you're selling back all the banks' assets and deposits to new private shareholders after a clean-up, together with a partial government guarantee of the bad assets (as was done in the resolution of the Indy Mac bank failure), you avoid having the government manage the bad assets.

Alternatively, if the bad assets are kept by the government after a takeover of the banks and only the good ones are sold back, through a reprivatization scheme, the government could outsource the job of managing these assets to private asset managers. In this way, the government can avoid creating its own Resolution Trust Corp. bank to work out such bad assets.

Nationalization also resolves the too-big-to-fail problem of banks that are systemically important, and that thus need to be rescued by the government at a high cost to the taxpayer. This too-big-to-fail problem has now become an even-bigger-than-too-big-to-fail problem, as the current approach has led weak banks to take over even weaker banks.

Merging two zombie banks is like having two drunks trying to help each other stand up. The JPMorgan Chase takeover of insolvent Bear Stearns and WaMu; the Bank of America takeover of insolvent Countrywide and Merrill Lynch; and the Wells Fargo takeover of insolvent Wachovia, all show that the too-big-to-fail monster has become even bigger.

In the Wachovia case, you had two wounded institutions (Citi and Wells Fargo) bidding for a zombie, insolvent one. Why? They both knew that becoming even bigger than too big to fail was the right strategy to extract an even greater bailout from the government. Instead, with the nationalization approach, the government can break up these financial supermarket monstrosities into smaller pieces to be sold to private investors as smaller (better) banks.

This "nationalization" approach was successfully undertaken by Sweden, while the current U.S. and U.K. approach may end up looking like the zombie banks of Japan that were never properly restructured and ended up perpetuating the credit crunch and credit freeze.

Japan wound up with a decade-long near-depression because of its failure to clean up the banks and the bad debts. The U.S., U.K. and other economies risk a similar near-depression and stag-deflation (multi-year recession and price deflation) if they fail to appropriately tackle this most severe banking crisis.

So why is the U.S. government temporizing and avoiding doing the right thing, i.e., taking over the insolvent banks? There are two reasons.

First, there is still some small hope (and a small probability) that the economy will recover sooner than expected, that expected credit losses will be smaller than expected, and that the current approach of recapping [recapitalizing] the banks and somehow working out the bad assets will work in due time.

Second, taking over the banks--whether you call it nationalization or, in a more politically correct way, "receivership"--is a radical action that requires most banks be clearly beyond the pale. Today, Citi and Bank of America look blatantly near-insolvent and ready to be taken over, but JPMorgan and Wells Fargo as yet do not.

But with the sharp rise in delinquencies and charge-off rates that we are experiencing now on mortgages, commercial real estate and consumer credit, even JPMorgan and Wells will likely look near-insolvent in six to 12 months (as suggested by Chris Whalen, one of the leading independent analysts of the banking system).

Thus, if the government were to take over only Citi and Bank of America today, wiping out common and preferred shareholders and forcing unsecured creditors to take a haircut, a panic may ensue for other banks, and the Lehman fallout that resulted from having unsecured creditors taking losses on their bonds will be repeated.

On the other hand, if, as is likely, the current "fudging" strategy does not work, and most banks--the major four and a good number of the remaining regional banks--all look clearly insolvent in six to 12 months, you can then take them all over, wipe out common and preferred shareholders and even force unsecured creditors to accept losses.

So, the current strategy--Plan A-- may not work, and Plan B (or better, "Plan N," for nationalization) may end up the way to go later this year. Wasting another six to 12 months may risk turning a U-shaped recession into an L-shaped near-depression.

The political constraints the new administration faces--and the remaining small probability that the current strategy may, by some miracle or luck, work--suggest Plan A should be first exhausted before there is a move to Plan N.

But with the government forcing Citi to shed some of its units and assets, and starting stress tests to figure out which institutions are so massively undercapitalized that they need to be taken over by the Federal Deposit Insurance Corp., the administration is laying the groundwork for the eventual, necessary takeover of the insolvent banks.

So while Plan A is now underway, the very negative market response to this Treasury plan suggests it will not fly. Markets were expecting a more clear plan, but also one that would bail out shareholders and creditors of insolvent banks. Unfortunately, that is politically and fiscally unfeasible. It is time to start to think and plan ahead for Plan N.” END QUOTE

Conclusions - Trillions of Dollars Being Thrown Around

As I have emphasized repeatedly over the last several weeks, the politicians in Washington, as well as our monetary officials such as Ben Bernanke, are scared to death about a “debt deflation” that could throw the country into a new depression – which would likely mean that they all lose their jobs! So they will stop at no lengths to avoid it. This is why we are seeing multiple trillions of dollars being thrown around.

The Geithner rescue plan announced last week, with almost no details to go along with it, would commit the government to at least another $2 trillion in spending, and maybe more. Add to that however much more spending President Obama is likely to announce tomorrow to rescue the housing market, which I expect to be up to another trillion.

Bloomberg estimates (based on government data they had to sue to get) that the government is already on the hook for $9.7 trillion in bailouts and various guarantee liabilities associated with the credit crisis – before the announcements over just the last week: 1) the $787 billion stimulus; and 2) at least $2 trillion in the Geithner plan. Not to mention what Obama announces tomorrow for housing.

We’ve never seen anything like this in the history of America, or even the planet for that matter. Making matters worse, no one knows if these efforts will work. And people wonder why the stock markets are going down.

Interestingly, I have been criticized over the last two weeks as I have written extensively about President Obama’s trillion-dollar “stimulus” package (if you add interest). I expect I’ll get more negative comments this week with the focus on the Geithner rescue package and Dr. Roubini’s piece on nationalizing the banks.

Some readers have complained that these are really just political matters that don’t belong in an economic/investment e-letter. I beg to differ – have you looked at the value of your investment portfolio recently? No one can argue any longer that politics don’t affect our investments.

Very best regards,

Gary D. Halbert

SPECIAL ARTICLES:

Obama’s Tainted Win
http://www.realclearpolitics.com/articles/2009/02/obamas_tainted_win.html

Obama Chose Urgency Over Transparency (this from a liberal)
http://www.slate.com/id/2210698/

Geithner Can’t Find Gun, Let Alone the Silver Bullet
http://www.bloomberg.com/apps/news?pid=20601039&refer=columnist_reilly&sid=aN_dadtIVMZo

Is Geithner Ready for Prime Time?
http://www.realclearpolitics.com/articles/2009/02/is_geithner_ready_for_prime_ti.html

Obama Seeks Multi-Trillion Dollar Bailouts

Gary D. Halbert — Tue, 03 Feb 2009 22:25:16 GMT

IN THIS ISSUE:

The Recession Continues To Deepen
So, How Deep & How Long?
Multi-Trillion Dollar Bailouts In The Works
Obama's $825 Billion "Stimulus" Package
Obama's Next "Big Bang" Bank Bailout
Fed Gearing Up To Buy Treasury Bonds

Introduction

We are witnessing the most aggressive government intervention into the US private sector in history, and I am not simply referring to President Obama's massive $825 billion so-called "stimulus" package passed last week by the House of Representatives. As we will discuss as we go along, there are also plans in the works to borrow and spend trillions more, which will result in the government owning even more of the private sector, starting with the banking system.

We should all recognize that President Obama and most of the Democrats in Congress have no problem whatsoever with the government owning (and eventually controlling) much of the private sector. What we are, and will be, witnessing is unprecedented and is being planned under the guise of the economic and financial crisis, when in fact there is a much larger political agenda ongoing now that the Democrats have control of the White House and the Congress.

Speaking of the economic and financial crisis, the US recession continues to deepen as does the global economy. The Commerce Department reported on Friday that US GDP slumped at an annual rate of 3.8% in the 4Q. Most of the other economic reports of late have also been on the negative side. Most forecasters now predict that 1Q GDP will also be down at least 3-4%. This week, we look at the latest data and some forecasts of what lies ahead for 2009.

Following that, we will examine the latest $825 billion stimulus package that was passed last week by the House. While initially touted as a way to jump-start the banks and unfreeze the credit markets, the final bill is loaded with pork-barrel spending and has nothing for the banks. Following that, we will discuss new government plans totaling $1-2 trillion to bail out the banking system. There is so much to talk about, I don't know where to start, but let's begin with the economy.

The Recession Continues To Deepen

As one analyst put it, there is still no light at the end of the tunnel for the US economy, which officially entered this recession in December 2007 (with the benefit of hindsight). As noted above, US Gross Domestic Product fell at an annual rate of 3.8% in the 4Q, the largest quarterly decline since 1982. The latest GDP number was not as bad as pre-report expectations, but it does reflect the reality that holiday retail sales plunged over 8% in December according to MasterCard.

The Consumer Confidence Index dropped to another all-time low in January, falling to a reading of 37.7, down from 87.3 one year ago. Consumers remain very pessimistic about the state of the economy and about their earnings. Those saying business conditions are "bad" increased to 47.9% from 45.8% in December, while those saying business conditions are "good" declined to 6.4% from 7.7% in December. These are the lowest readings since the Consumer Confidence Index has been in existence.

In what was initially thought to be a bright spot, the Conference Board announced last week that the Index of Leading Economic Indicators (LEI) rose 0.3% in December. However, the Conference Board was quick to point out that the increase in the LEI was almost entirely due to the large surge in the money supply in December. The economic component of the LEI was actually down -0.5% in December. The LEI has declined for the last seven months in a row.

The unemployment rate rose more than expected in December, to 7.2%, when every state in America saw its unemployment rate rise. The nation lost apprx. two million jobs in the last four months of 2008 alone. Employment data for January will be released this Friday, and analysts expect the unemployment rate to rise to 7.5%. At the rate major layoffs are being announced, the unemployment rate could approach 9% by the end of the year.

On the manufacturing side, most reports were worse than expected. The ISM Index fell to 32.4 in December, down from 36.2 in November, and worse than pre-report estimates of a decline to 35.4. This morning, the ISM Index for January showed a modest increase to 35.6, which was higher than expected. But keep in mind that any figure below 50 indicates an economy that is contracting.

Industrial production fell 2.0% in December, twice the pre-report consensus. Durable goods orders fell 2.6% in December following a decline of 3.7% in November. Factory orders plunged 4.6% in November (latest data available).

On the housing front, there finally were some encouraging reports. Sales of existing homes rose 6.5% in December to an annual sales pace of 4.74 million units according to the National Association of Realtors, although the NAR noted that many of the sales were "distressed sales" in an effort to avoid foreclosure.

Thanks to the unexpected home sales increase, the inventory of homes for sale decreased 11.7% in December to 3.68 million units. That represents a 9.3-month inventory of unsold homes at the current pace of sales, down from a 11.2-month supply in November. The median home sales price fell to $175,400 in December, which was down 15.3% from the same period in 2007.

New home sales, on the other hand, fell more than expected in December to apprx. 331,000 units. Housing starts fell more than expected in December to apprx. 550,000 units – this is actually a good thing. Building permits also fell more than expected in December to apprx. 549,000 units, also a good thing from an economic standpoint, though not so good if you are or work for a builder.

