How To Help Home Buyers And Make Everyone Else Happy

The government may offer a solution to home buyers offering them extremely low interest rates to purchase a home. The problem with that is that other home owners who are making payments on an existing mortgage will not be offered the lower interest rate. These existing home owners will be upset that they cannot get these lower interest rates.

This is definitely a problem but I see a way out of this. The government can move ahead with these super low interest rate mortgages that will be issued directly to home buyers but in return the home owner should be obliged to give up a portion of the gains from a house sale. This portion can be based upon the discount to a standard 30 year fixed mortgage. For instance if the Treasury issued a home owner a new 30 year fixed rate mortgage that is 30% cheaper than a typical 30 year mortgage, then the home owner will have to give up 30% of the profits when the home is sold. The terms can be specified when the mortgage is issued.

It's Official, The Recession Began in Q4 2007

Today the NBER officially declared that the US economy is in recession and that the recession began in December 2007. Interesting to look back at a past blog post I made on January 14, 2008.:

********************************************************

The Recession Started in Q4 2007

The US is likely in recession and it most likely started in December 2007. The December retail sales numbers from the chain stores last week (except for Wal Mart) were extraordinarily weak. The weakest percentage declines from these reports were on a similar trajectory to the percentage retail declines from the 1982 recession. The December monthly employment figures were recession-like. Sears Holdings numbers today were weak as well. Also surprisingly the Manhattan rental real estate market took a nose dive in the 4th quarter. (See the post on the Manhattan Residential Rental Market).

There are positives that I see too. If the US goes into a recession it is likely that commodity prices will fall and the dollar would strengthen. A drop in commodity prices, especially energy prices, would be welcome by the US consumer and a strengthening dollar would also benefit inflation indexes. The dollar would strengthen in a recession because as asset prices decline (think housing, equities) the amount of dollars in circulation would decrease. This cycle would create a scarcity of dollars which would lead to its increase in value. Commodity prices would likely get hit as the consumer would hold onto his dollars and search for replacements to high priced goods and services. In this cycle competition becomes even fiercer. An example of this can be seen from the company Harman today. Harman said "pricing pressures" have affected its business drastically. Hard to believe how quickly things are rolling over.

*********************************************************

Of note is that the NBER was not swayed by the uptick in the first two quarters of 2008 GDP. The uptick in the first two quarters of GDP was due to the $500 rebate to individuals from the Treasury. Q3 GDP was recently revised down to -0.50% and Q4 GDP may see a -5% or more drop in GDP. These are annual rates.

3 Month Tbills Now Yield 0.01%!!

This is insane, the 3 TMonth TBill has zero yield!!

The Deflationary Storm Continues To Grow

I have mentioned a number of times about the potential for a deflationary spiral. Back in March I warned that "The Fed Is Trying To Avert a Deflationary Spiral." In another essay I wrote "Inflation Will Vanish."

I was a bit early but it now seems to be happening. Deflation in asset prices (mostly housing and equities) is starting to effect the consumer. The US consumer has shut down and this is ripping through the economy causing waves throughout the world's economy.

For example on the Nightly Business Report this evening it was mentioned that some shipping rates which at one point were $150,000 are now down to $7,000.

A drop of that magnitude is shocking and very alarming. This example exemplifies deflation. Now what to do about it is the big question? Flood the system with cash makes sense until the US consumer can repair his balance sheet and pickup spending again. In the interim large government fiscal stimulus is needed to prop up the massive decline in US output / GDP. Lastly the government could offer incentives for people to buy homes. Offering cash rewards may make sense.

Eventually this beast will be put to rest but it is going to take some time for solutions to get traction and start working.

Offer a $2 Trillion Fiscal Stimulus Over 3 - 4 Years

Start in 2009 with a $700 billion stimulus and then in 2010 decrease it to $600 billion. In 2011 make it $500 billion and then finish it off in 2012 with $200 billion for a total of $2 trillion. The real economy stimulus should be front end loaded.

Name Tim Geithner Treasury Secretary Immediately

Geithner should be named Treasury Secretary. He is the best choice and has made some great macro calls. I heard Jim Cramer say that Geithner made a mistake by letting Lehman fail. It was a great mistake to let Lehman fail but I don't think this was Geithner's decision. From what I understand it was Paulson's decision and Geithner may have expressed reservations about letting Lehman fail.

This decision should be made immediately to remove one more unknown from the markets.

Incentivize Home Puchases By Offering Cash

Per Howard Meltzer of Carnegie Mellon University who suggested this evening on the News Hour with Jim Lehrer that the government should offer home buyers a tax credit. I have an alternative, why not offer home buyers cash? Give home buyers cash to buy a home. How much? Maybe offer 1% of the purchase price for homes valued up to $500,000.

Sports Owners, Sport Superstars, and Hollywood Are Next

The financial Cat 5 continues to wreak havoc on our economy. American athletes are some of the highest paid employees in any industry. Sports teams owners are often very profitable too. The financial savagery that this Monster of 2008 is wreaking will not spare the Derek Jeter's, Arods, or others. There is likely to be push back beginning with the consumer.

To be continued...

Issue Banks Certificates That Can Only Be Used To Lend

There might be a way to force banks to lend capital they receive. Bear with me as I am likely bundling stories from the Panic of 1907 with the 1929 Crash as I have recently read books on both from multiple authors.

Any way I think it was during the Panic of 1907 that cash became very scarce among the banks. There were many different types of banks back then so I am not sure I have the type of bank correct. Since there was a scarcity of cash the trust (I think Trusts) banking companies created a coupon like certificate that was like an IOU. This IOU was like its own currency equal to cash. Call it a coupon, call it what you will, but these IOU's sort of became a currency between the trust companies until cash was pumped into the system. These IOU / coupon like devices were basically equal to cash as they were backed by the government and the trust companies were able to function until the cash started to flow. These certificates were allowed to be included when calculating total capital.

Fast forward to the present. The Treasury can do something similar. The Treasury can issue special Tickets / coupons to banks that have the same exact value of cash but that could only be redeemed by the banks when the banks have borrowers lined up ready to borrow. These coupons would have no other purpose but for lending.

To recap: The Treasury can issue IOU / certificates to the banks that are equal to cash but can only be used to lend to borrowers. These coupons would serve no other function but to be issued by Treasury to banks and redeemed for cash by banks only for borrowing activities.

Of course the devil is in the details but since many ideas are getting floated it is hard to know what will get us out of this problem. Since the Treasury is in the dilemma of giving cash to banks and then watching them sit on it, this may help.

Federal Fiscal Stimulus Should Be $2 Trillion

The US should match China with a fiscal stimulus package that totals $2 trillion spread over 4 years. This would add about 3.5% to annual GDP and will help counterbalance the massive declines in GDP from the consumer, corporate and local government sectors. It should be front end loaded and scaled down over the 4 years.

"Nobody Knows What The Hell Is Going On"

This is a quote an elderly gentleman has used who closely follows the economy and the markets. He used it 6 months ago and I think it is a very accurate depiction of what is going on in the financial markets. The leaders and regulators are figuring it out as they go along. The economic storm is so large and fast-moving that throwing solutions into the mix and seeing what sticks and dismissing what does not is the way to move forward. As ad hoc as that is, it makes sense.

Q4 2008 GDP Could Decline by 5% (Annualized)

I very roughly estimate that Q4 GDP will decline by 5% (annualized). I base this on the export component of the October ISM. The ISM was released earlier this week. According to the report, exports in October collapsed.

When Q 3 GDP early estimates were released there were two components that held up well. One was exports and the second was government spending. The consumer component dropped by about 3%. With exports collapsing and the US consumer collapsing the Q 4 GDP rate of change is likely to be severely negative.

Of course, government spending could spike particularly if there is a new stimulus plan. But how long can the government "hold" up GDP? The US consumer makes up 72% of US GDP. Until the US consumer recuperates this economy is likely to decline.

I am saddened by the news and believe that eventually things will get better. It is just that it is going to take a lot of time for that to happen. But eventually things will pick up. For the time being, we slog our way through this very difficult stretch.

Note to the Fed: Lower Rates By 1.00% to 0.50%

The Fed should immediately cut interest rates to zero. The Fed has a chance to get in front of this crisis. Acting quickly and with force would be seen as a positive by the markets. Act now and signal to the markets that you mean business.

IRAs and 401Ks Can Help Home Owners

Home owners struggling to make housing payments should be a focus for regulators. Many home owners on the edge now will likely face difficulty in the days ahead. Some may even lose their homes.

