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How To Fix It

Mon, 31 Mar 2008 19:27:38 EST

How To Fix It - by jmauldin

This week we will look at what will be a fairly controversial essay by good friend Michael Lewitt of HCM. In light of today's speech by Treasury Secretary Henry Paulson of the re-organization of the regulatory system in the US, Michael suggest we look at what the real problems are before we begin the process of re-arranging the deck chairs on the Titanic. For many, some of what he says will be considered economic heresy. I do not agree with all of it (though I am in solid agreement on most of it), and look forward to talking with him in a few weeks in La Jolla when we are together. But the point of Outside the Box is not to find material that I or you agree with or that makes us comfortable, but something which causes us to think through our own opinions and biases.

But this is a debate that absolutely must happen if we are to move forward and away from the current crisis and to somehow see if we can avoid yet another crisis in five years. Simply adding new regulations without changing the incentive nature of the markets will not fix the things that really matter. None of us should cry when some fund that is leveraged 30 to 1 goes down and investors get wiped out. What were they thinking anyway? But when a fund or investment bank is so big that its demise threatens the system that we participate in, something is wrong in the way our society manages risk. Simply bailing out big banks is not an adequate regulatory response. While it may work for the immediate moment, it does not solve the longer term issues.

Please feel free to forward this letter to anyone you think should be part of that debate process.

John Mauldin, Editor
Outside the Box

How To Fix It
By Michael E. Lewitt

"This disposition to admire, and almost to worship, the rich and the powerful, and to despise, or, at least, to neglect, persons of poor and mean condition, though necessary both to establish and to maintain the distinction of ranks and the order of society, is, at the same time, the great and most universal cause of the corruption of our moral sentiments."

Adam Smith, The Theory of Moral Sentiments (1759)

Twelve Basis Points

One way of measuring how perilously close the U.S. financial system came to melting down in mid-March 2008 is to look at how low the rate on one-month Treasury bills fell at the depths of the crisis. That number is 12 basis points. 0.12%. The three-month Treasury bill rate, which our friend Jim Bianco of the highly respected Bianco Research points out is the "risk-free" rate for many models such as the capital asset pricing model, the arbitrage risk pricing model and the Black-Scholes pricing model, fell to a 50-year low of 56 basis points on Tuesday, March 25. 0.56%. As Mr. Bianco pointed out, these bills were yielding less than Japanese 3-month financial bills for the first time since July 14, 1993.

And it's not as though the Japanese economy is flourishing. In fact, quite the opposite is occurring as Japan continues to struggle with the aftermath of its lost decade (which is stretching into lost decades). Hilary Clinton, who looks increasingly unlikely to lead her party in the upcoming Presidential election, is definitely onto something when she warns that "[w ]e may be drifting into a Japanese-like situation. I don't think we can work our way out of the problems we're in for the broad-based economy through monetary policy alone. Japan tried that and tried and tried that."¹ The structural problems ailing the U.S. economy are severe. They derive from bad economic policies and bad political values.

American Capitalism In Need of Repair²

We all know Adam Smith as the author of the bible of capitalism, The Wealth of Nations (1776). But he first wrote what is arguably a far more important book, The Theory of Moral Sentiments, from which the quote that heads this month's newsletter is drawn. America is rushing headlong into the 21st century without a proper understanding of what economic policies and financial tools are going to be required to prosper in a changing world. For more than two decades, the United States economy has favored financial speculation over production. Over the past century, our legal system had developed an increasingly outmoded concept of fiduciary duty that privileges short-term, single-firm interests over the kind of long-term, society-wide interests that could lead to prolonged prosperity. The current meltdown in the financial markets is a symptom of a serious disease that is eating away at the stability of our most important institutions. What we are witnessing might well be the end of American financial hegemony, which is the result of a burgeoning global economy. The current crisis in financial markets gives us an opportunity to evaluate how we can better prepare ourselves to deal with a borderless world.

In spite of claims to the contrary, the American economy has become increasingly unstable in recent decades. This phenomenon picked up momentum in recent years as financial markets focused on trading derivative financial instruments rather than cash stocks and bonds. Paradoxically, the very financial instruments designed to manage risk increase mark volatility. As the distance separating lenders and borrowers as well managers and stockholders increased, debacles such as the Enron and WorldCom frauds earlier this decade and, more recently, the subprime mortgage and structured credit meltdown of today became more common. By effectively reducing all financial instruments and measures of financial value to "one's and zero's" - by digitalizing value - Wall Street removed crucial checks and balances on financial behavior, which ultimately remains a human activity. The growing use of quantitative trading models led to a market dominated by traders directing money into companies about which they know little or nothing. This leveling of all economic values to indistinguishable signs did untold damage to economic actors' ability to distinguish valuable assets from worthless ones.

In addition, unstoppable economic and historical trends such as globalization caused a shift of jobs and factories to geographic locations with lower labor and materials costs, resulting in a transformation of the U.S. economy from one that manufactures goods to one that traffics in intangible items. The result has been a shift from investing in activities that add to the productive capacity of the country to transactions and activities that are merely speculative in nature, i.e., that merely spawn more money but not more physical or capital assets. This shift from a tangible to an intangible economic base was accompanied by a change in the way in which businesses are financed. At the same time as the business base became increasingly intangible, so did the financial base. Equity was replaced by debt, and cash securities were replaced by derivatives. Much of the new financial architecture is now constructed outside the purview of the Federal Reserve and other regulators, allowing economic actors to avoid margin requirements and other limits on leverage that can prevent systemic threats. The new foundations of corporate finance can vaporize in the blink of a trader's eye. These trends have enormous policy consequences for the United States and our future standard of living.

The fiduciary law that governs our business culture reaches back to the 15th century and requires those who are entrusted with managing our largest corporations or pools of money to act in the best interests of their shareholders or clients. But the evolution of fiduciary law has developed into a mode of thinking that privileges short-term, single-company results over long- term, society-wide results. Consequently, fiduciaries are driven by a logic that dictates a focus on the short-term, which can be more accurately predicted than the long-term. But there is something deeper at work in this mindset. Fiduciary thought privileges form over substance, procedure over justice. Decisions that serve a single corporation's shareholders may cause significant harm to a wider array of interests. The entire concept of fiduciary duty must be rethought if capitalism is going to flourish in a borderless, digitalized world. Instead of a narrow focus on the interests of a single firm's shareholders, the fiduciaries of our large business enterprises are going to have to widen their arc of concern to a wider group of constituencies. Without such a broadening of focus, narrow interests will continue to place the entire system in jeopardy because of the networked nature of today's financial markets.

Some Specific Recommendations for Financial Reform

Nano-scopic interest rates are a sign of just how corrupted our financial system has grown from the twin diseases of leverage and greed. The collapse of Bear Stearns was an all-too predictable byproduct of a system that refuses to look itself in the mirror. The bailout of Bear was an obnoxious necessity in view of the fact that the firm was too interconnected as a Wall Street counterparty and prime broker to be permitted to fail. Its collapse would have placed many hedge funds and other financial firms at risk.³ So instead of being able to allow the firm to enter bankruptcy as a just dessert for its failure to properly manage the risks inherent in its business, the Federal Reserve and Treasury Department had to place the interests of the financial system first. The time to ask about moral hazard is not when the system is about the implode - the appropriate time for such questions is much earlier, when the seeds of destruction that lead to the necessity to bail out players that act in ways that threaten long-term systemic stability are being sown. Such questioning, and the requisite action to avoid future problems, requires degrees of forethought and forthrightness for which the power players on Wall Street and in Washington have little tolerance. Even when we skirt complete systemic collapse - and make no mistake about it, we have come as close to such an event as anyone should dare imagine - those with a stake in the game continuing are working behind the scenes to protect their interests.

