Thoughts From The Frontline : Mortgage

Is That Recovery We See?

John Mauldin — Sat, 11 Apr 2009 03:08:20 GMT

Is That Recovery We See?
Those Wild and Crazy Analysts
The Shadow Inventory of Homes
Commercial Real Estate Starts a Long, Slow Slide
P/E Ratios Go Negative!
The Effect of Earnings Surprises
Corporate Earnings and Recovery in Recessions
The Implosion in Social Security
Copenhagen, London, Newport Beach, etc.

The market, we keep hearing and reading, is telling us that there is recovery around the corner. And pundits point to data that seems to suggest the worst is behind us. The leading economic indicators, while still down significantly, seem to be in the process of bottoming. There is a large amount of stimulus in the pipeline. Mark-to-market has been modified. Housing seems to be finding a bottom, if you look at the rise in sales from January. And so on.

In this week's letter, we look at what past recoveries have looked like in terms of corporate earnings; and we look at the continued slide in earnings on the S&P 500, which has a negative price-to-earnings ratio looming in future months (yes, that is not a typo, we have an unprecedented earnings multiple). We take a peek at housing and foreclosures. There is just so much bad news out there (like continued unemployment) that it just has to get better, doesn't it? This should make for an interesting letter.

Is That Recovery We See?

This week the market seemed to like financial stocks and was buoyed on news that Pulte Homes would buy Centex to create the largest US homebuilder. And with banks having some room to adjust their writedowns as mark-to-market is modified, the market saw significant increases in the financial sector. Everywhere I keep hearing the old saw that the market predicts a recovery about six months out, so won't we see a recovery in the fourth quarter of 2009?

If you look at earnings estimates for 2009, that is what is suggested. Bloomberg reports that profits at S&P 500 companies probably fell 38% on average in the first quarter. The stretch of quarterly declines is the longest since at least the Great Depression, data compiled by S&P and Bloomberg show.

Earnings may drop 31% in the second quarter and 18% in the next before gaining 74% in the last three months of the year, analysts predict. Banks are projected to account for all of the rebound in the final quarter. Without financial companies, the gain turns into a 5% decline, the data show.

The above estimates are based on operating earnings, not as-reported earnings. Long-time readers know that operating earnings are actually earnings before interest and Bad Stuff. As-reported earnings are what companies actually report on their tax reports, and as a gauge of profitability they are much more reliable. Before the mid-'90s the difference between operating and as-reported earnings was typically quite small. Then companies found they could play the market if they played games with their operating earnings.

Operating earnings typically do not take into account one-time, nonrecurring events. The number of items which get classified as "nonrecurring" has mushroomed to the point where projected operating earnings for 2009 are more than double the estimates of as-reported earnings. Operating earnings for 2008 were almost three times actual, or as-reported, earnings. We certainly seem to have entered an era of really bad one-time events, which just keep on coming and coming. As recently as 2006, there was less than a 10% difference between the two. In some quarters it was only 5%. A far cry from today's 100%-plus.

Those Wild and Crazy Analysts

Analysts, who as a group have been egregiously bad at predicting earnings of financial stocks for the last two years, would have us believe they are due for a large rise in the 4^th quarter. Let's visit those assumptions for a few minutes.

They contend that much of the bad news in the subprime-loan and housing market has been written off. And one would have to admit that a lot has been; and with the relaxation of mark-to-market, there may indeed be some truth to that suggestion. But there are still some issues that remain for housing. Take a look at the graph below. (Not sure where it is from, as it was sent to me, but I have seen the same data elsewhere.) Notice that monthly mortgage-rate resets declined markedly in 2009 from 2008, but are expected to rise again in 2010 and 2011. There is still some heartburn in the mortgage market.

The Shadow Inventory of Homes

And foreclosures keep climbing, though some point to that fact that they seem to be leveling off. However, a strange thing is happening. We are seeing what is being called a "shadow inventory" of foreclosed homes.

"We believe there are in the neighborhood of 600,000 properties nationwide that banks have repossessed but not put on the market," said Rick Sharga, vice president of RealtyTrac, which compiles nationwide statistics on foreclosures. "California probably represents 80,000 of those homes. It could be disastrous if the banks suddenly flooded the market with those distressed properties. You'd have further depreciation and carnage." (San Francisco Chronicle)

A Realty Trac survey found that only 30% of foreclosures were listed for sale in real estate listings like the MLS (Multiple Listing Service). Add in homes that people would like to sell but simply can't find buyers for, and must either hold or rent, and the unsold inventory numbers that are public are likely far below actual available homes.

Might some homes in foreclosure be held off the market because banks eventually want to negotiate with the homeowner? Possibly, but other surveys show that anywhere from 30-40% of homes in the foreclosure process in many areas are actually already vacant. There is no one with whom to negotiate.

Typically a foreclosed home sells within a few weeks, as banks take the first "reasonable" offer. But it normally takes about three months from foreclosure to when the home is put on the market -- it takes a few months to get a home ready. But surveys show it is taking a lot longer now, and many homes have not made it onto the market, even as more homes are being foreclosed each month.

The Chronicle suggests several factors may be at work. First, there is the "pig-in-the-python" problem. There are just so many homes that it is hard to get them onto the market and sold. Normally there are about 160,000 homes a year in foreclosure sales. We are now seeing 80,000 a month, or six times normal levels, and rising.

Second, lenders could be deferring sales to put off having to acknowledge the actual extent of their losses. "With banks in the stress they're in, I don't think they're anxious to show losses in assets on their balance sheets," one observer said.

Finally, banks may not want to flood the market with foreclosures, driving prices down even more. They are simply managing their assets so as to recover the most capital they can.

Given that the graph above says there will be more mortgage misery as large numbers of mortgages reset in the next two years, and given the unknowable nature of the losses, it is somewhat optimistic to think financial profits will rise by 74% in the fourth quarter. But it gets worse.

Commercial Real Estate Starts a Long, Slow Slide

We are now starting to see some real deterioration in traditional bank lending. Delinquencies on home equity loans are rising rapidly. The American Banking Association released a composite index of eight different types of consumer loans, and the delinquency rate on this 35-year-old composite jumped to a record high of 3.22%.

The above reflects 4^th-quarter data. As unemployment is up 2% since then and is rising, it is more than reasonable to assume that we will see another record rise in delinquencies this quarter. With unemployment headed to over 10% and maybe 11% from today's 8.5%, delinquencies are likely to continue to rise for the entire year.

