Keep your eyes open!...

Hoofbeats of the Black Horseman

(Rev 6:5) When the Lamb opened the third seal, I heard the third living creature say, "Come!" I looked, and there before me was a black horse! Its rider was holding a pair of scales in his hand.

(Rev 6:6) Then I heard what sounded like a voice among the four living creatures, saying, "A quart of wheat for a day's wages, and three quarts of barley for a day's wages, and do not damage the oil and the wine!"

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Recession Time?

February 14, 2000

Summary Last week, U.S. bond markets saw the emergence of a strange yield curve with the yield of 30-year Treasury bonds falling below earlier maturities. While there is argument over what this meant – whether it meant anything at all – the yield curve is one of several indicators suggesting that a recession is in the making. At the very least, the yield curve has flattened dramatically, and it seems to us that most market forces are driving toward an inverted yield curve.

There are other signs, too. The performance of major stock indices has diverged. Commodity prices have risen, giving investment some place to go other than stocks. We remain bullish on the long-term prospects of the American economy but a short, sharp recession appears to be shaping up for late this year.

Analysis Stratfor’s readers are aware that we have been consistently bullish on the U.S. economy. Our basic view of the U.S.

market remains the one put forth in our recent decade forecast: “Our expectation is that the massive growth spurt will continue for the first half of the decade. Though it would not surprise to see a sudden, very frightening downturn in the markets or a short, sharp recession, not dissimilar to

1987, the basic upturn will continue until at least 2005 and probably for several years hereafter.” Last week we started to see some indications that the “short, sharp recession” that wouldn’t surprise us may be ready to not surprise us.

Our attention was riveted last week by the behavior of the “yield curve” on U.S. Treasury instruments. The yield curve is simply the interest rate that purchasers of these instruments would receive, depending on the maturity date of the bill or bond. Under normal circumstances, the yield curve is positive. That means that the shorter maturities pay lower interest rates, while longer maturities pay higher ones; the 30-year Treasury Bond pays the highest. The reason is simple: People who buy longer-term bonds take greater risks because the government doesn’t have to redeem these bonds for 30 years. If interest rates rise, the value of the bonds on the secondary market could fall. People buying short-term bonds can be paid off in months or even days, and they don’t risk their investment principle.

One of the important precursors of recessions is a negative yield curve, in which short-term rates are higher than long-term ones. And one of the triggers for a recession is a rise in interest rates. Higher interest rates cause businesses to try to avoid long-term borrowing and seek short-term borrowing. The result: Short-term interest rates rise even higher than increases in long-term rates. This inversion of the normal yield curve is a classic sign of impending recession.

What we saw last week was a truly weird yield curve. The three-month rate closed at about 5.7 percent, and the curve rose steadily until the one-year yield was at a little more than six percent. The yield curve was flat through three years, fell a bit at 10 years, and fell again at 30 years to a yield of about 6.3 percent. There was a lot of argument during the week about what this meant, with people arguing that there was simply a lack of demand for the 30-year bond, and that it therefore didn’t mean anything, since there was no piling on at the short end.

There may be some truth to this argument, but it misses the key point, which is that the yield curve is getting very flat. A year ago, the spread between the short-term rate and the long bond was about 22 percent of the short bond’s yield.

Last week, it was about 10 percent. As striking is the shift in just one week. Short-term rates rose about 0.2 percent while the long bond’s yield fell a little more than 0.3 percent. The fact of the matter is that the short-term and long-term rates behaved as they would prior to a recession. The mid-term rates did not conform.

And all this took place this week, taking us from a fairly normal positive curve to a dramatically strange curve – indeed, an unsustainable one. The question here is whether it will flip back to positive or proceed to a negative curve.

Our bet has to be that it will move to an inverted, negative curve, because we cannot explain what happened this week except as part of a transition. Healthy bond markets do not produce these strange results and then flop back to normal.

That is particularly the case with the Federal Reserve Bank clearly following a policy leading to higher interest rates.

Since the Fed’s operations have much more control over short-term rates than long-term ones, we expect that the flight from the long-term last week – coupled with Fed policy – will push up short-term rates at the expense of mid-term ones, giving us a classic negative yield curve fairly quickly.

Since that will pull not only borrowers, but lenders as well, on the short side of the curve, the final outcome should be a classic inversion – and a classical capital shortage.

The U.S. stock markets were also acting recessionary last week, with a massive divergence developing between the highly speculative NASDAQ, which reached new heights last week and the other indices, which were fairly weak. The S&P 500, for example, crashed below its 50-day moving average and wound up close to the 200-day moving average. In simple terms, that stinks. And if the S&P were to crash below the 200-day moving average, by following through on its decline this week, that would stink big time.

A classic indicator of market tops is a divergence in indices.

In previous markets, people looked for divergence between the Dow Jones average and the Dow Jones Transportation Index. Today, the two critical economic sectors are high tech and everything else. With the NASDAQ representing high tech, we see a tremendous divergence now developing between the two sectors. Worse, the NASDAQ seems caught in a classic buying climax that can’t be sustained for very long. Either the rest of the market resumes its trend upward, or the NASDAQ is going to be highly vulnerable.

One of the factors propping up the markets for the past half-decade has been the lack of alternative places to park money. With commodities at historically low prices and short-term interest rates unattractive, buying stocks has seemed the only prudent course. With short-term government interest rates moving toward six percent and corporate paper even higher, the safety of money funds is no longer quite so unattractive.

