Monday, September 25, 2006

Signs of the Economic Apocalypse, 9-25-06

From Signs of the Times, 9-25-06:

Gold closed at 594.90 dollars an ounce on Friday, up 1.5% from $586.00 at the close of the previous Friday. The dollar closed at 0.7817 euros Friday, down 1.0% from 0.7895 for the week. The euro closed at 1.2792, compared to 1.2666 at the end of the previous week. Gold in euros would be 465.06 euros an ounce, up 0.5% from 462.66 for the week. Oil closed at 60.28 dollars a barrel Friday, down 5.1% from $63.33 at the close of the previous Friday. Oil in euros would be 47.12 euros a barrel, down 6.1% from 50.00 euros for the week. The gold/oil ratio closed at 9.87, up 6.7% from 9.25 at the end of the week before. In U.S. stocks, the Dow closed at 11,508.10 Friday, down 0.5% from 11,560.77 at the close of the previous Friday. The NASDAQ closed at 2,218.93, down 0.8% from 2,235.59 for the week. In U.S. interest rates, the yield on the ten-year U.S. Treasury note closed at 4.59% Friday, down 20 basis points from 4.79% at the close of the Friday before.

The manipulated nature of the economy is becoming more obvious lately, with the U.S. election related sharp drop in oil prices. A drop taking place amid swirling rumors of an imminent U.S. bombing attack on Iran, an attack that will surely interrupt Persian Gulf oil shipping. Interestingly, if letters to the editor and water cooler conversations are any guide, many people in the U.S. see the oil price drop as an election-season ploy by the Bush regime and its allies in Big Oil. And, since an illusionary improvement in the economy will not be enough to counteract the foreign policy disasters of the neocons in the public mind, rumors are swirling as well about an October Surprise. As the saying goes, that can’t be good.

But the drop has had its intended effect:

Economy Fades as Election Issue on Falling Fuel Costs
By Matthew Benjamin

Sept. 22 (Bloomberg) -- Plummeting gasoline prices and a buoyant stock market may be weakening the power of the economy as an issue for Democrats less than seven weeks before U.S. congressional elections.

A majority of Americans -- 54 percent -- say the U.S. economy is doing well, according to a new Bloomberg/Los Angeles Times poll. That's up 4 percentage points from the beginning of August, when the price of a gallon of gasoline was an average of 54 cents higher and the Standard & Poor's 500 stock index was 4 percent lower. President George W. Bush's approval ratings on handling the economy also rose.

Almost 1 in 3 poll respondents said lower gasoline prices have enabled them to spend more on other household items.

“If there's any way that voters link economic uncertainty with what they experience on a daily basis, it's through what they feel at the gas pump,” said Amy Walter, an election analyst for the nonpartisan Cook Political Report in Washington.

According to Gary Dorsch, oil traders’ feeling that war with Iran is not going to happen has helped to bring about weak oil prices. These traders have been looking at Europe for indications of an attack on Iran:

Unwinding the $15 per barrel Iranian ‘War premium”

The most influential driver behind the CRB’s plunge since August 8th however, was the unwinding of the Iranian “war premium” which had inflated the price of crude oil by as much as $15 per barrel this year. Iranian negotiators have skillfully split the British, French and the German coalition away from the Bush administration’s hard-line stance for economic sanctions against Iran.

Iran’s rulers have always relied on the Russian and Chinese veto to any economic sanctions, but now there are signs the Europeans are also seeking a way out, once the moment of truth had finally arrived. On Sept 13th, British Foreign office minister Kim Howells waved the white flag, “I can’t see a military way through this, and I’m not sure that even there’s an easy way for the UN to impose sanctions," he told parliament’s Foreign Affairs Committee.

Economic sanctions against Iran would jeopardize more than 10,000 jobs, the German Chamber of Commerce said on Sept 1st. “Economic sanctions against Iran would solve none of the political problems. But the German economy would be hard hit in an important growing market.” France’s oil giant Total is interested in a 10-15% stake in Iran’s Azadegan, seen as one of the largest unexploited oilfields in the world, said head of exploration Christophe de Margerie on Sept 12th.

