Updating Impact of Mortgage Equity Withdrawals on Consumption
From John Mauldin: “…net MEWs have fallen precipitously in 2008, down 95% from three years ago. On this data alone, GDP should be off by 3% this year. No wonder we are in negative economic territory. In 2005 there was almost $595 billion in mortgage extractions that went into some kind of consumer spending. Remember…that translated into a 3% rise in GDP. In 2007, MEWs were down to $470 billion, for a boost of 2% to GDP. The second quarter of 2008 saw an anemic $9.5 billion. At that run rate, we could see a drop-off of well over 90% from 2005! Now, think what the second quarter would have been without the federal stimulus program of $150 billion. It might have looked and felt like this quarter!”
Time to Pay for Past Excesses?
From Newsweek by Robert Samuelson: “Unfortunately, slower growth seems probable. What the new president, and everyone else, needs to understand is that the present crisis marks the end of an economic era. For roughly a quarter century, the U.S. economy benefited from the expansionary side effects of falling inflation—lower interest rates, greater debt, higher personal wealth—to the point now that we have now overdosed on its pleasures and are suffering the hangover. In our zeal to identify the villains of the present economic debacle, we ought to recognize that the larger causes lie in this prolonged prosperity and the permissive attitudes and practices it inspired. Largely unrecognized, the dominant economic event of the past half century was the rise and fall of double-digit inflation. On the way up, starting at about 1 percent in 1960, inflation destabilized the economy. There were four recessions between 1969 and 1981. Unemployment peaked at 10.8 percent in late 1982. That last devastating recession, imposed by the then Fed chairman Paul Volcker with Reagan's backing, purged the worst inflationary psychology. By 1984, inflation had dropped from double digits to less than 4 percent; by 2001, it was 1 percent. This declining inflation—disinflation—bolstered the economy. Consider what happened. The stock market recovered spectacularly: lower inflation led to lower interest rates, which caused investors to switch from bonds to stocks. The Dow Jones industrial average, which traded under 1,000 for much of 1982, averaged about 2,500 in 1989 and almost 10,500 in 1999. There was a consumption boom. Feeling wealthier, Americans borrowed and spent. The personal savings rate dropped from 11 percent in 1982 to almost zero by 2005. There were only two mild recessions (1990–91 and 2001). But what's clear now is that this prosperity bred bad habits. The present crisis, though usually attributed to dubious "subprime" mortgages, really traces its origins in the widespread optimism unleashed by disinflation. By now, the perverse consequences are clear. As stocks and real estate rose sharply in value, many Americans became convinced that prices could only go up. Once that mind-set took hold, lax investment standards (in the case of high-tech companies) and lending practices (in the case of homes) mushroomed. "Bubbles" followed. People overinvested in tech stocks and overborrowed to buy homes at inflated prices or to raise cash from bloated real-estate values. But the borrowing surge could not last indefinitely, because debts increasingly outpaced the rise of incomes. By 2006, household debt was 134 percent of personal income. Sooner or later, consumers had to retrench. They are now; car sales and retail spending are down. The recession will end, but recovery won't ensure a return to previous rates of economic growth. Just beyond the horizon looms a larger threat: an aging society. Arithmetically, economic growth reflects the increases in workers' hours and their productivity—a.k.a. efficiency. From 1960 to 2005, annual U.S. economic growth averaged 3.4 percent, split almost evenly between labor-force growth (1.5 percent) and productivity gains (1.9 percent). As baby boomers retire, labor-force growth will shrink. By the mid-2020s, the Social Security Administration expects economic growth of about 2.1 percent, with scant labor-force increases (0.4 percent) and higher productivity gains (1.7 percent). Because productivity reflects many influences—technology, management, workers' skills—even that projection could be optimistic. If productivity falters, as in the 1970s, the U.S. economy would virtually stagnate in the face of growing claims on people's incomes…. people will fight over pieces of a fairly fixed economic pie rather than sharing ever-larger pieces of an expanding pie…. Already, Americans face far more claims on their incomes than can be easily met. Start with government. It's overcommitted in the sense that it's made more promises than can be sensibly afforded. The largest of these involve retirement costs. As is well known, three programs for the elderly dominate the federal budget: Social Security, Medicare (health insurance) and Medicaid (nursing-home care for the elderly poor). These programs now represent more than two fifths of the $3 trillion budget, and as baby boomers retire, they could nearly double—measured as a share of the economy, gross domestic product (GDP)—in 2030. The tough questions are obvious. How much will we permit spending on retirees to raise taxes or crowd out the rest of government? Health care compounds the difficulty. About three quarters of the projected increase in federal spending for the elderly involves Medicare and Medicaid. As a society, we haven't learned how to control health spending. Most Americans think that people should get all the medical care they need. Spending controls—for government and private insurance—haven't worked, because Americans don't want them to work. Health spending has gone from 5 percent of GDP in 1960 to 16 percent now and may hit 20 percent by 2015. For workers with employer-paid insurance, that's depressed take-home pay by diverting dollars from wages into premiums. For everyone, health spending puts upward pressure on taxes and downward pressure on other government programs…. the great forces that propelled the economy forward for the past quarter century, fed by disinflation and the accompanying rise in personal wealth and borrowing, have clearly spent themselves. If the economy is to retrieve faster growth in the future, it will need to nurture new sources of advance.
