Thoughts From The Frontline : Credit Crisis

The Best of Times

John Mauldin — Sat, 24 Oct 2009 02:52:00 GMT

It's The Best of Times
The Elements of Deflation
It's More Than Half Full
Argentina, Brazil, and Uruguay

What's a Fed to do? We get talk about tightening and taking away the easy credit, but we got the fourth largest monetization on record last week. This week we examine the elements of deflation, look at some banking statistics that are not optimistic, and then I write a reply to my great friend Bill Bonner about why it's the best of times to be young. I think you will get a few thought-provoking ideas here and there.

But before we get to the main letter, I want to recommend a book to you. I am on a 17-day, 12-city speaking tour. It is rather brutal, but I did it to myself. However, one of the upsides of traveling is that I get quiet time on airplanes to read books. I am working my way through a very large stack of books on my desk. One that caught my eye - and I'm glad it did - is a book by Tom Hayes called Jump Point: How Network Culture is Revolutionizing Business. Hayes writes about how we are getting ready to experience a cultural change every bit as profound as the Industrial Revolution. He argues that as the 3 billionth person gets online sometime in 2011, it will shift the dynamic of how we interact as businesses and consumers. We get to 5 billion by 2015. The mind boggles.

Clearly, it is already changing things, and I am not sure if I buy Hayes' thesis that 3 billion is a magical number, though it is great marketing. That being said, I found something on almost every page that I underlined or highlighted. This book made me think about the future in ways that my kids already get but Dad doesn't.

I like to read books about "important stuff" by people who have done a lot of thinking about their subjects, and who can write easily and fluidly and communicate their thoughts without weighing me down with unnecessary verbiage. Hayes has done that. (I am sure some of you, my patient readers, wish I could be better at that!)

No long review here. Go to Amazon and read the reviews. One writer wrote: "I gave the book 5 stars not because it was perfect -- I think Hayes's enthusiasm sometimes makes him jump to conclusions - but because there are so many ideas and observations here that it would take ages to put something like this together from other sources."

I agree. If you are in business, any business, you need to read this. As an aside, I will insist that all my partners worldwide get this book and read it. You can go to Amazon.com and buy the book. And Tom, if you get this (and I bet one of your friends will forward it to you), call me.

The Elements of Deflation

One of the advantages of travel is that it gives you time away from the tyranny of the computer to think. (Am I the only one who feels like I am drinking information through a fire hose?) But getting the information is important too, as it gives you something to think about. And I have been thinking a lot lately about deflation.

I get asked at almost every venue where I stop, whether I think we will see inflation, or deflation. And I answer, "Yes." And I am not trying to be funny. I think the primary forces in the developed world now are deflationary. When asked if I don't think that the Fed monetizing debt of all kinds won't eventually be inflationary, I answer, "We better hope so!"

Let's quickly summarize some of the ideas from the last few months of this letter. Just as water is made up of two parts hydrogen to one part oxygen, so deflation has its own elemental structure.

The first element is Rising Unemployment. There has never been a sustained inflationary period without wage inflation. Wages are basically flat and falling. With 9.8% unemployment, 7% underemployed (temporary), and another 3-4% off the radar screen because they are so discouraged they are not even looking for jobs, and thus are not counted as unemployed (who made up these rules?), it is hard to see how wage inflation is in our near future.

Think about this. Only a few years ago, less than 1 in 16 Americans was unemployed or underemployed. Today it is 1 in 5. That is a staggering, overwhelming statistic. Mind-numbing.

Keynes said that you should stimulate the economy in recessions in order to bring back consumer spending. That is not going to happen this time. As my friends at GaveKal point out, this time we will have to have an Austrian (economic) recovery, or a business-spending recovery. My argument will be, when I am with them in Dallas in December at their conference, "Where are we going to get business-investment spending when banks aren't lending and capacity utilization is at an all-time low?" This, of course, leads the Keynesians to jump in and say, "The government has to step up and jump-start consumption!" Which means more debt. Wash. Rinse. Repeat.

The next element of deflation is massive Wealth Destruction. Two bear markets and a housing market collapse have put the American consumer on the ropes. And the next bear market will bring him to the canvas.

Then we have Reduced Borrowing and Lending, as consumers are paying down debt and banks are reducing their lending. Both are necessary in a credit crisis-caused recession. Bank lending is basically back to where it was two years ago, and shows no sign off rebounding. Banks, as I have written, are buying US government debt in an effort to shore up their balance sheets. Lending to small business, the real engine of job creation, is sadly decreasing each month. (See graph below.)

Next up in our elemental list we have Decreased Final Demand and its counterpart Increased Savings. Although the savings rate has come back down to 3% from 6% a few months ago, almost every expectation is that it will rise over the next 3-5 years back up to the 9% level where it was only 20 years ago. The psyche of the American consumer has been permanently seared. Consumption and savings habits are being changed as I write.

And of course we must address the element of Low Capacity Utilization. While capacity utilization is rebounding, it is still lower than at any time since the data has been collected, other than the last few months. It is hard to see where businesses are going to get pricing power, when not only US but world capacity utilization is still extremely low. The chart below is not the stuff that inflation is made of.

And let's just quickly throw in Massive Deleveraging and $2 trillion in Bank Losses and a Very Weak Housing Market. Which brings us to a Slowing Velocity of Money.

As I have written on several occasions, prices are a function of the amount of money times the velocity of money. If the velocity of money is slowing, the amount of money can rise without bringing about inflation. It is a delicate balance, but nonetheless the hyperventilation in some circles about the coming hyperinflation is, well, overinflated. Simplistic. Economically naive.

The Fed is going to do what it takes to bring about inflation (in my opinion). But they will not monetize US government debt beyond what they have already agreed to. If they need to "print money" to fight deflation, they can buy mortgage or credit-card or other forms of private debt, which have the convenience of being self-liquidating. Read the speeches of the Fed presidents and governors. I can't imagine these people will recklessly monetize US debt. You don't get to their level without having a stiff backbone. (Yes, I know the gold bugs will call me terminally naive. We will have to wait to see who is right. Peter Schiff, care to make a bet on this one?)

Bernanke warned Congress again last week about rising deficits. Watch the deficit rhetoric coming from the Fed after the next two governors are appointed next year, side by side with Bernanke's reappointment. There will be a line drawn in the sand. Some in Congress will not be happy, but my bet is that the Fed will maintain its independence. If they do not, then my recent letters will prove far too optimistic (and many of you protest my rather less-than-positive suggestion of a double-dip recession). But I must admit I cannot imagine that happening. And there are not enough votes in Congress to change that independent status. There is a day of reckoning coming with the US debt. And thank God for that.

Bottom line: The Fed will do what it takes to keep us from deflation. They will deal with the problems of the ensuing inflation. I wrote six years ago that the best outcome from all the easy monetary policy and budget deficits would be stagflation. I see no need to change that assessment. I am not happy with stagflation, but as I came into my young adult life in the '70s (see below), I know that we can deal with that. The far more worrisome prospect is continued trillion-dollar deficits.

It Is the Best of Times

Now let's change the topic. My friend Bill Bonner, of Daily Reckoning and Agora Publishing fame, recently wrote about his mother. Bill also turned 60 recently. I wrote to him about the similarities between our mothers. Both were born in hard circumstances, on farms that had no indoor plumbing. They joined the WACs and met their husbands. They struggled raising families. Bill and I both grew up in rather humble circumstances (to put a mild spin on it).

That exchange caused Bill to write about the future our kids face. He has six kids and I have seven. He has graciously allowed all my kids to invade his chateau in rural France (where they mingle with his kids), and has invited us back next summer. I think Bill is the best writer, the best "turner of a phrase," in the business. I often feel like a house painter standing in front of a Rembrandt when I read his work.

But Bill is a tad pessimistic. He makes me look like Larry Kudlow. He wrote (among other books) Financial Reckoning Day, which has just been updated and is now titled Financial Reckoning Day Fallout: Surviving Today's Global Depression. It makes for some interesting reading. Get it with Jump Point.

Now to the point. As I said, Bill wrote about the future our kids face. I will repeat what he said and then respond. Bill's thoughts:

"We sat in a cab yesterday, stuck in traffic in central London. We watched people walk by and wondered. What are they thinking about? What do they want out of life? What do they think of themselves?

"There were hundreds of them...different shapes...different sizes. A businessman in a pin-striped suit, briefcase in hand, concentrating on his sales report; he almost stepped in front of a motorcycle. A salesgirl, grotesquely overweight...yellow hair streaked with brown...wishing she hadn't had so much to drink the night before. A lawyer daydreaming about his secretary. A man who would have rather been fishing...still in his waxed coat. A woman annoyed about something. A heavy construction worker, his legs splayed outward as he walked. A tense young woman who dared not look up. A woman worrying about her son. A man thinking about buying a new car. One man trying to remember a line from a song he learned 30 years ago. Another talking to herself. One looked like a doctor taking an afternoon stroll. Another was stark raving mad.

"All of them walking along...from one place to another...shuffling along...the living towards the dead.

"We were thinking of our children. What a different world they grow up in. And yet, it is still the same too. A man might have been stuck on a London street 50 years ago...and hundreds of years ago he might have watched the same shopkeepers and carpenters walk by, each caught in his own thoughts like a fly in a spider's web.

"Our old friend John Mauldin wrote to say that his mother's experience was not much different than ours. She joined the WACs during the war...met John's father...and then nature took her course.

"But both John and your editor had a big advantage in life. We both caught the upswing.

"Not so with our children. They inherit a different world. America was the world's leading nation in the '50s and '60s. And it was growing in power and wealth - rapidly. We grew up with it. Things were getting better and better...we were sure we'd live much grander, richer, and more exciting lives than our parents. The sky was always the limit!

"Now, America is in decline. China's economy grows while hers declines. The Far East has savings, while she has none. The Asia nations are net exporters, making huge profits...while American industries are judged too old, too expensive, and too highly regulated to compete. Americans have debt up the kazoo, while their competitors have little. A young person in America has to look forward to supporting 70 million retired baby boomers...and paying for their drugs, their food, their wars, and their bailouts.

"For our children - ours and John's - the situation on a personal level is different too. Coming from poor families, we could look forward to much more wealth and material success than our parents ever knew.

"We came back to Ireland this week for a reason that our parents would never have dreamed of. Your editor has set up a family office. It is a very modest affair by family office standards. The typical family office manages a fortune of $100 million, according to The New York Times. We may not even be on the same planet with these rich families; but we are in the same universe. That is, we try to think about...and manage...our wealth as rich people do...as a family legacy or an endowment, not as a retirement fund.

"What wealth we have accumulated - even if it is paltry - will be held by a family-owned corporation. Then, the corporation, run largely by the adult children, manages the assets - from our base in Ireland.

"Your editor, freed from the responsibility of managing his own money, will be free to wander and think...like a vagabond, a gypsy, a refugee, an itinerant mendicant...forced to sup on whatever is at hand and take lodging wherever he can find it - but favoring the Four Seasons and Chateau Margot when they are available.

"Whatever else this does, it puts the children in a very different situation from their parents. Instead of starting out with nothing, they're starting out with something. While this would seem to be a big advantage to them, it has huge hidden disadvantages. Like America itself, they are in danger of finding themselves slipping downhill. Instead of expecting things to get better, they may find it hard even to hold onto what they've got. Instead of the "Morning in America" that Ronald Reagan promised, they may find that it seems more like evening, both in their personal as well as their national lives.

"'From shirtsleeves to shirtsleeves in three generations,' say the French. The grandfather begins without a coat. His grandson ends that way.

"But what to do? Spend it all now...so the children begin with the same clean slate we had? Move to Brazil or India - countries with more obvious upside?

"In the deep, cosmic end, it probably doesn't matter. The advantage to starting out on an upper rung of the ladder may be about equal to the disadvantage of having to worry about falling off. Who can know?

"Every man has to play the cards he's been dealt. What else can he do? He may have a humpback or a beautiful voice. He may have had a hard upbringing or a soft head. He may have a fortune worth of poetry in his soul but not a dime in his pocket. As far as we can tell, every young man starts out even. Each one begins life in the same place - where he is. And every generation takes what it is given, and makes the best of it.

"The real advantage in life is having the gumption to get on with it; no one knows where that comes from."

It's More Than Half Full

Ok, Bill, let's review those wonderful days from whence we sprang, so fraught with the advantages of having nothing. So potent with opportunity. It was the middle of the '70s when we started our careers. Inflation was high and rising. The Soviets were seen as a major threat. Japan was beating our brains out and buying everything, even if nailed down (like Pebble Beach and New York skyscrapers). I had to borrow money at 15% (or more) to buy paper in order to meet customer demands for printing. And guess what? The banks got into trouble and called loans willy-nilly. (My bank even called my mother and threatened her to pay off my loan - against written agreements - and she did. Evil sons of bitches. The more things change... And that bank did fail, I report delightedly! Not that I hold a grudge.)

There were multiple successive and ever-deeper recessions. Gold was rising and the dollar was seen as a joke. Howard Ruff (a good friend to both of us when we were starting out!) and almost every newsletter writer were telling people to buy gold and freeze-dried food to protect themselves against a near-certain economic, if not apocalyptic, catastrophe. Unemployment was high and rising for a decade.

The correct answer to the question, "Where will the jobs come from?" back then was, "I don't know, but they will." And that is the correct answer today.

In 20 years, no one will want to come back to the halcyon days of 2005. Our kids (all 13 of them) are getting ready to live through what will be the most exciting period in human history. There will be a century's worth of change, measured by the standard of the 20^th century, just in the next ten years, and then we will double that pace in the next ten after that. Medical miracles will mean our kids and grandkids will live a lot longer than their dads, although I intend to be writing well into my 80s, like our mutual hero Richard Russell.

There will be whole new industries developed in the US. How do I know that? Follow the money. The rest of the world spends a fraction of what we do on research and development. Where do you go if you are looking for venture capital?

Do I care if the Chinese and the "developing" world are far better off, relatively speaking, than the US in 20 years? Not a whit. Good on them. I hope they make discoveries and inventions and grow new businesses that benefit us all. But we are not going into some long dark night. We, and our kids, get to choose how we respond to what is the reality of the day.

Our nation had to almost hit the wall in 1980 before a Volker could come along and force us to take the pain of recession to beat back inflation. And we will have to come perilously close to the wall this time before we take action as a nation. Way too close for comfort. Maybe you are right, and we have a soft depression. I hope not; but even so, the world will be better, far better, in 20 years, with far more opportunities than today.

It was not fun starting new businesses in the '70s and early '80s. But we did. I remember coming to Baltimore and being (literally) afraid to get out of the car to visit your offices in the slums. But that was what you could afford. A far cry from the chateau in Ouzilly.

I lived in a small mobile home. Tiffani was born there, and we converted part of the kitchen to be her bedroom. (Yes, I was white "trailer trash.") But I got up every morning just like you did and killed as many alligators as I could. The rest had to wait 'til the next day.

And that is the legacy our kids have. They know what it is to wade into the swamp every morning. Never quitting. In thinking about this, you may be the father I respect the most. You have raised your kids to be multilingual children of the world. What a work ethic. How did you get them to scrape window shutters at your chateaus? (I actually saw this, and my kids marveled. Thereafter I threatened to make them go live with you when they didn't behave!)

You have given your kids the opportunity to follow their dreams, even demanded that they do so. And such dreams they (and mine) have. Will they succeed? Who knows? But they will go at it with gusto, in a world with more opportunities than you and I ever imagined 40 years ago. And, oh boy, were we optimists back then. How else could we have done what we did? If we believed the rhetoric that the world was coming to an end, would we have dared to venture out?

You cannot have raised your kids to be such bold adventurers without instilling in them a certain high level of optimism. I am going to out you, Mr. Bonner. You present yourself to your readers as a bona fide end-of-the-world pessimist. But you are a really and truly a closet optimist. Your whole business empire (and what an empire it has become!) is based on finding people who are optimists, in the sense that they think they can actually get people to send them money for what they write. Which they do! Even if it is to read why the world will come to an end, which thankfully it never does.

You are right in this: it is personal gumption that makes or breaks us. There are those who started out with less than we did (hard to imagine but true) and made a lot more. And there are those who started out with far more and made less. But there are very few who are happier than either of us. Or luckier.

Our kids? It is not the times that dictate the man (or daughter!), but the response of the man which dictates his own time. Today promises a brighter future for someone young than any other time in history, whether they are in the US or Brazil or China. They just have to seize it.

And as our kids do just that, and as the millions of kids of those who read us do so, and the billions of kids who are just now getting ready to bust loose all work to achieve their dreams, the world is going to be a far more fantastic place. Smooth ride? Not a chance. We didn't get one; and in thinking through history, there have not been many smooth rides. Why should we think that will get any better? Our kids will just have to live with our generational (and individual) iniquities, government debt and all, and figure out how to master their own fates. But if I had a choice to take the '70s or today? In less than a heartbeat I would choose today. And I bet you would too!

(Side note: You can subscribe to the Daily Reckoning and read more of Bill's great prose. Warning: it is bearish, but lively and fun.)

Argentina, Brazil, and Uruguay

Tonight I am in Orlando, where I spoke at the Commonwealth national conference. I have been to a few conferences here and there, but I must admit to being impressed. A conference for brokers and advisors who are affiliated with them, it was exceptionally well done. And a very smart crowd. These guys have attracted some exceptional talent.

Tomorrow morning I fly back to Dallas, where I get to see my new grandson, Hayden, for the first time. Born this week a little early while I am on the road, I get a call at 3 am on Monday telling me the news and sending me a picture. Wow. The heck with deficits and deflation. How can you not be an optimist?

Then later in the afternoon I am off for Argentina, Brazil, and Uruguay, speaking in four cities and meeting with clients (and future clients) of my Latin American partner, Enrique Flynn. And then back to Philadelphia, again in Orlando, Scottsdale, and one trip to New York in early December. Then not much else is scheduled - but past performance says that will change.

There is a steak and a bottle of wine waiting for me down the hall, so it is time to hit the send button. Have a great week. I know I am. I love South America, and look forward to coming back to you with my impressions.

Your wondering who made up this schedule analyst,

John Mauldin

The Trend May Not Be Your Friend

John Mauldin — Sat, 18 Apr 2009 04:43:54 GMT

Thoughts on the Continuing Crisis
Dressing Like an Economist
The Trend Is Your Friend Until the End of the Trend
What Is Money?
MV=PQ
Newport Beach, Orlando, and Home

Two weeks ago I presented my thoughts on the current economic situation at my 6^th Annual Strategic Investment Conference in La Jolla (co-hosted with Altegris Investments). The speech was well-received, at least to judge from the comment forms. So this week and next, we are going to revisit that talk (with a few edits). Let's start with a little set-up to explain the first few paragraphs.

My speech was Saturday morning. On Friday, I wore a nice grey suit with a Leonardo tie. For those who know about Leonardo's, they are "statement" ties. I should note that Tiffani picked the tie out for me about ten years ago and persuaded me to wear it. It took some getting used to. It is 16 silk-screened colors, bright blues and pinks and grays, the central feature of which is a very vivid parrot. It is not subdued.

When my good friend George Friedman of Stratfor gave his speech on Friday, he commented rather derisively about my taste in ties, which got him a few laughs. This did not bother me too much since, while George is a brilliant geopolitical analyst, his sense of sartorial style is not exactly top-drawer. So now, let's jump into the speech.

Dressing Like an Economist

Three years ago I was here at our third conference, and my daughter Tiffani came to me in the middle of the conference and said with a very serious face, "Dad, we've got to have a talk." Oops, we have to have a talk? This was her "You've done something wrong" face. But I didn't know what I had done. Had I been speaking with my zipper down? Was something I said wrong? So I said, "Well, let's go talk right now." And she says. "No, we can do this when you get home." And I said "No, now."

So we go to another room, and I ask, "What's wrong?" And she says, "Dad, the partners wanted me to come and talk with you." Oh God, I think, what is it?

Now, Art Laffer (he of the napkin and Laffer Curve fame) had spoken earlier at that conference. If any of you have ever seen Art speak, Art dresses to the nines. He gave a speech with which I did not agree. It was brilliantly delivered, but he was just wrong. But he looked really good being wrong.

So Tiffani says, "Dad, the partners want me to talk with you. You dress like an economist. You are supposed to be a guru. We've got to get you some new clothes." And it was true, I had not bought many new clothes for years.

So this is my guru suit. Somebody at least has some sartorial taste -- Tiffani and others picked it out. You can see the evidence of true style and taste by the way she dresses, can't you? And she picked out the tie, too. (And I should point out that the one person in George's family with outstanding taste, his wife and partner Meredith, liked the tie as well.)

Thoughts on the Continuing Crisis

Ok, with that out of the way, let's talk about some of my thoughts on the continuing crisis.

This cartoon is pretty much where we are right now. The consumer is shell-shocked. That pot of gold has now become just a pot. The 401k's are now 201k's. People are trying to figure out how to go forward. Let's go back and get some sense on how we got here and what the landscape looks like and what I think the future will look like.

By the way, I started writing this speech at 1 o'clock yesterday because everyone else was saying what I was going to say, so my friend Kerri helped me create this PowerPoint yesterday. I'm making two classic mistakes that every speaker should never make, and they are: number one, if you are not a morning person, you should never speak first thing in the morning, but I had to trade places with Dennis Gartman; and number two, you should never make a speech to your most important audience that you haven't made somewhere already. So we'll see how it goes, but you guys are all my closest friends, okay? So cut me some slack.

In the beginning there were banks, and the banks were without form or regulation. That lack of regulation begat panics. You had the panic of 1807, then the 1827 panic and Andrew Jackson got rid of the Bank of the US. Then you had the panic of 1873 and the panic of 1907 And over time, the powers that be, not wanting to have any more panics, created first the Federal Reserve and then the FDIC. After World War II, there were basically no more worries about bank deposits. The FDIC covered them, and we entered a new era of "stability." This did not repeal the business cycle and prevent recessions, but it did stop major bank runs and banking panics. We can clearly have financial crises, but they will be different than those of the Depression.