On Sept 18th, Norwegian energy and aluminum giant Norsk Hydro, signed an oil exploration deal with the National Iranian Oil Company for the Khorramabad block in southwestern Iran. “If exploration proves to be successful, the period of the agreement will be 25 years,” Hydro said.

Iran’s chief nuclear negotiator Ali Larijani reportedly offered a 2-month suspension of Tehran’s nuclear enrichment program in talks with EU foreign policy chief Javier Solana, which sent crude oil plunging below $66 per barrel. Still, there are questions of whether or not Iran’s internal debate is over, and if the concession by Larijani is fully backed by the Ayatollah Khameinei and president Amadinejad in Tehran.

Without the imposition of UN sanctions or the threat of military action against Iran, crude oil succumbed to the laws of supply and demand. US stockpiles of crude oil were 327.7 million barrels last week, or 18% higher from two years ago, when crude oil was trading at $45 per barrel. Unleaded gasoline prices tumbled 65 cents a gallon since August 1st, and boosted US President George Bush’s approval ratings by 3% to 41% last week, with seven weeks left before mid-term US elections in Congress.

OPEC, which supplies 40% of the world’s oil, has been pumping 28 million barrels per day (bpd), since November 2004, when crude oil first touched a record $50 per barrel, but was unable to stop the surge in crude oil to a record $78.40 /bl in July 2006. But with a bearish market mood and unwinding of the Iranian “war premium”, crude oil traders seized upon OPEC’s Sept 11th pledge to leave its output unchanged at 28 mil bpd, and dumped oil to as low as $62 per barrel on Sept 15th.

Crude oil traders are beginning to view the Bush team as a paper tiger in dealing with Iran. Other traders think the gloves will come off after the US Congressional elections on November 7th, when whispers of a US military adventure could grow louder. In any case, China’s crude oil imports rebounded 15% to 11.8 million tons in August, which could put a floor under the market at $60 /barrel.

Of course, oil traders may have made the mistake of ascribing rational calculations to those who would be ordering the bombing of Iran. Colonel Sam Gardiner, in a recent paper for the Century Foundation reminds us that the Bush/Neocon decision-making process does not use the usual standards of self-interested diplomacy:

Unfortunately, the military option does not make sense. When I discuss the
possibility of an American military strike on Iran with my European friends,
they invariably point out that an armed confrontation does not make sense—
that it would be unlikely to yield any of the results that American policymakers
do want, and that it would be highly likely to yield results that they do not. I
tell them they cannot understand U.S. policy if they insist on passing options
through that filter. The “making sense” filter was not applied over the past four
years for Iraq, and it is unlikely to be applied in evaluating whether to attack

We have written about the puzzling nature of gold in financial markets. Gold is both a commodity and a currency. Lately, since the U.S. dollar has been holding its value, gold has acted more like a commodity, dropping along with other major commodities. But the drop seems to have found its bottom lately with downward pressures from general commodity markets counterbalanced by upward demand pressures. Here’s Gary Dorsch in “What’s behind the Meltdown in the Commodity Markets:”

Gold Tumbles Under $600 /oz

Gold tumbled under $600 per ounce last week, in line with a weaker crude oil and CRB index, telegraphing lower headline inflation in G-7 oil importing countries in the months ahead. Gold has also been pressured by fears of by European central bank sales ahead of a Sept 26th fiscal year-end that limits sales to 500 tons per year. So far, European central banks have only sold an estimated 340 to 360 tons this year.

With central bankers coordinating their tightening moves, there has been little volatility in the foreign exchange markets to influence the price of gold. Instead, gold traders are focusing on crude oil and other key industrial commodities for clues about the future direction of inflation. Supporting the gold market however, is speculation of eventual Chinese central bank diversification into gold. Only 1% of China’s $954 billion of foreign currency reserves are held in the yellow metal.

The US current account, the broadest measure of trade with the rest of the world, includes both trade in goods and investment flows, widened in the second quarter to $218.4 billion, and remains a major risk for the global economy. The US deficit totaled 6.6% of gross domestic output, the same as in the first quarter. That compares with China’s current account surplus of 7% of GDP.

