Thoughts on the Continuing Crisis

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There is so much that is happening each and every day as the Continuing Crisis moves slowly into month 8, so much news to follow, so many details that need to be followed up that it can get a little overwhelming. Where to begin? Maybe with a "minor" change of the rules on how we value assets, then a look at the proposed changes in regulations, some comments to my hedge fund friends, a quick look at the employment and ISM numbers which are clearly showing we are in a recession and then finish up with some thoughts as to what it all means. There is a lot of ground to cover, so we will jump right in without a "but first" today.

If the Rules are Inconvenient,

Change the Rules

Several times in the past few months I have reminded readers of the

problem that developed in 1980 when every major American bank was

technically bankrupt. They had made massive loans all over Latin

America because the loans were so profitable. And everyone knows that

governments pay their loans. Where was the risk? This stuff was rated

AAA. Except that the borrowers decided they could not afford to make

the payments and defaulted on the loans. Argentina, Brazil and all the

rest put the US banking system in jeopardy of grinding to a halt. The

amount of the loans exceeded the required capitalization of the US


Not all that different from today, expect the problem is defaulting

US homeowners. So what did they do then? The Fed allowed the banks to

carry the Latin American loans at face value rather than at market

value. Over the course of the next six years, the banks increased

their capital ratios by a combination of earnings and selling stock.

Then when they were adequately capitalized, one by one they wrote off

their Latin American loans, beginning with Citibank in 1986.

The change in the rule allowed the banks to buy time in order to

avoid a crisis. It did not change the nature of the collateral. They

still had to eventually take their losses, but the rule change allowed

both the banks and the system to survive. I have made the point that

the Fed and the regulators would do whatever it has to do to manage

the crisis.

All the major new multi-hundred billion dollar auctions at the Fed

where the Fed is taking asset backed paper as collateral for US

government bonds does not make the collateral any better, of course.

It just buys time for the institutions to raise capital and make

enough profits to eventually be able to write off the losses.

Thus it should not come as a surprise to you, gentle reader, that

the rules have been changed in much the same way as in 1980. In an

opinion letter posted on the SEC website last weekend clarifying how

banks are supposed to mark their assets to market prices is this

little gem (emphasis mine):

"Fair value assumes the exchange of assets or liabilities

in orderly transactions.

Under SFAS 157, it is appropriate for you to consider actual market

prices, or observable inputs, even when the market is less liquid than

historical market volumes, unless those

prices are the result of a forced liquidation or distress

sale. Only when actual market prices, or relevant

observable inputs, are not available is it appropriate for you to use

unobservable inputs which reflect your assumptions of what market

participants would use in pricing the asset or liability."

(The full letter is at

So, now banks can simply say that the low market prices for assets

they hold on their books are actually due to a forced liquidation or

distress sale and don't reflect what we believe is the true value of

the asset. Therefore we are going to give it a better price based on

our models, experience, judgment or whatever. In today's Continuing

Crisis, nearly every type of debt and its price can be classified as a

forced liquidation or distressed sale.

Does this make the asset any better? Of course not. But it buys

time for the bank to raise capital or make enough profits to

eventually take whatever losses they must. And who knows, maybe they

will get lucky and the price actually rises?

There are two problems with this rule. First, it clearly creates a

lack of transparency. The whole reason to require banks to mark their

assets to market price rather than mark to model was to provide

shareholders and other lenders transparency as to the real capital

assets of a bank or company.

Second, can a forced liquidation or distress sale be from a margin

call? Obviousy the answer is yes. But as Barry Ritholtz points out,

this opens the door for some rather blatant potential manipulation. If

a bank makes a margin call to hedge funds or their clients to make the

last price of a similar derivative on their own books look like a

forced liquidation, do they then get to not have to value the paper at

its market price? Is this not an incentive to make margin calls? One

price for my customers and a different one for the shareholders? If a

hedge fund was forced to sell assets and then they find out that the

investment bank is valuing them differently on their books than the

price at which they were forced to sell, there will be some very upset

managers and investors. Cue the lawyers.