The Trend Is Your Friend Until the End of the Trend

Stability, though, as we were taught by Hyman Minsky, leads to instability. The more stable things become and the longer things are stable, the more unstable they will be when the crisis hits, because we human beings learned to trade and invest by dodging lions and chasing antelopes on the African savannah. We now chase momentum and dodge bear markets. We are hard-wired to look around at our circumstances and predict trends far into the future.

We take the current trend and we project it forever. But the one thing we know about trends is that they are eventually going to end. The trend is only your friend until it ends. Trends are notoriously fickle. That stability breeds instability. Calvin Coolidge said in early 1929 that "In the domestic field, there is tranquility and contentment and the highest record of prosperity in years." The trend ended. "Apres moi, le deluge."

Now, so what happened in 1929, after this era of stability? The bubble burst and the stock market crashed.

By the way, I thought one of the great headlines in the papers from those days was, "The deluge of panic selling overwhelms the market. 19 million shares changed hands." 19 million shares changing hands caused the crash in 1929! That's about a minute today. Okay, before the Great Depression, Coolidge was telling us, at the end of his presidency, that everything was cool, and then we got Hoovered. They tried to balance the budget, and they didn't really provide any stimulus. We got Smoot-Hawley. Given the massive implosion of capital and the closing of banks, there clearly was not enough growth in the money supply. Government and the Fed just did a lot of wrong things.

So at the height of the Depression, in 1933, as Roosevelt was coming into his first term, we had 25% total unemployment; 37% (!) of non-farm workers were unemployed; 4004 banks had failed; $3.6 billion in deposits was lost. That's like trillions in dog years, okay? At least in 2009 dog years. You end up with bread lines, and the stock market just keeps going down, down, down (with a few marvelous bear-market rallies – maybe like what we are seeing today?).

Roosevelt comes along and we get the New Deal. He applied massive stimulus. By the way, his stimulus hired people. He put them to work building parks and the Tennessee Valley Authority. They were building a lot of infrastructure. He didn't put it into Democratic wish lists and permanent wealth transfers and welfare and special-interest agendas to increase the overall budget beyond what we could ever hope to actually pay for (without even more radical tax increases), which the Obama Administration is clearly doing. We'll get to the effectiveness of current policies in a moment.

Then let's look at what he did in 1937. With the economy somewhat on the mend, he tried to balance the budget, raise taxes, reduce deficit spending. And what happened? We had another deep recession and unemployment jumped back up to 20%. It was hard to pull that stimulus back out. And it's particularly dangerous to raise taxes in a weak economy.

Most of the people in this room are old enough to remember the Blue Screen of Death. Remember, you would be typing along on your computer and all of a sudden you would get this screen, saying, "You have an impossible error." (Okay, what's an "impossible" error? Clearly something happened that was possible.)

And the only thing you could do was just unplug the thing. You couldn't even turn it off -- you just had to unplug the computer. It was the Blue Screen of Death. Well, that is kind of what World War II was for the world. We unplugged the world economy, and then we started from a new base. We hit the reset button. We were at lows everywhere in the world; places were in a mess. So we began to grow from there. The bebt supercycle started. For all the recessions and bear markets, a new stability ensued, and debt and leverage began to grow.

We'll revisit that point in a moment. We are doing just what I do in my regular e-letter: I'm going to take three or four ideas, and at the end I'm going to try and tie them all together. Let's see how successful I am.

What Is Money?

Let's talk about what money is. For some people it's M-1 or M-2, and they worry that the money supply is growing too much. For some people it's gold; gold is the only real currency. I think those ideas each have their place, and there's some truths to them, but they focus us on the wrong thing.

It's a bit misleading to talk about money supply, because what money really is is roughly $2 trillion of cash and then $50 trillion in credit. Because what do the banks do? They take deposits in and then they borrow money to leverage them up. I take my credit card and I spend with it. I borrow against a house. I have an asset that rises, and I borrow against it.

We have two trillion dollars of actual cash propping up $50 trillion in credit. If we all decided to settle and pay off everything, we couldn't do it because there is not enough cash. There would be massive asset deflation. We, as a nation, are levered 25 to 1, or we were. Now, that $50 trillion is in a real sense the money supply because that is what we are all pretending is real money. I lend you money and you pretend you are going to pay me back. Then you pretend he [pointing at another attendee] is not going to call your debt for cash, and we are all going to keep the system going. Because if we all try to pay each other back at once, we are all collectively -- and this is a technical economic term -- screwed.

So we keep the system going. Now, where are we today? We are at the Great Deleveraging. We are seeing massive losses and destruction of assets, on a scale that is unprecedented. There was massive destruction of assets during the Great Depression, which caused a lot of problems, and we are seeing the same thing today. We are watching trillions simply being poofed (another technical economics term – which will drive my poor Chinese translator crazy!). We are watching people pay down their credit lines, which is one way of saying the supply of money and credit is shrinking.

This is not just in the US, but all over the world. Because when you start adding European cash-to-credit, and Japanese cash-to-credit, and Indonesian and Chinese cash-to-credit, it becomes multiple tens of trillions, and we are watching a goodly portion of that credit be vaporized. So we -- individuals and businesses -- are trying to find that $2 trillion in real cash and get some of it to pay down our debts. We are reducing that massive leveraged money supply down to some smaller number. We are hitting the Blue Screen of Death. We don't know what it is going to reset to, but we have permanently seared the psyche of the American consumer, and it is going to get reset to some lower number, about which I will speculate in a minute.

Now to give you some idea of how important credit was in our recent period of economic growth – and I keep using this slide, but it is an important slide because it shows you what would have happened in the economy without mortgage equity withdrawals. The red lines are what GDP would have been without MEWs. Notice that in 2001 and 2002 we would have had negative GDP for two years, that's 24 months. It would have been as long as or longer than the current recession. Not quite as deep, because we had the Bush stimulus and Bush tax cuts at the time. The Bush tax cuts were very important in keeping the economy rolling over in 2001 and 2002.

But notice that the recovery for the next four years would have been under 1%. We would have had under 1% GDP for four years running, without mortgage equity withdrawals, without people being able to spend more. That doesn't even count the leverage we increased on our auto loans, on credit cards -- you saw the two charts that Louie [Gave] and Martin [Barnes] used yesterday about the growth of credit, and we are now seeing it in reverse. Do you think George Bush would have stood even a small chance of being reelected without mortgage equity withdrawals?

Quarter 1-2006 we had $223 billion in mortgage equity withdrawals. Quarter 2-2008 it was $9.5 billion. Is it any wonder we were in recession by 2008? By the third and fourth quarters there was no money to keep the treadmill going That $50 trillion in credit was shrinking fast. We were imploding it. Further -- just as a little throwaway slide -- if you look at 2010 and 2011, we are getting ready for another huge wave of mortgage resets.

Now, we've gone through the last wave and we saw what happened; it created a lot of foreclosures. We are not out of the woods yet. It is going to be 2012 before we sell enough houses to really get back to reasonable levels, because we had 3.5 million excess homes at the top. We absorb about a million a year, it takes 3 years, that's kind of the math.

[Skipping some attempts at humor that you had to be there to get] ... By the way, this AIG thing and the bonuses, that's so bogus. I mean, the 40 people that created the problem were gone, they go to 40 other people and say, stick around because we've got to have somebody who actually knows what these things are to try and unwind it, and we'll give you a bonus. Some of them worked for a dollar against getting that bonus, and now we've told the world that a contract isn't a contract in the US of A, for a lousy 160 million dollars. No bank is going to want to play with the US again, because you don't want to be hauled up in front of Barney Frank.

MV=PQ

Okay, when you become a central banker, you are taken into a back room and they do a DNA change on you. You are henceforth and forever physically incapable of allowing deflation on your watch. It becomes the first and foremost thought on your mind: "Deflation, we can't have it." So let's move along to the next point, and then I'm going to tie them all together.

MV=PQ. This is an important equation; this is right up there with E=MC². M (money or the supply of money) times V (velocity, which is how fast the money goes through the system -- if you have seven kids it goes faster than if you have one) is equal to P (the price of money in terms of inflation or deflation) times Q (which roughly stands for the quantity of production, or GDP)

So what happens is, if we increase the supply of money and velocity stays the same, if GDP does not grow, it means we'll have inflation, because this equation must balance. But if you reduce velocity (which is happening today), and if you don't increase the supply of money, you are going to see deflation. Now, we are watching, for reasons we'll get into in a minute, the velocity of money slow. People are getting nervous, they are not borrowing as much, either because they can't or because the "animal spirits" that Keynes talked about are not quite there.

To fight that deflation (which we saw in this week's Producer and Consumer Price Indexes) the Fed is going to print money. A few thoughts. The Fed has announced they intend to print $300 billion. That is different from buying mortgages and securitized credit card debt -- that money (credit) already exists.

When they just print the money and buy Treasuries, like the $300 billion announced, they can sop that up pretty easily if they find themselves facing inflation down the road. But that problem is a long way off.

But sports fans, $300 billion is just a down payment on the "quantitative easing" they will eventually need to do. They can't announce what they are really going to do or the market would throw up. But we are going to get quarterly or semi-annual announcements, saying, we are going to do another $300 billion, another $500 billion.

When we first started out with TALF and everything, it was a couple hundred billion here and there, and now we throw the word trillions around and it just drips off of our tongues and we don't even think about it. A trillion is a lot. It's a big number. And the total guarantees and back-ups and all this stuff we are into -- I saw an estimate of $10-12 trillion. That's a lot of money.

Understand, the Fed is going to keep pumping money until we get inflation. You can count on it. I don't know what that number is, I'm guessing $2 trillion. I've seen some studies. Ray Dalio of Bridgewater thinks it's about $1.5 trillion. It's some big number, some number way beyond $300 billion, and they are going to keep at it until we get inflation.

Side point: what happens if the $300 billion they put in the system comes back to the Fed's books because banks don't put it into the LIBOR market because they are worried about credit risks? If that happens, it does absolutely nothing for the money supply. Okay? It's like, goes here, goes back there -- it doesn't help us. If the Fed creates money which is simply deposited back with the Fed, then there is effectively no money creation. We are still faced with deflation. The Fed has got to somehow get it into the financial system. They've got to figure out how to create some movement.

Will it create an asset bubble in stocks again? I don't know, it could. Dennis [Gartman] talked about being nervous yesterday. I would be nervous about stock markets, both on the long side, as I think we are in a bear market rally, but also there is real risk in being short. Bill Fleckenstein will be here tonight. He is a very famous short trader. He closed a short fund a couple of months ago. He says he doesn't have as many good opportunities, and basically he's scared of being short with so much stimulus coming in. So it's going to work, at least in terms of reflation, but the question is when. A year? Two years?

(This is about as good a break point as I can find in the speech, so we will end here and take it up again next week.)

One note from today's data on deflation. The headline in the Wall Street Journal says China grew at 6.1% last quarter. That doesn't sound bad. But what was not in the story is that nominal growth was just 3.7%. The other 2.4% was because of deflation. To get real (after-inflation) growth you subtract inflation and/or add deflation. Growth in China is slowing down more than the headlines suggest.

Newport Beach, Orlando, and Home

I am writing this somewhere over Canada as I fly back from London. I always try and stay up on the way back so I can get on local time quickly, although I did not get enough sleep this trip. I will need to catch up this weekend. It will be good to be home.

This Thursday Tiffani and I leave for Newport Beach to attend Rob Arnott's annual conference. Each spring Research Affiliates brings together a rather special group of analysts and money managers to work through current economic issues. Harry Markowitz, Burton Malkiel, Mohammed El-Erian, Paul McCulley, and Peter Bernstein are just a few of the luminaries who will be there. I think Rob invites me for comic relief. And just like Jeremiah, he always serves some mighty fine wine (a few of you will get that).

Sunday I get back and then leave Monday to go Orlando to speak at the national Chartered Financial Analysts conference. My assigned topic will be the "state of the union" for alternative investments. If you are attending, you might want to drop into the session, as it will be at the very least provocative and for a few people rather controversial. I think the whole industry is at a crossroads, and we are going to see some real changes in the coming years.

And then? I am home for awhile. I told my London partner Niels Jensen that I would show up for his 50^th birthday party in mid-July, and maybe try to take a vacation then. And Amanda gets married in Tulsa in August. And of course the annual Maine fishing trip in early August. Oh, and Freedom Fest is penciled in for July 11, in Vegas. But not much travel in May and June, at least not yet.

Copenhagen and London were a whirlwind this week. I ended up getting asked to do CNBC Europe for about 30 minutes on a wide range of topics. I really like their Squawkbox crew. And it was good to spend time with the team at Absolute Return Partners. We had some very thought-provoking client meetings.

There is a lot of change getting ready to happen in my business, and I am grateful that it all seems to be for the good. I will be making a few announcements over the next few months that I am quite excited about. There are a lot of people in the finance world (and the world in general) that are really struggling, and I appreciate the support of my clients, my partners, and you, gentle reader. You are why I write this letter. Well, maybe you and my one million other closest friends -- but we both know it is really for you.

It's time to hit the send button, get my bags, drive home, get a good meal, and find my own bed. Have a great week!

Your happy to be home analyst,

John Mauldin

Leverage Is an 8 Letter Word

John Mauldin — Sat, 22 Nov 2008 04:52:29 GMT

Leverage Is an 8 Letter Word
If Loans Are So Cheap, Why Don't They Sell?
Deflation and Helicopters: Time for a Review
Commercial Property Loans Start to Haunt the Banks
Warren Makes a Bet
Thanksgiving, Moving, and New Orleans

Leverage is an eight-letter word, which the markets now regard as twice as bad as the two four-letter words debt and pain (or fill in your own four-letter words). This week I try to give some insight into what is happening in the credit markets, some of it below the radar screen of most analysts. We will look at the potential for deflation and the Fed's response. There is a lot to cover, so let's jump right in.

If Loans Are So Cheap, Why Don't They Sell?

I talked with a friend who runs a collateralized loan obligation fund, or CLO. There are a lot of these funds in the Shadow Banking System. Typically they buy certain types of debt, with a lot of it in the bank loan space. In the "old" days of the last few years, banks would make loans to corporations and then sell them to CLOs and other institutions, making a spread on the loan and a profit on the servicing business. Some funds would typically leverage up somewhat and make a decent return.

Today, many highly rated loans are selling for 80 cents on the dollar. There is nothing wrong with the collateral or the corporation which owes the money; there is just no one with ready cash to buy the loans. I asked my friend why he doesn't buy them, since they offer very good returns.

The problem is that his fund, and most other CLOs, have covenants in their offering documents that prevent them from buying debt at less than 85 cents on the dollar. That covenant is a good thing in normal markets, as it prevents possible mischief by the manager, but right now it means that a lot of opportunity is being missed. The only way he can buy these highly undervalued bank loans is to create a new fund, which he is in the process of doing. But getting the money is tough, as the pension funds and endowments who would normally be the investors are waiting for cash to come from their redemptions in other funds, which are of course selling whatever they can to raise money for the redemptions, including these very same bank loans. Can you say vicious circle?

The good news is that the market is (albeit slowly) responding to low prices and a market for undervalued assets. But the bad news is that it could be months before there will be meaningful recovery in asset prices. In the meantime, these and many other assets are being marked down and impairing the balance sheet of a lot of banks, funds, and institutions.

As an aside, the prices for loans made for leverage buyouts in the last few years have fallen significantly. Anybody want to buy some loans made on the Chrysler sale to private equity fund Cerberus? I think not. Just because a loan is cheap does not mean it is necessarily a reasonable value.

Commercial Property Loans Start to Haunt the Banks

As I have written for a very long time, there are two aspects to the current recession and financial crisis. The first is the fallout from the subprime crisis, which has morphed into a full-blown credit crisis. That coupled with a housing crisis has sent the nation into what looks like it will be the worst recession since 1974.

The second phase to hit banks and lending institutions is the normal recession problem of increased losses on all sorts of loans. Credit cards, home equity loans, residential mortgages, and especially commercial property mortgages all suffer during a recession. As documented a few letters ago, default rates are soaring on all types of consumer loans. That is what you would expect to happen in a recession. The problem is that many of the larger banks have already had their capital depleted dealing with the credit crisis. Now they are going to have to raise even more capital (or reduce lending) to deal with the normal loan problems that come with a recession.

Let's look at a few charts from www.markit.com which show the stress in commercial property lending. A number of very large firms come together to create a market index for commercial mortgage-backed securities, or CMBS (which is listed at market.com). They put 25 different commercial property trusts, created by JPMorgan, Merrill, UBS (the usual suspects), and so on into the index. Traders can then trade on the market value of the underlying combined assets by trading the index. In principle, this is just like trading a stock index that gives you exposure to all the stocks included in the index.

If you have bought commercial mortgages and want to hedge your portfolio, you can do so with this index, or if you want to sell protection (insurance) you can also do so. The price is determined by the spread between the coupon and (I believe) the 10-year US Treasury bond. From trading at a spread of 100 basis points in May and 200 basis points (bps) in July, the spread on AAA-rated commercial mortgages skyrocketed in the last few weeks to 850 before settling back to 667, or more than six times what it was just a few months ago.

According to the Wall Street Journal, at the peak a few days ago this meant that the AAA part of this index was trading at $.70 on the dollar. That suggests there will be losses of 70% on the lower tranches!

Every six months the 12 investment banks that help create the index build a new index comprised of recently created trusts composed of hundreds of individual mortgages. As with most asset-backed paper, these trusts are divided into different tranches, with the highest-rated tranche getting the lowest return but first call on the return of principle and interest. Lower-rated tranches take successively more risk.

There are seven different indexes on the Markit platform, from AAA to lowly BB. Each index is composed of the corresponding tranche in the 25 trusts within the index. Let's look at what the lowest-rated tranche has done.

The lowest tranche is now trading at 4,750 basis points or, if you add in the Treasury price, at over 50%! If you were an institution or fund and wanted to buy protection on a BB-rated CMBS in your portfolio, you would have to be willing to pay 50% annual interest!

On the web site, they note that they have not created a new series that was planned for October 25^th of this year, as there have not been enough new commercial mortgages created to actually build an index. Why? Because any commercial mortgages that the banks now make will have to be kept on the books of those banks, since the price to securitize the loans is prohibitive. Is it any wonder there has been a serious reduction in large commercial property loans?

On a rather sad note, look at the logos of the banks involved in creating this index, from the marketing brochure that Markit uses to inform potential buyers and sellers of the CMBS index:

Fourteen banks were involved as of a few months ago, but now? Bear, Lehman, Wachovia, and Merrill have either passed from this world or have been swallowed up. It makes you wonder who is next. (Side bet: the Treasury or Fed will inject some capital into Citibank this weekend.)

We could do the same analysis on high-yield bonds. Interest on high-yield bonds is now approaching 20%. Credit default swaps on many issues are simply out of sight. That means that if a lower-rated company wanted to issue bonds, they would have to pay 20% or more! There are very few projects that can justify 20% in a low-inflation world. And without access to capital, it will be difficult for businesses to grow. It also means they have to cut costs and jobs. As noted above, even highly rated corporate bonds are selling at steep discounts. Deleveraging is going to be a problem for a few years. We need to get used to it.

Deflation and Helicopters: Time for a Review

I wrote six years ago (November 2002) about Ben Bernanke's speech on deflation, where he tried to make a joke about beating back deflation by dropping money from helicopters. He was immediately tagged as "Helicopter Ben." My thoughts on that speech took up about half of one chapter in Bull's Eye Investing, and I still think it is a very important speech.

I have been saying for a long time that we would be dealing with deflation next year, and that has been met with a lot of reader skepticism. And when inflation hit 5.6% last July, that skepticism was understandable. But this would be a strange world indeed if you had the twin bubbles of housing and credit burst and didn't see a whiff of deflation. Recessions and the bursting of bubbles are by definition deflationary.

And I have been giving thought to the idea that we may have seen a mini-bubble in the price of many commodities, and that bubble has been bursting as well. And since commodity prices were the main cause of inflation, as they retreat the rise in the inflation rate is retreating. This week the latest inflation numbers showed a drop to 3.7% on a year-over-year basis.

But the Consumer Price Index (CPI) fell by a full 1% in October. You have to go back to the 1930s to find a one-month drop as large. And I don't think this is just a one-month anomaly caused by falling energy prices. The housing component, which is 32% of the index, is based on Owners' Equivalent Rents (OER). As I have written elsewhere, over very long periods of time this works as well as actual housing prices. You simply have to pick your basis for comparison and stick with it.

If, for instance, we had been using house prices for the last ten years, we would have seen large increases in inflation up until a year ago, and since then the index would have been in outright (and serious) deflation. But we use OER, so prices in the CPI have been more stable. But that looks like it could be changing.

OER has been rising steadily over the last decade as rents went up. The index showed a 3% rise in 2007, for instance. The recent trend has been down from there, and last month there was no rise in the cost of shelter. Given the number of houses for sale and a weakened economy, I think it is likely we will see outright reductions in the cost of rent, which will translate into a much lower inflation number.

Lower prices are a two-way street. When they result from improved productivity and efficiency, that is considered to be a good thing. But when they are the result of lower demand, that can be problematic.

There is the likelihood that the Fed will lower rates to 50 basis points, and some major and very seasoned economists are now predicting a zero percent Fed funds rate early next year. Given that Fed funds are actually trading at 38 basis points, a drop to 50 basis points would change nothing on a practical level. (Can we say Japan?)

With that in mind, let's revisit Bernanke's speech. Every central banker is mindful of Japan and the 1930s in the US. Deflation is something that will not be allowed. But what if the Fed lowers interest rates to zero and demand does not pick up, along with a little inflation? Quoting Ben:

"To stimulate aggregate spending when short-term interest rates have reached zero, the Fed must expand the scale of its asset purchases or, possibly, expand the menu of assets that it buys. Alternatively, the Fed could find other ways of injecting money into the system -- for example, by making low-interest-rate loans to banks or cooperating with the fiscal authorities. Each method of adding money to the economy has advantages and drawbacks, both technical and economic. One important concern in practice is that calibrating the economic effects of nonstandard means of injecting money may be difficult, given our relative lack of experience with such policies. Thus, as I have stressed already, prevention of deflation remains preferable to having to cure it. If we do fall into deflation, however, we can take comfort that the logic of the printing press example must assert itself, and sufficient injections of money will ultimately always reverse a deflation."

