"There is Always an Easy Solution to Every Problem -- Neat, Plausible and Wrong." -H.L. Mencken

As the housing bubble and credit crisis accelerates, the Politicians, Federal Reserve, and the US Treasury wants to help fix the problem. The Federal Reserve in March “bailed out” Bear Sterns. The Fed agreed to provide a $30 Billion “non recourse loan” to J.P Morgan secured only by the worst tranche of Bear Sterns’ mortgage debt. This is not in fact a loan. If it were, J.P Morgan would be required to pay it back, but no such requirement (unless J.P. Morgan itself fails). Instead of a loan, this is a “put option” which protects J.P Morgan from losses on the collateral, regardless of J.P. Morgan’s own financial status. The effect of the Fed’s guarantee is not to protect the public, but to protect Bear Sterns’ bondholders.

The deal is being defended on the notion that the global financial system would have “failed” had Bear Sterns, not been rescued. But the orderly transfer, netting and settlement of financial contracts is precisely what Title IX of the Bankruptcy Act of 2005 was written to facilitate. In effect, the Federal Reserve and the Treasury decided to ignore existing law and provide a bailout to the benefit of Bear Sterns’ bondholders at public expense.

The clear historical role of the Federal Reserve has been to manage the composition of Federal liabilities (by varying the mix of Treasury securities and monetary base, currency and bank reserves-held by the public). The recent transaction is a dangerous break from that role, in which unelected bureaucrats are committing public funds to facilitate private business transactions and selectively defend the holders of corporate securities. Only Congress has the Constitutional right, by the representative will of the people, to commit public funds. The Bear Sterns deal is a dangerous precedent and a dilution of Congressional prerogative. Even worse, it indicates to risk seeking mismanaged financial institutions that they do not have to face the consequences of their erroneous acts.

Over the next six months there will be other financial institutions that will fail. Do the taxpayers bail out the whole mess (estimated to be $1 Trillion)?

Congress would like to have a Mortgage Rate Moratorium fixing interest rates for two years, and/or forgiving a portion of the principal on these sub-prime mortgages. Good idea. Let the taxpayers pay for this mess too. We now live in a world with high risk, without anyone taking responsibility stupidity and greed. Expect one thing next year - higher taxes, and higher rates of inflation.

I have attached 3 Graphs that indicate that we are clearly in a Recession and that Stock Market is in a Bear Market. Many pundits have expressed the belief that the worst is over for the Stock Market and Economy. I do not share this belief. The Market has had some rallies over the past two weeks which made headlines. Looking closer at these market advances indicate huge short covering, and very selective buying. Hardly the action required to end the Bear Market. The fact is, that selling pressure (supply), as measured by the Lowry Research Corporation (www.lowryondemand.com) is still very high. Selling pressure measures the supply of stock for sale. Historically there have been rallies in primary bear markets that can last 2 days to 3 months. It is my opinion that the market has lower to go.

The bear market will not end until stocks are undervalued. Currently in my opinion, stocks are still overvalued. The S&P 500 carries a PE Ratio of 20.71 times and a dividend yield of 2.02%. Does this valuation and yield sound like good value to you?

So we wait. The next six to twelve months probably will be very boring, with only unpleasant surprises coming. The good news is that the Olympics are coming this summer (assuming the US are allowed to go), the Baseball season has started.

"Two Things are Infinite: The Universe and Human Stupidity: and I'm Not Sure About the Universe." --Albert Einstein

“The Stock Market has reached a permanently high plateau.” Irving Fisher, Yale Economics Professor, September, 1929. The poor man was the leading Economist of his day, and was highly leveraged in the Stock Market before the great crash. After September 1929, Irving Fisher was financially wiped out.

Bear Sterns spokesmen Alan Schwartz CEO said on Tuesday March 11, 2008 that “Bear was not in trouble, and would withstand the Sub-Prime meltdown. On Friday March 14, 2008 “Bear” borrowed and unknown amount from the Federal Reserve to continue operations. The loan is for 28 days. Good luck! Read on.