Is this a bad ruling? Of course. But is it maybe necessary? It just

might be. My first reaction was that this tells us things are much

worse than we think. The struggle to get the mark to market ruling

only to abrogate it in certain circumstances less than a year later

has to gall a lot of responsible parties. It seems like it is 1980 and

Latin America all over again. Let me repeat: The Fed and the Treasury

(who oversees the SEC) will do what it takes to keep the game and the

system going.

Let's Re-arrange the Deck Chairs

Treasury Secretary Hank Paulson put forth a number of "new" ideas

for changes in the regulatory structures. Nothing I saw will help all

that much in the current crisis. It's more like re-arranging the deck

chairs as the ship is going down. It seems like most of it is being

proposed to prevent another crisis like the one we are in from

occurring in the future. That simply insures that Wall Street will

have to invent whole new ways to create a crisis in the future. I am

sure they will be up to the task.

Most of the proposals are basically good ideas that have been

discussed for a long time, like merging the CFTC (Commodity Futures

Trading Commission) and the SEC. We are the only country with such a

bifurcated regulatory system. Good luck with getting that through

Congress, though. The Agricultural Committees in the Senate and the

House oversee the CFTC and futures trading, dating back to the 1930's

when all that was traded was agricultural products. Now the CFTC

oversees a vast derivatives market, which of course makes campaign

donations to members of those committees. Think those Congressman want

to see their major campaign donors go away? Of course, that means the

Finance Committees would get new donors. It will be amusing to watch

and see who "wins."

The really interesting item is the potential for the Fed to

regulate investment banks, which makes some sense if they are going to

loan them money at the discount window. Left unsaid and up for future

negotiation is whether that would mean investment banks would have to

reduce their leverage. Right now, investment banks utilize about twice

the leverage as commercial banks. That leverage is what makes them so

profitable. Take that away and they lose a lot of their profit


A great part of the continuing crisis can be laid at the feet of

too much leverage in too many places. The world is de-leveraging

fairly rapidly. In some circles, it looks more like an implosion. The

Fed and the SEC have made it very clear they want to have more

authority to oversee all sorts of funds and investment banks so they

can get a handle on the amount of leverage in the system. What you do

with that information is another thing, but they want it and will use

the Continuing Crisis to get that authority. My bet is that investment

banks are going to be forced to reduce their overall leverage "for the

good of protecting the system from itself" or some such twisted


So, let's sum it up. The problem is so severe with the financial

companies assets that the SEC is going to allow some of them to "cook

the books" so they can survive. That means there are going to be large

and continuing write-downs for many quarters to come. There is a

minimum of another $3-400 billion in write-downs (and maybe a lot

more) coming from mortgage related assets, not to mention credit cards

and other consumer related debt. And the investment banks may be

forced to reduce their leverage and thus their profitability?

Putting money in the major financial stocks is not investing. It is

gambling on a very uncertain future. There is simply no way to know

what the value of the franchise is. There are other places to put your


Regulations Coming to a Hedge

Fund Near You

The SEC pushed through rules last year to regulate hedge funds. The

courts ruled (properly, I think) that the SEC did not have

congressional authority to do so. The hedge fund industry fought tooth

and nail to avoid regulation and dodged the bullet.

I think the mood in Congress is going to be such that as the

authorization for many of Paulsen's proposed changes make their way

through Congress, some of them are going to allow the SEC the

authorization they need to regulate hedge funds. The Continuing Crisis

almost makes it a sure thing.

So, a quick note to my friends in the hedge fund industry. Forget

fighting regulation and start negotiating. Recognize that regulations

are coming and do what you can to make them as rational as possible.

Also, make sure you (we) get the rights of other regulated funds, like

the ability to advertise and not be so secretive, at a minimum. And

maybe a more reasonable interpretation of the research analyst rules,

which I note that many seem unaware of the implications on hedge funds

and private offerings of the research analyst rules.

I am regulated by FINRA (the former NASD) which is overseen by the

SEC, the NFA (the self-regulatory arm of the CFTC) and various state

financial authorities. It seems like we get a regulatory audit almost

every year from someone. My small firm survives, and so will hedge

funds. Does it cost a lot of money and time to be regulated? Sure. But

that is the price of doing business.