The Bush Administration, under the intellectual leadership of Treasury Secretary Henry Paulson, has proposed a broad reorganization of financial industry regulation. Unfortunately, this plan merely addresses form over substance and does little or nothing to address the underlying problems that are eating away at the system like a cancer. If reform ultimately follows the path proposed by Mr. Paulson and goes no farther to outlaw the reckless practices that place the system at risk in order to line the pockets of a privileged few, we will have sadly learned nothing from the current crisis. The system is infected by deep, inbred flaws that are rendering it increasingly unstable. Free-market capitalism as practiced on Wall Street and in The City has run amok. If the current crisis, and the recurring crises of the last twenty years, tell us anything, it is that market solutions are insufficient to protect the system from the greed and fear that drive markets. If the deep structural cracks in the system are not addressed and corrected, the markets may not survive the next near-death experience.

This is not a time to mince words. As the poet William Blake wrote, "Opposition is true friendship." At the risk of offending many of our readers, here are HCM's thoughts on how to reform the financial system.

Financial Industry Regulation: There is too little, not too much, financial industry regulation. The problem with our current regulatory regime is that too many of our current regulations serve little or no purpose (for example, the pages of meaningless disclosure in Wall Street research reports that nobody reads and are often longer than the research reports themselves) or are enforced in a capricious and arbitrary manner by unqualified regulators and overzealous prosecutors. This breeds disrespect for the law and resentment among the regulated. As a result, we have a system of laws, not values, a system that privileges form over substance, process over justice. We are never going to have a sound regulatory system until we raise the compensation levels for those who are charged with insuring that millionaires are following the rules.

HCM often hears the argument that too much regulation will force business offshore and render the U.S. financial industry less competitive. Our response to that argument is that institutions and fiduciaries in the end will gravitate to the system with the strongest and wisest regulatory protections. Moreover, we should be pushing the most reckless practices out of our markets and into other markets. We should be creating global competition over best regulatory practices, not worst ones.
Wall Street Compensation: The financial incentive system that governs Wall Street - and by "Wall Street," we mean the investment and commercial banks, private equity firms and hedge funds - requires dramatic rethinking. As compensation is meted out today on Wall Street, too much is paid to too few for doing too little of value for society. Too much capital is allowed to exit investment banks in the form of annual cash compensation. Executive compensation should be calculated based on multiple years of performance and subject to high water marks and claw backs in the event one year's profits from a transaction or a specific activity are lost in later years when that activity turns out to have been fraudulent or flawed. The subprime mortgage business is a case in point. Why should bankers be permitted to retain bonuses earned with respect to the closing of subprime mortgage CDOs that subsequently led to losses for their firms and investors? Compensation should be based on a longer-term view of value-added. Furthermore, regulators should permit firms to maintain reserve accounts and make other arrangements to facilitate a more nuanced compensation structure with adequate disclosure to keep investors fully informed.

Private equity managers and hedge fund managers should not be compensated based on returns attributable to inflation or the market. Their performance fees should be subject to a hurdle rate that is based on annual inflation rates and the applicable asset class performance (equity market performance in the case of private equity firms, for instance) to insure that investors are really paying fees for performance, not for fortuity.
Private Equity: The private equity business has resulted in the overleveraging of American business. One result is that many businesses are short-changing capital expenditures and research and development in order to service debt. Despite the statistics promulgated by self-serving, private equity-financed industry groups, it is irrefutable that companies would have more money to contribute to the productive stock of the economy if they were devoting less money to servicing their enormous debts. We will look back at the private equity boom as a phenomenon that damaged the American economy and impaired America's competitive position in the world.

The private equity boom is the quintessential example of what the economist Hyman Minsky termed "speculative finance" and, in its most extreme form, "Ponzi finance."⁴ Private equity deals add little or nothing to the productive capacity or capital base of the economy. Instead, they merely create debts that have to be serviced and divert cash to the activity of servicing debt rather than creating jobs or funding new projects or research. In 50 years, it is going to be clear that the U.S. economy has paid a terrible price for this.

Private equity managers' (and hedge fund managers') "carried interests" should be taxed at ordinary tax rates, not at the capital gains rate. Such earnings are nothing other than compensation, not earnings on risk capital.⁵ The arguments that private equity firms have tried to promote on Capitol Hill that such a taxation regime would reduce risk-taking are completely unsupportable from a factual standpoint. Henry Kravis and Stephen Schwarzman are not going to stop doing deals because they have to pay taxes at the same rate as their chauffeurs. These arguments are also the most cynical kind of politicking that insults the intelligence of every American. If politicians want to be held in even lower regard than they already are, supporting these arguments is a good way to go.

Finally, private equity firms should not be permitted to go public. The discipline of the markets - i.e. 50 percent or more declines in the price of private equity firms' stocks such as The Blackstone Group (BX) and Fortress Investment Group (FIG) - is inadequate to police the abuses of such transactions. These firms are hopelessly and terminally conflicted between their fiduciary obligations to their limited partners and their fiduciary obligations to their shareholders. The fact that investors are willing to ignore the mind-boggling hypocrisy of IPOs of businesses that are built on the premise that public ownership is economically inefficient is a tribute to the insatiable greed that has consumed investors. That greed has not only corrupted investors' moral sentiments, as Adam Smith wrote more than two centuries ago, it has crippled their common sense.
Financial Institution Leverage: Allowing investment banks to be leveraged to the tune of 30 to 1 is the equivalent of playing Russian roulette with 5 of the 6 chambers of the gun loaded. If one adds the off-balance sheet liabilities to this leverage, you might as well fill the 6th chamber with a bullet and pull the trigger. If this continues, the odds of a systemic crisis more severe than the one we are experiencing are near 100%. An absolute leverage limit should be imposed on investment banks and other financial institutions.⁶ Some will argue that limiting financial institution leverage will render these businesses less profitable and less competitive with non-U.S. companies. HCM's response is - "so what?" Perhaps less profitable investment banks will result in more of America's talented students becoming scientists, engineers, doctors and teachers instead of investment bankers and mortgage traders. What would be so terrible about that?

Off balance sheet entities should be outlawed immediately, plain and simple. If first Enron and now the SIVs haven't taught us the necessary lessons about hidden liabilities, the system probably doesn't deserve to survive. Speaking as someone with extensive knowledge of these off-balance sheet entities, it would not be difficult to render them extinct relatively easily. It would be doing the world a favor.

