Look at the value of Social Security now that Wall Street has collapsed

We have heard for years from Investment salespeople what a bad investment Social Security is and how much better we can do if you buy their snake oil investment products.

Yeah. Right. Nathan Newman, riffing off of a Wall Street Journal article points out that for all the money investors have lost in the recent Wall Street meltdown, financial assets provide only 15.4% of the income for those over age 65 while Social Security provides 39.6% of their income.

That social security income is not tied to Wall Street ups and downs. Instead it is contracted to be delivered regularly with annual updates for inflation. The WSJ article points out that this is "an inflation-adjusted immediate annuity." As such it has an immediate value to retirees and those nearing retirement that can be measured in thousands of dollars. It is also guaranteed by the government and cannot be taken away, unlike all Wall Street products.

That makes Social Security a damned good investment for most Americans.

Oh, and the scare tactic line the investment salespeople offer "It won't be there when you retire?" That's a load of crap. The very worst case scenarios suggest that after 2041 the income of the Social Security System will be only 89% of what is needed to pay full promised benefits. OK. Say the worst case scenario comes true. The law already states that if there is a shortfall in revenue the Social Security System will pay out the benefits at the level permitted by the incoming revenue, which means at worst, the promised benefits would be reduced 11%.

But the fact is that the estimates for future benefits have always exceeded the most likely estimates, with the worst case never having occurred.

Which would you prefer? A contractual annuity paid by a private insurance company that could go bankrupt as AIG just did, or a contractual annuity that is guaranteed by the U.S. government? The best you could hope for if you had a contract with AIG or a similar insurance company is that the government would step in and guarantee your benefits. With Social Security you already have that.

That makes Social Security a very good investment.

That means that Social Security is a much more certain and reliable source of retirement income than the more volatile wall street gambles investments can provide.

The bail-out scam

What's wrong with the Bail-out legislation? It doesn't actually fix anything, that's what. So why is everyone so panicked when the Congress didn't pass the bail-out?

What does it mean: "the bail-out bill doesn't fix anything?"

From Paul Krugman we get this explanation.

Via Yves Smith, a very nice piece by John Hussman laying out the balance sheet issue:

Let’s return to the basic balance sheet of a typical financial company before the writedowns:

Good Assets: $95
Questionable Assets: $5
TOTAL ASSETS: $100

Liabilities to Customers: $80
Debt to Bondholders: $17
Shareholder Equity: $3
TOTAL LIABILITIES AND SHAREHOLDER EQUITY: $100

Now let’s write down the questionable assets - not all the way to zero, but to $2:

Good Assets: $95
Questionable Assets: $2
TOTAL ASSETS: $97

Liabilities to Customers: $80
Debt to Bondholders: $17
Shareholder Equity: $0
TOTAL LIABILITIES AND SHAREHOLDER EQUITY: $97

This shortfall of protection on the liability side of the balance sheet is what causes a run on the institution, because once shareholder equity is gone, the only way to get at the debt to bondholders is for the company to declare bankruptcy.

Hussman then explains why the Paulson plan as originally sold didn’t provide any real answer to the problem:

The Treasury plan seeks to buy up those questionable assets and thereby protect the institution against failure. Problem is, suppose the Treasury buys those questionable assets at their going value of $2. Here’s the result:

Good Assets: $95
Cash Proceeds from Sale of Questionable Assets to Treasury: $2
TOTAL ASSETS: $97

Liabilities to Customers: $80
Debt to Bondholders: $17
Shareholder Equity: $0
TOTAL LIABILITIES AND SHAREHOLDER EQUITY: $97

Does this transaction protect the institution against failure? No! If you buy the bad assets off the balance sheet at their market value, nothing changes on the liability side!

Some of the Democratic add-ons may actually change things economically, but the basic bail-out bill will not.

But everyone says failure to pass the bail-out bill will cause the Great Depression to reoccur!

Really? Here's Dean Baker on the subject:

That's easy. You ask the bleating D.C. Intellectuals how failure to pass the bailout will give us a Great Depression.

The odds are that your favorite DC intellectual type has uttered some dire warning like that. After all, they all heard some authority like President Bush or a highly respected news reporter make such a claim. All right-thinking people know that we just have to give $700 billion to the Wall Street crew or the economy will collapse.

While all right-thinking people might know we need the bailout, just about all right-thinking people don't have a clue as to what they are talking about.

The Great Depression story is of course the most extreme case. No one has yet sketched out the sequence of events that will give us ten years of double-digit unemployment. But hey, if the scare story helps get the bailout passed -- and gets those uneducated skeptics in the hinterlands to buy it -- why not talk about the Great Depression?

So why would the Bush administration try to panic the sheep D.C. Intellectuals about the economy?

Read the Shock Doctrine by Naomi Klein. Bush is coming to the end of his eight year term, and his ability to convert America into a plutocracy will end with his Presidency on January 20, 2009. If he can tie up $700 billion dollars of taxpayer money, then the incoming President will not be able to pass universal health care, improve American education, or even make an effort to rebuild the middle class which the conservative movement is dedicated to destroying.