The Saturday NY Times in an article this past Saturday mentioned a plan by Daniel Alpert. His plan consists of temporarily turning a home owner into a renter for 5 years. I will take the 5 year period from Mr. Alpert's plan. Also recently both presidential candidates mentioned a temporary reprieve on withdrawal penalties for 401k plans. I will use that 401k penalty reprieve.

Now my plan. It allows home owners to withdraw cash from their IRA or 401k. Penalties would still apply but will be considerably less. When a person under 59 years of age withdraws cash from an IRA he is assessed a penalty and required to pay taxes on the income. The penalty is 10%. Under my plan the IRA holder will only be assessed a penalty of 2% for 2009, 4% for 2010, 6% for 2011, 8% for 2012 and 10% for 2013. The regular income taxes would still apply. The maximum amount per year will be $18,000.00.

This plan would allow home owners in trouble to withdraw assets from their retirement accounts to help pay their current needs. The big problem with this plan is that the home owner is 'robbing' his retirement account. This could be very harmful as the money withdrawn from an account will not be gaining in value. Plus the number of years it will take to catch up will require the home owner to place much larger sums into a retirement plan.

That said this becomes a question of which is more important to a person - keeping a home under any circumstance or retiring on schedule. Maybe this decision would be best left up to the home owner. Just my two cents.

I am going to refine this a little but wanted to get the idea out there in the interim.

Incentivize Recapitalizations and Reward Lending

To get the financial system to function again the regulators should come up with ways in which to :

1 - Incentivize Recapitalization of the banking sector. This can be done by a number of ways. Perhaps one way is for companies to guarantee share prices at which recapitalizations are done. Lets say company XYZ needed cash and decides to try to sell shares. Lets say potential buyers have the cash but are afraid to make a purchase because of fears of a stock drop which would cause losses. If company XYZ offers the share buyer a guarantee the buyer may be more likely to step in. The guarantee can work something like this: If the purchaser of shares makes a purchase then the share price will be guaranteed for one year. If the price goes below the offering price at any time on a closing basis over the 12 months following the purchase then company XYZ will make up the difference by offering the buyer more shares or cash. This will likely help convince buyers to step up and buy shares. It may even create a stampede for anyone who wishes to buy the stock. To make this a fair offer, all shareholders should be allowed to participate.

2 - Reward lenders for lending out there cash.

What those incentives could be is an important question and needs to be examined more thoroughly.

The Fed Should Lend Directly To Borrowers

Since the Fed is pumping cash into the system via banks but the banks are still being stingy with their cash the Fed could go around the banks and become a direct lender.

The Fed can go right to the borrower and lend cash. This would likely be a very difficult step since there are so many financial institutions located where borrowers want to borrow. But maybe via an electronic venue the Fed can become a direct lender to anyone who wants to borrow.

I know the semantics here would be difficult. But in reality credit is the lifeline to our economy and it needs to be lent to borrowers at reasonable interest rates. The Fed has to think outside of the box and do whatever it takes to get money into borrowers hands.

Just a thought. For these rocky times all options should be considered. Even something from out of left field like this.

Swamp The System With Cash + The Bright Side

The US has had a number of banking crises since the 1850s. The way to fix it to to swamp the system with cash.

The negative economic forces currently are much larger than most understand. Even greater than what I thought in a worst case scenario. I would equate it to a wild fire. The regulators have to overwhelm the system with cash. Pour it in. Otherwise the fire in the banking arena may continue to show up in unexpected places as cinders stay hot. A half hearted effort will not restore confidence.

Now a look at the bright side. There are positives to this painful process. Eventually markets will stabilize and the credit markets will function properly. This is all a process that will make way for the next bull market. The excesses had to be cleaned out. No doubt we will be so much better for it in the future. Credit was way too easy and asset prices (real estate and equities, others too) went too high. However, the seeds of economic prosperity are now being formed. It will take some time, probably a lot of time but this is the necessary process to bring future prosperity.

Is The Worst Over

'Is the worst over?' This has been a common question over the past few months as Bear Stearns blew up, as Lehman went bankrupt as Fannie and Freddie were rescued. The list goes on. It seems like every time you think that things cannot get any worse wham another hit. One way to answer that question is to compare the current state of affairs with another time history.

From John Kenneth Galbraith's The Great Crash of 1929 page 108 (soft cover edition):

"In the Autumn of 1929 the New York Stock Exchange, under roughly its present constitution, was 112 years old. During this lifetime it had seen some difficult days. On September 18, 1873, the firm of Jay Cooke and Company failed, and, as a more or less direct result, so did fifty - seven other stock exchange firms in the next few weeks. On October 23, 1907, call money rates reached 125 per cent in the panic of that year. On September 16, 1920 - the autumn months are the off season in Wall Street - a bomb exploded in front of Morgan's next doors, killing thirty people and injuring a hundred more.

A common feature of all these earlier troubles was that having happened they were over. The worst was reasonably recognizable as such. The singular feature of the great crash of 1929 was that the worst continued to worsen. What looked one day like the end proved on the next to have been only the beginning."

A Plan To Stabilize the Financial System

Here is an alternative to the Treasury's plan. I came up with based on the US Treasury's plan and the hearings in Congress and other interviews I have watched on TV and what I have read. It will have flaws. I used game theory which means that the players involved have to sacrifice something but also receive something in return. I put myself into the shoes of all of the key players trying to look at what is best for all. I will likely change this.

-----------------------------------------------------------------------------


The Problem:

The financial system is melting down. Credit markets have seized up. A flight to safety away from risk based financial assets into the ultimate safe haven 3 Month T-Bills is occurring. If this continues credit flows will stop and money will sit in banks; depositors and investors will move money to perceived safe havens real or other wise. The financial system could come to a halt. The Treasury believes the solution lies in removing bad assets from financial institutions so that these institutions can re-lend money into the system.

The players and their goals:

- Tax Payers (Home owners and other). Access to loans at reasonable interest rates; jobs; a safe place to put cash; long term growth of retirement accounts; keep ownership of home. Not take much blame for the economic fallout. Not lose money. Not pick up the bill for Wall Street's excesses.

- The Financial Institutions and other Holders of decaying financial assets. Keep companies in business. Get rid of bad assets at a good price or best available price. Access to loans at reasonable interest rates; access to credit at reasonable rates, make profits for their shareholders, stay in business. Not get stuck with loans that people don't pay off. Not be seen as the bad guy. Do the right thing.

- The Corporate Executives - Keep their firms in business. Make profits. Not be blamed for financial melt down. Do the right thing.

- Congress - Stay in office. Not be blamed for financial melt down. Not get blamed for writing a blank check to Paulson. Over sight. Protect taxpayers. Do the right thing.

- The President - Stop financial melt down. Not get blamed for melt down. Do the right thing.

- The Secretary of the Treasury - Save the system. Provide leadership to get out of crisis. Push hard to accomplish objectives. Not get blamed for allowing crisis to get out of hand. Do the right thing.

- The Fed - Stop financial meltdown. Keep the economy rolling. Stop inflation / deflation. Do the right thing.

The Solution:

Keep Credit flowing, keep the economy afloat. Keep foreclosures to a minimum, keep as many home owners as possible in their homes.

What Needs to be Sacrificed and What is Received

- Tax payers. Temporarily pay for a solution through an addition of the Federal debt. Keeps job. Depending on the circumstance may keeps home (with excess cash Congress can put in place programs to help tax payers - see below) Financial stability. Worst scenario - May lose money and have to pay more in taxes. Best scenario - May make money and pay less taxes.

- Financial Institutions - Stay in business. Lose some oversight, get rid of bad assets, face financial / equity penalty.

- Corporate execs - Keep jobs, lose some compensation and oversight.

- Congress - Giving authority to use cash to buy assets. Credit for helping to save the system.

- The President - Give Secretary power to fix problem. Credit for helping to save the system.

- The Secretary of Treasury - Gives up some oversight. Gives congress more say in how program will work. Gets credit for the idea and for saving the system.

- The Fed - Makes their job easier to keep the economy afloat.

How to get there

The Treasury and Congress:

The best minds in the business believe that if financial institutions were relieved of decaying assets that the system would begin to heal itself. The Treasury thinks this will cost $700 billion. I don't have time to come up with an alternative dollar value. I will use that. So let the Treasury buy these decaying assets. At the end of every three month period a detailed financial report will be issued from the Treasury to Congress. It will show the costs and what was spent to purchase assets. This result will be audited by an outside firm hired by Congress to cull through the data.