Tying this issue to the compensation question in the financial industry, if investment banks want to leverage themselves 30 to 1, their executives should be required to retain 97 percent of their compensation in their firms in the form of equity capital. The way it stands now, the ratio between capital retained and cash out is much lower (perhaps 1:1) and effectively creates a "heads-I-win, tails-you-lose" culture. For institutions that play a central role as financial counterparties and lenders, this is an unacceptable risk-sharing arrangement for society to bear. These institutions need to understand that they have responsibilities to the system, not just to their own shareholders and employees. Sure, Jimmy Cayne sold stock once worth $1.2 billion for only $61 million, but he also took out hundreds of millions of dollars in cash compensation over the years. Nobody can argue that his incentives were anything but grossly asymmetric, which may explain his ability to keep his job while demonstrating a much greater understanding of the strategies of the game of bridge than of the balance sheet risks his firm was undertaking.
Hedge Fund Leverage: Allowing unregulated entities such as hedge funds to be leveraged 10 to 1 or 15 to 1 would be laughable if it wasn't so dangerous. Prime brokers continue to be suckers for big names and big clients (and especially for big name clients). As a result, they often extend credit to parties who are not qualified to employ it prudently. HCM has expressed its view on more than one occasion that fixed income strategies that require excessive amounts of leverage do not make sense and have never made sense. We would refer anybody who disagrees with us to the recent collapses of Sowood Capital Management, LP, Peloton Partners LLP and Carlyle Capital Corp. Each of these firms reportedly employed high amounts of leverage (reportedly more than 15x) in their strategies. An absolute leverage limitation should be placed on hedge funds immediately. Since the prime brokers don't seem to want to impose such a limitation, the Federal Reserve should do so with its new powers. If investors can't generate decent returns without employing grotesque amounts of leverage, they should find another profession.

We recently read⁷ that John Meriwether of Long Term Capital Management infamy is at risk of blowing up a hedge fund that was leveraged 14.9 to 1 as of the end of February (and is reportedly down 28 percent year-to-date). The fund in question, Mr. Meriwether's Relative Value Opportunity Fund, reportedly has earned about 7 percent per annum since inception in 1999 through February 2008 (according to The Wall Street Journal) despite the use of generous amounts of leverage. According to the Journal article, Mr. Meriwether, like many hedge funds, charges a 2 percent management fee and 20 percent performance fee for managing his fund. We really don't mean to pick on Mr. Meriwether. Everybody is entitled to a second chance. But one would hope that an individual whose firm almost cratered the entire financial system in 1998 would have learned from his mistakes. Any way you slice it, 15x leverage is imprudent. It may look prudent compared to the 100x leverage employed at Long Term Capital Management a decade ago, but that is like saying 2 degrees below zero isn't cold because it isn't 30 degrees below zero.

Of course, the real question is why hedge fund investors are still willing to risk their money in such highly leveraged strategies. HCM has been asking that question for years but has yet to hear a satisfactory explanation. But since the market won't impose the type of discipline that is necessary to protect the system from boom and bust cycles, it is time for the regulators to step in.

Quantitative Strategies: Quantitative investing has not only introduced an unhealthy amount of volatility into the markets, but has contributed to a larger trend in the financial markets that divorces the investment process from the concept of fundamental value. HCM would defy the quants to explain in any degree of detail what the companies in their portfolios do. This is another type of investing activity, like private equity, that does little or nothing to provide capital to increase the productive capacity or physical stock of the economy. In fact, quantitative investment strategies are the quintessential "hot money." Enslaved by their computer models, they trade in and out of positions at the blink of an eye. When things go wrong, they blame everybody but themselves. Being a quant means never having to say you're sorry.

At some point, society has to figure out that the way an investor earns his money is even more important than the amount of money he makes. This is why human beings were vested with moral sentiments, so they could distinguish the quality of human conduct from the quantity of its results. Until that happens, we will continue to extol the types of investment activity that contribute little to our world. HCM would respectfully propose that a new school of "ethical investing" be adopted that takes into account how particular kinds of investments contribute to the economy. On this basis, quantitative strategies would be eliminated from consideration.

Short Selling: Short selling is an absolutely legitimate way to invest or hedge a portfolio. The SEC made a major error when it repealed the downtick rule last year. The repeal of this rule increased downside volatility exponentially and contributed to the ability of quantitative and other computer-driven selling to push the market lower based on technical rather than fundamental investment considerations. The SEC should reinstitute the downtick rule immediately.

Financial Triage

The magnitude of the unprecedented steps that the Federal Reserve and U.S. Treasury have had to take to bail out the U.S. financial system speaks to the depth of the problems we are facing. We may have left some steps out, but by our account the following is a list of the extraordinary actions that the U.S. central bank has been required to take to address the current crisis.

Since last summer, the Fed has cut interest rates by 300 basis points. The result? Mortgage rates have barely budged, but they are finally starting to move lower. Unfortunately, this comes too late for many homeowners who are losing their homes.
On December 12, 2007, the Federal Reserve created the Term Auction Facility (TAF) whereby the Fed will auction term funds to depository institutions against a wide variety of collateral that can be used to secure loans at the discount window. On March 7, 2008, the Federal Reserve increased the size of the TAF to $100 billion and initiated a series of term repurchase transactions that were expected to cumulate to $100 billion. As with the TAF auction sizes, the Fed said it would increase the size of these term repo operations if necessary. No doubt these facilities will need to be increased.
On March 11, 2008, the Federal Reserve created a $200 billion Term Securities Lending Facility (TSLF) whereby primary dealers could borrow Treasury securities for a period of up to 28 days using as collateral federal agency debt, federal agency residential mortgage backed securities (MBS) and non-agency AAA/Aaa-rated private-label residential MBS.
On March 17, 2008, the Federal Reserve opened up the discount window to the investment banks, which are not subject to the same regulatory limitations as the commercial banks that have traditionally had access to the window.
The Federal Reserve made a $29 billion line of credit available to JP Morgan Chase in connection with its takeover of Bear Stearns.
The Office of Federal Housing Enterprise Oversight (OFHEO) announced on March 19 that it would reduce excess capital requirements for Fannie Mae and Freddie Mac by one-third, from 30 percent to 20 percent. This is calculated to permit these two entities to add another $200 billion of mortgages to their existing $1.4 trillion portfolios (on an equity base of less than $70 billion). The two agencies shortly thereafter announced that they were authorized to raise an additional $5-10 billion of equity capital each, which would still leave them grossly leveraged by HCM's count.
The Federal Housing Finance Board announced that it would increase the limit on Federal Home Loan Banks' MBS (mortgage backed securities) investment authority from 300 percent of capital to 600 percent of capital for two years. This is estimated to enable these institutions to purchase another $200 billion of this paper.

While these moves were probably necessary to save the system from complete collapse, it is abundantly clear that these drastic steps are going to have enormous negative long-term effects on the U.S. economy. Among those effects will be higher future inflation and an extension of the high levels of leverage in the system that pushed the economy to the precipice this time. Does anybody really think it's a good idea to have Federal Home Loan Banks buy more MBS paper? Or for Fannie and Freddie to leverage their balance sheets further? All of these actions are going to have to be unwound at some point, which means that the day of reckoning is simply being delayed.8 It is clear that the authorities are engaged in a desperate attempt at economic triage that bodes poorly for the future economic health and stability of the United States. Looked at in this context, it is difficult to argue against those who believe in long-term U.S. dollar weakness. If you want to look at the end of American economic hegemony, just look at the list of desperate actions taken by U.S. financial authorities above. It is a sad commentary on how the greed and short-sighted actions and policies of U.S. politicians and businessmen have inflicted permanent damage on our economy.

There is a way out, but it will not be easy. The way out is to accompany the drastic steps taken by the Federal Reserve and Treasury with a comprehensive regulatory revolution that addresses the flaws embedded in the system. HCM does not use the word "revolution" loosely, but nothing less than a drastic rethinking of our current system accompanies by action to change it is going to be required if we are to strengthen the global economic system for the challenges to come.

Michael E. Lewitt

Footnotes:

1 The Wall Street Journal, March 27, 2003, p. A3.

2 I want to thank Professor Mark C. Taylor of Columbia University for helping to edit this section of the newsletter. I urge all readers to pick up a copy of Professor Taylor's incredibly insightful and brilliant book, Confidence Games Money and Markets In A World Without Redemption (Chicago: The University of Chicago Press, 2004). This wonderful book is not available in paperback.