So, How Deep & How Long?

The truth is, no one knows for sure how long this recession will last or how bad it will get. As noted earlier, most forecasters are predicting that GDP will fall by 3-4% in the 1Q. Among the analysts and forecasting groups I read and respect, there are basically two camps. One camp believes that the recession will get worse, perhaps considerably worse, the credit markets will remain very tight all year, and that a mild recovery will not begin until sometime in 2010.

The other camp is less pessimistic and believes that the economy will begin a slow recovery and the credit markets will unfreeze in the second half of this year. Most in this camp believe that the vast sums (trillions as we will discuss below) the government and the Fed are throwing into the economy will fill the void left by contracting consumer spending. Some in this camp are optimistic that the unexpected upturn in existing home sales in December will have marked the bottom of the housing slump.

Personally, I have been leaning more toward the first camp. However, as we will discuss in the pages that follow, if the Treasury and the Fed are prepared to throw an additional $1-$3 trillion of liquidity into the economy, perhaps the outcome is somewhere between the two camps noted above. In either case, we will not be out of this recession any time soon.

Multi-Trillion Dollar Bailouts In The Works

As I noted earlier, I do not wish for this week's E-Letter to be considered a political piece, but there are some political realities that sophisticated investors must consider. The question for me is where to start. I choose to start this discussion with a quote from President Obama's Chief of Staff, Rahm Emanuel, shortly before Obama took office.

Rahm Emanuel, who was a senior political advisor to former president Bill Clinton, and most recently a member of the House of Representatives from the state of Illinois, is one of the most powerful (and foul-mouthed) members of the liberal Washington elite. Interestingly, Emanuel supported Hillary Clinton in the campaign, but Obama picked him as Chief of Staff anyway.

As President Obama's Chief of Staff, Emanuel is essentially the second most powerful politician in Washington. Mr. Emanuel stated the following to the Wall Street Journal after Barack Obama named him as Chief of Staff prior to his inauguration (read carefully):

"You never want a serious crisis to go to waste. What I mean by that is that you have an opportunity to do things you could never do before. Things that we had postponed for too long, that were long-term, are now immediate and must be dealt with."

Let me interpret this political message that Emanuel unintentionally stated: We are in an unprecedented financial crisis that will pave the way for the implementation of the liberal policies that we believe in, including things that the American people would not otherwise tolerate. And some of those things are now in the pipeline as I will elaborate below.

You have no doubt heard about President Obama's estimated $825 billion "stimulus" package that was passed by the House last week (with not a single Republican voting yes). As you probably also know, that "stimulus" package was loaded with pork-barrel spending that, during the campaign, Obama said he would not tolerate.

What you probably do not know is that Obama has an additional stimulus plan to recapitalize the banks and financial institutions that could total $2 trillion or more, and will mean that the government gains substantially more equity ownership of the major banks and financial institutions, as well as others.

Should President Obama run into problems financing these huge bailout initiatives, the Federal Reserve has let it be known that it stands ready to purchase a trillion or more in long-term bonds in order to keep interest rates low and keep the credit markets from seizing up, according to recent statements from his new Treasury Secretary, Timothy Geithner.

We will look in more detail at Obama's breathtaking plans in the pages that follow, beginning with the latest $825 billion "stimulus" package passed by the House last week. Then we will look into the potentially $2 trillion rescue package for the banks and the possibility that the Fed will be buying hundreds of billions of Treasury bonds, if needed.

Obama's $825 Billion "Stimulus" Package

Unless you are politically tone-deaf, you know that President Obama has proposed another so-called ‘economic stimulus package' of apprx. $825 billion, on top of President Bush's $700 billion "Troubled Asset Relief Program" (TARP) last year, of which only apprx. half has been spent so far. Obama will now get to decide how the other half is spent.

Oh, and let's not forget the additional $800 billion that the Fed intends to spend in an attempt to further unfreeze credit markets for homebuyers, consumers and small businesses. Never mind that the Fed's plan aims to do the very things that Secretary Paulson initially planned for TARP – buy up troubled mortgage securities – but then said there were better uses for the money.

Many analysts have argued for several months now that Bush's TARP program was not enough to keep our nation's largest banks afloat, and that much more in the way of rescue funds would need to be made available by the Treasury. Plus, most analysts also agreed that any such new stimulus package should include tax breaks and incentives to get consumers spending again to revive the plunging economy.

As a result, many of these same analysts welcomed the idea of the additional $825 billion Obama requested. That is, until they saw how Obama planned to spend the money. Most analysts figured that the $825 billion would go to banks in the form of loans or other capital injections, and to consumers in the form of tax cuts, rebates or other tax incentives to put money in their pockets.

But when the Obama administration finally released the substance of the $825 billion stimulus package, most analysts (your editor included) were shocked. The latest enormous stimulus package is loaded with pork. Around two-thirds of the $825 billion is liberal pork-barrel spending, with little for infrastructure rebuilding; only around one-third is tax cuts and credits for consumers; and there is nothing in the bill for helping the banks.

Remember, this was Obama's proposal. The House tweaked it a little, but not much in the end. The plan passed by the House last week totaled $819 billion, with only $275 billion for tax cuts and a whopping $544 billion in new spending programs as outlined below. The Senate, which has yet to vote on the bill, reportedly has plans to increase it to apprx. $900 billion. For discussion purposes below, I will simply refer to it as the $825 billion stimulus package.

As reported last week, the liberal spending components in Obama's plan include an estimated: 1) $92.3 billion for education, labor, etc.; 2) $88.9 billion for Medicaid to help out state budgets that are in the red; 3) another $79 billion for states that are running budget deficits; 4) $59.5 billion for transportation and urban development; 5) $48.9 billion for the Energy Department; 6) $27 billion for the Agriculture Department; and 7) $15 billion for the environment – just to name a few.

If your blood is not already boiling, get this. Obama's $825 billion bailout also includes over $5 billion that is targeted for low-income housing assistance organizations that prominently includes Chicago-based ACORN, which is really a left-wing political group that Obama worked for in his early days after law school. ACORN could be a big recipient of this money, even though it is under federal investigation for voter fraud. Hmmm.

As you can see, the bulk of Obama's $825 billion stimulus package is targeted toward government agencies – not consumers or banks – and is estimated to result in at least 600,000 new federal employees. So Obama's first major legislative initiative – supposedly a stimulus package to jump-start the economy – is a bloated spending package to increase the size of government, with only about one-third going directly to help consumers.

The Democrats in the House were surprised initially at the makeup of the bill, but quickly passed it last week with few changes. As you have likely heard, Obama's giant "stimulus" package was voted against by every Republican in the House of Representatives and even a number of Democrats. Assuming the Senate passes it (or something even larger) in the next week or two, it will soon become the law of the land.

Making matters worse, precious little of the spending and tax breaks will occur in 2009. According to the Congressional Budget Office, only apprx. $93 billion of the $825 billion will be spent in fiscal 2009, the time we need it most, and only apprx. $225 billion would be spent in fiscal 2010. The balance reportedly doesn't get spent until after that time, when we should be out of the recession.

Instead of giving the economy a "targeted, timely and temporary" injection as Obama had promised, the plan has been larded with spending on existing social programs or hastily designed new ones, with much of it permanent - and not enough of it likely to create new jobs. The Obama administration says that it wants 75% of the money to "spend out" within 18 months. But the Congressional Budget Office estimates that, under the House bill, only 64% of the spending and tax cuts will hit the economy by 2011.

Also troublesome is the likelihood that the bill will become a vehicle for new protectionism policies. The House added "Buy American" protectionism provisions for iron, steel and textiles, and the Senate seems bent on expanding the list of products. The Obama administration seems unconcerned about the danger these measures pose. The protectionism provisions insisted on by the Democrats could undo whatever measured job creation the stimulus plan achieves by provoking US trading partners to reduce purchases of American-made goods.

And finally, there is the question of whether or not these large new amounts of spending will be counted toward the "baseline budget" for all of the government departments receiving funds under Obama's $825 billion spending plan. For example, will the $92.3 billion going to education, labor, etc. mean that their baseline budget going forward is permanently $92.3 billion higher?

The $825 billion stimulus plan is supposed to be a "one-time" expenditure. But we will have to wait and see if this is true, or if all the departments getting this new money will try to say that their budgets should be increased by that amount permanently in future fiscal years. In Washington, it is easy to give money away, but it is next to impossible to scale it back.

Obama's Next "Big Bang" Bank Bailout

In addition to the $825 billion stimulus package discussed above, Congress also approved the release of the remaining $350 billion from the TARP program to the Obama administration last week. Late last week and over the weekend, Obama and his spokespersons promised that new Treasury Secretary Geithner will soon be announcing their plans for how to spend the remaining $350 billion of TARP monies – plus a whole lot more. What could this mean?

The Wall Street Journal reported on Thursday of last week that the Obama administration is planning another $1-$2 trillion bailout aimed at restoring the financial health of US banks. What, you haven't heard about this yet? Surprise, surprise. This may explain why none of Obama's $825 billion stimulus plan, and apparently none of the remaining $350 billion of TARP funds, will be targeted to banks and financial institutions that are teetering on the brink.

The Wall Street Journal noted the following last Thursday, January 29:

"Government officials seeking the revamp the U.S. financial bailout have discussed spending another $1 trillion to $2 trillion to help restore banks to health… The potential size of the rescue efforts being discussed suggests the administration may need to ask Congress for more funds [a trillion or two]… The administration is expected to take a series of steps, including relieving banks of bad loans and securities.

The so-called ‘bad bank' that would buy these assets could be seeded with…as much as $1 trillion to $2 trillion raised by selling government-backed debt or borrowing from the Federal Reserve."

Wow – another $1-$2 trillion bailout of the banks! The question that arises, of course, is how will the government make these enormous funds available to the banks? Will they be in the form of loans or direct giveaways? New Treasury Secretary Geithner said last week that such new money would be loaned to the banks. Thus far, government loans to the big banks have been made in return for non-voting "preferred shares" in these banks.

Yet given the magnitude of the loans they are talking about – $1-$2 trillion – it is entirely possible that the government will have to take collateral in the voting "common stock" of the banks, potentially giving the government some element of control over the banks and their operations. This sounds like the first step toward "nationalizing" the banks.

On Wednesday of last week, Treasury Secretary Geithner said that he wants to avoid nationalizing banks if possible. He stated: "We'd like to do our best to preserve that [banking] system." Read that quote very carefully. I read it as follows: We'll try to avoid nationalizing the large banks, but if we feel we have to, we will. This is very scary!

As I have stated twice over the last two months, President Obama comes from a political persuasion that has no problem with the government owning – and eventually controlling – large parts of the private sector. Many Americans who voted for Obama had no idea, or ignored the fact that he embraces this ideology.

So we should not be surprised if the government ends up owning big equity stakes in our nation's largest banks over the next year or so. And there is even the chance that the government will actually nationalize the banking system before it's over. Hello Europe!