Even more interesting, of course, is the fact that commodities, long languishing, are now booming, with gold leading the pack last week. Higher commodity prices are also a precursor to recession, since they raise the cost of production. Indeed, surging global production has helped raise commodity prices, in a self-correcting process.

Virtually all commodities, with the exception of oil, moved higher last week. Apart from being a recessionary sign in itself, the dramatic moves in commodity prices give speculative money an alternative arena in which to play, other than the stock markets.

If our thinking is correct, then we expect this to trigger a market sell-off in the near future. The market is a leading indicator to the economy, tending to move three to six months before the economy as a whole. Thus, if we are to begin to see a substantial downturn in the market in the next month or so, we could reasonably expect a recession to hit during the summer and fall of 2000.

There are certainly indicators that argue against a market decline. First, net free reserves, the measure of how much liquidity there is in the banking system, remain heavily positive. That means that the Fed, regardless of its management of interest rates, has not yet dramatically tightened banking liquidity. Second, for all the talk of speculative fever, the price-to-earnings ratio of the S&P 500 is no higher than it was last year, and is in fact somewhat lower, reflecting solid profits. By that measure, there is no reason for a correction. Finally, in Stratfor’s absolutely unscientific survey, everyone is convinced that the boom cannot go on much longer. There is such absolute conviction that the good times must end, that we tend to think they won’t.

Nevertheless, there is one good argument in favor of a short-term recession: We are way overdue for one. Certainly there have been major structural changes in the economy that have made the current expansion possible. But the laws of the business cycle have not been abolished; they’ve only been stretched. Tremendous inefficiency has crept into the very sector that has driven the boom – small businesses. These businesses are experiencing severe structural shortages, from skilled labor to office space, that limit the ability to expand. Consider how the shortage of programmers inhibits the ability of the software industry to expand, multiply it over other industries, and you begin to see the limiting factor. It is time for a pause.

Regardless of what the covers of Time and Newsweek may say in a few months, it is not the end of the world, nor even the end of capitalism – nor the end of prosperity. If what we think is happening is indeed happening, then this is merely a downturn in an economic expansion that began in 1982, and it will resume after a few rough quarters. We do believe there is more serious trouble looming later in the decade, but to paraphrase Redd Foxx, “This ain’t the big one.” However, this does open a very interesting political vista: the

2000 presidential election being fought out in the context of a recession. Recall how a minor downturn in 1991-92 cost George Bush the presidency and delivered Bill Clinton to the White House. One of the mainstays of the Democrats’ polling numbers is the fact that the economy has performed splendidly during Clinton’s presidency. It is not clear that his policies made this possible, but nothing he did prevented it.

Voters have short memories. A recession, no matter how mild, would make a Republican victory almost certain.

It would also awaken other sleeping issues, such as the trade deficit. The deficit is massive, but tolerable in the context of a booming economy. If the United States does go into recession later this year, with rising unemployment and increasing business failures, the question of foreign competition would certainly move to the fore. This would dramatically increase tensions with Asia. A recession would also close the door on any serious support for Russia’s economy, assuming that door is not already closed.

If we knew what the stock market was going to do we wouldn’t be working for a living, would we? And the stock market isn’t the economy. Nevertheless, when we lay all the accumulating facts side by side, it is difficult to avoid the conclusion that some serious problems are developing.

Obviously, the yield curve could correct itself next week, and all this could go away. But with the Fed policy being what it is, we find it hard to see how that curve can regain a healthy upward angle. The more we look at it, the more it appears that it may be time for a recession.

Oil Price Shocks on Macroeconomy

by Dr Stephen A Rinehart

The robustness of the recent real oil price increases (NOPI) at the pump prompted a review by me of the recent literature by the Federal Reserve Board [see Ref 1-5] on the subject of "Oil Price Shocks" on our economy. The overall results [i.e., from numerous advanced statistical analyses by various well-respected economists] on oil price increases in our economy [past 50 years] are as follows:

  1. There is a four -to -eight quarter lag between oil price shocks and peak macroeconomic responses.
  2. Net oil price increases (NOPI) induce Fed Fund Rate movements.
  3. Net oil price increases (NOPI) cause unemployment in all samples (highly correlated).
  4. Industrial production in US, UK and Japan share a common trend in real oil prices.
Hamilton [Ref 1] found that the changes in oil prices and GDP growth were highly correlated. Mork [Ref 2] further demonstrated that the impacts of oil price increases and declines on real GDP growth were asymmetric and that the impact of oil price increases was greater. In addition, a recent study [Ref 4] of a gas tax increase (1994) of 4.3 cents per gallon on gasoline consumption concluded " the additional 4.3 cent gasoline tax is expected to reduce gasoline consumption by approximately 54.3 million barrels or 2% of total consumption". A decrease in energy demand will reduce tax revenues. As gasoline prices rise sharply it impacts inflation through increasing shipping and operation costs. Once inflation rises, economic growth slows down and the Fed raises interest rates. This will eventually impact the entire economy by higher mortgage rates and potentially significant increases in already historically high credit card rates. We currently have about 130 million cars in the US using over 375 million gallons of gasoline (1996) per day.