3 Make no mistake, however, that by avoiding bankruptcy, Bear Stearns' executives benefitted greatly. In a bankruptcy, their 2007 bonuses would have been subject to repayment as "preferences" under the bankruptcy laws. Some will argue that Bear Stearns stock may have been worth a great deal more than $10 per share in a bankruptcy, but after time value, aggravation and illiquidity are factored in, HCM would argue that the JP Morgan Chase deal was still preferable to a bankruptcy ordeal.

4 See Hyman Minsky, Stabilizing an Unstable Economy (New Haven: Yale University Press, 1996), p. 70. ("A unit that expects its cash receipts to exceed its cash payments in each time period is engaged in what we will call hedge finance. On the other hand, an organization from which the contractual cash flow out over a time period exceeds its expected cash flow in is engaged in either speculative or Ponzi finance. A unit in a speculative or Ponzi financing posture obtains the cash to satisfy the debtors by selling some assets, rolling over maturing debt, or new borrowing; such units are dependent upon financial market conditions in a more serious way than units whose liability structures can be characterized as hedge financing." (emphasis in original)

5 To the extent private equity investors invest their own capital in their deals, earnings on those investments should be treated as capital gains.

6 The obvious question is what this leverage level should be, a question that requires a great deal of study. HCM would suggest that over a period of years, these firms should be required to bring their leverage down below a certain level in an orderly manner that is not disruptive to markets. HCM has no illusions about the anti-growth effects this could have on the economy, but we also have no illusions about the dangers of allowing the current regime to continue.

7 The following is based on an article in The Wall Street Journal, March 27, 2008, "A Decade Later, Meriwether Must Scramble Again," p. C1.

8 After rereading that sentence, HCM has to ask whether we are the only ones who think that it is really the case that these moves will have to be unwound or that they can be unwound. It may be more realistic to believe that these moves, such as the releveraging of Freddie and Fannie and Federal Home Loan Banks' increased purchases of MBS will remain permanent until the system can either work through its problems or collapses under its own weight once and for all. The only thing we know for sure is that pain delayed is pain increased. Failure to accompany these triage moves with substantive financial reforms will guarantee that the future pain will make the current crisis feel like a walk in the park.

Where is the Bottom in Housing?

Fri, 28 Mar 2008 21:04:13 EST

Where is the Bottom in Housing? - by jmauldin

Existing home sales rose by 2.9% in February, the first significant rise in home sales since the housing market started to decline last year. I was in my car and listening to CNBC as commentators started to celebrate the bottom of the housing market. Since the credit crisis has its roots in the US housing market, and will require a resolution of the housing market in order for credit markets to return to whatever will look like normalcy in the future, it is of more than passing interest to get a handle on the actual state of the housing market. So while this is about the US housing market, it will also affect the credit markets worldwide, as well as impact China and other nations who sell to the US, because of the connection with consumer spending. This week we look at the data from sources that are actually involved in analyzing these markets. It will make for interesting reading. This week's letter will print out rather longer than usual, as we are going to look at a lot of charts, but the actual word length will not be all that long.

But first, a quick note about a new "button" on my web site. As you know, I read a lot of material each week. Some of the more interesting material is passed on to me from readers of the letter. We now have a link on the right-hand side of my site (www.2000wave.com) that says, "Recommend an Article to John." You can click on the link and a page will come up that allows you to enter a web address, along with a brief description of the article, report, essay, etc. Of course, you can still reply to this letter with material or comments as well.

And speaking of replying, I am going to be doing a lot of traveling in the next few weeks, giving speeches. My favorite part of the speech is always the question and answer portion at the end. Some of the time on the road I will not have my usual access to research material. So I have decided that I am going to do one or two e-letters in the next few months that simply respond to your questions. If you would like to ask a question and get my thoughts on a topic, now is your chance. Simply reply to this letter, put "question" in the subject line, and then give me your question in the email. Thanks, and now on to the housing markets.

Housing - Finding the Elusive Bottom

Let me acknowledge up front that much of what you will read is from two main sources. The first is John Burns of John Burns Real Estate Consulting, which he founded in 1989. John consults with over 2000 of the largest banks and homebuilders in the country (his client list is a who's who of banks, builders, and hedge funds). He has a reputation for solid research and pulling no punches. Some of his hedge fund clients were the ones you read about who made billions. ( He wishes he had negotiated a percentage!) He is deeply involved in analyzing trends in the housing market. His web site is www.realestateconsulting.com. He has graciously put the PowerPoint presentation that I am working with on his site for you to read, should you want to dig deeper.

The second source is T2 Partners, a well-known value investing advisory firm in New York. They have a massive 76-page PowerPoint that you can review at your leisure at www.valueinvestingcongress.com, crammed with facts on the true extent of the problems in the subprime mortgage markets. It's rather sobering. While the thrust of the presentation is to analyze the true extent of the problems at Ambac and MBIA, there is a lot of data on the housing market as well. Remove sharp objects from your vicinity before you read it.

So, the question we seek to answer today: Have we seen the bottom of the housing market? Was last month's small rise a sign of the bottom, as many on CNBC and elsewhere opined?

First, let's look at five graphs from John Burns (out of several hundred that he graciously allowed me to review!). Starting with conclusions first, John predicted a 15% decline in home prices early last year and has recently raised it to 16%. I pointed out that there are a lot of firms, like Goldman Sachs, who are more bearish, thinking home prices will fall 20-25%. He laughed and noted that last year he was the bear, and now he is the optimist. But he points out that 16% is a national average, with some markets projected to do a lot worse. Here are his projections for the 20 largest markets. Note that in every market there are still more price reductions projected.

The reasons for the declines are many. Let's look at a few. First, we simply built more homes than the nation could absorb. In 2005 alone, there were 48% more housing-related transaction than there should have been. Note in the graph below the large rise since 2000 of transactions above the expected sales trend line. Sales are now back to that trend line, but are expected to fall further. Burns projects that sales activity will drop another 30%, to 1995 levels, and that will happen relatively soon.

This is going to mean that homebuilding is going to be forced to slow even more. Burns projects that permits to build new homes will fall anywhere from 32% to as much as 70% in the top 20 markets. The large majority of those markets have not seen permits fall even half as far as Burns think they will. Reality has not yet kicked in for many homebuilders. New and existing home inventories are hovering in the 10-month range and are likely to rise further as foreclosures put more homes on the market. This will likely mean that a buyer's market for at least another 3-4 years is the most likely scenario.

What all this speculation did was create 3.5 million excess homes that need to be filled. There are about 2,000,000 more homeowners than long-term trends would indicate, and many of these are buyers who used questionable mortgages to buy a home and are now in the foreclosure process. And as we will see later, it is going to get worse before it gets better.

But with the dramatic drop in the availability of subprime mortgages, we have reduced the number of potential home buyers. In many markets, the affordability of housing simply prices out many potential middle-class buyers. And potential buyers of rental properties have not seen prices drop to where they can make a profit by buying and renting the homes. The following graph shows that nationwide it costs almost twice as much to buy a home as to rent. I know that it would cost me much more than twice in monthly costs to buy a condo or home that is the equivalent of my apartment. I can't mentally justify the extra expense today, although that may change, as there are a lot of condominiums coming onto the market this year in Uptown Dallas. It will be interesting to see if prices drop. Note the rise in the differential between renting and buying since 1998.