Fed Gearing Up To Buy Treasury Bonds

The massive bailouts we have already seen, plus those outlined above to follow soon, lead to one pivotal question: How is the US Government going to pay for all of this? Since we're already running a trillion-dollar deficit, the new spending would have to be funded by selling even more Treasury debt. Thus, this leads to additional questions such as: 1) Who is going to buy these trillions in new government debt? Will foreigners continue to buy US Treasury securities as they have in the past; 2) Or will these trillion-dollar deficits spook them away; and 3) Will the US dollar plunge as a result and lose its status as the world's reserve currency?

It is impossible to know the answers to these questions, and the Obama administration knows this. Therefore, the Federal Reserve is gearing up to be the "lender of last resort" as Obama's massive bailout programs move forward. The Wall Street Journal reported last Thursday that the Fed is gearing up to purchase long-term US Treasury securities on a massive scale.

This has never happened in the post-Great Depression era. Yet the Fed is reportedly now gearing up to directly buy US Treasury bonds in case Obama's bailout plans for the banks don't work. Supposedly, the Fed has the legal authority to directly buy long-term US Treasury bonds, but it has never done so on a massive scale before.

Government officials are trying to put lipstick on this pig by claiming that the Fed's action to buy Treasuries will help to reduce long-term interest rates and thus facilitate more business and mortgage borrowing. However, the real reason is that there's likely not going to be anyone left to buy our Treasuries, especially if the Dems pursue idiotic protectionist measures that would harm the very trading partners we rely on to buy our debt.

And if the government usually sells Treasuries to finance its operations, where will the money come from to buy its own Treasury securities? That's right, folks. They'll just keep the printing press running until they have enough. As I have noted before, Obama and our monetary authorities are scared to death about deflation, and they will do anything within their power to avoid a debt deflation (a la: Japan) from unfolding in the US, regardless of the inflation implications down the road.

Fed chairman Ben Bernanke has recently stated in public that the possibility of the Fed buying Treasuries is real. The latest policy statement from the FOMC made it clear that the Fed "is prepared" to take such a step as a result of the "evolving circumstances" in the credit crisis. I interpret these developments to mean that the Fed will fire up the printing presses immediately if Obama has problems raising the trillions of dollars he plans to spend.

Conclusions?

I have always tried to tackle the complicated issues of the day and explain them in ways that most anyone could understand. Yet the current economic and financial crisis defies a simple explanation. Yes, we know what lead us into this crisis – home mortgages were made available to millions who had little or no chance of being able to make the payments.

Pundits can argue as to who is to blame for this. Conservatives can make a strong argument that the incentives for giving home loans to people who could never make the payments go back to the Clinton presidency, which is true. But liberals can argue, rightly so, that these sub-prime lending practices continued, and even increased, during the Bush administration.

Yet where to place the blame largely misses the point, in my opinion. We are now in what looks to be the worst economy since the Great Depression. Not even the best thinkers of our time suggested that we would be in such a broad-based financial crisis a year ago. But here we are.

It is clear that President Obama prefers a Keynesian approach to solving this crisis – that is by spending trillions of dollars and substantially increasing the size and scope (control) of government. This should not have come as a surprise to anyone who has read this E-Letter for long – I warned you about this on numerous occasions well before the election in November.

Interestingly, we learned yesterday that the Republicans in Congress are busy crafting their own economic stimulus package to counter President Obama's. There are few specific details known about this GOP rescue package as I prepare to hit the "send" button, but it appears that the Republicans' stimulus package will focus on numerous tax cuts and spending that might help the economy in the near-term. Depending on what the Republicans come up with, I might write about that next week – we'll see.

Getting back to the economic discussion at the beginning of this letter, this recession is clearly worse than even the naysayers predicted. As discussed above, it could last a few more months, or it could last well into 2010. Whatever proves to be the case, it will not be good news for the stock markets, which are flirting with new lows as this is written.

In recent weeks, I have emphasized that the mantra of "buy-and-hold" investing is going the way of the buggy whip. Investors around the world have seen their portfolios crushed by the bear market. And it may not be over.

Over the last couple of months, we have seen a significant increase in interest for our actively managed investment programs that have the ability to move to cash (money market) or hedge long positions, and especially our more aggressive programs that will "short" the market. It seems that more and more investors are coming around to my views on risk management.

If your investment portfolio has been hit hard over the last year or so, maybe now is the time to reallocate some or all of your portfolio to professional money managers and strategies that have the potential to get out of the way of bear markets. Call one of my Investment Consultants at 800-348-3601 if you are interested in learning more about these strategies.

Wishing you profits,

Gary D. Halbert

SPECIAL ARTICLES:

Obama Should Fix the Flawed Stimulus Package
http://www.washingtonpost.com/wp-dyn/content/article/2009/01/31/AR2009013101535.html

Lessons from the Stimulus Fight
http://www.weeklystandard.com/Content/Public/Articles/000/000/016/100dyjdy.asp

Public mixed on stimulus package.
http://www.usatoday.com/news/washington/2009-02-02-poll-stimulus_N.htm

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

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

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

Storms On The Horizon - The Entitlement Time Bomb

Gary D. Halbert — Tue, 19 Aug 2008 21:18:56 GMT

IN THIS ISSUE:

Largest Budget Deficit In History Coming In 2009
A Sobering Reminder From The Fed's Richard Fisher
Deficits To Explode In Coming Decades
Conclusions - Why No One Is Talking About This

Introduction

At the end of July, the White House announced its forecast for the federal budget deficit for fiscal year 2009, which begins next month. The deficit is shocking - an estimated $482 billion, and that does not include apprx. $80 billion that will be spent on the war in Iraq, or a possible second economic stimulus package that is being debated in Congress. So the 2009 deficit will go well beyond a half a trillion dollars! It will be the largest budget deficit in US history.

The national debt is now at $9.6 trillion and will rise well above $10 trillion next year. And that amount does not include the trillions of dollars in unfunded liabilities for Social Security, Medicare and Medicaid. The US faces a debt crisis of incredible proportion over the next several decades. Everyone knows it, but no one seems willing to do anything to stop it.

What follows is one of the most troubling things I have read in a long time. It is a recent speech by Dallas Federal Reserve President Richard W. Fisher. Last week I noted that Mr. Fisher has been the lone voice on the FOMC that has voted against Chairman Bernanke & Company, and argues that interest rates should be rising. In checking into Mr. Fisher's positions, I ran across the following speech he gave recently to the Commonwealth Club of California.

Let me warn you, Mr. Fisher's remarks are going to trouble you. They may even scare you. But you need to read what follows:

Remarks by Dallas Fed President Richard W. Fisher
May 28, 2008

[QUOTE] Thank you, Bruce [Ericson]. I am honored to be here this evening and am grateful for the invitation to speak to the Commonwealth Club of California.

Alan Greenspan and Paul Volcker, two of Ben Bernanke's linear ancestors as chairmen of the Federal Reserve, have been in the news quite a bit lately. Yet, we rarely hear about William McChesney Martin, a magnificent public servant who was Fed chairman during five presidencies and to this day holds the record for the longest tenure: 19 years...

Bill Martin was nominated to run and lose on the Alfalfa Party ticket in 1966, while serving as Fed chairman during Lyndon Johnson's term. In his acceptance speech, he announced that, given his proclivities as a central banker, he would take his cues from the German philosopher Goethe, "who said that people could endure anything except continual prosperity." Therefore, Martin declared, he would adopt a platform proclaiming that as a president he planned to "make life endurable again by stamping out prosperity."

"I shall conduct the administration of the country," he said, "exactly as I have so successfully conducted the affairs of the Federal Reserve. To that end, I shall assemble the best brains that can be found...ask their advice on all matters...and completely confound them by following all their conflicting counsel."

It is true, Bruce, that as you said in your introduction, I am one of the 17 people who participate in Federal Open Market Committee (FOMC) deliberations and provide Ben Bernanke with "conflicting counsel" as the committee cobbles together a monetary policy that seeks to promote America's economic prosperity, Goethe to the contrary. But tonight I speak for neither the committee, nor the chairman, nor any of the other good people that serve the Federal Reserve System. I speak solely in my own capacity. I want to speak to you tonight about an economic problem that we must soon confront or else risk losing our primacy as the world's most powerful and dynamic economy.

Forty-three years ago this Sunday, Bill Martin delivered a commencement address to Columbia University that was far more sober than his Alfalfa Club speech. The opening lines of that Columbia address were as follows: "When economic prospects are at their brightest, the dangers of complacency and recklessness are greatest. As our prosperity proceeds on its record-breaking path, it behooves every one of us to scan the horizon of our national and international economy for danger signals so as to be ready for any storm."

Today, our fellow citizens and financial markets are paying the price for falling victim to the complacency and recklessness Martin warned against. Few scanned the horizon for trouble brewing as we proceeded along a path of unparalleled prosperity fueled by an unsustainable housing bubble and unbridled credit markets. Armchair or Monday morning quarterbacks will long debate whether the Fed could have/should have/would have taken away the punchbowl that lubricated that blowout party. I have given my opinion on that matter elsewhere and won't go near that subject tonight. What counts now is what we have done more recently and where we go from here. Whatever the sins of omission or commission committed by our predecessors, the Bernanke FOMC's objective is to use a new set of tools to calm the tempest in the credit markets to get them back to functioning in a more orderly fashion. We trust that the various term credit facilities we have recently introduced are helping restore confidence while the credit markets undertake self-corrective initiatives and lawmakers consider new regulatory schemes.

I am also not going to engage in a discussion of present monetary policy tonight, except to say that if inflationary developments and, more important, inflation expectations, continue to worsen, I would expect a change of course in monetary policy to occur sooner rather than later, even in the face of an anemic economic scenario. Inflation is the most insidious enemy of capitalism. No central banker can countenance it, not least the men and women of the Federal Reserve.

Tonight, I want to talk about a different matter. In keeping with Bill Martin's advice, I have been scanning the horizon for danger signals even as we continue working to recover from the recent turmoil. In the distance, I see a frightful storm brewing in the form of untethered government debt. I choose the words—"frightful storm"—deliberately to avoid hyperbole. Unless we take steps to deal with it, the long-term fiscal situation of the federal government will be unimaginably more devastating to our economic prosperity than the subprime debacle and the recent debauching of credit markets that we are now working so hard to correct.

You might wonder why a central banker would be concerned with fiscal matters. Fiscal policy is, after all, the responsibility of the Congress, not the Federal Reserve. Congress, and Congress alone, has the power to tax and spend. From this monetary policymaker's point of view, though, deficits matter for what we do at the Fed. There are many reasons why. Economists have found that structural deficits raise long-run interest rates, complicating the Fed's dual mandate to develop a monetary policy that promotes sustainable, noninflationary growth. The even more disturbing dark and dirty secret about deficits—especially when they careen out of control—is that they create political pressure on central bankers to adopt looser monetary policy down the road. I will return to that shortly. First, let me give you the unvarnished facts of our nation's fiscal predicament.