Think that the 700 plus point drop in the stock market Monday means anything? Yeah. It did. It means that the Bush administration flacks could frighten a lot of stockholders into selling stock. But the next day, most of it was bought back at decent prices. The Stock market is not the economy. It is the froth that rides on the economy. It is emotional and highly volatile. One day is almost nothing. Wait and see if the credit markets remain frozen up, and if they do, then that matters. Unfortunately, nothing in the bail-out bill directly addresses the credit markets. It's just going to make a lot of very wealthy men even more wealthy because money the federal government is going to tax from the middle class is going to be handed to them to continue gambling with.

One thing that has happened in 2008 with remarkably little mention. The U.S. now has three mega banks with no real competition. Citibank, Bank of America, and J.P. Morgan Chase. Talk about too big to fail! The U.S. has never seen anything like them.

The whole thing is quite disgusting, but any nation willing to turn control of itself over to its wealthiest members - its plutocrats - probably deserves what they are getting. A plutocracy. That's why the bail-out bill will pass in much the same form it was when Henry Paulson handed it to Congress.

Whats wrong with the bail out bill

From Naked Capitalism:

Nouriel Roubini Really, Really Hates the Bailout Plan

Did we say really? Even by the normal standards of Roubini's tendency to hyperventilate state his case forcefully, the good professor rises to levels of choler heretofore unseen.

Roubini focuses on many of the issues we have discussed in our earlier posts (most notably this one) but he teases out some of the issues in more detail. And he really hates it, whoops, I think we covered that already.

His big bones of contention are, like ours:

1. The plan is inefficient (ie, it doesn't discriminate between who ought to be saved or not, and in fact rewards those who created dud assets)
2. It runs counter to the best models of how to deal with this sort of problem
3. It does not punish current shareholders or management

This is by Yves Smith who is read by Paul Krugman.

Wachovia Bank annouces it's problems

The credit crisis has claimed another victim - Wachovia Bank, America's fourth largest bank. The new CEO, hired two weeks ago, is planning to shrink the bank and get out of the mortgage business. This report si from the Charlotte Observer:

Wachovia Corp. announced a whopping second quarter loss of $8.9 billion this morning, with plans to shake up its mortgage unit, slash its dividend payout to shareholders, and cut thousands of jobs. [Snip]

As reported in today’s Observer, Wachovia announced this morning that it plans to cease making mortgages through third-party brokers. At the end of the first quarter, about 30 percent of the bank’s mortgage loans were made through third-party brokers. As recently as last month, the bank said it remained committed to using those brokers, especially in areas where it doesn’t have brokers.

But in a memo to employees yesterday, Tim Wilson, the head of loan origination for Wachovia Mortgage, wrote: “Going forward, we will primarily focus on customers who have relationships with the bank, and who are located in geographies where Wachovia branches are located.”

The change in strategy is part of a larger plan to rein in mortgage losses, which have been on the rise since Wachovia’s $24 billion purchase of Golden West Financial Corp., a troubled California mortgage lender, in 2006. The so-called Pick-a-Payment loans, which Wachovia inherited from Golden West, have proved a headache for the bank and a lightning rod for shareholders, defaulting at higher rates than other mortgages.

In April, the bank tightened underwriting standards, and last month, it stopped offering the “negative amortization” option for Pick-a-Pay loans, which let the borrower pay less than the interest owed. Those loans are criticized by consumer advocates because their balance can increase instead of decrease. Wachovia has also said that it will help customers with Pick-a-Pay mortgages refinance into traditional mortgages.

Compare this report from The UK Guardian about the other major bank with headquarters in Charlotte, NC.

NEW YORK, July 21 (Reuters) - Bank of America Corp reported quarterly profit on Monday that fell less than expected on record revenue, boosting shares of the largest U.S. retail bank and mortgage lender despite a surge in bad loans.

The bank became the fourth of the nation's five largest to top quarterly earnings forecasts, joining Citigroup Inc, JPMorgan Chase & Co and Wells Fargo & Co.

Profit at Bank of America fell 41 percent, the fourth straight quarterly decline, as the bank more than tripled its reserve for loan losses because of falling home prices and a weak economy.
Offsetting this was a higher lending margin, near-record investment banking income and a $357 million trading profit, following $8.55 billion of trading losses in the prior three quarters.
"It suggests the credit crisis isn't as bad as people thought" for lenders, said Steve Roukis, managing director at Matrix Asset Advisors Inc in New York, which invests $1.4 billion. "A week ago there was tremendous fear about systematic risk to the system. There's definitely a floor here."

Second-quarter net income for Charlotte, North Carolina- based Bank of America fell to $3.41 billion, or 72 cents per share, from $5.76 billion, or $1.28 per share, a year earlier.

Excluding merger costs, profit was 75 cents per share. On that basis, analysts had expected 48 cents per share, according to Reuters Estimates. Revenue increased 4 percent to $20.32 billion, topping the average $18.26 billion forecast.

Bank of America also said its July 1 purchase of Countrywide Financial Corp, once the largest mortgage lender, will add to profit in 2008, sooner than expected, and result in $900 million of cost savings, $230 million more than expected.

