Sea Change on the Street

Guys, there was a huge change of tone over the last two weeks and especially this week. The denial that has ruled Wall Street for so long is beginning to show major cracks. We're finally seeing grudging admissions that this is a much bigger problem than they were willing to admit. What used to be just a "subprime" crisis is now a "mortgage" crisis.

The terrible reports from major retailers like Pennys, Macys, Kohls and the spectrum of apparel shops along with restaurants like Starbucks, PF Chang, Chipotle, Brinker and Panera are causing the Street to question the "resilient consumer" thesis. They should since it is based on the ability of the consumer to dig themselves into an every deeper hole of debt. But McDonalds and Target did well and Walmart OK. What does it tell you when spending is switching from department stores to discounters and from premium or sit down restaurants to the golden arches?

We don't hear the word "contained" much anymore do we?


Smacking Fannie
Fannie Mae is messing with their accounting to hide rapidly rising losses. They snuck in the accounting change that cut reported losses by almost half. This sort of game has been very common at financial companies in the last few years. They usually get away with it but this time investors noticed and slammed the stock down 20% in just a few sessions. The executives at Fannie must feel like Mike Leach when one of his OLinemen gets called for holding. We're going to see a LOT more of this simply because there is so much out there to find.
More doubts about Fannie Mae's disclosures


Commercial Divers
Next, we get the first real world confirmation that commercial real estate pricing is now falling. Synthetic indexes like the CMBX and credit indicators have been indicating decline for many months. The MIT index covers CRE owned by large pension funds and showed a decline of 2.5% for Q3. That would imply that prices rolled over either during Q2 or early in Q3. Commercial joins residential and commercial construction spending should follow shortly.
MIT index shows first drop in commercial property value since '03

Just incidentally, the subtitle "Indicates housing woes, credit crunch 'may be spreading' " trips one of my pet peeves. There is not a housing crisis spreading to other sectors like a contagious disease. This is more like a genetic heart defect inherited by a group of brothers from the Credit family. One, let's call him "Bob Residential" has a near-fatal heart attack. Another, named "Joe Consumer" is in the hospital for major symptoms but nothing life-threatening yet. "Jim Commercial" and "John Corporate" are having chest pains. The media wants to blame Bob for everybody's problems but the reality is they were all flawed from birth (of the current crop of loans).


Goldman Shocker
Goldman Sachs, which had previously been very bullish, is now calling for $400 billion in direct losses from the crisis in mortgages, plus $2 trillion in withdrawn credit as bank reserves shrink. Well, at least they've got the right number of zeros now but they still fail to account for anything beyond residential real estate.
U.S. could face $2 trillion lending shock

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"The macroeconomic consequences could be quite dramatic," Hatzius said in the note to clients. "If leveraged investors see $200 billion of the $400 billion aggregate credit loss, they might need to scale back their lending by $2 trillion."

Hatzius said such a shock could produce a "substantial recession" if it occurred over one year, or a long period of sluggish growth if it occurred over two-to-four years.

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The related article in Forbes made me roll my eyes and mumble "nice job Goldman, what took you so long?" This was obvious to anyone who bothered to do elementary analysis even a year ago. It's also why the Ben Stein's of the world have always been full of it. His "analysis" failed to account for how much the losses would push down the price of everyone else's houses or how the damaged financial system would be forced to cut lending. Duh!
Cost Of The Crunch? $2 Trillion, Says Goldman

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In July, for example, Fed Chairman Ben Bernanke put subprime-related losses at $50 billion to $100 billion. "Even at the time, these numbers seemed quite optimistic," wrote Goldman economist Jan Hatzius, in a note Friday. "Now it is clear to most observers that they are far too low."

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So it looks as if the new bull case is huge losses and probable deep recession. Goldman has been a constant cheerleader since they have a lot to lose from this scenario. IMO, they have simply calculated that the loss of credibility from continuing to spew slanted nonsense now outweighs the loss of business if the economy and market fall a little sooner. Make no mistake, they would be extremely unlikely to make such a change unless they felt the events were already on the doorstep.


The Bleeding Edge
Of course, Hatzius at Goldman is just catching up to David Rosenberg at Merrill, who turned quite bearish 6 months. The guys who had this right from the beginning are Paul Kasriel at Northern Trust and a pair of academics - Nouriel Roubini at NYU and Robert Shiller at Yale. Notice that none of them work for investment or money center banks. Earlier, I linked the Bloomberg interview with Morgan Stanley's head of credit strategy, calling for a greater than 50% chance of the credit markets coming to a "grinding halt." The scary thing is that Roubini is now going further and saying the "risks of such a generalized systemic financial meltdown are now rising."
Nouriel Roubini's Global EconoMonitor

This is obviously not something I've foreseen. My expectation has been for severe and widespread losses, with a few major firms failing. Roubini has not yet published his full analysis but I pray that his conclusions are wrong though I will consider them with an open mind. Just as I've prayed that my own conclusions were wrong despite believing in them wholeheartedly. The problems seem inescapable. Hope for the best, prepare for the worst.

First Principles

Well, it's been one heck of a week. With all of the insanity going on around us, sometimes it's best to take a step back and return to first principles. One of those is the Business Cycle - you know that thing that the Fed has supposedly abolished? The two questions that come to mind immediately are "why did the cycle exist?" and "how did the Fed get rid of it?"


The first one is easy. Economic cycles have existed throughout our history and always will exist as long as emotional humans are making economic decisions. The National Bureau of Economic Research has tracked US economic cycles going back to the mid-19th century. In the immediate postwar period, the cycles became more predictable as the Fed began to regulate them and induce the occasional recession to purge excesses before the market did it for them. During this period, it was discovered that the cycle could be manipulated though not controlled. The typical pattern was roughly three years of expansion, followed by a 12 month recession. The only major exception was the long expansion which lasted through most of the 1960s. The excesses from that one contributed to the really ugly decade that followed - and I'm not just talking about disco and afros for white guys either.

Unfortunately, other than Paul Volcker the Fed seemingly learned little from that experience. After Saint Paul imposed a painful but effective remedy for inflation, his successor Alan Greenspan embarked on a policy of continuous credit expansion. This has "worked" in the sense that economic growth was sustained over a long period, few setbacks were encountered and those were short and shallow. But the price was a crumbling economic foundation. Consumption became the dominant basis of the economy. Consumption growth was funded first with falling savings, then with growing debt. The major collapses in the savings rate came during the 1990s as it fell from 7% to 2% and again after 2002 when it went from 2% to negative.

We essentially outsourced the necessary but burdensome job of saving to Asia. Few economists seem to have drawn any connection between the outsourcing of manufacturing and of savings. Manufacturing requires investment and investment requires savings. It would seem reasonable that the nations which save and invest in the real economy (not just financial paper) would increase their manufacturing and that seems to be the case. The US is left with little savings, heavy debt, bad loans and a weakened manufacturing base. The cycle has not been abolished. It has simply been stretched and distorted beyond all recognition.