Eight years ago, our federal budget, crafted by a Democratic president and enacted by a Republican Congress, produced a fiscal surplus of $236 billion, the first surplus in almost 40 years and the highest nominal-dollar surplus in American history. While the Fed is scrupulously nonpartisan and nonpolitical, I mention this to emphasize that the deficit/debt issue knows no party and can be solved only by both parties working together. For a brief time, with surpluses projected into the future as far as the eye could see, economists and policymakers alike began to contemplate a bucolic future in which interest payments would form an ever-declining share of federal outlays, a future where Treasury bonds and debt-ceiling legislation would become dusty relics of a long-forgotten past. The Fed even had concerns about how open market operations would be conducted in a marketplace short of Treasury debt.

That utopian scenario did not last for long. Over the next seven years, federal spending grew at a 6.2 percent nominal annual rate while receipts grew at only 3.5 percent. Of course, certain areas of government, like national defense, had to spend more in the wake of 9/11. But nondefense discretionary spending actually rose 6.4 percent annually during this timeframe, outpacing the growth in total expenditures. Deficits soon returned, reaching an expected $410 billion for 2008—a $600 billion swing from where we were just eight years ago. This $410 billion estimate, by the way, was made before the recently passed farm bill and supplemental defense appropriation and without considering a proposed patch for the Alternative Minimum Tax—all measures that will lead to a further ballooning of government deficits.

In keeping with the tradition of rosy scenarios, official budget projections suggest this deficit will be relatively short-lived. They almost always do. According to the official calculus, following a second $400-billion-plus deficit in 2009, the red ink should fall to $160 billion in 2010 and $95 billion in 2011, and then the budget swings to a $48 billion surplus in 2012.

If you do the math, however, you might be forgiven for sensing that these felicitous projections look a tad dodgy. To reach the projected 2012 surplus, outlays are assumed to rise at a 2.4 percent nominal annual rate over the next four years—less than half as fast as they rose the previous seven years. Revenue is assumed to rise at a 6.7 percent nominal annual rate over the next four years—almost double the rate of the past seven years. Using spending and revenue growth rates that have actually prevailed in recent years, the 2012 surplus quickly evaporates and becomes a deficit, potentially of several hundred billion dollars.

Doing deficit math is always a sobering exercise. It becomes an outright painful one when you apply your calculator to the long-run fiscal challenge posed by entitlement programs. Were I not a taciturn central banker, I would say the mathematics of the long-term outlook for entitlements, left unchanged, is nothing short of catastrophic.

Typically, critics ranging from the Concord Coalition to Ross Perot begin by wringing their collective hands over the unfunded liabilities of Social Security. A little history gives you a view as to why. Franklin Roosevelt originally conceived a social security system in which individuals would fund their own retirements through payroll-tax contributions. But Congress quickly realized that such a system could not put much money into the pockets of indigent elderly citizens ravaged by the Great Depression. Instead, a pay-as-you-go funding system was embraced, making each generation's retirement the responsibility of its children.

Now, fast forward 70 or so years and ask this question: What is the mathematical predicament of Social Security today? Answer: The amount of money the Social Security system would need today to cover all unfunded liabilities from now on—what fiscal economists call the "infinite horizon discounted value" of what has already been promised recipients but has no funding mechanism currently in place—is $13.6 trillion, an amount slightly less than the annual gross domestic product of the United States.

Demographics explain why this is so. Birthrates have fallen dramatically, reducing the worker-retiree ratio and leaving today's workers pulling a bigger load than the system designers ever envisioned. Life spans have lengthened without a corresponding increase in the retirement age, leaving retirees in a position to receive benefits far longer than the system designers envisioned. Formulae for benefits and cost-of-living adjustments have also contributed to the growth in unfunded liabilities.

The good news is this Social Security shortfall might be manageable. While the issues regarding Social Security reform are complex, it is at least possible to imagine how Congress might find, within a $14 trillion economy, ways to wrestle with a $13 trillion unfunded liability. The bad news is that Social Security is the lesser of our entitlement worries. It is but the tip of the unfunded liability iceberg. The much bigger concern is Medicare, a program established in 1965, the same prosperous year that Bill Martin cautioned his Columbia University audience to be wary of complacency and storms on the horizon.

Medicare was a pay-as-you-go program from the very beginning, despite warnings from some congressional leaders...who foresaw some of the long-term fiscal issues such a financing system could pose. Unfortunately, they were right.

Please sit tight while I walk you through the math of Medicare. As you may know, the program comes in three parts: Medicare Part A, which covers hospital stays; Medicare B, which covers doctor visits; and Medicare D, the drug benefit that went into effect just 29 months ago. The infinite-horizon present discounted value of the unfunded liability for Medicare A is $34.4 trillion. The unfunded liability of Medicare B is an additional $34 trillion. The shortfall for Medicare D adds another $17.2 trillion. The total? If you wanted to cover the unfunded liability of all three programs today, you would be stuck with an $85.6 trillion bill. That is more than six times as large as the bill for Social Security. It is more than six times the annual output of the entire U.S. economy.

Why is the Medicare figure so large? There is a mix of reasons, really. In part, it is due to the same birthrate and life-expectancy issues that affect Social Security. In part, it is due to ever-costlier advances in medical technology and the willingness of Medicare to pay for them. And in part, it is due to expanded benefits—the new drug benefit program's unfunded liability is by itself one-third greater than all of Social Security's.

Add together the unfunded liabilities from Medicare and Social Security, and it comes to $99.2 trillion over the infinite horizon. Traditional Medicare composes about 69 percent, the new drug benefit roughly 17 percent and Social Security the remaining 14 percent.

I want to remind you that I am only talking about the unfunded portions of Social Security and Medicare. It is what the current payment scheme of Social Security payroll taxes, Medicare payroll taxes, membership fees for Medicare B, copays, deductibles and all other revenue currently channeled to our entitlement system will not cover under current rules. These existing revenue streams must remain in place in perpetuity to handle the "funded" entitlement liabilities. Reduce or eliminate this income and the unfunded liability grows. Increase benefits and the liability grows as well.

Let's say you and I and Bruce Ericson and every U.S. citizen who is alive today decided to fully address this unfunded liability through lump-sum payments from our own pocketbooks, so that all of us and all future generations could be secure in the knowledge that we and they would receive promised benefits in perpetuity. How much would we have to pay if we split the tab? Again, the math is painful. With a total population of 304 million, from infants to the elderly, the per-person payment to the federal treasury would come to $330,000. This comes to $1.3 million per family of four—over 25 times the average household's income.

Clearly, once-and-for-all contributions would be an unbearable burden. Alternatively, we could address the entitlement shortfall through policy changes that would affect ourselves and future generations. For example, a permanent 68 percent increase in federal income tax revenue—from individual and corporate taxpayers—would suffice to fully fund our entitlement programs. Or we could instead divert 68 percent of current income-tax revenues from their intended uses to the entitlement system, which would accomplish the same thing.

Suppose we decided to tackle the issue solely on the spending side. It turns out that total discretionary spending in the federal budget, if maintained at its current share of GDP in perpetuity, is 3 percent larger than the entitlement shortfall. So all we would have to do to fully fund our nation's entitlement programs would be to cut discretionary spending by 97 percent. But hold on. That discretionary spending includes defense and national security, education, the environment and many other areas, not just those controversial earmarks that make the evening news. All of them would have to be cut—almost eliminated, really—to tackle this problem through discretionary spending.

I hope that gives you some idea of just how large the problem is. And just to drive an important point home, these spending cuts or tax increases would need to be made immediately and maintained in perpetuity to solve the entitlement deficit problem. Discretionary spending would have to be reduced by 97 percent not only for our generation, but for our children and their children and every generation of children to come. And similarly on the taxation side, income tax revenue would have to rise 68 percent and remain that high forever. Remember, though, I said tax revenue, not tax rates. Who knows how much individual and corporate tax rates would have to change to increase revenue by 68 percent?

If these possible solutions to the unfunded-liability problem seem draconian, it's because they are draconian. But they do serve to give you a sense of the severity of the problem. To be sure, there are ways to lessen the reliance on any single policy and the burden borne by any particular set of citizens. Most proposals to address long-term entitlement debt, for example, rely on a combination of tax increases, benefit reductions and eligibility changes to find the trillions necessary to safeguard the system over the long term.

No combination of tax hikes and spending cuts, though, will change the total burden borne by current and future generations. For the existing unfunded liabilities to be covered in the end, someone must pay $99.2 trillion more or receive $99.2 trillion less than they have been currently promised. This is a cold, hard fact. The decision we must make is whether to shoulder a substantial portion of that burden today or compel future generations to bear its full weight.

Now that you are all thoroughly depressed, let me come back to monetary policy and the Fed.

It is only natural to cast about for a solution—any solution—to avoid the fiscal pain we know is necessary because we succumbed to complacency and put off dealing with this looming fiscal disaster. Throughout history, many nations, when confronted by sizable debts they were unable or unwilling to repay, have seized upon an apparently painless solution to this dilemma: monetization. Just have the monetary authority run cash off the printing presses until the debt is repaid, the story goes, then promise to be responsible from that point on and hope your sins will be forgiven by God and Milton Friedman and everyone else.

We know from centuries of evidence in countless economies, from ancient Rome to today's Zimbabwe, that running the printing press to pay off today's bills leads to much worse problems later on. The inflation that results from the flood of money into the economy turns out to be far worse than the fiscal pain those countries hoped to avoid.

Earlier I mentioned the Fed's dual mandate to manage growth and inflation. In the long run, growth cannot be sustained if markets are undermined by inflation. Stable prices go hand in hand with achieving sustainable economic growth. I have said many, many times that inflation is a sinister beast that, if uncaged, devours savings, erodes consumers' purchasing power, decimates returns on capital, undermines the reliability of financial accounting, distracts the attention of corporate management, undercuts employment growth and real wages, and debases the currency.

Purging rampant inflation and a debased currency requires administering a harsh medicine. We have been there, and we know the cure that was wrought by the FOMC under Paul Volcker. Even the perception that the Fed is pursuing a cheap-money strategy to accommodate fiscal burdens, should it take root, is a paramount risk to the long-term welfare of the U.S. economy. The Federal Reserve will never let this happen. It is not an option. Ever. Period.

The way we resolve these liabilities—and resolve them we must—will affect our own well-being as well as the prospects of future generations and the global economy. Failing to face up to our responsibility will produce the mother of all financial storms. The warning signals have been flashing for years, but we find it easier to ignore them than to take action. Will we take the painful fiscal steps necessary to prevent the storm by reducing and eventually eliminating our fiscal imbalances? That depends on you.

I mean "you" literally. This situation is of your own creation. When you berate your representatives or senators or presidents for the mess we are in, you are really berating yourself. You elect them. You are the ones who let them get away with burdening your children and grandchildren rather than yourselves with the bill for your entitlement programs.

This issue transcends political affiliation. When George Shultz, one of San Francisco's greatest Republican public servants, was director of President Nixon's Office of Management and Budget, he became worried about the amount of money Congress was proposing to spend. After some nights of tossing and turning, he called legendary staffer Sam Cohen into his office. Cohen had a long memory of budget matters and knew every zig and zag of budget history. "Sam," Shultz asked, "tell me something just between you and me. Is there any difference between Republicans and Democrats when it comes to spending money?" Cohen looked at him, furrowed his brow and, after thinking about it, replied, "Mr. Shultz, there is only one difference: Democrats enjoy it more."