Plausibility Argument

In past nine months, the price of regular, unleaded gas has already increased about $0.65 per gallon. Viewed as a "tax increase", this may reflect by April 2001 as a 30%+ reduction in US gasoline consumption [based on analysis of Ref 4] and could cause a rate hike of ¼ to ½ point by the Federal Reserve each quarter after Sept 2000. Unless Congress acts quickly to offset this "oil price shock" we are going to see a coming "showstopper" in our economy, budgets, consumer prices, and unemployment - the likes of which we may have never seen before in FY2001. In addition, it is possible this situation could trigger a major sell-off (>25%) in the oil-sensitive stocks [transportation] by Sept/Oct of this year in conjunction with CPI increases. States are also facing a decrease of > 15% in gasoline tax revenues. OPEC meets again on March 27 to consider increasing production but this may not mean oil prices come down.

Ref [1] Hamilton, J.D., (1983) Oil and the Macroeconomy since WW II, Journal for Political Economy, 91, 228-48.

Ref [2] Mork, K.A., (1989) Oil and the Macroeconomy when prices go up and down: an extension of Hamilton’s results, Journal of Political Economy, 97, 740-44.

Ref [3] Dotsey, M and Reid, M. (1992) Oil shocks, monetary policy, and economic activity, Federal Reserve Bank of Richmond Economic Review, 78, 14-27.

Ref [4] Nsing, Yu (1994) Estimating the Impact of the higher fuel tax on US gasoline consumption and policy implications. Journal of Political Economy.

Ref [5] Hooker, M. A. (1997) Exploring the Robustness of the Oil-Price Macroeconomy Relationship, Federal Reserve Working Paper.

Sucker stock rallies threaten more blood
By Andrew Priest

Oct 25 (Reuters) - A recent snap back from U.S. stocks after recent gut-wrenching plunges could prove to be a Pandora's box for both investors and the U.S.  economy if it draws fresh money into the jaws of the 2000 bear market.  Falling stock markets this year have already dented America's wealth.  Eroding stocks dampen down economic growth as consumers, feeling the pinch from investment losses and evaporating stock options, rein in spending.  But if bullish American investors respond by ploughing more money into stocks, betting the worst is over, it could spell deeper trouble for the economy if stocks slide again, Wall Street economists warned.  "There's definitely been a diminution in the wealth effect since the stock markets peaked early this year," said David Jones, chief economist at Aubrey G.  Lanston & Co.  Stocks have taken it on the chin this year with the technology-studded Nasdaq skidding 21 percent lower and the blue chip Dow Jones industrial average off 8 percent since the beginning of September.

Top name U.S.  firms like home improvements retailer Home Depot (NYSE:HD -news) and personal computer maker Dell (NasdaqNM:DELL - news) saw their shares plummet after telling investors profit growth was ebbing.  The IPO market is barely breathing.  The housing market is drooping.  The junk, or high risk, corporate bond market is almost shut tight.  "At its peak the stock market was priced to perfection and we just haven't had anything close to perfection with oil price hikes, the collapse in the euro, Middle East hostilities -- and none of these are going away.  So there does have to be more reevaluation of stock markets from this unrealistic height,'' Jones said.  "If we're not in a bear market, we're close to one and the market may take a lot longer to recover than anyone thinks,'' he added.  Economists think tightening financial conditions brought on by the double whammy of falling shares and rising corporate debt costs will stem growth in the near term even if strong productivity -- output per unit of labour -- keeps the economy on its growth track longer-term.  "Weakness in equity markets is sapping much of the pipeline wealth that has helped fuel consumer spending over the past few years,'' economists at Salomon Smith Barney said in a note.  "By our calculation, the contribution to growth from equity wealth is slipping toward less than half a percent, compared to the one percentage point lift during the previous year,'' they estimated.

THE LIVING WAS EASY During the 1990s Americans smugly watched as their stock holdings soared.  Those lucky, or smart enough, to hang onto the rising balloon saw their wealth accumulate in bucket loads.  The Dow Jones industrial average of blue chip U.S.  stocks quadrupled in value during the 1990s.  The tech-heavy Nasdaq did even better, rising from 373 points in early 1991 to a peak of more than 5,100 by March this year.  While stocks were soaring, the wealth machine churned, sending Americans on a dizzying spending spree on everything from spiffy electronic gadgets to Sports Utility Vehicles.  The economy surged.  The annual rate of growth romped up to an annual rate of 8.3 percent in the fourth quarter of 1999 and was still speeding at a 5.6 percent rate in the second quarter of this year.  It wasn't just the man in the street who benefited.  The Treasury got its fair share too as record tax receipts poured in, pushing government finances solidly into the black.  But creaking stock markets have economists thinking that in the same way that soaring stocks gave a boost to the U.S.  economy, recent stock losses could sap growth and drain state coffers.

BILLIONAIRES BECOME OVERNIGHT MILLIONAIRES Silicon Valley may still be home to more millionaires than almost anywhere else on the planet but the stock convulsions of late have hit the Internet generation nouveau riche hard.  Joseph Carson, chief Americas economist at UBS, says rising energy prices -- by hammering company profits and therefore stock values -- has since June 30 put a $125 billion dent in the total value of stock options owned by Americans.  A barrel of oil costs three times today what it cost in early 1999.  As the dot-com millions evaporate, it could cost the U.S.  Treasury dearly.  The 1998 U.S.  budget surplus was the first since 1969, with the federal government spending more than it took in for 29 years.  The government recorded a surplus of $69.4 billion in its fiscal year 1998, which rose to $124.4 billion in fiscal 1999 and nearly doubled this year to $237 billion.  But weighty corporate and personal tax receipts could quickly be a distant memory if the economy slows and stocks keep falling.  ``Given the huge fall in the value of stock options, it is highly likely that the budget surplus in 20001 will come in below official estimates,'' Carson said.