David Rosenberg reports that "The National Federation of Independent Business found in a poll that 28% of small firms said they had a line of credit or credit card limit cut back in the second half of last year; 69% stated they are facing worse terms. A new FICO study found that 11% of US consumers -- 22 million people -- have had their credit lines cut or accounts closed even though they have been paying their bills on time and retain a solid rating." This is certainly not good news for those who expect a positive 4^th quarter. Cutting credit to small business, the engine of job growth in the US, is hardly a prescription for a growing economy.

Commercial mortgages are in trouble. S&P has warned they may cut ratings on $97 billion in commercial-mortgage asset-backed debt. The country's 10 biggest banks have $327.6 billion in commercial mortgages, according to regulatory filings. A projected tripling in the default rate would result in losses of about 7% of total unpaid balances, according to estimates from analysts at research firm Reis Inc. (Bloomberg)

I think, given the track record of the analysts who project a 74% rise in earnings for financial stocks in the 4^th quarter of this year, that we should remain a tad skeptical. And speaking of earnings, let's go to the S&P web site and see how things are progressing.

But first, let's look at just how badly analysts blew it in estimating 2008 earnings. In the table below we see that as recently as October 15 they were estimating AS-REPORTED earnings to be $54, down from $92 when I first saw the 2008 estimates. There were only two months to go in 2008. So, what are the actual 2008 earnings? Down to $14.88!!!

Not exactly a record to inspire confidence. So, how are we doing in 2009? We see the same pattern. There is a clear deterioration in earnings estimates. Yet, even with the ever lower estimates, they are still projecting nearly a doubling from 2008. Care to make a wager as to what the estimates will look like in a few quarters? Think we will see earnings rise?

P/E Ratios Go Negative!

When we last visited the S&P web site a few weeks ago, the P/E ratio for the quarter ending September 30 was around 181. I must confess that when I looked at it today, as jaded as I am, I was shocked. You can see the numbers for yourself at http://www2.standardandpoors.com/spf/xls/index/SP500EPSEST.XLS?GXHC_gx_session_id_=5350992f205e73e4&.

The P/E ratio for the end of the second quarter is 1944 (not a typo). The losses of the 4^th quarter wipe out almost all earnings for the 12 months ending June 30. But by the end of the 3^rd quarter, the estimated P/E ratio has dropped to a (negative) -467. That has never happened. We have never seen negative earnings over a 12-month period since WWII. (I don't have data for the Depression era.)

Then as the negative earnings of the 4^th quarter of 2008 drop off, we see the estimated P/E ratio rise back to 30, which is quite high. However, if actual earnings come in lower, as I think they will, the P/E ratio will rise and/or the market will fall as negative earnings surprises just keep on coming.

The Effect of Earnings Surprises

As William Hester of Hussman Funds writes in a recent article, the rise and fall of the stock market closely correlates with earnings surprises. Look at the following chart. (You can see the whole article at http://www.hussmanfunds.com/rsi/econsurprises.htm. I highly recommend it.)

As Hester writes, "To track the trends in economic performance, we keep an ongoing tally of how data is announced relative to expectations -- a method of analysis originally inspired by Bridgewater Advisors . Economic data that surpasses expectations gets added to a 3-month running total. Data that comes in weaker than expected gets subtracted. A rising line means that economic data is generally coming in above expectations, while a falling line means that the data has disappointed. A descending line could be the result of an economy that is not expanding as quickly as economists predict or -- like in 2008 -- it could be the result of an economy that is contracting at a faster rate than expected.

"... Much of the excitement in the stock market -- at least that is related to the current performance of the economy -- seems to be centered on an economy that is performing less badly than expected. The risks here seem to be that if the trends in data surprises change, so could investors' attitudes toward stocks that are currently overbought on a number of measures.

"... If the high correlation between stock prices and data surprises holds, the recent rally in stocks might be tested. Even if the economy has bottomed, it's very likely that the eventual recovery will prove to be uneven, causing the flow of positive surprises to be uneven. During these periods, the risks to stocks will be greatest when the market is overbought and investors have priced in high expectations of positive data surprises continuing."

The projections of many market analysts assume that we will have something that will look like a normal recovery. I have objected that that could be a very bad assumption, since we are not having a normal recession. This is already a very lengthy recession, and is just going to get longer. As I will note below, there are reasons to think we could see a mild recovery late this year, only to dip back into recession next year.

Corporate Earnings and Recovery in Recessions

Next, let's look at a very interesting chart sent to me by one of my readers, Chad Starliper of Rather and Kittrell in Knoxville, Tennessee. It shows all the cumulative drops in earnings from major peaks, along with the recovery paths. What is interesting is the divergence between the pre- and post-WWII periods. Our experience since 1945 is one of rather quick recoveries, averaging about 3-4 years until earnings rise above the old highs.

The thicker black line shows a drop of 69.2% from peak earnings since 2007. Prior to World War II, it took 12-20 years for earnings to recover. Earnings are still dropping. As I will point out in the next few e-letters, we live in a world (not just the US) that is in a deep recession. There is massive deleveraging and deflation. The recovery is going to be quite slow, and that portends a slow recovery in earnings, which suggests protracted churning in the stock market. (By the way, for those of you who print out this letter, the next graph will be hard to read if it is not in color.)

Even ignoring the disastrous 4^th quarter of 2008, what if earnings drop by 80% or more, which is quite possible? That means they have to rise by 400% to get back to new highs. That could take some time. Even if they could rise at an unlikely 24% a year, it would take six years to see new highs. Look at what a mountain corporate earnings must climb.

Consumers are retrenching, and savings rates are likely to rise for at least 3-4 years, back to 7% or more, leaving consumer spending not at 70% of US GDP but closer to 63%. That will be a rather large adjustment, and will mean that a lot of productive capacity will have to be closed or allowed to lie in disuse for a long time. We just built too many strip malls and car factories and restaurants. It is going to take some adjustments.

Further, the Democratic Congress and the Obama administration are going to enact the largest tax increase in history in 2010, just as the economy is barely recovering. The Bush tax cuts go away, because the Republicans could not make them permanent when they had the chance. We are going to pay for that with a likely dip back into a recession in 2010, or at the very least a prolonged weak economy.