Just a thought here. We could see real drops in the CPI next year. We could also see a US government deficit approach $1 trillion and go right on through that heretofore unthinkable number. As I wrote last week, a reduced trade deficit means that there will be fewer dollars abroad to buy our debt. The difference will have to be made up by either increased savings in the US or higher rates to attract buyers OR the Fed monetizing the debt.

I think the Fed would be highly reluctant to monetize debt in a period of inflation like we have been in, no matter what problems we face. But in a period where we could be facing deflation? It is very possible they would consider monetizing the debt, as will central banks all over the world.

We are in unprecedented times. A (1) deep recession coupled with (2) financial institutions deleveraging, added to (3) a consumer who is going to be forced to save more and spend less while (4) commodity prices are falling, on top of (5) a serious slowdown in the velocity of money, and you have the makings of a perfect deflationary storm. The Fed would be forced to fight it.

What would they do if lowering the Fed rate to zero was not enough? As Bernanke stated, they would simply set the rates for 1- and 2-year notes and further out the curve if they felt they needed to. And if Goldman Sachs is right in its latest revised forecast, the economy is going to need some help:

"Goldman said it now expects U.S. GDP to fall 5 percent in the current quarter, with unemployment rate reaching 9 percent in the fourth quarter of 2009. It also forecast the 10-year yield to fall to 2.75 percent by the end of the first quarter of 2009, as compared to previously estimated 3.5 percent.

" 'The combination of weaker real activity and slower inflation means that profits of U.S. companies will fall even more sharply than we had previously expected,' Goldman said in a note to clients. Goldman now sees economic profits falling 25 percent in 2009 on an annual average basis, the biggest drop since 1938. It had earlier expected a fall of 20 percent. Goldman expects unemployment rates to further go up in 2010 as well, as there is little chance of the economy returning to trend growth by that year."

Other mainstream economists think GDP might fall this quarter by as much as 5%. That does not bode well for retails sales this Christmas.

Warren Makes a Bet

And let's close on this note brought to my attention by Bill King.

"MSN Money's John Markman: Shares of Warren Buffett's insurance holding company are on the ropes this month, plunging 30% in part because the famed investor dabbled in an area of the market he has long publicly derided: derivatives. And due to a tangled web of financial relationships, they may be taking Goldman Sachs shares down with them. Investors are concerned about a $37-billion bet that Buffett made last year that U.S. and world equity values would be higher in 15 to 20 years than they were then, when the Dow Jones Industrials were trading around 13,000. Through his firm, Berkshire Hathaway, Buffett sold option contracts, known as "naked puts" to an undisclosed group of investors for around $4.85 billion, reportedly using Goldman as broker...

"Because of its solid-gold credit rating, Berkshire Hathaway was not required to put up collateral to make this trade. But now rumors are flying on Wall Street that the owners of the contracts have demanded that broker Goldman Sachs put up collateral for the rest of the amount due. Since the value of the trade could be infinite, the collateral demands are said to be large, and fears that Goldman will struggle to make good on its obligation has panicked shareholders. Indeed one theory making the rounds this week is that Buffett put $5 billion into Goldman at around $125 per share in September not as an investment but to help provide funds for the collateral.

http://blogs.moneycentral.msn.com/topstocks/archive/2008/11/20/buffett-s-huge-derivatives-bet-proves-costly.aspx

"Isn't this the oracle that called derivatives, 'financial weapons of mass destruction'?"

I personally think that Warren made a very good bet. I would be shocked if the Dow was not at 13,000 in 20 years. Inflation will do most of that heavy lifting. But it does make for an interesting discussion now.

Thanksgiving, Moving, and New Orleans

Tiffani has decreed that I am going with her to New Orleans in a month to spend four days huddled away from the office, pouring over the research for our new book Eavesdropping on Millionaires and getting started on the actual writing. Somehow, she thinks I will be distracted if I am in the office.

I am looking forward to Thanksgiving next week. Most of my kids and some of my family will be coming to my apartment. I will be cooking all morning, preparing prime, lots of mushrooms and veggies, and more. I really get into it when I get the chance. And a very thoughtful reader has sent Tiffani and me some really great wines, which we will uncork.

Hopefully, this year we can avoid a fire in the building and having to carry my 91-year-old mother down 21 flights of stairs. And then the next day we pack everything up and move a few miles away to a house that will become my office a few weeks later. I am really quite excited about the move, as I really do like the house and am really enamored of the thought of a ten-second down-the-hall commute. Ask me in three years how I like it.

Congratulations are in order to my assistant of the last three years, Sommer Dooley, who has passed the exams for her nursing degree. She will be leaving us soon. She has been a real help the last few years and will be missed.

Next week I am going to write a special letter on why I am optimistic that we will come through this whole financial mess, but now it is time to hit the send button. Have a great week and enjoy your family and Thanksgiving! I think it is my favorite holiday.

Your thinking life is really pretty good analyst,

John Mauldin

Electing the Janitor-in-Chief

John Mauldin — Sat, 01 Nov 2008 04:58:13 GMT

Electing the Janitor-in-Chief
Can't Borrow on Your Home? Whip out the Credit Card!
Deficits as High as an Elephant's Eye
Can You Count to 41?
Chairs, Moving, and Tony Bennett

This week we survey the economic landscape that the new president will inherit. It is a polite understatement to say that he will be getting a serious mess. In reality, the US goes to the polls this next Tuesday to elect a Janitor-in-Chief. He will face a task that rivals that of Hercules in cleaning out the Stygian stables (legendary huge stables that had not been mucked out for ten years). However, there are no convenient rivers at hand for a probable President Obama to redirect that will quickly be able to clean out the mess left in the stables of our economy. This will indeed be an Herculean task and one that will take most of the first term of the next administration. So, let's look at what will face the next president. It should make for an interesting, even if not optimistic, letter.

But first, a quick commercial. My friend Steve Blumenthal at CMG wanted me to remind you that there are money managers who have been able to create value in these markets. If you are wondering where to turn to in this rather difficult environment (to say the least!), I suggest you go to his website, register, and then let them show you what a blend of active managers that are on his platform would have done over the past few months and years. These are primarily managers who will trade a managed account (using various proprietary styles) in your name and are quite liquid. And if you are an advisor or broker and would like to see the managers on his platform and how you can access them for you clients, sign up and let Steve and his team know you are in the business. The link is http://www.cmgfunds.net/public/mauldin_questionnaire.asp.

CMG is the firm to which I refer investors who typically have a net worth of less than $2 million. If you are an accredited investor with a higher net worth and would like to see what a portfolio of alternative investments, including hedge funds and actively managed commodity funds, has done this year, I suggest you go to www.accreditedinvestor.ws and my partners at Altegris Investments in the US (and Absolute Return Partners in London and Europe) will be glad to talk with you. And if you are a registered investment advisor or broker in the US, you should seriously consider signing up and talking with the team at Altegris. Some of the solutions they have might be ideal for your clients. (In this regard, I am president and a registered representative of Millennium Wave Securities, LLC, member FINRA. Please note that past performance is not indicative of future results and pay special attention to all the risk disclosures at the websites and at the end of this letter.) And now to the letter.

Electing the Janitor-in-Chief

I normally do not get into politics in this letter, as my beat is economics and investing. But this election has large economic implications. Even though I am a long-time Republican, I can still read polls. And it looks like Obama will be our next president. (I have already paid off my bets made last year, for what it's worth.)

First, let's look at what will be the main problem facing the new president. George Bush came into office with the country already in recession. Over time the economy recovered, albeit somewhat slowly. As I have demonstrated numerous times, the recovery was fueled by Mortgage Equity Withdrawals. Over 2% and sometimes over 3% of GDP growth in 2002-2006 was the result of rising housing prices, allowing consumers to borrow against their homes and spend on whatever they chose.

I have used the chart below on a lot of occasions, but as it is central to today's letter. Let's review it.

The red bars show how the economy would look without that borrowing power. George Bush would most likely have been a one-term president, as the economy would have been in a serious recession for two years, followed by a very slow recovery of less than a 1% growth in GDP in 2003-04. Unemployment would have been dismally high. The slogan would have been "It's the Economy, Stupid" all over again. That was what beat his father in 1992 and would likely have done it to the son in 2004.

But the nation was in fact growing at over 4%, and 9/11 was not so distant a memory. The focus was on the War on Terror, and Bush won a close election.

But that is not the situation today. The economy is in recession. Over one million jobs have been lost in the last 12 months. The preliminary number came out today for third-quarter GDP and it was down by 0.3%, the first negative quarter since the last recession. As it is the preliminary number, and does not really have much data from September, it is likely that future revisions will see the number be even worse. 1% is not out of the question.

The fourth quarter that we are in will again be negative, and even worse than the third quarter. Bush came in with a recession that started in the waning months of the Clinton administration, and he will leave his successor with a much deeper recession and a consumer that is on the ropes.

Let's review this table from a few weeks ago. To understand the real economic problem facing the new administration, you have to understand this table. These are not normal problems that a likely President Obama will be facing. The above chart stopped at 2006. James Kennedy recently updated the data. Notice below how net MEWs have fallen precipitously in 2008, down 95% from three years ago. On this data alone, GDP should be off by 3% this year. No wonder we are in negative economic territory.

In 2005 there was almost $595 billion in mortgage extractions that went into some kind of consumer spending. Remember, according to the graph above, that translated into a 3% rise in GDP. In 2007, MEWs were down to $470 billion, for a boost of 2% to GDP.

The second quarter of 2008 saw an anemic $9.5 billion. At that run rate, we could see a drop-off of well over 90% from 2005! Now, think what the second quarter would have been without the federal stimulus program of $150 billion. It might have looked and felt like this quarter!

In the economic data which came out today, consumer spending was down 3.1%. You have to go back to the intense and deep recession of 1980 to find a worse number. And we are just in the middle innings of what is likely to become a much worse recession.

Can't Borrow on Your Home? Whip out the Credit Card!

So, did American consumers cut back on borrowing? Not if they had a credit card! Total loans from commercial banks to consumers grew by $89 billion for the 12 months ending in September. $61 billion of that was credit card debt, and the amount in recent weeks has exploded. Let's look at this analysis from my favorite slicer and dicer of numbers, data-wizard Greg Weldon (www.weldononline.com). Going with a Halloween theme:

"FAR MORE 'telling' is the LOPSIDED degree to which Credit Card balance growth is 'contributing' to total growth in Consumer Loans, a sign of intensifying 'stress' on consumers, amid accelerating job loss, home price deflation, and equity-market paper wealth devaluation.

"Even the raging Frankenstein stops to note the shockingly UGLY data details:

Commercial Banks, Outstanding Credit Card Balances ... SOARED by an eye-opening + $7.1 billion in the WEEK ending October 15th, representing a +1.9% single-week rate of expansion ... or ... nearly ONE-HUNDRED PERCENT annualized (+98.4%).

"Even more 'telling' is the 'read' acquired by contemplating the following pair of data FACTS:

* Credit Card Loans, 10 months Sep07-thru-Jul-08 ... up + $29.1 billion

* Credit Card Loans, 10 weeks Aug-08-to-mid-Oct-08 ... up + $32.3 billion

"In other words, Commercial Bank 'exposure' via the total amount of Credit Card 'loans' outstanding has risen MORE in the last ten WEEKS, than it did in the previous ten MONTHS COMBINED !!!

"Moreover, the growth in the last ten-weeks, $32.3 billion, or about $600 million per 'shopping day' since the beginning of August ... represents nominal growth of + 9.3% ... or ... + 48.3% annualized over the last ten weeks.

"According to American Express, delinquencies on credit payments rose to 4.1% of all credit outstanding in the 3Q, up from 2.5% in 3Q of 2007, with Bank of America's rate rising even more steeply, to 5.9% in the quarter.

"Moreover, the 'pool' of loans deemed 'uncollectable' rose to a high 6.7% in the 3Q, soaring from 3.6% last September."[Emphasis mine.]

What consumer spending there is has been fueled in part by credit card. Greg notes this uncomfortable piece of data: the second largest "merchant-vendor" for credit card use is now McDonalds. This suggests that many consumers are in serious distress when they need to get their $4 Big Mac and fries with a credit card.

This is the problem facing the economy next year. Credit card growth like we have seen in the last few months has never been sustained at such a level, and is unlikely to be this time either. This is especially true as credit card delinquencies have been rising, as noted above.

The next administration is going to be faced with a retrenching consumer, which will likely push the economy even deeper into recession. This will of course result in higher unemployment. In the first year of the next president's term, he is likely to see another one million people lose their jobs, pushing unemployment to almost 8%.

Peter Bernstein, in his regular letter, notes the rising levels of the DURATION of unemployment. It is now over 9 months, close to 38 weeks. As the recession deepens, this means a lot of people will stop receiving unemployment benefits. Oh, and of course, unemployment is not good for consumer spending. And it will put even more pressure on homeowners behind on their mortgages. And unemployed people do not pay taxes, widening the deficit.

If you thought the recovery under Bush was the "jobless recovery," wait until you see the next version without the benefit of profligate consumer borrowing and spending.

Deficits as High as an Elephant's Eye

Congress, in a sadly bipartisan way, aided and abetted by a Bush administration that simply did not use its veto power, has given the next president deep and growing deficits. Official projections are close to $500 billion. In a recession that will reduce tax revenues and increase costs due to rising unemployment? Can you say $600 billion? $700 billion? Add in the costs of bailing out various entities and it could be much higher. Is a Democratic Congress likely to pass another huge economic stimulus program? Add another $150 billion.

Home prices are likely to continue to slide. Consumers already shell-shocked by falling home values will face even more pain. Already, one in five homeowners owe more than the value of their mortgages. That number will rise. Aging boomers and retirees who thought they would be able to sell their home as part of their retirement plan now have seen that nest egg cut by a considerable amount.

The stock market crash has reduced global wealth by over $16 trillion dollars. A lot of that has been in US retirement accounts. Consumers are going to start to see the need to save once again, which of course reduces consumer spending. There are going to be calls to rescue the consumer and 401k plans.

Think about this. Broad stock indexes are about where they were almost 11 years ago. If you take inflation into account, you have lost considerable buying power. What cost $1,000 in 1997 today costs $1287. Put another way, the inflation-adjusted S&P 500 is 764 instead of the actual 968 at which it closed today. An entire generation is beginning to learn that "stocks for the long run" means a lot longer than most of them thought it meant.

Let's sum it up. Here is what faces President Obama. The economy is in a recession that is getting worse by the day. This is the first consumer-led recession in 27 years. Unemployment is rising and the time between jobs is probably over ten months by the time he takes office. The US deficit is likely to be soaring above $500 billion. Consumers are retrenching, hit by the double whammy of falling home prices and seriously lower stock values and retirement savings.

You will not have the luck of George Bush to have consumers borrow $500 billion a year from their homes and resort to a negative savings rate. Banks will be cutting back on consumer lending, and consumers will be cutting back on spending and increasing their savings. The economy is unlikely to begin even a slow recovery until later in 2009, without serious and continuous large deficit-busting stimulus packages. Even then, the recovery is going to be prolonged, because the causes of the recession are the bursting of the twin bubbles of the housing and credit markets. These problems cannot be solved in a short amount of time. It will be several years into your administration before the housing market recovers, and the credit markets will be on life support for some time.

The Fed has run up its balance sheet by over a trillion dollars. Interest rates have been cut to less than 1%. There is no cavalry coming from the Fed to save the economy with more rate cuts.

What are your options? You have made promises to various constituencies. One is a tax cut for 95% of Americans. The problem is that 47% of Americans do not pay taxes, so what you are really talking about it a massive expansion of welfare. But if you use that tax increase on the "rich" to pay for your "tax cuts" to other Americans, you have no money to pay for other programs, let alone get anywhere close to a balanced budget.

And of course, as each year passes there is less net Social Security income to the government. If you use your tax increase to fund more expenses today, you will not have that to fund Social Security in 2017 when the program goes into a cash-flow deficit. Or, taxes will really have to rise later in the decade. But then again, that will be another president's problem.

How do you offer the increased medical programs you propose if you use the tax increase for tax cuts for 95% of Americans (read: welfare for 50%) without really busting the budget? Or any of the $600 billion in programs that you want to see?

And your serious economic advisors are going to point out (at least in private) that raising taxes on the 5% of wealthiest Americans is eerily similar to what Herbert Hoover did in his administration, along with legislation to restrict free trade and increase tariffs, which you have also advocated. Look where that got him and the country.

75% of those "rich" you are targeting are actually small businesses that account for 50-75% (depending on how you measure growth) of the net new job growth in the US. When you tax them, you limit their ability to grow their businesses. Further, you reduce their ability to consume at a time when consumer spending is already negative.

Reduced consumer spending will be reducing corporate profits and thus corporate tax revenues. Just when you need more revenues.

A tax hike in 2010 of the magnitude you currently propose, in a weak economy, is almost guaranteed to create a double-dip recession. That will not be good for your mid-term elections. Given that the recovery from a second recession is likely to be long and drawn out, it would also make it difficult to get re-elected, as the economy would be the first and foremost issue.

Both Obama and McCain have said they are the candidate for change. And the large majority of the country believes we are headed in the wrong direction and need change. But I am reminded of a quote attributed to Lord Palmerston, a former prime minister of England (in the mid 1800s). Queen Victoria was talking of the need for change in order to help the country. He is reported to have said, "Change, change, all this talk about change. Aren't things quite bad enough already?"

We are going to get change. I just hope it is not too much and the wrong kind of change.

Can You Count to 41?

For my international readers, it is likely that Obama will be the next president. The real thing to watch on election night is how many Republican senators there will be at the end of the evening. Under the rather curious rules of the US Senate, 41 Senators (out of 100) can block any given legislation. Things, including polls, are quite volatile this election. It is possible the Republicans will lose as many as 9 senators, giving them only 40. If such a thing transpires, and there is a real possibility it might, the changes we will see will be epochal in nature.

You have only to look at the legislation the House of Representatives passed this last session, only to have it blocked in the Senate, to see what would soon become the law of the land. Let's just say trial lawyers, unions, and far-left liberals will be happy. Those who believe in free trade and lower taxes will not. And it will not be change that can be "fixed" if Republicans ever get back to power. It is unlikely that we will see the day when Republicans will have the necessary 60 Senators to change things back any time soon.

Republicans deserve to have lost control of the House and Senate, as well as the presidency. They got power and then went on a spending binge, letting deficits get out of control. Shame on them! I just hope we can keep 41 Senators, to have some check on things. We will see if my countrymen agree.

And maybe we can learn from this near-death experience and get it right the next time. But we are going to pay a price the next four years in terms of liberal activist judges who will be around for decades, a real setback to free trade and lower taxes. The Republic will survive, as it always has. But it should not have come to this.

Chairs, Moving, and Tony Bennett

Last Tuesday I went to hear Tony Bennett. He is 82. He still has it. It was one of the more magical music moments of my life. He put down the microphone at one point, and with a smooth Les Paul guitar backing him up, began to sing "Fly Me to the Moon," in the rather large new Meyerson Symphony Hall in Dallas. The hush in the room was amazing, as everyone wanted to hear this old favorite. I wondered if he could do it in such a large hall, but he did. Just Tony, no microphone and a soft guitar. It was magic. If he comes to a place near you (he is in New York, New Jersey, and Vegas next month), drop what you are doing and go.

We are making plans to move. I will move to a new home in Dallas (leased) the weekend after Thanksgiving, and then we will move the office into it in the middle of December. Rather ambitious while trying to write a book as well. But I look forward to the 5-second commute.

Tiffani and I are doing about 15 interviews a week with millionaires from all around the world as part of the research for our new book, Eavesdropping on Millionaires. Tiffani asked me to let those of you who have asked to be interviewed to have a little patience if she has not gotten back to you. We had so many more volunteers than we ever imagined would come forth. As we plan a series of books, we will be doing interviews (though not at this pace) for several years, so it is our intention to get to as many of you as possible.

We have had almost 17,000 people take the survey (25% from outside the US). We hope to get 20,000. The survey is quite thought-provoking and takes about ten minutes to complete. If you haven't taken it yet and want to participate in this research (and we want everyone to take it, as you don't have to be a millionaire - if you are reading this, you can take it), please visit: http://survey.frontlinethoughts.com/index.php?sid=12431&lang=en

Reading one of those surveys, I was reminded about my recommendation of the Health Chair. The interviewee had bought one, and he agreed with me that it was one of the best investments he had made. I know it has really helped my back, given how much time I spend in front of a computer. Lots of people responded to my recommendation last year and got the chair, and the accolades are still coming in. Freddy V from Switzerland wrote the designer the following letter, which says it all.

"... recently I had to do some truly tedious work on the compy. I sat for days and consequently for long stretches of hours on my new chair. After a few hours my back started with familiar symptoms of pain coming from the muscles. What did I do? I simply moved the back supporters into different positions and wowie, the pain disappeared without me noticing first. I never had to pause, to interrupt my work. I sat for hours and hours and could do the job without being bothered by any kind of tiredness or pain. Am I a fan of your health chair, this is simply outstanding and unbelievable! Congratulations from my side and a huge thank you for making this possible. I will stay grateful for a long time. I only hope this chair is surviving me, it will be the most precious thing my heirs have to fight about. Unless the other two kids opt for one too... Freddy."

You can read more about the chair by going to: http://www.thehealthchair.com/jmep.html. Your back will thank you.

Have a great week. Let's hope Tuesday is not as scary as it could be.