Yet no one, Democrat or Republican, enjoys placing our children and grandchildren and their children and grandchildren in harm's way. No one wants to see the frightful storm of unfunded long-term liabilities destroy our economy or threaten the independence and authority of our central bank or tear our currency asunder.

Of late, we have heard many complaints about the weakness of the dollar against the euro and other currencies. It was recently argued in the op-ed pages of the Financial Times that one reason for the demise of the British pound was the need to liquidate England's international reserves to pay off the costs of the Great Wars. In the end, the pound, it was essentially argued, was sunk by the kaiser's army and Hitler's bombs. Right now, we—you and I—are launching fiscal bombs against ourselves. You have it in your power as the electors of our fiscal authorities to prevent this destruction. Please do so.

Note: The views expressed by the author do not necessarily reflect official positions of the Federal Reserve System. [END QUOTE]

Deficits To Explode In Coming Decades

The following chart provided by the Heritage Foundation, based on Congressional Budget Office projections, illustrates how federal deficits will explode over the next 70 or so years due to the skyrocketing costs of Social Security, Medicare and Medicaid. Sadly, this is the future we are leaving for our children and grandchildren.

Conclusions

I think any intelligent person who reads Mr. Fisher's speech above will realize that there is no way the United States can afford to pay the nearly one hundred trillion dollars (or more) in unfunded liabilities of Social Security, Medicare and Medicaid over the coming decades. Some might argue that the government should simply "print" the money to pay for it. That would be disastrous! It would result in an explosion in inflation, followed by a depression, in my opinion, not to mention the implosion of the major investment markets.

I wish I had the solution or at least some creative suggestions for the future, so that we could end this E-Letter on a positive note. But I do not. Our politicians have knowingly created an entitlement state that we can never pay for - all with the unstated purpose of buying our votes.

Mr. Fisher's admonishment to all of us is to elect responsible representatives who will take necessary action. And what action would that be? Cut government spending dramatically and balance the budget. Yetwe've seen both parties spend outrageously when in power, and neither party has made any serious attempt to address the looming Social Security and Medicare crises.

President Bush made a half-hearted attempt to put Social Security on the table following his re-election in 2004. He was roundly criticized by the Democrats and ignored by the Republicans. Thus, Mr. Fisher's advice is easy to give, but hard to follow.

Even if we had disciplined leaders in the White House and in Congress who were willing to risk their political careers to tackle the massive unfunded entitlement liability, now approaching $100 trillion dollars, the question is, have we waited too long? Obviously. Are these expenditures on autopilot without any way to avoid the massive deficits that are sure to come? They certainly are today.

So why is virtually no one talking about it? Why is it that we are only hearing this warning from the president of the Federal Reserve Bank of Dallas? Why not Fed chairman Bernanke? And why is it that this isn't an issue for either of the current presidential candidates?

I wish I knew the answers. In closing, the following civilization cycle comes to mind. Each of the great civilizations in the world passed through a series of stages from their birth to their decline to their death. Historians have listed these in ten stages:

Bondage to spiritual faith, to great courage to liberty, to abundance to selfishness, to complacency to apathy, to moral decay to dependence, and back to bondage.

Sorry to end on a negative note, but it is what it is.

Very best regards,

Gary D. Halbert

SPECIAL ARTICLES:

How Obama is like his communist father (bet you haven't seen this).
http://www.ibdeditorial.com/IBDArticles.aspx?id=303952499910291

McCain Shines at Saddleback Forum (he really did!)
http://www.realclearpolitics.com/articles/2008/08/small_hopes_and_large_upsets.html

Is the tide turning for McCain? (libs are getting nervous)
http://ac360.blogs.cnn.com/2008/08/18/is-the-tide-turning/

Ukraine & Georgia should be admitted to NATO now.
http://ibdeditorials.com/IBDArticles.aspx?id=303952651252204

The Fed, The Stock Market & What To Do Now

Gary D. Halbert — Tue, 12 Aug 2008 20:31:00 GMT

IN THIS ISSUE:

Fed Leaves Interest Rates Unchanged Again
But Will Inflation Really Moderate?
Stocks - Stuck In A Long-Term Sideways Pattern?
Bad News For Millions Of Baby Boomers
A Wall Street Myth About To Be Shattered?
Avoiding Big Losses Is The Key, Maybe It's Time You Join Us
The Bottom Line For Your Investments

Fed Leaves Interest Rates Unchanged Again

For the last 2-3 months, the media has warned us that inflation is rising and that the Federal Reserve was very likely going to raise short-term interest rates soon. I have argued, on the other hand, that the Fed would leave interest rates unchanged - probably for the rest of this year, at least - due to the ongoing housing/credit crunch and the sluggish economy.

Despite media warnings of a hike, the Fed Open Market Committee (FOMC) met last week and once again voted 10-1 to leave the Federal Funds rate unchanged at 2%. In its policy statement released along with the announcement of the decision, the Fed noted the following:

"Economic activity expanded in the second quarter [+1.9% GDP], partly reflecting growth in consumer spending and exports. However, labor markets have softened further and financial markets remain under considerable stress. Tight credit conditions, the ongoing housing contraction, and elevated energy prices are likely to weigh on economic growth over the next few quarters. Over time, the substantial easing of monetary policy, combined with ongoing measures to foster market liquidity, should help to promote moderate economic growth.

Inflation has been high, spurred by the earlier increases in the prices of energy and some other commodities, and some indicators of inflation expectations have been elevated. The Committee expects inflation to moderate later this year and next year, but the inflation outlook remains highly uncertain. [Emphasis added, GDH.]

Although downside risks to growth remain, the upside risks to inflation are also of significant concern to the Committee. The Committee will continue to monitor economic and financial developments and will act as needed to promote sustainable economic growth and price stability."

Fed watchers carefully parse the words in these policy statements. The key in the latest policy statement is the underlined text above. In the prior policy statement on June 25, the Fed basically said it had no clear idea how high inflation might go. However, in the August 5 statement above, the Fed indicates it expects inflation to moderate later this year. I would speculate that the Fed's revised view on inflation may have been somewhat influenced by the latest drop in oil prices.

Some financial pundits had, at the least, expected that the latest FOMC vote on policy would be closer than 10-1 as it was on June 25. Yet the lone dissenter remained Richard W. Fisher, president of the Federal Reserve Bank of Dallas. All of the other FOMC members, including Chairman Bernanke, appear more concerned with the credit crunch and the sluggish economy than the latest inflation numbers.

But Will Inflation Really Moderate?

The government's latest report on GDP for the 2Q showed the economy growing at a +1.9% annual rate. That same report cited consumer inflation having risen 4.2% (annual rate) in the 2Q versus 3.5% in the 1Q. However, the core rate of consumer inflation (minus food and energy) was only 2.2%, unchanged from the 1Q.

The Consumer Price Index rose 1.0% in June, slightly above pre-report estimates, as compared to a rise of 0.6% in May. The CPI core rate rose 0.3% in June, up slightly from 0.2% in May. Year over year, the headline CPI rose 5.0% in the 12 months ended June. The core rate rose 2.4% over the same period. This is still above the presumed Fed target for core inflation of 2% or less, but not dramatically so.

Obviously, consumer spending is one of the major drivers in inflation rates. Personal consumption expenditures rose 1.5% in the 2Q as compared to 0.9% in the 1Q. Some analysts attributed the rise in 2Q spending to the government rebate checks; however, the rebate checks were not all mailed by the end of June, so they were only partly a factor. The rebate checks should also help boost 3Q consumer spending, at least marginally, which argues that the inflation rate is likely to stay on the high side a bit longer.

On the positive side, most commodity prices have plunged over the last two months, after many set all-time record highs earlier this year. Corn, which peaked around $7.75 per bushel earlier this year, has now plunged to below $5.00. Wheat has plunged from around $12.50 per bushel to near $6.00. Rice is down sharply as well. And we all know that oil and gasoline prices have declined recently as well.

Barring any major weather problems as we head into the harvest season, and assuming we don't have any killer hurricanes in the Gulf, I could see commodity prices continuing to drift lower over the next several months. Thus, the Fed may be proven correct in projecting that inflation will moderate later this year.

Finally, the latest report on 2Q GDP which showed the economy growing at a 1.9% annual rate has put to rest much of the talk that we are already in a recession. What remains to be seen is whether or not still-high gas and energy prices will put a serious dent in consumer spending nationally in the current quarter and/or the 4Q.

Analysts at Wachovia Economics Group now estimate that GDP will rise 2.2% in the 3Q and 1.2% in the 4Q. I tend to think those numbers may be a bit optimistic, unless oil prices drop below $100 per barrel, but we'll see.

Stocks - Stuck In A Long-Term Sideways Pattern?

The recent sharp declines in US stock prices have caused many analysts and investors alike to rethink their forecasts for market returns going forward. If we look back to late 1999 and 2000 when many believe the last bull market ended, I could argue that the stock market has simply been in a broad trading range since then, particularly when we note that the recent top in the S&P 500 (right hand side of the chart below) occurred at roughly the same level as the top in early 2000.

I hesitate to point this out, but the US stock markets have experienced some very long sideways periods over the last century or so. The good folks at Rydex Funds put together the chart below which shows the performance of the Dow Jones Industrial Average from 1896 to 2007. Rydex illustrates that there have been three extremely long sideways periods in the market, lasting 18 years (1906-1923), 26 years (1929-1954) and 17 years (1966-1982), respectively. These extended periods of sideways movement are often referred to as "secular" bear markets.

[If you click on the chart above, a new browser window will display the full-sized chart. You can click on the image to zoom in closer for more detail; a second click will zoom back out.]

Rydex also notes that the current sideways market has lasted since early 2000, with an unstated suggestion that we may have several more years to go in this difficult market. I don't propose to know what the stock markets will do over the next 5-10 years.

What I do know is more and more respected market analysts, including The Bank Credit Analyst, have come to the view that US stock market returns are likely to be disappointing over the next several years or longer.

Some analysts now believe that investors should expect no more than single digit annual returns over the next several years, at best, and that assumes we do not experience a serious recession along the way.

Bad News For Millions Of Baby Boomers

So-called Baby Boomers are those apprx. 78 million Americans born between 1946 and 1964, most all of whom will retire between now and 2029. The first Baby Boomer, born one second after midnight on January 1, 1946, took early retirement (age 62) in February of this year and began to collect her Social Security benefits.

Estimates vary, but reportedly about 10 million Baby Boomers will retire over the next five years alone. An estimated 3.2 million Baby Boomers will turn 62 this year and 65 in 2011. Various studies conclude that most Baby Boomers have not saved nearly enough for their retirement. That comes as no surprise, since our national savings rate has been negative for the last two years.

Unfortunately, many Baby Boomers are hoping for another late 1990s stock market boom to propel them to where they need to be to fund their retirement - at the age they wish to retire and in the lifestyle they wish to afford. They may be sadly disappointed! And this doesn't begin to consider the fact that we are living longer than ever before.