But here is where the picture gets clouded. There are parts of the country where homes are quite affordable. Note the difference in affordability between the coasts and the middle of America. So, we have to be careful when we talk about the crisis in housing. All real estate is local.

Let's look at a few more facts. Due to falling interest rates, a typical adjustable-rate mortgage (ARM) buyer saw his buying power rise 55% from 2000 to 2004. Since then there has been a 21% deterioration. That has helped lower sales traffic for new homes to the lowest level since they began collecting statistics in 1985.

But on a note of optimism, Burns notes the housing market is extremely cyclical. We have had times of extreme distress before, which typically last 3-5 years, and this one too shall pass. Burns projects that sales should be higher than current levels by 2012. Median resale prices will bottom out in 2010, only about 16% below the top.

Bottom Line? There is no Bottom in Sight

His most likely timeline is that resale stability will come back by 2011, and it will be even earlier for the homebuilders. He is projecting 6,000,000 home sales (new and existing) in 2008, but falling to only 4,000,000 in 2009. Low sales volume and high foreclosures will delay inventory reduction, which is required for there to be a stable market.

This means that home ownership will fall to 66% of the population in 2009 from the recent high of 69%. He thinks that may overcorrect to 65% in 2010. When I asked him why the overcorrection, he said it has to do with psychology. Housing will go from the greatest investment in 2006 to a bad one by 2009. The market typically overcorrects at the end of every cycle. It will take rising prices to lure the marginal homebuyer back into the market.

We discussed the recent rise in the price of the homebuilder stocks, which he attributes to short covering. Many of the homebuilders, public and private, are selling land at 16% of book value, or are trying to. He suggests that many of the privately owned homebuilders are in the worst shape.

Bottom line? We are nowhere near the bottom in the home markets.

Where is the Value in Housing?

In a lengthy presentation, the partners at T2 Partners state that we are still in the early innings of the bursting of the housing and credit bubbles, a theme I have also stated for quite some time.

Let's look at some facts they present. 8.8 million homeowners will have mortgage balances equal to or greater than the value of their homes by the end of March. 30% of subprime loans written in 2005 and 2006 are already underwater. Nearly 3 million homeowners were behind on their mortgages at the end of 2007, with 1 million at risk of imminent foreclosure. As of the end of last year, 5.82% (!) of all mortgages were delinquent, the highest level in 23 years. 0.83% were in the process of foreclosure, also an all-time high. When you look at just subprime mortgages, you find that 20% are delinquent (the number is rising rapidly), and almost 6% were in foreclosure. Finally, the average American's percentage of equity has fallen below 50% for the first time since 1945. Given Burn's forecast for prices, as well as that of T2 Partners, all these statistics are going to get worse.

The Real ARMs Race

As an example, 5% of home sales in January of 2007 in San Diego were foreclosures. In January of this year, 34% of existing home sales were foreclosures. This is going to turn into a monster wave as ARMs reset in the coming years.

As T2 notes:

"Loans with teaser rates were never supposed to reset. Reinforced by many years of experience, both lenders and borrowers assumed that home prices would keep rising and easy credit would keep flowing, allowing borrowers to refinance before the reset. Now that home prices are falling and the mortgage market has frozen up, very few borrowers can refinance, which, as shown later in this presentation, is leading to a surge in defaults -in many cases, even before the interest rate resets!"

"Mortgage lending standards became progressively worse starting in 2000, but really went off a cliff beginning in early 2005. The worst loans are those with two-year teaser rates. As the subsequent pages show, they are defaulting at unprecedented rates, especially once the interest rates reset. Such loans made in Q1 2005 started to default in high numbers in Q1 2007, which not surprisingly was the beginning of the current crisis."

Look at the following chart, which shows the serious plummet in lending standards. How could a rating agency look at the statistics, which they surely had, and suggest that the probability of repayment would be the same as for loans made prior to this period? I mean, seriously. When 15% of loans in 2006 were for 100% loan-to-value with no documentation? Cue the lawyers.

"The crisis has continued to worsen as even lower quality loans made over the remainder of 2005 reset over the course of 2007, triggering more and more defaults. It takes an average of 15 months from the date of the first missed payment by a homeowner to a liquidation (generally a sale via auction) of the home. Thus, the Q1 2005 loans that defaulted in Q1 2007 are leading to foreclosures and auctions in early 2008.

"Given that lending standards got much worse in late 2005, through 2006, and into the first half of 2007, there are sobering implications for expected defaults, foreclosures and auctions in 2008 and 2009, which promise to drive home prices down dramatically."

And here is the most ominous quote in the entire 76 pages: "In summary, today we are only seeing the tip of the iceberg: an enormous wave of defaults, foreclosures and auctions is just beginning to hit the United States. We believe it will get so bad that large-scale federal government intervention is likely."

I sadly agree. In an election year, it will take a brave politician to resist the siren call of "caring." 2,000,000 potential foreclosures, which is rather typical of the estimates I have seen, will motivate politicians to do something. I hope that someone can limit the damage to taxpayers, but I have doubts. In later letters, I will comment on the possible bailout solutions. But let's get back to the facts.

Merrill Lynch may have to write down another $4.5 billion this quarter, with other banks also continuing to add to their losses. And it is going to get worse. There were $828 billion dollars of securitized first-lien mortgages made in 2005-7 that were comprised of loans that have little or no historical precedent in terms of documentation or loan-to-value. Another $56 billion in second-lien mortgages were made with little or no attempt to actually and properly value the loans. These are loans that are likely to be in trouble.

A realtor friend in Dallas tells me she is involved in a "short sale," or an offer to the bank to buy a home for less than the mortgage on the home. They are offering $560,000 for a home with a first-lien mortgage of $620,000. I said that doesn't sound too bad. Then she told me there was a second-lien mortgage for over $400,000 that will be completely wiped out. We are talking about a home that lenders were willing to loan over $1,000,000 on a year ago, that is going to sell for less than 60% of that. $1 million dollars in a Dallas suburb will buy you a lot of home. There has been no bubble here. And now, evidently $560,000 will buy you a great home. Securitized second-lien mortgages are in real trouble. There are still tens of billions to be written down. And many of these loans were (and still are) rated AAA, don't you know!

In a series of slides, T2 Partners graphically shows how lending standards plummeted in 2005-7. Default rates for June 2005 no-documentation loans (so-called liar's loans) are already over 30% in some categories. T2 projects that for no-doc loans from late 2005 and on, default rates could climb to over 70%!

Citigroup projects that mortgage losses will exceed $300 billion. T2 thinks this is way too low. They look at several mortgage-backed securities and slice into them. In one, the average loan is only 17 months old. Already 20% of the loans are 90 days delinquent or worse, and another 9% are 30-60 days delinquent. Statistics suggest that 65% of these loans will go on to become 90 days or more and then into foreclosure. And the interest rate resets have not even started!

Go back to the second chart from T2. The combined loan-to-value of the loans made in 2006 was 89%. That means the average loan from 2006 is already underwater. 33% were made with 100% financing. With home values down in some areas by 40%, the temptation to simply walk away is going to be large. It will take many years for a homeowner to have any equity.

One bright spot? Homes in the bubble areas are going to once again become affordable to middle-class citizens. Teachers, policemen, and firemen who could not afford to live in the cities they worked for will now have an opportunity, as will the young who have yet to buy their first home.