Tech stocks may never be the same again
December 21, 2000 by Thomas Coyle

NEW YORK -- There is a distinct possibility that the technology market will never be the same again.  Wednesday's sharp decline of the tech-rich Nasdaq -- its seventh in a row, and another in a long line of precipitous drops stretching back to late last winter -- was a body-blow to investor confidence.

All that matters

"Utter chaos" was the label Brian Belski, a market strategist for US Bancorp Piper Jaffray, chose for Wednesday's trading session.  "This is a stereotypically emotional market." The immediate reasons for the market's jumpiness -- the Federal Reserve's grim economic outlook coupled with its inaction on interest rates, and mega-brokerage Merrill Lynch's downgrades of three tech heavyweights -- are almost beside the point.  Even tech's longer-term debilities -- the airiness, bordering on idiocy, of the dotcom run-up, the reliance of communication companies on vast and risky capital expenditure amid increasing competition, and declining demand for computer hardware -- fade to insignificance as the market enters a phase of rare, and potentially debilitating, technical anomaly.

One of a few

"This is not just a market correction," said Donald Coxe, Harris Bank's chief strategist and chairman of its Equity Fund.  "This is a triple waterfall." A triple waterfall is a three-stage market decline that follows a sharp upward spike.  Its principal effect is to alter permanently the pattern of trading by destroying investor confidence in the sector around which the market's enthusiasm had previously centered.  Coxe could point to only four marketwide triple waterfalls this century.  The first was on Wall Street in 1929.  No.  2 was more prolonged: the U.S.  market collapse of 1973 through 1975.  Then came the triple waterfall that roiled the Japanese Nikkei from 1989 through 1995.  And now, Coxe said, it's the Nasdaq's turn.  "I wasn't sure I'd live to see another one," said Coxe. "They're so rare."

Anatomy of melancholy

Coxe's description of a triple waterfall bears an eerie resemblance to the Nasdaq's performance over the past 12 months.  "You have a final run-up that sucks up all the available oxygen," he said, delineating behavior that mimics the Nasdaq's run-up from mid October 1999 through late March 2000.  "By then even the skeptics are aboard -- skeptical fund managers get in because they're losing clients." After a bubbly run-up comes an initial drop (read late March through late May 2000), followed by a rally that quickly runs out of steam and drifts sideways (June through mid-July).  Then the real trouble starts.  Although the first dip in a triple waterfall may look like groundless panic in retrospect, the second decline is triggered by news of shrinking corporate revenue -- which sounds a lot like the ill tidings from telcos that first whacked the Nasdaq in mid-July.  Then the market, buoyed by its brawnier issues, might recover a tad -- remember August?  -- but, in a triple waterfall, it soon resumes its southward route -- as the Nasdaq did right after Labor Day.  Then comes the third and last phase of the triple waterfall, when "safe haven" stocks -- Coxe mentioned Intel (INTC), Microsoft (MSFT), Hewlett-Packard (HWP) and IBM (IBM) -- start wasting away.  "These older stocks become the basis of the margin accounts," Coxe said, in describing what he termed "the early stages" of a market's final slide over the precipice: the fall of the stocks on whose strength other more speculative plays had been financed.  "As these leaders collapse they're being pulled down because of the need to create 'marginability.'"

Decline and fall

"We didn't know [the triple waterfall] was for real until Cisco broke $50," said Coxe, who cited the giant networker as the stock that best "encapsulated the mania." Cisco closed under $50 for the first time this year on Oct.  12.  And so, if Coxe is right, and the Nasdaq is still in the early innings of its decline, when will a bottom finally heave itself into sight?  "It won't be over until the same people who said that nothing could go wrong [when the Nasdaq was] at 5,000 start saying that nothing can go right [when the Nasdaq is] under 2,000," Coxe replied.  But even that might not signal tech's return to its former glory.  "When this market comes back, it won't be led by tech," Coxe said, "because what you're destroying is a belief system." Despite his severe prognosis, Coxe said he saw an upside -- albeit a fairly esoteric one -- to the Nasdaq's decline.  "This is a fascinating time for students of human nature," he said.  "It's like the plot of a Jane Austen novel."

Look back in anguish

Those with scant affinity to early 19th century literature might find a closer analogy to recent events in John Kenneth Galbraith's "The Great Crash," first published in 1955.  "Since a speculative collapse can only follow a speculative boom, one might expect that Wall Street would lay a heavy hand on any resurgence of speculation," Galbraith writes in a passage outlining ways in which a repetition of the 1929 crash might be forestalled.  "The Federal Reserve would be asked by bankers and brokers to lift margins to the limit; it would be warned to enforce the requirement sternly against those who might try to borrow on their own stocks and bonds in order to buy more of them.  The public would be warned sharply and often of the risks inherent in buying stocks on the rise.  Those who persisted, nonetheless, would have no one to blame but themselves."