The Tax payer and financial institutions:

The tax payer pays for the $700 billion for the program. The pricing of the asset that the tax payer buys from the financial institution will be important. The lower the price that is paid for the asset the better it will be for the tax payer as it becomes more likely the tax payer will be able to make a profit. However, the institution selling the asset has to replenish its balance sheet so the higher the price the asset is sold for the better for the financial entity.

I will demonstrate the pricing mechanism via an example. Lets say that Fair Value for an asset is twenty cents on the dollar which is what the financial entity values the asset on the balance sheet. If the Treasury buys it for that amount, nothing is accomplished. So the Treasury needs to pay a premium to the asset price. Lets use a 25% premium. I picked that on the belief that it will help recapitalize the banking system. The asset is sold to the Treasury for twenty-five cents on the dollar (0.20 x 1.25). In return, the Treasury receives the asset and a special bond-like security. The security that the Treasury receives will be payable to the Treasury at the end of 10 years. It will be issued at 10% fixed interest rate. (The 10% interest rate comes from the Berkshire deal with Goldman Sachs.) The principal amount of the bond will be the amount that the Treasury pays over the fair market value of the asset bought from the financial entity. OK, an example may help. The Treasury buys an asset that has a $1 billion fair market value (say $0.20) but pays $1.25 billion (or $0.25). In return, the Treasury receives the asset and a bond for $250 million. The bond will mature in 10 years and will pay 10.00%. This bond will be highest up on the structure of corporate debt and will be first in line in any bankruptcy proceeding.

Oversite. Financial institutions that participate in this solution will have their executives take pay cuts and a cut in bonuses. The top 3 executives would be subject to this. A 25% cut in both the salary and bonus would suffice.

Summary:

With some luck the assets bought by the Treasury will increase in value, the bonds received by the Treasury will pay for the other costs like the oversight. Excess cash earned by the Treasury can go to the tax payer in the form of low interest loans to home owners or other types of programs. With a $700 billion plan recommended by the Treasury, $560 billion would be used to buy the frozen assets, the other $140 billion will be used to replenish the financial entities balance sheet. If the asset purchased by the Treasury goes up in value the Tax payer makes out. The Treasury will also own $140 billion in bonds that pay 10.00% in interest and throw off $14 billion annually to the tax payer. Congress can use this to help home owners with some type of plan. Over the 10 years the interest will amount to $140 billion. That money and the potential appreciation of the bought asset will likely make this a winning situation for the taxpayer.

The Upside Down Street and Risk Management

The financial world has changed rather quickly of late. Equity indices from all over the world have collapsed and capital has fled to US treasuries. As an example the 3 Month TBill Yielded 0.05% at the close of trading yesterday. The day prior the yield on the 3 Month T-Bill was at 1.50%. Money was leaving all instruments and running to the 3 Month Tbill. According to the WSJ that 0.05% yield was the lowest since the 1950s.

I hope that the readers out there are finding ways to survive. The only advice I wish to give at the moment as far as trading or investing is that Risk Management has to be the highest priority right now. Cutting losses and keeping position sizes small enough that even if a large percentage loss were to occur that it does not damage your portfolio or trading account too much.

Live to fight another day is really the motto to go by right now. Heroes are not made in markets like this. Be a hero today with a large position size might work out, but eventually a large position size will back fire and may even be catastrophic. This point cannot be stressed enough as those who survive this massive down turn will be either very lucky or very good at risk management.

The World Is In Recession

The US entered recession in November 2007 as the recently revised GDP data showed US growth declining during Q4. Germany's output recently declined. Japan GDP declined from the most recently released data. A large question remains - What happens to Chinese growth in the face of these headwinds? Can Chinese growth "carry" the world away from recession? This remains to be seen. But from where I sit most of the world is now in recession.

Credit

We are in the early stages of a credit maelstrom. The credit storm will continue moving through the world's economies creating difficulties in ways that are unforeseen at the moment. Last week it was some of the auto companies getting rid of auto leases as a means of financing vehicles. This morning on the CNBC news ticker I saw that Wachovia will no longer underwrite certain types of student loans. What will be next?

Equities

Ouch

The Fed

The Fed may be forced to raise interest rates to fight the rise in commodities. Just like the Fed was forced to slash rates to save the banking system the Fed may be forced to raise rates to keep commodities in check. The Fed may go back and forth between saving the banking system and to squashing commodity inflation. Depending on the month the Fed may move to the area that is more troublesome. Sort of like a fire department with limited resources that is forced to put out too many fires at the same time. It will move to whichever fire is strongest at the moment. This is just my opinion. I have taken this view because of the move commodities have had ever since the Fed has cut rates. We will see what the Fed does tomorrow. What a tough job.

US Equities Year To Date

From Yahoo Finance. As of the close of trading on Monday June 16th 2008:

Dow = 12,269.08, YTD = -7.51%

S and P 500 = 1,360.14, YTD = -7.37%

Nasdaq = 2,474.78, YTD = -6.69%

Jim McKay

I was saddened to hear that Jim McKay died over the weekend. In the 70s and 80s I grew up watching him broadcast the TV show Wide World of Sports on Saturday afternoons. Wide World of Sports covered all types of sporting event including some of the most exotic events from all over the world. The program was very entertaining and his announcing abilities made the broadcast that much better. He was one of the great ones.

Thoughts To Myanmar and China

My thoughts go out to the people affected by the cyclone in Myanmar and the earthquake in China.

Some Analysis of The TED Spread

Someone asked me about what the Ted spread has been doing lately and if its movements had any impact on the stock market today. Here was my response:

"Today TED has come back down to 1.0 then bounced back to around 1.10. This level was the lowest it has been since March. In January and February its lows were at 0.83 and 0.79 before turning back up to above 2.0 on March 20th. As recently as April 23rd it was above 2.0. Also for reference on August 20th it spiked to 2.3 or so before falling back to 1.0 on August 24th.

The TED spread is the difference between the LIBOR and the 3 Month TBill. When the Fed cuts rates the 3 month TBill moves lower almost exactly the same amount. However LIBOR is determined by an average of what banks are willing to lend to each other at. If the Fed cuts rates theoretically the banks should be cutting the rates that they charge to each other. However due to persistent nervousness in the banking sector banks are charging a premium to other banks if another bank wants to borrow money. This has the Fed worried. Clearly some banks are being charged higher rates, but the question remains why? Since LIBOR is an average rate it is hard to know exactly where the problem lies.

My take is that the Fed watches this like a hawk and is concerned. Therefor it has been a piece of information that I follow closely. The Fed wants the spreads to drop to around 0.50 that is why they increased the treasury facilities - they are trying to funnel money into the problem. TED has been elevated for quite some time and that is also a component of this problem. In my view the TED spread has been very high since August and although a couple of times it made an attempt to normalize by going below one it never made it and soon after retreated back to above 1.0 before spiking twice to 2.0 or above.

Did it cause the market turmoil today? Not really if anything it may have helped the markets since the spread narrowed a little today and over the past week or so. That said it still is in elevated territory and remains a big problem for the Fed. If it makes its way below 1.0 and sticks and eventually makes its way to 0.50 that would mean things are better but until that time there is a persistent problem in these spreads."

This Week's Abelson Commentary

I love reading Abelson in Barron's every week. He is definitely tilted to the bearish side so you have to really analyze his arguments carefully. This week though I think he hit the nail on the head. The Employment report released yesterday used a rather large number for the birth / death factor that the Labor Department uses to calculate job losses for April. The birth / death adjustment seems to be a guess as to how many new businesses were formed (births) and how many businesses went out of business (deaths). According to Abelson's article this estimated number added about 200,000+ jobs to the payroll number. Had this number been zero the number of jobs lost to the economy would have approached 300,000. He astutely pointed out that the Labor Department estimated that finance jobs were created as well which does not blend well with the massive retrenchment occurring on Wall Street. Great stuff Mr. Abelson!

George Vecsey on Character

I am a little late with this but there was a great article this past Wednesday in the NY Times sports section written by George Vecsey. I will not do Mr. Vecsey justice by writing my summary about it so it is best to read it if you can. I will just mention that if you ever need to define the word character then the behavior of these young ladies in this article fit the description. The title of the article is "A Sporting Gesture Touches 'Em All." A very uplifting story, so great job Mr. Vecsey! Here is a link to the article:

http://www.nytimes.com/2008/04/30/sports/baseball/30vecsey.html?_r=1&oref=slogin

April Employment Estimate

From Yahoo Finance and Briefing, the non farm payrolls estimate is for the loss of 75,000 jobs. Based on all of the information that I take in my guess is that the job losses will be much larger than that for a loss of 130,000 jobs. Again I may be skewed because how bad things are in finance around the New York City area. I also follow the residential rental market around the tri - state and it has been extraordinarily weak, plus the very small businesses I speak to all say that business has been weak.