The Implosion in Social Security

And then there is the last piece of data I want to bring to your attention, which is the most troubling of all. Everyone knows that the government spends the Social Security surpluses on current needs, "borrowing" the money and putting it into a "Social Security Trust Fund," which is basically just US debt we owe to the trust fund. In other words, there is no trust fund with anything other than paper debt. It is accounting legerdemain.

Everyone assumed that the real problem would come sometime later next decade, when there would no longer be surpluses. In 2008, the Congressional Budget Office (CBO) projected there would be $703 billion in surpluses from 2009-18. Recently, the CBO has revised those estimates downward. It now projects surpluses to be only $83 billion. Here is a table that was sent to me from a blog by Chris Martensen. (http://www.chrismartenson.com)

Writes Chris, "In the projections for the table above, the CBO has assumed no cost of living adjustments (COLAs) in 2010, 2011, or 2012 and a return to economic growth next year. If either of those assumptions proves wrong, the table above gets smoked to the downside."

Losing $700 billion (and likely a lot more) out of your budget projections is a huge blow to the US taxpayer. That money is going to have to be borrowed, or spending reduced. But the plans are for huge increases in spending.

In one of the great ironies, the Democrats and the Obama administration are going to have to deal with the Social Security crisis, and soon. Bush tried to do so, and he got torpedoed from both sides of the aisle. Politicians just do not want to be seen doing anything to SS. Given the massive, multi-trillion-dollar deficits that are projected, the US is going to face some difficulty in borrowing to meet those deficits in the not-too-distant future. Is it 3 years? 4? 5? No one can say for certain, but that day is coming and it now appears much closer.

Let's say that US consumers do save 7%. That's almost a trillion a year. The trade deficit dropped to $26 billion last month, as imports continued to drop. That's another $300 billion that foreign central banks could recycle. The Fed could print a few trillion here or there without really pushing up inflation in today's deflationary world.

But there is a limit to continued $2-trillion deficits without the appreciable rise in interest rates that will be needed to attract buyers of Treasury bonds, which of course would increase interest-rate payments on the national debt, while also crowding out corporate and personal borrowing. This is not going to end well, and the end game is getting a lot closer.

All in all, the next few years are going to be a very difficult environment for corporate earnings. To think we are headed back to the halcyon years of 2004-06 is not very realistic. And if you expect a major bull market to develop in this climate, you are not paying attention.

The original question was "Is that recovery we see?" I think the answer is no.

Copenhagen, London, Newport Beach, etc.

Last week's Strategic Investment Conference was the best we have ever had. Many attendees said it was the best investment conference they had ever attended. We are transcribing speeches and will make some of them available over time.

The Richard Russell Tribute Dinner was a great success. We had video crews there as well as photographers, and intend to allow those who wish they could have been there to see part of the evening. It was a very emotional evening, and I want to thank the roughly 450 people who came from all over the world just to pay tribute to one of the true wonders of the investment-writing world.

I leave Monday evening for Copenhagen, where I will meet with Tom Fischer of Jyske Bank, and then day-long, back-to-back board meetings with Niels Jensen of Absolute Return Partners, and back to London Wednesday night for more meetings.

I get back Friday in time to write the letter, then off the next Thursday to Orange County, where I will attend Rob Arnott's annual conference. More on that later. Back on Sunday, and then out Monday to the Charter Financial Analyst conference in Orlando, where I speak on the "state of the union" of the alternative investment world. Then I am home for awhile, and gladly.

We had 300 people in for the Strategic Investment Conference, and the staff of my partners and co-hosts, Altegris Investments, did a magnificent job making everything go smoothly. There were so many friends there, the only disappointment was that I did not have all the time I wanted to meet with everyone. It was like drinking from a fire hose for three days, but it was fun.

It's time to hit the send button, as all my kids are in town and most of us are going to have some dinner and then see the Dallas Mavericks play. Brunch on Easter, of course, with family and friends, and then the final day of the Masters to round out a perfect weekend. I have been watching some of it on ESPN, and seeing Augusta on high-definition TV is truly spectacular.

I hope your weekend will be as good as mine. Spend time with family and friends if you can. That time is an investment that will pay dividends forever, and doesn't run up the national debt. Well, a little bit, if you have to buy the tickets and pay for brunch for about 16. But that's what Dads are for.

Your starting to think about the end game more 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

Betting on Financial Armageddon

John Mauldin — Sat, 20 Sep 2008 01:40:00 GMT

Pricing in Financial Armageddon
Inside a RMBS
Ratings to Collateral to Ratings: A Vicious Cycle
This Too Shall Pass
South Africa, Boulder and Stand Up to Cancer

My Dad used to tell me there is no accounting for standards when looking at something that seemed odd. Today, we have faulty standards for accounting that are ripping apart the fabric of the world's economy. How can a security that has a high probability of full repayment be downgraded from AA to junk levels? What we will explore today tell us a lot about why we are in the crisis state of affairs. Since I wrote you last Friday, the financial landscape of the world has changed even more. And what will happen this weekend will change it even more. And our kids will be paying for it for a long, long time. At the end I offer a few thoughts on the events, and if there is time my thoughts on the new short covering rules. All in all, it should make for an instructive and interesting letter. We'll jump right in with no "but first."

I was invited to an invitation only presentation to a room of chief executives of a number of small Texas banks made by Rich Berg of Performance Trust Capital Partners this week (http://ptcp.performancetrust.com). He graciously gave me permission to go over the main points of his presentation. I think you will find it eye-opening to say the least. You probably have seen Rich, as he is all over the media lately.

Let's jump back 18 months. I spent several letters going over how subprime mortgages were sold and then securitized. Let's quickly review. Huge Investment Bank (HIB) would encourage mortgage banks all over the country to make home loans, often providing the capital, and then HIB would purchase these loans and package them into large securities called Residential Mortgage Backed Securities or RMBS. They would take loans from different mortgage banks and different regions. They generally grouped the loans together as to their initial quality as in prime mortgages, ALT-A and the now infamous subprime mortgages. They also grouped together second lien loans, which were the loans generally made to get 100% financing or cash-out financing as home owners borrowed against the equity in their homes.

Typically, a RMBS would be sliced into anywhere from 5 to 15 different pieces called tranches. They would go to the ratings agencies, who would give them a series of ratings on the various tranches, and who actually had a hand in saying what the size of each tranche could be. The top or senior level tranche had the rights to get paid back first in the event there was a problem with some of the underlying loans. That tranche was typically rated AAA. Then the next tranche would be rated AA and so on down to junk level. The lowest level was called the equity level, and this lowest level would take the first losses. For that risk, they also got any residual funds if everyone paid. The lower levels paid very high yields for the risk they took.