In the mid 70’s, Continental Illinois Bank set out to become the largest Commercial and Industrial lender in the World. Between 1976 and 1981 the banks lending jumped form about $5 billion to more than $14 billion, while its total assets grew from $21.5 billion to $45 billion. A 1978 article in Dun’s Review pronounced the bank one of the top five companies in the nation. An analyst at First Boston Corp praised Continental, noting that it had “superior management at the top and its management are very deep”. In 1981 a Solomon Brothers analyst echoed this sentiment, calling Continental “one of the finest money-center banks going.” During late 1981 and early 1982 the stock market price of Continental was deteriorating (from a high of 42.00 to 6.50-a drop of 84%). However, Analysts continued to recommend purchase. Interestingly enough, Continental was offering 16% fixed rate loans with the Prime at 20%. Many bankers muttered, “I don’t know how they do it?”

In March 1982 Fitch Investors Service downgraded six large bank ratings, but retained its AAA rating on Continental. In May 1984, The Office of the Controller of the Currency departed from their policy of not commenting on individual banks, took the extraordinary step of issuing a statement denying the agency had sought assistance for Continental and noting the OCC was unaware “of any significant changes in the bank’s operations, as reflected by rumors.

Optimism about Continental’s financial condition ended abruptly in July 1982, when Penn Square Bank, N.A. in Oklahoma failed. Penn Square had generated billions of dollars in extremely speculative oil and gas exploration loans, many of which were nearly worthless, and Continental had purchased a monumental $1 billion in participations from Penn Square. Depositor raids (pulling there money out) crippled the bank. Continental and other banks pressed regulators to find a way to prevent a deposit payoff of Penn Square, a course preferred by the Federal Reserve. The other large banks refused either to inject money into Penn Square or to waive their claims on the Bank. The refusal to waive their claims meant that the contingent liabilities of the Federal Deposit Insurance Corporation would have incurred payouts that were in excess of their funds. This presumably left only one course, namely, the Federal Reserve must “bail out” the bank. The bottom line was that the Fed’s “loaned” the bank the money (printed it) in the amount of $4.5 billion.

Technically the Federal Reserve purchased the banks bad loans. This “loan” was not paid back until 1993 (eleven years). All this going on while the CEO stated that the bank “had no intention of pulling in its
horns.” Does any of this sound familiar? Who really paid for the bailout? You did of course, through Income Taxes and Inflation. We pay for extraordinary speculation by others. A wonderful concept.

Last week my Wife called me and asked if I knew anything about Fremont Savings and Loan, a local Savings and Loan that has a branch across the street from Leisure World. I asked her why? and she said a friend of hers had gone to the bank prior to its opening to make a deposit and was greeted with a line a block long. The people in line told her the bank is going broke. I looked up the bank (Fremont General Corp) and discovered they were large originators of sub-prime loans. There problem was they had sold this crap into Mortgage backed bonds with the caveat that they would maintain a Net Worth at a minimum of $250 million. Woops, their net worth is presumably about $100 million. The bank on March 4, 2008 received a default notice on $3.15 billion. Maintaining a net worth level of at least $250 million was part of the agreement with investors who purchased the loans in March 2007 to support the bank’s obligation to repurchase any loans sold in the deal. To meet the sales terms, Fremont would need to put the amount of money required to make up the difference between its net worth and the agreed upon level in a reserve account or provide a letter of credit for that amount, and Fremont in a press release said that it is not in a position to do either. So far, Fremont has been asked to repurchase about $11 million of the loans sold under the deal. Not surprisingly, Fremont has not filed a Financial Statement since March of 2007.

The good news is that my Wife’s friend got her money, and as she left the bank, she noticed the line at the bank had expanded to about 3 city blocks. Good luck Fremont.