Your hoping we can count to 41 next Tuesday analyst,

John Mauldin

The Economic Blue Screen of Death

John Mauldin — Sat, 18 Oct 2008 03:34:31 GMT

The Psyche of the American Consumer
The Consumer Weakens
The Paradox of Thrift
An Economic Blue Screen Of Death
Those Wild And Crazy Analysts
London, Stockholm, Malta, and Becoming a Grandfather

This week I am in California giving two speeches to the Financial Planning Associations of San Diego and Orange County. This and next week's letters will be the broad outline of the speech. We will look at how the retreat of the American consumer will affect the stock market. Has the recent drop (can we say crash, gentle reader?) in stock market valuations given us an opportunity to find value? We look at some very powerful evidence that suggests that may be so. Then we look at the counter to that view. Are we at the bottom, or is there more pain? And given the current state of affairs, how should we then invest? Where do we put our money to work when the dust settles, as it surely will.

As I noted above, this will be a two-part letter, finishing up next week. It will also print out a lot longer than normal as I have a lot of PowerPoint slides that are really important for you to see. A note to the 25% of my one million-plus readers who are outside the US: I am using illustrations from the US stock market to discuss timing and valuations, but the principles will translate to markets worldwide. In fact, considering that most stock markets worldwide are down even more than the US markets, they may be even more applicable. The time to become bullish on a lot of markets may be closer than we think. Let's jump right in.

The Psyche of the American Consumer

You have to have a bit of humor, and I think this cartoon says a lot.

The psyche of the American consumer has been seared, and perhaps permanently, reminiscent of the manner in which our grandparents who lived during the Great Depression were permanently scarred with the memories of that time. How it works out will be different this time, of course, and we will explore that later on. But one thing that is very likely is a major impact on consumer spending going forward. Let's look at a few facts on the state of the consumer.

The Consumer Weakens

Retail sales have fallen for the last three months. This is the first time sales have fallen in such a manner since the record keeping began. They are falling at an annual rate of 2%, which is unprecedented.

Auto sales are down, virtually in freefall, with many auto company sales down more than 30% (Volvo is down 50%!). And it may get worse. GMAC, the financing arm of GM, has announced it will not lend to anyone whose credit score is not 700 or more! Only 58% of Americans qualify. That means, for a large swath of the consumer marketplace, cheap auto financing is a thing of the past, unless auto companies underwrite loans with guarantees.

However, what we are seeing is auto companies abandoning leasing programs and other traditional marketing avenues in order to search for elusive profits. Where you could buy a car two years ago for little or no money down, many dealers are now requiring an average of 12% down. While this makes sense, it is definitely a change.

And it is not just in the US. Auto sales throughout Europe are off significantly, especially in countries that had their own equivalent of the US housing bubble.

How bad is it? We are becoming a morose nation, staying at home to drown our sorrows - even bar sales are down, almost 1%. While I am sure this audience is doing its part to help out the bartenders of the world, our clients are not.

Falling consumer and retail sales are not surprising, given the fact that almost one million jobs have been lost in the last 12 months, bringing unemployment to 6.1%. California, which is a bellwether state, has seen its unemployment rise to 7.7%. That is a (sadly) reasonable target for nationwide unemployment. Back-of-the-napkin analysis suggests that means at least another million jobs will be lost this cycle.

Falling consumer sales are showing up in the share prices of retailers and shopping mall REITs. Many are down to prices last seen 12-16 years ago, with price drops far below the market averages. Think Vegas is immune? MGM and Trump, to name just two, are down 90%!

But we lost a lot of jobs in the last (2001-2002) recession, and consumer spending did not go down. Won't the present trend reverse soon? Might it not just be from the shock of the credit crisis? And with gasoline prices down, giving us a $100 billion plus "tax break," is the worst not over?

It is reasonable therefore to ask why it should be different this time. Predicting the demise of the American consumer has been a favorite pastime of bearish analysts for over 50 years. And they have always been wrong. The American consumer has proven resilient through feast and famine, war and peace. But, the data and circumstances suggest this time may be different.

Let's look at the data that came out this week on the delinquency rates of various types of consumer debt. The delinquency rate on auto loans is 3.8%, up from 2.9% two years ago. Consumer finance? Up to a very high 8.3%. Credit card delinquencies are 4.8%, rising from 4%. Is it any wonder credit card companies are cutting credit lines and raising interest rates to try and stem the bleeding? Mortgage delinquencies have doubled from 2.5% to a current 5%. Consumer credit in general is up to 5% delinquent, more than two-thirds higher than two years ago. This is all illustrative of a consumer in trouble.

Look at this next chart from John Burn Real Estate Consulting. He surveys hundreds of homebuilders nationwide. The long and short of it is that new home sales forecasts are at all-time lows. Traffic (potential buyers) looking at new homes is dismal. In my own area in Dallas, there are brand new homes which builders are willing to lease at very attractive rates in order to generate some cash flow, at much less than the cost of buying. And given the level of prospective buyers looking for a new home, that is a trend likely to continue.

I should note that this morning housing permits fell to a 26-year low, around 786,000. But that statistic can be misleading. Back in 1982, the population of the US was 230 million. Today it is 305 million. We are roughly one-third larger. If you adjust for population, the number would be in the 600,000 range, which is far worse than a mere 26-year low. Those permits mean jobs, and permits need to rise with the population to maintain the job base.

And since we're looking at today's data, the Michigan consumer sentiment number simply fell off a cliff, plunging to 57 from over 70 last month and an average of 85 last year. It was only a few years ago that the number was over 100. The last time it was this low? We were in the midst of a very serious recession in 1982.

Let's get back to housing. This next chart is from www.dismal.com, showing the fall-off in mortgage applications. Mortgage applications for purchase are down by over 30% since the end of 2007, and down much more than that from the peak of 2006, as the subprime lending market has disappeared.

Let's pay particular attention to the fall-off in applications for re-financing, down by almost 60%. This was the source of mortgage equity withdrawals, which fueled consumer-spending growth even in the face of the last recession. Let's look at a graph I used two years ago, from work done by James Kennedy and Alan Greenspan, on the effect of mortgage equity withdrawals (MEWs) on the growth of the US economy.

Notice that in both 2001 and 2002, the US economy continued to grow on an annual basis (the "technical" recession was just a few quarters). Their work suggests that this growth was entirely due to MEWs. In fact, MEWs contributed over 3% to GDP growth in 2004 and 2005, and 2% in 2006. Without US homeowners using their homes as an ATM, the economy would have been very sluggish indeed, averaging much less than 1% for the six years of the Bush presidency. Indeed, as a side observation, without home equity withdrawals the economy would have been so bad it would have been almost impossible for Bush to have won a second term.

Now let's look at the update that James Kennedy posted last week to his numbers. While he does not have an update to the chart above, we do have the actual numbers for new mortgage equity withdrawals through the second quarter of this year. And what they show is MEWs simply withering on the vine. The engine of our GDP growth has essentially been turned off. Look at the fall in the numbers for yourself:

The second quarter of 2008 saw an anemic $9.5 billion. At that run rate, we could see a drop-off of over 90% from 2005! Now, think what the second quarter would have been without the federal stimulus program of $150 billion. It might have looked and felt like this quarter!

While credit card growth has indeed risen to take up some of the "slack," it is nowhere near the previous levels of MEWs. With almost 20% of American mortgages either now or soon to be "under water," and because lending standards are tightening, it will be a long time before we see a significant upsurge in home equity withdrawals. Whatever growth we see in the next few years will have to come from old-fashioned sources, like real productivity and reality-based lending. Homeowner hallucinations are a thing of the past.

And for those of you who like to digest your numbers visually, here is the chart of the decrease in MEWs.

It is likely that whatever recovery we see will be slow in coming. Without MEWs, the period from 2001-2007 would have seen GDP growth of less than 1%! What has changed for the better? It is going to be a rather serious recession and a slow Muddle Through recovery of several years. Unless Obama, Pelosi, and Reid push through their tax increase. Then it will be a lot longer. Maybe even a repeat of 1980 and 1982, where we had back-to-back recessions in two years. Increasing taxes in a recession is the worst possible economic policy. You increase taxes, from an economic perspective, in good times.

Last year, I predicted we would see three things as a result of the bursting of the housing and credit crisis bubbles:

1. We are in a period where earnings disappointments are going to be the rule, not the exception.

2. Lower corporate profits puts pressure on the stock market,

3. Resulting in lower than expected long-term returns.

Let me add a fourth. The psyche of the American consumer has been seared, and perhaps permanently.

The Paradox of Thrift

We are (finally!) going to see US consumers start to increase their savings. Increasing home prices and increasing stock prices made many consumers feel comfortable that their retirement future was assured. Now that feeling has been crushed. Home values are not likely to bounce back for a very long time. And as I have written for a long time, we are facing a low-return environment for stocks.

Now, while it is a good thing for an individual to save money, it is not good for the economy as a whole, at least in terms of consumer spending and GDP growth. This is the Paradox of Thrift.

An Economic Blue Screen Of Death

The lack of the ability to borrow on homes, coupled with the need to save more money, is going to put a large dent in the US and world economy. My older readers will remember the Microsoft "blue screen of death" that would pop up from time to time when your computer froze. All you could do was hit the reset button. It is as if we have hit a giant economic blue screen of death. All we can do is hit the reset button. We are going to a new, lower level of consumer spending on an absolute basis, and perhaps as a percentage of GDP. Once that new level has been reached, we will start slowly growing from there; but until that point, the growth of the US economy is going to be severely challenged. We got ahead of ourselves through borrowing and confidence in the bull market, and now we have to deal with the new reality.

That means corporate earnings for many US companies are going to come under increased pressure. And as we will see below, the drop in corporate earnings is in line with the drop in the stock market.

Those Wild And Crazy Analysts

Look at how the projections for earnings per share for the S&P 500 have dropped over the past year. Every few months, estimates have dropped. It will get worse (teaser for next week: we look at graphs which show where earnings may go if they drop as much as in the last recession. And remember, that recession had growing consumer spending!).

Given the malaise and mood of the US consumer, the already low numbers for this year are likely to be revised down again. Let's go to the chart:

Now let's look at 2009 projections.

Notice that in February of 2008, earnings for 2008 had been revised downward to $71.20. But analysts were still bullish. They projected the next month an almost 10% increase in earnings for 2009. They are now down to $48. Remember the old Limbo song, "How Low Can You Go?" 2009 earnings can go a lot lower.

One last graph for this week and then we will call it a day. This is the actual data from S&P, which I copied from their web site. Notice the huge disparity between the as-reported earnings and operating earnings estimate for 2009. The operating earnings are literally double the reported earnings. Reported earnings are what companies use for tax purposes. They are also the basis for any historical comparisons you see. Operating earnings are what I call EBBS or Earnings Before Bad Stuff, or whatever term you use for BS.

The operating earnings estimates are "bottom up" (no pun here). That means that S&P gets the estimates from each of the analysts that follow the individual companies, and add them up for the estimate. The top-down estimates take into account economic conditions. It makes a HUGE difference as to who is more accurate. If the optimists are right, we are at single-digit price to earnings ratios (around 8). If the as-reported team is right, we are at relatively high levels, even after the recent large drop. How high? As of 11 AM Pacific, the 2009 P/E projected ratio is 20.2. That is not a level from which major bull markets are launched.

But is that the level we should be looking at? As we will see next week, if you take a longer-term view of a few years, you can make a case that we are getting closer to a secular bear price-cycle low. Next week, we look at how secular bear markets work and where we could go, and then I offer a few areas where you can look to place your portfolio. I am getting closer to the time when I can be cautiously optimistic.

We will get through this current crisis, and the falls in prices of assets of all types are beginning to create some real opportunities. We will explore those thoughts and a lot more next week.

London, Stockholm, Malta, and Becoming a Grandfather

As noted at the beginning of the letter, I am in California, but will fly home this afternoon. Tomorrow I explore some of the local Dallas housing values (leasing) and then fly on to London in the late afternoon, meeting with my London partners, Absolute Return Partners for a fast few days, and then on to Stockholm where I speak and will chair the day's events for Kaupthing Bank, which was a branch of the Icelandic bank a few weeks ago but now has been taken over by the Swedish government. I expect to learn a lot. And I get to spend some time with old friend Marc Faber. The original focus for the day, many months ago, was "Investing in an Age of Scarcity," but we will expand the topics covered with a nod to current affairs.

Then an ungodly early wake-up call, and on to Malta on Friday, where I will be involved in a series of board meetings of various hedge funds. Even more interesting. Saturday I start to work my way back to Dallas, and then I am mostly home for the next three months, where I will be researching and writing with Tiffani our new book, called Eavesdropping on Millionaires. We have been interviewing millionaires from all levels and from all over the world, but their stories have some common threads. This has had a huge impact on both Tiffani and me. I hope we can convey in the book what we are learning. It is changing my outlook and habits, I can tell you.

I got a text message late last night from my oldest son Henry. He assumed I was already asleep, but I was still up working. He wrote: "I know you wanted us to wait a little longer, but you are going to be a grandpa." He wrote a few more nice thoughts, along the line of wanting my advice and wisdom, etc. Like I have a clue. I feel supremely lucky that my (7!) kids have turned out so well. And we all enjoy and love one another, and I get to spend time with them as young adults. And I guess almost 60 is not be that bad to be a first-time grandfather. Should be an interesting and fun new chapter in my life, if my many friends who have traveled that road are any indication.

It is time to hit the send button. I have this speech to do in an hour, and my really good friend Rob Arnott is coming to have lunch. Life is a lot of fun. Enjoy your week and remember that friends, family, and health are where our true wealth is.

Your thinking more about the Big Stuff analyst,

John Mauldin

Where Do We Go From Here?

John Mauldin — Sat, 11 Oct 2008 03:20:20 GMT

Construction Lending: The Next Shoe to Drop
Lehman at the Center
Iceland Guarantees What?
Letters of Credit: Going, Going Gone?
What to Do and Where Do We Go from Here?
London, Stockholm, and California

I have been writing for almost a year that the next shoe to drop on US banks would be commercial construction lending. Today we look at some hard numbers. We look across the pond to sort out the problems in Europe. We look at the consequences of the losses stemming from Lehman. Then we look at one of the more serious consequences of the banking crisis, one that will bring the crisis home to you. Finally, we look at what the various governments of the world must do in response. It may not be fun, but it should be interesting. And it is important. Feel free to forward this letter to anyone who asks why we not only need the bailout but will need even more coordinated government action.

But first, let me offer a note of optimism before I serve up the not so good news. This is not the end of the world. There are a lot of very positive things happening in the US and the world. Companies are creating new inventions. Much of the economy, including health care, is moving along fine. I have lived through two serious recessions (1973-74 and 1980-82), and the point is that a free-market economy will find a way to eventually get back to solid growth. Recessions are simply part of the business cycle. Congress cannot repeal the business cycle. This will not be the last recession of my life. I hope to live long enough to go through 4 or 5 more.

Depressions are caused by governments making major policy mistakes. And we have made some in the areas of not regulating mortgage lending, allowing the five large investment banks to increase their leverage to 30 or 40 to one in 2004 (what was the SEC thinking?), and failing to oversee the rating agencies. That is behind us. It will make a normal recession deeper and the recovery longer, as I have been forecasting for some time.

But as I argue below, immediate actions must be taken by the government to avoid a much deeper problem. To not take actions to stem the credit crisis would be that major policy mistake which would compound all the other mistakes. I think everyone knows the seriousness of the problem and will act. Let's pray they do.

But whatever happens, there will be plenty of opportunity for investors and entrepreneurs to exploit. The world is on the cusp of a remarkable explosion of new technology of all sorts that will transform our lives. This march of progress went on unchecked last century, through two world wars, major depressions, numerous smaller wars, recessions, financial crises all over the world, famines and natural disasters, not to mention a lot of man-made ones.

The current crisis will pass. None of us will want to go back to the "good old days" in 20 years, for we will be living in the best of times. Just make sure you keep your powder dry so that you can enjoy it. And now, let's look at some less than uplifting news.

Construction Lending: The Next Shoe to Drop

The Bank Credit Analyst is one of the more reliable sources I know for information. They estimate that total losses from the current debt crisis could be anywhere from $1.1 trillion to $1.7 trillion. They estimate roughly half to be in the banking sector, or around $750 billion, and almost $590 billion of that has already been written off. That means that the $700 billion from the TARP (government bailout) program may actually be enough to handle the losses and inject some actual capital into the banks. Maybe.

The losses from subprime and other mortgage-related loans are well known. Most of those losses are in the larger banks, as smaller banks simply could not participate to any great extent. What is less well understood are the potential losses which smaller banks are in fact exposed to in the area of construction lending. Lisa Marquis Jackson, now writing for John Burns Real Estate Consulting (one of the best sources for hard real estate data), gives us some answers to the question of "how much?"

Outside of the large home builders and developers, most of the lending for construction of homes and commercial property comes from regional and local banks. A local home builder may finance 5-10 homes, or a developer a small strip mall or apartment complex, from their local bank. Look at the graph below. Since 2001, delinquencies had been rather small and well-contained. Then starting 18 months ago, the delinquency rates started rising.

Again, note that these are delinquency rates for business loans from banks and not for individual mortgages.

Over 16% of loans made for condominium construction are now delinquent. Loans made for single-family home construction are only slightly more than 12% overdue. But that masks a much bigger problem. Single-family loans account for 86% of all for-sale residential construction loans outstanding.

The good news is that for the top 100 banks by size, single-family loans make up only 2% of the total. But that small portion totals $245 billion. And condos add another $41 billion. That puts almost $40 billion at risk of default at today's delinquency levels.

It will be worse for many smaller banks, as they have larger commercial construction loan portfolios. As noted below, this may require some proactive action on the part of regulators.

Lehman at the Center

Now we know the consequences of allowing Lehman to fail. The severity of the credit crisis was deeply, severely worsened by the failure of Lehman. Based on the results of the credit auction today, sellers of protection will need to make cash payments of more than $270 billion, BNP Paribas SA strategist Andrea Cicione said in London. Some funds may be forced to dump assets to meet the payment demands if they haven't hedged.

How much of that debt will eventually have to be absorbed by various government programs or direct capital infusions? It is too soon to say, but you can bet it will be a lot.

If there is any good news to this, it is that much of the write-downs have already been made. It now looks like the Lehman CDS market sorted itself out with no failures, according to the International Swaps and Derivatives Association.

We have dodged a huge bullet. But the anguish this has put the credit markets through the past month was avoidable. The CDS markets MUST be made to migrate to a regulated clearing entity like the Chicago Mercantile Exchange. Next week would be a good time. While there have been serious losses by various players in other exchange-traded markets, there was no systemic risk, as everyone knew the value of their various securities, whether futures or options or other derivatives, and knew they would get their full value when sold.

With Lehman, no one really knew until late today. Thus banks and hedge funds had to sell anything they could in order to meet possible payments or losses, which caused wildly swinging prices in every market.

It is my bet that future memoirs of the various main actors and books on the credit crisis will look back at the failure of Lehman as the proverbial "last straw" for the unregulated CDS markets.

Iceland Guarantees What?

Let's get this straight. Iceland is a country of 300,000 people. I've never met an Icelander I didn't like. They are an extraordinary people. A few decades ago, they made their money on fishing, farming, and trading. Then they discovered banking and started to take deposits from anywhere and everywhere and make loans outside the country. Soon, the various banks' assets were over $140 billion, about 10 times the total GDP of the country, and they had far more foreign depositors than citizens. With foreign reserves of just 2 billion euros, what could the government do if there was a crisis?

Now Iceland has had to take over the banks and guarantee deposits. They also had to turn to Russia for a loan. Does anyone think Putin would hand out a no-strings-attached loan? Russia needs a refueling station for its Navy and will likely get it.

Note that Iceland gave its citizens the ability to withdraw money but did not extend that same privilege to the citizens of other countries. England and the Netherlands have already gone to court.

As noted by good friend Dennis Gartman this morning, "Since then, things have only gotten worse, with the UK government moving to freeze the assets of Icelandic companies in the UK, and Her Majesty's government has said that it will take whatever further actions it deems necessary to protect the assets of British companies and citizens currently held in Iceland, doing 'whatever is necessary to recover [our] money.'

"Thus, not only are banks fearful of lending money to banks; and not only are banks fearful of lending money to individuals and/or companies; and not only are individuals and/or companies fearful of lending money to the banks, but now nations are fearful of lending to other nations. This is Smoot-Hawley writ large, and of all of the circumstances that have prevailed in the course of the past several days, this is the worst; this is the most difficult to deal with. This is madness."

As noted last week, Ireland set off a feeding frenzy when it guaranteed all deposits in its banking institutions. Five billion euros poured in over the last week. One by one, European governments are having to guarantee their loans to keep money from leaving their institutions.

Let's look at the Irish guarantee on the face of it. There are six Irish banks, holding assets of $576 billion. That works out to three times Ireland's gross domestic product, or about $200,000 for every working person in the country. (Bedlam Asset Management) Yet depositors flooded them with money in just a few days.

This is a sign of panic. One goes where one can, trying to protect what one has. On the face of it, how could Ireland really guarantee all the deposits? Yes, there are real assets against the loans, but at what price? Could Ireland borrow enough to make good on even a portion of those assets, should they decide to walk? This is sheer panic.

Letters of Credit: Going, Going Gone?

Just as the business world is dependent upon commercial paper as its life blood, the world of global trade depends on letters of credit (LOC). Without LOCs, the world of trade quickly freezes up.

If you are a manufacturer of a product and want to sell to someone outside your borders, you typically require a letter of credit from the buyer before you load any cargo at a port. A letter of credit from a prime bank is considered to be proof of your ability to pay. It not only can be a source of ultimate payment, it can be a source of inventory financing while goods are in transit.

And if you are a business which is buying a product, you do not want to release money until you know the product is on the way. There are buyer's and seller's agents who make sure these things happen seamlessly, and world commerce had grown because of it.

Now we are starting to get anecdotal evidence that this extremely vital market is also freezing up. If you think the problems stemming from a meltdown with the commercial paper markets are threatening to the world economy, they are small potatoes when compared to a seizure in the letter of credit markets.