Will making hedge funds register make them any safer? I doubt it.

Think of Enron and WorldCom. REFCO was registered and somehow hid a

$500 million dollar bogus loan from regulators, their investment

bankers and auditors. But it will make them more transparent. If we

are going to have to pay the costs of being regulated let's make sure

we get the benefits.

More Fun in the Unemployment


Payrolls tumbled by 80,000 today, more than forecast and the third

monthly decline, the Labor Department said today in Washington. The

unemployment rate rose to 5.1%, the highest level since September

2005, from 4.8%. The household survey shows the number of unemployed

people rose by 438,000. (That is not a typo!) In March, the number of

persons unemployed because they lost jobs increased by 300,000 to 4.2

million. Over the past 12 months, the number of unemployed job losers

has increased by 914,000.And of course, when you look into the numbers

it is worse than the headlines implies.

Prediction: we will see 6% unemployment before the end of the


There were negative revisions totaling 67,000 job losses for the

last two months, making those months even worse. This means that the

Bureau of Labor Statistics (BLS) is clearly over-estimating the number

of jobs in the first announcement. That is because they have to

extrapolate based on recent past data. And as I continually point out,

as the economy softens, they are going to continue to overestimate the

number of jobs. It's one of the problems of using past performance to

predict future results.

Job losses since December are now at 286,000 in the private sector

and 232,000 overall, counting for growth in government. What was up?

Health care (23,000) and bars and restaurants (23,000 also). Initial

unemployment claims are up by almost 25% for the last four weeks over

last year, and this week were over 400,000. Given the job losses, this

is not surprising.

This month the BLS hypothecates 142,000 jobs being created in their

birth/death model. You can guarantee this will be revised down. For

instance, they assume the creation of 28,000 new construction jobs as

the construction industry is imploding. Total construction spending

has fallen for the last four months in a row. Somehow they estimate

6,000 new jobs in the finance industries. Does anyone really think we

saw a rise in employment in mortgage and investment banks?

Buried in the data is a picture of a squeezed consumer. Inflation

is now running ahead of the growth in wages. As the chart below shows,

average hourly earnings were up just 3.6%, but inflation was 4.5%.

That means consumers must struggle to maintain their standard of

living. No wonder retail stores shed 12,000 jobs last month. Light

vehicle retail sales are down by 20% form last year. This all paints a

picture of a very challenged consumer.

A Muddle Through Recession

The business sector is clearly in recession. The ISM manufacturing

index came in at 48.6. Anything below 50 means manufacturing is in

decline. There was a sharp drop in new orders. New orders have been

below 50 for four months. Employment has been below 50 for four

months. Backlog of orders has been well below 50 for six months.

Yesterday the ISM service index was again below 50 for the month of


Given all the data, why then do I still think we will not see a

deep recession? Because corporate America is in much better shape than

in the beginning of past recessions. Lower inventories, better cash to

debt ratios, not as much as excess capacity, and so on. As Peter

Bernstein notes in his latest letter, nonfinancial corporate debt is

at its lowest level in 50 years, and four standard deviations below

the average from 1960 to 2000.

The recession we are now in is a consumer spending led recession

driven by a falling housing market which is infecting the entire

country. Can anyone still claim that the subprime problems would be

contained as many did just last summer? Consumer spending is going to

fall even more as credit becomes harder to get.

The situation is neatly summer up by Bernstein:

"The debate over whether we are or are not in a recession

continues. There is, however, no debate about resumption of rapid

economic growth in the near future. That's without question the most

unlikely outcome. Yes, there are some bright spots, such as exports in

the governmental largess that lies just ahead - and the likelihood of

additional government assistance in some form. The Federal Reserve is

also doing its part to lubricate the snarls in the financial


"But the household sector is in deep trouble and will remain in

trouble for an extended period of time. The combination of falling

home prices, the complex problems in the mortgage area, limited

financial resources and high debt levels, new constraints and higher

costs on consumer installment credit, and probably rising unemployment

already sluggish growth and jobs tend to restrain spending by the

largest and most important sector of the economy.