The Fed and The World Wide Food Riots

With the Fed holding a two day meeting they have an opportunity to discuss things at length and topics that they may not have the time for when they hold a one day meeting. Which temporarily brings me to another point - that the Fed should hold two day meetings all the time as the one day meeting from my perspective seems to be a bit hurried. I will have to look at that another day as today I wanted to mention that the Fed may be able to discuss the food riots that have occurred during the past couple of months. What do the food riots have to do with the Fed? Well the Fed is the steward of the US dollar (even if the US dollar is officially the Treasury's territory) and since the Fed has slashed rates so much the dollar has been in rapid descent. The lower dollar has caused many commodities which are priced and traded in US dollars to march higher. These higher costs have been passed onto the consumer and often to the consumer in foreign countries whose populace receives low wages. This has caused food riots. A terrible situation and my heart does go out to those who are suffering. Amazing though how the Fed's lower interest rates have led to food riots half way around the world. We live in a very inter-related world, actions here can be felt around the world and vice versa. Members of the Fed are aware of the problems and some in recent days have turned rather hawkish. Today's meeting and the Fed's communique that follows will be all the more interesting because of these factors.

The Bouncing $ - Another Prop Removed From the Manhattan Housing Market

With the dollar taking off in recent days, albeit from extremely cheap levels, the high end of the Manhattan Real Estate market may experience a pull back from the foreign buyer, especially from the European buyer. The European high end purchaser has feasted on the Manhattan condo market for the past 4 years due to a combination of rising apartment prices and a sliding US dollar (especially vs the Euro where it has been killed during the past 5 years or so). With apartment prices in Manhattan already sliding and the dollar rallying, the European high end buyer will likely be giving second thoughts to buying any future Manhattan apartments.

Q1 2008 GDP - My Guess = -0.5

The Q1 GDP first estimate will be released this week. From Yahoo Finance I picked up the following:

Briefing Forecast: +0.7

Market Expects: +0.4

Prior #: +0.6

Important to note that these are annualized numbers (so they were multiplied by 4). I will throw my hat into the ring and say that the GDP Q1 2008 will have shown a decline.

My Guess: -0.5 (Made on Sunday April 27th)

I only am going off of the earnings reports that I have followed and the economic reports I have followed for the quarter also a ton of anecdotal information in the NYC tri state area. I talk to everyone when I buy something and here around New York City businesses all tell me that things have fallen off pretty hard. On the positive side there are the agricultural commodities and the boom in infrastructure related equipment related to commodities. Also the tech sector was very strong as Google, Intel and others said they have not any pull back. So a large propeller will be the exports. Starbucks has felt the consumer retrenchment though as the ultimate discretionary item moves lower on the list of consumer must haves. In combination with a weak dollar the exports really helped the economy out. Locally here in the US though the consumer was getting beaten around from all sides as the Bear Stearns storm hit, the employment picture sharply weakened and wage growth was weak.

The Fed's Bag Of Tricks

The Federal Reserve meets this coming week. The Fed's interest rate cuts may be only slightly helping the borrowing problems that exist in the economy. This is occurring because liquidity in the credit markets continues to dry up. This dried up liquidity has been caused by loss of confidence from the lenders. Who are the lenders that have loss confidence? And why are they snake bit? In this case the lenders are all of those entities all over the world that participated in the securitization process during the past 5 - 6 years or so. The lenders are snake bit because their loans that they owned decreased sharply in value and large losses were taken. So now they have become more careful. Also they have less capital to give because of the large losses they have sustained already. This brings me back to the Fed. The Fed sees the problems and they know that until the log jam from the credit markets breaks free that the system will not be able to be fully repaired. They know that further interest rate cuts may not help much if at all. Maybe the Fed will come up with some other weapon to work on the credit market problems or maybe the Fed will revert back to one of its other weapons that seem to have given it some traction. Those special auctions seemed to have helped get the Fed some traction. what will they come up with this time?

The WSJ on Friday mentioned that some credit spreads have come down. Notably the junk bond spread which had been up at 9 points fell back to the 7 - 7 1/2 points. They note though that this spread is still way above normal levels of 2 points or so. Another part of the credit markets that I have observed more closely is the Ted Spread. I have both the WSJ and Bloomberg TV to thank for pointing this out - that the Fed watches the TED Spread very very closely. The bottom line - TED under 0.50 is normal, TED above 2.0 is very worrisome, and in between is well in between. What is interesting is that the TED Spread has not stayed this elevated for this length of time since the 1987 crash. It currently is around 1.56.

Why Did An Institution Buy 10,000 Call Contracts on AMR

Today's Wall Street Journal had a blurb in their Option column on AMR. They reported that an institution purchased 10,000 contracts at about 2.60 on the January 2009 7.50s. This is a $2.6 million bet. For the purchaser to make money on these contracts the stock would have to get over 10.10. The big question is why did this institution make such a large bet?

I will put some possibilities out, but they are really guesses:

- The institution believes AMR will get taken over.

-This is not a bet but rather a hedge to offset a large short position in AMR.

- The institution believes the business is going to soar and that profits will follow.

- The institution believes that fuel prices will collapse.

Lets say for a second that this institution is not making this bet to hedge a position. In this case the belief that the stock would go up must be so strong that this size bet was deemed reasonable. Maybe a hedge fund who has come upon a thesis that seems likely to happen. Very interesting.

* Note I do not have a position in AMR but may take on at any point. I also may decide to not do anything. I am not aware of any position that the firm I work for has.

The Advantages and Disadvantages To A 130/30 Hedge Fund

Not long ago I attended a presentation at Columbia University that included a discussion on Equity Hedge funds and the percentage allocations that are popular. One of the popular allocations seems to be the 130% Long 30% Short fund. So what does this type of fund attempt to accomplish? A close examination brings to light some interesting observations.

First, what does this 130/30 break down mean? It may be easier to first look at a 100% Long only fund. A 100% Long fund means that every dollar of the assets is invested in equities. For example, if the fund had $10 million in assets, then the fund would own $10 million worth of equities (as close as reasonably possible, less commissions). Let's move from the 100% Long fund to the 130/30 fund. This fund would use leverage and would increase its Long exposure by 30% and initiate a Short position of 30%. If the fund had $10 million in assets, the fund would own $13 million in equities and simultaneously be short $3 million in equities. The leverage in this case would be 60%.

Another way to look at the 130/30 fund is to back out the leverage for a moment. In this case the fund would be 81.75% Long and 18.75% short. This is the same ratio as the 130/30 fund. The 130/30 fund is just an 81.75/18.75 fund on steroids. The important question is why do such an elaborate percentage as 130/30? If the fund is really an 81.75/18.75 fund in disguise why not just make the fund 81.75/18.75? The first reason is the potential for increased return. Instead of using only 100% of the assets, by using 160% of the funds assets the fund manager is levering the portfolio and therefor increasing potential returns. There is tremendous upside potential with this type of leverage. For example in a down market, the upside exists if the fund manager is able to pick longs that decrease less than the market and or pick shorts that go down more. If the fund managers wits exactly match the market then the fund will match the market exactly. The market and the fund will move identically.

However there is potential risk as well. The largest risk is that the extra 60% leverage goes against the manager. For instance in a worst case scenario lets say that the manager made poor picks. In this case the 130% Long positions decrease in value and simultaneously the 30% Short positions decrease in value (as the stocks the manager is short go up). Let's say that the longs go against the manager by 20% and the shorts go against the manager by 20%. The $10 million fund would drop to $6.8 million for a drop of 32%. If the fund had not used any leverage the fund would have only lost 20% and the assets would have been $8 million. In this case the manager would have been better without the leverage.

Tread carefully when using leverage. I have seen my fair share of problems arising from too much leverage and returns can definitely increase when used properly. Again it all comes down to risk management. Make the positions too big and your problems could cascade. Even if you think you are 100% Long via a 130/30 fund if there is a problem such that the extra 60% margin is really neutralized reality may be completely different if both the longs and the shorts go against you. In that case, action should be taken to lower the leverage and quickly.

The Dollar Strikes Back

Good to see the US dollar flex its muscles. In the short run the direction of the dollar will depend on the Fed. The strength of the economy and the rate of inflation will also factor in. Over the longer term the dollars position in the world will depend on the deficits it runs.