I had been thinking about this for a few weeks. Then an article posted on Naked Capitalist caught my eye. Quoting:

"At the end of the day, if every counterparty is bad then you don't have a market and you don't have an economy. I spoke to another friend of mine this afternoon, whose father has been in the shipping business forever. Pristine credit rating, rock solid balance sheet. He says if he takes his BNP Paribas letter of credit to Citi today for short term funding for his vessels, they won't give it to him. That means he can't ship goods, which means that within the next 2 weeks, physical shortages of commodities begin to show up. THE CENTRAL BANKS CAN'T LET THAT HAPPEN OR WE HAVE NO ECONOMY, LET ALONE A CREDIT SYSTEM."

And they quote the following story from The Financial Post of Canada:

"The credit crisis is spilling over into the grain industry as international buyers find themselves unable to come up with payment, forcing sellers to shoulder often substantial losses.

"Before cargoes can be loaded at port, buyers typically must produce proof they are good for the money. But more deals are falling through as sellers decide they don't trust the financial institution named in the buyer's letter of credit, analysts said.

"'There are all kinds of stuff stacked up on docks right now that can't be shipped because people can't get letters of credit,' said Bill Gary, president of Commodity Information Systems in Oklahoma City. 'The problem is not demand, and it's not supply because we have plenty of supply. It's finding anyone who can come up with the credit to buy.'

"So far the problem is mostly being felt in U.S. and South American ports, but observers say it is only a matter of time before it hits Canada. 'We've got a nightmare in front of us and a lot of people are concerned it's going to get a lot worse,' said Anthony Temple, a grain marketing expert based in Vancouver.

"Access to credit is key to the survival of maritime trade and insiders now say the supply is being severely restricted. More than 90% of the world's trade by volume goes by ship. 'The credit crisis has made banks nervous and the last thing on their minds is making fresh loans,' Omar Nokta, an analyst at investment bank Dahlman Rose, said in an interview with Reuters.

"While shipping has always been a cyclical industry whose fortunes rise and fall with the global economy, analysts said the current crisis over the drying up of credit is something they have never seen before."

If banks are refusing to go into the LIBOR market and lend to each other, then why would they want to take a letter of credit either? At first, it will be a small trickle, which is how the commercial paper meltdown started. Then it will be a flood.

The one good sector in the US is its export sector. Start slowing that down due to a lack of ability to ship or receive payments and see what happens to an already shrinking economy. If anyone wants to see how the credit crisis can affect Main Street, look no further.

It is hard to overstate the problem and the potential for it to create a true economic meltdown. It must be dealt with, and soon. See more below.

What to Do and Where Do We Go from Here?

The credit markets are frozen. Period. The chart below shows one week LIBOR going back for four years. Notice the gradual rise into 2005? It was a lock-step move with the Fed funds rate. And the less smooth drop was also in concert with the Fed funds rate. The recent spike is not responding to this week's Fed funds cut. The spreads are wider than ever. The problem is not just the price of LIBOR. There is no trading at any price. The LIBOR market is a fiction today. And left unchecked, this lack of dealing with other banks will spread to letters of credit and the international trade markets.

The G-7 group of nations is holding an emergency meeting this weekend. As I write this, reports are coming in that there are serious disagreements as to what to do. They cannot even agree on a press release.

Former Federal Reserve Chairman Paul Volcker urged that "all of them [the G-7 nations] now admit or all of them own up to the fact their own banks are going to need support," in an interview on PBS Television's Charlie Rose Show yesterday.

The real leadership and innovation in the banking crisis seems to be coming from London. UK Chancellor of the Exchequer Alistair Darling told Bloomberg Television that "It is absolutely essential that the world's largest economies act together, and act together now." Darling wants countries to guarantee lending between banks, either by turning central banks into clearing houses for the loans or having governments back them. (Bloomberg)

Sadly, he is right. It has come to that. We are close to the point of no return. Now, we are not talking about bailing out financial institutions. We are literally talking about saving the world economic system. Failed bank lending and a large decrease in letters of credit would guarantee a deep world recession. The last depression produced severe political backlash and a world war.

Frankly, it is simply not worth the risk to say that we should sit back and let the markets work. They are not working, and there are no signs they will. As with a patient whose heart has stopped, it is time to apply the shock treatment.

What should we do? We must simply guarantee LIBOR (interbank) lending worldwide for some period of time (say 3-6 months) or until banks can trust each other's balance sheets. With the Lehman crisis going on, with more mortgage credit problems being revealed, no one knows what their own exposure is, let alone what the exposures of other banks are. Until that dust settles, the LIBOR market will remain frozen. The longer this is allowed to continue, the worse the problems will be. And it needs to be handled on a coordinated basis.

Banking is truly global. The system cannot just be guaranteed by England or the US. It must be done in concert with all major nations contributing their share. Businesses must be able to trade across borders through banks that will accept one another's letters of credit.

Second, we must consider direct investment in some banks. This should be done as preferred shares, with the view to eventually selling the paper back into the market. To make sure that money is not invested poorly or on bad terms, the various governments should invest alongside private investors, on the same terms. If a bank cannot find private investors willing to invest alongside the government, then they should be quietly assisted into the arms of stronger banks. Banks that are too big to fail must be taken over.

Businesses must have access to credit as well. They cannot get it from banks with impaired balance sheets. This is critical to world trade as well as local commerce.

Third, for a short period of time, all bank deposits in the US must be guaranteed. Weak banks must be absorbed into stronger banks as soon as possible. There are banks with large construction loan books in the hardest-hit parts of the US housing crisis, and they need to be put down as quickly as possible. We are already seeing deposits leave banks, many of them small, due to depositor concerns that small banks will not be seen as too big to fail. This must stop. A blanket guarantee will help.

Fourth, mark-to-market rules must be reconsidered. A blanket one-size-fits-all rule clearly does not work and is part of the problem. As I have documented for the last month, there are numerous assets that have a market price far below their intrinsic value. That is because there are simply no buyers. If everyone is selling in order to raise capital, then that will drive down prices to bargain levels below intrinsic value. That does not mean the asset in question would not have a higher value in a market not in crisis.

These are extraordinary times. I know there will be those who believe the markets should be allowed to work or simply want those who created the crisis to pay. I do understand the anger. I too am angry, and have been for a long time. Those of us who saw this crisis coming are frustrated that no one bothered to pay attention.

But now that we are in it the midst of the crisis, there is no going back. We must look forward and do what we can to avoid an even worse crisis and potential depression. I believe we can do so if governments act promptly.

We are already in what will prove to be one of the longer recessions on record. If we look at the Leading Economic Indicators, which have about a 9-month forward-looking view, it will be late next year before we start to grow once again. Given that everything peaked last October through January (sales, employment, etc.), it is likely that the recession will be dated from the beginning of this year.

Long-time readers know I have been wary of the stock market for several years, suggesting that investors either avoid stocks or have close stop losses. No one taking my advice is long-only this market. Not that I have been perfect, but as it turns out, I was right on this one.

I have been fielding calls all week asking me if I think we are close to a bottom in the stock market. And my answer is, we are close to a short-term bottom, but I think we will trade lower over time due to what I think are going to be poor earnings for the next few quarters. If you are a trader (and that means you have been doing it for some time - not the time to get on the job training!), then maybe you can catch a rebound, which is overdue. But (and here is the big caveat) if there is no global coordination on some or all of the recommendations I made above, this is not going to be pretty. It will end in tears. Let's hope the authorities can get their collective act together.

The next two weeks I'll send a two-part letter on the longer-term investment view and how you should position your portfolios. Stay tuned.

London, Stockholm, and California

Next Thursday and Friday I am in Southern California, speaking at two financial planning conferences. Saturday I leave for London to meet with my London partners, Absolute Return Partners, and clients. Then on to Stockholm, where I will speak for the now-Swedish-government-backed bank Kaupthing. The government took the bank over last Monday (it was affiliated with the Icelandic bank of the same name). That conference will be on investing in an age of scarcity. I will be speaking and chairing the panels, and good friend Marc Faber will be there as well. It will be an interesting time to be in London and Europe. A quick trip to Malta, and then I will make my way back to Dallas.

Tomorrow night all seven of my kids and family will gather to celebrate my son Chad's birthday and mine as well (it was last week). It will be nice to have them all under the roof, if only for a day or two. And a pleasant reminder of what is really important.

It is time to hit the send button. My friend Jack Harrod has front-row seats on the glass for the Dallas Stars. I don't understand hockey, but it is exciting sitting that close. All the best, and have a great week - and here's hoping for a bounce in the markets.

Your hoping we see some positive news this weekend analyst,

John Mauldin

Additional Thoughts on the Continuing Crisis

John Mauldin — Sat, 06 Sep 2008 00:09:10 GMT

Thoughts on the Continuing Crisis
Fool Me Once, Shame on You
Delinquencies and Foreclosures Spike UP
Unemployment Rises to 6.1%
Action Is Needed Now
Annapolis, La Jolla and Wedding Videos

We are entering the next stage of the credit crisis, and one which is potentially more troubling than what we have seen over the past year, absent some policy reactions by the central banks and governments world wide. The crisis was started by an intense run-up in leverage by financial institutions and investors world wide, investing in increasingly risky assets such as subprime mortgages and then the realization that leverage could hurt. The deleveraging process started to intensify last year about this time. The easy part of that process has been just about done. Now is the time for the really hard work. It will not be pretty. In this week's letter, we look at the process and think about its implications for the markets and the economy, and visit some data on the housing market and unemployment.

And just for the record, the problems I am describing in this letter are very real. But we will get through them, as we have always done. This is not the end of the world. There are a lot of very good things happening here and there. As we will see, for most smaller banks, it is business as usual. In general, in most places and for most people, life is going on just fine. There are opportunities being created. The markets will find new solutions. But there is some more short-term pain for many market participants, and we need to be aware of the problems and see if we can avoid them for ourselves.

But first, let me ask you for some help. I get to travel a lot with my daughter and business partner Tiffani (actually she runs the business) and meet new people. Over the years, she has become as fascinated as I have with their individual stories. Everyone has a story to tell or a lesson to teach. As I announced a few months ago, we have decided to write a book (or series of books) about those stories, looking at the differences in perspective between old and young, retired and working, those who are wealthy and those who aspire to wealth. What are the differences in attitudes, in work habits, in how you manage money, in how you look at the future, and a score of other items? How do all of these things correlate?

We have created a totally anonymous online survey seeking answers to these questions and more. We have had more than 12,000 of my readers fill out the survey (thank you!!!) and we are learning a lot. We are eager to see what we find as we pore over the resulting data and engage in a lot of in-depth analysis. Are the rich really different? Is there a difference in people from Europe, Asia, Latin America, Africa, and the US? I think we will find some very interesting information.

Please note: this is not just a survey for millionaires. We want everyone, of all income levels and ages, to take the survey, so we can get a true representative sample. We would especially like more ladies and international individuals to take the survey.

You can get to the survey page by clicking here. It will take about 10-15 minutes to complete, and I think that going through the questions will make you think about your own situation. Some have told us the survey is quite thought-provoking. If you have attempted to take the survey and had problems, we think we have worked out the bugs.

Thanks in advance. And now on to the letter.

Thoughts on the Continuing Crisis

Let's start by explaining the process of de-leveraging in what I know are VERY simplistic terms. On average today, FDIC insured banks have about 7.89% of capital for their outstanding assets (loans are generally about 60% of assets), so they are roughly levered up by about 12.5 times. Some investment banks are leveraged up to 30 times. Fannie and Freddie are leveraged 50 times their capital. But to make matters simple, let's assume leverage of 10 times.

(For the record, to be considered "well capitalized" you have to have at least 5% of capital in Tier One assets, and 10% of what is considered risk based assets, with anecdotal evidence that the regulators want to see 12%.)

That means for every $1 million in capital you have, you can lend out $10 million. The profit you make is the difference in the cost of your capital and money your borrow to lend and the interest rate you charge. If your are paying 4% for your money and charging 8%, you would make 4% times $10 million, or gross profits of $400,000. That is a return of 40% on invested capital, which is why so many small banks are being started all over the country every year. Nice business if you can get it.

Of course, you have to be able to take some losses. If you had a $500,000 loan go bad, you would have eaten up all your profits and dipped into your capital. Now you would only have $900,000 in capital. That means you could only make $9 million in loans. Either you will have to raise more capital from investors or reduce your loan portfolio, in addition to writing off the bad loan.

Now, what constitutes capital at real world banks is a very complex thing. How much it costs to find money to lend can vary wildly. Many of us "lend" money to our banks at zero cost to the bank in our checking accounts. They pay more for savings accounts, borrowing from other banks, etc. They charge different rates for different types of loans. It is a very complicated business, and we will not go into any details. The basics of my simple illustration will get us to where we need to go.

When I want to find out something about US banks, I turn to my friends at PL Capital. They run a fund which invests in smaller banks, and have been consulting with banks for many, many years. They really know the business. I caught up with Rich Lashley and asked him to give me his thoughts. I am going to pass them on to you, as they are not as bad as one would think.

In the US, and in much of the developed world, there are two tiers of banking. There are about 8500 banks. The top 50 banks have more than 80% of the assets. The rest of the banks are generally much smaller. Outside of five states hit particularly hard by the housing crisis (see more below), for most of the under top 50 banks, it is business as usual.

There is money for most smaller businesses and projects at the smaller banks except for residential development. The true credit crunch is at the top for larger projects. Want to do a $3 million deal? If you have a reasonable project, it can get financed. Want to do a $300 million deal? Lot's of luck, for reasons we note below.

Most of the smaller banks have plenty of capital and are looking to put it too work. Rich guesses there are about 4-500 banks (5% of the total, with concentrations in states with bad housing markets) which are in some level of financial stress, meaning they need to raise capital or reduce lending. His guess is that we will see about 100-150 banks fail over this cycle. He would be surprised if we saw more than 3 top 50 banks fail. Most of the larger banks, if they get into trouble, would be absorbed by better capitalized banks in search of market share.

In fact, Rich is quite bullish on selected bank shares. 86% of the banks/thrifts in the U.S. made money in Q1 2008 and almost 50% earned more in Q1 2008 than they made in Q1 2007 (i.e. they made more money after the credit crunch than before.) But nearly all banks stocks have declined in sympathy with the problems brought on by the credit crunch. Over times, growing earnings will make for a rebound.

So, middle America and middle American business, except for construction, are not by and large experiencing a credit crunch. The smaller banks are not cutting home equity lines and Rich says they are not experiencing abnormal losses. That is because they are local bankers who know their customers. It is the banks which offer home equity loans and have brokers do the lending without really having any incentive to make sure the loan will be good which are the ones in trouble. Securitized home equity loans and second mortgages are showing significant losses.

Fool Me Once, Shame on You

It is a different story at many of the larger banks. Let's look at two tables from my friend Gary Shilling's latest letter. (www.agaryshilling.com) It is well worth the $275 a year (the investment professional version is $1,000).

To set up the tables, there have been writedowns and losses of about $501 billion in both investment and commercial banks. They have raised $353 billion in capital. As I have written repeatedly, it is likely that we will see another $500 billion in losses. The IMF estimates total losses of $1 trillion. Private estimates from credible sources can run as high as $2 trillion.

As you would expect, the largest losses are typically in the larger banks, with some exceptions. Goldman has only written off $3.8 billion. Citigroup has written off $55 billion. The table, if I am adding correctly, sums up the losses from 64 banks, and adds in "other" banks losses from European, US, Asian and Canadian banks. Outside of the top 64, there have only been writedowns of $16 billion. Again, that speaks to the phenomenon Rich alluded to earlier. It seems that the bigger banks took the riskier bets, getting stuck with the "Old Maid" of subprime and other mortgages and loans. Banks that could not afford to get into the game did not have the losses. In this case, being small was an advantage.

So, how did the investors who gave the various banks capital do on their investment. Shilling shows us 9 deals done by sovereign wealth funds. The best return was down a mere 26.6%. The worst was Singapore in UBS for down 56% in less than nine months.

The old line is "Fool me once, shame on you! Fool me twice, shame on me!" How difficult do you think it is for any major bank to go back to sovereign wealth funds and ask for more? If they got it, you can bet the terms will not be favorable to current shareholders.

Last week I talked about how much it costs for many banks to raise money today. For weaker banks, the cost of new capital is prohibitive.

But going back to my simplistic illustration, regulatory requirements mean that if you are deemed not to have adequate capital, you have to raise money or reduce your loan portfolio. Raising money in today's environment is going to be difficult for many banks. Lehman has been shopping for capital for months. Merrill has had to sell some key assets. It is a strange philosophy of selling the best and keeping the rest, but that is what regulations require you to do. Merrill, for instance, recently sold $30.6 billion of poorly performing mortgage related assets for (which they valued at $11.1 billion) to a private equity firm called Lone Star for $6.7 billion, which is a 78% discount to the original face value. But Merrill had to finance 75% of the deal, which means they may only get 5 cents on the dollar.

And while I am picking on Merrill, let me quote this paragraph from Shilling's latest letter to illustrate the problems the large banks have.

"To add insult to injury, Merrill Lynch recently announced plans to sell $8.5 billion in new common stock, which will dilute shareholders by 38%. Previously, in response to writedowns, which totaled $46 billion since June 2007, Merrill has raised $15 billion in common and preferred stock. And this new common stock sale will be even more costly to Merrill since earlier sales of $5 billion in stock at $48 per share to Temasek, a Singapore state owned investment company, required compensation for the difference if Merrill sold stock at a lower price within 12 months. The stock is now $27 per share, which will cost Merrill over $2 billion."

If there are in fact more large losses coming in the next year, what will the banks do? Raising capital is going to be tough and come at serious costs to current shareholders. We will see some of that, and that is a reason I would be very cautious about the stocks of large financial companies. The bulls would say that the problems are already in the price. Of course, that is that they said six months ago as well. Caution is to be taken.

The second thing they can do to repair their balance sheet is reduce their loan books or sell off assets or loans. And that is happening. And it is going to happen more and more. It is going to be increasingly difficult to get large new loan deals done and that is going to put a damper on the economy. 60% of banks report they are tightening their lending standards. In the recent Beige Book, the Fed reported that all districts have seen tightening standards, something that is unusual.

Leverage loan for mergers and buyouts have dropped 75% since last year. They were only $50 billion in the first quarter, and it is almost certain to have dropped to even lower levels this last quarter.

And the leverage that was so helpful as it rose? It is now going to have the opposite effect. If you lose a billion and can't raise the capital, you are going to have to reduce your loan book or sell off assets by (using my analogy) $10 billion. If we have potential write-downs of several hundred billion more, that pain is going to be felt in both the corporate and individual worlds, as credit availability is going to decrease and rates are going to go up.

And the pain may not be abating. While some suggest that we have seen the bottom in housing and the economy, the data out the last three days suggest that is not the case.

Delinquencies and Foreclosures Spike UP

Phillippa Dunne (The Liscio Report) sent me this note a few moments ago:

"The MBA delinquency numbers just came out. In Q2, foreclosures were started on 1.19% of outstanding mortgages, up from 0.99% in Q1, and nearly three times the pre-2000 record. The total stock in foreclosure was 2.75% of all mortgages, more than twice the pre-2000 record. Seriously delinquent (90 days or more, plus those in foreclosure): 4.50%, also more than twice the pre-2000 record. Most of the previous records were set in the 1980s, when both unemployment and interest rates were considerably higher than they are now."

If 4.5% are 90 days or more behind, it is likely that foreclosures will rise precipitously. If you think there is a crisis today, just wait six months. Mortgages past due by 30 days are more are now at a nose bleed 6.35%

Think about this. Freddie and Fannie guarantee 50 times their capital in mortgages. What would a 2% default rate do to them? 8,000,000 homeowners now have negative equity in their homes as of the end of the first quarter. That number is rising as home values drop.

Some cheered the fact that home sales rose last month, and that is a good thing. But the number of homes for sale rose even more. There are now 11.4 months of inventory in the existing home market. New homes show an inventory of over 8 months versus an industry norm of 4.3 months.

As I have been saying for almost two years, the housing market will not normalize until some time in 2010. It is going to take a long time for the markets to work off the excess inventory.

Anecdotally, I have a realtor friend in Dallas who is working with a number of investors buying distressed homes (using some leverage) and condos and then leasing them for returns of 8-10% or more. I am sure that is happening in a lot of places. Such activity is needed to get excess inventory off the "for sale" lists.

Unemployment Rises to 6.1%

There is a reason that consumers are falling behind on their home loans (and on credit cards, auto loans and student loans - you get the picture). Over the last 8 months, unemployment has risen by 685,000. And that assumes there are hundreds of thousands of jobs created in the birth/death model. When the numbers are revised next year, I would be willing to wager that job losses are closer to 1,000,000. That would be consistent with an unemployment number of 6.1%, up from 5.7% last month. That is the highest level in five years.

Greg Weldon provides us with the following thought (www.weldononline.com)

"From the top-down macro-perspective, there is NO denying that the US Labor Market is in a RECESSION, as might be best evidenced via a perusal of the chart on display below, in which we plot the monthly change in the headline Non-Farm Payrolls, along with its 12-Month Exponential Moving Average. Indeed, EVERY time the moving average falls below zero ... it has indicated that the broader economy has dipped into a RECESSION, in 1973-74, 1980-81, 1990-91, 2000-01 ... and ... 2008 !!!!"

Action Is Needed Now

It is unfortunate that the crisis in housing and the credit markets seems to be coming to a head in the middle of a hotly contested election cycle and a lame duck president. Matters are such that waiting until a new president is in power and has his new appointees in place is a very bad option. Things could spiral down very quickly without action by the Treasury and the Fed and other regulators.

Lax regulation of both the mortgage industry and the rating agencies allowed the current crisis to develop. While new regulations will be helpful in the future, we have to deal with the problems as they are today. As I noted above, the credit crunch has the potential to get much worse in the coming quarters. It is clear to a number of observers that Freddie and Fannie are dead men walking. They are going to need capital from the Treasury. Those with mortgages that have the ability to pay at some level should be helped, and the rest need to be sold off at market clearing prices. But that means mortgage debt must be available. Because of the problems in the markets, mortgage rates are higher than they should be, making the housing problems worse.