Then, since it was hard to sell some of the lower levels of these securities, HIB would take a lot of the lower level tranches and put them into another security called a Collateralized Debt Obligation or CDO. And yes, they sliced them up into tranches and went to the rating agencies and got them rated. The highest tranche was typically again AAA. Through the alchemy of finance, HIB took subprime mortgages and turned 96% (give or take a few points depending on the CDO) of them into AAA bonds. At the time, I compared it with taking nuclear waste and turning it into gold. Clever trick when you can do it, and everyone, from mortgage broker to investment bankers was paid handsomely to dance at the party.

Will we ever forget Charlie Prince's line, the CEO of Citigroup, saying that "As long as they are playing music, you have to get up and dance?" just a few weeks before the market imploded? Apart from having his rhythm being proven totally horrendous and overseeing an implosion which cost Citigroup tens of billions, it was a great statement of the zeitgeist of the financial world at the time.

The key word here is model. The ratings agencies used data supplied by the investment banks on what the likely default rates would be. It was something like taking an open book test where you get to write the questions. And since home values had only gone up, default rates were low. And of course, the data was from an ear when bankers lent money actually expecting to get paid back.

Inside a RMBS

Let's look at a RMBS. As Berg points out, when you are buying a mortgage backed security, there are really only three questions you need to know the answers to:

How many mortgages will default?
How much will I get back on a defaulted loan?
How much credit enhancement is there in the security?

Let's set the table by looking at a few terms and definitions. Using his example, let's take a mortgage where the home was originally appraised for $400,000 and there is a $300,000 mortgage on the home. Let's assume a default and the bank takes back the home. If they sell the home and recover $240,000 that means they lose $60,000. This is called a 20% severity. If they sold and recovered $150,000 it would be said to have a 50% severity.

Next, let's look at how the rating agencies come up with the AAA rating. First they model the expected losses, with emphasis on the word model. If they figure that worst case that 8% of the loans default at a severity of 50%, then the security would lose 4% of its value. To get an AAA rating you have to have at least two times the coverage of the "modeled" loss. In this illustration, that means that 92% of the loans would be put into the AAA tranche. An A rating assumes a coverage of more than 1 times but less than 2. B means you expect to get your money back and if they model that you will get below 100% back then the rating would be at junk levels.

Now, this next fact is important. All ratings assume a par value of 100. The rating of these bonds has nothing to do with price. After the presentation, Rich sat down with me and pulled up an actual mortgage backed security that was being offered that day on his screen. It was once a AAA rated Alt-A security. If I remember correctly it was a 2006 vintage security.

As of the latest reporting, a little over 5% of the mortgages were over 60 days past due or in foreclosure. In this security, there are no toxic option ARMS. The numbers of mortgages in this security that are in trouble are rising. S&P has downgraded that AAA tranche to BBB, which of course means its value is going down.

And sure enough, the offered price of the security is 70 cents on the dollar, or 70% of the original par value. Now remember, this particular AAA bond will only start to lose money after the lower tranches take up the first 8% of losses. Thus, this bond can be said to have an 8% credit enhancement.

Pricing in Financial Armageddon

Now, let's stress test that loan. For the AAA portion of the loan to lose money, that would mean that 16% of the loans would have to default with a severity of 50% losses. Could that happen? Sure.

But let's look at what buying that loan at 70 cents on the dollar does for the new owner. First, you are getting a much higher yield (interest rate) because you are buying the security at a lower valuation. But something else even more interesting happens.

Even though the security sold at 70 cents, it still gets all of the first of the proceeds of the home owners who pay their mortgages, up to 92% of the original value in the security. How many loans would have to default in order to make the buyer at 70 cents lose money? Remember, we already had credit enhancement of 8%. But at 70 cents, we just "bought" or priced in another 30%. Let's think Armageddon and that 50% of the mortgages default and they only recover 50% of the loans. That would only be a total loss of 25% to the entire collateral of the deal, but it would mean that the new investor still get all of my 70 cents plus another 13% back! The proud new owner could get up to 92% of the monies paid. Even in a pretty bad scenario, you get more than you paid for the security.

Let's walk through the math. Let's say the original security was $100 million (which would be a very small RMBS). The AAA tranche would have cost $92 billion. If you have it at 70 cents on the dollar you paid approximately $64 billion. In my Armageddon scenario above, the security loses 25% or $250 million. The lower rated tranches are completely wiped out losing $8 billion. Your tranche loses the remaining $17 billion which means you get $75 billion and you only paid $64 billion.

So, how bad would things have to get to lose money on this security? If I am doing the math right, 72% of the loans would have to default with a severity of 50% before your investment of $64 billion was impaired by even so much as 1 dollar. If that happened, it would be Armageddon.

So, why is it rated BBB? Because the rating is over the entire tranche and it is made at a par price of 100. The rating is not affected by the current price. As of today, assuming that even double the number of mortgages currently delinquent default with a 50% severity, your returns over the life of the security would be well over 12%. You would get back $92 million for your $64 billion dollar investment along with interest payments.

The reason this presentation was being made to banks and institutions? Because if you are a bank, you can generally only get prime plus 2% on a loan you make. But if you buy this security with your capital, you can make prime plus 6%. That is a large difference to a bank. Performance Trust has sold billions of this type of paper to banks and institutions.

If this is such a good deal, then why isn't everyone hitting the bid? Because these securities are very difficult to analyze. It is time consuming. You need to analyze every loan and develop your own valuations. You simply can't trust the ratings, as they are measuring something completely different.

And the real truth is that many of the various RMBS securities will in fact be totally wiped out or lose a great deal. Many are seeing default rates of 30% or more. You have to be very careful when you walk through this minefield. And in a time of crisis, it is not clear what the new rules will be. What if the government forces lenders to re-set mortgages at some loss level? What if the housing crisis gets worse? On the other hand, what if the government comes in and buys up all the bad mortgages in an attempt to stop the erosion in the home markets. The level of uncertainty in these times makes people a lot more cautious.