Japan admits economy is facing disaster

Japan is close to financial disaster after running up a huge public debt trying to spend its way out of stagnation, Kiichi Miyazawa, the Finance Minister, said yesterday. Issuing the most serious warning on the economy from a senior minister, Mr Miyazawa called for drastic action to reduce the public debt. “Japan’s fiscal condition is approaching a state of collapse,” he told parliament. “We have to make painful decisions.”

It is exceptional for government officials to express concerns about the economy so forcefully, and Mr Miyazawa’s comments triggered a sell-off of the yen. The authorities have poured billions of yen into public works in a largely vain attempt to rescue the economy from its worst malaise in decades. Wasteful spending on airports, dams and roads has inflated public debt to the biggest in the industrial world. In the past ten years it has more than doubled to reach 134 per cent of Japan’s total annual economic output. Mr Miyazawa, who admits that he has presided over the build-up of the debt, did not elaborate on what reforms he thought were necessary but hinted that taxes would have to rise to stave off catastrophe.

Alarmed by his candour, government colleagues rushed to put their own spin on his comments. Yasuo Fukuda, the Chief Cabinet Secretary, said Mr Miyazawa meant that “Japan would be in trouble if it didn’t do anything about its finances in the coming ten or 20 years”. But Toshiro Muto, the Deputy Finance Minister, told journalists that Mr Miyazawa was referring to the serious state of the Government’s finances. At one point the dollar rose above 120 yen for the first time in 20 months, helped by a growing view that Japanese authorities will tolerate a weaker yen. Despite Mr Miyazawa’s concerns, the Government is not expected to tackle the runaway debt before the July election for the Upper House. The nation lacks a leader capable of making tough decisions on how to clean up the financial mess. But even though the Liberal Democrats cannot agree on a replacement, the fate of Yoshiro Mori, the Prime Minister, is becoming clearer. After being condemned for repeated gaffes, he has agreed to go, probably next month.

Debt pinches consumers

The bills are coming due for the shopping spree of the 1990s, and Americans are having trouble paying up.

Personal debt is at an all-time high, and the amount of income Americans are dedicating to making payments on it is at levels unseen in 15 years. Mortgage delinquencies and write-offs by credit card companies are rising, and personal bankruptcy filings could hit a record this year.

That translates to serious financial pain for families that are overextended at a time when unemployment is rising, experts say. It also means that just when the cooling U.S. economy needs spending by consumers to sustain growth, they're hard-pressed to do so.

"Consumer debt isn't a problem unless and until people lose their jobs, and that has started to happen," said David Orr, chief economist at the First Union Corp. in Charlotte, N.C. "It's not the cause of the economy's problems, but it can make the snowball roll downhill faster."

The Bush administration hopes lower tax rates and the tax rebates to be mailed starting in July can help revive consumer spending, a major engine of the economy.

But will debt-burdened Americans will rush out and spend their $300 to $600 rebate checks or will they just pay off existing bills?

Build your debt reduction plan here

Marcia O'Duggan of Lewiston, Minn., says that at least half of her family's rebate check will go toward debt payment. Since getting help from credit counselors three years ago, she and her husband have whittled their debt to $15,000, but figure they've still got 2 1/2 more years of tight budgets ahead.

"It used to be that if someone needed pants and we didn't have $30 in our account, we just charged it," she said. "We don't do that anymore. We don't use credit. And you know what? We're OK."

Feeling the squeeze

But many families aren't.

Durant Abernethy, president of the National Foundation for Credit Counseling, a nonprofit organization that helps families with debt problems, says the number of people seeking assistance is rising rapidly.

"Our average client is carrying more debt than they've ever carried, and they're in trouble," Abernethy said. "If their overtime is cut back or a husband or wife is laid off, they have virtually no savings, so they go over the edge."

The national balance on credit cards, auto loans and other consumer loans rose to a record $1.58 trillion in April, according to the Federal Reserve. Mortgage debt totals about $5.2 trillion.

Americans are spending 14.3 percent of their take-home pay on debts -- the highest percentage since 1986, Fed figures show.

Credit card delinquencies -- accounts at least 30 days past due
-- have been hovering at about 5 percent, up from 4.3 percent a year ago.

In April, credit-card issuers wrote off uncollectible balances at an annual rate of 6.7 percent, according to Standard & Poor's. That was the highest loss rate since February 1997.

"We had good economic times through the middle of last year, so people felt they could borrow money," said David Blitzer, S&P's chief investment strategist. "In our society, people don't cut debt until they're squeezed."

Bankruptcies on the rise

Mortgage delinquencies rose to 4.5 percent of outstanding loans in the final quarter of 2000, according to the Mortgage Bankers Association of America. That was the highest since 4.6 percent in the third quarter of 1992. There was a slight improvement in the first quarter this year.

Perhaps the strongest measure of American debt distress is the rise in bankruptcies.

The number of bankruptcy cases filed in the first quarter rose to about 367,000, up 17.5 percent from a year earlier, according to federal figures. Most of the debtors were consumers.

If the trend continues, filings this year will exceed the record 1.44 million in 1998.

Some of the activity could be by debtors worried that Congress soon may tighten bankruptcy laws.

Japanese Economy in Terminal Decline
A Stratfor Commentary


The Sept. 11 attacks on the World Trade Center and Pentagon did more than just gut American confidence. They also heralded the downfall of the world's second-largest economy, Japan. About the only option left for the Japanese prime minister is to restart massive deficit spending.