With pressure mounting on Beijing to revalue it yuan upwards, China could quietly build a gold position in a declining market. Fan Gang, a member of China’s central bank monetary policy committee said on August 29th, "The US dollar is no longer a stable anchor in the global financial system, nor is it likely to become one, therefore it is time to look for alternatives.”

We can probably expect weak gold and oil prices until the October Surprise, whatever it turns out to be and whoever is directing it. Be that as it may, if commodities are dropping in anticipation of reduced industrial demand, then why are stocks doing so well? According to Michael Nystrom stocks are reacting to one thing only: interest rates. Nystrom makes a useful distinction between the real economy (the economy of those who make things) and the financial economy. The real economy is doing very poorly in the United States, while the financial economy has been fine.

Imminent Decline Dead Ahead

A number of factors are converging this week that I think will lead to a substantial reversal. While I normally don't like to go out on such a limb, there are enough factors lined up this time that I think it is warranted, and if I am wrong, it should be immediately obvious. This week is do or die time for the market.

Ford's Example

Let's start off by looking at the chart of the Ford Motor Company. Last Friday, Ford announced big news and the stock got killed - down almost 12% in one day! The price action in Ford, I think, is a preview of what we're going to see going forward in the general stock market.

Since mid July, Ford's stock rallied over 50%. It was an impressive gain, but the price action was purely technical: It was a standard short-covering rally with prices advancing steeply over a short period of time on very little volatility. There was a jittery drop in mid-August but a quick recovery and resumption of the steady upward progress, culminating in a two-day price explosion just before Friday's big bomb. Why did Ford rally? For the past several years, and certainly through the entire recent rally, the situation at Ford was grim and getting worse: The company was/is/has been losing market share, losing money, has high costs, the wrong products, etc, and everyone knew it and had known it for years. There had been no change in Ford's fundamentals. The fuel for the brief, sharp rally was therefore provided by bears who were short and got caught in a typical short squeeze. In this case, the squeeze culminated in a mini buying panic that sent the stock up nearly 9% in just two days before the big drop on Friday. The funny thing in this case is that Friday's sharp drop was precipitated by news that Wall Street usually likes: Ford is laying people off, slashing jobs, slashing salaries, cutting costs and closing plants. Under Wall Street's standard logic, what is bad a company's employees is usually good for its stock price. (In this instance, however, Ford is also suspending its dividend, which is very bad for shareholders and a sign that things are very grim indeed.) Parallels to the General Market

Now I'd like to look at the lessons that Ford holds for the overall market, represented by the S&P 500 cash index. Like Ford, the SPX has had a decent rally from mid July to present - close to 8% - while the news for the real economy has been getting progressively worse. The housing market is really slowing down, the trade deficit just hit a record high, and corporate layoffs are surging. We've had no fundamental change in this story, and in fact things appear to be getting worse. But while the real US economy - the economy that is involved in making things - seems to be on the ropes, the financial economy - the one that is involved in using money to make more money - seems to be doing just fine, as measured by a single indicator: Interest rates. They're coming down. And the most recent data indicates that the Fed is done raising them. This single factor is the primary impetus behind the current rally. It is what has gotten the ball rolling, and short covering is taking care of the rest. But to see how this one is going to end, just refer back to the Ford chart above.

Look at the shape of the most recent rally, from the July lows. From a classical technical analysis perspective, this is called a rising wedge. From p. 189 of Edwards & Magee's technical analysis classic, we learn that:

Once prices break out of the Wedge downside, they usually waste little time before declining in earnest. The ensuing drop ordinarily retraces all of the ground gained within the Wedge itself, and sometimes more (p.189)

From an Elliott Wave perspective, this is called a rising diagonal or an ending diagonal:

