Market and Economic Outlook Part III

This is a third excerpt from the October issue of “Moving Markets”, for a full complimentary copy visit www.usawealthmanagement.com.

Meanwhile, unemployment continues to climb. An October 1, 2009 story on ‘Bloomberg’ revealed first time jobless claims were up in the most recent week:

The number of Americans filing first-time claims for jobless benefits rose more than forecast last week, a sign companies are still cutting workers as the economy pulls out of the recession.

Applications rose by 17,000 to 551,000 in the week ending Sept. 26, from a revised 534,000 the week before, Labor Department data showed today in Washington. The total number of people collecting unemployment insurance fell in the prior week to 6.09 million, the least since April.

Monthly job losses have slowed as government stimulus measures spur production and consumer demand, helping to end the worst economic slump since the 1930s. The Labor Department may report tomorrow that the economy lost the fewest jobs in more than a year last month, while the unemployment rate kept rising, indicating a rebound in hiring will be gradual.

“The economy is on track for a jobless recovery, and unemployment will likely remain high well into next year,” said Sal Guatieri, a senior economist at BMO Capital Markets in Toronto. “We’re just not seeing a pickup in hiring. It means a long road to full recovery.”

What is a ‘jobless recovery’? This from “The New York Times” September 5, 2009:

Many experts envision a jobless recovery, in which the economy grows but job losses persist. That would reprise the end of the last recession in 2001, when payrolls continued to decline for nearly two years afterward.

Such an outcome would confront the Obama administration with a potentially nettlesome political problem heading into next year’s midterm elections. After the government unleashed $787 billion to stimulate economic growth, and after it bailed out financial institutions and the auto industry, the unemployment rate exceeds worst-case projections envisioned by the administration early this year.

I’d argue a jobless recovery isn’t really a recovery at all. I’d also make the case the recession that ‘ended’ in 2001 didn’t really end at all, at least as far as economic fundamentals are concerned. Evidence suggests something quite the contrary.

In an attempt to end the recession, then Federal Reserve Chairman Alan Greenspan, reduced the Federal Funds rate much the same way Bernanke has. Arguably, it was this activity that may have helped create, perhaps even have caused the real estate bubble fallout we’re dealing with now. Greenspan’s actions simply added to the level of private debt, resulting in the false appearance of economic expansion. Instead, by reducing interest rates, consumers began to borrow, acquiring ‘cheap money’ wherever possible.

Take a look at the history of the Federal Funds rate (Source: Federal Reserve Bank of New York)

For a period of 3 years from 2001 to 2004, the Fed Funds rate was 3% or less. During that time the real estate bubble was building. Note the chart below:

The blue arrow I’ve inserted on the chart illustrates the approximate point in time the Federal Reserve Reduced the Fed Funds interest rate. Note the red line on the chart represents inflation adjusted housing prices. At the time the Fed reduced interest rates, inflation adjusted housing prices were at a high from 1970. Then look at what happened to housing prices as a result of reduced interest rates. By the time the Federal Reserve increased the fed Funds rate back to the 3% level, home prices had increased about 50% on average in only a 3-year time frame.

During this time, homeowners were encouraged to use their homes as ATM machines. “Pull the equity out of your home and spend it, invest it, or blow it – your home will continue to appreciate in value,” claimed the commercials of many mortgage companies. Consumers bit and bit hard, further fueling the housing bubble.

Investment bankers smelled blood as they were no longer hindered by Glass-Steagall, the act passed in 1933 that established the Federal Deposit Insurance Corporation and required banks to clearly define whether the institution was a commercial bank or an investment bank. The act was designed primarily to prevent many of the abuses that took place in the 1920’s and lead to the stock market collapse that began in 1929.

Prior to the passage of the Glass-Steagall Act, 11,000 of the nation’s 25,000 banks had failed or were forced to merge – better than 40% of the banking universe. The ability of banks to engage in both lending and investing, something the Glass-Steagall Act prevented, was one of the reasons for so many bank failures. (Source: “The Separation of Commercial and Investment Banking: The Glass-Steagall Act Revisited and Reconsidered.”)

In 1999, 66 years after its original passage, the Glass-Steagall Act was repealed and banks once again were allowed to engage in commercial banking as well as investment banking. Bankers began to market low interest loans using real estate as collateral as soon as the Federal Reserve began to reduce interest rates. Thanks to the repeal of Glass-Steagall, banks were no longer limited to commercial banking and could now ‘package up’ these loans and sell them as collateralized mortgage obligations to investors. The repeal of the act permitted banks to make money both on the loan and on the selling of the loans packaged up as securities.