So what will the Baby Boomers do to fund their retirement if the stock market doesn't cooperate with a big bull market over the next five years (or longer)? Simple: they will have to work longer to make up for their lack of saving and investment. The government has already raised the Social Security retirement age to 67 for those Americans born after 1959, and sooner or later the government will almost certainly have to raise the retirement age yet again.

A Wall Street Myth About To Be Shattered?

For decades, Wall Street has preached the buy-and-hold mantra (read: never get out of the market). They continue to warn that if you get out during the downtrends to minimize losses, you are likely to miss the uptrends. Therefore, you should stay fully invested at all times, take a long-term view, and be prepared to ride out some nasty bear markets and big losses along the way.

As the buy-and-hold strategy increasingly came under fire after the last couple of bear markets, Wall Street simply repackaged and renamed the buy-and-hold strategy and called it "asset allocation." Sounds much better, doesn't it? Asset allocation implies that you spread your investments over several asset classes (stocks, bonds, etc.). But the strategy is still the same: you buy and hold, and subject yourself to large losses whenever the asset classes hit a bear market.

Now, let's reasonably assume that millions of Baby Boomers are behind the curve in saving for their retirement, and that they need the stock market to boom over the next five years or longer to bail them out. Next, let's also assume that most of these Baby Boomers are also invested in the traditional buy-and-hold strategy that Wall Street has preached for years.

So what happens if the stock markets (and the bond markets for that matter) essentially go sideways, or only deliver single digit annual returns, over the next five years or longer? I think it is safe to say that there will be a revolt. Add in a recession, if we get one, and "revolt" could be putting it mildly! Baby Boomers could reject Wall Street's buy-and-hold mantra in a stampede.

Why? Because Baby Boomers no longer have 20-30 years to hold on as Wall Street suggests. Retirement for most will come much sooner, for many in the next 5-10 years. And if the stock markets continue to go sideways, or even marginally higher, over the next several years, Baby Boomers are going to become increasingly restless, to say the least.

Avoiding Big Losses Is The Key

My advice over the last 30 years has been consistent: avoid the big losses. In my view, you don't have the luxury of simply riding out bear markets and hoping you won't bail out near the bottom as so many investors do. The following "Breakeven Table" illustrates just how hard it is to come back from large losses.

Amount of Loss Incurred	Return Required To Break Even

10%	11.1%
15%	17.7%
20%	25.0%
25%	33.3%
30%	42.9%
35%	53.9%
40%	66.7%
45%	81.8%
50%	100.0%
60%	150.0%
70%	233.3%

I have consistently argued for "active management" strategies that can move you to cash (money market) or hedge long positions during bear markets and/or major downward market corrections, as a part of your overall portfolio.

The financial media decided some years ago to vilify active management strategies that can take you to cash from time to time as "market timing," and assured the investment public that market timing is impossible. Making matters worse, there were some market scandals in recent years that were deemed as ‘market timing' or ‘late trading,' when indeed they were nothing close or similar to traditional market timing, which simply seeks to take you out of the market and into the safety of cash, or hedge long positions, during major market downturns.

I have made a successful business out of promoting alternative investment strategies, including traditional market timing. We spend a lot of money each year seeking out active managers that have been successful in protecting clients from significant stock market downturns. Granted, there are many active money managers that have not been successful, but there are those who have admirable performance records.

The money managers I recommend in general: 1) have matched or exceeded stock market returns over time; but more importantly, 2) have limited losses during down market periods. This can be a WIN-WIN combination. Of course, past performance does not guarantee future results. The problem is, most investors don't know how to find these successful money managers.

Maybe It's Time You Join Us

This E-Letter goes out to apprx. one million presumably high net worth subscribers each and every week. I don't mind admitting that this E-Letter has been the largest source of new clients over the five-plus years I have written it. Still I wonder why more of my readers haven't come onboard with Halbert Wealth Management. I have some thoughts on why, in order.

1) As noted above, Wall Street has advocated for years that a buy-and-hold approach to your investments is the ONLY one that works over time; the stock market always goes up over time, right? But not if you seriously look at the chart above which shows multi-year periods when the stock market goes sideways or down.

2) Many investors have been conditioned to believe that their financial advisor/broker needs to be local, so you can sit down with him/her face to face every now and then. Fact: I have over one thousand clients all across America, and I have never met the vast majority of them. We do just fine over the phone.

3) Because many investors have been indoctrinated to Wall Street's mantra of buy-and-hold and asset allocation as the only way to go, they are therefore not open to active management strategies that just might get you out of the market during big downturns, or "alternative investments" that offer additional diversification beyond stocks and bonds.

4) Most investors are reluctant to change. Old habits are hard to break. We learn what we are taught, and it is hard to change, even if we need to in order to meet our financial goals. That will soon change, I predict, especially for Baby Boomers who are approaching retirement and are banking on a new bull market in stocks to bail them out.

The Bottom Line:
Stocks May Disappoint When We Need Them The Most

I realize that many of my clients and readers are already retired. But this week's message is primarily intended for those of you who are approaching retirement in the next 5-10 years. Many of you in this position have not yet saved enough to be comfortable in retirement. The stock market outlook may not be favorable for your retirement needs over the next several years, at least based on my best sources.

Maybe it's time to consider some active management strategies, and some alternative investments, that have historically limited losses during market downturns, and have met or exceeded market rates of return over time. Think about it. (As always, past performance does not guarantee future results.)

I understand that you may have concerns because Halbert Wealth Management is in Austin, Texas and you live somewhere else. But keep in mind that this is the greatest age of global communications in the history of the world. We have the Internet after all. As noted above, I have never met most of my clients all across America, yet we get along just fine.

How is that? #1: If you are one of my clients, you have access to me personally - I am happy to talk to clients as needed. #2: My experienced Investment Consultants (and all of my other employees) are on salary - no commissions - so they have your best interest at heart.

And one more thing. Be assured that I have my own money invested in every program, every fund and every manager we currently recommend. I don't expect anyone to invest in something that I don't also have my own money invested in. You have my word on that.

At the end of the day, maybe you should consider becoming one of my clients and allocating some of your portfolio to the active management strategies and professionally managed programs I recommend, even if you live hundreds or thousands of miles away.

But more importantly, you need to think about whether your traditional buy-and-hold investments are going to get you to where you need to be in the next 5-10 years. What if the stock markets are in one of those long sideways periods as illustrated in the chart above?

Maybe you need to consider a change. Are you really comfortable about funding your retirement? If not, consider what we have to offer. You can access certain of the money managers I recommend for as little as $25,000-$50,000. That way, you can start off small and add to it when you're comfortable.

For more information, call one of my experienced Investment Consultants at 800-348-3601. You may also contact us via e-mail at info@halbertwealth.com, or you can visit our website at www.halbertwealth.com to learn about the types of investment programs we offer.

Wishing you profits,

Gary D. Halbert

SPECIAL ARTICLES

Obama fights offshore oil exploration (bet you don't know this)
http://www.ibdeditorial.com/IBDArticles.aspx?id=303344360938478

Five GOP Stooges Blow The Drilling Opportunity
http://www.ibdeditorial.com/IBDArticles.aspx?id=303088152935198

Obama vs. McCain on the Economy
http://www.washingtontimes.com/news/2008/aug/11/obama-vs-mccain-on-the-economy

Why Barack Obama Is In Trouble (wish everyone could read this)
http://www.realclearpolitics.com/articles/2008/08/why_barack_obama_will_not_win.html

The War in Georgia Is a War for the West
http://online.wsj.com/article/SB121841306186328421.html?mod=opinion_main_commentaries

On The Economy, The Fed & President Obama

Gary D. Halbert — Wed, 30 Jul 2008 14:30:41 GMT

IN THIS ISSUE:

Economy Holding Up Better Than Expected
Consumer Spending Remains Strong
The Fed In A Policy Box
Obama Acts As If He's Already The President
John McCain's Electoral Mountain
The Vice Presidential Sweepstakes

Introduction

If you talk to people on the street just about anywhere in the US, you find there is a broad consensus that the US economy is well into a recession at this point. Yet the US economy is holding up better than expected. 1Q GDP was revised upward once again in the final report at the end of June. This Thursday, we get the Commerce Department's first estimate of 2Q GDP, and the pre-report consensus may surprise you. We will look at this and more economic indicators below.

Meanwhile, the Federal Reserve finds itself in an increasingly uncomfortable position. It has repeatedly lowered short-term interest rates over the last 12-18 months in an effort to combat the negative consequences of the housing slump, the sub-prime mortgage crisis and the resulting credit crunch. In recent months, however, even with the economy slowing down, inflation is on the rise. Now the Fed is in a dilemma – keep rates low to help the economy or raise rates to head off inflation and risk a potentially serious recession later on. We will discuss this in detail below.

Finally, we take a look at the presidential race and my latest thoughts about Barack Obama who is acting like he is already the president-elect, just waiting to occupy the White House in January. This man has to be the most arrogant presidential candidate in my adult lifetime. This would seem surprising given that his political and policy positions are extremely liberal and his background is suspect. Despite that, he may well be our next president.

My Obama misgivings aside, we will look at the political landscape as it seems to stand now – which states are likely to go to Obama and which are likely to go to McCain – and most importantly, the “battleground states” that could still tip either way. This should be a lively discussion all the way around, so let's jump in.

Economy Holding Up Better Than Expected

Whether you are a conservative, a liberal or somewhere in between, I trust you realize that the Democrats and their accomplices in the media want you to believe that the US economy is in a serious recession and, of course, it is all the fault of President Bush. Likewise, they want you to believe that soaring oil, gasoline and energy prices are the direct result of Bush and Cheney and Big Oil lining their pockets at our expense.

There is no debate on whether the US economy is in a slump – we can all agree on that. Yet the US economy is holding up better than even I have expected in light of the housing slump and the credit crisis. But you will not hear this in the mainstream media. They want the American people in a foul mood, at least until after the election. Despite that, let's look at the latest economic reports, and you can decide for yourself. Here we go.

We start with the latest figures on Gross Domestic Product, the bellwether indicator of the trend in the economy. In its advance report, the Commerce Department estimated 1Q GDP at an anemic +0.6% annual rate of growth. In its second report, the government raised its GDP estimate to +0.9% for the 1Q. And in its final report in late June, the Commerce Department raised its final 1Q GDP number to +1.0%.

What, you didn't hear this reported in the media? Not surprising. +1.0% is nowhere near recession levels. So, what is likely in store for the 2Q? The Commerce Department's first estimate of 2Q GDP will be released this Thursday (July 31). Remember that most analysts, your editor included, have previously predicted that GDP would fall into negative growth territory in the 2Q of this year.

But the pre-report estimates suggest yet another surprise – GDP may have outperformed yet again in the 2Q ended June 30. The consensus estimate is that 2Q GDP rose 1.8%. Where is that recession, may I ask? Here are some of the pre-report estimates on 2Q GDP. Morgan Stanley estimates that 2Q GDP rose 2.2%, well above the consensus estimate. Another source I follow, Macroeconomic Advisers (www.macroadvisers.com), now predicts that 2Q GDP will come in at a surprising +2.6%. If so, that will be another big surprise.