Countrywide lost $2.33 billion in the quarter, including about $3.7 billion of credit-related write-downs and losses, Bank of America said. About 7,500 jobs, or 3 percent, will be eliminated from the combined companies, the bank has said.

Bank of America set aside $5.83 billion for bad loans, up from $1.81 billion a year earlier, largely for home equity, residential mortgage and homebuilding exposure.

The provision was nearly as large as the first quarter's $6.01 billion. Net charge-offs more than doubled from a year earlier to $3.62 billion from $1.5 billion.

Each bank, Wachovia and Bank of America, recently merged with a major mortgage broker. Each has suffered severe losses as a result, which is going to come straight out of bank capital. Losses from bank capital limit the ability of a bank to continue lending. Wachovia is shrinking as a result and getting out of the business of providing loans to independent mortgage brokers. That will at least give Wachovia more control over the quality of the loans they accept going forward.

Since Wachovia bought Golden West Financial a while back, before the mortgage crisis had blown up into the utter disaster it has recently become, they probably paid a great deal more for it than BoA did for CountryWide. In fact, BoA got CountryWide by issuing stock instead of paying for it. It was a fire sale of a company that could not survive otherwise.

In either case, though, mortgage lending is going to be quite restricted for the foreseeable future. Since both banks have lost capital all kinds of lending is going to be constrained. I'd bet the lending particularly to consumers is going to be reduced.

The current financial problems are not going to be fixed this year. That's the "bottom line" from this news.

I wonder what we will learn tomorrow?

The government is saving the mortgage industry by nationalizing the loses and handing the later profits to the bankers

Daniel Gross at Newsweek has now published a mainstream article that tells much of the unspoken the truth about the mortgage mess. He points out that the continued announcements over the last nine months that the latest gimmick to save the mortgage industry had solved the problem, only to be followed by new and larger problems, has made it very difficult to get investors to step in and refinance Freddy Mac and Sallie Mae.

The result is that the only remaining solution is for the government to take over those two agencies. Since Freddy Mac and Sallie Mae have been responsible for 70 of all mortgages sold in 2008, that means that the mortgage industry has already been nationalized. It belongs to the government. The only question is how explicit the ownership documentation actually is.

That means that the conservatives in government are directly responsible for subsidizing the losses while giving away all the profits in the mortgage industry since Alan Greenspan created the housing bubble by lowering interest rates to avoid a recession that would defeat Bush in 2004. [See Economics and politics of the Fed fund rate.]

The unregulated free market dreamed of by conservatives and pushed for by the Reagan Revolution has failed disastrously. The result is going to be more government subsidy, handing out taxpayer funds. The only question is whether the conservatives will obstruct efforts by the government to recover gains to pay the taxpayers back instead of just handing future profits to the bankers who created this mess.

Oh, wait. I forgot. Phil Gramm has told us all the Truth (as viewed by conservatives and Libertarians.) This is "this is a mental recession. .... We have sort of become a nation of whiners." Right. Phil Gramm and John McCain have theirs already in hand and to Hell with the rest of us.

Go read the Newsweek article. Then prepare for the lengthy period of stagflation that has already started.

More problems for consumers as the consumption-driven Recession grows

As I have said before, the current economic problems are not like the last two recessions. This one is driven by inadequate consumption, now complicated by the increase in energy costs. It's not part of the normal business cycle, it's a breakdown in the economic system itself.

Consumption can be "jacked up" by expanding the money supply (the Fed) and by expanding credit to consumers (the Banks.) The Fed has been pumping more money into the banking system hand and fist, but the major effect has been lower to international value of the dollar and add to the increase in energy prices. The credit crunch growing out of the mortgage problems and mixed with a large number of "innovative" investment vehicles like Collatoralized Debt Obligations (CDOs) has caused the collapse of Bear Stearns and has required all of the major American banks to obtain more capital in order to avoid a fate similar to that of Bear Stearns. We have been hearing reports that the credit crisis is nearing the end and that things are looking up for bankers and, as a result, for the economy.

If only.

Now we get a new set of problems growing larger.

By Kevin G. Hall | McClatchy Newspapers

WASHINGTON — The credit crisis triggered by bad home loans is spreading to other areas, forcing banks to tighten credit and probably extending the credit crisis that's dragging down the economy well into next year, and perhaps beyond.

That means consumers are going to have an increasingly difficult time getting bank loans for car purchases, credit cards, home equity credit lines, student loans and even commercial real estate, experts say.

When financial analyst Meredith Whitney wrote in a report last October that the nation's largest bank, Citigroup, lacked sufficient capital for the risks it had assumed, she was considered a heretic.

However, Whitney was proved correct: Citigroup pushed out its CEO, sought foreign investors and slashed its dividend. Her comments now carry added weight on Wall Street, and she has a new warning for ordinary Americans: The crisis in credit markets is far from over, and it increasingly will affect consumers.

"In fact, we believe that what lies ahead will be worse than what is behind us," Whitney and colleagues at Oppenheimer & Co. wrote in a lengthy report last month about threats faced by big national banks, including Bank of America, Wachovia and others.