The more profits bankers made from this type of business, the more creative they became, both on the lending side and on the securitization of these mortgages. Just prior to the collapse of the housing market, many banks were offering sub-prime mortgages, payment optional mortgages and rate reset mortgages. And, banks continued selling securities comprised of these mortgages to investors regardless of the risk of default.

You may be wondering how banks could find investors for these high risk mortgages, especially in light of the fact these mortgages required zero money down and no income verification on part of the borrower (an idea invented by these very banks). After all, who in their right mind would buy such a risky mortgage?

One explanation - there is evidence the rating agencies, companies in the business recognized as experts in rating the quality of an investment , may have fallen down on the job.

Here are some excerpts from an article published by “The Market Oracle” on December 18, 2008. The piece was written by Shah Gilani, quotes from the article are reprinted here (highlighting mine):

Underlying the credit crisis gripping the U.S. and world economies is a crisis of confidence. Blame has been laid at the feet of the U.S. Federal Reserve, and an investment bankers’ brew of toxic financial products. Ultimately, however, it was the supposedly trustworthy rating agencies that got everyone to drink the poisoned Kool-Aid……

Letter and number ratings – such as AAA, Aa1, BBB and Caa1 – are financial shorthand for the due diligence supposedly done by rating agencies after they’ve examined an issuer or a security’s financial structure, and evaluated the likelihood of its being able to pay interest and principal at maturity. Investors rely on the objectivity and fiduciary responsibility of the rating agencies to publish fair, accurate and uncompromised assessments.

By law, certain investors must rely on the ratings of a handful of Securities and Exchange Commission designated “Nationally Recognized Statistical Rating Organizations” (NRSROs). For example, most state insurance regulators require that only assets rated in the top four ratings categories by NRSROs are eligible investments. Similarly, money market funds can only invest in securities with the highest NRSRO ratings. In fact, innumerable institutions – public and private, and domestic and international – mandate asset quality levels predicated on the major rating agencies’ due diligence……….

The problem with the business of rating the issuers of securities, and rating the securities they issue – such as mortgage-backed securities and collateralized mortgage-backed obligations – is that the rating agencies are paid by the issuers to rate them. Objectivity aside, ratings firms are in business not to rate but to make money for themselves by rating issuers and their securities. It’s like all the contestants in the Miss World pageant paying the judges with country funds … who’s not going to be judged beautiful?

What was even more problematic in the scheme of the ratings business model was that analysts didn’t understand how to analyze and rate the very complex cash flow structures of these new collateralizedmortgage-backed securities. Not wanting to lose business to their competitors, who were all in the same boat, they used the same rating model structures that they used to rate corporate bonds, though the two different securities had nothing in common.

It was like asking your local car mechanic to certify your Citation V jet – just before you take off for a transatlantic flight to London. God help you if there’s a problem.

And there were problems. Lots of them. According to a Feb. 15 “Review & Outlook” piece in The Wall Street Journal , Joseph Mason, professor of finance at Drexel University, studied collateralized debt obligations rated “Baa” by Moody’s and determined that they were 10 times more likely to default than equivalently rated corporate bonds. The article went on to say that an S&P spokesperson, when asked if they actually examined the underlying mortgages in the pools, answered: “We are not auditors; we are not accounting firms.

It was a ‘perfect storm’ of low interest rates, ‘creative’ banking made legal by the repeal of Glass-Steagall and a failure of rating agencies to properly identify the risk associated with these new and imaginative mortgage backed securities. This very combination of activities helped create a huge debt bubble and became a leading factor in the economic downturn.

The economic debt bubble continues to inflate at a rate never before seen due to Keynesian government spending. Spending designed to create the economic demand needed to keep the economy growing since consumers are no longer spending at normal rates. Assuming the government is successful in stimulating the economy yet again, the ultimate price to be paid by both the public and private sector will be much higher than if the debt was dealt with now.

Securities offered through USA Advanced Planners (Member FINRA/SIPC). Advisory services offered through USA Wealth Management. USA Advanced Planners and USA Wealth Management are affiliated companies. The opinions expressed herein are those of the writer and not necessarily that of the above noted affiliated companies. This update may contain forward-looking statements, including, but not limited to, statements as to future events that involve various risks and uncertainties. Forward-looking statements involve known and unknown risks, uncertainties and other factors which may cause actual events or results to differ materially from those that were forecasted. The information obtained from third party resources is believed to be reliable but the accuracy cannot be guaranteed.

This information is education in nature and, therefore, is not intended to constitute investment advice and should not be interpreted as a recommendation to purchase, sell or hold a particular security. Prior to making any investment decision, the services of an appropriate professional should be sought as investment related recommendations are dependent upon the personal situation of each individual investor. Investing in market related securities involves a risk of principal loss.