Since we are going to have to take action sooner rather than later, we should do it sooner. One of the main rules in investing is that "The first losses are the best losses." The longer we wait, the more distress there will be in the housing markets and the lower values will go. Putting off action until next year will mean more losses for taxpayers and more pain in the markets when action is finally taken.

It physically hurts me to write those words. It is so against my free market economic beliefs. But a slow implosion of Freddie and Fannie, and a non-existent jumbo loan market, will mean a very serious recession if not checked soon. Art Cashin sent me this note today: "Paul Volcker at Calgary Conf. says financial crisis "most complicated" he's ever seen. Losses will clearly exceed $500B and U.S. growth will be slowest since the Great Depression."

Those are not light words from a man who is one of the better insights into the economy. I will leave it to wiser men than I to figure out how to stabilize the housing market and Fannie and Freddie. But it must be done.

Further, some thought should be given to allow for slower writedowns of assets, giving troubled banks with otherwise profitable businesses the time to heal. This should be done in conjunction with better regulations and a requirement for reduced leverage over time from investment banks that have access to the Fed window would be helpful.

And while I am indulging myself in wishful thinking, would someone please force Credit Default Swaps onto a regulated derivative exchange like futures and options? This has the potential to magnify the credit crisis into a real nightmare. Maybe we can dodge that, but why risk it? I see no reason to do so, and about $60 trillion (the value of the CDS markets) reasons to do so.

Annapolis, La Jolla and Wedding Videos

It is a good thing I looked at the invitation a few days ago. I thought I was going to Baltimore. As it turns out, I will be traveling to Annapolis (not too far away) tomorrow morning with Tiffani to go to my really good friend Bill Bonner's 60^th birthday bash. We met 26 years ago. How time has gone by. When I first went to his office in a very bad part of Baltimore so long ago, I was seriously nervous about walking two blocks from my car. Bill decided that low rents were worth it. And as rich as he is, he is still frugal. He scraped and painted 100 shutters himself (with his kids) at his chateau in Ouzilly in the country side in France.

We have some things in common. Both our mother's are alive and served in the Women's Army Corps in WW2. He has six kids and I have seven. We both have several New York Times Best sellers. We have ridiculous travel schedules. And life has blessed us immensely. We also have a lot of mutual friends, so this is going to be a very fun weekend! Bill throws great parties.

Bill writes the Daily Reckoning. He is one of the best pure writers I know. I sometimes feel like a house painter looking at a Rembrandt when I read his essays. You can read some of his essays and subscribe to the free Daily Reckoning (be warned: Bill is quite bearish) by clicking on this link: http://www.dailyreckoning.com/rpt/mauldin.html.

Tiffani just sent me a link to this short version of what will be a major video production of her wedding in a few months. If you have a bride coming up in your family, you might view this to see what a non-traditional wedding can look like. And she is a very beautiful bride. Pay attention to the fireworks in the background as they kiss. You can see it at http://vimeo.com/1615007. And yes, the strawberries on the treasure chest wedding cake are to hide where I put my thumb through it, thinking it was a real chest.

Take some time this week to see families and call that old friend up and say hello.

Your really ready to party analyst,

John Mauldin

Who Holds the Old Maid?

John Mauldin — Sat, 30 Aug 2008 05:47:50 GMT

It's All About the Spread
The Coming Bank Credit Crunch
More Thoughts on Fannie and Freddie
Who Is Holding the Old Maid?
Baltimore, La Jolla, South Africa, and London

When is the credit crisis going to end? How will we know? The credit crisis is getting ready to enter its second phase. This week we examine what that means, and what the economic environment will look like over the coming quarters. We also (sadly) re-visit Freddie and Fannie and examine the risks that they put into the markets. Risks, by the way, that were sanctioned by regulators and encouraged by a Congress that took in hundreds of millions in campaign contributions and lobbying fees. We (the US taxpayer) have taken on a huge risk and potential loss for that paltry few hundred million. Sadly, those who encouraged that risk will by and large be voted back into office rather than ridden out of town on a rail (an old US custom, rather barbaric, but one which should maybe be revived for this purpose). It should make for an interesting letter as we count down the last days of summer.

But first, last winter I mentioned that I am looking for private equity and venture capital funds and investment professionals who specialize in those deals, and asked those who would be interested in looking at the potential deals I see from time to time to write me. I had a nice response, but my filing system is somehow inadequate to the task and I seemed to have misplaced about half the respondees. If you have not heard from me lately and would like to be "at the table," just drop me a note at this email address. And now, let's jump into the letter.

It's All About the Spreads

Credit spreads have been increasing and getting ever more volatile. We are going to look at them in detail this week, as one of the signs that the credit crisis is waning will be when spreads start behaving more normally.

Briefly, when we talk about credit spreads we are generally talking about the difference between a benchmark cost of a bond or index and the higher cost for another unrelated loan or bond. As an example, as of Wednesday, a high-grade corporate bond yielded 3.15% more than US Treasury bonds, based on a Merrill Lynch index. Very roughly speaking, in finance terms that means a typical corporation paid 315 basis points more than a similar longer-dated US Treasury. Thus we talk about the spread being 315 basis points or bps. (A basis point is 1/100 of a percent, which means that there are 100 basis points for each 1% difference in interest rates.)

To see how much credit spreads have moved over the past year, let's look at a few charts (I apologize for some of the fuzziness, but I had to resize them). The data is from www.investinginbonds.com . First, let's look at the cost for a typical US financial firm. The cost has gone from 70 bps to 390 bps! That is over a 500% move - a big hit to margins and profitability.

Merrill Lynch US Financials Index

And it can get much worse for some banks. In the "for what it's worth" department, Iraq's bonds are now considered safer than those of many US banks. The country's $2.7 billion of 5.8% bonds due 2028 have gained 45% since August 2007, according to Merrill Lynch & Co. indexes. Investors demand 4.84 percentage points more in yield to own the debt instead of Treasuries, down from 7.26 percentage points a year ago. The spread is narrower than for notes of Ohio banks National City Corp. and KeyCorp, suggesting Baghdad may be safer for bond investors than Cleveland. National City and KeyCorp, based in Cleveland, have debt ratings of A and spreads of 959 basis points (9.59%) and 7.55 basis points (7.55%), respectively. Iraq debt has no ratings. Clearly the market is ignoring the rating agencies which give the banks an "A" rating. Their debt is priced at the junk level. Go figure. (Source: Bloomberg)

Utilities, which you would think would be somewhat immune to the economic crisis and the recession, have seen their borrowing costs rise by almost 300%.

Merrill Lynch US Utilities Index

Your basic investment-grade corporate bond has risen threefold, from just over 90 bps to almost 280 bps. Again, that puts a real squeeze on profits.

Merrill Lynch US Industrials Index

That's the short-term view. Now, let's drop back and look at what has happened since 1997. Credit spreads are now much higher than even in the worst of the last recession. (Source: Bespoke)

And if you have to go into the high-yield market, which is now once again referred to as the junk bond market, you have really been hit. Your spreads, on average, have risen from 240 bps to over 860 bps in the last year. That means IF (and that is a Big IF) you can find someone to loan you money, you will likely be paying an interest rate close to 13% for your money. (The spread is the green line in the chart below.)

Merrill Lynch US High Yield Index

One last chart. This one is the spread between LIBOR and the Fed funds rate. LIBOR is the London Inter Bank Offer Rate. This is what banks charge each other to lend money among themselves. (This chart courtesy of my friends at GaveKal.) Notice the spikes since 1988: the recession of 1991, the 1998 Long Term Capital Management crisis, and then the lead-up to Y2K. After that, LIBOR went flat.

LIBOR may be the most important rate of all, as so many contracts, including many US and European mortgages, are based on LIBOR. Hedge funds, mortgage banks, large and small corporations, and a host of interest-rate-sensitive investments borrow money based on LIBOR. Few of them anticipated such wild swings.

Bottom line? One of the clues as to the end of the credit crisis will be when credit spreads move back closer to historical norms. And we are not close to that yet.

The Coming Bank Credit Crunch

Banks in the US are going to need to roll over almost $800 billion dollars in medium-term debt in the next 16 months. Banks borrowed heavily in 2006, a lot of it in 2-3 year floating-rate notes, and now they must refinance those notes. Say a bank borrowed at LIBOR plus 50bps. In today's environment, many banks are not going to be able to borrow at such low rates. Remember the two Ohio banks mentioned earlier? These regional banks will have to pay spreads of 7-9%, based on the price of their debt today. If you have to pay 12% to borrow money when prime is at 5% and you are lending at 6-8%, you clearly cannot make a profit. That means they will have to sell assets or raise very expensive equity capital.

There are a lot of small and regional banks that are in trouble. The FDIC has a list of 117. Out of (I think) 8500 banks that does not sound bad. But remember, Indy Mac, which failed a few months ago, was not on that list. Banks can get into trouble rather quickly if they cannot raise capital, sell assets, or borrow money due to perceived distress.

The problem is that these banks will have less money to lend and will be calling loans from otherwise good customers, which of course makes the economic situation even worse. It is a vicious cycle.

Even many mainstream economists are now suggesting we will be in a recession by the 4^th quarter, if we are not in one now. (The 2^nd quarter revised GDP was 3.3%. This is an anomaly, and is highly unlikely to be repeated.) The recovery, when it comes, will be tepid until credit spreads signal an end to the credit crisis. It is going to be Muddle Through for 2009. This is NOT going to be good for the stock market. When will it be safe to get back into the water? Pay attention to credit spreads.

One other thing to watch. When the Fed feels it is no longer necessary to offer "temporary" Term Auction Facilities (loans) to commercial and investment banks, that will be a significant event. Notice that these were to be temporary. These auctions will last well into 2009 and maybe longer.

More Thoughts on Fannie and Freddie

First, let me correct an error. It was not JP Morgan that Treasury Secretary Hank Paulson asked to come up with a plan to fix Fannie and Freddie. It was Morgan Stanley. Sorry.

Warren Buffett has stated that Freddie and Fannie are toast, as have many establishment analysts. Buffett told CNBC that the firms had no net worth and would need tens of billions of capital to shore up their balance sheets. Since their combined capitalization is less than $6 billion, it is unlikely that there is any way they could get even a sovereign wealth fund to come to their aid in the form of stock.

Congressional oversight committees estimate losses for Fannie and Freddie to be $25 billion, given current housing values. As home values drop, those estimates keep going up. Also, as the economy gets worse, those losses will increase. Independent estimates are double that or more. If only that were the extent of the problem.

There is $36 billion in preferred shares as of June 2007. Then there is $19 billion in subordinated debt. These firms back $5.2 trillion in mortgage securities. As an aside, that means even a 1% loss from foreclosures would mean a $50 billion portfolio loss. Care to make an over/under wager on a 1% loss by this time next year? I don't think I would want the under.

Gretchen Morgenstern reported last week that there are - drum roll - $62 trillion (with a "T") in credit default swaps written against Fannie and Freddie debt, or somewhere near 12 times the actual debt. Even if you cut this in half - because technically, when a buyer and a seller enter into a single transaction they create twice the value of the transaction in credit derivatives - this is a huge sum, far out of proportion to the underlying assets. More on this later.

The team at Morgan Stanley has a very interesting problem to solve. It is not just about putting $25 to $50 billion into Fannie and Freddie (assuming that would be enough). If that's all it was, just issue preferred shares, wipe out the current shareholders and, as the smoke cleared in a few years, even with less leverage the actual value of the two companies might actually approach that number and some private equity firms could take out the US taxpayer. But it is not that simple.

What do you do with the current preferred shares? A significant portion is held by banks in their capital base. JP Morgan Chase just wrote down $600 million in Fannie and Freddie preferred shares this week. Many other banks will be doing so as well. As noted last week, there are banks that have more than 20% of their capital base in these shares. In today's current environment, do we want to deal with the costs to the FDIC of even more failed banks? And even if you don't force a bank into outright failure, you at best limit its ability to function as an efficient market lending agency to local businesses and consumers.

But you can't just say, "We will cover the preferred shares in banks but not in personal accounts or in the accounts of other institutions." It is an all or nothing proposition. A $36 billion proposition. It is a potential Hobson's choice. Wipe out the preferreds or wipe out the shareholders of a lot of banks and have the FDIC pick up the costs. By the way, Congress and bank regulators encouraged banks to buy preferred shares by giving them special status and tax breaks.

But what about the $19 billion subordinated debt? That $19 billion is actually on the banks' books as capital for Fannie and Freddie and not as debt, because there is a clause in the bond that says if the bank is in a situation where it must be bailed out, the interest payments on those bonds can be postponed for five years. That allows them to count the debt as capital. If the companies are declared insolvent by their regulators, it could trigger the credit default swaps.

I say could, because depending on how the "credit event" is characterized, it may allow the seller of the insurance to postpone payment for five years as well. Just a technical loophole that I am sure most buyers of said credit insurance did not notice.

And even then, I think it is unlikely that many of the sellers of such credit insurance could make anywhere close to the amount of payments they have contracted for. And since the subordinated debt is precisely what you would want to buy credit insurance on, I bet a disproportionate amount of that $62 trillion in credit default swaps is on the lower-rated debt.

Who Is Holding the Old Maid?

And here's the ugly truth. No one knows who is ultimately on the hook for these derivatives. If I sell a credit default swap (CDS) to you and then buy a CDS on the same issue from Joe down the street for a small profit, my "book" looks neutral. And as long as Joe has the capital, I am. But at 12 times the actual underlying debt instruments, there are not just three parties to my mythical transaction, but at least 10. Joe sells to Mary who sells to Bill, etc., etc. Where does the real guarantee ultimately reside?

Like the children's card game, someone is stuck with the Old Maid at the end.

If there is a problem, you are going to come to me but I am going to tell you to go to Joe who will tell you to go to Mary and on down the line until someone tells you to go to hell. Then you come back at me and take me to court. That's the way it works.

This is why I keep pounding the table that CDS transactions must be moved to a regulated exchange. There has to be transparency and provisions for adequate capitalization of these instruments. Bear Stearns was too big to fail not because it was too big, but because of its derivative book of $1.9 trillion. We would have awoken on that Monday morning and, if Bear had been allowed to fail, the markets would have been frozen, because no one knew who was on the hook to Bear (and vice versa) and for how much. And if you don't know, you don't invest or lend to any financial institution or fund, because you put yourself at more risk.

That was just a lousy $1.9 trillion (admittedly at one institution). But $62 trillion? Where is it? Who owns it? Who thinks they are covered and may not be, but their balance sheet reflects a fully valued bond because "I have insurance?" How long will it take to find out where the real problems lurk?

So, let's add up the damage. $50 billion for loan losses in a market where home values will be down 20% at the least - but let's be optimistic here. Add in another $36 billion for the preferred shares, because if we let the banks go down, we just have to pay it through the FDIC. And add in another $19 billion for the subordinated debt, because the risk of setting off a firestorm in the CDS market may just be too great. That adds up to $105 billion.

Maybe those sharp guys at Morgan Stanley can figure out a way to get around these problems. The regulators recently forced buyers of Ambac CDS to take anywhere from $.13 to $.60 on the dollar. Maybe they can make everybody play nice in the sandbox, but this is a very big sandbox, far larger than Ambac.

And why? Critics have said that Fannie and Freddie were nothing but hedge funds with an implicit government guarantee. This is an insult to hedge funds. Hedge funds don't pay hundreds of millions in campaign contributions so that they can risk taxpayer dollars, prop up their profits, and pay huge bonuses to executives. They risk their own capital with no safety net.

Fannie and Freddie are banks that are levered between 40 and 50 times. I can think of two hedge funds, Carlyle Capital and Long Term Capital Management, that had leverage at those levels. They both went bankrupt, as will any such levered business.

As long as the prices of homes kept rising, Fannie and Freddie had no problems. That extra leverage allowed them to post record profits every quarter, boosting stock prices and keeping those bonuses and options for executives rising. And Congress let them do it. In fairness, there was a significant minority who wanted tougher regulations, including the Bush administration. But a bipartisan majority decided to take the campaign contributions and listen to the fabrications about how much Fannie and Freddie did for the country and how there was no risk.

And so now we are at a point where we are going to be forced to pick up the very expensive pieces. The alternative is to let the world as we know it go up in smoke. The mortgage market is dysfunctional now without Freddie and Fannie. The housing crisis would be far worse if you let them die. And once you determine to pick up the costs, you have gone down a very slippery slope. Yet if we don't do it, the systemic crisis will be far worse than the problems resulting from Bear, and those would have been horrific.

This is the Savings and Loan Crisis, Part 2. Maybe they can figure a way to lessen the cost. And the hope is that at some point the companies once again regain their value and the costs will be somewhat mitigated.

But if we don't get credit derivatives on an exchange, we are going to have to continue to do this. It is all so maddening. The only bright side to bailing out Freddie and Fannie is that it will make Bill Bonner wrong in his prediction of a soft depression.

Baltimore, La Jolla, South Africa, and London

On a personal note, things are going well. My arm is much better. The doctor said I tore a pronator muscle which broke a vein and resulted in some serious pain for about a week and a very ugly bruise along my whole arm. Who knew golf was such a rough sport?

My oldest son Henry just graduated from the University of Texas at Arlington with a degree in history, after going part-time for eight years. He has worked at UPS all that time, but kept at his school work. I am proud of him. He turned 27 yesterday. Tiffani is back from her honeymoon with Ryan. She says she will have pictures up in a week or two, and I will post a link.

Business is good. I am amazed at the opportunities out there. I will be in Baltimore next weekend for Bill Bonner's birthday. Then on to La Jolla to meet with my partners at Altegris (and drinks with Richard and Faye Russell). The next weekend I host Chuck Butler of Everbank and his compadres from the Sovereign Wealth Society at a Friday night Rangers game, and then take off the next morning for South Africa for a speech, then back to London for a day to meet with the team (and my partners) at Absolute Return Partners.

Life is busy but good. And this weekend I am going to take it easy and fire up the grill for some steaks and barbecue at Tiffani's new home. It will be a great weekend. And I hope your Labor Day will be as enjoyable. (There will be no Outside the Box on Monday.)

Your happy I don't have to figure out the Freddie and Fannie mess analyst,

John Mauldin

It's more than Fannie and Freddie

John Mauldin — Sat, 23 Aug 2008 01:12:02 GMT

It's More Than Freddie and Fannie
The US Banking System Is in Trouble
$500 Billion and Counting
Fannie, Freddie, and the Credit Crisis
Baltimore, La Jolla, and South Africa

Yet another crisis confronts us, as we will have to deal with the aftermath of a rather large number of bank failures over the next year, which is likely to overwhelm the ability of the FDIC to insure your bank deposits. Today we look at the banking system, the FDIC, and Freddie and Fannie. It's not pretty, but as realists we must know what we are facing.

But first, I just want to say I am glad that Richard Russell is doing fine. For those who do not know, he suffered a mild stroke last Friday. I talked to him yesterday, and he was a little tired but doing better. He has decided to cut back his writing schedule and relax a bit more, which is a good thing. At 84, he has written a daily (and sometimes lengthy) commentary and has been writing the monthly Dow Theory Letter since 1958. He is the dean of newsletter writers. He has forgotten more than most of us will ever know about the markets.

His doctor told him he needed to seek some balance in his life and cut down on the stress. I know how much it takes to write my one letter each week; I can't imagine what it takes to write five. Basically, his plan is now to post his stats and only write about the markets when something important is happening, about every two weeks. I hope he sticks with that plan, as I want to be sharing dinner and drinks with him for many years to come. I am sure you join me in wishing him and his lovely wife Faye all the best and a healthy and quick recovery.

The US Banking System Is in Trouble

A few weeks ago when I was in Maine, I met Chris Whalen. Chris is the managing director of a service called Institutional Risk Analytics, whose primary business is analyzing the health of banks and financial institutions. If you are one of their clients, you can go to their web site and drill quite deep into all aspects of every bank in America. And what they have done is come up with various metrics which compare how well-capitalized a bank is, how much risk it is taking, and what kind of losses (or profits) it can expect. It is a one of a kind firm, and the data gives Chris a very special perspective on the US banking system.

And what he sees is not pretty. There is a crisis brewing. He expects 100 banks to fail between now and July of 2009. Most of them will be small, but there will be a few large banks. The total assets of those banks he estimates to be $850 billion (not a typo!). Those are the assets the FDIC is going to have to cover when they take over the banks.

Take Washington Mutual as an example. There are problems there. Their debt now trades at 20%, which is worse than junk. There is no way they could issue preferred stock to recapitalize their business. And they are going to need more capital, as they have writedowns in their future due to the slowing of the economy. Any common issue would have to seriously dilute existing shareholders almost to the point of nothing. There are circumstances in which they can survive, but it would take a remarkable recovery for the US economy, which is not likely. Maybe management can pull a rabbit out of the hat, but it will need some strong magic to get the capital they need at a cost they can live with.

The FDIC has about $50 billion. These reserves have been built up over the years from deposit insurance paid by banks that are part of the program. They are going to need an estimated $20 billion just to cover the failure of Indy Mac. The FDIC will have to cover only a small percentage of the $850 billion, as some of those assets will surely be good. But if they have to cover 10%, then the FDIC would need another $50 billion. Does that sound like a lot? Chris thinks a more conservative number for planning purposes would be 20-25% potential losses, and you hope it does not get there.

Sometime in the next few quarters, Congress and the President, either the current group or early in the term of the next President, are going to have to address that potential shortfall, before we see bank runs as people fear that FDIC insurance reserves may not be enough. The very sad fact is that taxpayers are going to be on the hook for some time. What is likely to happen is that a loan facility will be made to the FDIC so they can borrow as much as they need, and pay it back from future bank insurance payments.

You can't make up the shortfall just by raising fees. Chris points out that raising fees right now is not really a winning option, as that just makes the financial books of marginal banks even worse. You can raise rates as the banking system returns to health.