There are Alt-A RMBS like the one mentioned above that are probably not worth even 70 cents on the dollar. These things are marked to a market that is frozen. Everything gets lumped into the same basket and it all has to be marked to market by the new accounting rules called FASB 157. The institution selling the above mentioned security is being forced to do so, either because they are in financial trouble or they are not allowed to hold BBB securities in their portfolios and by law are required to sell. And in times of crisis, the selling price is not that of normal times.

Ratings to Collateral to Ratings: A Vicious Cycle

What's a recipe for a perfect financial storm? Let's make a massive amount of bad loans and get them on the books of most of the major financial institutions because they are rated investment grade. Then let's have the loans start to go bad. Throw in some general panic as everyone tries to sell the loans. No one is buying.

Let's make a new rule that you have to mark your illiquid securities to the last price paid by someone desperate to sell. That means that many institutions now have to mark their capital down and that means those pesky rating agencies must by their own rules mark down the ratings of the institutions which of course means that it costs them more to raise capital at a time when they can't get it which means they get lower ratings and so on. It becomes a vicious cycle.

In the early 80's, every major US bank was bankrupt because they had loaned Latin American countries far more than their capital they had on their books. The Latin American countries defaulted. If the US banks had been forced to mark to market, they would have all gone down taking the US economy along with them. So, the Fed simply allowed them to carry the loans at book value, offering liquidity and allowing the banks to buy time to make enough money to eventually write off the loans.

The current mark to market rule, while nice in theory, works in normal times. But it has the unintended consequence of making things worse in crisis times. Why should an institution have to write down a security which over time is going to pay back the lion's share or more of its value just because a severely stressed institution was forced to sell that security at a very low price in a time of crisis?

Yes, there needs to be transparency and we as investors need to know what is on the books of the companies that we invest in. But it is somewhat like my bank asking me to mark to market my home and pricing my loan daily based on that new price. If my neighbor loses his job and sells his home at auction, does that mean my home is now worth less two years from now. Maybe an even better analogy, if I am renting that home to a very good tenant, does my neighbor's price impair my income?

I was, and am, a fan of mark to market pricing. But we need to think through what a market price is. Not all things can be easily marked to market. This is doubly true when "market price" is a nebulous index of mortgage securities which may or not have a fundamental relationship with an illiquid security on the books of an institution which has no intention of selling, especially in a time of credit crisis.

It is one thing to require that you mark your stocks or bonds to market values. It is another thing entirely to require all mortgage backed securities, which are extremely complex things, can be very different one from another and which require a lot of time and effort to value, to be priced as though they are all the same.

FASB 157 needs to be amended this week. If Congress can create a new Resolution Trust Corp in a week, the surely the accounting board, with the suggestion of Treasury, can figure out a better way to price illiquid securities.

This Too Shall Pass

I know that you probably are reeling from all that has happened the past few months and especially the past two weeks. Lehman and Mother Merrill gone? We the people own AIG? Fannie and Freddie? A new housing bailout which will cost hundreds of billions? The Fed creating whole new programs to provide liquidity? Did you notice they loaned some $250 billion this last week to banks all over the world? Stopping short selling?

Want to see in graph form how bad it got and what spooked Paulson, Bernanke and company to act so quickly? Look at these graphs from my friends at Casey Research (http://www.caseyresearch.com/crpmkt/crpSolo.php?id=119&ppref=JMD119ED0908A). 30 day commercial paper went to 5% from 3% a week ago. The market was literally freezing. And the amount of paper issued is in free fall. Commercial paper is the life blood of the financial and business world. Without it commerce will soon grind to a halt.

It simply takes your breathe away. As President Bush said today, it does not help to find who is at fault today, we have to figure out how to get out of this mess. It is going to cost the taxpayers a lot of money. While I think the losses on AIG will be rather minor in the grand scheme of things, if you add up Fannie and Freddie and a new RTC, coupled with the stimulus package, you can easily get to $500 billion, and that is probably a low number.

For such a price, we had better get a new regulatory scheme which requires reduced leverage. Want to get really mad? Up until 2003, all investment banks were allowed only 12 to 1 leverage. Then in 2004, the SEC basically gave five banks (and only five banks) the ability to lever up 30 or even 40 to 1. Bet you can guess the five banks. Bear, Lehman, Merrill, Morgan and Goldman. Three down.

As Barry Ritholtz wrote: "So while the SEC runs around reinstating short selling rules, and clueless pension fund managers mindlessly point to the wrong issue, we learn that it was the SEC who was in large part responsible for the reckless leverage that led to the current crisis." (Don't get me started on blaming the short sellers. Let's not blame the people who leveraged up their companies 40 to 1 with bad investments.)

We absolutely must move credit default swaps to a regulated exchange, no matter how much investment banks and hedge funds scream. Must be done. Do it now. Real rules about writing mortgages, although now that losses are in the hundreds of billions, underwriting rules are already becoming quite restrictive.

And while we are at it, a thorough revamping of the rating agencies and the rules they use should be at the top of someone's list.

South Africa, Boulder and Stand Up to Cancer

It is time to hit the send button. Chuck Butler of Everbank and Thomas Fischer of Jyske Bank just walked into the office to watch the Texas Rangers play Anaheim from my balcony (which is inside the Ballpark where the Rangers play). That would be baseball to those not from the states. Chuck is a huge baseball fan and when I heard he was going to be in town I had to have him come, even on a writing day.

Everbank is known for letting clients open CDs denominated in scores of different currencies. If you are interested in diversifying away from the dollar, you can go to Everbank.com. Or call EverBank at 800-926-4922.

Chuck has had some very serious cancer, and has been going through lots of chemo. He just told me that his latest scan shows him 100% cancer free, and he is going off the chemo. Sometimes good things do happen to good guys.

And speaking of cancer, Stand Up to Cancer is a charity formed to raise money to find cures for cancer and fund innovative new therapies and research. SU2C is going to make a difference in how cancer research is conducted over the next five years, with its focus on targeted treatments that interrupt the mechanisms of uncontrolled cell growth. This is the kind of emphasis that can make cancer into a disease patients live with, rather than one they die from (sort of like AIDS has become for most of its victims in developed countries). You can and should see the program broadcast live a few weeks ago on most major networks. And then send money. Their web site, with tons of information is http://www.standup2cancer.org/ and the TV show is at http://www.nbc.com/Movies_Specials_More/Stand_Up_To_Cancer/video/episodes/.