This “Financial Panic” as I have said cannot be averted with interest rates cuts. It’s a Credit Crisis for which the average Joe in the street has lost there trust in the Banks. The next chapter in this “speculative bubble” could be very painful for investors, and the general public. The Political and Social solution to all these mounting problems will be printing more money, Bail Out’s, and higher Income Taxes.

For those of you, who have CD’s at any Federally Insured Bank; remember that you are only insured up to $100,000 per account. It may be time to move money in excess of $100,000 into Treasury Obligations.

My solution is simple: over the next few weeks we will own US Treasury Bills and Notes, Gold, and some Silver. I will watch from the sidelines. Yield on Treasuries are very low, but remember, in the Depression (1932) 90 Day T-Bills traded at a negative yield because it was the only safe place to put “cash”. Now is not the time to panic, but defense, safety, risk aversion, and liquidity is currently the only strategy.

The Bailout

I hate to write about negative events and problems. I would prefer to write about happy things, like my Grandchildren, the joy of Italian Food, and NY Giants making the Super Bowl. I always have preferred a Bull Market to a Bear Market, and a healthy, and happy Economy. The problem I have is that we have big problems. We have some real Economic and Financial Problems that need to be addressed. No doubt, in time, all the problems will be resolved in the long run, but (as John Maynard Keynes said) we eat in the short run. Here are some of the problems we confront for this year:

In the past five years, Wall Street has created yet another derivative-namely, “Credit Rate Swaps”, whereby “bets” are placed between two parties that a given debt will default or make good. The market is about $45 Trillion, which is equal to all of the Deposit’s in the Banks around the World. A Party for a price assumes the value of an “insurance” contract that rises or falls with perceptions of risk. Some players buy them just to speculate. A financial institution, hedge fund, or other player can make unlimited bets on whether loans will either strengthen or go sour. If they default, everyone is supposed to settle up with each other. Even if there isn’t a default, if the market value of the debt changes, parties in the swap may be required to make large payment to each other. Many of the contracts are leveraged. Warrant Buffet says” you are essentially counting on the reliability of strangers to pay up on their contract. The rate swaps are largely unregulated, and the derivatives are off-balance sheet transactions. Who’s going to bail out these transactions? Taxpayers? Who’s watching the store, and what are these instruments worth? Nobody knows!

The lowering of the Fed Funds Rate twice in a matter of weeks excited Wall Street. Yet the Stock Market has not had any significant rally so far. Could it be that this is a credit crunch and not an interest rate problem? No doubt the lowering of interest rates will help the helpless, hapless Banking System and some Reset Mortgages coming due over the next 9 months, but remember, the Mortgage Obligor must now pay higher rates and at the same time make principal payments.

Mammoth infusions of Capital into the US Banking System from Foreign Soveirgn Wealth Funds (Saudi Arabia, Korea, and China) have bolstered Bank Capital, but the Banks are paying 15% to 18% interest on the “loans”. The US Dollar is recycled. We pay foreigners buying Oil and Consumer Goods, and now Foreigners give us the money back.

The US Dollar is in free fall. A nations currency value measures the wealth of a country. If a nation’s currency goes lower, it indicates the lower purchasing power of that currency for World Wide Goods and Services. The US Dollar versus all currencies was 121.29 in June 2001. It now stands at 74.48, a 38.50% decline in purchasing power. Factor in the inflation rate, and our populace has given up over 42% in value in 7 ½ years.

As our we go from “Bubble to Bubble”, The Federal Reserve and Congress keep bailing us out (we pay for it) by lowering interest rates and providing funds to prevent a Recession. In the Great Depression, this was a very good idea. However, in the current economic environment this strategy poises several major problems, namely:

1. Interest Rates cannot go to zero percent (can they?),
   
2. it takes greater and greater infusions of liquidity to prevent a Recession (inflationary). This process is very much like narcotics addiction. Each injection does not create the desired high, so the addict injects more narcotics trying to capture the original high. This process cannot go on,
   
3. the whole process assures a penalty free atmosphere for those that created irrational and inefficient processes, In fact, Wall Street calls this the “Federal Reserve Put”, meaning that any half-baked scheme will be “bailed out”.
   