It's time to hit the send button. So, let's wrap things up. Those who think we are close to a bottom in the housing bubble are engaged in wishful thinking. You read above what those who really do their homework are saying. If we had more space, I could give you even more statistics and forecasts from Gary Shilling, Greg Weldon, Dr. Nouriel Roubini and others who do their homework, rather than trying to see a trend in one month's statistics. Many of the home sales from February are foreclosures. Those are going to rise. The key pieces of data to look at will be the months of supply of homes for sale and foreclosures. Until the supply of homes gets back to 6 months, we will probably not have seen the bottom. Until we have worked through the millions of foreclosures that are in front of us, it is hard to think in terms of a bottom.

We are in a recession, and that means rising unemployment and falling consumer spending. It means tighter profit margins. Etc. It is going to take a long time for the economy to recover. Welcome to Muddle Through.

One final thought: If we do end up with a government bailout, and I agree that it's likely, I sincerely hope that no one who cannot document that the information they submitted for their no-documentation loan was accurate will be given any assistance. If you lied, you do not deserve taxpayer money. If you took out a loan on which you could not demonstrate that you could make the payments, just because you wanted to profit from a resale of a home which was "surely" going to rise, you should not get tax-payer money. For every person we help like that, we keep a house from going down to a price that someone who deserves a home and has played by the rules could buy. Just my take.

Cancun, La Jolla, London, and Switzerland

As I noted above, I am traveling a lot in the next month. I look forward to writing from the road and answering your questions, so send them in! I am in Cancun tomorrow for two days for a speech to a group of quite successful NFL players. Now that should be interesting. Tuesday I fly to Austin to speak at the University of Texas to some graduate classes, where I will be working on the speech I will give the following week in La Jolla at my 5th annual Strategic Investment Conference. It is sold out this year, and we sadly had to turn people away due to space limitations. Then I fly out the next day for London and Switzerland.

Things are getting busy around here. Tiffani is getting married on August 8, and there are so many things that have to be done. It is quite fun to hear her talk about the honeymoon. They are going to Ireland and South Africa, and are doing it right. But she is worried about being gone so long from the office. I have told her I think we will survive through August, and that she HAS to figure out how to get to Victoria Falls. One of the great highlights of my life was a whitewater rafting trip on the Class 5 rapids of the Zambezi below Vic Falls. Now that is an adrenaline rush. Have a great weekend.

Your finally got an upgrade for tomorrow on American analyst,

John Mauldin

Let's Get Real About Bear

Mon, 24 Mar 2008 23:13:06 EST

Let's Get Real About Bear - by jmauldin

I already have a slew of emails from people upset about what they see as a bailout of a big bank, decrying the lack of "moral hazard." And I can understand the sentiment, as it appears that tax-payer money may have been used to bail out a big Wall Street bank that acted recklessly in the subprime mortgage markets.

But that is not what has happened. This is not a bailout. The shareholders at Bear have been essentially wiped out. Note that a third of the shares of Bear were owned by Bear employees. Many of them have seen a lifetime of work and savings wiped out, and their jobs may be at risk, even if they had no connection with the actual events which caused the crisis at Bear. Don't tell them there was no moral hazard.

For all intents and purposes, Bear would have been bankrupt this morning. The $2 a share offer is simply to keep Bear from having to declare bankruptcy which would mean a long, drawn out process and would have precipitated a crisis of unimaginable proportions. Cue the lawyers.

As I understand this morning, JP Morgan will take a $6 billion write down, which is essentially what they are paying for Bear. The Fed is taking $30 billion dollars in a variety of assets. They may ultimately take a loss of a few billion dollars over time, although they may actually make a profit. When you look at the assets, much of it is in paper that will likely get close to par over time, and the good paper will pay premiums mitigating the potential loss. The problem is, as the essays below point out, no one is prepared to take that risk today.

If it was 2005, Bear would have been allowed to collapse, as the system back then could deal with it, as it did with REFCO. But it is not 2005. We are in a credit crisis, a perfect storm, which is of unprecedented proportions. If Bear had not been put into sounds hands and provided solvency and liquidity, the credit markets would simply have frozen this morning. As in ground to a halt. Hit the wall. The end of the world, impossible to fathom how to get out of it type of event.

The stock market would have crashed by 20% or more, maybe a lot more. It would have made Black Monday in 1987 look like a picnic. We would have seen tens of trillions of dollars wiped out in equity holdings all over the world.

As I have been writing, the Fed gets it. Their action today is actually re-assuring. I have been writing for a long time that they would do whatever it takes to keep the system intact. As one of the notes below points out, this was the NY Fed stepping in, not the FOMC. The NY Fed is responsible for market integrity, not monetary policy, and they did their job. And you can count on other actions. They are going to change the rules on how assets can be kept on the books of banks. Mortgage bail-outs? Possibly. The list will grow.

Yes, tax-payers may eventually have to cover a few billion here or there on the Bear action. But the time to worry about moral hazard was two years ago when the various authorities allowed institutions to make subprime loans to people with no jobs and no income and no means to repay and then sold them to institutions all over the world as AAA assets. And we can worry in the near future when we will need to do a complete re-write of the rules to prevent this from happening again.

But for now, we need to bail the water out the boat and see if we can plug the leaks. Allowing the boat to sink is not an option. And get this. You are in the boat, whether you realize it or not. You and your friends and neighbors and families. Whether you are in Europe or in Asia, you would have been hurt by a failure to act by the Fed. Everything is connected in a globalized world. Without the actions taken by the Fed, the soft depression that many have thought would be the eventual outcome of the huge build-up of debt would in fact become a reality. And more quickly than you could imagine.

As I have repeatedly said, recessions are part of the business cycle. There is nothing we can do to prevent them. But depressions are caused by massive policy mistakes on the part of central banks and governments. And it would have been a massive failure indeed to let Bear collapse. I should note that this was not just a Fed action. Both President Bush and Secretary Paulson signed off on this.

The Fed risking a few billion here and there to keep the boat afloat is the best trade possible today. Their action saved trillions in losses for investors all over the world. It is a relatively small price. If you want to be outraged, think about the multiple billions in subsidies for ethanol and the hundreds of billions of so-called earmarks over the past few years to build bridges to nowhere. And think of the billions in lost tax revenue that would result from the ensuing crisis. I repeat, this was a good trade from almost any perspective, unless you are from the hair-shirt, cut-your-nose-off-to-spite-your-face camp of economics.

The Fed is to be applauded for taking the actions they did. And they may have to do it again, as there are rumors that another major investment bank is on the ropes. I hope that is not the case, and will not add to the rumors in print, but I am glad the Fed is there if we need them.

It is precisely because the Fed is willing to take such actions that I am modestly optimistic that we will "only" go through a rather longish recession and slow recovery and not the soft depression that would happen otherwise.

I got a very sad letter today from a lady whose husband is in the construction business an hour from Atlanta. He has had no work for four months and they are rapidly going through their savings. The jobs he can get require them to spend more in gas to drive to than he would make. He is sadly part of the construction industry which everyone knows is taking a major hit.

But without the Fed action, that story would have multiplied many times over, as the contagion of the debt crisis would have spread to sectors of the economy that so far have seen only a relatively small impact. Unemployment would have sky-rocketed over the next year and many more families would have been devastated like the family above. It would have touched every corner of the US and the globe.

Bailing out the big guys? No, the Fed does not care about the big guys, and only mildly pays attention to the stock market, despite what conspiracy theorists think. In the last few years, I have had the privilege of meeting at length with a number of Fed economists and those who have their ear. They are far more focused on the economy, their mandates for stable inflation and keeping unemployment as possible.