I am still a believer that the US is will be in the throes of a deflationary spiral and that the early stages of a deflationary spiral exist and can be seen through the housing market. However the deflationary run although deep in the housing market has not yet begun for either of two reasons. One: I am plain wrong and deflation will not spread from the housing market to the rest of the economy or two: My synopsis was just early and deflation has not made its way through yet. I am not sure of the answer but still believe deflation is coming and I was just very early. I think another sign to look out for will be the local and state governments and their budgets. If the state and local tax revenues fall off precipitously these local governments will be forced to do one of two things. They will either have to find a way to raise more revenues which likely means higher taxes or two they will have to make cuts to their budgets. Neither of these scenarios are of the pleasant variety. If deflation does take hold expect to see the dollar g on a tear and the model Giselle may then wish to rethink her wishes to getting paid in Euros.

TED Spread Again Moving Higher

The TED Spread is again moving higher. It is still below that important '2' level but it is showing tremendous nervousness again. Maybe there is nothing behind this but fear, but if there is something behind this move higher in the TED then caution is the word.

US Equity Indexes Year To Date

The stats here are from the close of trading on Friday April 18th 2008 and are taken from Yahoo Finance ( http://finance.yahoo.com/ ). The calculations are from me.

Dow = 12,849.36, -3.13% YTD

Dow 50 DMA = 12,366.02

Dow 200 DMA = 13,093.80

------------------------------------------

S & P 500 = 1,390.33, -5.31% YTD

S & P 500 50 DMA = 1,340.87

S & P 500 200 DMA = 1439.78

-----------------------------------------

Nasdaq = 2,402.97, -9.40% YTD

Nasdaq 50 DMA = 2,300.42

Nasdaq 200 DMA = 2,536.14

The Ted Spread

Interesting Ted Spread Chart I picked up from Bloomberg. The TED Spread refers to the difference between the London rate or LIBOR and the 'risk free' 3 month TBill. The spread usually stays around 0.50 or less. When it is in this 0.50 vicinity it means that there is less risk in the system. Currently at around 1.58 it is elevated. It has come down from the 2.4 in August 2007 and the 2.3 in December 2007 and the 2.05 in January 2008 but it still is relatively high. This means that there is still fear in the system and that the credit markets are still under considerable strain. The Fed watches this closely. The topic has popped up a lot since last August due to all of the market turmoil. There was an article in today's Wall Street Journal on this topic.

http://www.bloomberg.com/apps/cbuilder?ticker1=.TEDSP:IND

Could China's GDP Decline?

This is a pretty far out title. Many times in the markets I take a contrarian position. At times it looks like the dumbest call on the planet. Often I am wrong. It goes with the territory of being a contrarian. However when my contrarian view is correct often the position goes in my favor by a large amount.

Back to this title about China's economic output actually dropping. This is such a contrarian view point that I have not heard it - any where. Nobody thinks this could happen. But if the facts are examined closely even though it is an unlikely scenario it may not be as unlikely as people think. First let's look at the stock market. The Shanghai index has been clocked losing at least 35% from the top. The stock market is considered by some to be a leading indicator. Is it saying that China's growth will slow down sharply? Not necessarily but at least it is something to think about. What about the theory that a country that is growing so fast can't fall into recession. Well that doesn't hold much water since the US in the late 1800s and early 1900s had a very fast growing economy whose output was derailed a number of times as recessions ensued. If the US in its hyper - growth spurt a hundred years ago could fall into a recession, couldn't China? The Chinese currency (the Yuan or Remnimbi, not sure why there are two names but there are) has been appreciating as the Chinese authorities try to curb inflation. This is starting to hit the Chinese exporters. Lastly the US economy is rapidly falling deeper into recession. As a consequence the US consumer is pulling back sharply. The US consumer (according to Fred Hickey in Barron's in the Round Table) is about 19% of world GDP. A large portion of China's GDP is exports to the US consumer. Doesn't that mean that China is feeling the pull back too?

China falling into a recession is unlikely. I went through this thought process though to show that although unlikely it is not as unlikely as most believe. China go into recession? What would Jimmy Rogers do? He just packed his bags left New York and moved to China. He could always come back.

Gross Domestic Income - Mr. Nalewaik of the Fed

Looking for a date for the Q1 GDP release date I stumbled on this amazing paper titled, "Estimating Probabilities Of Recession In Real Time Using GDP and GDI." It was written by Jeremy Nalewaik in December 2006. Mr Nalewaik works at the Fed and this paper was part of the staff working papers in the Finance and Economics Discussion series. One always hears about these brilliant people in the background at the Fed. Well this looks like one of these really bright economists that that no one really hears about. Let me check that. After reading Mr. Nalewaik's bio, which says PHD University of Chicago. Well that pretty much says it all. Also here is a link to the paper:

http://www.federalreserve.gov/pubs/feds/2007/200707/200707pap.pdf

I just skimmed it a little. I found it interesting because from the anecdotal data I have been getting in the NYC tri-state area I have come to the guess / conclusion that the depth of the current recession may be much steeper than most think. My data may well be skewed because the tri-state area around New York City is heavily influenced by what happens in finance. And it is pretty easy to say that currently the world of finance has experienced some massive pain. Regardless it is still my gut opinion that Q1 GDP may be really ugly.

Now back to the paper by Mr Nalewaik. The main idea of the paper is that GDI may be a leading indicator for the strength or weakness of the economy. Now again I have not gone through the entire paper but it does seem intriguing. The next question someone may ask is well when does the GDI stat come out and where is it at the moment? It looks like it is released with the GDP number so we will have to wait. Since we already have Q4 2007 a GDI number must have been released from that. I will try to dig some more on this.

The Book - Beat The Dealer and Money Management

A couple of weeks ago I read the weekend edition of the Wall Street Journal and there was a great interview / article with Bill Gross and Edward Thorp. Bill Gross is the billionaire bond manager who controls the bond firm PIMCO on the West coast. Edward Thorp is the author of the book 'Beat The Dealer.' Edward Thorp was an MIT professor and wrote 'Beat the Dealer' after studying Black Jack and writing a paper about it. The book was written in the 1960s and it explains in elaborate detail how to win at the game of Black Jack. Bill Gross came across the book and studied the method then went to Vegas and applied it and won. What I found interesting is that Bill Gross who now manages about $1 trillion in assets uses some of the techniques to manage money at PIMCO. The big rule that he uses is the one about money management.

In the book Thorp teaches that unless your edge is strong to 'play' a small hand but that once the odds increase in your favor to then increase the bet size. I have read over and over again in many trading books about money management and that sizing the bet is one of the most important factors to longevity and success in the money management business. I personally believe that it is the most important factor. The reason is that if one makes bets that are consistently too large without having a consistent edge in all of those positions then the chances are very high that the trader is going to blow up. This was LTCM's problem in 1998 when they 'blew up'. No matter how strong their edge was it was not strong enough to outlast the negative forces that overtook their portfolio. Their bets were simply too large and they ran out of money before the positions came back to their favor. This was the SocGen problem with that trader Kerviel as well - position size.

Learn to size trades and you may be successful in this brutal business. Thanks to the Wall Street Journal for writing that great article and to Edward Thorp for writing that amazing book and to Bill Gross for explaining again the importance of money management. If you want an entertaining book and want to show off to your friends when you go to a casino, read Thorp's book 'Beat The Dealer'. It cost me $12. Definitely up there with some of the best $12 I have ever spent.

What Does the $13 Trillion Notional Value Derivative Contracts of Bear Really Mean?

I have previously written about counterparty risk and how the financial system is intertwined. Well Bear Stearns was one of these larger twine turners. The approximate notional value of their underlying derivatives was about $13 trillion. This does not mean that they were on the hook for $13 trillion but rather this $13 trillion represents the value of the underlying assets behind the derivatives had the derivatives been converted into that underlying asset. If this doesn't make sense then I will provide an example. Since most people understand stock options I will use that as an example. Before I begin I want to reference the Wall Street Journal for the $13 trillion. Around the week of March 17th they ran an article explaining the meaning of the $13 trillion notional value of Bear's derivative book. It helped me understand what notional value means. When large numbers get thrown around (and trillions of dollars are fairly large numbers) then people may not understand the actual risk behind these derivative contracts.