Given the scope and scariness of the financial crisis, it has already stimulated massive government intervention—and there will be more. But there is a parallel danger that too much intervention, or the wrong kind of intervention, will suppress the impulse for expansion, investment and risk-taking.”
Government Entitlement Problems Lurk Like Sub-Prime Issues – Off Balance Sheet
From Fortune (By David Walker, former U.S. Comptroller General): “The U.S. Government Accountability Office (GAO), noting that the federal balance sheet does not reflect the government's huge unfunded promises in our nation's social-insurance programs, estimated last year that the unfunded obligations for Medicare and Social Security alone totaled almost $41 trillion. That sum, equivalent to $352,000 per U.S. household, is the present-value shortfall between the growing cost of entitlements and the dedicated revenues intended to pay for them over the next 75 years. Why call it a super-subprime crisis? Besides its gigantic scale, there are very disturbing similarities between the current mortgage-related crisis and our next potential disaster. First, like the securitized investment vehicles that blew up, federal programs were launched without adequately thinking through who would bear the ultimate cost and related risk. Just as originators of mortgages let themselves off the hook by unloading packages of dubious loans onto others, lawmakers have increased spending, expanded entitlement programs, and cut taxes while expecting future generations to pay the bill. Second, just as a lack of transparency associated with mortgage-backed securities resulted in big surprises and large losses for investors, our nation's huge off-balance-sheet obligations for Social Security and Medicare present a threat wrapped in camouflage. After all, the government's "trust funds" don't really provide much security since they don't hold anything but more government debt. Third, in the same way that private sector "risk management" executives failed to prevent the subprime mortgage crisis, overseers in Congress and the executive branch have turned a blind eye to costs associated with entitlement programs and tax cuts. While lax regulation of banks fed the current subprime crisis, a lack of statutory budget controls has led to a widening gap between the government's revenues and costs. At the heart of these problems is our leaders' collective failure to act in the face of known challenges. Our country has veered from its founding principles, which held to individual responsibility and accountability today in order to create more opportunity tomorrow. When our constitution was written, the concepts of thrift and prudence were no less at the During past financial crises and wars, the government went into debt because our nation's survival was at stake. What has changed is that piling up debt has become business as usual, even during times of prosperity.
Today we are headed toward debt levels that far exceed the all-time record as a percentage of our economy. In fact, by 2040 we are projected to see debt as a percentage of our economy that is double the record set at the end of World War II. Based on GAO data, balancing the budget in 2040 could require us to cut federal spending by 60% or raise overall federal tax burdens to twice today's levels. Medicare, Medicaid, and Social Security already account for more than 40% of the total federal budget. And their portion of the budget is expected to grow so fast that their cost, and the cost of servicing our debt, will soon crowd out vital programs, including research and development, critical infrastructure, education, and even national defense. The crisis we face is one of numbers and demographics but also of attitudes. Promises were made in an earlier time, when they seemed more affordable. Like homeowners borrowing against the value of their homes in the expectation that the values would go up forever, the American government borrowed against the future and assumed that the economy would grow fast enough to make that debt affordable. But our national debt is not limitless, and our foreign lenders are not fools. If we persist on our current "do nothing" path, our future will be jeopardized. Americans need to reconcile the government we want with the taxes we're willing to pay for it.”