An ending diagonal is a special type of wave that occurs primarily in the fifth wave position at times when the preceding move has gone "too far too fast," as Elliott put it…In all cases, they are found at the termination points of larger patterns, indicating exhaustion of the larger movement." (EWP , page 36) Furthermore, "A rising diagonal is bearish and is usually followed by a sharp decline retracing at least back to the level where it began." (EWP, p.39)
To make matters even worse for the bullish case, the index is right at resistance provided by both the upper end of the diagonal, but also by the recent May highs. Sustaining an advance beyond this resistance will not be easy. And Friday's price action was weak: The market hit its high in the first hour of trading, then spent the rest of the day giving back its gains. Based on the indicators I look at, this market is overbought at multiple levels of trend: monthly, weekly, and daily. Like with Ford, all it needs now is a trigger to set it off.
Talk about a “trigger” brings us right back to the October Surprise.
But what about the price of oil, you ask? Since it's falling, isn't that fundamentally bullish for the market? And since interest rates are falling, won't the housing bubble be able to reflate? The short answer is, no. Falling oil prices reflect falling demand, which signals a recession. And yes, the housing market may see a second wind due to falling interest rates, but it is likely to be no more than a dead-cat bounce. The top is already in.

CEO’s, in their capacity as managers of the real economy, that is, and not as participants in the financial economy, see recession ahead:
CEOs grow pessimistic about outlook
Business Roundtable index falls to lowest mark in three years
By Greg Robb, MarketWatch
Sep 18, 2006
WASHINGTON (MarketWatch) -- Chief executives at major U.S. corporations are more downbeat about prospects for the economy than at anytime in the past three years.

The Business Roundtable CEO economic outlook index fell to 82.4 in the third quarter from a reading of 98.6 in the second quarter. This is the lowest level since July-September 2003 for the survey, which had averaged 97.6 over the past year. Read full survey.

Seventeen straight interest-rate hikes engineered by the Federal Reserve as well as higher energy costs are beginning to slow growth, said Harold McGraw, chairman of the Business Roundtable and chairman and CEO of McGraw-Hill Cos.

Of those CEOs surveyed, 39% said they anticipate increasing their capital spending in the next six months, while half see no change in their spending plans and about 11% expect to cut their capital spending,

CEOs see "a much-slower second half that will logically continue into next year," said McGraw during a teleconference with reporters.

The nation's softening housing market has also been a burden, he said.

"The overall picture for the economy in the months ahead remains a bit unclear," in light of mixed variables, McGraw said.

Energy prices "remain the wild card." There has been some improvement in energy prices, but prices seem to be event-driven, he noted.

The biggest concern for big companies is the impact of energy costs and other inflationary pressures on profits.

There was a mixed response to a special survey question asking CEOs to assess if their companies are able to pass along higher energy costs.

Only about 21% of the companies said they have been able to pass increased energy prices to along their customers, while another 33% of CEOs said they were only partially able to pass along these increases.

The Mainstream Media also see problems ahead for stocks due to the clear bursting of the housing bubble:

Can Wall Street withstand weak housing?
Some experts say real estate slump may spell trouble for equities

Peter Coy
BusinessWeek Online
Sept 19, 2006

If your nest egg is made of 2-by-4s and you're watching the real estate slowdown with a mixture of fear and nausea, then this article is for you.

The question: If real estate tanks, will stocks follow? Or will the market ignore housing? Or maybe — just maybe — will a decline in housing trigger a rise in stocks? It's something you really ought to think about if you're trying to figure out where to put your money.

Conventional wisdom, and some historical evidence, suggests that a decline in housing is associated with a fall in stocks. Evidence of a slump continues to mount: On Sept. 18, the National Association of Home Builders said its monthly sentiment index fell to a 15-year low. And on Sept. 19, the Commerce Dept. said that housing construction fell 6 percent in August to its lowest level in three years — an annual rate of 1.67 million starts.

"If that's not meltdown, it's pretty close," Ian Shepherdson, chief U.S. economist of High-Frequency Economics, said in a research note. The prospect of stocks plummeting at the same time housing falls into a slump is bad for homeowners, because it means no port in the storm. But the case isn't completely closed: There's some tantalizing counter-evidence that stocks might do just fine in a housing downturn, or even benefit from it.