I leave for Cape Town in South Africa tomorrow morning. I will be speaking at the ABSIP (Association for Black Securities & Investment Professionals) Annual Conference in Cape Town on September 23. Then that evening I fly to London for meetings with my partners and clients there and fly back to Dallas on Thursday. I hope to be able to keep up with what is going on and write the letter next Friday. And then Sunday I fly to Boulder to meet with Dr. Bart Stuck and learn about a company called InPhase which is making holographic memory. Pretty cutting edge stuff.

I mention this because it is companies like InPhase, and a thousand more like them, which will power the next big wave of change. The crisis on Wall Street will pass and the world will continue to change. I think it is going to change for the better for most people.

The game ahs started, so I think I am going to find an adult beverage and really, truly celebrate with Chuck, who was on the road when he got the news. I know he will be celebrating with his family when he gets home.

Your not looking forward to a 15 hour flight 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

Whatever Happened to Decoupling?

John Mauldin — Sat, 16 Aug 2008 04:52:00 GMT

A Mid-Year Correction
Whatever Happened to Decoupling?
The UK Starts to Slow
A Recession by Any Other Name
What's a Central Banker to Do?

The old mantra was that if the United States sneezed, the rest of the world would catch a cold, as the US was seen as the main driver of world growth. That was then. Economists and analysts began to argue that China and the developing markets were starting to provide a consumer base for the world. And Europe's new and growing markets would be able to stave off problems from abroad and stay on their own growth path. The world, we were assured last year, would not suffer from problems in the US economy.

Today, we look at evidence that this might not quite be the case. And if it is not, those who look for diversification in global markets may be disappointed. Also, I quickly look back at my January forecasts and feel it may be time for a mid-course correction. It seems I may have been a little too optimistic. It should make for an interesting letter.

But first, a quick commercial. I spent two days at the Caves Valley Golf Club outside of Baltimore with good friend and business partner Steve Blumenthal, the president of CGM. He has developed a platform of money managers who can take direct accounts, and I recommend that readers interested in outside money management take a look at them. Normally, to take a look at the managers, we have you sign up to get a "pass" to take a peek behind the curtain. We decided we would change that policy, at least for this week. If you would like to look at a manager I think quite highly of, you can click on this link to see a few details about him. http://www.cmgfunds.net/sys/docs/118/ARS%20Scotia_new.pdf (Remember, past performance is not indicative of future results.) If you would like to talk with Steve or his team about this manager or the others that are on the platform, simply click on the following link, fill out the form, and they will call you. http://www.cmgfunds.net/public/mauldin_questionnaire.asp

And as always, if you have a net worth of $1.5 million or more and are interested in hedge funds, commodity funds, and other alternative investments, you can go to www.accreditedinvestor.ws and one of partners from around the world will show you what is available on their platforms. (In this regard, I am president and a registered representative of Millennium Wave Securities, LLC, member FINRA.) And now to the letter.

A Mid-Year Correction

I wrote in my January 4 letter the following predictions:

"So let's get to the predictions. I think that we are in a recession for most of the first half of this year, and that we begin a slow recovery in the second half. It will be a Muddle Through Economy for at least another year after that. That would suggest that most companies will come under serious earnings pressure. If history is any indicator, that means we should see a bear market in the first half of this year. How deep will depend on how fast the Fed cuts, but I don't think we are looking at anything close to the bear market of 2000-2001. Still, I wouldn't want to stand in front of a bear market train.

"Consumer spending is going to slow, and it will be slower to rebound, for reasons outlined above. That will also make the recovery in the stock market a little slower. But I expect to become bullish on the market sometime this summer, if not before. I'm looking forward to it."

To be blunt, that optimism now seems misplaced. I think we are likely to stay in recession for perhaps the rest of the year and well into 2009 before we start a very slow recovery. It is not time to get bullish on stocks, as I have been writing for the past few months. Earnings are going to continue to come under pressure, and earnings are what drive the stock market over the long term. We could see total S&P 500 as-reported earnings drop below $50. You do the math. Even with a 20 multiple, that does not yield a pretty picture.

I think we are going to test the recent lows and then watch the market go lower as the market gets disappointed in the earnings from the third quarter, and re-test those lows again. We are in for an extended period of Muddle Through, while we wait for the housing market to find a bottom and the credit crisis to abate. Banks and other institutions have written off about $500 billion. There is at least another $500 billion to go. The amount of capital that is going to need to be raised is astronomical, and it is going to be very dilutive to current shareholders.

I did predict that the euro would top out against the dollar this summer, and that looks to be the case, although the dollar went lower against the euro than I thought it would when I forecast $1.50 about 4-5 years ago.

Whatever Happened to Decoupling?

I was reminded of an article by Desmond Lachman of the American Enterprise Institute (by Leo Kolivakis of www.pensionpulse.blogspsot.com). Lachman wrote these very prescient words last January in a paper called "The Myth of Decoupling." Quoting:

"Sadly, the 'decoupling' thesis has little support in theory or in practice. Its proponents overlook the fact that during the past five years the U.S. economy grew faster than all the other G-7 economies. During that time, America's economy remained the principal generator of global aggregate demand, accounting for around one-fifth of global imports and 25 percent of global production. This evidence suggests that, as in the past, if the U.S. economy sneezes the rest of the world will catch a cold.

"... A number of the shocks presently affecting the U.S. economy are global in nature, and are already slowing European and Japanese growth. The credit crunch flowing from America's subprime woes is causing a global increase in market interest rate spreads and a global tightening of bank lending standards. This is hardly surprising: almost half of all U.S. asset-backed subprime mortgage securities were distributed abroad.

"... The 'decoupling' optimists are ever hopeful that China's rapid growth, together with the rest of Asia's emerging market economies, will offset any U.S. economic downturn. But they tend to forget that Asia is filled with export-dependent economies: in some countries, exports to the United States alone [emphasis mine] account for more than 10 percent of annual GDP. The "decouplers" also forget how relatively small these Asian economies still are, at least in relation to the G-7 industrialized economies. Even the vaunted Chinese economy is barely 15 percent the size of the U.S. economy."

We are now seeing the major economies of the world go into simultaneous recessions and in many of them elevated inflation as well, giving way to stagflation. Let's first take Europe. Today we learned that "GDP growth is easing in a number of European economies as highlighted by national accounts figures out during the week. The flash second quarter GDP data for the euro zone noted a 0.2% q/q contraction, following a 0.7% expansion in the first three months of the year. This was primarily the result of a 0.5% downturn in the region's largest economy, Germany, and a 0.3% contraction in second biggest, France." (www.economy.com) The chart below shows the latest data results.