New statistics from Japan show that consumer prices dropped 1.2 percent in August, the
24th-straight month of decline. The data indicate Japan's deflationary spiral is intensifying. But Tokyo's problems are far more severe than economically crippling deflation.

About the only option left for Japanese Prime Minister Junichiro Koizumi to stop the economic degradation is to restart massive deficit spending, even though it may appear self-destructive, as soon as possible. Japan's economy has been extremely weak for more than a decade. But due to the Sept. 11 terrorist attacks in the United States, the country is now locked into an irreversible and terminal decline.

With its own people unwilling to spend, Japan is dependent on foreign consumers, particularly Americans, to sustain itself. To keep its exports flowing, Japan also repeatedly intervenes in the currency markets to keep the yen artificially low.

Such actions have made Japan hostage to international events. It has already completely tapped out monetary and stimulus policies as viable options. Now its federal debt, a nearly $6 trillion behemoth that makes America's 1980s debt seem small in comparison, is so high that industry-boosting tax cuts are no longer possible either. Adding to the misery, Japan's Nikkei-225 stock exchange is at an 18-year low, having shed 30 percent of its value in the past nine months.

The country's banks are helpless as well. Their capital adequacy ratio is estimated at a mere 1.4 percent, the Economist reports, following numerous bailout plans that required no one to take responsibility or truly write off losses. International banking rules require an
8 percent adequacy ratio.

The downturn still won't be fatal as long as foreign demand for Japanese goods remains high. Throughout the 1990s the United States, Japan's largest export market, was in the midst of its longest economic boom ever. The 2001 slowdown threatened Japan's precarious perch, but with the United States poised for recovery in the third quarter, there was a light at the end of the tunnel. Sept. 11 changed all that.

Germany's Teetering Banks
JUNE 19, 2002

May 16 was a day that customers of Bank für Kleine & Mittlere Unternehmen, a small German bank, won't soon forget.  In a stormy meeting with depositers in Berlin's Karl-Liebknect-Haus, bank board Chairman Marlene Kück declared that BKMU was bankrupt and the most the depositers could expect to get back would be the 20,000 euros ($19,000) guaranteed under the state-sponsored deposit-insurance scheme.  "It's an absolute scandal," said Andreas Popp, a pensioner who claims that the bank's demise will cost him tens of thousands of euros.  "I had always assumed German banks were as safe as houses. Then this happens." In fact, German banks haven't been very safe at all of late.  Recent months have seen a string of bankruptcies and near bankruptcies -- and financial experts caution that more could come.


Just before BKMU closed its doors, Gontard & Metallbank, a Frankfurt-based deposit-taker that had grown quickly during the boom years of the Neuer Markt, declared bankruptcy, a victim of the downturn in the equity and initial public offering markets.  Last November, Schmidt Bank, one of the country's oldest private banks, had to be rescued by a consortium hastily put together by the financial market regulators.  It subsequently emerged that the bank had lost 1.3 billion euros ($1.25 billion) during 2001, more than twice as much as had initially been expected.  "A shocking number," says Paul Wieandt, who was brought in to salvage the ailing institution.  German prosecutors are now investigating the bank's former head, Karl Gerhard Schmidt.  Just one thing is certain at this stage: 40% of all Schmidt Bank's loans -- largely made to the Middelstand, the midsize companies that form the backbone of the German economy -- have turned sour.


It's not just small and private banks that have run into difficulties.  Last year, Bankgesellschaft Berlin, the sixth-biggest bank in the country, almost collapsed under the weight of bad loans and had to be rescued by the city-state of Berlin with a capital injection of 1.7 billion euros ($1.62 billion).  If the bank had gone under, it would have been the biggest financial-sector bankruptcy in Germany's history.  While most of the country's large publicly listed or government-owned banks are well capitalized and in no danger of collapse, problems have been mounting even there, too.  Bayerische Landesbank, the Munich-based bank that is 50% owned by the state of Bavaria, could lose up to 1 billion euros ($950 million) following the collapse of Kirch Group, the media empire to which it was heavily exposed. Other banks have also lost money because of Kirch and have been affected by the financial crisis in Argentina and the Enron collapse.


Things could easily get worse. Creditreform, a research house that collects data on bankruptcies, predicts that the number of corporate insolvencies in Germany this year could rise by as much as 25%, to 40,000 this year.  Banks have already increased their bad-loan provisions by an average of 10% in anticipation of a big rise in bad debts.  "We'll go through the valley of tears," worries Deutsche Bank Chief Economist Norbert Walter.  Not surprisingly, banks have cut back dramatically on lending, threatening the country with a credit crunch just as it's beginning to claw its way out of recession.  Net lending increased by less than 1% in April and May, according to Deutsche Bundesbank, the central bank.  "We're threatened with being sucked into a vicious circle," says one banker in Frankfurt.  "We don't lend because we fear bad debts, but that slows the economy and leads to more bankruptcies, which means our bad debts increase anyway." Analysts say banks need to protect themselves by strengthening their balance sheets.  But they can do that only if they boost their lackluster profitability.  That's a tall order in a market that analysts think has too many banks.  Return on equity at most German banks hovers below 10%, so investors aren't exactly eager to stump up new money.  And profitability will increase only when the government-backed and state-owned savings banks that account for half of all lending are forced to compete on a level playing field with the private-sector banks and start making loans at normal market rates.