Time lag

Let's start with the main, bearish case. Making the rounds of investment advisers is a chart prepared by Merrill Lynch showing the Standard & Poor's 500 stock index overlaid on an index of homebuilding activity from the National Assn. of Home Builders. The chart shows that the S&P 500 goes up one year after the homebuilding index goes up, and goes down one year after the homebuilding index goes down. (The correlation is 0.8, which means it's pretty strong.)
The scary part: The homebuilding index has plunged over the past year. If you believe that history repeats itself, the S&P 500 is about ready for a nosedive.

Another chart — this one from InvesTech Research — correlates changes in private residential construction with recessions. Going back to 1968, it shows that with just one exception, every time there has been a downturn in residential construction, a recession has occurred at the same time or shortly after. (The exception: 1995.) That indicator, too, is flashing red, because residential construction has shrunk over the past year.

"Being a student of history, I would think I would want to play it very cautiously from a stock standpoint," says Standard & Poor's Chief Investment Strategist Sam Stovall.

Wealth effect

It makes some sense that a housing slump would be bad for stocks. First, there's the direct effect on jobs in construction, real estate brokering, mortgage lending, and so on. Goldman Sachs estimates that housing and related industries account for nearly 10 million jobs (payroll and nonpayroll combined).

Second, consumer spending has been buoyed by the housing boom. People spent more freely because they felt wealthier and because they turned their homes into piggy banks through home equity loans, cash-out refinancing, and other means. Take away jobs and consumer spending, and it's no wonder that many experts expect a housing slump to hurt stocks.

By this view, stocks aren't a good choice right now. What, then? Barry Hyman, equity market strategist for EKN Financial Services, says that the same rising rates that have squeezed housing have given investors a nice alternative: money market accounts, which are yielding better than 4 percent, and bank certificates of deposit, some of which yield 5 percent or more.

'Down But Not Out'

Super-bears on housing have different advice. John Talbott, author of the none-too-subtly titled "Sell Now! The End of the Housing Bubble," recommends avoiding not only the stock market, but banks, too, since lots of banks could be hurt by lax mortgage lending standards.

But not everyone is convinced that housing will crush stocks. Why? Some figure that the housing slump won't be severe or prolonged. Robert DiClemente of Citigroup argues that the adjustment to a slower rate of sales is well under way. He says that the issuance of building permits is actually 10 percent below the rate of new-home sales. This process "will clear the overhang of houses within the next six to nine months," DiClemente predicts in a recent research note. The headline on his report: "Down But Not Out."

Others say it's too soon to declare the stock market dead because of housing. "Summing it up, I'm in the camp that says I don't know and the jury is still out," says Jeffrey Saut, equity strategist for Raymond James Financial.

Back to the future

Then there are the outright optimists. Bob Carey, chief investment officer for First Trust Advisors in Lisle, Ill., says that the stock market is 20 percent to 25 percent undervalued at current levels and should reach full valuation by sometime next year, which means: Get ready for a heck of a bull market. Carey says the demand for housing is driven by incomes and jobs, and since corporate profits are extremely strong, the outlook for income and job growth is good. Says Carey: "It's hard to imagine Corporate America doing well and somehow people not doing well on the employment side."

Carey has seen Merrill Lynch's chart showing a tight correlation between homebuilding and the S&P, but he says the pattern dates back only a decade or so. Before then, there was very little correlation, and he says the economy might return to that older pattern.

It's also possible that the housing slowdown could prod the Federal Reserve into cutting interest rates, which could boost stocks. Maybe, too, speculative investors will go back to dabbling in stocks instead of real estate, the way they did before the dot-com bubble burst and the real estate boom began.

Clearly the bulls have been vastly underestimating the consequences of a housing bust. Here’s Michael Shedlock:

No Hard Landing
Monday, September 18, 2006

I have it on great authority that there will not be a hard landing in real estate.Who told me that? It was none other than Mike Morgan at MorganFlorida. Please listen in to what Morgan has to say.

Mike Morgan:

Will there be a hard landing? No!

Will there be a crash landing? Absolutely!

Despite September’s short covering of home builders and value buyers trying to cash in on low P/Es and stocks selling at or below book value, a hard landing is now out of the question. We’re in for a market crash. Read between the lines, or read actual comments for content.

