sunny outlook

Consumer confidence is up. That had the markets all jazzed up and we saw another rally yesterday. Unfortunately, it won't last. Consumers may feel more confident now that the sun is out and the weather is getting warmer, but it won't lead to economic recovery. We are a long way away from that. Much more hardship is to come before we can start dreaming about recovery. 

The sunny mood was everywhere. Several newscasts did specials on Memorial Day sales and retailers tried to sound hopeful and upbeat. Even the real estate guys saw signs of a "turnaround" or a "reduction in inventory." Call it a calm before the storm. Rest assured that another round of foreclosures is coming our way. The first reason is quite simple: the moratorium imposed by the new administration is about to run out. The second reason is far less obvious but much more damaging.

The most onerous mortgages, the ones with negative amortization and pay-as-you-go schedules have yet to reset. Their 5 year grace periods will be ending soon. Starting this summer the first ones will hit their resets. When they do, a major wave of foreclosures is inevitable, even if the economy stays where it is (or improves). California will be especially hard hit as most of these "creative mortgages" were written in the golden state.

Foreclosure is inevitable is because people who bought houses with such mortgages were unable to pay their true mortgage rate 5 years ago when they acquired the house. They are even less likely to be able to pay it now. 

What will happen soon is that people who could not afford a 30 year mortgage of say $400K will now suddenly have to a pay a 25 year mortgage of $425K. With no equity in their homes and the residual values hovering around 50-60% (i.e. $250-300K in our example), these people will walk. They would be fools not to.

There is a third reason: the deteriorating job market. Everyone who have lost their jobs since the crisis started is also in trouble. That has added an additional pool of foreclosures in the prime mortgage category. People who have equity in their homes but who can no longer afford to pay the remainder of their loans.

All three factors are likely to exacerbate our problems starting this summer. Expect another big drop in housing prices. To be followed soon thereafter by another big wave of job losses and layoffs.

double digit unemployment

The job losses for 2008 were the worst since 1945. So says the Wall Street Journal. It is good to note that there were half as many people then, and that the nation was switching from a war time economy, where everyone -young and old, firm and infirm- were put to work producing much needed ammunition and machinery. It is also good to note that there was huge demand after world war 2 to rebuild all the devastation. There wasn't a glut of housing and a mountain of personal debt.

Furthermore, since the US won the war it was in a dominant position to make sure that a huge chunk of that rebuilding effort went to US companies. The country also took over many lucrative foreign businesses, both in Germany and to a lesser extent in Japan. Stimulus plans to rebuild Europe created ample opportunity. An era of unheard of prosperity was waiting in the wings.

Today is much different, the job losses that started in the last few months of 2008 are by no means a thing of the past. Many more layoffs were announced in January of 2009 and there are many more to come. 

Not only is the population much larger now, it is also older and aging fast. Despite glorious ads of retirement spent in luxury and travel, older people spend far less than young people, and if one excludes health care, the difference is even larger. The situation in Europe, where many of our customers are is even worse, and many countries have an even older population.

There are two further complications. Our aging population has overspent like there was no tomorrow. They are deeply in debt and without savings. Many don't have pensions or other guaranteed income. They also don't have good health care coverage. They have no more money to spend and most can't even save up enough to keep living the way they are now.

A lot are deeply in debt and in danger of losing their homes. Most of the negative amortization mortgages have not reset yet. The majority of people with such mortgages could never afford the reset, let alone if they lose their jobs. Furthermore, they are deeply underwater as is and that makes it nearly impossible to refinance. Their 401k's, IRA's, and other retirement vehicles have lost tremendous value.

Advertised unemployment hit 7.2%. The number is overly optimistic. In the US we count people applying for unemployment, a very short-lived remedy that is often bypassed by a significant number of out-of-work persons. It makes our numbers look good, and better than European numbers. But 7.2% in the US is much, much worse than 7.2% in Germany, where all jobs come with a decent wage, health and retirement benefits and the like. Germany also has a safety net that is almost completely absent in the US. The same applies to most other European nations.

Real unemployment, or actual number of people out work, a number that includes workers who have dropped out of the labor force, or work part-time at odd jobs because they can't find full-time jobs, hit 13.5% in December. That is solidly in the double-digit range. I predicted previously that real unemployment could hit 15-20% and I stand by that prediction.