If Congress and the President wait too long, there could be a very serious problem, as depositors could start moving their funds under $100,000 (the insured amount) to what they perceive may be a safer bank than their current bank. Rumors could run rampant. This is something that needs to be addressed now. Frankly, this should be addressed right after the elections AT THE LATEST, in consultation with Congress and the new President.

If you are worried about your bank, you can go to Chris's web site and pay $50 for a brief analysis of your bank and an update for the next four quarters. If you have less than $100,000 in your accounts, you should not worry. But for businesses with large deposits and cash flows, it might be worth checking on the health of your bank. The link is http://us1.institutionalriskanalytics.com/Cart/Request.asp?affiliate=bmg123.

You can click on the link that says "Click here for the free samples" in the lower right corner of the page to see if the format of what they offer is something you would find useful.

$500 Billion and Counting

We have seen some $505 billion in bank write-offs so far in this credit crisis. It is serious naiveté to assume that this will be the extent of it. Most of the write-offs have been mortgage-related. We have not yet seen the write-offs that will come as consumers start defaulting on credit cards, auto loans, and other consumer debt. Neither have we seen the losses that will come from commercial real estate or corporate loan as the recession progresses. You can't write off something until it goes bad, although you can increase your loan loss provisions. This of course hits earnings and your stock price and thus your ability to raise new equity. It presents a very difficult dilemma for bank managers and investors deciding whether to invest or go away.

Sober-minded analysis from the IMF suggests that the total write-offs by all banks may be $1 trillion. Dr. Nouriel Roubini is much more alarmed and puts the potential losses at closer to $2 trillion. That means that banks over time are going to have to increase their loan loss provisions, hitting both earnings and capital. And that means they will have to raise more investment capital and equity at a time when their stock prices are low.

It is a vicious spiral. Banks have less capital, so they are able to lend less to the very businesses that need the money; and without said money the businesses will be less capable of paying their current loans, which means that banks have less capital. Rinse and repeat.

That only prolongs the recession and Muddle Through Economy, which hurts consumers and corporate profits, which in turn puts more pressure on banks. Ultimately it means that banks are going to have to raise a lot more capital than anyone who is buying financial stocks today imagines. And it is largely going to be expensive capital. Look at this note from Bennet Sedacca of Atlantic Advisors:

"Financial entities like banks, broker/dealers, regional banks, finance companies, and insurance companies need credit at reasonable rates in order to finance themselves. I have been concerned for many years that the door would finally shut on banks, brokers and others to raise new capital in the debt markets.

"For many regional banks like KeyCorp, Zions, Regions, and National City, the door has already shut on them--if they wanted to raise capital in the debt market at levels where their outstanding issues regularly trade, they would have to pay 12-15%, hardly economic levels. GM bonds trade near 27% yields. Washington Mutual trades north of 15%.

"Then there are the 'good banks', like J.P. Morgan and Wells Fargo. J.P. Morgan recently sold $600 million of preferred stock at 8 3/4 % and Wells Fargo sold $1.3 billion at 8 5/8%, plus underwriting fees.

"Below I offer up a few guesses of what other issuers would have to pay to issue preferred stock.

Lehman Brothers--11-13%.
Merrill Lynch--11-12%.
Morgan Stanley--9-10%.
Citigroup--9 1/2-10 1/2%.
CIT Group--12-15%.
Fannie Mae/Freddie Mac---15%
Keycorp--11-13%.
National City--13-15%.
Wachovia--10-12%.
Zions Bancorp--13-15%.
GM/GMAC--not possible.
Washington Mutual--not possible.
Ford--not possible."

Bennet does note a good point. Banks that conserved capital and managed their risks well will be in good shape to take over weaker brethren. They will have access to the capital markets for the money they need for expansion. My own bank was acquired recently by another small regional bank. Deals are getting done.

In another note, and to illustrate this point, Sedacca points out that it is not just Freddie and Fannie. Besides Washington Mutual, mentioned above, "RF (Regions Financial) needs to raise $2 billion says Sanford Bernstein. Let's see, what are their options? They can sell debt. The problem here is that you couldn't sell debt if you wanted. The last reported trade in RF paper was 2 weeks ago nearly +700 to the 30 year or close to 12%. Their preferreds trade at 10% and the stock is now a 'single digit midget' near $8 a share. So if you could even get a deal done, shareholders would get a 50% haircut."

Fannie, Freddie, and the Credit Crisis

Let's turn to Freddie and Fannie. There must be some people who think there is some way that the shareholders of Fannie and Freddie will not lose everything, as their shares actually trade. This just simply goes to show that you can fool some of the people some of the time. And as we will see, some of those people are very serious institutions.

It is almost a forgone conclusion that the US Treasury will have to step in and for all intents and purposes nationalize the two government-sponsored enterprises. The estimated losses in these two firms are far beyond what they could raise in a traditional market. And the longer the government waits, the worse the situation is likely to get.

Moody's downgraded the preferred stock in these firms to almost junk level because of the increased likelihood of "direct support" from the US Treasury, which, depending on the nature of the support, could wipe out both the holders of the common and the preferred. The preferred shares have already lost half their value since June 30 on speculation that an intervention would mean a stop in dividend payments (highly likely) and issuance of new preferred that would take preference over current preferred.

Interestingly, this would put more pressure on the banking system, as many banks hold the GSE preferred shares as assets, choosing to get a little extra return over traditional and more conservative assets. But then of course, Fannie and Freddie preferred were considered safe just a few months ago, with the best ratings from Moody's.

"Regional banks including Midwest Bank Holdings Inc., Sovereign Bancorp and Frontier Financial Corp., may have the most to lose. Melrose Park, Illinois-based Midwest has $67.5 million, or as much as 23 percent of its risk-weighted assets, in the preferred stock, while Philadelphia-based Sovereign owns about $623 million and Everett, Washington-based Frontier about $5 million." (Bloomberg)

It is doubtful that banks which hold these assets have written them down yet, but with a downgrade they will almost certainly be forced to do so in the near future. For the record, Fannie Mae has 17 classes of preferred stock, with more than 600 million shares outstanding. Freddie Mac has 24 classes of preferred stock, with about 460 million shares outstanding. The existing shares are trading worse than junk bonds, paying 17-19%.

And it may be a total write-off. It is hard to imagine how Treasury Secretary Paulson, or a new Treasury Secretary next year, could put US taxpayer money into the companies at risk without wiping out the current common and preferred shareholders. The justified outrage would be huge.

The basic problem is that without Freddie and Fannie the US mortgage market would go from crippled to moribund, if not dead. We have created a system that could not function in the short term without them, and the pain of allowing them to collapse would be another 1930s-style Depression, the era in which these firms were first created. They were never designed to take on the huge leverage they did, or to use hundreds of millions in lobbyist money and campaign contributions to create a massive payment scheme for management and shareholders. Congressional estimates are that this could cost US taxpayers $25 billion, a significant multiple of their current market caps.

Fannie and Freddie will not be able to raise capital on their own. At this point, why would any rational investor put that much money into a company with such a convoluted preferred share scheme, without government guarantees? That estimated loss assumes that the housing market does not get worse from this point. Losses could be much worse, or things could get better. Who knows? Why invest in something with so much uncertainty?

But there are more problems. You can't just take someone else's property, and that is what stock is, without some serious reasons. You almost are forced to wait for a crisis, otherwise shareholders would sue, saying that they suffered unnecessary losses. You can certainly expect the preferred shareholders to sue. That is why Paulson hired JP Morgan to figure out how to recapitalize the banks. I don't envy the people who are working on that one. Maybe there is some magic somewhere, but as we saw with Bear Stearns, at the end of the day it is all about adequate capital.

The GSE companies should be adequately capitalized and broken up into much smaller firms that would not be too big too fail in the future, and put under a regulator that would enforce reasonable leverage limits, with the profits going to pay back the US taxpayer before any profits or dividends are paid to any other future owners.

That is, if the government takes the two GSEs and puts capital (probably in the form of loans and guarantees) into them, which puts taxpayers at risk, then allows a public offering of the smaller entities to raise capital to repay the loans, any shortfall should be made up by the issuance of preferred shares, and the common shareowners would wait until the government loan was repaid before they would be eligible for a dividend.

And the people responsible for creating the leveraged systems, the board, et al., should be forced to resign. New top management all around.

The ultimate goal should be for taxpayers to get their money back and any guarantee, implicit or explicit, to be removed. No mortgage bank should ever again be allowed to be too big too fail.

Now, taken as a part of the total credit crisis, which will run to over $1 trillion (at least), $25 billion may not seem like a lot. But I hope this is a wake-up call for better regulations and safeguards.

And before I go, let me reiterate my call for regulators to force banks to move their credit default swaps to an exchange. The potential for a blow-up is serious, and it could dwarf the current credit crisis. I am not saying it will happen, just that it could. Even a low-risk event should be protected against. Credit default swaps are legitimate business transactions. They are very useful. They should just be put on an exchange, like futures or options, where there is 100% transparency as to counterparty risk.

Baltimore, La Jolla, and South Africa

I am home for a few weeks, enjoying the tail end of summer. On September 6, Tiffani and I will head to Baltimore to be with Bill Bonner, founder of Agora Publishing, and a host of friends, to celebrate his 60^th birthday. It is hard to believe that we have known each other for 26 years. What an incredible business model he has created. He has adapted with the times, letting his business evolve into a multi-hundred-million-dollar enterprise. I remember first going to his offices in Baltimore, which were definitely in a very bad part of town. I was nervous just walking two blocks in broad daylight; but the offices were inexpensive, I suppose.

He is the one of the best pure writers I know. You can read some of his essays and subscribe to the free Daily Reckoning (be warned: Bill is quite bearish) by clicking on this link: http://www.dailyreckoning.com/rpt/mauldin.html.

Tiffani and I will then be going to La Jolla September 15 to meet with my partners at Altegris, and meet some new potential associates. Right now, drinks with Richard and Faye Russell is on the calendar, and I really look forward to it.

Then a few weeks later I will head off on a quick trip to South Africa, where I will be speaking for an investment group in Cape Town, then maybe stop off in London for a day and then hurry home in time to do my regular letter.

That is enough to make me tired, so I think I will hit the send button and go home and see who is there. Have a great week.

Your needing to seek my own balance analyst,

John Mauldin

The Rise of A New Asset Class

John Mauldin — Fri, 01 Aug 2008 15:44:36 GMT

This week I am in Maine on vacation with my son, and next week is my daughter Tiffani's wedding, so for the next two weeks I am going to send an updated version of a speech I have been giving the past few months on what I think is the likely potential for the rise of a brand new asset class. It is too long to be sent as one letter, so we will start with the first part today and finish with the second part next week. This first part can be read as a standalone letter.

The Rise of A New Asset Class

I think we're at a watershed moment, what Peter Bernstein defines as an "epochal event," with the very order of the investment world changing as it did in 1929, in '50, in 1981, where a number of things came together - it wasn't just one thing but a number of events happening that conspired to change the nature of what worked in the investment world for the next period of time. It took most people a decade after 1981-2 to recognize that we were in a different period, because we make our future expectations out of past experience. It's very hard for us to recognize a watershed moment in the process. We're going to look back in five or ten years and go, "Wow, things changed." As we will see, it's going to be a change that's going to cost people in their portfolios and in their retirement habits.

We're going to look at a number of different concepts and separate ideas that in and of themselves don't make that much difference. But I think their confluence in the present moment is going to change things.

Now, some of this is new, some of it is old. The old stuff we're going to fly through. Most of you have been reading me for a while now, and you've got the concepts down. So let's start.

The first thing to note is that we're in a Muddle Through Economy. We're in a recession that's fueled by the bursting of two bubbles: the housing bubble and the credit crisis. The real question is: when do we come out of the recession? At what time do we come back to trend growth, which is 3 to 3.5 percent a year?

I believe that over the next 20 years the US economy will grow at roughly a rate of 3 percent compounded, in real terms. But I believe that we have some headwinds for the next year or two. So I think the real bottom of this economic cycle will be later this year, during the fourth quarter and possibly into the first quarter of next year. But it will take two years, for some reasons we are going to get into, to get back to long-term trend growth. It will take much longer than normal because the things that created the problem – the housing bubble and the credit crisis – aren't things that can respond to Fed policy, and they aren't things that can respond to the normal cycles. It's going to take a long time to work through these.

First, we had an investor-driven transaction bubble in housing. There were 48% more houses built since 2005 than should have been built, if you were simply looking at trends.

What that means is there are 3.5 million homes we have to work through. Now, that means that the 8 or 9 hundred thousand homes that we're now down to building a year, is going to end up going down to 400,000. It's going to take some time to work through those excess homes – for the prices to drop enough that people can go in and buy them or rent them. We are probably talking 2011 before we finally work through this housing crisis and get back to a normal market where housing contributes significantly to GDP growth.

Sales activity is probably going to correct another 30 percent. That's not fun. By the middle to the end of this year, sales are going to be really low. As a side issue, those of you who like to invest in real estate and actually want to own a home to rent are going to have some good opportunities.

Let's look at the credit crisis very quickly. We vaporized 60 percent to the shadow banking system, the SIVs and CDOs, the people who actually bought US mortgages, who bought student loans, who bought credit cards, who bought car loans. That's gone and it's never coming back. As we'll see, it's going to take well into the next decade for us to create a completely new infrastructure to replace the broken one. It took decades to get to where we were last year. I don't think it will take decades to recover, but it's going to take five, six, seven years. That means things are going to be difficult if you want to borrow money. Credit spreads are going to be wider; it's going to affect you more. By the way, if you're in business, if you're paying more, it's going to put pressure on your profits.

Let's look at GDP growth for the last ten years, with and without mortgage equity withdrawal.

Without MEW, we would have had two years, in 2001 and 2002, with negative GDP growth. We're not going to go get those levels of mortgage equity withdrawals today, not in this environment. We're still seeing some cash-out borrowing, but it's getting more and more difficult; and as home values drop, there are going to be fewer and fewer people pulling less and less money out of the "home ATMs." As Paul McCulley says, your home ATM is starting to spit out negative twenty-dollar bills.

That means consumer spending is going to continue to slow. We haven't had a consumer recession since 1990-91. There are a lot of people today who have kind of forgotten that consumer spending can actually slow down. That's going to happen from lower mortgage equity withdrawals, and it's going to happen because of higher gas and energy costs that are displacing normal spending. You've got to fill up your Ford F-150 to be able to get to work. I saw $4 a gallon gasoline when we arrived in La Jolla. I mean, I guess around here people don't really pay attention, but that means it would cost a hundred bucks to fill up my big SUV. That's just a lot of money. That's a hundred bucks I can't spend on something else – on clothes or kids or education. It means I'm going to be consuming less.

We're in a recession. Recessions by definition mean that we're going to be seeing rising unemployment. We're already up past 5.5 percent. We'll probably see 6 percent and maybe higher. We're not going to see the 9 and 10 percents like we did in the '70s or '80s, because we're not as subject to the manufacturing cycle as we were back then. That's both good and bad. We don't have that boom-bust in the manufacturing world. We're seeing a bust in the construction world and we're starting to see commercial lending and commercial building go down. But I don't think we're going to see the large 8 and 9 percent unemployment rates that we typically see in a recession. But still, if you see rising unemployment – and unemployment rises by 20 percent, from 5 to 6 — that means those people are going to have less money and they're not going to be spending it.

We're seeing inflation in an environment of low real-income growth. Inflation is running over 4 percent now. And real-income growth is running a little bit less. While we may see some nominal growth in consumer spending, real spending is going to be dropping over the next year. That has some consequences that we'll talk about later. Also, consumer spending is going to drop because we have less availability of easy credit. Now, it probably hasn't hit this room. But there is a wave of letters going out from credit card companies, cutting people's credit lines, cutting people's home mortgage lines. There are a lot of people actually hitting their home equity credit lines and putting it in a savings account because they're afraid that it's going away. They're afraid that they may not be able to get the cash when they need it. "What happens if I lose my job? I better get the cash, and I'll pay the difference in interest costs just to make sure that I'm OK." That's happening a lot.

In summary, lower mortgage equity withdrawals, higher gas and energy costs, rising unemployment, inflation in an environment of low real-income growth, and less availability of cheap and easy credit are all contributing factors to slowing consumer spending.

This has three major effects. First, lower corporate earnings. We're in a period where earnings disappointments are going to be the rule and not the exception. We're going to go into this in detail in just a little bit. But GE wasn't a one-off announcement. Yes, it was their financial system. But we're going to see a lot of earnings disappointments from all sorts of retailers, from all sorts of companies, for a variety of reasons. We're going to look at the documentation for a minute to demonstrate that. Second, lower corporate profits put pressure on the stock market. There's a relationship between earnings, valuations, and stock prices. And third, that also means we're going to see lower than expected long-term returns. That's going to be a problem for people who are looking for traditional assets to be the bulk of the growth for their retirement portfolios.

Now, I think we're still in a bear market. Remember that in 2000 and 2001, we had three corrections of over plus 20% percent and one in the plus 30% range. It's not unusual to see large corrections inside an overall bear market.

Why do I think we're in a bear market? Long-term markets – and we're going to talk long term for a second and then come to the shorter term – long-term markets in bear cycles have several characteristics. Number one, they all start with high P/E ratios. Now, Vitaliy Katsenelson, who wrote my e-letter this week so that I could be here, lays out what he calls "cowardly lion markets," as distinct from bear markets, because stocks tend to go sideways for a long period of time. We'll talk about why that is in a minute, but I think he's right on that.

You are told that you should invest for the long run. Twenty years for a lot of people is the long run. However, what they do not tell you is that you can see negative real stock market returns over 20 years. It's happened four or five times. So when you're reading in somebody's book that says, "Hey stocks are going to compound at 11 percent a year" or whatever la-la number can be seduced from the data, think twice.

In secular bear markets, you can have returns for long periods of time from zero to 3 percent, every 15 to 30 years. We're kind of starting one here again. If you went to Standard and Poor's website in March of 2007 and you asked what the earnings were going to be for 2008, their analysts said that earnings would be $92 for 2008. Two months later, at the end of the year in December 2007 – this is four months ago – they were projecting $84. In February, it was $71.20. Today Merrill Lynch estimates that earnings could drop to as low as $45 next year. Notice a trend here?

When you go into a recession, analysts begin to project lower earnings. They keep ratcheting them down. What do they use to project future earnings? Past performance. There are very few analysts who actually go out and say, "OK, how is this company going to perform in a recession?" They all say, "The company that I cover is an exception." This is how they're going to cover it, because they're talking to management.

And when's the last time management said, "Oh man, we're really going to get clobbered; there's a recession coming." Not if they want to keep their jobs. John Chambers will be telling us that Cisco's going to be doing wonderfully, just like he did all of '99, all of 2000 and all of 2001.

Now, what does this mean for P/E ratios? About 30 days ago, it was estimated, based on prices, that the P/E ratio for the end of the last quarter would be 20.5. Today, as companies mark their earnings down, the P/E ratio is 22.5. For the end of September, third quarter, a month ago, they were saying the P/E ratio would be 21. Today they're projecting that if the market stayed at the same price, it would be 28. Now, does anyone think we're going to see a P/E ratio of 28 at the end of the third quarter? People are going to be projecting positive earnings forward – and we're going to see one earnings surprise after another.

Remember, it takes three to four really good earnings disappointments to reach a point where investors really begin to understand that things are different, because we project future performance from past performance. When past performance disappoints us three or four times, then we begin to project negative performance, and that's when the stock market drops. It's not that the stock market is telling us that things are going to be better. It's that we have expectations of things getting better because that's what our past experience has been – so we need those disappointments.

This is from Vitaliy Katsenelson's book: If you take 10-year trailing P/Es – you average them together so you don't have the effect of just one year – you find that valuations go from high to low from where bull markets start, in what he calls a range-bound market or what I would call a secular bear.

They go from high valuations to low valuations and back. Around 2000 we were at 48. It's down to 30 today on those long, ten-year runs, and it always corrects below the mean. Valuations are mean-reverting machines.

If you just look at one year, you get the same effect. You have a P/E average of 15 – remember they're projecting 28. You don't have a projection of 28 in a recession and not have the stock market feel that.

Maine, Maryland, and Weddings

It takes a full day to get from Texas to Leen's Lodge (http://www.leenslodge.com/) in Grand Lake Stream, Maine. Trey and I make the last part of the trip by float plane. This is the third time I've gone with Trey, and I really look forward to the trip. It's just a great bunch of guys. As I have noted, we do make predictions about the markets. Last year a number of readers sent in their predictions, and we have tabulated those. I will report back on how well we all did, and some of you will win a book for being the best predictors.

It looks like I am going to Maryland for a day in a few weeks, and New York is looming on the horizon again, as well as another trip to Baltimore to be with my really good friend Bill Bonner (of Daily Reckoning fame) for his 60^th birthday party. Now that should be a blast.

It is amazing how many details have to be worked out for a wedding. And it is just a few days away. Tiffani will be gone on her honeymoon for almost an entire month, so a lot of business details have to be worked out for the interim. She and Ryan will be in South Africa and Ireland, and I really do want to leave her alone. She deserves some time away. When she comes back, we will really start to work on our book.

Have a great week. Enjoy the summer with friends and family.

Your ready for some fishing analyst,

John Mauldin

$1.6 Trillion in Losses and Counting

John Mauldin — Sat, 12 Jul 2008 04:13:00 GMT

$1.6 Trillion in Losses and Counting
Banks Start to Reduce Their Lending
Take Freddie Mac. Please.
The Ugly Muddle Through
Once Again, the BLS Numbers Paint a False Picture
Las Vegas, Maine, and a Wedding

It seems that with each passing month the estimates for losses in the international banking system keep rising. This time last summer the largest estimates (from credible sources), if memory serves me correct, were around $400 billion, give or take a few months. By the end of the year it was in the neighborhood of twice that. Then last quarter we saw estimates approaching $1 trillion. Last week, the number being broached was $1.6 trillion, by Bridgewater Associates, one of the top, and more credible, analytical firms in the world. In this week's letter we look at the implications of that projection, analyze recent lending patterns by banks, briefly touch on the implications of the recent unemployment numbers, and end with a few comments on the bear market. It will make for an interesting letter. Warning: remove sharp objects from your vicinity before reading.