I will use the example of a call stock option. I am going to assume that the reader understands how a call option works. If not, then I may write an article explaining stock options, but that will be for another day. I will use IBM. I will also use the IBM 110 call with one week left to expiration. I will assume IBM is trading for 100 per share and there is about 1 week left before the contract expires and that the price of the call option is going to be very inexpensive. It may be 'Bid' 0.03 'Asking' 0.05. Let's say I wanted to be very daring and thought that the stock could jump over 110 by week's end or prior to expiration. Assume I am willing to risk $50,000 (note this is a bad bet as it is extremely unlikely that IBM moves 10 points higher in 1 week's time and that I am likely to lose $50,000). So I buy 10,000 contracts for 0.05 per contract. (Lets assume that there is no commission) then I have a position that gives me tremendous leverage. With a $50,000 position I now control 10,000 contracts or 1 million shares. With IBM trading for $100 per share the notional value of this position would be 1 million shares x $100 per share or $100 million dollars. Am I liable for $100 million? No. Is the entity (or counterparty) on the other side of the trade liable for the $100 million? Very unlikely, but they are liable for a portion of the contract if it went into 'the money'. For instance, if IBM went to 120 before the week's end my counterparty would have to pay me $10 million. Back to my side of the trade and what I receive. Essentially I now have exposure to the stock that if it were to clear that level of 110 that would give me leverage and exposure as if I owned 1 million shares. Notional value of a derivative assumes the full price of the underlying asset instead of just a portion of it. This is sort of what the $13 trillion of notional value that Bear was exposed to means.

*********************************

Another way to look at the notional value of the swaps market is that it represents the amount that the swap is insuring. On one side of the transaction a payment stream is often assumed. Therefor the notional value is not something that is paid out but rather just what is insured. I give credit for this further clarification to the CFA program curriculum. In recent days after reading the CFA derivatives book in preparation for the CFA exam I have a better understanding of notional value.

S&P 500 - Q1 Volatility

The number of days in which the S&P 500 had at least a 1% move in Q1 2008 was 51%. This was the largest percentage for a Q1 since 1934 and the 5th highest percentage for a Q1 in history. I read this stat in an article in yesterday's journal recapping the first quarter US equity markets.

What does this stat mean? An analogy may help explain what this means. On about 51% of the days in Q1 I felt like I was a piece of laundry in the washing machine spun around in all different directions and speeds. Not really the most pleasant of feelings. Basically this means that for a Q1, the S&P 500 volatility was at unprecedented levels and at the highest levels since the heart of the Great Depression.

$99 Trillion

$99 Trillion is the total Present Value of the funding needed today if Social Security and Medicare were to be fully funded. I caught this stat in a speech by the Dallas Fed president Mr. Fisher the other day. He was quoting recent figures from a study and Mr. Fisher was trying to bring this massive problem to the attention of those in the financial community. It seems that very few in the political world want to talk about this massive problem. The Social Security Present Value was placed at $13 Trillion and the Medicare Present Value was placed at $86 Trillion. His point was that these numbers dwarf the US's annual GDP which is around $13 Trillion and that the political will must be strong enough to attack this problem, now.

Who Has The Fed's Back?

If the Fed runs out of money, who has the Fed's back? I ask this question not to knock the Fed but rather as a question that may need to be answered. The Fed's balance sheet is about $700 billion worth of Treasuries. They have recently opened up quite a bit of that to the Street. What if the Fed over extends itself? Who has the Fed's back?

Maybe there is nothing here. I thought it might be worth exploring though. First it was just regular banks that the Fed lent to. Now it is also the Investment Banks. Interesting as the Fed has expanded its reach. I would doubt that at the moment that the Fed is extended but if it continued to expand its reach and other banks or investment banks needed its help, would the Fed be able to answer the call? Something to ponder.

3 Month Tbill Now Yields 0.51%

0.51% for 3 Month T-Bills. The Lowest since the 1950s. Amazing. I am just stunned to see this low yield. Add this amazing stat to the list of off-the-wall stats from the past 8 months. There have been so many. Wall Street stats are made to be broken. But to see so many statistical oddities happen simultaneously is the stunning part. Amazing just amazing.

The list of the Deflationary Spiral of 2007 - 2008 is getting longer by the day.

Commodities - It Was Bloody Out There

I was just re-reading an old post I wrote about the day Wheat soared 25% in one day. I said in the post that with moves like that that there had to be some real damage to a hedge fund or trader or some entity. Well with the tremendous down moves today in ALL of the commodities I think it may be safe to say that there is someone on the wrong sides of these commodity moves today. The 60 point move in the Gold futures contract was enough to create large scale pain. But with the carnage across the entire spectrum there are likely many players hurting. The forces of these moves are amazing. Silver, Oil, Gold the list goes on. Just huge moves. I don't wish carnage out there on anyone as I have been on the wrong side of many a trade. I am just making an observation. It is just from my experience that says that with huge down moves like today's some person, trader or entity is likely in very large financial pain tonight.

The Fed Is Trying To Avert A Deflationary Spiral

The other morning CNBC had an interview with an analyst. I forgot his name as it was very early. But what he said made a lot of sense to me. He said that people (investors, traders) are underestimating the collective brain power of the Fed. His point was that those who thought the Fed had been asleep at the wheel were mistaken. He believed that the Fed would eventually figure a way out of the large economic problems facing the United States.

I recall that now as I think about where the US economy is at the moment. My line of thinking is that the US residential real estate market's rapid decline if left unchecked could spread through the system creating a possible deflationary spiral. If that were to happen money would become scarce and therefore much more valuable. Consumers would have a tendency to hold onto their cash thinking that prices would drop. Consumers would also begin to worry about how they were going to replace those precious dollars. A scenario like this would be devastating to the US economy. At the moment a scenario like this is also hard to imagine when commodities have been soaring along with prices of almost everything else. In my view today's inflation is past history and was caused by monetary policy errors made in the past. It is unlikely to continue. The possibility of a deflationary spiral though is real. It is real because cash and debt have become harder to get and because asset price deflation is occurring in many areas of the economy. The assets deflating include the US residential housing market, the US equity markets, and most importantly the US credit markets.

Ben Bernanke as leader of the Fed studied the Great Depression and is an expert on the problems to watch out for in the economy if deflation tried to gain a foothold. Unfortunately Bernanke gets a misplaced nick-name, 'Helicopter Ben' by traders and others in the business because many years ago he made a reference to monetary policy stating that to avert a deflationary spiral the Fed could drop dollars from helicopters. I believe that Bernanke through the thick smoke screen of current inflation really sees the possibility of a deflationary spiral and that this is what is driving his and the Fed's current thinking. The Fed and Bernanke do get it and know what the real threats to the economy are. It is still too early to see if the remedies offered are going to work though. Consumers can be offered cash but if they are not going to spend it then that can be troublesome. But at least the right man and is on the job. And to quote that guest on CNBC the collective brain power at the Fed should not be underestimated. The commodity markets sure received a dose of the Fed's brainpower the past couple of days.

The Markets are Killing Everyone

Equity bears were gored yesterday. Equity bulls got their comeuppance today (and since August). Commodity bulls were slaughtered today. Come on Gold futures down about $60 today! I repeat 60 points in one day!! Oil down $6. Silver $1.50!! These moves are enormous (but for the US and world consumers the commodity slide is very welcome). Of course Gold and many other commodities have been going up since 2002. And in the commodities market there often is much more leverage used. Wheat had that huge run up. Have to wonder how much was caused by leverage. I think commodity players can lever their accounts by up to 10 times. In the stock market one is only allowed to lever by a 1:1 ratio. In the financial markets it seems as though there has been one giant margin call. At the moment there are no hiding spots. Even those who thought they were safe in cash - like investments have at times run into trouble. Look at the ARS market. The ARS or Auction Rate Securities market has frozen and those who have their cash invested are locked in. The cash is likely to be returned but the timing is unknown. Unless it is good old fashioned T-Bills or Bank CDs for under $100,000 savers need to be careful what type of investments they use. Everyone is feeling this one. Unless you are a hermit and have your cash in Berkshire Hathaway CD's (they don't exist just offering a hypothetical), this has just been brutal.

Whiplash

One day the US indexes are soaring the next day they are crashing. I am getting whiplash.

The JP Morgan Bid for Bear Is a Joke

Bear shareholders should turn this deal down, this is an absolute joke. The assets that Bear holds are not getting any bids but the underlying cash flows behind the structured products exist. This bid by JP Morgan values those assets at zero. Those assets are not worth zero. Bear should shop the book around, as it should be worth much more than zero.

Disclosure: I have no Bear position nor am I aware of any position that the firm I work for has in Bear.

Later in day disclosure: I traded a tiny position in the equity from the long side and barely broke even.

Happy St Patrick's Day!

St Patrick's Day is a special day for my family as two of my grandparents met on St Patrick's Day.

So a Happy St. Patrick's Day to everyone!