4. We (taxpayers) pay for the mess made by others,
   
5. Our Economy goes from one bubble to another bubble. We already had the Dot.Com bubble, and the Housing bubble. With cheap money and borrowing rates at all time low’s, the tendency is for investors to borrow and bid asset prices up. The question is what asset class will investors buy next?
   
6. As other Foreign Currencies go up against the dollar, Foreign Central Banks are motivated to keep their trading advantage. To do this, they print more money to prop the US Dollar up (thus selling their currency). We then have an expansion of all Currencies that is inflationary for the World.

The Gold Reserves of the United States have not been full and independently audited for half a century. Our Gold Reserves are being used for the surreptitious manipulation of the international currency. The Treasury Department acknowledges that their Exchange Stabilization Fund has undertaken gold swaps. Barrick Gold Corp acknowledged that the mining company was the instrument of Central Banks in shorting the Gold Market. Now our Government is fooling with our Gold Reserves.

There are two opposing economic possibilities confronting the US Economy. Deflation or Inflation If the Credit crunch gets out of control, we will have a deflation (collapse of credit). If the Politicians and Federal Reserve keep up their advertised cures, we will have inflation. Either extreme is not satisfactory. My bet is we will have increasing levels of inflation, which makes Gold and precious metals viable candidate’s for the next Bubble. Cash is King and Gold glimmers.

The Perfect Storm

The results are in: The sub-prime mess has surfaced (what a surprise), the "carry trade" is unwinding, the housing market is a catastrope, derivative hedges don't work, and the Market is tanking. Where do we go from here? The Mortgage Resets have started but will get worse through the 1st quarter of 2008. Housing prices and Units sold will go lower through 2008, and the Stock Market will probably have a rally once in a while followed by new declines. My Economic model is forecasting a recession starting within the next 4 months.

Many of the so called experts have maintained the Stock Market is properly valued. A stock market that pays a sub-par dividend with PE ratios in excess of 17 times in my view is not properly valued. In theory a Stocks Prices is equal to the present value of their future dividends. Most stocks don't pay dividends, which brings to mind the greater fool theory.

My advise is to dig in, stay liquid and wait for the panic to subside. The "unintended consequences" of crap lending has just begun to surface.

AS THE WORLD TURNS

Many of the Economic Indicators have turned down including the Leading and Coincidence Indicators, indicating at best a slow down and at worst a recession. As the sub-prime mortgage market takes its lumps, and the Federal Reserve holds fast to not changing interest rates, the Stock Market takes it on the chin.

The Federal Reserve has a real problem-If they raise rates, that will certainly doom whats left of the housing market and trigger a recession, and if they decrease interest rates, the Dollar will drop against most currencies and we will suddenly be importing inflation. The risk of lower interest rates is not only inflation, but the chance that many holders of US Bonds denominated in Dollars (China, etc) will be inclined to sell US$ Bonds and go elsewhere (other currencies with higher yielding Bonds.) Thus do want a recession or do want inflation. In order to save the Kingdom, I believe the Fed will lower interest rates sooner than later, and take its chances with inflation.

The housing Economic Statistics have focused on units sold. However, the most important statistic in housing is the total units sold times the average sales price. The total sales for the year ended June 30, 2007, in dollars, of new Single Family Dweling units has dropped 26.03%, and existing homes 14.20%. Both these figures have posted hugh declines which in the past has been a lead indicator of recessions. For example, total sales posted large delines in: August 1966, February 1970. October 1973, December 1979, July 1981, August 1990. and June 2000. Subsequent to these delines a recession occured. We therefore are poised for another Recession if the Fed does not lower interest rates, and it might be too late.

Good chance of Recession

Leading Indicators continue to go down, the $ continues to decline, and the Market is overbought. Time to lighten up and play anti-dollar investments, like Gold, Silver, and Energy plays.