Next, capacity must be taken out of the system by bank mergers and restructurings.  German banks have been reluctant to merge, unlike their competitors in other European countries.  As a result, their cost-income ratios are higher than those at their international competitors, and profitability is lower.  Many banks have started cutting costs.  But driving up profits and restoring health to the banking sector will take time.  In the meantime, other banks -- especially small institutions with limited capital -- could run into difficulties.  Says the Frankfurt banker: "This is going to be a rough ride." The reputation of German banks being "safe as houses" will be tested as never before.

Corporate debt saps nation
Credit stress hits Depression level

Sunday, August 18, 2002 - U.S. corporate debt nearly doubled in the past five years - to $3.9 trillion by the month of May. U.S. consumers spent that same amount on all services - from haircuts to dog grooming - during 2001.

The burden, already buckling many companies under the load, threatens to send the nation into a prolonged recession.

"We're looking at an economic heart attack in front of us," said John Riley, president of Cornerstone Investment Services, a money management firm in Providence, R.I. "We're faced with owning up to the excesses of the late 1990s."

In 1997, U.S. corporate debt - which includes bonds issued by companies to finance their activities as well as bank loans - was $2 trillion, according to the Bond Market Association.

Moody's Investor Research now says the nation is in the worst credit stress since the Great Depression of the 1930s.

The result, thus far: Forty-two companies defaulted on $46 billion in loans during the second quarter, breaking the record in dollars, according to a July report by Moody's.

The tally was double the volume during the same time last year. For the first half of this year, companies failed to pay $76.6 billion in loans, a 64 percent increase over the first half of 2001.

Moody's expects the defaults will keep rolling in through next summer but predicts the trend has already reached its peak.

Yet as those defaults keep coming, the economy will continue to feel the pain, quashing investor and lender confidence and slowing hiring, expansion and new investment elsewhere.

The fallout could even lead to higher monthly premiums on the average person's life, car or home insurance policy, said Mac Clouse, director of the University of Denver's Reiman School of Finance.

Why? Because life insurance companies, pension funds and investors buy bonds - which historically are safer than stocks - with the intent of earning interest on that debt. Insurance companies put 90 percent of their investments into the bond markets, which will inevitably suffer when companies can't make their payments.

"If there are a lot of claims and fewer dollars to pay the claims, the only way they can make that up is with higher premiums," Clouse said.

The companies that don't default and struggle to pay down their debt may still do harm to the economy with cutbacks. Experts say more layoffs, fewer services and little new hiring will result as companies preserve cash for debt payments.

"It's a bunch of dominoes that could collapse," said Mike Gasior, president of American Financial Service, which trains and consults for institutional investors. "All that money is going to have to be paid back."

But that wasn't the logic back in the heyday of the late 1990s.

Companies borrowed billions to grow as quickly as possible. Cable TV and telecommunications companies were the biggest borrowers in their pursuit of building the world's high-speed Internet and phone connections. Those plans collapsed with the economy.

Telecom companies accounted for 61 percent of loan defaults during the second quarter of this year, according to Moody's. Last year, pundits compared the telecom meltdown to the savings-and-loan crisis that cost U.S. taxpayers $150 billion a decade ago.

"There was a lot of momentum, and you had to keep up," said Clouse of DU. "Your stock price said you were a growth firm. That's what the market was expecting. So, well, you had to grow."

That growth was even more attractive because of low interest rates, tax-deductible interest and the wide availability of money.

Just as investors chased dot-coms, they also jumped at the chance to lend to growth companies, Gasior said.

"You could bring any debt deal to the market, and there was money to back it up," Gasior said. "It was the same hubris of the Internet stocks."

The 29 most indebted U.S. companies, not counting financial companies, piled on $446 billion in debt over the past five years, Denver Post research shows.

A Storm Is Coming
by Charley Reese

Years ago I read a most significant book – "The Rich and the Super-Rich," by Ferdinand Lundberg. What he had to say is very pertinent to our present economic situation.

The first point he made is that wealth is not money. Wealth consists of assets – land, tools, factories and skills. Money is merely a medium of exchange. The difference is important. A truly rich man owns stuff – land, houses, factories, means of transportation. He does not depend on a salary for cash flow. Nelson Rockefeller, for example, once testified before Congress that many years he had no taxable income. He, of course, didn't need it. He owned stuff, and he owed nothing.

The easiest way to understand this difference is to imagine that you are about to be marooned on a deserted island. You are given a choice of one of three cases: one case contains $1 million in gold; another contains $1 million in Federal Reserve notes; and the third case contains tools. Which would you choose? Well, unless you are hopelessly stupid, you'd choose the tools. With the tools, you could create the wealth necessary for survival – shelter and food. Gold and dollars are useless unless there is someone willing to exchange real wealth for them.

Let's look at a guy who has the appearance of being rich. He drives a fancy car, but it is leased; he lives in a big mansion, but he pays a monthly mortgage; he belongs to several private clubs, but he pays dues; he buys pretty much what he wants to buy, but he uses credit cards; and he has a gold-standard health-insurance policy, for which he pays a high monthly premium. What is clear is that this guy is not really rich; he is living off his cash flow. Cut that cash flow and all his appearances of wealth will vanish. Layoffs and bankruptcies cut cash flow.