Inflation Will Vanish

No doubt commodities have been on a tear. There is also no doubt that inflation has jumped back into the economic picture here in the US. Wheat Gold Oil. You name it it is likely to have gone up. Gasoline has lagged and Nat gas has lagged although they are both up. I don't think this is likely to last though as I am already seeing deflation pop into the picture.

The US consumer (courtesy of Fred Hickey from the Barrons round table in January) is about 70% of the US GDP and about 19% of world GDP. In other words the US consumer is king. The consumer is still spending but barely at positive growth rates year over year. The retail sales numbers show that. Most retailers except for WalMart are hurting. Interesting if you look at Walmart they have been actually cutting prices. Hard to believe when so many commodities are running that Walmart is cutting prices. I think it is interesting to look at the Manhattan real estate rental market as well. In February price increases in some locations were met by prices declines in others so basically a slight rebound from January. I quote the most recent REGNY report ( http://www.tregny.com/manhattan-apt-rental-report.jsp ), " In general, however, we’re seeing more inventory on the market than we have in a long time, and landlords struggling with excessive vacancies continue to offer concessions to support existing prices or attract new tenants quickly." This quote to me shouts deflation. "Landlords struggling with excess vacancies continue to offer concessions to support existing prices." If the banking sector continues to retrench then the Manhattan rental market will only get worse due to its large exposure to the financial industry.

So deflation does exist. It exists in the rapidly deflating housing ownership market and has now spread into the real estate rental market (at least in Manhattan). It exists in the credit markets. Credit is becoming more and more difficult to get with each passing day. Fannie Mae has to pay a lot more for money and that makes it more difficult for them to lend to home owners which then leads to existing home owners cutting prices to move their homes. HELOCS are getting tougher to get. Refinancing a mortgage has become problematic as the equity in the home has dropped from lower prices. The asset backed commercial paper market has stabilized although at much lower levels than previously. LIBOR has fallen back in line which should help home owners with ARMs but LIBOR does bear watching. The private equity sector of finance has come to a crawl as lenders are less willing to lend to fund equity purchases. The US stock market has taken about a 20% hit, so money is vanishing there as well. The cumulative effect on this is that there will be less dollars to lend, decreased sums of dollars from asset sales (housing and equities) and fewer dollars to buy goods. This will lead to possible deflation. This is why the Fed is pumping so much money into the system and will do so for the foreseeable future.

A disclosure here. In 2004 when the Fed kept rates at 1%, I worried about inflation as I thought the US was well on its way to recovery. I even emailed the Fed to tell them they were making a mistake by keeping rates so low. They politely responded with a form email. So its not like I am an inflation lover. But rather I see real signs that deflation is a problem and it is already starting to spread. I think it is possible that the US dollar rallies strongly as inflation pulls back and that commodities are likely to pull back as well. The key question is how bad does the recession get? If the US went into a deep recession then deflation could spiral. If the recession were mild lasting about two quarters then price pressures that exist now would some what pull back. If the US consumer continues to have trouble getting access to cash from asset sales or job losses increase then inflation should follow suit and vanish as well.

US Stock Indexes Year To Date Through Feb 29th

As of the close of February 29th 2008:

Dow = 12.266.39, -998.43, -7.5%

S & P 500 = 1330.63, -137.73, -9.38%

Nasdaq = 2271.48, -380.80, -14.35%

The stats are from Yahoo Finance and the calculations are from me.

Espey Manufacturing and Garan

I have not recommended stocks before because the firm I work with trades a lot and it is hard to know all of the positions at the exact moment I write the article. Tonight I will mention a stock though. At the moment I have no position in it and I know that the firm I consult for does not either.

The symbol is ESP and the company is called Espey Manufacturing. The stock is a microcap with the market cap at $52 million. If you read the profile about me you will see that years ago I went through an entire S and P stock guide looking for value stocks. I would do rough calculations in my head moving from one stock to the next. There were possibly 8,000 stocks in the guide but definitely at least 5,000. Any way I gathered a list of names and came up with maybe 30 - 50 names form the initial 5,000. What was strange about these stocks is that many were microcaps that never traded. And often the stocks would just sit there for days and never really do anything. Two of the names that were on the list were Garan (Old symbol - GAN) and Espey Manufacturing symbol ESP. This may have been around 1993 or so. Well I did my due diligence and liked both of these companies but only bought Garan. Garan was an interesting company and easy to understand as they made stuff for little kids. I think like clothes that kids would wear and these animals would be on the clothing. Kids loved them and the animals were called Garanimals. So I bought it. I then held the stock and I waited and waited and there were days that the stock did not even trade. After about 4 months I had enough as the stock just sat there. So I sold the stock and maybe wound up making a little money on it. Any way maybe about 18 months later or maybe even 5 years or so later Berkshire came in and bought the company at a huge premium. Had I held the stock I think I would have at least tripled my money.

Fast forward to today and I was watching CNBC the other day and actually saw ESP go by on the tape. I remembered ESP it was one of those value stocks I picked from that S and P guide back in 1993. Immediately I remembered the Garanimals story and that Berkshire wound up buying the company out. I am not saying to buy ESP. I have not done any work on it but I was just amazed to see the stock on the tape and to see the market cap at $50 million, amazing. I can tell you that in 1993 when I found it, it was a bargain. Is it still a bargain today? I have not done my due diligence on it yet to know but I am interested in finding more about it.

Disclosure: I do not own ESP, nor does the firm I consult for. However at some point I may buy the stock if after doing my research I decide to step in.

Wheat (ECBOT) Today Swung 25%

Electronic Trading at the CBOT for Wheat today swung from 1065.25 to 1334.50, a 269.25 point move or a 25.28% move in one day. To put this into perspective this is like the Dow starting at 10,000 and then hitting an intra-day high of 12,500. Can you imagine the Dow moving 25% in a day? Only in 1987 did a move like that happen in the US equity markets. The daily limits on Wheat were just lifted on Feb 25th so it is logical that the high - low band would increase but to increase to a 25% swing. Maybe the authorities that be will rethink the change to the daily limits in the Wheat market because it doesn't seem to be dampening the volatility in the market place and may even be contributing to an increase in volatility.

I am an equities guy, but for me there has to be some blood out there. To see commodities swinging like this must mean that there have to be some traders on the wrong side of this. Some of the wheat shorts have got to be getting carried out. I imagine that we will hear about some commodity fund 'blowing up' due to the swings in Wheat. Maybe even due to the swings in Wheat this week. Geesh 25% in a day! The leverage involved has to be thought about as well commodities can be bought with a 10% down payment, unlike in equities when you need to put down 50%. Maybe the commodities regulators will eventually look at that - the margin needed to put down. Amazing 25% swing in Wheat today, I can' get over that.

The Wheat information about the ECBOT came from:

http://futures.tradingcharts.com/intraday/ZW/38

US Indexes Year To Date

As of the close of trading for Friday February 22nd:

Dow = 12,381.02, -883.80, -6.66%

S and P 500 = 1,353.11, -115.25, -7.85%

Nasdaq = 2303.35, -348.93, -13.16%

The stats are from Yahoo Finance (http://finance.yahoo.com/), I calculated the point changes and the %age changes.

How Worried Is the Fed?

On Fridays I like to watch the Nightly Business Report. It is a business program on PBS that is on daily at 6:30 PM ET. One of the main reporters is Paul Kangas. He has been reporting for NBR since I was a young fellow and really knows the markets. I remember when I was growing up he used to say, "And on Wall Street, the bulls and the bears went at it again." On Fridays Kangas has a segment with a guest that is called the market monitor. Last weeks market monitor was Jim Stack. Stack is another 'solid fellow' as he has all sorts of stats at his fingertips. The one quote that Stack said that stuck with me after the interview went something like this, "The last time the Fed has cut the discount rate twice in a ten day period was in 1914... This goes to show how worried the Fed is. "

Thanks Paul for that interview and Jim for that stat. Wow the last time the Fed reacted by cutting the discount rate twice in a 10 day period was almost a hundred years ago!

A Hidden Problem - The Credit Markets and New York City Coops

What I write here is just a hypothesis. I do not have access to coop data to support this hypothesis nor have I gotten around to doing the research. So it may be completely off base as it is just a hunch. Also for disclosure purposes I do not own shares of a coop. The purpose of the essay is to notify coop boards and share holders of the possible difficulties faced when a coop tries to refinance its mortgage, and the ramifications of those difficulties including the possibility that coop sales prices decline.