Credit Markets Showing Signs of Imporving
From Bloomberg: “Credit markets are still creaking even after the biggest decline on record in the rate banks say they charge each other to borrow dollars. The London interbank offered rate, or Libor, for three- month loans fell to 2.51 percent today, from 4.82 percent on Oct. 10. The rate is still 151 basis points more than the Federal Reserve's target interest rate for overnight bank loans, compared with an average of 22 basis points in the five years before the global credit crisis began in August 2007. ``Banks are cutting back, the economy is in a deepening recession and in that environment, I don't think banks are going to become a lot more willing to extend credit soon,'' said Jan Hatzius, chief U.S. economist in New York at Goldman Sachs Group Inc., the world's biggest securities firm. Government bailouts totaling about $3 trillion, interest- rate cuts around the world and unprecedented cash injections by central banks drove Libor, the benchmark for $360 trillion of securities worldwide, lower in the past month without convincing financial institutions to lend. About 85 percent of U.S. banks tightened lending standards on loans to large and mid-size companies in the past three months, the Fed said on Nov. 3, the highest since the survey began in its current format in 1991…The credit-market seizure that began after BNP Paribas SA halted withdrawals on three hedge funds last year worsened when Lehman Brothers Holdings Inc. filed for bankruptcy on Sept. 15,
driving dollar Libor up 200 basis points, or 2 percentage points, in the next 25 days to the highest level in 2008. The difference between Libor and the overnight indexed swap
rate, a measure former Fed Chairman Alan Greenspan uses to gauge the state of money markets, was at 201 basis points today. That compares with 87 basis points on the last day before Lehman's collapse and an average 11 basis points in the five years before
the crisis started…``Libor fixings are improving but it's too early to say that this
pattern is being replicated in the actual money markets.''…Central banks have driven money-market rates lower by offering financial institutions as much dollar funding as they need and acting in concert to slash interest rates. The Reserve Bank of Australia cut its benchmark rate 75 basis points yesterday, joining policy makers in China, Hong Kong, India, Japan and the U.S. in reducing borrowing costs in the past week. The European Central Bank and Bank of England will cut their key rates by 50 basis points tomorrow, according to Bloomberg surveys of economists. While cutting the U.S. target rate during the past 13 months to 1 percent from 5.25 percent, Fed Chairman Ben S. Bernanke has created six loan programs channeling at least $700 billion in cash and collateral into money markets as of Oct. 22….``It's all about buying time.'' Central bank operations helped the MSCI World Index of stocks rise almost 20 percent since falling to a five-year low on Oct. 27. Company borrowing costs have declined, with yields on the highest-ranked 30-day commercial paper, or CP, falling today to the lowest level since June 2004. The market, used by companies to cover daily expenses, grew last week for the first time since Lehman's collapse. Cash injections have had a limited impact because instead of lending the extra money received in auctions, some financial institutions are holding it on deposit with central banks. Banks lodged a record 296 billion euros ($381 billion) overnight with the ECB yesterday. The daily average in the first eight months of the year was 427 million euros. ``The money-market players remain cautious but we're at least seeing an improvement … ``Transactions remain limited and we still have a dislocated market, but we're seeing a significant pullback'' in rates, he said. In its quarterly Senior Loan Officer Survey, the Fed said about 95 percent of U.S. banks raised the costs on credit lines to large firms, and ``nearly all banks'' increased the spread on
borrowing rates over the cost of funds on loans to firms from July. About 70 percent of U.S. banks indicated they tightened standards on prime mortgage loans. Banks may not pass all of the benefits of lower interest rates on to consumers and businesses. Banks around the world are re-evaluating the price they put on risk, raising the cost of loans when compared with levels of pervious years, said David Hodgkinson, chief operating officer of HSBC Holdings Plc, Europe's biggest bank. ``Credit has to be priced appropriately to reflect the risk,'' Hodgkinson said in a Nov. 3 interview in Abu Dhabi. ``If interest rates are brought down significantly, then rates for borrowers will come down. But I'm not going to say it's absolutely linear because it depends on the particular transaction and the risk.'' In another sign that lending remains restricted, corporate bond sales in Europe dropped in October to the lowest level this year… U.S. investment-grade offerings fell to $21.6 billion, the least since July 2002. ``No one wants to lend because they are still wary of values of bank balance sheets, and no one wants to borrow from the money market because they can borrow directly from the central banks,'' …In effect, the measures taken by central banks are not providing incentives to go into the interbank market.''”