Consumption drives the economy. Consumption creates the markets that investors build organizations to exploit and profit from. Without consumption spending there are no investable opportunities for investors to profit from. And people who want to be consumers are not customers unless they have money to spend. Since bout 1970 that money has come from savings, second family incomes, credit, and most recently, pulling out home equities by refinancing homes that have appreciated because of inflation and the housing bubble. Real wages have not increased to increase consumption because the increased income from greater productivity has been siphoned off in profits given to the already very wealthy who do not spend it on consumption. Sources of consumer income other than wages have topped out, and in the case of home refinancing, been sharply reduced. All that's left is expanding credit.

Only the banks are short of capital themselves, as the article shows, and are cutting back on credit. So don't count on the "strength and resiliency" of the American economy to make this a short recession. The economic happy-talk is being spouted by high-ranking bankers who do not yet realize that the fundamentals of the economy have changes, and their happy-talk is being picked up by mostly economically illiterate reporters who are trying to publish good news in the face of trouble.

So until enough policy makers realize that the bankers don't have control of the situation and that the economy has changed, the Recession will continue, to be followed by inflation. It's going to take wage earners being paid for their increased productivity to change that. That's going to take a while.

The homebuilding industry is in real trouble

From Calculated Risk:

The public builder BKs are coming. I'm not saying Horton will go BK [bankrupt], but more of the public builders probably will (like Levitt & Sons). There is simply too much capacity in the industry, plus too much debt, too much inventory, and poor demographics for housing in general. The next few years will be very difficult for the homebuilders, and I suspect 2008 will make 2007 look like a good year.

Greenspan kept the U.S. economy afloat during the Bush administration by lowering interest rates and encouraging both mortgage lending and the taking our of second mortgages to pay off credit card debt.

Consumer demand has been 70% of total demand and demand determines the level of the economy. Since real wages have not increased since 2000, the only source for increased consumer demand has been debt (credit card and then second mortgages or total refinancing to get access to the increased value from housing price increase during the housing bubble) or more work - moonlighting or overtime, or more work by the spouse - to fund consumer spending.

Now the housing bubble has collapse followed by the mortgage market, and as a reaction the credit markets which had expanded by borrowing on the supposedly secure home mortgages has also collapsed. The impact on the homebuilding industry is only just beginning.

Atrios points out that the unemployment rate is inching up. The CNBC report he links to also points out that inflation is creeping up. the New York Times also points out that Federal Reserve is pumping money into the economy by letting banks borrow directly from the fed - that indicates that the banks can't get the money they need to keep operating from the markets, so they are going hat-in-hand to the fed. That money being pumped into the economy, together with increased prices for imports (especially oil) as the dollar drops is going to cause more inflation.

The fed is trying to keep the inevitable 2008 recession from being a serious one, but what they are really doing is kicking the can down the road so that the coming Democratic President is in office before they let the full force of the Recession hit. Like Greenspan did in Bush's first term, the fed will keep interest rates as low as possible during the Republican administration, then turn around and deal with the inflation they are currently causing by sharply increasing interest rates in 2009.

This is not a conspiracy theory. Look at what Greenspan did - lowered interest rates through the 2004 Presidential election and released the mortgage brokers to issue junk mortgages to people who couldn't pay them back. Then, immediately after Bush was sworn in the second time he started increasing the interest rates sharply, killing the housing bubble he had created. The timing makes it clear that it was all about manipulating the economy to ensure Bush's reelection.

Bernanke is kicking the can of recession down the line until after the November 2008 election to protect as many Republicans as possible. Then, the Federal Reserve will have to deal with the inflation the only way possible - make the Recession even worse by increasing the interest rates.

The Wall Street Republicans got us into this mess to keep Bush in office. They will do everything they can to prevent the Democrats from being able to deal with the problems.

Count on it. Watch the the fed let inflation grow in 2008 along with a mild recession, then watch the fed crack down in early 2009 and end the inflation with increased interest rates that cause a hard recession. The Wall Street Republicans wouldn't have it any other way.

Stories of financial problems from Credit Crisis

Why don't the finance experts know how much of the economy is going to be 'hit' by the fallout from the Mortgage crisis? Here are some examples:

E*Trades' problems E*Trade just sold a large batch securities backed by prime mortgages at fire sale prices. The problem has gone far beyond subprime mortgages.

They sold $3 billion worth of mortgages, of which $1.35 billion were prime secure mortgages to people with good credit ratings and good payment histories (prime, first-lien residential mortgages rated “AA” or better), for $800,000,000. That means they got $800,000,000 for the $1,350, 000,000 and nothing at all for the subprime mortgages! Those really good mortgages are worth 59% of face value in the current market.

The Florida local Government Investment PoolThe Florida “Local Government Investment Pool” is getting nasty. This Summer Florida Counties and cities had $27 billion in the pool. Then the credit crisis hit, and a lot of those governments got antsy and started withdrawing their money, so now it has only $14 billion. The State Board of Administration that runs the pool, and its three trustees, Governor Charlie Crist, Chief Financial Officer Alex Sink and Attorney General Bill McCollum, have declared that no other withdrawal requests will be honored. How widespread is this problem?