**********************************************************************************

New York City apartments are classified as rentals, condos or coops. Rentals are easy to understand and condominiums are fairly common across the country so I won't discuss them except to say that it is my understanding that condominium associations are not allowed to have debt. Cooperatives on the other hand are corporations that can issue debt. Often when a building converts from a rental to a coop, the coop will take on mortgage debt to buy the physical assets such as the building and the land. When someone buys a cooperative apartment the individual is buying shares of a corporation. The coop corporation then leases the apartment to the share holder. However the individual who becomes a share holder assumes a liability for his portion of the coop mortgage debt. This mortgage debt is part of the coop monthly maintenance payment that the share holder makes to the coop corporation.

Usually the coop sets up mortgage payments that only pay off the interest and not the principal, so the mortgage never gets paid down but rather is rolled over into a new mortgage. It is possible that many coop share holders are unaware of this mortgage since it is a part of the maintenance payment nor are they aware that the principal does not get paid down. This is not supposed to be problematic though as the coop corporation usually will just refinance the mortgage when it comes due. However in recent weeks when the debt markets have given fits to borrowers such as the Port Authority and the state of Michigan, cooperative associations may be facing larger hurdles to refinance their mortgage debt. I am curious to see if the past relationship in which coop corporations borrowed money fairly easily still holds. Maybe coop corporations will not have any trouble refinancing their mortgage debt. Maybe they will face modestly higher interest rates. Perhaps they will be facing much higher interest rates. Could coops be paying the 20% interest rates that the Port Authority recently paid in the debt markets? In this debt environment anything is possible. I was stunned to see that the Port Authority had to pay 20% to borrow money.

So the question remains, how easy will it be for New York City Coops to refinance their mortgages in the debt markets when they have to roll over their old mortgage from a maturing one into a new one? If a new mortgage can't be issued, will shareholders be forced to immediately come up with the money to pay off the old mortgage? Usually these mortgages are in the millions of dollars so if coop share owners were immediately responsible for their portion of the mortgage, could this add thousands of dollars in bills to each share holder? If each share holder were then burdened with a large one time payment could this cause a flood of coop owners to sell their apartments before hit with this charge? Could this adversely affect New York City coop prices? Since there are thousands of coop buildings in New York City, how many residents could this adversely effect? I heard a stat that excluding rentals 70% of individual apartments in Manhattan are coops. I am not sure coop share owners are aware of the current problems that are occurring in the debt markets and the problems that coop corporations may face when refinancing their mortgages. It is possible that the New York City real estate and particularly New York City cooperatives may not be so insulated from the credit crunch or the housing decline after all.

St. Valentine

I read a short bio on Saint Valentine the other day and found it interesting as I did not know his story. So here is a rather simplified note on the famous Saint.

Not sure of the dates he lived but he was a priest who married Christians even though he was forbidden to do so by the Roman authorities. He defied the authorities and still performed the Christian marriages. So he was executed. Talk about conviction, you could see why the church made him a saint.

Freedom to pursue religion is such a basic right in this country that it is almost second nature. You want to go to a house of worship, go right ahead. You want to be an atheist or a Druid go right ahead. Freedom of religion does not exist in all countries in the world though so it is something to be cherished here. Saint Valentine unfortunately did not have that freedom.

About 3/4 Of Hedge Funds Lost Money In January

The stat above came from today's NY Times. It was a quote from an article titled, "Bad Bets and Accounting Flaws Bring Staggering Losses" and is about losses in the financial industry but particularly hedge funds. The article points out that all types of hedge funds are struggling this year. Whether the fund is Long/Short, Long only, Short only, overseas, or other, the fund is likely to be under water. I am not sure of the historical precedence of a stat like that, but I do know that the US equity markets have had one of the worst starts ever. What I find particularly interesting is that even the equity short funds are suffering. It seems that the market's violent turns are wreaking havoc even if you happened to be short the market. Even the great Goldman Sachs has not come out unscathed. According to the article the approximate $7 billion Goldman Sachs Partner Fund was down 6% in January. If the risk managers that Goldman's Partners hire to run their money are down 6% in a month, then you know that things are really tough out there.

OPEC Can Expect Some Backlash

OPEC recently announced that it may cut production if the price of oil approached $80 / barrel. If oil approached $80 / barrel and OPEC followed through on the cut back, OPEC could expect European backlash. Recently because of the cheap dollar, as oil has soared European countries have not experienced the full brunt of the price increase. But the recent rebound in the dollar changes that and if the dollar were to continue to increase European consumers would experience more of the pain caused by the high oil price. If oil prices recede to the $80 range and OPEC moves to counter balance the price decrease with a production cut, and a recession in Europe ensued, OPEC could expect some strong condemnation from the European countries. Note to OPEC, it would be wise to reconsider this.

US Equity Indexes, Year To Date Stats

Here are the year to date stats for US equity indexes as of Friday February 8th.

Dow = 12,182.13, YTD = -1,082.69, YTD % = - 8.16%

Dow 50 DMA = 12,913.73

Dow 200 DMA = 13,346.73

S & P 500 = 1,331.29, YTD = -137.07, YTD % = - 9.33%

S & P 500 50 DMA = 1,421.32

S & P 500 200 DMA = 1,480.73

Nasdaq = 2,304.85, YTD = -347.43, YTD% = -13.10%

Nasdaq 50 DMA = 2,519.71

Nasdaq 200 DMA = 2,602.95

As the above shows all of the averages are deep in the red for the year to date. The Nasdaq has taken the lead as the year's worst performing index. Also of note is that all of the indexes are deep below their 50 DMA and 200 DMA.

The stats are from Yahoo Finance: http://finance.yahoo.com/

The percentage calculations and the Moving average calculations were calculated by me.

The Movie 'The Train' and This Bear Market

There is a classic World War Two movie called 'The Train.' It is loosely based on the French Resistance during World War Two and the means it used to stop the Germans from looting French art at the end of the war. The great American actor Burt Lancaster plays the French antagonist Labiche and the German officer is played by Paul Scofield. Turner classics puts it on every once in a while and it is well worth watching if you get the time.

(Sorry for spoiling the movie if you haven't seen it but to get my point across I have to reveal the main plot. So if you want to watch the movie some day and have not seen it, please don't read on.)

In the movie there is a train loaded with French paintings that is headed for Germany. Along the route though it gets sabotaged by the French resistance so it keeps getting delayed. The main leader of the sabotage is Labiche. What I found especially memorable is the will Labiche had to try to stop the train. He was injured and barely could walk and yet he would somehow find a way to sabotage the tracks miles ahead of the train. He would single handedly vandalize the rails. To the German officer he was like a pest with magical powers that kept popping up and that would never go away. The German officer was always muttering to himself, "Labiche!" So as Labiche became obsessed with stopping this train during its journey the German officer becomes obsessed with trying to stop Labiche. It became a matter of wills.

This movie reminds me so much of the current bear market. As Labiche would hound the train to stop the French art from being looted, the current bear market is stalking investors. Every time the German officer thought the train was free to speed to Germany Labiche would thwart his efforts. The same thing can be said about the bear market. The bear is stalking investors and every time investors think they are in the clear (sounds familiar to the last two weeks of January when the Dow roared 1200 points and investors thought they were in the clear) the bear comes back with a vengeance. The Bear market wreaks havoc and is unrelenting in its pursuit of investors just like Labiche was in pursuit of that train. By the end of the movie the German officer was so frustrated he just gave up. And I believe that until investors do the same this bear market will not rest.

Yahoo and Google

When Google was still private it generated a great deal of interest, so much so that Yahoo offered to buy them out at one point. I don't remember the details exactly so the numbers here are very rough and are just an approximation of the numbers being thrown around at the time:

(The numbers here are rough estimate from my memory. I use the numbers to give a rough estimate of how Google was being valued back then.) Google was a small but growing rapidly search company in the early 2000s. Yahoo came around and liked what they saw and offered to buy them. I don't remember the price but it may have been about $300 million. Whatever the number it was a very large multiple of revs. Google came back and said OK but we want a higher price how about $600 million - $800 million (Again an approximation). Yahoo thought about it and said OK. But then Google changed their minds again and said no we want $1 billion. At this point Yahoo walked away.

What if Yahoo had bought them for $1 billion? All one can say in response to that is wow, especially since Google's market cap is over $150 billion. I do give Yahoo management credit though as they were able to sniff out a real business in its early stages and they came so close to owning them. Yahoo did own Google shares when Google went public in the summer 2004, so maybe Google will return the favor and buy a stake in Yahoo. I don't see them buying Yahoo but I do think they could make a strategic investment in Yahoo though. After all these are all former Stanford guys.

* Disclosure - I do not have any position in either Yahoo or Google. The firm I advise may or may not have positions in either of these two companies.