Here’s what Robert Toll, CEO of Toll Brothers said at the Credit Suisse conference. “The market got ahead of itself in recent years, citing "greed on the part of buyers and sellers, and that the current level of speculative inventory is probably the largest ever.”

And how about Don Tomnitz, CEO of D.R. Horton. “We have never seen housing prices and demand slow as quickly as they have during this down cycle."

Take it a step further and look at the statistics. Never before have we seen inventories at these levels. Recently NAR finally admitted home price are coming down. Never before have we seen home prices fall. And RealtyTrac just announced that foreclosures are up 53% from a year ago.

For those “value investors” buying the home builders because the P/Es are so low, I ask, “What happens when there are no earnings?” And for those “value investors” buying for the book value, I ask, “What happens when the builders take massive write downs to land, and burn up cash with carrying costs of unsold inventory?”

But that’s not even the heart of the current problems. For the last two weeks I’ve been receiving daily calls from desperate mortgage brokers, real estate attorneys, insurance brokers, title companies and subcontractors looking for deals and work. This week I spoke with a real estate attorney closing his office and returning to the corporate world. And several of the smaller builders have called me offering triple commissions to entice sales of their inventory. It doesn’t end there.

Who will the housing crash effect? Everyone. Real estate agents will be first. As a group, they’ve made a ton of money during the housing boom, and they’ve spent millions on new cars, vacations, restaurants, clothes, and everything else that comes with excessive discretionary income. That’s over now. Agents are not buying the luxury items that helped feed the economic boom, and they are cutting back on business spending like advertising and marketing. That hits the vendors and newspapers revenues.

Take it a step further. With sales off 50% and more, all of the industries that have benefited from the boom, will suffer loss of revenue and jobs at accelerated rates and massive proportions. Home builders and condo developers have been announcing cancellations of projects and cut backs in spec building. The flippers fed the housing boom, and they’re washed up right now. In fact, they are making the crash much worse than it should have been.

Many flippers bought multiple properties. When in the history of the world have we ever seen the housing industry conduct business like a stock exchange. We had bidding wars. We had lotteries on new developments, just like we had allocations for new tech offerings during the late 90’s. And just like the tech boom, the buyers were not making decisions based on fundamentals. Take a look at the recent Vonage offering, where buyers don’t want to pay for their stock, because the price dropped after the public offering. The same thing is happening in the housing market, with thousands of buyers walking away from deposits, refusing to close on homes. That adds to the woes of the builders.

And just like we saw a tech crash with everyone rushing to sell, we’re now just starting to see flippers dump properties for 200-400% losses on their deposits. Add to the woes, the fact that interest rates are up and most flippers bought using creative financing and low rate ARMs.

But this is all old news for us. The other shoe is dropping now. Loss of hundreds of thousands of jobs created from housing will act like a virus and spread throughout our economy. As real estate agents, attorneys and mortgage brokers reign in their spending, it will effect restaurants, car dealers, advertising companies, jewelers, remodeling contractors, furniture manufacturers, bank profits, electronic retailers, clothing and the list goes on and on and on.

As the primary players are effected, and they cut back on spending, so will the secondary players in this market. These companies will be forced to lay off employees, and the cycle will grow like a virus. Is that it? Not a chance.

The housing market benefits most when rates are low and jobs are being created. With rates rising and job loss skyrocketing, the affordability index for homes drops in step. The buyers that are still in the market can not afford the same home they could a year ago. On average, with the rise in interest rates, the buyer that could afford a $500,000 home a year ago, can now only afford a $425,000 home. But with the loss of jobs growing, there are fewer buyers that can afford the $425,000 home and many existing homeowners that can no longer afford to make their monthly mortgage payments.

So now we have a third group of sellers scrambling for the ever dwindling buyers’market. You’ve got the flippers desperate to sell. You’ve got the builders stuck with inventory of unsold homes, and now you have the group of sellers that are being foreclosed or simply decide to sell because they can no longer swing the monthly mortgage payments after losing their jobs.