Nobody ever really knows precisely what's going on when a crisis like this hits. There might be as many as 100 pools like this across the nation, with assets of something like $200 billion.

They are supposed to offer daily liquidity for the public sector in much the same way that money-market funds do for the private sector. They are supposed to invest their clients' money in the safest possible securities, good old boring things like U.S. Treasuries, top-rated commercial paper and certificates of deposit.

It seems, however, that some of the commercial paper investments the Florida pool, and others like it across the country, purchased were backed by subprime mortgages and other things that have declined precipitously in value.

The people who manage the funds find themselves in the position of not being able to figure out exactly what the assets are worth, because they don't trade, or don't trade much, and no one seems to know what the stuff is. [Snip]

If enough participants withdraw, the pools will have to sell some of that stuff that nobody can figure out what it's worth. You can bet that Wall Street, which packaged and sold the stuff in the first place, isn't going to offer 100 cents on the dollar for it.

This means that not everyone will get all their money back. On Nov. 30, an advisory panel of local governments in the Florida pool held a conference call with members of the State Board of Administration.

You can also bet that the local governments that invested in those secure pools are not going to accept less than 100% of their investment back.

And it’s not just in the U.S.

The town in Norway The New York Times has the story of NARVIK, Norway, a town north of the arctic circle that purchased ‘secure’ investments in order to get a return on the money they did not need immediately but expect to need in the near future. The people of Narvik and those of three nearby town have lost at least $64 million Kroner, and maybe more.

Rental Property Where else is the mortgage crunch/credit crisis hitting? California, of course.

Unable or unwilling to sell their homes at declining prices, homeowners in Riverside and San Bernardino counties are converting them to rentals, glutting the market and causing rents to fall for the first time in years, according to Inland property managers.

Among the new landlords are investors who bought houses at peak prices and have watched their equity evaporate or homeowners who have relocated, leaving behind a house they can't sell.

There are so many Inland homes for sale, that even if no more come on the market, it will take more than two years to sell the houses available, according to the California Association of Realtors. [Snip]

"It is a good time to be a renter and a lousy time to become a landlord," said Denver. He said in the past six months, the average time it takes to rent out a house in Perris has lengthened from two or three weeks to two months. Rents have fallen about 5 percent. He said the average monthly rent has slipped to $1,100 in Perris.
Denver said today a $300,000 house purchased with a 7 percent down payment would likely require a monthly mortgage payment of $2,500. The same house, he said, can be rented for $1,300 a month, "and the owner has to do the repairs."

The common thread here is that a lot of people bought what were supporse to be safe, secure investments and treated them as such. The risk was hidden from the investors, so they literally have no idea how risky the investments they own, or as is the case of the people trying to sell homes, they can't sell because no one can get mortgages to buy them out.

The Florida investment pool mirrors what is happening to a lot of investment funds. What if your retirement is in one of them - well, you still have Social Security, as long as it is not privatized. Had Bush privatized Social Security, it would be going down the tubes just like the investment funds in Florida, in Norway, and in pension funds who don't dare tell anyone how much trouble they are having. That's assuming they even know right now themselves. They will know.

There are two big points. First, no one knows how extensive the problems are, but right now we are learning that they are extensive. There are going to be a lot more stories like these. Second, Things are getting worse and will continue to do so for an unknown period of time.

Let's not forget who brought this financial disaster down on us. See my Saturday post laying out Who's to blame for the credit mess.

Krugman explains the credit crunch in plain language

Paul Krugman's explanation of the credit crunch and the current market problems lays out both the problem and the reasons quite clearly. Certain statements are especially important:

• The ability to raise cash on short notice, which is what people mean when they talk about “liquidity,” is an essential lubricant for the markets, and for the economy as a whole.
  
• ...liquidity has been drying up.
  
• “What we are witnessing,” says Bill Gross of the bond manager Pimco, “is essentially the breakdown of our modern-day banking system, a complex of leveraged lending so hard to understand that Federal Reserve Chairman Ben Bernanke required a face-to-face refresher course from hedge fund managers in mid-August.”
  
• The freezing up of the financial markets will, if it goes on much longer, lead to a severe reduction in overall lending, causing business investment to go the way of home construction — and that will mean a recession, possibly a nasty one.
  
• Behind the disappearance of liquidity lies a collapse of trust: market players don’t want to lend to each other, because they’re not sure they’ll be repaid.
  
• ...what has really undermined trust is the fact that nobody knows where the financial toxic waste is buried.
  
• How did things get so opaque? The answer is “financial innovation” ...
  
• Why was this allowed to happen? At a deep level, I believe that the problem was ideological: policy makers, committed to the view that the market is always right, simply ignored the warning signs.
  
• policy makers left the financial industry free to innovate — and what it did was to innovate itself, and the rest of us, into a big, nasty mess.
  