And it's not just Germany and France. "Preliminary data suggest the Italian economy also contracted 0.3% during the quarter, the Netherlands reported no growth, and Spain grew at its slowest pace since the 1993 recession, with a minimal 0.1% expansion. The Spanish government fears recession in the second half of the year and called for emergency discussions on Thursday to deal with the situation. Latvia and Estonia also contracted in the second quarter, with Estonia reporting a technical recession after also shrinking in the first three months of the year. While no flash estimate is available for Ireland, the economy is on the brink of recession."

Inflation in Europe is running at 3.6%. Since the European Central Bank has just one mandate, and that is to provide for a stable currency, it will be difficult for them to ease this year.

The UK Starts to Slow

The Bank of England is forecasting a flat (0%) GDP over the next year. The United Kingdom is probably already in recession, but the problem is that the central bank is going to have difficulty cutting rates, with inflation at 4.4%; and that problem may get worse, as major energy suppliers like British Gas are announcing price increases of as much as 35%. Producer prices in the UK rose by 10.2% in July. The head of the British central bank, Mervyn King, is forecasting an inflation of 5%.

And in Asia? Real GDP declined 0.6% in the second quarter in Japan. Chinese stocks are forecasting trouble, as stocks are down more than 54% this year and 60% since the peak last year. And it is not just China. Stock markets all over Asia are in serious decline, although my friends at GaveKal note that Chinese stocks may be seriously oversold and a buy from here. I think I would wait until we see just how much a prolonged US slowdown will affect Asian economies and exporters. And inflation pressures are evident all over Asia. Producer prices in China are rising more than 10%. Inflation is at 12.4% in India, a 16-year high.

Inflation in the US? Data came in this week that was rather shocking. July CPI rose by 0.8% in July and 5.5% year over year, and core inflation on a three-month basis (less food and energy) rose by 3.4%.

A Recession by Any Other Name

Remember the comfort the bulls took in the fact that GDP when first reported was a positive 0.6% in the fourth quarter of 2007? Now is has been revised to a negative 0.2%. As I have repeatedly said, GDP numbers will be revised downward in this part of the cycle, but maybe a few years after the fact when real data and not estimates are available.

Let's look at this piece from David Rosenberg, the North American Economist for Merrill Lynch. He does a good job of telling us why GDP estimates that suggest the economy is not on recession may not reflect the facts on the ground.

"You'll miss a lot of action waiting for GDP to go negative. More to the point, if you're waiting as an investor for GDP to actually turn negative, you're going to miss a lot of action along the way. I think the best example is to just go back to Japan. They had a real estate bubble that turned bust and they had their own credit contraction back in the early 1990s. Guess what; Japan didn't post its first back-to-back contraction of real GDP until the second half of 1993. By the time the back-to-back negative that people seem to be waiting for happened, the Nikkei had already plunged 50%, the 10-year JGB yield rallied 300 basis points, and the Bank of Japan had cut the overnight rate 500 basis points, which said a thing or two about the efficacy of using the traditional monetary policy response of cutting interest rates into a credit contraction (as we're now finding out here in the US)."

Dating the recession is a very scientific process:

"The point is we can't make the assumption that we've avoided a recessionary condition in the economy, just because we have so far managed to avoid back-to-back quarters of negative GDP. I'm just telling you as the economist that it is basically irrelevant. The only body that officially makes the call on the broad contours - when the recession started, when it ends, when the expansion starts, when it ends - is the National Bureau of Economic Research, the NBER. It's a very scientific process. It's not a gut check or a judgment call.

"We should actually be welcoming the recession call. When they make the determination - it's very interesting, by the way - when they make the announcement that the recession began, when they actually date it for us, traditionally we're a month away from the recession actually ending. The announcement, in fact, is going to be a rather cathartic event, something we should actually welcome happening, but so far they are still taking their sweet time in making the proclamation.

"Four factors used to determine recession:

1) Employment

"The NBER relies on four different variables. The first is employment. Now I've told you before; employment is down seven months in a row. Does employment go in the GDP? The answer is no. Is it correlated? Yes. Does it help grow the business cycle? Of course.

2) Industrial production

"The next variable is industrial production. Does that go into GDP? The answer is no. Does it help grow the business cycle? The answer is yes. This is a number that comes from the Fed. The GDP comes from the Commerce Department. It's a very important variable.

3) Real personal income net government transfers

"The next variable, the third one, is real personal income excluding government transfers. This metric is now down four months in a row. Does personal income go into GDP? The answer is no; of course, it doesn't. GDP is all about spending. Personal income goes into gross domestic income, which is another chart of the national accounts.

4) Real sales activity

"The fourth variable and the only variable that actually feeds into GDP is real sales activity in manufacturing, retail and wholesale sectors.

"A Recession probably started in January. When I take a look at these four key indicators that define the broad contours of the business cycle, they all peaked and began to roll over sometime between October of last year and February of this year. I am convinced that when the NBER does make the final proclamation, it will tell us that a recession officially began in January. Of course, to any market person, this would make perfect sense, because of when the S&P 500 peaked. It did a double top into October, right when it usually does, before a recession begins.

"This recession won't end before mid-2009, in our view. Now I'm just giving you the rearview mirror. What's most important to you folks is let's look through the front window and see when this recession is going to end. The tea leaves that I'm reading at this point in time show that this recession is not ending any time before the mid part of 2009, which would mean that, if you're looking for, not the Mary Ann Bartels intermediate bottoms, but the fundamental bottom, I don't think you can expect to see it before February or March of next year, if I'm correct on when this recession ends. Historically the S&P 500 troughs four months before the economy actually hits its bottom point."

I agree with Rosenberg. And if we see a recession lasting into 2009, then earnings are going to be under a lot of pressure. Buying index funds today could be very risky to your portfolio.

What's a Central Banker to Do?

Central bankers everywhere are faced with a serious dilemma. Do they raise rates to fight inflation, cut rates to stimulate their economies, or sit tight and hope that prices moderate as the world economy slows? Hope is an interesting strategy for a central bank, but it may have come to that.