As I mentioned before, many of the forces that will make matters worse have yet to show their faces. Housing losses are far from hitting bottom. Retailers still think of spring and summer fashions. Fashion is one of the concepts that may disappear for a while. I can't see cash strapped consumers ditching good items simply because they went out of style. And while it will be painful, the latter is actually a good thing. Good for our habitat, and good for our long term survival.

you be the judge

We read in today's WSJ Opinion columns that the panic of 2008 is a crisis of trust. Nobody trusts anybody else anymore and so the financial system "froze." So far so good. I think everybody more or less agrees with that viewpoint.

Then Mr. Crovitz, the article's author goes on to make a few other, rather remarkable statements. One he asks, "How did the smartest people at the best banks running the most sophisticated financial models fail to forecast the collapse of mortgage-related securities?" Well, to be quite honest, it beats me. For more than two years now it has been painfully obvious to me, not working at any bank and not using any "sophisticated" models that housing was going to collapse. And that was not just an idea among many others. All you had to do was look around you. Bay Area housing prices in Modesto?

One can only conclude that the most sophisticated models were not all that sophisticated. Maybe Mr. Crovitz realized that and the large cap insert shows the "Value at Risk Formula, complex as it is," that is surely meant to impress us with mathematical sophistication. Unfortunately long formulas like that do not impress me. For one, they often indicate a complicated data-fitting model that is by definition only as good as the data it is meant to fit. Great equations, such as e=mc2 are simple. Understanding is by definition simple. If you can't express it simply, you probably don't understand it.

Second, the "smartest people" are often those with little sense of reality. They hail from a distant orbit. Witness the fact that many don't know how to tie their shoe-laces or button their shirts. Such smarts may play well at the large hadron collider but they tend to underwhelm when it comes to day-to-day living. Once again we are not impressed. And as for the best banks, we will leave that one as a home work assignment.

There is more however. Mr. Crovitz thinks we need to examine the failures because, "modern finance has delivered enormous benefits." What those are, apart from millions of dollars in the pockets of the perpetrators is not quite clear to me. 

Once again, Mr. Crovitz must sense there is something wrong because he goes on to list the enormous benefits of modern finance. For example, it goes "from explaining to investors why they should diversify their investments," to "the creation of mutual and index funds."

Maybe you want to read that again. The "enormous benefits" of modern finance are, 1. don't put all your eggs in one basket (I thought this was a old idea, but you learn something new everyday), and 2. the mutual and index funds.

That is not all. "Related innovations helped financial institutions speed capital to its best use, fund new businesses and accelerate global prosperity."

All hail "modern finance" and the "smartest people at the best banks" for bringing us these wonderful gifts. Let's not forget to thank Mr. Crovitz for highlighting these gems too.

and miles to go before i sleep

If you think the crisis is over, think again. The worst is yet to come. I don't want to sound like an alarmist, but it should be obvious to everyone now that this is true. There is simply no other way. Even if the Fed can restore normal lending in the weeks to come, the fallout from what went before, and what is underway is still to hit. The lag could be as long as six months to one year.

Banks have failed while others were taken over for peanuts. What that means is that many are out of work and soon many more will be. Of those who survived, the mergers are likely going to be followed by massive rounds of layoffs. People out of work will result in more foreclosures, and more losses. To say nothing about reduced spending. Remember, 2/3's of our economy is based on consumer spending. And much of that spending is on credit. Up to half of it comes during the holiday season. A season that is now upon us.

If the holiday spending is much reduced, and it will be significantly reduced, many retailers will go under. That too won't happen for another six to nine months. Apart from hitting pocket books, it will hit commercial real-estate. Other highly-leveraged businesses will fail soon too. Many in California got a bit of extra "help" here from the delayed budget. That budget has also pushed some cities over the brink. Vallejo went bankrupt, Oakland is considering 120 layoffs, San Francisco has problems.

Even in the mortgage arena there is more to come. The majority of the so-called option-ARMs have yet to reset. Sixty percent of these ultra-toxic loans are in California. Many have been negatively amortized for their entire life-span. So not only will people now have to pay the full price, which they were never able to, their loan balance is now higher than it was before they started.

Unfortunately, that is not the only problem. A key problem is that the recession will be world-wide. What that means is that exports will get hit and exports are -for now-the only bright spot left.

It has been said that we are a long ways from Great Depression II. As of today, there is no doubt. However, experts have been surprised before about how quickly and how profoundly things can unravel. The wizards from the Treasury, the Fed, and the Administration have all gone on record months before the current crisis, stating how solid the economy was, and how resilient the markets were.

I think it is time to buy some gold.