Another point to keep in mind is that owning stocks is owning paper. Go back to the deserted island. The only use $1 million worth of blue-chip stocks would be is as a fire starter. If you own stocks, you own pieces of paper, and unless you can sell them, they are, in fact, worthless. Remember Enron?

While it's out of the experience of most living Americans, what made the Great Depression so devastating was that it cut cash flows and rendered paper wealth worthless. Many people who thought of themselves as well-off were suddenly impoverished. They lost their jobs. They lost their homes. They lost their investments. They lost most of their possessions. The Great Depression wasn't the first depression to hit the United States, and despite the bunk you hear, it won't be the last.

I would not in a million years pretend to be a financial guru or even an adviser, but believe the ancient wisdom: Get out of debt and stay out. Live within your means. Strive for ownership of tangible assets free of any debt. I cringe every time I see one of these incessant television ads urging people to put a second mortgage on their home. Another bit of ancient wisdom is never borrowing money to purchase a depreciating asset. And remember, even homes and land can become a depreciated asset. In Florida in the late 1920s, land that was selling for $6,000 an acre, a few months later, couldn't attract a buyer at $2 an acre. The value of land, other than as a place to live and to grow food, depends entirely on someone else's willingness and ability to buy it.

We as a nation are living beyond our means. The federal government is in debt. Most state and local governments are in debt (their form of deficit spending is to issue bonds). Most assuredly the American consumer is dangerously in debt. And, finally, the American dollar is losing its purchasing power steadily and daily. Remember, debt is the promise of future income to pay for today's consumption. Nobody is guaranteed a future, much less future income.

George Soros, the billionaire financier, did not oppose the re-election of George Bush because Soros is a left-winger. He opposed Bush's re-election because, as a man who understands finance, he is fearful for the economic future of this country unless we change directions.

When the money-smart folks get scared, us country boys had better pucker up, too. Get out of debt, slam the door in the faces of all salespeople and turn off the TV. I believe a storm is just over the horizon.

Economic `Armageddon' predicted

Stephen Roach, the chief economist at investment banking giant Morgan Stanley, has a public reputation for being bearish. But you should hear what he's saying in private. Roach met select groups of fund managers downtown last week, including a group at Fidelity.

His prediction: America has no better than a 10 percent chance of avoiding economic "armageddon.''

Press were not allowed into the meetings. But the Herald has obtained a copy of Roach's presentation. A stunned source who was at one meeting said, ``it struck me how extreme he was - much more, it seemed to me, than in public.''

Roach sees a 30 percent chance of a slump soon and a 60 percent chance that ``we'll muddle through for a while and delay the eventual armageddon.'' The chance we'll get through OK: one in 10. Maybe.

In a nutshell, Roach's argument is that America's record trade deficit means the dollar will keep falling. To keep foreigners buying T-bills and prevent a resulting rise in inflation, Federal Reserve Chairman Alan Greenspan will be forced to raise interest rates further and faster than he wants. The result: U.S. consumers, who are in debt up to their eyeballs, will get pounded.
Less a case of ``Armageddon,'' maybe, than of a ``Perfect Storm.''

Roach marshalled alarming facts to support his argument.

To finance its current account deficit with the rest of the world, he said, America has to import $2.6 billion in cash. Every working day. That is an amazing 80 percent of the entire world's net savings. Sustainable? Hardly.

Meanwhile, he notes that household debt is at record levels. Twenty years ago the total debt of U.S. households was equal to half the size of the economy. Today the figure is 85 percent.
Nearly half of new mortgage borrowing is at flexible interest rates, leaving borrowers much more vulnerable to rate hikes. Americans are already spending a record share of disposable income paying their interest bills. And interest rates haven't even risen much yet. You don't have to ask a Wall Street economist to know this, of course. Watch people wielding their credit cards this Christmas.

Roach's analysis isn't entirely new. But recent events give it extra force. The dollar is hitting fresh lows against currencies from the yen to the euro. Its parachute failed to open over the weekend, when a meeting of the world's top finance ministers produced no promise of concerted intervention. It has farther to fall, especially against Asian currencies, analysts agree.
The Fed chairman was drawn to warn on the dollar, and interest rates, on Friday.

Roach could not be reached for comment yesterday. A source who heard the presentation concluded that a ``spectacular wave of bankruptcies'' is possible. Smart people downtown agree with much of the analysis. It is undeniable that America is living in a ``debt bubble'' of record proportions. But they argue there may be an alternative scenario to Roach's. Greenspan might instead deliberately allow the dollar to slump and inflation to rise, whittling away at the value of today's consumer debts in real terms. Inflation of 7 percent a year halves ``real'' values in a decade. It may be the only way out of the trap.

Higher interest rates, or higher inflation: Either way, the biggest losers will be long-term lenders at fixed interest rates. You wouldn't want to hold 30-year Treasuries, which today yield just 4.83 percent.

Latest Economic News Update

Nouriel Roubini predicts the worst financial crisis since the Great Depression and the worst U.S. Recession in the last few decades.

New York, July 15, 2008- In a series of recent writings on the RGE Monitor Nouriel Roubini – Chairman of  RGE Monitor and Professor of Economics at the NYU Stern School of Business - has argued that the U.S. is experiencing its worst financial crisis since the Great Depression and will undergo its worst recession in the last few decades. His analysis leads to the following conclusions:

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