Macroeconomic Advisors also predicts that the US economy will grow by 1.4% in the 3Q. I don't know if they will be correct, but if they are remotely in the ballpark, the media's predictions of a recession this year are out the window.

The point is, we are not in a recession now, as defined by two consecutive quarters of negative GDP. Certainly, there are parts of the US that are experiencing a recession in terms of job losses and the drop in home values. Yet there are other parts of the country where the economy remains strong and home prices and sales remain vibrant, such as where I live in Austin, Texas.

Gary D. Halbert, ProFutures, Inc. and Halbert Wealth Management, Inc. are not affiliated with nor do they endorse, sponsor or recommend the following product or service.

Consumer Spending Remains Strong

The GDP numbers simply do not support arguments that we are in a recession. But what about other reports? Let's quickly go through the list of recent economic reports. Let me warn you in advance that more of the recent reports have been positive than negative. I'm sure this will come as a surprise, based on what you hear in the media.

The Index of Leading Economic Indicators (LEI), one of my favorite reports, was down –0.1% for June, following rises of a similar amount in April and May. FYI, the LEI has not moved more than 0.2% either way since the first of the year, which is an indication of an economy that is essentially directionless, but not headed into a recession.

It is widely agreed that consumer spending makes up apprx. 70% of GDP. Admittedly, continued strong consumer spending has astounded not only me but most other analysts in the marketplace for quite a while now. The latest data bear this out. Retail sales were up 0.1% in June, following a rise of 0.8% in May. These gains over the last two months came despite a continued drop in consumer confidence.

As I have pointed out often over the last year, US consumers continue to spend despite the drop in confidence and rising consumer debt levels. Several readers have asked me to explain this phenomenon. I have several theories I could advance, but space does not permit, so here is my short answer.

The media has blatantly contributed to the plunge in consumer confidence, but that has not translated into a nationwide plunge in jobs. The labor markets continue to be relatively firm. The unemployment rate remains historically low at 5.5%, although I expect it to rise to 5.6-5.7% for July. Meanwhile, personal income has continued to go up month after month. So most Americans are doing OK in their jobs, and they continue to spend on the things we all spend our money on, which keeps the economy from falling into a recession.

Other Economic Indicators Are Mixed

Here we go with the other recent reports. First and foremost, consumer confidence continues to plunge month after month. Yet consumer spending remains firm as discussed above. Take retail sales, for example. Retail sales rose 0.1% in June following a surprising rise of 0.8% in May. According to the Commerce Department, personal consumption expenditures rose 1.1% in the 1Q, to the surprise of many. Personal spending rose another 0.8% in May according to the latest report. Translation: the economy is in a slump, but it is a minor one and most consumers have not substantially changed their lifestyles – at least not yet.

The latest durable goods orders report for June released last Friday was significantly stronger than expected, rising 0.8% when the consensus was for a decline of 0.3%. The Commerce Department also revised its May durable goods report from a negative to +0.1%. Durable goods are generally long-lasting, higher priced items.

In other reports, industrial production rose 0.5% in June, following a decline of 0.2% in May. The ISM manufacturing index rose modestly to 50.2 in June from 49.6 in May. On the other side, the unemployment rate remained at 5.5% in June. Advance reports suggest the unemployment rate may rise to near 6% by the end of this year.

On the housing front, most reports remain negative, although a few indicators suggest the worst may be over. For example, housing starts and new building permits actually rose modestly in June. Yet sales of new and existing homes continued to fall. Pending home sales fell in May (latest data available), which is good, but is hardly a trend. It remains to be seen what happens just ahead with home prices, but it would seem that a bottom on the national level may finally be in sight by the end of this year.

On the inflation front, indicators are turning higher, or so it would seem. The Consumer Price Index for June was up 1.1% year over year, and the “core” rate was up 0.3%. The Producer Price Index (wholesale prices) was up for June 1.8%, and the core rate was up 0.2%, minus food and energy.

It is increasingly hard to separate the headline inflation rates from the ‘core' rates which exclude food and energy. It will be interesting to see how the government adapts its inflation reports in coming months to reflect this changing dynamic, if in fact they do.

The Fed In A Policy Box

Fed Chairman Ben Bernanke and his fellow members of the Fed Open Market Committee (FOMC) that sets interest rates are becoming increasingly concerned about rising inflation rates. Although the Fed has long been believed to focus on the core rate of inflation (minus food and energy), there is no doubt that Bernanke & Company are closely monitoring headline inflation as well. Bernanke made the following remarks in a speech on June 3:

“The possibility that commodity prices will continue to rise is an important risk to the inflation forecast. Another significant upside risk to inflation is that high headline inflation, if sustained, might lead the public to expect higher long-term inflation rates, an expectation that could ultimately become self-confirming. The Federal Reserve's mandate is to foster maximum sustainable employment and price stability. To achieve these goals, we must also support the return of financial markets to more normal functioning… For now, policy seems well positioned to promote moderate growth and price stability over time. We will, of course, be watching the evolving situation closely and are prepared to act as needed to meet our dual mandate.”

Those remarks delivered at an international monetary conference seemed to suggest that Bernanke is content to keep the Fed Funds rate at 2%, at least for the time being. However, there is believed to be a growing dissent among certain other members of the FOMC. The last FOMC meeting was on June 24-25 when the Fed once again elected to leave the Fed Funds rate at 2%. The FOMC policy statement included the following language:

“The Committee expects inflation to moderate later this year and next year. However, in light of the continued increases in the prices of energy and some other commodities and the elevated state of some indicators of inflation expectations, uncertainty about the inflation outlook remains high…

Although downside risks to [economic] growth remain, they appear to have diminished somewhat, and the upside risks to inflation and inflation expectations have increased. The Committee will continue to monitor economic and financial developments and will act as needed to promote sustainable economic growth and price stability.”

These policy statements are carefully scrutinized, and there is little doubt that the Fed is increasingly concerned about inflation. The question is, will the Fed raise short-term rates at a time when the economy is struggling and the credit crunch is still far from over? The interest rate futures markets believe the Fed will raise rates at least once before the end of the year. My best sources, however, believe the Fed will not raise rates before the end of the year.

The next FOMC policy meeting will be held on August 5.

Do Most Americans Really Know Barack Obama?

To the surprise of most conservatives, Senator Barack Obama continues to hold a lead over Senator John McCain in most of the national tracking polls, although McCain has made some gains over the last week or two as Obama went on his global “fact-finding” tour. Most conservatives are astonished at how many Americans have jumped on the Obama bandwagon, especially given his liberal positions on so many issues, his lack of experience and his questionable background.

Let's start with the questionable background. We are told that Obama served as a “community organizer” in Chicago for ACORN (the Association of Community Organizations for Reform Now), which is one of the largest radical groups in America. You can easily check this out on the Internet. Next, there are Obama's ties to now-convicted felon, Tony Rezko. Rezko, a Chicago mover and shaker, was one of Obama's earliest supporters. After Obama was elected to the Senate in 2006, he and Rezko were involved in a questionable real estate transaction involving the purchase of Obama's mansion in Chicago. Obama has since admitted it was a mistake.

Then there is the issue of Obama's former minister of 20 years, Jeremiah Wright, who hit the national spotlight recently with his outrageous sermons. Wright also has a close relationship with and has praised Louis Farrakhan, who is the Supreme Minister of the Nation of Islam and an outspoken anti-Semite.

In addition to his questionable background, there are his various liberal policy positions and votes. Obama has been rated “the most liberal Senator in Congress” by National Review, a prominent conservative think tank in Washington. Obama is pro-abortion and pro-gun control. He will raise income taxes, especially on those making $250,000 or more a year, and he says he will increase the capital gains tax (not good for the stock markets).

He vows to nationalize health care, which in my view is one of the scariest things about Obama. He is opposed to increased offshore drilling for oil and natural gas – ANWR would definitely not be allowed. He is a global warming enthusiast. He opposed the war in Iraq. He refuses to admit that the “surge” in Iraq has worked, even after his latest visit there. And the list goes on.

Then there is the critical question of the Supreme Court. With the advanced ages of several current Justices, it is very likely that Obama will get to nominate at least two Supreme Court justices in his first term should he be elected. He could well nominate another one or two should he win a second term.

As discussed at length in my July 1, 2008 E-Letter, the Supreme Court is fairly balanced at present with four generally conservative Justices and four generally liberal ones, with one swing vote in Anthony Kennedy. Depending on which Justices retire in the next 4-8 years, Obama could swing the court significantly to the liberal side. And with the Democrats firmly in control of the Senate, you can bet Obama's Supreme Court nominees will be approved quickly.

Gary D. Halbert, ProFutures, Inc. and Halbert Wealth Management, Inc. are not affiliated with nor do they endorse, sponsor or recommend the following product or service.

Obama Acts As If He's Already The President

Despite the negatives noted above, the mainstream media fawns over Obama's every word and refuses, for the most part, to write anything negative about the man – past or present. The ultimate proof of this was his latest overseas trip in which the evening news anchors from ABC, CBS and NBC all jumped at the chance to accompany Obama on his global junket.

Actually, I think Obama hurt himself on his foreign trip by talking and negotiating with foreign leaders as if he is already the President-elect. Excuse me, but we haven't voted yet! Not that I care to admit it, but I have marveled at Obama's confidence (at least when he has a teleprompter). However, his ill-advised discussions with foreign leaders now make me believe that he is one of the most arrogant politicians I have ever seen.

Given all of the above, why is Obama leading in the polls to become our next Commander-In-Chief? Much of it, I believe, is “Bush Fatigue.” Liberals and the media always hated Bush. Everything in the world that is wrong is Bush's fault. Many conservatives have turned against President Bush as well – he has disappointed us on many occasions. Unfortunately, many conservatives don't like McCain and may simply sit out this election, which is effectively a vote for Obama.

It is my belief that many Obama supporters are really just anti-Bush voters who simply want someone in the White House that is not the GOP candidate. That, in my view, is why many Obama supporters have dismissed (or failed to investigate) his questionable past and his liberal policy positions.

I have no doubt that I will receive many scathing e-mails in response to the analysis above from our more liberal readers. But take heart, Obama supporters! The following state-by-state electoral analysis will be sure to warm your hearts. I've asked my associate Spencer Wright to review the latest state polls and crunch the electoral numbers. Unfortunately, it does not look very good for John McCain. Take it away Spencer.

John McCain's Electoral Mountain

National tracking polls have recently narrowed, thus putting the contest between McCain and Obama close to the margin of error as of last week. In fact McCain is enjoying a rather healthy rise in public opinion. In the face of the Obama World Tour 2008, this is very encouraging news. To say nothing of a very real dose of Bush Fatigue throughout the country combined with rising energy prices and the poor economy. So, all things considered, the McCain campaign should be thrilled with the week they have had. Indeed, ANY Republican candidate would struggle in this environment, although it does not help matters that McCain is viewed by many as a weak candidate.