Nonsense? Hardly. I spoke with a real estate agent the other day that has not sold a home in three months. His wife works for a title company and was just laid off. He’s now sending out applications for a job in his former field of banking. Lots of luck. He’s been out of the field for five years, and he’s 54 years old. They have two kids in college and a hefty mortgage. Oh, by the way, did I mention they own three flip properties that they can’t sell.

How about the attorney that is closing his office and returning to the corporate world. He’s laying off six people in his office. And how about the builder that called me this week. He employs about a dozen people, as well as a small army of subcontractors. He’s closing up, and he has unsold inventory that he cannot sell at a profit. That means the dozen employees are out of work, and his army of subcontractors are out of work for the first time in four years.

And how about my office. I’ve decided to lay off one of my team members. She’s a single Mom, but as much as it hurts to break the news to her, I have no choice. If things don’t pick up within the next 30 days, I will be forced to lay off a second team member. When you do the math, the choice is survival. It doesn’t end there. Realistically, if things do not pick up within 90 days, I will close my office and concentrate on my other businesses. This is reality, and you’re hearing it from the horse’s mouth.

Multiply these four scenarios by thousands and you have a crash. A hard landing is out of the question at this point. The economists should be talking about how devastating the crash will be.

…When we last talked we were both laughing about the Senate Hearings on the Housing Industry. All of the negative comments were sugar coated. Both of us think this is the tip of the iceberg. This mess is going to spread to subprime lenders, mortgage companies offloading mortgages to pension plans, and all sorts of other fiascos that neither of us can clearly see at the moment. Senate hearings have just begun.

The USA Today is reporting More fall behind on mortgages.

Calls to the Homeownership Preservation Foundation, which provides free credit counseling, hit a record 2,464 in August, a 25% jump over July. More than half of the distressed callers had ARM loans."It's alarming. It really is," says Pam Canada, executive director of the NeighborWorks Homeownership Center in Sacramento. Her non-profit counseling center used to receive two or three calls a week from homeowners in financial quicksand; now, it's 20 a week.More homeowners with shaky credit are falling behind on their mortgage payments, especially in such states as Ohio, Alabama, Tennessee, Michigan and West Virginia, where job losses have struck the local economies, the Mortgage Bankers Association said Wednesday.The problem is the worst for those with subprime credit who pay higher-than-usual interest rates and who have adjustable loans that have been resetting to higher rates. About 12.2% of such borrowers were late paying their loans in April through June, the highest level since the end of 2003.

In Ohio, which has lost thousands of manufacturing jobs, the foreclosure process was already underway for 11% of homeowners with subprime ARMs — the nation's highest rate. In California, which had the nation's highest number of risky ARM loans, delinquency rates are still near historic lows. "There's no place to go but up," says Doug Duncan, the MBA's chief economist.

Foreclosures and delinquencies have "no place to go but up". That is the key message that Morgan, Duncan, and I have been saying for quite some time. No, there will not be a hard landing. We will crash.

Another major economic storm on the horizon is the future of the China boom.

Is China on the Brink?—and Why It Matters for the United States

September 18, 2006
Thomas Au

China is now feeling the strain of almost a decade of torrid growth. Although there are plenty of worrisome signs, the conventional wisdom is that things will be fine through the 2008 Olympics. I have a slightly different view of the timing of a pullback in that country’s economy, which could be especially bad, given likely upcoming developments in the United States (and elsewhere in the world).

One example of prevailing opinion is that of James Jubak, a guest columnist, who thinks that the Chinese economy is headed for “a train wreck,” having just passed “the point of no return.” Cheap U.S money, operating through China’s mammoth trade surpluses and dollar reserves, has fueled a steroidal double-digit GDP growth that has even the local authorities worried. The result is that key industries such as cement and steel are seeing profit plunges because of price pressures caused by overcapacity. This is spreading to a number of areas, mainly the commodity producers dominated by state-owned-enterprises (SOEs), many of which are bankrupt in all but name, and are propped up by outstanding bad loans from state banks.