The problem has the bankers scared, because they simply don't know how bad it is, nor what risks they have taken when they invested funds. The various new types of alphabetical investments were supposed to diversify away risk while keeping the high rates of income normally associated with greater risk in investing, but what those investments really did was just hide the risk so it could be ignored. Then many of the the investment institutions have leveraged themselves to make even more money, thinking that they were working with safe investments. Now they are finding that leverage not only magnifies earnings, it also magnifies losses, and the investments weren't safe at all.

So the economy has already lost home building and home buying as net positive sources of jobs and incomes. If the credit markets freeze up and cease to function, then business investment will join the housing industry and the economy will start losing even more jobs.

The job losses may have already started. The Commerce Department has just revised their second quarter 2007 report to say "personal income from wages and salaries grew at an annual rate of 1.6 percent in the second quarter, far below the 4.5 percent that had previously been estimated." As Kevin Drum reports, this is probably a result of revised estimates. It's not surprising that they got the estimates wrong, since the many banking innovations have created a set of financial markets that no one currently understands.

I have yet to see any reports on the credit crunch and the economic reactions that would even suggest a positive outcome in the near future, so I continue to expect a severe recession beginning early in 2008.

Let's not forget who brought this financial disaster down on us. See my Saturday post laying out Who's to blame for the credit mess. The collapse of the subprime loans, ARMs and poorly underwritten mortgages triggered the rest of the credit crunch, because mortgages were supposed to be a safe investment and the rest of the credit structure was built on the belief of that low risk investment.

Administration has admitted recession coming but how bad will it be?

What is happening to the economy?

Now that we know to expect a recession in 2008, how bad will it be? I've written before about the bind the federal reserve is in. If the economy slows down, the prescription is to lower interest rates. If inflation starts (and the dropping dollar and rising price of oil are pressing for inflation) the prescription is to raise interest rates. The fed can't do both at once, so it is hoping it can "muddle through" with only a little pain and no more rate cuts, and that the economy bail them out by turning back up so that they aren't faced with inflation that demands an interest rate increase.

Can the Fed make this work?

Throw in the current credit crunch as a monkey wrench in those Fed hopes. Jim Jubak at MSN Money points to the differing views of Wall Street and the Federal Reserve. Wall Street is of the opinion that the subprime mortgage credit crunch is just the tip of the iceberg. The Fed has already been pushed into making one interest rate cut it didn't want to make, and Wall Street thinks that there is a 90% chance that they will be forced to make another this year at their December 11th meeting.

The Fed believes U.S. economic growth can rebound in 2008 without another interest-rate cut and that cutting again raises the risk of igniting inflation and further weakening the U.S. dollar. Wall Street believes the debt markets and the big banks that support them are in such bad shape that disaster looms without another rate cut and another and another. Inflation be damned, Wall Street argues, the economy is at risk.

But what if there are more scary monsters hidden away in the securitized mortgages that the banks have been selling investors as investment grade investments that pay junk bond interest rates? And what about the survival of the companies who have purchased those investments and then borrowed money on them to make further investments?

The causes of the current problem

As we now know, those so-called investment grade securities paying junk bond interest rates were really junk (meaning high risk) in disguise. But a lot of investment companies treated them as low risk investments because that's what everyone else was doing. Jon Markman also at MSN Money, has written a report on hedge fund manager Mike Burry who recognized the mismatched risks and learned how to make money on the collapse of the mortgage market. He bet against the

fly-by-night mortgage brokers and major banks taking what he deemed "extremely unsuitable risks," using outlandish interest-only and adjustable-rate mortgages to get customers into houses they could not otherwise afford.

After listening to quarterly earnings conference calls by companies such as Countrywide Financial (CFC, news, msgs) and Washington Mutual (WM, news, msgs) and reading real-estate journals, Burry came to realize that home-price appreciation was the assumption behind every decision by borrowers, lenders, insurers and ratings agencies. He figured that once California home prices started to fall, the entire lending apparatus would fail and a credit crisis would ensue.

"It became clear to me that many people never expected to pay their loans back and depended on a rise in home values every two years to allow them to refinance," he says.

Burry has made about a 400% return on his bet this year as the mortgage crisis has become clear.

What's next?

The companies that bought those investments borrowed against them and loaned out that money also. When a lot of he investments default within a short time, those companies will also become insolvent and fail.

"I think we're headed into a deep recession, the worst since the Depression, as dozens of banks will fail," Burry says. "With massive foreclosures, there are homes that won't see the prices of two years ago for decades." And with the $500 billion home-equity spigot turned off, the money to pay off credit card debt, student loans and auto loans has evaporated. "We're looking at a lot of pain ahead."

How large is the problem?

This goes way beyond just subprime and ARM mortgages sold to people who can't pay the monthly mortgage after the ARMs reset. Merrill Lynch recently avoided hiring their first choice for their new CEO when he set a precondition that they determine how risky their investments were first. The Merrill Lynch Board of Directors would rather not know just how bad their investments really are all together. They just want the bad ones to pop up a few at a time so that they can be handled. It is my opinion that if they ever found out all at once how bad it is, the Board feared they would have to admit they were insolvent. Burry is not through shorting the credit market.