No one who owned Bear stock was protected. This was to protect the small guys who don't even realize they were at risk. To decry this deal means you just don't get how dire a mess we were almost in. It is all well and good to be rich or a theoretical purist and talk about how the Fed should let the system collapse so that we can have a "cathartic" pricing event. Or that the Fed should just leave well enough alone. But the pain to the little guy in the streets who did nothing wrong would simply be too much. The Fed and other regulatory authorities leaving well enough alone is part of the reason we are where we are. First, get the water out of the boat and fix the leaks, and then make sure we never get here again.

And yes, I know there are lots of implications for the dollar, commodities, markets, interest rates, etc. But we will get into that in later letters.

For now, let's go to the essays from my friends and then a quick note about the stock market.

John Mauldin

Muddle Through and Your Long Term Returns

Mon, 24 Mar 2008 23:06:46 EST

Muddle Through and Your Long Term Returns - by jmauldin

The Muddle Through Economy:
The Future of the Market and Your Investments

It is increasingly widely agreed that we are now in a recession as I predicted this time last year. The good news is that much of the underlying economy is not in that bad a shape, but it has had two serious body blows administered by the twin collapsing bubbles of the housing market and the credit crisis.

My position is that the recession will be rather long and relatively shallow, and the inevitable recovery will be longer and more drawn out than is typical, resulting in what I call The Muddle Through Economy for a period of several years. I define a Muddle Through Economy as one which grows below normal trend GDP growth of 3% for a period of time, typically in the 2% range.

So, one of the key questions is: "When does the recovery start and how long will it take to get back to 3% GDP?"

I think the answer is that it will not be before the latter half of the year and will take at least two years to get back to trend growth. The reason for such a drawn out recovery is simple. The twin causes (housing and the credit crisis) will take at least two years and possibly longer to normalize, and that process is going to negatively effect several other sectors of the economy.

But then I am an optimist. Duke University released a survey yesterday of Chief Financial Officers of major corporations. This is a gloomy bunch. 54% think we are already in a recession. My friend Duke Professor Campbell Harvey said: "In contrast, 90 percent of the CFOs do not believe the economy will turn the corner in 2008. Indeed, many of them believe it will be late 2009 before a recovery takes hold."

Let's look at a chart courtesy of John Burns Real Estate Consulting. This shows that part of the bubble in housing was in the number of transactions that occurred during the bubble years. In 2005 alone, there were 48% more housing transactions that occurred than should have been expected based on historical average sales per household. In large part this was caused by "investors," many of dubious financial strength, buying homes and condos on readily available credit with no real lending standards and no way to pay the loans if they were not able to sell them at a higher price.

As a result, there are now 3.5 million excess homes that need to be filled by qualified homeowners. Over time, due to growth in the population, the demand will eventually catch up, but that will be a process of several years. Housing prices will have to fall by another 15-20% or so to get to a place where homes become affordable to the marginal buyer. And that assumes rates can stay low.

Annual new and existing home sales are currently running at about 5.5 million. John Burns expect that will fall to about 4 million before we see the bottom of the market. Notice, in the above chart, the drop in sales after the increase in housing sales above the trend projection in the 70's. We have a long way to go to correct the recent bubble, and Burns's research suggests that we will get there sooner rather than later.

But this means that home values will drop another 15% or more. Homeowners are going to see $5-6 trillion in home equity vanish in the next year. Remember that point as we will address it in a minute.

Honey, I Vaporized My Customers

By now, everyone knows that the subprime crisis started with non-existent lending standards which resulted in the large numbers of foreclosures we are seeing today. Those foreclosures will be rising throughout the year. We are not near anything like the top of the rising number of foreclosures. Ben Bernanke said last July that losses from the subprime would be in the $100 billion dollar range. True confession. I think I wrote six months earlier that it would be $200 billion. I point that out to make the point that I am an optimist by nature. The latest "bidding war" number for the amount of total losses is about $500 billion from Goldman Sachs, and a neat $1 trillion from uber-bear Nouriel Roubini.

Add in hundreds of billions from losses which are piling up in other credit markets and you can easily get to $1 trillion in losses which are going to have to be eaten by all sorts of financial institutions, without being all that pessimistic.

Banks are being forced to reduce their loan and margin books in order to get the necessary capital required by regulatory authorities. Plus, credit is now more expensive as risk premiums rise from absurdly low levels in what more than one authority called a "new era of finance." Turns out it was just normal old era greed.

It is not just the mortgage market. It is commercial mortgages, safe municipal bonds, credit card debt, student loans and a host of credit that is under fire and cannot find a buyer at what should be a realistic price.

We should not be surprised at the lack of liquidity in the credit markets. We have essentially vaporized 60% of the buyers of debt in the last six months. The various alphabet of SIVs, CLOs, CDO, ABS, CMBS, and their kin that were the real shadow banking system are either gone or on life support. It took decades to build these structures and it is not realistic to think we can replace them in six months. This is going to take some time.

And time is what the Fed has bought this week by offering to take AAA mortgage paper and swap it for T-bills. They will start with $200 billion on offer. Remember you read it here first that that number will be increased and increased again. From the markets initial euphoric response, you would think the problems have been solved and banks will once again start lending. Sadly, this is probably not true.

This is similar to the action by the bank regulators in 1980, when nearly every major bank had losses that were greater than their capital on Latin American loans which had defaulted. The Fed, with a wink and a nod, allowed the banks to carry these worthless loans on their books at full face value. It took six years before they started to actually write them down. But without that measure, every major bank in the US would have gone bankrupt. And technically, they were for several years. But the Fed action simply bought the banks time to re-liquefy. It was the right thing to do.

This week's action by the Fed is essentially the same thing. It buys time. This 28 day auction will be around for a long time. If the banks had to write down the potential losses on their AAA Fannie Mae paper and other similar assets, it could have brought the banking system to its knees. Eventually, we will get a market clearing price for all this paper, but the key word here is eventually. We are going to see foreclosures and losses for another 18 months. It is going to take a long time to know exactly what the losses will be.

I think the losses on many of the various forms of debt have been marked down way too far by the various derivative markets. (I would hasten to add this does not include the subprime markets, as many of those assets are going to zero.) I doubt the loss in a lot of the debt paper will be nearly as much as the current credit default swaps prices indicate. For instance, some municipal bond debt is priced for 10-15% losses, when losses of less than 0.5% are normal. When there is a buyers strike, prices fall, and sometime to quite low levels. In the fullness of time, the price of these bonds will rise back to "normal" levels. There is a reason Bill Gross is buying municipal bonds by the train car load. Many are simply at the best prices we will see in my lifetime.

But if that debt is now on a bank's capital books, they have to write it down to the latest mark-to-market. The Fed's move simply allows the banks to move what will eventually (or maybe the better word is should eventually) be marked back to reasonable values. It avoids a crisis today.

The next crisis? I read a very chilling piece from Michael Lewitt this morning. He speculates on what if the rumors were true that Bear Stearns is basically bankrupt. Bear is in the too big to fail category. They are at the heart of the chain of Credit Default Swaps which run like fault lines throughout the world's financial system. If Bear were allowed to collapse, it would simply cascade throughout the world so fast it would truly make the current level of the credit crisis seem small potatoes.

So, why can I be so sanguine? Because the regulators (the Fed and the SEC) would step in and whatever large bank was failing would be merged or bought very fast. Liquidity and assets would be provided. The Fed and the rest of the world's central banks get that we are in a crisis. They will do what is necessary. Those of us sitting in the cheap seats in the back of the plane may not like it, as it will look like a bailout of the big guys who caused the problem, but you have to maintain the integrity of the system. A hedge fund here or there can go, but not one of the world's premier banks.