I disagree with Jubak about one important thing though, in my belief that the crisis in the Chinese economy will not take place in 2009, after the Olympics as Jubak opines; it will take place before, in late 2007 or early 2008. What has been driving the Chinese economy is not the 2008 Olympics per se, but rather the anticipation of the Olympics, which will mostly end in 2007. The infrastructure buildup in advance of the hosting of the games has been giving a one-time artificial, and foreign-based, stimulus to the economy, creating a gap that domestic demand cannot fill. By early 2008 on the other hand, investment for the Olympics will be winding down, as attention turns to last-minute fine-tuning of the event itself, likely causing a sharp drop in aggregate demand at that time. And markets often move on anticipation of major events, not necessarily on the events themselves. (“Buy on rumor, sell on news.”)

Jonathan Laing raised some related concerns in a recent Barron’s article. Runaway development is creating massive environmental problems, including calling into question the safety of air and water in much of the country. China needs five to six times as much energy to produce a dollar of GDP as the United States, so its energy use is now starting to approach ours, despite the vastly larger GDP stateside. And more of China’s energy is from pollution-creating coal. And there have already been spot shortages of essential commodities such as water and electricity. Given the country’s overloaded infrastructure, it wouldn’t take all that much to bring about a general shortage. Either this, or environmental problems, could quickly halt, rather than merely slow, growth.

In fact, one important question is how large is the size of the black hole of bad loans to SOEs, meaning how costly is it to keep the country more or less fully employed, thereby dampening social unrest. The official estimate of such bad loans is about $200 billion, an unpleasant, but manageable amount. But Ernst and Young did a study that initially pegged the true figure as closer to $900 billion, roughly the size of China’s foreign exchange reserves (the world’s largest), before the firm withdrew its findings under heavy pressure from the Chinese government. And as we learned from a painful experience with a company called Enron, America’s accounting firms tend not to overestimate the magnitude of problems. My guess is that China’s bad loans are north, rather than south of $1 trillion.

Moreover, there is widespread corruption at the banks that lend to the SOEs; officials at China’s second and fourth largest state banks were recently arrested for embezzlement and fraud. Less dishonest, but only slightly less troubling problems include the lack of underwriting standards and regulatory oversight, because of the banks’ social mission to prop up the SOEs, which provide the largest proportion of China’s jobs (because the private sector is more efficient, and hence less labor intensive).

Moral hazard is clearly at work, as rapid growth encourages a “get rich quick” mentality, causing people to cut corners and bend the rules, creating widespread discontent among the hundreds of millions of people who are not participating in, and are fact harmed by, the recent “economic miracle.” This is causing protests, riots, and other events that threaten social stability. In order prevent the details from getting out, China is passing laws forbidding the divulging of “government secrets,” particularly those about natural or other disasters, especially when reports about bureaucratic incompetence are involved. Even printing a critical article like this one, while legal in the United States, might soon be illegal under evolving Chinese law. When a government goes out of its way to suppress the truth (as it did in the former Soviet Union), it is a sign that the truth is probably too bad to tell.

All this wouldn’t seem so critical if it weren’t for the fact that I believe that the United States will have a recession in 2007. This would be a result of our own, somewhat milder version of China’s problems, which would start with the impending bursting of the consumer bubble (particularly in housing) caused by the Fed’s earlier easing and more recent tightening. Under ordinary circumstances, the U.S. economy should begin a comeback in 2008, after a cleansing period, although whether that would be enough to elect a Republican President would be very much open to question. (The muted 1992 recovery from the 1990-91 decline was not enough to re-elect George Bush Sr.)

But the timing and degree of a prospective Chinese crash raises the stakes. In 1931, the United States was in a recession that then-President Herbert Hoover reasonably thought would soon end. The impending recovery was derailed by the collapse of the German economy, then the second most important in the world, not only because of its sheer size, but because of its connections to other countries in Europe. China’s economy plays a similar “second most important” role today because of her ties in Asia and elsewhere, and because its swings are larger than those of other, nominally larger, economies such as those of Germany and Japan. If a collapse of the Chinese economy comes hard on the heels of a deep U.S. recession in 2007-2008, the result could be a prolonged slowdown of global growth such as we saw in the 1930s.


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