Burry remains short the corporate debt of major U.S. financial institutions, as he believes several will collapse under the weight of their write-offs. Optimists believe a Fannie Mae (FNM, news, msgs) or Citigroup (C, news, msgs) may be too big to fail, but Burry asks, "How many too-big-to-fail companies can fail at the same time?"

"Too big to fail." That means that if a company is so large that its failure threatens the existence of the market itself, the Federal Reserve will organize a rescue operation. But if too many companies that size fail at the same time, there will be no one left to bail out the ones that are failing.

That is a recipe for the worst recession since the Great Depression. I don't yet know if such a financial disaster is on the horizon. I do know that the experts expect a recession next year, and I also know that they tend to speak in very positive tones so as to not cause runs on the banks simply by acknowledging that there are financial problems. So I assume that the story that the recession is expected to be a mild one is the best possible scenario, not the most likely one. So I expect a reality that is somewhere between the disaster Burry says he expects and the mild recession the Bush administration Financial experts have admitted we should expect next year.

So with recession, there will be no inflation. Right?

One thing that seems very likely to be, though, is that along with the recession of next year we can expect inflation. The Fed is being forced into lowering interest rates, the dollar is dropping, oil prices are rising, and that all should lead us to expect inflation, unless by some miracle the economy turns around quickly and bails the Fed out. Exports are rising as the dollar drops. Unfortunately, employment is not increasing very fast, so the consumer (who provided 70% of the demand in the economy) is not getting any more money to spend.

A best case scenario would have the economy increase as exports increase, followed by an increase in total employment that exceeded the number of new workers entering the economy, and at the same time a lot of people who had given up looking for work would reenter the economy and keep the the unemployment rate around 5%. The real purpose of the unemployment rate measure is to predict the likelihood of inflation. If it drops below about 4%, then that is another pressure on the economy towards inflation.

Stagflation?

Unfortunately, the most likely scenario that I see gives us the combination of recession and inflation that lasted from the Ford administration through the first three years of the Reagan administration and was called Stagflation. That will be the direct result of the working out of the credit problems and the simultaneous actions by the Fed to lower interest rates to head off the worse recession and satisfy Wall Street.

So my present expectations are a worse recession than we are being warned to expect, together with extended Stagflation until the Fed clamps down on the economy and lets the bad securities take out the insolvent investment companies.

The blame

And this will be somewhere between bad and really bad. Who's to blame? It is the greed of a bunch of wall street investors and mortgage brokers who were unrestrained because of the Republican free trade mantra (most of the bad mortgages never should have been made), the rating agencies who were bought by the sellers of the junk securitized mortgages (the security seller would give the business of rating the security to the company that offered the best rating - again something that only government regulation could have prevented), Alan Greenspan who allowed the housing bubble to exist and did not clamp down on it because to do so threatened the reelection of Bush in 2004, and the Bush administration who knew what was happening but fought off either regulation or exposure of the problem just as they had in the Enron crisis.

Preparing for the future

Sensible people right now are getting out of credit card debt, paying down their bills, and saving what they can for emergencies. Anyone with a choice will want to be paid in Euros. Don't refinance a house with a fixed rate mortgage if you can afford the payments, because you may be able to pay off the home with inflated dollars soon. Just the uncertainty of what is happening is going to cause problems.

A lot of people will be making adjustments in their lifestyle. Start now and live more cheaply. The powers-that-be will be urging everyone to go out and spend more, in hopes that such spending will help the economy. the fact is, people who follow their instructions will be thrown under the bus when the real problems hit, and the free market conservatives will blame the individuals who listened to those who told them to spend.

Who knows? Maybe I am just acting as a Casandra. Maybe just a pessimist. But we know a recession of some level is coming, so this is not a time to be taking financial risks.

Another mortgage company in trouble

From Bloomberg:

Nov. 15 (Bloomberg) -- The risk of Residential Capital LLC defaulting on its debt soared on concern the biggest privately held U.S. mortgage lender may violate bank loan agreements, trading in credit-default swaps show.

Traders are speculating that Cerberus Capital Management LP and General Motors Corp. may allow the Minneapolis-based mortgage unit of GMAC LLC to fall into bankruptcy as the U.S. housing slump continues to deepen.

``As we continue to see conditions get worse and worse, the company clearly at some point has to reevaluate,'' Kathleen Shanley, an analyst at Gimme Credit Publications Inc. in Chicago, said in an interview. ``ResCap has an awful lot of secured debt, which raises the issue of `is it worth it.'''

Credit-default swap investors are demanding upfront payments of 37 percent and 500 basis points a year to protect ResCap bonds from default for five years, the highest on record, according to CMA Datavision in London. That compares with 32.5 percent upfront and 500 basis points a year yesterday. The cost rises as investors grow less confident in a company's ability to repay debt.

Credit-default swaps are financial instruments that cover losses on the underlying debt if the borrower fails to meet payments. A basis point on a credit-default swap contract protecting $10 million of debt from default for five years is equivalent to $1,000 a year.