I wrote the above paragraphs on Thursday, and sure enough, the NY Fed and JP Morgan stepped in to bail out Bear. This will not be the only time or bank. The regulators may have been asleep, but the depth of this crisis has awakened them.

But this is a boost for my contention that we will be in a Muddle Through Economy for a long time. This latest Fed actions simply draw out the time over which the market will correct. But that is a good thing, as a too swift, dead drop correction could spawn a very deep recession, destroying vast amounts of capital, which would take much longer to come out of.

Now, let's look at the implications of this crisis on our long term returns and retirement portfolios.

Consumer Spending is Going, Going...South

I have used this graph before, but it bears keeping this in mind. Mortgage Equity Withdrawals (MEWs) accounted from 1.5%-3% of overall GDP from 2001 through 2006, as the US consumer used borrowed on the equity in their homes to spend.

And it's not just MEWs weighing on the consumer. Higher energy costs are just as effective as a tax in lowering consumer spending. If oil stays where it is today, gasoline will be $4 a gallon this summer. Unemployment is slowly rising, which of course is not good for consumer spending. Inflation is hurting, especially in light of the very low growth in real consumer income. Combine that with less availability of cheap and easy borrowing and the consumer is clearly going to have to re-trench.

So, what does that mean? Two things. I think it will mean lower corporate profits for a variety of US corporations, and as we will see, in a normal recessionary pattern pull the stock market lower. And that is going to lead to less than expected long term returns on retirement portfolios, which will have its own consequences.

Let's review some basics. I made the contention in Bull's Eye Investing that we should look at bull and bear market cycles in terms of valuations rather than price. Stock markets go from high valuations to low valuations and back to high valuations over very long term cycles, averaging around 17 years. That would mean we are roughly halfway through this secular bear market which began in 2000. I also pointed out a few weeks ago that the bottom in terms of price in the last secular bear market (1966-1982) was made in 1974, but it was 8 years later than the bottom in valuations as expressed by Price to Earnings Ratio was reached. These periods of low valuation are the springboard for the next bull market rise, so there is a bull market coming. We just have to be patient.

It is entirely possible that we see the bottom of the market in terms of price this year as the market falls due to the pressures of the recession we are in, yet valuations continue to fall even as prices rise. In fact, that is typical of the secular bear cycles. This happens as earnings rise faster than stock prices.

And why is that important? Because the returns on your stock portfolio are closely and highly correlated with the P/E ratios at the time of your investments. Besides the following chart, you can go to www.2000wave.com and look at the stock market charts on the right side to see what kind of returns you would have had over any given period during the last 100 years. Notice on those charts that if you start with high P/E ratios, your returns could be negative for 20 years! Not quite the 10% compounding that many planners promise.

So, where are today's P/E ratios? Let's go to the data provided by Standard and Poor's for the S&P 500. In January of 2007, S&P estimated that earnings for 2007 would be $89. Earnings for 2007 were actually $71.56, down about 20%. Last year about this time S&P estimated that earnings for 2008 would be $92. Today they estimate 71.20 for 2008. Lately every time new estimates come out they are down. But that is typical in a recession. Analysts are generally behind the curve.

But as the table below shows, we are now at P/E ratios that are back up over 20, and going to 22 by the middle of the summer. That would suggest that total returns are going to be under pressure for the next few years at a minimum and maybe for a decade. That does not bode well for retirees who are expecting the stock market to compound at 8-10% annually in order for them to be able to retire in the style to which the want to be accustomed. Real (inflation adjusted) returns of between 0 and 4% are more likely based on historical returns from today's valuations.

The Boomers Break the Deal

I have good news and bad news. First, the good news. Basically, my generation – the Baby Boomers- is going to break the deal my Dad's generation made with my kids. They agreed to die on time. The Boomer Generation and subsequent generations are going to live longer –potentially much longer - than the current actuarial tables suggest because of major breakthroughs in medicine and health care. It is quite conceivable that we will see another average ten years of average life for the Baby Boomer Generation. I personally fully intend to enjoy those years.

But the bad news is that many have not saved enough for an extended life span, let alone 30 years of retirement. My friend Ed Easterling at Crestmont Research did some very interesting analysis a few months ago. You have saved and invested, and now you want to retire. You decide to take out 5% of your total portfolio to live each year and increase the amount for inflation, so that you can maintain your lifestyle (a number which a surprising number of investment advisors would say is ok). Let's say you are an aggressive older couple and decide to stay in the stock market because that is where you are told that you can get the best returns over time. And you know that at least one of you have the probability of living 30 years. On average you are going to get 7-8% or more on your stock portfolio, right?

Ed calculates what you would get for 78 different 30-year periods since 1900. Let's say you start with a million dollars. On average, this has been a good bet. You could maintain your lifestyle and end up with $3.6 million. You've been pretty conservative, right?

Wrong. Because the returns you get over the next 30 years are highly dependent on the P/E ratios at the beginning of those 30 years. Let's break up those 30-year periods into four quartiles of beginning valuation. If you start in a period when P/E ratios are in the highest quartile, you find that over 50% of the time you end up penniless, on average within 22 years. Here's that data from Ed:

As we saw above, valuations are well into that top 25% quartile. Notice that even when starting with the lowest-quartile valuations that 5% of the time you ran out of money within 23 years. Want to take a lifestyle bet that you have a 1 in 20 chance of losing? It will not be fun to have to go to work as a Wal-Mart greeter at 80.

Of course, there are other implications. A generation living longer means that the seemingly pessimistic forecasts of doom and gloom for Social Security and Medicare are not pessimistic enough. Defined benefit pension plans will be in real trouble at the end of the next decade.

So, what should you do? In secular bear cycles like we are in now, you should look for absolute return style investments, like income portfolios, hedge funds and other alternative style investments, be more nimble in your stock picking rather than using index funds and expect overall lower returns. We need to be patient and wait for the lower valuations which have always eventually made themselves evident.

Mexico, London, and Switzerland

The Newport Group brought in Chris Gardner to speak after me. It was one of the most inspirational stories I have ever heard. Chris was the man who wrote the Pursuit of Happyness which was the basis for the movie of the same name with Will Smith playing the role of Chris. As he related his life, it was even tougher than the movie. It makes me realize how important being a father is, and how much we owe to our parents who stayed with us, and how incredibly important it I to be there for our kids. Get the book and see the movie, and if you ever get a chance to her him speak, do so.

I get more than a few letters from readers who think my Muddle Through Scenario is a little too optimistic. If you want to read the bearish case, you can sign up for my friend Bill Bonner's the Daily Reckoning. It is a free service and very well written. Bill and his associates are from the Austrian economic camp, and go through a lot of data in an entertaining manner. You can subscribe for free at: http://www.dailyreckoning.com/Sub/MWAVEsignup.html

As noted above, I am in Orlando and getting ready to go to the Arnold Palmer Invitational Golf tournament in a few minutes. The speech went well, and now it is R&R time. It looks like I will be going to Playa del Carmen in Mexico (south of Cancun) in a few weeks over a weekend to speak to a group of NFL football players. Now that should be interesting. Then I will be in London for two days April 15-16 and then on to Switzerland for the rest of the week. Drop me a note if you want to meet.

Lunch and golf are calling, so I am going to his the send button early. Have a great week, and remember to have some fun on the way as we Muddle Through.

Your life is getting better every week analyst,

John Mauldin