Russian Economy Remains Too Dependant on Commodity Exports
From The FT: “Russia … Its annual economic growth in real terms averaged 7 per cent in the years during which Vladimir Putin was president (2000-08), annual real wages rose by almost 15 per cent, the federal budget was continually in surplus… The Russian stock market has lost 70 per cent of its value this year. The commodity prices that spearheaded its boom are now falling. The easy credit money from the west that fuelled it has now fled. Russia has failed to diversify its economy and its politics have long made investors nervous. A confrontation with reality is long overdue. Metals, energy, and food account for 80 per cent of Russian exports. The growth of the economy in the Putin years was largely driven by the devaluation of the rouble in 1998-99 and the increase in the prices of these products: between 2000 and 2007 real prices of metals went up by 275 per cent, of energy by 210 per cent, and of food by 160 per cent… Since July, the commodity price index has dropped by more than 20 per cent…The downturn in the commodity economy will thus have a multiplied effect on the consumer economy and the Russian standard of living. Second, the government's spending plans are based on a $70 a barrel oil price. Every one-dollar decrease in the barrel price implies $3bn less in export revenues a year… Russia's banking system has been a poor channeller of commodity wealth into non-energy businesses. There are too many banks; most are undercapitalised. Growth in the non-energy sectors has been fuelled by collateralised loans from western banks. Russian banks and companies have about $450bn (€362bn, £292bn) of foreign debt, $50bn of which must be repaid or refinanced by the year end. So Russian businesses are exposed to the troubled European banking system when the value of the shares they put up as collateral may have fallen below the cost of the loans…Russia needs to scale down its geopolitical ambition to its real weight - that of an emerging economy with only 3 per cent of the world's gross domestic product and a quarter of America's living standard. Also, it desperately needs to develop its human capital.”
MISC
From Merrill Lynch: “The vast majority of questions we receive are about inflation, and whether the US is "printing money" to solve the crisis. Investors need to keep in mind that inflation is a lagging variable and that credit is a leading variable. Any devout monetarist will say that it is impossible to get inflation without credit creation. There is no credit creation. Investors should probably start worrying about inflation only after the credit cycle turns.”
From Deutsche Bank: “Massive long-end supply is coming The Treasury announced major changes to its auction schedule, reflecting what is likely to be a record high $1 trillion-plus budget deficit this year. Next week, the Treasury will begin auctioning monthly 3-year notes at $25 billion in size; the Treasury will then auction $20B in 10-year notes and these notes will be reopened in each of the ensuing two months (i.e., a double reopening). The Treasury did not specify the size of the 10-year reopenings but our initial guess is that it will be somewhere in the $10 to $15B range. The Treasury also decided that beginning next February it will begin auctioning quarterly 30-year bonds. Next week, though, the Treasury will…”
From Bloomberg: “Voters in states led by California embraced municipal debt as they approved about $39.7 billion of new borrowing, representing about 83 percent of measures for which results were available. Californians approved at least $27 billion, including money for schools and loans to veterans. Voters in 41 states from Rhode Island to Alaska considered $66.4 billion of bond proposals yesterday, the second-biggest slate after November 2006's $78.6 billion…”
End-of-Day Market Update
From Bloomberg: “The stock market posted its biggest plunge following a presidential election as reports on jobs and service industries stoked concern the economy will worsen even as President-elect Barack Obama tries to stimulate growth. Citigroup Inc. tumbled 14 percent and Bank of America Corp. lost 11 percent as the Standard & Poor's 500 Index and Dow Jones Industrial Average sank more than 5 percent. Nucor Corp., the largest U.S.-based steel producer, slid 10 percent after bigger rival ArcelorMittal doubled production cuts amid slowing demand. Boeing Co., the world's second-largest commercial planemaker, lost 6.9 percent after UBS AG forecast a 3 percent drop in global air traffic next year. `We had an election yesterday; that doesn't mean the problems go away,…``We still have an economic slowdown.'' The S&P 500 tumbled 52.96 points, or 5.3 percent, to 952.79, erasing yesterday's 4.1 percent rally. The Dow retreated 486.01, or 5.1 percent, to 9,139.27 and the Nasdaq Composite Index dropped 98.48, or 5.5 percent, to 1,681.64. Twelve stocks fell for each that rose on the New York Stock Exchange. The retreat halted an 18 percent rebound from the S&P 500's five-year low on Oct. 27. The benchmark for U.S. equities has lost more than 35 percent this year, the steepest annual plunge since 1937, and Obama will have to contend with an economy pummeled by the fastest contraction in manufacturing in 26 years and the lowest consumer confidence. The market's decline came a day after the biggest presidential Election Day gain since the NYSE first opened for trading on a voting day in 1984.”
From UBS: “ Prices as of 4:45PM (Based on Bloomberg)
Three month T-Bill yield fell 9 bp to 0.39%
Two year T-Note fell 4 bp to 1.33%
Ten year T-Note yield fell 4 bp to 3.68%
30-year FNMA current coupon fell 14 bp to 5.47%
Dow fell 486 points to 9139
S&P fell 53 points to 953
Dollar index fell 0.18 points to 84.61
Yen at 98.2
Euro at 1.297
Gold fell $21 to $742
Oil fell $5 to $65.50