In short, the world has not decoupled, but is more closely intertwined because of the global financial community. Housing problems and excesses in California (and the rest of the US, the UK, Spain, etc.) affect banks in Europe and Asia and the US simultaneously.

You cannot have a worldwide recovery until the financial crisis in the major lending institutions is dealt with. A functioning banking system is the lubricant for a world economy, and the banking industry is cutting back on loans and tightening the standards by which they do make loans. Look at these survey results from Northern Trust:

In reality, it is not just mortgage lending that is getting tighter. Every survey done on any type of lending worldwide shows bankers are setting tougher standards; and most are simply lending less, partially as a result of shrinking capital ratios. Until lenders have adequate capital to be able to make loans, it will be hard to see anything other than a very tepid recovery sometime next year.

Look at the graph below. The spread of the difference between US 10-year treasuries and a 30-year mortgage is the highest in over 22 years. In May of 2007 it was 1.37%. Today it is 2.53%. The historical average is 1.68%. That means a mortgage costs almost 1% a year more than it would under a normally functioning market. That reflects that lenders are having trouble finding investors who will buy their mortgages, and of course it makes housing less affordable and puts off the day when inventories will again be reasonable.

Bottom line is that there is a long way to go before either the world economy or markets will be seen as functional. I continue to believe the data suggests we are still in a secular bear market and that valuations are not anywhere close to signaling a new bull market. Paying attention to daily market movements to confirm your bias one way or another is pointless. Daily market moves are random noise.

Pay attention to the fundamentals like earnings and valuation. In this type of market, you should be looking for absolute-return types of investing rather than relative-value index funds. And absolutely avoid anything linked to the US consumer or financial stocks unless you have some special knowledge of a specific situation. There are more write-downs and earnings disappointments to come.

Weddings, Baltimore, and South Africa

As noted above, I met with Steve Blumenthal and wealth manager Cliff Draughn at the Caves Valley Golf Club on Wednesday and Thursday this week for a quick trip to talk business and get in my first real game of golf in over two years. This maybe is the most beautiful course I have ever played, and Cliff was a great host. Oddly, as the game went on, I started to get some twinges in my right arm, but I thought it was just a little stiff from not playing golf for so long and tried to work it out. By the 17^th hole I just couldn't follow through as the pain in the forearm was too much, and so I called it quits. The pain continued through the night coming back on the plane. And this morning I woke up to find my right forearm and up to my middle inner bicep was one ugly bruise. Not sure what happened. That is a first for me. But I worked through the pain and finished the letter tonight.

I will be in Cape Town, South Africa, on September 21-23 to do a speech. I will go back to Baltimore to attend my good friend of 25 years Bill Bonner's 60^th birthday party the first weekend in September. 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 the following link: http://www.dailyreckoning.com/rpt/mauldin.html

The wedding was a spectacular success, and I know Tiffani and Ryan will post pictures and video when they get back from South Africa. I have to confess that when I saw Tiffani she was so beautiful that I actually teared up, and then we both got misty-eyed. It was a very special moment. I surprised myself getting so emotional.

As I was walking through the dining area before the wedding, I noticed that they had put out a treasure chest on one of the tables. I assumed that it was for putting gifts into. As I walked by, I tried to lift the lid. Turns out it was a very realistic looking cake and I put my thumb through the top of the "lid." Tiffani had personally designed every aspect of this wedding, and I had just left a very large impression on one part of it. When I sadly told Tiffani, she just laughed. She said it was such a "Dad thing" to do and made the night perfect. I just wish the Dad things I do weren't so embarrassing. Oh, well.

As I did my toast, right before the fireworks, I welcomed Ryan into the family as Tiffani's six brothers and sisters, plus in-laws, gathered around. Part of it went something like this. I mentioned to the crowd that Tiffani had been responsible for the total design of the tables, decorations, dinner, the flower arrangements, the (very) elaborate cake, etc. No detail went by without her input. And then I added:

"Ryan, the bad news is that you have married a lady who, just as she organized this wedding, is going to pay attention to every detail in your life, making sure you stay on your toes. I know that from personal experience from working with her for ten years. But the good news is that she will also make your life as beautiful as this wedding. You have my treasure. Take care of her."

Your still misting up analyst,

John Mauldin

Where is the Bottom in Housing?

John Mauldin — Fri, 28 Mar 2008 15:10:15 GMT

Housing - Finding the Elusive Bottom Where is the Value in Housing? Bottom Line? There is no Bottom in Sight The Real ARMs Race Cancun, La Jolla, London, and Switzerland Existing home sales rose by 2.9% in February, the first significant rise in home...(read more)

The Panic of 2007

John Mauldin — Fri, 17 Aug 2007 08:08:00 GMT

The Panic of 2007 Muddle Through or End of the World? An Alphabet Soup of Credit Turning Nuclear Waste Into Gold (and Back Again!) Mrs. Watanabe and the Hedge Fund Connection The Rating Agency Blame Game Where Do We Go From Here? Hedge Funds to the Rescue...(read more)

The Mortgage Pig in the Python

John Mauldin — Fri, 03 Aug 2007 08:06:00 GMT

The Mortgage Pig in the Python Inflation is Baked into the CPI Numbers The Mortgage Pig in the Python Housing Starts Look to Stop A Few Thoughts on the Recent Credit Crisis Half of All Hedge Funds Gone? Golf, Weddings, and Europe With the economy increasingly...(read more)

Fun in the Subprime Summer

John Mauldin — Fri, 20 Jul 2007 08:04:00 GMT

Fun in the Subprime Summer Hot Fun In The Summertime Collateralized Loan Obligations The Economic Outlook for Leveraged Credits The New Mickey Mouse Club Planes, Trains and Automobiles This week I am already in Maine and getting ready for a weekend of...(read more)

$250 Billion in Subprime Losses?

John Mauldin — Fri, 29 Jun 2007 07:59:00 GMT

$250 Billion in Subprime Losses? Is the subprime mortgage market collapsing before our eyes, or did we avoid a disaster as Bear Stearns stepped up to the plate with $3.2 billion to help its ailing funds? As we will see from the data, the problems in the...(read more)

The US Mortgage Market - Overexposed and Overrated

John Mauldin — Fri, 25 May 2007 07:53:00 GMT

Introduction This week we look at the US mortgage market to see what fallout there is from the subprime mortgage woes. It is both less of a problem and/or more of a problem, depending on your perspective, as I predicted it would be last year. Score one...(read more)