A buyer of contracts for ResCap would pay $3.7 million upfront and $500,000 a year.

As long as new stories about companies in trouble because of the housing slump or the credit crisis keep appearing, things are getting worse rather than better.

Credit crisis is and will be really bad

Dow Jones has downgraded $37.2B Of collateralized debt obligations (CDOs). Of the $37.2 B, $14 billion worth of the highest rated CDOs were reduced from the highest rating of AAA to junk status. This follows nearly $20 billion worth of transactions which were reduced to junk status, while another 60 CDO transactions are still on watch for potential downgrade.

CDOs are risky mortgages which were bundled together and sold as less risky financial instruments because the bond rating agencies assumed that they would not all go bad at once, so the overall security should be safer than the individual mortgages.

This is another symptom of the fact that there are More mortgage loan problems.

What's behind the reports on this.

The Fed Chief has already reported that he is pessimistic about the further of the economy. When he suggests bad news for the future, he will always downplay the severity because if he ever said that the problems were going to be severe, his very announcement would set off troubles in the market that would make things economically more severe.

Combine the credit market problems with the dropping dollar and the increasing price of oil with the inability of the Federal Reserve to effect the problems by either increasing or reducing the interest rate, The American economy is looking at a tough period. The two questions remaining unanswered are how tough and how long.

The biased reporters

There is no clear answer to those questions, but keep in mind that the Fed Chief, Ben Bernanke, cannot announce any prediction that is not already common wisdom in the financial markets which are already built into market prices. So his prediction that there will be a recession in 2008 is common market wisdom already.

The only problem is, the market-makers themselves make a living by selling their services brokering the buying and selling of credit securities. If they as a group claim to be pessimistic about the future of the market, all orders will be to sell and no one will buy. That shuts down the markets and puts them out of business, so they will be uniformly biased towards predicting mild market shifts rather than extreme ones. So Bernanke is restricted to announcing the common wisdom of the market makers, and the market makers are biased towards expecting minor changes in the market.

No one is going to stand up and say that the future of the American economy and economic markets is bleak.

My reaction

Neither am I. I am no professional economic pundit. The best (or worst) that I will say is that no one is going to tell us how bad things are going to get, because that message, delivered from someone who might really know, would be a self-fulfilling prophesy.

I will say that now it s probably a good idea not to have any debt that comes due in the next two or three years, avoid debts in foreign currencies that you depend on dollar revenue to pay, buy foreign assets and currencies, and consider real assets rather than dollar-dominated financial assets in your portfolio. Oh, and switch your IRAs into foreign investments. Don't let a mild increase in transaction costs keep you from making those financial moves.

Oh, and don't pay off your fixed interest rate mortgage now, since you may be able to repay it with depreciated dollars in the relatively near future. That's if you don't depend on a dollar-based pension that is not increased for inflation.

My expectations

My bet is that the U.S. can expect to conduct an Argentine-style financial collapse. But it may not be as bad for us as it was for Argentina because the U.S. has had the international reserve currency, and the American economy has been the engine of international growth. So many nations have very large Dollar debt holdings that they will fight to keep the dollar from dropping too badly, and those nations (cough *China* cough) who have used exports to the U.S. to keep their economy working are likely to want to avoid a collapse of American buying. So the U.S. has advantages that Argentina did not have. Still, the near future for the American economy is not going to be a good period.

So get ready for Inflation, a lot of foreclosures, more bankruptcies (in spite of the credit card company friendly bankruptcy bill), a slower economy and a rapid increase in inflation. That's the near future.

Blame Bush as well as Greenspan who manipulated the economy to reelect Bush.

How bad will it really get?

By the way, I do expect an extremely severe recession. (Bad, but not disastrous.) I don't know how long the Recession will last, but I do NOT expect a Depression. Our economists do not even yet fully understand what happened in the 1930's, but they have learned a whole lot. No one in government is going to wait on the economy to fix itself, the federal reserve understands that bank failures reduce the money supply so we have bank insurance as well as the Federal Reserve, and we do not have the Gold Standard which transmitted the Depression from America to the rest of the Industrialized world.

Still, the credit crisis is currently really bad an getting worse. It is one bad element of a simultaneous set of economic problems. 2008 is not going to be an economically pleasant period.

Fed takes action to improve market liquidity

Bondad reports on the market reaction to the Federal Reserves 1/2% decrease in the discount rate.

What is "the discount rate?"

US banks use a fractional reserve system. All this means is a bank much have x% of its total assets on hand at any given time. However, in a banks usual business affairs their reserves may dip below this percentage amount. When this happens, banks must borrow short-term money from somewhere. Usually, they go to other banks. The interest rate banks charge each other is the Federal Funds rate. In addition, a bank can go directly to the Federal Reserve and borrow money. The Fed will charge the bank the discount rate. Going to the Federal Reserve to borrow money is a last resort and is usually considered a sign of weakness. Therefore, lowering the Discount rate is largely a symbolic gesture because it isn't used nearly as much as the Federal Funds rate.

Go read Bonddad's report on what the market did as a result. He posts neat tech analysis charts.