But first, I need your help, and in return I would like to give you a link to a recent speech I gave, where I speak about what I think is the development of an important new asset class, one which will come about precisely because of the problems I am writing abut today. I have not yet written about this topic in public, and the speech has been well-received. I think you will like it. Now, as to how you can help me ...

I get to travel a lot with my daughter and business partner Tiffani (actually she runs the business) and meet new people. Over the years, she has become as fascinated as I have with their individual stories. Everyone has a story to tell or a lesson to teach. We have decided to write a book about those stories, looking at the differences in perspective between old and young, retired and working, those who are wealthy and those who aspire to wealth. What are the differences in attitudes, in work habits, in how you manage money, in how you look at the future, and a score of other items? How do all of these things correlate?

We have created a totally anonymous online survey seeking answers to these questions and more. We hope to get at least 10,000 people to fill out the survey; and we are eager to see what we find as we pore over the resulting data and engage in a lot of in-depth analysis. Are the rich really different? Is there a difference in people from Europe, Asia, Latin America, Africa, and the US? I think we will find some very interesting information. Please note: this is not just a survey for millionaires. We want everyone, of all income levels and ages, to take the survey, so we can get a true representative sample.

You can get to the survey page by clicking here. It will take about ten minutes to complete, and I think that going through the questions will make you think about your own situation. Some have told us the survey is quite thought-provoking. If you have attempted to take the survey and had problems, we think we have worked out the bugs.

At the end of the survey, you will be sent to a page with the speech. If you cannot listen to it immediately, then simply save the page or the address. And of course, you can just take the survey to help us.

Also, Tiffani and I want to do live (mostly by phone) interviews with 200 millionaires, of all shapes and sizes and locales. We will interview you for about 30 minutes, and then you can have equal time asking me anything you want. Since I will have learned a lot about you, those questions can be as detailed or as general as you like. We want at least 20% of the interviews to come from outside the US. We will use those interviews in the book, but will attach no identifying items or real names. If we use something from your interview in the book, we will let you see it first. If you are interested in being one of the interviewees, just drop Tiffani a note at eu@2000wave.com and she will get back to you and work out the details.

I am really excited about this project and even more so about working with Tiffani. We will report back to you on what we find. Thanks for your help.

$1.6 Trillion in Losses and Counting

One of the great privileges I have is getting to read a wide variety of economic research. While I get a lot of material direct from the source, I also have a wide network of people who read other sources and send me what they think is important. When Ambrose Evans-Pritchard wrote this week about a report done by Bridgewater Associates, it got my attention, and fortunately this report was sent to me by a few friends. In my book, Bridgewater is one of the top analytical groups in the world. I pay attention and give strong credence to what they write. And this report is quite sobering.

First, let's look at what Evans-Pritchard wrote in the London Telegraph:

"Bridgewater Associates has issued an apocalyptic warning to clients that bank losses from the worldwide credit crisis may reach $1,600bn [$1.6 trillion], four times official estimates and enough to pose a grave risk to the financial system.

"The giant US hedge fund said that it doubted whether lenders would be able to shoulder the full losses, disguised until now by 'mark-to-model' methods of valuing structured credit.

" 'We are facing an avalanche of bad assets. We have big doubts as to whether financial institutions will be able to obtain enough new capital to cover their losses. The credit crisis is going to get worse,' said the group in a confidential report, leaked to the Swiss newspaper Sonntags Zeitung.

"Bank losses on this scale would have far-reaching effects. Lenders would have to curtail loans by roughly 10-to-one to preserve their capital ratios. This would imply a further contraction of credit by up to $12,000bn [$12 trillion] worldwide unless banks could raise fresh capital."

Let's look at some of the details in the report. First, these losses are not all subprime. In fact, more than half of it is from corporate liabilities, around $800 billion. About $550 billion of the corporate losses have yet to be written off. As an example, Bridgewater estimates losses on commercial loans to be as much as $149 billion, none of which has been written off.

Better than 90% of the losses from subprime assets that are on the books have already been written off. That is good. But Bridgewater estimates that there are losses lurking in the prime and Alt-A loan portfolios that could be much bigger than the subprime problems, as those loan books are more than six times the size of the subprime. Quoting:

"The US commercial banks are in a position to suffer the greatest losses, because the core of their portfolio is risky US debt assets. In order to get a sense of their expected losses we examine both their loan book and their securities portfolio and price each type of asset out based upon a reference market. If we use this current market pricing as a guide, there is a long way to go, as these institutions have only acknowledged about 1/6 of the expected losses that they will incur as a result of the credit crisis."

I could go on, but the details are not important. The bottom line is that they estimate there is at least another $1.1 trillion of losses that will have to be written off by institutions all over the developed world, including very large potential write-offs from insurance companies.

Banks and investment institutions worldwide may need another $400 billion in capital infusions. But where they are going to get it is the problem. They have burned through the usual suspects, and burned is the correct word. Any sovereign wealth fund or large investor who has put money into an investment or commercial bank has watched their investment take large losses in a very short time. How likely are they to be willing to belly back up to the bar with more money, on anything except very dilutive terms to current shareholders? The answer is obvious.

And let me be clear. There are some very large commercial and investment banks which are simply going to be absorbed, as regulators move to keep the entire system working. Bear Stearns is not a one-off deal. I think it is likely we will see at least one European bank nationalized. Losses the size that Bridgewater describes are beyond ugly. They are life-threatening for more than one major institution. More on this later.

Banks Start to Reduce Their Lending

Further, let's revisit a theme I have written about on several occasions over the past year. As banks incur losses, they either have to find new capital or reduce their lending in order to maintain their capital ratios, or some combination of both. And what we are seeing is that lending is starting to actually decrease.

Earlier this year lending rose as normal, even though anecdotal reports told of tightening lending standards and reduced loan lines. The tightening of standards did not seem to be affecting actual loans being made, which was odd. But this was partly illusion, as banks were taking back loans they had spun off in SIVs, taking capital away from their traditional loan business. This gave the appearance of expanding loan capacity. Evidently, this bringing back of off-book loans is now being worked through, as evidenced by this analysis by good friend and analyst par excellence Greg Weldon, who slices and dices the data to give us this view (www.weldononline.com):

"[looking at the chart below] ... FOR SURE, the recent decline strongly suggests that the risk of a US recession has intensified CONSIDERABLY, as defined by what amounts to one of the largest nominal credit contractions in DECADES, at (-) $154.3 billion, and a clear-cut violation of the uptrend in place since at least 2001."

Greg goes on to suggest that bank credit could contract a further $6-700 billion over the next nine months, which is a contraction of about 8%. Healthy economies have a rising rate of bank credit, which is one source of expansion. When banks have to reduce their lending, it reduces the growth of the economy or can put it into outright recession.

And if the Bridgewater report is anything close to right, Greg is being an optimist, which is not his normal milieu. Now, do I think worldwide credit will shrink $12 trillion, as Evans-Pritchard suggests? (Note, that was not a suggestion or conclusion by Bridgewater.) Not in my worst nightmares. Capital will be raised, and the various central banks of the world will do what is necessary to give banks the time to work through their problems.

But in the meantime, the trend toward lower lending is likely to continue. And lower lending is going to be a huge headwind for an economy that is already struggling.

This week Ben Bernanke suggested that the "temporary" Term Auction Facility might be extended into 2009. Let me suggest that it will be extended into at least 2010 before it is no longer needed. Banks are going to need to be able to take their illiquid paper and convert it into liquid Treasuries against which they can make loans and continue to function.

As I have written for a long time, it is all about buying time. In 1980, every major bank in the US was technically bankrupt, as they all had large amounts of Latin American bonds in their portfolios, at a size far larger than their capitalization. When the Latin American countries started to default, if the Fed had made the banks mark their portfolios to market, it would have been a disaster of biblical proportions. There would have been no American banks left standing. The US economy would have gone into a deep depression.

Instead, with a wink and nod, they let them keep the bad bonds on their books at face value, which they all did. Then in the latter part of the decade, starting with Citibank in 1986 (cue the irony), they began one by one to write off the bad loans, but only when they had enough capital to do so. It took six years (or more) of profits and capital raising to get to where they could deal with the problems without imploding themselves and the economy of the US at the same time.

Today is only different in the details. The Fed and central banks around the world are allowing banks to buy time to work through their problems. There really is no other option. That extra $1.1 trillion that the research by Bridgewater says will have to be written off? You can take it to the bank, pardon the pun, that it will not be written off this quarter. This is going to be an ongoing process that will take several years at a minimum. Just like in 1980, the regulators are going to allow banks to write down their losses as they can, except in the most egregious of circumstances, in which case those banks will be "absorbed," a la Bear Stearns.

Treasury Secretary Paulson said Thursday that no bank is too big to fail. That is for public consumption. The fact is that there are any number of banks that are too big to fail, depending upon (and borrowing from my favorite linguist, Bill Clinton) what your definition of fail is. If by fail you mean that shareholders are wiped out, then he is correct, there is no institution too big to fail. If by fail you mean that the operations and debt obligations will be allowed to collapse, then there are institutions whose collapse would pose major systemic risk to the world markets. They cannot be allowed to collapse.

Take Freddie Mac. Please.

(Cue Henny Youngman) Take Freddie Mac. Please. Its shares are down almost 90%. "Freddie Mac owed $5.2 billion more than its assets were worth in the first quarter, making it insolvent under fair-value accounting rules. The fair value of Fannie Mae [down 78%] assets fell 66 percent to $12.2 billion, data provided by the Washington-based company show, and may be negative next quarter, former St. Louis Federal Reserve President William Poole said." (Bloomberg) Poole asserted that these institutions are essentially on a short path to insolvency.

But in the same story, Senators Schumer and McCain both said Freddie and Fannie would not be allowed to fail. Even curmudgeonly former Fed Vice-Chairman Wayne Angell (someone whom I sincerely respect), said on CNBC yesterday that the government regulator of the GSEs (Government Sponsored Enterprises) ought to get some money from Congress to buy preferred stock and then get even larger amounts from the public through an offering of preferred stock. He said that Congress ought to learn about its responsibilities with regard to a GSE; and the public ought to realize that we are in for a long, tough fight. (He also expects the second half of 2008 to be no better than the first half, and he sees 1% growth in 2009.)

I wrote the above paragraph, and a few I deleted below, on Thursday, as I am on a plane to Las Vegas and need to finish the letter in order to attend a conference. I wrote with suggestions about how a collapse of the two Government Sponsored Enterprises might be handled. Last night, the New York Times broke a story that government officials are looking at how to go about taking over operations at Freddie and Fannie, should worse come to worst. Then this morning, the Wall Street Journal in its lead story elaborated on this theme.

The basic problem is that both Fannie and Freddie need more capital, and perhaps far more than their current market capitalization. Where to find it? What investor wants to try and catch this falling safe, without government guarantees? The Journal article quotes numerous people with various ideas about what to do. Most of their ideas will potentially cost US taxpayers.

And make no mistake. The problems with Fannie and Freddie have to be solved. They are now doing 80% of the mortgages in the US. Without them the housing market would grind to a halt quickly and housing prices would drop even beyond Gary Shilling's pessimistic views.

Not to mention that the world has assumed the implicit backing of the government in buying the paper of Freddie and Fannie. How easy would it be to finance US debt if this paper was allowed to default? The implications are serious. I understand the arguments for allowing them to fail, and I think shareholders should bear the risk they take on when buying equity.

A very reasonable idea was broached by Steve Forbes on a BizRadio program this afternoon, which Dan Frishberg graciously allowed me to co-host. He suggests breaking Fannie and Freddie into eight smaller companies, giving them whatever backing they need in the form of public financing to start business, and then cut them off to sink or swim on their own, with much tighter capitalization controls. Remember, this is one of the more free-market conservative thinkers.

The authorities are slowly losing control. All they can do is crisis manage. There are no good solutions, only expedient ones. And we must all hope they choose the best among a handful of not particularly pleasing options. Allowing the system to devolve into chaos is not an option. The Fed and whatever administration comes in will do the same as the current group, which is to buy time so that the wounds can heal, and hopefully put in place rules to prevent another such occurrence.

(Sidebar: I will go into greater detail in a later letter, but regulators need to move NOW to create a Credit Default Swaps Exchange. A problem/crisis in that unregulated market is actually a far bigger problem than the current subprime crisis. Why do you think Bear Stearns was not allowed to go into bankruptcy? There are banks that are too big to fail, despite what Paulson says for public consumption.)

There are a lot of conflicting opinions, which you can read at www.bloomberg.com if you care. Some say Fannie and Freddie will have to lose $70 billion before the regulators step in. Poole says they are insolvent now, using fair market accounting methods. I don't know, and neither do 99.9 % of the shareholders. At this point Fannie and Freddie are not an investment, they are a gamble. Sitting here at Caesar's in Vegas, and reading the opinions, makes me think I have better odds at the tables below me.

I hope that when (not if!) taxpayer money is used, it is at market rates and means that shareholders are last in line, if at all, to recoup any money. For those of us who for years have called for tighter regulation and increased capitalization of the GSEs, as well as a clear removal of any government backing, implicit or explicit, being able to say "I told you so" does not feel all that good. Freddie and Fannie cannot be allowed to go out of existence. They are too tightly wound into the core and fiber of the US economy.

What can and should happen is that shareholders bear their losses, taxpayers pick up the bill, and when they are healthy again, as they will be at some point, another public offering should be done to hopefully recoup the losses to taxpayers. Or perhaps an auction with some guarantees to a potential buyer, but a complete removal of implicit government guarantees on future loans, and higher capitalization requirements. There are any numbers of ways to lessen the ultimate cost to the taxpayer.

What I fear is that politicians will use the opportunity to prop up the mortgage markets with taxpayer guarantees and create much larger losses, which could quickly mount into the hundreds of billions if not properly dealt with. A new populist-oriented administration could find this problem on their desk as they take office.

I would not want to own any stock in the financial sector. There is going to be a continual stream of write-offs over the coming year, at a minimum. Yes, some banks are better managed and will avoid the real life-threatening problems. Some will be like JP Morgan and end up with solid assets backed by government guarantees.

But which ones? Do you want to trust the analysts that have been telling you there is value in the financials at each step, all the way down? The management who insists they are in good shape, then raises capital at dilutive prices? The very people who did not see the problems to begin with, telling you that they are now solved?

The "value" that analysts optimistically see in various financial stocks is evaporating with each quarter, as they slowly write down ever more losses. With another potential $1 trillion to be written off or absorbed through earnings from profitable parts of the business, there is more pain to come. Investing in financials today is like trying to catch a falling safe.

The Ugly Muddle Through

Goldman Sachs published a report Thursday in which they suggest the most probable scenario for the next 12 months is GDP growth between -0.25% and 0.25%, or basically zero. Wayne Angell, mentioned above, expects the second half of '08 to be no better than the first half and for GDP growth to be 1%.

In the Bridgewater report mentioned above, they estimate that the net worth of US-based assets is down about 13% since January 2007, a total loss of almost $8 trillion. This is hitting pension plans, corporations, and consumers, making them think twice about planned investments and expenditures.

Earnings estimates are being cut with each passing month. The P/E ratio for the S&P 500 is currently at a sporty 23. Historically, in times of rising inflation, the stock market goes through "multiple compression." That means P/E ratios fall more than earnings. If multiples fell just 20%, back to 18, which is still above long-term trends, the market would see another 20% drop from here. Even with earnings growth, the market is going to have a challenge rising in the current environment.

Sidebar: A number of you have written questioning my source for the P/E ratio, as you read or hear different numbers from what I write. You can indeed find estimates of forward P/E ratios as low as 12 a year from now. That is a lot different than the 23 I cited above.

There are two basic types of earnings that are reported. One is "operating earnings," or what I call EBBS, or Earnings Before Bad Stuff. Then there is "reported earnings," which is what the corporations report on their tax forms. Not all that long ago, in the mid-'90s, operating earnings and reported earnings were generally in line with each other. Companies would deduct genuine one-time, unusual losses from their reported earnings to give us operating earnings. And such a system has a valid basis for existence. If something is truly one-time, maybe an investor should overlook it when evaluating the company's potential.

But then the media and analysts started using the operating earnings as the primary number, and companies began to game the system. More and more items were considered one-time. One of the more egregious examples was when Waste Management Systems declared that painting the garbage trucks was a one-time extraordinary expenditure and should be accounted as such. Today the difference between as-reported and operating earnings can be 20-40% or more! It seems there are many losses that management assures us are just one-time items.

Standard and Poor's has a web page where you can see a spreadsheet of historical data and projections for both types of earnings. That is the source of my data. It is at http://www2.standardandpoors.com/spf/xls/index/SP500EPSEST.XLS?GXHC_gx_session_id_=5350992f205e73e4& .

Analysts' estimates do tend to get brighter the further out one looks on the table. But if the growth scenarios mentioned above come about, and banks have to curtail all sorts of lending, the earnings projections are going to be way too high, as they have been for the last 12 months. That is going to mean more pain for the stock market.

I think it is quite likely we see the Dow slip below 11,000. (Ok, I wrote that Thursday!) As I said on Kudlow the other night, another 10% drop in the market would take us only to the average bear market. A "9 handle" on the Dow seems quite possible, if not likely. (Note: when someone says "a 9 handle," they mean that the first number in the index or stock price is a 9. The first number is the handle.) The risk is to the downside, given the tepid potential growth of the economy.

Once Again, the BLS Numbers Paint a False Picture

I almost get tired of writing this each month, but it is important, and I will do it quickly. The unemployment number from the BLS last week showed a loss of 62,000 jobs. Private sector jobs were off by 91,000, with the government showing growth of 29,000.

But once again, the birth/death ratio of estimated new jobs was 177,000. As The Liscio Report noted: "... without the b/d's contribution, private employment would have been down by something like 268,000. It added 29,000 [new jobs] to construction, 22,000 to professional and business services, and 86,000 to leisure and hospitality. Given the weakness of the economy and the crunchiness of credit, we doubt that there are enough startups around to match these imputations."

Revisions to the prior two months were a negative 52,000. When they do the final numbers a few years from now, we will find that the revisions will be in the hundreds of thousands for the first half of the year. We have now had five consecutive months of downward revisions, which is typical of recessions.

Unemployment held steady at 5.5%, but that masks an underlying and growing problem. There has been a huge increase in the number of people working "part-time for economic reasons" and a large number of people who are discouraged and not looking for a job but would like one. These two categories are not counted as unemployed. If you add them into the equation, the unemployment or underemployment number goes to 10.3%! (per Greg Weldon)

As I warned above, this has not made for pleasant reading. But it is reality, and we need to deal with it.

And let me say that even given the above, I am a long-term (and even mid-term) optimist. We have to work through some serious problems, but we will. Valuations are going to be low once again, and it will be time to become bullish. And researching and writing my book on how the world will change in 20 years makes me very optimistic. No one in 20 years will think of today as the "good old days." The changes that are in front of us will be amazing. So, simply take a deep breath, be conservative today, and get ready for a really wild and fun ride.

And speaking of investment banks, I need an introduction to someone who is deeply involved in the creation of Exchange-Traded Notes. Drop me a line.

Las Vegas, Maine, and a Wedding

I am at Freedom Fest in Las Vegas, and want to hit the send button so I can attend the sessions and see a lot of old friends. I really think it will be good fun. I have dinner with Frank Holmes of US Global tonight, and look forward to it. Frank is the consummate gentleman and always very interesting.

And speaking of dinner, I was with Barry Ritholtz (of Big Picture fame) last week, and we agreed we are psyched about going to Maine at the end of the month for David Kotok's annual fishing extravaganza. Lots of good friends, wine, and conversation - and I will get to collect on at least one of the group bets we made last year predicting markets, etc. And I was way wrong, but everyone else was even more wrong. Go figure. I will tell you all the details after the trip.

Daughter Tiffani's wedding is getting closer. 08-08-08. Less than a month, and a lot of coordination to be done. It is at the point where I am sitting in on meetings. Flowers cost what? Fireworks? Credit lines are being squeezed. But it is going to be so much fun!

Remember, the markets are not where you live. If your investments keep you up at night, sell until you can sleep. Life is to be enjoyed, and I am doing my part. So have fun this week! And call some friends and share a few laughs.

Your wishing he could be a bull analyst,

John Mauldin

More Thoughts on the Continuing Crisis

John Mauldin — Sat, 05 Apr 2008 05:14:00 GMT

There is so much that is happening each and every day as the Continuing Crisis moves slowly into month 8, so much news to follow, so many details that need to be followed up that it can get a little overwhelming. Where to begin? Maybe with a "minor" change of the rules on how we value assets, then a look at the proposed changes in regulations...(read more)

Thoughts on the Continuing Crisis

John Mauldin — Sat, 22 Mar 2008 05:51:46 GMT

Thoughts on the Continuing Crisis Margin Clerks of the World, Unite! Where Do We Find New Sources of Credit? In Defense of Alan Greenspan What Now for Gold, Oil, Etc? Baseball, Mexico, and Travel Costs My essay in Outside the Box last Monday seemed to...(read more)

Stagflation and the Fed

John Mauldin — Sat, 01 Mar 2008 04:47:16 GMT

How Do You Spell Stagflation? Memo from the Fed: Inflation? What Inflation? The Fed Will Cut and Cut Again Damn the Inflation Torpedoes! Full Speed Ahead! Apple, Sprint, AT&T, and Going to the Dark Side This week's topic was inspired by a discussion...(read more)

Credit Crisis to Credit Crunch

John Mauldin — Sat, 10 Nov 2007 04:03:00 GMT

In this issue: A Confidence Credit Crunch Credit Crisis How Much is That Dog in Your Net Capitalization? King Dollar Faces the Guillotine The Euro-Yen Cross The Consumer is Getting Tired New York, Philadelphia, Switzerland and Phoenix Just when it felt...(read more)