It is important to keep in mind that at this stage most polls are reflecting the views of partisans who do not pick the president. It has been the soft middle of American politics – the so-called “swing voters” - that have determined our president since 1988. And those that comprise the middle generally are tuned out until the party conventions, which is why the conventions have become glitzy five-day infomercials that normally give each candidate a nice bounce in the polls just afterward.

That is why, at this pre-convention stage, the national tracking polls are of marginal value, whereas looking at the individual state polling numbers is a much better way to get a read on the potential outcome. I am not going to bother looking at states that are solidly for McCain or Obama as there is no point. Instead, let's look at the handful of “battleground” states that will determine the outcome of the election.

The battleground states currently are: FL, OH, MI, NC, VA, IN, MO, CO, NM, NV and NH. This leaves Obama with a solid 238 electoral votes and McCain with a solid 163 electoral votes, leaving the 11 battlegrounds to account for a total of 137 electoral votes. Already you can see the path to 270 is much easier for Obama than McCain, as he holds a 75 electoral vote lead in solid states.

Here's my list of where the battleground states stand based on the RealClearPolitics averages. This may differ slightly from some that you see on TV, but I think this is where the race is now. (Note that “EV” stands for Electoral Votes.)

FL (27 EV): Florida was looking like a McCain stronghold until recently. Obama has made substantial gains in the state over the last month. Current Standing: Obama 45.8% / McCain 45.8%. FL is a definite ‘must win' for McCain.

OH (20 EV): Ohio is the battleground of battlegrounds, and it has been hard hit by the recent economic downturn. Bush won the state by thin margins in 2000 and 2004. Current Standing: Obama 46% / McCain 45%. Ohio is a ‘must win' for McCain.

MI (17 EV): Like Ohio, Michigan has been hard hit by the recent economic slump. Add to that its history of voting Democrat across the board from 1992 on and you get a tough landscape for McCain, although recent Democrat victories in the state have been narrow. Current Standing: Obama 46% / McCain 42%. This is a ‘must win' state for Obama.

NC (15 EV): North Carolina is yet another state that leans Republican and should not be this close, another indication of how McCain is doing poorly with the base. Current Standing: Obama 43% / McCain 47%. NC is another ‘must win' for McCain.

VA (13 EV): Virginia is another state that really should not be in contention. While VA went for George Bush in 2000 and 2004, it has been trending Democrat over the past 12 years. Current Standing: Obama 47% / McCain 46%. VA is ‘must win' for McCain.

IN (11 EV): Indiana should not be a battleground state since this state hasn't voted for a Democrat in almost 40 years. This is a sign of McCain's weakness with the GOP base. Current Standing: Obama 47% / McCain 46.5%. IN is a ‘must win' for McCain.

MO (11 EV): Missouri has been in the GOP portfolio more often than not over the last 40 years, voting for a Democrat only three times over the last 10 cycles. Yet the polls are currently very tight in this Midwest bellwether state. Current Standing: Obama 45% / McCain 47%. MO is a ‘must win' for McCain.

CO (9 EV): Colorado voted for Bush twice but by fairly small margins. The Democrats are convinced that it can be flipped. Look for lots of action in this state. Current Standing: Obama 47% / McCain 45%. CO is a ‘must win' for Obama. More on Colorado below.

NM (5 EV): New Mexico split over the last two general elections going narrowly for Gore and then narrowly for Bush. This is another western state that the Democrats believe they can take. Democratic Governor Bill Richardson is very popular and has endorsed Obama and may be in the running for the VP nod. Current Standing: Obama 49% / McCain 43%. NM is a ‘must win' for Obama.

NV (5 EV): Nevada voted for Clinton twice and Bush twice, but never by large margins. Mark this as the third western state the Democrats think they can capture. The YuccaMountain nuclear waste disposal area is a big hot button issue. Current Standing: Obama 45% / McCain 43%. NV is a ‘must win' for Obama.

NH (4 EV): New Hampshire is the rare New England state that does actually vote for a Republican now and then. It voted for Bush in 2000. McCain is very popular in the state, which is why the polls remain close. Current Standing: Obama 44% / McCain 43%. NH is a ‘must win' for Obama.

As noted at the beginning of this state-by-state analysis, Obama has a large lead over McCain in the electoral vote based on the current polls. Thus, you may be wondering why, if Obama already has a built in 75 EV lead, does he need to win any of the “must win” states marked for him? Well, those states represent Obama's path of least resistance to the magic 270 EV total needed to win.

Let's say, for example, that McCain manages to poach MI and salvage OH, VA, MO, NC and FL – states that Republicans normally have a good chance in. Based on current polls, that would be a good showing for McCain. However, Obama can still win by carrying NH, NM, CO and NV. That would give him 272 EV vs. 266 EV for McCain.

Fortunately, I have it from a good source on the ground that McCain is surging in Colorado, with its nine electoral votes, and has pulled to even with Obama in the last week. Assuming McCain carries the states he is expected to – which is a huge assumption – this race could ultimately come down to only one or two key states. We will revisit the standings after the Democratic convention, and again after the GOP convention.

The Vice Presidential Sweepstakes

McCain's biggest problem of late is that he can't get in the news. Obama, with his World Tour, has dominated the news cycles. Yet despite Obama sucking all of the oxygen out of the room, McCain has closed the gap in the national tracking polls to close to the margin of error. But for McCain to get back in the news, he has to do something big.

There is rampant speculation that McCain is on the verge of making his VP announcement to get back into the spotlight. Some believe this would be a good idea as it would not only build upon recent gains, but would shift the media attention from Obama to McCain, at least for a few days. Others like Karl Rove advise McCain to announce his VP choice only after Obama announces his. We'll see.

Of course the size of the McCain VP bounce will depend on who he picks. In my opinion he has three basic options for his running-mate: 1) base; 2) buzz; and 3) boring. He could select Mitt Romney to shore up the GOP base; he could pick Louisiana governor Bobby Jindahl, a young rising star in the GOP, which would create a real buzz; or he can pick someone boring like his old friend Tim Pawlenty, the governor of Minnesota.

Gary and I firmly believe that Mitt Romney is the best choice if McCain is to have any chance to win. Romney could solidify the GOP base and would certainly help McCain in states like Virginia, North Carolina, Ohio, Indiana, Florida and certainly Michigan where his father was a very popular governor. The problem is, McCain doesn't like Romney. Hopefully, his advisors are urging him to pick Romney anyway. We feel that if he picks Jindahl or Pawlenty or some other lightweight, it will be a sign that McCain doesn't think he can win.

And what about Obama? Rumor has it he will also announce any day now. The Democratic National Convention begins on August 25, and Obama should make his choice very soon. Unlike McCain, Obama will likely make his VP pick based purely on two factors: experience and gravitas. Obama is believed to be considering three possible VP choices (in no particular order): 1) former Georgia Senator Sam Nunn; 2) Virginia Governor Tim Kaine; and 3) NM Governor Bill Richardson, who we consider a distant third.

What about Hillary? Gary and I believe that Obama would only choose Hillary if he was falling down in the polls. We could be wrong, of course, but we don't see Obama opting to take on the Clintons' baggage, and the chance that he could be upstaged by either Bill or Hillary. As noted above, Obama still has a lead in the polls. Thus, assuming Obama announces his VP choice before the convention, we do not expect it to be Hillary.

Sam Nunn would seem an unlikely pick because he is a conservative Democrat. However, Nunn is a political heavyweight, even though he retired from the Senate in 1996. On the one hand, conservatives might hope that Obama picks Nunn who might temper Obama's liberalism. On the other hand, I think an Obama-Nunn ticket would be virtually unbeatable.

That's it for the state electoral analysis and my take on the VP sweepstakes. Back to you, Gary.

Conclusions – Pass This Along

Thanks, Spencer. As noted previously, this is one of the more interesting presidential elections in some time. This is one of the most important presidential elections, in that more is at stake than in a long time. Obama is arguably the most liberal presidential candidate to get the Democratic nomination in a generation or more, yet many Americans who are going to vote for him do not know this. Unfortunately, for many, it is simply “anyone but Bush and the GOP.”

Feel free to forward this E-Letter to as many people as you wish, in whole or in part. Investors in particular need to know where Obama stands, because I do not think he will be good for the markets. Senator McCain was not my choice for the GOP nominee, but conservatives need to come out and support him.

Very best regards,

Gary D. Halbert

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Bailouts - Bear Stearns, Housing - What's Next?

Gary D. Halbert — Tue, 08 Apr 2008 19:47:00 GMT

Bailouts are on the rise. Over the weekend of March 15-16, in a desperate move, the Federal Reserve bailed out Bear Stearns, the large investment bank that got into trouble over subprime mortgages and related securities in a deal with J.P. Morgan-Chase. But for the first time, the Fed...(read more)

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)

Forecasts & Trends : The Fed

Is The Recession Over? Don't Bet On It

Have We Turned The Corner On The Recession?

Who Will Buy America’s Trillions In New Debt?

Introduction

Federal Bailouts Surpassing $10 Trillion

Government Finance 101

Who Will Buy All This New Debt?

Bernanke: Crank Up The Printing Presses

Real Storm Clouds On The Horizon

Conclusions – Not Many I Can Find

Throwing Trillions Around Like Crazy

Obama Seeks Multi-Trillion Dollar Bailouts

Introduction

The Recession Continues To Deepen

So, How Deep & How Long?

Multi-Trillion Dollar Bailouts In The Works

Obama's $825 Billion "Stimulus" Package

Obama's Next "Big Bang" Bank Bailout

Fed Gearing Up To Buy Treasury Bonds

Conclusions?

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

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?

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

Storms On The Horizon - The Entitlement Time Bomb

Introduction

Remarks by Dallas Fed President Richard W. FisherMay 28, 2008

Deficits To Explode In Coming Decades

Conclusions

The Fed, The Stock Market & What To Do Now

Fed Leaves Interest Rates Unchanged Again

But Will Inflation Really Moderate?

Stocks - Stuck In A Long-Term Sideways Pattern?

Bad News For Millions Of Baby Boomers

A Wall Street Myth About To Be Shattered?

Avoiding Big Losses Is The Key

Maybe It's Time You Join Us

The Bottom Line:Stocks May Disappoint When We Need Them The Most

On The Economy, The Fed & President Obama

Introduction

Economy Holding Up Better Than Expected

Consumer Spending Remains Strong

Other Economic Indicators Are Mixed

The Fed In A Policy Box

Do Most Americans Really Know Barack Obama?

Obama Acts As If He's Already The President

John McCain's Electoral Mountain

The Vice Presidential Sweepstakes

Conclusions – Pass This Along

Bailouts - Bear Stearns, Housing - What's Next?

Market Mayhem & Credit Fears - What's Next?

Is A Subprime Recession Inevitable?

Stock Prices Plunge In The Perfect Storm

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

Remarks by Dallas Fed President Richard W. Fisher
May 28, 2008

The Bottom Line:
Stocks May Disappoint When We Need Them The Most