"Imagine what would happen if all of these adverse forces struck a

business sector stuffed with inventories, busy installing a massive

amount of new productive capacity, with labor costs rising and

productivity falling, and an overload of new debt to service. A

difficult situation in the rest of the economy could be rapidly

converted into a deep recession. But the business sector has kept

inventory accumulation to a moderate pace, has limited in capacity

growth, and has been conservative in adding to debts outstanding. How

lucky can you get?

"Some observers are convinced that we are heading toward a deep

depression in any case. We are not so sure. We believe the likely

duration of these troubles is a greater concern than the depths the

system might reach. The condition of the business sector as pictured

above is the primary reason for this more hopeful outlook."

But a recession for at least two quarters and a Muddle Through

Economy for at least another 18 months is not going to be good for

consumer spending, job creation and most especially corporate profits.

I continue to predict more disappointment for corporations that are

tied to consumer spending and industries that are associated with


S&P analysts continue to project earnings to be up by 15% in

the third quarter of this year and by almost 100% for the fourth

quarter this year over last year. Yes, I know there are a lot of one

time charges and write-offs in the last two quarters of last year

which make comparisons difficult. But in a recession and a slow

recovery, how likely is it that we will not see even more "one-time"

write-offs. And as noted above, there are more than twice as much

subprime losses in our future as we have written off as of yet.

As I have written about at length in past issues, bear markets are

made by continued earnings disappointments. It typically takes at

least three difficult quarters to truly disappoint investors. We are

just in the early stages. The recent drop in the stock market has been

primarily caused by the Continuing Crisis in the credit markets, and

only modestly by disappointing earnings. We need a few more quarters

of disappointment to really get to a bottom in the stock market. It

could be a long summer.

How Much do we Borrow for a $1

growth in GDP?

Finally, I want to give you a chart from my old friend Ian McAvity

from his latest newsletter Deliberations, which he has been writing

for 36 years! Basically, it makes the point that the amount of new

debt in relationship to GDP is rising. We borrowed in one form or

another $5.70 for each $1 rise in GDP last year.

Debt in all forms rose $7.86 trillion for the previous 8 quarters

to $48.8 trillion dollars. Nominal GDP was only $14.1 trillion. This

is of course unsustainable. At some point, debt growth must slow

dramatically. As the world deleverages, decreasing debt and the

resultant slowing of consumer spending will become a head wind for GDP


London, Switzerland and South Africa

Next Wednesday I head out to California for my 5th

annual Strategic Investment Conference in La Jolla. It is completely

sold out for the first time. My partners in the conference, Altegris

Investments have been doing yeoman work to make it come off in high

fashion, and I thank them. I return and immediately head over to

London and then Switzerland. I will be speaking for Bank Sarasin at a

resort in Switzerland in the Interlaken area, and will stay on for a

few days to be tourist and take some needed R&R and fly back on

Monday evening.

I will be in South Africa in Johannesburg from May 5 - 8 and in

Cape Town from May 12 - 14. If you are interested in attending my

presentations you should contact Prieur du Plessis. You can use the

contact button on his excellent blog:

I am going to try and play golf for the first time in at least a

year. I will be terrible, but I will be playing with good friend and

savvy commodity trader Greg Weldon and I look forward to it. Then in

the afternoon two of the best Science Fiction writers and futurists in

the world, Vernor Vinge and David Brin are going to join me, serious

technology maven Dr. Bart Stuck and financial guru and brilliant

thinker Rob Arnott for two hours of rambling conversations about the

future. My daughter Tiffani wants to record it, and if we do (and with

everyone's permission) we will post it on the net. Then 240 new and

old friends gather Friday and Saturday to hear some really interesting

speakers and enjoy each other's company. It looks to be a great


I hope you can enjoy your week as much as I will. And make it a

good one. Now if the Rangers can just win their home opener on

Tuesday, it will get even better.

Your amazed at how lucky I am analyst,

John Mauldin

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John Mauldin is a multiple New York Times best selling author and recognized financial expert. He has been heard on CNBC, Bloomberg and many radio shows across the country. He is the editor of the weekly economic and investment e-letter "Thoughts from the Frontline."
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